[Federal Register Volume 81, Number 93 (Friday, May 13, 2016)]
[Rules and Regulations]
[Pages 29960-30151]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-10918]
[[Page 29959]]
Vol. 81
Friday,
No. 93
May 13, 2016
Part II
Securities and Exchange Commission
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17 CFR Part 240
Business Conduct Standards for Security-Based Swap Dealers and Major
Security-Based Swap Participants; Final Rule
Federal Register / Vol. 81 , No. 93 / Friday, May 13, 2016 / Rules
and Regulations
[[Page 29960]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-77617; File No. S7-25-11]
RIN 3235-AL10
Business Conduct Standards for Security-Based Swap Dealers and
Major Security-Based Swap Participants
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: In accordance with Section 764 of Title VII (``Title VII'') of
the Dodd-Frank Wall Street Reform and Consumer Protection Act (the
``Dodd-Frank Act''), the Securities and Exchange Commission (``SEC'' or
``Commission'') is adopting new rules under the Securities Exchange Act
of 1934 (``Exchange Act'') that are intended to implement provisions of
Title VII relating to business conduct standards and the designation of
a chief compliance officer for security-based swap dealers and major
security-based swap participants. The final rules also address the
cross-border application of the rules and the availability of
substituted compliance.
DATES: Effective Date: July 12, 2016.
Compliance Date: The compliance dates are discussed in Section IV.B
of this release.
FOR FURTHER INFORMATION CONTACT: Lourdes Gonzalez, Assistant Chief
Counsel--Sales Practices, Joanne Rutkowski, Senior Special Counsel,
Cindy Oh, Special Counsel, Lindsay Kidwell, Special Counsel, Stacy
Puente, Special Counsel, Devin Ryan, Special Counsel, Office of Chief
Counsel, Division of Trading and Markets, at (202) 551-5550, at the
Securities and Exchange Commission, 100 F Street NE., Washington, DC
20549. For further information on cross-border application of the
rules, contact: Carol McGee, Assistant Director, Richard Gabbert,
Senior Special Counsel, Joshua Kans, Senior Special Counsel, and
Margaret Rubin, Special Counsel, Office of Derivatives Policy, Division
of Trading and Markets, at (202) 551-5550, at the Securities and
Exchange Commission, 100 F Street NE., Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Summary of Final Rules
B. Cross-Border Application of the Final Rules
C. Consistency With CFTC Rules
D. Department of Labor ERISA Fiduciary Regulations
E. Investment Adviser and Municipal Advisor Status
F. Intersection With SRO Rules
II. Discussion of Rules Governing Business Conduct
A. Scope, Generally
B. Exceptions for Anonymous SEF or Exchange-Traded Transactions
C. Application of the Rules to SBS Dealers and Major SBS
Participants
D. Reliance on Representations
E. Policies and Procedures Alternative
F. Definitions
G. Business Conduct Requirements
1. Counterparty Status
2. Disclosure
a. Disclosure Not Required When the Counterparty Is an SBS
Entity or a Swap Entity
b. Timing and Manner of Certain Disclosures and Scope of
Disclosure Rules
c. Material Risks and Characteristics of the Security-Based Swap
d. Material Incentives or Conflicts of Interest
e. Daily Mark
f. Clearing Rights
3. Know Your Counterparty
4. Recommendations by SBS Dealers
5. Fair and Balanced Communications
6. Obligation Regarding Diligent Supervision
H. Rules Applicable to Dealings With Special Entities
1. Scope of Definition of ``Special Entity''
2. ``Acts as an Advisor'' to a Special Entity
3. Definition of ``Best Interests''
4. Antifraud Provisions
5. SBS Entities Acting as Counterparties to Special Entities
6. Qualifications of the Independent Representative
a. Written or Other Representations Regarding Qualifications
b. Sufficient Knowledge To Evaluate Transaction and Risks
c. No Statutory Disqualification
d. Undertakes a Duty To Act in the Best Interests of the Special
Entity
e. Makes Appropriate and Timely Disclosures to Special Entity
f. Pricing and Appropriateness
g. Subject to ``Pay To Play'' Prohibitions
h. ERISA Fiduciary
i. Safe Harbor
7. Disclosure of Capacity
8. Exceptions for Anonymous, Special Entity Transactions on an
Exchange or SEF
9. Certain Political Contributions by SBS Dealers
I. Chief Compliance Officer
J. Prime Brokerage Transactions
K. Other Comments
III. Cross-Border Application and Availability of Substituted
Compliance
IV. Explanation of Dates
A. Effective Date
B. Compliance Date
C. Application to Substituted Compliance
V. Paperwork Reduction Act
VI. Economic Analysis
A. Introduction and Broad Economic Considerations
B. Baseline
1. Available Data Regarding Security-Based Swap Activity
2. Security-Based Swap Market: Market Participants and Dealing
Structures
a. Security-Based Swap Market Participants
b. Participant Domiciles
c. Market Centers
d. Common Business Structures for Firms Engaged in Security-
Based Swap Dealing Activity
e. Current Estimates of Number of SBS Dealers and Major SBS
Participants
3. Security-Based Swap Market: Levels of Security-Based Swap
Trading Activity
4. Global Regulatory Efforts
5. Dually Registered Entities
6. Cross-Market Participation
7. Pay To Play Prohibitions
C. Costs and Benefits of Business Conduct Rules
1. Verification of Status and Know Your Counterparty Rules
2. Disclosures and Communications
a. Risks, Characteristics, and Conflicts of Interest
b. Daily Mark
c. Clearing Rights
3. Suitability
a. Costs and Benefits
b. Institutional Suitability Alternative
4. Special Entities
a. Scope and Verification
b. SBS Entities as Counterparties to Special Entities
c. SBS Dealers as Advisors to Special Entities
d. Independent Representation: Alternatives
e. Reliance on Representations
f. Magnitude of the Economic Effects
5. Fraud, Fair and Balanced Communications, Supervision
a. Antifraud
b. Fair and Balanced Communications
c. Supervision
6. CCO Rules
a. Annual Compliance Report, Conflicts of Interest, Policies and
Procedures
b. CCO Removal and Compensation
7. Pay To Play
8. Scope
a. Inter-Affiliate Transactions
b. Opt Out
9. Cross-Border Application
a. Scope of Application to SBS Entities
b. Substituted Compliance
D. Effects on Efficiency, Competition and Capital Formation
VII. Regulatory Flexibility Act Certification
Statutory Basis and Text of Final Rules
I. Introduction
The Commission is adopting Rules 15Fh-1 through 15Fh-6 and Rule
15Fk-1 to implement the business conduct standards and chief compliance
officer (``CCO'') requirements for security-based swap dealers (``SBS
Dealers'') and major security-based swap participants (``Major SBS
Participants'' and, together with SBS
[[Page 29961]]
Dealers, ``SBS Entities'') as set forth in Title VII of the Dodd-Frank
Act.\1\ The Commission is also amending Rules 3a67-10 and 3a71-3 and
adopting Rule 3a71-6 with respect to the cross-border application of
the rules and the availability of substituted compliance.
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\1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
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The Dodd-Frank Act was enacted, among other reasons, to promote the
financial stability of the United States by improving accountability
and transparency in the financial system.\2\ The 2008 financial crisis
highlighted significant issues in the over-the-counter derivatives
markets, which experienced dramatic growth in the years leading up to
the financial crisis and are capable of affecting significant sectors
of the U.S. economy. Title VII of the Dodd-Frank Act provides for a
comprehensive new regulatory framework for swaps and security-based
swaps by, among other things: (1) Providing for the registration and
comprehensive regulation of SBS Entities, swap dealers (``Swap
Dealers''), and major swap participants (``Major Swap Participants''
and, together with Swap Dealers, ``Swap Entities''); (2) imposing
clearing and trade execution requirements for swaps and security-based
swaps, subject to certain exceptions; (3) creating recordkeeping,
regulatory reporting, and public dissemination requirements for swaps
and security-based swaps; and (4) enhancing the rulemaking and
enforcement authorities of the Commission and the Commodity Futures
Trading Commission (``CFTC'').
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\2\ See Public Law 111-203, Preamble.
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The Commission initially proposed Rules 15Fh-1 through 15Fh-6 and
Rule 15Fk-1 in June 2011.\3\ In May 2013, the Commission re-opened the
comment period for all of its outstanding Title VII rulemakings,
including the external business conduct rulemaking.\4\
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\3\ See Business Conduct Standards for Security-Based Swap
Dealers and Major Security-Based Swap Participants, Exchange Act
Release No. 64766 (Jun. 29, 2011), 76 FR 42396 (Jul. 18, 2011)
(``Proposing Release'').
\4\ See Reopening of Comment Periods for Certain Rulemaking
Releases and Policy Statement Applicable to Security-Based Swaps
Proposed Pursuant to the Securities Exchange Act of 1934 and the
Dodd-Frank Wall Street Reform and Consumer Protection Act, Exchange
Act Release No. 69491 (May 1, 2013), 78 FR 30800 (May 23, 2013)
(``Reopening Release'').
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The Commission received 40 comments on the Proposing Release, of
which 9 were comments submitted in response to the Reopening
Release.\5\ Of the comments directed at the Cross-Border Proposing
Release,\6\ five referenced the proposed external business conduct
standards specifically,\7\ while others addressed cross-border issues
generally, such as the application of substituted
[[Page 29962]]
compliance,\8\ without specifically referring to the Proposing Release.
Of the comments submitted in response to the U.S. Activity Proposing
Release,\9\ eight addressed the proposed cross-border application of
the business conduct standards.\10\
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\5\ See letters from Kenneth M. Fisher, Senior Vice President
and Chief Financial Officer, Noble Energy, dated July 7, 2011
(``Noble''); Chris Barnard, dated Aug. 10, 2011 (``Barnard''); R.
Glenn Hubbard, Co-Chair, Committee on Capital Markets Regulation,
John L. Thornton, Co-Chair, Committee on Capital Markets Regulation,
and Hal S. Scott, Director, Committee on Capital Markets Regulation,
dated Aug. 26, 2011 (``CCMR''); John F. Damgard, President, Futures
Industry Association, Robert Pickel, Executive Chairman,
International Swaps and Derivatives Association, Inc., and Kenneth
E. Bentsen, Jr., Executive Vice President, Public Policy and
Advocacy, Securities Industry and Financial Markets Association,
dated Aug. 26, 2011 (``FIA/ISDA/SIFMA''); Gerald W. McEntee,
President, American Federation of State, County and Municipal
Employees, dated Aug. 29, 2011 (``AFSCME''); Mark Hepsworth,
President, Institutional Business, Interactive Data Corporation,
dated Aug. 29, 2011 (``IDC''); Sen. Carl Levin, U.S. Senate, dated
Aug. 29, 2011 (``Levin''); Susan N. Kelly, Senior Vice President of
Policy Analysis and General Counsel, American Public Power
Association, and Noreen Roche-Carter, Chair, Tax and Finance Task
Force, Large Public Power Council, dated Aug. 29, 2011 (``APPA'');
Stuart J. Kaswell, Executive Vice President & Managing Director,
General Counsel, Managed Funds Association, dated Aug. 29, 2011
(``MFA''); Dennis M. Kelleher, President & CEO, and Stephen W. Hall,
Securities Specialist, Better Markets, Inc., dated Aug. 29, 2011
(``Better Markets (August 2011)''); Christopher A. Klem and Molly
Moore, Ropes & Gray LLP, dated Aug. 29, 2011 (``Ropes & Gray'');
Joanne T. Medero, BlackRock, Inc., dated Aug. 29, 2011
(``BlackRock''); Joseph Dear, Chief Investment Officer, California
Public Employees' Retirement System, Jennifer Paquette, Chief
Investment Officer, Colorado PERA, Keith Bozarth, Executive
Director, State of Wisconsin Investment Board, Brian Guthrie,
Executive Director, Teacher Retirement System of Texas, and Rick
Dahl, Chief Investment Officer, Missouri State Employees' Retirement
System, dated Aug. 29, 2011 (``CalPERS (August 2011)''); Barbara
Roper, Director of Investor Protection, Consumer Federation of
America, Marcus Stanley, Policy Director, Americans for Financial
Reform, and Michael Greenberger, Law School Professor and Founder &
Director, University of Maryland Center for Health & Homeland
Security, dated Aug. 29, 2011 (``CFA''); American Benefits Council,
dated Aug. 29, 2011 (``ABC''); Jeff Gooch, Chief Executive Officer,
MarkitSERV, dated Aug. 29, 2011 (``MarkitSERV''); Timothy W.
Cameron, Esq. Managing Director, Asset Management Group, Securities
Industry and Financial Markets Association, dated Aug. 29, 2011
(``SIFMA (August 2011)''); John D. Walda, President and Chief
Executive Officer, National Association of College and University
Business Officers, dated Aug. 29, 2011 (``NACUBO''); Kevin Gould,
President, Markit North America, Inc., dated Aug. 29, 2011
(``Markit''); Daniel F. C. Crowley, Partner, K&L Gates LLP, on
behalf of the Church Alliance, dated Aug. 29, 2011 (``Church
Alliance (August 2011)''); Christopher J. Ailman, California State
Teachers' Retirement System, dated Aug. 30, 2011 (``CalSTRS''); John
M. McNally, National Association of Bond Lawyers, dated Sept. 1,
2011 (``NABL''); Colette J. Irwin-Knott, National Association of
Independent Public Finance Advisors, dated Sept. 6, 2011
(``NAIPFA''); ABA Securities Association, American Council of Life
Insurers, Financial Services Roundtable, Futures Industry
Association, Institute of International Bankers, International Swaps
and Derivatives Association, and Securities Industry and Financial
Markets Association, dated Sept. 8, 2011 (``ABA Securities
Association''); Kent A. Mason, Davis & Harman LLP, dated Sept. 15,
2011 (``Mason''); Senator Tim Johnson, Chairman, U.S. Senate
Committee on Banking, Housing, and Urban Affairs, and Representative
Barney Frank, U.S. House Committee on Financial Services, dated Oct.
4, 2011 (``Johnson''); Lawrence B. Patent, K&L Gates LLP, on behalf
of the Church Alliance, dated Oct. 4, 2011 (``Church Alliance
(October 2011)''); Joseph Dear, Chief Investment Officer, California
Public Employees' Retirement System et al., dated Oct. 4, 2011
(``CalPERS (October 2011)''); Susan Gaffney Director, Federal
Liaison Center, Government Finance Officers Association, dated Oct.
31, 2011 (``GFOA''); Jeffery W. Rubin, Chair, Federal Regulation of
Securities Committee, American Bar Association Business Law Section
and Nir D. Yarden, Chair, Institutional Investors Committee,
American Bar Association, dated Dec. 7, 2011 (``ABA Committees'');
Bruce E. Stern, Chairman, Association of Financial Guaranty
Insurers, dated Sept. 17, 2012 (``AFGI (September 2012)'');
Financial Services Roundtable, Future Industry Association,
Institute of International Bankers, International Swaps and
Derivatives Association, Investment Company Institute, Securities
Industry and Financial Markets Association, dated May 21, 2013
(``Financial Services Roundtable''); Bruce E. Stern, Chairman,
Association of Financial Guaranty Insurers, dated July 22, 2013
(``AFGI (July 2013)''); Robert Pickel, Executive Vice Chairman,
International Swaps and Derivatives Association, Inc., dated July
22, 2013 (``ISDA (July 2013)''); Dennis M. Kelleher, President and
CEO, and Stephen W. Hall, Securities Specialist, Better Markets,
Inc., dated July 22, 2013 (``Better Markets (July 2013)''); Dennis
M. Kelleher, President and CEO, Better Markets, Inc., dated Oct. 18,
2013 (``Better Markets (October 2013)''); Angie Karna, Managing
Director, Legal, Nomura Global Financial Products Inc., dated Sept.
10, 2014 (``Nomura''); Kyle Brandon, Managing Director, Securities
Industry and Financial Markets Association, dated Aug. 7, 2015
(``SIFMA (August 2015)''); Kyle Brandon, Managing Director,
Securities Industry and Financial Markets Association, dated Sept.
23, 2015 (``SIFMA (September 2015)''); Kyle Brandon, Managing
Director, Securities Industry and Financial Markets Association,
dated Nov. 3, 2015 (``SIFMA (November 2015)''). The comments that
the Commission received on the Proposing Release and the Reopening
Release are available on the Commission's Web site at http://www.sec.gov/comments/s7-25-11/s72511.shtml.
\6\ Cross-Border Security-Based Swap Activities; Re-Proposal of
Regulation SBSR and Certain Rules and Forms Relating to the
Registration of Security-Based Swap Dealers and Major Security-Based
Swap Participants, Exchange Act Release No. 69490 (May 1, 2013), 78
FR 30968 (May 23, 2013) (``Cross-Border Proposing Release'').
\7\ See letters from Robert Pickel, International Swaps and
Derivatives Association, Inc., dated Aug. 14, 2013 (``ISDA (August
2013)''); Karrie McMillan, General Counsel, Investment Company
Institute and Dan Waters, Managing Director, ICI Global, dated Aug.
21, 2013 (``ICI''); Dennis M. Kelleher, President & CEO, Better
Markets, Inc., Stephen W. Hall, Securities Specialist, Better
Markets, Inc., and Katelynn O. Bradley, Attorney, Better Markets,
Inc., dated Aug. 21, 2013 (``Better Markets (August 2013)'');
Kenneth E. Bentsen, Jr., President, Securities Industry and
Financial Markets Association, Walt Lukken, President & Chief
Executive Officer, Futures Industry Association; and Richard M.
Whiting, Executive Director and General Counsel, The Financial
Services Roundtable, dated Aug. 21, 2013 (``SIFMA (August 2013)'');
Matti Lepp[auml]l[auml], Secretary General/CEO, PensionsEurope,
dated Sep. 3, 2013 (``PensionsEurope''). These comment letters are
available on the Commission's Web site at https://www.sec.gov/comments/s7-02-13/s70213.shtml.
\8\ See letters from Stephen Maijoor, Chair, European Securities
and Markets Authority, dated Aug. 21, 2013 (``ESMA''); Stuart J.
Kaswell, Executive Vice President & Managing Director, General
Counsel, Managed Funds Association and Adam Jacobs, Director, Head
of Markets Regulation, Alternative Investment Management
Association, dated Aug. 19, 2013 (``MFA/AIMA''); Marcus Stanley,
Policy Director, Americans for Financial Reform, dated Aug. 22, 2013
(``AFR''); Sarah A. Miller, Chief Executive Officer, Institute of
International Bankers, dated Aug. 21, 2013 (``IIB (August 2013)'');
Catherine T. Dixon, Chair, Federal Regulation of Securities
Committee, American Bar Association, Business Law Section, dated
Oct. 2, 2013 (``ABA (October 2013)''); Agricultural Retailers
Association, Business Roundtable, Financial Executives
International, National Association of Corporate Treasurers,
National Association of Manufacturers, U.S. Chamber of Commerce,
dated Aug. 21, 2013 (``CDEU''); Futures Options Association, dated
Aug. 21, 2013 (``FOA''); Kevin Nixon, Managing Director, Institute
of International Finance, dated August 8, 2013 (``IIF''); Koichi
Ishikura, Executive Chief of Operations for International
Headquarters, Japan Securities Dealers Association, dated Aug. 21,
2013 (``JSDA''); Patrick Pearson, European Commission, dated Aug.
21, 2013 (``EC''); Jonathan Kindred and Shigesuke Kashiwagi, Japan
Financial Markets Council, dated Aug. 15, 2013.
The SEC Chair and Commissioners were copied on a comment letter
to the CFTC in connection with the CFTC's own cross-border
initiative. See letter from Sherrod Brown, U.S. Senator, Tom Harkin,
U.S. Senator, Jeff Merkley, U.S. Senator, Carl Levin, U.S. Senator,
Elizabeth Warren, U.S. Senator, Dianne Feinstein, U.S. Senator, to
the Honorable Gary Gensler, dated May 22, 2013 (``U.S. Senators'').
\9\ See Application of Certain Title VII Requirements to
Security-Based Swap Transactions Connected with a Non-U.S. Person's
Dealing Activity that are Arranged, Negotiated, or Executed by
Personnel Located in a U.S. Branch or Office or in a U.S. Branch or
Office of an Agent, Exchange Act Release No. 74843 (Apr. 29, 2015),
80 FR 27443 (May 13, 2015) (``U.S. Activity Proposing Release'').
\10\ See letters from Kenneth E. Bentsen, Jr., President & CEO,
Securities Industry and Financial Markets Association and Financial
Services Roundtable and Rich Foster, Senior Vice President & Senior
Counsel for Regulatory and Legal Affairs, Financial Services
Roundtable, dated July 13, 2015 (``SIFMA/FSR (July 2015)''); Sarah
A. Miller, Chief Executive Officer, Institute of International
Bankers, dated July 13, 2015 (``IIB (July 2015)''); Dan Waters,
Managing Director, ICI Global, dated July 13, 2015 (``ICI Global
(July 2015)''); Dennis M. Kelleher, President and CEO, Stephen W.
Hall, Securities Specialist, Todd Phillips, Attorney, Better
Markets, Inc., dated July 13, 2015 (``Better Markets (July 2015)'');
Timothy W. Cameron, Esq., Managing Director and Laura Martin,
Managing Director and Associate General Counsel, Asset Management
Group, Securities Industry and Financial Markets Association, dated
July 13, 2015 (``SIFMA-AMG (July 2015)''); David Geen, General
Counsel, International Swaps and Derivatives Association, Inc.
(``ISDA (July 2015)''); Chris Barnard, dated June 26, 2015
(``Barnard (July 2015)''); Stuart J. Kaswell, Executive Vice
President, Managing Director & General Counsel, Managed Funds
Association, dated July 13, 2015 (``MFA (July 2015)''). These
comment letters are available on the Commission's Web site at http://www.sec.gov/comments/s7-06-15/s70615.shtml.
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The Commission is now adopting Rules 15Fh-1 through 15Fh-6 and Rule
15Fk-1, with certain revisions suggested by commenters or designed to
clarify the rules and conform them to the rules adopted by the CFTC.
The principal aspects of the rules are briefly described immediately
below. A detailed discussion of each rule follows in Sections II.A.-
II.J, below.\11\
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\11\ If any of the provisions of these rules, or the application
thereof to any person or circumstance, is held to be invalid, such
invalidity shall not affect other provisions or application of such
provisions to other persons or circumstances that can be given
effect without the invalid provision or application.
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A. Summary of Final Rules
Rule 15Fh-1, as adopted, defines the scope of Rules 15Fh-1 through
15Fh-6 and Rule 15Fk-1, and provides that an SBS Entity can rely on the
written representations of a counterparty or its representative to
satisfy its due diligence requirements under the rules, unless it has
information that would cause a reasonable person to question the
accuracy of the representation.
Rule 15Fh-2, as adopted, sets forth the definitions used throughout
Rules 15Fh-1 through 15Fh-6. The defined terms are discussed in
connection with the rules in which they appear.
Rule 15Fh-3, as adopted, defines the business conduct requirements
generally applicable to SBS Entities with respect to: (1) Verification
of counterparty status as an eligible contract participant (``ECP'') or
special entity; (2) disclosure to the counterparty of material
information about the security-based swap, including material risks,
characteristics, incentives, and conflicts of interest; (3) disclosure
of information concerning the daily mark of the security-based swap;
(4) disclosure regarding the ability of the counterparty to require
clearing of the security-based swap; (5) communication with
counterparties in a fair and balanced manner based on principles of
fair dealing and good faith; and (6) the establishment of a supervisory
and compliance infrastructure. Rule 15Fh-3, as adopted, additionally
requires an SBS Dealer to: (1) Establish, maintain and enforce written
policies and procedures reasonably designed to obtain and retain a
record of the essential facts concerning each known counterparty that
are necessary to conduct business with that counterparty; and (2)
comply with certain suitability obligations when recommending a
security-based swap, or trading strategy involving a security-based
swap, to a counterparty.
Rule 15Fh-4(a), as adopted, provides that it shall be unlawful for
an SBS Entity to: (i) Employ any device, scheme, or artifice to defraud
any special entity or prospective customer who is a special entity;
(ii) 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.
Rule 15Fh-4(b), as adopted, sets forth particular requirements for
SBS Dealers acting as advisors to special entities.\12\ Specifically,
an SBS Dealer that acts as an advisor to a special entity must act in
the ``best interests'' of the special entity, and make reasonable
efforts to obtain information that it needs to determine that the
recommendation is in the ``best interests'' of the special entity.\13\
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\12\ The statutory definition of ``special entity'' includes
federal agencies, states and political subdivisions, employee
benefit plans as defined under the Employee Retirement Income
Security Act of 1974 (``ERISA''), governmental plans as defined
under ERISA, and endowments. See Rule 15Fh-2(d) (defining ``special
entity'' to include employee benefit plans that are defined in Title
I of ERISA but permitting employee benefit plans that are not
subject to regulation under Title I of ERISA to elect not to be
special entities).
\13\ Rule 15Fh-2(a), as adopted, defines what it means to ``act
as an advisor'' to a special entity, and provides a safe harbor
under which the parties can establish that the SBS Dealer is not
acting as an advisor to the special entity.
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Rule 15Fh-5, as adopted, sets forth particular requirements for SBS
Entities acting as counterparties to special entities. Under the rule,
those SBS Entities must have a reasonable basis to believe that the
counterparty has a qualified representative who: (1) Has sufficient
knowledge to evaluate the transaction and risks; (2) is not subject to
a statutory disqualification; (3) is independent of the SBS Entity; (4)
undertakes a duty to act in the best interests of the special entity;
(5) makes appropriate and timely disclosures to the special entity of
material information concerning the security-based swap; and (6)
provides written representations regarding fair pricing and the
appropriateness of the security-based swap. If the special entity is an
employee benefit plan that is subject to regulation under Title I of
ERISA (``ERISA plan''), these requirements are satisfied if the
independent representative is a ``fiduciary'' under ERISA. In addition,
the independent representative must be subject to pay-to-play
regulation if the special entity is a ``municipal entity'' or a
``governmental plan'' as defined in Section 3 of ERISA.
Rule 15Fh-6, as adopted, imposes certain pay-to-play restrictions
on SBS Dealers. The rule generally prohibits an SBS Dealer from
engaging in security-
[[Page 29963]]
based swap transactions with a ``municipal entity'' within two years
after certain political contributions have been made to officials of
the municipal entity. As with other pay-to-play rules, Rule 15Fh-6 does
not prohibit political contributions.
Rule 15k-1, as adopted, requires an SBS Entity to designate a CCO
and imposes certain duties and responsibilities on that CCO.
B. Cross-Border Application of the Final Rules
Rule 3a71-3(c) and related amendments to Rule 3a71-3(a), as
adopted, define the scope of application of the business conduct
standards described in Section 15F(h) of the Exchange Act, and the
rules and regulations thereunder (other than the rules and regulations
prescribed by the Commission pursuant to Section 15F(h)(1)(B)) to SBS
Dealers. As adopted, these rules require a registered U.S. SBS Dealer
to comply with transaction-level business conduct requirements with
respect to all of its transactions, except for certain transactions
conducted through such dealer's foreign branch. The rules further
require a registered foreign SBS Dealer to comply with transaction-
level business conduct requirements with respect to any transaction
with a U.S. person (except for a transaction conducted through a
foreign branch of the U.S. person) and any transaction that the SBS
Dealer arranges, negotiates, or executes using personnel located in the
United States.
Rule 3a67-10(d) and related amendments to Rule 3a67-10(a), as
adopted, define the scope of application of the business conduct
standards described in Section 15F(h) of the Exchange Act, and the
rules and regulations thereunder (other than the rules and regulations
prescribed by the Commission pursuant to Section 15F(h)(1)(B)) to
registered Major SBS Participants. As adopted, these rules, like those
applicable to registered SBS Dealers, require a registered U.S. Major
SBS Participant to comply with transaction-level business conduct
requirements with respect to all of its transactions, except for
certain transactions conducted through such participant's foreign
branch. The rules further require a registered foreign Major SBS
Participant to comply with transaction-level business conduct
requirements with respect to any transaction with a U.S. person (except
for a transaction conducted through a foreign branch of the U.S.
person) but not any transaction with a non-U.S. person.
Finally, Rule 3a71-6, as adopted, provides a framework under which
foreign SBS Dealers and foreign Major SBS Participants may seek to
satisfy certain business conduct requirements under Title VII by means
of substituted compliance.
In developing these final rules, including their cross-border
application, we have consulted and coordinated with the CFTC and the
prudential regulators \14\ in accordance with the consultation mandate
of the Dodd-Frank Act.\15\ The Commission also has consulted and
coordinated with foreign regulatory authorities through Commission
staff participation in numerous bilateral and multilateral discussions
with foreign regulatory authorities addressing the regulation of OTC
(over-the-counter) derivatives.\16\ Through these discussions and the
Commission staff's participation in various international task forces
and working groups,\17\ we have gathered information about foreign
regulatory reform efforts and their impact on and relationship with the
U.S. regulatory regime. The Commission has taken and will continue to
take these discussions into consideration in developing rules, forms,
and interpretations for implementing Title VII of the Dodd-Frank
Act.\18\
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\14\ The term ``prudential regulator'' is defined in section
1a(39) of the Commodity Exchange Act, 7 U.S.C. 1a(39), and that
definition is incorporated by reference in section 3(a)(74) of the
Exchange Act, 15 U.S.C. 78c(a)(74). Pursuant to the definition, the
Board of Governors of the Federal Reserve System, the Office of the
Comptroller of the Currency, the Federal Deposit Insurance
Corporation, the Farm Credit Administration, or the Federal Housing
Finance Agency (collectively, the ``prudential regulators'') is the
``prudential regulator'' of a security-based swap dealer or major
security-based swap participant if the entity is directly supervised
by that regulator.
\15\ Section 712(a)(2) of the Dodd-Frank Act provides in part
that the Commission shall ``consult and coordinate to the extent
possible with the Commodity Futures Trading Commission and the
prudential regulators for the purposes of assuring regulatory
consistency and comparability, to the extent possible.''
\16\ For example, senior representatives of authorities with
responsibility for regulation of OTC derivatives have met on a
number of occasions to discuss international coordination of OTC
derivatives regulations. See, e.g., Report of the OTC Derivatives
Regulators Group to G20 Leaders on Cross-Border Implementation
Issues November 2015 (Nov. 2015), available at: http://www.cftc.gov/idc/groups/public/@internationalaffairs/documents/file/odrgreportg20_1115.pdf.
\17\ Commission representatives participate in the Financial
Stability Board's Working Group on OTC Derivatives Regulation
(``ODWG''), both on the Commission's behalf and as the
representative of the International Organization of Securities
Commissions (``IOSCO''), which is co-chair of the ODWG. See
Security-Based Swap Transactions Connected with a Non-U.S. Person's
Dealing Activity That Are Arranged, Negotiated, or Executed By
Personnel Located in a U.S. Branch or Office or in a U.S. Branch or
Office of an Agent; Security-Based Swap Dealer De Minimis Exception,
Exchange Act Release No. 77104 (February 10, 2016), 81 FR 8597 n.15
(Feb. 19, 2016) (``U.S. Activity Adopting Release''), (describing
the Commission representative's role).
\18\ See Section 752(a) of the Dodd-Frank Act (providing in part
that ``[i]n order to promote effective and consistent global
regulation of swaps and security-based swaps, the Commodity Futures
Trading Commission, the Securities and Exchange Commission, and the
prudential regulators . . . as appropriate, shall consult and
coordinate with foreign regulatory authorities on the establishment
of consistent international standards with respect to the regulation
(including fees) of swaps.'').
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C. Consistency With CFTC Rules
The Commission and CFTC staffs, prior to the proposal of rules by
their respective agency, held approximately 30 joint meetings with
interested parties regarding the agencies' respective business conduct
rules to solicit a variety of views.\19\ As discussed in Section I.D.
below, the agencies' staffs also consulted with Department of Labor
(``DOL'') representatives on this rulemaking. In the Proposing Release,
the Commission solicited comment on the impact of any differences
between the Commission's and CFTC's approaches to business conduct
regulations, and whether the Commission's proposed business conduct
regulations should be modified to conform to the proposals made by the
CFTC.\20\ Subsequently, in February 2012, the CFTC adopted final rules
with respect to the external business conduct standards of Swap
Entities that are generally consistent with the Commission's proposed
rules.\21\ In addition, in April 2013, the CFTC adopted final rules
with respect to internal business conduct standards regarding, among
other things, the obligation of a Swap Entity to diligently supervise
its business.\22\ These rules also require each Swap Entity to
designate a CCO, prescribe qualifications and duties of the CCO, and
require that the CCO prepare, sign, and furnish the annual report
containing an assessment of the
[[Page 29964]]
registrant's compliance activities to either the board of directors or
the senior officer.\23\ The rules further require the annual report to
be furnished to the CFTC.\24\
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\19\ A list of Commission staff meetings in connection with this
rulemaking is available on the Commission's Web site under
``Meetings with SEC Officials'' at http://www.sec.gov/comments/df-title-vii/swap/swap.shtml and at http://www.sec.gov/comments/s7-25-11/s72511.shtml.
\20\ See Proposing Release, 76 FR at 42438, supra note 3.
\21\ See Business Conduct Standards for Swap Dealers and Major
Swap Participants With Counterparties, 77 FR 9734 (Feb. 17, 2012)
(``CFTC Adopting Release'').
\22\ See Swap Dealer and Major Swap Participant Recordkeeping,
Reporting, and Duties Rules; Futures Commission Merchant and
Introducing Broker Conflicts of Interest Rules; and Chief Compliance
Officer Rules for Swap Dealers, Major Swap Participants, and Futures
Commission Merchants, 77 FR 20128 (Apr. 3, 2013) (``CFTC CCO
Release'').
\23\ Id.
\24\ Id.
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In May 2013, in the Reopening Release, the Commission sought
comment on certain specific issues, including: (1) The relationship of
the proposed rules to any parallel requirements of other authorities,
including the CFTC and relevant foreign regulatory authorities; and (2)
with respect to the CFTC rules, whether and to what extent the
Commission, in adopting its own rules, should emphasize consistency
with the CFTC rules versus adopting rules that are more tailored to the
security-based swap market, including any specific examples where
consistency or tailoring of a particular rule or rule set is more
critically important.\25\
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\25\ See Reopening Release, supra note 4.
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The Commission received numerous comments regarding consistency
with the CFTC's external business conduct rules both before and after
the CFTC adopted its final rules.\26\ Comments specific to individual
rules are addressed in the discussions of the respective rules below.
As a general matter, these comments had, as an overarching theme, that
the Commission should coordinate with the CFTC to achieve consistent
regulations.\27\ Commenters stressed that differences between the
regulatory regimes would, among other things, increase regulatory
burdens and costs for market participants, delay execution of
transactions, and lead to confusion.\28\
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\26\ See, e.g., Barnard, supra note 5; FIA/ISDA/SIFMA, supra
note 5; AFSCME, supra note 5; Levin, supra note 5; APPA, supra note
5; Ropes & Gray, supra note 5; BlackRock, supra note 5; Nomura,
supra note 5; GFOA, supra note 5; NABL, supra note 5; ISDA (July
2013), supra note 5; AFGI (July 2013), supra note 5; CFA, supra note
5; SIFMA (August 2015), supra note 5; SIFMA (September 2015), supra
note 5; SIFMA (November 2015), supra note 5.
\27\ See, e.g., Barnard, supra note 5; FIA/ISDA/SIFMA, supra
note 5; AFSCME, supra note 5; Levin, supra note 5; APPA, supra note
5; Ropes & Gray, supra note 5; BlackRock, supra note 5; Nomura,
supra note 5; GFOA, supra note 5; NABL, supra note 5; ISDA (July
2013), supra note 5; AFGI (July 2013), supra note 5; SIFMA (August
2015), supra note 5; SIFMA, supra note 5 (September 2015); SIFMA
(November 2015), supra note 5.
\28\ See, e.g., Barnard, supra note 5; Levin, supra note 5;
BlackRock, supra note 5; NABL, supra note 5; GFOA, supra note 5.
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Before the CFTC adopted its final external business conduct rules,
commenters were divided as to whether they preferred the Commission's
\29\ or the CFTC's \30\ proposed approach to specific issues, in
instances in which the CFTC's proposed approach differed from the
Commission's proposed rules. However, the comments received by the
Commission in response to the Reopening Release, which was issued after
the CFTC adopted its final rules, overwhelmingly urged the Commission
to harmonize its external business conduct rules with those of the CFTC
because the CFTC's rules have already been implemented by the
industry.\31\ A number of these comments have suggested specific and
detailed modifications. Where we believe the external business conduct
rules, if modified in accordance with these suggestions, will continue
to provide the protections (as explained in the context of the
particular rule) that the rules are intended to accomplish, we have
modified the proposed rules to harmonize with CFTC requirements to
create efficiencies for entities that have already established
infrastructure for compliance with analogous CFTC requirements.\32\
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\29\ See, e.g., SIFMA (August 2011), supra note 5; GFOA, supra
note 5; NABL, supra note 5.
\30\ See, e.g., CFA, supra note 5.
\31\ See, e.g., Nomura, supra note 5; GFOA, supra note 5; ISDA
(July 2013), supra note 5; SIFMA (August 2015), supra note 5; SIFMA
(September 2015), supra note 5; SIFMA (November 2015), supra note 5.
Commenters also urged, with respect to supervision and CCO
obligations (``internal'' business conduct standards), that our
final rules be informed by industry experience complying with the
analogous Financial Industry Regulatory Authority, Inc. (``FINRA'')
supervision and CCO rules, as well as the CFTC internal business
conduct standards. See SIFMA (September 2015), supra note 5, at 2
(urging the Commission to harmonize its rules with, among other
things, ``the FINRA Supervision Rules, [and] the FINRA CCO Rule'').
\32\ One commenter noted that more than 17,000 entities have
already adhered to a multilateral protocol that had been developed
in response to the CFTC rules. See SIFMA (November 2015), supra note
5.
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D. Department of Labor ERISA Fiduciary Regulations
Section 15F(h)(2)(C) of the Exchange Act defines the term ``special
entity'' to include ``an employee benefit plan, as defined in section 3
of the Employee Retirement Income Security Act of 1974.'' \33\
---------------------------------------------------------------------------
\33\ 29 U.S.C. 1001 et seq. See History of EBSA and ERISA,
available at http://www.dol.gov/ebsa/aboutebsa/history.html.
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Prior to proposing the business conduct standards rules, the
Commission received submissions from commenters concerning the
interaction with ERISA, DOL's proposed fiduciary rule, and current
regulation regarding the definition of ERISA fiduciaries.\34\ As noted
above, the Commission, CFTC and DOL staffs consulted on issues
regarding the intersection of ERISA fiduciary status with the Dodd-
Frank Act business conduct provisions, prior to the Commission's
proposing rules in this area.\35\
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\34\ See, e.g., letter from Kenneth E. Bentsen, Jr., Executive
Vice President, Public Policy and Advocacy, Securities Industry and
Financial Markets Association and Robert G. Pickel, Executive Vice
Chairman, International Swaps and Derivatives Association, Inc. to
Elizabeth M. Murphy, Secretary, Commission and David A. Stawick,
Secretary, CFTC (Oct. 22, 2010) (``SIFMA/ISDA 2010 Letter''), at 8
n.19. This comment letter is available on the Commission's Web site
at http://www.sec.gov/comments/df-title-vii/swap/swap.shtml.
\35\ See Proposing Release, 76 FR at 42398, supra note 3.
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The Commission received numerous comments concerning the
interaction of ERISA and existing fiduciary regulation with the
business conduct standards under the Exchange Act and the Commission's
proposed rules.\36\ Commenters, including ERISA plan sponsors, dealers
and institutional asset managers, stated that although ERISA plans
currently use security-based swaps as part of their overall hedging or
investment strategy, the statutory and regulatory intersections of
ERISA and the external business conduct standards under Title VII of
the Dodd-Frank Act could prevent ERISA plans from participating in
security-based swap markets in the future, and the proposed business
conduct standards rules, if adopted without clarification, could have
unintended consequences for SBS Entities dealing with ERISA plans.\37\
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\36\ See, e.g., ABC, supra note 5; CFA, supra note 5; FIA/ISDA/
SIFMA, supra note 5; IDC, supra note 5; MFA, supra note 5;
BlackRock, supra note 5; Johnson, supra note 5.
\37\ See, e.g., ABC, supra note 5; FIA/ISDA/SIFMA, supra note 5;
IDC, supra note 5; MFA, supra note 5; BlackRock, supra note 5;
Johnson, supra note 5.
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Commenters were primarily concerned that compliance with the
business conduct standards under the Exchange Act or the Commission's
proposed rules would cause an SBS Entity to be an ERISA fiduciary to an
ERISA plan and thus, subject to ERISA's prohibited transaction
provisions.\38\ If an SBS Entity were to become an ERISA fiduciary to
an ERISA plan, it would be prohibited from entering into a security-
based swap with that ERISA plan absent an exemption.\39\ One commenter
[[Page 29965]]
asserted that the penalties for violating ERISA's prohibited
transaction provisions would discourage SBS Entities from dealing with
ERISA plans.\40\ Other commenters asserted that compliance by SBS
Entities with the following obligations could cause an SBS Entity to be
an ERISA fiduciary: (1) Providing information regarding the risks of
the security-based swap; (2) providing the daily mark; (3) reviewing
the ability of the special entity's advisor to advise the special
entity with respect to the security-based swap; and (4) acting in the
best interests of the special entity.\41\ Accordingly, commenters
requested that the Commission and DOL coordinate the respective rules
to clarify that compliance with the business conduct standards rules
will not make an SBS Entity an ERISA fiduciary.\42\
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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 ABC, supra note 5.
\41\ See, e.g., ABC, supra note 5; FIA/ISDA/SIFMA, supra note 5;
IDC, supra note 5; MFA, supra note 5; BlackRock, supra note 5;
Johnson, supra note 5.
\42\ See, e.g., ABC, supra note 5; FIA/ISDA/SIFMA, supra note 5;
IDC, supra note 5; MFA, supra note 5; BlackRock, supra note 5;
Johnson, supra note 5.
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DOL staff reviewed the CFTC's final business conduct standards
rules for Swap Entities and provided the CFTC with the following
statement:
The Department of Labor has reviewed these final business
conduct standards and concluded that they do not require swap
dealers or major swap participants to engage in activities that
would make them fiduciaries under the Department of Labor's current
five-part test defining fiduciary advice 29 CFR 2510.3-21(c). In the
Department's view, the CFTC's final business conduct standards
neither conflict with the Department's existing regulations, nor
compel swap dealers or major swap participants to engage in
fiduciary conduct. Moreover, the Department states that it is fully
committed to ensuring that any changes to the current ERISA
fiduciary advice regulation are carefully harmonized with the final
business conduct standards, as adopted by the CFTC and the SEC, so
that there are no unintended consequences for swap dealers and major
swap participants who comply with these business conduct
standards.\43\
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\43\ See Letter from Phyllis C. Borzi, Assistant Secretary,
Employee Benefits Security Administration, U.S. Department of Labor
to The Hon. Gary Gensler et al., CFTC (Jan. 17, 2012), CFTC Adopting
Release, Appendix 2--Statement of the Department of Labor, 77 FR
9835, supra note 21.
Thereafter, in April 2015, the DOL reproposed a change to the
definition of fiduciary under ERISA.\44\ The DOL noted that its staff
had ``consulted with staff of the SEC.'' \45\
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\44\ See Definition of the Term ``Fiduciary''; Conflict of
Interest Rule--Retirement Investment Advice, 80 FR 21927 (Proposed
Rule, Apr. 20, 2015).
\45\ Id. at 21937.
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On April 6, 2016, DOL issued its final rule.\46\ We understand that
DOL's revised definition of ``fiduciary'' in its final rule is intended
to allow SBS Entities to avoid becoming ERISA fiduciaries when acting
as counterparties to a swap or security-based swap transaction. For
example, DOL makes the following statement in the preamble to its final
rule:
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\46\ See Definition of the Term ``Fiduciary''; Conflict of
Interest Rule--Retirement Investment Advice, 81 FR 20946 (Final
Rule, Apr. 8, 2016).
The Department has provided assurances to the CFTC and the SEC
that the Department 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 and security-based swap dealers and major swap and
security-based swap participants who comply with the business
conduct standards. See, e.g., Letter from Phyllis C. Borzi,
Assistant Secretary, Employee Benefits Security Administration, U.S.
Department of Labor, to The Hon. Gary Gensler et al., CFTC (Jan. 17,
2012). In this regard, we note that the disclosures required under
the business conduct standards, including those regarding material
information about a swap or security-based swap concerning material
risks, characteristics, incentives and conflicts of interest;
disclosures regarding the daily mark of a swap or security-based
swap and a counterparty's clearing rights; disclosures necessary to
ensure fair and balanced communications; and disclosures regarding
the capacity in which a swap or security-based swap dealer or major
swap participant is acting when a counterparty to a special entity,
do not in the Department's view compel counterparties to ERISA-
covered employee benefit plans, other plans or IRAs to make a
recommendation for purposes of paragraph (a) of the final rule or
otherwise compel them to act as fiduciaries in swap and security-
based swap transactions conducted pursuant to section 4s of the
Commodity Exchange Act and section 15F of the Securities Exchange
Act. This section of this Notice discusses these issues in the
context of the express provisions in the final rule on swap and
security-based swap transactions and on transactions with
independent fiduciaries with financial expertise.\47\
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\47\ Id. at 20985, n. 36.
Furthermore, DOL's final rule establishes a ``swap and security-
based swap transactions'' exclusion \48\ which, in DOL's view, is
intended to establish conditions under which persons acting as SBS
Entities, among others, ``do not become investment advice fiduciaries
as a result of communications and activities conducted during the
course of swap or security-based swap transactions regulated under the
Dodd-Frank Act provisions in the Commodity Exchange Act or the
Securities Exchange Act of 1934 and applicable CFTC and SEC
implementing rules and regulations.'' \49\ In addition, DOL has stated
that its exclusion for ``transactions with independent plan fiduciaries
with financial expertise'' has been significantly adjusted and expanded
in the final rule and gives an alternative avenue for parties involved
in swap, security-based swap, or other investment transactions to
conduct the transaction in a way that would ensure they do not become
investment advice fiduciaries under the final rule.\50\
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\48\ See id. at 20984-86 (discussing the swap and security-based
swap transactions exception).
\49\ Id. at 20985. See also id. (explaining that in DOL's view,
``when Congress enacted the swap and security based swap provisions
in the Dodd-Frank Act, including those expressly applicable to ERISA
covered plans, Congress did not intend that engaging in regulated
conduct as part of a swap or security-based swap transaction with an
employee benefit plan would give rise to additional fiduciary
obligations or restrictions under Title I of ERISA'').
\50\ See id. at 20986 (noting that DOL ``does not believe
extending the swap and security-based swap provisions to IRA
investors is appropriate'' and, rather, concluding ``that it was
more appropriate to address this issue in the context of the
`independent plan fiduciary with financial expertise' provision
described elsewhere in this Notice'').
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The Commission staff has continued to coordinate with DOL staff to
ensure that the final business conduct standards rules are
appropriately harmonized with ERISA and DOL regulations. DOL staff has
provided the Commission with a statement that:
It is the Department's view that the draft final business
conduct standards do not require security-based swap dealers or
major security-based swap participants to engage in activities that
would make them fiduciaries under the Department's current five-part
test defining fiduciary investment advice. 29 CFR 2510.3-21(c). The
standards neither conflict with the Department's existing
regulations, nor compel security-based swap dealers or major
security-based swap participants to engage in fiduciary conduct.
Moreover, the Department's recently published final rule amending
ERISA's fiduciary investment advice regulation was carefully
harmonized with the SEC's business conduct standards so that there
are no unintended consequences for security-based swap dealers and
major security-based swap participants who comply with the business
conduct standards. As explained in the preamble to the Department's
final rule, the disclosures required under the SEC's business
conduct rules do not, in the Department's view, compel
counterparties to ERISA-covered employee benefit plans to make
investment advice recommendations within the meaning of the
Department's final rule or otherwise compel them to act as ERISA
fiduciaries in
[[Page 29966]]
swap and security-based swap transactions conducted pursuant to
section 4s(h) of the Commodity Exchange Act and section 15F of the
Securities Exchange Act of 1934.\51\
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\51\ See Letter from Phyllis C. Borzi, Assistant Secretary,
Employee Benefits Security Administration, U.S. Department of Labor
to The Hon. Mary Jo White et al., SEC (Apr. 12, 2016).
Finally, the Commission has modified its proposed treatment of
special entities to take into account the comprehensive regulatory
scheme established under ERISA. In particular, as discussed more fully
in Section II.H below, if the special entity is an ERISA plan, our
rules deem certain requirements satisfied if the plan has an
independent representative that is a fiduciary under ERISA.
E. Investment Adviser and Municipal Advisor Status
In addition to questions about ERISA fiduciary status, commenters
also questioned whether compliance with the business conduct standards
might cause an SBS Entity to be deemed an investment adviser or, when
transacting with a special entity that meets the definition of
municipal entity, a municipal advisor.\52\ Two commenters expressed
concern more generally that compliance with the daily mark requirement
(in Rule 15Fh-3(c)) might raise questions as to whether an SBS Entity
has advisory or fiduciary responsibilities under applicable common law,
state law or federal law (e.g., DOL regulations, provisions of the
Investment Advisers Act of 1940 (``Advisers Act''), or the Dodd-Frank
Act's municipal advisor provisions).\53\
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\52\ See, e.g., FIA/ISDA/SIFMA, supra note 5; SIFMA (August
2011), supra note 5.
\53\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (August 2011),
supra note 5.
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As we noted in the Proposing Release, the duties imposed on an SBS
Dealer (or Major SBS Participant) under the business conduct rules are
specific to this context, and are in addition to any duties that may be
imposed under other applicable law.\54\ Thus, an SBS Entity must
separately determine whether it is subject to regulation as a broker-
dealer, an investment adviser, a municipal advisor or other regulated
entity.\55\ For example, an SBS Dealer that acts as an advisor to a
special entity may fall within the definition of ``investment adviser''
under Section 202(a)(11) of the Advisers Act.\56\
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\54\ See Proposing Release, supra note 3, 76 FR at 42424.
\55\ The Dodd-Frank Act amended the Exchange Act definition of
``dealer'' so that a person would not be deemed to be a dealer as a
result of engaging in security-based swaps with eligible contract
participants. See Section 3(a)(5) of the Exchange Act, 15 U.S.C.
78c(a)(5), as amended by section 761(a)(1) of the Dodd-Frank Act.
The Dodd-Frank Act does not include comparable amendments for
persons who act as brokers in swaps and security-based swaps.
Because security-based swaps, as defined in Section 3(a)(68) of the
Exchange Act, are included in the Exchange Act Section 3(a)(10)
definition of ``security,'' persons who act as brokers in connection
with security-based swaps must, absent an exception or exemption,
register with the SEC as a broker pursuant to Exchange Act Section
15(a), and comply with the Exchange Act's requirements applicable to
brokers.
As discussed in Section I.F, infra, the Commission has issued
temporary exemptions under the Exchange Act in connection with the
revision of the ``security'' definition to encompass security-based
swaps. Among other aspects, these temporary exemptions extended to
certain broker activities involving security-based swaps.
\56\ See 15 U.S.C. 80b-2(a)(11).
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We further stated in the Proposing Release that an SBS Dealer that
acts as an advisor to a municipal entity also may be a ``municipal
advisor'' under Section 15B(e) of the Exchange Act.\57\ We note,
however, that we subsequently adopted rules in 2013 that interpret the
statutorily defined term ``municipal advisor'' and provide a regulatory
exemption for persons engaging in municipal advisory activities in
circumstances in which a municipal entity or obligated person is
otherwise represented by an independent registered municipal advisor
with respect to the same aspects of a municipal financial product or an
issuance of municipal securities so long as the following requirements
are satisfied: (1) The independent registered municipal advisor is
registered pursuant to Section 15B of the Exchange Act and the rules
and regulations thereunder, and is not, and within at least the past
two years was not, associated with the person seeking to rely on the
exemption; (2) the person seeking to use the exemption receives from
the municipal entity or obligated person a representation in writing
that it is represented by, and will rely on the advice of, the
independent registered municipal advisor, and such person has a
reasonable basis for relying on the representation; and (3) the person
seeking to use the exemption provides written disclosure to the
municipal entity or obligated person, with a copy to the independent
registered municipal advisor, stating that such person is not a
municipal advisor and is not subject to the fiduciary duty to municipal
entities that the Exchange Act imposes on municipal advisors, and such
disclosure is made at a time and in a manner reasonably designed to
allow the municipal entity or obligated person to assess the material
incentives and conflicts of interest that such person may have in
connection with the municipal advisory activities.\58\ We explained
that if a municipal entity or obligated person is represented by a
registered municipal advisor, parties to the municipal securities
transaction and others who are not registered municipal advisors should
be able to provide advice to the municipal entity or obligated person
without being deemed themselves to be municipal advisors, so long as
the responsibilities of each person are clear.\59\
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\57\ See 15 U.S.C. 78o-4(e)(4).
\58\ See Registration of Municipal Advisors, Exchange Act
Release No. 70462 (Sept. 20, 2013), 78 FR 67468, 67509-11 (Nov. 12,
2013) (``Municipal Advisor Registration Release'').
\59\ Id. at 67471.
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F. Intersection With SRO Rules
Under the framework established in the Dodd-Frank Act, SBS Entities
are not required to be members of self-regulatory organizations
(``SROs''). Some commenters have, however, urged us to harmonize Title
VII business conduct requirements applicable to SBS Entities with
relevant SRO requirements applicable to the SRO's members to avoid
unnecessary differences, which they argue could create duplication and
conflicts when an SBS Entity is also registered as a broker-dealer, or
when an SBS Entity uses a registered broker-dealer to intermediate its
transactions.\60\
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\60\ See IIB (July 2015), supra note 10, at 13; SIFMA/FSR (July
2015), supra note 10, at 9-10 (due to the possibility of dually
registered firms, the Commission and FINRA, ``must work to harmonize
existing sales practice requirements'' because, to the extent
requirements differ, ``there may be unnecessary duplication and
conflicts that cause a disparate impact on security-based swap
dealers acting through broker-dealers as compared to other security-
based swap dealers.''); SIFMA (September 2015), supra note 5, at 2
(urging the Commission to harmonize its rules with, among other
things, ``the FINRA Supervision Rules, [and] the FINRA CCO Rule'').
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The rules we proposed were designed to implement the business
conduct requirements enacted by Congress regarding security-based swap
activity of SBS Entities. At the same time, in proposing these rules,
we were mindful that an SBS Entity also may engage in activity that
will require it to register as a broker-dealer, and thus become subject
to SRO rules applicable to registered broker-dealers that may impose
similar business conduct requirements.\61\ As we noted in the Proposing
Release, the existing rules of various SROs served as an important
point of reference for our proposed
[[Page 29967]]
business conduct rules.\62\ For example, a number of the proposed
rules, including those regarding ``know your counterparty,'' \63\
suitability,\64\ fair and balanced communications,\65\ supervision,\66\
and designation of a CCO,\67\ were patterned on standards that have
been established by SROs for their members. However, we tailored the
proposed rules to the specifics of the regulatory scheme for security-
based swaps under Title VII.\68\
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\61\ See Exchange Act Section 15(b)(8) (generally making it
illegal for a registered broker-dealer to effect a transaction in,
or induce or attempt to induce the purchase or sale of, any security
unless it is a member of a registered securities association or
effects transactions in securities solely on a national securities
exchange of which it is a member). 15 U.S.C. 78o(b)(8).
\62\ We looked, in particular, to the requirements imposed by
FINRA, the Municipal Securities Rulemaking Board (``MSRB''), and the
National Futures Association (``NFA''), in addition to the business
conduct standards, both internal and external, adopted by the CFTC.
\63\ Proposed Rule 15Fh-3(e). Cf. FINRA Rule 2090.
\64\ Proposed Rule 15Fh-3(f). Cf. FINRA Rules 2090 and 2111.
\65\ Proposed Rule 15Fh-3(g). See Exchange Act Section
15F(h)(3)C), 15 U.S.C. 78o-10(h)(3)(C). Cf. NASD Rule 2210(d)(1)(A).
\66\ Proposed Rule 15Fh-3(h). See Exchange Act Section
15F(h)(1)(B), 15 U.S.C. 78o-10(h)(1)(B). Cf. NASD Rules 3010 and
3012.
\67\ Proposed Rule 15Fk-1. See Exchange Act Section 15F(k), 15
U.S.C. 78o-10(k). Cf. FINRA Rule 3130.
\68\ For example, we provided in the proposed rules for an
institutional suitability alternative, which was modeled on FINRA's
institutional suitability rule (Rule 2111(b)) but tailored to take
into account the definition of eligible contract participant
included in Title VII, which includes, among other persons,
individuals with aggregate amounts of more than $10 million invested
on a discretionary basis (or $5 million if hedging), and entities
with a net worth of at least $1 million that are hedging commercial
risk. See discussion in Section II.G.4, infra. In addition, proposed
Rule 15Fh-3(g) would impose obligations regarding fair and balanced
communications that are consistent with, but less detailed than, the
obligations imposed on registered broker-dealers under FINRA Rule
2210. See Section II.G.5, infra.
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We recognize, as the commenters noted, that the security-based swap
and other securities activities of certain entities may require them to
register both as broker-dealers and as SBS Dealers or Major SBS
Participants.\69\ To the extent an entity will be subject to regulation
both as a broker-dealer and as an SBS Entity, there may be overlapping
regulatory requirements applicable to the same activity. The Commission
is mindful of potential regulatory conflicts or redundancies and has
sought in adopting these final rules to avoid such conflicts and
minimize redundancies, consistent with the statutory business conduct
requirements for SBS Entities. As discussed throughout this release,
the rules we are adopting today take into account the comments
received, both comments specific to the application of the proposed
rules to the security-based swap market and the role that the SBS
Entities play in that market, and comments asking us to modify the
proposed rules to more closely align with the similar SRO rules
applicable to broker-dealers.\70\ Overall, we believe that the business
conduct rules we are adopting today are generally designed to be
consistent with the relevant SRO requirements, taking into account the
nature of the security-based swap market and the statutory requirements
for SBS Entities.\71\
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\69\ See, e.g., IIB (July 2015), supra note 10. In addition, as
noted above, there may instances in which a registered broker-dealer
acts on behalf of an SBS Entity, and so both our rules and the SRO
business conduct rules may apply to the activity of the broker-
dealer in its capacity as agent of the SBS Entity.
\70\ One commenter urged harmonization with SRO (as well as
CFTC) rules to allow SBS Entities ``to leverage existing processes
and speed implementation.'' SIFMA (September 2015), supra note 5, at
2.
\71\ Generally, when a business conduct standard in these
proposed rules is based on a similar SRO standard, we would expect--
at least as an initial matter--to take into account the SRO's
interpretation and enforcement of its standard when we interpret and
enforce our rule. At the same time, we are not bound by an SRO's
interpretation and enforcement of an SRO rule, and our policy
objectives and judgments may diverge from those of a particular SRO.
Accordingly, we would also expect to take into account such
differences in interpreting and enforcing our rules. Proposing
Release, 76 FR at 42399, supra note 3.
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On July 1, 2011, the Commission issued a separate order granting
temporary exemptive relief (the ``Temporary Exemptions'') from
compliance with certain provisions of the Exchange Act in connection
with the revision, pursuant to Title VII of the Dodd-Frank Act, of the
Exchange Act definition of ``security'' to encompass security-based
swaps.\72\ Consistent with the Commission's action, on July 8, 2011,
FINRA filed for immediate effectiveness FINRA Rule 0180, which, with
certain exceptions, is intended to temporarily limit the application of
FINRA rules with respect to security-based swaps, thereby helping to
avoid undue market disruptions resulting from the change to the
definition of ``security'' under the Act.\73\
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\72\ See Order Granting Temporary Exemptions Under the
Securities Exchange Act of 1934 in Connection With the Pending
Revision of the Definition of ``Security'' Encompass Security-based
Swaps, and Request for Comment, Exchange Act Release No. 64795 (Jul.
1, 2011), 76 FR 39927 (Jul. 7, 2011) (the ``Exemptive Release'').
The term ``security-based swap'' is defined in Section 761 of the
Dodd-Frank Act. 15 U.S.C. 78c(a)(68). See also Further Definition of
``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap
Agreement''; Mixed Swaps; Security-Based Swap Agreement
Recordkeeping, Exchange Act Release No. 67453 (Jul. 18, 2012), 77 FR
48208 (Aug. 13, 2012) (``Products Definitions Adopting Release'')
for further discussion regarding the meaning of the term security-
based swap.
\73\ FINRA Rule 0180 temporarily limits the application of
certain FINRA rules with respect to security-based swaps. See Notice
of Filing and Immediate Effectiveness of Proposed Rule Change to
Adopt FINRA Rule 0180 (Application of Rules to Security-Based
Swaps); File No. SR-FINRA-2011-033, Exchange Act Release No. 64884
(Jul. 14, 2011), 76 FR 42755 (July 19, 2011) (``FINRA Rule 0180
Notice of Filing''). See also Notice of Filing and Immediate
Effectiveness of a Proposed Rule Change to Extend the Expiration
Date of FINRA Rule 0180 (Application of Rules to Security-Based
Swaps); File No. SR-FINRA-2016-001, Exchange Act Release No. 76850
(Jan. 7, 2016), 81 FR 1666 (Jan. 13, 2016) (extending until February
11, 2017 the expiration date of the exemptions under FINRA Rule
0180) (``FINRA Rule 0180 Extension Notice'').
In its Exemptive Release, the Commission noted that the relief
is targeted and does not include, for instance, relief from the
Exchange Act's antifraud and anti-manipulation provisions. FINRA has
noted that FINRA Rule 0180 is similarly targeted. For instance,
paragraph (a) of FINRA Rule 0180 provides that FINRA rules shall not
apply to members' activities and positions with respect to security-
based swaps, except for FINRA Rules 2010 (Standards of Commercial
Honor and Principles of Trade), 2020 (Use of Manipulative, Deceptive
or Other Fraudulent Devices), 3310 (Anti-Money Laundering Compliance
Program) and 4240 (Margin Requirements for Credit Default Swaps).
See also paragraphs (b) and (c) of FINRA Rule 0180 (addressing the
applicability of additional rules); FINRA Rule 0180 Notice of
Filing; FINRA Rule 0180 Extension Notice.
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The Commission, noting the need to avoid a potential unnecessary
disruption to the security-based swap market in the absence of an
extension of the Temporary Exemptions, and the need for additional time
to consider the potential impact of the revision of the Exchange Act
definition of ``security'' in light of recent Commission rulemaking
efforts under Title VII of the Dodd-Frank Act, issued an order that
extended and refined the applicable expiration dates of the previously
granted Temporary Exemptions.\74\ In the Temporary Exemptions Extension
Release, the Commission extended the expiration date of the expiring
Temporary Exemptions that are not directly linked to pending security-
based swap rulemakings until the earlier of such time as the Commission
issues an order or rule determining whether any continuing exemptive
relief is appropriate for security-based swap activities with respect
to any of these Exchange Act provisions or until three years following
the effective date of the
[[Page 29968]]
Temporary Exemptions Extension Release.\75\ The Commission further
extended the expiration date for many expiring Temporary Exemptions
directly related to pending security-based swap rulemakings until the
compliance date for the related security-based swap-specific
rulemaking.\76\
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\74\ See Order Extending Temporary Exemptions Under the
Securities Exchange Act of 1934 in Connection With the Revision of
the Definition of ``Security'' to Encompass Security-Based Swaps,
and Request for Comment, Exchange Act Release No. 71485 (Feb. 5,
2014), 79 FR 7731 (Feb. 10, 2014) (``Temporary Exemptions Extension
Release''). See also Extension of Exemptions for Security-Based
Swaps, Securities Act of 1933 (``Securities Act'') Release No. 9545,
Exchange Act Release No. 71482 (Feb. 5, 2014), 79 FR 7570 (Feb. 10,
2014) (extending the expiration dates in interim final rules that
provide exemptions under the Securities Act, the Exchange Act, and
the Trust Indenture Act of 1939 for those security-based swaps that
prior to July 16, 2011 were security-based swap agreements and are
defined as ``securities'' under the Securities Act and the Exchange
Act as of July 16, 2011 due solely to the provisions of Title VII of
the Dodd-Frank Act).
\75\ See Temporary Exemptions Extension Release, 79 FR at 7734,
supra note 74. These Temporary Exemptions are currently scheduled to
expire in February 2017.
\76\ Id. at 7731. The Commission extended a subset of the
Temporary Exemptions until they are addressed within relevant
rulemakings relating to: (i) Capital, margin, and segregation
requirements for security-based swap dealers and major security-
based swap participants, (ii) recordkeeping and reporting
requirements for security-based swap dealers and major security-
based swap participants, (iii) security-based swap trade
acknowledgement rules, and/or (iv) registration requirements for
security-based swap execution facilities.
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In establishing Rule 0180, and in extending the rule's expiration
date,\77\ FINRA noted its intent, pending the implementation of any
Commission rules and guidance that would provide greater regulatory
clarity in relation to security-based swap activities, to align the
expiration date of FINRA Rule 0180 with the termination of relevant
provisions of the Temporary Exemptions provided by the Commission, so
as to avoid undue market disruptions resulting from the change to the
definition of ``security'' under the Exchange Act.
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\77\ As noted in the FINRA Rule 0180 Extension Notice, FINRA has
indicated that it intends to amend the expiration date of Rule 0180
in subsequent filings as necessary such that the expiration date
will be coterminous with the termination of relevant provisions of
the Temporary Exemptions.
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II. Discussion of Rules Governing Business Conduct
A. Scope, Generally
1. Proposed Rule
Proposed Rule 15Fh-1 would provide that Rules 15Fh-1 through 15Fh-6
(governing business conduct) and Rule 15Fk-1 (requiring designation of
a CCO) are not intended to limit, or restrict, the applicability of
other provisions of the federal securities laws, including but not
limited to Section 17(a) of the Securities Act, Sections 9 and 10(b) of
the Exchange Act, and the rules and regulations thereunder.
Additionally, it would provide that Rules 15Fh-1 through 15Fh-6 and
Rule 15Fk-1 would not only apply in connection with entering into
security-based swaps but also would continue to apply, as appropriate,
over the term of executed security-based swaps.
In the Proposing Release, the Commission solicited comment on the
scope of the business conduct rules, including whether the rules should
apply to transactions between an SBS Entity and its affiliates, whether
any of the rules should apply to security-based swaps that were entered
into prior to the effective date of the rules, and to the extent that
any of the rules were intended to provide additional protections for a
particular counterparty, whether the counterparty should be able to opt
out of those protections.\78\
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\78\ See Proposing Release, 76 FR at 42401-42402, supra note 3.
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2. Comments on the Proposed Rule
a. General
Eleven commenters addressed the general scope of the proposed
business conduct standards.\79\ One commenter recommended that the
Commission apply the proposed rules to security-based swaps that are
offered as well as those that are executed.\80\ The other commenters
addressed: The application of the rules to inter-affiliate
transactions, the application of the rules to security-based swaps
entered into prior to the effective date, and whether counterparties
should be able to opt out of the protections provided by the rules.
---------------------------------------------------------------------------
\79\ See CFA, supra note 5; ABA Securities Association, supra
note 5; FIA/ISDA/SIFMA, supra note 5; SIFMA (August 2011), supra
note 5; NABL, supra note 5; AFGI (September 2012), supra note 5;
AFGI (July 2013), supra note 5; CalPERS (August 2011), supra note 5;
ABC, supra note 5; MFA, supra note 5; CalSTRS, supra note 5; SIFMA
(August 2015), supra note 5.
\80\ See CFA, supra note 5.
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b. Application to Security-Based Swaps Entered Into Prior to the
Effective Date
Seven commenters addressed the application of the rules to
security-based swaps that were entered into prior to the compliance
date of the rules, and all seven recommended that the rules not apply
to such transactions.\81\ Three further indicated that the rules should
not generally apply to amendments to, or other lifecycle events arising
under, a security-based swap that was executed before the compliance
date of the rules.\82\ Another commenter also specifically argued that
the rules should not apply to either partial or full terminations of
security-based swaps executed prior to the compliance date, or the
exercise of an option on a security-based swap where the option was
executed prior to the compliance date.\83\
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\81\ See SIFMA (August 2011), supra note 5; FIA/ISDA/SIFMA,
supra note 5; NABL, supra note 5; AFGI (September 2012), supra note
5; AFGI (July 2013), supra note 5; ABC, supra note 5; SIFMA (August
2015), supra note 5.
\82\ See FIA/ISDA/SIFMA, supra note 5; NABL, supra note 5; SIFMA
(August 2011), supra note 5.
\83\ See SIFMA (August 2015), supra note 5.
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One commenter argued that amendments to existing transactions
typically do not alter the risk and other characteristics of a
transaction sufficiently to merit application of the rules and that
application of the rules in these cases may frustrate their
purpose.\84\ Others believed that any potential retroactive application
would be burdensome, noting that it would undermine the expectations
that the parties had when entering into the security-based swap.\85\
---------------------------------------------------------------------------
\84\ See FIA/ISDA/SIFMA, supra note 5.
\85\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5; SIFMA (August 2011), supra note 5.
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c. Application to Inter-Affiliate Transactions
Three commenters discussed the application of the rules to inter-
affiliate transactions.\86\ All three recommended that the rules
generally not apply to security-based swap transactions between
affiliates,\87\ but one recognized that entity-level requirements (such
as CCO and supervision responsibilities) will necessarily apply.\88\
One commenter asserted that the rules are intended to protect investors
in arm's length transactions and therefore, would be irrelevant in
inter-affiliate transactions.\89\ The second commenter similarly argued
that because affiliates are not ``external clients'' of the SBS Entity,
the protections afforded by the rules are inapposite.\90\ The second
commenter also suggested that the Commission define ``affiliate'' to
mean an entity that is ``under common control and that reports
information or prepares its financial statements on a consolidated
basis'' with another entity, and opined that the definition should be
consistently applied across Title VII rulemakings.\91\ The third
commenter also advocated for a common control standard, arguing that
the rules should not apply to transactions between an SBS Entity and
``a person controlling, controlled by, or under common control with the
[SBS Entity].'' \92\
---------------------------------------------------------------------------
\86\ See ABA Securities Association, supra note 5; FIA/ISDA/
SIFMA, supra note 5; SIFMA (August 2015), supra note 5.
\87\ See ABA Securities Association, supra note 5; FIA/ISDA/
SIFMA, supra note 5; SIFMA (August 2015), supra note 5.
\88\ See ABA Securities Association, supra note 5.
\89\ See FIA/ISDA/SIFMA, supra note 5.
\90\ See ABA Securities Association, supra note 5.
\91\ Id.
\92\ See SIFMA (August 2015), supra note 5.
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d. Counterparty Opt-Out
Nine commenters addressed whether to permit counterparties to opt
out of certain protections provided by the
[[Page 29969]]
rules.\93\ Six commenters were in favor of allowing an opt out in at
least some circumstances,\94\ and three were against it.\95\
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\93\ See FIA/ISDA/SIFMA, supra note 5; CalPERS (August 2011),
supra note 5; SIFMA (August 2011), supra note 5; ABC, supra note 5;
MFA, supra note 5; CalSTRS, supra note 5; CFA, supra note 5; Better
Markets (August 2011), supra note 5; Levin, supra note 5.
\94\ See FIA/ISDA/SIFMA, supra note 5; CalPERS (August 2011),
supra note 5; SIFMA (August 2011), supra note 5; ABC, supra note 5;
MFA, supra note 5; CalSTRS, supra note 5.
\95\ See CFA, supra note 5; Better Markets (August 2011), supra
note 5; Levin, supra note 5.
---------------------------------------------------------------------------
Three commenters suggested that the Commission permit institutional
or ``sophisticated investors'' to opt out of provisions intended to
protect counterparties.\96\ Specifically, one endorsed allowing
``qualified institutional buyers'' as defined in Rule 144A under the
Securities Act and institutions with total assets of $100 million or
more to opt out, asserting that the costs, delays in execution, and
requirements to make detailed representations and disclosure to the SBS
Entity may outweigh the benefits that such counterparties would
receive.\97\ Another asserted that ``sophisticated'' counterparties
should be able to opt out of receiving ``material information''
disclosures and the written disclosures related to clearing rights to
lower their hedging costs and avoid potential trading delays and
inefficiencies.\98\
---------------------------------------------------------------------------
\96\ See FIA/ISDA/SIFMA, supra note 5; CalPERS (August 2011),
supra note 5; MFA, supra note 5.
\97\ See FIA/ISDA/SIFMA, supra note 5.
\98\ See MFA, supra note 5.
---------------------------------------------------------------------------
Three other commenters suggested an opt out for specific types of
counterparties.\99\ One suggested that an ERISA plan should be
permitted to opt out because SBS Entities might use the information
they receive as a result of compliance with the business conduct
standards to disadvantage the ERISA plan.\100\ A second asserted that
pension funds acting as end users should be allowed to opt out of any
rules that impose ``heightened fiduciary duties'' on SBS Dealers
because pension funds do not need extra protection, and compliance with
the fiduciary duties would only increase costs for SBS Dealers, leading
them to either pass the costs along or refrain from entering into
transactions with pension funds.\101\ A third suggested that any entity
advised by a qualified independent representative should be able to
waive the protections of the rules to avoid execution delays and
administrative costs.\102\
---------------------------------------------------------------------------
\99\ See ABC, supra note 5; CalSTRS, supra note 5; SIFMA (August
2011), supra note 5.
\100\ See ABC, supra note 5.
\101\ See CalSTRS, supra note 5.
\102\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
Three commenters opposed allowing counterparties to opt out of the
special protections in the rules.\103\ One commenter noted that a
``theoretically optional opt out would likely become mandatory''
because SBS Dealers would make it a condition of doing business, and
that an opt-out approach could be used to perpetuate abuses the rules
are intended to prevent.\104\ Another commented that an opt-out would
``only add confusion to an already complex regulatory framework and
create opportunities for market participants to evade compliance with
the much-needed business conduct standards.'' \105\ A third
specifically opposed allowing counterparties to opt out of the
disclosure requirements, noting that even sophisticated investors may
be misled.\106\
---------------------------------------------------------------------------
\103\ See CFA, supra note 5; Better Markets (August 2011), supra
note 5; Levin, supra note 5.
\104\ See CFA, supra note 5.
\105\ See Better Markets (August 2011), supra note 5.
\106\ See Levin, supra note 5.
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3. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-1, predesignated as Rule 15Fh-1(a), with certain modifications.
a. General
The Commission is adopting, as proposed, the provision in final
Rule 15Fh-1(a) specifying that Rules 15Fh-1 through 15Fh-6 and Rule
15Fk-1 apply ``in connection with entering into security-based swaps''
and also will continue to apply, as appropriate, over the term of
executed security-based swaps. Many of the rules impose obligations on
an SBS Entity with respect to its ``counterparty'' that must be
satisfied before the SBS Entity has actually entered into a security-
based swap with that counterparty (e.g., Rule 15Fh-3(a) (verification
of counterparty status) and Rule 15Fh-3(b) (disclosure of material
risks and characteristics, and material incentives or conflicts of
interest)). This is consistent with the language specifying that the
rules apply ``in connection with entering into security-based swaps''
in Rule 15Fh-1(a). Accordingly, when the rules refer to a
``counterparty'' of the SBS Entity, the term ``counterparty'' includes
a potential counterparty where compliance with the obligation is
required before the SBS Entity and the ``counterparty'' has actually
entered into the security-based swap.\107\
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\107\ We believe that our reading of the term ``counterparty''
to include a potential counterparty addresses the concerns raised by
the commenter that requested that the Commission apply the rules to
security-based swaps that are offered as well as those that are
executed. See CFA, supra note 5.
---------------------------------------------------------------------------
b. Application to Security-Based Swaps Entered Into Prior to the
Effective Date
To address concerns raised by commenters,\108\ the Commission is
clarifying that the business conduct rules generally will not apply to
any security-based swap entered into prior to the compliance date of
the rules, and generally will apply to any security-based swap entered
into after the compliance date of these rules, including a new
security-based swap that results from an amendment or modification to a
pre-existing security-based swap.\109\
---------------------------------------------------------------------------
\108\ See SIFMA (August 2011), supra note 5; FIA/ISDA/SIFMA,
supra note 5; NABL, supra note 5; AFGI (September 2012), supra note
5; AFGI (July 2013), supra note 5; ABC, supra note 5; SIFMA (August
2015), supra note 5.
\109\ See infra Sections IV.B and C (discussing the compliance
dates of these rules).
---------------------------------------------------------------------------
In response to commenters' concerns about applying the business
conduct rules to amendments to and other lifecycle events of a
security-based swap entered into before the compliance date of these
rules,\110\ the Commission is clarifying that the business conduct
rules generally will not apply to amendments or modifications to a pre-
existing security-based swap unless the amendment or modification
results in a new security-based swap (and occurs after the compliance
date of these rules). The Commission has previously determined that if
the material terms of a security-based swap are amended or modified
during its life based on an exercise of discretion and not through
predetermined criteria or a predetermined self-executing formula, the
amended or modified security-based swap is viewed as a new security-
based swap.\111\ Thus, if there is such a material amendment or
modification, which could include a change in the economic terms of the
transaction that the parties would not have provided for when entering
into the security-based swap contract, the Commission will consider the
amended or modified security-based swap to be a new
[[Page 29970]]
security-based swap for purposes of the business conduct rules. If that
material amendment or modification occurs after the compliance date of
these rules, these rules will apply to the resulting new security-based
swap.
---------------------------------------------------------------------------
\110\ See FIA/ISDA/SIFMA, supra note 5; NABL, supra note 5;
SIFMA (August 2015), supra note 5.
\111\ See Products Definitions Adopting Release, supra note 72,
77 FR at 48286 (``If the material terms of a Title VII instrument
are amended or modified during its life based on an exercise of
discretion and not through predetermined criteria or a predetermined
self-executing formula, the Commissions view the amended or modified
Title VII instrument as a new Title VII instrument.'').
---------------------------------------------------------------------------
In response to concerns raised by a commenter, the Commission also
is clarifying that the rules generally will not apply to either a
partial or full termination of a pre-existing security-based swap.\112\
In these instances we anticipate that the expectations of the parties
will be governed by the pre-existing terms of the original security-
based swap, and so the business conduct requirements generally will not
apply. If, however, the partial termination involves a change in the
material terms of the original security-based swap ``based on an
exercise of discretion and not through predetermined criteria or a
predetermined self-executing formula'' the business conduct rules will
apply.
---------------------------------------------------------------------------
\112\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
As requested by a commenter,\113\ we are clarifying that the
business conduct rules generally will not apply to a new security-based
swap that results from the exercise of an option on a security-based
swap (whether or not the exercise occurs before or after the compliance
date of these rules), as long as the terms upon which a party can
exercise the option and the terms of the underlying security-based swap
that will result upon the exercise of the option are governed by the
terms of the pre-existing option. If, however, the material terms of
either the option or the resulting security-based swap are amended or
modified based on an exercise of discretion and not through
predetermined criteria or a predetermined self-executing formula, our
business conduct rules will apply to the amended or modified option or
security-based swap resulting from the exercise of the option (assuming
that such amendment or modification occurs after the compliance date of
these rules).
---------------------------------------------------------------------------
\113\ Id.
---------------------------------------------------------------------------
We believe it appropriate to apply the rules in this manner to help
to ensure that counterparties receive the benefits of the rules in
circumstances where they are warranted, while providing firms adequate
time to review the business conduct rules being adopted today and make
appropriate changes to their operations before they have to begin
complying with those rules.
The Commission emphasizes that the above clarifications relate to
the business conduct rules that by their terms apply when an SBS Entity
offers to enter into or enters into a security-based swap, such as
verification of status (Rule 15Fh-3(a)), certain disclosures (Rule
15Fh-3(b) and (d)), requirements for special entities as counterparties
(Rule 15Fh-5), and pay-to-play (Rule 15Fh-6)). Other rules being
adopted today are broader in their application, such as those relating
to know your counterparty (Rule 15Fh-3(e)), recommendations of
security-based swaps or trading strategies (Rule 15Fh-3(f)), fair and
balanced communications (Rule 15Fh-3(g)), supervision (Rule 15Fh-3(h)),
antifraud (Rule 15Fh-4(a)), requirements when an SBS Dealer is acting
as an advisor to a special entity (Rule 15Fh-4(b)), and the CCO (Rule
15Fk-1). Thus, if an SBS Entity takes an action after the compliance
date that independently implicates one of the business conduct rules,
it will need to comply with the applicable requirements. For example,
if an SBS Dealer makes a recommendation of a trading strategy that
involves termination of a pre-existing security-based swap, the SBS
Dealer would need to comply with the suitability requirements of Rule
15Fh-3(f) regarding such recommendation. In addition, an SBS Entity
will need to comply with ``entity level'' rules relating to supervision
and CCO after the compliance date of those rules for all of its
security-based swap business.
c. Application to Inter-Affiliate Transactions
The Commission agrees with the concerns raised by commenters
regarding the treatment of inter-affiliate transactions.\114\ As the
Commission noted in the Definitions Adopting Release (defined below),
market participants may enter into inter-affiliate security-based swaps
for a variety of purposes, such as to allocate risk within a corporate
group or to transfer risks within a corporate group to a central
hedging or treasury entity.\115\ As discussed below, we believe that
transactions by SBS Entities with certain of their affiliated persons
do not implicate the concerns that the business conduct requirements
regarding verification of counterparty status (Rule 15Fh-3(a)),
disclosures regarding the product and potential conflicts of interest,
daily mark and clearing rights (Rule 15Fh-3(b), (c) and (d)), ``know
your counterparty'' and suitability obligations (Rules 15Fh-3(e) and
(f)), and obligations when advising or acting as counterparty to a
special entity (Rules 15Fh-4(b) and 15Fh-5) are intended to address
(referred to as ``transaction specific obligations'').\116\ We
therefore are providing in Rule 15Fh-1(a) as adopted that Rules 15Fh-
3(a) through (f), 15Fh-4(b) and 15Fh-5 are not applicable to security-
based swaps that SBS Entities enter into with certain affiliates.
---------------------------------------------------------------------------
\114\ See ABA Securities Association, supra note 5; FIA/ISDA/
SIFMA, supra note 5; SIFMA (August 2015), supra note 5.
\115\ See Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-
Based Swap Participant'' and ``Eligible Contract Participant,''
Exchange Act Release No. 66868 (Apr. 27, 2012), 77 FR 30596, 30624-
30625 (May 23, 2012) (``Definitions Adopting Release'').
\116\ As one commenter suggested, because affiliates are not
``external clients'' of the SBS Entity, the protections afforded by
these rules may be inapposite. See ABA Securities Association, supra
note 5.
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We are not, however, extending the exception to transactions with
all affiliates, as requested by some commenters.\117\ Rather, the
Commission is limiting the exception from the business conduct
requirements to security-based swap transactions between majority-owned
affiliates. The rule defines ``majority-owned affiliates'' consistent
with the Definitions Adopting Release such that, for these purposes,
the counterparties to a security-based swap are majority-owned
affiliates if one counterparty directly or indirectly owns a majority
interest in the other, or if a third party directly or indirectly owns
a majority interest in both counterparties to the security-based swap,
where ``majority interest'' is the right to vote or direct the vote of
a majority of a class of voting securities of an entity, the power to
sell or direct the sale of a majority of a class of voting securities
of an entity, or the right to receive upon dissolution or the
contribution of a majority of the capital of a partnership.\118\
---------------------------------------------------------------------------
\117\ See SIFMA (August 2015), supra note 5; FIA/ISDA/SIFMA,
supra note 5. See also ABA Securities Association, supra note 5
(suggesting an ``affiliated group'' definition that was considered
but not adopted in the Definitions Adopting Release). As noted
above, the Commissions instead adopted the exception for ``majority-
owned affiliates'' that we are providing here. See Definitions
Adopting Release, supra note 115.
\118\ See Exchange Act Rules 3a71-1(d)(1) and 15Fh-1(a).
---------------------------------------------------------------------------
The transaction-specific obligations outlined above and included in
Rule 15Fh-1(a) generally are designed to provide an SBS Entity
counterparty with certain information in connection with the security-
based swap transaction that would help reduce potential information
asymmetries, and to help ensure that the SBS Entity knows its
counterparty and acts in a fair manner towards that counterparty, even
in the face of potential conflicts of interest. The Commission does not
believe that these objectives and
[[Page 29971]]
concerns are implicated in the same manner or to the same extent when
there is an alignment of economic interests between the SBS Entity and
a counterparty, such as is the case when the counterparty is a
majority-owned affiliate. However, absent majority ownership, we cannot
be confident that there would be an alignment of economic interests
that is sufficient to eliminate the concerns that underpin the need for
regulation in this area.\119\ Accordingly, the Commission is modifying
Rule 15Fh-1(a) to provide that Rules 15Fh-3(a)-(f), 15Fh-4(b) and 15Fh-
5 are not applicable to security-based swaps that SBS Entities enter
into with their majority-owned affiliates. These generally are the
transaction specific exceptions requested by a commenter.\120\
---------------------------------------------------------------------------
\119\ See Definitions Adopting Release, 77 FR at 30625, supra
note 115 (declining to adopt a ``common control'' standard, noting
that, ``[a]bsent majority ownership, we cannot be confident that
there would be an alignment of economic interests that is sufficient
to eliminate the concerns that underpin dealer regulation.'').
\120\ See SIFMA (August 2015), supra note 5 (requesting
exceptions with respect to Rules 15Fh-3(a) through (f), 15Fh-4(b)
and 15Fh-5).
---------------------------------------------------------------------------
Further, consistent with the commenter's request, we are not
granting an exception for transactions with affiliates with respect to
the antifraud requirements of Rule 15Fh-4(a) or the requirements of
Rule 15Fh-3(g) (fair and balanced communications).\121\ The exception
for inter-affiliate transactions from the transaction specific
obligations discussed above is generally predicated on the assumption
that entities with aligned economic interests have an incentive to act
fairly when dealing with each other. However, we believe it important
to continue to provide the protections of the antifraud and fair and
balanced communication rules in situations where an SBS Entity acts in
a manner contrary to this assumption. We also are not granting
exceptions to the entity-level requirements regarding supervision (Rule
15Fh-3(h)) and CCO obligations (Rule 15Fk-1), which are intended to
help to ensure the compliance of SBS Entities in their security-based
swap transactions.
---------------------------------------------------------------------------
\121\ See id.
---------------------------------------------------------------------------
d. Counterparty Opt-Out
The Commission has considered the concerns raised by commenters
\122\ and determined, on balance, not to permit counterparties
generally to opt out of the protections provided by the business
conduct rules. As discussed throughout the release in the context of
specific rules, the rules being adopted today are intended to provide
certain protections for counterparties, including certain heightened
protections for special entities. We think it is appropriate to apply
the rules so that counterparties receive the benefits of those
protections and so do not think it appropriate to permit parties
generally to elect to ``opt out'' of the benefits of those
provisions.\123\
---------------------------------------------------------------------------
\122\ See FIA/ISDA/SIFMA, supra note 5; CalPERS (August 2011),
supra note 5; SIFMA (August 2011), supra note 5; ABC, supra note 5;
MFA, supra note 5; CalSTRS, supra note 5; CFA, supra note 5; Better
Markets (August 2011), supra note 5; Levin, supra note 5.
\123\ However, as discussed in Section II.H.1.c.iii below, in
order to resolve any tension between Exchange Act Sections
15F(h)(2)(C)(iii) and (iv), we are allowing employee benefit plans
that are defined in Section 3 of ERISA but not subject to Title I of
ERISA to opt out of special entity status.
---------------------------------------------------------------------------
While we are not adopting a general opt-out provision, 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 (e.g., Rule 15Fh-1(b)
(reliance on representations)) and, where appropriate, allow SBS
Entities to take into account the sophistication of the counterparty
(e.g., Rule 15Fh-3(f) (regarding recommendations of security-based
swaps or trading strategies)).
B. Exceptions for Anonymous SEF or Exchange-Traded Transactions
Section 15F(h)(7) of the Exchange Act provides a statutory
exception ``from the requirements of this subsection'' for security-
based swap transactions that are: ``(A) initiated by a special entity
on an exchange or security-based swaps execution facility; and (B) the
security-based swap dealer or major security-based swap participant
does not know the identity of the counterparty to the transaction.''
\124\ More generally, commenters have asked the Commission to provide
exceptions to the application of our rules in situations in which an
SBS Entity does not know the identity of its counterparty, or where a
security-based swap transaction is executed on a registered national
securities exchange or security-based swap execution facility
(``SEF''), without regard to whether the counterparty is a special
entity.\125\
---------------------------------------------------------------------------
\124\ 15 U.S.C. 78o-10(h)(7).
\125\ See, e.g., SIFMA (August 2011), supra note 5; BlackRock,
supra note 5; FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
1. Proposal
Noting that there may be circumstances in which it may be unclear
which party ``initiated'' the communications that resulted in the
parties entering into a security-based swap transaction on a registered
SEF or registered national securities exchange, the Commission proposed
to interpret Section 15F(h)(7) to apply to any transaction with a
special entity on a registered SEF or registered national securities
exchange, where the SBS Entity does not know the identity of its
counterparty at any time up to and including execution of a
transaction.
The Commission further proposed to interpret Section 15F(h)(7) to
apply with respect to requirements specific to dealings with special
entities. Proposed Rule 15Fh-4(b)(3) would provide an exception from
the special requirements for SBS Dealers acting as advisors to special
entities, including the requirement that an SBS Dealer act in the best
interests of a special entity for whom it acts as an advisor, if the
transaction is executed on a registered exchange or SEF and the SBS
Dealer does not know the identity of the counterparty at any time up to
and including execution of the transaction. Under the same
circumstances, proposed Rule 15Fh-5(c) would similarly provide an
exception from the special requirements for SBS Entities acting as
counterparties to special entities, including the qualified independent
representative and disclosure requirements of proposed Rule 15Fh-
5.\126\ Proposed Rule 15Fh-6(b)(2)(iii) would provide an exception from
the pay to play rules with respect to transactions on a registered
exchange or SEF where the SBS Dealer does not know the identity of the
counterparty at any time up to and including execution of the
transaction.\127\
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\126\ See Section II.H.8, infra for a discussion of the proposed
exceptions from the requirements of Rules 15Fh-4(b) and 15Fh-5.
\127\ Rule 15Fh-6, as proposed, would apply only with respect to
transactions ``initiated'' by a municipal entity. The Commission is
modifying the exception under Rule 15Fh-6(b)(2)(iii) to apply to all
security-based swap transactions that are executed on a registered
national securities exchange or registered or exempt SEF, rather
than just with respect to transactions ``initiated by a municipal
entity'' on such exchange or registered SEF (as long as the other
conditions of Rule 15Fh-6(b)(2)(iii) are met). These revisions are
consistent with the exceptions to Rules 15Fh-4 and 15Fh-5 for
anonymous, exchange-traded or SEF transactions. See Section II.H.9,
infra.
---------------------------------------------------------------------------
Consistent with Section 15F(h)(7), we also proposed to limit the
application of certain other requirements to situations in which the
identity of a counterparty (whether a special entity or not) is known
to the SBS Entity. The rules as proposed would limit the verification
of counterparty status obligations (proposed Rule 15Fh-3(a)),\128\ and
know your counterparty obligations (proposed Rule 15Fh-3(e)) to
transactions with
[[Page 29972]]
counterparties whose identity is known to the SBS Entity.\129\
---------------------------------------------------------------------------
\128\ See Section II.G.1, infra.
\129\ See Sections II.G.1 and II.G.3, infra.
---------------------------------------------------------------------------
2. Comments on the Proposal
The Commission received five comment letters that addressed the
exception for anonymous, exchange or SEF-traded security-based swaps in
the context of special entity-specific requirements,\130\ and four
comment letters that addressed more broadly the issue of an exception
for anonymous or SEF and exchange-traded security-based swaps.\131\ The
comment letters that address the exception in the context of the
special entity requirements are discussed infra in Sections II.H.8 and
II.H.9. The comment letters that address the broader issue of an
exception from business conduct requirements for anonymous or SEF and
exchange-traded security-based swaps are discussed below.
---------------------------------------------------------------------------
\130\ See ABC, supra note 5; CFA, supra note 5; SIFMA (August
2015), supra note 5; Better Markets (August 2011), supra note 5;
FIA/ISDA/SIFMA, supra note 5.
\131\ See SIFMA (August 2011), supra note 5; MFA, supra note 5;
BlackRock, supra note 5; SIFMA (August 2015), supra note 5
---------------------------------------------------------------------------
Two commenters asserted that, where a security-based swap is
cleared (through registered clearing organizations) and SEF or
exchange-traded, the transaction should not be subject to the
requirements of the proposed rules--regardless of whether the identity
of the counterparty is known at the time of execution.\132\ The
commenters argued that knowledge or identification of a counterparty's
identity should not compel compliance with the business conduct
standards.\133\ The commenters further argued that the concerns
addressed by business conduct standards were largely inapplicable to
security-based swaps entered into through registered SEFs, swap
execution facilities or registered national securities exchanges.\134\
The commenters asserted that compliance with the proposed rules would
result in delay, additional complexity, individual negotiation and
potentially less transparency, which the trading and clearing
requirements of the Dodd-Frank Act sought to avoid.\135\
---------------------------------------------------------------------------
\132\ See SIFMA (August 2011), supra note 5 (arguing that
parties to exchange-traded security-based swaps likely know the
identity of their counterparty before the transaction, either
because the exchange uses a request for quote system (where the
participants can seek quotes from specific counterparties) or a
single-dealer platform, or because information about the
counterparties to the trade is necessary to complete the execution
process); BlackRock, supra note 5.
\133\ See SIFMA (August 2011), supra note 5 (``mere
knowledge''); BlackRock, supra note 5 (``mere identification'').
\134\ See SIFMA (August 2011), supra note 5 (``largely
inapplicable''); BlackRock, supra note 5 (``simply will not be an
issue'').
\135\ See SIFMA (August 2011), supra note 5; BlackRock, supra
note 5.
---------------------------------------------------------------------------
However, one of the commenters acknowledged that some security-
based swaps executed on a SEF or exchange might be bilaterally
negotiated, and the SEF or exchange subsequently used to process the
trade, in which case it might be appropriate to apply the business
conduct standards.\136\
---------------------------------------------------------------------------
\136\ See BlackRock, supra note 5 (also noting that, conversely,
generally ``when a swap or a security-based swap is cleared and
exchange-traded, the counterparty to the trade should be viewed as
fungible, rendering compliance with the specific requirements of
[the proposed rules] unnecessary'').
---------------------------------------------------------------------------
After adoption of the CFTC's business conduct standards, one
commenter urged the Commission to adopt an exception for exchange-
traded security-based swaps that are intended to be cleared if: (1)(a)
The transaction is executed on a registered or exempt SEF or registered
national securities exchange; and (b) is of a type that is, as of the
date of execution, required to be cleared pursuant to Section 3C of the
Exchange Act; or (2) the SBS Entity does not know the identity of the
counterparty, at any time up to and including execution of the
transaction.\137\ The commenter argued that these changes would
harmonize the scope of the Commission's requirements with the scope of
the parallel requirements under the relief provided by CFTC No-Action
Letter 13-70.\138\ The commenter argued that the considerations on
which the CFTC staff based its no-action relief would also apply to the
security-based swap market, namely: ``(i) the impossibility or
impracticability of compliance with certain rules by a Swap Entity when
the identity of the counterparty is not known prior to execution; (ii)
the likelihood that swaps initiated anonymously on a designated
contract market or swap execution facility will be standardized and,
thus, information about the material risks and characteristics of such
swaps is likely to be available from the designated contract market or
swap execution facility or other widely available source (including the
product specifications of a derivatives clearing organization where the
swaps are accepted for clearing); and (iii) the likelihood that such
relief would provide an incentive to transact on designated contract
markets and swap execution facilities, thus enhancing transparency in
the swaps market.'' \139\
---------------------------------------------------------------------------
\137\ See SIFMA (August 2015), supra note 5.
\138\ Id. See Swaps Intended to Be Cleared, CFTC Letter No. 13-
70 (Nov. 15, 2013), available at http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/13-70.pdf.
\139\ Id.
---------------------------------------------------------------------------
3. Response to Comments and Final Rules
After considering the comments, the Commission has determined to
adopt two sets of exceptions from the business conduct requirements. As
discussed in Sections II.H.8 and II.H.9, infra, we are adopting
exceptions from the requirements of Rules 15Fh-4(b), 15Fh-5 and 15Fh-6
(collectively, ``special entity exceptions'') for anonymous
transactions executed on a registered national securities exchange or a
registered or exempt SEF, where the identity of the special entity is
not known to the SBS Entity at a reasonably sufficient time prior to
execution of the transaction to permit the SBS Entity to comply with
the obligations of the rule.\140\
---------------------------------------------------------------------------
\140\ See Rules 15Fh-4(b)(3)(ii), 15Fh-5(d)(2) and 15Fh-
6(b)(3)(iii). We have similarly modified the verification of special
entity counterparty status requirements in Rule 15Fh-3(a)(2), as
discussed infra in Section II.G.1.
---------------------------------------------------------------------------
In addition to the special entity exceptions, the Commission is
adopting a second set of exceptions that are not limited to
transactions with special entities, under which certain of the business
conduct standards rules will apply only where the SBS Entity knows the
identity of the counterparty at a reasonably sufficient time prior to
execution of the transaction to permit the SBS Entity to comply with
the obligations of the rule.\141\ These exceptions are intended to
address the impracticalities and potential business disruption that
could result if an SBS Entity were required to comply with the
disclosure requirements in Rule 15Fh-3(b) (requiring an SBS Entity to
disclose material risks and characteristics of a security-based swap
and material incentives or conflicts in connection with a security-
based swap, prior to entering into that security-based swap with a
counterparty) and Rule 15Fh-3(d) (requiring certain pre-transaction
disclosures to counterparties regarding clearing rights), before
learning the identity of its counterparty.\142\ By only applying these
rules' requirements to situations where the counterparty's identity is
known ``at a reasonably sufficient time prior to'' the execution of a
transaction, the rules' requirements are limited to situations where an
SBS
[[Page 29973]]
Entity has sufficient time before the execution of the transaction to
comply with its obligations under the rules. For this reason, we
decline to adopt language, suggested by a commenter, which would apply
the exception to circumstances where the identity of the counterparty
``is not known at any time up to and including execution of the
transaction.'' \143\
---------------------------------------------------------------------------
\141\ See ABC, supra note 5; FIA/ISDA/SIFMA, supra note 5.
\142\ As discussed in Section II.G.3, infra, we are adopting as
proposed the exception in Rule 15Fh-3(e), which limits SBS Dealers'
counterparty obligations under the rule to transactions with
``known'' counterparties.
\143\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
We are not, however, accepting the commenter's suggestion that we
revise our exceptions to provide an exception for transactions intended
to be cleared so long as the transaction is either executed on a
registered national securities exchange or registered or exempt SEF and
required to be cleared pursuant to Section 3C of the Exchange Act,
regardless of whether or not the transaction is anonymous.\144\
Similarly, we reject commenters' more general assertions that the
exceptions should apply to all SEF or exchange-traded transactions,
even where the identity of the counterparty is known,\145\ and that the
protections provided by the business conduct standards are unnecessary
for security-based swaps that are entered into through registered SEFs,
swap execution facilities or registered national securities
exchanges.\146\ The rules being adopted today are intended to provide
certain protections for counterparties, and we think it is appropriate
to apply the rules, to the extent practicable, so that counterparties
receive the benefits of those protections. We have determined not to
apply those rules where it may not be possible or practical to do so,
specifically where a transaction is executed on a registered exchange
or SEF and the identity of the counterparty is not known to the SBS
Entity at a reasonably sufficient time prior to execution of the
transaction to permit the SBS Entity to comply with the obligations of
the rule. However, where the identity of the counterparty is known in a
timely manner, we believe that it is appropriate to apply the rules so
that the counterparty receives the benefits of the protections provided
by the rules, including the assistance of an advisor or qualified
independent representative acting in the best interests of a
counterparty that is special entity.
---------------------------------------------------------------------------
\144\ Id.
\145\ See SIFMA (August 2011), supra note 5; BlackRock, supra
note 5.
\146\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
C. Application of the Rules to SBS Dealers and Major SBS Participants
1. Proposal
As noted in the Proposing Release, in general, where the Dodd-Frank
Act imposes a business conduct requirement on both SBS Dealers and
Major SBS Participants, we proposed rules that would apply to SBS
Dealers and Major SBS Participants.\147\ Where, however, a business
conduct requirement is not expressly addressed by the Dodd-Frank Act,
the proposed rules generally applied only to SBS Dealers.\148\ We
solicited comment on whether this approach was appropriate.
Specifically, where the Dodd-Frank Act requires that a business conduct
rule apply to all SBS Entities, we asked if the rule should impose the
same requirements on Major SBS Participants as on SBS Dealers, and
where we proposed rules for SBS Dealers that are not expressly
addressed by the Dodd-Frank Act, we asked if any of those rules should
also apply to Major SBS Participants.
---------------------------------------------------------------------------
\147\ See Proposing Release, 76 FR at 42400-42401, supra note 3.
\148\ As noted in the Proposing Release, there are exceptions to
this principle. We proposed that all SBS Entities be required to
determine if a counterparty is a special entity. In addition,
Section 3C(g)(5) of the Exchange Act creates certain rights with
respect to clearing for counterparties entering into security-based
swaps with SBS Entities but does not require disclosure. We proposed
a rule that would require an SBS Entity to disclose to a
counterparty certain information relating to these rights. See 15
U.S.C. 78c-3(g)(5); Proposing Release, 76 FR at 42401 n.39, supra
note 3.
---------------------------------------------------------------------------
2. Comments on the Proposal
Three commenters addressed the general application of the rules to
SBS Dealers and Major SBS Participants.\149\ One commenter agreed it
may be appropriate, ``in light of their somewhat different roles,'' to
adopt different approaches to rules governing SBS Dealers and Major SBS
Participants in certain areas.\150\ The commenter asserted that absent
an affirmative reason to adopt a different approach for SBS Dealers and
Major SBS Participants, the Commission should seek to promote
consistency and adopt uniformly strong rules.\151\ The commenter argued
that the determining factor should be whether Major SBS Participants
are likely to be engaged in conduct that would appropriately be
regulated under the relevant standard.\152\
---------------------------------------------------------------------------
\149\ See CFA, supra note 5; MFA, supra note 5; BlackRock, supra
note 5.
\150\ See CFA, supra note 5.
\151\ Id.
\152\ Id.
---------------------------------------------------------------------------
In contrast, another commenter urged the Commission to consider
separate regulatory regimes for SBS Dealers and Major SBS Participants,
arguing that they are different, and there are ``different reasons why
the Dodd-Frank Act requires additional oversight of each.'' \153\ The
commenter recommended that the Commission focus regulation of Major SBS
Participants on reducing default risk, and focus regulation of SBS
Dealers on market making and pricing and sales practices in addition to
reducing default risk.\154\ The commenter argued that to the extent
Major SBS Participants transact at arm's-length, they will not be
advising counterparties and therefore, neither fiduciary duties nor
``dealer-like obligations'' (regarding ``know your counterparty,''
suitability and ``pay-to-play'' restrictions, for example) should be
imposed on them.\155\
---------------------------------------------------------------------------
\153\ See MFA, supra note 5.
\154\ Id.
\155\ Id.
---------------------------------------------------------------------------
A third commenter generally supported our proposed approach in not
applying certain business conduct requirements to Major SBS
Participants where the Dodd-Frank Act does not expressly impose such
standards.\156\ In the alternative, if the Commission determines to
require Major SBS Participants to disclose ``material information'' and
to provide daily marks to their counterparties, the commenter asked
that we make these requirements inapplicable to transactions between a
Major SBS Participant and an SBS Dealer, and to allow all other parties
to opt out of receiving such disclosures in their dealings with a Major
SBS Participant.\157\
---------------------------------------------------------------------------
\156\ See BlackRock, supra note 5.
\157\ Id.
---------------------------------------------------------------------------
3. Response to Comments and Final Rules
After considering the comments, the Commission has determined to
apply the rules to SBS Dealers and Major SBS Participants as proposed.
To that end, as discussed below, where a statutory provision
encompasses both SBS Dealers and Major SBS Participants,\158\
[[Page 29974]]
we are adopting rules that would apply equally to SBS Dealers and Major
SBS Participants.\159\ We think this is important to ensure that
counterparties of Major SBS Participants, as well as counterparties of
SBS Dealers, receive the protections the rules are intended to provide.
For example, to the extent that Major SBS Participants may be better
informed about the risks and valuations of security-based swaps due to
information asymmetries, disclosures may help inform counterparties
concerning the material risks and characteristics of security-based
swaps, and material conflicts of interest of Major SBS Participants
entering into security-based swaps.\160\
---------------------------------------------------------------------------
\158\ See Section 15F(h)(1) (requiring SBS Dealers and Major SBS
Participants to conform to business conduct standards as prescribed
by Section 15F(h)(3) (regarding duty to verify counterparty status
as ECP, required pre-trade disclosures and ongoing daily mark
disclosures)); Section 15F(h)(1)(A) (requiring SBS Dealers and Major
SBS Participants to comply with standards as may be prescribed by
the Commission regarding fraud); Section 15F(h)(1)(B) (requiring SBS
Dealers and Major SBS Participants to comply with standards as may
be prescribed by the Commission regarding diligent supervision of
the business of the SBS Dealer or Major SBS Participant); Section
15F(h)(4)(A) (antifraud provisions applicable to both SBS Dealers
and Major SBS Participants); Section 15F(h)(5) (regarding special
requirements for SBS Dealers and Major SBS Participants that enter
into a security-based swap with a special entity); and Section
15F(k) (imposing CCO obligations).
\159\ See Rules 15Fh-3(a) (verification of counterparty status),
15Fh-3(b) (pre-trade disclosures), 15Fh-3(c) (daily mark), 15Fh-3(h)
(supervision), 15Fh-5 (special requirements for SBS Entities acting
as counterparties to special entities) and 15Fk-1 (CCO
requirements).
\160\ See discussion infra in Section VI.B.
---------------------------------------------------------------------------
Where, however, a business conduct requirement is not expressly
addressed by the Dodd-Frank Act or we read the statute to apply a
requirement only to SBS Dealers,\161\ the adopted rules generally would
not apply to Major SBS Participants.\162\ Thus, the obligations under
Rules 15Fh-3(e) (know your counterparty), 15Fh-3(f) (recommendations of
security-based swaps or trading strategies), 15Fh-4(b) (special
obligations when acting as an advisor to a special entity) and 15Fh-6
(pay to play rules) do not apply to a Major SBS Participant. In
addition, our rules provide exceptions to Major SBS Participants, as
discussed in Section II.G.2.a, from certain disclosure requirements
when entering into security-based swaps with an SBS Dealer, another
Major SBS Participant, a swap dealer or a swap participant.
---------------------------------------------------------------------------
\161\ See Section II.H.2 (regarding application of ``act as an
advisor'' obligations under Rule 15Fh-4(b) to SBS Dealers but not
Major SBS Participants).
\162\ As noted in the Proposing Release, there are exceptions to
this principle. Because an SBS Entity must comply with the
requirements of Rule 15Fh-5 if it is acting as a counterparty to a
special entity, the obligation to verify special entity status under
Rule 15Fh-3(a)(2) applies to all SBS Entities. See Section II.G.1.
In addition, Section 3C(g)(5) of the Exchange Act creates certain
rights with respect to clearing for counterparties entering into
security-based swaps with SBS Entities but does not require
disclosure. As discussed in Section II.G.2.f, infra, Rule 15Fh-3(d)
would require all SBS Entities to disclose to a counterparty certain
information relating to these clearing rights.
---------------------------------------------------------------------------
In determining whether or not to apply certain requirements to
Major SBS Participants, as explained in the Proposing Release, we have
considered how the differences between the definitions of SBS Dealer
and Major SBS Participant may be relevant in formulating the business
conduct standards applicable to these entities. The Dodd-Frank Act and
our rules define ``security-based swap dealer'' in a functional manner,
by reference to the way a person holds itself out in the market and the
nature of the conduct engaged in by that person, and how the market
perceives the person's activities.\163\ Unlike the definition of
``security-based swap dealer,'' which focuses on those persons whose
function is to serve as the points of connection in those markets, the
definition of ``major security-based swap participant'' focuses on the
market impacts and risks associated with an entity's security-based
swap positions.\164\ Despite the differences in focus, however, the
Dodd-Frank Act applies substantially the same statutory standards to
SBS Dealers and Major SBS Participants.\165\ We explained in the
Proposing Release that, in this way, the statute applies comprehensive
regulation to entities (i.e., Major SBS Participants) whose security-
based swap activities do not cause them to be dealers, but nonetheless
could pose a high degree of risk to the U.S. financial system
generally.
---------------------------------------------------------------------------
\163\ See Exchange Act Section 3(a)(71), 15 U.S.C. 78c(a)(71),
and Rule 3a-71, 17 CFR 240.3a71.
\164\ See Exchange Act Section 3(a)(67), 15 U.S.C. 78c(a)(67),
and Rule 3a-67, 17 CFR 240.3a67.
\165\ In particular, under Section 15F of the Exchange Act, SBS
Dealers and Major SBS Participants generally are subject to the same
types of margin, capital, business conduct and certain other
requirements, unless an exclusion applies. See 15 U.S.C. 78o-10.
---------------------------------------------------------------------------
We are mindful, as noted by a commenter, that there are ``different
reasons why the Dodd-Frank Act requires additional oversight of each.''
\166\ We have attempted to take into account these differing
definitions and regulatory concerns in considering whether the business
conduct requirements that we proposed, and that we are adopting, for
SBS Dealers should or should not apply to Major SBS Participants as
well. Accordingly, as noted, in general, where the Dodd-Frank Act
imposes a business conduct requirement on both SBS Dealers and Major
SBS Participants, the rules will apply equally to SBS Dealers and Major
SBS Participants, and where a business conduct requirement is not
expressly addressed by the Dodd-Frank Act, the rules generally will not
apply to Major SBS Participants. We believe this approach addresses the
concern of the commenter who argued that the determining factor should
be the conduct in which a Major SBS Participant is likely to be
engaged.\167\
---------------------------------------------------------------------------
\166\ See MFA, supra note 5.
\167\ See CFA, supra note 5.
---------------------------------------------------------------------------
The external business conduct requirements promulgated under
Section 15F(h) are intended to provide certain protections for
counterparties, and we believe the rules we are adopting today
appropriately apply those requirements to SBS Dealers and Major SBS
Participants so that counterparties receive the benefit of those
protections. At the same time, mindful of the different role to be
played by Major SBS Participants (which, by definition, are not SBS
Dealers), we have not sought to impose the full range of business
conduct requirements on Major SBS Participants. We note that our
approach in this regard largely mirrors that of the CFTC, under whose
rules Swap Dealers and Major Swap Participants have operated for some
time. We believe that this consistency will result in efficiencies for
entities that have already established infrastructure to comply with
the CFTC standard.
We proposed and are adopting limited exceptions (as discussed in
connection with the applicable rules) from the disclosure requirements
in Rules 15Fh-3(b), 15Fh-3(c) and 15Fh-3(d) for transactions with an
SBS Entity or a Swap Entity.\168\ We are not, however, adopting the
suggestion that we broaden the exceptions to permit other types of
counterparties to opt out of the disclosures and other protections
provided under the rules when entering into a transaction with a Major
SBS Participant. As noted above, the external business conduct
requirements promulgated under Section 15F(h) are intended to provide
certain protections for counterparties, and we believe the rules we are
adopting today appropriately tailor those requirements so that
counterparties receive the benefit of those protections.
---------------------------------------------------------------------------
\168\ See BlackRock, supra note 5.
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D. Reliance on Representations
1. Proposal
The Proposing Release solicited input on whether the rules adopted
by the Commission should include a standard addressing the
circumstances in which an SBS Entity may rely on representations to
establish compliance with the business conduct rules.\169\ We sought
comment on two alternative approaches.\170\ One approach would permit
an SBS Entity to rely on a representation from a counterparty
[[Page 29975]]
unless it knows that the representation is not accurate (``actual
knowledge standard'').\171\ The other would permit an SBS Entity to
rely on a representation unless the SBS Entity has information that
would cause a reasonable person to question the accuracy of the
representation (``reasonable person standard'').\172\ After the
Commission issued its proposed rules, the CFTC in its final rules
adopted a ``reasonable person standard'' that generally permits a Swap
Entity to rely on written representations to satisfy its due diligence
obligations unless it has information that would cause a reasonable
person to question the accuracy of the representation.\173\
---------------------------------------------------------------------------
\169\ See Proposing Release, 76 FR at 42404, supra note 3.
\170\ Id.
\171\ Id.
\172\ Id.
\173\ See CFTC Adopting Release, 77 FR at 9749, supra note 21.
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2. Comments on the Proposal
Twelve commenters generally addressed the proposed standards for
reliance on counterparty representations.\174\ With one exception,\175\
these comments predate the 2012 adoption of the CFTC rules.
---------------------------------------------------------------------------
\174\ See CCMR, supra note 5; FIA/ISDA/SIFMA, supra note 5;
APPA, supra note 5; BlackRock, supra note 5; SIFMA (August 2011),
supra note 5; ABC, supra note 5; ABA Committees, supra note 5; NABL,
supra note 5; Better Markets (August 2011), supra note 5; AFSCME,
supra note 5; CFA, supra note 5; SIFMA (August 2015), supra note 5.
\175\ See SIFMA (August 2015), supra note 5 (asking the
Commission to adopt a reasonable person standard consistent with the
standard under the parallel CFTC rules).
---------------------------------------------------------------------------
In 2011, seven commenters supported the actual knowledge
standard.\176\ One asserted its view that the actual knowledge standard
would offer greater legal certainty to SBS Entities when making
required subjective judgments under the rules (for example, judgments
regarding the qualifications of a special entity's independent
representative).\177\ Another commenter argued that the actual
knowledge standard is preferable because the reasonable person standard
would require an assessment of what a reasonable person would conclude
if such person had the same information as the SBS Entity, which could
cause uncertainty and additional cost for market participants.\178\
---------------------------------------------------------------------------
\176\ See FIA/ISDA/SIFMA, supra note 5; APPA, supra note 5;
BlackRock, supra note 5; SIFMA (August 2011), supra note 5; ABC,
supra note 5; ABA Committees, supra note 5; NABL, supra note 5.
\177\ See FIA/ISDA/SIFMA, supra note 5.
\178\ See NABL, supra note 5.
---------------------------------------------------------------------------
One commenter, writing after the CFTC rules were adopted, asked the
Commission to adopt a ``reasonable person standard'' that is
``consistent with the parallel CFTC EBC Rules,'' which generally permit
a Swap Entity to rely on written representations to satisfy its due
diligence obligations unless it has information that would cause a
reasonable person to question the accuracy of the representations.\179\
Additionally, two other commenters supported the reasonable person
standard in 2011.\180\ One commenter asserted that the reasonable
person standard would help to ensure that SBS Entities are acting on
reliable information because of the duty it would impose to verify the
accuracy of a representation if the SBS Entity had some reason to
question it.\181\ The commenter also argued that the reasonable person
standard would be easier to monitor and enforce because it would be
objective rather than subjective.\182\
---------------------------------------------------------------------------
\179\ See SIFMA (August 2015), supra note 5.
\180\ See Better Markets (August 2011), supra note 5; CCMR,
supra note 5. See also CFA, supra note 5 (opposing both proposed
standards but noting a preference for the reasonable person standard
over the actual knowledge standard).
\181\ See Better Markets (August 2011), supra note 5.
\182\ Id.
---------------------------------------------------------------------------
Some commenters suggested that the Commission require detailed
representations.\183\ One commenter asked the Commission to clarify
that, for purposes of ``red flags,'' the knowledge test should apply
only to individuals with knowledge of the security-based swap
transaction; information that may be available to other parts of the
SBS Entity organization should not be imputed to those
individuals.\184\ Another commenter requested that the Commission
clarify that any representations made by a special entity or its
representative to satisfy the rules do not give any party any
additional rights, such as rescission or monetary compensation (e.g.,
if the representations turn out to be incorrect).\185\ Additionally,
the commenter asserted that an SBS Dealer should be permitted to rely
on a single set of representations made by a special entity at the
beginning of a trading relationship, rather than requiring the SBS
Dealer to obtain a new representation with each transaction, if the
special entity represents that it will notify the SBS Dealer when the
representations become inaccurate.\186\
---------------------------------------------------------------------------
\183\ See AFSCME, supra note 5 (recommending requiring written
representations that are ``sufficiently detailed and informative to
permit reliance,'' and requiring SBS Entities to have a reasonable
basis for believing the representations to be true); CFA, supra note
5 (recommending requiring that the written representations be
sufficiently detailed to allow such an assessment).
\184\ See FIA/ISDA/SIFMA, supra note 5.
\185\ See ABC, supra note 5.
\186\ Id.
---------------------------------------------------------------------------
More generally, another commenter recommended allowing
representations to be contained in counterparty relationship
documentation if agreed to by the counterparties, and requiring
counterparties to undertake to update such representations with any
material changes.\187\ The commenter also suggested that an SBS Entity
that is also registered with the CFTC as a Swap Entity should be
permitted to rely on a counterparty's written representations with
respect to the CFTC's business conduct rules to satisfy its due
diligence requirements under the Commission's business conduct rules
provided that the SBS Entity provides notice of such reliance to the
counterparty and the counterparty does not object.\188\ The commenter
argued that this would speed implementation and lower costs without
reducing counterparty protections.\189\ Finally, the commenter
recommended including both a general reliance on representations
provision and also specific reliance on representations safe harbors in
the individual rules that specify what representations the SBS Entity
should obtain to satisfy the safe harbor.\190\
---------------------------------------------------------------------------
\187\ See SIFMA (August 2015), supra note 5.
\188\ Id. In a subsequent letter, the commenter explained that
there is a multilateral protocol that has been adopted by most
market participants as a means of complying with the CFTC rules. See
SIFMA (November 2015), supra note 5. The commenter noted that the
representations contained in this protocol only expressly address
market participants' trading in swaps, but asserted that ``the
factual matters addressed by those representations typically do not
vary as between trading in swaps and trading in [security-based
swaps]. As a result, requiring SBS Entities to obtain separate
representations specifically addressing [security-based swaps] would
impose additional costs with few, if any, additional benefits.'' Id.
\189\ SIFMA (November 2015), supra note 5.
\190\ Id.
---------------------------------------------------------------------------
3. Response to Comments and Final Rule
The Commission is adopting new Rule 15Fh-1(b), which provides that
an SBS Entity may rely on written representations to satisfy its due
diligence requirements under the business conduct rules unless it has
information that would cause a reasonable person to question the
accuracy of the representation. Under this standard, if an SBS Entity
has in its possession information that would cause a reasonable person
to question the accuracy of the representation, it will need to make
further reasonable inquiry to verify the accuracy of the
representation.\191\
---------------------------------------------------------------------------
\191\ See Proposing Release, 76 FR at 42404, supra note 3. As
described infra in Section II.G.0, Rule 15Fh-3(e) will require an
SBS Dealer to have policies and procedures reasonably designed to
obtain and retain certain essential facts regarding a known
counterparty. As a result, information in the SBS Entity's
possession will include information gathered by an SBS Dealer
through compliance with the ``know your counterparty'' provisions of
Rule 15Fh-3(e), as well as any other information the SBS Entity has
acquired through its interactions with the counterparty, including
other representations obtained from the counterparty by the SBS
Entity.
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[[Page 29976]]
We understand that this is a market in which parties rely heavily
on representations both with respect to relationship documentation and
the transactions themselves. While both standards we proposed for
comment could be workable in this context, we recognize that neither
provides the absolute certainty sought by some commenters. As we
explained in the Proposing Release, under either approach an SBS Entity
could not ignore information in its possession as a result of which the
SBS Entity would know that a representation is inaccurate.\192\ Under
an ``actual knowledge'' standard, however, an SBS Entity can rely on a
representation unless it knows that the representation is inaccurate.
This alternative could allow SBS Entities to rely on questionable
representations insofar as they do not have actual knowledge that the
representation is inaccurate, even if they have information that would
cause reasonable persons to question their accuracy. As a result, this
alternative could potentially reduce the benefits of the verification
of status, know your counterparty, suitability and special entity
requirements and result in weaker protections for counterparties to SBS
Entities. In contrast, the ``reasonable person'' standard under the
rule as adopted should help ensure that SBS Entities do not disregard
facts that call into question the validity of the representation.\193\
---------------------------------------------------------------------------
\192\ See Proposing Release, 76 FR at 42404, supra note 3.
\193\ Cf. Exchange Act Rule 3a71-3(4) (permitting reliance on a
counterparty representation unless the party seeking to rely on the
representation ``knows or has reason to know that the representation
is not accurate; . . . a person would have reason to know that the
representation is not accurate if a reasonable person should know,
under all of the facts of which the person is aware, that it is not
accurate''). See also Application of ``Security-Based Swap Dealer''
and ``Major Security-Based Swap Participant'' Definitions to Cross-
Border Security-Based Swap Activities; Final Rule; Republication,
Exchange Act Release No. 72472 (Jun. 25, 2014), 79 FR 47277, 47313
(Aug. 12, 2014 (republication)) (``Cross-Border Adopting Release'')
(noting that ``this `known or have reason to know' standard should
help ensure that potential [SBS Entities] do not disregard facts
that call into question the validity of the representation'').
---------------------------------------------------------------------------
Further, this standard also is consistent with the standard adopted
by the CFTC under which a Swap Entity cannot rely on a representation
if the Swap Entity has information that would cause a reasonable person
to question the accuracy of the representation.\194\ This consistency
will result in efficiencies for entities that have already established
infrastructure to comply with the CFTC standard.
---------------------------------------------------------------------------
\194\ See CFTC Adopting Release, 77 FR at 9749, supra note 21.
---------------------------------------------------------------------------
The rule as adopted would permit an SBS Entity to reasonably rely
on the representations of a counterparty or its representative to
satisfy its due diligence obligations under the business conduct rules,
including Rules 15Fh-2(a) and (d), 15Fh-3(a), (e) and (f), 15Fh-4 and
15Fh-5. We are not requiring a specified level of detail for these
representations but note that they should be detailed enough to permit
the SBS Entity to form a reasonable basis for believing that the
applicable requirement is satisfied.\195\
---------------------------------------------------------------------------
\195\ See AFSCME, supra note 5 (recommending requiring written
representations that are ``sufficiently detailed and informative to
permit reliance,'' and requiring SBS Entities to have a reasonable
basis for believing the representations to be true); CFA, supra note
5 (recommending requiring that the written representations be
sufficiently detailed to allow such an assessment).
---------------------------------------------------------------------------
Nothing in our rules would prohibit an arrangement under which the
parties agree that representations will be provided in counterparty
relationship documentation, and that they will update such
representations with any material changes, as suggested by
commenters.\196\
---------------------------------------------------------------------------
\196\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (August 2015),
supra note 5.
---------------------------------------------------------------------------
We are not accepting the commenter's suggestion that we provide
that in every instance an SBS Entity that is also registered with the
CFTC as a Swap Entity will be permitted to rely on a counterparty's
pre-existing written representations with respect to the CFTC's
business conduct rules to satisfy its due diligence requirements under
the Commission's business conduct rules, provided that the SBS Entity
provides notice of such reliance to the counterparty and the
counterparty does not object.\197\ Rule 15Fh-1(b) as adopted sets out
the standard pursuant to which an SBS Entity can rely on
representations to satisfy its due diligence obligations, and does not
speak to the process the SBS Entity will need to undertake to meet the
standard. The question of whether reliance on the representations that
had been obtained with respect to the CFTC business conduct rules,
including the process by which the SBS Entity makes that determination,
would satisfy an SBS Entity's obligations under our business conduct
rules will depend on the facts and circumstances of the particular
matter.\198\
---------------------------------------------------------------------------
\197\ Id. In a subsequent letter, the commenter explained that
there is a multilateral protocol that has been adopted by most
market participants as a means of complying with the CFTC rules. See
SIFMA (November 2015), supra note 5. The commenter noted that the
representations contained in this protocol only expressly address
market participants' trading in swaps, but asserted that ``the
factual matters addressed by those representations typically do not
vary as between trading in swaps and trading in [security-based
swaps]. As a result, requiring SBS Entities to obtain separate
representations specifically addressing [security-based swaps] would
impose additional costs with few, if any, additional benefits.'' Id.
\198\ See SIFMA (August 2015), supra note 5; SIFMA (November
2015), supra note 5.
---------------------------------------------------------------------------
We are not adopting the suggestion of one commenter that ``the
knowledge test should be applied only to individuals with knowledge of
the SBS transaction.'' \199\ In some instances it may be appropriate to
look only to the knowledge of persons involved in a security-based swap
transaction for purposes of determining whether an SBS Entity
reasonably relied on representations. However, the determination
whether to impute to the individuals that are involved in a securities-
based swap transaction knowledge that may be available in other parts
of the SBS Entity will depend on the facts and circumstances of the
particular matter. At a minimum, an SBS Entity seeking to rely on
representations cannot ignore information that would cause a reasonable
person to question the accuracy of those representations.
---------------------------------------------------------------------------
\199\ See FIA/ISDA/SIFMA, supra note 5 (arguing that information
that may be available to other parts of the SBS Entity organization
should not be imputed to those individuals involved in the SBS
transaction).
---------------------------------------------------------------------------
E. Policies and Procedures Alternative
1. Proposal
The Commission solicited comment on whether an SBS Entity should be
deemed to have complied with a requirement under the proposed rules if
it has: (1) Established and maintained written policies and procedures,
and a documented system for applying those policies and procedures,
that are reasonably designed to achieve compliance with the
requirement; and (2) reasonably discharged the duties and obligations
required by the written policies and procedures and documented system,
and did not have a reasonable basis to believe that the written
policies and procedures and documented system were not being
followed.\200\
---------------------------------------------------------------------------
\200\ See Proposing Release, 76 FR at 42402, supra note 3.
---------------------------------------------------------------------------
[[Page 29977]]
2. Comments on the Proposal
One commenter addressed the policies and procedures
alternative.\201\ The commenter opposed the alternative, arguing that
it would reward the process of achieving compliance more than actually
achieving compliance.\202\ However, the commenter asserted that SBS
Entities should be required to establish, maintain, document and
enforce appropriate policies and procedures, and that the Commission
should take them into account when determining the sanctions for
violations.\203\ The commenter argued that the requirement regarding
policies and procedures should supplement the requirements or
prohibitions in the rules, not supplant them.\204\
---------------------------------------------------------------------------
\201\ See CFA, supra note 5.
\202\ Id.
\203\ Id.
\204\ Id.
---------------------------------------------------------------------------
3. Response to Comments and Final Rule
After taking into consideration the comment, the Commission is not
adopting a general policies and procedures safe harbor. The Commission
acknowledges the importance of policies and procedures as a tool to
achieving compliance with applicable regulatory and other requirements
but agrees with the commenter that a general policies and procedures
safe harbor could have the unintended effect of rewarding the process
towards achieving compliance more than the result of actually achieving
compliance.\205\
---------------------------------------------------------------------------
\205\ See CFA, supra note 5.
---------------------------------------------------------------------------
As discussed more fully herein, Rule 15Fh-3(h) requires that an SBS
Entity establish, maintain and enforce written policies and procedures
that are reasonably designed to prevent violations of applicable
securities laws, and rules and regulations thereunder. Rule 15Fh-3(h)
also provides an affirmative defense to a charge of failure to
supervise diligently based, in part, on the establishment and
maintenance of these policies and procedures, where the entity has
reasonably discharged the duties and obligations required by the
written policies and procedures and documented system, and did not have
a reasonable basis to believe that the written policies and procedures
and documented system were not being followed. In addition, consistent
with the approach of the CFTC, we are providing targeted
representations-based safe harbors,\206\ which should result in
efficiencies for entities that have already established infrastructure
to comply with the CFTC rules.
---------------------------------------------------------------------------
\206\ See, e.g., Rule 15Fh-3(f)(3), discussed in Section II.G.3,
infra, under which an SBS Dealer can generally satisfy its
obligations by obtaining representations with respect to certain
suitability requirements, and Rule 15Fh-5(b), discussed in Section
II.H.6, infra, under which an SBS Entity can generally satisfy its
obligations with respect to having a reasonable basis to believe
that a special entity counterparty has a qualified independent
representative.
---------------------------------------------------------------------------
F. Definitions
1. Proposed Rule
Proposed Rules 15Fh-2(a), (c), (e) and (f), which would define
``act as an advisor to a special entity,'' ``independent representative
of a special entity,'' ``special entity,'' and ``subject to a statutory
disqualification,'' respectively are discussed in Section II.H below in
the context of the special entity requirements.
Proposed Rule 15Fh-2(b) would define ``eligible contract
participant'' to mean any person defined in Section 3(a)(66) of the
Exchange Act.
Proposed Rule 15Fh-2(d) would provide that ``security-based swap
dealer or major security-based swap participant'' would include, where
relevant, an associated person of the SBS Dealer or Major SBS
Participant.
2. Comments on the Proposed Rule
a. Definitions Relating to the Rules Applicable to Dealings With
Special Entities
Comments on paragraphs (a), (c), (e) and (f) of proposed Rule 15Fh-
2 defining ``act as an advisor,'' ``independent representative of a
special entity,'' ``special entity'' and ``subject to a statutory
disqualification,'' respectively are addressed below in Section II.H.
b. Eligible Contract Participant
One commenter addressed proposed Rule 15Fh-2(b) defining ``eligible
contract participant.'' \207\ The commenter pointed out an error in the
cross-reference in the rule to the Exchange Act definition and
recommended adding a reference to applicable rules and interpretations
of the Commission and the CFTC.\208\
---------------------------------------------------------------------------
\207\ See SIFMA (August 2015), supra note 5.
\208\ Id.
---------------------------------------------------------------------------
c. SBS Dealer or Major SBS Participant
Three commenters addressed proposed Rule 15Fh-2(d) defining SBS
Dealer or Major SBS Participant.\209\ Two commenters suggested that the
Commission adopt a broader definition that would apply the business
conduct rules to any person acting on behalf of the SBS Entity,
including an associated person, consistent with the CFTC business
conduct rules.\210\ One commenter asserted that this would prevent SBS
Entities from ``evad[ing] the business conduct rules by doing through
third parties what they would not be permitted to do directly.'' \211\
The commenter also discouraged the Commission from seeking to identify
all of the requirements that would apply to an associated person of an
SBS Entity, suggesting that the rules should apply in any circumstance
where an SBS Entity acts through or by means of an associated person or
other party.\212\
---------------------------------------------------------------------------
\209\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5; SIFMA
(August 2015), supra note 5.
\210\ See CFA, supra note 5; SIFMA (August 2015), supra note 5.
\211\ See CFA, supra note 5.
\212\ Id.
---------------------------------------------------------------------------
A third commenter recommended that the Commission clarify that
associated persons of an SBS Entity should only be directly responsible
for complying with the disclosure rules and rules involving
interactions with counterparties, and should not be responsible for
complying with internal business conduct standards, such as the rules
relating to supervision and requiring designation of a CCO.\213\ The
commenter also suggested that the Commission define ``associated
person'' as ``an associated person of an [SBS Dealer] or [Major SBS
Participant] through whom the [SBS Dealer] or [Major SBS Participant]
acts.'' \214\
---------------------------------------------------------------------------
\213\ See FIA/ISDA/SIFMA, supra note 5.
\214\ Id.
---------------------------------------------------------------------------
3. Response to Comments and Final Rule
The Commission is moving the definition of ``independent
representative of a special entity'' from Rule 15Fh-2 to Rule 15Fh-5
and accordingly, re-designating paragraphs (d) through (f) of Rule
15Fh-2 as paragraphs (c) through (e). The definition of ``independent
representative of a special entity'' and paragraphs (a), (d) and (e) of
Rule 15Fh-2 (defining ``act as an advisor,'' ``special entity'' and
``subject to a statutory disqualification,'' respectively) are
addressed below in Section II.H.
The Commission is adopting Rule 15Fh-2(b) with two modifications.
In response to a suggestion from a commenter,\215\ the Commission is
correcting a typographical error in the cross-reference to the Exchange
Act definition of ``eligible contract participant'' in the proposed
rule. The proposed rule referenced ``Section 3(a)(66)'' of the Exchange
Act, but should have referenced Section 3(a)(65) of the Exchange Act,
which defines an
[[Page 29978]]
eligible contract participant. Section 3(a)(65) of the Exchange Act, in
turn, provides that the term eligible contract participant ``has the
same meaning as in section 1a of the Commodity Exchange Act.'' We have
also revised the definition in response to the same commenter's request
that we add a reference to applicable rules and interpretations of the
Commission and the CFTC to incorporate the joint SEC-CFTC rulemaking
adopted in May 2012.\216\ In this regard, we note that the Commission
and the CFTC jointly further defined the term eligible contract
participant by adopting rules and regulations under the Commodity
Exchange Act.\217\ Thus, as adopted, the definition of ``eligible
contract participant'' in Rule 15Fh-2(b) refers to: ``any person as
defined in Section 3(a)(65) of the Act and the rules and regulations
thereunder and in Section 1a of the Commodity Exchange Act and the
rules and regulations thereunder.''
---------------------------------------------------------------------------
\215\ See SIFMA (August 2015), supra note 5.
\216\ Section 712(d)(1)(A) of the Dodd-Frank Act provides, among
other things, that the CFTC and the Commission, in consultation with
the Board of Governors, shall further define the term ``eligible
contract participant.'' Public Law 111-203, 124 Stat. 1376 (2010).
Moreover, Section 712(d)(4) provides that any interpretation of, or
guidance by either Commission regarding, a provision of Title VII of
the Dodd Frank Act shall be effective only if issued jointly by the
CFTC and the Commission, after consultation with the Board of
Governors, if this title requires the Commissions to issue joint
regulations to implement the provision. Id.
\217\ See Definitions Adopting Release, supra note 115.
---------------------------------------------------------------------------
After considering the comments, the Commission is adopting Rule
15Fh-2(d) as proposed, re-designated as Rule 15Fh-2(c). The statute
defines the term ``associated person of a security-based swap dealer or
major security-based swap participant'' to include ``any person
directly or indirectly controlling, controlled by, or under common
control with'' an SBS Dealer or Major SBS Participant.\218\ While the
SBS Entity remains ultimately responsible for compliance with the
business conduct standards, to the extent that an SBS Entity acts
through, or by means of, an associated person of that SBS Entity, the
associated person must comply as well with the applicable business
conduct standards.
---------------------------------------------------------------------------
\218\ Section 3(a)(70)(A)(ii) of the Exchange Act, 15 U.S.C.
78c(a)(70)(A)(ii).
---------------------------------------------------------------------------
The Commission declines to modify the definition, as requested by
some commenters, to apply to persons acting on behalf of the SBS
Entity.\219\ We believe it unnecessary to expand the definition
because, as noted above, the SBS Entity remains ultimately responsible
for compliance with the business conduct standards, whether the SBS
Entity is acting through, or by means of, an associated person or other
person.
---------------------------------------------------------------------------
\219\ See CFA, supra note 5; SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
In response to the commenter that raised concerns that associated
persons should not be responsible for complying with ``internal''
business conduct standards,\220\ the Commission notes that Rule 15Fh-
2(c) provides that the definition of an SBS Entity includes associated
persons of the SBS Entity ``where relevant.'' Certain rules, including
the so-called ``internal'' business conduct rules (e.g., Rule 15Fh-3(h)
(supervision) and Rule 15Fk-1 (designation of CCO)) may apply to some
but not all associated persons of an SBS Entity, and the registrant
remains ultimately responsible for compliance with all of the business
conduct rules that are the subject of this rulemaking.
---------------------------------------------------------------------------
\220\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
G. Business Conduct Requirements
1. Counterparty Status
a. Proposed Rule
Section 15F(h)(3)(A) of the Exchange Act directs that business
conduct requirements adopted by the Commission shall establish a duty
for an SBS Entity to verify that any counterparty meets the eligibility
standards for an ECP.\221\
---------------------------------------------------------------------------
\221\ 15 U.S.C. 78o-10(h)(3)(A).
---------------------------------------------------------------------------
Proposed Rule 15Fh-3(a)(1) would require an SBS Entity to verify
that a counterparty whose identity is known to an SBS Entity prior to
the execution of the transaction meets the eligibility standards for an
ECP, before entering into a security-based swap with that counterparty
other than on a registered national securities exchange or SEF.\222\
Proposed Rule 15Fh-3(a)(2) would require an SBS Entity to verify
whether a counterparty whose identity is known to the SBS Entity prior
to the execution of the transaction is a special entity before entering
into a security-based swap with that counterparty, no matter where the
transaction is executed.\223\
---------------------------------------------------------------------------
\222\ Proposed Rule 15Fh-3(a)(1). See Section 6(l) of the
Exchange Act (making it unlawful to effect a security-based swap
transaction with or for a person that is not an ECP unless such
transaction is effected on a registered national securities
exchange). See also Section 5(e) of the Securities Act of 1933, 15
U.S.C. 77e(e)) (``unless a registration statement meeting the
requirements of section 10(a) [of the Securities Act] is in effect
as to a security-based swap, it shall be unlawful for any person . .
. to offer to sell, offer to buy or purchase or sell a security-
based swap to any person who is not an eligible contract
participant''). See also Registration and Regulation of Security-
Based Swap Execution Facilities, Exchange Act Release No. 63825
(Feb. 2, 2011), 76 FR 10948 (Feb. 28, 2011) (``SEF Registration
Proposing Release'') (proposed Rule 809 would limit SEF
participation to registered SBS Dealers, Major SBS Participants,
brokers and ECPs).
\223\ Proposed Rule 15Fh-3(a)(2). See generally Section
15F(h)(1)(D) of the Exchange Act, 15 U.S.C. 78o-10(h)(1)(D)
(authorizing the Commission to prescribe business conduct standards
that relate to ``such other matters as the Commission determines to
be appropriate'').
---------------------------------------------------------------------------
b. Comments on the Proposed Rule
Three commenters addressed proposed Rule 15Fh-3(a).\224\ One
opposed limiting the application of the rule to known counterparties,
noting that this would invite SBS Entities to promote anonymous off-
exchange transactions that would allow them to avoid obligations
otherwise owed to special entities.\225\ The commenter asserted that
the only exemption from the verification requirement should be for
transactions on a registered exchange or SEF, and that for such
transactions, if the SBS Entity knows the identity of the counterparty
prior to the transaction and has reason to believe it may not be an
ECP, the SBS Entity should be required to undertake an additional
inquiry to verify the counterparty's status.\226\ The commenter also
recommended that verification take place before the SBS Entity offers
to enter into a transaction, rather than before execution.\227\
---------------------------------------------------------------------------
\224\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5; SIFMA
(August 2015), supra note 5.
\225\ See CFA, supra note 5.
\226\ Id. The commenter also recommended that the Commission
conform to the CFTC's then-pending proposal, which would have
required counterparty status verification in any transaction other
than anonymous transactions on a swap execution facility. We note,
however, that the CFTC subsequently adopted a rule that clarified
that the exemption from verification applies to all transactions on
a designated contract market (``DCM'') and to anonymous transactions
on a swap execution facility. See CFTC Adopting Release, 77 FR at
9757, supra note 21.
\227\ See CFA, supra note 5.
---------------------------------------------------------------------------
Two commenters recommended that the exception for transactions on a
registered exchange or SEF be broadened to apply to the verification of
special entity status in addition to the verification of ECP
status.\228\ One commenter also recommended expanding the exception to
include exempt SEFs, such as a foreign SEF that the Commission
determines to be subject to a comparable home country regime.\229\
Additionally, as part of a series of recommendations to harmonize with
the CFTC's treatment of employee benefit plans defined in Section 3 of
ERISA, the commenter suggested requiring an SBS Entity to verify
whether a counterparty is eligible to
[[Page 29979]]
elect to be a special entity, and if so, to notify such
counterparty.\230\
---------------------------------------------------------------------------
\228\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (August 2015),
supra note 5.
\229\ SIFMA (August 2015), supra note 5.
\230\ Id. See also discussion in Section III.H.1, infra.
---------------------------------------------------------------------------
The other commenter also recommended further narrowing the
application of the rule by excluding transactions in which the identity
of the counterparty is known just prior to execution, arguing that an
SBS Entity would have insufficient time to exchange representations
with the counterparty or otherwise verify the counterparty's status in
those situations.\231\ Alternatively, the commenter requested that the
Commission require SEFs to adopt rules that would permit verification
of the counterparty's status.\232\ The commenter also opposed
establishing specific documentation requirements regarding counterparty
status, asserting that it would not allow for flexible risk management
and investment decisions through private contractual negotiation.\233\
---------------------------------------------------------------------------
\231\ FIA/ISDA/SIFMA, supra note 5.
\232\ Id.
\233\ Id.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(a) with certain modifications.
Rule 15Fh-3(a)(1), as adopted, requires an SBS Entity to verify the
ECP status of a counterparty before entering into a security-based swap
with that counterparty other than a transaction executed on a
registered national securities exchange. We are not adopting the
further provision of the proposed rule that would have limited the
application of the verification requirement to a counterparty ``whose
identity is known to the SBS Entity prior to the execution of the
transaction.'' We also are not adopting the provision of the proposed
rule that would have provided that the verification requirement does
not apply to transactions executed on a SEF. These changes reflect the
Commission's further consideration of the regulatory framework provided
by the Dodd-Frank Act.
In particular, Section 6(l) of the Exchange Act makes it unlawful
to effect a transaction in a security-based swap with or for a person
that is not an ECP, unless the transaction is effected on a registered
national securities exchange.\234\ Section 6(l) of the Exchange Act
does not provide an exception for transactions effected on SEFs, or for
transactions where the identity of a counterparty is not known to the
SBS Entity prior to the execution of the transaction. Thus, upon
further consideration of the proposed rule in the context of the
statute, we are not providing an exception for transactions executed
other than on a registered national securities exchange, and we are not
limiting the requirement to known counterparties because Section 6(l)
of the Exchange Act does not contain a similar exception or limitation,
and we do not wish to suggest to SBS Entities that Section 6(l) is
similarly limited. In this regard, we note that, even with these
modifications, the scope of Section 6(l) of the Exchange Act
(``unlawful to effect a transaction in a security-based swap'') is
broader than the activity covered by Rule 15Fh-3(a)(1) (``before
entering into a security-based swap''), and that SBS Entities, and
other market participants, have an independent obligation under Section
6(l) for any action covered by that section.\235\
---------------------------------------------------------------------------
\234\ See Proposing Release, 76 FR at 42403, supra note 5. 15
U.S.C. 78f(l) (``[i]t shall be unlawful for any person to effect a
transaction in a security-based swap with or for a person that is
not an eligible contract participant, unless such transaction is
effected on a [registered] national securities exchange'').
\235\ See also Section 5(e) of the Securities Act, 15 U.S.C.
77e(e) (``unless a registration statement meeting the requirements
of [section 10(a) of the Securities Act] is in effect as to a
security-based swap, it shall be unlawful for any person . . . to
offer to sell, offer to buy or purchase or sell a security-based
swap to any person who is not an eligible contract participant'').
This rulemaking does not address and has no applicability with
respect to the requirements under the Securities Act applicable to
security-based swap transactions.
---------------------------------------------------------------------------
As noted in the Proposing Release, an SBS Entity that has complied
with the requirements of Rule 15Fh-3(a)(1) concerning a counterparty's
eligibility to enter into a particular security-based swap fulfills its
obligations under the rule for that security-based swap, even if the
counterparty subsequently ceases to meet the eligibility standards for
an ECP during the term of that security-based swap.\236\ However, an
SBS Entity will need to verify the counterparty's status for any
subsequent action covered by Rule 15Fh-3(a)(1), (which it could do by
relying on written representations from the counterparty, as described
above). An SBS Entity could satisfy this obligation by relying on a
representation in a master or other agreement that is renewed or
``brought down'' as of the date of the subsequent action covered by
15Fh-3(a)(1). In this manner, counterparties will be able to make
representations about their status at the outset of a relationship, and
can undertake to ``bring down'' that representation for each relevant
action involving a security-based swap. In addition, as noted above,
market participants have an independent obligation under Section 6(l)
of the Exchange Act for any action covered by that section.
---------------------------------------------------------------------------
\236\ See Proposing Release, 76 FR at 42404, supra note 5.
---------------------------------------------------------------------------
Rule 15Fh-3(a)(2), as adopted, requires an SBS Entity to verify
whether a counterparty is a special entity before entering into a
security-based swap transaction with that counterparty, unless the
transaction is executed on a registered or exempt SEF or registered
national securities exchange and the SBS Entity does not know the
identity of the counterparty at a reasonably sufficient time prior to
execution of the transaction to permit the SBS Entity to comply with
the obligations of the rule. The rule as proposed would have limited
the verification of special entity status to counterparties whose
identity is known to the SBS Entity prior to the execution of the
security-based swap transaction. Because the question of special entity
status figures most significantly in connection with the application of
the special entity rules (Rules 15Fh-4, 15Fh-5 and 15Fh-6), we have
modified the special entity verification rule to track the exceptions
to those rules.\237\ Accordingly, the verification of special entity
status requirements will not apply where the transaction is executed on
a registered or exempt SEF or registered national securities exchange,
and the SBS Entity does not know the identity of the counterparty at a
reasonably sufficient time prior to execution of the transaction to
permit the SBS Entity to comply with the obligations of the rule.
---------------------------------------------------------------------------
\237\ See Section II.B.
---------------------------------------------------------------------------
An SBS Entity that has complied with the requirements of Rule 15Fh-
3(a)(2) concerning verification whether a counterparty is a special
entity before entering into a particular security-based swap with that
counterparty fulfills its obligations under the rule for that security-
based swap.\238\ However, an SBS Entity will need to verify the
counterparty's status for any subsequent action covered by Rule 15Fh-
3(a)(2) (which it could do by relying on written representations from
the counterparty, as described above). An SBS Entity could satisfy this
obligation by relying on a representation in a master or other
agreement that is renewed or ``brought down'' as of the date of the
subsequent action covered by 15Fh-3(a)(2). In this manner,
counterparties will be able to make representations about their status
at the outset of a relationship, and can undertake to ``bring down''
that
[[Page 29980]]
representation for each relevant action involving a security-based
swap.
---------------------------------------------------------------------------
\238\ See Proposing Release, 76 FR at 42404, supra note 5.
---------------------------------------------------------------------------
Additionally, the Commission is adding a new paragraph (a)(3),
special entity election, which requires an SBS Entity, in verifying the
special entity status of a counterparty pursuant to Rule 15Fh-3(a)(2),
to verify whether a counterparty is eligible to elect not to be a
special entity as provided for in the adopted special entity definition
in Rule 15Fh-2(d)(4), and if so, notify such counterparty. This change
is intended to provide the greatest protections to the broadest
categories of special entities, while still allowing them the
flexibility to elect not to avail themselves of special entity
protections.\239\
---------------------------------------------------------------------------
\239\ As explained in Section II.H.1, we are interpreting the
definition of ``special entity'' to distinguish entities that are
``defined in'' section 3 of ERISA but not ``subject to'' regulation
under Title I of ERISA. Our rules as adopted would include within
the ``special entity'' definition entities such as church plans and
plans maintained solely for the purpose of complying with applicable
workmen's compensation laws, unemployment compensation, or
disability insurance laws but allow them to elect not to be treated
as ``special entities.''
---------------------------------------------------------------------------
Although the Dodd-Frank Act does not specifically require an SBS
Entity to verify whether a counterparty is a special entity or is
eligible to elect not to be a special entity, the Commission believes
that such verification will help to ensure the proper application of
the business conduct rules that apply to SBS Entities dealing with
special entities.\240\
---------------------------------------------------------------------------
\240\ See Section II.H, infra.
---------------------------------------------------------------------------
The Commission is not revising the rule, as suggested by a
commenter,\241\ to require that verification of special entity
counterparty status take place before an SBS Entity ``offers'' to enter
into a transaction. We agree with the commenter that it is important
for an SBS Entity to verify special entity status ``as soon as possible
. . . to ensure timely compliance with the other obligations that
accompany transactions with these entities.'' As explained in Section
II.A, when the rules refer to a ``counterparty'' of the SBS Entity, the
term ``counterparty'' includes a potential counterparty where
compliance with the obligation is required before the SBS Entity and
the ``counterparty'' have actually entered into the security-based
swap.
---------------------------------------------------------------------------
\241\ See CFA, supra note 5.
---------------------------------------------------------------------------
The Commission is not specifying the manner of documentation or
procedures required for compliance with Rule 15Fh-3(a).\242\ Among
other things, an SBS Entity could rely on representations in accordance
with Rule 15Fh-1(b). For example, an SBS Entity could verify that a
counterparty is an ECP by obtaining a written representation from the
counterparty as to specific facts about the counterparty (e.g., that it
has $100 million in assets) to conclude that the counterparty is an
ECP, unless the SBS Entity has information that would cause a
reasonable person to question the accuracy of the representation.
Similarly, an SBS Entity could seek to verify that a counterparty is
not a special entity by obtaining a written representation from the
counterparty that it does not fall within any of the enumerated
categories of persons that are ``special entities'' for purposes of
Section 15F of the Exchange Act. The SBS Entity also could seek to
obtain a representation in writing from the counterparty if it elects
not to be a special entity, as provided for in the special entity
definition in Rule 15Fh-2(d)(4). Consistent with Rule 15Fh-1(b),
however, an SBS Entity cannot disregard information that would cause a
reasonable person to question the accuracy of the representation.
---------------------------------------------------------------------------
\242\ See Proposing Release, 76 FR at 42403, supra note 3. The
Commission separately has proposed rules regarding recordkeeping and
reporting requirements for SBS Entities that would require an SBS
Entity to keep records of its verification. See Recordkeeping and
Reporting Requirements for Security-Based Swap Dealers, Major
Security-Based Swap Participants, and Broker-Dealers; Capital Rule
for Certain Security-Based Swap Dealers, Exchange Act Release No.
71958 (Apr. 17, 2014), 79 FR 25193, 25208 and 25217-25218 (May 2,
2014) (``Recordkeeping Release'') (proposed Rules 18a-5(a)(17) and
18a-5(b)(13)).
---------------------------------------------------------------------------
2. Disclosure
Section 15F(h)(3)(B) of the Exchange Act broadly requires that
business conduct requirements adopted by the Commission require
disclosures by SBS Entities to counterparties of information related to
``material risks and characteristics'' of the security-based swap,
``material incentives or conflicts of interest'' that an SBS Entity may
have in connection with the security-based swap, and the ``daily mark''
of a security-based swap.\243\
---------------------------------------------------------------------------
\243\ 15 U.S.C. 78o-10(h)(3)(B).
---------------------------------------------------------------------------
a. Disclosure Not Required When the Counterparty is an SBS Entity or a
Swap Entity
i. Proposed Rules
Section 15F(h)(3)(B) provides that disclosures under that section
are not required when the counterparty is ``a security-based swap
dealer, major security-based swap participant, security-based swap
dealer, or major security-based swap participant.'' \244\ As explained
in the Proposing Release, the Commission believes that the repetition
of the terms ``security-based swap dealer and major security-based swap
participant'' in this Exchange Act provision is a drafting error, and
that Congress instead intended an exclusion identical to that found in
the Commodity Exchange Act, which provides that these general
disclosures are not required when the counterparty is ``a swap dealer,
major swap participant, security-based swap dealer, or major security-
based swap participant.'' \245\ Accordingly, proposed Rule 15Fh-3(b)
(information about material risks and characteristics, and material
incentives or conflicts of interests), proposed Rule 15Fh-3(c) (the
daily mark), and proposed Rule 15Fh-3(d) (clearing rights) would not
apply whenever the counterparty is an SBS Entity or Swap Entity.
---------------------------------------------------------------------------
\244\ 15 U.S.C. 78o-10(h)(3)(B).
\245\ 7 U.S.C. 6s(h)(3)(B). See Proposing Release, 76 FR at
42405, supra note 3.
---------------------------------------------------------------------------
ii. Comments on the Proposal
Two commenters submitted comments on the application of the
disclosure requirements when the counterparty is an SBS Entity or Swap
Entity.\246\ One commenter asserted that the disclosure requirements
should apply even when the counterparty is also an SBS Entity.\247\
Another commenter agreed with the Commission's interpretation that
Congress intended the exclusion to apply to transactions with other SBS
Entities and Swap Entities.\248\ However, in response to a specific
request for comment, the commenter asserted that the Commission should
not exempt transactions with other entities (such as banks or broker-
dealers) from the disclosure requirements, or otherwise subject them to
different disclosure standards, because while more sophisticated banks
or brokers may benefit, less sophisticated parties would be left
without adequate protections.\249\
---------------------------------------------------------------------------
\246\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5.
\247\ See Better Markets (August 2011), supra note 5.
\248\ See CFA, supra note 5.
\249\ Id.
---------------------------------------------------------------------------
Additionally, as discussed in Section II.B, a commenter advocated
for adding exceptions to the disclosure requirements in Rules 15Fh-3(b)
and (d) to cover security-based swaps that are intended to be cleared
and that are either (1) executed on a registered national securities
exchange or registered or exempt SEF and required to be cleared
pursuant to Section 3C of the Exchange Act, or (2) anonymous.\250\ The
commenter argued that this would harmonize the scope of the
Commission's disclosure requirements with no-action relief provided by
the
[[Page 29981]]
CFTC with respect to its parallel requirements.\251\
---------------------------------------------------------------------------
\250\ See SIFMA (August 2015), supra note 5.
\251\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rules
After considering the comments, the Commission is adopting, as
proposed, the exceptions from the disclosure requirements under Rule
15Fh-3(b) (information about material risks and characteristics, and
material incentives or conflicts of interests), Rule 15Fh-3(c) (the
daily mark), and Rule 15Fh-3(d) (clearing rights) for transactions in
which the counterparty is an SBS Entity or Swap Entity. We are not
adopting the suggestion that disclosure requirements apply even when
the counterparty is an SBS Entity or Swap Entity. We believe that an
SBS Entity would be well-positioned to negotiate with another SBS
Entity, and nothing in our rules precludes an SBS Entity from
requesting such disclosures.
In addition, the exceptions under the rules as adopted parallel the
exceptions in the analogous CFTC rules. This consistency will result in
efficiencies for entities that have already established infrastructure
to comply with the CFTC standard.
For the reasons discussed in Section II.B, we are not providing
additional exceptions for transactions that are intended to be
cleared.\252\
---------------------------------------------------------------------------
\252\ Id. See Swaps Intended to Be Cleared, CFTC Letter No. 13-
70 (Nov. 15, 2013), available at http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/13-70.pdf.
---------------------------------------------------------------------------
b. Timing and Manner of Certain Disclosures and Scope of Disclosure
Rules
i. Proposed Rules
Proposed Rule 15Fh-3(b) would require that disclosures regarding
material risks and characteristics and material incentives or conflicts
of interest be made to potential counterparties before entering into a
security-based swap, but would not mandate the specific manner in which
those disclosures are made as long as they are made ``in a manner
reasonably designed to allow the counterparty to assess'' the
information being provided.\253\ Proposed Rule 15Fh-3(d) similarly
would require that disclosures regarding certain clearing rights be
made before entering into a security-based swap, but would not mandate
the manner of disclosure. To the extent such disclosures were not
otherwise provided to the counterparty in writing prior to entering
into a security-based swap, proposed Rules 15Fh-3(b)(3) and 15Fh-
3(d)(3) would require an SBS Entity to make a written record of the
non-written disclosures made pursuant to proposed Rules 15Fh-3(b) and
15Fh-3(d), respectively, and provide a written version of these
disclosures to the counterparty in a timely manner, but in any case no
later than the delivery of the trade acknowledgement of the particular
transaction.
---------------------------------------------------------------------------
\253\ Section 15F(h)(3)(B) of the Exchange Act is silent
regarding both form and timing of disclosure. See 15 U.S.C. 78o-
10(h)(3)(B).
---------------------------------------------------------------------------
ii. Comments on Proposed Rules
Timing and Manner of Certain Disclosures
Five commenters addressed the timing and manner of required
disclosures.\254\ One commenter recommended allowing disclosure
requirements to be satisfied by the execution of a master agreement and
provision of a trade acknowledgment.\255\ Similarly, another commenter
urged the Commission to permit all required disclosures to be made
upfront at the beginning of a trading relationship, rather than on a
transaction-by-transaction basis.\256\
---------------------------------------------------------------------------
\254\ See ABC, supra note 5; CFA, supra note 5; FIA/ISDA/SIFMA,
supra note 5; Better Markets (August 2011), supra note 5; SIFMA
(August 2015), supra note 5.
\255\ See FIA/ISDA/SIFMA, supra note 5.
\256\ See ABC, supra note 5.
---------------------------------------------------------------------------
Alternatively, if the Commission requires disclosure beyond the
master agreement and trade acknowledgment, the first commenter
encouraged the Commission to permit the use of standardized
disclosures.\257\ The commenter also recommended that the Commission
not dictate the timing of required disclosures and permit SBS Entities
to make required disclosures in advance, as opposed to immediately
prior to the execution of a trade, so as not to interfere with the
parties' desired timing.\258\ However, the commenter noted that advance
disclosure requirements would be infeasible for transactions executed
on a SEF or exchange, or where the counterparty is known only
immediately prior to or after execution.\259\
---------------------------------------------------------------------------
\257\ See FIA/ISDA/SIFMA, supra note 5.
\258\ Id.
\259\ Id.
---------------------------------------------------------------------------
In contrast, two commenters advocated for more specific
requirements with respect to the timing and manner of disclosure.\260\
Both recommended that disclosure be required in writing and at a
``reasonably sufficient time'' prior to the execution of the
transaction to allow counterparties to evaluate the information before
deciding whether to enter the transaction.\261\ One commenter also
asserted that disclosure should be in a clear and intelligible format
that permits comparison between derivatives offered by different market
participants.\262\ The other commenter opposed allowing SBS Entities to
satisfy disclosure requirements through entry into a master agreement
and provision of a trade acknowledgement, arguing that key information
could be lost in the fine print of legal documents.\263\ At a minimum,
if a master agreement is used, the commenter recommended that the
required disclosures regarding material risks and characteristics and
material incentives or conflicts of interest be provided in a clearly
labeled, separate narrative incorporated into the overall document, and
that all key issues be disclosed before the trade is executed and not
in a post-trade acknowledgement.\264\
---------------------------------------------------------------------------
\260\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5.
\261\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5.
\262\ See Better Markets (August 2011), supra note 5.
\263\ See CFA, supra note 5.
\264\ Id.
---------------------------------------------------------------------------
Another commenter also recommended that disclosure regarding
material risks and characteristics and material incentives or conflicts
of interest be required at a ``reasonably sufficient time'' prior to
the execution of the transaction to harmonize with the CFTC's
disclosure requirements.\265\ Additionally, as discussed in Section
II.B, the commenter advocated for adding exceptions to the disclosure
requirements in Rules 15Fh-3(b) and (d) to cover security-based swaps
that are intended to be cleared and that are either: (1) Executed on a
registered national securities exchange or registered or exempt SEF and
required to be cleared pursuant to Section 3C of the Exchange Act, or
(2) anonymous.\266\
---------------------------------------------------------------------------
\265\ See SIFMA (August 2015), supra note 5.
\266\ Id.
---------------------------------------------------------------------------
Written Records of Non-Written Disclosure
One commenter addressed the written record requirements in proposed
Rules 15Fh-3(b)(3) and 15Fh-3(d)(3).\267\ The commenter opposed
permitting SBS Entities to make required disclosures orally, asserting
that oral disclosure fails to promote pre-trade transparency and makes
enforcement more difficult, and that SBS Entities may minimize
disclosure of conflicts of interest when making them orally.\268\ The
commenter also argued that the Commission's approach to permitting oral
disclosure ``doesn't even have the benefit of saving
[[Page 29982]]
labor, since the Commission proposes to require after-the-fact written
disclosures of any information not made in writing prior to the
transaction.'' \269\
---------------------------------------------------------------------------
\267\ See CFA, supra note 5.
\268\ See CFA, supra note 5.
\269\ Id.
---------------------------------------------------------------------------
Scope of Disclosure Rules
If the Commission requires disclosure beyond the master agreement
and trade acknowledgment, one commenter encouraged the Commission to
exclude from such requirements counterparties that are regulated
entities such as banks, broker-dealers, and investment advisers.\270\
Two other commenters argued that Major SBS Participants should not be
subject to the disclosure requirements because they will be transacting
with counterparties at arm's length.\271\ Alternatively, one commenter
suggested exempting transactions between Major SBS Participants and SBS
Dealers from the disclosure requirements, and allowing all other
counterparties to opt out of certain disclosure requirements, in
particular receiving written records of non-written disclosure.\272\
Similarly, another commenter suggested that ECPs should have the option
of opting-out of disclosures.\273\
---------------------------------------------------------------------------
\270\ See FIA/ISDA/SIFMA, supra note 5.
\271\ See BlackRock, supra note 5; MFA, supra note 5.
\272\ See BlackRock, supra note 5.
\273\ See MFA, supra note 5.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rules
After considering the comments, the Commission is adopting the
rules substantially as proposed, with certain modifications. In
response to commenters' concerns, the Commission is requiring that an
SBS Entity make the disclosures required by Rule 15Fh-3(b) regarding
material risks and characteristics and material incentives or conflicts
of interest at a reasonably sufficient time prior to entering into a
security-based swap to allow the counterparty to assess the
disclosures. This will also be consistent with the CFTC's timing
requirement for its parallel disclosures rules, resulting in
efficiencies for entities that have already established infrastructure
to comply with the CFTC standard.
With respect to the manner of disclosure, we are not adopting the
commenters' suggestion that we impose more specific requirements with
respect to the timing and manner of disclosure.\274\ Instead, the
Commission continues to believe it is appropriate to require only that
disclosures regarding material risks and characteristics and material
incentives or conflicts of interest be made ``in a manner reasonably
designed to allow the counterparty to assess'' the information being
provided pursuant to Rule 15Fh-3(b). As noted in the Proposing Release,
this provision is intended to require that disclosures be reasonably
clear and informative as to the relevant material risks or conflicts
that are the subject of the disclosure, and is not intended to impose a
requirement that disclosures be tailored to a particular counterparty
or to the financial, commercial or other status of that
counterparty.\275\
---------------------------------------------------------------------------
\274\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5.
\275\ See Proposing Release, 76 FR at 42406, supra note 3.
---------------------------------------------------------------------------
After considering the comments, the Commission is also adopting as
proposed the requirements in Rules 15Fh-3(b)(3) and 15Fh-3(d)(3) that
an SBS Entity make a written record of any non-written disclosures made
pursuant to Rules15Fh-3(b) and 15Fh-3(d), respectively, and provide a
written version of these disclosures to the counterparty in a timely
manner, but in any case no later than the delivery of the trade
acknowledgement \276\ of the particular transaction. As noted in the
Proposing Release and suggested by commenters, the Commission
understands that security-based swaps generally are executed under
master agreements, with much of the transaction-specific disclosure
provided over the telephone, in instant messages or in
confirmations.\277\ The Commission believes that parties should have
the flexibility to make disclosures by various means, including master
agreements and related documentation, telephone calls, emails, instant
messages, and electronic platforms.\278\ Similarly, while we
acknowledge the commenter's concern that SBS Entities may minimize
disclosure of conflicts of interest when making them orally, we are not
persuaded that requiring all disclosures be provided in writing prior
to the parties' entering into a security-based swap would be necessary
to provide protections under the rule as adopted. We further note that
Rule 15Fh-3(b)(3), discussed in Section II.G.2.c, separately requires
that an SBS Entity provide a written record of non-written disclosures
no later than the delivery of the trade acknowledgement of the
particular transaction. Accordingly, the Commission anticipates that
SBS Entities may elect to make certain required disclosures of material
information to their counterparties in a master agreement or other
written document accompanying such agreement. While certain forms of
disclosure may be highly standardized, certain provisions may need to
be tailored to the particular transaction, most notably pricing and
other transaction-specific commercial terms. As noted in the Proposing
Release, the Commission believes this approach is generally consistent
with the use of standardized disclosures suggested by industry groups
and commenters.\279\
---------------------------------------------------------------------------
\276\ See Trade Acknowledgement and Verification of Security-
Based Swap Transactions, Exchange Act Release No. 63727 (Jan. 14,
2011), 76 FR 3859 (Jan. 21, 2011) (proposing Rule 15Fi-1(c)(1),
which would require a trade acknowledgement to be provided within 15
minutes of execution for a transaction that has been executed and
processed electronically; within 30 minutes of execution for a
transaction that is not electronically executed, but that will be
processed electronically; and within 24 hours of execution for a
transaction that the SBS Entity cannot process electronically).
\277\ See Proposing Release, 76 FR at 42406, supra note 3; FIA/
ISDA/SIFMA, supra note 5.
\278\ When SBS Entities rely on electronic media, their
counterparties generally should have the capability to effectively
access all of the information required by Rule 15Fh-3(b)(3) in a
format that is understandable but not unduly burdensome for the
counterparty. See generally Use of Electronic Media by Broker-
Dealers, Transfer Agents and Investment Advisers for Delivery of
Electronic Information, Securities Act Release No. 7288 (May 9,
1996), 61 FR 24644 (May 15, 1996). See also Use of Electronic Media,
Exchange Act Release No. 42728 (Apr. 28, 2000), 65 FR 25843 (May 4,
2000).
\279\ See Proposing Release, 76 FR at 42406, supra note 3.
---------------------------------------------------------------------------
We do believe, however, that is it is important that the required
disclosures be made at a reasonably sufficient time before the
execution of the transaction to allow the counterparty to assess the
disclosures. While this time may vary depending on the product and the
counterparty, we do not believe, as suggested by some commenters, that
SBS Entities should be able to rely on trade acknowledgements alone to
satisfy certain disclosure requirements.\280\ As noted in the Proposing
Release, however, SBS Entities could rely on trade acknowledgements to
memorialize non-written disclosures they made prior to entering into
the proposed transaction.\281\
---------------------------------------------------------------------------
\280\ See FIA/ISDA/SIFMA, supra note 5.
\281\ See Proposing Release, 76 FR at 42406, supra note 3.
---------------------------------------------------------------------------
As discussed in Section II.B above, the Commission is limiting the
disclosure requirements in Rules 15Fh-3(b) and (d) to circumstances
where the identity of the counterparty is known to the SBS Entity at a
reasonably sufficient time prior to execution of the transaction to
permit the SBS Entity to comply with the obligations of the rule. The
disclosure requirements in Rules 15Fh-3(b) and (d) will not apply where
the identity of the counterparty is not discovered until after the
execution of the transaction, or where the SBS Entity learns the
identity of the counterparty
[[Page 29983]]
with insufficient time to be able to provide the necessary disclosures
to satisfy its obligations under the rule without disrupting or
delaying the execution of the transaction. Similarly, for the reasons
discussed in Section II.A.3.d, we are not providing additional
exceptions or ``opt-out'' rights.
Finally, we are not adopting the suggestion of one commenter that
the Commission exclude from the disclosure requirements transactions
with counterparties that are regulated entities such as banks, broker-
dealers, and investment advisers.\282\ Because information asymmetries
exist in a market for opaque and complex products, even for regulated
entities, such disclosures may help inform counterparties concerning
the valuations and material risks and characteristics of security-based
swaps in the sometimes rapidly changing market environment.\283\ In
this regard, the external business conduct requirements promulgated
under Section 15F(h) are intended to provide certain protections for
counterparties, including information regarding the material risks and
characteristics of the security-based swap, any material incentives or
conflicts of interest that the SBS Entity may have, and the daily mark
of the security-based swap. We believe the rules we are adopting today
appropriately apply those requirements so that counterparties receive
the benefit of those protections, and so are not providing counterparty
exclusions beyond the exception for transactions with SBS Entities and
Swap Entities discussed in Section II.G.2.a, infra.
---------------------------------------------------------------------------
\282\ See FIA/ISDA/SIFMA, supra note 5.
\283\ See Section VI.C, infra.
---------------------------------------------------------------------------
c. Material Risks and Characteristics of the Security-Based Swap
i. Proposed Rule
Proposed Rule 15Fh-3(b)(1) would require an SBS Entity to disclose
the material risks and characteristics of the particular security-based
swap, 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
would experience under specified circumstances. In the Proposing
Release, the Commission also solicited comment regarding whether SBS
Entities should be specifically required to provide scenario analysis
disclosure.\284\
---------------------------------------------------------------------------
\284\ See Proposing Release, 76 FR at 42409, supra note 3.
---------------------------------------------------------------------------
ii. Comments on the Proposed Rule
General
Seven commenters addressed the disclosure of material risks and
characteristics of security-based swaps.\285\ One commenter expressed
support for the proposed disclosure requirements, agreeing that the
disclosure should include any information for which there is a
substantial likelihood that a reasonable investor would consider the
information to be important in making an investment decision.\286\
---------------------------------------------------------------------------
\285\ See Barnard, supra note 5; Better Markets (August 2011),
supra note 5; CFA, supra note 5; Levin, supra note 5; FIA/ISDA/
SIFMA, supra note 5; SIFMA (August 2011), supra note 5; SIFMA
(August 2015), supra note 5.
\286\ See Barnard, supra note 5.
---------------------------------------------------------------------------
Two commenters argued that the Commission should adopt different or
modified disclosure requirements.\287\ One commenter requested that the
Commission clarify in the rule that: (1) The rule only requires
disclosure about the material risks and characteristics of the
security-based swap itself and not with respect to the underlying
reference security or index, and (2) the rule does not require
disclosure in relation to any particular counterparty.\288\ The
commenter also asked the Commission to eliminate the proposed
requirement that risk disclosures set forth the approximate magnitude
of the gains or losses the security-based swap will experience under
specified circumstances because this is the functional equivalent of a
requirement to provide a scenario analysis, which the commenter does
not support (discussed below).\289\ Additionally, the commenter noted
its view that the Commission should not require an SBS Entity to
disclose the absence of certain material provisions typically contained
in master agreements for security-based swap transactions because
master agreements differ and what is ``typical'' is not clear.\290\ A
second commenter requested a clarification that only material
information is required to be disclosed.\291\
---------------------------------------------------------------------------
\287\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (August 2015),
supra note 5.
\288\ See FIA/ISDA/SIFMA, supra note 5.
\289\ Id.
\290\ Id.
\291\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Three commenters argued for additional or modified
requirements.\292\ One asserted that the proposed disclosure
obligations are too limited in terms of scope, form, and content.\293\
The commenter suggested that the disclosure provisions should require
``more complete, timely, and intelligible disclosure of all the risks,
costs, and other material information relating to [security-based swap]
transactions,'' including disaggregated prices and risks, listed hedge
equivalents, scenario analysis (discussed below), and embedded
financing costs.\294\ Similarly, another commenter requested
clarification regarding what material risks and characteristics must be
disclosed, arguing that the disclosure should include liquidity risks,
the details of (and separate prices for) the standardized component
parts of any customized security-based swap, any features of the
security-based swap that could disadvantage the counterparty (such as
differences in interest rates paid versus those received), and where
credit arrangements are built into security-based swaps through
forbearance of collateral posting, the embedded credit and its
price.\295\ A third commenter also suggested that the Commission
clarify what material risks and characteristics must be disclosed,
proposing that SBS Entities be required to disclose any material risk
related to the source of a security-based swap's assets and any
negative view by the SBS Entity itself of the assets' riskiness.\296\
The commenter also recommended that SBS Entities be required to
disclose the material risks and characteristics not just of the
security-based swap itself, but also of any reference securities,
indices, or other assets, noting that this disclosure would be
particularly important when the security-based swap references unique
pools of assets arranged by the SBS Entity.\297\
---------------------------------------------------------------------------
\292\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5; Levin, supra note 5.
\293\ See Better Markets (August 2011), supra note 5.
\294\ Id.
\295\ See CFA, supra note 5.
\296\ See Levin, supra note 5.
\297\ Id.
---------------------------------------------------------------------------
Another commenter, writing after the CFTC adopted its final rules,
recommended that the Commission harmonize with the CFTC's requirement
to disclose material risks and characteristics.\298\ Specifically, the
commenter requested that, like the CFTC, the Commission describe the
material risks and characteristics to be disclosed as including
``market, credit, liquidity, foreign currency, legal, operational, and
any other applicable risks,'' and ``the material economic terms of the
security-based swap, the terms relating to the operation of the
[[Page 29984]]
security-based swap, and the rights and obligations of the parties
during the term of the security-based swap.'' \299\ The commenter
argued that harmonization with the CFTC would help support the
continued development of standard disclosures, reducing compliance
costs and preventing undue delays in execution, and would reduce the
likelihood of inconsistent disclosures for similar products and
resulting counterparty confusion.\300\
---------------------------------------------------------------------------
\298\ See SIFMA (August 2015), supra note 5.
\299\ Id.
\300\ Id.
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Scenario Analysis
We sought comment on whether we should require scenario analysis
and, if so, what standards should apply. Eight commenters addressed the
disclosure of scenario analysis.\301\ Four commenters supported
requiring scenario analysis disclosure to some degree.\302\ Of these
commenters, one suggested that the analysis include specific
information about the security-based swap's liquidity and
volatility.\303\ Another recommended only requiring scenario analysis
disclosure for ``high-risk complex security-based swaps,'' and
suggested that the Commission provide additional clarification or a
definition for determining what security-based swaps are high-risk and
complex.\304\ A third commenter advocated requiring SBS Entities to
notify counterparties of their right to receive a scenario analysis and
to provide a scenario analysis at the request of a non-SBS Entity
counterparty.\305\ To reduce the costs associated with providing
scenario analyses and to mitigate the disclosure of SBS Entities'
proprietary information, the commenter suggested that the Commission
permit SBS Entities to delegate the provision of scenario analyses to
qualified third-parties.\306\ The commenter explained that requiring
scenario analysis disclosure on a transaction-by-transaction basis
would not be necessary because SBS Entity counterparties are generally
sophisticated enough to create their own, more meaningful, portfolio-
based analyses, but that scenario analyses could help a less
sophisticated counterparty understand the dynamics and potential
exposure of security-based swaps on a portfolio-level.\307\ The
commenter also noted that the Commission should encourage all market
participants to create or obtain a portfolio-level scenario analysis,
in keeping with industry best practices.\308\
---------------------------------------------------------------------------
\301\ See Barnard, supra note 5; Better Markets (August 2011),
supra note 5; CFA, supra note 5; Markit, supra note 5; FIA/ISDA/
SIFMA, supra note 5; SIFMA (August 2011), supra note 5; MFA, supra
note 5; SIFMA (August 2015), supra note 5.
\302\ See Barnard, supra note 5; Better Markets (August 2011),
supra note 5; CFA, supra note 5; Markit, supra note 5.
\303\ See Better Markets (August 2011), supra note 5.
\304\ See Barnard, supra note 5.
\305\ See Markit, supra note 5.
\306\ Id.
\307\ Id.
\308\ Id.
---------------------------------------------------------------------------
Four commenters opposed requiring disclosure of scenario
analysis.\309\ One noted that requiring scenario analysis disclosure
would have potentially significant adverse consequences for special
entities and other counterparties, and urged the Commission to refrain
from requiring it.\310\ Specifically, the commenter explained that
requiring scenario analysis would likely delay execution of
transactions and expose counterparties to market risk for potentially
extended periods of time (including at critical times when the
counterparty is seeking to hedge its positions in volatile markets)
because the development of scenario analyses depends upon the specific
terms agreed by the parties and therefore, cannot be performed until
full agreement on the material terms is reached.\311\ Additionally, the
commenter noted that the development of such analyses would cause SBS
Entities to incur substantial costs, which ultimately would be passed
on to counterparties.\312\ Another commenter opposed a requirement to
provide scenario analysis and asserted that, if a scenario analysis is
required, it should only be at the request of the counterparty and only
with respect to scenarios based on parameters selected by the
counterparty.\313\ The commenter also expressed concern that providing
a scenario analysis could be viewed as a ``recommendation'' that
triggers other requirements under the proposed rules (e.g., suitability
requirements).\314\
---------------------------------------------------------------------------
\309\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (August 2011),
supra note 5; MFA, supra note 5; SIFMA (August 2015), supra note 5.
\310\ See SIFMA (August 2011), supra note 5.
\311\ Id.
\312\ Id.
\313\ See FIA/ISDA/SIFMA, supra note 5.
\314\ Id.
---------------------------------------------------------------------------
A third commenter, writing after the CFTC adopted final rules,\315\
stated that, in its experience, the CFTC's scenario analysis
requirement has complicated the ability of SBS Dealers to provide
different pricing scenarios, either voluntarily or at the request of a
counterparty, because it creates ``uncertainty as to when those
scenarios must satisfy the requirements for scenario analysis set forth
in the CFTC EBC rules.'' \316\
---------------------------------------------------------------------------
\315\ The CFTC had proposed to require scenario analysis for
``high-risk complex bilateral swaps'' but in its final rules
determined instead to require scenario analysis only when requested
by the counterparty for any swap not ``made available for trading''
on a designated contract market or swap execution facility. To
comply with the CFTC rule, swap dealers must disclose to
counterparties their right to receive scenario analysis and consult
with counterparties regarding design. See CFTC Adopting Release, 77
FR at 9762-9763, supra note 21. See also 17 CFR 23.431(b).
\316\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
A fourth commenter recommended that, to the extent a Major SBS
Participant is transacting with an ECP at arm's-length, the Commission
should explicitly exclude scenario analysis from the information that
the Major SBS Participant is required to disclose pursuant to Rule
15Fh-3(b).\317\ The commenter asserted that scenario analysis
disclosure would be costly and redundant since the rule would already
require Major SBS Participants to undertake a transaction-specific
analysis, and prepare tailored disclosures of a transaction's loss
sensitivities to market factors and conditions, and the magnitude of
gains and losses the transaction may experience under specified
circumstances.\318\
---------------------------------------------------------------------------
\317\ See MFA, supra note 5.
\318\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(b)(1) with some modifications requested by commenters to more
closely align the requirements of our rules with those of the CFTC.
We have revised the descriptions in Rule 15Fh-3(b)(1) of the
required disclosures of material risks and characteristics of a
security-based swap to harmonize with the descriptions in the parallel
CFTC disclosure requirement. As adopted, Rule 15Fh-3(b)(1) requires an
SBS Entity to disclose material information in a manner reasonably
designed to allow the counterparty to assess the material risks and
characteristics of the particular security-based swap, which may
include (1) market risk,\319\ credit risk,\320\ liquidity risk,\321\
foreign
[[Page 29985]]
currency risk, legal risk,\322\ operational risk\323\ and any other
applicable risks, and (2) the material economic terms of the security-
based swap, and the rights and obligations of the parties during the
term of the security-based swap. These changes are intended to provide
an illustrative list of material risks and characteristics. In
addition, these changes will harmonize our rule with the requirements
of the CFTC rule, which should result in efficiencies for SBS Entities
that have already established infrastructure to comply with the CFTC
rules, while still achieving the objectives of the rule to provide
information to a counterparty to help them assess whether, and under
what terms, they want to enter into the transaction.
---------------------------------------------------------------------------
\319\ By ``market risk,'' we mean the risk to the value of a
security-based swap ``resulting from adverse movements in the level
or volatility of market prices.'' See Proposing Release, 76 FR at
42408 n.82, supra note 3.
\320\ By ``credit risk,'' we mean the risk that a counterparty
to a security-based swap ``will fail to perform on an obligation''
under the security-based swap. See Proposing Release, 76 FR at 42408
n.80, supra note 3.
\321\ By ``liquidity risk,'' we mean the risk that a
counterparty to a security-based swap ``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 or because
of disruptions in the marketplace.'' See Proposing Release, 76 FR at
42408 n.83, supra note 3.
\322\ By ``legal risk,'' we mean the risk that agreements are
unenforceable or incorrectly or inadequately documented. See
Proposing Release, 76 FR at 42408 n.85, supra note 3.
\323\ By ``operational risk,'' we mean the risk that
``deficiencies in information systems or internal controls,
[including human error,] will result in unexpected loss.'' See
Proposing Release, 76 FR at 42408 n.84, supra note 3.
---------------------------------------------------------------------------
The rule as adopted requires disclosure of ``material'' information
regarding material risks and characteristics and material incentives or
conflicts of interests. We believe that this modification will provide
for an appropriate level of disclosure by requiring disclosure of
``material'' information, that is, the information most relevant to a
counterparty's assessment of whether and under what terms to enter into
a security-based swap. In addition, it will harmonize with the CFTC
approach, promoting regulatory consistency across the swap and
security-based swap markets, particularly among entities that transact
in both markets and have already established infrastructure to comply
with existing CFTC regulations. In response to comment, the Commission
believes that for purposes of evaluating the material risks and
characteristics of the particular security-based swap, including its
economic terms, material information about the referenced security,
index, asset or issuer should be disclosed.\324\ As one commenter
suggested, this disclosure would be particularly important when, for
example, the security-based swap references unique pools of assets
arranged by the SBS Entity.\325\
---------------------------------------------------------------------------
\324\ The manner in which and extent of information about the
referenced security, index, asset or issuer is disclosed would
depend on the particular facts and circumstances, including the
public availability of the information.
\325\ See Levin, supra note 5.
---------------------------------------------------------------------------
The Commission anticipates that SBS Entities may provide these
disclosures through various means, including by providing a scenario
analysis, as noted in the Proposing Release.\326\ We are not, however,
adopting any requirements that would require an SBS Entity to provide
scenario analysis. Although scenario analysis may prove a valuable
analytic tool, it is one means by which information may be conveyed,
and we acknowledge the concerns of commenters that a scenario analysis
may not be necessary or appropriate in every situation to ensure that
appropriate disclosures are made. We note, however, that nothing in our
rules would preclude parties from requesting such analysis, even if a
security-based swap is ``made available for trading.'' In this regard,
our approach differs from that of the CFTC which requires a Swap Dealer
to provide scenario analysis when requested by a counterparty for any
swap that is not ``made available for trading'' on a designated
contract market or swap execution facility. We believe, however, that
the approaches are consistent because, as noted above, the Commission
is not prohibiting counterparties from requesting scenario analysis
disclosure.
---------------------------------------------------------------------------
\326\ See Proposing Release, 76 FR at 42408 n.88, supra note 3.
---------------------------------------------------------------------------
As noted in the Proposing Release, these disclosures are intended
to pertain to the material risks and characteristics of the security-
based swap, and not the material risks and characteristics of the
security-based swap with respect to a particular counterparty.\327\
---------------------------------------------------------------------------
\327\ See Proposing Release, 76 FR at 42408 n.87, supra note 3.
However, if an SBS Dealer recommends a security-based swap or
trading strategy involving a security-based swap, or acts as an
advisor to a special entity, for example, Rules 15Fh-3(f) and 15Fh-
4, respectively, impose certain counterparty-specific requirements.
See Rules 15Fh-3(f) and 15Fh-4, discussed infra in Sections II.G.0
and II.H.3.
---------------------------------------------------------------------------
d. Material Incentives or Conflicts of Interest
i. Proposed Rule
Proposed Rule 15Fh-3(b)(2) would require the SBS Entity to disclose
any material incentives or conflicts of interest that it may have in
connection with the security-based swap, including any compensation or
other incentives from any source other than the counterparty in
connection with the security-based swap to be entered into with the
counterparty.\328\ We explained in the Proposing Release that we
preliminarily believed that the term ``incentives''--which is used in
Section 15F(h)(3)(b)(ii) of the Dodd-Frank Act--refers not to any
profit or return that the SBS Entity would expect to earn from the
security-based swap itself, or from any related hedging or trading
activities of the SBS Entity, but rather to any other financial
arrangements pursuant to which an SBS Entity may have an incentive to
encourage the counterparty to enter into the transaction. This
disclosure would include, among other things, information concerning
any compensation (e.g., under revenue-sharing arrangements) or other
incentives the SBS Entity receives from any source other than the
counterparty in connection with the security-based swap to be entered
into with the counterparty, but would not include, for example,
expected cash flows received from a transaction to hedge the security-
based swap or that the security-based swap is intended to hedge.\329\
---------------------------------------------------------------------------
\328\ See Section 15F(h)(3)(B)(ii) of the Exchange Act, 15
U.S.C. 78o-10(h)(3)(B)(ii) (providing that business conduct
requirements adopted by the Commission shall require disclosure by
an SBS Entity of ``any material incentives or conflicts of
interest'' that the SBS Entity may have in connection with the
security-based swap).
\329\ See Proposing Release, 76 FR at 42409, supra note 3.
---------------------------------------------------------------------------
ii. Comments on the Proposed Rule
Seven commenters addressed the disclosure of material incentives or
conflicts of interest.\330\ One commenter expressed strong support for
the proposed rule.\331\ A second commenter also supported the proposed
rule, noting that it is consistent with the CFTC's parallel
requirement, except for the CFTC's requirement to disclose a pre-trade
mid-market mark, which the commenter argued is of limited benefit and
delays execution of transactions.\332\ Three other commenters expressed
support for the proposed rule but also suggested certain revisions to
the rule.\333\ One recommended modifying the rule to include specific
disclosures by SBS Entities of any affiliations or material business
relationships they may have with any provider of security-based swap
valuation services.\334\ Another noted that an SBS Entity's biggest
conflict of interest would likely be the difference in compensation
between selling a security-based swap (and in particular, a customized
security-based swap) versus another
[[Page 29986]]
product with similar economic terms.\335\ Accordingly, the commenter
recommended that SBS Entities be required to include any differential
compensation in their disclosure.\336\ Additionally, the commenter
asserted that if an SBS Entity is entering a trade as part of a trading
strategy to move a position off its books, the SBS Entity should be
required to disclose that particular conflict of interest and that the
security-based swap is recommended to effect that strategy.\337\ A
third commenter suggested coordinating the proposed rule with the
conflict of interest prohibitions in Sections 619 and 621 of the Dodd-
Frank Act to clarify that those prohibitions cannot be circumvented
through application of the business conduct disclosure
requirements.\338\ The commenter also recommended including in these
required disclosures any otherwise hidden profits or returns that the
SBS Entity expects to make from a security-based swap, related
agreement or arrangement, or related hedging or trading activity.\339\
---------------------------------------------------------------------------
\330\ See Barnard, supra note 5; IDC, supra note 5; CFA, supra
note 5; Levin, supra note 5; FIA/ISDA/SIFMA, supra note 5; SIFMA
(August 2015), supra note 5.
\331\ See Barnard, supra note 5.
\332\ See SIFMA (August 2015), supra note 5.
\333\ See IDC, supra note 5; CFA, supra note 5; Levin, supra
note 5.
\334\ See IDC, supra note 5.
\335\ See CFA, supra note 5.
\336\ Id.
\337\ Id.
\338\ See Levin, supra note 5.
\339\ Id.
---------------------------------------------------------------------------
One commenter objected to any requirement that an SBS Entity
disclose its anticipated profit for the security-based swap.\340\ The
commenter asserted that the best protection for a counterparty is
reviewing and selecting the best available pricing.\341\
---------------------------------------------------------------------------
\340\ See FIA/ISDA/SIFMA, supra note 5.
\341\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(b)(2) as proposed.
As noted in the Proposing Release, the Commission believes that the
term ``incentives''--which is used in Section 15F(h)(3)(b)(ii) of the
Dodd-Frank Act--refers not to any profit or return that the SBS Entity
would expect to earn from the security-based swap itself, or from any
related hedging or trading activities of the SBS Entity, but rather to
any other financial arrangements pursuant to which an SBS Entity may
have an incentive to encourage the counterparty to enter into the
transaction.\342\ Accordingly, the disclosure required pursuant to Rule
15Fh-3(b)(2) generally should include information concerning any
compensation (for example, under revenue-sharing arrangements) or other
incentives the SBS Entity receives from any source other than the
counterparty in connection with the security-based swap to be entered
into with the counterparty but will not include, for example, expected
cash flows received from a transaction to hedge the security-based swap
or that the security-based swap is intended to hedge.
---------------------------------------------------------------------------
\342\ See Proposing Release, 76 FR at 42409, supra note 3.
---------------------------------------------------------------------------
As discussed above, whether a conflict or incentive is material
depends on the facts and circumstances of the particular matter.
Although we are not expressly requiring disclosure of differential
compensation as requested by the commenter, the difference in
compensation an SBS Entity may receive for selling a security-based
swap versus another product with similar economic terms may create a
material incentive or conflict of interest that would need to be
disclosed under the framework discussed above. Similarly, an SBS Entity
would need to disclose material information concerning affiliations or
material business relationships it may have with any provider of
security-based swap valuation providers if those relationships create a
material incentive or conflict of interest. Regarding the commenter's
concern that the conflict of interest prohibitions in Sections 619 and
621 of the Dodd-Frank Act might be circumvented through application of
the business conduct disclosure requirements,\343\ nothing in our rules
limits or restricts the applicability of other relevant laws.\344\
---------------------------------------------------------------------------
\343\ See Levin, supra note 5.
\344\ For instance, depending on the facts and circumstances,
failure to disclose material conflicts of interest when there is a
recommendation by a broker-dealer can be a violation of the
antifraud rules. See, e.g., Chasins v. Smith, Barney & Co., 438 F.2d
1167, 1172 (2d Cir. 1970) (explaining that failure to inform a
customer fully of a possible conflict of interest in the securities
which the broker recommended for purchase was an omission of
material fact in violation of Rule 10b-5). See also In the Matter of
Richmark Capital Corp., Exchange Act Release No. 48758 (Nov. 7,
2003) (Commission opinion) (``When a securities dealer recommends
stock to a customer, it is not only obligated to avoid affirmative
misstatements, but also must disclose material adverse facts of
which it is aware. That includes disclosure of `adverse interests'
such as `economic self-interest' that could have influenced its
recommendation.'') (citations omitted).
---------------------------------------------------------------------------
e. Daily Mark
Exchange Act Section 15F(h)(3)(B)(iii) directs that business
conduct requirements adopted by the Commission require an SBS Entity to
disclose to a counterparty (other than to another SBS Entity or Swap
Entity): (i) For cleared security-based swaps, upon request of the
counterparty, the daily mark from the appropriate derivatives clearing
organization;\345\ and (ii) for uncleared security-based swaps, the
daily mark of the transaction.
---------------------------------------------------------------------------
\345\ As noted in the Proposing Release, although Section
15F(h)(3)(B)(iii) of the Exchange Act refers to a ``derivatives
clearing organization,'' the Commission believes that this was a
drafting error and that Congress intended to refer to a ``clearing
agency'' because the Dodd-Frank Act elsewhere requires security-
based swaps to be cleared at registered clearing agencies, not
derivatives clearing organizations. See Proposing Release, 76 FR at
42410 n.98, supra note 3; Section 17A(g) of the Exchange Act, 15
U.S.C. 78q-1(g).
---------------------------------------------------------------------------
i. Proposed Rule
Proposed Rule 15Fh-3(c) would require an SBS Entity to disclose to
its counterparty (other than to another SBS Entity or Swap Entity): (1)
For a cleared security-based swap, upon the request of the
counterparty, the daily end-of-day settlement price that the SBS Entity
receives from the appropriate clearing agency, and (2) for an uncleared
security-based swap, the midpoint between the bid and offer, or the
calculated equivalent thereof, as of the close of business, unless the
parties agree in writing to a different time, on each business day
during the term of the security-based swap. Proposed Rule 15Fh-3(c)(2)
would specify that the daily mark for an uncleared security-based swap
may be based on market quotations for comparable security-based swaps,
mathematical models or a combination thereof. Proposed Rule 15Fh-
3(c)(2) also would require disclosure of the data sources and a
description of the methodology and assumptions used to prepare the
daily mark for an uncleared security-based swap, as well as any
material changes to such data sources, methodology or assumptions
during the term of the security-based swap.
ii. Comments on Proposed Rule
Ten comment letters addressed the requirement for SBS Entities to
provide a daily mark.\346\
---------------------------------------------------------------------------
\346\ See Barnard, supra note 5; Levin, supra note 5; IDC, supra
note 5; AFGI (September 2012), supra note 5; AFGI (July 2013), supra
note 5; FIA/ISDA/SIFMA, supra note 5; MFA, supra note 5; BlackRock,
supra note 5; SIFMA (August 2011); SIFMA (August 2015), supra note
5.
---------------------------------------------------------------------------
One commenter suggested modifications to the daily mark requirement
to harmonize with the CFTC's parallel requirement.\347\ Specifically,
for cleared security-based swaps, the commenter recommended that an SBS
Entity simply be required to notify a counterparty of its right to
receive the daily mark from the appropriate clearing agency upon
request.\348\ The commenter also argued that the CFTC's description of
the clearinghouse's mark is less
[[Page 29987]]
prescriptive.\349\ Additionally, the commenter recommended that the
Commission provide guidance clarifying that an SBS Entity will be
deemed to satisfy the daily mark requirement for cleared security-based
swaps if the counterparty has agreed to receive its daily mark from its
clearing member.\350\
---------------------------------------------------------------------------
\347\ See SIFMA (August 2015), supra note 5.
\348\ Id.
\349\ Id.
\350\ Id.
---------------------------------------------------------------------------
One commenter asserted that requiring SBS Entities to provide daily
marks would not further the goal of providing helpful transparency
because in most transactions marks are typically either based on
internal models or derived from indices with which the transactions are
not perfectly matched.\351\ Another commenter asked the Commission to
carefully review and consider the costs of such a requirement before
imposing any obligation to provide daily marks, other than those agreed
upon for collateral purposes or for which midmarket quotations are
observable.\352\ The commenter also requested that ``sophisticated
counterparties'' be permitted to opt out of this requirement, and
recommended that the Commission clarify that where parties have agreed
upon a basis for margining uncleared security-based swaps, providing
the daily mark used to make the related margin calculation should
satisfy the SBS Entity's daily mark disclosure obligations.\353\
---------------------------------------------------------------------------
\351\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
\352\ See FIA/ISDA/SIFMA, supra note 5.
\353\ Id.
---------------------------------------------------------------------------
One commenter suggested that the data sources, methodology and
assumptions used to prepare the daily mark should be required to
constitute a complete and independently verifiable methodology for
valuing each security-based swap entered into between the parties,
noting that this would promote objectivity and transparency, and aid in
the resolution of disputes.\354\ In this regard, a second commenter
also expressed support for requiring the provision of a daily mark and
specifically for requiring disclosure of any material changes to the
data sources, methodology and assumptions used to prepare the daily
mark, noting that this should include disclosing if the data sources
become unreliable or unavailable and any resulting changes to the
valuations.\355\
---------------------------------------------------------------------------
\354\ See Barnard, supra note 5.
\355\ See Levin, supra note 5.
---------------------------------------------------------------------------
A third commenter recommended requiring disclosure as to how the
daily mark is calculated, including such information as whether the
daily mark was calculated based on inputs related to actual trade
activity, using mathematical models, quotes and prices of other
comparable securities, and whether those inputs came from third-party
valuation service providers.\356\ The commenter added, however, that
the proposed disclosure of the data sources and the description of the
methodology and assumptions used were not likely to require the
disclosure of proprietary information and that a general description of
key valuation inputs should be sufficient.\357\ Likewise, another
commenter also recommended that the Commission clarify in rule text
that an SBS Entity is not required to disclose confidential,
proprietary information about any model it may use to prepare the daily
mark.\358\
---------------------------------------------------------------------------
\356\ See IDC, supra note 5.
\357\ Id.
\358\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
This commenter also recommended that an SBS Entity should disclose
additional information concerning its daily mark to ensure a fair and
balanced communication, including that: (1) The daily mark may not
necessarily be a price at which the SBS Entity or counterparty would
agree to replace or terminate the security-based swap; (2) calls for
margin may be based on considerations other than the daily mark; and
(3) the daily mark may not necessarily be the value of the security-
based swap that is marked on the books of the SBS Entity.\359\
Additionally, this commenter advocated for eliminating the proposed
requirement for the SBS Entity to disclose its data sources used to
prepare the daily mark to harmonize more closely with the CFTC rule,
which requires disclosure of assumptions and methodologies but not data
sources.\360\
---------------------------------------------------------------------------
\359\ Id.
\360\ Id.
---------------------------------------------------------------------------
One commenter noted that Major SBS Participants, unlike SBS
Dealers, will not always have access to sufficient market information
to provide a daily mark, particularly if the security-based swap is not
actively traded or if there are no current bid and offer quotes.\361\
The commenter expressed concern that this could cause Major SBS
Participants to have to reveal proprietary information about their
trading book positions, particularly when providing the methodology and
inputs that they used to prepare the daily mark.\362\ The commenter
suggested permitting sophisticated counterparties to opt out of
receiving daily marks.\363\ Another commenter suggested either not
requiring Major SBS Participants to provide the daily mark to its
counterparties or in the alternative, to exempt transactions between
Major SBS Participants and SBS Dealers and allow all other
counterparties to opt out of receiving such disclosures.\364\
---------------------------------------------------------------------------
\361\ See MFA, supra note 5.
\362\ Id.
\363\ Id.
\364\ See BlackRock, supra note 5.
---------------------------------------------------------------------------
Several commenters raised potential conflicts of interest concerns
in connection with providing the daily mark for uncleared security-
based swaps. Two commenters recommended requiring SBS Entities to use
third-party quotations whenever possible to calculate the daily mark
for uncleared security-based swaps.\365\ One commenter suggested
allowing use of the midpoint between an SBS Entity's bid and offer
prices only when the SBS Entity's internal book value falls within the
same price range.\366\ Additionally, this commenter suggested that the
Commission consider requiring the SBS Entity to provide clients with
actionable quotes or prices at which the SBS Entity would terminate the
swap or allow the client to buy more, and with actionable quotes at a
significant size as a means to ensure accuracy.\367\ Another commenter
noted its view that defining the daily mark for uncleared security-
based swaps as the midpoint between the bid and offer prices, or the
calculated equivalent thereof, could be problematic because it may
present a conflict of interest for SBS Entities, particularly when the
security-based swaps are not actively traded or do not have consistent
or up-to-date bid and offer quotes.\368\ This commenter also suggested
requiring SBS Entities and their counterparties to have a clearly
defined process for resolving any potential valuation disputes. \369\
---------------------------------------------------------------------------
\365\ See Levin, supra note 5; and IDC, supra note 5.
\366\ See Levin, supra note 5.
\367\ Id.
\368\ See IDC, supra note 5.
\369\ See IDC, supra note 5.
---------------------------------------------------------------------------
Two commenters addressed the communication of daily marks,
supporting the use of web-based methods of communication.\370\ One
commenter advocated for web-based systems to be the preferred method of
communication, but noted that since some market participants prefer
more traditional methods of communication, web-based systems should not
be required.\371\ The commenter recommended requiring SBS Entities to
have policies and procedures in place that reasonably ensure that any
non-electronic means of communication is safe and secure and is
otherwise
[[Page 29988]]
comparable to web-based systems.\372\ Additionally, the commenter
generally requested that the Commission provide greater clarity on
permissible methods for delivering daily mark disclosures, establish
minimum requirements for the communication of daily marks (for
instance, that the interfaces used provide counterparties with
appropriate tools to initiate, track and close valuation disputes), and
require SBS Entities to ensure that the method of communication is
designed to protect the confidentiality of the data and prevent any
unintentional or fraudulent addition, modification or deletion of a
valuation record.\373\ The second commenter suggested that the use of a
secure Web site or electronic platform should be required to enhance
data security.\374\ The commenter noted that such a platform could also
be used to provide transparency into the inputs used to determine the
daily mark and to initiate inquiries or challenges to the daily
mark.\375\ The commenter also recommended that the Commission require
daily mark information to be provided without charge.\376\
---------------------------------------------------------------------------
\370\ See Markit, supra note 5; IDC, supra note 5.
\371\ See Markit, supra note 5.
\372\ Id.
\373\ Id.
\374\ See IDC, supra note 5.
\375\ Id.
\376\ Id.
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iii. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(c) as proposed, with modifications.
Cleared Security-Based Swaps
In response to concerns raised by a commenter,\377\ the Commission
is modifying the requirement in Rule 15Fh-3(c)(1) concerning delivery
of the daily mark for cleared security-based swaps. For cleared
security-based swaps, the proposed rule would have required the SBS
Entity upon the request of the counterparty to provide the counterparty
with the end-of-day settlement price the SBS Entity received from the
clearing agency. As adopted, for cleared security-based swaps, Rule
15Fh-3(c)(1) requires an SBS Entity upon the request of the
counterparty to provide to the counterparty the daily mark that the SBS
Entity receives from the appropriate clearing agency.
---------------------------------------------------------------------------
\377\ SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
In response to comments, the Commission is clarifying that to
fulfill its obligation to provide the daily mark upon request, the SBS
Entity may agree with the clearing agency, a clearing member or another
agent, for such clearing agency, clearing member or other agent to
provide the daily mark directly to the counterparty.\378\ The SBS
Entity, however, would retain the regulatory responsibility to provide
the daily mark upon request. We understand that current market practice
is for a clearing agency to provide access to end-of-day settlement
prices to the counterparty. We believe that this flexibility is
appropriate, as we believe errors in transmission are less likely to
occur if the counterparty receives the information directly from the
appropriate clearing agency, which is the source of the daily mark for
cleared security-based swaps. In addition, these changes will align our
rule more closely with the comparable CFTC rule, which allows for the
counterparty to receive the daily mark for a cleared swap from access
to the derivatives clearing organization or futures commodities
merchant or from the Swap Entity, which should result in efficiencies
for SBS Entities that have already established infrastructure to comply
with the CFTC rule.\379\ We note that an SBS Entity's obligation to
provide the daily mark, if requested by the counterparty, exists for
the life of the security-based swap between the SBS Entity and the
counterparty. Depending on the form of clearing that is used to clear
the security-based swap, the security-based swap between the SBS Entity
and the counterparty may be terminated upon clearing by the clearing
agency.\380\
---------------------------------------------------------------------------
\378\ See SIFMA (August 2015), supra note 5.
\379\ See 17 CFR 23.431(d); and CFTC Adopting Release, supra
note 21.
\380\ If, for example, the security-based swap between the SBS
Entity and counterparty is terminated upon novation by the clearing
agency, the SBS Entity would no longer have any obligation to
provide a daily mark to the original counterparty because a
security-based swap no longer exists between them.
---------------------------------------------------------------------------
Rule 15Fh-3(c)(1), as adopted, also requires that the SBS Entity
provide the daily mark (as opposed to the end-of-day settlement price)
upon request to the counterparty to allow clearing agencies the
flexibility to provide a different calculation of the mark in the
future. As noted above, we understand that current market practice is
for the clearing agency to provide an end-of-day settlement price as
its mark. In addition, this change will conform our rule more closely
to the parallel CFTC rule described above.
Uncleared Security-Based Swaps
The Commission is adopting Rule 15Fh-3(c)(2) as proposed. The
Commission agrees with commenters \381\ that the daily mark for
uncleared security-based swaps will provide helpful transparency to
counterparties during the lifecycle of a security-based swap by
providing a useful and meaningful reference point against which to
assess, among other things, the calculation of variation margin for a
security-based swap or portfolio of security-based swaps, and otherwise
inform the counterparty's understanding of its financial relationship
with the SBS Entity.\382\ We continue to believe that even if the mark
is calculated based on internal models or such indices, its provision
by the SBS Entity will further the goal of providing helpful
transparency into the SBS Entity's pricing and valuation of the
security-based swap by providing a helpful reference point that the SBS
Entity's counterparty can take into account when evaluating the pricing
and valuation of the SBS. Thus, we disagree with the commenter \383\
who believes that providing the daily mark will not enhance
transparency.
---------------------------------------------------------------------------
\381\ See Barnard, supra note 5; Levin, supra note 5; IDC, supra
note 5; SIFMA (August 2015), supra note 5.
\382\ See Proposing Release, 76 FR at 42410, supra note 3.
\383\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
---------------------------------------------------------------------------
As noted in the Proposing Release, though the daily mark may be
used as an input to compute the variation margin between an SBS Entity
and its counterparty, it is not necessarily the sole determinant of how
such margin is computed. Differences between the daily mark and
computations for variation margin may result from adjustments for
position size, position direction, credit reserve, hedging, funding,
liquidity, counterparty credit quality, portfolio concentration, bid-
ask spreads, or other costs. Moreover, we understand that the actual
computations may be highly negotiated between the parties. Therefore,
we decline to implement the commenter's suggestion that the basis for
margining uncleared security-based swaps would satisfy the daily mark
disclosure obligations.
For uncleared security-based swaps, Rule 15Fh-3(c)(2) as adopted
defines the daily mark as the midpoint between the bid and offer prices
for a particular uncleared security-based swap, or the calculated
equivalent thereof, as of the close of business unless the parties
otherwise agree in writing to a different time.\384\ The Commission
continues to believe that, absent specific agreement by the parties
otherwise, the rule will
[[Page 29989]]
result in a daily mark that reflects daily changes in valuation and
that is: (a) The same for all counterparties of the SBS Entity that
have a position in the uncleared security-based swap, (b) not adjusted
to account for holding-specific attributes such as position direction,
size, or liquidity, and (c) not adjusted to account for counterparty-
specific attributes such as credit quality, other counterparty
portfolio holdings, or concentration of positions.\385\
---------------------------------------------------------------------------
\384\ As noted in the Proposing Release, parties could agree
that the daily mark would be computed as of a time other than the
close of business but could not agree to waive the requirement that
the daily mark be provided on a daily basis, as required by the
statute. See Proposing Release, 76 FR at 42411 n.103, supra note 3.
\385\ See Proposing Release, 76 FR at 42411, supra note 3.
---------------------------------------------------------------------------
As noted in the Proposing Release, for actively traded security-
based swaps that have sufficient liquidity, computing a daily mark as
the midpoint between the bid and offer prices for a particular
security-based swap, known as a ``midmarket value,'' would be
consistent with Rule 15Fh-3(c)(2).\386\ For security-based swaps that
are not actively traded, or do not have up-to-date bid and offer
quotes, the SBS Entity may calculate an equivalent to a midmarket value
using mathematical models, quotes and prices of other comparable
securities, security-based swaps, or derivatives, or any combination
thereof. In this regard, the rule as adopted requires that the SBS
Entity disclose its data sources and a description of the methodology
and assumptions used to prepare the daily mark, and promptly disclose
any material changes to such data sources, methodology and assumptions
during the term of the security-based swap. One commenter suggested
that the disclosures should include how the daily mark is calculated,
including whether the daily mark is calculated based on inputs related
to actual trade activity or using mathematical models, quotes and
prices of other comparable securities, and whether those inputs came
from third-party valuation service providers.\387\ We believe that the
requirement in the rule to disclose data sources, methodologies and
assumptions encompasses this commenter's suggestion. On the other hand,
another commenter has expressed concern that disclosure of data
sources, methodology and assumptions would require the SBS Entity to
disclose confidential, proprietary information about its models.\388\
We believe achieving the benefits underlying the statutory daily mark
requirement require that each counterparty knows the data sources,
methodology and assumptions used to calculate the mark. This
information is critical for a counterparty to properly understand how
the daily mark was calculated. The Commission believes that such
disclosures will provide the counterparty useful context with which it
can assess the quality of the mark received.\389\ The Commission
further agrees with the commenter that these disclosures would promote
objectivity and transparency.\390\ This commenter also suggested that
this description of data sources, methodologies and assumptions should
be required to constitute a complete and independently verifiable
methodology for valuing each security.\391\ To satisfy the duty to
disclose the data sources, methodology and assumptions used to prepare
the daily mark, SBS Entities may choose to provide to counterparties
methodologies and assumptions sufficient to independently validate the
output from a model generating the daily mark. The Commission does not
foresee that these disclosures would require SBS Entities to disclose
confidential, proprietary information about any model it may use to
prepare the daily mark.\392\ With these disclosures, counterparties
should not be misled or unduly rely on the daily mark provided by the
SBS Entities. Therefore, the Commission's final rule requires
disclosure of the data sources, methodology and assumptions underlying
the daily mark for uncleared security-based swaps.
---------------------------------------------------------------------------
\386\ See Proposing Release, 76 FR at 42411, supra note 3. See
also Improving Counterparty Risk Management Practices, Counterparty
Risk Management Policy Group (June 1999) at 7 (for use of the term
``mid-market value''). For a discussion of mid-market value and
costs, see also ISDA Research Notes, The Value of a New Swap, Issue
3 (2010), available at http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf.
\387\ See IDC, supra note 5.
\388\ See SIFMA (August 2015), supra note 5.
\389\ The Commission recognizes that different SBS Entities may
produce somewhat different marks for similar security-based swaps,
depending on the respective data sources, methodologies and
assumptions used to calculate the marks. Thus, the data sources,
methodologies and assumptions would provide a context in which the
quality of the mark could be evaluated. See Disclosure of Accounting
Policies for Derivative Financial Instruments and Derivative
Commodity Instruments and Disclosure of Quantitative and Qualitative
Information about Market Risk Inherent in Derivative Financial
Instruments, Other Financial Instruments and Derivative Commodity
Instruments, Securities Act Release No. 7386 (Jan. 31, 1997), 62 FR
6044 (Feb. 10, 1997). The Commission understands that industry
practice is often to include similar disclosures for margin calls in
swap documentation, such as a credit support annex. See Proposing
Release, 76 FR at 42411 n.109, supra note 3.
\390\ See Barnard, supra note 5.
\391\ See Barnard, supra note 5.
\392\ We also note that methodologies and assumptions with
respect to various models are disclosed in the context of financial
statement reporting in footnotes to publicly available financial
statements and Management's Discussion and Analysis in periodic
reports under the Exchange Act without disclosing confidential
proprietary information about models. See FASB Accounting Standards
Codification Topic 820, Fair Value Measurements and Disclosures; 17
CFR 229.303; and 17 CFR 229.305.
---------------------------------------------------------------------------
A commenter suggested that the daily mark disclosures would assist
in resolving valuation disputes during the term of the security-based
swap.\393\ Another commenter suggested requiring SBS Entities and their
counterparties to have a clearly defined process for resolving any
potential valuation disputes about daily marks for both cleared and
uncleared security-based swaps.\394\ The Commission notes that many
market participants separately negotiate a dispute resolution mechanism
for disagreements regarding valuations or include standardized language
regarding dispute resolution in their agreements. At this time, the
Commission declines to require parties to have a process for resolving
valuation disputes and leaves the parties the flexibility to include
such dispute resolution mechanisms in their negotiations if desired.
---------------------------------------------------------------------------
\393\ See Barnard, supra note 5.
\394\ See IDC, supra note 5.
---------------------------------------------------------------------------
Two commenters suggested that Major SBS Participants should not be
required to provide the daily mark for uncleared security-based
swaps.\395\ We believe that the benefits of Rule 15Fh-3(c), as
discussed above, would inure equally to counterparties that transact
with SBS Dealers as well as those that transact with Major SBS
Participants. As we have noted above, even with the use of proprietary
models to calculate the daily mark, we do not believe that the level of
detail required to be disclosed would require an SBS Entity to disclose
confidential proprietary information, whether the SBS Entity is an SBS
Dealer or a Major SBS Participant. The commenter that expressed
concerns regarding the reliability of the daily mark illustrates the
necessity of the disclosure of the data sources, methodologies and
assumptions underlying the calculation. Counterparties may evaluate the
[[Page 29990]]
calculation and reliability of the daily mark calculation and determine
for themselves whether or not to rely on the calculation. Furthermore,
we do not find the arms-length nature of relationships with
counterparties to be a persuasive argument to eliminate the daily mark
requirement. To the extent that Major SBS Participants may be better
informed about the valuations of security-based swaps due to
significant information asymmetries in a market for opaque and complex
products, disclosures may help inform counterparties concerning the
valuations and material risks and characteristics of security-based
swaps in the sometimes rapidly changing market environment.\396\ The
commenter also states that the vast majority of transactions by a Major
SBS Participant would be with an SBS Dealer, in which circumstance, the
disclosure is not required. As a result, we are not adopting the
commenters' suggestions to exclude Major SBS Participants from the
requirement of providing the daily mark disclosure at this time.
---------------------------------------------------------------------------
\395\ See MFA, supra note 5 (suggesting that Major SBS
Participants will have to use proprietary models, which will force
the Major SBS Participants to reveal proprietary information about
their trading book positions and that such calculations would be
sufficient to calculate a fund's total asset value but should not be
relied upon by other market participants) and BlackRock, supra note
5 (arguing that the security-based swaps are arms-length
transactions so the Major SBS Participant should not be required to
develop systems to deliver the daily mark information, particularly
since most transactions will be with an SBS Dealer). As an
alternative to eliminating the daily mark requirement for Major SBS
Participants, these commenters suggest that sophisticated
counterparties should be permitted to opt out of receiving the daily
mark. See discussion above regarding the Commission's reasons for
not permitting counterparties to opt out of receiving the daily mark
disclosure.
\396\ See Section II.C., supra.
---------------------------------------------------------------------------
The Commission has considered the rationale raised by commenters
and decided not to allow counterparties, even ``sophisticated
counterparties,'' to opt-out of the protections afforded by the daily
mark disclosures. It is our understanding that counterparties have a
range of sophistication and some are unlikely to have their own
modeling capabilities or access to relevant data to calculate a daily
mark themselves. We think it is appropriate to apply the rule so that
counterparties receive the benefits of the daily mark and related
disclosures, and do not think it appropriate to permit parties to ``opt
out'' of the benefits of those provisions.
A commenter suggested modifying the rule text for uncleared
security-based swaps to require that the SBS Entity disclose 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 SBS
Entity would agree to replace or terminate the security-based 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 security-based swap that is marked on the books of the SBS
Entity.\397\ While the Commission declines to modify the rule text in
this way, it does note that Rule 15Fh-3(g) as adopted requires an SBS
Entity to communicate with its counterparty in a fair and balanced
manner.\398\ As a result, an SBS Entity may generally wish to consider
disclosing this information.
---------------------------------------------------------------------------
\397\ See SIFMA (August 2015), supra note 5 (requesting that the
Commission insert additional required disclosures into Rule 15h-3(c)
to ensure a fair and balanced communication).
\398\ See Section II.G.5, infra.
---------------------------------------------------------------------------
Against this background, the Commission is not prescribing the
means by which an SBS Entity determines the daily mark for an uncleared
security-based swap. Commenters have made various suggestions as to
additional requirements as to the inputs used for the daily mark
calculation, such as requiring independent third-party quotes or
limiting the context in which an SBS Entity can use its own bid and
offer prices or requiring the daily mark to be an actionable
quote.\399\ At this time, the Commission declines to adopt these
additional requirements. We believe that the rule as adopted will
provide appropriate flexibility for SBS Entities to determine how to
calculate the daily mark while providing disclosure of sufficient
information--data sources, methodologies and assumptions, which are
designed to allow the counterparty to assess the quality of the marks
it receives from the SBS Entity. One of these commenters also suggested
that using its own bid and offer prices for the calculation of the
daily mark may present a conflict of interest for the SBS Entity.\400\
If the SBS Entity is presented with a conflict of interest, we believe
that the SBS Entity likely would disclose the conflict to the
counterparty pursuant to Rule 15Fh-3(b)(2) if the conflict is material.
After receiving such disclosures, the counterparty will be able to
factor that information into its assessment of the quality of the marks
it receives. Consistent with the considerations outlined above, an SBS
Entity may choose to do these calculations in-house or to use
independent third-party valuation services, as suggested by a
commenter.\401\
---------------------------------------------------------------------------
\399\ See Levin, supra note 5; and IDC, supra note 5.
\400\ Id.
\401\ See IDC, supra note 5.
---------------------------------------------------------------------------
As noted above, Rule 15Fh-3(c)(2) requires an SBS Entity to
disclose to the counterparty its data sources and a description of the
methodology and assumptions used to prepare the daily mark for an
uncleared security-based swap. Additionally, Rule 15Fh-3(c)(2) requires
an SBS Entity to promptly disclose any material changes to the data
sources, methodology, or assumptions during the term of the security-
based swap. As noted in the Proposing Release, an SBS Entity is not
required to disclose the data sources or a description of the
methodology and assumptions more than once unless it materially changes
the data sources, methodology or assumptions used to calculate the
daily mark.\402\ For the purposes of this rule, a material change would
generally include any change that has a material impact on the daily
mark provided, such as if the data sources become unreliable or
unavailable, as requested by one commenter.\403\
---------------------------------------------------------------------------
\402\ See Proposing Release, 76 FR at 42412, supra note 3.
\403\ See Levin, supra note 5.
---------------------------------------------------------------------------
A commenter has requested that we eliminate the requirement to
disclose data sources to harmonize more closely with the CFTC.\404\ We
believe that the requirement to disclose data sources is important for
the counterparty to understand and assess the mark being provided.
Therefore, we decline to eliminate this requirement.
---------------------------------------------------------------------------
\404\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Applicable to Both Cleared and Uncleared Security-Based Swaps
Rule 15Fh-3(c) as adopted, does not mandate the means by which an
SBS Entity must make the required disclosures and the Commission
declines to mandate any particular means at this time. The Commission
believes that SBS Entities are best positioned to determine the most
appropriate means of communication of the disclosures. Commenters have
made several specific suggestions for additional requirements regarding
the means of communication of the daily mark.\405\ One commenter
suggested that we require the use of a secure Web site or electronic
platform.\406\ Another commenter requested web-based systems to be the
preferred method of communication, but noted that since some market
participants prefer more traditional methods of communication, web-
based systems should not be required.\407\ The commenter recommended
requiring SBS Entities to have policies and procedures in place that
reasonably ensure that any non-
[[Page 29991]]
electronic means of communication is safe and secure and is otherwise
comparable to web-based systems.\408\ Additionally, the commenter
generally requested that the Commission provide greater clarity on
permissible methods for delivering daily mark disclosures, establish
minimum requirements for the communication of daily marks (for
instance, that the interfaces used provide counterparties with
appropriate tools to initiate, track and close valuation disputes), and
require SBS Entities to ensure that the method of communication is
designed to protect the confidentiality of the data and prevent any
unintentional or fraudulent addition, modification or deletion of a
valuation record.\409\ The Commission continues to believe that such a
method of communication would be an appropriate way for SBS Entities to
discharge their obligations with respect to daily marks.\410\
---------------------------------------------------------------------------
\405\ Suggestions include: Requiring interfaces that allow the
counterparty to initiate, track and close valuation disputes; a
method of communication designed to protect the confidentiality of
the data and prevent any unintentional or fraudulent addition,
modification or deletion of a valuation record; or require the use
of a secure Web site or electronic platform. See Markit, supra note
5; IDC, supra note 5.
\406\ See IDC, supra note 5.
\407\ See Markit, supra note 5.
\408\ Id.
\409\ Id.
\410\ See Proposing Release, 76 FR at 42412, supra note 3.
---------------------------------------------------------------------------
One commenter suggested that we require an SBS Entity to have
policies and procedures to reasonably ensure the safety and security of
non-electronic means of communication.\411\ To provide SBS Entities
with flexibility in the manner of disclosure, we have not specified
requirements with respect to the safety and security of either
electronic or non-electronic communication of the daily mark.\412\
---------------------------------------------------------------------------
\411\ See Markit, supra note 5.
\412\ See the discussion of Timing and Manner of Certain
Disclosures above in Section II.G.2.b. SBS Entities have to comply
with their obligations under Section 15F(j) and Rule 15Fh-3(h). In
addition, as a practical matter, we believe SBS Entities are likely
to have such policies and procedures with respect to both electronic
and non-electronic means of communication in the course of prudent
business practices.
---------------------------------------------------------------------------
In the Proposing Release, the Commission stated that the daily mark
for both cleared and uncleared security-based swaps should be provided
without charge and with no restrictions on internal use by the
counterparty, although restrictions on dissemination to third parties
are permissible.\413\ One commenter supported the requirement that the
daily mark disclosure be provided free of charge.\414\ The daily mark
disclosures are relevant to a counterparty's ongoing understanding and
management of its security-based swap positions. We believe that
counterparties to whom the SBS Entity provides the daily mark should
have the opportunity to effectively use, retain, and analyze the
information with respect to such management. Therefore, the Commission
continues to believe that effective access to the daily mark
information is necessary to ensure a counterparty's ability to manage
its security-based swap positions over the life of the security-based
swaps. Charging for provision of the daily mark, or allowing
restrictions on the internal use of the daily mark by the counterparty
with respect to managing their security-based swap positions, could
undermine this objective. Thus, the Commission continues to believe
that the daily mark for both cleared and uncleared security-based swaps
should be provided without charge and with no restrictions on internal
use by the counterparty, although restrictions on dissemination to
third parties are permissible.\415\ Accordingly, the Commission has
included these requirements in a new paragraph (3) to Rule 15Fh-3(c),
as adopted.
---------------------------------------------------------------------------
\413\ See Proposing Release, 76 FR at 42412, supra note 3.
\414\ See IDC, supra note 5.
\415\ For these purposes, providing the daily mark to a third
party that is the agent of the counterparty, such as the independent
representative of a special entity, for use consistent with its
duties to the client, generally should be considered internal use.
---------------------------------------------------------------------------
f. Clearing Rights
Section 15F(h)(1)(D) of the Exchange Act authorizes the Commission
to prescribe business conduct standards that relate to ``such other
matters as the Commission determines to be appropriate.'' \416\ When an
SBS Entity enters into a security-based swap with a counterparty that
is not an SBS Entity or a Swap Entity, Section 3C(g) of the Exchange
Act establishes a right for the counterparty: (i) To select the
clearing agency at which the security-based swap will be cleared, if
the security-based swap is subject to the mandatory clearing
requirement under Section 3C(a); \417\ and (ii) to elect to require the
clearing of the security-based swap, and to select the clearing agency
at which the security-based swap will be cleared, if the security-based
swap is not subject to the mandatory clearing requirement.\418\
---------------------------------------------------------------------------
\416\ 15 U.S.C. 78o-10(h)(1)(D).
\417\ See Exchange Act 3C(g)(5)(A), 15 U.S.C. 78c-3(g)(5)(A):
With respect to any security-based swap that is subject to the
mandatory clearing requirement under subsection (a) and entered into
by a security-based swap dealer or a major security-based swap
participant with a counterparty that is not a swap dealer, major
swap participant, security-based swap dealer, or major security-
based swap participant, the counterparty shall have the sole right
to select the clearing agency at which the security-based swap will
be cleared.
\418\ See Exchange Act Section 3C(g)(5)(B), 15 U.S.C. 78c-
3(g)(5)(B): With respect to any security-based swap that is not
subject to the mandatory clearing requirement under subsection (a)
and entered into by a security-based swap dealer or a major
security-based swap participant with a counterparty that is not a
swap dealer, major swap participant, security-based swap dealer, or
major security-based swap participant, the counterparty--(i) may
elect to require clearing of the security-based swap; and (ii) shall
have the sole right to select the clearing agency at which the
security-based swap will be cleared.
---------------------------------------------------------------------------
i. Proposed Rule
Proposed Rule 15Fh-3(d) would require an SBS Entity, before
entering into a security-based swap with a counterparty, other than an
SBS Entity or Swap Entity, to disclose to the counterparty its rights
under Section 3C(g) of the Exchange Act concerning submission of a
security-based swap to a clearing agency for clearing. The
counterparty's rights, and thus the proposed disclosure obligations,
would differ depending on whether the clearing requirement of Section
3C(a) applies to the relevant transaction.\419\
---------------------------------------------------------------------------
\419\ Section 3C(a)(1) of the Exchange Act provides that: ``[i]t
shall be unlawful for any person to engage in a security-based swap
unless that person submits such security-based swap for clearing to
a clearing agency that is registered under this Act or a clearing
agency that is exempt from registration under this Act if the
security-based swap is required to be cleared.'' 15 U.S.C. 78c-
3(a)(1).
---------------------------------------------------------------------------
When the clearing requirements of Section 3C(a) apply to a
security-based swap, proposed Rule 15Fh-3(d)(1)(i) would require the
SBS Entity to disclose to the counterparty the clearing agencies that
accept the security-based swap for clearing and through which of those
clearing agencies the SBS Entity is authorized or permitted, directly
or through a designated clearing member, to clear the security-based
swap. Under proposed Rule 15Fh-3(d)(1)(ii), the SBS Entity would also
be required to notify the counterparty of the counterparty's sole right
to select which clearing agency is to be used to clear the security-
based swap, provided it is a clearing agency at which the SBS Entity is
authorized or permitted, directly or through a designated clearing
member, to clear the security-based swap.
For security-based swaps that are not subject to the clearing
requirement under Exchange Act Section 3C(a), proposed Rule 15Fh-
3(d)(2) would require the SBS Entity to determine whether the security-
based swap is accepted for clearing by one or more clearing agencies
and, if so, to disclose to the counterparty the counterparty's right to
elect clearing of the security-based swap. Proposed Rule 15Fh-
3(d)(2)(ii) would require the SBS Entity to disclose to the
counterparty the clearing agencies that accept the security-based swap
for clearing and whether the SBS Entity is authorized or permitted,
directly or through a designated clearing member, to clear the
security-based swap through such
[[Page 29992]]
clearing agencies. Proposed Rule 15Fh-3(d)(2)(iii) would require the
SBS Entity to notify the counterparty of the counterparty's sole right
to select the clearing agency at which the security-based swap would be
cleared, provided it is a clearing agency at which the SBS Entity is
authorized or permitted, directly or through a designated clearing
member, to clear the security-based swap.
ii. Comments on Proposed Rule
Four commenters addressed the required disclosure regarding
clearing rights.\420\ One commenter requested confirmation that a
counterparty's clearing elections could affect the price of the
security-based swap so long as this is disclosed to the counterparty at
the time of the other disclosures regarding clearing.\421\
Additionally, the commenter asked for clarification that standardized
disclosure could be used to satisfy this requirement.\422\ Another
commenter recommended that the Commission not impose the clearing
rights disclosure requirement on Major SBS Participants transacting
with counterparties at arm's length, or alternatively, that the
Commission allow ECP counterparties to opt out of receiving such
disclosures.\423\
---------------------------------------------------------------------------
\420\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5; MFA,
supra note 5; SIFMA (August 2015), supra note 5.
\421\ See FIA/ISDA/SIFMA, supra note 5.
\422\ Id.
\423\ See MFA, supra note 5.
---------------------------------------------------------------------------
An additional commenter advocated for harmonizing the clearing
rights disclosure requirement with the CFTC's parallel
requirement.\424\ Specifically, the commenter recommended eliminating
the proposed requirements to disclose the names of the clearing
agencies that accept the security-based swap for clearing, and through
which the SBS Entity is authorized to clear the security-based
swap.\425\ The commenter argued that given the limited number of
security-based swap clearing agencies, such additional disclosure is
unlikely to be necessary, and that the Commission could always require
it at a future date if the number increases.\426\ Additionally, as
discussed in Section II.B, the commenter advocated for adding an
exception to the requirements regarding the disclosure of clearing
rights to include security-based swaps that are intended to be cleared
and that are either (1) executed on a registered national securities
exchange or registered or exempt SEF and required to be cleared
pursuant to Section 3C of the Exchange Act, or (2) anonymous.\427\
---------------------------------------------------------------------------
\424\ See SIFMA (August 2015), supra note 5.
\425\ Id.
\426\ Id.
\427\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(d) largely as proposed, but with modifications. First, as
discussed above in Section II.B, we are limiting an SBS Entity's
disclosure obligations regarding clearing rights pursuant to Rule 15Fh-
3(d) to counterparties whose identity is known to the SBS Entity at a
reasonably sufficient time prior to the execution of the transaction.
The Commission is also making a second modification to the proposed
rule. We also added the phrase ``subject to Section 3C(g)(5) of the
Act,'' to Rule 15Fh-3(d)(1)(ii) to clarify the source of the
counterparty's right to select which of the clearing agencies described
in paragraph (d)(1)(i) shall be used to clear the security-based swap.
A commenter suggested that, due to the limited number of security-
based swap clearing agencies, disclosure of clearing agencies by name
was unnecessary.\428\ Regardless of the current limited number of
clearing agencies for security-based swaps, not every security-based
swap will be accepted for clearing at every clearing agency, so the
Commission believes that it is still useful for the counterparty to
know whether the particular security-based swap is able to be cleared
at a particular clearing agency.
---------------------------------------------------------------------------
\428\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Rule 15Fh-3(d) requires that disclosure be made before a
transaction occurs. As noted in the Proposing Release, the Commission
believes that it would be appropriate for a counterparty to exercise
its statutory right to select the clearing agency at which its
security-based swaps will be cleared on a transaction-by-transaction
basis, on an asset-class-by-asset-class basis, or in terms of all
potential transactions the counterparty may execute with the SBS
Entity.\429\ While Rule 15Fh-3(d) does not require an SBS Entity to
become a member or participant of a specific clearing agency, an SBS
Entity could not enter into security-based swaps that are subject to a
mandatory clearing requirement without having some arrangement in place
to clear the transaction.\430\
---------------------------------------------------------------------------
\429\ See Proposing Release, 76 FR at 42413, supra note 3.
\430\ See Section 3C(a)(1) of the Exchange Act, 15 U.S.C. 78c-
3(a)(1).
---------------------------------------------------------------------------
Consistent with the discussion regarding manner of disclosures
above in Section II.G.2.b, the Commission agrees with the commenter
that SBS Entities could use standardized disclosure to satisfy Rule
15Fh-3(d).
The Commission also recognizes that a counterparty's clearing
elections could affect the price of the security-based swap and
recognizes that counterparties may wish to receive disclosures about
the effect of clearing on the price. Although the rule does not
explicitly require that the SBS Entity provide specific disclosures
regarding the effect of clearing on the price of the security-based
swap, the SBS Entity may wish to consider whether their obligations
under Rule 15Fh-3(b)(1) to disclose the material risks and
characteristics of the particular security-based swap, as well as their
obligation pursuant to Rule 15Fh-3(g) to communicate with
counterparties in a fair and balanced manner based on principles of
fair dealing and good faith (including providing a sound basis for
evaluating the facts with regard to any particular security-based swap
or trading strategy involving a security-based swap) may require such
disclosure given their particular facts and circumstances.
One commenter recommended that the Commission not impose the
clearing rights disclosure requirement on Major SBS Participants
transacting with counterparties at arm's length or as an alternative
allow ECP counterparties to opt out of receiving the clearing rights
disclosure.\431\ As explained in the Proposing Release, the required
disclosure is intended to promote that, wherever possible and
appropriate, derivatives contracts formerly traded exclusively in the
OTC market are cleared through a regulated clearing agency.\432\ The
Commission has considered the concerns raised by commenters and
determined that it is appropriate to require Major SBS Participants to
provide such disclosures, and to not to permit counterparties to opt
out of the protections provided by the business conduct rules. We
believe that the benefits of Rule 15Fh-3(d), as discussed above, would
inure equally to counterparties that transact with SBS Dealers as well
as those that transact with Major SBS Participants.\433\ We further
believe that allowing counterparties to effectively opt out of the rule
would deprive them of the express protections that the rules were
intended to provide. As a result, we are not adopting the commenters'
suggestions to allow counterparties to opt out of the clearing rights
disclosure
[[Page 29993]]
requirement when transacting with a Major SBS Participant nor to
exclude Major SBS Participants from the requirement of providing the
clearing rights disclosure at this time.
---------------------------------------------------------------------------
\431\ See MFA, supra note 5.
\432\ See MFA, supra note 5; Proposing Release 76 FR at 42413,
supra note 3.
\433\ See Section II.C above.
---------------------------------------------------------------------------
3. Know Your Counterparty
Section 15F(h)(1)(D) of the Exchange Act authorizes the Commission
to prescribe business conduct standards that relate to ``such other
matters as the Commission determines to be appropriate.'' \434\
---------------------------------------------------------------------------
\434\ 15 U.S.C. 78o-10(h)(1)(D).
---------------------------------------------------------------------------
a. Proposed Rule
Proposed Rule 15Fh-3(e) would establish a ``know your
counterparty'' requirement under which an SBS Dealer would be required
to establish, maintain and enforce policies and procedures reasonably
designed to obtain and retain a record of the essential facts that are
necessary for conducting business with each counterparty that is known
to the SBS Dealer. For purposes of the proposed rule, ``essential
facts'' would be defined as: (i) Facts required to comply with
applicable laws, regulations and rules; (ii) facts required to
implement the SBS Dealer's credit and operational risk management
policies in connection with transactions entered into with such
counterparty; (iii) information regarding the authority of any person
acting for such counterparty; and (iv) if the counterparty is a special
entity, such background information regarding the independent
representative as the SBS Dealer reasonably deems appropriate.\435\
---------------------------------------------------------------------------
\435\ Proposed Rule 15Fh-3(e)(1)-(4).
---------------------------------------------------------------------------
b. Comments on the Proposed Rule
Four commenters addressed the proposed know your counterparty
requirement.\436\ Two commenters generally supported the proposed
rule.\437\ However, one requested clarification that since the
requirement only applies to ``known'' counterparties, it would not
apply to an SBS Dealer transacting on a SEF or other electronic
execution platform where such SBS Dealer only learns the identity of
the counterparty immediately before the execution and must execute the
transaction within a limited time frame after learning the
counterparty's identity.\438\ The other commenter asserted that the
requirement should apply to Major SBS Participants in addition to SBS
Dealers.\439\
---------------------------------------------------------------------------
\436\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5; ABC,
supra note 5; SIFMA (August 2015), supra note 5.
\437\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5.
\438\ See FIA/ISDA/SIFMA, supra note 5.
\439\ See CFA, supra note 5.
---------------------------------------------------------------------------
A third commenter expressed concern that the proposed rule would
inappropriately empower SBS Dealers to adopt and enforce rules and to
collect information about independent representatives.\440\ The
commenter asserted that the use of the word ``enforce'' in the proposed
rule suggests that the rule would improperly empower SBS Dealers to
adopt policies and procedures that have the force of law with respect
to their counterparties.\441\ Specifically, the commenter asserted that
the proposed rule authorizes SBS Dealers to collect unlimited
information about the representatives of special entities, as well as
proprietary information, which would give dealers an unfair competitive
advantage.\442\ The commenter argued that SBS Dealers should be
required to adopt policies that comply with the law, and that these
policies should not be binding to the extent they require more than the
law requires.\443\
---------------------------------------------------------------------------
\440\ See ABC, supra note 5.
\441\ Id.
\442\ Id.
\443\ Id.
---------------------------------------------------------------------------
A fourth commenter recommended eliminating the proposed requirement
to collect background information regarding the independent
representative of a special entity.\444\ First, the commenter asserted
that this change would harmonize the Commission's rule with the
parallel CFTC requirement.\445\ Second, the commenter stated that the
proposed requirement would be duplicative of the requirements imposed
on SBS Entities acting as counterparties to special entities pursuant
to Rule 15Fh-5.\446\ Additionally, as discussed in Section II.B, the
commenter advocated for adding an exception to the know your
counterparty requirement to cover security-based swaps that are
intended to be cleared, executed on a registered national securities
exchange or registered or exempt SEF, and of a type that is, as of the
date of execution, required to be cleared pursuant to Section 3C of the
Exchange Act.\447\
---------------------------------------------------------------------------
\444\ See SIFMA (August 2015), supra note 5.
\445\ Id.
\446\ Id.
\447\ Id.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(e) with two modifications. First, in response to a specific
suggestion from a commenter,\448\ the Commission is eliminating the
proposed requirement that an SBS Dealer obtain background information
regarding the independent representative of a special entity
counterparty, as the SBS Dealer reasonably deems appropriate. The
Commission agrees with the commenter that the proposed requirement
would have been duplicative of the requirements imposed on SBS Entities
acting as counterparties to special entities pursuant to Rule 15Fh-5
(discussed below in Section II.H).
---------------------------------------------------------------------------
\448\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Second, the Commission is adding the word ``written'' before
policies and procedures in the rule text to clarify that the policies
and procedures required by the rule must be written. The Commission
believes that this change clarifies the proposal and reflects the
requirement in Rule 15Fh-3(h), discussed in Section II.G.6 below, that
an SBS Dealer establish, maintain and enforce written policies and
procedures that are reasonably designed to prevent violations of the
applicable federal securities laws and rules and regulations
thereunder. Thus, as adopted, Rule 15Fh-3(e) requires SBS Dealers to
``establish, maintain and enforce written policies and procedures
reasonably designed to obtain and retain a record of the essential
facts concerning each counterparty.''
In response to concerns raised by a commenter,\449\ the Commission
is clarifying that the provision stating that an SBS Dealer shall
``establish, maintain and enforce'' policies and procedures does not
vest such policies and procedures with force of law with respect to
their counterparties. An SBS Dealer would, however, have an obligation
to enforce (i.e., follow) its internal policies and procedures.
---------------------------------------------------------------------------
\449\ See ABC, supra note 5.
---------------------------------------------------------------------------
We have determined, as proposed, not to apply the rule where an SBS
Dealer does not know the identity of its counterparty. We are not
adopting the suggestion of one commenter that we provide an additional
exception to cover security-based swaps that are intended to be
cleared, executed on a registered national securities exchange or
registered or exempt SEF, and of a type that is, as of the date of
execution, required to be cleared pursuant to Section 3C of the
Exchange Act, even if not anonymous.\450\ However, we note that Rule
15Fh-3(e) requires SBS Dealers to establish policies and procedures
that are ``reasonably designed to obtain and retain a record of the
essential facts concerning each
[[Page 29994]]
[known counterparty] that are necessary for conducting business with
such counterparty.'' Reasonably designed policies and procedures
established pursuant to Rule 15Fh-3(e) may address situations in which
there are few, if any, essential facts that are necessary for
conducting business with a counterparty. For example, if the only
security-based swaps that an SBS Dealer enters into with a counterparty
are intended to be cleared security-based swaps that are executed on a
registered exchange or SEF and of a type that is, as of the date of
execution, required to be cleared pursuant to Section 3C of the
Exchange Act, then there may be few, if any, essential facts that the
SBS Dealer needs to know about such counterparty in that circumstance.
---------------------------------------------------------------------------
\450\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
In response to a commenter's request for clarification that since
the requirement only applies to ``known'' counterparties, it would not
apply to an SBS Dealer transacting on a SEF or other electronic
execution platform where such SBS Dealer only learns the identity of
the counterparty immediately before the execution and must execute the
transaction within a limited time frame after learning the
counterparty's identity,\451\ the Commission notes that Rule 15Fh-3(e)
does not contain a specific timing requirement. Rule 15Fh-3(e) requires
SBS Dealers to establish policies and procedures that are ``reasonably
designed to obtain and retain a record of the essential facts
concerning each [known counterparty] that are necessary for conducting
business with such counterparty.'' To be ``reasonably designed'' such
policies and procedures generally should provide for the collection of
counterparty information prior to execution of a transaction with that
counterparty. However, if the SBS Dealer does not learn a
counterparty's identity until immediately prior to or subsequent to
execution, then it would be reasonable for collection to occur within a
reasonable time after the SBS Dealer learns the identity of the
counterparty.\452\
---------------------------------------------------------------------------
\451\ See FIA/ISDA/SIFMA, supra note 5.
\452\ The application of the know your counterparty requirement
in these circumstances does not affect the application of the other
business conduct obligations in Rules 15Fh-3(b) and (d), 15Fh-4(b),
15Fh-5, and 15Fh-6, including the exceptions to the application of
those rules where the identity of the counterparty is not known to
the SBS Entity at a reasonably sufficient time prior to execution of
the transaction, and, in the case of Rules 15Fh-4(b), 15Fh-5 and
15Fh-6, executed on a registered national securities exchange or
registered or exempt SEF.
---------------------------------------------------------------------------
As noted in the Proposing Release, the ``know your counterparty''
obligations under Rule 15Fh-3(e) are a modified version of the ``know
your customer'' obligations imposed on other market professionals, such
as broker-dealers, when dealing with customers.\453\ Although the
statute does not require the Commission to adopt a ``know your
counterparty'' standard, the Commission continues to believe that such
a standard is consistent with basic principles of legal and regulatory
compliance, and operational and credit risk management.\454\ Further,
the Commission continues to believe that entities that currently
operate as SBS Dealers typically would already have in place, as a
matter of their normal business practices, policies and procedures that
could potentially satisfy the requirements of the rule.\455\
---------------------------------------------------------------------------
\453\ See Proposing Release, 76 FR at 42414, supra note 3. Cf.
FINRA Rule 2090 (``[e]very member shall use reasonable diligence, in
regard to the opening and maintenance of every account, to know (and
retain) the essential facts concerning every customer and concerning
the authority of each person acting on behalf of such customer'').
Supplementary Material .01 to FINRA Rule 2090 defines the
``essential facts'' for purposes of the FINRA rule to include
certain information not required by Rule 15Fh-3(e). For purposes of
FINRA Rule 2090, facts ``essential'' to ``knowing the customer'' are
those required to (a) effectively service the customer's account,
(b) act in accordance with any special handling instructions for the
account, (c) understand the authority of each person acting on
behalf of the customer, and (d) comply with applicable laws,
regulations, and rules.
\454\ See Proposing Release, 76 FR at 42414, supra note 3.
\455\ Id.
---------------------------------------------------------------------------
The Commission is applying the requirements in Rule 15Fh-3(e) to
SBS Dealers but declines to apply them to Major SBS Participants, as
suggested by a commenter.\456\ As discussed above in Section II.C, the
Commission has determined that where a business conduct requirement is
not expressly addressed by the Dodd-Frank Act, the rules generally will
not apply to Major SBS Participants.
---------------------------------------------------------------------------
\456\ See CFA, supra note 5.
---------------------------------------------------------------------------
4. Recommendations by SBS Dealers
Section 15F(h)(1)(D) of the Exchange Act authorizes the Commission
to prescribe business conduct standards that relate to ``such other
matters as the Commission determines to be appropriate.'' \457\
Additionally, Section 15F(h)(3)(D) of the Exchange authorizes the
Commission 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 this Act.'' \458\
---------------------------------------------------------------------------
\457\ 15 U.S.C. 78o-10(h)(1)(D).
\458\ 15 U.S.C. 78o-10(h)(3)(D).
---------------------------------------------------------------------------
a. Proposed Rule
i. General
Proposed Rule 15Fh-3(f) generally would require an SBS Dealer that
recommends a security-based swap or trading strategy involving a
security-based swap to a counterparty, other than an SBS Entity or Swap
Entity, to have a reasonable basis for believing that the recommended
security-based swap or trading strategy is suitable. Specifically,
proposed Rule 15Fh-3(f)(1)(i) would require an SBS Dealer to have a
reasonable basis to believe, based on reasonable diligence, that the
recommended security-based swap or trading strategy is suitable for at
least some counterparties. Additionally, proposed Rule 15Fh-3(f)(1)(ii)
would require an SBS Dealer to have a reasonable basis to believe that
the recommended security-based swap or trading strategy is suitable for
the particular counterparty that is the recipient of the SBS Dealer's
recommendation (``customer-specific suitability''). Under proposed Rule
15Fh-3(f)(1)(ii), to establish a reasonable basis to believe that a
recommendation is suitable for a particular counterparty, an SBS Dealer
would need to have or obtain relevant information regarding the
counterparty, including the counterparty's investment profile, trading
objectives, and its ability to absorb potential losses associated with
the recommended security-based swap or trading strategy.
ii. Institutional Suitability Alternative
Proposed Rule 15Fh-3(f)(2) would provide an alternative to the
general suitability requirements, under which an SBS Dealer could
fulfill its suitability obligations with respect to a particular
counterparty if: (1) The SBS Dealer reasonably determines that the
counterparty (or its agent) is capable of independently evaluating
investment risks with regard to the relevant security-based swap or
trading strategy involving a security-based swap; (2) the counterparty
(or its agent) affirmatively represents in writing that it is
exercising independent judgment in evaluating the recommendations by
the SBS Dealer; and (3) the SBS Dealer discloses that it is acting in
the capacity of a counterparty, and is not undertaking to assess the
suitability of the security-based swap or trading strategy for the
counterparty.
The Commission sought comment on whether different categories of
ECPs should be treated differently for purposes of suitability
[[Page 29995]]
determinations.\459\ The Proposing Release noted that, under our
proposed rules, an SBS Dealer could rely on the institutional
suitability alternative when entering into security-based swaps with
any person that qualified as an ECP, a category that includes persons
with $5 million or more invested on a discretionary basis that enter
into the security-based swap ``to manage risks.'' \460\ In contrast,
under FINRA rules, in order to apply an analogous institutional
suitability alternative, a broker-dealer must be dealing with a person
(whether a natural person, corporation, partnership, trust, or
otherwise) with total assets of at least $50 million.\461\ The
Proposing Release asked whether the Commission should apply a different
standard of suitability depending on whether the counterparty would be
protected as a retail investor under FINRA rules when the SBS Dealer is
also a registered broker-dealer.\462\ More generally, the Commission
sought comment on whether the institutional suitability alternative
available under proposed Rule 15Fh-3(f)(2) should be limited to
counterparties that would not be protected as retail investors under
FINRA rules or another category of counterparties.
---------------------------------------------------------------------------
\459\ See Proposing Release, 76 FR at 42417, supra note 3.
\460\ See Section 1a(18)(A)(xi) of the Commodity Exchange Act, 7
U.S.C. 1a(18)(A)(xi).
\461\ See FINRA Rule 2111(b) (referring to FINRA Rule 4512(c)).
\462\ Under FINRA rules, institutional suitability is limited to
transactions with so-called ``institutional'' investors:
(1) A bank, savings and loan association, insurance company or
registered investment company;
(2) an investment adviser registered either with the SEC under
Section 203 of the Investment Advisers Act or with a state
securities commission (or any agency or office performing like
functions); or
(3) any other person (whether a natural person, corporation,
partnership, trust or otherwise) with total assets of at least $50
million.
See FINRA Rule 4512(c) (regarding definition of ``institutional
account'').
---------------------------------------------------------------------------
iii. Special Entity Suitability Alternative
Proposed Rule 15Fh-3(f)(3) would provide another alternative to the
general suitability requirements for SBS Dealers transacting with
special entity counterparties. Under proposed Rule 15Fh-3(f)(3), an SBS
Dealer would be deemed to satisfy its suitability obligations with
respect to a special entity counterparty if the SBS Dealer either is
acting as an advisor to the special entity and complies with proposed
Rule 15Fh-4(b),\463\ or is deemed not to be acting as an advisor to the
special entity pursuant to proposed Rule 15Fh-2(a).
---------------------------------------------------------------------------
\463\ As discussed below in Section II.H.2, proposed Rule 15Fh-
4(b) would impose certain requirements on SBS Dealers acting as
advisors to special entities.
---------------------------------------------------------------------------
b. Comments on the Proposed Rule
i. General
Six commenters addressed the suitability requirements.\464\ Three
commenters recommended expanding the suitability requirements.\465\ One
commenter suggested two changes to the rule: (1) Clarifying that SBS
Dealers would be prohibited from recommending to investors financial
products that the dealers believe will fail; and (2) requiring that an
SBS Dealer making recommendations regarding a certain product or type
of product have the background necessary to understand the
product.\466\ Another commenter urged the Commission to consider
developing suitability standards for the types of financial products
that can be sold to state and local governments, including those
products in the swaps arena.\467\ A third commenter suggested that the
Commission conform its requirements to the CFTC's proposal, noting that
the CFTC proposal would have required the dealer to obtain information
through reasonable due diligence concerning the counterparty's
financial situation and needs, objectives, tax status, ability to
evaluate the recommendation, liquidity needs, risk tolerance or other
relevant information.\468\ The commenter also recommended explicitly
requiring SBS Dealers to: (1) Gather information sufficient to make the
suitability assessment; and (2) maintain sufficient documents to allow
the Commission to effectively enforce compliance.\469\ Additionally,
the commenter asserted that the suitability requirement should apply to
all SBS Entities, not just SBS Dealers, noting that the suitability
obligation would only be imposed on a Major SBS Participant if the
Major SBS Participant makes a recommendation to a non-SBS Entity.\470\
While the commenter supported the exclusion from the suitability
requirement for recommendations to other SBS Entities, it strongly
opposed any additional exclusions (e.g., for recommendations to broker-
dealers or other market intermediaries who are not SBS Entities).
Finally, the commenter also strongly opposed limiting the requirement
to recommendations to retail investors.\471\
---------------------------------------------------------------------------
\464\ See Levin, supra note 5; GFOA, supra note 5; CFA, supra
note 5; Barnard, supra note 5; FIA/ISDA/SIFMA, supra note 5; SIFMA
(August 2015), supra note 5.
\465\ See Levin, supra note 5; GFOA, supra note 5; CFA, supra
note 5.
\466\ See Levin, supra note 5.
\467\ See GFOA, supra note 5.
\468\ See CFA, supra note 5. The CFTC subsequently adopted a
rule that is similar to proposed Rule 15Fh-3(f). See CFTC Adopting
Release, 77 FR at 9771-9774, supra note 21.
\469\ See CFA, supra note 5.
\470\ Id.
\471\ Id. The commenter explained that, under the institutional
suitability alternative, ``the SBS Dealer wouldn't even have to have
a reasonable basis to believe that the swap was suitable . . . for
the particular counterparty to the transaction.'' The commenter
expressed its concern that:
Given the profits at stake, SBS Dealer will have strong
incentives to conclude that the counterparty is capable of
evaluating the transaction. Counterparties who turn to the
derivatives markets out of questionable motives will have equally
strong incentives to assert their capacity to independently evaluate
investment risk. And even those with purer motives may be reluctant
to confess to a lack of expertise.
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Two other commenters recommended narrowing the suitability
requirements.\472\ One commenter suggested that any suitability
standard for SBS Dealers be applied at the least granular level (e.g.,
on a transaction-by-transaction basis, on an asset-class-by-asset-class
basis, or in terms of all potential transactions between the parties,
as appropriate).\473\ The second commenter opposed the suitability
requirement more broadly, stating that Congress did not impose such a
requirement.\474\ The commenter suggested, as an alternative to the
proposed rule, that any suitability requirement for recommendations to
counterparties other than special entities be imposed through a
requirement to adopt and enforce policies and procedures reasonably
designed to assess the suitability of recommendations, and that the
proposed rule be incorporated as guidance establishing a safe harbor
for whether an SBS Dealer's policies are reasonable.\475\ The commenter
also asserted that the proposed rule could conflict with the specific
suitability rules of other (unidentified) regulators, and accordingly,
urged the Commission to clarify that an SBS Dealer that complies with
suitability requirements of another qualifying regulator will also be
deemed to have adopted and enforced reasonable suitability policies
under the Commission's rule.\476\ Finally, the commenter recommended
allowing sophisticated counterparties to opt out of suitability
protection, noting that some counterparties will find the suitability
analysis burdensome and intrusive, and that the costs of the
[[Page 29996]]
proposed suitability rule for those counterparties will likely outweigh
any benefits.\477\
---------------------------------------------------------------------------
\472\ See Barnard, supra note 5; FIA/ISDA/SIFMA, supra note 5.
\473\ See Barnard, supra note 5.
\474\ See FIA/ISDA/SIFMA, supra note 5.
\475\ Id.
\476\ Id.
\477\ Id.
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Finally, a sixth commenter advocated for harmonizing the
suitability requirement in proposed Rule 15Fh-3(f)(1)(i) with the
CFTC's parallel requirement.\478\ Specifically, the commenter
recommended changing the wording of the suitability requirement in
proposed Rule 15Fh-3(f)(1)(i) to ``undertake reasonable diligence to
understand the potential risks and rewards associated with the
recommended security-based swap or trading strategy involving a
security-based swap.'' \479\
---------------------------------------------------------------------------
\478\ See SIFMA (August 2015), supra note 5.
\479\ Id.
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ii. Institutional Suitability Alternative
Three commenters submitted comments regarding the institutional
suitability alternative in proposed Rule 15Fh-3(f)(2).\480\ Two
commenters expressed concerns regarding the proposed alternative.\481\
One commenter expressed concern that the counterparty representations
upon which the SBS Dealer would rely may become outdated or boilerplate
language that is inappropriate for the counterparty to which it is
directed.\482\ Accordingly, the commenter suggested requiring SBS
Dealers to conduct routine audits to ensure that these institutional
level suitability determinations are not over-utilized, that they are
appropriate for the particular counterparties involved, and that the
appropriate written documentation was provided and signed in applicable
transactions.\483\ Additionally, the commenter recommended that as part
of that audit process, and to prevent inaccurate determinations, SBS
Dealers should be required to test, perhaps on an annual basis, whether
counterparties continue to have the personnel and expertise needed to
conduct independent evaluations of the security-based swap products
being marketed.\484\
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\480\ See Levin, supra note 5; CFA, supra note 5; SIFMA (August
2015), supra note 5.
\481\ See Levin, supra note 5; CFA, supra note 5.
\482\ See Levin, supra note 5.
\483\ Id.
\484\ Id.
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The second commenter strongly opposed the institutional suitability
alternative, asserting that the complexity and opacity of structured
finance products has made them impenetrable to all but the most
sophisticated industry experts.\485\ At a minimum, the commenter
recommended that if the Commission adopts the institutional suitability
alternative, it should require an SBS Dealer to have a reasonable basis
to believe its counterparty has the capacity to absorb potential losses
related to the security-based swap or trading strategy being
recommended.\486\
---------------------------------------------------------------------------
\485\ See CFA, supra note 5.
\486\ Id.
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A third commenter advocated for harmonizing the institutional
suitability alternative with the CFTC's parallel provision, citing
potential counterparty confusion.\487\ Specifically, the commenter
recommended that the Commission: (1) Clarify that the institutional
suitability alternative only satisfies an SBS Dealer's customer-
specific suitability obligation in proposed Rule 15Fh-3(f)(1)(ii), not
its suitability obligation in proposed Rule 15Fh-3(f)(1)(i); and (2)
add a safe harbor providing that an SBS Dealer can satisfy its
requirement to make a reasonable determination that the counterparty is
capable of independently evaluating investment risks with regard to the
security-based swap if the SBS Dealer receives written representations
from the counterparty regarding the counterparty's compliance with
appropriate policies and procedures.\488\
---------------------------------------------------------------------------
\487\ See SIFMA (August 2015), supra note 5.
\488\ Id.
---------------------------------------------------------------------------
iii. Special Entity Suitability Alternative
Four commenters submitted comments regarding the suitability
alternative for special entity counterparties in proposed Rule 15Fh-
3(f)(3).\489\ Three commenters supported the proposed rule.\490\
Another commenter recommended adding a requirement to the institutional
suitability alternative, in lieu of the special entity suitability
alternative, that the SBS Dealer comply with the requirements of Rule
15Fh-4(b) (regarding acting as an advisor to a special entity) if the
SBS Dealer's recommendation to a special entity would cause it to be
acting as an advisor to the special entity.\491\
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\489\ See BlackRock, supra note 5; GFOA, supra note 5; ABC,
supra note 5; SIFMA (August 2015), supra note 5.
\490\ See BlackRock, supra note 5; GFOA, supra note 5; ABC,
supra note 5.
\491\ See SIFMA (August 2015), supra note 5.
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c. Response to Comments and Final Rule
i. General
After considering the comments, the Commission is adopting Rule
15Fh-3(f)(1) with two modifications. The first modification is to
rephrase the suitability obligation in proposed Rule 15Fh-3(f)(1)(i),
in response to a specific suggestion from a commenter,\492\ to make it
consistent with the CFTC's parallel suitability requirement in
Commodity Exchange Act Rule 23.434(a)(1), which explicitly requires SBS
Dealers to understand the risk-reward tradeoff of their
recommendations. We believe that our proposed formulation and the
CFTC's formulation would have achieved the same purpose. However, to
alleviate concerns among commenters that compliance with the two rules
would require anything different, we are harmonizing the wording of our
rule with the CFTC's parallel suitability obligation.\493\ As adopted,
Rule 15Fh-3(f)(1)(i) requires an SBS Dealer that recommends a security-
based swap or trading strategy involving a security-based swap to a
counterparty, other than an SBS Entity or Swap Entity, to ``undertake
reasonable diligence to understand the potential risks and rewards
associated with the recommended security-based swap or trading strategy
involving a security-based swap.'' Consistency with the CFTC standard
will result in efficiencies for entities that have already established
infrastructure to comply with the CFTC standard. Consistent wording
will also allow SBS Entities to more easily analyze compliance with the
Commission's rule against their existing activities to comply with the
CFTC's parallel suitability rule for Swap Entities.
---------------------------------------------------------------------------
\492\ See SIFMA (August 2015), supra note 5. The Commission
believes this change also responds to another commenter's concern
that the proposed rules could conflict with the CFTC's suitability
rule. See FIA/ISDA/SIFMA, supra note 5.
\493\ See CFTC Adopting Release, 77 FR at 9771-9774, supra note
21. The new formulation is also consistent with FINRA's approach to
this aspect of suitability. See Supplementary Material .05(a) to
FINRA Rule 2111 (effective July 9, 2012) (``[a] member's or
associated person's reasonable diligence must provide the member or
associated person with an understanding of the potential risks and
rewards associated with the recommended security or strategy'').
---------------------------------------------------------------------------
The second modification the Commission is making is to add the
phrase ``involving a security-based swap'' to the final line of the
customer-specific suitability obligation in proposed Rule 15Fh-
3(f)(1)(ii) to modify ``trading strategy.'' Accordingly, Rule 15Fh-
3(f)(1)(ii), as adopted, requires an SBS Dealer that recommends a
security-based swap or trading strategy involving a security-based swap
to a counterparty, other than an SBS Entity or Swap Entity, to have a
reasonable basis to believe that a recommended security-based swap or
trading strategy involving a security-based swap is suitable for the
counterparty, and to establish a
[[Page 29997]]
reasonable basis for a recommendation, to have or obtain relevant
information regarding the counterparty, including the counterparty's
investment profile, trading objectives, and its ability to absorb
potential losses associated with the recommended security-based swap or
trading strategy ``involving a security-based swap.'' The Commission
does not believe that this is a substantive change. It simply clarifies
that the term trading strategy as used in the final line of the rule is
the same as recommended trading strategy involving a security-based
swap that is referenced earlier in the rule.
As noted in the Proposing Release, although suitability is not
expressly addressed in Section 15F(h) of the Exchange Act, the
obligation to make only suitable recommendations is a core business
conduct requirement for broker-dealers and other financial
intermediaries.\494\ Municipal securities dealers also have a
suitability obligation when recommending municipal securities
transactions to a customer.\495\ Depending on the scope of its
activities, an SBS Dealer may be subject to one of these other
suitability obligations, in addition to those under Rule 15Fh-3(f). In
particular, an SBS Dealer that also is a registered broker-dealer and a
FINRA member, would be subject to FINRA's suitability requirements in
connection with the recommendation of a security-based swap or trading
strategy involving a security-based swap.\496\ Rule 15Fh-3(f) is
intended to ensure that all SBS Dealers that make recommendations are
subject to this obligation, tailored as appropriate in light of the
nature of the security-based swap markets.\497\
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\494\ See Proposing Release, 76 FR at 42415, supra note 3. See
also, e.g., FINRA Rules 2090 and 2111 (effective Jul. 9, 2012);
Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943) (enforcing
suitability obligations under the antifraud provisions of the
Exchange Act).
\495\ MSRB Rule G-19(c) provides that:
In recommending to a customer any municipal security
transaction, a broker, dealer, or municipal securities dealer shall
have reasonable grounds: (i) Based upon information available from
the issuer of the security or otherwise, and (ii) based upon the
facts disclosed by such customer or otherwise known about such
customer, for believing that the recommendation is suitable.
\496\ See FINRA Rule 2111. Under FINRA rules, unless a customer
is an ``institutional account'' that meets the requirements of the
institutional account exemption, he or she would be entitled to the
protections provided by retail suitability obligations in the
broker-dealer context. An ``institutional account'' means the
account of a bank, savings and loan association, insurance company,
registered investment company, registered investment adviser or any
other person (whether a natural person, corporation, partnership,
trust, or otherwise) with total assets of at least $50 million. See
FINRA Rule 2111(b) (referring to FINRA Rule 4512(c)).
\497\ Some dealers have indicated that they already apply
``institutional suitability'' principles to their swap business.
See, e.g., Letter from Richard Ostrander, Managing Director and
Counsel, Morgan Stanley, to Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission, and David A. Stawick, Secretary,
Commodity Futures Trading Commission (Dec. 3, 2010) at 5; Report of
the Business Standards Committee, Goldman Sachs (Jan. 2011), http://www2.goldmansachs.com/our-firm/business-standards-committee/report.pdf.
---------------------------------------------------------------------------
The Commission continues to believe that the determination of
whether an SBS Dealer has made a recommendation that triggers
suitability obligations should turn on the facts and circumstances of
the particular situation and, therefore, whether a recommendation has
taken place is not susceptible to a bright line definition.\498\ This
follows the FINRA approach to what constitutes a recommendation for
purposes of FINRA's suitability rule.\499\ In the context of the FINRA
suitability rule, factors considered in determining whether a
recommendation has taken place include whether the communication
``reasonably could be viewed as a `call to action' '' and ``reasonably
would influence an investor to trade a particular security or group of
securities.'' \500\ We note that this could include a call to action
regarding buying, selling, materially amending or early termination of
a security-based swap. The more individually tailored the communication
to a specific customer or a targeted group of customers about a
security or group of securities, the greater the likelihood that the
communication may be viewed as a ``recommendation.'' The Commission
continues to believe that this approach to determining whether a
recommendation has taken place should apply in the context of Rule
15Fh-3(f) as well.\501\
---------------------------------------------------------------------------
\498\ See Proposing Release, 76 FR at 42415, supra note 3.
\499\ See FINRA Regulatory Notice 12-25 (May 2012) Q.2 and Q.3
(regarding the scope of ``recommendation'').
\500\ See FINRA Notice to Members 01-23 (Mar. 19, 2001), and
Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090
(Know Your Customer) and 2111 (Suitability) in the Consolidated
FINRA Rulebook, Exchange Act Release No. 62718 (Aug. 13, 2010), 75
FR 51310 (Aug. 19, 2010), as amended, Exchange Act Release No.
62718A (Aug. 20, 2010), 75 FR 52562 (Aug. 26, 2010) (discussing what
it means to make a ``recommendation'').
\501\ See Proposing Release, 76 FR at 42415, supra note 3.
---------------------------------------------------------------------------
As noted in the Proposing Release, an SBS Dealer typically would
not be deemed to be making a recommendation solely by reason of
providing general financial or market information, or transaction terms
in response to a request for competitive bids.\502\ Again, this follows
the FINRA approach to determining whether a recommendation has
occurred.\503\ Furthermore, compliance with the requirements of the
other business conduct rules, in particular, Rules 15Fh-3(a)
(verification of counterparty status), 15Fh-3(b) (disclosures of
material risks and characteristics, and material incentives or
conflicts of interest), 15Fh-3(c) (disclosures of daily mark), and
15Fh-3(d) (disclosures regarding clearing rights) would not, in and of
itself, result in an SBS Dealer being deemed to be making a
``recommendation.'' \504\
---------------------------------------------------------------------------
\502\ See Proposing Release, 76 FR at 42415, supra note 3.
\503\ See Supplementary Material .03 to FINRA Rule 2090.
\504\ Additionally, as discussed in Section I.E, supra, the
duties imposed on an SBS Dealer under the business conduct rules are
specific to this context, and are in addition to any duties that may
be imposed under other applicable law. Thus, an SBS Dealer must
separately determine whether it is subject to regulation as a
broker-dealer, an investment adviser, a municipal advisor or other
regulated entity.
---------------------------------------------------------------------------
We believe that the suitability obligation in Rule 15Fh-3(f)(1)(i)
should address one commenter's concerns about the possibility that an
SBS Dealer will recommend a financial product that it believes will
fail or that it does not have the necessary background to
understand.\505\ When making recommendations, SBS Dealers are always
required to meet their suitability obligation in Rule 15Fh-3(f)(1)(i),
regardless of whether they avail themselves of the institutional
suitability alternative to meet their customer-specific suitability
obligations. In that respect, SBS Dealers will always be required to
undertake reasonable diligence to understand the risks and rewards
behind any recommended security-based swap.
---------------------------------------------------------------------------
\505\ See Levin, supra note 5.
---------------------------------------------------------------------------
With respect to another commenter's concerns about SBS Dealers'
gathering sufficient information to make the customer-specific
suitability assessment,\506\ the Commission notes that Rule 15Fh-
3(f)(1)(ii) requires an SBS Dealer to ``have a reasonable basis to
believe'' that a recommended security-based swap or trading strategy is
suitable for the counterparty. To establish that reasonable basis, the
rule requires the SBS Dealer to ``have or obtain relevant information
regarding the counterparty, including the counterparty's investment
profile, trading objectives, and its ability to
[[Page 29998]]
absorb potential losses associated with the recommended security-based
swap or trading strategy.'' The list of ``relevant information'' in the
rule is exemplary, not exhaustive. Whether an SBS Dealer has a
reasonable basis to believe that a recommended security-based swap or
trading strategy is suitable for the counterparty is a determination
that depends on the facts and circumstances of the particular
situation.
---------------------------------------------------------------------------
\506\ See CFA, supra note 5. In response to the commenter's
other concern regarding the Commission requiring SBS Dealers to
maintain sufficient documentation to effectively enforce compliance
with the suitability rule, we note that the Commission has
separately proposed recordkeeping requirements for SBS Dealers. See
Recordkeeping Release, 79 FR at 25135, supra note 242.
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The Commission declines to apply Rule 15Fh-3(f) to Major SBS
Participants, as suggested by one commenter.\507\ As discussed above in
Section II.C, where a business conduct requirement is not expressly
addressed by the Dodd-Frank Act, the Commission is generally not
applying such a rule to Major SBS Participants. The Commission
continues to believe that it is appropriate not to impose suitability
obligations on Major SBS Participants, given that, by definition, Major
SBS Participants are not engaged in security-based swap dealing
activity at levels above the de minimis threshold.\508\ However, if a
Major SBS Participant is, in fact, recommending security-based swaps or
trading strategies involving security-based swaps to a counterparty,
this would indicate that the Major SBS Participant is actually engaged
in security-based swap dealing activity.\509\ If a Major SBS
Participant engages in such activity above the de minimis threshold in
Exchange Act Rule 3a71-2, it would need to register as an SBS Dealer
and, as such, would need to comply with the suitability obligations
imposed by Rule 15Fh-3(f).
---------------------------------------------------------------------------
\507\ See CFA, supra note 5.
\508\ See Exchange Act Rule 3a61-1(a)(1) (limiting the
definition of ``major security-based swap participant'' to persons
that are not security-based swap dealers).
\509\ See Proposing Release, 76 FR at 42416 n.140, supra note 3.
See also Definitions Adopting Release, 77 FR at 30618, supra note
115 (``Advising a counterparty as to how to use security-based swaps
to meet the counterparty's hedging goals, or structuring security-
based swaps on behalf of a counterparty, also would indicate
security-based swap dealing activity.'').
---------------------------------------------------------------------------
Further, Rule 15Fh-3(f) will not impose suitability obligations on
an SBS Dealer transacting with an SBS Entity or Swap Entity. The
Commission continues to believe that these types of counterparties,
which are professional intermediaries or major participants in the
swaps or security-based swaps markets, would not need the protections
that would be afforded by this rule. However, taking into account the
concerns of one commenter,\510\ the Commission is not adopting any
additional exclusions to the rule at this time, nor is the Commission
applying the suitability obligations at the least granular level (e.g.,
on a transaction-by-transaction basis, on an asset-class-by-asset-class
basis, or in terms of all potential transactions between the parties),
as suggested by another commenter.\511\ The Commission is also not, as
suggested by one commenter,\512\ providing an opt out from the rule or
a policies and procedures alternative. As discussed above in Sections
II.A.3.d and II.E, the Commission believes that it is appropriate to
apply the suitability rule so that counterparties receive the benefits
of the protections provided by the rule; permitting parties to ``opt
out'' of the benefits of the rule or providing a policies and
procedures alternative would undermine its core purpose of protecting
counterparties. However, while we are not adopting an opt out provision
or a policies and procedures alternative, the Commission has determined
to permit means of compliance with Rule 15Fh-3(f) that should promote
efficiency and reduce costs (e.g., reliance on representations pursuant
to Rule 15Fh-1(b)) and allowing SBS Dealers to take into account the
sophistication of the counterparty by way of the institutional
suitability alternative in Rule 15Fh-3(f)(2) (described below).
---------------------------------------------------------------------------
\510\ See CFA, supra note 5.
\511\ See Barnard, supra note 5.
\512\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
The Commission is not adopting one commenter's suggestion to impose
additional standards for the types of financial products that can be
sold to state and local governments, including security-based
swaps.\513\ We have determined that additional standards are not needed
and that the rules we are adopting appropriately regulate the business
conduct of the professional market intermediaries selling these
products. We also note that the MSRB is developing a regulatory
framework for municipal advisors, including detailed standards of
conduct that municipal advisors owe to municipal entities.\514\
---------------------------------------------------------------------------
\513\ See GFOA, supra note 5.
\514\ See, e.g., Order Granting Approval of a Proposed Rule
Change, as Modified by Amendment No. 1 and Amendment No. 2,
Consisting of Proposed New Rule G-42, on Duties of Non-Solicitor
Municipal Advisors, and Proposed Amendments to Rule G-8, on Books
and Records to be Made by Brokers, Dealers, Municipal Securities
Dealers, and Municipal Advisors, Exchange Act Release No. 76753
(Dec. 23, 2015), 80 FR 81614 (Dec. 30, 2015); Order Granting
Approval of a Proposed Rule Change Consisting of Proposed Amendments
to Rule G-20, on Gifts, Gratuities and Non-Cash Compensation, and
Rule G-8, on Books and Records to be Made by Brokers, Dealers,
Municipal Securities Dealers, and Municipal Advisors, and the
Deletion of Prior Interpretive Guidance, Exchange Act Release No.
76381 (Nov. 6, 2015), 80 FR 70271 (Nov. 13, 2015); see also Notice
of Filing of a Proposed Rule Change Consisting of Proposed
Amendments to Rule G-37, on Political Contributions and Prohibitions
on Municipal Securities Business, Rule G-8, on Books and Records,
Rule G-9, on Preservation of Records, and Forms G-37 and G-37x,
Exchange Act Release No. 76763 (Dec. 23, 2015), 80 FR 81709 (Dec.
30, 2015).
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ii. Institutional Suitability Alternative and Special Entity
Suitability Alternative
After considering the comments, the Commission is adopting Rules
15Fh-3(f)(2)-(4) with a number of modifications. First, in response to
a specific suggestion from a commenter,\515\ the Commission is
correcting a typographical error in proposed Rule 15Fh-3(f)(2). The
institutional suitability alternative in proposed Rule 15Fh-3(f)(2) was
intended to provide SBS Dealers with an alternative method to fulfill
their customer-specific suitability obligations described in proposed
Rule 15Fh-3(f)(1)(ii), not their suitability obligations described in
proposed Rule 15Fh-3(f)(1)(i). Accordingly, the cross-reference in the
proposed rule should have been to ``paragraph (f)(1)(ii),'' not to
``paragraph (f)(1).'' The Commission is correcting this cross-reference
in the final rules.
---------------------------------------------------------------------------
\515\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Second, in response to concerns raised by a commenter,\516\ the
Commission is also limiting the availability of the institutional
suitability alternative to recommendations made to ``institutional
counterparties.'' This is a change from the proposed rule under which
the institutional suitability alternative would have been available
with respect to recommendations made to any counterparty. Rule 15Fh-
3(f)(4), as adopted, defines the term ``institutional counterparty''
for these purposes to mean a counterparty that is an eligible contract
participant as defined in clauses (A)(i), (ii), (iii), (iv), (viii),
(ix) or (x), or clause (B)(ii) (other than a person described in clause
(A)(v)) of Section 1a(18) of the Commodity Exchange Act and the rules
and regulations thereunder, or any person (whether a natural person,
corporation, partnership, trust or otherwise) with total assets of at
least $50 million. This more closely aligns the treatment of the
persons who may most need the protections of the suitability
requirements with their treatment under FINRA rules, which limit the
application of FINRA's analogous institutional suitability alternative
to recommendations to persons (whether a natural person, corporation,
partnership, trust or otherwise) with
[[Page 29999]]
total assets of at least $50 million.\517\ Rule 15Fh-3(f)(2), as
adopted, generally provides that an SBS Dealer may rely on the
institutional suitability alternative when making recommendations to
institutional counterparties. For a counterparty that is not an
institutional counterparty, an SBS Dealer will need to have or obtain
relevant information regarding the counterparty to establish a
reasonable basis to believe that a recommended security-based swap or
trading strategy involving a security-based swap is suitable for the
counterparty.\518\
---------------------------------------------------------------------------
\516\ See CFA, supra note 5.
\517\ See FINRA Rule 2111(b) (referring to FINRA Rule 4512(c)).
\518\ See Rule 15Fh-3(f)(1)(ii).
---------------------------------------------------------------------------
Third, in response to specific suggestions from a commenter, the
Commission is making changes to harmonize the institutional and special
entity suitability alternatives with the CFTC's parallel
provisions.\519\ Specifically, the Commission is eliminating the
separate special entity suitability alternative. Accordingly, an SBS
Dealer may satisfy its customer-specific suitability obligations in
Rule 15Fh-3(f)(1)(ii) with respect to any institutional counterparty,
including a special entity counterparty that meets the $50 million
asset threshold described above, by complying with the requirements of
the institutional suitability alternative in Rule 15Fh-3(f)(2). Having
a single institutional suitability alternative will result in greater
consistency with the CFTC's parallel rule, which will result in
efficiencies for entities that have already established infrastructure
to comply with the CFTC standard.\520\ However, the Commission is not
adopting the commenter's suggestion to add a new fourth prong to Rule
15Fh-3(f)(2) that requires an SBS Dealer to comply, in addition to the
requirements of the first three prongs (as outlined below), with the
requirements of Rule 15Fh-4(b) if the SBS Dealer's recommendation to a
special entity would cause it to be acting as an advisor to the special
entity.\521\ The Commission is not making this change because the rules
impose independent requirements, and the Commission believes that SBS
Dealers should comply with each rule to the extent applicable.
---------------------------------------------------------------------------
\519\ See SIFMA (August 2015), supra note 5. See also CFTC
Adopting Release, 77 FR at 9771-9774, supra note 21.
\520\ See SIFMA (August 2015), supra note 5 (noting that
``[a]lthough conforming to the [parallel CFTC suitability rule]
would impose additional diligence and compliance requirements on the
[SBS Dealer], these requirements would not result in material costs
because [SBS Dealers] are already complying with the same
requirements under the [parallel CFTC rule]''). However, we note
that the CFTC does not limit the availability of its institutional
suitability alternative to recommendations to ``institutional
counterparties.'' See Commodity Exchange Act Rule 23.434(b).
\521\ See SIFMA (August 2015), supra note 5. As discussed in
Section II.H.2 below, Rule 15Fh-4(b) generally requires an SBS
Dealer that acts as an advisor to a special entity to make a
reasonable determination that any recommended security-based swap or
trading strategy involving a security-based swap is in the best
interests of the special entity.
---------------------------------------------------------------------------
The proposed special entity suitability alternative would have
provided that an SBS Dealer would be deemed to satisfy its suitability
obligations with respect to a special entity counterparty if the SBS
Dealer either (1) is acting as an advisor to the special entity and
complies with proposed Rule 15Fh-4(b), or (2) is deemed not to be
acting as an advisor to the special entity pursuant to proposed Rule
15Fh-2(a).\522\ With respect to the former, the Commission believes
that when an SBS Dealer is acting as an advisor to a special entity, it
is appropriate for both the best interests requirements of Rule 15Fh-
4(b) and the suitability requirements of Rule 15Fh-3(f) to apply. As
discussed in Section II.H.3 below, there is some overlap between the
requirements, so an SBS Dealer's efforts to satisfy one set of
requirements may result in satisfaction of the other. With respect to
the latter, the Commission continues to believe, as noted in the
Proposing Release, that the standards for determining that an SBS
Dealer is not acting as an advisor under Rule 15Fh-2(a) are
substantially the same as the standards that an SBS Dealer must satisfy
to qualify for the institutional suitability alternative under Rule
15Fh-3(f)(2) (with the exception of the new institutional counterparty
limitation described above).\523\ However, the Commission agrees with
the commenter that having a single institutional suitability
alternative more consistent with the CFTC's rule will result in
efficiencies and a lower likelihood of counterparty confusion.\524\
Additionally, as we note above, the rules being adopted today are
intended to provide certain protections for counterparties, including
certain heightened protections for special entities. In this regard, we
believe it is important that the rules impose both sets of requirements
on SBS Dealers that make recommendations to special entities so that
special entities receive the full range of benefits that the rules are
intended to provide.
---------------------------------------------------------------------------
\522\ See proposed Rule 15Fh-3(f)(3).
\523\ See Proposing Release, 76 FR at 42416 n.137, supra note 3.
\524\ See SIFMA (August 2015), supra note 5. However, as noted
above, the CFTC does not limit the availability of its alternative
to recommendations to ``institutional counterparties.'' See
Commodity Exchange Act Rule 23.434(b). The ``institutional
counterparty'' limitation is discussed above.
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Fourth, the Commission is adding the words ``with regard to the
relevant security-based swap or trading strategy involving a security-
based swap'' to modify ``recommendations of the [SBS Dealer]'' in the
second prong of the institutional suitability alternative to match the
language used in the first prong and clarify that those are the only
recommendations to which the rule refers. The Commission is adopting
the other two prongs of the institutional suitability alternative as
proposed. Accordingly, as adopted, Rule 15Fh-3(f)(2) provides that when
an SBS Dealer makes a recommendation, it may fulfill its customer-
specific suitability obligations under Rule 15Fh-3(f)(1)(ii) with
respect to an institutional counterparty, if: (1) The SBS Dealer
reasonably determines that the counterparty (or its agent) is capable
of independently evaluating investment risks with regard to the
relevant security-based swap or trading strategy involving a security-
based swap; (2) the counterparty (or its agent) affirmatively
represents in writing that it is exercising independent judgment in
evaluating the recommendations of the SBS Dealer with regard to the
relevant security-based swap or trading strategy involving a security-
based swap; and (3) the SBS Dealer discloses that it is acting in the
capacity of a counterparty, and is not undertaking to assess the
suitability of the security-based swap or trading strategy for the
counterparty. If an SBS Dealer cannot rely on the institutional
suitability alternative provided by Rule15Fh-3(f)(2), it would need to
make an independent determination that the recommended security-based
swap or trading strategy involving security-based swaps is suitable for
the counterparty.
The Commission believes that the SBS Dealer reasonably could
determine that the counterparty (or its agent) is capable of
independently evaluating investment risks with regard to the relevant
security-based swap or trading strategy for purposes of Rule 15Fh-
3(f)(2)(i) through a variety of means. However, in response to specific
suggestions from a commenter \525\ and to provide additional clarity,
the Commission is adding a safe harbor in Rule 15Fh-3(f)(3) providing
that an SBS Dealer can satisfy its requirement under the first prong of
the institutional suitability alternative in Rule 15Fh-3(f)(2) to make
a reasonable determination that the counterparty (or
[[Page 30000]]
its agent) is capable of independently evaluating investment risks with
regard to the relevant security-based swap or trading strategy if the
SBS Dealer receives appropriate written representations from its
counterparty. As discussed above in Section II.D, an SBS Dealer can
rely on a counterparty's written representations unless the SBS Dealer
has information that would cause a reasonable person to question the
accuracy of the representation. Under Rule 15Fh-3(f)(3)(i),if the
counterparty is not a special entity, the representations must provide
that the counterparty has complied in good faith with written policies
and procedures reasonably designed to ensure that the persons
evaluating the recommendation and making trading decisions on behalf of
the counterparty are capable of doing so. Under Rule 15Fh-3(f)(3)(ii),
if the counterparty is a special entity, the representations must
satisfy the terms of the safe harbor in Rule 15Fh-5(b).\526\ If an SBS
Dealer chooses not to take advantage of the safe harbor provided by
Rule 15Fh-3(f)(3), the Commission believes that the SBS Dealer
reasonably could determine that the counterparty (or its agent) is
capable of independently evaluating investment risks with regard to the
relevant security-based swap or trading strategy for purposes of Rule
15Fh-3(f)(2)(i) through a variety of means. For example, an SBS Dealer
could comply with this requirement by having a counterparty indicate in
a signed agreement or other document that the counterparty is capable
of independently evaluating investment risks with respect to
recommendations or an SBS Dealer could call its counterparty, have that
discussion, and (if it chooses or circumstances require) document the
conversation to evidence the counterparty's affirmative indication.
---------------------------------------------------------------------------
\525\ See SIFMA (August 2015), supra note 5.
\526\ As discussed in Section II.H.6.i below, Rule 15Fh-5(b)
provides a safe harbor under which an SBS Entity can comply with its
obligation to have a reasonable basis to believe that its special
entity counterparty has a qualified independent representative that,
among other things, has sufficient knowledge to evaluate the
transaction and risks and undertakes to act in the best interests of
the special entity. Rule 15Fh-5(b) specifies the representations
that the SBS Entity must obtain from its special entity counterparty
and, in some cases, from such counterparty's representative, to
satisfy the safe harbor.
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The Commission continues to believe that parties should be able to
make the disclosures and representations required by Rules 15Fh-3(f)(2)
and (3) on a transaction-by-transaction basis, on an asset-class-by-
asset-class basis, or broadly in terms of all potential transactions
between the parties.\527\ However, where there is an indication that a
counterparty is not capable of independently evaluating investment
risks, or does not intend to exercise independent judgment regarding,
all of an SBS Dealer's recommendations, the SBS Dealer necessarily will
have to be more specific in its approach to complying with the
institutional suitability alternative. For instance, in some cases an
SBS Dealer may be unable to determine that a counterparty is capable of
independently evaluating investment risks with respect to any security-
based swap. In other cases, the SBS Dealer may determine that a
counterparty is generally capable of evaluating investment risks with
respect to some categories or types of security-based swaps, but that
the counterparty may not be able to understand a particular type of
security-based swap or its risk. Additionally, the requirements of Rule
15Fh-1(b) will apply when an SBS Dealer is relying on representations
from a counterparty or its representative.\528\
---------------------------------------------------------------------------
\527\ See Proposing Release, 76 FR at 42416, supra note 3.
\528\ See discussion in Section II.D, supra.
---------------------------------------------------------------------------
We are not adopting one commenter's suggestions to require SBS
Dealers to conduct routine audits to ensure that the institutional
suitability alternative is used appropriately.\529\ The Commission does
not believe that routine audits are the sole means through which an SBS
Dealer could supervise its associated persons' use of the institutional
suitability alternative. The Commission thinks that the totality of the
supervisory requirements in Rule 15Fh-3(h) (discussed below) are
appropriate to promote effective supervisory systems and believes that
SBS Dealers should have the flexibility to determine what means they
will use to supervise their associated persons' use of the
institutional suitability alternative. The Commission notes that in
supervising the use of the institutional suitability alternative, SBS
Dealers should generally consider whether their associated persons'
reliance on representations from counterparties is reasonable. As
discussed above and in Section II.D, an SBS Dealer (or its associated
person) can rely on a counterparty's written representations unless the
SBS Dealer has information that would cause a reasonable person to
question the accuracy of the representation. In this context,
information that might be relevant to this determination includes
whether the counterparty has previously invested in the type of
security-based swap or been involved in the type of trading strategy
that the SBS Dealer is now recommending, and whether the counterparty
(or its representative) appreciates what differentiates the recommended
security-based swap from a less complex alternative. If the associated
person knows that the recommended security-based swap or trading
strategy represents a significant change from the counterparty's prior
investment strategy or knows that the counterparty (or its
representative) lacks an appreciation of what differentiates the
recommended security-based swap from a less complex alternative, the
associated person should generally consider whether it can reasonably
rely on the counterparty's representation that it is capable of
independently evaluating the investment risks.\530\
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\529\ See Levin, supra note 5.
\530\ As discussed in Section II.D, under Rule 15Fh-1(b), an SBS
Dealer can reasonably rely on written representations from a
counterparty or its representative to satisfy its due diligence
obligations. Because reliance must be reasonable, the question of
whether reliance on representations would satisfy an SBS Dealer's
obligations under our business conduct rules will depend on the
facts and circumstances of the particular matter. At a minimum, an
SBS Dealer seeking to rely on representations cannot ignore
information that would cause a reasonable person to question the
accuracy of those representations.
---------------------------------------------------------------------------
The Commission is also not adopting another commenter's suggestion
to add a requirement to the institutional suitability alternative that
an SBS Dealer have a reasonable basis to believe its counterparty has
the capacity to absorb potential losses related to the recommended
security-based swap or trading strategy.\531\ The Commission believes
that the requirement in Rule 15Fh-3(f)(2)(i) that an SBS Dealer ``have
a reasonable basis to believe'' that the counterparty is capable of
evaluating investment risks independently is appropriate to support the
objectives of the institutional suitability alternative, and does not
believe it is necessary to specifically require an SBS Dealer to have a
reasonable basis to believe its counterparty has the capacity to absorb
potential losses related to the recommended security-based swap or
trading strategy.
---------------------------------------------------------------------------
\531\ See CFA, supra note 5.
---------------------------------------------------------------------------
5. Fair and Balanced Communications
Section 15F(h)(3)(C) of the Exchange Act requires the Commission to
adopt rules establishing a duty for SBS Entities to communicate in a
fair and balanced manner based on principles of fair dealing and good
faith.\532\
---------------------------------------------------------------------------
\532\ 15 U.S.C. 78o-10(h)(3)(C).
---------------------------------------------------------------------------
[[Page 30001]]
a. Proposed Rule
Proposed Rule 15Fh-3(g) would require SBS Entities to communicate
with counterparties in a fair and balanced manner based upon principles
of fair dealing and good faith. In particular, the rule would require:
(1) Communications to provide a sound basis for evaluating the facts
with regard to any particular security-based swap or trading strategy
involving a security-based swap; (2) communications not to imply that
past performance will recur or make any exaggerated or unwarranted
claim, opinion or forecast; and (3) any statement referring to the
potential opportunities or advantages presented by a security-based
swap to be balanced by an equally detailed statement of the
corresponding risks.\533\
---------------------------------------------------------------------------
\533\ Proposed Rule 15Fh-3(g)(1)-(3).
---------------------------------------------------------------------------
b. Comments on the Proposed Rule
Three commenters addressed the fair and balanced communications
requirement.\534\ Two commenters expressed support for the proposed
rule,\535\ and one was opposed.\536\ One of the commenters supporting
the proposed rule stated that there should not be any exceptions to the
proposed fair and balanced communications requirement.\537\ The other
commenter asserted that to be fair and balanced, communications must
inform investors of both the potential rewards and risks of their
investments, and also the SBS Entity's involvement and interests in the
investments, in specific terms.\538\ Specifically, the commenter noted
that all material adverse interests should be disclosed, and that the
rule should clarify that it is not enough to inform a customer that the
SBS Entity ``may'' have an adverse interest if that adverse interest
already exists.\539\
---------------------------------------------------------------------------
\534\ See CFA, supra note 5; Levin, supra note 5; AFGI
(September 2012), supra note 5; AFGI (July 2013), supra note 5.
\535\ See CFA, supra note 5; Levin, supra note 5.
\536\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
\537\ See CFA, supra note 5.
\538\ See Levin, supra note 5.
\539\ Id.
---------------------------------------------------------------------------
The commenter in opposition to the proposed rule asserted that a
fair and balanced communications requirement is unnecessary.\540\ The
commenter explained that the proposed rule is not relevant in the
context of SBS Entities' legacy portfolios since the proposed rule
would generally prohibit puffery used to induce a counterparty to enter
into new transactions.\541\ Additionally, the commenter noted that due
to the sophisticated nature of counterparties in the security-based
swaps market, the fair and balanced communications requirement is not
critical, particularly where all SBS Entities' communications are
already subject to the antifraud provisions of the Dodd-Frank Act and
the Exchange Act.\542\
---------------------------------------------------------------------------
\540\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
\541\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
\542\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(g) as proposed. The rule applies in connection with entering
into security-based swaps, and will continue to apply over the term of
a security-based swap.\543\
---------------------------------------------------------------------------
\543\ See Rule 15Fh-1(a). In response to concerns expressed by a
commenter, the Commission notes that there are no exceptions to Rule
15Fh-3(g). See CFA, supra note 5.
---------------------------------------------------------------------------
The Commission does not believe any changes to the rule are
necessary to address a commenter's concern that to be fair and
balanced, communications must inform investors of both the potential
rewards and risks of their investments because Rule 15Fh-3(g)(3)
already provides that ``[a]ny statement referring to the potential
opportunities or advantages presented by a security-based swap shall be
balanced by an equally detailed statement of the corresponding risks.''
\544\ With respect to the commenter's assertion that fair and balanced
communications should also include information regarding the SBS
Entity's involvement and interests in the investments,\545\ the
Commission notes that although specific disclosure regarding conflicts
of interest is not required by Rule 15Fh-3(g), it is required by Rule
15Fh-3(b)(2) (disclosure of material incentives or conflicts of
interest).
---------------------------------------------------------------------------
\544\ See Levin, supra note 5.
\545\ Id.
---------------------------------------------------------------------------
The standard set forth in Rule 15Fh-3(g) is consistent with the
similarly worded requirement in the FINRA rule on communications.\546\
Rule 15Fh-3(g) also includes three specific standards, drawn from the
FINRA rule, which should clarify the rule requirement. The standards
are: (1) Communications must provide a sound basis for evaluating the
facts with respect to any security-based swap or trading strategy
involving a security-based swap; \547\ (2) communications may not imply
that past performance will recur, or make any exaggerated or
unwarranted claim, opinion, or forecast; \548\ and (3) any statement
referring to the potential opportunities or advantages presented by a
security-based swap or trading strategy involving a security-based swap
shall be balanced by an equally detailed statement of the corresponding
risks.\549\ As noted in the Proposing Release, these standards do not
represent an exclusive list of considerations that an SBS Entity must
take into account in determining whether a communication with a
counterparty is fair and balanced.\550\ In addition to complying with
Rule 15Fh-3(g), SBS Entities should also keep in mind that all their
communications with counterparties will be subject to the specific
antifraud provisions added to the Exchange Act under Title VII of the
Dodd-Frank Act,\551\ as well as general antifraud provisions under the
federal securities laws.\552\ The Commission declines to eliminate the
fair and balanced communications requirement, as suggested by a
commenter,\553\ because we believe the requirement promotes investor
protection by prohibiting SBS Entities from overstating the benefits or
understating the risks to inappropriately
[[Page 30002]]
influence counterparties' investment decisions.
---------------------------------------------------------------------------
\546\ FINRA Rule 2210(d). See NASD IM-2210-1(1), Guidelines to
Ensure That Communications with the Public Are Not Misleading
(``Members must ensure that statements are not misleading within the
context in which they are made. A statement made in one context may
be misleading even though such a statement could be appropriate in
another context. An essential test in this regard is the balanced
treatment of risks and potential benefits.'').
\547\ Cf. FINRA Rule 2210(d)(1)(A) (``All member communications
with the public shall be based on principles of fair dealing and
good faith, must be fair and balanced, and must provide a sound
basis for evaluating the facts in regard to any particular security
or type of security, industry, or service.'').
\548\ Cf. FINRA Rule 2210(d)(1)(F) (``Communications may not
predict or project performance, imply that past performance will
recur or make any exaggerated or unwarranted claim, opinion or
forecast.'').
\549\ Cf. FINRA Rule 2210(d)(1)(D) (``Members must ensure that
statements are clear and not misleading within the context in which
they are made, and that they provide balanced treatment of risks and
potential benefits. Communications must be consistent with the risks
of fluctuating prices and the uncertainty of dividends, rates of
return and yield inherent to investments.'') The Commission believes
that this requirement addresses concerns raised by a commenter that
to be fair and balanced, communications must inform investors of
both the potential rewards and risks of their investments. See
Levin, supra note 5.
\550\ See Proposing Release, 76 FR at 42418, supra note 3.
\551\ See Sections 9(j) and 15F(h)(4)(A) of the Exchange Act, 15
U.S.C. 78i(j) and 15 U.S.C. 78o-10(h)(4)(A)). See also Prohibition
Against Fraud, Manipulation, and Deception in Connection with
Security-Based Swaps, Exchange Act Release No. 63236 (Nov. 3, 2010),
75 FR 68560 (Nov. 8, 2010) (proposing Rule 9j-1 to implement the
antifraud prohibitions of Section 9(j) of the Exchange Act).
\552\ See, e.g., 15 U.S.C. 77q and 78i, and, if the SBS Entity
is registered as a broker-dealer, 15 U.S.C. 78o.
\553\ See AFGI (September 2012), supra note 5; AFGI (July 2013),
supra note 5.
---------------------------------------------------------------------------
6. Obligation Regarding Diligent Supervision
Section 15F(h)(1)(B) of the Exchange Act authorizes the Commission
to adopt rules for the diligent supervision of the business of SBS
Entities.\554\
---------------------------------------------------------------------------
\554\ 15 U.S.C. 78o-10(h)(1)(B).
---------------------------------------------------------------------------
a. Proposed Rule
Proposed Rule 15Fh-3(h)(1) would require an SBS Entity to
establish, maintain and enforce a system to supervise, and to
diligently supervise, its business and associated persons, with a view
to preventing violations of applicable federal securities laws, rules
and regulations relating to its business as an SBS Entity. Proposed
Rule 15Fh-3(h)(2) would require an SBS Entity's supervisory system to
be reasonably designed to achieve compliance with applicable securities
laws, rules and regulations, and would establish minimum requirements
for the supervisory system. Specifically, proposed Rule 15Fh-3(h)(2)(i)
would require an SBS Entity to designate at least one person with
authority to carry out the supervisory responsibilities of the SBS
Entity for each type of business in which it engages for which
registration as an SBS Entity is required. Proposed Rule 15Fh-
3(h)(2)(ii) would require an SBS Entity to use reasonable efforts to
determine that all supervisors are qualified and meet standards of
training, experience, and competence necessary to effectively supervise
the security-based swap activities of the persons associated with the
SBS Entity.
Proposed Rule 15Fh-3(h)(2)(iii) would require an SBS Entity to
establish, maintain and enforce written policies and procedures
addressing the supervision of the types of security-based swap business
in which the SBS Entity is engaged. The policies and procedures would
need to be reasonably designed to achieve compliance with applicable
securities laws, rules and regulations,\555\ and include, at a minimum:
(1) Procedures for the review by a supervisor of transactions for which
registration as an SBS Entity is required; \556\ (2) procedures for the
review by a supervisor of incoming and outgoing written (including
electronic) correspondence with counterparties or potential
counterparties and internal written communications relating to the SBS
Entity's business involving security-based swaps; \557\ (3) procedures
for a periodic review, at least annually, of the security-based swap
business in which the SBS Entity engages that is reasonably designed to
assist in detecting and preventing violations of, and achieving
compliance with, applicable federal securities laws and regulations;
\558\ (4) procedures to conduct a reasonable investigation regarding
the character, business repute, qualifications, and experience of any
person prior to that person's association with the SBS Entity; \559\
(5) procedures to consider whether to permit an associated person to
establish or maintain a securities or commodities account in the name
of, or for the benefit of such associated person, at another SBS
Dealer, broker, dealer, investment adviser, or other financial
institution, and if permitted, procedures to supervise the trading in
such account, including the receipt of duplicate confirmations and
statements related to such account; \560\ (6) a description of the
supervisory system, including the titles, qualifications and locations
of supervisory persons and the specific responsibilities of each person
with respect to the types of business in which the SBS Entity is
engaged; \561\ (7) procedures prohibiting supervisors from supervising
their own activities or reporting to, or having their compensation or
continued employment determined by, a person or persons they are
supervising; \562\ and (8) procedures preventing the standards of
supervision from being reduced due to any conflicts of interest of a
supervisor with respect to the associated person being supervised.\563\
Additionally, proposed Rule 15Fh-3(h)(2)(iv) would require an SBS
Entity to include written policies and procedures reasonably designed,
taking into consideration the nature of the SBS Entity's business, to
comply with the duties set forth in Section 15F(j) of the Exchange
Act.\564\
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\555\ Proposed Rule 15Fh-3(h)(2)(iii).
\556\ Proposed Rule 15Fh-3(h)(2)(iii)(A).
\557\ Proposed Rule 15Fh-3(h)(2)(iii)(B).
\558\ Proposed Rule 15Fh-3(h)(2)(iii)(C).
\559\ Proposed Rule 15Fh-3(h)(2)(iii)(D).
\560\ Proposed Rule 15Fh-3(h)(2)(iii)(E).
\561\ Proposed Rule 15Fh-3(h)(2)(iii)(F).
\562\ Proposed Rule 15Fh-3(h)(2)(iii)(G).
\563\ Proposed Rule 15Fh-3(h)(2)(iii)(H).
\564\ See 15 U.S.C. 78o-10(j).
---------------------------------------------------------------------------
Under proposed Rule 15Fh-3(h)(3), the Commission proposed two
mechanisms under which an SBS Entity or associated person would not be
deemed to have failed to diligently supervise any other person. The SBS
Entity or associated person could demonstrate that: (1) Such person is
not subject to his or her supervision, or (2) it meets the terms of a
safe harbor. The safe harbor would require the SBS Entity or associated
person to satisfy two conditions. The first condition would be that the
SBS Entity has established and maintained written policies and
procedures, and a documented system for applying those policies and
procedures, that would reasonably be expected to prevent and detect,
insofar as practicable, any violation of the federal securities laws
and the rules and regulations thereunder relating to security-based
swaps.\565\ The second condition would be that the SBS Entity or
associated person has reasonably discharged the duties and obligations
required by such written policies and procedures and documented system
and did not have a reasonable basis to believe that such written
policies and procedures and documented system were not being
followed.\566\
---------------------------------------------------------------------------
\565\ Proposed Rule 15Fh-3(h)(3)(i).
\566\ Proposed Rule 15Fh-3(h)(3)(ii).
---------------------------------------------------------------------------
Finally, proposed Rule 15Fh-3(h)(4) would require an SBS Entity to
promptly amend its written supervisory procedures as appropriate when
material changes occur in either applicable securities laws, rules or
regulations, or in the SBS Entity's business or supervisory system, and
to promptly communicate any material amendments to its supervisory
procedures throughout the relevant parts of its organization.
b. Comments on the Proposed Rule
Five commenters addressed the proposed supervision rule.\567\ One
commenter supported the requirement in proposed Rule 15Fh-3(h)(2)(iv)
that SBS Entities adopt written policies and procedures reasonably
designed to ensure compliance with the duties set forth in Section
15F(j) of the Exchange Act.\568\ The commenter noted that this
approach, which does not mandate the inclusion of specific elements or
prohibitions, will provide SBS Entities flexibility in establishing
compliance policies appropriate for their management and organizational
structure.\569\
---------------------------------------------------------------------------
\567\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5; MFA,
supra note 5; NABL, supra note 5; SIFMA (September 2015), supra note
5.
\568\ See NABL, supra note 5.
\569\ Id.
---------------------------------------------------------------------------
Another commenter argued for additional diligent supervision
requirements.\570\ The commenter recommended requiring supervisory
personnel to report to upper management or the board, as appropriate,
if they have reason to believe the SBS Entity's supervisory procedures
are not proving effective in
[[Page 30003]]
preventing violations.\571\ The commenter also suggested requiring SBS
Entities to reevaluate their supervisory procedures when they fail to
detect or deter significant violations, and determine whether revisions
are needed.\572\
---------------------------------------------------------------------------
\570\ See CFA, supra note 5.
\571\ Id.
\572\ Id.
---------------------------------------------------------------------------
In contrast, a third commenter requested that the Commission narrow
the proposed supervision requirements.\573\ The commenter suggested
that the Commission clarify that when an SBS Entity is already subject
to, and complies with, comparable requirements of another ``qualifying
regulator'' (such as risk management standards imposed by a prudential
regulator), the SBS Entity's supervisory policies and procedures will
be deemed to be reasonably designed for purposes of the proposed
rule.\574\ The commenter also requested that the Commission clarify
that a person committing a violation will not be viewed as being
subject to the supervision of another person unless the putative
supervisor knew or should have known that he or she had the authority
and responsibility to exercise control over the other person that could
have prevented the violation.\575\
---------------------------------------------------------------------------
\573\ See FIA/ISDA/SIFMA, supra note 5.
\574\ Id.
\575\ Id.
---------------------------------------------------------------------------
A fourth commenter opposed the application of the proposed rule to
Major SBS Participants.\576\ The commenter asserted that the proposed
rule imposes burdensome and costly supervisory procedures on Major SBS
Participants that are not appropriate given their non-dealer role in
the marketplace, and that the potential costs of compliance would be
without any meaningful offsetting benefit for other market participants
or the financial markets as a whole.\577\
---------------------------------------------------------------------------
\576\ See MFA, supra note 5.
\577\ Id.
---------------------------------------------------------------------------
A fifth commenter recommended harmonizing the Commission's
supervision requirements with FINRA Rule 3110 to enable SBS Entities
that are also broker-dealers to make use of their existing supervisory
systems and to minimize confusion.\578\ Specifically, the commenter
suggested eliminating the proposed requirements in proposed Rule 15Fh-
3(h)(1) to ``enforce'' a system to supervise and to diligently
supervise ``the business'' (as opposed to the associated persons) of
the SBS Entity, and changing the description of the supervisory system
from ``with a view to preventing violations of'' to ``reasonably
designed to ensure compliance with'' the provisions of applicable
federal securities laws and the rules and regulations thereunder
relating to its business as an SBS Entity.\579\ The commenter also
recommended eliminating the redundant description of the supervisory
system in proposed Rule 15Fh-3(h)(2), and making a number of changes to
the wording of the minimum requirements listed in sub-section (h)(2) to
align them with FINRA Rule 3110.\580\ The commenter also asked that the
Commission modify the rule text to reflect that security-based swaps
are not necessarily traded in an ``account'' but rather pursuant to a
bilateral trading relationship.\581\ Additionally, the commenter
recommended adding a provision allowing an SBS Entity that cannot
comply with the requirement in proposed Rule 15Fh-3(h)(2)(iii)(G)
(preventing a supervisor from supervising his or her own activities or
reporting to a person he or she is supervising) to document its
determination that compliance is not possible because of the firm's
size or a supervisory person's position within the firm and document
how the supervisory arrangement otherwise complies with proposed Rule
15Fh-3(h)(1).\582\ The commenter also requested that the Commission
provide guidance regarding risk-based reviews that is consistent with
FINRA supplementary material on the topic.\583\ Finally, the commenter
recommended wording changes to the maintenance of written supervisory
procedures requirement in proposed Rule 15Fh-3(h)(4) to harmonize with
FINRA Rule 3110, including eliminating the proposed requirement to
update the written supervisory procedures when material changes occur
to the ``business,'' as opposed to the supervisory system.\584\
---------------------------------------------------------------------------
\578\ See SIFMA (September 2015), supra note 5. Although the
Commission modeled proposed Rule 15Fh-3(h) in part on NASD Rules
3010 (Supervision) and 3012 (Supervisory Control System), the
Commission subsequently approved new consolidated FINRA Rules 3110
(Supervision) and 3120 (Supervisory Control System), which are
largely based on and replace NASD Rules 3010 and 3012, and
corresponding provisions of the NYSE Rules and Interpretations. See
Order Approving Proposed Rule Change as Modified by Amendment No. 1,
Exchange Act Release No. 71179 (Dec. 23, 2013), 78 FR 79542 (Dec.
30, 2013).
\579\ Id.
\580\ Id.
\581\ Id.
\582\ Id.
\583\ Id.
\584\ Id.
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c. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-3(h) With certain modifications. In response to commenters'
concerns regarding SBS Entities that will also be registered as broker-
dealers or Swap Entities being subject to overlapping requirements with
respect to their supervisory systems,\585\ the modifications (discussed
below) are primarily intended to make the final rule more consistent
with FINRA Rule 3110 and the CFTC's supervision rule for Swap Entities
while continuing to provide protections intended to help ensure that
SBS Entities have effective supervisory systems.\586\ While, as
discussed throughout this release, we are making changes to many of the
business conduct rules that are intended to make the final rules more
consistent with the parallel CFTC requirements, for the supervision and
CCO rules, in particular, we agree with a commenter that consistency
with the parallel FINRA rules is also important because many SBS
Entities have already established infrastructure to comply with those
rules in the context of broader supervisory and compliance programs
across their security-based swap and related securities and swaps
businesses.\587\ This consistency will result in efficiencies for SBS
Entities that have already established supervisory systems to comply
with the FINRA and/or CFTC standards. Consistent wording will also
allow SBS Entities to more easily analyze compliance with the
Commission's rule against their existing activities to comply with
FINRA Rule 3110 and the CFTC's supervision rule for Swap Entities.
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\585\ See SIFMA (September 2015), supra note 5; FIA/ISDA/SIFMA,
supra note 5.
\586\ As noted above, although the Commission modeled proposed
Rule 15Fh-3(h) in part on NASD Rules 3010 (Supervision) and 3012
(Supervisory Control System), the Commission subsequently approved
new consolidated FINRA Rules 3110 (Supervision) and 3120
(Supervisory Control System), which are largely based on and replace
NASD Rules 3010 and 3012, and corresponding provisions of the NYSE
Rules and Interpretations. Among other changes to the rules, the new
FINRA rules contain new or modified requirements with respect to:
(i) Which personnel can supervise other personnel; (ii) which
personnel are permitted to perform office inspections; (iii) review
of certain internal communications; and (iv) obligations to monitor
for insider trading, conduct internal investigations and provide
reports to FINRA regarding such investigations. The new FINRA rule
also codified guidance regarding the permissible use of risk-based
systems for review of transactions and correspondence. See Order
Approving Proposed Rule Change as Modified by Amendment No. 1,
Exchange Act Release No. 71179 (Dec. 23, 2013), 78 FR 79542 (Dec.
30, 2013).
\587\ See SIFMA (September 2015), supra note 5.
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First, in response to a specific suggestion made by a
commenter,\588\ the
[[Page 30004]]
Commission is making several wording changes to the description of the
general requirement to establish a supervisory system in Rule 15Fh-
3(h)(1). The Commission is deleting the words ``and enforce'' from the
description and adding the modifying language ``the activities of''
before associated persons so that it requires an SBS Entity to
``establish and maintain a system to supervise, and [to] diligently
supervise, its business and the activities of its associated persons.''
\589\ Rule 15Fh-3(h)(2)(iii) (discussed below) includes an express
requirement to enforce supervisory policies and procedures, making the
additional language regarding enforcing the system to supervise
unnecessary. Accordingly, the Commission believes that the rule, as
adopted with these wording changes, will continue to establish
requirements to help ensure that SBS Entities have effective
supervisory systems, consistent with the proposed rule. At the same
time, the changes will make the wording of the rule more consistent
with the corresponding FINRA and CFTC requirements, as requested by a
commenter. This consistency will result in efficiencies for SBS
Entities that have already established supervisory systems to comply
with the FINRA and/or CFTC standards, as discussed above.
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\588\ See SIFMA (September 2015), supra note 5.
\589\ Cf. FINRA Rule 3110(a) (``Each member shall establish and
maintain a system to supervise the activities of each associated
person. . .''); Commodity Exchange Act Rule 23.602(a) (``Each [Swap
Entity] shall establish and maintain a system to supervise, and
shall diligently supervise, all activities relating to its business
performed by its partners, members, officers, employees, and agents
(or persons occupying a similar status or performing a similar
function) . . .'').
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Second, the Commission is making further wording changes to the
descriptions of the required supervisory system in Rule 15Fh-3(h)(1)
and (2) in response to concerns raised by a commenter regarding the
redundancy of the descriptions.\590\ Proposed Rule 15Fh-3(h)(1) would
require SBS Entities to ``establish . . . a system to supervise . . .
with a view to preventing violations of the provisions of applicable
federal securities laws and the rules and regulations thereunder
relating to its business [as an SBS Entity],'' and proposed Rule 15Fh-
3(h)(2) would specify that the required system be ``reasonably designed
to achieve compliance with applicable securities laws and the rules and
regulations thereunder.'' The Commission does not believe that the two
descriptions (``prevent violations'' and ``achieve compliance'') are
substantively different, nor did we intend to give the appearance of
creating two different standards for what is essentially the same
requirement. Accordingly, the Commission is changing and consolidating
the description of the supervisory system in Rule 15Fh-3(h)(1) to state
that an SBS Entity's supervisory system ``shall be reasonably designed
to prevent violations of applicable federal securities laws and the
rules and regulations thereunder relating to its business [as an SBS
Entity],'' and eliminating the redundant description in Rule 15Fh-
3(h)(2).\591\ Additionally, the Commission is making parallel changes
to Rules 15Fh-3(h)(2)(iii) and 15Fh-3(h)(2)(iii)(C). Specifically, the
Commission is changing the requirement in Rule 15Fh-3(h)(2)(iii) that
the supervisory system provide for the establishment, maintenance and
enforcement of certain written policies and procedures from policies
and procedures that are ``reasonably designed to achieve compliance
with'' to policies and procedures that are ``reasonably designed to
prevent violations of applicable federal securities laws and the rules
and regulations thereunder.'' The Commission is also changing the
requirement in Rule 15Fh-3(h)(2)(iii)(C) that an SBS Entity's
supervisory policies and procedures include procedures for a periodic
review of the SBS Entity's security-based swap business by eliminating
the redundant requirement that the review be reasonably designed to
assist in ``achieving compliance with'' applicable federal securities
laws and regulations and conforming the remaining language.
Accordingly, as adopted, Rule 15Fh-3(h)(2)(iii)(C) requires an SBS
Entity's written supervisory policies and procedures to include
``[p]rocedures for a periodic review, at least annually, of the
security-based swap business in which the [SBS Entity] engages that is
reasonably designed to assist in detecting and preventing violations of
applicable federal securities laws and the rules and regulations
thereunder.''
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\590\ See SIFMA (September 2015), supra note 5.
\591\ This formulation tracks the requirement in Exchange Act
Rule 15Fb2-1(b) that a senior officer of the SBS Entity certify on
Form SBSE-C that ``[a]fter due inquiry, he or she has reasonably
determined that the [SBS Entity] has developed and implemented
written policies and procedures reasonably designed to prevent
violation of federal securities laws and the rules thereunder.'' Cf.
FINRA Rule 3110(a) (``Each member shall establish and maintain a
system to supervise the activities of each associated person that is
reasonably designed to achieve compliance with applicable securities
laws and regulations, and with applicable FINRA rules.''); Commodity
Exchange Act Rule 23.602(a) (``Each [Swap Entity] shall establish
and maintain a system to supervise . . . Such system shall be
reasonably designed to achieve compliance with the requirements of
the Commodity Exchange Act and [CFTC] regulations.'').
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Third, in response to concerns raised by a commenter,\592\ the
Commission is changing the wording of the minimum requirements for a
supervisory system listed in Rule 15Fh-3(h)(2) to more closely align
the requirements of our rule with those of FINRA Rule 3110, and to
reflect the fact that security-based swaps are not necessarily traded
in an ``account'' but rather pursuant to a bilateral trading
relationship. Specifically, the Commission is: (1) Changing the
description of the requirement that supervisors be qualified in Rule
15Fh-3(h)(2)(ii) from ``qualified and meet standards of training,
experience, and competence necessary to effectively supervise the
security-based swap activities of the persons associated with the [SBS
Entity]'' to ``qualified, either by virtue of experience or training,
to carry out their assigned responsibilities;'' \593\ (2) adding ``and
the activities of its associated persons'' to the policies and
procedures requirement in Rule 15Fh-3(h)(2)(iii) so that it requires
``written policies and procedures addressing the supervision of the
types of security-based swap business in which the [SBS Entity] is
engaged and the activities of its associated persons;'' \594\ (3)
adding ``good'' to the description of the requirement to have
procedures for background investigations on associated persons in Rule
15Fh-3(h)(2)(iii)(D) so that it requires ``procedures to conduct a
reasonable investigation regarding the good character'' of an
associated person; \595\ (4) adding ``or a trading relationship'' to
the description of the requirement to have procedures for considering
whether to allow an associated person to conduct trading for his or her
own benefit at another financial institution in Rule 15Fh-
3(h)(2)(iii)(E) so that it requires ``procedures to consider whether to
permit an associated person to establish or maintain a securities or
commodities account or a trading relationship;'' and (5) changing the
description of the
[[Page 30005]]
requirement to have conflicts of interest procedures in Rule 15Fh-
3(h)(2)(iii)(H) from ``procedures preventing the standards of
supervision from being reduced due to any conflicts of interest of a
supervisor with respect to the associated person being supervised'' to
``procedures reasonably designed to prevent the supervisory system
required by paragraph (h)(1) from being compromised due to the
conflicts of interest that may be present with respect to the
associated person being supervised, including the position of such
person, the revenue such person generates for the [SBS Entity], or any
compensation that the associated person conducting the supervision may
derive from the associated person being supervised.'' \596\ The
Commission believes that the rule, as adopted with these changes, will
continue to provide protections intended to help ensure that SBS
Entities have effective supervisory systems, consistent with the
proposed rule. At the same time, the changes will make the wording of
the rule more consistent with the parallel FINRA requirement, resulting
in efficiencies for SBS Entities that have already established
supervisory systems to comply with the FINRA standard, as discussed
above.
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\592\ See SIFMA (September 2015), supra note 5.
\593\ Cf. FINRA Rule 3110(a)(6) (``A member's supervisory system
shall provide . . . for . . . [t]he use of reasonable efforts to
determine that all supervisory personnel are qualified, either by
virtue of experience or training, to carry out their assigned
responsibilities.'').
\594\ Cf. FINRA Rule 3110(b)(1) (``Each member shall establish,
maintain, and enforce written procedures to supervise the types of
business in which it engages and the activities of its associated
persons . . .'').
\595\ Cf. FINRA Rule 3110(e) (``Each member shall ascertain by
investigation the good character . . . of an applicant before the
member applies to register that applicant with FINRA . . .'').
\596\ Cf. FINRA Rule 3110(b)(6)(D) (``The supervisory procedures
. . . shall include . . . procedures reasonably designed to prevent
the supervisory system required pursuant to paragraph (a) of this
Rule from being compromised due to the conflicts of interest that
may be present with respect to the associated person being
supervised, including the position of such person, the revenue such
person generates for the firm, or any compensation that the
associated person conducting the supervision may derive from the
associated person being supervised, including the position of such
person, the revenue such person generates for the firm, or any
compensation that the associated person conducting the supervision
may derive from the associated person being supervised.'').
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In addition to the wording changes described above, the Commission
is making two other sets of changes to the minimum requirements for a
supervisory system listed in Rule 15Fh-3(h)(2). First, the Commission
is eliminating the specific requirement in proposed Rule 15Fh-
3(h)(2)(iii)(E) that the supervision of trading in an associated
person's securities or commodities account at another financial
institution ``includ[e] the receipt of duplicate confirmations and
statements related to such accounts.'' This change is intended to more
closely align our requirement with the analogous FINRA rule, which was
amended after our proposal.\597\ The amended FINRA rule replaced the
requirement to receive duplicate confirmation and statements with a
more flexible standard by which firms can determine the data source(s)
that are the most effective means to review trading activity. Likewise,
this change is also intended to provide SBS Entities reasonable
flexibility to craft appropriate supervisory policies and procedures
relevant to their business model and to ascertain the means to obtain
the necessary data for effective supervision. The Commission notes that
the rule, in permitting flexibility, does not limit the SBS Entity's
discretion to request from the associated person such transaction and
account information as the SBS Entity deems necessary to fulfill its
supervisory obligations (including confirmations and statements related
to the account or trading relationship), and SBS Entities may consider
the availability of such information and whether activity in the
account can be properly monitored when determining whether to provide
consent to an associated person to open or maintain an account or
trading relationship at another financial institution.
---------------------------------------------------------------------------
\597\ See Order Approving Proposed Rule Change to Adopt FINRA
Rule 3210 (Accounts at Other Broker-Dealers and Financial
Institutions), as Modified by Partial Amendment No. 1 and Partial
Amendment No. 2, in the Consolidated FINRA Rulebook, Exchange Act
Release No. 77550 (Apr. 7, 2016), 81 FR 21924 (Apr. 13, 2016)
(``Proposed FINRA Rule 3210(c) would require an executing member,
upon written request by the employer member, to transmit duplicate
copies of confirmations and statements, or the transactional data
contained therein, with respect to an account subject to the
rule.'').
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Second, in response to concerns raised by a commenter,\598\ the
Commission is modifying Rule 15Fh-3(h)(2)(iii)(G) to address
circumstances where an SBS Entity is unable to comply with the
supervisory requirements due to the SBS Entity's size or supervisor's
position within the SBS Entity. Pursuant to final Rule 15Fh-
3(h)(2)(iii)(G), an SBS Entity that cannot comply with the requirement
in Rule 15Fh-3(h)(2)(iii)(G) (preventing a supervisor from supervising
his or her own activities or reporting to a person he or she is
supervising) will be required to document its determination that
compliance is not possible because of the firm's size or a supervisory
person's position within the firm, document how the supervisory
arrangement otherwise complies with Rule 15Fh-3(h)(1), and include a
summary of such determination in the annual compliance report prepared
by the SBS Entity's CCO pursuant to Rule 15Fk-1(c). This change is
designed to address concerns raised by a commenter that due to the size
or structure of some SBS Entities, it may not always be possible to
prohibit an associated person who performs a supervisory function at an
SBS Entity from supervising his or her own activities or reporting to a
person whom he or she is supervising.\599\ The Commission believes
adding the provision described above will make the supervisory
requirements more operationally workable by providing flexibility, in
particular for supervision of very senior SBS Entity personnel, while
still maintaining appropriate investor protection through the
requirement to document how the supervisory arrangement otherwise
complies with Rule 15Fh-3(h)(1). The Commission notes that SBS Entities
relying on this provision will also be subject to the other
requirements of Rule 15Fh-3(h), including the requirement in Rule 15Fh-
3(h)(2)(iii)(H) to have procedures reasonably designed to prevent the
supervisory system from being compromised due to the conflicts of
interest that may be present with respect to the associated person
being supervised, including the position of such person, the revenue
such person generates for the SBS Entity, or any compensation that the
associated person conducting the supervision may derive from the
associated person being supervised.
---------------------------------------------------------------------------
\598\ See SIFMA (September 2015), supra note 5.
\599\ See SIFMA (September 2015), supra note 5.
---------------------------------------------------------------------------
The Commission notes that the minimum requirements for a
supervisory system listed in Rule 15Fh-3(h)(2) are not an exhaustive
list. SBS Entities should keep in mind their overarching obligation in
Rule 15Fh-3(h)(1) to establish and maintain a supervisory system that
is reasonably designed to prevent violations of applicable federal
securities laws and the rules and regulations thereunder relating to
the SBS Entity's business as an SBS Entity. For instance, although Rule
15Fh-3(h)(2)(iii)(B) only requires procedures ``for the review by a
supervisor of incoming and outgoing written (including electronic)
correspondence with counterparties or potential counterparties and
internal written communications relating to the [SBS Entity's] business
involving security-based swaps,'' if an SBS Entity records oral
communications with counterparties or potential counterparties, the SBS
Entity generally should consider providing for the supervisory review
of such communications.\600\ Similarly, if an SBS
[[Page 30006]]
Entity chooses to provide certain disclosures required by Rule 15Fh-
3(b) orally, the SBS Entity should consider how it will supervise these
oral communications.
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\600\ Section 15F(g)(1) of the Exchange Act provides that each
SBS Entity shall maintain daily trading records of the security-
based swaps of the SBS Entity and all related records (including
related cash or forward transactions) and recorded communications,
including electronic mail, instant messages, and recordings of
telephone calls, for such period as may be required by the
Commission by rule or regulation. See 15 U.S.C. 78o-10(g)(1). To
implement Section 15F(g)(1) of the Exchange Act, the Commission has
proposed to amend the preservation requirement in paragraph (b)(4)
of Exchange Act Rule 17a-4 to include ``recordings of telephone
calls required to be maintained pursuant to [Section 15F(g)(1) of
the Exchange Act].'' Under this proposed requirement, a broker-
dealer SBS Entity would be required to preserve for three years
telephone calls that it chooses to record to the extent the calls
are required to be maintained pursuant to Section 15F(g)(1) of the
Exchange Act. The Commission has also proposed a parallel
requirement for stand-alone SBS Entities. See Recordkeeping Release,
79 FR at 25213-25214, supra note 242.
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In response to a specific suggestion made by a commenter,\601\ the
Commission is modifying the maintenance of written supervisory
procedures requirement in Rule 15Fh-3(h)(4) to harmonize with FINRA
Rule 3110. Specifically, we are changing the requirement to promptly
communicate material amendments to an SBS Entity's supervisory
procedures from ``throughout the relevant parts of its organization''
to ``to all associated persons to whom such amendments are relevant
based on their activities and responsibilities.'' \602\ We believe that
the new formulation will be more effective at achieving its intended
result by targeting the communications to the associated persons to
whom such amendments are relevant. The Commission believes that under
the proposed formulation, potential interpretations of the phrase
``relevant parts of its organization'' may have resulted in
communications to a broader than necessary group. The Commission
declines to adopt the commenter's suggestion to eliminate the proposed
requirement in Rule 15Fh-3(h)(4)(i) for an SBS Entity to update its
written supervisory procedures when material changes occur to its
``business,'' in addition to its supervisory system.\603\ Rule 15Fh-
3(h)(1) requires an SBS Entity to diligently supervise its business.
Implicit in that obligation is a requirement that the SBS Entity update
its supervisory system as necessary to accommodate changes to its
business. The Commission does not want to create confusion regarding
this obligation by eliminating the explicit requirement in Rule 15Fh-
3(h)(4)(i) for an SBS Entity to update its supervisory procedures when
material changes occur to its business.
---------------------------------------------------------------------------
\601\ See SIFMA (September 2015), supra note 5.
\602\ Cf. FINRA Rule 3110(b)(7) (``Each member shall promptly
amend its written supervisory procedures to reflect changes in
applicable securities laws or regulations, including FINRA rules,
and as changes occur in its supervisory system. Each member is
responsible for promptly communicating its written supervisory
procedures and amendments to all associated persons to whom such
written supervisory procedures and amendments are relevant based on
their activities and responsibilities.'').
\603\ See SIFMA (September 2015), supra note 5.
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In addition to the modifications discussed above, the Commission is
making several clarifying changes to the rule. First, the Commission is
correcting a typographical error in Rule 15Fh-3(h)(2). The cross-
reference in the proposed rule should have been to ``paragraph
(h)(1),'' not to ``paragraph (g)(1).'' The Commission is correcting
this cross-reference in the final rule.
Second, the Commission also is making two other changes to the rule
to clarify that Rule 15Fh-3(h) does not require multiple sets of
written supervisory policies and procedures. Specifically, the
Commission is: (1) Re-designating proposed Rule 15Fh-3(h)(2)(iv) as
Rule 15Fh-3(h)(2)(iii)(I); and (2) clarifying that the written policies
and procedures referred to in Rule 15Fh-3(h)(3) are those required by
Rule 15Fh-3(h)(2)(iii) by adding the modifying language ``as required
in Sec. 240.15Fh-3(h)(2)(iii)'' after ``written policies and
procedures'' in Rule 15Fh-3(h)(3)(i), and by changing the references in
Rule 15Fh-3(h)(3)(ii) from ``the written policies and procedures'' to
``such written policies and procedures.''
Rule 15Fh-3(h) establishes supervisory obligations that incorporate
principles from both Exchange Act Section 15(b) and existing SRO rules.
The concept of diligent supervision in these rules is consistent with
business conduct standards for broker-dealers that have historically
been established by SROs for their members, subject to Commission
approval. As with diligent supervision by a broker-dealer, the
Commission believes that it generally would be appropriate for an SBS
Entity to use a risk-based review system to satisfy its supervisory
obligations under Rule 15Fh-3(h) instead of conducting detailed reviews
of every transaction or every communication, so long as the SBS Entity
uses a risk-based review system that is reasonably designed to provide
the entity with sufficient information to allow it to focus on the
areas that pose the greatest risks of federal securities law
violations.\604\ Use of a risk-based system allows SBS Entities the
flexibility to establish their supervisory systems in a manner that
reflects their business models, and based on those models, focus on
areas where heightened concern may be warranted.
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\604\ This guidance is intended to respond to a request from a
commenter to provide guidance regarding risk-based reviews that is
consistent with Supplementary Material .05 and .06 to FINRA Rule
3110. See SIFMA (September 2015), supra note 5.
---------------------------------------------------------------------------
Rule 15Fh-3(h)(2)(iii)(I), as adopted, requires an SBS Entity to
adopt written policies and procedures reasonably designed, taking into
consideration the nature of such SBS Entity's business, to comply with
the duties set forth in Section 15F(j) of the Exchange Act. Section
15F(j) of the Exchange Act requires an SBS Entity to comply with
obligations concerning: (1) Monitoring of trading to prevent violations
of applicable position limits; (2) establishing sound and professional
risk management systems; (3) disclosing to regulators information
concerning its trading in security-based swaps; (4) establishing and
enforcing internal systems and procedures to obtain any necessary
information to perform any of the functions described in Section 15F of
the Exchange Act, and providing the information to regulators, on
request; (5) implementing conflict-of-interest systems and procedures;
and (6) addressing antitrust considerations such that the SBS Entity
does not adopt any process or take any action that results in any
unreasonable restraint of trade or impose any material anticompetitive
burden on trading or clearing.\605\ While the requirements of Section
15F(j) are self-executing, we highlight in particular the duty of an
SBS Entity under Section 15F(j)(2) to ``establish robust and
professional risk management systems adequate for managing the day-to-
day business'' of the SBS Entity. Any risk management system
established by an SBS Entity should be effective to manage the risks of
the SBS Entity within the risk tolerance limits to be determined for
each type of risk. We have separately proposed a rule regarding the
requirement for an SBS Entity for which there is not a prudential
regulator to establish, document, and maintain controls to assist it in
managing the risks associated with its business activities, including
market, credit, leverage, liquidity, legal, and operational risks.\606\
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\605\ 15 U.S.C. 78o-10(j).
\606\ The Commission has separately proposed to require every
SBS Entity for which there is not a prudential regulator (``Non-bank
SBS Dealers'') to comply, with certain exceptions, with the
requirements of Rule 15c3-4 under the Exchange Act ``as if it were
an OTC derivatives dealer with respect to all of its business
activities.'' See Exchange Act Rule 18a-1(g). See also Capital,
Margin, and Segregation Requirements for Security-Based Swap Dealers
and Major Security-Based Swap Participants and Capital Requirements
for Broker-Dealers, Capital, Margin, and Segregation Requirements
for Security-Based Swap Dealers and Major Security-Based Swap
Participants and Capital Requirements for Broker-Dealers, Exchange
Act Release No. 68071 (Oct. 18, 2012), 77 FR 70214, 70250-70251
(Nov. 23, 2012), explaining that application of Rule 15c3-4 would
require a Non-bank SBS Entity to ``establish, document, and maintain
a system of internal risk management controls to assist in managing
the risks associated with its business activities, including market,
credit, leverage, liquidity, legal, and operational risks.'' Rule
15c3-4 identifies a number of elements that must be part of the risk
management system including, among other things: A risk control unit
that reports directly to senior management and is independent from
business trading units; separation of duties between persons
responsible for entering into a transaction and those responsible
for recording the transaction on the dealer's books; and periodic
reviews (which may be performed by internal audit staff) and annual
reviews (which must be conducted by independent certified public
accountants) of the dealer's risk management systems. Id.
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[[Page 30007]]
We are not adopting a commenter's \607\ suggestion that when an SBS
Entity is already subject to, and complies with, comparable
requirements of another ``qualifying regulator'' (such as risk
management standards imposed by a prudential regulator), the SBS
Entity's supervisory policies and procedures will be deemed to be
reasonably designed for purposes of Rule 15Fh-3(h). Exchange Act
Section 15F(h)(1)(B) directs the Commission to adopt rules relating to
the diligent supervision of SBS Entities' business. Although we have
closely conformed our supervision rule to parallel SRO requirements and
believe it is also consistent with parallel CFTC requirements, we do
not believe it is appropriate to defer to other regulators' rules,
other than as discussed below in Section III. In addition, we are not
excluding Major SBS Participants from the scope of the rule, as one
commenter suggested.\608\ We note that Exchange Act Section 15Fh(1)(B)
explicitly contemplates that Major SBS Participants, as well as SBS
Dealers, will have obligations to supervise diligently their security-
based swap business. As discussed above in Section II.C, where the
Dodd-Frank Act imposes a business conduct requirement on both SBS
Dealers and Major SBS Participants, the rules will apply to both
entities.
---------------------------------------------------------------------------
\607\ See FIA/ISDA/SIFMA, supra note 5.
\608\ See MFA, supra note 5.
---------------------------------------------------------------------------
Rule 15Fh-3(h)(3), as adopted, provides that SBS Entities and
associated persons will not be liable for failure to supervise another
person if either the other person is not subject to the SBS Entity's or
associated person's supervision, or if the safe harbor described in the
rule is satisfied.\609\ The safe harbor contains two conditions. First,
the SBS Entity must have established policies and procedures, and a
system for applying those policies and procedures, which would
reasonably be expected to prevent and detect, to the extent
practicable, any violation of the federal securities laws and the rules
and regulations thereunder relating to security-based swaps. Second,
the SBS Entity or associated person must have reasonably discharged the
duties and obligations incumbent on it by reason of such procedures and
system without a reasonable basis to believe that such procedures were
not being followed.\610\ Both conditions must be met in order for an
SBS Entity to satisfy the safe harbor. However, as noted in the
Proposing Release, the inability to rely on the safe harbor would not
necessarily mean that an SBS Entity or associated person failed to
diligently supervise any other person.\611\
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\609\ One commenter requested clarification that a person
committing a violation will not be viewed as subject to the
supervision of another person unless such other person knew or
should have known that he or she had authority and responsibility to
exercise control over the violator that could have prevented the
violation. See FIA/ISDA/SIFMA, supra note 5. The Commission notes
that if the conditions of the safe harbor in Rule 15Fh-3(h)(3) are
not met, liability for failure to supervise would be a facts and
circumstances determination, which would take into account the
factors described by the commenter.
\610\ We are not adopting a commenter's recommendation that our
rules expressly require supervisory personnel to ``report up'' to
upper management of the board, and require an SBS Entity to
reevaluate its supervisory procedures if they fail to detect or
deter significant violations. See CFA, supra note 5. We note that
Rule 15Fh-3(h) provides a baseline for an effective supervisory
system, but, as noted in the Proposing Release, a particular system
may need additional elements to be effective. See Proposing Release,
76 FR at 42419, supra note 3. For that reason, Rule 15Fh-3(h)(2)
states that it establishes only minimum requirements. Id.
\611\ See Proposing Release, 76 FR at 42420, supra note 3. With
respect to broker-dealers, the Commission's policy regarding failure
to supervise is well established. See 15 U.S.C. 78o(b)(4)(E) and 15
U.S.C. 78o(b)(6)(A). As the Commission has explained in other
contexts:
The Commission has long emphasized that the responsibility of
broker-dealers to supervise their employees is a critical component
of the federal regulatory scheme . . . In large organizations it is
especially imperative that those in authority exercise particular
vigilance when indications of irregularity reach their attention.
The supervisory obligations imposed by the federal securities laws
require a vigorous response even to indications of wrongdoing. Many
of the Commission's cases involving a failure to supervise arise
from situations where supervisors were aware only of ``red flags''
or ``suggestions'' of irregularity, rather than situations where, as
here, supervisors were explicitly informed of an illegal act. Even
where the knowledge of supervisors is limited to ``red flags'' or
``suggestions'' of irregularity, they cannot discharge their
supervisory obligations simply by relying on the unverified
representations of employees. Instead, as the Commission has
repeatedly emphasized, ``[t]here must be adequate follow-up and
review when a firm's own procedures detect irregularities or unusual
trading activity. . . .'' Moreover, if more than one supervisor is
involved in considering the actions to be taken in response to
possible misconduct, there must be a clear definition of the efforts
to be taken and a clear assignment of those responsibilities to
specific individuals within the firm.
John H. Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992)
(report pursuant to Section 21(a) of the Exchange Act) (footnotes
omitted). See Proposing Release, 76 FR at 42419 n.158, supra note 3.
---------------------------------------------------------------------------
H. Rules Applicable to Dealings With Special Entities
Sections 15F(h)(4) and (5) of the Exchange Act provide certain
additional protections for ``special entities''--such as
municipalities, federal and state agencies, pension plans, and
endowments \612\--in connection with security-based swaps.\613\
---------------------------------------------------------------------------
\612\ See Section II.D.2.a, infra.
\613\ 15 U.S.C. 78o-10(h)(4)-(5).
---------------------------------------------------------------------------
Special entities, like other market participants, may use swaps and
security-based swaps for a variety of purposes, including risk
management and portfolio adjustment. In adopting the special entity
provisions of the Exchange Act, the Commission seeks to implement the
statute, while not impeding special entities' access to security-based
swaps.
1. Scope of Definition of ``Special Entity''
a. Proposed Rule
Exchange Act Section 15F(h)(2)(C) defines 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.\614\ Proposed
Rule 15Fh-2(e) defines a ``special entity'' as: (i) A Federal agency;
(ii) a State, State agency, city, county, municipality, or other
political
[[Page 30008]]
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(32) 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.
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\614\ Section 501(c)(3) of the Internal Revenue Code of 1986
includes, in its list of ``exempt organizations'':
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 (but only if no part of its activities involve the
provision of athletic facilities or equipment), or for the
prevention of cruelty to children or animals, no part of the net
earnings of which inures to the benefit of any private shareholder
or individual, no substantial part of the activities of which is
carrying on propaganda, or otherwise attempting, to influence
legislation (except as otherwise provided in subsection (h)), and
which does not participate in, or intervene in (including the
publishing or distributing of statements), any political campaign on
behalf of (or in opposition to) any candidate for public office.
26 U.S.C. 501(c)(3).
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The Proposing Release noted that commenters had raised questions
about the scope of the ``special entity'' definition. The Commission
requested comment regarding: (1) Whether to interpret the phrase
``employee benefit plan, as defined in Section 3'' of ERISA to mean a
plan that is subject to regulation under ERISA; (2) whether the phrase
``governmental plan'' should include government investment pools or
other plans, programs or pools of assets; (3) the definition of the
term ``endowment;'' (4) the treatment of collective investment vehicles
in which one or more special entities are invested; (5) the treatment
of foreign entities; and (6) the treatment of master trusts holding the
assets of one or more funded plans of a single employer and its
affiliates.
b. Comments on the Proposed Rule
One commenter argued that the term ``special entity'' was
adequately defined in the Exchange Act, and that it ``should not
require extensive clarification.'' \615\ However, most commenters
requested that the Commission exclude or include specific groups from
the ``special entity'' designation. These comments are addressed below.
---------------------------------------------------------------------------
\615\ See CFA, supra note 5. See also Exchange Act Section
15F(h)(2)(C).
---------------------------------------------------------------------------
i. Federal Agency
We received no comments regarding the inclusion of federal agencies
within the special entity definition. In the Proposing Release, we
noted that the definition of ``security-based swap'' excludes an
``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.'' \616\
---------------------------------------------------------------------------
\616\ Proposing Release, 76 FR 42421, n. 176, supra note 3
(citing Section 3(a)(68) of the Exchange Act).
---------------------------------------------------------------------------
ii. State and Municipal Entities
One commenter suggested that we modify the description of state and
municipal entities to include ``any instrumentality, department, or a
corporation of or established by a State or political subdivision of a
State.'' \617\ According to the commenter, this modification would
harmonize the SEC's definition of ``special entity'' with that of the
CFTC.\618\
---------------------------------------------------------------------------
\617\ See SIFMA (August 2015), supra note 5.
\618\ Id.
---------------------------------------------------------------------------
iii. Employee Benefit Plans and Governmental Plans
As stated above, Exchange Act Section 15F(h)(2)(C)(iii) defines
``special entity'' to include ``any employee benefit plan, as defined
in Section 3 of [ERISA].'' \619\ Section 15F(h)(2)(C)(iv) separately
adds ``any governmental plan, as defined in Section 3 [ERISA]'' to the
special entity definition. Section 3 of ERISA defines the term
``employee benefit plan'' to include plans, such as most private sector
employee benefit plans, that are subject to regulation under Title I of
ERISA.\620\ However, Section 3 of ERISA also defines the following
additional categories of employee benefit plans that are not subject
to'' ERISA regulation: (1) Governmental plans; (2) church plans; (3)
plans maintained solely for the purpose of complying with applicable
workmen's compensation laws or unemployment compensation or disability
insurance laws; (4) plans maintained outside the U.S. primarily for the
benefit of persons substantially all of whom are nonresident aliens; or
(5) unfunded excess benefit plans. \621\ These latter categories of
employee benefit plans, including governmental plans, are therefore
``defined in'' ERISA, but not ``subject to'' regulation under ERISA.
---------------------------------------------------------------------------
\619\ 15 U.S.C. 78o-10(h)(2)(C)(iii).
\620\ See generally 29 U.S.C. 1002(1)-(2).
\621\ See 29 U.S.C. 1003(b).
---------------------------------------------------------------------------
Commenters asked the Commission at the proposing stage to limit the
scope of Section 15F(h)(2)(C)(iii) to employee benefit plans that are
subject to regulation under ERISA, and not to extend the definition of
``special entity'' to plans that are merely ``defined in'' ERISA,
``unless they are covered by another applicable prong of the ``special
entity'' definition (e.g., governmental plans).'' \622\ As the
commenters noted, Exchange Act Section 15F(h)(2)(C)(iv) separately
defines ``special entity'' to include any governmental plan, as defined
in Section 3 of ERISA. Mindful of the redundancy that would result if
the statute were interpreted to include governmental plans twice in the
definition of ``special entity,'' the Commission therefore requested
comment regarding whether to interpret the phrase ``employee benefit
plan, as defined in Section 3 of [ERISA]'' in Exchange Act Section
15F(h)(2)(C)(iii), or to mean a plan that is ``subject to'' regulation
under ERISA.\623\
---------------------------------------------------------------------------
\622\ SIFMA/ISDA 2010 Letter at 2, supra note 34.
\623\ Proposing Release, 76 FR at 42422 n.182, supra note 3.
---------------------------------------------------------------------------
Seven comment letters addressed this issue. One commenter argued
that the expansive language of the statute suggested that any employee
benefit plan ``defined in'' ERISA, including a church plan, should be
treated as a special entity, and that, as a matter of policy, church
plans should not be treated differently than ERISA or governmental
plans when entering into security-based swaps with SBS Entities.\624\
This commenter recommended that the Commission revise the proposed
special entity definition to clarify that church plans are special
entities, or that the Commission permit church plans to ``opt in'' to
special entity status, since opting in would provide potential
counterparties greater certainty regarding whether a church plan was,
in fact, a special entity.\625\ Another commenter recommended that the
Commission cover plans ``defined in'' ERISA.\626\
---------------------------------------------------------------------------
\624\ See Church Alliance (August 2011), supra note 5. See also
Church Alliance (October 2011), supra note 5.
\625\ Id.
\626\ See CalPERS (August 2011), supra note 5.
---------------------------------------------------------------------------
A collective group of three commenters argued that the definition
of special entity should include only employee benefit plans that are
``subject to'' ERISA.\627\ This group asserted that, ``[s]ince Congress
included a separate `governmental plans' prong in the definition of
special entity, the `employee benefit plan' prong necessarily excludes
governmental plans (both domestic and foreign) and should be read
narrowly to include only employee benefit plans ``subject to'' ERISA.''
\628\ However, one of these commenters later independently submitted a
comment after the CFTC adopted business conduct rules, and expressed
its support for an ``opt in'' approach.\629\ This commenter asserted
that the special entity definition should be limited to employee
benefit plans that are ``subject to'' ERISA, although other employee
benefit plans defined in ERISA, such as church plans, should be allowed
to opt in to special entity status. According to this commenter, these
modifications would harmonize the SEC and CFTC special entity
definitions.
---------------------------------------------------------------------------
\627\ See FIA/ISDA/SIFMA, supra note 5.
\628\ Id.
\629\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
One commenter suggested treating plans subject to ERISA and
government plans subject to ERISA similarly, so long as both are acting
as end-users and are
[[Page 30009]]
otherwise complying with their fiduciary obligations.\630\ Another
commenter suggested including governmental plans as special entities,
arguing that ``the taxpayers and government workers who stand behind
government pensions are precisely the sort of constituents Congress
sought to protect through the heightened protections of special
entities.'' \631\
---------------------------------------------------------------------------
\630\ See CalSTRS, supra note 5.
\631\ See CFA, supra note 5.
---------------------------------------------------------------------------
More broadly, one commenter recommended that the business conduct
standards should only apply to certain governmental special entities,
and that they should not apply to ERISA plans--since these plans
already have similar or greater protections under ERISA.\632\ The
commenter argued that, by applying these standards to all special
entities, the SEC ``has extended its regulatory reach significantly
beyond the scope of the statute,'' resulting in ``redundant'' or
``overlapping'' regulations.\633\ The commenter recommended that the
proposed rules be modified to exclude ERISA plans with security-based
swap advisors that are ``already sufficiently regulated.'' \634\
---------------------------------------------------------------------------
\632\ See ABC, supra note 5.
\633\ Id.
\634\ Id.
---------------------------------------------------------------------------
iv. Master Trusts
The Commission additionally requested comment regarding whether to
include a master trust that holds the assets of one or more funded
plans of a single employer and its affiliates within the special entity
definition. Three commenters supported the treatment of master trusts
as special entities.\635\
---------------------------------------------------------------------------
\635\ See FIA/ISDA/SIFMA, supra note 5; Church Alliance (August
2011), supra note 5; SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
One comment letter suggested that the term ``special entity''
should be modified to include master trusts holding the assets of one
or more funded plans of a single employer.\636\ Another comment letter
urged the Commission to clarify that master trusts would be treated as
special entities, noting that, by making this clarification, the SEC
would harmonize the interpretation of its rules with that of the
CFTC.\637\
---------------------------------------------------------------------------
\636\ See FIA/ISDA/SIFMA, supra note 5.
\637\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
One commenter urged the Commission to include church benefit boards
that hold the assets of multiple church plans, church endowments, and
other church-related funds on a commingled basis within the special
entity definition, arguing that the functions of church benefit boards
are similar to those of tax-exempt trusts, or master trusts established
by several multiple-employer pension plans, and that such a definition
would reflect the close relationship--recognized in ERISA--between
church benefit boards and their constituent church plans.\638\
---------------------------------------------------------------------------
\638\ See Church Alliance (August 2011), supra note 5.
---------------------------------------------------------------------------
v. Collective Investment Vehicles
The Commission requested comment regarding whether to interpret
``special entity'' to include a collective investment vehicle in which
one or more special entities had invested. All eight commenters that
commented on this question opposed the designation of collective
investment vehicles as special entities, even where such collective
investment vehicles have special entity investors.\639\
---------------------------------------------------------------------------
\639\ See ABC, supra note 5; SIFMA (August 2011), supra note 5;
ABA Committees, supra note 5; FIA/ISDA/SIFMA, supra note 5;
BlackRock, supra note 5; MFA, supra note 5; NACUBO, supra note 5;
SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Commenters generally argued that requiring SBS Entities to
investigate or ``look through'' their collective investment vehicle
counterparties to determine whether they held special entity
investments would create uncertainty in the market, increase compliance
costs, disrupt the gains of special entity investors, and restrict
special entities' access to security-based swaps--since collective
investment vehicle managers may either limit or reject investments by
special entities to avoid limitations on their security-based swap
trading activities.\640\
---------------------------------------------------------------------------
\640\ Id.
---------------------------------------------------------------------------
One commenter asked the Commission to clarify that it would not
``look through'' collective investment vehicles to align its
interpretation of the special entity definition with that of the
CFTC.\641\
---------------------------------------------------------------------------
\641\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Two commenters argued to exclude collective investment vehicles
because these vehicles are almost always passive investors, and that
including them within the adopted rules would serve no regulatory
purpose, since Congress' intent was to protect special entities as
defined within the statute.\642\
---------------------------------------------------------------------------
\642\ See ABA Committees, supra note 5; NACUBO, supra note 5.
---------------------------------------------------------------------------
Lastly, two commenters urged the Commission to exclude hedge funds,
even where a special entity invests in that hedge fund.\643\
---------------------------------------------------------------------------
\643\ See FIA/ISDA/SIFMA, supra note 5; BlackRock, supra note 5.
---------------------------------------------------------------------------
vi. Endowments
The Commission requested comment regarding how to apply the special
entity definition to endowments, and whether certain organizations that
qualify as endowments should be included in that definition. The five
commenters addressing this issue suggested that the Commission limit
the definition of endowments in the special entity context, with
various caveats.\644\
---------------------------------------------------------------------------
\644\ See FIA/ISDA/SIFMA, supra note 5; NABL, supra note 5;
NACUBO, supra note 5; ABA Committees, supra note 5; SIFMA (August
2015), supra note 5.
---------------------------------------------------------------------------
Three commenters suggested limiting the definition of
``endowments'' to endowments that, themselves, enter into swaps.\645\
Two of these commenters urged the Commission to clarify that the term
``endowments'' would not include non-profit organizations whose assets
might include funds designated as an endowment,\646\ while another
asked that the Commission exclude organizations that use endowment
assets to pledge, maintain, enhance or support the organization's
collateral obligations.\647\ Another commenter similarly requested that
the Commission interpret the definition of endowment to exclude
charitable organizations that enter into security-based swaps for which
their counterparties have recourse to the organizations'
endowment.\648\ The commenter noted that, by making this clarification,
the SEC would bring its interpretation of the rules into harmony with
that of the CFTC.\649\
---------------------------------------------------------------------------
\645\ See FIA/ISDA/SIFMA, supra note 5; NABL, supra note 5;
NACUBO, supra note 5.
\646\ See FIA/ISDA/SIFMA, supra note 5; NABL, supra note 5.
\647\ See NACUBO, supra note 5.
\648\ See SIFMA (August 2015), supra note 5.
\649\ Id.
---------------------------------------------------------------------------
The last commenter requested clarification that private foundations
would not be included within the special entity definition.\650\ The
commenter argued that these foundations are, by statute, non-profit
organizations that are not publicly supported, and that ``no evidence''
exists that Congress intended to treat private foundations as
``endowments'' under Dodd-Frank.\651\
---------------------------------------------------------------------------
\650\ See ABA Committees, supra note 5.
\651\ Id.
---------------------------------------------------------------------------
Similarly, this same commenter suggested that ``institutional
investor organizations'' (such as large non-profits and
``sophisticated'' endowments) with over $1 billion of net assets under
management should be excluded from the special entity definition, since
large ``sophisticated'' endowments employ professional money managers
already subject to oversight and review.\652\ The commenter argued that
a special entity designation for these organizations could reduce the
number of SBS Entities willing to trade in security-based swaps,
[[Page 30010]]
given the increased compliance costs associated with evaluating the
qualifications of an independent representative.
---------------------------------------------------------------------------
\652\ See ABA Committees, supra note 5.
---------------------------------------------------------------------------
vii. Foreign Plans, Foreign Entities
The Commission requested comment on whether to exclude from the
definition of ``special entity'' any foreign entity. Six commenters
responded to this issue.\653\ All six commenters asserted that foreign
entities should not be deemed special entities, although one commenter
recommended that the U.S. reserve the right to extend application of
its business conduct standards to foreign entities if international
regulatory efforts fail.\654\
---------------------------------------------------------------------------
\653\ See ABC, supra note 5; SIFMA (August 2011), supra note 5;
Johnson, supra note 5; BlackRock, supra note 5; CFA, supra note 5;
PensionsEurope, supra note 7.
\654\ See Johnson, supra note 5. This same commenter argued that
Congress limited the territorial scope of Title VII to activities
within the United States, and that extraterritorial application of
these laws should only apply when international activities of U.S.
firms have a ``direct and significant connection with or effect on
U.S. commerce,'' or are designed to evade U.S. rules. Id. For
further discussion, see Cross Border Application and Availability of
Substituted Compliance, Section III.
---------------------------------------------------------------------------
Four other commenters objected to the inclusion of foreign pension
and employee benefit plans within the special entity definition on the
grounds that the statutory language reflected a lack of Congressional
intent to provide special protection for such plans under Dodd-Frank,
and that extending the SEC's authority outside the United States would
create the potential for conflict with other nations' regulatory
regimes.\655\ These commenters requested that the Commission revise the
proposed definition of ``special entity'' to specifically exclude
foreign entities.\656\
---------------------------------------------------------------------------
\655\ See ABC, supra note 5; BlackRock, supra note 5; SIFMA
(August 2011), supra note 5.
\656\ One commenter urged the Commission to only apply the
business conduct standards to security-based swap transactions
involving U.S. counterparties. See PensionsEurope, supra note 7,
discussed in Section III below.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
After consideration of all comments, the Commission has determined
to modify the scope of the special entity definition as described
below.
i. Federal Agency
As noted above, the Commission did not receive any comments on the
inclusion of federal agencies within the special entity definition. The
Commission continues to believe it is appropriate to include federal
agencies within the special entity definition, and is therefore
adopting Rule 15Fh-2(e)(1) as proposed, renumbered as Rule 15Fh-
2(d)(1).
ii. State and Municipal Special Entities
After further consideration and in light of the comment received,
the Commission is modifying proposed Rule 15Fh-2(e)(2), adopted as Rule
15Fh-2(d)(2), to further define state and municipal entities to include
``any instrumentality, department, or a corporation of or established
by a State or political subdivision of a State.'' \657\ As the
Commission explained in another context, states may delegate powers to
their political subdivisions, including the power to create corporate
instrumentalities.\658\ Similarly, the Commission believes a department
or a corporation organized as a municipal corporate instrumentality of
a state's political subdivision should be considered a municipal
corporate instrumentality of a state. Corporate instrumentalities,
departments, or corporations created by states or their political
subdivisions are therefore taxpayer-backed institutions. Consequently,
the Commission believes it is important to include ``any
instrumentality, department, or a corporation of or established by a
State or political subdivision of a State'' within the special entity
definition to provide heightened protections for taxpayer-backed
institutions that transact in security-based swaps.
---------------------------------------------------------------------------
\657\ See SIFMA (August 2015), supra note 5; and SIFMA (November
2015), supra note 5 (asking the Commission to clarify that an
instrumentality, department, or a corporation of, or established by,
a State or political subdivision of a State is a special entity).
This is consistent as well with the ECP definition for governmental
entities, which includes ``an instrumentality, agency, or
department'' of a State or political subdivision of a State. See
Section 3(a)(65) of the Exchange Act, referring to Section
1a(18)(A)(vii)(III) of the CEA.
\658\ See Municipal Advisor Registration Release, 78 FR at
67483, supra note 5.
---------------------------------------------------------------------------
In addition, the inclusion of this language will conform the
special entity definition to that of a ``municipal entity'' in the
Exchange Act, as well as to the CFTC's definition of State and
municipal special entities, thereby providing all categories of
municipal entities with heightened protections,\659\ as well as
addressing the commenter's concern regarding the need for a consistent
definition across the security-based swaps and swaps markets.\660\ This
consistency should result in efficiencies for entities that transact in
security-based swaps, particularly where such entities have already
established a compliance infrastructure that satisfies the requirements
of the existing CFTC business conduct standards.
---------------------------------------------------------------------------
\659\ See Exchange Act Section 15B(e)(8), 15 U.S.C. 78o-4(e)(8)
(defining ``municipal entity'' to include ``any agency, authority,
or instrumentality of the States, political subdivision, or
municipal corporate entity'').
\660\ See SIFMA (August 2015), supra note 5; and SIFMA (November
2015), supra note 5.
---------------------------------------------------------------------------
iii. Employee Benefit Plans and Governmental Plans
Upon further consideration and in light of the comments received,
the Commission is modifying proposed Rule 15Fh-2(e)(3), which stated
``any employee benefit plan defined in Section 3 of [ERISA]'' to state
in adopted Rule 15Fh-2(d)(3) ``any employee benefit plan subject to
Title I of [ERISA].'' Under this modification, Rule 15Fh(2)(d)(3) only
includes employee benefit plans that are subject to regulation under
Title I of ERISA. Furthermore, proposed Rule 15Fh-2(e)(4), renumbered
as Rule 15Fh-2(d)(5), is being adopted as proposed, to include ``any
governmental plan, as defined in section 3(32) of [ERISA].''
In reaching this determination, we believe that Exchange Act
Sections 15F(h)(2)(C)(iii) (employee benefit plans defined in Section 3
of ERISA) and 15F(h)(2)(C)(iv) (governmental plans defined in Section 3
of ERISA) should be read together ``to avoid rendering superfluous''
any statutory language of the Exchange Act.\661\ As discussed above in
Section II.H.1.b.3, Exchange Act Section 15F(h)(2)(C)(iii), read
literally as any employee benefit plan ``defined in'' Section 3 of
ERISA, would render Section 15F(h)(2)(C)(iv) superfluous, since
governmental plans ``defined in'' ERISA are specifically designated as
special entities under Section 15F(h)(2)(C)(iv). The Commission
therefore agrees with the commenter that Congress' separate inclusion
of governmental plans within the special entity definition supports a
narrower reading of Section 15F(h)(2)(C)(iii), such that the definition
only includes employee benefit plans ``subject to'' regulation under
ERISA.\662\
---------------------------------------------------------------------------
\661\ Astoria Fed. Sav. & Loan Assn. v. Solimino, 501 U.S. 104,
112 (1991).
\662\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
We recognize that this interpretation of ``special entity'' would
exclude other types of employee benefit plans ``defined in'' Section
4(b) of ERISA, including church plans and workmen's compensation plans.
Therefore, upon further consideration, and in response to commenters
who support a broader interpretation of the term ``special entity,''
including those commenters who assert that a church plan should be
treated as a special entity, the
[[Page 30011]]
Commission has determined to include an additional prong to the special
entity definition.\663\ Specifically, Rule 15Fh-2(d)(4), as adopted,
defines a special entity to include ``[a]ny employee benefit plan
defined in Section 3 of [ERISA] and not otherwise defined as a special
entity, unless such employee benefit plan elects not to be a special
entity by notifying a security-based swap dealer or major security-
based swap participant of its election prior to entering into a
security-based swap with the particular security-based swap dealer or
major security-based swap participant.'' The Commission believes that
the inclusion of this additional provision appropriately resolves any
tension between Exchange Act Sections 15F(h)(2)(C)(iii) and (iv), while
granting broad coverage under the enhanced business conduct protections
for special entities provided by the Dodd Frank Act.
---------------------------------------------------------------------------
\663\ See Church Alliance (August 2011), supra note 5; CalPERS
(August 2011), supra note 5; Church Alliance (October 2011), supra
note 5; SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Under Rule 15Fh-2(d)(4), as adopted, an employee benefit plan that
is ``defined in'' Section 3 of ERISA but not ``subject to'' regulation
under ERISA is included within the special entity definition, although
it may elect to opt out of special entity status by notifying an SBS
Entity counterparty of its election to opt out prior to entering into a
security-based swap. Therefore, for example, under Rule 15Fh-2(d)(4),
any church plan, as defined in Section 3(33) of ERISA, would be
considered a special entity unless it elected to opt out of special
entity status.\664\ It is also consistent with Rule 15Fh-3(a)(3), which
requires an SBS Entity to verify whether a counterparty is eligible to
elect not to be a special entity, and if so, to notify the counterparty
of its right to make such an election.\665\ Further, by requiring
employee benefit plans to notify SBS Entities of their decision to opt
out, the provision will provide SBS Entities greater clarity regarding
their counterparty's election to be treated as a special entity, as
requested by a commenter.\666\
---------------------------------------------------------------------------
\664\ See Church Alliance (August 2011), supra note 5.
\665\ See Section II.G.1.b, supra.
\666\ See Church Alliance (August 2011), supra note 5.
---------------------------------------------------------------------------
We note that the special entity definition the Commission is
adopting today differs from the CFTC's special entity definition, which
instead includes an opt-in provision for plans ``defined in''
ERISA.\667\ While we agree with the CFTC's objective of ``providing
protections broadly,'' \668\ we have determined that inclusion of an
opt-out provision will afford the maximum protections to the broadest
categories of special entities, while still allowing them the
flexibility to elect not to be special entities when they do not wish
to avail themselves of those protections. In making this determination,
we acknowledge the commenter's request that we conform our special
entity definition to that of the CFTC.\669\ However, we believe that
the practical effect of an opt-out versus an opt-in regime should be
minimal since, in either case, the SBS Entity will need to advise the
counterparty of its option to be treated as a special entity. The
result should be greater clarity for SBS Entities regarding the
regulatory status of their counterparties.
---------------------------------------------------------------------------
\667\ See CFTC Adopting Release, 77 FR at 9774, supra note 21.
\668\ 77 FR at 9776.
\669\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Lastly, we disagree with the commenter's assertions that the SEC
``has extended its regulatory reach'' beyond the statute by applying
the business conduct rules to ERISA plans, and that the resulting
regulations would overlap with the preexisting regulations established
under ERISA.\670\ As noted above, the plain language of Exchange Act
Section 15F(h)(2)(C)(iii) includes ERISA plans within the special
entity definition, and we continue to believe that such plans are
deserving of the heightened protections of the business conduct rules
specific to special entities. Moreover, wherever practical, we have
adopted bifurcated rules that acknowledge the existing federal
regulatory framework for ERISA plans, thereby minimizing the tension
that may arise between that framework and the business conduct
standards adopted today.\671\
---------------------------------------------------------------------------
\670\ See ABC, supra note 5.
\671\ See, e.g., Section II.H.2.c.ii, infra.
---------------------------------------------------------------------------
iv. Master Trusts
The Commission agrees with commenters that master trusts should be
treated as special entities, where a master trust holds the assets of
more than one ERISA plan, sponsored by a single employer or by a group
of employers under common control.\672\ In this regard, the Commission
clarifies that, if a master trust holds the assets of an ERISA plan,
the SBS Entity may satisfy the business conduct requirements being
adopted today by treating the master trust as a special entity, rather
than applying the business conduct rules to each underlying ERISA plan
in a master trust. 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 SBS Dealer or Major SBS
Participant had to separately comply with the final rules with respect
to each ERISA plan whose assets are held in the master trust.
---------------------------------------------------------------------------
\672\ See FIA/ISDA/SIFMA, supra note 5; Church Alliance (August
2011), supra note 5; SIFMA (August 2015), supra note 5. See also
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)); 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.'').
---------------------------------------------------------------------------
The Commission similarly agrees with the commenter that, where a
church benefit board holds the assets of multiple church plans as
defined in Section 3(33) of ERISA, the function of the church benefit
board is similar to that of a master trust.\673\ Because church plans
are recognized in ERISA, and a church benefit board holds only the
assets of constituent church plans,\674\ a church benefit board that
holds the assets of church plans will be deemed a special entity under
final Rule 15Fh-2(d)(4), although it will have the ability to opt out
of special entity protections.
---------------------------------------------------------------------------
\673\ See Church Alliance (August 2011), supra note 5.
\674\ See generally 29 U.S.C. 1003(b).
---------------------------------------------------------------------------
Lastly, this clarification addresses the commenter's request that
the Commission interpret the special entity definition in harmony with
the CFTC, as the CFTC also includes master trusts as special entities
where a master trust holds the assets of more than one ERISA plan,
sponsored by a single employer or by a group of employers under common
control.\675\ Such uniformity will help establish regulatory
consistency across the security-based swap and swap markets, thereby
creating efficiencies for SBS entities that transact in security-based
swaps and swaps.
---------------------------------------------------------------------------
\675\ See SIFMA (August 2015), supra note 5. See also CFTC
Adopting Release, 77 FR at 9776, supra note 21.
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v. Collective Investment Vehicles
The Commission requested comment on whether to interpret ``special
entity'' to include collective investment vehicles in which one or more
special entities had invested. After
[[Page 30012]]
consideration of the comments, the Commission has determined not to
interpret ``special entity'' in that way. The Commission agrees with
commenters that uniformly urged the Commission not to treat a
collective investment vehicle as a special entity, solely because the
collective investment vehicle may have one or more special entity
investors.\676\
---------------------------------------------------------------------------
\676\ See ABC, supra note 5; SIFMA (August 2011), supra note 5;
ABA Committees, supra note 5; FIA/ISDA/SIFMA, supra note 5;
BlackRock, supra note 5; MFA, supra note 5; NACUBO, supra note 5;
SIFMA (August 2015), supra note 5. See ABC, supra note 5; SIFMA
(August 2011), supra note 5; ABA Committees, supra note 5; FIA/ISDA/
SIFMA, supra note 5; BlackRock, supra note 5; MFA, supra note 5;
NACUBO, supra note 5; SIFMA (August 2015), supra note 5. For
clarification, and in response to commenters, the term ``collective
investment vehicle'' in our discussion includes, but is not limited
to, hedge funds that hold the assets of special entity investors.
See FIA/ISDA/SIFMA, supra note 5; BlackRock, supra note 5.
---------------------------------------------------------------------------
Unlike master trusts, formed for the purpose of holding assets of
ERISA plans, a collective investment vehicle may be formed for a
variety of reasons and only incidentally accept investments from
special entities. We share the concerns of commenters that requiring
SBS Entities to investigate or ``look through'' their collective
investment vehicle counterparties to determine whether they held
special entity investments could create uncertainty in the market, and
could potentially increase compliance costs, disrupt the gains of
special entity investors, and restrict special entities' access to
security-based swaps--since collective investment vehicle managers may
either limit or reject investments by special entities to avoid
application of the special entity requirements.\677\
---------------------------------------------------------------------------
\677\ Id.
---------------------------------------------------------------------------
At the same time, we recognize the potential benefits of applying
heightened protections to special entities that have invested in
collective investment vehicles, either by applying those protections to
the collective investment vehicle itself or requiring the SBS Entity to
``look through'' the collective investment vehicle. After further
consideration, we have determined that it would neither be appropriate
to treat the entire collective investment vehicle as a special entity,
nor to require an SBS Dealer to ``look through'' the collective
investment vehicle to determine whether any of its investors qualify as
special entities. While the special entity has made the decision to
invest in the collective investment vehicle, it is the collective
investment vehicle that enters into the security-based swap--not the
special entity. In light of the foregoing, we do not believe that
collective investment vehicles should be included within the special
entity definition.
Lastly, our decision not to include collective investment vehicles
in the special entity definition will address the commenter's
suggestion that we harmonize the Commission's special entity definition
with that of the CFTC to increase regulatory consistency across the
security-based swap and swap markets.\678\
---------------------------------------------------------------------------
\678\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
vi. Endowments, Non-Profit Organizations, and Private Foundations
The Commission requested comment regarding application of the
special entity definition to endowments. After taking into
consideration the comments, the Commission has determined to interpret
the term ``endowment,'' as used in Section 15F(h)(2)(C)(v) of the
Exchange Act, not to include entities or persons other than the
endowment itself. The Commission therefore agrees with commenters that
special entity status should be limited to endowments that are,
themselves, counterparties to security-based swaps.\679\ Accordingly,
the Commission does not interpret the term ``endowment'' to include
organizations that use endowment assets to pledge, maintain, enhance or
support the organization's collateral obligations, or situations where
a counterparty has recourse to the organization's endowment.\680\
---------------------------------------------------------------------------
\679\ See FIA/ISDA/SIFMA, supra note 5; NABL, supra note 5;
NACUBO, supra note 5.
\680\ See NACUBO, supra note 5; SIFMA (August 2015), supra note
5.
---------------------------------------------------------------------------
For clarification, and in response to comment,\681\ a private
foundation will be subject to special entity protections where the
private foundation qualifies as an endowment under applicable state
laws, rules, or regulations, including the Uniform Prudent Management
of Institutional Funds Act. Although we acknowledge the commenter's
assertion that private foundations typically derive their financial
support through private donations,\682\ we do not agree that public
funding is a prerequisite to special entity status, or that private
funding should necessarily exclude a foundation from qualifying for
special entity status.
---------------------------------------------------------------------------
\681\ See ABA Committees, supra note 5.
\682\ Id.
---------------------------------------------------------------------------
As noted above in Section II.G.1.b, Rule 15Fh-3(a)(2) generally
requires an SBS Entity to verify whether its counterparty is a special
entity before entering into the security-based swap with that
counterparty. Such verification should generally include a
determination whether the counterparty may be deemed an endowment under
applicable state law, as described above. However, as discussed in
Section II.G.1.b, supra, counterparties may make representations about
their status as special entities at the outset of a relationship with
an SBS Entity, and can ``bring down'' that representation for each
relevant action involving a security-based swap.
Also, as with collective investment vehicles, we believe that a
more expansive interpretation of the special entity definition would
require a burdensome ``look through'' process to determine whether
endowment funds had, for instance, been invested or used as collateral
in a particular security-based swap, and could ultimately restrict the
ability of entities that are neither themselves endowments nor special
entities (such as organizations described in section 501(c)(3) of the
Internal Revenue Code of 1986 whose assets merely include funds
designated as an endowment) to transact in security-based swaps.
By making the foregoing clarifications, the Commission more closely
aligns its interpretation of the term ``endowment'' with that of the
CFTC.\683\ This consistency in the definition will address the
commenter's concern regarding the need to promote regulatory clarity,
and result in operational efficiencies for entities that have been
operating under the CFTC's business conduct regime since 2012.\684\
---------------------------------------------------------------------------
\683\ See CFTC Adopting Release, 77 FR at 9776, supra note 21
(``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
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 obligations to make payments
on the swap . . . .'').
\684\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Lastly, as discussed in more detail above in Section II.A.2.d., we
decline the commenter's suggestion to permit endowments to opt out of
special entity status.\685\ As stated in the Proposing Release,
Congress created heightened protections to mitigate the potential for
abuse in SBS transactions with special entities, as the financial
sophistication of special entities varies greatly.\686\ As discussed
above in Section II.A, the rules being adopted today are intended to
provide certain protections for counterparties, including certain
[[Page 30013]]
heightened protections for special entities. We think it is appropriate
to apply the rules so that counterparties receive the benefits of those
protections and do not think it is appropriate to permit parties to
``opt out'' of those provisions. Furthermore, we note that the CFTC's
adopted rules do not contain such an opt-out provision, and that Swap
Entities and their special entity counterparties have been operating
under this regime since 2012. For all of the foregoing reasons, and to
achieve regulatory consistency across the security-based swap and swap
markets, we decline to adopt an opt-out provision for endowments in the
final rules.
---------------------------------------------------------------------------
\685\ Id.
\686\ See Proposing Release, 76 FR at 42401, supra note 3.
---------------------------------------------------------------------------
vii. Foreign Plans and Foreign Entities
The Commission requested comment on whether to exclude from the
definition of ``special entity'' any foreign entity. After considering
the comments, all of which asserted that foreign entities should not be
deemed special entities, the Commission is declining to include foreign
entities within the definition of ``special entity.'' The Commission
believes that, as stated in the Cross-Border Adopting Release, the term
``special entity'' applies to ``legal persons organized under the laws
of the United States.'' \687\ This reading addresses the concerns
raised by commenters regarding the need for clarification concerning
the application of the rules as they relate to special entity-specific
provisions.\688\
---------------------------------------------------------------------------
\687\ See Application of ``Security-Based Swap Dealer'' and
``Major Security-Based Swap Participant'' Definitions to Cross-
Border Security-Based Swap Activities; Final Rule; Republication, 79
FR 47278, 47306 n.234 (Aug. 12, 2014) (``Consistent with the
proposal, `special entities,' as defined in Section 15F(h)(2)(C) of
the Exchange Act, are U.S. persons because they are legal persons
organized under the laws of the United States'').
\688\ See ABC, supra note 5; SIFMA (August 2011), supra note 5;
BlackRock, supra note 5. For a more detailed discussion on the
cross-border application of U.S. business conduct standards, see
Section III, infra.
---------------------------------------------------------------------------
2. ``Acts as an Advisor'' to a Special Entity
a. Proposed Rule
As discussed below in Section II.H.3, Section 15F(h)(4)(B) of the
Exchange Act imposes a duty on an SBS Dealer acting ``as an advisor''
to a special entity to act in the best interests of the special
entity.\689\ The Dodd-Frank Act does not define the term ``advisor,''
nor does it establish specific criteria for determining when an SBS
Dealer is acting as an advisor within the meaning of Section 15F(h)(4).
---------------------------------------------------------------------------
\689\ Under proposed Rule 15Fh-4(b), an SBS Dealer that ``acts
as an advisor'' to a special entity regarding a security-based swap
must: (1) Act in the best interests of the special entity; and (2)
make reasonable efforts to obtain such information that the SBS
Dealer considers necessary to make a reasonable determination that a
security-based swap or trading strategy involving a security-based
swap is in the best interests of the special entity. See Section
II.H.3, infra.
---------------------------------------------------------------------------
The Commission proposed Rule 15Fh-2(a), which states that an SBS
Dealer ``acts as an advisor to a special entity when it recommends a
security-based swap or a trading strategy that involves the use of a
security-based swap to the special entity.'' We explained in the
Proposing Release that, for these purposes, to ``recommend'' has the
same meaning as that discussed in connection with Rule 15Fh-3(f).\690\
---------------------------------------------------------------------------
\690\ See Proposing Release, 76 FR at 42424, supra note 3.
---------------------------------------------------------------------------
While the Dodd-Frank Act does not preclude an SBS Dealer from
acting as both advisor and counterparty, the Commission recognized in
the Proposing Release that it could be impracticable for an SBS Dealer
acting as a counterparty to a special entity to meet the ``best
interests'' standard imposed by Section 15F(h)(4) if it were deemed to
be acting as an advisor to the special entity.\691\ Proposed Rule 15Fh-
2(a) would therefore provide a three-pronged safe harbor for an SBS
Dealer to establish that it is not acting as an advisor. To qualify for
the safe harbor, the SBS Dealer's special entity counterparty must
first represent in writing that it will not rely on the SBS Dealer's
recommendations, but that it will instead rely on advice from a
``qualified independent representative.'' \692\ Second, the SBS Dealer
must have a ``reasonable basis'' to conclude that the special entity is
being advised by a qualified independent representative.\693\ Toward
this end, the SBS Dealer could rely on the special entity's written
representations unless the SBS Dealer has information that would cause
a reasonable person to question the accuracy of the
representation.\694\ Third, the SBS Dealer must disclose that it is not
undertaking to act in the special entity's best interests, as would
otherwise be required under Section 15F(h)(4).\695\
---------------------------------------------------------------------------
\691\ Id.
\692\ Proposed Rule 15Fh-2(a)(1).
\693\ Proposed Rule 15Fh-2(a)(2).
\694\ See also discussion on SBS Entities acting as
counterparties to special entities, Section II.H.5, infra.
\695\ Proposed Rule 15Fh-2(a)(3).
---------------------------------------------------------------------------
b. Comments on the Proposed Rule
The Commission received numerous comments in response to the
definition of ``acts as an advisor'' to a special entity in proposed
Rule 15Fh-2(a). One commenter asserted that the meaning of the phrase
``acts as an advisor to a special entity'' was critical to several
regulatory rulemakings, and that this term should be applied as
consistently as possible.\696\ That commenter and another recommended
that, in developing recommendations for the final rules, the Commission
staff coordinate with the Commission staff working on rules regarding
municipal advisors, as well as the MSRB and the CFTC.\697\ The
commenter urged the Commission to work with the CFTC and the MSRB to
make the definition as consistent as possible across regulatory
regimes.
---------------------------------------------------------------------------
\696\ See NABL, supra note 5.
---------------------------------------------------------------------------
However, the majority of comment letters addressing proposed Rule
15Fh-2(a) related to: (1) The use of the term ``recommends'' when
defining the phrase ``acts as an advisor to a special entity;'' and (2)
the safe harbor from acting as an advisor to a special entity set forth
in proposed Rule 15Fh-2(a)(1)-(3). These comments are summarized below.
i. ``Recommends'' an SBS or Related Trading Strategy to a Special
Entity
Eight comment letters addressed whether an SBS Dealer should be
deemed to act as an advisor if it ``recommends'' a security-based swap
or trading strategy to a special entity.\698\
---------------------------------------------------------------------------
\698\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5; Ropes & Gray, supra note 5; APPA, supra note 5; FIA/ISDA/
SIFMA, supra note 5; NACUBO, supra note 5; SIFMA (August 2011),
supra note 5; SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
One commenter argued that the definition of ``acting as an
advisor'' was too narrow, and should be expanded to include not only
making recommendations, but also providing ``more general information
and opinions.'' \699\ That commenter and another recommended that the
definition of ``act as an advisor'' should parallel that of an
``investment adviser,'' such that the definition would encompass
advising special entities as to the value of a security-based swap or
as to the advisability of a security-based swap or trading strategies
involving security-based swaps.\700\ The second commenter asserted that
this definition would more closely conform the definition of ``act as
an advisor'' to the definition of ``investment adviser'' under the
Advisers Act, as well as to the definition of ``commodity trading
[[Page 30014]]
advisor'' under the CEA, while preserving the benefits of the
Commission's proposed safe harbor.\701\
---------------------------------------------------------------------------
\699\ See Better Markets (August 2011), supra note 5.
\700\ Id. Under the commenter's approach, the SBS Dealer need
not receive compensation for the advice to be deemed acting as an
advisor. See also FIA/ISDA/SIFMA, supra note 5.
\701\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
A third commenter generally supported our proposed approach, noting
that ``defining recommendations as advice is consistent . . . with
congressional intent.'' \702\ The commenter, however, would narrow the
definition of advice to ``recommendations related to a security-based
swap or a security-based 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.'' \703\ Another
commenter suggested that the term ``recommendation'' exclude
communications to groups of customers or to investment managers with
multiple clients, unless the communication was tailored to a member of
the group or to a specific client known to the SBS Dealer.\704\
According to the commenter, the Commission should clarify that a
recommendation must be tailored to the circumstances of a known
special-entity counterparty before giving rise to advisor status,
because, without this clarification, general communications to
investment advisers (that potentially have special entity clients)
might result in the SBS Dealer unknowingly ``acting as an advisor.''
\705\ In 2015, after the CFTC adopted its final business conduct rules,
a commenter similarly proposed that the Commission narrow the scope of
the definition of ``act as an advisor to a special entity'' to include
only recommendations that are ``tailored to the particular needs or
characteristics of the special entity.'' \706\
---------------------------------------------------------------------------
\702\ See CFA, supra note 5.
\703\ Id.
\704\ See FIA/ISDA/SIFMA, supra note 5.
\705\ Id.
\706\ See SIFMA (August 2015), supra note 5. As the commenter
stated, these modifications would harmonize the SEC and CFTC
standards for determining when a Swap Dealer or SBS Dealer is acting
as an advisor to a special entity. In addition, the commenter argued
that this modification would align the definition with applicable
guidance under the Advisers Act.
---------------------------------------------------------------------------
Another commenter argued that a definition premised on an SBS
Dealer's ``recommend[ing]'' a security-based swap or related trading
strategy was ``overly broad and unwise,'' and that acting as an advisor
``requires a more formal, acknowledged agency, as part of a
relationship of trust and confidence.'' \707\ This commenter expressed
concern that a definition based on recommendations could chill
communications, including informal ``market chatter.'' \708\ Two other
commenters similarly urged the Commission to adopt a bright line,
objective standard, where an explicit agreement by the parties would
determine whether the SBS Dealer acts as advisor to the special
entity.\709\ Under this approach, unless the special entity and SBS
Dealer agree that information provided by the SBS Dealer would form the
primary basis for an investment decision, the SBS Dealer's
communications would not be considered a ``recommendation'' under
proposed Rule 15Fh-2(a).\710\
---------------------------------------------------------------------------
\707\ See Ropes & Gray, supra note 5.
\708\ Id.
\709\ See SIFMA (August 2011), supra note 5; APPA, supra note 5
(arguing that special entities would suffer the economic impact of
the uncertainty resulting from a ``facts and circumstances'' test).
\710\ Id.
---------------------------------------------------------------------------
Several commenters requested that the Commission clarify whether
certain communications constitute ``acting as an advisor.'' One
commenter was concerned that an SBS Dealer could provide a counterparty
with data, analysis, and opinions that constituted recommendations in
fact, but were not labeled or characterized as such.\711\ A second
commenter suggested the Commission clarify that the phrase ``acting as
an advisor'' does not include providing general transaction, financial
or market information to the special entity.\712\ A third commenter
recommended the final rule clarify that an SBS Dealer's ``customary
product explanations and marketing activities, provision of general
market information, quotes in response to requests, and information
pursuant to requirements in the business conduct rules would not
constitute `acting as an advisor' to a special entity.'' \713\
---------------------------------------------------------------------------
\711\ See Better Markets (August 2011), supra note 5.
\712\ See CFA, supra note 5.
\713\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
ii. Safe Harbor
The Commission received a number of comment letters on the proposed
rule's safe harbor provisions. Ten comment letters generally supported
the safe harbor, subject to various suggestions or objections.\714\
Three commenters objected to the safe harbor.\715\
---------------------------------------------------------------------------
\714\ See ABC, supra note 5; GFOA, supra note 5; NABL, supra
note 5; NACUBO, supra note 5; APPA, supra note 5; FIA/ISDA/SIFMA,
supra note 5; Ropes & Gray, supra note 5; Black Rock, supra note 5;
SIFMA (August 2015), supra note 5; SIFMA (November 2015), supra note
5.
\715\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5; AFSCME, supra note 5.
---------------------------------------------------------------------------
Commenters supporting the adoption of safe harbor provisions that
would protect an SBS Dealer from being deemed an advisor to a special
entity, argued that market participants would benefit from greater
certainty provided by the safe harbor, which would enable contracting
parties to specify the nature of their relationship.\716\
---------------------------------------------------------------------------
\716\ See NABL, supra note 5; APPA, supra note 5; FIA/ISDA/
SIFMA, supra note 5; NACUBO, supra note 5.
---------------------------------------------------------------------------
A number of commenters, however, expressed concern about the
possible interaction of the proposed safe harbor with ERISA. One
commenter, for example, generally agreed with the proposed safe harbor
but expressed concern that requiring an SBS Dealer to have a
``reasonable basis'' to believe a special entity was being advised by a
qualified independent representative could allow the SBS Dealer's
opinion of an ERISA plan representative to ``trump'' that of the ERISA
plan fiduciary.\717\ For these reasons, the commenter urged the
Commission to prohibit an SBS Dealer that acts as a counterparty to an
ERISA plan from vetoing the plan's choice of representative.\718\
---------------------------------------------------------------------------
\717\ See ABC, supra note 5. The commenter expressed concern
that such a veto power could render the Department of Labor's
Prohibited Transaction Class Exemption 84-14 for Qualified
Professional Asset Managers (``QPAMs'') unavailable, and make ERISA
plan representatives hesitant to vigilantly represent the plan's
interests for fear of a future veto. The commenter also argued that,
through this same provision, an SBS Dealer acting as an ERISA plan
counterparty could learn confidential information regarding the plan
or its representative.
\718\ Id.
---------------------------------------------------------------------------
Another commenter suggested the proposed safe harbor be revised to
provide that either: (1) The special entity will rely on advice from a
qualified independent representative, or (2) if the special entity or
its representative is relying on the Qualified Professional Asset
Manager (``QPAM'') or In-House Asset Manager (``INHAM'') Exemption, the
decision to enter into the transaction will be made by a QPAM or
INHAM.\719\ One commenter expressed concern with the proposed safe
harbor's requirement that the special entity represent it is not
[[Page 30015]]
``relying'' on recommendations from the SBS Dealer.\720\ As the
commenter explained, since reliance is one of the essential elements of
a securities fraud action, an SBS Dealer could seek to rely on the
special entity's representation that it did not ``rely'' on the SBS
Dealer's recommendation in defense of a subsequent securities fraud
action against the SBS Dealer.\721\ Instead, the commenter suggested
``as a purely technical matter'' that the safe harbor instead require a
special entity to acknowledge that the SBS Dealer is not acting as
advisor to the special entity.\722\
---------------------------------------------------------------------------
\719\ See BlackRock, supra note 5. Section 406(a) of ERISA
generally prohibits the fiduciary of a plan from causing the plan to
engage in various transactions with a ``party in interest'' (as
defined in Section 3(14) of ERISA), unless a statutory or
administrative exemption applies to the transaction. Prohibited
Transaction Exemption 84-14 (the ``QPAM Exemption''), an
administrative exemption, permits certain parties in interest to
engage in transactions involving plan assets if, among other
conditions, the assets are managed by a ``qualified professional
asset manager'' (QPAM), which is independent of the parties in
interest. Prohibited Transaction Exemption 96-23 (the ``INHAM
Exemption'') provides similar conditional prohibited transaction
relief for certain transactions involving plan assets that are
managed by an in-house asset management affiliate of a plan sponsor.
\720\ See Ropes & Gray, supra note 5.
\721\ Id.
\722\ Id.
---------------------------------------------------------------------------
In August 2015, another commenter suggested modifying the proposed
rule to harmonize with the CFTC's approach by creating a second
separate safe harbor for employee benefit plans subject to Title I of
ERISA that ``recognizes the unique fiduciary regime already applicable
to such special entities.'' \723\ In addition to recommending a safe
harbor for ERISA plans, the commenter requested two changes to the non-
ERISA safe harbor: (1) Adding a requirement that an SBS Dealer may not
express an opinion as to whether a special entity should enter into the
recommended security-based swap or related trading strategy; and (2)
eliminating the safe harbor condition that an SBS Dealer have a
reasonable basis to believe that the special entity is advised by a
qualified independent representative.\724\ The commenter noted that the
``reasonable basis'' provision is absent from the parallel CFTC
business conduct rule, and argued that the provision is unnecessary in
light of the fact that the SBS Dealer will already receive a written
representation that the special entity will rely on advice from the
independent representative.\725\ The commenter explained that its
suggested modifications were generally intended to bring the
Commission's safe harbor provisions into conformity with those of the
CFTC.\726\ The same commenter subsequently urged the Commission to
either (i) permit SBS Entities to reasonably rely on written
representations that satisfy the CFTC's safe harbor, or (ii) adopt a
parallel safe harbor.\727\
---------------------------------------------------------------------------
\723\ See SIFMA (August 2015), supra note 5.
\724\ See SIFMA (November 2015), supra note 5.
\725\ Id.
\726\ Id.
\727\ Id.
---------------------------------------------------------------------------
Three commenters opposed the proposed safe harbor, arguing that it
would erode the statutory protections for special entities. For
instance, one commenter argued that the safe harbor would effectively
allow SBS Dealers to give advice that might not be in the best
interests of the special entity.\728\ A second commenter opposed the
safe harbor on the grounds that it would cause special entities to
waive their right to ``best interest'' recommendations as a condition
of transacting with SBS Dealers, and force them to rely solely on an
independent representative that might be ``financially beholden to the
security-based swap industry.'' \729\ The commenter also expressed
concern that ``in any transaction involving a customized swap, the
special entity will by definition be relying on the swap dealer's
assertion that the customization was designed with the particular needs
of the special entity in mind,'' and if the SBS Dealer knows or has
reason to know that the swap is not in the best interests of the
special entity, the SBS Dealer ``should be precluded from doing the
transaction regardless of what representations the special entity
provides about who it may be relying on.'' \730\
---------------------------------------------------------------------------
\728\ See Better Markets (August 2011), supra note 5.
\729\ See CFA, supra note 5.
\730\ Id.
---------------------------------------------------------------------------
Similarly, a third commenter characterized the safe harbor as
permitting ``an SBS Dealer to escape the critical responsibilities
associated with `acting as an advisor' by having Special Entities waive
this right,'' and expressed concern that special entities would be
forced to sign ``boilerplate'' waivers to enter into a security-based
swap.\731\
---------------------------------------------------------------------------
\731\ See AFSCME, supra note 5.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
As stated above, proposed Rule 15Fh-2(a) defined what it means for
an SBS Dealer to act as an advisor to a special entity, and proposed
Rule 15Fh-4 imposed certain requirements on SBS Dealers acting as
advisors. Thus, the proposed rules would not impose these obligations
on Major SBS Participants.\732\ One commenter stated its view that it
is appropriate to impose Rule 15Fh-4(b)'s heightened standards of
conduct on professional market participants that are likely to be
acting as advisors to special entities,\733\ and another commenter
stated that the ``dealer-like obligations'' of Rule 15Fh-4(b) should
not be imposed on Major SBS Participants, transacting at arm's-length,
as they will not likely advise special entities with respect to
security-based swap transactions.\734\ The Commission continues to
believe that it is appropriate not to impose the heightened obligations
when acting as an advisor to a special entity on Major SBS
Participants, given the nature of their participation in the security-
based swap markets.\735\ However, if a Major SBS Participant is, in
fact, recommending security-based swaps or trading strategies involving
security-based swaps to a special entity, this could indicate that the
Major SBS Participant is actually engaged in security-based swap
dealing activity.\736\ A Major SBS Participant that engages in such
activity above the de minimis threshold in Exchange Act Rule 3a71-2
would need to register as an SBS Dealer and comply with the obligations
imposed on SBS Dealers, including the obligations imposed by Rule 15Fh-
4(b) when an SBS Dealer is acting as an advisor to a special entity.
---------------------------------------------------------------------------
\732\ Although Section 15F(h)(2)(A) of the Exchange Act
generally requires all SBS Entities to comply with the requirements
of Section 15F(h)(4), the specific requirements of Sections
15F(h)(4)(B) and (C), by their terms, apply only to SBS Dealers that
act as advisors to special entities.
\733\ See CFA, supra note 5 (arguing that the determining factor
in whether a rule should apply to a Major SBS Participant is whether
it is engaged in conduct that would appropriately be regulated under
the relevant standard).
\734\ See MFA, supra note 5.
\735\ See Section II.C.3 (discussing bases for applying certain
requirements to SBS Dealers but not to Major SBS Participants).
\736\ See Proposing Release, 76 FR at 42416 n.140, supra note 3.
See also Definitions Adopting Release, 77 FR at 30618, supra note
108 (``Advising a counterparty as to how to use security-based swaps
to meet the counterparty's hedging goals, or structuring security-
based swaps on behalf of a counterparty, also would indicate
security-based swap dealing activity.'').
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Upon review and consideration of the comments, the Commission is
adopting Rule 15Fh-2(a) as described below.
i. ``Recommends'' an SBS or Related Trading Strategy to a Special
Entity
We are adopting, as proposed, Rule 15Fh-2(a), under which an SBS
Dealer is defined to ``act as an advisor to a special entity'' when it
recommends a security-based swap or a trading strategy that involves a
security-based swap to a special entity.\737\ For these purposes, to
``recommend'' has the same meaning as discussed in connection with Rule
15Fh-3(f).\738\ The determination of whether an SBS Dealer has made a
``recommendation'' turns on the facts and circumstances of the
particular situation and, therefore, whether a
[[Page 30016]]
recommendation has taken place is not susceptible to a bright line
definition.\739\
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\737\ Although we are adopting Rule 15Fh-2(a), as proposed, we
are adopting the safe harbor under proposed rule 15Fh-2(a)(1)-(3)
with various modifications, as discussed in Section II.H.2.c.ii,
infra.
\738\ See Section II.G.4, infra.
\739\ See Proposing Release, 76 FR at 42415, supra note 3. As
discussed in Section II.G.4, supra, this is consistent with the
FINRA approach as to what constitutes a recommendation.
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The Commission is not expanding the definition of
``recommendation'' to encompass ``more general information and
opinions,'' as suggested by a commenter.\740\ Such a broad definition
could have the unintended consequence of chilling commercial
communications, restricting customary commercial interactions, and
generally reducing market information shared with special entities
regarding security-based swaps.\741\ As we discussed in Section II.G.4,
the Commission continues to believe that the meaning of the term
``recommendation'' is well-established and familiar to intermediaries
in the financial services industry, including broker-dealers that rely
on institutional suitability determinations, and we believe that the
same meaning should be ascribed to the term in this context.
---------------------------------------------------------------------------
\740\ See Better Markets (August 2011), supra note 5.
\741\ See, e.g., Ropes & Gray, supra, note 5.
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As explained in Section II.G.4, the factors considered in
determining whether a recommendation has taken place include whether
the communication ``reasonably could be viewed as a `call to action' ''
and ``reasonably would influence an investor to trade a particular
security or group of securities.'' \742\ The more individually tailored
the communication to a specific customer or a targeted group of
customers about a security or group of securities, the greater the
likelihood that the communication may be viewed as a
``recommendation.'' \743\ Thus, in response to commenters' requests for
clarification, an SBS Dealer typically would not be making a
recommendation--and would therefore not be ``acting as an advisor'' to
a special entity with a duty to act in the ``best interests'' of a
special entity--solely by reason of providing general financial or
market information or transaction terms in response to a request for
competitive bids.\744\ Furthermore, provision of information pursuant
to the requirements of the business conduct rules will not, in and of
itself, result in an SBS Dealer being viewed as making a
``recommendation,'' as suggested by one commenter.\745\ Rather, as
stated above, the determination of whether providing information about
the valuation of a security-based swap, or concerning the advisability
of a security-based swap or a trading strategy, involving a security-
based swap constitutes a ``recommendation'' turns on the particular
facts and circumstances.
---------------------------------------------------------------------------
\742\ Our approach here is consistent with that of the CFTC. See
CFTC Adopting Release, 77 FR at 9783, n. 699, supra note 22.
\743\ Id. at n. 698.
\744\ See CFA, supra note 5; SIFMA (August 2011), supra note 5.
See also Proposing Release, 76 FR at 42415, supra note 3.
\745\ See SIFMA (August 2011), supra note 5.
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To avoid unnecessarily narrowing the definition of
``recommendation,'' we decline to limit the definition of ``act as an
advisor'' to recommendations that are designed to meet the needs of a
specific counterparty after taking into account the counterparty's
individual circumstances.\746\ We also decline to exclude from the
definition of ``recommendation'' communications to groups of customers
or to investment managers with multiple clients.\747\ We believe that
such an exclusion could unnecessarily deprive groups or special entity
investors of the intended protections of the rules when there are
communications regarding a particular security-based swap or trading
strategy to a targeted group of special entities that share common
characteristics, e.g., school districts. As stated above, such
communications should be evaluated based on whether, in light of all
the facts and circumstances, the communications could ``reasonably
could be viewed as a `call to action' '' and ``reasonably would
influence an investor to trade a particular security or group of
securities.'' \748\ We also note that the number of recipients of a
given communication does not necessarily change the characteristics of
the communication.
---------------------------------------------------------------------------
\746\ See CFA, supra note 5.
\747\ See FIA/ISDA/SIFMA, supra note 5.
\748\ See Section II.G.4, supra.
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Furthermore, we are not limiting the definition of ``act as an
advisor'' to a special entity to situations in which parties
affirmatively contract or otherwise establish ``more formal,
acknowledged agency relationships that are part of a relationship of
trust and confidence'' \749\ We believe this could limit the scope of
the obligations and corresponding protections for special entities when
an SBS Dealer ``acts as an advisor'' in a manner that is not consistent
with the intended objectives of the rule. In short, the rule could be
stripped of its intended protections if those protections only applied
when the regulated entity agreed to be regulated.\750\
---------------------------------------------------------------------------
\749\ See Ropes & Gray, supra note 5; SIFMA (August 2011), supra
note 5; APPA, supra note 5.
\750\ The CFTC has taken the same approach in its treatment of
swap dealers. See CFTC Adopting Release, 77 FR at 9785, supra note
22.
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For the same reason, SBS Dealers may not avoid making a
``recommendation'' as defined in this context through disclaimer, or
simply by not characterizing or labeling a recommendation as such.\751\
An interpretation that would permit an SBS Dealer to disclaim its
``best interests'' duty, irrespective of the SBS Dealer's conduct,
could essentially relieve SBS Dealers of their obligations and deprive
special entities of the corresponding protections intended by Rule
15Fh-4. Rather than require the affirmative agreement of the parties to
establish an advisory relationship, we are providing a safe harbor, as
described in Section II.H.2.c.ii, infra, by which the parties can agree
that an SBS Dealer is not ``acting as an advisor'' to a special entity
where certain conditions are met--specifically, where the special
entity agrees to rely on the advice of an ERISA fiduciary or other
qualified, independent representative with respect to a security-based
swap transaction.
---------------------------------------------------------------------------
\751\ See Better Markets (August 2011), supra note 5.
---------------------------------------------------------------------------
We reject the commenters' suggestion that we conform the definition
of an SBS Dealer that ``acts as an advisor'' to a special entity to the
definition of ``investment adviser'' under the Advisers Act, or to the
definition of ``commodity trading advisor'' under the CEA.\752\ We do
not agree that either definition is necessarily tailored to the
specific attributes of security-based swap transactions or the unique
relationships between SBS Dealers and their special entity
counterparties; therefore we believe that those definitions would not
necessarily provide special entities that trade in security-based swaps
with the protections the business conduct rules are intended to
provide.
---------------------------------------------------------------------------
\752\ See Better Markets (August 2011), supra note 5; FIA/ISDA/
SIFMA, supra note 5.
---------------------------------------------------------------------------
The Commission continues to believe that the duties imposed on an
SBS Dealer that ``acts as an advisor'' (as well as the definition of
``act as an advisor'' under Rule 15Fh-2(a)) are supplemental to any
duties that may be imposed under other applicable law.\753\ In
particular, we acknowledge the commenter's suggestion that the
Commission coordinate with the MSRB regarding the definition of ``acts
as an advisor.'' \754\ As explained in Section
[[Page 30017]]
I.E, supra, we have adopted rules that provide an exemption from
``municipal advisor'' status for persons providing advice with respect
to municipal financial products or the issuance of municipal securities
where certain conditions are met, such as where the municipal entity is
represented by an independent registered municipal advisor.\755\ More
generally, as discussed in Section I.E, supra, the duties imposed on an
SBS Dealer under the business conduct rules are specific to this
context, and are in addition to any duties that may be imposed under
other applicable law. Thus, an SBS Dealer must separately determine
whether it is subject to regulation as a broker-dealer, an investment
adviser, a municipal advisor or other regulated entity.
---------------------------------------------------------------------------
\753\ See Proposing Release, 76 FR at 42424, supra note 13.
\754\ See FIA/ISDA/SIFMA, supra note 5.
\755\ See Municipal Advisor Registration Release, supra note 54.
---------------------------------------------------------------------------
Lastly, the Commission considered and agrees with the comment that
the definition of ``acting as an advisor'' to a special entity should
be applied as consistently as possible across various rulemakings, and
that the Commission should coordinate with the CFTC with respect to
this definition.\756\ As noted in Section I.C, the staffs of the
Commission and the CFTC extensively coordinated and consulted in
connection with their respective rulemakings in an effort to establish
a consistent rule regime across the swap and security-based swap
markets. These efforts are reflected in the rules adopted today.
---------------------------------------------------------------------------
\756\ See NABL, supra note 5; FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
We note that the Commission's definition of ``acts as an advisor''
to a special entity under Rule 15Fh-2(a) differs slightly from the
CFTC's parallel rule, under which a swap dealer is deemed to be an
advisor when it ``recommends a swap or trading strategy involving a
swap that is tailored to the particular needs or characteristics of the
Special Entity.'' \757\ While we agree that 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,'' we do not
agree that a security-based swap communication must be so tailored to
constitute a recommendation for purposes of Rule 15Fh-2(a). In adopting
this more expansive definition of ``acts as an advisor'' to a special
entity, the Commission believes that it will better provide the
intended protections of the statute to groups of special entity
investors that may be treated similarly by SBS Dealers, such as school
districts.
---------------------------------------------------------------------------
\757\ 17 CFR 23.440(a).
---------------------------------------------------------------------------
ii. Safe Harbor
After the Commission issued the Proposing Release, the CFTC adopted
final rules that provide two safe harbors from the definition of ``acts
as an advisor to a special entity.'' The first provides a safe harbor
for communications between a swap dealer and an ERISA plan that has an
ERISA fiduciary, and the second provides a safe harbor for
communications between a swap dealer and any special entity (including
a special entity that is an ERISA plan). Qualifying for either safe
harbor requires specified representations in writing by the swap dealer
and special entity. In response to requests from commenters, and upon
further consideration, we are adopting an approach that similarly
recognizes the use of ERISA fiduciaries by ERISA plans, thereby
avoiding the potential conflict or confusion that may result where the
existing ERISA rules intersect with the business conduct rules adopted
today.\758\
---------------------------------------------------------------------------
\758\ See ABC, supra note 5; BlackRock, supra note 5; SIFMA
(August 2015), supra note 5.
---------------------------------------------------------------------------
In adopting a separate safe harbor for ERISA plans, we recognize
that Congress has already established a comprehensive federal
regulatory framework for ERISA plans. Such recognition of the existing
federal regulatory framework for ERISA plans maintains statutory
protections for ERISA plans, while addressing the potential conflict,
recognized by commenters, between the ERISA rules and the business
conduct standards we are adopting today.\759\ Lastly, in adopting a
bifurcated approach that provides a safe harbor specifically for ERISA
plans and another that is available with respect to all special
entities, we are responding to the commenter's request that we more
closely align the Commission's rules with those of the CFTC to promote
regulatory consistency and operational efficiency for entities that
have been operating under the CFTC's business conduct regime since
2012.\760\
---------------------------------------------------------------------------
\759\ Id.
\760\ See SIFMA (August 2015), supra note 5. See also CFTC
Adopting Release, 77 FR at 9784, n. 701, supra note 22.
---------------------------------------------------------------------------
Under Rule 15Fh-2(a)(1), as adopted, an SBS Dealer may establish
that it is not acting as an advisor to a special entity that is an
ERISA plan if the special entity is represented by a qualified
independent representative that meets the standard for an ERISA
fiduciary. Specifically, the rule provides that an SBS Dealer will not
be acting as an advisor to an ERISA special entity if: (i) The ERISA
plan represents in writing that it has an ERISA fiduciary; (ii) the
ERISA fiduciary represents in writing that it acknowledges that the SBS
Dealer is not acting as an advisor; and (iii) 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 SBS Dealer involving a security-
based swap transaction is evaluated by an ERISA fiduciary before the
transaction is entered into; or (B) any recommendation the special
entity receives from the SBS Dealer involving a security-based swap
transaction will be evaluated by an ERISA fiduciary before that
transaction is entered into.
Allowing the ERISA plan to either make written representations
about its policies and procedures or represent in writing that the
security-based swap transaction will be evaluated by an ERISA fiduciary
provides the ERISA plan greater flexibility in structuring its
relationship with the SBS Dealer. Moreover, these requirements, taken
together, are designed to ensure that the ERISA fiduciary, not the SBS
Dealer, is evaluating the security-based swap transaction on behalf of
the ERISA plan. As an ERISA fiduciary is already required by statute
to, among other things, act with prudence and loyalty when evaluating a
transaction for an ERISA plan,\761\ the Commission believes it is
appropriate to provide the safe harbor for when an SBS Dealer would not
be deemed to be acting as an advisor to the ERISA plan for purposes of
this rule.
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\761\ ERISA fiduciaries are required to act with both loyalty
(see Section 404(a)(1)(A)) and prudence (see Section 404(a)(1)(B))
when evaluating a transaction for an ERISA plan. In addition, ERISA
fiduciaries are subject to statutory prohibitions against entering
into certain categories of transactions between a plan and a ``party
in interest'' (see Section 406(a)), and prohibitions against self-
dealing and other conflicts of interest (see Section 406(b)). See
supra note 38.
---------------------------------------------------------------------------
Under Rule 15Fh-2(a)(2), as adopted, an SBS Dealer can establish it
is not acting as an advisor to any special entity (including a special
entity that is an ERISA plan) when the special entity is relying on
advice from a qualified independent representative that satisfies
specific criteria. An SBS Dealer will not be ``acting as an advisor''
to any special entity (including a special entity that is an ERISA
plan) if: (i) The special entity represents in writing that it
acknowledges that the SBS Dealer is not acting as an advisor, and that
the special entity will rely on advice from a qualified independent
representative; and (ii) the SBS Dealer discloses that it
[[Page 30018]]
is not undertaking to act in the best interests of the special
entity.\762\
---------------------------------------------------------------------------
\762\ However, as noted above in Section II.G.4.c.ii, an SBS
Dealer that makes a recommendation to a special entity will still
need to have a reasonable basis to believe that a recommended
security-based swap or trading strategy involving a security-based
swap is suitable for the special entity.
---------------------------------------------------------------------------
In adopting the safe harbor, the Commission agrees with commenters
that the provisions in Rule 15Fh-2(a)(1)-(2) will reduce uncertainty
regarding the role of an SBS Dealer when transacting with a special
entity.\763\ Requiring special entities (or their fiduciaries) to
affirm in writing that they acknowledge the SBS Dealer is not acting as
an advisor, and that they will instead obtain advice from a qualified
independent representative, will help ensure that the parties are aware
of their respective rights and obligations regarding a security-based
swap transaction. While our rules would permit an SBS Dealer to rely on
the special entity's (or its fiduciary's) written representations, the
SBS Dealer's reliance must still be reasonable, as required under Rule
15Fh-1(b). Specifically, the SBS Dealer may not rely on a
representation if the SBS Dealer has information that would cause a
reasonable person to question the accuracy of the representation.\764\
The requirement that a special entity or its fiduciary represents in
writing that it acknowledges the SBS Dealer is not acting as an advisor
differs from the proposed safe harbor, which would have required the
special entity to represent that it would not rely on the SBS Dealer's
recommendations. The Commission is making this change in response to a
commenter's concern.\765\ The Commission does not intend to affect the
rights of parties in private actions.
---------------------------------------------------------------------------
\763\ See NABL, supra note 5; APPA, supra note 5; FIA/ISDA/
SIFMA, supra note 5; NACUBO, supra note 5.
\764\ Rule 15Fh-1(b).
\765\ See Ropes & Gray, supra note 5.
---------------------------------------------------------------------------
The safe harbor under 15Fh-2(a)(2), as adopted, also differs from
the proposed rule, which would have required that an SBS Dealer must
have a reasonable basis to believe that the special entity is advised
by a qualified independent representative. Rather, under adopted Rule
15Fh-2(a)(2)(i), the safe harbor requires written representations from
the special entity that it will rely on advice from a qualified
independent representative.\766\ The Commission agrees with the
commenter that requiring special entities to make representations to
SBS Dealers in writing that they are relying on advice from a qualified
independent representatives addresses the proposed rule's underlying
policy concern--i.e., that the special entity is represented by a
qualified independent representative.\767\ Moreover, we believe that
requiring special entities to effectively confirm that they have
qualified independent representatives addresses the commenter's concern
that the proposed rule would allow SBS Dealers to evaluate the
qualifications of a special entity's independent representative and
vest SBS Dealers with the authority to ``trump'' the special entity's
choice of representative.\768\ An SBS Dealer could rely on the special
entity's written representations unless the SBS Dealer has information
that would cause a reasonable person to question the accuracy of the
representation, including the representation that the special entity is
relying on advice from a qualified independent representative.
---------------------------------------------------------------------------
\766\ In addition, the safe harbor as adopted continues to
require that the SBS Dealer disclose to the special entity that it
is not undertaking to act in the best interest of the special
entity. See Rule 15Fh-2(a)(2)(ii).
\767\ See SIFMA (November 2015), supra note 5.
\768\ See ABC, supra note 5. See also Section II.H.5, infra.
---------------------------------------------------------------------------
While we acknowledge commenters' concerns that the safe harbor
might erode the statutory protections for special entities,\769\ we
also have considered the inherent tensions that arise where SBS Dealers
have concurrent, potentially conflicting roles as advisor and
counterparty to special entities. On the one hand, the SBS Dealer as
advisor is subject to a duty to act in the ``best interests'' of the
special entity. On the other hand, a broad application of the ``best
interests'' standard could have the unintended consequences of chilling
commercial communications, restricting customary commercial
interactions, reducing market information shared with special entities,
as well as reducing the ability of special entities to engage in
security-based swaps. In adopting the safe harbor, we acknowledge the
tension between the SBS Dealer's potentially conflicting roles as
advisor and counterparty by recognizing that the special entity may be
separately advised by a fiduciary or other qualified independent
representative, who will act in the special entity's best interests.
---------------------------------------------------------------------------
\769\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5; AFSCME, supra note 5.
---------------------------------------------------------------------------
We disagree with commenters that adoption of the safe harbor could
cause special entities to waive their right to ``best interests''
standards or sign ``boilerplate agreements'' as a condition of
transacting with SBS Entities.\770\ Rather, the safe harbor reflects an
approach that is conditioned upon the involvement of an ERISA fiduciary
or other qualified independent representative that is otherwise
required to act in the best interests of the special entity.
---------------------------------------------------------------------------
\770\ See CFA, supra note 5; AFSCME, supra note 5.
---------------------------------------------------------------------------
Although the safe harbor the Commission is adopting today largely
aligns with that of the CFTC, it differs from that of the CFTC in four
respects: (1) Rules 15Fh-2(a)(1)(ii) and 15Fh-2(a)(2)(i)(A) require the
special entity or its fiduciary to represent in writing that it
acknowledges the SBS Dealer is not acting as an advisor, whereas the
CFTC requires the special entity or its fiduciary to represent it will
not rely on the SBS Dealer's recommendations; \771\ (2) Rules 15Fh-
2(a)(1)(iii)(A) and (B) apply to any recommendation the special entity
receives from the security-based swap dealer ``involving'' a security-
based swap transaction, while the parallel CFTC rules apply to
recommendations ``materially affecting'' a security-based swap
transaction; \772\ (3) Rule 15Fh-2(a)(1)(iii) requires a security-based
swap transaction to be evaluated by a fiduciary before the transaction
``is entered into,'' whereas the CFTC's safe harbor requires a swap
transaction to be evaluated by fiduciary before the transaction
``occurs''; \773\ and (4) the safe harbor in Rule 15Fh-2(a) does not
prohibit an SBS Dealer acting as an advisor from expressing an opinion
as to whether a special entity should enter into a recommended
security-based swap or trading strategy.\774\ The Commission believes
it is appropriate to differ from the CFTC in these three discrete areas
for the following reasons.
---------------------------------------------------------------------------
\771\ See 17 CFR 23.440(b)(1)(ii), (b)(2)(ii)(A).
\772\ See 17 CFR 23.440(b)(1)(iii)(A)-(B).
\773\ See 17 CFR 23.440(b)(1)(iii).
\774\ Cf. 17 CFR 23.440(b)(2)(i).
---------------------------------------------------------------------------
First, as discussed above, the Commission believes that replacing
the requirement that the special entity or its fiduciary represent it
will not ``rely'' on the SBS Dealer's recommendations with the
requirement that the special entity or its fiduciary represent in
writing that it acknowledges that the SBS Dealer is not ``acting as an
advisor'' will afford special entities the same statutory protections.
As noted above, the Commission is making this change in response to a
commenter's concern.\775\ The Commission does not intend to affect the
rights of parties in private actions.
---------------------------------------------------------------------------
\775\ See Ropes & Gray, supra note 5.
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[[Page 30019]]
Second, the Commission has determined to replace the phrase
``materially affecting'' with the word ``involving'' in relation to the
recommendations that a special entity receives from an SBS Dealer. We
believe that further clarification is needed in the context of Rule
15Fh-2(a)(1) to make clear that all recommendations made by the SBS
Dealer are covered by this provision.
Third, the Commission has determined to use the phrase ``is entered
into,'' as it is consistently used throughout the business conduct
rules being adopted today.\776\ However, because we also believe that
the CFTC's usage of the word ``occurs'' was intended to have the same
meaning as the phrase ``is entered into,'' we expect the practical
effect of CFTC Regulation 23.440(b)(1)(iii) to be substantially the
same as Rule 15Fh-2(a)(1)(iii).\777\
---------------------------------------------------------------------------
\776\ See, e.g., Rule 15Fh-1 (``Sections 240.15h-1 through
240.15Fh-6, and 240.15Fk-1 apply, as relevant in connection with
entering into security-based swaps . . .''); Rule 15Fh-3(a)(1), (2)
(``. . . before entering into a security-based swap . . .''); Rule
15Fh-3(b) (``At a reasonably sufficient time prior to entering into
a security-based swap . . .''); Rule 15Fh-6(b)(1) (``It shall be
unlawful for a security-based swap dealer to offer to enter into, or
enter into, a security-based swap . . .'') (emphasis added).
\777\ See generally CFTC Adopting Release, 77 FR at 9784, supra
note 22.
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Fourth, the Commission declines to adopt the provision in CFTC
Regulation 23.440(b)(2)(i), under which Swap Dealers seeking to avail
themselves of the safe harbor would be precluded from ``expressing an
opinion'' as to whether the special entity should enter into a
recommended security-based swap or trading strategy. Under the rules
adopted today, the determination of whether an SBS Dealer has provided
advice to a special entity turns on whether a communication is
considered a ``recommendation,'' not whether the SBS Dealer has
``expressed an opinion.'' Unlike the word ``recommendation,'' the
phrase ``express an opinion'' is not defined or described in the
federal securities laws in this context, and therefore may have other
meanings that could cause confusion. Further, we also believe the
concern that underlies the CFTC's provision (i.e., that the special
entity obtain advice regarding a security-based swap from an ERISA
fiduciary or other qualified independent representative) is
sufficiently addressed by the requirement in Rules 15Fh-2(a)(1)-(2)
that the special entity or its fiduciary represent that it acknowledges
that the SBS Dealer is not acting as an advisor. It is therefore the
Commission's view that prohibiting SBS Dealers from ``expressing an
opinion'' would neither increase regulatory clarity regarding whether
an SBS Dealer's conduct falls within the safe harbor, nor provide a
corresponding increase in protection for special entities.
3. Definition of ``Best Interests''
Exchange Act Section 15F(h)(4)(B) imposes on an SBS Dealer that
``acts as an advisor'' to a special entity a duty to act in the ``best
interests'' of the special entity. In addition, Section 15F(h)(4)(C)
requires the SBS 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
SBS Dealer is in the ``best interests'' of the special entity.\778\ The
term ``best interests'' is not defined in the Dodd-Frank Act, and the
Commission did not propose to define ``best interests.'' In the
Proposing Release, we noted that the ``best interests'' duty for an SBS
Dealer acting as an advisor to a special entity ``goes beyond and
encompasses the general suitability requirement of proposed Rule 15Fh-
3(f).'' We sought comment on whether we should define the term ``best
interests,'' and if so, whether such definition should use formulations
based on the standards applied to investment advisers,\779\ municipal
advisors,\780\ ERISA fiduciaries,\781\ or some other formulation.
---------------------------------------------------------------------------
\778\ Section 15F(h)(5) of the Exchange Act also requires an SBS
Entity that is a counterparty to a special entity to have a
``reasonable basis'' to believe the special entity has an
independent representative that undertakes to act in the best
interests of the special entity.
\779\ We have stated that an adviser must deal fairly with
clients and prospective clients, seek to avoid conflicts with its
clients and, at a minimum, make full disclosure of any material
conflict or potential conflict. See Amendments to Form ADV,
Investment Advisers Act Release No. 3060 (Jul. 28, 2010), 75 FR
49234 (Aug. 12, 2010), citing SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180, 191-194 (1963) (holding that investment advisers
have a fiduciary duty enforceable under Section 206 of the Advisers
Act, that imposes upon investment advisers the ``affirmative duty of
`utmost good faith, and full and fair disclosure of all material
facts,' as well as an affirmative obligation to `employ reasonable
care to avoid misleading''' their clients and prospective clients).
\780\ See, e.g., Exchange Act Section 15B(b)(2)(L), 15 U.S.C.
78o-4(b)(2)(L) (requiring the MSRB to prescribe means reasonably
designed to prevent acts, practices, and courses of conduct that are
not consistent with a municipal advisor's fiduciary duty to its
municipal entity clients). In April 2015, the MSRB filed proposed
Rule G-42 with the Commission for approval, which rule would
establish core standards of conduct for municipal advisors when
engaging in municipal advisory activities, other than municipal
advisory solicitation activities. The rule was published in the
Federal Register on May 8, 2015. See Exchange Act Release No. 74860
(May 4, 2015), 80 FR 26752. See also Exchange Act Release Nos. 75628
(Aug. 6, 2015), 75737 (Aug. 19, 2015), and 76420 (Nov. 10, 2015).
The rule was approved, with amendments, on December 23, 2015. See
Exchange Act Release No. 76753 (Dec. 23, 2015).
\781\ See, e.g., 29 U.S.C. 1104(a)(1)(A) (``a fiduciary shall
discharge his duties with respect to a plan solely in the interest
of the participants and beneficiaries and for the exclusive purpose
of: (i) Providing benefits to participants and their beneficiaries;
and (ii) defraying reasonable expenses of administering the plan'')
and 29 U.S.C. 1104(a)(1)(B) (a fiduciary must act ``with the care,
skill, prudence, and diligence under the circumstances then
prevailing that a prudent man acting in a like capacity and familiar
with such matters would use in the conduct of an enterprise of a
like character and with like aims'').
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a. Proposed Rules
Proposed Rule 15Fh-4(b)(1) would generally require an SBS Dealer
that acts as an advisor regarding a security-based swap to a special
entity to act in the ``best interests'' of the special entity.
Proposed Rule 15Fh-4(b)(2) would require the SBS Dealer to make
``reasonable efforts'' to obtain the information necessary to make a
reasonable determination that a security-based swap or trading strategy
involving a security-based swap is in the best interests of the special
entity, and that such information shall include but not be limited to:
(i) The authority of the special entity to enter into a security-based
swap; (ii) the financial status of the special entity, as well as
future funding needs; (iii) the tax status of the special entity; (iv)
the investment or financing objectives of the special entity; (v) the
experience of the special entity with respect to entering into
security-based swaps, generally, and security-based swaps of the type
and complexity being recommended; (vi) whether the special entity has
the financial capability to withstand changes in market conditions
during the term of the security-based swap; and (vii) such other
information as is relevant to the particular facts and circumstances of
the special entity, market conditions and the type of security-based
swap or trading strategy involving a security-based swap being
recommended.
[[Page 30020]]
b. Comments on the Proposed Rules
The Commission received six comment letters on the imposition of a
``best interests'' standard.\782\ One commenter argued that the
Commission should define what it means to act in the ``best
interests,'' and proposed that the definition must ``be at least as
strong as the concept of `best interest' [that] has evolved under the
fiduciary principles applicable to investment [advisers].'' \783\ The
commenter additionally requested that the Commission acknowledge ``that
the best interest standard intended by Congress is a fiduciary concept
that goes well beyond suitability.'' \784\
---------------------------------------------------------------------------
\782\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5; Johnson, supra note 5; ABC, supra note 5; BlackRock, supra
note 5; SIFMA (August 2015), supra note 5.
\783\ See Better Markets (August 2011), supra note 5 (noting
that Congress expressly described the standard as ``best interest''
in Exchange Act Sections 15F(h)(2)(A) and (B), 15F(h)(4) and
15F(h)(5)).
\784\ Id.
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Similarly, a second commenter supporting a best interests standard
stated it did not believe it was ``necessary, or even appropriate,'' to
strictly define best interests.\785\ The commenter asked the Commission
to provide guidance on how to apply the standard in particular
circumstances. This commenter asserted that Congress did not intend to
apply the ERISA fiduciary standard, and argued that the intended model
for the ``heightened standard'' was the Advisers Act fiduciary
duty.\786\ The commenter stated that Congress did not seek to eliminate
all conflicts of interest but to ensure that such conflicts of interest
would be appropriately managed and fully disclosed.\787\ The commenter
urged that in providing guidance in this area, it is important for the
Commission to clarify that not all suitable recommendations would
satisfy a best interest standard and that the best interest standard
would impose a ``heightened duty beyond mere suitability'' and would
require SBS Dealers to ``recommend from among the various suitable
options the approach they believe to be best for the special entity.''
\788\ In addition, the commenter stated that the guidance should
``clarify that the best interest standard is consistent with various
different methods of compensation and with proprietary trades, but that
it requires the full disclosure of any conflicts of interest.'' In the
context of an SBS Dealer acting as an advisor and serving as a
counterparty, the commenter suggested that the Commission clarify that
it would not be inconsistent with the SBS Dealer's duty to act in the
best interests of the special entity if the SBS Dealer, as principal,
earned a reasonable profit or fee from transacting with the special
entity.\789\
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\785\ See CFA, supra note 5.
\786\ Id.
\787\ Id.
\788\ Id.
\789\ Id.
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A third commenter asserted that Congress rejected the imposition of
a fiduciary duty on SBS Dealers as incompatible with their role as
market makers and asked the Commission to ``respect Congressional
intent'' to protect the ability of end users and pension plans to
transact in security-based swaps in a cost-effective manner by
rejecting such a duty.\790\
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\790\ See Johnson, supra note 5.
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Two additional commenters argued that an SBS Dealer that ``acts as
an advisor to a special entity'' and complies with the ``best
interest'' requirements might become an ERISA fiduciary under the DOL's
proposed redefinition of the term ``fiduciary.'' \791\ Accordingly, one
of these commenters requested that the Commission clarify that
compliance with the business conduct standards would not transform an
SBS Dealer into a fiduciary under ERISA or under the final DOL
regulation.\792\
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\791\ See ABC, supra note 5; BlackRock, supra note 5.
\792\ See ABC, supra note 5.
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One of these commenters also opposed the best interest requirement,
and recommended that it be omitted from the final rules.\793\ The
commenter expressed its concern that ``[r]equiring that an SBS Dealer
act in the best interests of a counterparty who is a special entity
would confuse the roles of the parties and have an adverse impact on
the flow of information regarding investment and trading strategies.''
\794\ Additionally, if the requirement is retained, the commenter
recommended that the term ``best interests'' be defined as complying
with proposed Rule 15Fh-3(g) (fair and balanced communications),\795\
and NASD Rule 2010(d), which would require that communications be based
on principles of fair dealing and good faith, be fair and balanced, and
provide a sound basis for evaluating the transaction.\796\
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\793\ See BlackRock, supra note 5.
\794\ Id.
\795\ See Section II.G.5, supra.
\796\ Id.
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After the CFTC adopted its rules in 2012, one commenter asserted
that ``to promote legal certainty and the ability of SBS dealers to
continue to trade with special entities, the SEC should provide
guidance clarifying the nature of an SBS Dealer's `best interests'
duty.'' \797\ Specifically, the commenter asserted that, to harmonize
with CFTC guidance, the Commission should clarify that the best
interest duty is not a fiduciary duty, but is rather a duty for the SBS
Dealer to: (1) Comply with the requirement to make a reasonable effort
to obtain necessary information; (2) act in good faith and make full
and fair disclosure of all material facts and conflicts of interest
with respect to the recommended security-based swap or related trading
strategy; and (3) employ reasonable care that any recommendation made
to the special entity be designed to further the special entity's
stated objectives.\798\ The commenter also suggested that, consistent
with the CFTC's guidance, a recommendation need not represent the best
of all possible alternatives to meet the best interest standard.
Additionally, the commenter stated that the determination whether a
recommendation is in a special entity's best interest should be based
on the information known to the SBS Dealer at the time a recommendation
was made.\799\ Furthermore, according to the commenter, the best
interest duty should not impede an SBS Dealer from negotiating the
terms of a transaction in its own interests, or from making a
reasonable profit in a transaction; nor should it impose an ongoing
obligation on the SBS Dealer to act in the best interest of the special
entity.\800\ This commenter also suggested deleting the requirement
under Rule 15Fh-4(b)(i) that the SBS Dealer ``make reasonable efforts
to obtain information regarding `the authority of the special entity to
enter into a security based swap.' '' \801\ Toward this end, the
commenter argued that the CFTC eliminated this requirement as it was
``duplicative'' of the know your customer requirement under the CFTC's
business conduct rules. As the commenter stated: ``Since proposed Rule
15Fh3(e)(3) would require an SBS dealer to obtain this information, we
believe the same considerations support eliminating that requirement
here.'' \802\ Moreover, the commenter proposed a bifurcated treatment
of ERISA and non-ERISA special entities under Rule 15Fh-5(a) to
recognize the ``unique fiduciary regime'' already applicable to ERISA
special entities, as well as to ``reduce costs for special entities
since most of them have
[[Page 30021]]
already conformed their relationships with their representatives to
satisfy the CFTC's qualification criteria.'' \803\
---------------------------------------------------------------------------
\797\ See SIFMA (August 2015), supra note 5.
\798\ Id.
\799\ Id.
\800\ Id.
\801\ Id.
\802\ Id.
\803\ Id.
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c. Response to Comments and Final Rules
Upon consideration of commenters' views, the Commission is adopting
Rules 15Fh-4(b)(1) and (2), regarding the ``best interests'' obligation
for an SBS Dealer that acts as an advisor to a special entity regarding
a security-based swap, with certain modifications.
Under Rule 15Fh-4(b)(1), as adopted, an SBS Dealer that acts as an
advisor to a special entity will have a ``duty to make a reasonable
determination that any security-based swap or trading strategy
involving a security based swap recommended by the security based swap
dealer is in the best interests of the special entity.'' We believe
that this language, suggested by a commenter,\804\ appropriately
interprets the statutory requirements imposed on an SBS Dealer that is
acting as an advisor to a special entity.\805\ While the Commission is
not specifically defining the term ``best interests,'' it is providing
further guidance below regarding how an SBS Dealer that acts as an
advisor to a special entity can comply with the duty to make a
reasonable determination that a security-based swap or security-based
swap trading strategy is in the ``best interests'' of the special
entity.
---------------------------------------------------------------------------
\804\ See SIFMA (August 2015), supra note 5.
\805\ Proposed Rule 15Fh-4(b)(1) generally required an SBS
Dealer to ``act in the best interests of the special entity.''
---------------------------------------------------------------------------
Under Rule 15Fh-4(b)(2), as adopted, the advisor will be obligated
to ``make reasonable efforts to obtain such information that the
security-based swap dealer considers necessary to make a reasonable
determination that a security-based swap or trading strategy involving
a security-based swap is in the best interests of the special entity.''
Whether a recommended security-based swap or trading strategy is in the
best interests of the special entity is based on information known to
the advisor (after it has employed its reasonable efforts under Rule
15Fh-4(b)(2)) at the time the recommendation is made.
Various commenters questioned whether the ``best interest'' duty
was tantamount to, or would give rise to, a ``fiduciary duty.'' \806\
The Commission has considered commenters' views and the legislative
history in regard to whether Section 15Fh-4 imposes a fiduciary
duty.\807\ As noted above, Rule 15Fh-4(b)(1), as adopted, requires that
an SBS Dealer ``make a reasonable determination that any security-based
swap or trading strategy involving a security based swap recommended by
the security based swap dealer is in the best interests of the special
entity.'' In response to comments, and for clarification, the
determination whether a recommended security-based swap or trading
strategy is in the ``best interests'' of the special entity will turn
on the facts and circumstances of the particular recommendation and
particular special entity. In response to a commenter, and as stated in
the Proposing Release, we continue to believe that the ``best
interests'' obligation for an SBS Dealer acting as an advisor to a
special entity goes beyond and encompasses the general suitability
requirements of Rule 15Fh-3(f).\808\ The Commission generally believes
that it would be difficult for an SBS Dealer acting as an advisor to a
special entity to fulfill its obligations under Rule 15Fh-4(b)(1), as
adopted, unless the SBS Dealer, at a minimum: (1) Complies with the
requirement of Rule 15Fh-4(b)(2) that it make a reasonable effort to
obtain necessary information to make a reasonable determination that a
security-based swap or related trading strategy is in the best
interests of the special entity; \809\ (2) acts in good faith and makes
full and fair disclosure of all material risks and characteristics of
and any material incentives or conflicts of interest with respect to
the recommended security-based swap; \810\ and (3) employs reasonable
care that any recommendation made to a special entity is suitable
taking into account the information collected by the SBS Dealer
pursuant to Rules 15Fh-3(f)(1)(ii) and 15Fh-4(b)(2), including the
special entity's objectives.\811\ In taking reasonable care that any
recommendation made to a special entity is suitable, an SBS Dealer
acting as an advisor to a special entity should consider, among other
things, the fair pricing and appropriateness of the security-based swap
or trading strategy, and must act without regard to its own financial
or other interests in the security-based swap transaction or trading
strategy.\812\ As discussed below, this does not prevent an SBS Dealer
from negotiating commercially reasonable terms or earning a profit.
---------------------------------------------------------------------------
\806\ See, e.g., Better Markets (August 2011), supra note 5;
CFA, supra note 5; Johnson, supra note 5; ABC, supra note 5;
BlackRock, supra note 5.
\807\ In the Senate bill, the business conduct standards
provision provided that ``a security-based swap dealer that provides
advice regarding, or offers to enter into, or enters into a
security-based swap with [a Special Entity] shall have a fiduciary
duty to the [Special Entity], as appropriate.'' Restoring American
Financial Stability Act of 2010, H.R. 4173, Section 764 (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 15F(h)(2)(A) and (B) of the Exchange Act), available at
https://www.congress.gov/bill/111th-congress/house-bill/4173/text/pp). Instead, Congress adopted the following best interests
standard: ``Duty.--Any security-based 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.'' H.R. Rep. No. 111-517, 111th
Cong., 2d Sess., p. 423 (June 29, 2010) (Dodd-Frank Act Conference
Report). See also Section 15F(h)(4)(B) of the Exchange Act.
\808\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5. See also Proposing Release, 76 FR at 42417, supra note 3.
This is the case even if the SBS Dealer is not acting as
counterparty to the special entity for which it is acting as an
advisor.
\809\ Also, as stated above, to comply with its customer-
specific suitability obligations under Rule 15Fh-3(f)(1)(ii), an SBS
Dealer must have a reasonable basis to believe that a recommended
security-based swap or trading strategy involving a security-based
swap is suitable for the counterparty. To establish a reasonable
basis for a recommendation, an SBS Dealer must have or obtain
relevant information regarding the special entity, including its
investment profile, trading objectives, and its ability to absorb
potential losses associated with the recommended security-based swap
or trading strategy involving a security-based swap. Furthermore,
where an SBS Dealer's reasonable efforts to obtain necessary
information result in limited or incomplete information, the SBS
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.
\810\ The Commission believes that to ``act in good faith'' in
this context generally involves taking steps to manage material
conflicts of interest in addition to disclosing them.
\811\ See note 809, supra and Rule 15Fh-4(b)(2). An SBS Dealer
generally should consider evaluating ``best interests'' in
accordance with policies and procedures that are reasonably designed
to prevent violations of the requirement that a recommended swap is
in the best interests of the special entity. See Rule 15Fh-
3(h)(2)(iii) (requiring SBS Entities to have supervisory policies
and procedures that are reasonably designed to prevent violations of
applicable federal securities laws and the rules and regulations
thereunder). Furthermore, the Commission has separately proposed
that SBS Dealers be required to make and keep current a record that
demonstrates their compliance with Rule 15Fh-4, among others, as
applicable. See Recordkeeping and Reporting Requirements for
Security-Based Swap Dealers, Major Security-Based Swap Participants,
and Broker-Dealers; Capital Rule for Certain Security-Based Swap
Dealers; Proposed Rules, Exchange Act Release No. 34-71958, 79 FR
25194 at 25208 (May 2, 2014).
\812\ Exercising reasonable care would also require, among other
things, undertaking reasonable diligence to understand the potential
risks and rewards associated with the recommended security-based
swap or trading strategy. See Rule 15Fh-3(f)(1)(i).
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In response to commenters' requests for clarification, we do not
believe that, to act in the best interests of a special entity, an SBS
Dealer acting as an advisor would be required to recommend the ``best''
of all possible alternatives that might exist.\813\ The
[[Page 30022]]
determination whether a recommended security-based swap is in the
``best interests'' of the special entity must be based on information
known to the SBS Dealer, acting as an advisor, (after it has employed
its reasonable efforts under Rule 15Fh-4(b)(2)) at the time the
recommendation is made. We believe that a broader requirement could
introduce legal uncertainty into the determination of what an SBS
Dealer must do to fulfill its obligation under the rule, given the
broad range of objectives for which a security-based swap might be
used, and how such objectives may vary for different transactions. The
Commission believes, however, that generally an SBS Dealer should
consider, based on the information about existing alternatives known to
the SBS Dealer, any reasonably available alternatives in fulfilling its
best interests obligations.
---------------------------------------------------------------------------
\813\ See CFA, supra note 5; SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
For further clarification in response to comments, we believe that
the ``best interests'' duty would not necessarily preclude an SBS
Dealer from acting as a counterparty.\814\ However, an SBS Dealer
acting in both capacities would be required to comply with the full
range of requirements under Rules 15Fh-4 and 15Fh-5, applicable to SBS
Dealers acting as advisors and as counterparties to special entities.
In addition to the substantive requirements, Rule 15Fh-5(c) would
require that the SBS Dealer disclose to the special entity in writing
the capacities in which is it acting, and the material differences
between its capacities as advisor and counterparty to the special
entity.
---------------------------------------------------------------------------
\814\ See CFA, supra note 5.
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We also do not believe that the ``best interests'' duty would
prevent an SBS Dealer from negotiating commercially reasonable
security-based swap terms in its own interest,\815\ or that it would
preclude an SBS Dealer from making a reasonable profit or fee from a
transaction with a special entity.\816\ We do not believe that the
profit motive inherent in any security-based swap transaction
necessarily precludes an SBS Dealer, acting as an advisor, from
fulfilling its ``best interests'' duty to a special entity, although it
raises the potential for material conflicts that would need to be
disclosed--particularly when the SBS Dealer is acting as both an
advisor and a counterparty to the special entity. A prohibition on
receipt of reasonable profits or fees would likely reduce SBS Dealers'
willingness to act as advisors to and transact with special entities at
the same time, and therefore could limit special entities' access to
security-based swap transactions that might be necessary to their
particular objectives.
---------------------------------------------------------------------------
\815\ See SIFMA (August 2015), supra note 5. For example, the
SBS Dealer may negotiate appropriate provisions relating to
collateral and termination rights to manage its risks related to the
security-based swap.
\816\ See CFA, supra note 5. Furthermore, as noted throughout
this release, the duties imposed on an SBS Dealer under these
business conduct rules are specific to this context, and are in
addition to any duties that may be imposed under other applicable
law. Thus, an SBS Dealer must separately determine whether it is
subject to regulation as a broker-dealer, an investment adviser, a
municipal advisor or other regulated entity.
---------------------------------------------------------------------------
As additional guidance in response to comments,\817\ the ``best
interests'' duty would not require the SBS Dealer acting as an advisor
to undertake an ongoing obligation to act in the ``best interests'' of
the special entity, unless such obligation is established through
contract or other arrangement or understanding (e.g., a course of
dealing). As noted above, Rule 15Fh-4(b), as adopted, requires an SBS
Dealer to make a reasonable determination, after making reasonable
efforts to obtain the necessary information, that a recommended
security-based swap or related trading strategy is in the best
interests of the special entity. Thus, the ``best interests'' duty
applies only to recommendations by the SBS Dealer. For example, if an
SBS Dealer makes a recommendation in connection with a material
amendment to a security-based swap or a recommendation to terminate a
security-based swap early, the ``best interests'' duty would apply.
However, we note that an SBS Dealer would have an ongoing ``best
interests'' duty if it were to assume the additional responsibility of
monitoring a special entity's security-based swap transaction on an
ongoing basis.
---------------------------------------------------------------------------
\817\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Commenters have suggested that we apply principles applicable to
investment advisers under the Advisers Act in the ``best interests''
standard of Rule 15Fh-4(b).\818\ As noted above in Section II.H.2.c.i.,
we believe that the protections included in the business conduct rules
address the relationships between SBS Dealers and their special entity
counterparties for which they act as advisors, so long as their
activities are limited to those that would not, under the facts and
circumstances, implicate other applicable law. However, as discussed in
Section I.E, supra, the duties imposed on an SBS Dealer under the
business conduct rules are specific to this context, and are in
addition to any duties that may be imposed under other applicable law.
Thus, an SBS Dealer must separately determine whether it is subject to
regulation as a broker-dealer, an investment adviser, a municipal
advisor or other regulated entity. We also decline to adopt a
commenter's suggestion that we either omit the term ``best interests''
from the final rules, or state that ``best interests'' means complying
with the fair and balanced communications requirements of Rule 15Fh-
3(g) and FINRA Rule 2010 (Standards of Commercial Honor and Principles
of Trade).\819\ We do not believe that either approach would be
consistent with the statute, which uses the terms ``fair and balanced
communications,'' ``fair dealing,'' and ``good faith'' in separate
provisions, indicating that they impose duties separate and apart from
``best interests.'' \820\
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\818\ See Better Markets (August 2011), supra note 5; CFA, supra
note 5.
\819\ See BlackRock, supra note 5. We interpret BlackRock's
comment as referring to FINRA Rule 2010, (or its predecessors, NYSE
Rule 2010 or NASD Rule 2110) which states: ``A member, in the
conduct of its business, shall observe high standards of commercial
honor and just and equitable principles of trade.''
\820\ Compare Exchange Act Section 15F(h)(3)(C) (requiring
business conduct requirements to ``establish a duty for security-
based swap dealer or major security-based swap participant to
communicate in a fair and balanced manner based on principles of
fair dealing and good faith'') with Exchange Act Section
15F(h)(4)(B) (``Any security-based 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'').
---------------------------------------------------------------------------
The Commission also has modified the information that an SBS Dealer
must ``make reasonable efforts to obtain'' and consider in making its
reasonable determination that a security-based swap or security-based
swap strategy is in the ``best interests of the special entity.''
Specifically, Rule 15Fh-4(b)(2) now includes the special entity's
hedging, investment, financing, or other stated objectives as
information that shall be considered by the SBS Dealer in making this
determination. The addition of ``hedging'' and ``other'' objectives in
Rule 15Fh-4(b)(2)(iii) addresses a commenter's suggestion that these
terms be included,\821\ and recognizes that there may be a broader set
of objectives for a special entity to enter into a security-based swap.
The added language expressly recognizes special entities' use of
security-based swaps to mitigate risk, as well as other possible uses
for security-based swaps that might be necessary for a special entity
to achieve these objectives. We believe that requiring an SBS Dealer to
make reasonable efforts to obtain information about a wider array of
possible investment objectives of special entities will allow SBS
Dealers to more accurately determine a special entity's
[[Page 30023]]
objectives in entering into a security-based swaps, which is one of the
factors it must consider when making a best interest determination (as
discussed above). Furthermore, as requested by a commenter, this change
conforms the obligation under our rules with that under the rules of
the CFTC.\822\ Such conformity promotes regulatory consistency across
the swap and security-based swap markets, particularly among entities
that transact in both markets and have already established
infrastructure to comply with existing CFTC regulations.
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\821\ See SIFMA (August 2015), supra note 5.
\822\ Id. CFTC Regulation Sec. 23.440(c)(2)(iii) states 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 or trading strategy
involving a swap recommended by the swap dealer is in the best
interests of the Special Entity, including . . . information
relating to . . . the hedging, investment, financing, or other
objectives of the Special Entity.'' See CFTC Adopting Release, 77 FR
at 9825, supra note 22.
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Furthermore, we reject the commenter's request to delete the
requirement under proposed Rule 15Fh-4(b)(2)(i) that an SBS Dealer make
reasonable efforts to obtain ``information regarding the authority of
the special entity to enter into a security-based swap.'' \823\ In so
doing, we disagree with the commenter's assertion that the requirement
under Rule 15Fh-4(b)(2)(i) is ``duplicative'' of the ``know your
counterparty'' requirement of Rule 15Fh-3(e)(3), which, according to
the commenter, already imposes an obligation on SBS Dealers to obtain
information about the authority of the special entity to enter into a
security-based swap. To the contrary, the know your customer
requirements of Rule 15Fh-3(e)(3) require an SBS Dealer to learn
``information regarding the authority of any person acting for such
counterparty.'' A determination regarding the authority of any person
acting for a counterparty (under Rule 15Fh-3(e)(3)) is different from a
determination regarding the authority of the counterparty itself to
enter into a security-based swap itself (under Rule 15Fh-4(b)(2)(i)).
The SBS Dealer's duty to act in the best interests of a special entity
would encompass the requirement to ensure that a special entity has the
requisite authority to enter into an SBS transaction. Moreover, the
``know your counterparty'' requirements of Rule 15Fh-3(e)(3) only apply
to known counterparties.\824\ Also, the ``know your counterparty''
requirements apply only to counterparties, whereas the requirements
imposed on SBS Dealers that ``act as an advisor'' to special entities
are not limited to special entities that are counterparties.
Accordingly, we continue to believe that requiring SBS Dealers to
obtain information regarding the authority of a special entity to enter
into a security-based swap is not duplicative, but is necessary to
achieving the overarching purpose of the rule: Determining whether a
recommended security-based swap or related trading strategy is in the
best interests of the special entity.
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\823\ See SIFMA (August 2015), supra, note 5.
\824\ See Section II.G.3, supra.
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Lastly, as noted above, commenters requested that we clarify that
an SBS Dealer that ``acts as an advisor to a special entity'' and
complies with the ``best interests'' requirements of these business
conduct standards will not necessarily become an ERISA fiduciary under
the DOL's proposed (now final) redefinition of the term ``fiduciary.''
\825\ As discussed in Section I.D, supra, DOL staff has provided the
Commission with a statement that:
---------------------------------------------------------------------------
\825\ See ABC, supra note 5; BlackRock, supra note 5; CFA, supra
note 5.
It is the Department's view that the draft final business
conduct standards do not require security-based swap dealers or
major security-based swap participants to engage in activities that
would make them fiduciaries under the Department's current five-part
test defining fiduciary investment advice. 29 CFR 2510.3-21(c). The
standards neither conflict with the Department's existing
regulations, nor compel security-based swap dealers or major
security-based swap participants to engage in fiduciary conduct.
Moreover, the Department's recently published final rule amending
ERISA's fiduciary investment advice regulation was carefully
harmonized with the SEC's business conduct standards so that there
are no unintended consequences for security-based swap dealers and
major security-based swap participants who comply with the business
conduct standards. As explained in the preamble to the Department's
final rule, the disclosures required under the SEC's business
conduct rules do not, in the Department's view, compel
counterparties to ERISA-covered employee benefit plans to make
investment advice recommendations within the meaning of the
Department's final rule or otherwise compel them to act as ERISA
fiduciaries in swap and security-based swap transactions conducted
pursuant to section 4s(h) of the Commodity Exchange Act and section
15F of the Securities Exchange Act of 1934.\826\
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\826\ See Letter from Phyllis C. Borzi, Assistant Secretary,
Employee Benefits Security Administration, U.S. Department of Labor
to The Hon. Mary Jo White et al., SEC (Apr. 12, 2016).
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4. Antifraud Provisions
a. Proposed Rule 15Fh-4(a)
Proposed Rule 15Fh-4(a) would track the language of Section
15F(h)(4)(A) of the Exchange Act, and prohibit an SBS Entity from: (1)
Employing any device, scheme, or artifice to defraud any special entity
or prospective customer who is a special entity; (2) engaging 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) engaging in any act, practice, or course of
business that is fraudulent, deceptive, or manipulative. The first two
provisions are specific to an SBS Entity's interactions with special
entities, while the third applies more generally.
b. Comments on the Proposed Rule
The Commission received two comment letters on this issue.\827\ The
first commenter argued that the antifraud provisions of proposed Rule
15Fh-4(a) would be duplicative in light of the general antifraud and
anti-manipulation provisions of the existing federal securities laws
and proposed Rule 9j-1.\828\
---------------------------------------------------------------------------
\827\ See Barnard, supra note 5; SIFMA (August 2015), supra note
5.
\828\ See Barnard, supra note 5. See also Prohibition Against
Fraud, Manipulation, and Deception in Connection With Security-Based
Swaps, Exchange Act Release No. 34-63236, 75 FR 68560 (Nov. 8,
2011).
---------------------------------------------------------------------------
The second commenter argued that, because the antifraud
prohibitions of proposed Rule 15Fh-4(a)(3) were modeled on language in
the Advisers Act applicable to conduct by investment advisers, and SBS
Entities do not typically act as advisers to their counterparties, the
SEC should include an affirmative defense against alleged violations of
the antifraud prohibitions in its final rules.\829\ Specifically, the
commenter suggested that the Commission establish an affirmative
defense for an SBS Entity that: (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.\830\ The commenter noted that the CFTC included such a
provision in its parallel business conduct rules, and urged the
Commission to rely on the same considerations that led the CFTC to
adopt its affirmative defense.\831\
---------------------------------------------------------------------------
\829\ See SIFMA (August 2015), supra note 5.
\830\ Id.
\831\ Id.
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c. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-4(a) as proposed. However, we are re-titling Rule 15Fh-4
``Antifraud provisions and
[[Page 30024]]
special requirements for security-based swap dealers acting as advisors
to special entities. We also are re-titling Rule 15Fh-4(a) ``Antifraud
provisions'' and Rule 15Fh-4(b) ``Special requirements for security-
based swap dealers acting as advisors to special entities.''
Rule 15Fh-4(a) codifies the statutory requirements of Exchange Act
Section 15F(h)(4)(A).\832\ Inclusion of the rule in the business
conduct standards will provide SBS Entities and their counterparties
with easy reference to the antifraud provisions that Congress expressly
provided under Section 15F(h)(4) of the Exchange Act. These
requirements, which by their terms are applicable to all SBS Entities,
apply in addition to those prohibitions imposed by Section 9(j) of the
Exchange Act--along with any rules the Commission may adopt thereunder,
and any other applicable provisions of the federal securities laws and
related rules and regulations. The Commission is not adopting the
commenter's recommendation that the final rules incorporate an
affirmative ``policies and procedures defense.'' We recognize that the
CFTC adopted an express, affirmative defense in its parallel antifraud
rules, in part in response to concerns that the statute may impose non-
scienter liability for fraud in private rights of action.\833\ The
Exchange Act, however, does not contain a parallel provision.\834\
Moreover, the Commission has considered the concerns raised by
commenters and determined not to provide a similar safe harbor from
liability for fraud on behalf of SBS Entities. As discussed throughout
the release in the context of specific rules, the rules being adopted
today are intended to provide certain protections for counterparties,
including certain heightened protections for special entities. We think
it is appropriate to apply the rules so that counterparties receive the
benefits of those protections, and therefore we do not think it would
be appropriate to provide the safe harbor requested by the commenter
from liability for fraud. While we are not adopting a safe harbor from
liability for fraud, as discussed below in connection with the relevant
rules, the Commission has adopted rules that permit reasonable reliance
on representations (e.g., Rule 15Fh-1(b)) and, where appropriate, allow
SBS Entities to take into account the sophistication of the
counterparty (e.g., Rule 15Fh-3(f) (regarding recommendations of
security-based swaps or trading strategies)).
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\832\ This language mirrors the language in Sections 206(2) and
206(4) of the Advisers Act, which does not require scienter to prove
liability. See SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992).
The court in Steadman analogized Section 206(4) of the Advisers Act
to Section 17(a)(3) of the Securities Act, which the Supreme Court
had held did not require a finding of scienter. See id., citing
Aaron v. SEC, 446 U.S. 680 (1980). The Steadman court concluded
that: ``[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 . . . .'' SEC v. Steadman, 967 F.2d at 647 (internal
citations omitted). The Steadman court observed that, similarly, a
violation of Section 206(2) of the Adviser Act could rest on a
finding of simple negligence. Id. at 642 note 5.
\833\ See CFTC Adopting Release, 77 FR at 9752, supra note 21
(``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'').
\834\ See also Proposing Release, 76 FR 42401, fn. 44, supra
note 3 (``Section 15F(h) of the Exchange Act does not, by its terms,
create a new private right of action or right of rescission, nor do
we anticipate that the proposed rules would create any new private
right of action or right of rescission'').
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5. SBS Entities Acting as Counterparties to Special Entities
a. Scope of Qualified Independent Representative Requirement
i. Proposed Rules
Under Exchange Act Section 15F(h)(5)(A), an SBS Entity that offers
to enter into or enters into a security-based swap with a special
entity must comply with any duty established by the Commission
requiring the SBS Entity to have a ``reasonable basis'' to believe the
special entity has an ``independent representative'' that meets certain
qualifications. Proposed Rules 15Fh-2(c) and 15Fh-5(a) would implement
this provision. In particular, proposed Rule 15Fh-2(c) would define an
``independent representative,'' and proposed Rule 15Fh-5(a) would
require an SBS Entity that ``offers to enter into'' or enters into a
security-based swap with a special entity to have a ``reasonable
basis'' to believe that the special entity has a ``qualified
independent representative.''
ii. Comments on the Proposed Rule
Application to SBS Dealers and Major SBS Participants
Under proposed Rule 15Fh-5(a), an SBS Dealer or a Major SBS
Participant that offers to enter into or enters into an SBS with a
special entity must have a reasonable basis to believe that the special
entity has a qualified independent representative. Although Exchange
Act Section 15F(h)(2)(B) only imposes an express obligation on SBS
Dealers to comply with the requirements of Section 15F(h)(5), we
proposed to apply the qualified independent representative requirement
to Major SBS Participants as well as SBS Dealers because the specific
requirements under Section 15F(h)(5)(A) apply by their terms to both a
``security-based swap dealer and major security-based swap participant
that offers to or enters into a security-based swap with a special
entity.'' \835\
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\835\ See 15 U.S.C. 78o-10(h)(5)(A).
---------------------------------------------------------------------------
The sole commenter on this issue supported the proposed Rule, and
agreed that it should apply to both SBS Dealers and Major SBS
Participants.\836\
---------------------------------------------------------------------------
\836\ See NAIPFA, supra note 5.
---------------------------------------------------------------------------
Application to Any Special Entity
In proposed Rule 15Fh-5(a), we proposed to apply the qualified
independent representative requirements to transactions with all
special entities. In the Proposing Release, we explained that while
Exchange Act Section 15F(h)(5)(A) provides broadly that an SBS Entity
that offers to or enters into a security-based swap with a special
entity must comply with the requirements of that section, Section
15F(h)(5)(A)(i) on its face would apply these requirements only to
dealings only with ``a counterparty that is an eligible contract
participant within the meaning of subclause (I) or (II) of clause (vii)
of section 1a(18) of the Commodity Exchange Act.'' A reliance on
Section 15Fh(5)(A)(i) read in isolation would lead to an anomalous
result in which special entity obligations could apply with respect to
entities such as multinational and supranational government entities,
which are ECPs ``within the meaning of subclause (I) or (II) of clause
(vii) of section 1a(18) of the Commodity Exchange Act,'' but that do
not fall within the definition of special entity in Section
15F(h)(2)(C). Conversely, Section 15Fh(5)(A)(i) read in isolation could
lead to special entity obligations not being applied with respect to
dealings with state agencies, which are special entities as defined in
Section 15Fh(2)(C) but are not ECPs as defined in Section
1a(18)(A)(vii)(I) and (II) of the CEA.\837\
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\837\ See Proposing Release, 76 FR at 42426, supra note 3.
---------------------------------------------------------------------------
To resolve the ambiguity in the statutory language, we proposed to
apply the qualified independent requirement under Section 15F(h)(5) to
[[Page 30025]]
security-based swap transactions or offers to enter into security-based
swap transactions between an SBS Entity and any counterparty that is a
``special entity'' as defined in Section 15F(h)(1)(C). This approach
would address the statutory ambiguity by including dealings with a
special entity that is an ECP within the meaning of subclause (I) or
(II) of clause (vii) of Commodity Exchange Act Section 1a(18).\838\ The
Proposing Release noted that this reading would be consistent with the
categories of special entities mentioned in the legislative
history.\839\ It also would give meaning to the requirement of Section
15F(h)(5)(A)(i)(VII) concerning ``employee benefit plans subject to
ERISA,'' that are not ECPs within the meaning of subclause (I) or (II)
of clause (vii) of section 1a(18) of the Commodity Exchange Act but are
included in the category of retirement plans identified in the
definition of special entity.\840\
---------------------------------------------------------------------------
\838\ Id. See also proposed Rule 15Fh-5(a).
\839\ See H.R. Conf. Rep. 111-517 (June 29, 2010) (``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.'') (emphasis added).
\840\ See Section 15F(h)(1)(C)(iii) of the Exchange Act.
---------------------------------------------------------------------------
The Commission received one comment letter that addressed the
question of whether proposed Rule 15Fh-5(a) should apply to security-
based swap transactions with any special entity.\841\ According to the
commenter, proposed Rule 15Fh-5(a) was overly broad in scope and
ignored the limiting language of Section 15F(h)(5)(A). This commenter
suggested interpreting the requirement as applying to only those
referenced governmental entities that are special entities.'' \842\
---------------------------------------------------------------------------
\841\ See Ropes & Gray, supra note 5.
\842\ Id. The commenter suggested two other possible
alternatives for resolving the statutory ambiguity: ``(i)
interpreting the de facto independent representative requirements as
applying to both those referenced governmental entities that are
special entities and those that are not, (ii) interpreting the
independent representative requirement to be generally inapplicable
(as clearly most special entities were not intended to be covered in
the reference)'' but expressed a preference for including
governmental entities that are special entities ``absent
clarification from Congress.''
---------------------------------------------------------------------------
Application to ``Offers''
As stated above, proposed Rule 15Fh-5(a) would apply to an SBS
Dealer or Major SBS Participant that ``offers to enter into'' or enters
into a security-based swap with a special entity. The Commission
requested comment regarding whether the phrase ``offers to enter into''
a security-based swap was sufficiently clear, and if not, how the
requirement should be clarified.\843\ Three commenters responded to
this request.\844\
---------------------------------------------------------------------------
\843\ See Proposing Release, 76 FR at 42426, supra note 3.
\844\ See APPA, supra note 5; FIA/ISDA/SIFMA, supra note 5;
SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
One commenter suggested that the ``offer'' stage of a security-
based swap transaction would often be too early for the counterparty to
ensure that the independent representative requirement was
satisfied.\845\ Instead, the commenter argued that the independent
representative requirement should be satisfied if the counterparty had
an independent representative at the time the transaction was
executed.\846\ A second commenter recommended that the Commission
exclude preliminary negotiations from the definition of ``offer,'' and
that the communication of an interest in trading a security-based swap
should only be viewed as an ``offer'' when, based on the relevant facts
or circumstances, the communication was ``actionable'' or ``firm.''
\847\ A third commenter asked that the Commission, like the CFTC,
clarify the term ``offer'' to mean an ``offer to enter into an SBS
that, if accepted, would result in a binding contract under applicable
law.'' \848\
---------------------------------------------------------------------------
\845\ See APPA, supra note 5.
\846\ Id.
\847\ See FIA/ISDA/SIFMA, supra note 5.
\848\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
``Reasonable Basis''
The Commission additionally sought comment regarding the degree of
inquiry required for an SBS Entity to form a ``reasonable basis'' to
believe the special entity was represented by a qualified independent
representative. Three commenters expressed concern with the additional
duties of inquiry and diligence imposed on SBS Entities under proposed
Rule 15Fh-5(a).\849\ One of these commenters argued that the CFTC's
proposed requirement that a Swap Dealer perform substantial diligence
to confirm a swap advisor's qualifications could pose a serious
conflict of interest, give the Swap Dealer too much power, and
ultimately interfere with, prove more costly for, and be problematic to
state or local governments.\850\ Another commenter similarly argued
that an inherent conflict of interest existed in granting one party to
a transaction the authority to effectively determine who has the
requisite qualifications to represent the other party.\851\ The second
commenter would impose additional due diligence obligations on SBS
Entities before they could rely on special entities' representations
regarding the qualifications of representatives, even where the SBS
Entity does not have information that would cause a reasonable person
to question the accuracy of the representations.\852\ The commenter
conceded that requiring such additional diligence might limit the
willingness or ability of SBS Entities to provide special entities with
access to security-based swaps. However, it argued that, in the absence
of such diligence, special entities' access to security-based swaps
should be limited to the extent suitability is in question.\853\
---------------------------------------------------------------------------
\849\ See MFA, supra note 5; GFOA, supra note 5; CalPERS, supra
note 5.
\850\ See GFOA, supra note 5.
\851\ See CalPERS, supra note 5. This commenter therefore
recommended an approach that would permit a special entity to choose
between either relying on the Commission's proposed framework, or
relying on an alternative approach under which it would be permitted
to enter into off-exchange security-based swap transactions with an
SBS Entity if the special entity had a representative, whether
internal or a third party, that had been certified as able to
evaluate security-based swap transactions. The commenter
contemplated that the certification process would involve passage of
a proficiency examination to be developed by the Commission or FINRA
``or another recognized testing organization.'' A certified
independent representative would be required to complete periodic
continuing education. Id.
\852\ See NAIPFA, supra note 5.
\853\ Id.
---------------------------------------------------------------------------
Other commenters expressed a range of views in response to our
request for comment on whether an SBS Entity should be able to rely on
representations to form the necessary ``reasonable basis'' for
believing that a special entity counterparty is represented by a
qualified independent representative. One commenter argued that no
particular level of specificity should be required in the
representations, and that the SBS Dealer should not be required to
conduct further diligence before relying on the special entity's
representations, as ``any such diligence would interfere with the
relationship between the special entity and its independent advisor and
could result in the SBS Dealer second-guessing the special entity's
choice of representative.'' \854\ Another commenter argued that an SBS
Dealer should be required to rely on the representations of a special
entity concerning the qualifications of its independent representative,
absent actual knowledge of facts that clearly contradict material
aspects of the representative's purported qualifications.\855\
---------------------------------------------------------------------------
\854\ See BlackRock, supra note 5.
\855\ See SIFMA (August 2011), supra note 5. The commenter
asserted that requiring an SBS Dealer to undertake an independent
due diligence investigation into representative's qualifications
would impose upon the SBS Dealer a duty to second-guess the special
entity's own assessment of its representative and provide the SBS
Dealer with the ability to trump a special entity's choice of asset
manager. According to the commenter, this could result in a reduced
number of security-based swap counterparties for special entities,
as SBS Dealers would likely limit transactions with special entities
to avoid the potential liability, cost, delay, and uncertainty
arising from this added responsibility.
---------------------------------------------------------------------------
[[Page 30026]]
One commenter suggested adopting a presumption that the special
entity's selection of independent representative was acceptable if the
special entity represents to the SBS Entity that the representative
satisfies the criteria in Exchange Act Section 15F(h)(5)(A)(i).\856\
---------------------------------------------------------------------------
\856\ See ABA Committees, supra note 5. That presumption would
be voidable only if one or more senior representatives of the SBS
Entity with expertise in security-based swap transactions possessed
actual knowledge that a representation regarding the independent
representative's qualifications was false. In that situation, the
Special Entity's senior representative must present his or her
determination promptly in writing to the special entity's Chief
Investment Officer and Chair of the Board, or equivalent person.
---------------------------------------------------------------------------
Two other commenters supported the actual knowledge standard
because they believe the reasonable person standard in practice could
require an SBS Entity to perform substantial due diligence to rely on
representations.\857\ One commenter noted that this additional due
diligence could reduce the number of SBS Entities willing to contract
with special entities, and could increase the cost of security-based
swaps for those persons.\858\ The other expressed concern that
additional due diligence, in the context of the qualifications of a
special entity's independent representative, would be intrusive, time
consuming and unnecessary, and would ``come very close to having the
SBS Dealer `approve' the special entity's representative.'' \859\ A
third commenter expressed similar concerns, noting that absent actual
knowledge that a representation is incorrect, SBS Dealers should not be
able to second-guess a special entity's selection of a
representative.\860\
---------------------------------------------------------------------------
\857\ See APPA, supra note 5; BlackRock, supra note 5.
\858\ See APPA, supra note 5.
\859\ See BlackRock, supra note 5.
\860\ See ABC, supra note 5. According to the commenter, without
such a bright-line rule, SBS Dealers might face litigation initiated
by ERISA plans for approving a representative who is subsequently
determined to lack needed expertise, or by the representatives whom
they have chosen to disqualify. This potential liability would
ultimately discourage SBS Dealers from transacting with ERISA plans
altogether.
---------------------------------------------------------------------------
Another commenter supported permitting an SBS Dealer to rely on a
special entity's representation that its independent representative met
the statutory and regulatory requirements, unless the SBS Dealer had
reason to believe that the special entity's representations with
respect to its independent representative were inaccurate.\861\
---------------------------------------------------------------------------
\861\ See CCMR, supra note 5.
---------------------------------------------------------------------------
After the adoption of the CFTC's final rules, one commenter urged
the Commission to adopt the CFTC's reasonable person approach, under
which an SBS Entity would be deemed to have a reasonable basis to
believe the special entity has a qualified independent representative
when it relies on written representations that the special entity's
representative meets the criteria for a qualified independent
representative.\862\ Alternatively, in the ERISA context, the commenter
suggested that an SBS Entity be deemed to have a reasonable basis to
believe a special entity subject to ERISA has a representative that
satisfies the requirements for a qualified independent representative
when it relies on written representations that the representative is a
fiduciary as defined in Section 3 of ERISA.\863\ The commenter's
suggested modifications were intended to harmonize the SEC's standard
with that adopted by the CFTC.\864\
---------------------------------------------------------------------------
\862\ Id.
\863\ Id.
\864\ Id.
---------------------------------------------------------------------------
Another commenter requested that the Commission clarify that any
representations made by a special entity or its representative to
satisfy the rules do not give any party any additional rights, such as
rescission or monetary compensation (e.g., if the representations turn
out to be incorrect).\865\
---------------------------------------------------------------------------
\865\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After consideration of the comments, we are adopting Rule 15Fh-
5(a), subject to the modifications described below.
Application to SBS Dealers and Major SBS Participants
As a preliminary matter, we continue to believe and agree with the
commenter that Rule 15Fh-5(a) should apply to both SBS Dealers and
Major SBS Participants.\866\ As discussed in Section II.C. above, in
making this determination, the Commission recognizes that the statutory
language of the business conduct standards generally does not
distinguish between SBS Dealers and Major SBS Participants. Where the
statute does make that distinction, the Commission also makes that
distinction in the corresponding rule.\867\ Here, we believe Congress
intended to impose the independent representative requirement equally
with respect to SBS Dealers and Major SBS Participants, since the
specific requirements under Section 15F(h)(5)(A) of the Exchange Act
apply by their terms to both ``security-based swap dealer[s] and major
security-based swap participant[s] that offer[ ] to or enter[ ] into a
security-based swap with a special entity.'' \868\ We also believe that
the protections of Rule 15Fh-5 should inure equally to those special
entities that transact with SBS Dealers as well as those that transact
with Major SBS Participants.
---------------------------------------------------------------------------
\866\ See NAIPFA, supra note 5.
\867\ For example, the requirements under Exchange Act Section
15F(h)(4)(B) apply only to an SBS Dealer that acts as an advisor to
a special entity, a distinction that is reflected in Rule 15Fh-4(b).
\868\ See 15 U.S.C. 78o-10(h)(5)(A).
---------------------------------------------------------------------------
Application to Any Special Entity
Moreover, the Commission continues to believe that the qualified
independent representative requirements in Rule 15Fh-5 should apply
whenever an SBS Entity acts as a counterparty to any special entity. We
acknowledge the commenter's suggestion that the Commission ``give
appropriate effect to the limiting language in Exchange Act Section
15F(h)(5)(A)'' regarding the types of special entities to which the
independent representative requirement applies.\869\ However, given the
ambiguity between the language of Sections 15F(h)(2)(C) and
15F(h)(5)(A)(i), we believe that our interpretation is appropriate and
promotes a more consistent reading of both provisions of the statute,
providing protections to all special entities.\870\
---------------------------------------------------------------------------
\869\ See Ropes & Gray, supra note 5.
\870\ See Proposing Release, 76 FR at 42426, supra note 3. See
also H.R. Conf. Rep. 111-517 (Jun. 29, 2010) (``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.'') (emphasis added).
---------------------------------------------------------------------------
This interpretation also gives meaning to the requirement of
Section 15F(h)(5)(A)(i)(VII) concerning ``employee benefit plans
subject to ERISA.'' Although these benefit plans are not ECPs within
the meaning of subclause (I) or (II) of clause (vii) of section 1a(18)
of the Commodity Exchange Act, they are included in the category of
plans identified as special entities in Exchange Act section
15F(h)(2)(C). For these reasons, we believe Rule 15Fh-5(a) should apply
to any special entity as counterparty.
[[Page 30027]]
Application to Offers
The Commission continues to believe that, consistent with statutory
language, the independent representative requirement of the business
conduct rules should be triggered when an ``offer'' to enter into a
security-based swap is made. We disagree with the commenter that
applying Rule 15Fh-5(a) at the offer stage is premature.\871\ The rules
are intended to provide benefits to special entities by, among other
things, requiring that a special entity has a qualified independent
representative that undertakes a duty to act in its best interests in
determining whether to enter into a security-based swap. The benefits
of these protections could be lost if the rule were to require only
that the special entity counterparty have an independent representative
at the time the transaction is executed.\872\
---------------------------------------------------------------------------
\871\ See APPA, supra note 5.
\872\ Id.
---------------------------------------------------------------------------
Some commenters argued that the appropriate definition of the term
``offer'' should be consistent with contract law, and that a
communication should only be considered an offer when, based on the
relevant facts and circumstances, it is ``actionable'' or ``firm.''
\873\ The Commission agrees with the commenter that the term ``offer''
for purposes of the independent representative requirement of these
business conduct rules means an ``offer to enter into a security-based
swap that, if accepted, would result in a binding contract under
applicable law.'' \874\ Given that the relationship between the SBS
Entity and the counterparty is defined and shaped by contract (e.g.,
generally a master agreement and credit documents), we believe that the
contractual interpretation is the appropriate interpretation in this
context. This interpretation is also the same as the CFTC's
interpretation of an offer to enter into a swap and would harmonize the
scope of the term offer for purposes of the independent representative
requirement of these business conduct rules.\875\ We believe that this
harmonization will result in efficiencies for entities that have
already established infrastructure to comply with the CFTC standard.
---------------------------------------------------------------------------
\873\ See FIA/ISDA/SIFMA, supra, note 5. See also SIFMA (August
2015), supra note 5.
\874\ See SIFMA (August 2015), supra note 5.
\875\ See CFTC Adopting Release at 9741.
---------------------------------------------------------------------------
Whether preliminary negotiations would be deemed an ``offer'' will
depend upon the facts and circumstances and details of the
communication.\876\ For example, if the preliminary communication
contains enough details (or if taken in the context of several
communications) that, if accepted, would result in a binding contract,
it likely may be an ``offer'' under the rule.
---------------------------------------------------------------------------
\876\ See FIA/ISDA/SIFMA, supra, note 5.
---------------------------------------------------------------------------
Reasonable Basis
The Commission recognizes and believes it appropriate that Rule
15Fh-5(a) imposes on SBS Entities a duty of inquiry to form a
reasonable basis to believe the special entity has a qualified
independent representative. The amount of due diligence the SBS Entity
must perform to form a reasonable basis to believe the independent
representative meets a particular qualification will depend upon the
particular facts and circumstances. For example, if the SBS Entity has
no prior dealings or familiarity with the particular independent
representative, it will likely require more diligence on the part of
the SBS Entity than a transaction with an independent representative
that the SBS Entity has had numerous recent dealings in various
different contexts. Furthermore, if the SBS Entity has dealt with the
independent representative in other contexts, but not necessarily in
the context of a security-based swap, it may require some limited
diligence to form a reasonable basis regarding the requisite
qualifications.
The Commission agrees, however, with the concerns of commenters
that requiring SBS Entities to perform substantial due diligence
regarding the qualifications of independent representatives may provide
SBS Entities with the ability to second guess or negate the special
entity's choice of independent representative, which may generally
increase transaction costs for security-based swaps with special
entities, and allow SBS Entities to exert undue influence over the
special entity's selection of an independent representative.\877\ To
address these concerns, final Rule 15Fh-1(b), as discussed in Section
II.D, allows SBS Entities to reasonably rely on written representations
regarding the qualifications and independence of special entities'
representatives.\878\ This generally comports with an SBS Entity's
heightened standard of care when transacting with special entities,
while avoiding the potential conflict of interest and increased
transaction costs that could result if SBS Entities effectively second-
guessed special entities' choice of independent representatives. In
addition, we are adopting safe harbors as discussed below, pursuant to
which an SBS Entity will be deemed to have a reasonable basis to
believe that the special entity has a representative that meets the
qualification and independence requirements of Rule 15Fh-5(a). We
believe the availability of the safe harbor also addresses the concerns
of certain commenters that SBS Entities not exert undue influence on
the special entity's selection of representative.\879\
---------------------------------------------------------------------------
\877\ See MFA, supra note 5; GFOA, supra note 5.
\878\ See Rule 15Fh-1(b).
\879\ See e.g., CalPERS (August 2011) supra note 5.
---------------------------------------------------------------------------
The Commission acknowledges one commenter's recommended approach
that would permit a special entity to choose between either: (1)
Relying on the Commission's proposed framework regarding a reasonable
basis to believe the qualifications of the independent representative;
or (2) relying on an alternative approach under which it would be
permitted to enter into off-exchange security-based swap transactions
with an SBS Entity if the special entity had a representative, whether
internal or a third party, that had been certified as able to evaluate
security-based swap transactions. The commenter contemplated that the
certification process would involve the development and implementation
of a proficiency examination by the Commission or FINRA ``or another
recognized testing organization,'' and that a certified independent
representative would be required to complete periodic continuing
education.\880\ We do not believe that this suggested alternative would
appropriately provide the protections to special entities that the
statute and our proposed Rule 15Fh-5 were designed to provide. First,
we believe that this alternative would effectively permit special
entities to opt out of the express protections that the rules are
intended to provide. In addition, we are not aware of the existence of
a certification process as described by the commenter, and we did not
propose and are not adopting such a process.\881\
---------------------------------------------------------------------------
\880\ See CalPERS, supra note 5.
\881\ However, to the extent that such a proficiency examination
were created, the results of the examination could inform the SBS
Entity's assessment of the qualifications of the independent
representative.
---------------------------------------------------------------------------
As with final Rule 15Fh-2(a), we have determined to adopt Rule
15Fh-5(a) in a bifurcated format to avoid potential conflict with ERISA
and DOL regulations, as well as to more closely harmonize with existing
CFTC business conduct rules. Rule 15Fh-5(a)(1), as adopted, requires an
SBS Entity that offers to enter into or enters into a security-based
swap with a special entity other than an ERISA special entity to form a
reasonable basis to believe that the special entity has a
[[Page 30028]]
qualified independent representative. Rule 15Fh-5(a)(2), as adopted,
requires an SBS Entity that offers to enter into or enters into a
security-based swap with an ERISA special entity to have a reasonable
basis to believe that the special entity has a fiduciary, as defined in
Section 3 of ERISA. By adopting separate criteria for the independent
representatives of ERISA and non-ERISA special entities, the Commission
is addressing the concerns of numerous commenters that the business
conduct standards, if adopted without regard for the potential
regulatory intersections of ERISA, could cause confusion and unintended
consequences for SBS Entities dealing with ERISA plans.\882\ In
addition, this change will provide greater consistency with the
parallel CFTC rule, which will result in efficiencies for SBS Entities
that have already established infrastructure to comply with the CFTC
rule.
---------------------------------------------------------------------------
\882\ See Section I.D., supra. See also ABC, supra note 5; FIA/
ISDA/SIFMA, supra note 5; IDC, supra note 5; MFA, supra note 5;
BlackRock, supra note 5; Johnson, supra note 5.
---------------------------------------------------------------------------
The newly bifurcated rule, detailing the requisite criteria for an
SBS Entity to form a reasonable basis to believe that ERISA and non-
ERISA special entities have qualified independent representatives, is
discussed in greater detail below.
b. Qualified Independent Representative
i. Proposed Rule
Proposed Rule 15Fh-5(a)(6) would require an SBS Entity to have a
reasonable basis to believe that, in the case of a special entity that
is an employee benefit plan subject to ERISA, the independent
representative was a ``fiduciary'' as defined in section 3(21) of that
Act (29 U.S.C. 1002).\883\ The proposed rule was not intended to limit,
restrict, or otherwise affect the fiduciary's duties and obligations
under ERISA.\884\
---------------------------------------------------------------------------
\883\ See Section 15F(h)(5)(A)(i)(VII) of the Exchange Act, 15
U.S.C. 78o-10(h)(5)(A)(i)(VII). See note 225, supra and related text
regarding an SBS Entity's reliance on a representation from the
special entity to form this reasonable basis.
\884\ See notes 99, 198 and 189, supra regarding the DOL's
proposal to amend definition of ``fiduciary'' for purposes of ERISA.
---------------------------------------------------------------------------
The Proposing Release solicited feedback regarding any specific
requirements that should be imposed on SBS Entities with respect to
this obligation, as well as what other independent representative
qualifications might be deemed satisfied if an independent
representative of an employee benefit plan subject to ERISA, is a
fiduciary as defined in section 3 of ERISA.
ii. Comments on the Proposed Rule
The Commission received six comment letters advocating a
presumption of qualification for ERISA plan fiduciaries, since ERISA
already imposes fiduciary duties upon the person who decides whether to
enter into a security-based swap on behalf of an ERISA plan, and
imposes on this person a statutory duty to act in the best interests of
the plan and its participants, thereby prohibiting certain self-dealing
transactions.\885\ According to these commenters, the Commission's
proposed standards would be unnecessary, redundant, would overlap with
ERISA's standards, and would only serve to increase the administrative
burden and cost on SBS Entities without any corresponding benefit.\886\
---------------------------------------------------------------------------
\885\ See ABA Committees, supra note 5; ABC, supra note 5;
BlackRock, supra note 5; Mason, supra note 5; SIFMA (August 2011),
supra note 5; SIFMA (August 2015), supra note 5.
\886\ See ABC, supra note 5; BlackRock, supra note 5; Mason,
supra note 5.
---------------------------------------------------------------------------
To address the potential conflict with ERISA standards, one
commenter suggested that the Commission's definition of ``independent
representative'' should be inapplicable to ERISA plans, and that the
Commission should merely cross-reference the requirements under ERISA
for ERISA representatives.\887\
---------------------------------------------------------------------------
\887\ See ABC, supra note 5.
---------------------------------------------------------------------------
Another commenter supported the presumptive qualification for ERISA
plan fiduciaries, provided that the plan satisfied a minimum $1 billion
net asset requirement for institutional investor organizations.\888\
The commenter asserted that no public policy objective would be
achieved by permitting an SBS Entity to reject a risk manager fiduciary
selected by a sophisticated institutional investor organization with
over $1 billion in net assets, which did not require the protections of
the rules.\889\
---------------------------------------------------------------------------
\888\ See ABA Committees, supra note 5.
\889\ Id.
---------------------------------------------------------------------------
Since the adoption of the CFTC's final rules, another commenter
recently advocated for the separate treatment of independent
representatives of special entities subject to ERISA.\890\ Under this
commenter's proposal, an SBS Entity that transacts with a special
entity subject to Title I of ERISA must have a reasonable belief that
the qualified independent representative is a fiduciary, as defined in
Section 3 of ERISA.\891\ An SBS Entity that transacts with a non-ERISA
special entity would be required to form a reasonable belief that the
special entity has a qualified independent representative, defined by
specific criteria. The commenter's proposed modification recognizes
``the unique fiduciary regime already applicable to such special
entities,'' and harmonizes the Commission's criteria for qualified
independent representatives with those of the CFTC.\892\
---------------------------------------------------------------------------
\890\ See SIFMA (August 2015), supra note 5.
\891\ Id.
\892\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After consideration of the comments, the Commission is
reformulating the rules to reflect a separate treatment for
transactions with special entities subject to ERISA, and transactions
with special entities other than those subject to ERISA. Toward this
end, we have bifurcated Rule 15Fh-5(a) into parts (a)(1) (applicable to
dealings with special entities other than those subject to ERISA), and
(a)(2) (applicable to dealings with special entities subject to ERISA).
Under Rule 15Fh-5(a)(1), as adopted, an SBS Entity that transacts
with a special entity that is not subject to ERISA must have a
reasonable basis to believe that the special entity has a qualified
independent representative. As defined in the rule, a qualified
independent representative is a representative who: Has sufficient
knowledge to evaluate the transaction and risks; is not subject to a
statutory disqualification; undertakes a duty to act in the best
interests of the special entity; makes appropriate and timely
disclosures to the special entity of material information concerning
the security-based swap; will provide written representations to the
special entity regarding fair pricing and the appropriateness of the
security-based swap; in the case of a special entity defined in 15Fh-
2(2) or (5), is subject to pay to play rules of the Commission, the
CFTC, or a SRO subject to the jurisdiction of the Commission or the
CFTC; and is independent of the SBS Entity. These qualifications are
addressed, separately, in Section II.H.7, infra.
Under new Rule 15Fh-5(a)(2), (formerly proposed Rule 15Fh-5(a)(6)),
an SBS Entity that transacts with a special entity subject to ERISA
must have a reasonable basis to believe that the special entity has a
representative that is a fiduciary, as defined in Section 3 of
ERISA.\893\ In this regard, the SBS Entity need not undertake further
inquiry into the ERISA fiduciary's qualifications. Such a presumption
is based on the pre-existing,
[[Page 30029]]
comprehensive federal regulatory regime governing ERISA
fiduciaries.\894\
---------------------------------------------------------------------------
\893\ 29 U.S.C. 1002.
\894\ See 29 U.S.C. 1001 et seq.; History of EBSA and ERISA,
available at http://www.dol.gov/ebsa/aboutebsa/history.html.
---------------------------------------------------------------------------
The Commission agrees with commenters that ERISA fiduciaries should
be presumptively deemed qualified as special entity
representatives,\895\ particularly because an ERISA fiduciary is
already required by statute and regulations to, among other things, act
with prudence and loyalty when evaluating a transaction for an ERISA
plan.\896\ Moreover, as several commenters noted, to overlap existing
ERISA standards with the business conduct standards would be
unnecessary, redundant, and would unnecessarily increase administrative
costs for SBS Entities.\897\
---------------------------------------------------------------------------
\895\ See ABA Committees, supra note 5; ABC, supra note 5;
BlackRock, supra note 5; Mason, supra note 5; SIFMA (August 2011),
supra note 5; SIFMA (August 2015), supra note 5.
\896\ See supra notes 786 and 799 and accompanying text.
\897\ See ABC, supra note 5; BlackRock, supra note 5; Mason,
supra note 5.
---------------------------------------------------------------------------
This bifurcated rule is designed to address the commenter's
concerns regarding the need to align the Commission's treatment of
ERISA plans with that of the CFTC,\898\ and will reflect the potential
intersection of the business conduct rules with the comprehensive
framework of regulation under ERISA. Specifically, as discussed above
in Section I.D., supra, the bifurcated format of the rule addresses the
concerns of numerous commenters that the intersection between ERISA's
existing fiduciary regulation and the business conduct standards could
lead to conflict and unintended consequences for SBS Entities
transacting with ERISA special entities, up to and including the
preclusion of ERISA plans from participating in security-based swap
markets in the future.\899\ By providing separate means for SBS
Entities to comply with the rules when transacting with ERISA and non-
ERISA special entities, the final rule will avoid the potential
conflict between the comprehensive framework of regulation under ERISA
and business conduct rule regimes.
---------------------------------------------------------------------------
\898\ See SIFMA (August 2015), supra note 5.
\899\ See, e.g., ABC, supra note 5; FIA/ISDA/SIFMA, supra note
5; IDC, supra note 5; MFA, supra note 5; BlackRock, supra note 5;
Johnson, supra note 5.
---------------------------------------------------------------------------
However, the Commission declines the commenter's suggestion to
exclude ERISA plans with a minimum net asset requirement from the
requirements of the rule.\900\ Rule 15Fh-5 is designed to ensure that
special entities are represented by a qualified independent
representative pursuant to the statutory requirement. The Commission
does not believe that it is appropriate in this context to provide an
exception to ERISA plans from the protections of representation by a
qualified and independent representative based on a net asset
threshold. Different entities will have differing levels of
understanding of the security-based swap market, which may or may not
be impacted by the amount of their net assets. More generally, the
rules are intended to provide certain protections to special entities,
and we think it appropriate to apply the rules so that special entities
receive the benefits of those rules.
---------------------------------------------------------------------------
\900\ See ABA Committees, supra note 5.
---------------------------------------------------------------------------
c. Definition of ``Independent Representative''
i. Proposed Rule
As noted above, an SBS Entity must have a reasonable basis to
believe that a special entity has a ``qualified independent
representative.'' Proposed Rule 15Fh-2(c) would establish parameters
for the term ``independent representative'' of a special entity.
For instance, proposed Rule 15Fh-2(c)(1) would generally require
that a representative of a special entity be ``independent'' of the SBS
Entity that is the counterparty to a proposed security-based swap.
Proposed Rule 15Fh-2(c)(2) would provide that a representative of a
special entity is ``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. In the
Proposing Release, the Commission noted that the SBS Entity should
obtain the necessary information to determine if, in fact, a
relationship existed between the SBS Entity and the independent
representative that could impair the independence of the representative
in making decisions that affect the SBS Entity.
Proposed Rule 15Fh-2(c)(3) would deem a representative of a special
entity to be independent of an SBS Entity where two conditions are
satisfied: (i) The representative is not and, within one year, was not
an associated person of the SBS Entity; and (ii) the representative had
not received more than ten percent of its gross revenues over the past
year, directly or indirectly, from the SBS Entity. This latter
restriction would apply, for example, with respect to revenues received
as a result of referrals by the SBS Entity. It was intended to
encompass situations where a representative was hired by the special
entity as a result of a recommendation by the SBS Entity. The
restriction would also apply to revenues received, directly or
indirectly, from associated persons of the SBS Entity.
In order for an SBS Entity to reasonably believe that the
independent representative received less than ten percent of its gross
revenue over the past year from the SBS Entity, the Commission noted
that the SBS Entity would likely need to obtain information regarding
the independent representative's gross revenues from either the special
entity or independent representative.
ii. Comments on the Proposed Rule Independence From the Special Entity
The Commission requested comment on whether an independent
representative must be independent of the special entity entering into
the security-based swap, or whether the representative need only be
independent of the SBS Entity. All five commenters agreed that the
independent representative need only be independent from the SBS
Entity, and emphasized that the intent of the proposed rule was to
ensure a special entity received advice from someone in no way
affiliated with an SBS Entity.\901\
---------------------------------------------------------------------------
\901\ See APPA, supra note 5; Ropes & Gray, supra note 5;
BlackRock, supra note 5; GFOA, supra note 5; ABA Committees, supra
note 5.
---------------------------------------------------------------------------
One commenter, representing two trade associations for municipal
power producers, argued that the intended benefit of the proposed
independent representative requirement was to ensure that a special
entity receives security-based swap advice from a person other than the
SBS Entity--not to force special entities to hire third-parties as
independent representatives.\902\ The commenter noted that although
many municipal power producers rely on third-party advisors when
entering interest-rate swaps, they have internal experts to advise them
on energy contracts.
---------------------------------------------------------------------------
\902\ See APPA, supra note 5.
---------------------------------------------------------------------------
Another commenter asserted that the legislative history for Dodd-
Frank indicated that a representative's ``independence'' referred to
its independence from the dealer or broker--not its independence from
the special entity.\903\ The commenter pointed out that Congress
specifically recognized the possibility that special entities would use
an in-house risk specialist, and that the proposed rules
[[Page 30030]]
seemed to incorporate this assumption.\904\
---------------------------------------------------------------------------
\903\ See ABA Committees, supra note 5.
\904\ Id.
---------------------------------------------------------------------------
Standards for ``Independence''
The Commission solicited comment regarding whether to adopt a
different test for a representative's independence, or whether the
definition of ``independent representative'' should exclude certain
categories of associated persons. Eleven comment letters addressed the
independence test in proposed Rule 15Fh-2(c)(2)-(3).\905\
---------------------------------------------------------------------------
\905\ See ABC, supra note 5; NABL, supra note 5; NAIPFA, supra
note 5; AFSCME, supra note 5; Better Markets (August 2011), supra
note 5; CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5; APPA, supra
note 5; BlackRock, supra note 5; SIFMA (August 2011), supra note 5;
SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
Four commenters argued that the proposed rule would not
sufficiently ensure a representative's independence.\906\ For instance,
one commenter suggested that the one-year prohibition on a
representative being an associated person of the SBS Entity be extended
to two years.\907\ This commenter also recommended that representatives
who receive any compensation of any kind, directly or indirectly, from
an SBS Entity during the prior year be disqualified.\908\ According to
this commenter, representatives and associated persons should be barred
from, directly or indirectly, working for or receiving compensation
from any SBS Entities for one year to act as an independent
representative for any special entity.\909\
---------------------------------------------------------------------------
\906\ See AFSCME, supra note 5; Better Markets (August 2011),
supra note 5; CFA, supra note 5; NAIPFA, supra note 5.
\907\ See Better Markets (August 2011), supra note 5.
\908\ Id.
\909\ Id.
---------------------------------------------------------------------------
Another commenter argued that under the proposed rule, a
representative might be deemed to be independent even if he or she
``worked with the SBS Entity as recently as a year ago, was recommended
by the SBS Entity, has a direct business relationship with the SBS
Entity that makes the representative highly financially dependent on
that entity, and earns more of its revenues from the SBS Entity than
from the Special Entity he or she purports to represent.'' \910\ This
commenter also noted that, under the proposed rule, a representative
could earn virtually all of its gross revenues from various SBS
Entities, so long as no more than ten percent originated from the
entity on the other side of the transaction. For these reasons, the
commenter urged the Commission to adopt instead the version of the
independence standard proposed by the CFTC, under which a
representative would be deemed to be independent if: ``(1) the
representative is not and, within one year, 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; and (3) the representative does not have a
material business relationship with the swap dealer or major swap
participant, provided however, that if the representative received any
compensation from the swap dealer or major swap participant, the swap
dealer or major swap participant must ensure that the Special Entity is
informed of the compensation and the Special Entity agrees in writing,
in consultation with the representative, that the compensation does not
constitute a material business relationship.'' \911\
---------------------------------------------------------------------------
\910\ See CFA, supra note 5.
\911\ See Business Conduct Standards for Swap Dealers and Major
Swap Participants With Counterparties, 75 FR 80638, 80660 (Dec. 22,
2010) (``CFTC Proposing Release'').
---------------------------------------------------------------------------
Similarly, since the adoption of the CFTC's final business conduct
rules, one commenter has argued that the Commission should harmonize
its standards of independence with those of the CFTC, replacing the
SEC's restriction on revenues received by the independent
representative from the SBS Entity with the following qualifications:
(1) The representative is not, and within one year of representing the
special entity in connection with the security-based swap, was not an
associated person of the SBS Entity; (2) there is no principal
relationship between the special entity's representative and the SBS
Entity; (3) the representative provides timely and effective
disclosures to the special entity of all material conflicts of
interest, complies with policies and procedures designed to mitigate
conflicts of interest, is not directly or indirectly controlled by the
SBS Entity, and does not receive referrals, recommendations, or
introductions from the SBS Entity within one year of representing the
special entity in connection with the security-based swap.\912\ As the
commenter asserted, ``the CFTC's standard has, in our members'
experiences, proved sufficient to ensure the independence of special
entity representatives and mitigate possible conflicts of interest,
while also establishing an objective standard that special entities can
apply in practice. As a result, we believe harmonization would achieve
the proposed rules' intended objective while also minimizing the extent
to which SBS Entities and special entities need to incur significant
additional costs.'' \913\
---------------------------------------------------------------------------
\912\ See SIFMA (August 2015), supra note 5.
\913\ Id.
---------------------------------------------------------------------------
A third commenter suggested that the Commission revise the
independence test for special entity representatives by: (1) Using
ERISA standards in assessing the independence of a representative (but
rejecting the DOL's fiduciary standard, under which a fiduciary may not
derive more than 1% of its annual income from a party in interest and
its affiliates); (2) considering a representative's relationships with
an SBS Entity on behalf of multiple special entities, including the
representative's relationships with an SBS Entity outside of the
security-based swap transaction at issue; (3) including the revenues of
an independent representative's affiliates in applying the gross
revenues test; (4) decreasing the ten-percent gross revenue threshold;
and (5) adopting a two-year timeframe (rather than one year) to
determine whether a representative is independent of the SBS
Entity.\914\ The commenter argued that an independent representative
should be permitted to receive compensation from the proceeds of a
security-based swap, so long as the compensation was authorized by, and
paid at the written direction of, the special entity.\915\ However, the
commenter did not believe that a special entity should be allowed to
consent to an independent representative's conflicts of interest, even
if fully disclosed, as such conflicts might still affect the
independence of the representative.\916\
---------------------------------------------------------------------------
\914\ See NAIPFA, supra note 5.
\915\ Id.
\916\ Id. Nor did the commenter believe that an SBS Entity
should be required to have a reasonable basis to believe that the
representative would make the appropriate and timely disclosures of
any potential conflicts of interest.
---------------------------------------------------------------------------
The sole commenter that supported the independence test as proposed
did so on the grounds that market participants would benefit from the
certainty of its safe harbor.\917\
---------------------------------------------------------------------------
\917\ See NABL, supra note 5.
---------------------------------------------------------------------------
Another commenter argued that the proposed rules' definition of
``independent representative'' should not apply to ERISA plans, as
ERISA already defines the criteria for ``independence'' of a
representative.\918\ According to this commenter, if a plan's
representative is not independent of the plan's counterparty, the
transaction violates the prohibited transaction rules under ERISA
section 406(b). Rather than
[[Page 30031]]
adopt such overlapping regulations, the commenter suggested cross-
referencing the independence requirements under ERISA. Otherwise, the
prohibition on investment managers who receive revenues from SBS
Dealers from serving as independent representatives could cause plans
to lose their best investment managers and counterparties. Moreover,
the commenter argued that ``the administrative burden of applying the
gross revenue test could in many cases be enormous at best and simply
unworkable at worst.'' \919\
---------------------------------------------------------------------------
\918\ See ABC, supra note 5.
\919\ Id.
---------------------------------------------------------------------------
However, the majority of commenters urged the Commission to modify
the proposed independence standards. For instance, while one commenter
supported the Commission's one-year prohibition on associated persons
of SBS Entities serving as special entity representatives, the
commenter suggested four changes to the gross revenues component of the
proposed rule: (1) Only payments by or on behalf of the SBS Entity (not
by or on behalf of any affiliates or other associated persons) should
be taken into account; (2) the revenue computations should be based on
the representative's prior fiscal year rather than a rolling twelve-
month look-back to simplify the calculations and reduce compliance
costs; (3) payments to any affiliate (other than a wholly-owned
subsidiary) of the representative should not be taken into account for
purposes of this test; and (4) an SBS Entity should be able to rely on
representations from the representative as to its gross revenues and
whether payments that have been made to the representative equal or
exceed the ten percent threshold.\920\
---------------------------------------------------------------------------
\920\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
Another commenter proposed reducing the one year disqualification
period for association with the SBS Entity to six months.\921\ This
commenter also suggested excluding from the gross revenue test: (1)
Income from referrals from the gross revenue test, because referrals
``can be difficult to track;'' and (2) income paid by an SBS Entity on
behalf of the special entity.\922\
---------------------------------------------------------------------------
\921\ See APPA, supra note 5.
\922\ Id.
---------------------------------------------------------------------------
A third commenter generally opposed the proposed rule on the basis
that it was unclear, would require costly enhancements to compliance
systems, and ``would be particularly problematic in instances where a
corporate transaction changes the identity of associated persons during
the look-back year.'' \923\ With respect to the first prong of the
proposed rule, this commenter supported eliminating the one-year look
back period, as it believed the costs of compliance with that provision
would outweigh any benefits. Instead, the commenter argued that
``independence'' should be established if the representative is not an
associated person of an SBS Entity at the time of the transaction.\924\
With respect to the gross revenue test, the commenter argued that the
term ``indirect compensation'' was vague, and that ``determining what
would comprise indirect compensation and establishing a compliance
system to track that indirect compensation represents a significant and
time consuming burden,'' the expense of which would likely be passed on
to special entities.\925\ The commenter therefore suggested limiting
the gross revenue test to direct revenue received by the representative
from the SBS Dealer--and not its affiliates.\926\
---------------------------------------------------------------------------
\923\ See BlackRock, supra note 5.
\924\ Id.
\925\ Id.
\926\ Id.
---------------------------------------------------------------------------
A fourth commenter objected to the compliance burdens raised by the
proposed rule, as well as various implementation concerns on the
grounds that both prongs of the test were ``moving targets'' that would
substantially complicate compliance and impose additional burdens and
costs on advisors and special entities.\927\ The commenter recommended
that the Commission eliminate the twelve-month ``look-back'' provision
altogether, but argued that if the Commission retained this provision,
it should apply only where a continuing agreement exists between the
representative and the SBS Entity (such as an ongoing corporate
services agreement), that the one-year period be defined as a calendar
year rather than a rolling twelve-month period, and that it should only
be triggered by the SBS Entity and the representative--not by any
associated persons of the SBS Entity or the representative.\928\ This
commenter additionally urged the Commission to eliminate the gross
revenue test on the grounds that it was unduly restrictive and
difficult to apply. However, if the Commission retained the gross
revenue test, the commenter requested that the final rule clarify how
gross revenues are to be calculated.\929\
---------------------------------------------------------------------------
\927\ See SIFMA (August 2011), supra note 5.
\928\ Id.
\929\ Id.
---------------------------------------------------------------------------
Another commenter argued that the final version of proposed Rule
15Fh-2(c) clarify that the ten percent gross revenue test would not
apply to any independent representative employed by the special entity,
as such a prohibition would be inappropriate.\930\ The commenter also
suggested that the prohibition on independent representatives who have
worked for an SBS Entity within the past year should not apply if the
independent representative is an employee of the special entity, who
owes the special entity a fiduciary duty.\931\ The commenter asserted
that if an independent representative is an employee of and owes a
fiduciary duty to an institutional investor organization, an SBS Entity
should have no authority to assess the representative's qualifications.
The commenter pointed out that, as a fiduciary, the employee's prior
employment by an SBS Entity would be irrelevant--since any actual
breach of fiduciary duty would be governed by the special entity's
charter, state law or other applicable legal requirements, rather than
the Dodd-Frank Act.\932\
---------------------------------------------------------------------------
\930\ See ABA Committees, supra note 5.
\931\ Id.
\932\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After consideration of the comments, the Commission is adopting
Rule 15Fh-2(c), with certain modifications. First, we moved the rule
defining the ``independence'' of a special entity's representative from
Rule 15Fh-2 to Rule 15Fh-5 in an effort to minimize confusion, and to
consolidate the requirements of the qualified independent
representative into Rule 15Fh-5. Specifically, the Commission is
renumbering proposed Rule 15Fh-2(c) as Rule 15Fh-5(a)(1)(vii). In doing
so, we have subsumed the requirement that a representative be
independent of the SBS Entity under the criteria for a special entity's
qualified independent representative.
Consistent with our proposal and with comments received, we
continue to believe that a qualified independent representative should
be independent of the SBS Entity, but need not be independent of the
special entity itself.\933\ We do not believe that special entities
would receive any greater protection by being required to incur the
cost of retaining a representative that was independent of the special
entity; in fact, the special entity may be better served by someone who
has an ongoing relationship with it and is more familiar with the uses
of the proceeds of the swap and other needs of the special entity.
Although the Dodd-Frank Act is
[[Page 30032]]
silent concerning the question of independence from the special entity,
nothing in the Dodd-Frank Act precludes the use of a qualified
independent representative that is affiliated with the special entity.
Accordingly, Rule 15Fh-5(a)(1) only requires that the independent
representative be independent of the SBS Entity to be a qualified
independent representative.
---------------------------------------------------------------------------
\933\ See Proposing Release, 76 FR at 42426, supra note 3. See
also APPA; Ropes & Gray, supra note 5; and BlackRock, supra note 5.
---------------------------------------------------------------------------
We are adopting Rule 15Fh-5(a)(1)(vii) (formerly proposed Rules
15Fh-2(c)(1) and (2)) with one modification. Proposed Rule 15Fh-2(c)(1)
defined an independent representative of a special entity, in part, as
``independent of the security-based swap dealer or major security-based
swap participant that is the counterparty to a proposed security-based
swap.'' Rule 15Fh-5(a)(1)(vii) as adopted eliminates the phrase ``that
is the counterparty to a proposed security-based swap'' from the
definition. As described immediately below, this change is intended to
reconcile the use of the term ``qualified independent representative''
in Rules 15Fh-5(a)(1) and 15Fh-2(a)(2) as adopted.
Specifically, Rule 15Fh-2(a)(2) as proposed and as adopted, under
which an SBS Dealer may seek to establish that it is not acting as an
advisor to a special entity, refers to the definition of ``qualified
independent representative'' as defined in Rule 15Fh-5(a).\934\
However, although the relevant part of the definition of the term
``independent representative of a special entity'' in proposed Rule
15Fh-2(c)(1) included the phrase ``that is a counterparty to a proposed
security-based swap,'' the requirements in Rule 15Fh-2(a)(2) (as
proposed and as adopted) are not limited to transactions in which the
SBS Dealer is a counterparty to the special entity with respect to the
security-based swap. Thus, as noted, we are eliminating the phrase
``that is the counterparty to a proposed security-based swap'' in Rule
15Fh-5(a)(1)(vii) as adopted to reconcile the cross reference to the
term ``qualified independent representative'' in Rule 15Fh-2(a)(2).
---------------------------------------------------------------------------
\934\ Specifically, Rule 15Fh-2(a)(2) requires, among other
things, a written representation by the special entity that it
``will rely on advice from a qualified independent representative as
defined in [Rule] 15Fh-5(a)'' (emphasis added).
---------------------------------------------------------------------------
This change will not alter the scope of Rule 15Fh-5(a) as adopted,
because that rule is only applicable to an SBS Entity acting as
counterparty to a special entity. It will, however, align the
definition of qualified independent representative with the scope of
Rule 15Fh-2(a), which applies to recommended transactions whether or
not the SBS Dealer is a counterparty to the recommended security-based
swap. As a result, there must always be someone independent of the SBS
Dealer reviewing any recommended security-based swap transaction on
behalf of the special entity, whether or not the SBS Dealer making the
recommendation is the counterparty to the transaction. Furthermore, the
elimination of the phrase ``that is the counterparty to a proposed
security-based swap'' in the rule as adopted will harmonize the rule
more closely with the parallel CFTC requirement.
Under Rule 15Fh-5(a)(1)(vii)(A) as adopted, a representative of a
special entity is 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.'' Rule 15Fh-
5(a)(1)(vii)(B) (as adopted) modifies the criteria for determining the
independence of the representative that was proposed in proposed Rule
15Fh-2(c)(3) by replacing the ten percent gross revenues test with
requirements for timely disclosures of all material conflicts of
interest and a prohibition against referrals, recommendations or
introductions by the SBS Entity within one year of the representative's
representation of the special entity. Under Rule 15Fh-5(a)(1)(vii)(B)
as adopted, a representative of a special entity will be deemed to be
independent of an SBS Entity if three conditions are met: (1) The
representative is not and, within one year of representing the special
entity in connection with the security-based swap, was not an
associated person of the SBS Entity; (2) the representative provides
timely 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 complies with policies and procedures reasonably designed to
manage and mitigate such material conflicts of interest; and (3) the
SBS Entity 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 security-
based swap.
Rule 15Fh-5(a)(1)(vii)(B)(1) (formerly proposed Rule 15Fh-2(c)(2))
requires that the independent representative is not and was not an
associated person of the SBS Entity ``within one year of representing
the special entity in connection with the security-based swap.'' One
commenter agreed with the one-year time frame in this provision.\935\
One commenter suggested that one year was not long enough and suggested
a two-year look back \936\ and another commenter suggested that one
year was too long and suggested a six-month look back.\937\ After
consideration of the comments, the Commission continues to believe that
an appropriate amount of time is necessary to ``cool off'' any
association with an SBS Entity before being considered independent of
the SBS Entity, and believes that a one-year period between being an
associated person of an SBS Entity and functioning as an independent
representative is an appropriate amount of time. We disagree with the
commenter that a shorter six-month look back would be appropriate, as
we believe that a one-year cooling off period provides greater
assurances of independence. At the same time, we do not want to
unnecessarily place lengthy restrictions on a representative's ability
to work as an independent representative or unnecessarily restrict a
special entity's access to qualified independent representatives. For
this reason, we believe that a one year restriction strikes an
appropriate balance. In addition to the comments received, we note that
many market participants have established compliance policies and
procedures to address a one-year look-back to comply with the CFTC rule
that requires that the independent representative was not an associated
person of the Swap Entity within the preceding twelve months or the
independent representative complied with policies and procedures
reasonably designed to manage and mitigate the conflict of being an
associated person within the last twelve months.\938\
---------------------------------------------------------------------------
\935\ See FIA/ISDA/SIFMA, supra note 5.
\936\ See CFA, supra note 5.
\937\ See APPA, supra note 5.
\938\ See CFTC Adopting Release, 77 FR at 9795, supra note 21.
---------------------------------------------------------------------------
Rule 15Fh-5(a)(1)(vii)(B)(2) adds the new requirement that a
representative must provide timely disclosures to the special entity of
all material conflicts of interest that could reasonably affect the
judgment or decision making of the representative regarding its
obligations to the special entity, and the representative must comply
with policies and procedures reasonably designed to manage and mitigate
such material conflicts of interest. This requirement establishes a
standard that is designed to support the development of an SBS Entity's
reasonable belief regarding the independence of the representative
advising a special entity. One commenter recommended adopting
[[Page 30033]]
such a requirement, asserting that the CFTC standard, including the
requirement for timely disclosures has, in their ``members' experiences
proved sufficient to ensure the independence of special entity
representatives and mitigate possible conflicts of interest, while also
establishing an objective standard that special entities can apply in
practice.'' \939\ In addition, harmonization with the parallel CFTC
rule will result in efficiencies for SBS Entities that have already
established infrastructure to comply with the CFTC rule.
---------------------------------------------------------------------------
\939\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
In the Commission's view, to be ``timely,'' a representative's
disclosures must allow the special entity sufficient opportunity to
assess the likelihood or magnitude of a conflict of interest prior to
entering into the security-based swap.
To determine which conflicts of interest disclosures are required,
an SBS Entity generally would need a reasonable basis to believe that
the representative reviewed its relationships with the SBS Entity and
its affiliates, including lines of business in which the representative
solicits business. Additionally, where applicable, the SBS Entity
generally would also need a reasonable basis to believe the
representative reviewed the relationships of its principals and
employees, who could affect the judgment or decision making of the
representative on behalf of the special entity.
Lastly, Rule 15Fh-5(a)(1)(vii)(B)(3) replaces the proposed ``gross
revenues'' test with a standard under which a representative will not
be deemed independent if the SBS Entity 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 security-based swap. The change is intended to provide a
simpler standard for achieving the policy goal that a special entity's
choice of representative and the advice the representative provides
should be made without any influence or input from the SBS Entity.
In making this modification to the rule as adopted, the Commission
seeks to address commenters' concerns about cost, clarity, and
practicality.\940\ Commenters had expressed concerns regarding the
gross revenues test and an SBS Entity's ability to accurately track the
revenues.\941\ One commenter suggested eliminating the gross revenues
standard altogether.\942\ After consideration of the comments, the
Commission believes that the disclosures provided and the prohibition
against referrals, recommendations or introductions adequately
addresses concerns regarding independence more simply and directly than
the proposed ``gross revenues'' test.\943\ Furthermore, this
prohibition harmonizes the Commission's standards for the independence
of the representative with those of the CFTC.
---------------------------------------------------------------------------
\940\ See SIFMA (August 2011), supra note 5; FIA/ISDA/SIFMA,
supra note 5; APPA, supra note 5; BlackRock, supra note 5; and SIFMA
(August 2015), supra note 5.
\941\ See SIFMA (August 2011), supra note 5 (expressing concerns
about calculating a rolling twelve months of revenues and arguing
that the ten percent threshold would create a revenue ceiling that
is unduly restrictive and difficult to apply (e.g., a representative
to multiple collective investment vehicles would be required to
consider each of its multiple distributors for each collective
investment vehicle as a source of indirect revenue)); FIA/ISDA/
SIFMA, supra note 5 (arguing for clarification that (1) payments to
or from affiliates of the SBS Entity or representative would not be
taken into account; (2) revenue computations should be determined as
of the end of the prior fiscal year; and (3) the SBS Entity may rely
on representations from the representative as to its gross revenues
and whether payments equal or exceed the ten percent threshold);
APPA, supra note 5 (suggesting (1) elimination of income from
referrals from the gross revenue test because referrals are
difficult to track; and (2) gross revenues test should not take into
account income paid by an SBS Entity on behalf of the special
entity); BlackRock, supra note 5 (expressing concerns regarding what
would comprise ``indirect compensation'' and the compliance systems
to track it and arguing that revenue received from affiliates of the
SBS Dealer should not be considered); and SIFMA (August 2015), supra
note 5 (arguing for the replacement of the gross revenues test with
the CFTC standard).
\942\ See SIFMA (August 2011), supra note 5; and SIFMA (August
2015), supra note 5.
\943\ Although the independence safe harbor under Rule 15Fh-
5(a)(vii)(B) does not include a gross revenues test, SBS Entities
should consider whether the sources of revenues of a representative
create a conflict of interest that must be disclosed pursuant to
Rule 15Fh-5(a)(vii)(B)(2) or 15Fh-5(b) or otherwise impede the
independence of the representative. Depending on the facts and
circumstances, failure to disclose material conflicts of interest
when there is a recommendation by a broker-dealer can be a violation
of the antifraud rules. See, e.g., Chasins, 438 F.2d at 1172.
---------------------------------------------------------------------------
6. Qualifications of the Independent Representative
Proposed Rules 15Fh-5(a)(1)(i)-(vii) would list the required
qualifications of a special entity's independent representative. The
qualifications would be that the independent representative: (1) Has
sufficient knowledge to evaluate a security-based swap and its risks;
(2) is not subject to statutory disqualification; (3) will undertake a
duty to act in the best interests of the special entity; (4) makes
appropriate and timely disclosures to the special entity of material
information concerning the security-based swap; (5) will provide
written representations to the special entity regarding fair pricing
and the appropriateness of the security-based swap; (6) (in the case of
employee benefit plans subject to ERISA) is a fiduciary as defined in
ERISA; and (7) is subject to the pay to play prohibitions of the
Commission, the CFTC, or an SRO that is subject to the jurisdiction of
the Commission or the CFTC. Each of these proposed qualifications is
discussed in turn below.
As discussed above in Section II.H.5.a.iii.B and more fully below,
the rules as adopted will distinguish between transactions with special
entities subject to ERISA, and transactions with special entities other
than those subject to ERISA. Specifically, Rule 15Fh-5(a)(1) as adopted
addresses the qualifications for the independent representatives of
special entities other than those subject to regulation under ERISA,
and Rule 15Fh-5(a)(2) as adopted addresses the qualifications for
independent representatives of special entities subject to regulation
under ERISA.
a. Written or Other Representations Regarding Qualifications
i. Proposal
In the Proposing Release, the Commission also requested comment
regarding whether independent representatives must furnish written
representations about their qualifications, or whether the rules should
permit other means of establishing that a special entity's independent
representative possessed the requisite qualifications.
ii. Comments on the Proposal
The Commission received three comment letters on this point, all in
favor of a written representation requirement.\944\ Although one such
commenter agreed that written representations should be sufficient to
ensure that a qualified independent swap advisor had been hired, the
commenter proposed that the written representations include a
verification that the external swap advisor had registered with and met
professional standards set by the appropriate regulatory body
overseeing swap advisors.\945\ According to the commenter, this would
provide for independent verification that was not associated with the
SBS Dealer or the
[[Page 30034]]
special entity, thereby minimizing any potential conflict of
interests.\946\
---------------------------------------------------------------------------
\944\ See NAIPFA, supra note 5; GFOA, supra note 5; APPA, supra
note 5.
\945\ See GFOA, supra note 5.
\946\ Id.
---------------------------------------------------------------------------
Another commenter suggested that, in the case of an internal
representative, written representations should be obtained either from
the representative or from the special entity, or a combination of the
two, depending on the circumstances.\947\ In the case of third-party
representatives, the commenter suggested that the third-party
representative provide the statement either directly to the SBS Entity
or to the special entity acknowledging that the statement would be
relied on by SBS Entities for purposes of the business conduct
rules.\948\
---------------------------------------------------------------------------
\947\ See APPA, supra note 5.
\948\ Id. See also SIFMA (August 2015), supra note 5 (asserting
that an SBS Entity should be deemed to have formed a reasonable
basis to believe that a special entity has a qualified independent
representative by relying on written representations that the
representative is either an ERISA fiduciary, or that the
representative satisfies the criteria for a qualified independent
representative).
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
After considering the comments, the Commission has determined not
to mandate a manner of compliance with the requirements of Rule 15Fh-
5(a). As discussed above, the obligation is on the SBS Entity to have a
reasonable basis for believing that an independent representative has
the necessary qualifications. An SBS Entity may use various means, such
as reliance on representations from the special entity or its
representative or due diligence, to form its reasonable basis to
believe the special entity's independent representative meets the
qualifications outlined in Rule 15Fh-5(a).
When an SBS Entity is relying on representations from a special
entity or its representative to satisfy the requirements of the rule,
the requirements of Rule 15Fh-1(b) will apply.\949\ Consistent with our
approach to representations used to make institutional suitability
determinations, we believe that parties should be able to make
representations regarding the knowledge and qualifications of the
independent representative on a transaction-by-transaction basis, on an
asset-class-by-asset-class basis, or broadly in terms of all potential
transactions between the parties. However, where there is an indication
that the independent representative is not capable of independently
evaluating investment risks, or does not intend to exercise independent
judgment regarding all of an SBS Entity's recommendations, the SBS
Entity necessarily will have to be more specific in its approach. For
instance, in some cases, an SBS Entity may be unable to determine that
an independent representative is capable of independently evaluating
investment risks with respect to any security-based swap. In other
cases, the SBS Entity may determine that the independent representative
is generally capable of evaluating investment risks with respect to
some categories or types of security-based swaps, but that the
independent representative may not be able to understand a particular
type of security-based swap or its risk.
---------------------------------------------------------------------------
\949\ See discussion in Section II.D, supra.
---------------------------------------------------------------------------
b. Sufficient Knowledge To Evaluate Transaction and Risks
i. Proposed Rule
Proposed Rule 15Fh-5(a)(1) would require an SBS Entity to have a
reasonable basis to believe that the independent representative has
sufficient knowledge to evaluate the security-based transaction and
related risks.
ii. Comments on the Proposed Rule
The Proposing Release solicited comment regarding what
circumstances, if any, would give rise to a presumption of
qualification for certain independent representatives other than ERISA
fiduciaries.
Presumptive Qualification
Two commenters supported a finding of presumptive qualification for
sophisticated, professional advisers, such as banks, Commission-
registered investment advisers, registered municipal advisors, or other
similarly qualified professionals.\950\ The commenter stated its view
that applicable federal and/or state regulations governing these
entities already impose requirements that ensure a minimum
qualification level, and any additional evaluation of such
representatives' qualifications would add little or no value to a
special entity's representative selection process.\951\
---------------------------------------------------------------------------
\950\ See ABC, supra note 5; SIFMA (August 2011), supra note 5.
\951\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
Other commenters supported the presumption of qualification for in-
house representatives of a special entity, since those representatives
should presumably act in the best interests of the special entity by
virtue of their employment with the special entity.\952\ More
specifically, one commenter supported this presumption on the grounds
that the representative had been hired by the special entity to perform
a hedging and risk control function, that he or she would be subject to
direct control by his or her employer, and that he or she would be
subject to regular review.\953\ Another commenter supported this
presumption so long as the in-house representative met established
requirements for qualification, testing and continuing education.\954\
---------------------------------------------------------------------------
\952\ See ABA Committees, supra note 5; NAIPFA, supra note 5;
CalPERS, supra note 5; Ropes & Gray, supra note 5; APPA, supra note
5; GFOA, supra note 5.
\953\ See APPA, supra note 5.
\954\ See NAIPFA, supra note 5. NAIPFA did not support a
presumption of qualification for ``a sophisticated, professional
adviser such as a bank, Commission-registered investment adviser,
insurance company or other qualifying QPAM or INHAM for Special
Entities subject to ERISA, a registered municipal advisor, or a
similar qualified professional.''
---------------------------------------------------------------------------
Similarly, one commenter supported the presumption of qualification
for independent representatives where a governmental entity had
verified the qualifications of its independent representative employee
through the hiring process.\955\
---------------------------------------------------------------------------
\955\ See GFOA, supra note 5.
---------------------------------------------------------------------------
Registration of Representative as Municipal Advisor or Investment
Adviser
In the Proposing Release, the Commission asked whether to require
that an independent representative be registered as a municipal advisor
or an investment adviser or otherwise subject to regulation, such as
banking regulation.\956\ Three commenters expressed some support for
the proposed registration requirement for independent
representatives,\957\ while one commenter opposed it.\958\
---------------------------------------------------------------------------
\956\ See Proposing Release, 76 FR at 42429, supra note 3. Such
registration would subject independent representatives to rules such
as MSRB rules (for example, Notice 2011-04 Pay to Play Rules for
Municipal Advisors) or other regulation (for example, 17 CFR
275.206(4)-5). See also Proposing Release, 76 FR at 42431 n.245-247,
supra note 3.
\957\ See NAIPFA, supra note 5; GFOA, supra note 5; FIA/ISDA/
SIFMA, supra note 5.
\958\ See APPA, supra note 5.
---------------------------------------------------------------------------
The first commenter supporting the registration requirement
suggested that the written representations regarding a representative's
qualifications include a verification that the external swap advisor
had registered with and met professional standards set by the
appropriate regulatory body overseeing swap advisors.\959\
---------------------------------------------------------------------------
\959\ See GFOA, supra note 5.
---------------------------------------------------------------------------
Another commenter supported the requirement that independent
representatives be registered with the Commission as municipal advisors
or
[[Page 30035]]
investment advisers, or that they otherwise be subject to regulation,
such as banking regulations, under which the independent representative
would be bound by a fiduciary duty of loyalty and care at all
times.\960\
---------------------------------------------------------------------------
\960\ See NAIPFA, supra note 5.
---------------------------------------------------------------------------
The third commenter requested that the Commission establish a safe
harbor permitting an SBS Entity to conclude that the special entity's
representative was ``qualified'' (but not necessarily ``independent'')
if the representative was a registered municipal advisor or an SEC-
registered investment adviser that provides investment advice with
respect to security-based swaps (or a foreign entity having an
equivalent status abroad).\961\
---------------------------------------------------------------------------
\961\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
As noted above, one commenter opposed requiring employees of a
special entity to register in any capacity, and suggested that any
requirement to register third-party representatives should first be
issued in the form of a notice of proposed rulemaking.\962\
---------------------------------------------------------------------------
\962\ See APPA, supra note 5.
---------------------------------------------------------------------------
Proficiency Examination
In the Proposing Release, the Commission requested comment
regarding whether a proficiency examination should be developed to
assess the qualifications of independent representatives. Four
commenters supported the development and usage of a proficiency
examination,\963\ while one commenter opposed any proficiency
examination for in-house representatives.\964\
---------------------------------------------------------------------------
\963\ See CFA, supra note 5; CalPERS (August 2011), supra note
5; GFOA, supra note 5; NAIPFA, supra note 5.
\964\ See APPA, supra note 5.
---------------------------------------------------------------------------
One commenter, advocating for a proficiency examination, argued
that such testing should be mandatory for both in-house and third-party
representatives.\965\ Another commenter suggested that the proficiency
examination could be developed by the Commission, an SRO (e.g., FINRA),
or another recognized testing organization.\966\ Furthermore, after
passing the examination, this commenter suggested that an independent
representative be required to complete periodic continuing
education.\967\
---------------------------------------------------------------------------
\965\ See NAIPFA, supra note 5.
\966\ See CalPERS (August 2011), supra note 5.
\967\ Id.
---------------------------------------------------------------------------
On the other hand, one commenter opposed any proficiency
examination for in-house representatives, and argued that a proficiency
exam for third-party representatives might provide a false sense of
expertise.\968\ This commenter also expressed concern that an
examination requirement might, directly or indirectly, impose
additional costs or burdens on special entities or SBS Entities.\969\
---------------------------------------------------------------------------
\968\ See APPA, supra note 5.
\969\ Id.
---------------------------------------------------------------------------
Periodic Re-Evaluation of Qualifications
In the Proposing Release, the Commission asked whether an SBS
Entity should be required to reevaluate (or, as applicable, require a
new written representation regarding) the qualifications of the
independent representative on a periodic basis.
The Commission received three comment letters in response to the
request for comment.\970\ The first commenter viewed the reevaluation
of a representative's qualifications as unnecessary if independent
representatives were subject to continuing education and periodic
testing requirements.\971\ Another commenter suggested that the
Commission permit the representations regarding a representative's
qualifications to be set forth in a letter that could be relied on for
the duration of a swap master agreement.\972\ However, this commenter
acknowledged a value in requiring periodic re-certification for third-
party representatives, and recommended that such re-certification occur
every two years.\973\ The third commenter was concerned that trade-by-
trade documentation of the independent representative criteria could
reduce the speed of trade execution for special entities and add
compliance burdens to each transaction.\974\ This commenter requested
that the Commission clarify that an SBS Dealer may meet its burden of
confirming the qualifications of an independent representative through
appropriate representations provided by the special entity no more
frequently than annually.\975\
---------------------------------------------------------------------------
\970\ See NAIPFA, supra note 5; APPA, supra note 5; Ropes &
Gray, supra note 5.
\971\ See NAIPFA, supra note 5.
\972\ See APPA, supra note 5.
\973\ Id.
\974\ See Ropes & Gray, supra note 5.
\975\ Id.
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iii. Response to Comments and Final Rule
Upon consideration of the comments, the Commission is adopting Rule
15Fh-5(a)(1)(i) (formerly proposed Rule 15Fh-5(a)(1)), as proposed.
Rule 15Fh-5(a)(1)(i) as adopted requires that SBS Entities have a
reasonable basis to believe that the independent representative has
sufficient knowledge to evaluate the transaction and risks. The
independent representative may be required to register by the statutes
and rules of another regulatory regime, such as municipal advisor or
investment adviser, and nothing in the business conduct standards
modifies or otherwise alters those registration requirements. Whether
or not an independent representative is otherwise registered under a
different regulatory regime may inform the SBS Entity's view of the
independent representative's knowledge and qualifications, but would
not automatically satisfy the qualification requirements of the
independent representative. For example, an independent representative
registered as an investment adviser may be very knowledgeable with
respect to a variety of asset classes that do not include security-
based swaps.
While some commenters supported the development of a proficiency
examination, we are neither developing nor requiring that a proficiency
examination be developed to assess the qualifications of independent
representatives.\976\ As noted above, an SBS Entity may reasonably rely
on written representations about the qualifications of the independent
representative to satisfy this obligation. In this regard, the
Commission believes that the framework of Rule 15Fh-5(a)(1) provides an
appropriate criteria for assessing the qualifications of special entity
representatives.\977\
---------------------------------------------------------------------------
\976\ See CFA, supra note 5; CalPERS (August 2011), supra note
5; GFOA, supra note 5; NAIPFA, supra note 5.
\977\ However, as noted above in Section II.H.5., supra, to the
extent a proficiency examination or certification process develops
in the future, such examination or certification may inform an SBS
Entity's reasonable basis to believe the qualifications of the
independent representative.
---------------------------------------------------------------------------
As discussed below, we are separately providing in new Rule 15Fh-
5(a)(2) that the qualified independent representative requirement will
be satisfied if a special entity that is subject to regulation under
ERISA has a representative that is a fiduciary as defined in Section 3
of ERISA. We recognize that Congress has established a comprehensive
federal regulatory framework that applies to plans subject to
regulation under ERISA.\978\ Such recognition of the federal regulatory
framework for ERISA plans maintains statutory protections for ERISA
plans, while addressing the potential conflict, recognized by
commenters, between the
[[Page 30036]]
ERISA rules and business conduct standards adopted today.\979\
---------------------------------------------------------------------------
\978\ See 29 U.S.C. 1104 and 1106.
\979\ See Section I.D. supra; see also CFTC Adopting Release,
supra note 21.
---------------------------------------------------------------------------
Commenters have suggested various time frames in which an
independent representative's qualifications should be confirmed or
recertified.\980\ Whether or not an independent representative's
qualifications should be periodically re-evaluated will likely be
dependent on whether it is reasonable for the SBS Entity to continue to
rely on the representations regarding the independent representative's
qualifications. The Commission recognizes the potential benefit of
requiring periodic re-evaluation, but is also mindful of the costs of
doing so. The Commission has determined that it is appropriate to allow
the SBS Entity to determine the necessity for a re-evaluation based on
the reasonableness of its reliance on the representations it receives
from the special entity regarding the qualifications of the independent
representatives, which will provide the SBS Entities and the special
entities with flexibility to address their particular facts and
circumstances while still affording the special entities the
protections of the rules.\981\
---------------------------------------------------------------------------
\980\ See Ropes & Gray, supra note 5 (no more frequently than
annually); and APPA, supra note 5 (recertified every two years).
\981\ As discussed above in Section II.D, the question of
whether reliance on representations would satisfy an SBS Entity's
obligations under our business conduct rules will depend on the
facts and circumstances of the particular matter. An SBS Entity can
rely on a counterparty's written representations unless the SBS
Entity has information that would cause a reasonable person to
question the accuracy of the representation. Similar to our approach
to the reasonableness of reliance of representations with respect to
institutional suitability in Section II.G.4, information that might
be relevant to this determination includes whether the independent
representative has previously advised with respect to this type of
security-based swap or been involved in the type of trading
strategy, and whether the independent representative has a basic
understanding of what makes the security-based swap distinguishable
from a less complex alternative. If the SBS Entity knows that the
security-based swap or trading strategy represents a significant
change from prior security-based swaps that the independent
representative has evaluated or knows that the representative lacks
a basic understanding of what distinguishes the security-based swap
from a less complex alternative, the SBS Entity generally should
consider whether it can reasonably rely on the representations
regarding the qualifications of the independent representative.
---------------------------------------------------------------------------
c. No Statutory Disqualification
i. Proposed Rule
Proposed Rule 15Fh-5(a)(2) would require an SBS Entity to have a
reasonable basis to believe that an independent representative is not
subject to a statutory disqualification. Although Exchange Act Section
15F(h) does not define ``subject to a statutory disqualification,'' the
term has an established meaning under Section 3(a)(39) of the Exchange
Act,\982\ which defines circumstances that would subject a person to a
statutory disqualification with respect to membership or participation
in, or association with a member of, an SRO. While Section 3(a)(39)
would not literally apply here, the Commission proposed to define
``subject to a statutory disqualification'' for purposes of proposed
Rule 15Fh-5 by reference to Section 3(a)(39) of the Exchange Act.
---------------------------------------------------------------------------
\982\ 15 U.S.C. 78c(a)(39).
---------------------------------------------------------------------------
ii. Comments on the Proposed Rule
In the Proposing Release, the Commission solicited comment
regarding whether it should require an SBS Entity to check publicly
available databases, such as FINRA's BrokerCheck and the Commission's
Investment Adviser Public Disclosure program, to determine whether an
independent representative was subject to a statutory disqualification.
The Commission received two comment letters on this issue. To
minimize the degree of diligence imposed on SBS Dealers, one commenter
suggested requiring third-party representatives to affirm that they are
not subject to statutory disqualification, are not under investigation,
and are not listed on the publicly available databases described
above.\983\
---------------------------------------------------------------------------
\983\ See APPA, supra note 5.
---------------------------------------------------------------------------
After the adoption of the CFTC's final rules, the Commission
received one comment letter addressing the definition of ``statutory
disqualification in the Proposing Release.'' \984\ This commenter
stated that, although the statutory disqualification standards under
the Exchange Act and the CEA differ somewhat, both cover comparable
types of disqualifying events.\985\ Therefore, requiring a dual
registrant to apply different standards for statutory disqualification
``would impose substantial and duplicative diligence documentation,
without material countervailing benefits.'' \986\ To avoid this
conflict, the commenter suggested including language to accommodate
dually registered SBS Entities by establishing a safe harbor where they
are deemed to have a reasonable basis to believe that a person is not
subject to statutory disqualification under the Exchange Act if the
dually registered SBS Entity has a reasonable basis to believe that the
person is not subject to statutory disqualification under the CEA.\987\
According to the commenter, this would allow dually registered SBS
Entities to determine whether a special entity's representative is
subject to statutory disqualification based on the information it
obtained to ensure compliance with the parallel CFTC business conduct
rule.\988\
---------------------------------------------------------------------------
\984\ See SIFMA (August 2015), supra note 5.
\985\ Id.
\986\ Id.
\987\ Id.
\988\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
The Commission is adopting proposed Rule 15Fh-5(a)(2), renumbered
as Rule 15Fh-5(a)(1)(ii), as proposed, with one modification. The
Commission is incorporating the definition of ``statutory
disqualification'' under Section 3(a)(39)(A)-(F) of the Exchange Act,
whereas the proposed rule incorporated the definition under Section
3(a)(39) of the Exchange Act.
Exchange Act Section 15F(h) does not define ``subject to a
statutory disqualification,'' however Exchange Act Section 3(a)(39)
defines the term ``statutory disqualification.'' As discussed in the
SBS Entity Registration Adopting Release, the definition in Exchange
Act Section 3(a)(39) specifically relates to persons associated with an
SRO. In recognition of the fact that an independent representative of a
special entity may not be associated with an SRO, we have modified the
text of proposed Rule 15Fh-2(f) to reference Sections 3(a)(39)(A)-(F)
of the Securities Exchange Act of 1934. This updated cross-reference
incorporates the underlying issues that give rise to statutory
disqualification without reference to SRO membership.\989\
---------------------------------------------------------------------------
\989\ See Registration Process for Security-Based Swap Dealers
and Major Security-Based Swap Participants, Exchange Act Release No.
75611 (Aug. 5, 2015), 80 FR 48964 (Aug. 14, 2015) (``Registration
Adopting Release'').
---------------------------------------------------------------------------
In defining the phrase ``subject to statutory disqualification,''
the Commission declines to reference any parallel provisions of the
CEA.\990\ The CFTC defines ``statutory disqualification'' under
relevant sections of the CEA, without reference to parallel provisions
of the Exchange Act. Therefore the inclusion of references to the CEA
might lead to greater confusion and less certainty among market
participants regarding
[[Page 30037]]
what persons would be subject to statutory disqualification.
---------------------------------------------------------------------------
\990\ In determining whether an SBS Entity has a reasonable
basis to believe an independent representative is not subject to a
statutory disqualification, the SBS Entity may reasonably rely on
representations regarding the absence of a statutory
disqualification. See Sections II.D. and II.H.6.a above.
---------------------------------------------------------------------------
The Commission declines to adopt a commenter's suggestion to
require third-party representatives to provide specific affirmations
that they are not subject to statutory disqualifications, are not under
investigation, and are not listed on publicly available databases as
subject to a statutory disqualification. We do not believe that it is
necessary or appropriate to prescribe in Rule 15Fh-5(a)(1)(ii) how an
SBS Entity must form its reasonable basis to believe that the
independent representative is not subject to a statutory
disqualification; rather, the rule provides SBS Entities the
flexibility to determine how best to meet their obligation. The SBS
Entity may reasonably rely on representations regarding the
qualifications of the independent representative to form its reasonable
basis, but it is not required to do so. Nor is it required to obtain
any specific representations or affirmations.
d. Undertakes a Duty To Act in the Best Interests of the Special Entity
i. Proposed Rule
Proposed Rule 15Fh-5(a)(3) would require an SBS Entity to have a
reasonable basis to believe that the independent representative would
undertake a duty to act in the best interests of the special entity.
ii. Comments on the Proposed Rule
The Commission requested comment regarding what circumstances, if
any, would give rise to a presumption that an independent
representative was acting in the best interests of the special entity.
The Commission received seven comment letters supporting the
presumption that certain representatives would act in the best
interests of the special entity by virtue of their employment with the
special entity or their status as fiduciaries.\991\ According to these
commenters, in-house representatives of a special entity should
presumably act in the best interests of their special entity employer,
particularly where their performance would be subject to the special
entity's review and evaluation.\992\
---------------------------------------------------------------------------
\991\ See ABA Committees, supra note 5; NAIPFA, supra note 5;
CalPERS, supra note 5; Ropes & Gray, supra note 5; APPA, supra note
5; GFOA, supra note 5; SIFMA (August 2015), supra note 5.
\992\ See ABA Committees, supra note 5; NAIPFA, supra note 5;
CalPERS, supra note 5; Ropes & Gray, supra note 5; APPA, supra note
5; GFOA, supra note 5.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
As discussed in Section I.D., supra, the Commission has modified
Rule 15Fh-5 to address the intersection of Dodd-Frank and ERISA
regulation by distinguishing between non-ERISA special entities and
ERISA special entities. With respect to non-ERISA special entities,
under Rule 15Fh-5(a)(1), an SBS Entity must have a reasonable basis for
believing that a non-ERISA special entity counterparty has a qualified
independent representative that, among other things, undertakes a duty
to act in the ``best interests'' of the special entity.\993\ With
respect to ERISA special entities, under Rule 15Fh-5(b)(2), the SBS
Entity must have a reasonable basis to believe a special entity
counterparty that is ``subject to'' regulation under ERISA has a
representative that is a ``fiduciary'' as defined in Section 3 of
ERISA. This bifurcated treatment of ERISA and non-ERISA special
entities under Rule 15Fh-5(a) addresses the commenter's recommendation
that the business conduct rules recognize the comprehensive federal
regulatory framework that applies to plans that are subject to
regulation under ERISA, as well as creates efficiencies for special
entities that have already conformed their relationships with their
representatives to satisfy the CFTC's qualification criteria.\994\
---------------------------------------------------------------------------
\993\ Rule 15Fh-5(a)(1)(iii).
\994\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
The Commission is adopting proposed Rule 15Fh-5(a)(3), renumbered
as Rule 15Fh-5(a)(1)(iii), as proposed. The Commission agrees with
commenters that an SBS Entity may rely on information about legal
arrangements between the special entity and its representative to
establish that the representative is obligated to act in the best
interests of the special entity, including by contract, employment
agreement, or other requirements under state or federal law. In
addition, Rule 15Fh-5(b) provides safe harbors for forming a reasonable
basis regarding the qualifications of the independent
representative.\995\ Specifically, part of the safe harbor is satisfied
if the independent representative provides a written representation
that it is legally obligated to comply with the applicable requirements
in Rule 15Fh-5(a)(1) that describe the qualifications of the
independent representative--including that it undertakes to act in the
best interests of the special entity--by agreement, condition of
employment, law, rule, or other enforceable duty. Given the relief
provided by the safe harbor, at this time, the Commission does not
believe a presumption is necessary regarding the reasonable belief of
the SBS Entity relating to the undertaking of the independent
representative to act in the best interests of the special entity.
---------------------------------------------------------------------------
\995\ See Section II.H.6.g. below for a more detailed discussion
of the safe harbor.
---------------------------------------------------------------------------
e. Makes Appropriate and Timely Disclosures to Special Entity
i. Proposed Rule
Proposed Rule 15Fh-5(a)(4) would require an SBS Entity to have a
reasonable basis to believe that the special entity's independent
representative would make ``appropriate and timely'' disclosures to the
special entity of material information concerning the security-based
swap.
ii. Comments on the Proposed Rule
The Proposing Release solicited comment regarding whether to impose
specific requirements with respect to the content of the disclosures in
proposed Rule 15Fh-5(a)(4). The Commission received six letters
addressing this provision of the proposed rule. Two commenters
supported the use of specific disclosures to satisfy this
requirement.\996\ In contrast, two commenters argued that the
Commission should not require specific content disclosures.\997\ One
commenter appeared to argue that the standard of the proposed rule was
too low,\998\ and two commenters cautioned against reading this portion
of the proposed rule as requiring the disclosure of information before
the execution of each trade.\999\
---------------------------------------------------------------------------
\996\ See ABC, supra note 5; SIFMA (August 2011), supra note 5.
\997\ See APPA, supra note 5.
\998\ See NAIPFA, supra note 5.
\999\ See BlackRock, supra note 5; SIFMA (August 2011), supra
note 5.
---------------------------------------------------------------------------
A commenter recommended that the final rules expressly state that
the appropriate and timely disclosure requirement would be satisfied if
the SBS Entity received a written representation affirming that the
representative is ``obligated by law and/or agreement or undertaking to
provide appropriate and timely disclosures to the special entity.''
\1000\ However, this commenter additionally believed that, because this
provision of the proposed rule could be read to mandate pre-execution
disclosure on a transaction-by-transaction basis, it could cause delays
in the execution of security-based swaps, interfere with special
entities' ability to hedge positions and
[[Page 30038]]
portfolio risks, and deprive them of trading opportunities.\1001\
Another commenter requested that the Commission clarify that proposed
Rule 15Fh-5(a)(4) would not require the disclosure of information
before a trade is executed.\1002\
---------------------------------------------------------------------------
\1000\ See SIFMA (August 2011), supra note 5.
\1001\ Id.
\1002\ See BlackRock, supra note 5.
---------------------------------------------------------------------------
A third commenter urged the Commission not to impose specific
requirements regarding the content of the disclosures.\1003\ According
to this commenter, there are too many types of swaps and circumstances
to allow for a uniform set of mandated disclosures.\1004\ After the
adoption of the CFTC's final rules, a commenter argued against the
specific requirement that the qualified independent representative
disclose ``material information concerning the security-based swap.''
\1005\ The commenter requested that the Commission instead make the
requirement a general requirement to make appropriate and timely
disclosures to the special entity to harmonize this provision with the
parallel CFTC requirement, ``which would reduce costs for special
entities since most of them have already conformed their relationships
with their representatives to satisfy the CFTC's qualification
criteria.'' \1006\
---------------------------------------------------------------------------
\1003\ See APPA, supra note 5.
\1004\ Id.
\1005\ See SIFMA (August 2015), supra note 5.
\1006\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
As noted above, the SBS Entity may reasonably rely on
representations regarding the independent representative making
appropriate and timely disclosures to the special entity to form its
reasonable basis to believe that the independent representative will
comply with Rule 15Fh-5(a)(1)(iv). As with Rule 15Fh-5(a)(1)(iii), an
SBS Entity may rely on appropriate legal arrangements between a special
entity and its representative to form a reasonable basis to believe the
representative will make appropriate and timely disclosures to the
special entity of material information regarding the security-based
swap--such as an existing contract or employment agreement.
In response to the comments arguing that pre-trade disclosure
should not be required, we believe the necessity of pre-trade
disclosure will depend on the facts and circumstances of the particular
security-based swap in the context of the special entity and
independent representative. The SBS Entity is required to have a
reasonable basis to believe the independent representative will provide
the appropriate and timely disclosures. To the extent that any
disclosures from the independent representative are necessary for the
special entity to make an investment decision with respect to the
security-based swap, the disclosure would not be timely if it was given
after the investment decision was made. Similarly, the CFTC rule also
requires that the Swap Entity have a reasonable basis to believe that
the independent representative will make ``appropriate and timely''
disclosures. Although the language of the Commission's rule narrows the
requirement found in the parallel CFTC rule to appropriate and timely
disclosures of ``material information concerning the security-based
swap,'' the timing requirement is the same.\1007\
---------------------------------------------------------------------------
\1007\ See Section II.H.5., supra.
---------------------------------------------------------------------------
f. Pricing and Appropriateness
i. Proposed Rule
Proposed Rule 15Fh-5(a)(5) would require an SBS Entity to form a
reasonable basis to believe that the special entity's independent
representative would provide written representations to the special
entity regarding fair pricing and the appropriateness of the security-
based swap.
ii. Comments on the Proposed Rule
Four commenters addressed this proposed rule. Two commenters
supported the Commission's proposal that it ``should be sufficient if
the representation states that the representative is obligated, by law
and/or contract, to review pricing and appropriateness with respect to
any swap transaction in which the representative serves as such with
respect to the plan.'' \1008\ Both commenters urged the Commission to
incorporate this approach into the adopted rules.
---------------------------------------------------------------------------
\1008\ See ABC, supra note 5; SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
The third commenter suggested that an independent representative
should be required to disclose the basis on which it determined that a
particular transaction was fairly priced, and that the underlying
documentation should be sufficiently detailed to enable a third party
to evaluate the representative's conclusion.\1009\
---------------------------------------------------------------------------
\1009\ See CFA, supra note 5.
---------------------------------------------------------------------------
After the adoption of the CFTC's business conduct rules, the fourth
commenter urged the Commission to harmonize with the CFTC and require
that the qualified independent representative ``evaluate[ ], consistent
with any guidelines provided by the special entity, regarding fair
pricing and the appropriateness of the security-based swap.'' \1010\
The commenter asserted that this harmonization would reduce compliance
costs for special entities that have already conformed their
relationships with their representatives to satisfy the CFTC's
qualification criteria.\1011\
---------------------------------------------------------------------------
\1010\ See SIFMA (August 2015), supra note 5.
\1011\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
Upon consideration of the comments, the Commission is modifying
proposed Rule 15Fh-5(a)(5), renumbered as Rule 15Fh-5(a)(1)(v). The
Commission agrees with the commenter's suggestion that the Commission
should harmonize with the language of the CFTC's parallel provision,
which requires an SBS Entity to form a reasonable basis that the
special entity's independent representative will ``evaluate'' fair
pricing and the appropriateness of the security-based swap,
``consistent with any guidelines provided by the special entity.'' In
the Commission's view, requiring an SBS Entity to form a reasonable
basis to believe that an independent representative will evaluate,
consistent with any guidelines provided by the special entity, fair
pricing and the appropriateness of the security-based swap will achieve
the purpose of the proposed rule to ensure the special entity receives
advice specifically with respect to pricing and whether or not to enter
into the security-based swap. The rule will also provide the special
entity the flexibility to provide parameters to its independent
representative regarding the pricing and appropriateness of its
security-based swap. The Commission therefore agrees with the
commenter's suggestion that the special entity's guidelines, to the
extent a special entity provides them, should establish the criteria
for assessing the fair pricing and appropriateness of a security-based
swap. In addition, this change will harmonize the rule with the
parallel CFTC rule, thus creating efficiencies for entities that have
already established infrastructure to comply with the CFTC standard. In
the absence of any guidelines provided by the special entity, Rule
15Fh-5(a)(1)(v) requires the SBS Entity to form a reasonable basis to
believe that the independent representative will evaluate the fair
pricing and appropriateness of the security-based swap.
[[Page 30039]]
An SBS Entity also could form a reasonable basis for its
determination by relying on a written representation that the
independent representative will document the basis for its conclusion
that the transaction was fairly priced and appropriate in accordance
with any guidelines provided by the plan, and that the independent
representative or the special entity will maintain that documentation
in its records for an appropriate period of time, and make such records
available to the special entity upon request.\1012\ In response to
commenters' concerns, the Commission clarifies that this provision does
not necessarily require that a representative provide the special
entity transaction-by-transaction documentation with respect to fair
pricing and appropriateness of each security-based swap. For example,
where the representative is given trading authority, the representative
could consider undertaking in its agreement with the special entity to
ensure that the representative will evaluate the pricing and
appropriateness of each swap consistent with any guidelines provided by
the Special Entity prior to entering into the swap. In such a
situation, the independent representative could prepare and maintain
adequate documentation of its evaluation of pricing and appropriateness
to enable both the representative and the special entity to confirm
compliance with any such agreement.
---------------------------------------------------------------------------
\1012\ Id.
---------------------------------------------------------------------------
g. Subject to ``Pay to Play'' Prohibitions
i. Proposed Rule
Proposed Rule 15Fh-5(a)(7) would require an SBS Entity to have a
reasonable basis to believe that a special entity's independent
representative is subject to rules of the Commission, the CFTC, or an
SRO subject to the jurisdiction of the Commission or the CFTC that
prohibit it from engaging in specified activities if certain political
contributions have been made, unless the independent representative is
an employee of the special entity.
While not addressed in the Dodd-Frank Act, the Commission proposed
to include this ``pay-to-play'' provision among the qualifications for
independent representatives.\1013\ As discussed more fully in Section
II.H.10, infra, pay-to-play practices in connection with security-based
swap transactions could result in significant harm to special
entities--particularly where, as here, the independent representative
is intended to act in the best interests of special entities.\1014\ The
pay-to-play provisions of the proposed rules were intended to deter
independent representatives from participating, even indirectly, in
such practices.
---------------------------------------------------------------------------
\1013\ See Exchange Act Section 15F(h)(1)(C) (authorizing the
Commission to prescribe business conduct standards that relate to
``such other matters as the Commission determines to be
appropriate''). For a discussion of abuses associated with pay to
play practices, see Section II.D.5, infra. See note 213, supra, and
related text regarding an SBS Entity's reliance on a representation
from the special entity to form this reasonable basis.
\1014\ See note 32, supra.
---------------------------------------------------------------------------
ii. Comments on the Proposed Rule
The Commission received one comment letter addressing the inclusion
of a pay-to-play restriction among the qualifications for independent
representatives. This commenter supported the exception to the pay-to-
play restrictions for advisors who are employees of the special
entity.\1015\
---------------------------------------------------------------------------
\1015\ See APPA, supra note 5. See also ``Certain Political
Contributions by SBS Dealers: Proposed Rule 15Fh-6'' at Section
II.D.4.a., infra.
---------------------------------------------------------------------------
iii. Response to Comment and Final Rule
The Commission is adopting proposed Rule 15Fh-5(a)(7), renumbered
as Rule 15Fh-5(a)(1)(vi), as proposed. Accordingly, an SBS Entity must
have a reasonable basis for believing that the independent
representative is subject to rules of the Commission, the CFTC or an
SRO subject to the jurisdiction of the Commission or the CFTC that
prohibit it from engaging in specified activities if certain political
contributions have been made, unless the independent representative is
an employee of the special entity.\1016\ As stated in the Proposing
Release, the Commission continues to believe that an independent
representative in these circumstances would likely be either a
municipal advisor or an investment adviser that is already subject to
the MSRB's or the Commission's pay-to-play prohibitions. The Commission
does not, however, intend to prohibit other qualified persons from
acting as independent representatives, so long as those persons are
similarly subject to pay-to-play restrictions. The Commission believes
that Rule 15Fh-5(a)(1)(vi) will sufficiently deter SBS Entities from
participating, even indirectly, in such unlawful practices.
---------------------------------------------------------------------------
\1016\ See Exchange Act Section 15B(e)(4), 15 U.S.C 78o-4(e)(4)
(defining ``municipal advisor'' as a person ``other than a municipal
entity or an employee of a municipal entity'' that engages in the
specified activities).
---------------------------------------------------------------------------
h. ERISA Fiduciary
i. Proposed Rule
Proposed Rule 15Fh-5(a)(6) would require an SBS Entity to have a
reasonable basis to believe that, in the case of a special entity that
is an employee benefit plan subject to ERISA, the independent
representative was a ``fiduciary'' as defined in section 3(21) of that
Act (29 U.S.C. 1002).\1017\ The proposed rule was not intended to
limit, restrict, or otherwise affect the fiduciary's duties and
obligations under ERISA.\1018\
---------------------------------------------------------------------------
\1017\ See Section 15F(h)(5)(A)(i)(VII) of the Exchange Act, 15
U.S.C. 78o-10(h)(5)(A)(i)(VII). See note 225, supra, and related
text regarding an SBS Entity's reliance on a representation from the
special entity to form this reasonable basis.
\1018\ See notes 99, 198 and 189, supra, regarding the DOL's
proposal to amend definition of ``fiduciary'' for purposes of ERISA.
---------------------------------------------------------------------------
The Proposing Release solicited feedback regarding any specific
requirements that should be imposed on SBS Entities with respect to
this obligation, as well as what other independent representative
qualifications might be deemed satisfied if an independent
representative of an employee benefit plan subject to ERISA, is a
fiduciary as defined in section 3 of ERISA.
ii. Comments on the Proposed Rule
The Commission received six comment letters advocating for a
presumption of qualification for ERISA plan fiduciaries, since ERISA
already imposes fiduciary duties upon the person who decides whether to
enter into a security-based swap on behalf of an ERISA plan, and
imposes on this person a statutory duty to act in the best interests of
the plan and its participants, thereby prohibiting certain self-dealing
transactions.\1019\ According to these commenters, the Commission's
proposed standards would be unnecessary, redundant, would overlap with
ERISA's standards, and would only serve to increase the administrative
burden and cost on SBS Entities without any corresponding
benefit.\1020\
---------------------------------------------------------------------------
\1019\ See ABA Committees, supra note 5; ABC, supra note 5;
BlackRock, supra note 5; Mason, supra note 5; SIFMA (August 2011),
supra note 5; SIFMA (August 2015), supra note 5.
\1020\ See ABC, supra note 5; BlackRock, supra note 5; Mason,
supra note 5.
---------------------------------------------------------------------------
To address the potential conflict with ERISA standards, one
commenter suggested that the Commission's definition of ``independent
representative'' should be inapplicable to ERISA plans, and that the
Commission should merely cross-
[[Page 30040]]
reference the requirements under ERISA.\1021\
---------------------------------------------------------------------------
\1021\ See ABC, supra note 5.
---------------------------------------------------------------------------
Another commenter supported the presumptive qualification for ERISA
plan fiduciaries, provided that the plan satisfied a minimum $1 billion
net asset requirement for institutional investor organizations.\1022\
The commenter asserted that no public policy objective would be
achieved by permitting an SBS Entity to reject a risk manager fiduciary
selected by a sophisticated institutional investor organization with
over $1 billion in net assets, which did not require the protections of
the rules.\1023\ Another commenter advocated for the separate treatment
of independent representatives of special entities subject to
ERISA.\1024\ Under this commenter's proposal, an SBS Entity that
transacts with a special entity subject to Title I of ERISA must have a
reasonable belief that the qualified independent representative is a
fiduciary, as defined in Section 3 of ERISA.\1025\ The commenter's
proposed modification for ERISA special entities was intended to
recognize ``the unique fiduciary regime already applicable to such
special entities,'' and to harmonize the Commission's criteria for
qualified independent representatives with those of the CFTC.\1026\
---------------------------------------------------------------------------
\1022\ See ABA Committees, supra note 5.
\1023\ Id.
\1024\ See SIFMA (August 2015), supra note 5.
\1025\ Id.
\1026\ Id.
---------------------------------------------------------------------------
One commenter asserted that, for ERISA plans, the determination
whether a disclosure was ``appropriate'' and ``timely'' should be made
with reference to ERISA.\1027\ However, in the event the Commission
imposed its own, separate requirements on such disclosures, the
commenter requested that the Commission allow the following
representations to satisfy this provision of the proposed rule: (1)
That the representative shall provide the special entity with such
information, at such times, as the special entity may reasonably
request regarding any swap trade (either individually or in the
aggregate) entered into by such representative on behalf of the special
entity; and (2) that, in the absence of specific instruction to the
contrary by the special entity regarding swap trade disclosure, the
representative shall comply with the disclosure requirements imposed on
the representative under other applicable law (e.g., ERISA) and by the
special entity under the special entity's investment management
agreement and investment guidelines.\1028\
---------------------------------------------------------------------------
\1027\ See ABC, supra note 5.
\1028\ Id.
---------------------------------------------------------------------------
iii. Response to Comments and Final Rule
As discussed in Section II.H.5.b.iii, we are adopting a new Rule
15Fh-5(a)(2) that expressly addresses dealings with special entities
subject to ERISA.
Under new Rule 15Fh-5(a)(2), (formerly proposed Rule 15Fh-5(a)(6)),
an SBS Entity that acts as a counterparty to an employee benefit plan
subject to Title I of ERISA must have a reasonable basis to believe
that the special entity has a representative that is a fiduciary as
defined in Section 3 of ERISA. In this regard, an ERISA fiduciary will
be presumed to be a qualified independent representative, and the SBS
Entity need not undertake further inquiry into the ERISA fiduciary's
qualifications. Such a presumption acknowledges the pre-existing,
comprehensive federal regulatory regime governing ERISA fiduciaries and
the importance of harmonizing the Dodd-Frank Act requirements with
ERISA to avoid unintended consequences.\1029\ This formulation also
will align the Commission's treatment of ERISA plans with that of the
CFTC.
---------------------------------------------------------------------------
\1029\ See Section I.D., supra.
---------------------------------------------------------------------------
i. Safe Harbor
i. Summary of Comments
Although not included in the proposed rules, after adoption of the
CFTC's final rules, one commenter requested that the Commission adopt
separate safe harbors for transactions with ERISA and non-ERISA special
entities regarding the requirement that an SBS Entity form a reasonable
basis to believe that the special entity has a qualified independent
representative.\1030\ According to this commenter, the adoption of
separate safe harbors for ERISA and non-ERISA special entities would
align the Commission's requirements with those of the CFTC by
recognizing the ``unique fiduciary regime already applicable to'' ERISA
special entities, and, for transactions with non-ERISA special
entities, the safe harbor would ``help speed implementation, reduce
costs, and mitigate counterparty confusion, because most special entity
representatives have already taken steps to ensure that they can
provide the representations contained in the CFTC's safe harbor.''
\1031\
---------------------------------------------------------------------------
\1030\ See SIFMA (August 2015), supra note 5.
\1031\ Id.
---------------------------------------------------------------------------
ii. Response to Comments and Final Rule
After consideration of the comments, the Commission has determined
to add a new bifurcated safe harbor in Rule 15Fh-5(b), similar to that
adopted by the CFTC. The Commission believes the safe harbor will
provide SBS Entities an efficient manner with which to comply with the
requirement to have a reasonable basis to believe an independent
representative meets certain enumerated qualifications while meeting
the purposes of the rule.
Under Rule 15Fh-5(b)(1) as adopted, an SBS Entity shall be deemed
to have a reasonable basis to believe that a non-ERISA special entity
has a representative that satisfies the requirements of Rule 15Fh-
5(a)(1) if: (i) The special entity represents in writing to the SBS
Entity 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 requirements of Rule 15Fh-5(a)(1),
and that such policies and procedures provide for ongoing monitoring of
the performance of such representative consistent with Rule 15Fh-
5(a)(1); and (ii) the representative represents in writing to the
special entity and the SBS Entity that the representative: Has policies
and procedures reasonably designed to ensure that it satisfies the
requirements of Rule 15Fh-5(a)(1); meets the independence test of Rule
15Fh-f(a)(1)(vii); has the knowledge required under paragraph (a)(1)(i)
of this section; is not subject to a statutory disqualification under
paragraph (a)(1)(ii) of this section; undertakes a duty to act in the
best interests of the special entity as required under paragraph
(a)(1)(iii) of this section; and is subject to the requirements
regarding political contributions, as applicable, under paragraph
(a)(1)(vi) of this section; and is legally obligated to comply with the
requirements of Rule 15Fh-5(a)(1) by agreement, condition of
employment, law, rule, regulation, or other enforceable duty.\1032\
---------------------------------------------------------------------------
\1032\ SBS Entities should keep in mind that reliance on these
representation must be reasonable. As discussed in Section II.D,
supra, reliance on a representation would not be reasonable if the
SBS Entity has information that would cause a reasonable person to
question the accuracy of the representation.
---------------------------------------------------------------------------
Under Rule 15Fh-5(b)(2) as adopted, an SBS Entity shall be deemed
to have a reasonable basis to believe that an ERISA special entity has
a representative that satisfies the requirements of Rule 15Fh-5(a)(2),
provided that the special entity provides in writing to the SBS Entity
the
[[Page 30041]]
representative's name and contact information, and represents in
writing that the representative is a fiduciary as defined in Section 3
of ERISA. Obtaining the name and contact information provides the SBS
Entity with basic information to investigate further if it becomes
questionable whether it can reasonably rely on the special entity's
representation or if the need arises for it to further investigate any
of the representatives qualifications. In addition, it is highly likely
that the SBS Entity will have the information in the ordinary course of
negotiating the security-based swap if the independent representative
is advising or negotiating the security-based swap on behalf of the
special entity.
The Commission believes that the safe harbor will better enable an
SBS Entity to fulfill its obligations under Rule 15Fh-5(a), while at
the same time appropriately providing protections for special entities.
The Commission also agrees with commenters that the safe harbor will
increase the efficiency of SBS transactions, reduce costs, and mitigate
counterparty confusion. We believe that although SBS Entities will need
to obtain additional representations relating to meeting certain of the
standards in Rule 15Fh-5(a)(1), most SBS Entities and special entity
representatives will still be able to leverage any existing compliance
infrastructure established pursuant to the CFTC's safe harbor.\1033\
Additionally, as discussed above, the bifurcated nature of the safe
harbor appropriately recognizes existing ERISA regulations.\1034\
---------------------------------------------------------------------------
\1033\ See Section VI.C.4.iv., infra. However, the CFTC safe
harbor does not require the representative to represent that it has
the knowledge required under paragraph (a)(1)(i) of this section; is
not subject to a statutory disqualification under paragraph
(a)(1)(ii) of this section; undertakes a duty to act in the best
interests of the special entity as required under paragraph
(a)(1)(iii) of this section; and is subject to the requirements
regarding political contributions, as applicable, under paragraph
(a)(1)(vi) of this section.
\1034\ See Section II.H.6.g., supra.
---------------------------------------------------------------------------
7. Disclosure of Capacity
a. Proposed Rule
Proposed Rule 15Fh-5(b) would require that, before initiation of a
security-based swap with a special entity, an SBS Dealer must disclose
in writing the capacity or capacities in which it is acting, and, if
the SBS Dealer engages in business or has engaged in business within
the last twelve months with the counterparty in more than one capacity,
the SBS Dealer must disclose the material differences between such
capacities in connection with the security-based swap and any other
financial transaction or service involving the counterparty.\1035\
Therefore, an SBS Dealer that is acting as a counterparty but not an
advisor to a special entity would need to make clear to the special
entity the capacity in which it is acting (i.e., that it is acting as a
counterparty, but not as an advisor).
---------------------------------------------------------------------------
\1035\ See Section 15F(h)(5)(A)(2)(i) of the Exchange Act, 15
U.S.C. 78o-10(h)(5)(A)(2)(i).
---------------------------------------------------------------------------
As noted in the Proposing Release, a firm might act in multiple
capacities in relation to a special entity. For example, the firm might
act as an underwriter in a bond offering, as well as a counterparty to
a security-based swap used to hedge the financing transaction.\1036\
Because the SBS Dealer's duty to the special entity might vary
according to the capacity in which it is acting, the special entity and
its independent representative should understand the SBS Dealer's roles
in any transaction.\1037\ The proposed rule would therefore require an
SBS Dealer that engages in business, or has engaged in business within
the last twelve months, with the counterparty in more than one capacity
to disclose the material differences between such capacities in
connection with the security-based swap and any other financial
transaction or service involving the counterparty.\1038\ The
requirements of the proposed rule would apply to SBS Dealers, but not
Major SBS Participants, because the statutory requirement, by its
terms, requires disclosure in writing of ``the capacity in which the
security-based swap dealer is acting'' (emphasis added).
---------------------------------------------------------------------------
\1036\ See Swap Financial Group Presentation at 55.
\1037\ In the case of special entities that are municipal
entities, MSRB Rule G-23 generally prohibits dealer-financial
advisors from acting in multiple capacities in the same municipal
securities transactions. See also MSRB Notice 2011-29 (May 31, 2011)
(discussing rule amendment and interpretive notice). Similarly,
Section 206(3) of the Investment Advisers Act of 1940 governs
disclosure to a client when acting in certain capacities.
\1038\ See proposed Rule 15Fh-5(b).
---------------------------------------------------------------------------
b. Comments on the Proposed Rule
The Commission received five comment letters on this proposed rule.
Three commenters expressed concern over the burden imposed on large
institutions, which would have to identify and disclose a myriad of
possible relationships with special entities.\1039\ Conversely, one
commenter suggested broadening the rule to apply to Major SBS
Participants in addition to SBS Dealers.\1040\ The last commenter
suggested conforming the disclosure of capacity requirement to that of
the CFTC.\1041\
---------------------------------------------------------------------------
\1039\ See SIFMA (August 2011), supra note 5; ABC, supra note 5;
FIA/ISDA/SIFMA, supra note 5.
\1040\ See Better Markets (August 2011), supra note 5.
\1041\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
The first commenter argued that the Commission's proposed capacity
disclosure requirement was problematic for two reasons.\1042\ First, it
might conflict with some SBS Dealers' obligations to keep certain lines
of business separated from one another. In this commenter's view, to
comply with this requirement, large, multifaceted SBS Dealers that have
different relationships with the same special entity could be forced to
review activities throughout their entire organizations--in some cases,
across informational walls that separate the different business lines
of the firm. Second, the requirement might cause execution delays for
special entities, since the SBS Dealer would need time to determine the
disclosures it must make to the special entity. The commenter asked the
Commission to clarify in the final rule that this disclosure
requirement applied only to the SBS Dealer and the special entity, and
that it would not apply to any associated persons of either the SBS
Dealer or the special entity. The commenter additionally argued that
the twelve-month look back period constituted a ``moving target,'' and
suggested that the Commission define the period as a calendar year,
rather than a rolling twelve-month period.\1043\
---------------------------------------------------------------------------
\1042\ See SIFMA (August 2011), supra note 5.
\1043\ Id.
---------------------------------------------------------------------------
Another commenter urged the Commission to allow SBS Entities to
represent the capacity in which they were acting with respect to an
ERISA plan in a schedule or amendment to an ISDA Master Agreement,
other transactional document, or in an annual disclosure document
provided by the SBS Entity to the special entity, which could be
changed if the SBS Entity were to act in a different capacity.\1044\
Because ERISA plans generally deal with SBS Entities as counterparties,
the commenter believed this would be an effective and non-burdensome
way to make such representations. The commenter additionally asserted
that it might be harmful to a special entity to require an SBS Entity
to disclose the myriad different capacities in which the SBS Entity has
acted with respect to the special entity--since requiring SBS Dealers
with diverse global operations to disclose every relationship with a
plan (which often has multiple investment managers and service
[[Page 30042]]
providers), then requiring the plan manager to review such disclosures
would pose a significant administrative burden and result in high costs
and delayed trades. These costs would likely be passed on to special
entities.
---------------------------------------------------------------------------
\1044\ See ABC, supra note 5. Some commenters referenced both
SBS Dealers and Major SBS Participants although the Commission only
proposed to apply the requirement to SBS Dealers.
---------------------------------------------------------------------------
Another commenter argued that it ``would be impossible for an SBS
Entity to ascertain and disclose every other relationship it may have
with its counterparties'' because large financial institutions have
multiple points of contact with counterparties, making it impossible to
systematically collect and disclose the required information.\1045\
This commenter argued that the Proposing Release did not include an
analysis of the costs associated with the requirement to disclose
capacity. The commenter recommended that the Commission narrow this
requirement to cover only disclosure of the material differences
between the capacities in which the SBS Entity itself (and not any of
its affiliates or other associated persons) acted in connection with
the relevant security-based swap transaction. In the alternative, the
commenter suggested that the Commission require disclosure regarding
the capacities in which the SBS Entity has acted with respect to the
counterparty other than in connection with the relevant security-based
swap transaction, and that the SBS Entity should be permitted to
satisfy that requirement with a generic disclosure of the general types
of capacities in which it may act or have acted with respect to the
counterparty (along with a statement distinguishing those capacities
from the capacity in which the SBS Entity is acting with respect to the
present security-based swap).
---------------------------------------------------------------------------
\1045\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
One commenter suggested that the capacity disclosure requirement be
applied equally to SBS Dealers and Major SBS Participants, as it would
maximize the protection for special entities.\1046\
---------------------------------------------------------------------------
\1046\ See Better Markets (August 2011), supra note 5.
---------------------------------------------------------------------------
After the adoption of the CFTC's final rules, a commenter
subsequently recommended deleting this twelve-month ``look back''
period, as well as the requirement that SBS Dealers disclose the
material differences between such capacities ``in connection with the
security-based swap and any other financial transaction or service
involving the counterparty.'' \1047\ According to the commenter, these
modifications would harmonize the Commission's rule with the parallel
CFTC rule, and reduce confusion among counterparties regarding the
nature of their relationship with an SBS Dealer.\1048\
---------------------------------------------------------------------------
\1047\ See SIFMA (August 2015), supra note 5.
\1048\ Id.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
Upon consideration of the foregoing comments, the Commission is
adopting proposed Rule 15Fh-5(b), renumbered as Rule 15Fh-5(c), with
several modifications in response to comments. Proposed Rule 15Fh-5(b)
would require that, before initiation of a security-based swap with a
special entity, an SBS Dealer must disclose in writing the capacity or
capacities in which it is acting, and, if the SBS Dealer engages in
business or has engaged in business within the last twelve months with
the counterparty in more than one capacity, the SBS Dealer must
disclose the material differences between such capacities in connection
with the security-based swap and any other financial transaction or
service involving the counterparty. As discussed below, in response to
comments, the Commission is amending the first part of the rule to
clarify that the disclosure of the capacity in which the SBS Dealer is
acting is ``in connection with the security-based swap.'' The
Commission also is amending the second part of the rule to clarify the
capacities between which material differences must be disclosed. In
addition, we are deleting the 12 month look-back period. Specifically,
under the rule, as adopted (renumbered as Rule 15Fh-5(c)), before
initiation of a security-based swap, an SBS Dealer must disclose to the
special entity in writing the capacity in which the SBS Dealer is
acting ``in connection with the security-based swap,'' and, if the SBS
Dealer engages in business \1049\ with the counterparty in more than
one capacity, the SBS Dealer must disclose the material differences
between the capacity in which the SBS Dealer is acting with respect to
the security-based swap and the capacities in which it is acting with
respect to any other financial transaction or service involving the
counterparty to the special entity.
---------------------------------------------------------------------------
\1049\ As discussed below, the rule is designed to help ensure
that the special entity understands the SBS Dealer's role in the
security-based swap transaction that is being initiated, and to
distinguish that role, if applicable, from its role with respect to
any other services the SBS Dealer is providing or transactions in
which it is involved with the special entity. The term ``engages
in'' should be interpreted broadly to achieve that goal.
---------------------------------------------------------------------------
Several commenters argued that the proposed requirement that the
SBS Dealer disclose the capacity in which it was acting was too broad
and would require the disclosure of a myriad of possible
relationships.\1050\ Some commenters suggested that the relevant
disclosure should be the capacity in which the SBS Dealer is acting
``in connection with the security-based swap'' and suggested the rule
should be narrowed accordingly.\1051\ A commenter also suggested that
the Commission revise the disclosure of different capacities to
eliminate the language that requires such disclosures to be ``in
connection with the security-based swap and any other financial
transaction or service involving the counterparty.'' \1052\
---------------------------------------------------------------------------
\1050\ SIFMA (August 2011), supra note 5; FIA/ISDA/SIFMA, supra
note 5; and ABC, supra note 5.
\1051\ See ABC, supra note 5; SIFMA (August 2011), supra note 5.
\1052\ See SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
The Commission agrees with commenters that the disclosure of
capacity in the first part of the rule should be limited to the
capacity in which the SBS Dealer is acting in connection with the
security-based swap, and has amended the rule to clarify this
limitation. However, the Commission declines the commenter's suggestion
to eliminate the disclosure of material differences between or among
the different capacities in which the SBS Dealer is acting ``in
connection with the security-based swap and any other financial
transaction or service involving the counterparty.'' \1053\ The
proposed rule was designed to provide the counterparty with sufficient
information about the capacity in which the SBS Dealer is acting, and
any material differences between its capacity in connection with the
security-based swap and any other financial transaction or service
involving the counterparty, to help ensure that the counterparty
understands the SBS Dealer's role in the security-based swap
transaction that is being initiated, and to distinguish that role, if
applicable, from its role with respect to any other services it is
providing or transactions in which it is involved with the
counterparty. Eliminating the requirement that the SBS Dealer disclose
the material differences in the different capacities in which it is
acting would not address potential counterparty confusion that could
arise when a SBS Dealer changes status from transaction to transaction.
---------------------------------------------------------------------------
\1053\ See FIA/ISDA/SIFMA, supra note 5; and SIFMA (August
2015), supra note 5.
---------------------------------------------------------------------------
Some commenters expressed concerns regarding the burden and
practical issues relating to having to apply this disclosure
requirement to the activities of associated persons of the SBS
[[Page 30043]]
Dealer \1054\ and associated persons of the special entity.\1055\ The
Commission recognizes the practical and operational difficulties
described in the comment letters in determining the capacity in which
associated persons, including affiliates, are acting or have acted with
respect to the special entity. The Commission also recognizes the role
of the independent representative in advising the special entity with
respect to these transactions. Given these considerations, the
Commission agrees with the commenter it would be appropriate for the
SBS Dealer to use generalized disclosures regarding the other
capacities in which the SBS Dealer and its associated persons,
including affiliates, have acted or may act with respect to the special
entity and its associated persons, along with a statement
distinguishing those capacities from the capacity in which the SBS
Dealer is acting with respect to the present security-based swap.\1056\
Such disclosure would require consideration of the SBS Dealer's
business and the types of capacities in which it and its associated
persons has acted or may act with respect to the particular special
entity. We believe that this generalized disclosure of other capacities
will help ensure that the counterparty understands the SBS Dealer's
role in the security-based swap transaction that is being initiated,
and to distinguish that role, if applicable, from its role with respect
to any other services it is providing or transactions in which it is
involved with the counterparty.
---------------------------------------------------------------------------
\1054\ See SIFMA (August 2011), supra note 5.
\1055\ See FIA/ISDA/SIFMA, supra note 5.
\1056\ Id.
---------------------------------------------------------------------------
After consideration of the comments, the Commission also
acknowledges the commenters' concerns regarding the workability and
potential delay in execution of transactions and increased costs the
twelve month look back may cause. Accordingly, the Commission has also
modified the adopted rule to eliminate the 12-month look back period
for business in which the SBS Dealer has engaged.
As discussed in Section II.G.2.b. above, the Commission does not
prescribe the manner in which these disclosure must be made. In
response to comments received,\1057\ the Commission notes that the
required disclosures could be made in a transactional document or an
annual disclosure document, depending on the number of capacities in
which the SBS Dealer is acting and whether such capacities have
changed. In any event, the disclosure must be sufficient to meet the
requirements of the rule, which is designed to ensure that the special
entity understands the SBS Dealer's role in the security-based swap
transaction that is being initiated, and to distinguish that role, if
applicable, from its role with respect to any other services the SBS
Dealer is providing or transactions in which it is involved with the
special entity.
---------------------------------------------------------------------------
\1057\ See ABC, supra note 5.
---------------------------------------------------------------------------
Finally, the Commission declines to apply Rule 15Fh-5(c) to Major
SBS Participants, since the statutory requirement, by its terms,
requires disclosure in writing of ``the capacity in which the security-
based swap dealer is acting.'' Furthermore, as discussed in Section
II.C., supra, we have not sought to impose the full range of business
conduct requirements on these Major SBS Participants. We note that our
approach in this regard largely mirrors that of the CFTC, under whose
rules Swap Entities have operated for some time.
8. Exceptions for Anonymous, Special Entity Transactions on an Exchange
or SEF
a. Proposed Rules
As previously discussed in Section II.B, supra, Section 15F(h)(7)
of the Exchange Act provides that ``[t]his subsection shall not apply
with respect to a transaction that is (A) initiated by a special entity
on an exchange or security-based swap execution facility; and (B) one
in which the security-based swap dealer or major security-based swap
participant does not know the identity of the counterparty to the
transaction.'' \1058\ We proposed to read Section 15F(h)(7) to apply to
any transaction with a special entity on a SEF or an exchange where the
SBS Entity does not know the identity of its counterparty.\1059\ We
further proposed exceptions from the requirement of proposed Rules
15Fh-4 (special requirements for SBS Dealers acting as advisors to
special entities) and 15Fh-5 (special requirements for SBS Entities
acting as counterparties to special entities) for such transactions.
---------------------------------------------------------------------------
\1058\ 15 U.S.C. 78o-10(h)(7).
\1059\ See Proposing Release, 76 FR at 42421, supra note 3.
---------------------------------------------------------------------------
b. Comments on the Proposed Rules
The Commission received five comments that generally addressed the
exception for anonymous or SEF and exchange-traded security-based
swaps,\1060\ and five comments that specifically addressed the
exception for anonymous, exchange or SEF-traded security-based swaps
with special entities.\1061\ The comment letters that generally address
this exception are discussed above, in Section II.B, supra.
---------------------------------------------------------------------------
\1060\ See CFA, supra note 5; SIFMA (August 2011), supra note 5;
FIA/ISDA/SIFMA, supra note 5; MFA, supra note 5; BlackRock, supra
note 5.
\1061\ See ABC, supra note 5; SIFMA (August 2015), supra note 5;
CFA, supra note 5; Better Markets (August 2011), supra note 5; FIA/
ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
In the specific context of security-based swap transactions with
special entities, one commenter suggested that the business conduct
standards should only apply to non-SEF and non-exchange traded
transactions, regardless whether the transaction is anonymous.\1062\
This commenter urged the Commission to clarify that the proposed rules
would not apply to any security-based swap transaction that is entered
into by a special entity on a designated contract market or SEF.\1063\
---------------------------------------------------------------------------
\1062\ See ABC, supra note 5.
\1063\ Id.
---------------------------------------------------------------------------
Two commenters addressed the Commission's proposal to apply the
statutory exception to any anonymous transaction with a special entity
on a registered exchange or SEF.\1064\ One commenter supported this
proposal as a ``reasonable approach which is consistent with
Congressional intent that the enhanced protections apply to
transactions where there is a degree of reliance by the special entity
on the dealer or major swap participant.'' \1065\ The second commenter
argued that the exception in Section 15Fh(7) was intended to apply to
all external business conduct requirements promulgated under subsection
(h), and not merely those requirements relating to SBS Dealers acting
as advisors or counterparties to special entities.\1066\
---------------------------------------------------------------------------
\1064\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5.
\1065\ See CFA, supra note 5.
\1066\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
Another commenter argued that Congress did not intend for the
exception to apply when SBS Entities initiate transactions on a SEF or
an exchange.\1067\ According to this commenter, SBS Entities seeking to
conduct business on a SEF or exchange should bear the risk that their
counterparties are special entities, as the risk would incentivize SBS
Entities to determine the identity of their counterparties when they
initiate security-based swap transactions on an SEF or exchange. The
commenter recommended that the Commission adopt a ``clear test'' for
determining when a special entity ``initiates'' a security-based swap
transaction, and that the test differentiate between
[[Page 30044]]
initiating a negotiation and initiating a transaction.\1068\ After
adoption of the CFTC's business conduct standards, another commenter
urged the Commission to adopt an exception for exchange-traded
security-based swaps that are intended to be cleared if: (1) The
transaction is executed on a registered or exempt security-based swap
execution facility or registered national security exchange; and (2) is
of a type that is, as of the date of execution, required to be cleared
pursuant to Section 3C of the Exchange Act; or (3) the SBS Dealer does
not know the identity of the counterparty, at any time up to and
including execution of the transaction.\1069\ The commenter argued that
these modifications would harmonize the scope of the SEC's special
entity requirements with the parallel CFTC requirements set forth under
the relief provided by CFTC No-Action Letter 13-70.\1070\
---------------------------------------------------------------------------
\1067\ See Better Markets (Aug. 2011), supra note 5.
\1068\ Id.
\1069\ See SIFMA (August 2015), supra note 5.
\1070\ Id.
---------------------------------------------------------------------------
c. Response to Comments and Final Rules
After consideration of the comments, the Commission is adopting
Rule 15Fh-4(b)(3) and Rule 15Fh-5(c) (the latter renumbered as 15Fh-
5(d)) with several modifications. Under the rules as adopted, the
business conduct requirements of Rules 15Fh-4 and 15Fh-5 will not apply
to a security-based swap with a special entity if: (1) The transaction
is executed on a registered SEF, exempt SEF, or registered national
securities exchange; and (2) the SBS Dealer and/or Major SBS
Participant does not know the identity of the counterparty at a
reasonably sufficient time prior to the execution of the transaction to
permit the SBS Dealer and/or Major SBS Participant to comply with the
obligations of the rule.\1071\ The language of these exceptions, as
adopted, differs from the language of the proposed rules, which would
have applied the exceptions where the SBS Dealer or Major SBS
Participant did not know the identity of its counterparty ``at any time
up to and including'' execution of the transaction, and only to
transactions executed on a registered SEF or national exchange.
---------------------------------------------------------------------------
\1071\ As noted above, Rule 15Fh-4 applies only to SBS Dealers,
whereas Rule 15Fh-5 applies to both SBS Dealers and Major SBS
Participants. See Sections II.H.2 and II.H.5.a.iii.A, respectively,
supra.
---------------------------------------------------------------------------
As discussed in Section II.B, by limiting the scope of the business
conduct standards to situations where the counterparty's identity is
known at a reasonably sufficient time prior to the execution of a
transaction to permit the SBS Dealer and/or Major SBS Participant to
comply with the obligations of the rule, the Commission seeks to
relieve SBS Dealers and/or Major SBS Participants of the duty to comply
with the rules' requirements where the counterparty's identity is
learned immediately prior to the execution of a transaction, so that
the SBS Entity would be able to comply with the requirements of the
rules in a manner that would not be disruptive to the counterparties to
the transaction. This change is intended to address commenters'
concerns that compliance with the rules might be unreasonable or
impractical where a counterparty's identity is learned immediately
prior to the transaction, and compliance could result in the delay or
disruption of the transaction.\1072\ Such delay or disruption would
negate a primary advantage of electronic trading and discourage market
participants from executing security-based swaps on electronic
platforms. By only applying the rules' requirements to situations where
the counterparty's identity is known ``at a reasonably sufficient time
prior to'' the execution of a transaction, the rules' requirements are
limited to situations where an SBS Entity has sufficient time before
the execution of the transaction to comply with its obligations under
the rules. For this reason, we decline to adopt language, suggested by
a commenter, which would apply the exception to circumstances where the
identity of the counterparty ``is not known at any time up to and
including execution of the transaction.'' \1073\ For clarification, and
in response to commenters,\1074\ the exception would encompass
transactions that are executed by an SBS Entity on a registered or
exempt SEF or registered national securities exchange via a request for
quote method, as long as the identity of the counterparty is not known
to the SBS Entity at a reasonably sufficient time prior to the
execution of a transaction to permit the SBS Entity to comply with the
obligations of the rules.\1075\
---------------------------------------------------------------------------
\1072\ See CFA, supra note 5; FIA/ISDA/SIFMA, supra note 5.
\1073\ See SIFMA (August 2015), supra note 5.
\1074\ See FIA/ISDA/SIFMA, supra note 5; MFA, supra note 5.
\1075\ The rule will apply to situations where an SBS Entity
negotiates or pre-arranges a security-based swap transaction with a
special entity and routes such a pre-arranged transaction through a
SEF or registered national securities exchange. In such instances,
we believe the SBS Entity would have known the identity of the
counterparty at a reasonably sufficient time prior to the execution
of the transaction to permit the SBS Entity to comply with the
obligations of the rule.
---------------------------------------------------------------------------
Also, as explained in Section II.B, the exception would apply with
respect to transactions on exempt as well as registered SEFs. We
believe that including transactions on exempt SEFs is appropriate
since, as discussed in Section II.B, the practical considerations that
underlie the exception are not affected by whether a SEF is registered
or not.
We believe that the exceptions under Rule 15Fh-4(b)(3) and 15Fh-
5(d), as adopted, appropriately interpret the intended statutory carve-
outs for SBS Entities engaged in anonymous, registered exchange-traded,
registered or exempt SEF transactions with special entities, while
avoiding the ambiguity inherent in determining which party
``initiated'' the security-based swap. The final rule therefore
obviates the need to differentiate between initiating a negotiation and
initiating a transaction, as one commenter had requested.\1076\
---------------------------------------------------------------------------
\1076\ See Better Markets (August 2011), supra note 5.
---------------------------------------------------------------------------
We acknowledge the commenter's suggestion that the exception should
apply irrespective of which party initiates a transaction,\1077\ as
well as another commenter's suggestion that Congress may have intended
to deny the exception in situations in which an SBS Entity initiates a
transaction, so that SBS Entities would be incentivized to determine
the identities of their counterparties when they initiate security-
based swap transactions.\1078\ As explained in Section II.B, we
understand there may be practical difficulties in determining which
counterparty ``initiates'' a transaction on a SEF or an exchange.
However, we believe the rules adopted today avoid the ambiguity
inherent in determining which party ``initiated'' the security-based
swap, while appropriately interpreting the intended statutory carve-
outs for SBS Entities that execute anonymous, security-based swap
transactions with special entities on a registered or exempt SEF or
registered national securities exchange.
---------------------------------------------------------------------------
\1077\ See CFA, supra, note 5.
\1078\ See Better Markets (August 2011), supra note 5.
---------------------------------------------------------------------------
We are not accepting the commenter's suggestion that we revise the
exceptions under 15Fh-4(b)(3) and 15Fh-5(d) to include transactions
that are intended or required to be cleared, which are either executed
on a registered national securities exchange or SEF, regardless of
whether the transaction is anonymous.\1079\ Similarly, we reject
commenters' more general assertion that
[[Page 30045]]
the exceptions should apply to all SEF or exchange traded transactions,
even where the identity of the counterparty is known.\1080\ Rather, we
agree with the commenter that it is appropriate to apply the
protections of the business conduct rules to all security-based swap
transactions with special entities other than anonymous transactions
executed on a registered national securities exchange or SEF.\1081\ The
rules adopted today are intended to provide certain protections for
special entities, and we think it is appropriate to apply the rules, to
the extent practicable, so that special entities receive the benefits
of those protections. Where the identity of the special entity is
known, we believe that it is appropriate to apply the rules so that the
special entity receives the benefits of the protections provided by the
rules, including the assistance of an advisor or qualified independent
representative acting in the best interests of that special entity.
---------------------------------------------------------------------------
\1079\ See SIFMA (August 2015), supra note 5.
\1080\ See ABC, supra note 5; FIA/ISDA/SIFMA, supra note 5.
\1081\ See CFA, supra note 5.
---------------------------------------------------------------------------
Lastly, we acknowledge the improbability that an SBS Dealer who is
acting as an advisor to a special entity and is therefore subject to
the requirements of Rule 15Fh-4 would not know the identity of its
special entity counterparty. Consequently, we also acknowledge that the
circumstances where the exception under Rule 15Fh-4(b)(3) would apply
are unlikely, and, in any event, we would question the appropriateness
of an SBS Dealer making a recommendation to an unknown special entity.
Nevertheless, we believe there is value is providing legal certainty
for SBS Dealers that seek to transact on a registered national
securities exchange or a registered or exempt SEF without regard to the
regulatory status of their counterparty.
9. Certain Political Contributions by SBS Dealers
a. Proposed Rule
As proposed, Rule 15Fh-6(b)(1) would generally make it unlawful for
an SBS Dealer to offer to enter into, or enter into, a security-based
swap, or a trading strategy involving a security-based swap, with a
``municipal entity'' within two years after any ``contribution'' to an
``official of such municipal entity'' has been made by the SBS Dealer
or any of its ``covered associate[s].'' Proposed Rule 15Fh-6(b)(3)(i)
would also prohibit an SBS Dealer from paying a third party to
``solicit'' municipal entities to offer to enter into, or enter into, a
security-based swap, unless the third party is a ``regulated person''
that is itself subject to a pay to play restriction under applicable
law. Proposed Rule 15Fh-6(b)(3)(ii) would prohibit an SBS Dealer from
coordinating or soliciting a third party, including a political action
committee, to make any: (a) Contribution to an official of a municipal
entity with which the SBS Dealer is offering to enter into, or has
entered into, a security-based swap, or (b) payment to a political
party of a state or locality with which the SBS Dealer is offering to
enter into, or has entered into, a security-based swap. Finally,
proposed Rule 15Fh-6(c) would make it unlawful for an SBS Dealer 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.
As proposed, Rule 15Fh-6(b) included three main exceptions. First,
proposed Rule 15Fh-6(b)(2)(i) would permit an individual who is a
covered associate to make aggregate contributions without being subject
to the two-year time out period, of up to $350 per election, to any one
official for whom the individual was entitled to vote at the time of
the contributions, and up to $150 per election, to any one official for
whom the individual was not entitled to vote at the time of the
contributions.\1082\ Second, proposed Rule 15Fh-6(b)(2)(ii) would not
apply the proposed pay to play rules to contributions made by an
individual more than six months prior to becoming a covered associate
of the SBS Dealer, unless such individual solicits the municipal entity
after becoming a covered associate. Third, proposed Rule 15Fh-
6(b)(2)(iii) would not apply the proposed pay to play rules to a
security-based swap that is initiated by a municipal entity on a
registered national securities exchange or SEF, for which the SBS
Dealer does not know the identity of the counterparty at any time up to
and including the time of execution of the transaction.
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\1082\ As discussed below, we are modifying the text of this
rule to clarify that the de minimis contribution exception is
limited to contributions made by individuals so that the rule text
tracks the explanation of the exception that was outlined in the
Proposing Release and in the CFTC's Adopting Release for its
analogous exception, as well as the text of the Advisers Act Rule,
upon which the exception is modeled and is intended to complement.
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In addition to the above exceptions, proposed Rule 15Fh-6(e)(1)
would provide an automatic exception to allow an SBS Dealer a limited
ability to cure the consequences of an inadvertent political
contribution where: (i) The SBS Dealer discovered the contribution
within four months (120 calendar days) of the date of the contribution;
(ii) the contribution made did not exceed $350; and (ii) the
contribution was returned to the contributor within 60 calendar days of
the date of discovery. However, an SBS Dealer would not be able to rely
on this exception more than twice in any 12-month period, or more than
once for any covered associate, regardless of the time between
contributions.
Furthermore, under proposed Rule 15Fh-6(d) an SBS Dealer may apply
to the Commission for an exemption from the two-year ban. In
determining whether to grant the exemption, the Commission would
consider, among other factors: (i) Whether the exemption is necessary
or appropriate in the public interest and consistent with the
protection of investors and the purposes of the Exchange Act; (ii)
whether the SBS Dealer, (a) before the contribution resulting in the
prohibition was made, had adopted and implemented policies and
procedures reasonably designed to prevent violations of the proposed
rule, (b) prior to or at the time the contribution was made, had any
actual knowledge of the contribution, and (c) after learning of the
contribution, had taken all available steps to cause the contributor to
obtain return of the contribution and such other remedial or
preventative measures as may be appropriate under the circumstances;
(iii) whether, at the time of the contribution, the contributor was a
covered associate or otherwise an employee of the SBS Dealer, or was
seeking such employment; (iv) the timing and amount of the
contribution; (v) the nature of the election (e.g., state or local);
and (vi) the contributor's intent or motive in making the contribution,
as evidenced by the facts and circumstances surrounding the
contribution.
b. Comments on the Proposed Rule
Six commenters addressed proposed Rule 15Fh-6.\1083\ One commenter,
who supported the proposal as applied to SBS Dealers, stated that pay-
to-play is an appropriate area for the Commission to exercise its
authority and suggested that this proposal ``would help to eliminate
what would otherwise be a serious gap in protections.'' \1084\ However,
this same commenter does not believe the Commission should exempt Major
SBS Participants from the proposed pay-to-play rules based on what this
commenter claims ``may turn out to be a false `assumption' that they
[[Page 30046]]
will not be engaged in the type of activity that would make them
appropriate.'' \1085\
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\1083\ See APPA, supra note 5; CFA, supra note 5; FIA/ISDA/
SIFMA, supra note 5; NAIPFA, supra note 5; SIFMA (August 2011),
supra note 5; SIFMA (August 2015), supra note 5.
\1084\ CFA, supra note 5.
\1085\ CFA, supra note 5.
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Another commenter agreed that the prohibition timeframe should be
two years, consistent with proposed Rule 15Fh-6(b)(1).\1086\ That same
commenter also believed that there are no circumstances where an
independent representative that is advising a special entity that is a
State, State agency, city, county, municipality, or other political
subdivision of a State, or a governmental plan, as defined in Section
3(32) of ERISA, other than an employee of the special entity, would not
be subject to pay to play rules.\1087\
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\1086\ See NAIPFA, supra note 5.
\1087\ See NAIPFA, supra note 5.
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One commenter recommended that, with respect to the proposal that
independent representatives be subject to ``pay to play'' limitations,
an exception is needed ``for advisors that are employees of the special
entity, given the employer-employee relationship.'' \1088\ That same
commenter also urged the Commission to delay imposing the proposed pay
to play rule until after the ``dealer'' definitions are
finalized.\1089\
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\1088\ APPA, supra note 5.
\1089\ APPA, supra note 5 (stating in support of that suggestion
that ``[w]hile financial institutions that deal with municipal
entities are more likely to have compliance procedures in place to
deal with pay-to-play rules, other entities that may ultimately be
considered SBS Dealers are much less likely to have such systems in
place or to be familiar with these types of rules'').
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Another commenter suggested, as a general matter, that because the
Dodd-Frank Act did not mandate any restrictions on political
contributions by SBS Dealers it is not clear to that commenter that the
Commission needs to impose such a requirement on a discretionary
basis.\1090\ This same commenter, however, recommended that the
Commission revise the language of the proposed rule to, at least in the
commenter's view, parallel the following aspects of MSRB's regulations:
(1) Replace as the triggering occasion for the application of the
proposed rule an ``offer to enter into or enter into a security-based
swap or a trading strategy involving a security-based swap'' with a
term--``engage in municipal security-based swap business''--which they
suggest is ``more akin to the terms used in the relevant MSRB Rules'';
(2) define ``municipal security-based swap business'' in the proposed
rule to mean ``the execution of a security-based swap with a municipal
entity''; (3) narrow the definition of ``solicit'' in the proposed rule
to include only ``any direct communication by any person with a
municipal entity for the purpose of obtaining or retaining municipal
security-based swap business,'' so that the term ``solicit'' does not
``implicate communication by employees of a financial institution that
do not have a role in the security-based swap business and who are
already regulated by the MSRB or the SEC''; (4) clarify the definition
of ``solicit'' in the proposed rule to ``exclude[s] any communication
by any person with a municipal entity for the sole purpose of obtaining
or retaining any other type of business covered under pay to play
restrictions, such as municipal securities business or municipal
advisory business''; and (5) modify the proposed rule to allow for up
to three exemptions for inadvertent contributions, depending on the
number of SBS Dealer employees.\1091\ The same commenter also
recommended that the Commission include a provision specifying ``an
operative date of the rule such that it only applies to contributions
made on or after its effective date.'' \1092\
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\1090\ See FIA/ISDA/SIFMA, supra note 5 (stating that MSRB rules
``on political contributions made in connection with municipal
securities business will already cover most [SBS Dealers] doing
business with municipal entities, and, there may not be much
marginal benefit to imposing additional restrictions on SBSDs
generally''). See also id. (``Because the Commission's proposal is
nearly identical to the CFTC Proposal, our comments generally track
those we made in response to the CFTC Proposal.'').
\1091\ FIA/ISDA/SIFMA, supra note 5.
\1092\ FIA/ISDA/SIFMA, supra note 5.
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Finally, one commenter suggested that the Commission create a safe
harbor from the pay to play rule for a special entity that is
represented by a qualified independent representative that
affirmatively selects the SBS Dealer.\1093\ That commenter also
suggests excluding state-established plans that are managed by a third-
party, such as 529 college savings plans, from the pay to play
provisions because otherwise, the provisions would deter SBS Dealers
from transacting with the plans.
---------------------------------------------------------------------------
\1093\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
After the adoption of the CFTC's rules in 2015, this same commenter
subsequently proposed that the Commission expressly except from the
prohibitions of Rule 15Fh-6(b)(1) contributions that were ``made before
the security-based swap dealer registered with the Commission as
such.'' \1094\ According to the commenter, these changes would be
consistent with CFTC No-Action relief, which clarified that the ``look
back'' period would not include any time period before an SBS Dealer is
required to register as such, and would therefore prevent retroactive
application of the rule.\1095\ The commenter further suggested that the
Commission modify the exception under 15Fh-6(b)(2)(B)(iii), such that
it would apply to a security-based swap that was ``executed'' by a
municipal entity on a registered national securities exchange or
registered or an ``exempt'' security-based swap execution facility, and
was of a ``type that is, as of the date of execution, required to be
cleared pursuant to Section 3C of the Act.'' \1096\ In the alternative,
the commenter suggested that the exception should apply where the SBS
Dealer does not know the identity of the counterparty to the
transaction at any time up to and including execution of the
transaction.\1097\
---------------------------------------------------------------------------
\1094\ See SIFMA (August 2015), supra note 5.
\1095\ Id.
\1096\ Id.
\1097\ Id.
---------------------------------------------------------------------------
c. Response to Comments and Final Rule
After considering the comments, the Commission is adopting Rule
15Fh-6 with six modifications. First, after the Proposing Release was
published, an inadvertent omission was identified in the definition of
``contribution'' in proposed Rule 15Fh-6(a)(1)(i). The Proposing
Release inadvertently omitted the word ``federal'' in subsection (i) of
the proposed definition of ``contribution'' in Rule 15Fh-6(a)(1).
Although the Commission did not receive any comments noting this
omission, we are modifying the rule text to include the word
``federal'' in subsection (i) of the final definition of
``contribution'' in Rule 15Fh-6(a)(1)).\1098\ Furthermore, and as
stated in the Proposing Release, the Commission explained that ``Rule
15Fh-6 is modeled on, and intended to complement, existing restrictions
on pay to play practices under Advisers Act Rule 206(4)-5 . . . and
under MSRB Rules G-37 and G-38.'' \1099\ Importantly, both Advisers Act
Rule 206(4)-5(f)(1)(i) and MSRB Rule G-37(g)(i)(A)(1) include the word
``federal'' in their largely identical definitions of the term
``contribution.'' The Commission is correcting this inadvertent
omission to make the definition of ``contribution'' in Rule 15Fh-
6(a)(1)(i) consistent with the
[[Page 30047]]
Commission's existing definition of ``contribution'' under Advisers Act
Rule 206(4)-5(f)(1)(i).\1100\ Correcting this omission also will make
the definition of ``contribution'' in Rule 15Fh-6(a)(1) consistent with
the existing definition of ``contribution'' under CFTC Regulation
23.451(a)(1)(i) and, therefore, create a harmonized regulatory
framework that complements and is comparable to Advisers Act Rule
206(4)-5, MSRB Rules G-37 and CFTC Regulation 23.451.\1101\ Based on
the foregoing, the Commission believes that correcting this inadvertent
omission in a rule that was, as set forth in the Proposing Release,
``modeled on, and intended to complement, existing restrictions on pay
to play practices'' \1102\ will eliminate an unintentional gap in pay
to play protections across regulatory regimes that would otherwise be
created. In light of cross-market participation and expected dual
registration of some entities, substantial consistency across pay to
play regulatory regimes, including having largely consistent
definitions of ``contribution,'' will also be helpful for those
entities that have already established a regulatory infrastructure to
comply with pay to play standards under existing rules.
---------------------------------------------------------------------------
\1098\ As such, Final Rule 15Fh-6(a)(1)(i) will read ``[f]or the
purpose of influencing any election for federal, state or local
office.'' In light of this modification, and for purposes of
internal consistency with a parenthetical reference to this rule
text elsewhere in the rule, a parallel modification is being made to
Final Rule 15Fh-6(d)(5), which will read: ``The nature of the
election (e.g., federal, state or local).''
\1099\ Proposing Release, 76 FR at 42433, supra note 3.
\1100\ See Political Contributions by Certain Investment
Advisers, Advisers Act Release No. 3043 (Jul. 1, 2010), 75 FR 41018
(Jul. 14, 2010) (``Advisers Act Pay-to-Play Release'') (adopting
Advisers Act Rule 206(4)-5 and stating, among other things, that the
definition of ``contribution'' in Advisers Act Rule 206(4)-5 ``is
the same as . . . the one used in MSRB rule G-37'').
\1101\ Although subsection (iii) of CFTC Regulation 23.451(a)(1)
also includes the term ``federal'' in the definition of
``contribution''--``[f]or transition or inaugural expenses incurred
by the successful candidate for federal, state, or local office.''--
as explained by the Commission in the Advisers Act Pay-to-Play
Release, neither Rule 206(4)-5 nor MSRB Rule G-37 includes the
transition or inaugural expenses of a successful candidate for
federal office in the definition of ``contribution.'' See Advisers
Act Pay-to-Play Release, 75 FR at 41030, n.154, supra note 1100.
Therefore, because this rule is modeled on, and intended to
complement, existing restrictions on pay to play practices under
Advisers Act Rule 206(4)-5 and MSRB Rules G-37, we also do not
include the term ``federal'' in subsection (iii) of Rule 15Fh-
6(a)(1) for the same reasons stated by the Commission when adopting
the Advisers Act pay-to-play rules.
\1102\ Proposing Release, 76 FR at 42433, supra note 3.
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Second, the Commission is correcting another inadvertent omission
in the text of Rule 15Fh-6(b)(2)(i). As outlined in the Proposing
Release, the de minimis contribution exception found in Rule 15Fh-
6(b)(2)(i) is intended to be limited to contributions made by
individuals that are covered associates to track and complement the
similar de minimis contribution exception found in Advisers Act Rule
206(4)-5(b)(1), upon which this exception was modeled.\1103\ Because
this exception is conditioned on whether the covered associate was
entitled to vote for the official at the time of the contribution, we
believe it was implicit in the proposed rule text that this exception
only applies to contributions made by a natural person since other
legal persons are not entitled to vote. However, we are modifying the
text of Rule 15Fh-6(b)(2)(i) to clarify that this exception only
applies to contributions made by a natural person. With that
modification, the rule text as adopted will track the explanation
behind this exception, as explained in the Proposing Release, as well
as the text of Advisers Act Rule 206(4)-5(b)(1). This modification will
also make Rule 15Fh-6(b)(2)(i) consistent with the CFTC's analogous de
minimis contribution exception, which the CFTC described as similarly
intended to be limited to individuals that are covered
associates.\1104\
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\1103\ See Proposing Release, 76 FR at 42434, supra note 3
(``The proposed rule would permit an individual who is a covered
associate to make aggregate contributions without being subject to
the two-year time out period, of up to $350 per election, for 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.'') (emphases added).
\1104\ See CFTC Adopting Release, 77 FR at 9799, supra note 21
(explaining that CFTC's ``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.'') (emphases added).
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Third, as discussed in Section II.B, the Commission is modifying
the exception under Rule 15Fh-6(b)(2)(iii) so as to apply when the SBS
Dealer does not know the identity of the counterparty with reasonably
sufficient time prior to execution of the transaction to permit the SBS
Dealer to comply with the obligations of the rule. This language
differs from the language used in the proposal, which would apply the
exception when the dealer does not know the identity of the
counterparty ``at any time up to and including execution of the
transaction.'' The adoption of this language will comport with the
language used in the verification of counterparty status and disclosure
requirements of final Rule 15Fh-3, as well as the exceptions to the
special entity requirements under Rules 15Fh-4(b)(3) and 15Fh-5(d). As
discussed in those sections, this language is intended to exclude
situations where the identity of the counterparty is not discovered
until after execution of a transaction, or where the SBS Dealer learns
the identity of the counterparty with insufficient time to be able to
satisfy its obligations under the rule without delaying the execution
of the transaction.
Fourth, as discussed above in Section II.H.8, the Commission is
also modifying the exception under Rule 15Fh-6(b)(2)(iii) to apply to
all security-based swap transactions executed on a registered or exempt
SEF or registered national securities exchange, rather than just with
respect to transactions ``initiated by a municipal entity'' on such
exchange or SEF (as long as the other conditions of Rule 15Fh-
6(b)(2)(iii) are met). We are revising the rule to be consistent with
the adopted Rules 15Fh-4(b)(3) and 15Fh-5(d), and avoid the ambiguity
inherent in determining which party ``initiated'' the security-based
swap.\1105\
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\1105\ See supra Section II.H.8.
---------------------------------------------------------------------------
Fifth, we are also modifying Rule 15Fh-6(e)(2), as one commenter
suggested,\1106\ to allow for up to three exemptions for inadvertent
contributions per calendar year, depending on the number of natural
person covered associates at the SBS Dealer. Specifically, we are
modifying the text of Rule 15Fh-6(e)(2), as suggested by this same
commenter,\1107\ to provide that an SBS Dealers that has more than 50
covered associates would be able to rely on this exception no more than
three times per calendar year, while an SBS Dealer that has 50 or fewer
covered associates would be able to rely on this exception no more than
two times per calendar year. This modification will parallel the
provision in Advisers Act Rule 206(4)-5, which also allows ``larger''
investment advisers to avail themselves of three automatic exceptions,
instead of two, in any calendar year. As the Commission noted when
modifying its Advisers Act rule proposal to include three automatic
exceptions for larger firms, we agree that inadvertent violations of
the rule are more likely at firms with greater numbers of covered
associates, and we believe that the twice per year limit is appropriate
for smaller firms and that the three times per year limit is
appropriate for larger firms.\1108\
[[Page 30048]]
Although we recognize that this modification will create an additional
exception not found in the CFTC's analogous rule,\1109\ we believe that
harmonization across the Commission's regulatory regimes will help to
create regulatory efficiencies for entities that have already
established a regulatory infrastructure based on the Commission's
analogous exception.
---------------------------------------------------------------------------
\1106\ FIA/ISDA/SIFMA, supra note 5 (suggesting that the
Commission modify proposed rule to allow for up to three exemptions
for inadvertent contributions, depending on the number of SBS Dealer
employees).
\1107\ See id. (suggesting that the Commission modify proposed
rule to parallel the provisions in SEC Rule 206(4)-5, relating to
contributions from certain covered associates of investment
advisers).
\1108\ See Advisers Act Pay-to-Play Release, 75 FR at 41035-36,
n. 238, supra note 1100 (``We do not believe it is appropriate for
there to be greater variation in the number of times advisers may
rely on the exception than that based either on their size or on
other characteristics. We are seeking to encourage robust monitoring
and compliance.'').
\1109\ See CFTC Adopting Release, 77 FR at 9828, supra note 21.
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Finally, the Commission is also correcting in the final rule the
following typographical errors: (1) Revising an internal cross-
reference in Rule 15Fh-6(a)(2)(iii) to cross-reference ``paragraphs
(a)(2)(i) and (a)(2)(ii) of this section'' rather than ``paragraphs
(c)(2)(i) and (c)(2)(ii) of this section''; (2) revising an internal
cross-reference in Rule 15Fh-6(d) to cross-reference ``paragraph (b) of
this section'' rather than ``paragraph (a)(1) of this section''; (3)
revising Rule 15Fh-6(b)(3)(ii)(A) to delete a phrase that was
inadvertently repeated ``a security-based swap security-based swap'';
and (4) revising Rule 15Fh-6(b)(3)(ii)(B) to also delete a phrase that
was inadvertently repeated ``a security-based swap security-based
swap.''
With respect to the balance of Rule 15Fh-6, after considering the
comments submitted, the Commission is adopting the Rule as proposed.
The Commission disagrees with certain commenters' view that Rule 15Fh-6
is not an appropriate area for the Commission to exercise its authority
to prescribe business conduct standards.\1110\ The Commission also
disagrees with one commenter's suggestion that there may not be much
marginal benefit to imposing additional restrictions on SBS Dealers
generally.\1111\ We proposed the rule in the context of security-based
swaps because pay to play practices may result in municipal entities
entering into transactions not because of hedging needs or other
legitimate purposes, but rather because of campaign contributions given
to an official with influence over the selection process. Where pay to
play exists, SBS Dealers may compete for security-based swap business
based on their ability and willingness to make political contributions,
rather than on their merit or the merit of a proposed transaction. We
believe these practices may result in significant harm to
municipalities and others in connection with security-based swap
transactions, just as they do in connection with other municipal
securities transactions.\1112\ We note that SBS Dealers may have an
incentive to participate in pay to play practices out of concern that
they may be overlooked if they fail to make such contributions. These
concerns, coupled with the furtive nature of pay to play practices and
the inability of markets to properly address them, strongly support the
need for prophylactic measures to address them in the context of
security-based swaps.\1113\ Furthermore, and as the same commenter
concedes, there would still be a regulatory gap as only ``most'' SBS
Dealers would be covered and, as another commenter observed, this rule
would help to eliminate that gap in protection.\1114\ We made this same
point in the Proposing Release, noting that while Rule 15Fh-6 is
consistent with and would complement the pay to play prohibition
adopted by the MRSB and CFTC, there are no existing federal pay to play
rules that would apply to all SBS Dealers in their dealings with
municipal entities.\1115\ Therefore, this rule was proposed to help
eliminate that regulatory gap.
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\1110\ See, e.g., FIA/ISDA/SIFMA, supra note 5 (suggesting that
because Dodd-Frank did not mandate any restrictions on political
contributions by SBS Dealers it is not clear that the Commission
needs to impose such a requirement on a discretionary basis). But
see CFA, supra note 5.
\1111\ See FIA/ISDA/SIFMA, supra note 5.
\1112\ See id. See SEC v. Larry P. Langford, Litigation Release
No. 20545 (Apr. 30, 2008) and SEC v. Charles E. LeCroy, Litigation
Release No. 21280 (Nov. 4, 2009) (charging Alabama local government
officials and J.P. Morgan employees with undisclosed payments made
to obtain municipal bond offering and swap agreement business from
Jefferson County, Alabama). See also J.P. Morgan Securities Inc.,
Securities Act Release No. 9078 (Nov. 4, 2009) (settled order
instituting administrative and cease-and-desist proceedings and
imposing remedial sanctions against a broker-dealer that the
Commission alleged was awarded bond underwriting and interest rate
swap agreement business by Jefferson County in connection with
undisclosed payments by employees of the firm).
\1113\ Cf. Blount v. SEC, 61 F.3d 938, 945 (D.C. Cir. 1995),
cert. denied, 116 S. Ct. 1351 (1996) (``no smoking gun is needed
where, as here, the conflict of interest is apparent, the likelihood
of stealth great, and the legislative purpose prophylactic'').
\1114\ CFA, supra note 5 (supporting the proposal as applied to
SBS Dealers and stating that this proposal ``would help to eliminate
what would otherwise be a serious gap in protections'').
\1115\ Proposing Release, 76 FR at 42433, supra note 3.
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The Commission continues to believe and a commenter also agrees
that the two-year time out provided for in Rule 15Fh-6 is
appropriate.\1116\ As explained in the Proposing Release, Rule 15Fh-
6(b)(1) would prohibit an SBS Dealer from offering to enter into, or
entering into, a security-based swap or a trading strategy involving a
security-based swap, with a municipal entity within two years after a
contribution to an official of such municipal entity has been made by
the SBS Dealer or any of its covered associates. We believe the two-
year time out requirement strikes an appropriate balance, as it is
sufficiently long to act as a deterrent but not so long as to be
unnecessarily onerous. The two-year time out is generally consistent
with the time out provisions in Advisers Act Rule 206(4)-5, MSRB Rule
G-37 and CFTC Regulation 23.451.
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\1116\ See NAIPFA, supra note 5.
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As we also explained in the Proposing Release, because the rule
would attribute to an SBS Dealer those contributions made by a person
even prior to becoming a covered associate of the SBS Dealer, SBS
Dealers need to ``look back'' in time to determine whether the two-year
time out applies when an employee becomes a covered associate.\1117\
Given that one commenter suggested further specificity as to whether
the rule applies only to contributions made on or after the rules
effective date,\1118\ we are interpreting the prohibition in Rule 15Fh-
6(b)(1) and its exceptions in Rule 15Fh-6(b)(2), as well as the
restrictions on soliciting or coordinating contributions found in Rule
15Fh-6(b)(3), to not be triggered for an SBS Dealer or any of its
covered associates by contributions made before the SBS Dealer
registered with the Commission as such. This interpretation is, as one
commenter noted, also consistent with CFTC No-Action relief.\1119\
However, such prohibitions will apply to contributions made on or after
the SBS Dealer is required to register with the Commission. We also
note that these prohibitions do not apply to contributions made before
the compliance date of this rule by new covered associates to which the
rule's ``look back'' applies (i.e., a person who becomes a covered
associate within two years after the contribution is made).
[[Page 30049]]
This interpretation is similar to the approach taken by the Commission
in connection with Advisers Act Rule 206(4)-5.\1120\ For example, if an
individual who becomes a covered associate on or after the effective
date of the rule made a contribution before the effective date of the
rule, that new covered associate's contribution would not trigger the
two-year time out. On the other hand, if an individual who later
becomes a covered associate made the contribution on or after the
compliance date of this rule, the contribution would trigger the two-
year time out if it were made less than, as applicable, six months or
two years before the individual became a covered associate.\1121\
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\1117\ See Proposing Release, 76 FR at 42434, supra note 3. In
the Proposing Release, we explained, as an example, that if the
contribution at issue was made less than two years (or six months,
as applicable under Rule 15Fh-6(b)(2)(ii)) before an individual
becomes a covered associate, the rule would prohibit the firm from
entering into a security-based swap with the relevant municipal
entity until the two-year time out period has expired. As noted
above, Rule 15Fh-6(b)(2)(ii) provides an exception to the
prohibition in Rule 15Fh-6(b)(1) such that the prohibition would not
apply to contributions made by an individual more than six months
prior to becoming a covered associate of the SBS Dealer, unless such
individual solicits the municipal entity after becoming a covered
associate.
\1118\ See FIA/ISDA/SIFMA, supra note 5 (requesting
clarification that ``the rule would not unintentionally ban SBS
activity as a result of contributions made during the pre-
effectiveness period''). See also SIFMA (August 2015), supra note 5.
\1119\ See SIFMA (August 2015), supra note 5. See also CFTC
Letter No. 12-33 (November 29, 2012).
\1120\ See Advisers Act Pay-to-Play Release, 75 FR at 41051,
n.434, supra note 1100 (noting, similarly, that the prohibitions in
Rule 206(4)-5 also do not apply to contributions made before the
compliance date established for Rule 206(4)-5 by new covered
associates to which the look back applies).
\1121\ See id. (providing similar examples in connection with
Rule 206(4)-5).
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With respect to the comment recommending amending the proposed rule
to include Major SBS Participants in the prohibitions of Rule 15Fh-
6,\1122\ the Commission does not believe that it is necessary or
appropriate to do so. We have considered how the differences between
the definitions of SBS Dealer and Major SBS Participant may be relevant
in formulating the business conduct standards applicable to these
entities.\1123\ The Commission does not believe it is necessary to
revisit its assumption, outlined in the Proposing Release, that Major
SBS Participants are unlikely to give rise to the pay-to-play concerns
that this rule is intended to address.\1124\ As discussed above, SBS
Dealers may have an incentive to compete for security-based swap
business based on their ability and willingness to participate in pay
to play activity, rather than on their merit or the merit of a proposed
transaction, out of concern that they may be overlooked if they fail to
make such contributions. However, we believe the incentives for Major
SBS Participants to engage in pay to play activity are unlikely to be
as strong as the incentives for SBS Dealers given that, by definition,
Major SBS Participants are not engaged in security-based swap dealing
activity at levels above the de minimis threshold.\1125\ As such, Major
SBS Participants are less likely than SBS Dealers to be acting as
dealers in the security-based swap market and, like any other person
whose dealing activity does not exceed the dealer de minimis
thresholds, should therefore be less susceptible to the types of
competitive pressures that may create an incentive to participate in
pay to play activity. We further note that, if a Major SBS Participant
is, in fact, engaged in security-based swap dealing activity above the
de minimis threshold, it would need to register as an SBS Dealer and,
as such, would need to comply with the pay to play rules imposed by
Rule 15Fh-6.
---------------------------------------------------------------------------
\1122\ CFA, supra note 5.
\1123\ See, e.g., Section II.B (explaining that, unlike the
definition of ``security-based swap dealer,'' which focuses on the
way a person holds itself out in the market and whose function is to
serve as the point of connection in those markets, the definition of
``major security-based swap participant,'' focuses on the market
impacts and risks associated with an entity's security-based swap
positions).
\1124\ See, e.g., MFA, supra note 5 (urging the Commission to
consider separate regulatory regimes for SBS Dealers and Major SBS
Participants, arguing that they are different, and there are
``different reasons why the Dodd-Frank Act requires additional
oversight of each'').
\1125\ See Exchange Act rule 3a61-1(a)(1) (limiting the
definition of ``major security-based swap participant'' to persons
that are not security-based swap dealers).
---------------------------------------------------------------------------
Therefore, SBS Dealers, unlike Major SBS Participants, may have an
incentive to participate in pay to play practices out of concern that
they may be overlooked if they fail to make such contributions which,
in turn, would necessitate application of pay to play prohibitions.
Furthermore, the exclusion of Major SBS Participants from Rule 15Fh-6
will also be consistent with the pay to play prohibition adopted by the
CFTC.\1126\ Substantial consistency across pay to play regulatory
regimes will be helpful for those entities that have already
established a regulatory infrastructure to comply with existing rules.
One commenter suggested that, with respect to the proposal that
independent representatives be subject to pay to play limitations, an
exception is needed ``for advisors that are employees of the special
entity, given the employer-employee relationship.'' \1127\ However, the
Commission notes that the rules already include such an exception. As
explained previously, Rule 15Fh-5(a)(1)(vi) as adopted requires an SBS
Entity to have a reasonable basis for believing that the independent
representative is a person that is subject to rules of the Commission,
the CFTC or an SRO subject to the jurisdiction of the Commission or the
CFTC prohibiting it from engaging in specified activities if certain
political contributions have been made, unless the independent
representative is an employee of the special entity.
---------------------------------------------------------------------------
\1126\ See CFTC Adopting Release, 77 FR at 9800, supra note 21.
\1127\ APPA, supra note 5.
---------------------------------------------------------------------------
The same commenter also urged the Commission, in a comment letter
dated August 2011, to delay imposing the proposed pay to play rule
until after the ``dealer'' definitions are finalized.\1128\ As
explained in Section IV.B below, the Commission is adopting a
compliance date for final Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1
that is the same as the compliance date of the SBS Entity registration
rules.\1129\
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\1128\ APPA, supra note 5.
\1129\ The Commission explained in the Registration Adopting
Release that persons determined to be SBS Dealers or Major SBS
Participants under those rules need not register as such until the
dates provided for in the Commission's final rules regarding SBS
Entity registration requirements, ``and will not be subject to the
requirements applicable to those dealers and major participants
until the dates provided in the applicable final rules.''
Registration Adopting Release, supra note 989.
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The Commission declines to revise Rule 15Fh-6, as one commenter
suggested, by limiting the triggering event for the application of the
pay to play rules to ``engag[ing] in municipal security-based swap
business'' or ``the execution of a security-based swap with a municipal
entity.'' \1130\ As explained in the Proposing Release, pay to play
occurs when persons seeking to do business with municipal entities make
political contributions, or are solicited to make political
contributions, to elected officials or candidates to influence the
selection process.\1131\ Hence, pay to play could occur when an SBS
Dealer is merely offering to enter into a security-based swap with a
municipal entity, before that SBS Dealer has yet to actually enter
into, engage in, or execute any such transaction. Rather, the SBS
Dealer is seeking to influence the selection process to generate
business. Therefore, the Commission believes that further parsing of
the trigging event applicable to this rule, as suggested by the
commenter, would create an unintended regulatory gap that would not
capture those who offer to enter into a security-based swap transaction
with a municipal entity with the hope that their contributions or
payments will influence the selection process so that they may later
enter into, engage in, or execute security-based swaps with that
municipal entity. As one court noted,''[w]hile the risk of corruption
is obvious and substantial, actors in this field are presumably shrewd
enough to structure their relations rather indirectly.'' \1132\
Furthermore, this same suggestion was
[[Page 30050]]
raised to and declined by the CFTC.\1133\ As a result, the triggering
event for the application of Rule 15Fh-6 is consistent with the CFTC's
rule and substantially consistent with the trigging event for certain
prohibitions found in the Commission's Advisers Act Rule 206(4)-
5.\1134\
---------------------------------------------------------------------------
\1130\ FIA/ISDA/SIFMA, supra note 5 (suggesting that the
Commission consider replacing the proposed ``triggering occasion for
the application of the rule'').
\1131\ See Proposing Release, 76 FR at 42432, supra note 3.
\1132\ Id. (citing Blount, 61 F.3d at 945).
\1133\ See CFTC Adopting Release, 77 FR at 9799-800, supra note
21.
\1134\ See Advisers Act Rule 206(4)-5(2)(ii) (including, among
other triggering activities, when the investment adviser is
``providing or seeking to provide investment advisory services to a
government entity'').
---------------------------------------------------------------------------
One commenter that addressed the definition of ``solicit'' in the
proposed rule generally urged us to adopt a narrower definition.\1135\
However, the Commission declines to revise Rule 15Fh-6 to further parse
the definition of ``solicit.'' We believe that it is unnecessary, as
the commenter suggested, for the definition to cover only direct
communications or to state what communications are not covered by the
term ``solicit.'' \1136\ The proposed definition makes clear that to
fall within its scope the communication, whether direct or indirect,
must be ``with a municipal entity for the purpose of obtaining or
retaining an engagement related to a security-based swap.'' Further
parsing and thus narrowing of the definition of ``solicit'' is
unwarranted given the covert and secretive nature of pay to play
practices where, as noted above, ``actors in this field are presumably
shrewd enough to structure their relations rather indirectly.'' \1137\
Rule 15Fh-6 is intended to deter SBS Dealers from participating, even
indirectly, in pay to play practices. The Commission believes that the
definition of ``solicit'' is clear as to what communications are
covered by the pay to play rule, and the definition is also consistent
with the CFTC's rule and the Commission's definition of ``solicit'' in
Advisers Act Rule 206(4)-5 \1138\ which, as noted above, Rule 15Fh-6
was modeled on and intended to complement.
---------------------------------------------------------------------------
\1135\ FIA/ISDA/SIFMA, supra note 5 (recommending that the
Commission clarify the definition of ``solicit'' include only ``any
direct communication by any person with a municipal entity for the
purpose of obtaining or retaining municipal security-based swap
business'').
\1136\ See id. (suggesting that the rule should exclude any
communication with a municipal entity for the sole purpose of
obtaining or retaining any other type of business covered under pay-
to-play restrictions because, in that commenter's view, such
communications would already trigger pay-to-play restrictions under
other regulations).
\1137\ Proposing Release, 76 FR at 42432, supra note 3 (citing
Blount, 61 F.3d at 945).
\1138\ 17 CFR 275.206(4)-5(f)(10)(i) (defining ``solicit,'' in
part, to mean ``to communicate, directly or indirectly, for the
purpose of obtaining or retaining a client for . . . an investment
adviser'').
---------------------------------------------------------------------------
Another commenter suggested that the Commission revise Rule 15Fh-6
to create a safe harbor from the pay to play rule for a special entity
that is represented by a ``qualified independent representative'' that
affirmatively selects the SBS Dealer.\1139\ However, the Commission
declines to create a safe harbor as the commenter suggested. For one,
the commenter's argument that such a safe harbor would ``assist
municipal entities and their advisors by preserving their ability to
execute security-based swap transactions'' is not persuasive to support
this suggested modification when, for example, one of the purposes
behind this rule is the need for prophylactic measures to address
stealthy pay to play practices.\1140\ As stated in the Proposing
Release and noted above, by its nature, pay to play is covert and
secretive because participants do not broadcast that contributions or
payments are made or accepted for the purpose of influencing the
selection of a financial services provider. The Commission believes
that adopting such a safe harbor, as suggested, could create a means
for would-be wrongdoers to covertly and secretively engage in pay to
play practices by, among other things, using situations where the
special entity, represented by a qualified independent representative,
selects the SBS Dealer as a way to evade or otherwise circumvent the
rule's prohibitions. The commenter's suggestion would also create a
material difference between the regulatory regimes established by the
Commission under the Advisers Act as well as the CFTC's rules and would
decrease regulatory efficiencies for market participants.
---------------------------------------------------------------------------
\1139\ SIFMA (August 2011), supra note 5.
\1140\ Cf. Blount, 61 F.3d at 945 (noting that, with respect to
pay to play practices ``the likelihood of stealth great,'' while
``the legislative purpose prophylactic'').
---------------------------------------------------------------------------
Finally, we are not expressly excluding, as one commenter
suggested, state-established plans that are managed by a third-party,
such as 529 college savings plans, from the pay to play
provisions.\1141\ We do not find the commenter's unsupported claim that
pay to play provisions will deter SBS Dealers from transacting business
with such plans persuasive. More importantly, even if we were to accept
this argument, the same concerns, outlined above, that we are
attempting to address with these pay to play restrictions, including
but not limited to the furtive nature of pay to play practices, are
also applicable for state-established plans that are managed by a
third-party. As noted above, we believe that SBS Dealers may have an
incentive to participate in pay to play practices, even in connection
with state-established plans that are managed by a third-party, out of
concern that they may be overlooked for business if they fail to make
such contributions. We further believe these practices may result in
significant harm to municipalities and others, including state-
established plans, in connection with security-based swap transactions.
Rule 15Fh-6(b)(3)(i) is intended to deter SBS Dealers from
participating, even indirectly, in such practices.
---------------------------------------------------------------------------
\1141\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
I. Chief Compliance Officer
Section 15F(k) of the Exchange Act requires an SBS Entity to
designate a CCO, and imposes certain duties and responsibilities on
that CCO.\1142\
---------------------------------------------------------------------------
\1142\ 15 U.S.C. 78o-10(k).
---------------------------------------------------------------------------
1. Proposed Rule
a. Designation, Reporting Line, Compensation and Removal of the CCO
Proposed Rule 15Fk-1(a) would require an SBS Entity to designate a
CCO on its registration form. Proposed Rule 15Fk-1(b)(1) would require
that the CCO report directly to the board of directors or to the senior
officer of the SBS Entity.\1143\ Proposed Rule 15Fk-1(e)(1) would
define ``board of directors'' to include a body performing a function
similar to the board of directors. Proposed Rule 15Fk-1(e)(2) would
define ``senior officer'' to mean the chief executive officer or other
equivalent officer. Finally, proposed Rule 15Fk-1(d) would require that
the compensation and removal of the CCO be approved by a majority of
the board of directors of the SBS Entity.
---------------------------------------------------------------------------
\1143\ See Section 15F(k)(2)(A) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(A).
---------------------------------------------------------------------------
b. Duties of the CCO
Proposed Rule 15Fk-1(b) would impose certain duties on the CCO.
Proposed Rule 15Fk-1(b)(2) would require the CCO to review the
compliance of the SBS Entity with respect to the requirements in
Section 15F of the Exchange Act and the rules and regulations
thereunder.\1144\ Proposed Rule 15Fk-1(b)(2) would further require
that, as part of the CCO's obligation to review compliance by the SBS
Entity, the CCO establish, maintain, and review policies and procedures
that are reasonably designed to achieve compliance by the SBS Entity
with
[[Page 30051]]
Section 15F of the Exchange Act and the rules and regulations
thereunder.
---------------------------------------------------------------------------
\1144\ See Section 15F(k)(2)(B) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(B).
---------------------------------------------------------------------------
Proposed Rule 15Fk-1(b)(3) would require that the CCO, in
consultation with the board of directors or the senior officer of the
organization, promptly resolve conflicts of interest that may
arise.\1145\ Under proposed Rule 15Fk-1(b)(4), the CCO would be
responsible for administering each policy and procedure that is
required to be established pursuant to Section 15F of the Exchange Act
and the rules and regulations thereunder.\1146\ Proposed Rule 15Fk-
1(b)(5) would require the CCO to establish, maintain and review
policies and procedures reasonably designed to ensure compliance with
the provisions of the Exchange Act and the rules and regulations
thereunder relating to the SBS Entity's business as an SBS
Entity.\1147\ Proposed Rule 15Fk-1(b)(6) would require the CCO to
establish, maintain and review policies and procedures reasonably
designed to remediate promptly non-compliance issues identified by the
CCO through any compliance office review, look-back, internal or
external audit finding, self-reporting to the Commission and other
appropriate authorities, or complaint that can be validated.\1148\
Proposed Rule 15Fk-1(e)(3) would define ``complaint that can be
validated'' to mean any written complaint by a counterparty involving
the SBS Entity or an associated person that can be supported upon
reasonable investigation. Proposed Rule 15Fk-1(b)(7) would require the
CCO to establish and follow procedures reasonably designed for prompt
handling, management response, remediation, retesting, and resolution
of non-compliance issues.\1149\
---------------------------------------------------------------------------
\1145\ See Section 15F(k)(2)(C) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(C).
\1146\ See Section 15F(k)(2)(D) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(D).
\1147\ See Section 15F(k)(2)(E) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(E).
\1148\ See Section 15F(k)(2)(F) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(F).
\1149\ See Section 15F(k)(2)(G) of the Exchange Act, 15 U.S.C.
78o-10(k)(2)(G).
---------------------------------------------------------------------------
c. Annual Compliance Report
Proposed Rule 15Fk-1(c)(1) would require that the CCO annually
prepare and sign a report describing the SBS Entity's compliance
policies and procedures (including the code of ethics and conflicts of
interest policies) and the compliance of the SBS Entity with the
Exchange Act and rules and regulations thereunder relating to its
business as an SBS Entity.\1150\ Proposed Rule 15Fk-1(c)(2) would
require that each compliance report also contain, at a minimum, a
description of: (1) The SBS Entity's enforcement of its policies and
procedures relating to its business as an SBS Entity; (2) any material
changes to the policies and procedures since the date of the preceding
compliance report; (3) any recommendation for material changes to the
policies and procedures as a result of the annual review, the rationale
for such recommendation, and whether such policies and procedures were
or will be modified by the SBS Entity to incorporate such
recommendation; and (4) any material compliance matters identified
since the date of the preceding compliance report. Proposed Rule 15Fk-
1(e)(4) would define ``material compliance matter'' to mean any
compliance matter about which the board of directors of the SBS Entity
would reasonably need to know to oversee the compliance of the SBS
Entity, and that involves, without limitation: (1) A violation of the
federal securities laws relating to its business as an SBS Entity by
the SBS Entity or its officers, directors, employees or agents; (2) a
violation of the policies and procedures of the SBS Entity relating to
its business as an SBS Entity by the SBS Entity or its officers,
directors, employees or agents; or (3) a weakness in the design or
implementation of the policies and procedures of the SBS Entity
relating to its business as an SBS Entity.
---------------------------------------------------------------------------
\1150\ See Section 15F(k)(3)(A) of the Exchange Act, 15 U.S.C.
78o-10(k)(3)(A). As noted in the Proposing Release, the Commission
believes there is a drafting error in the reference to compliance of
the ``major swap participant'' in Section 15F(k)(3)(A) of the
Exchange Act, and accordingly, proposed Rule 15Fk-1(c)(1) would
apply the requirement with respect to the compliance of the ``major
security-based swap participant.'' See Proposing Release, 76 FR at
42436 n.288, supra note 3.
---------------------------------------------------------------------------
Proposed Rule 15Fk-1(c)(2)(ii)(D) would require the compliance
report to include a certification, under penalty of law, that the
compliance report is accurate and complete.\1151\ Proposed Rule 15Fk-
1(c)(2)(ii)(A) would require that the compliance report accompany each
appropriate financial report of the SBS Entity that is required to be
furnished or filed with the Commission pursuant to Exchange Act Section
15F and the rules and regulations thereunder.\1152\ To allow the
compliance report to accompany each appropriate financial report within
the required timeframe, proposed Rule 15Fk-1(c)(2)(ii)(B) would require
the compliance report to be submitted to the board of directors, the
audit committee and the senior officer of the SBS Entity at the earlier
of their next scheduled meeting or within 45 days of the date of
execution of the certification.
---------------------------------------------------------------------------
\1151\ See Section 15F(k)(3)(B)(ii) of the Exchange Act, 15
U.S.C. 78o-10(k)(3)(B)(ii).
\1152\ See Section 15F(k)(3)(B)(i) of the Exchange Act, 15
U.S.C. 78o-10(k)(3)(B)(i).
---------------------------------------------------------------------------
Proposed Rule 15Fk-1(c)(2)(ii)(C) would require the compliance
report to include a written representation that the chief executive
officer(s) (or equivalent officer(s)) has/have conducted one or more
meetings with the CCO in the preceding 12 months, the subject of which
addresses the SBS Entity's obligations as set forth in the proposed
rules and in Exchange Act Section 15F. The subject of the meeting(s)
must include: (1) The matters that are the subject of the compliance
report; (2) the SBS Entity's compliance efforts as of the date of such
meeting; and (3) significant compliance problems and plans in emerging
business areas relating to its business as an SBS Entity.\1153\
---------------------------------------------------------------------------
\1153\ Id.
---------------------------------------------------------------------------
Under proposed Rule 15Fk-1(c)(2)(iii), if compliance reports are
separately bound from the financial statements, the compliance reports
shall be accorded confidential treatment to the extent permitted by
law.
2. Comments on the Proposed Rule
a. Designation, Reporting Line, and Compensation and Removal of the CCO
Five commenters addressed the designation, reporting line and
compensation and removal of the CCO.\1154\ Two commenters argued for
greater flexibility for SBS Entities with respect to these
requirements.\1155\ The first commenter objected to the mandated line
of reporting of the CCO in the proposed rule (which would require the
CCO to report directly to the board of directors or to the senior
officer of the SBS Entity) and recommended allowing SBS Entities
greater flexibility in determining the most effective reporting
framework in light of their individual structure and
circumstances.\1156\ The commenter noted that, particularly in large
institutions where security-based swap transactions are one of many
lines of business, the proposed rule would prohibit the CCO from
reporting to other senior management who may be more familiar with the
security-based swap activities of the SBS Entity.\1157\ Accordingly,
the commenter recommended that the Commission
[[Page 30052]]
define the term ``senior officer'' to include a more senior officer
within the SBS Entity's compliance, risk, legal or other control
function as the SBS Entity shall reasonably determine to be
appropriate.\1158\
---------------------------------------------------------------------------
\1154\ See FIA/ISDA/SIFMA, supra note 5; CFA, supra note 5;
Better Markets (August 2011), supra note 5; Better Markets (October
2013), supra note 5; Barnard, supra note 5; SIFMA (September 2015),
supra note 5.
\1155\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (September 2015),
supra note 5.
\1156\ See FIA/ISDA/SIFMA, supra note 5.
\1157\ Id.
\1158\ Id.
---------------------------------------------------------------------------
Similarly, the second commenter asked the Commission to provide
guidance specifying that if a division of a larger company is an SBS
Entity, then the CCO of such entity could report to the senior officer
of that division.\1159\ Additionally, the commenter requested guidance:
(1) Regarding the supervisory liability of compliance and legal
personnel employed by SBS Entities that is consistent with the guidance
it has issued for broker-dealers' legal and compliance personnel; and
(2) clarifying that the CCO may share additional executive
responsibilities within the SBS Entity.\1160\
---------------------------------------------------------------------------
\1159\ See SIFMA (September 2015), supra note 5.
\1160\ Id.
---------------------------------------------------------------------------
Both commenters objected to the proposed requirement that the
compensation and removal of the CCO be approved by a majority of the
SBS Entity's board of directors.\1161\ The first commenter recommended
eliminating the requirement, noting that the provision is not mandated
by the Dodd-Frank Act, is not consistent with other requirements
applicable to similarly situated employees, and would impose
organizational inefficiencies and other unwarranted costs while
offering minimal benefits.\1162\ The second commenter recommended
allowing either the board of directors or the senior officer of the SBS
Entity to approve the compensation or removal of the CCO to be
consistent with the parallel CFTC requirement, asserting that this
change would reasonably ensure the independence and effectiveness of
the CCO while providing for greater flexibility.\1163\
---------------------------------------------------------------------------
\1161\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (September 2015),
supra note 5.
\1162\ See FIA/ISDA/SIFMA, supra note 5.
\1163\ See SIFMA (September 2015), supra note 5.
---------------------------------------------------------------------------
Three commenters argued for more stringent requirements with
respect to the designation, reporting line and compensation and removal
of the CCO.\1164\ The first commenter asserted that ensuring market
participants have CCOs with real authority and autonomy to police a
firm from within is one of the most efficient and effective tools
available to regulators, and accordingly, recommended adopting
additional measures to protect the authority and independence of
CCOs.\1165\ Specifically, the commenter suggested: (1) Requiring the
CCO to meet competency standards, including a lack of disciplinary
history and criteria demonstrating relevant knowledge and experience;
(2) prohibiting the CCO from serving as General Counsel or a member of
the legal department of the SBS Entity; (3) appointing a senior CCO
with overall responsibility for compliance by a group of affiliated or
controlled entities; (4) vesting authority in independent board members
to oversee the hiring, compensation, and termination of the CCO; (5)
requiring the CCO to have direct access to the board; and (6)
prohibiting attempts by officers, directors, or employees to coerce,
mislead, or otherwise interfere with the CCO.\1166\
---------------------------------------------------------------------------
\1164\ See CFA, supra note 5; Better Markets (August 2011),
supra note 5; Better Markets (October 2013), supra note 5; Barnard,
supra note 5.
\1165\ See Better Markets (October 2013), supra note 5.
\1166\ See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5.
---------------------------------------------------------------------------
Similarly, the second commenter recommended that the authority and
responsibility to appoint or remove the CCO, or to materially change
its duties and responsibilities, be vested only in the independent
directors and not the full board.\1167\ Additionally, the commenter
suggested that the CCO have only a compliance role and no other role or
responsibility that could create conflicts of interest or threaten its
independence, and that the CCO's compensation be designed in a way that
avoids conflicts of interest.\1168\
---------------------------------------------------------------------------
\1167\ See Barnard, supra note 5.
\1168\ Id.
---------------------------------------------------------------------------
The third commenter asserted that firms should not be permitted to
allow the CCO to report to a senior officer of the firm as a substitute
for reporting to the board.\1169\
---------------------------------------------------------------------------
\1169\ See CFA, supra note 5.
---------------------------------------------------------------------------
b. Duties of the CCO
Three commenters addressed the duties of the CCO.\1170\ The first
commenter supported the Commission's approach in the proposal regarding
the role and responsibilities of the CCO, but recommended the following
modifications: (1) Changing the phrase ``ensure compliance'' in
proposed Rule 15Fk-1(b)(5) to ``achieve compliance,'' (2) confirming
that the relevant conflicts of interest under proposed Rule 15Fk-
1(b)(3) would be those which are reasonably identified by the SBS
Entity's policies and procedures, taking into consideration the nature
of the SBS Entity's business, and (3) clarifying that a CCO's
responsibility under proposed Rule 15Fk-1(b)(4) to ``administer'' a
firm's policies and procedures is limited to coordinating supervisors'
administration of the relevant policies and procedures.\1171\
---------------------------------------------------------------------------
\1170\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (September 2015),
supra note 5; CFA, supra note 5.
\1171\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
The second commenter recommended harmonizing the Commission's CCO
requirements with FINRA Rule 3130 and the CFTC's CCO requirements for
Swap Entities to enable SBS Entities that are also broker-dealers and/
or Swap Entities to make use of their existing infrastructure and to
minimize confusion.\1172\ Specifically, the commenter recommended a
number of changes to proposed Rule 15Fk-1(b) to align the description
of the duties of an SBS Entity's CCO with those of a broker-dealer CCO,
as described in applicable FINRA and SEC guidance, and guidance in the
Proposing Release regarding the supervisory responsibilities of an SBS
Entity's CCO.\1173\ In particular, the commenter sought clarification
that the SBS Entity has the responsibility, and not the CCO in his or
her personal capacity, to establish, maintain and review required
policies and procedures.\1174\ The recommended changes include: (1)
Replacing the requirement in proposed Rule 15Fk-1(b)(2) to ``establish,
maintain and review'' written policies and procedures reasonably
designed to achieve compliance with Section 15F of the Act and the
rules and regulations thereunder with a requirement to ``prepare the
registrant's annual assessment of'' such policies and procedures; (2)
qualifying the requirement in proposed Rule 15Fk-1(b)(3) to promptly
resolve conflicts of interest in consultation with the board of
directors or the senior officer of the SBS Entity with the qualifying
language ``take reasonable steps to'' resolve; (3) clarifying that the
requirement in proposed Rule 15Fk-1(b)(4) to administer required
policies and procedures involves ``advising on the development of, and
reviewing, the registrant's processes for (i) modifying those policies
and procedures as business, regulatory and legislative changes and
events dictate, (ii) evidencing supervision by the personnel
responsible for the execution of those policies and procedures, and
(iii) testing the registrant's compliance with those policies and
procedures;'' (4) qualifying the requirements in proposed Rules 15Fk-
1(b)(5)-(7) to establish, maintain and review certain policies and
procedures with the qualifying language ``take reasonable steps to
ensure that the
[[Page 30053]]
registrant'' establishes, maintains and reviews such policies and
procedures; and (5) eliminating the timing requirements in proposed
Rules 15Fk-1(b)(6) and (7) that the CCO ``promptly'' take the required
actions.\1175\ Finally, the commenter requested that the Commission
provide guidance explaining that resolution of a conflict of interest
encompasses both elimination and mitigation of the conflict, and that
the CCO's role in resolving conflicts may involve actions other than
making the ultimate decision with regard to such conflict.\1176\
---------------------------------------------------------------------------
\1172\ See SIFMA (September 2015), supra note 5.
\1173\ Id.
\1174\ Id.
\1175\ Id.
\1176\ Id.
---------------------------------------------------------------------------
In contrast, the third commenter recommended mandating that CCOs
have greater authority to resolve and mitigate conflicts of interest
that may cause compliance problems.\1177\ At a minimum, the commenter
suggested requiring the CCO to highlight in the compliance report any
recommendations it made with regard to resolution or mitigation of
conflicts of interest that were not adopted.\1178\
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\1177\ See CFA, supra note 5.
\1178\ Id.
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c. Annual Compliance Report
Four commenters addressed the annual compliance report
requirements.\1179\ One commenter noted several concerns with the
annual compliance report requirement.\1180\ First, the commenter
requested that the Commission permit the consolidation of annual
compliance reporting requirements for SBS Entities under common control
(including those that are also registered broker-dealers) to avoid
forcing a consolidated financial institution to submit separate
compliance reports for each SBS Entity and broker-dealer within the
corporate structure.\1181\ Second, the commenter expressed concern
regarding the requirement in proposed Rule 15Fk-1(c)(1)(i) that the
compliance report contain a description of the compliance of the SBS
Entity, as well as a description of the SBS Entity's compliance
policies and procedures, as required under proposed Rule 15Fk-
1(c)(1)(ii).\1182\ The commenter requested that the Commission clarify
that proposed Rule 15Fk-1(c)(1)(i) would be satisfied by a description
of the particular matters set forth in proposed Rule 15Fk-1(c)(2)(i),
noting that a requirement to describe an SBS Entity's ``compliance'' in
an absolute sense is so broad and so vague as to be incapable of being
fulfilled in practice.\1183\ Third, the commenter recommended that the
Commission amend its Freedom of Information Act regulations in a manner
consistent with proposed Rule 15Fk-1(c)(2)(iii), which would provide
that compliance reports bound separately from financial statements
shall be accorded confidential treatment to the extent permitted by
law.\1184\
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\1179\ See FIA/ISDA/SIFMA, supra note 5; CFA, supra note 5;
Better Markets (August 2011), supra note 5; Better Markets (October
2013), supra note 5; SIFMA (September 2015), supra note 5.
\1180\ See FIA/ISDA/SIFMA, supra note 5.
\1181\ Id.
\1182\ Id.
\1183\ Id.
\1184\ Id.
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The commenter also had several concerns regarding the required
certification of the compliance report in proposed Rule 15Fk-
1(c)(2)(ii)(D).\1185\ The commenter noted that the Dodd-Frank Act does
not explicitly require the CCO to be the individual responsible for
certifying the compliance report and recommended that the CEO or other
relevant senior officer, not the CCO, be responsible for the
certification.\1186\ Alternatively, if the CCO is required to certify,
the commenter requested that the CEO also be required to do so.\1187\
Additionally, the commenter requested that the Commission clarify that
the liability standard for the certification is the same as that which
applies to other documents filed with the Commission, including
liability under Section 32 of the Exchange Act for willfully and
knowingly making false or misleading material statements or omissions
to the Commission.\1188\ The commenter also asserted that the certifier
should, as in other contexts, be responsible solely for stating that
the documents were prepared under his or her direction or supervision
in accordance with a system designed to ensure that qualified personnel
would properly gather and evaluate the documents, and that based on his
or her inquiry of those persons who were responsible for gathering the
documents, to the best of his or her knowledge, the documents are
accurate in all material respects.\1189\
---------------------------------------------------------------------------
\1185\ Id.
\1186\ Id.
\1187\ Id.
\1188\ Id.
\1189\ Id.
---------------------------------------------------------------------------
Similarly, the second commenter requested that the Commission
provide guidance clarifying that if a certifying officer has complied
in good faith with policies and procedures reasonably designed to
confirm the accuracy and completeness of annual compliance report, both
the SBS Entity and the certifying officer would have a basis for
defending accusations of false, incomplete, or misleading statements or
representations made in the report.\1190\ The commenter also requested
a number of changes to the annual compliance report requirements in
proposed Rule 15Fk-1(c) to harmonize them with the CFTC's parallel
requirements.\1191\ The commenter argued that alignment of the content
requirements for annual compliance reports ``would allow SBS Entities
to leverage the extensive and rigorous procedures they have adopted to
comply with the CFTC CCO Rule and related guidance.'' \1192\
Specifically, the recommended changes include: (1) Eliminating the
proposed requirement to include a ``description of compliance'' in the
annual compliance report, asserting that this requirement would add
unnecessary ambiguity; (2) specifying that the report need only contain
a description of the ``written'' compliance policies and procedures of
the SBS Entity; (3) changing the proposed description requirement in
proposed Rule 15Fk-1(c)(2)(i)(A) from ``enforcement'' of the SBS
Entity's policies and procedures to an ``assessment of the
effectiveness'' of such policies and procedures; (4) specifying that
the requirement to describe material changes to policies and procedures
in proposed Rule 15Fk-1(c)(2)(i)(B) refers to the ``registrant's''
policies and procedures; (5) changing the proposed description
requirement in proposed Rule 15Fk-1(c)(2)(i)(C) from ``any
recommendation for material changes to the policies and procedures'' to
``areas for improvement, and recommended potential or prospective
changes or improvements to its compliance program and resources devoted
to compliance;'' (6) changing the proposed description requirement in
proposed Rule 15F-1(c)(2)(i)(D) from ``any material compliance
matters'' to ``any material non-compliance matters'' identified since
the date of the preceding report (and eliminating the definition of
material compliance matter); (7) aligning the deadline for filing of
the compliance report with the CFTC's 90 day deadline; (8) allowing for
submission of the compliance report to either the board of directors or
the senior officer, as opposed to requiring submission to both the
board of directors (and audit committee) and the senior officer, as
proposed; (9) eliminating the proposed requirement that the report
contain a written representation regarding the required annual meeting
between the CEO and the CCO; (10) eliminating the proposed
specifications for what topics such
[[Page 30054]]
meeting must cover; (11) allowing either the CCO or the senior officer
to certify the annual compliance report to the best of his or her
knowledge; and (12) providing for amendments to, extensions of filing
deadlines for, and incorporation of other reports by reference in the
annual compliance report.\1193\
---------------------------------------------------------------------------
\1190\ See SIFMA (September 2015), supra note 5.
\1191\ Id.
\1192\ Id.
\1193\ Id.
---------------------------------------------------------------------------
The third commenter suggested: (1) Requiring the CCO to meet
quarterly with the Audit Committee in addition to annual meetings with
the board of directors and senior management; and (2) requiring the
board to review and comment on, but not edit, the compliance
report.\1194\ Similarly, the fourth commenter expressed support for
requiring the audit committee to review and the CCO to certify the
compliance report, and argued that the CCO should not be permitted to
qualify its report.\1195\
---------------------------------------------------------------------------
\1194\ See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5.
\1195\ See CFA, supra note 5.
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3. Response to Comments and Final Rule
Rule 15Fk-1, as adopted, is designed to be generally consistent
with the current compliance obligations applicable to CCOs of other
Commission-regulated entities,\1196\ as well as with the CFTC's CCO
rules applicable to Swap Entities. As noted in the Proposing Release,
the requirements of Rule 15Fk-1 underscore the central role that sound
compliance programs play to help ensure compliance with the Exchange
Act and rules and regulations thereunder applicable to security-based
swaps.\1197\ The Commission believes that these requirements will help
foster sound compliance programs.\1198\
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\1196\ See, e.g., FINRA Rule 3130; Rule 38a-1(a) under the
Investment Company Act of 1940, 17 CFR 270.38a-1(a)(1); Rule 206(4)-
7(a) under the Advisers Act, 17 CFR 275.206(4)-7(a); Rule 13n-11
under the Exchange Act, 17 CFR 240.13n-11.
\1197\ See Proposing Release, 76 FR at 42435, supra note 3.
\1198\ See Exchange Act Sections 15F(h)(1)(B) (authorizing the
Commission to prescribe duties for diligent supervision), and
15F(h)(3)(D) (providing authority to prescribe business conduct
standards). 15 U.S.C. 78o-10(h)(1)(B) and 78o-10(h)(3)(D).
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a. Designation, Reporting Line, and Compensation and Removal of the CCO
After considering the comments, the Commission is adopting Rule
15Fk-1(a) (designation of the CCO), Rule 15Fk-1(b)(1) (reporting line
of the CCO), Rule 15Fk-1(d) (compensation and removal of the CCO), and
the associated definitions of ``board of directors'' and ``senior
officer'' in Rule 15Fk-1(e)(1) and (2) as proposed. To address concerns
that an SBS Entity's commercial interests might have undue influence on
a CCO's ability to make forthright disclosure to the board of directors
or the senior officer about any compliance failures, the rule is
designed to help promote CCO independence and effectiveness by
establishing a direct reporting line to the board or senior officer,
and by requiring compensation and removal decisions to be made by a
majority of the board of directors. Accordingly, Rule 15Fk-1(b)(1)
requires the CCO to report directly to the board or senior officer of
the SBS Entity.\1199\ In addition, pursuant to Rule 15Fk-1(d) any
decision to remove the CCO from his or her responsibilities or approve
his or her compensation must be made by a majority of the board. The
Commission is not eliminating the requirement that only a majority of
the board can approve the compensation or removal of the CCO, as
suggested by one commenter,\1200\ nor is the Commission broadening the
rule to allow an SBS Entity's senior officer to approve the
compensation and removal of the CCO, as suggested by another
commenter.\1201\ The Commission believes that eliminating the
requirement that only a majority of the board can approve the
compensation or removal of the CCO, or allowing an SBS Entity's senior
officer to approve the compensation and removal of the CCO could
undermine the CCO's independence and effectiveness, particularly if the
CCO is responsible for reviewing the senior officer's compliance with
the Exchange Act and the rules and regulations thereunder.\1202\
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\1199\ One commenter recommended that the Commission define the
term ``senior officer'' to include a more senior officer within the
SBS Entity's compliance, risk, legal or other control function as
the SBS Entity shall reasonably determine to be appropriate. See
FIA/ISDA/SIFMA, supra note 5. The Commission declines to make this
change because it could potentially undercut the independence of the
CCO, and as noted above, the Commission believes it is important for
the CCO to be independent to mitigate potential conflicts for the
CCO in reporting or addressing compliance failures. Another
commenter requested that the Commission provide guidance specifying
that if a division of a larger company is an SBS Entity, then the
CCO of such entity could report to the senior officer of that
division. See SIFMA (September 2015), supra note 5. The Commission
has not yet addressed a process through which firms could submit an
application for limited designation as an SBS Entity, such as for a
division within a larger company. See Registration Adopting Release,
80 FR at 48966 n.13, supra note 989 (addressing limited designation
and registration).
\1200\ See SIFMA (September 2015), supra note 5.
\1201\ See FIA/ISDA/SIFMA, supra note 5.
\1202\ This is consistent with the position the Commission took
in adopting CCO requirements for security-based swap data
repositories (``SDRs''). See Security-Based Swap Data Repository
Registration, Duties, and Core Principles, Exchange Act Release No.
74246 (Feb. 11, 2015), 80 FR 14438, 14507 (Mar. 19, 2015) (``SDR
Registration Release'') (``The Commission is not extending the
applicability of this rule to an SDR's senior officer because the
Commission believes that this may unnecessarily create conflicts of
interest for the CCO, particularly if the CCO is subsequently
responsible for reviewing the senior officer's compliance with the
Exchange Act and the rules and regulations thereunder.''). The
Commission also declines to narrow the reporting line requirement to
specify that the CCO must report only to the board of directors (and
not the senior officer), as suggested by one commenter. See CFA,
supra note 5. Exchange Act Section 15F(k)(2)(A) gives SBS Entities
the flexibility of allowing the CCO to report to either the board or
senior officer, and the Commission believes that requiring a
majority of the board to approve the compensation or removal of the
CCO is sufficient to promote the independence of the CCO, allowing
for greater flexibility in the reporting line.
---------------------------------------------------------------------------
In promoting a CCO's independence and effectiveness, the Commission
does not believe that it is necessary to adopt additional requirements
suggested by commenters prohibiting a CCO from having additional roles
or responsibilities outside of compliance, such as being a member of
the SBS Entity's legal department or from serving as the SBS Entity's
general counsel.\1203\ To the extent that this poses a potential or
existing conflict of interest, the Commission believes that an SBS
Entity's written policies and procedures can be designed to adequately
identify and mitigate any such conflict.\1204\
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\1203\ See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5; Barnard, supra note 5. Cf.
SIFMA (September 2015), supra note 5 (requesting clarification that
the CCO may share additional executive responsibilities within the
SBS Entity). The Commission is also not adopting a commenter's
suggestion to require the appointment of a senior CCO with overall
responsibility for compliance by a group of affiliated or controlled
entities. See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5. The Commission believes
entities should have the flexibility to design their organizational
structure to meet their business needs.
\1204\ As discussed in Section II.G.6, supra, Rule 15Fh-
3(h)(2)(iii)(H) requires SBS Entities to establish, maintain, and
enforce written policies and procedures reasonably designed to
prevent the supervisory system from being compromised due to the
conflicts of interest that may be present with respect to the
associated person being supervised. This is consistent with the
position the Commission took in adopting CCO requirements for SDRs.
See SDR Registration Release, 80 FR at 14507, supra note 1202 (``In
promoting a CCO's independence and effectiveness, the Commission
does not believe that it is necessary to adopt, as two commenters
suggested, a rule prohibiting a CCO from being a member of the SDR's
legal department or from serving as the SDR's general counsel. To
the extent that this poses a potential or existing conflict of
interest, the Commission believes that an SDR's written policies and
procedures can be designed to adequately identify and mitigate any
associated costs.'').
---------------------------------------------------------------------------
The Commission also is not adopting rules requiring independent
board members to oversee the hiring, compensation and termination of
the
[[Page 30055]]
CCO or any material changes to the CCO's duties, requiring the CCO to
have direct access to the board, or expressly prohibiting attempts by
officers, directors, or employees to coerce, mislead or otherwise
interfere with the CCO, as suggested by commenters.\1205\ The
Commission continues to believe that requiring a majority of the board
to approve the compensation and removal of the CCO is appropriate to
promote the CCO's independence and effectiveness, and believes that it
is appropriate not to provide for additional requirements such as those
suggested by the commenters.\1206\ With this approach, the Commission
intends to promote the independence and effectiveness of the CCO while
also providing SBS Entities flexibility in structuring their businesses
and directing their compliance resources.
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\1205\ See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5; Barnard, supra note 5.
\1206\ The Commission also believes that requiring a majority of
the board to approve the compensation of the CCO will address a
commenter's concern regarding designing the compensation of the CCO
in a way that avoids conflicts of interest. See Barnard, supra note
5.
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One commenter suggested requiring the CCO to meet certain
competency standards, including criteria demonstrating relevant
knowledge and experience.\1207\ Given the critical role that a CCO is
intended to play in helping to ensure an SBS Entity's compliance with
the Exchange Act and the rules and regulations thereunder, the
Commission believes that an SBS Entity's CCO generally should be
competent and knowledgeable regarding the federal securities laws,
empowered with full responsibility and authority to develop appropriate
policies and procedures for the SBS Entity, as necessary, and
responsible for monitoring compliance with the SBS Entity's policies
and procedures adopted pursuant to rules under the Exchange Act.\1208\
However, we believe that such considerations are properly vested in the
SBS Entity, based on the particulars of its business, and thus, the
Commission is not adopting specific requirements concerning the
background, training or business experience for a CCO.
---------------------------------------------------------------------------
\1207\ See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5.
\1208\ This is generally consistent with the position the
Commission took in adopting CCO requirements for SDRs. See SDR
Registration Release, 80 FR at 14510, supra note 1202 (``Given the
critical role that a CCO is intended to play in ensuring an SDR's
compliance with the Exchange Act and the rules and regulations
thereunder, the Commission believes that an SDR's CCO should be
competent and knowledgeable regarding the federal securities laws,
should be empowered with full responsibility and authority to
develop and enforce appropriate policies and procedures for the SDR,
as necessary, and should be responsible for monitoring compliance
with the SDR's policies and procedures adopted pursuant to rules
under the Exchange Act. However, the Commission will not
substantively review a CCO's competency, and is not requiring any
particular level of competency or business experience for a CCO.'').
---------------------------------------------------------------------------
Another commenter asked that the Commission provide guidance
regarding the supervisory liability of compliance and legal personnel
employed by SBS Entities to reflect the guidance Commission staff has
issued for broker-dealers' legal and compliance personnel.\1209\ The
Commission recognizes that compliance and legal personnel play a
critical role in efforts by regulated entities to develop and implement
effective compliance systems, including by providing advice and counsel
to business line personnel. As noted in the Proposing Release, the
title of CCO does not, in and of itself, carry supervisory
responsibilities, and a CCO does not become a ``supervisor'' solely
because he or she has provided advice or counsel concerning compliance
or legal issues to business line personnel, or assisted in the
remediation of an issue. Consistent with current industry practice, the
Commission generally would not expect a CCO appointed in accordance
with Rule 15Fk-1 to have supervisory responsibilities outside of the
compliance department.\1210\ Accordingly, absent facts and
circumstances that establish otherwise, the Commission generally would
not expect that a CCO would be subject to a sanction by the Commission
for failure to supervise other SBS Entity personnel.\1211\ Moreover, a
CCO with supervisory responsibilities could rely on the provisions of
Rule 15Fh-3(h)(3), under which a person associated with an SBS Entity
shall not be deemed to have failed to reasonably supervise another
person if the conditions in the rule are met.\1212\ The fact that the
Exchange Act does not presume that compliance or legal personnel are
supervisors solely because of their compliance or legal functions does
not in any way diminish the compliance duties of the CCO pursuant to
Rule 15Fk-1(b), as discussed below.
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\1209\ See SIFMA (September 2015), supra note 5 (referencing
Division of Trading and Markets Frequently Asked Questions about
Liability of Compliance and Legal Personnel at Broker-Dealers under
Sections 15(b)(4) and 15(b)(6) of the Exchange Act (Sept. 30, 2013),
available at: http://www.sec.gov/divisions/marketreg/faq-cco-supervision-093013.htm).
\1210\ See Proposing Release, 76 FR at 42436, supra note 3.
\1211\ Id. Regardless of their status as supervisors, compliance
and legal personnel who otherwise violate the federal securities
laws or aid and abet or cause a violation may independently be held
liable for such violations.
\1212\ See Proposing Release, 76 FR at 42436, supra note 3.
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b. Duties of the CCO
After considering the comments, the Commission is adopting Rule
15Fk-1(b)(2)-(4) (duties of the CCO) with a number of modifications. In
response to a commenter's concerns,\1213\ the modifications (discussed
below) are primarily intended to provide certainty regarding the CCO's
duties under the final rule, consistent with the duties in FINRA Rule
3130 and the CFTC's CCO requirements for Swap Entities, and to clarify
the role of the CCO generally. To the extent our requirements are
consistent with FINRA and/or CFTC standards, this consistency should
result in efficiencies for SBS Entities that have already established
infrastructure to comply with the FINRA and/or CFTC standards.
Consistent wording regarding expectations for CCOs will also allow such
SBS Entities to more easily analyze compliance with the Commission's
rule against their existing activities to comply with FINRA Rule 3130
and the CFTC's CCO rule for Swap Entities.
---------------------------------------------------------------------------
\1213\ See SIFMA (September 2015), supra note 5.
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First, we are reorganizing Rule 15Fk-1(b)(2) to provide additional
clarity and certainty as to the obligations of the CCO. Specifically,
our modifications are designed to make clear that in taking reasonable
steps to ensure that the SBS Entity establishes, maintains and reviews
written policies and procedures reasonably designed to achieve
compliance with the Exchange Act and the rules and regulations
thereunder relating to its business as an SBS Entity, the CCO must
satisfy the three specific obligations enumerated in Rule 15Fk-
1(b)(2)(i)-(iii), discussed below.
Second, in addition to the reorganization described above, we are
making some changes to the descriptions of the duties listed in Rule
15Fk-1(b)(2). As described above, we are making changes to the duty
that now appears in Rule 15Fk-1(b)(2). Specifically, the Commission
agrees with a commenter that it is the responsibility of the SBS
Entity, not the CCO in his or her personal capacity, to establish and
enforce required policies and procedures.\1214\ Accordingly, to reflect
that, the Commission is qualifying the proposed requirement to
establish, maintain and review policies and procedures reasonably
designed to ensure compliance with the Exchange Act and rules and
regulations thereunder with the qualifying language
[[Page 30056]]
``take reasonable steps to ensure that the registrant'' establishes,
maintains and reviews such policies and procedures. The Commission is
also changing the requirement in Rule 15Fk-1(b)(2) from a requirement
to ``ensure compliance'' to a requirement to ``achieve compliance''
with the Exchange Act and rules and regulations thereunder relating to
the SBS Entity's business as an SBS Entity in response to a specific
suggestion from a commenter,\1215\ and adding the word ``written''
before policies and procedures to clarify that the policies and
procedures required by the rule must be written. Similar to the
qualifying language with respect to the registrant's policies and
procedures, the Commission is making the change from ``ensure
compliance'' to ``achieve compliance'' to clarify that it is not the
role of the CCO to ``ensure'' compliance. The Commission believes the
formulation ``take reasonable steps to ensure that the registrant
establishes, maintains and reviews written policies and procedures
reasonably designed to achieve compliance'' (as opposed to the proposed
formulation of ``establish, maintain and review policies and procedures
reasonably designed to ensure compliance'') more appropriately
describes the CCO's role. The Commission also notes that the policies
and procedures referred to in Rule 15Fk-1(b)(2) include those required
by Rules 15Fh-3(h)(2)(iii), 15Fk-1(b)(2)(ii) and 15Fk-1(b)(2)(iii), and
any other policies and procedures the SBS Entity deems necessary to
achieve compliance with the Exchange Act and the rules and regulations
thereunder relating to its business as an SBS Entity.
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\1214\ See SIFMA (September 2015), supra note 5.
\1215\ See FIA/ISDA/SIFMA, supra note 5.
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We are also modifying the three specific obligations of the CCO now
enumerated in Rule 15Fk-1(b)(2)(i)-(iii) that the CCO must perform to
satisfy his or her duty to take reasonable steps to ensure that the
registrant establishes, maintains and reviews policies and procedures
reasonably designed to achieve compliance. As adopted, Rule 15Fk-
1(b)(2)(i) requires the CCO to ``revie[w] the compliance of the [SBS
Entity] with respect to the [SBS Entity] requirements described in
[S]ection 15F of the [Exchange Act], and the rules and regulations
thereunder, where the review shall involve preparing the registrant's
annual assessment of its written policies and procedures reasonably
designed to achieve compliance with [S]ection 15F of the [Exchange Act]
and the rules and regulations thereunder, by the [SBS Entity].'' The
requirement that the CCO ``prepare the registrant's annual assessment
of its'' written policies and procedures reasonably designed to achieve
compliance with Section 15F of the Exchange Act and the rules and
regulations thereunder represents a change from the proposed
requirement that the CCO ``establish, maintain and review'' such
policies and procedures. We are making this change in response to a
specific suggestion from a commenter.\1216\ As discussed above, the
Commission agrees with the commenter that it is the responsibility of
the SBS Entity, not the CCO in his or her personal capacity, to
establish and enforce required policies and procedures, and believes
that this change clarifies that point.
---------------------------------------------------------------------------
\1216\ See SIFMA (September 2015), supra note 5.
---------------------------------------------------------------------------
As adopted, Rule 15Fk-1(b)(2)(ii) requires the CCO to ``tak[e]
reasonable steps to ensure that the registrant establishes, maintains
and reviews policies and procedures reasonably designed to remediate
non-compliance issues identified by the [CCO] through any means,
including any: (A) Compliance office review; (B) Look-back; (C)
Internal or external audit finding; (D) Self-reporting to the
Commission and other appropriate authorities; or (E) Complaint that can
be validated.'' This represents a change from the proposed
requirements: (1) That the CCO ``establish, maintain and review'' such
policies and procedures, and (2) that such policies and procedures be
reasonably designed to remediate ``promptly'' non-compliance issues.
Additionally, as adopted, Rule 15Fk-1(b)(2)(iii) requires the CCO to
``tak[e] reasonable steps to ensure that the registrant establishes and
follows procedures reasonably designed for the handling, management
response, remediation, retesting, and resolution of non-compliance
issues.'' This also represents a change from the proposed requirements:
(1) That the CCO ``establish and follow'' such procedures, and (2) that
such procedures be reasonably designed for the ``prompt'' handling,
management response, remediation, retesting, and resolution of non-
compliance issues.'' We are making these changes in response to
specific suggestions from a commenter.\1217\ As discussed above, the
Commission agrees with the commenter that it is the responsibility of
the SBS Entity, not the CCO in his or her personal capacity, to
establish and enforce required policies and procedures, and believes
that the first change to each provision clarifies that point.
Additionally, as discussed above, eliminating the proposed timing
requirements with respect to the ``prompt'' remediation and handling of
non-compliance issues provides greater consistency with the parallel
CFTC requirements. With this change, the Commission intends to focus
the CCO's efforts on the effective remediation and handling of non-
compliance issues, without placing undue emphasis on speed at the
expense of other factors. We believe, however, that the remediation and
handling of non-compliance issues generally should occur within a
reasonable timeframe.
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\1217\ See SIFMA (September 2015), supra note 5.
---------------------------------------------------------------------------
In addition to the changes described above, the Commission is
making one more modification to the duty to remediate non-compliance
issues in final Rule 15Fk-1(b)(2)(ii). The proposed rule referred only
to non-compliance issues ``identified by the [CCO] through any: (A)
Compliance office review; (B) Look-back; (C) Internal or external audit
finding; (D) Self-reporting to the Commission and other appropriate
authorities; or (E) Complaint that can be validated.'' However, as
noted above, Rule 15Fk-1(b)(2)(iii) requires that the CCO ``tak[e]
reasonable steps to ensure that the registrant establishes and follows
procedures reasonably designed for the handling, management response,
remediation, retesting, and resolution of non-compliance issues''
(emphasis added). Because this requirement is not limited to non-
compliance issues identified by the CCO through a specific means, the
Commission believes it is appropriate to clarify that final Rule 15Fk-
1(b)(2)(ii) covers non-compliance issues identified by the CCO through
any means, including the means specifically listed in sub-paragraphs
(A)-(E) of the rule.
Third, the Commission is modifying the duties of the CCO now
enumerated in Rules 15Fk-1(b)(3) and (4). As adopted, Rule 15Fk-1(b)(3)
requires the CCO to ``[i]n consultation with the board of directors or
the senior officer of the [SBS Entity], take reasonable steps to
resolve any material conflicts of interest that may arise.'' This
represents a change from the proposed requirement, which would have
required the CCO to ``[i]n consultation with the board of directors or
the senior officer of the [SBS Entity], promptly resolve any conflicts
of interest that may arise.'' The Commission is adding the ``take
reasonable steps'' language and materiality qualifier to further
clarify and qualify the role of the CCO in resolving conflicts of
interest in response to concerns raised by commenters.\1218\ Such
conflicts of
[[Page 30057]]
interest could include conflicts between the commercial interests of an
SBS Entity and its statutory and regulatory responsibilities, and
conflicts between, among, or with associated persons of the SBS Entity.
As noted in the Proposing Release and consistent with the discussions
of the CCO's role above, the Commission understands that the primary
responsibility for the resolution of conflicts generally lies with the
business units within SBS Entities because the business line personnel
are those with the power to make decisions regarding the business of
the SBS Entity.\1219\ As a result, the Commission anticipates that the
CCO's role with respect to such resolution and mitigation of conflicts
of interest would include the recommendation of one or more actions, as
well as the appropriate escalation and reporting with respect to any
issues related to the proposed resolution of potential or actual
conflicts of interest, rather than responsibility to execute the
business actions that may be associated with the ultimate resolution of
such conflicts. Furthermore, the Commission recognizes that a CCO
typically will not exercise the supervisory authority to resolve
conflicts of interest, and the revisions to the rule are intended to
clarify that CCOs are not required to actually resolve such
conflicts.\1220\ Finally, in response to a specific suggestion made by
a commenter,\1221\ the Commission is eliminating the proposed timing
requirement with respect to the ``prompt'' resolution of conflicts of
interest to harmonize with the parallel CFTC requirement. With this
change, the Commission intends to focus the CCO's efforts on the
effective resolution of conflicts of interest, without placing undue
emphasis on speed at the expense of other factors. We believe, however,
that the resolution of conflicts of interest generally should occur
within a reasonable timeframe.
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\1218\ See FIA/ISDA/SIFMA, supra note 5 (requesting confirmation
that the relevant conflicts of interest under proposed Rule 15Fk-
1(b)(3) would be those which are reasonably identified by the SBS
Entity's policies and procedures, taking into consideration the
nature of the SBS Entity's business); SIFMA (September 2015), supra
note 5 (recommending qualifying the requirement to promptly resolve
conflicts of interest in consultation with the board or senior
officer with the qualifying language ``take reasonable steps to''
resolve, and requesting guidance explaining that resolution of a
conflict of interest encompasses both elimination and mitigation of
the conflict and that the CCO's role in resolving conflicts may
involve actions other than making the ultimate decision with regard
to such conflict).
\1219\ See Proposing Release, 76 FR at 42436, supra note 3.
\1220\ This is consistent with the position the Commission took
in adopting a similar requirement for CCOs of SDRs. See SDR
Registration Release, 80 FR at 14510, supra note 1202. The
Commission is not, as suggested by one commenter, expressly
requiring the CCO to highlight in the annual compliance report any
recommendations he or she made with regard to resolution or
mitigation of conflicts of interest that were not adopted. See CFA,
supra note 5. The Commission believes the requirement in Rule 15Fk-
1(c)(2)(i)(C) to include a description in the annual compliance
report of areas for improvement, and recommended potential or
prospective changes or improvements to its compliance program and
resources, as discussed below, will adequately cover such issues.
The requirement is broadly framed and will allow the CCO the
flexibility to include in the annual compliance report a description
of any areas where the CCO thinks the compliance program needs to be
improved, including, as appropriate, any recommendations the CCO
made with regard to the resolution or mitigation of conflicts of
interest that have not yet been adopted.
\1221\ See SIFMA (September 2015), supra note 5.
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As adopted, Rule 15Fk-1(b)(4) requires the CCO to ``[a]dminister
each policy and procedure that is required to be established pursuant
to [S]ection 15F of the [Exchange Act] and the rules and regulations
thereunder.'' This represents a change from the proposed requirement
that the CCO ``be responsible for'' administering such policies and
procedures. The Commission is eliminating the words ``be responsible
for'' because we believe they are unnecessary and could cause
confusion. The CCO is responsible for complying with all of the duties
listed in Rule 15Fk-1(b)(2)-(4). Commenters requested clarifications as
to what the CCO's administration of the required policies and
procedures would entail.\1222\ The Commission recognizes that the CCO
cannot be a guarantor of the SBS Entity's conduct. The Commission
believes that such administration generally should involve: (1)
Reviewing, evaluating, and advising the SBS Entity and its risk
management and compliance personnel on the development, implementation
and monitoring of the policies and procedures of the SBS Entity,
including procedures reasonably designed for the handling, management
response, remediation, retesting and resolution of non-compliance
issues as required by Rule 15Fk-1(b)(2)(iii); and (2) reviewing,
evaluating, following and reasonably responding to the development,
implementation and monitoring of the SBS Entity's processes for (a)
modifying its policies and procedures as business, regulatory and
legislative changes dictate; (b) evidencing supervision by the
personnel responsible for the execution of its policies and procedures;
(c) testing the SBS Entity's compliance with, and the adequacy of, its
policies and procedures; and (d) resolving, escalating and reporting
issues or concerns. In carrying out this administration, the Commission
believes that the CCO generally should consult, as appropriate, with
business lines, management and independent review groups regarding
resolution of compliance issues.
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\1222\ See SIFMA (September 2015), supra note 5 (requesting the
addition of rule text explaining that ``such administration shall
involve advising on the development of, and reviewing, the
registrant's processes for (i) modifying those policies and
procedures as business, regulatory and legislative changes and
events dictate, (ii) evidencing supervision by the personnel
responsible for the execution of those policies and procedures, and
(iii) testing the registrant's compliance with those policies and
procedures''); FIA/ISDA/SIFMA, supra note 5 (requesting
clarification that a CCO's responsibility to administer a firm's
policies and procedures is limited to coordinating supervisors'
administration of the relevant policies and procedures).
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c. Annual Compliance Report
After considering the comments, the Commission is adopting Rule
15Fk-1(c) (annual compliance report) with a number of modifications, as
discussed below. In response to concerns raised by a commenter,\1223\
these changes are primarily intended to harmonize the annual compliance
report requirements with the CFTC's parallel requirements. As discussed
above, this consistency will result in efficiencies for SBS Entities
that have already established infrastructure to comply with the CFTC
requirements. Consistent wording regarding expectations for the annual
compliance report will also allow such SBS Entities to more easily
analyze compliance with the Commission's rule against their existing
activities to comply with the CFTC's parallel rule for Swap Entities.
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\1223\ See SIFMA (September 2015), supra note 5.
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First, the Commission is making a clarifying change to Rule 15Fk-
1(c)(1) to consistently refer to the annual report required by Rule
15Fk-1(c) as the ``compliance report.'' This wording change will not
alter the substantive requirements of the rule. It is only meant to
clarify that the rule refers to a single annual compliance report.
Second, the Commission is eliminating the proposed requirement to
include a description of ``the compliance'' of the SBS Entity in the
annual compliance report in response to concerns raised by
commenters,\1224\ and specifying that the requirement to include a
description of the compliance policies and procedures only requires a
description of the ``written'' compliance policies and procedures of
the SBS Entity pursuant to Rule 15Fk-1(c)(1), in response to a specific
suggestion from a commenter.\1225\ The Commission agrees
[[Page 30058]]
with commenters that the proposed requirement to describe ``the
compliance'' of the SBS Entity was vague and believes these clarifying
changes will facilitate SBS Entities' compliance with the rule, which
will still require an SBS Entity to provide information demonstrating
how the SBS Entity complies with the applicable requirements of the
Exchange Act and the rules and regulations thereunder in the form of
the SBS Entity's written compliances policies and procedures. As
adopted, Rule 15Fk-1(c)(1) requires the CCO to ``annually prepare and
sign a compliance report that contains a description of the written
policies and procedures of the [SBS Entity] described in paragraph (b)
(including the code of ethics and conflict of interest policies).'' The
Commission believes that SBS Entities can fulfill this requirement by
either providing copies or summaries of their written compliance
policies and procedures in the annual compliance report. These changes
will also harmonize the annual compliance report requirements with the
CFTC's parallel requirements, as discussed above.
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\1224\ See SIFMA (September 2015), supra note 5; FIA/ISDA/SIFMA,
supra note 5.
\1225\ See SIFMA (September 2015), supra note 5. Cf. Commodity
Exchange Act Rule 3.3(e)(1) (``The annual report shall, at a minimum
. . . [c]ontain a description of the written policies and
procedures, including the code of ethics and conflicts of interest
policies, of the futures commission merchant, swap dealer, or major
swap participant.'').
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The Commission is also making certain modifications to the required
content of the annual compliance report in Rule 15Fk-1(c)(2) in
response to specific suggestions from a commenter.\1226\ First, the
Commission is specifying that the requirement to describe material
changes to policies and procedures since the date of the preceding
compliance report in Rule 15Fk-1(c)(2)(i)(B) refers to the
``registrant's'' policies and procedures. This is a clarification and
does not change the substance of the requirement. The phrase ``since
the date of the preceding compliance report'' in the rule refers to the
coverage date of the prior year's compliance report, not the date on
which it was prepared. Accordingly, pursuant to Rule 15Fk-
1(c)(2)(i)(B), as adopted, an SBS Entity must describe in its annual
compliance report any material changes to the SBS Entity's policies and
procedures for the time period covered by the report.
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\1226\ See SIFMA (September 2015), supra note 5.
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Second, the Commission is making a number of changes to harmonize
the content requirements for the annual compliance report with the
CFTC's parallel requirements for the annual compliance reports of Swap
Entities. The Commission agrees with the commenter that alignment of
the content requirements will allow SBS Entities that are also
registered as Swap Entities to leverage the procedures they have
adopted to comply with the CFTC's parallel CCO rule.\1227\
Specifically, the Commission is changing the proposed requirement in
Rule 15Fk-1(c)(2)(i)(A) that the annual compliance report contain a
description of the ``enforcement'' of the SBS Entity's policies and
procedures to an ``assessment of the effectiveness'' of such policies
and procedures.\1228\ The Commission believes that an ``assessment of
the effectiveness'' of the SBS Entity's policies and procedures is a
more appropriate description because the Commission is looking for a
self-evaluation in the annual compliance report, not a detailed
description of the mechanisms through which the SBS Entity's policies
and procedures are enforced. Additionally, the Commission believes that
providing consistency with the parallel CFTC requirement will allow SBS
Entities to leverage any existing procedures, as discussed above.
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\1227\ See SIFMA (September 2015), supra note 5.
\1228\ Cf. Commodity Exchange Act Rule 3.3(e)(2)(ii) (``The
annual report shall, at a minimum . . . [r]eview each applicable
requirement under the Act and Commission regulations, and with
respect to each . . . [p]rovide an assessment as to the
effectiveness of these policies and procedures.'').
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The Commission is also changing the proposed requirement in Rule
15Fk-1(c)(2)(i)(C) that the annual compliance report contain a
description of ``any recommendation for material changes to the
policies and procedures'' to a requirement to describe ``areas for
improvement, and recommended potential or prospective changes or
improvements to its compliance program and resources devoted to
compliance.'' \1229\ As discussed above, this change is in response to
a specific suggestion from a commenter.\1230\ A description of ``areas
for improvement, and recommended potential or prospective changes or
improvements to [an SBS Entity's] compliance program and resources
devoted to compliance'' is broader and would include any
recommendations made by the CCO with respect to material changes to the
SBS Entity's compliance policies and procedures. Accordingly, the
Commission does not believe this wording change diminishes the scope of
the required content of the annual compliance report. At the same time,
however, this wording change makes the rule consistent with the
parallel CFTC requirements and thus will allow SBS Entities to leverage
any existing procedures, as discussed above.
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\1229\ Cf. Commodity Exchange Act Rule 3.3(e)(2)(iii) (``The
annual report shall, at a minimum . . . [r]eview each applicable
requirement under the Act and Commission regulations, and with
respect to each . . . [d]iscuss areas for improvement, and recommend
potential or prospective changes or improvements to its compliance
program and resources devoted to compliance.'').
\1230\ See SIFMA (September 2015), supra note 5.
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Additionally, the Commission is changing the proposed requirement
that the annual compliance report contain a description of ``any
material compliance matters identified since the date of the preceding
compliance report'' to a requirement to describe ``any material non-
compliance matters identified'' in Rule 15Fk-1(c)(2)(i)(D).\1231\ The
change from ``material compliance matter'' to ``material non-compliance
matter'' is in response to a specific suggestion from a
commenter.\1232\ It is not a substantive change and is simply intended
to provide consistency with the parallel CFTC requirement to allow SBS
Entities to leverage any existing procedures, as discussed above. The
Commission is also otherwise adopting the definition of material non-
compliance matter in Rule 15Fk-1(e)(4), as proposed.\1233\ The
elimination of the phrase ``since the date of the preceding compliance
report'' in the final rule is also intended to harmonize with the
parallel CFTC requirement and respond to commenters' general concerns
regarding consistency with parallel CFTC requirements.\1234\
Additionally, with this change, the Commission intends to clarify that
the annual compliance report should describe both material non-
compliance matters that are newly identified during the time period
covered by the report and previously identified material non-compliance
matters that have not yet been resolved as of the end of the time
period covered by the report.
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\1231\ Cf. Commodity Exchange Act Rule 3.3(e)(5) (``The annual
report shall, at a minimum . . . [d]escribe any material non-
compliance issues identified, and the corresponding action
taken.'').
\1232\ See SIFMA (September 2015), supra note 5.
\1233\ The Commission declines to eliminate the definition of
material non-compliance matter to be consistent with the CFTC's
parallel requirement (which does not contain a definition), as
suggested by a commenter. See SIFMA (September 2015), supra note 5.
The Commission believes it is important to provide an explanation in
the rule of what should be included in the annual compliance report.
\1234\ See, e.g., Barnard, supra note 5; Levin, supra note 5;
BlackRock, supra note 5; Nomura, supra note 5.
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Finally, the Commission is adding a requirement in Rule 15Fk-
1(c)(2)(i)(E) for an SBS Entity to include a description in its annual
compliance report of the ``financial, managerial, operational, and
staffing resources set aside for compliance with the [Exchange Act] and
the rules and regulations
[[Page 30059]]
thereunder relating to [the SBS Entity's] business as [an SBS Entity],
including any material deficiencies in such resources.'' \1235\ The
Commission is adding this requirement to harmonize with the CFTC's
parallel content requirement for the annual compliance reports of Swap
Entities, and to respond to commenters' general concerns regarding
consistency with parallel CFTC requirements.\1236\ The Commission
believes that a description of an SBS Entity's compliance resources and
any deficiencies in such resources will be useful in assessing the
compliance of the SBS Entity.
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\1235\ Cf. Commodity Exchange Act Rule 3.3(e)(4) (``The annual
report shall, at a minimum . . . [d]escribe the financial,
managerial, operational, and staffing resources set aside for
compliance with respect to the [Commodity Exchange Act] and [CFTC]
regulations, including any material deficiencies in such
resources.'').
\1236\ See, e.g., Barnard, supra note 5; Levin, supra note 5;
BlackRock, supra note 5; Nomura, supra note 5.
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The Commission is also making a number of changes with respect to
the submission of the annual compliance report. First, the Commission
is aligning the deadline for submitting the report with the CFTC's
deadline of 90 days after the end of the Swap Entity's fiscal year in
response to concerns raised by a commenter.\1237\ As adopted, Rule
15Fk-1(c)(2)(ii)(A) will require an SBS Entity's compliance report to
``be submitted to the Commission within 30 days following the deadline
for filing the [SBS Entity's] annual financial report with the
Commission pursuant to Section 15F of the Act and rules and regulations
thereunder.'' \1238\ This represents a change from the proposed
requirement that the compliance report ``[a]ccompany each appropriate
financial report of the [SBS Entity] that is required to be furnished
to or filed with the Commission pursuant to Section 15F of the Act and
rules and regulations thereunder.'' In response to concerns raised by a
commenter, this change will provide SBS Entities with additional time
to prepare their annual compliance reports after they have filed their
annual financials.\1239\ The Commission proposed a 60 day deadline from
the end of the SBS Entity's fiscal year for the filing of an SBS
Entity's annual financials, so to the extent the Commission adopts its
proposed deadline for the annual financials, this change should also
result in consistency with the CFTC's 90 day deadline for furnishing
the annual compliance report.\1240\
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\1237\ See SIFMA (September 2015), supra note 5; No-Action
Relief for Futures Commission Merchants, Swap Dealers, and Major
Swap Participants from Compliance with the Timing Requirements of
Commission Regulation 3.3(f)(2) Relating to Annual Reports by Chief
Compliance Officers, CFTC Letter No. 15-15 (Mar. 27, 2015),
available at http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/15-15.pdf.
\1238\ Section 15F(k)(3)(B)(i) of the Exchange Act provides that
a compliance report shall ``accompany each appropriate financial
report of the [SBS Entity] that is required to be furnished to the
Commission pursuant to this section.'' 15 U.S.C. 78o-10(k)(3)(B)(i).
The Commission is interpreting ``accompany'' in Section
15F(k)(3)(B)(i) to mean follow within 30 days.
\1239\ See SIFMA (September 2015), supra note 5.
\1240\ See Recordkeeping Release, 79 FR at 25135, supra note
242.
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Second, in connection with the change described above, the
Commission is eliminating the proposed provision that ``[i]f compliance
reports are separately bound from the financial statements, the
compliance reports shall be accorded confidential treatment to the
extent permitted by law.'' The Commission believes this provision is no
longer necessary in light of the changes we are making to Rule 15Fk-
1(c)(2)(ii)(A), discussed above, which will no longer require the
compliance report to accompany the SBS Entity's financial report. SBS
Entities may request confidential treatment for their annual compliance
reports pursuant to Exchange Act Rule 24b-2.\1241\
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\1241\ See 17 CFR 240.24b-2. The change to the rule renders moot
a commenter's request that the Commission amend its FOIA regulations
in a manner consistent with proposed Rule 15Fk-1(c)(2)(iii). See
FIA/ISDA/SIFMA, supra note 5.
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Third, in response to comment,\1242\ the Commission is adding a new
Rule 15Fk-1(c)(2)(iii) allowing an SBS Entity to request from the
Commission an extension of the deadline for submitting its annual
compliance report to the Commission. The Commission agrees with the
commenter that it is appropriate to establish a framework for when an
SBS Entity is unable to meet the deadline. Pursuant to Rule 15Fk-
1(c)(2)(iii), an SBS Entity may request an extension, provided that the
SBS Entity's failure to timely submit the report could not be
eliminated without unreasonable effort or expense. Extensions of the
deadline will be granted at the discretion of the Commission. Rule
15Fk-1(c)(2)(iii) will also be consistent with CFTC rules regarding
extensions of deadlines for compliance reports by Swap Entities.\1243\
---------------------------------------------------------------------------
\1242\ See SIFMA (September 2015), supra note 5.
\1243\ See Swap Dealer and Major Swap Participant Recordkeeping,
Reporting, and Duties Rules; Futures Commission Merchant and
Introducing Broker Conflicts of Interest Rules; and Chief Compliance
Officer Rules for Swap Dealers, Major Swap Participants, and Futures
Commission Merchants, 77 FR 20128, 20201 (Apr. 3, 2012) (``CFTC CCO
Adopting Release'').
---------------------------------------------------------------------------
Fourth, the Commission is changing the required timing of
submission of the compliance report to the board of directors, audit
committee and senior officer of the SBS Entity. The timing requirement
in proposed Rule 15Fk-1(c)(3)(ii)(B) (``at the earlier of their next
scheduled meeting or within 45 days of the date of execution of the
required certification'') was based on the timeframe provided in the
FINRA rule regarding annual certification of compliance and supervisory
processes.\1244\ The FINRA rule allows for submission of the compliance
report to the board of directors either before or after execution of
the required certification.\1245\ The Commission understands, however,
that prudent corporate governance generally would require submission to
the board of directors and senior officer before the execution of the
certification. Accordingly, as adopted, Rule 15Fk-1(c)(2)(ii)(B)
requires that the compliance report be submitted to the board of
directors, audit committee and senior officer of the SBS Entity ``prior
to submission to the Commission.'' This timing requirement will be
consistent with both Commission rules regarding compliance reports by
SDRs and CFTC rules regarding compliance reports by Swap
Entities.\1246\ This consistency with CFTC requirements will allow SBS
Entities to leverage any existing procedures, as discussed above.
---------------------------------------------------------------------------
\1244\ See FINRA Rule 3130(c).
\1245\ Id.
\1246\ See SDR Registration Release, 80 FR at 14512, supra note
1202; CFTC CCO Adopting Release, 77 FR at 20201, supra note 1243.
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The Commission declines to modify this provision, as suggested by a
commenter, to allow for submission of the compliance report to either
the board or the senior officer.\1247\ The Commission believes that
requiring submission to the board, audit committee and senior officer
will promote an effective compliance system by ensuring that all of
these groups, not just the senior officer, have the opportunity to
review the report. The Commission believes it is important for the
board, the audit committee and the senior officer to all have the
opportunity to receive the compliance report so that they remain
informed regarding the SBS Entity's compliance system in the context of
their overall responsibility for governance and internal controls of
the SBS Entity. However, the Commission declines to explicitly require
the board to review and comment on the compliance report, require the
audit committee to review the compliance report, or require the CCO to
meet quarterly with the audit committee, as
[[Page 30060]]
suggested by other commenters.\1248\ The Commission does not think it
is necessary to explicitly require the board, audit committee or senior
officer to review or comment on the compliance report that they
receive, or to require the CCO to meet with the audit committee because
we believe the goals of the rule can be achieved without such a
requirement.
---------------------------------------------------------------------------
\1247\ See SIFMA (September 2015), supra note 5.
\1248\ See Better Markets (August 2011), supra note 5; Better
Markets (October 2013), supra note 5; CFA, supra note 5.
---------------------------------------------------------------------------
Additionally, in response to concerns raised by a commenter \1249\
and to harmonize with the parallel CFTC requirement and FINRA Rule
3130, the Commission is eliminating: (1) The proposed requirement that
the report contain a written representation regarding the required
annual meeting between the senior officer and the CCO, and (2) the
proposed specifications for what topics such meeting must cover. The
Commission agrees with the commenter that since the purpose of the
required annual meeting between the senior officer and CCO is to
discuss the annual compliance report and since the contents of the
annual compliance report are already specified in Rule 15Fk-1(c)(2)(i),
it is unnecessary to also specify the topics that should be discussed
in the annual meeting. Additionally, this consistency with CFTC and
FINRA requirements will allow SBS Entities to leverage any existing
procedures, as discussed above.
---------------------------------------------------------------------------
\1249\ See SIFMA (September 2015), supra note 5.
---------------------------------------------------------------------------
To address concerns raised by commenters,\1250\ we also are
modifying Rule15Fk-1(c)(2)(ii)(D) to provide that either the senior
officer or CCO can execute the compliance report certification and to
add knowledge and materiality qualifiers to the certification
requirement. The proposed rule would have required the compliance
report to include a certification that, under penalty of law, the
compliance report is accurate and complete, without specifying who must
execute the certification. As adopted, Rule 15Fk-1(c)(2)(ii)(D)
requires the compliance report to include a certification ``from the
senior officer or Chief Compliance Officer that, to the best of his or
her knowledge and reasonable belief, under penalty of law, the
compliance report is accurate and complete in all material respects.''
The Commission believes that allowing either the senior officer or CCO
to execute the certification is appropriate because both the senior
officer and the CCO should be in a position to certify the accuracy and
completeness of the compliance report. As noted by a commenter,\1251\
Exchange Act Section 15F(k)(3)(B)(ii) requires that the compliance
report include a certification but does not specify who must execute
the certification.\1252\ The FINRA rule regarding annual certification
of compliance and supervisory processes requires the CEO (or an
equivalent officer) to execute the certification.\1253\ In contrast,
Commission rules regarding compliance reports by SDRs require the CCO
to execute the certification.\1254\ CFTC rules regarding compliance
reports by Swap Entities allow either the CEO or the CCO to execute the
required certification.\1255\ Rule 15Fk-1(c)(2)(ii)(D) will be
consistent with the parallel CFTC rule and will allow flexibility for
SBS Entities who might also be registered broker-dealers and FINRA
members, and therefore, subject to the FINRA rule regarding annual
certification of compliance and supervisory processes. As discussed
above, consistency with CFTC requirements will allow SBS Entities to
leverage any existing procedures.
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\1250\ See FIA/ISDA/SIFMA, supra note 5 (requesting that the CEO
or other relevant senior officer be the individual responsible for
executing the certification, or in the alternative, if the CCO is
required to certify, that the CEO also be required to do so); CFA,
supra note 5 (requesting that the CCO be the individual responsible
for executing the certification); SIFMA (September 2015), supra note
5 (requesting that either the senior officer or CCO be permitted to
execute the certification).
\1251\ See FIA/ISDA/SIFMA, supra note 5.
\1252\ See Section 15F(k)(3)(B)(ii) of the Exchange Act, 15
U.S.C. 78o-10(k)(3)(B)(ii).
\1253\ See FINRA Rule 3130(c).
\1254\ See SDR Registration Release, 80 FR at 14511-14512, supra
note 1202.
\1255\ See CFTC CCO Adopting Release, 77 FR at 20201, supra note
1243.
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Additionally, the Commission believes it is appropriate to add the
knowledge and materiality qualifiers described above to the required
certification to address commenters' concerns regarding the liability
standard for the certification.\1256\ The Commission believes that a
certification to the best of the knowledge and reasonable belief of the
certifying officer that the compliance report is accurate and complete
in all material respects is appropriate to ensure effective reporting
with respect to the compliance of the SBS Entity.\1257\
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\1256\ See FIA/ISDA/SIFMA, supra note 5; SIFMA (September 2015),
supra note 5. Contra. CFA, supra note 5 (arguing that the CCO should
not be permitted to qualify its report).
\1257\ Cf. General Rule of Practice 153(b)(1)(ii), 17 CFR
201.153(b)(1)(ii) (requiring an attorney who signs a filing with the
Commission to certify that ``to the best of his or her knowledge,
information, and belief, formed after reasonable inquiry, the filing
is well grounded in fact and is warranted by existing law or a good
faith argument for the extension, modification, or reversal of
existing law'').
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In response to a specific suggestion from a commenter,\1258\ the
Commission is also adding a new Rule 15Fk-1(c)(2)(iv) allowing an SBS
Entity to incorporate by reference sections of a compliance report that
have been submitted within the current or immediately preceding
reporting period to the Commission. The rule allows an SBS Entity to:
(1) Incorporate by reference items from a previous year's compliance
report, or (2) for an SBS Entity that is registered in more than one
capacity with the Commission and required to submit more than one
compliance report,\1259\ incorporate by reference into its compliance
report required by Rule 15Fk-1(c) sections in another compliance report
submitted to the Commission by it in its capacity as another type of
registered entity within the current or immediately preceding reporting
period.\1260\ The Commission is limiting incorporation by reference to
reports submitted within the current or immediately preceding reporting
period, which will be the fiscal year of the SBS Entity, because we
want to ensure that compliance reports do not simply continue to refer
back to prior year's reports. Rule 15Fk-1(c)(2)(iv) will also be
consistent with CFTC rules regarding compliance reports by Swap
Entities.\1261\
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\1258\ See SIFMA (September 2015), supra note 5.
\1259\ See SDR Registration Release, 80 FR at 14510-14512, supra
note 1202.
\1260\ The Commission declines to permit the consolidation of
annual compliance reporting requirements for SBS Entities under
common control, as suggested by one commenter. See FIA/ISDA/SIFMA,
supra note 5. The Commission believes it is appropriate to require
an SBS Entity to submit a separate compliance report, as
contemplated by Section 15F(k)(3)(B) of the Exchange Act. However,
as discussed above, the Commission has made a number of changes to
Rule 15Fk-1 to further harmonize the requirements of the rule with
FINRA Rule 3130 and the CFTC's CCO requirements for Swap Entities so
that SBS Entities that are also registered broker-dealers that are
FINRA members and/or Swap Entities can leverage their existing
procedures to comply with the rule.
\1261\ See CFTC CCO Adopting Release, 77 FR at 20201, supra note
1243.
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Finally, in response to a specific suggestion from a
commenter,\1262\ the Commission is adding a new Rule 15Fk-1(c)(2)(v)
requiring an SBS Entity to submit an amended compliance report if
material errors or omissions in the report are identified. The amended
report must contain the required certification by the CCO or senior
officer, described above. The Commission is adding this rule to promote
accurate and complete compliance reports. When an SBS Entity discovers
a material error or omission in its annual compliance report subsequent
to submitting the
[[Page 30061]]
report to the Commission, we believe it is appropriate for an SBS
Entity to be required to submit an amended report. This does not
include a situation where an SBS Entity's annual compliance report
becomes inaccurate or incomplete due to events occurring after the
coverage date of the report. Material errors or omissions should be
judged as of the coverage date of the report. Rule 15Fk-1(c)(2)(v) will
also be consistent with CFTC rules regarding amended compliance reports
by Swap Entities.\1263\
---------------------------------------------------------------------------
\1262\ See SIFMA (September 2015), supra note 5.
\1263\ See CFTC CCO Adopting Release, 77 FR at 20201, supra note
1243.
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J. Prime Brokerage Transactions
One commenter recommended that the Commission adopt a new rule that
would, in connection with security-based swaps executed under a prime
brokerage arrangement, permit the executing dealer and prime broker to
allocate responsibility for compliance with certain external business
conduct obligations in a manner consistent with CFTC No-Action Letter
13-11.\1264\ The commenter noted that the Commission staff has
previously addressed circumstances in which the executing broker and
prime broker in a securities prime brokerage arrangement allocate
certain responsibilities between themselves in different
contexts.\1265\
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\1264\ See SIFMA (August 2015), supra note 5.
\1265\ See Letter to Mr. Jeffrey C. Bernstein, Prime Broker
Committee, from Brandon Becker, Director, Division of Market
Regulation, Commission, dated January 25, 1994.
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The commenter described a particular situation in which a
counterparty (``Prime Broker Client'') enters into an agreement with a
registered SBS Dealer (``Prime Broker''). That agreement establishes
parameters under which the Prime Broker Client, acting as agent of the
Prime Broker, can negotiate and enter into security-based swaps with
certain registered SBS Dealers (collectively, the ``Executing
Dealer''). If a security-based swap negotiated by the Prime Broker
Client with the Executing Dealer is accepted by the Prime Broker, the
Prime Broker will enter into a corresponding security-based swap with
the Prime Broker Client, the terms of which mirror the terms of the
security-based swap between the Executing Dealer and the Prime Broker,
subject to associated prime brokerage fees agreed by the parties.
In these circumstances, the Prime Broker Client may have entered
into a security-based swap with the Prime Broker based not only on
communications with the Prime Broker but also on communications
including disclosure of material terms and other representations, and
possibly on the basis of a recommendation by the Executing Dealer.
According to this commenter, in these circumstances, the Prime Broker
is in the best position to take responsibility for compliance with the
external business conduct standards that relate to the general
relationship between the Prime Broker and the Prime Broker Client,
whereas the Executing Dealer is in the best position to take
responsibility for compliance with business conduct standards that are
transaction-specific. The commenter expressed the view that unless SBS
Dealers are permitted to allocate compliance with the external business
conduct standards between the Prime Broker and the Executing Dealer, it
would be impossible to continue existing prime brokerage
arrangements.\1266\
---------------------------------------------------------------------------
\1266\ We recognize that there may be other ways that parties
structure their prime brokerage arrangements. The above discussion
is based on the description of the arrangement in the proposed rule
text provided by the commenter.
---------------------------------------------------------------------------
The commenter proposed a rule under which the Prime Broker and the
Executing Dealer would have the full range of business conduct
obligations that they would allocate between themselves. The
commenter's request is beyond the scope of this rulemaking although we
acknowledge the concerns raised by the commenter, and may consider them
in the future.
K. Other Comments
The CFTC proposed rules regarding best execution and front running
that it did not ultimately adopt. One commenter urged the Commission to
adopt a best execution requirement similar to the CFTC's
proposal.\1267\ Another commenter urged the Commission not to adopt a
prohibition on front running.\1268\ Although the Commission is not
adopting such rules, we note that SBS Entities remain subject to the
antifraud provisions of the federal securities laws, including the
antifraud provisions of Exchange Act Section 15H(h)(4)(A) and Rule
15Fh-4(a), as discussed in Section II.H.4, with respect to their
dealings with counterparties.
---------------------------------------------------------------------------
\1267\ See CFA, supra note 5.
\1268\ See SIFMA (August 2011), supra note 5. Front running
refers to an entity entering into a transaction for its own benefit
ahead of executing a counterparty transaction.
---------------------------------------------------------------------------
The Commission did not propose rules regarding portfolio
reconciliation and compression. Four commenters generally supported
portfolio reconciliation and compression requirements.\1269\ A fifth
commenter asserted that inter-affiliate swaps should not trigger
portfolio reconciliation and compression requirements.\1270\ The
Commission is not adopting rules regarding portfolio reconciliation and
compression at this time.
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\1269\ See Barnard, supra note 5; Levin, supra note 5; Markit,
supra note 5; MarkitSERV, supra note 5.
\1270\ See ABA Securities Association, supra note 5.
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III. Cross-Border Application and Availability of Substituted
Compliance
A. Cross-Border Application of Business Conduct Requirements
1. Proposed Rule
The Commission proposed generally to apply all requirements in
Section 15F of the Exchange Act, and the rules and regulations
thereunder, to all SBS Entities, whether U.S. persons or non-U.S.
persons.\1271\ The Commission also proposed to classify each
requirement that applies to SBS Entities either as a transaction-level
requirement, which applies to specific transactions, or as an entity-
level requirement, which applies to the dealing entity as a
whole.\1272\ In this taxonomy, entity-level requirements would include
most requirements applicable to SBS Entities, including those relating
to the CCO requirements under Section 15F(k) of the Exchange Act, the
supervision requirement under Section 15F(h)(1)(B) of the Exchange Act,
and the requirement to establish procedures to comply with the duties
set forth in Section 15F(j) of the Exchange Act, including conflict of
interest systems and procedures.\1273\ Transaction-level requirements
would include primarily business conduct standards under Section 15F(h)
of the Exchange Act (except for the diligent supervision requirement
under Section 15F(h)(1)(B) of the Exchange Act).\1274\
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\1271\ See Cross-Border Proposing Release, 78 FR 31009, 31035,
supra note 6. The Commission noted in the Cross-Border Proposing
Release its longstanding ``view that an entity that has registered
with the Commission subjects itself to the entire regulatory system
governing such registered entities.'' Id. at 30986.
\1272\ See Cross-Border Proposing Release, 78 FR 31009, 31035,
supra note 6.
\1273\ See Cross-Border Proposing Release, 78 FR 31014-15,
31035, supra note 6.
\1274\ See Cross-Border Proposing Release, 78 FR 31010, 31035,
supra note 6. See also U.S. Activity Proposing Release, 80 FR 27473,
supra note 9.
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Under the proposed approach, the entity-level requirements would
apply to all transactions of an SBS Entity, regardless of the U.S.-
person status of the SBS Entity or its counterparty to any particular
transaction.\1275\ With respect to the business conduct standards under
Section 15F(h) of the Exchange Act (except for the diligent supervision
requirement under Section 15F(h)(1)(B) of the Exchange Act), however,
the
[[Page 30062]]
Commission proposed to provide an exception from these requirements for
certain transactions of SBS Entities, proposing slightly different
approaches for SBS Dealers and Major SBS Participants.
---------------------------------------------------------------------------
\1275\ See Cross-Border Proposing Release, 78 FR 31026-27,
31035, supra note 6.
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With respect to SBS Dealers, the Commission proposed a rule that
would have provided that registered foreign SBS Dealers and registered
U.S. SBS Dealers, with respect to their foreign business, would not be
subject to the requirements relating to business conduct standards
described in Section 15F(h) of the Exchange Act,\1276\ and the rules
and regulations thereunder, other than the rules and regulations
prescribed by the Commission pursuant to Section 15F(h)(1)(B).\1277\
The proposed rule would define ``foreign business'' for both foreign
SBS Dealers and U.S. SBS Dealers to mean any security-based swap
transactions entered into, or offered to be entered into, by or on
behalf of the SBS Dealer that do not include its U.S. business.\1278\
The proposed definition of ``U.S. business,'' however, would differ for
foreign SBS Dealers and U.S. SBS Dealers. For a foreign SBS Dealer,
``U.S. business'' would mean (i) any transaction entered into, or
offered to be entered into, by or on behalf of such foreign SBS Dealer,
with a U.S. person (other than with a foreign branch), or (ii) any
transaction conducted within the United States.\1279\ For a U.S. SBS
Dealer, ``U.S. business'' would mean any transaction by or on behalf of
such U.S. SBS Dealer, wherever entered into or offered to be entered
into, other than a transaction conducted through a foreign branch with
a non-U.S. person or another foreign branch of a U.S. person.\1280\
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\1276\ 15 U.S.C. 78o-10(h). See proposed Rule 3a71-3(c)
(providing a partial exception from certain transaction-level
business conduct standards for foreign SBS Dealers in connection
with their foreign business); see also Cross-Border Proposing
Release, 78 FR 31016-18, supra note 6.
\1277\ See Cross-Border Proposing Release, 78 FR 31016, supra
note 6. Section 15F(h)(1)(B) requires registered SBS Dealers to
conform with such business conduct standards relating to diligent
supervision as the Commission shall prescribe. See 15 U.S.C. 78o-
10(h)(1)(B).
\1278\ See Cross-Border Proposing Release, 78 FR 31016, supra
note 6.
\1279\ See Cross-Border Proposing Release, 78 FR 31016, supra
note 6. Whether the activity in a transaction involving a registered
foreign SBS Dealer occurred within the United States or with a U.S.
person for purposes of identifying whether security-based swap
transactions are part of U.S. business would have turned on the same
factors used in that proposal to determine whether a foreign SBS
Dealer is engaging in dealing activity within the United States or
with U.S. persons and whether a U.S. person was conducting a
transaction through a foreign branch. See Cross-Border Proposing
Release, 78 FR 31016, supra note 6.
\1280\ See Cross-Border Proposing Release, 78 FR 31016, supra
note 6.
---------------------------------------------------------------------------
In April 2015, the Commission re-proposed the rule defining the
application of business conduct rules to SBS Dealers to incorporate the
modified approach to U.S. activity proposed in that release and to make
certain technical changes to the ``foreign business'' definition
relating to transactions conducted through a foreign branch.\1281\
Under the modified approach, ``U.S. business'' of a foreign SBS Dealer
would have been defined to mean (i) any transaction entered into, or
offered to be entered into, by or on behalf of such foreign SBS Dealer,
with a U.S. person (other than a transaction conducted through a
foreign branch of that person), or (ii) any security-based swap
transaction that is arranged, negotiated, or executed by personnel of
the foreign SBS Dealer located in a U.S. branch or office, or by
personnel of its agent located in a U.S. branch or office.\1282\ With
respect to a U.S. SBS Dealer, ``U.S. business'' would have been defined
to mean ``any transaction by or on behalf of such U.S. SBS Dealer,
entered into or offered to be entered into, other than a transaction
conducted through a foreign branch with a non-U.S. person or with a
U.S.-person counterparty that constitutes a transaction conducted
through a foreign branch of the counterparty.'' \1283\ The definitions
of ``U.S. security-based swap dealer,'' \1284\ ``foreign security-based
swap dealer,'' \1285\ and ``foreign business'' \1286\ remained
unchanged from the initial proposal, as did the text of re-proposed
Rule 3a71-3(c), which would create the exception to the business
conduct requirements for the foreign business of registered security-
based swap dealers.
---------------------------------------------------------------------------
\1281\ U.S. Activity Proposing Release, 80 FR 27475, supra note
9. See also proposed Rule 3a71-3(c) and proposed Rules 3a71-3(a)(6),
(7), (8), and (9).
\1282\ Proposed Rule 3a71-3(a)(8)(i). The Commission explained
in the U.S. Activity Proposing Release that it intended the proposed
rule to indicate the same type of activity by personnel located in
the United States as it proposed to use in the de minimis context.
Moreover, for purposes of proposed Rule 3a71-3(a)(8)(i)(B), the
Commission explained that it would interpret the term ``personnel''
in a manner consistent with the definition of ``associated person of
a security-based swap dealer'' contained in section 3(a)(70) of the
Exchange Act, 15 U.S.C. 78c(a)(70), regardless of whether such non-
U.S. person or such non-U.S. person's agent is itself a security-
based swap dealer. See U.S. Activity Proposing Release 80 FR at
27469 n.193, supra note 9.
\1283\ Proposed Rule 3a71-3(a)(8)(ii).
\1284\ See proposed Rule 3a71-3(a)(6).
\1285\ See proposed Rule 3a71-3(a)(7).
\1286\ See proposed Rule 3a71-3(a)(9).
---------------------------------------------------------------------------
With respect to Major SBS Participants, the Commission proposed to
provide an exception from the business conduct standards as described
in Section 15F(h) of the Exchange Act, and the rules and regulations
thereunder (other than the rules and regulations prescribed by the
Commission pursuant to Section 15F(h)(1)(B)), only for foreign Major
SBS Participants, with respect to their transactions with non-U.S.
persons.\1287\
---------------------------------------------------------------------------
\1287\ See proposed Rule 3a67-10(b) (providing that a Major SBS
Participant ``shall not be subject, with respect to its security-
based swap transactions with counterparties that are not U.S.
persons, to the requirements relating to business conduct
standards'' in Section 15F(h) of the Exchange Act and the rules and
regulations thereunder, other than rules and regulations prescribed
pursuant to Section 15F(h)(1)(B) of the Exchange Act); proposed Rule
3a67-10(a)(1) (defining ``foreign major security-based swap
participant'').
---------------------------------------------------------------------------
2. Comments on the Proposed Application of Business Conduct
Requirements to SBS Entities
In response to the U.S. Activity Proposing Release, commenters
focused on the proposal to impose business conduct standards on a
transaction of a registered foreign SBS Dealer with other non-U.S.
persons when the SBS Dealer uses personnel located in the United States
to arrange, negotiate, or execute the transaction. Several commenters
expressed general support for the Commission's proposed test to
determine when various Title VII requirements should apply to
transactions between two non-U.S. persons based on U.S. activity.\1288\
Moreover, although these commenters generally urged that the Commission
not impose business conduct requirements (or impose only certain of the
requirements, as described below) on a registered foreign SBS Dealer
solely based on U.S. activity, they indicated that they support the
tailoring of the Commission's test (``U.S. Activity Test'') from the
initial proposal, if the Commission ultimately determines that the
business conduct requirements should apply to such transactions.\1289\
One commenter urged the Commission to return to its initially proposed
approach to the definition of
[[Page 30063]]
``transactions conducted within the United States,'' which would have
looked to the location of relevant activity of both
counterparties.\1290\ Such an approach would thus apply the business
conduct requirements fully to any transactions involving activity in
the United States, not just dealing activity in the United States but
also relevant activity carried out by a non-dealing counterparty in the
United States.\1291\
---------------------------------------------------------------------------
\1288\ See, e.g., SIFMA/FSR (July 2015), supra note 10; IIB
(July 2015), supra note 10.
\1289\ See IIB (July 2015), supra note 10, at 2; SIFMA/FSR (July
2015), supra note 10, at 3, 10. One commenter supported the
proposal's use of the same U.S. Activity Test for business conduct
as for de minimis calculations because applying the business conduct
standards solely based on the use of a U.S. fund manager is not
dealing activity, would be inconsistent with investor expectations,
and is unnecessary to protect the U.S. markets. See ICI Global (July
2015), supra note 10, at 2, 5.
\1290\ See Better Markets (July 2015), supra note 10, at 3, 6.
\1291\ See id.
---------------------------------------------------------------------------
Some commenters that objected to the Commission's proposed approach
argued that none of the business conduct requirements should apply to
transactions between non-U.S. persons, even if these transactions
involve U.S. activity and therefore constitute ``U.S. business'' under
the proposed definition.\1292\ These commenters explained that the non-
U.S. counterparties of foreign SBS Dealers do not expect these
protections; the dealer is likely to be subject to similar requirements
in its home jurisdiction; and application is unlikely to protect the
U.S. market and is inconsistent with international comity.\1293\ In a
related comment, one commenter explained that the business conduct
requirements, as well as other requirements related to reporting and
dealer registration, should not apply to transactions that are executed
on an anonymous electronic platform or other means that ``involve[s] no
human contact within the United States,'' because the parties would
have no expectation that the rules would apply to such a
transaction.\1294\
---------------------------------------------------------------------------
\1292\ See ICI Global (July 2015), supra note 10, at 2, 5-6;
SIFMA-AMG (July 2015), supra note 10, at 2, 5 (stating that non-U.S.
clients do not expect U.S. protections to apply to transactions
between two non-U.S. persons). See also ISDA (July 2015), supra note
10, at 2 (urging that the Commission not apply the business conduct
requirements to transactions solely because the transaction involves
U.S. activity); ISDA (July 2015), supra note 10, at 8 (arguing that
the Commission does not have a supervisory interest in imposing
entity-level requirements in connection with security-based swap
transactions between two non-U.S. persons that are cleared outside
the United States, even if they are arranged, negotiated, or
executed by personnel located in the United States).
\1293\ See ICI Global (July 2015), supra note 10, at 5-6; SIFMA-
AMG (July 2015), supra note 10, at 2, 5; IIB (July 2015), supra note
10, at 11; SIFMA/FSR (July 2015), supra note 10, at 9. See also ISDA
(July 2015), supra note 10, at 2, n.7 (recommending that the final
business conduct rules be consistent with the CFTC's business
conduct rules); Barnard (July 2015) at 2, supra note 10
(recommending that the rules proposed in the U.S. Activity Proposing
Release be consistent with the rules proposed by the CFTC); MFA
(July 2015), supra note 10, at 4 (emphasizing need for Commission
and its U.S. counterparts to develop a single, harmonized approach
to cross-border derivatives regulation).
\1294\ See ISDA (July 2015), supra note 10, at 7.
---------------------------------------------------------------------------
Some commenters taking this view also explained that U.S. asset
managers may face challenges in servicing non-U.S. client accounts
under the proposed approach, noting that non-U.S. clients may be
reluctant to deal with Dodd-Frank-related documentation or to make
required representations and describing the significant burdens these
requirements would impose on asset managers.\1295\ One of these
commenters argued that the U.S. Activity Proposing Release considered
only the costs of the SBS Dealers that would be directly subject to the
business conduct requirements but not the costs borne by buy-side
market participants, such as asset managers.\1296\
---------------------------------------------------------------------------
\1295\ Specifically, the commenters expressed concern that,
under the proposal, the U.S. asset manager executing a trade on
behalf of a non-U.S. client would need to know whether the
transaction involved U.S. activity and would also need to verify
that the non-U.S. client satisfies the business conduct
requirements. See SIFMA-AMG (July 2015), supra note 10, at 4; ICI
Global (July 2015), supra note 10, at 6 (explaining that regulated
fund parties would need appropriate documentation and
representations in place to execute such trades and would face
interruptions in investment activities in doing so).
\1296\ See SIFMA-AMG (July 2015), supra note 10, at 4-5. This
commenter specifically argued that the proposed rules would
effectively require asset managers to verify the eligibility of a
non-U.S. client as having satisfied the Commission's business
conduct requirements, imposing costs on asset managers and, through
impeding block trades on behalf of U.S. persons and non-U.S.
persons, negatively affecting liquidity and execution price. See
SIFMA-AMG (July 2015), supra note 10, at 4. The commenter also
argued that the proposed approach has ``no ascertainable benefit''
to non-U.S. counterparties who would not expect the protections and
would instead look to the law of the dealer's jurisdiction or its
own jurisdiction. See SIFMA-AMG (July 2015), supra note 10, at 5.
---------------------------------------------------------------------------
Some commenters that objected to the Commission's proposed
application of business conduct requirements to transactions between
two non-U.S. persons solely on the basis of activity in the United
States urged the Commission to limit the application to specific
requirements that, in the commenters' views, address regulatory
concerns directly related to the relevant activity in the United
States. These commenters supported dividing the business conduct
requirements into two separate categories of ``relationship-based''
requirements and ``transaction-specific'' or ``communication-based''
requirements.\1297\ Commenters argued that relationship-based
requirements--which they identified as requirements related to
counterparty status, disclosure of daily marks, know your counterparty,
and counterparty suitability--should not apply to transactions between
two non-U.S. persons solely on the basis of U.S. activity for reasons
similar to those described above.\1298\
---------------------------------------------------------------------------
\1297\ See SIFMA/FSR (July 2015), supra note 10, at 8-10; IIB
(July 2015), supra note 10, at 11-13.
\1298\ For example, one commenter argued that non-U.S.
counterparties would not expect such protections and that the
requirements may duplicate requirements in the counterparty's home
jurisdiction. See SIFMA/FSR (July 2015), supra note 10, at 8-9.
Commenters also argued that the non-U.S. counterparty would not
expect to provide any representations as to its status or to
complete questionnaires to comply with U.S. relationship-level
requirements, particularly at the beginning of a trading
relationship when neither counterparty may expect the relationship
to involve U.S. activity and that such burdens have no benefit. See
SIFMA/FSR (July 2015), supra note 10, at 8-9; IIB (July 2015), supra
note 10, at 11-12 (arguing that non-U.S. counterparties would not
expect the ``trade-relationship'' requirements to apply in their
trades with non-U.S. persons and would be surprised to be required
to agree to covenants or fill out questionnaires related to U.S.
requirements); SIFMA-AMG (July 2015), supra note 10, at 4
(explaining that non-U.S. clients of asset managers would be
surprised to need to verify eligibility under the business conduct
requirements after instructing asset managers to trade only with
non-U.S. dealers). See also ICI Global (July 2015), supra note 10,
at 6 (noting that, even though the registered dealer (and not the
non-U.S. person) is subject to the business conduct requirements,
the non-U.S. fund counterparty would likely need to have in place
appropriate documentation and representations if its dealer is
subject to business conduct requirements, which may cause
interruptions in their investment activities).
---------------------------------------------------------------------------
On the other hand, commenters explained that application of
business conduct requirements that are ``communication-based'' or
transaction-specific--which they identified as including disclosure of
material risks and characteristics and material incentives or conflicts
of interest and related recordkeeping, disclosures regarding clearing
rights and related recordkeeping, product suitability, and fair and
balanced communications and supervision--to such transactions would be
simpler and less costly to implement.\1299\ These commenters, however,
urged the Commission, if it does apply the transaction-specific
requirements to these transactions, to harmonize FINRA's existing sales
practice requirements with the ``communication-based'' or transaction-
specific rules applicable under Title VII to avoid unnecessary
duplication or conflicts, as the U.S. activity in many of these
transactions may be carried out by registered broker-dealers subject to
[[Page 30064]]
FINRA requirements.\1300\ One commenter requested that if the
Commission does apply relationship-based requirements to transactions
involving U.S. activity, it make substituted compliance available to
foreign registered SBS Dealers in such transactions.\1301\
---------------------------------------------------------------------------
\1299\ See IIB (July 2015), supra note 10, at 12-13 (noting that
compliance with these requirements would not require ``wholesale
modifications'' to the relationship documentation or onboarding
processes as long as the non-U.S. security-based swap dealer is able
to satisfy the requirements under the rules of the relevant non-U.S.
jurisdictions and that there may be benefits to applying these rules
uniformly to front office personnel in the United States as a
supplement to generally applicable antifraud and anti-manipulation
rules); SIFMA/FSR (July 2015), supra note 10, at 9-10 (explaining
that the application of these rules would be consistent with the
parties' expectations).
\1300\ See SIFMA/FSR (July 2015), supra note 10, at 9-10; IIB
(July 2015), supra note 10, at 13. Commenters also urged the
Commission to work toward a harmonized approach to all the business
conduct rules with the CFTC and FINRA to ensure that security-based
swap dealers and swap dealers are not subject to two different sets
of business conduct requirements. See ISDA (July 2015), supra note
10, at 2, n.7; IIB (July 2015), supra note 10, at 6, 7. See also
ISDA (July 2015), supra note 10, at 9 (asking the Commission to
evaluate whether imposing business conduct requirements adds value
if the intermediary is already subject to broker-dealer regime).
\1301\ See IIB (July 2015), supra note 10, at 12.
---------------------------------------------------------------------------
Two commenters suggested that, if the Commission does apply the
business conduct requirements as proposed, it offer an ``opt-out'' for
sophisticated non-U.S. person counterparties that would allow them to
trade under their existing documentation rather than develop new
documentation pursuant to U.S. rules.\1302\ One commenter explained
that, because the requirements are for the benefit of the non-U.S.
counterparty, that counterparty should be able to waive them.\1303\
---------------------------------------------------------------------------
\1302\ See IIB (July 2015), supra note 10, at 13; SIFMA/FSR
(July 2015), supra note 10, at 10-11 (requesting the non-U.S.
counterparty have option to opt-out of ``transaction-specific''
rules if they apply solely as a result of U.S. activity).
\1303\ See SIFMA/FSR (July 2015), supra note 10, at 10-11.
---------------------------------------------------------------------------
Two commenters argued that the Commission should not allow concern
about special entity protections to influence its consideration of
whether U.S. activity alone should trigger business conduct
requirements. These commenters noted that the Commission has previously
explained that only U.S. persons would be special entities and, as
such, a registered foreign SBS Dealer would already be subject to the
full range of business conduct requirements in transactions with
special entities, because such transactions would constitute ``U.S.
business'' under the proposed approach even if the Commission were to
eliminate U.S. Activity from the definition of ``U.S. business.''
\1304\
---------------------------------------------------------------------------
\1304\ See IIB (July 2015), supra note 10, at 12; SIFMA/FSR
(July 2015), supra note 10, at 9.
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3. Response to Comments and Final Rule
After considering the comments, the Commission is adopting final
Rule 3a71-3(c) and amendments to the definitions in Rule 3a71-3(a)
largely unchanged from the April 2015 re-proposal.\1305\ The Commission
is also adopting amendments to Rule 3a67-10 to incorporate an exception
from these requirements for registered Major SBS Participants, modified
slightly from the initial proposal. Consistent with the Cross-Border
Proposing Release, the Commission is not providing any exception from
the entity-level requirements being adopted in this release.\1306\
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\1305\ The final rules incorporate minor conforming edits. The
definition of U.S. business for U.S. security-based swap dealers
(Rule 3a71-3(a)(8)(ii)) is modified for consistency with the
surrounding rules by moving the phrase ``entered into or offered to
be entered into'' and deleting the word ``wherever'' to further
clarify that the definition of U.S. business for a U.S. security-
based swap dealer does not depend on the location of personnel
arranging, negotiating, or executing the transaction. Rule 3a71-
3(a)(9) defining foreign business and Rule 3a71-3(c) contain minor
edits to simplify the rule text primarily by eliminating unnecessary
separate references to U.S. and foreign security-based swap dealers.
\1306\ The Commission does not believe that these final rules
apply Title VII to persons that are ``transact[ing] a business in
security-based swaps without the jurisdiction of the United
States,'' within the meaning of section 30(c) of the Exchange Act. A
final rule that did not treat security-based swaps that a registered
foreign security-based swap dealer has arranged, negotiated, or
executed using its personnel or personnel of its agent located in
the United States as the ``U.S. business'' of that dealer for
purposes of proposed Exchange Act rule 3a71-3(c) would, in our view,
reflect an understanding of what it means to conduct a security-
based swap dealing business within the jurisdiction of the United
States that is divorced both from Title VII's statutory objectives
and from the various structures that non-U.S. persons use to engage
in security-based swap dealing activity. But in any event we also
believe that the final rule is necessary or appropriate as a
prophylactic measure to help prevent the evasion of the provisions
of the Exchange Act that were added by the Dodd-Frank Act, and thus
help prevent the relevant purposes of the Dodd-Frank Act from being
undermined. See Cross-Border Adopting Release, 79 FR 47291-92, supra
note 193 (interpreting anti-evasion provisions of Exchange Act
Section 30(c)). Without this rule, non-U.S. persons could simply
carry on a dealing business within the United States with non-U.S.
persons. Permitting this activity could allow these firms to retain
full access to the benefits of operating in the United States while
avoiding compliance with business conduct requirements, which could
increase the risk of misconduct. See U.S. Activity Proposing
Release, 80 FR 27477 n.255, supra note 9.
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a. Entity-Level Requirements for SBS Entities
The Commission continues to believe that the rules and regulations
prescribed by the Commission relating to diligent supervision pursuant
to Section 15F(h)(1)(B), those relating to the CCO under Section 15F(k)
of the Exchange Act, and those relating to requirements under Section
15F(j) of the Exchange Act should be treated as entity-level
requirements that apply to the entire business of the registered
foreign or U.S. SBS Entity.\1307\ Accordingly, the following
requirements would apply to all security-based swap transactions of an
SBS Entity, regardless of the U.S.-person status of the SBS Entity or
that of its counterparty in any particular transaction: \1308\
Supervision requirements under Rule 15Fh-3(h), including the
requirement in Rule 15Fh-3(h)(2)(iii)(I) that SBS Entities establish
procedures reasonably designed to comply with the duties set forth in
Section 15F(j) of the Exchange Act; and CCO requirements under Rule
15Fk-1. The Commission, however, is adopting a rule that would
potentially make substituted compliance available for these
requirements for registered foreign SBS Entities as discussed
below.\1309\
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\1307\ See Cross-Border Proposing Release, 78 FR 31013-15, supra
note 6 (classifying these requirements, among others, as entity-
level). But see ISDA (July 2015), supra note 10, at 8 (arguing that
the Commission does not have a supervisory interest in imposing
entity-level requirements in connection with security-based swap
transactions between two non-U.S. persons that are cleared outside
the United States, even if they are arranged, negotiated, or
executed by personnel located in the United States).
\1308\ See Cross-Border Proposing Release, 78 FR 31026-27,
31035, supra note 6.
\1309\ See Section III.B, infra.
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As the Commission has previously stated, it is appropriate to
subject a registered SBS Entity to the diligent supervision
requirements regardless of the status or location of its counterparties
to ensure that the SBS Entity is adequately supervising its business
and its associated persons to ensure compliance with the full range of
its obligations under the federal securities laws.\1310\ Similarly, the
Commission continues to believe that Rule 15Fh-3(h)(2)(iii)(I), which
requires SBS Entities to establish procedures to comply with the duties
set forth in Section 15F(j) of the Exchange Act, including conflict of
interest systems and procedures, should apply to all of an SBS Entity's
security-based swap transactions, as such systems and procedures cannot
be effective unless so applied.\1311\ As we have previously noted, to
prevent conflicts of interest from biasing the judgment or supervision
of these entities, application to only a portion of an SBS Entity's
security-based swap transactions would not be effective at addressing
conflicts that may arise as a result of transactions that arise out of
an SBS Entity's foreign business.\1312\ Each of the remaining duties
under section 15F(j) \1313\ would
[[Page 30065]]
not be effective if not applied at the entity level.\1314\
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\1310\ See Cross-Border Proposing Release, 78 FR 31014, 31017,
supra note 6.
\1311\ See Cross-Border Proposing Release, 78 FR 31013-14, supra
note 6.
\1312\ See Cross-Border Proposing Release, 78 FR 31014, supra
note 6.
\1313\ Section 15F(j) of the Exchange Act requires an SBS Entity
to comply ``at all times'' with obligations concerning: (1)
Monitoring of trading to prevent violations of applicable position
limits; (2) establishing sound and professional risk management
systems; (3) disclosing to regulators information concerning its
trading in security-based swaps; (4) establishing and enforcing
internal systems and procedures to obtain any necessary information
to perform any of the functions described in Section 15F of the
Exchange Act, and providing the information to regulators, on
request; (5) implementing conflict-of-interest systems and
procedures; and (6) addressing antitrust considerations such that
the SBS Entity does not adopt any process or take any action that
results in any unreasonable restraint of trade or impose any
material anticompetitive burden on trading or clearing. See 15
U.S.C. 78o-10(j).
\1314\ See Cross-Border Proposing Release, 78 FR 31014, supra
note 6 (explaining that the purpose of the diligent supervision
requirements is to prevent violations of applicable federal
securities laws, and the rules and regulations thereunder, relating
to an entity's entire business as a security-based swap dealer,
which is not limited to either its foreign business or its U.S.
business, but rather is comprised of its entire global security-
based swap dealing activity, and as such, to be effective, the
requirements should apply at the entity level).
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The CCO requirements under Rule 15Fk-1 also raise entity-wide
concerns. CCO's responsibilities include establishing, maintaining, and
reviewing policies and procedures reasonably designed to ensure
compliance with applicable Exchange Act requirements.\1315\ Because
such responsibilities apply to the entity as a whole and many of the
requirements that the CCO oversees are entity-level requirements, the
Commission believes that it is necessary to treat the CCO requirement
as an entity-level requirement applicable to all of an SBS Entity's
security-based swap business.\1316\
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\1315\ See Section II.I, supra.
\1316\ See Cross-Border Proposing Release, 78 FR 31014-15, supra
note 6.
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b. Transaction-Level Requirements for SBS Dealers
As noted above, the Commission is adopting final Rule 3a71-3(c) and
amendments to the definitions in Rule 3a71-3(a) largely unchanged from
the proposal. Accordingly, the final rule provides that registered SBS
Dealers, with respect to their foreign business, shall not be subject
to the requirements relating to business conduct standards described in
Section 15F(h) of the Exchange Act,\1317\ and the rules and regulations
thereunder,\1318\ other than the rules and regulations prescribed by
the Commission pursuant to Section 15F(h)(1)(B).\1319\ The final rule
defines ``foreign business'' for both foreign SBS Dealers and U.S. SBS
Dealers to mean any security-based swap transactions entered into, or
offered to be entered into, by or on behalf of the SBS Dealer that do
not include its U.S. business.\1320\
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\1317\ 15 U.S.C. 78o-10(h).
\1318\ These rules and regulations are Rules 15Fh-1 through
15Fh-6. With the exception of Rule 15Fh-3(h), which prescribes
certain entity-level requirements pursuant to Exchange Act Section
15F(h)(1)(B), these rules are transaction-level requirements, which
is consistent with the proposed approach. See, supra, Section III.0.
\1319\ See Rule 3a71-3(c).
Section 15F(h)(1)(B) requires registered security-based swap
dealers to conform with such business conduct standards relating to
diligent supervision as the Commission shall prescribe. See 15
U.S.C. 78o-10(h)(1)(B). The rules being prescribed pursuant to
Exchange Act Section 15F(h)(1)(B) are those in Rule 15F-3(h), which
are entity-level requirements, as discussed above. See, supra,
Section III.0. The exception as adopted applies to Section
15F(h)(1)(A) of the Exchange Act, and any rules and regulations
thereunder. However, this exception does not affect applicability of
the general antifraud provisions of the federal securities laws to
the activity of a foreign SBS Dealer. See Cross-Border Proposing
Release, 78 FR 31016 n.476, supra note 6.
\1320\ See Rule 3a71-3(a)(9).
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However, the final rule defines ``U.S. business'' differently for
foreign SBS Dealers and U.S. SBS Dealers. The final rule defines ``U.S.
business'' of a foreign SBS Dealer to mean (i) any transaction entered
into, or offered to be entered into, by or on behalf of such foreign
SBS Dealer, with a U.S. person (other than a transaction conducted
through a foreign branch of that person), or (ii) any security-based
swap transaction that is arranged, negotiated, or executed by personnel
of the foreign SBS Dealer located in a U.S. branch or office, or by
personnel of its agent located in a U.S. branch or office.\1321\ For a
U.S. SBS Dealer, the final rule defines ``U.S. business'' to mean ``any
transaction entered into or offered to be entered into by or on behalf
of such U.S. security-based swap dealer, other than a transaction
conducted through a foreign branch with a non-U.S. person or with a
U.S.-person counterparty that constitutes a transaction conducted
through a foreign branch of the counterparty.'' \1322\ The Commission
also is adopting, unchanged from the proposals, the definitions of
``U.S. security-based swap dealer,'' \1323\ and ``foreign security-
based swap dealer.'' \1324\ The Commission also is adopting the
definition of ``foreign business,'' \1325\ with minor edits to simplify
the rule text primarily by eliminating unnecessary separate references
to foreign SBS Dealers and U.S. SBS Dealers. Finally, the Commission is
adopting Rule 3a71-3(c), which creates the exception from the
application of the business conduct requirements to foreign business,
again, unchanged from the proposal except for minor edits eliminating
separate references to foreign SBS Dealers and U.S. SBS Dealers.
---------------------------------------------------------------------------
\1321\ See Rule 3a71-3(a)(8)(i).
\1322\ Rule 3a71-3(a)(8)(ii).
\1323\ See Rule 3a71-3(a)(6).
\1324\ See Rule 3a71-3(a)(7).
\1325\ See Rule 3a71-3(a)(9).
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The final rule reflects the Commission's continuing view that all
registered SBS Dealers should be required to comply with the
transaction-level elements of the business conduct standards with
respect to their U.S. business.\1326\ The Dodd-Frank counterparty
protection mandate focuses on the U.S. markets and participants in
those markets.\1327\ The business conduct standards are intended to
bring professional standards of conduct to, and increase transparency
in, the security-based swap market and to require registered SBS
Dealers to treat parties to these transactions fairly.\1328\
Accordingly, with respect to both foreign and U.S. SBS Dealers, we are
adopting a definition of ``U.S. business'' that encompasses those
transactions that appear particularly likely to affect the integrity of
the security-based swap market in the United States and the U.S.
financial markets more generally or that raise concerns about the
protection of participants in those markets.
---------------------------------------------------------------------------
\1326\ See U.S. Activity Proposing Release, 80 FR 27475, supra
note 9.
\1327\ See Cross-Border Proposing Release, 78 FR 31017-018,
supra note 6.
\1328\ See id. The rules require, among other things, that
registered SBS Dealers communicate in a fair and balanced manner
with potential counterparties and that they disclose conflicts of
interest and material incentives to potential counterparties.
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With respect to foreign SBS Dealers, the Commission continues to
believe that the final definition of ``U.S. business'' should generally
encompass transactions with U.S. persons and transactions that the
foreign SBS Dealer arranges, negotiates, or executes using personnel
located in a U.S. branch or office.\1329\ As we have previously noted,
this approach would both preserve customer protections for U.S.
counterparties that would expect to benefit from the protection
afforded to them by Title VII of the Dodd-Frank Act and help maintain
market integrity by subjecting the large number of transactions that
involve relevant dealing activity in the United States to these
requirements, even if both counterparties are non-U.S. persons.\1330\
---------------------------------------------------------------------------
\1329\ We also note that relying on the same approach to U.S.
activity that is used in the de minimis context should simplify
implementation of Title VII for market participants. See U.S.
Activity Proposing Release, 80 FR 27473, supra note 9.
\1330\ The exception from the definition for transactions
involving the foreign branch of a U.S. person reflects our view that
transactions between the foreign branch of a U.S. person and a non-
U.S. person, in which the personnel arranging, negotiating, and
executing the transaction are all located outside the United States,
are less likely to affect the integrity of the U.S. market and
reflects our consideration of the role of foreign regulators in non-
U.S. markets. See Cross-Border Proposing Release, 78 FR 31017, supra
note 6.
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[[Page 30066]]
With respect to U.S. SBS Dealers, the Commission continues to
believe that the definition of ``U.S. business'' should encompass all
of their transactions, regardless of the U.S.-person status of the
counterparty, except for transactions that a U.S. SBS Dealer arranges,
negotiates, or executes through a foreign branch with another foreign
branch or with a non-U.S. person. As noted above, Title VII is
concerned with the protection of U.S. markets and participants in those
markets, and it remains our view that imposing these requirements on a
U.S.-person dealer when it arranges, negotiates, or executes through
its foreign branch with another foreign branch or a non-U.S. person
would produce little or no benefit to U.S. market participants.\1331\
---------------------------------------------------------------------------
\1331\ See Cross-Border Proposing Release, 78 FR 31018, supra
note 6.
---------------------------------------------------------------------------
One commenter urged the Commission to return to its initially
proposed approach to the definition of ``transactions conducted within
the United States,'' which would have looked to the location of
relevant activity of both counterparties.\1332\ Such an approach would
thus apply the business conduct requirements fully to any transactions
involving activity in the United States, not just dealing activity in
the United States but also relevant activity carried out by a non-
dealing counterparty in the United States. Given the structure of the
security-based swap market and the concentration of security-based swap
dealing among a small group of firms, the Commission believes the final
rules are appropriately tailored to apply the business conduct
requirements to dealing activity, including dealing activity in the
United States, that is likely to raise market integrity and
transparency concerns.\1333\ Further, as the Commission discussed in
the U.S. Activity Adopting Release, the final rules adopted in that
release should mitigate some commenters' concerns regarding the costs
associated with the initially proposed application of the de minimis
exception to ``transactions conducted within the United States.''
\1334\ The initially proposed approach supported by the commenter would
have required a dealer engaged in dealing activity to consider both the
location of its personnel and the personnel of its counterparty in
determining whether to include transactions in its de minimis
calculation thresholds.\1335\ The final rules in the U.S. Activity
Adopting Release and the final rule being adopted here focus on the
location of relevant personnel of only the dealer (or its agent), which
should impose lower costs on market participants than the initially
proposed approach, while applying the business conduct requirements to
dealing activity in the United States that is likely to raise the types
of concerns addressed by the business conduct requirements.\1336\
Moreover, given the Commission's action in the U.S. Activity Adopting
Release, taking a different approach in the definition of ``U.S.
business'' would mean using a different test to identify relevant U.S.
activity from the test used in the de minimis context. The Commission
believes that this would present unnecessary implementation and
compliance challenges.\1337\
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\1332\ See note 1291, supra (citing Better Markets (July 2015),
supra note 10).
\1333\ See U.S. Activity Adopting Release, 81 FR 8624, n.241
(explaining that the U.S. activity test is appropriately tailored to
capture dealing activity that raises the types of concerns addressed
by the Title VII dealer regime).
\1334\ See U.S. Activity Adopting Release, 81 FR 8627.
\1335\ See Cross-Border Proposing Release, 78 FR 31000-01, supra
note 6.
\1336\ See U.S. Activity Adopting Release, 81 FR 8627.
\1337\ See also U.S. Activity Proposing Release, 80 FR 27467,
supra note 9 (discussing the change in approach in the context of
the de minimis calculation from the Cross-Border Proposing Release,
which proposed to focus both on the dealing and non-dealing
counterparty, to the U.S. Activity Proposing Release, which proposed
to focus only on the activity of personnel in the United States of
the dealing counterparty).
---------------------------------------------------------------------------
Some commenters have argued that the business conduct standards
should not apply to any transactions between two non-U.S. persons
because the foreign counterparties may not expect to receive such
protections, or to any such transactions where expectations of
receiving such protections are likely to be particularly low.\1338\ The
Commission has determined not to limit the application of the business
conduct standards in this way. Counterparty expectations are not
particularly relevant in determining whether a transaction that
involves relevant activity in the United States has the potential to
affect the integrity of the U.S. markets, particularly given that all
of the registered foreign SBS Dealers subject to these requirements
will have, by definition, a sufficient level of activity in the U.S.
security-based swap market to exceed the de minimis threshold, many by
an order of magnitude.\1339\ Given the significant role registered SBS
Dealers play in the market, applying the business conduct requirements
to their U.S. business should help protect the integrity of the U.S.
market.\1340\
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\1338\ See ICI Global (July 2015), supra note 10, at 2, 5-6;
SIFMA-AMG (July 2015), supra note 10, at 2, 5 (stating that non-U.S.
clients do not expect U.S. protections to apply to transactions
between two non-U.S. persons). See also ISDA (July 2015), supra note
10, at 2 (urging that the Commission not apply the business conduct
requirements to transactions solely because the transaction involves
U.S. activity); ISDA (July 2015), supra note 10, at 7 (arguing that
business conduct requirement, as well as other requirements, should
not apply to transactions that are executed on an anonymous
electronic platform or other means that ``involve[s] no human
contact within the United States,'' because the parties would have
no expectation that the rules would apply to such a transaction).
\1339\ See U.S. Activity Adopting Release, 81 FR 8623 (rejecting
commenter concerns that counterparties would not expect automated
electronic trades to be subject to de minimis counting).
\1340\ See U.S. Activity Adopting Release, 81 FR 8616 and n.166
(explaining that overwhelming majority of transactions captured by
U.S. Activity Test are likely to be inter-dealer transactions
carried out between non-U.S. persons whose dealing activity likely
exceeds the de minimis threshold by at least an order of magnitude).
---------------------------------------------------------------------------
Moreover, the approach to identifying relevant dealing activity in
the United States reflects the Commission's determination that focusing
solely on the location of the personnel arranging, negotiating, or
executing the transaction on behalf of the foreign SBS Dealer
appropriately balances the regulatory objectives of the business
conduct standards with concerns about workability of an activity-based
test. To create additional exceptions, particularly for activity
occurring in the United States, based on the expectations of the non-
dealing counterparty or the mode of its interaction with the foreign
SBS Dealer would unnecessarily complicate this approach in a manner, as
noted above, that would not advance the regulatory objectives served by
these standards.\1341\
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\1341\ To the extent that anonymously executed transactions
raise specific challenges or concerns, these are not unique to
transactions between two non-U.S. persons involving relevant dealing
activity in the United States. The Commission has separately
addressed this issue above. See Section II.B, supra.
---------------------------------------------------------------------------
Some commenters have urged the Commission to harmonize any
standards that the Commission does impose on these transactions with
requirements that may separately apply to the foreign registered SBS
Dealer's U.S.-person intermediary to avoid unnecessary duplication or
conflicts.\1342\ The Commission
[[Page 30067]]
recognizes that business conduct standards could apply to transactions
arising from relevant dealing activity in the United States, including
Title VII and home jurisdiction requirements on the registered SBS
Dealer and SRO requirements on the U.S. intermediary. As discussed
above, the rules being adopted today are generally designed to be
consistent with the relevant SRO requirements (and to harmonize with
CFTC requirements), taking into account the nature of the security-
based swap market and the statutory requirements for SBS
Entities.\1343\ The Commission does not believe that the commenters'
concerns warrant a complete or partial exception from Title VII
requirements for the registered SBS Dealer.
---------------------------------------------------------------------------
\1342\ Commenters urged the Commission to harmonize FINRA's
existing sales practice requirements with the ``communication-
based'' or transaction-specific rules applicable under Title VII.
See SIFMA/FSR (July 2015), supra note 10, at 9-10; IIB (July 2015),
supra note 10, at 13. Commenters also urged the Commission to work
toward a harmonized approach to all the business conduct rules with
the CFTC and FINRA to ensure that security-based swap dealers and
swap dealers are not subject to two different sets of business
conduct requirements. See also ISDA (July 2015), supra note 10, at
2, n.7; IIB (July 2015), supra note 10, at 6, 7.
\1343\ See Sections I.C and I.F, supra.
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First, as discussed below, the Commission is adopting a rule that
potentially would make substituted compliance available for the
business conduct requirements following a substituted compliance
determination by the Commission.\1344\ Accordingly, substituted
compliance, if available, could mitigate the commenters' concerns
regarding home country regulation.\1345\ A person relying on
substituted compliance would remain subject to the applicable Exchange
Act requirements, but could comply with those requirements in an
alternative fashion.\1346\ In practice, however, we recognize that
there will be limits to the availability of substituted compliance. For
example, it is possible that substituted compliance may be permitted
with regard to some requirements and not others with respect to a
particular jurisdiction. For certain jurisdictions, moreover,
substituted compliance may not be available with respect to any
requirements depending on our assessment of the comparability of the
relevant foreign requirements, as well as the availability of
supervisory and enforcement arrangements among the Commission and
relevant foreign financial regulatory authorities. Although
comparability assessments will focus on regulatory outcomes rather than
rule-by-rule comparisons, the assessments will require inquiry
regarding whether foreign regulatory requirements adequately reflect
the interests and protections associated with the particular Title VII
requirement. In some circumstances, such a conclusion may be difficult
to achieve.
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\1344\ See Rule 3a71-6. See also note 1301, supra (citing IIB
(July 2015), supra note 10, at 12).
\1345\ See note 1338, supra (citing ICI Global (July 2015),
supra note 10, at 5-6; SIFMA-AMG (July 2015), supra note 10, at 2,
5; IIB (July 2015), supra note 10, at 11; SIFMA/FSR (July 2015),
supra note 10, at 9).
\1346\ See Cross-Border Proposing Release, 78 FR 31085, supra
note 6.
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In the event that we are unable to determine that an entity may
satisfy certain Title VII requirements via substituted compliance, we
recognize that such persons may, as a result, be subject to
requirements that are duplicative of particular Title VII requirements.
While we recognize the significance of such a result, in our view
compliance with the Title VII requirements is necessary to advance the
policy objectives of Title VII. This would be undermined by permitting
foreign dealers to comply with their Title VII obligations by
satisfying foreign requirements, unless the alternative route provided
by substituted compliance has been made available.
Second, although the Commission is mindful that the U.S.
intermediary of a registered foreign SBS Dealer may be subject to
business conduct requirements under the Exchange Act and relevant SRO
rules and that such requirements may be similar in certain respects to
those in Title VII,\1347\ the Commission continues to believe that
notwithstanding any requirements that may apply to such intermediaries,
it is appropriate to impose the Title VII business conduct standards
directly on registered foreign SBS Dealers when they use personnel
located in the United States to arrange, negotiate, or execute
security-based swaps, even with counterparties that are also non-U.S.
persons.\1348\ The Commission continues to believe that it is
appropriate to subject all registered SBS Dealers engaged in U.S.
business to the same business conduct framework, rather than
encouraging a patchwork of business conduct protections under U.S. law
that may offer counterparties varying levels of protections and limit
the Commission's ability to pursue enforcement actions against the
registered SBS Dealer for violation of Title VII depending on the
business model that the registered SBS Dealer has chosen to use in its
U.S. business.\1349\
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\1347\ See U.S. Activity Proposing Release, 80 FR 27476 n.249,
supra note 9 (stating that the agent of a foreign SBS Dealer would
need to consider whether it separately would need to register as a
security-based swap dealer (if, for example, the agent acted as
principal in a security-based swap with the counterparty, and then
entered into a back-to-back transaction with the booking entity), a
broker (e.g., by soliciting or negotiating the terms of security-
based swap transactions), or other regulated entity); Cross-Border
Proposing Release, 78 FR 31027 n.574, supra note 6 (same).
Commenters urged the Commission to harmonize FINRA's existing
sales practice requirements with the ``communication-based'' or
transaction-specific rules applicable under Title VII. See SIFMA/FSR
(July 2015), supra note 10, at 9-10; IIB (July 2015), supra note 10,
at 13. Commenters also urged the Commission to work toward a
harmonized approach to all the business conduct rules with the CFTC
and FINRA to ensure that security-based swap dealers and swap
dealers are not subject to two different sets of business conduct
requirements. See ISDA (July 2015), supra note 10, at 9; IIB (July
2015), supra note 10, at 6, 7.
\1348\ See U.S. Activity Proposing Release, 80 FR 27476, supra
note 9. Consistent with the Commission's position in the Cross-
Border Proposing Release, the dealer and its agent(s) may choose to
allocate the responsibility for compliance with all U.S. business
conduct requirements in a manner consistent with its business
structure, although the foreign security-based swap dealer would
remain responsible for ensuring that all relevant Title VII
requirements applicable to a given security-based swap transaction
are fulfilled. See U.S. Activity Proposing Release, 80 FR 27476
n.249, supra note 9; Cross-Border Proposing Release, 78 FR 31026-27,
supra note 6. This allocation, however, would not affect the non-
U.S. person's responsibilities with respect to performing the de
minimis calculations required under Rules 3a71-2 and 3a71-3(b). See
U.S. Activity Proposing Release, 80 FR 27476 n.249, supra note 9;
Cross-Border Proposing Release, 78 FR 31026-27 n.574, supra note 6.
\1349\ See U.S. Activity Proposing Release, 80 FR 27476, supra
note 9.
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Further, as we have previously discussed, Congress established a
comprehensive framework of business conduct standards in Title VII that
applies to registered SBS Dealers, and we continue to believe that the
transactional requirements we adopt to implement this framework should
govern their transactions with counterparties when such transactions
raise market integrity, transparency, and counterparty protection
concerns that are addressed by these requirements.\1350\ As we have
already noted, SBS Dealers are involved in an overwhelming majority of
SBS transactions in the U.S., meaning that business conduct standards
intended to achieve market
[[Page 30068]]
integrity, transparency, and counterparty protection across the U.S.
market in security-based swaps are more likely to achieve these
objectives if they apply to all transactions that SBS dealers arrange,
negotiate, or execute using personnel located in a U.S. branch or
office.\1351\
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\1350\ See U.S. Activity Adopting Release, Sections IV.B.2,
IV.B.3, and n.162 (describing regulatory concerns raised by
security-based swap dealing activity carried out in the U.S.,
including risk, market integrity and transparency, and counterparty
protection). See Section II.G.3, supra (explaining that the ``know
your counterparty'' standard would be consistent with basic
principles of legal and regulatory compliance, and operational and
credit risk management); Section II.G.2.e, supra (explaining that
the daily mark disclosure requirement is directly relevant to a
counterparty's understanding of its financial relationship under a
security-based swap transaction and ensures a counterparty's ability
to monitor the transaction during the relationship); Section II.G.4,
supra (explaining that the suitability requirement enables security-
based swap dealers to understand the risk-reward tradeoff of their
security-based swap transactions).
\1351\ Firms that act as dealers play a central role in the
security-based swap market. Based on an analysis of 2014 single name
CDS data in TIW, dealer accounts of those firms that are likely to
exceed the de minimis thresholds and trigger registration
requirements intermediated transactions with a gross notional amount
of approximately $8.5 trillion, over 60% of which was intermediated
by top 5 dealer accounts. Commission staff analysis of TIW
transaction records indicates that approximately 99% of single name
CDS price-forming transactions in 2014 involved an ISDA-recognized
dealer. See U.S. Activity Adopting Release, 81 FR 8606 n.77.
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Some commenters supported dividing the business conduct standards
into two categories, one of which they argued should not apply to
transactions between two non-U.S. persons. These commenters urged the
Commission not to impose ``relationship-based'' requirements (which
they defined to include rules relating to the counterparty's ECP
status, ``know your counterparty'' requirements, daily mark disclosure,
and suitability requirements) on these transactions but suggested that
imposing ``trade-specific'' or ``communication-based'' requirements
(which they which they identified as including disclosure of material
risks and characteristics and material incentives or conflicts of
interest and related recordkeeping, disclosures regarding clearing
rights and related recordkeeping, product suitability, and fair and
balanced communications and supervision) could be a reasonable
approach, particularly if they were made more consistent with similar
FINRA rules that may apply to the U.S. intermediary.\1352\
---------------------------------------------------------------------------
\1352\ See notes 1297-1299, supra.
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The Commission does not agree with commenters who argue that the
foreign SBS Dealers should be excepted from the ``relationship-based''
requirements when entering into transactions with other non-U.S.
persons.\1353\ The Commission believes that applying each of these
requirements should improve market integrity and enhance transparency
and counterparty protections, even if that dealing activity is entirely
with non-U.S.-person counterparties, particularly given that the
foreign SBS Dealers that engage in the relevant dealing activity in the
United States at levels above the de minimis threshold account for a
significant proportion of transactions in the U.S. market. Moreover,
certain underlying substantive requirements may require SBS Dealers to
obtain representations from counterparties (or to otherwise confirm
their status) even absent these business conduct requirements, meaning
that, as a practical matter, for example, we would not expect that the
requirement in Rule 15Fh-3(a)(1) to verify ECP status would increase
the burden on market participants.\1354\ Accordingly, the Commission
does not believe it would be appropriate to provide an exception from
these ``relationship-based'' requirements for foreign SBS Dealers when
they are required to comply with the business conduct standards in a
security-based swap transaction with a non-U.S.-person counterparty
because they have used personnel located in the United States to
arrange, negotiate, or execute the transaction.
---------------------------------------------------------------------------
\1353\ See note 1298, supra.
\1354\ The Exchange Act prohibits any person from effecting a
security-based swap with a non-ECP unless the security-based swap is
effected on a national securities exchange and the Securities Act
makes it unlawful to offer to sell, offer to buy or purchase or sell
a security-based swap to any person who is not an eligible contract
participant unless a registration is in effect. See Section
II.G.1.c, supra. See also Section 6(l) of the Exchange Act; Section
5(e) of the Securities Act. Accordingly, section 6(l) is broader
than the activity covered by Rule 15Fh-3(a)(1), and the SBS Dealer
has an independent obligation under section 6(l) even absent the
requirement in Rule 15Fh-3(a)(1), to perform some due diligence in
confirming that its counterparty is an ECP. The requirement to
verify the ECP-status of a counterparty pursuant to Rule 15Fh-
3(a)(1) simply provides a means for complying with certain of the
relevant substantive statutory provisions. See id. See Section
II.G.1.c, supra.
---------------------------------------------------------------------------
The Commission recognizes that some non-U.S. person counterparties
may express reservations about making certain representations or
completing questionnaires to comply with the ``relationship-based''
business conduct requirements when they have no intention of
interacting with the dealer's personnel located in the United
States.\1355\ At the same time, nothing in the rule requires a
registered SBS Dealer to comply with these requirements if it intends
to engage in transactions with a counterparty solely as part of its
foreign business. If the relationship later develops in such a way that
future transactions may be expected to be part of the SBS Dealer's U.S.
business, under the final rules the SBS Dealer then would be required
to comply with these business conduct standards, including these
``relationship-based'' requirements.
---------------------------------------------------------------------------
\1355\ See SIFMA/FSR (July 2015), supra note 10, at 8-9. See
also ICI Global (July 2015), supra note 10, at 6 (noting that, even
though the registered dealer (and not the non-U.S. person) is
subject to the business conduct requirements, the non-U.S. person
counterparty would likely need to have in place appropriate
documentation and representations if its dealer is subject to
business conduct requirements, which may cause interruptions in
their investment activities); IIB (July 2015), supra note 10, at 11-
12 (arguing that non-U.S. counterparties would not expect the
``trade-relationship'' requirements to apply in their trades with
non-U.S. persons and would be surprised to be required to agree to
covenants or fill out questionnaires related to U.S. requirements).
See note 1298, supra.
---------------------------------------------------------------------------
As noted above, some commenters acknowledged that the
``communication-based'' or ``trade-specific'' requirements likely would
advance regulatory objectives, such as the prevention of fraud or
manipulation, even in connection with SBS transactions between two non-
U.S. persons where one counterparty is using personnel located in the
United States to arrange, negotiate, or execute transactions.\1356\
They urged, however, that the Commission harmonize its Title VII
business conduct standards to existing FINRA rules to the extent that
it chooses to impose Title VII requirements on these
transactions.\1357\ As discussed above, the rules being adopted today
are generally designed to be consistent with the relevant SRO
requirements (and to harmonize with CFTC requirements), taking into
account the nature of the security-based swap market and the statutory
requirements for SBS Entities.\1358\
---------------------------------------------------------------------------
\1356\ See note 1299, supra.
\1357\ See note 1300, supra.
\1358\ See Sections I.C and I.F, supra.
---------------------------------------------------------------------------
The Commission recognizes that application of these requirements
may impose costs on asset managers servicing non-U.S. clients and
impede their ability to execute certain block trades.\1359\ However, we
believe that the rules appropriately balance the regulatory objectives
of the business conduct rules with concerns for a workable approach.
The rules adopted here are generally applicable to transactions of
registered SBS Dealers; the rules do not apply directly to asset
managers, and asset managers will incur no liability under these rules.
We recognize that SBS Dealers may arrange their business in a variety
of ways and may have certain expectations of asset managers in
connection with the transactions involving funds. The entities involved
in the transaction may
[[Page 30069]]
allocate these costs in the manner most efficient for the
counterparties to the transactions. Although the Commission recognizes
that, depending on how the SBS Dealer and the asset manager choose to
allocate these responsibilities, the asset manager may incur certain
costs, neither these private allocation issues nor the potential
liquidity or execution price concerns change the Commission's view that
the U.S. business of SBS Dealers should be subject to these business
conduct requirements.
---------------------------------------------------------------------------
\1359\ See notes 1295 and 1296, supra. Specifically, the
commenters expressed concern that, under the proposal, the U.S.
asset manager executing a trade on behalf of a non-U.S. client,
including in the context of a block trade, would need to know
whether the transaction involved U.S. activity and would also need
to verify that the non-U.S. client satisfies the business conduct
requirements. See SIFMA-AMG (July 2015), supra note 10, at 4; ICI
Global (July 2015), supra note 10, at 6 (explaining that regulated
fund parties would need appropriate documentation and
representations in place to execute such trades and would face
interruptions in investment activities in doing so).
---------------------------------------------------------------------------
The Commission also disagrees with the commenters that urged the
Commission to permit sophisticated counterparties to ``opt-out''
completely from the business conduct standards and with commenters that
requested that the U.S. Activity Test not be applied to transactions
with special entities.\1360\ The Commission has considered the concerns
raised by commenters and determined, on balance, not to permit
counterparties to opt out of the protections provided by the business
conduct rules. The rules are intended to provide certain protections
for counterparties, including certain heightened protections for
special entities. We think it is appropriate to apply the rules so that
counterparties receive the benefits of those protections and so do not
think it appropriate to permit parties to ``opt out'' of the benefits
of those provisions.\1361\
---------------------------------------------------------------------------
\1360\ See IIB (July 2015), supra note 10, at 13; SIFMA/FSR
(July 2015), supra note 10, at 10-11 (requesting the non-U.S.
counterparty have option to opt-out of ``transaction-specific''
rules if they apply solely as a result of U.S. activity). See note
1302, supra. See note 1304 (citing IIB (July 2015), supra note 10,
at 12; SIFMA/FSR (July 2015), supra note 10, at 9-10).
\1361\ See Section II.A.3, supra. We also explained above that,
while we are not adopting an opt out provision, as discussed 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 (e.g., Rule 15Fh-1(b) (reliance on
representations)) and, where appropriate, allow SBS Entities to take
into account the sophistication of the counterparty (e.g., Rule
15Fh-3(f) (regarding recommendations of security-based swaps or
trading strategies)).
---------------------------------------------------------------------------
c. Transaction-Level Requirements for Major SBS Participants
As noted above, the Commission is also adopting amendments to Rule
3a67-10 to incorporate a modified exception from the business conduct
standards for registered foreign Major SBS Participants.\1362\ The
Commission received no comments in response to the proposed exception
from the business conduct requirement for registered foreign Major SBS
Participants in their transactions with non-U.S. persons. However, the
final rule is slightly modified from the proposal to address the
concerns that non-U.S. persons would limit or stop trading with foreign
branches of U.S. banks that led us to adopt a similar exception in the
Cross-Border Adopting Release for certain transactions from the
position threshold calculations to determine whether one is a Major SBS
Participant.\1363\
---------------------------------------------------------------------------
\1362\ Rule 3a67-10(d).
\1363\ See Rule 3a67-10. See Cross-Border Adopting Release, 79
FR 47343, supra note 193 (explaining the Commission's view that an
exclusion from the counting requirement for positions that arise
from transactions conducted through foreign branches of registered
security-based swap dealers appropriately accounts for the risk in
the U.S. financial system created by such positions).
---------------------------------------------------------------------------
As proposed, Exchange Act Rule 3a67-10(c), which addressed cross-
border application of the definition of ``major security-based swap
participant,'' would require non-U.S. persons to count toward the Major
SBS Participant thresholds only their security-based swap transactions
with U.S. persons and would have permitted no exception from that
requirement. As adopted, however, in the Cross-Border Adopting Release,
the relevant rule (Exchange Act Rule 3a67-10(b)) provides that a non-
U.S. person need not include in these threshold calculations its
security-based swap positions with a U.S. person to the extent that the
positions ``arise from transactions conducted through a foreign branch
of the counterparty, when the counterparty is a registered SBS
Dealer.'' \1364\ This change to the final rule made the Commission's
approach to the threshold calculations for Major SBS Participant
consistent with its final approach to the SBS Dealer de minimis
calculation thresholds under Exchange Act rule 3a71-3(b)(1)(iii)(A)(1),
which also permitted non-U.S. persons to exclude such transactions with
U.S. persons from their de minimis threshold calculations.\1365\ The
Commission noted that this expanded exception from counting certain
security-based swap positions towards a non-U.S. person's Major SBS
Participant thresholds should help mitigate concerns that non-U.S.
persons will limit or stop trading with foreign branches of U.S.
banks.\1366\
---------------------------------------------------------------------------
\1364\ See Exchange Act rule 3a67-10(b)(3)(i)(A).
\1365\ See Cross-Border Adopting Release, 79 FR 47343, supra
note 193.
\1366\ See id.
---------------------------------------------------------------------------
The Commission believes similar concerns about the ability of
foreign branches of U.S. banks to do business with non-U.S. persons
apply in the context of application of the business conduct requirement
to these transactions. This exception from the application of the
business conduct requirements adopted in the final rules today should
address concerns that non-U.S. persons would limit or stop trading with
foreign branches of U.S. banks. The Commission is therefore amending
Exchange Act rule 3a67-10 to incorporate exceptions for transactions
through the foreign branch of a U.S. person modeled on those that are
available in the final rule as it applies to registered SBS
Dealers.\1367\ Accordingly, the final rules except registered foreign
Major SBS Participants from the business conduct standards described in
section 15F(h) of the Exchange Act, and the rules and regulations
thereunder (other than the rules and regulations prescribed by the
Commission pursuant to section 15F(h)(1)(B)) \1368\ with respect to any
transaction with a non-U.S. person, as proposed, or with a U.S. person
in a transaction conducted through the foreign branch of the U.S.
person.\1369\ The final rules also except a registered U.S. Major SBS
Participant from the business conduct standards described in section
15F(h) of the Exchange Act, and the rules and regulations thereunder
(other than the rules and regulations prescribed by the Commission
pursuant to section 15F(h)(1)(B)) \1370\ with respect to any
transaction of the registered U.S. Major SBS Participant that is a
transaction conducted through a foreign branch with a non-U.S. person,
or with a U.S.-person counterparty that constitutes a transaction
conducted through a foreign branch of the counterparty.\1371\
---------------------------------------------------------------------------
\1367\ See Exchange Act rule 3a71-3(a)(8)(i)(A) (excluding from
the definition of ``U.S. business'' of a foreign SBS Dealer any
transaction with U.S. persons that constitutes a transaction
conducted through a foreign branch of that U.S. person); Exchange
Act rule 3a71-3(a)(8)(ii) (excluding from the definition of ``U.S.
business'' of U.S. SBS Dealers any transaction of the U.S. SBS
Dealer that is a transaction conducted through a foreign branch with
a non-U.S. person or with a U.S.-person counterparty that
constitutes a transaction conducted through a foreign branch of the
counterparty).
\1368\ See, supra, notes 1318-1319.
\1369\ See Exchange Act rule 3a67-10(d)(1). Consistent with the
Cross-Border Proposing Release, the Commission is also amending
Exchange Act rule 3a67-10(a) to define ``foreign major security-
based swap participant.'' See Exchange Act rule 3a67-10(a)(6).
\1370\ See, supra, notes 1318-1319.
\1371\ See Exchange Act rule 3a67-10(d)(2). The Commission is
also amending Exchange Act rule 3a67-10(a) to define ``U.S. major
security-based swap participant.'' See Exchange Act rule 3a67-
10(a)(5).
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[[Page 30070]]
B. Availability of Substituted Compliance
1. Proposed Substituted Compliance Rule
As part of the Cross-Border Proposing Release, the Commission
proposed to make substituted compliance potentially available in
connection with the requirements applicable to SBS Dealers pursuant to
Exchange Act Section 15F, other than the registration requirements
applicable to dealers.\1372\ Because the business conduct requirements
being adopted today are grounded in Section 15F, substituted compliance
generally would have been available for those requirements under the
proposal.
---------------------------------------------------------------------------
\1372\ See Cross-Border Proposing Release, 78 FR at 31088,
31207-08, supra note 6 (proposed Exchange Act Rule 3a71-5).
---------------------------------------------------------------------------
The proposal would have specifically provided that a foreign SBS
Dealer \1373\ could satisfy applicable requirements under Section 15F
by complying with comparable regulatory requirements of a foreign
jurisdiction.\1374\ The Commission explained that a person relying on
substituted compliance would remain subject to the applicable Exchange
Act requirements, but could comply with those requirements in an
alternative fashion. Failure to comply with the applicable foreign
requirement would mean that the person would be in violation of the
requirement in the Exchange Act.\1375\
---------------------------------------------------------------------------
\1373\ In the Cross-Border Proposing Release, the Commission
proposed to define a ``foreign security-based swap dealer'' as a
security-based swap dealer that is not a U.S. person. See 78 FR at
31206, supra note 6 (proposed Exchange Act Rule 3a71-3(a)(3)).
\1374\ See Cross-Border Proposing Release, 78 FR at 31207, supra
note 6 (proposed Exchange Act Rule 3a71-5(b), providing that a
security-based swap dealer may comply with Section 15F requirements
by complying with certain corresponding foreign requirements).
\1375\ See id. at 31085.
---------------------------------------------------------------------------
The Commission further explained that allowing substituted
compliance for the dealer requirements would have the goal of
increasing the efficiency of the security-based swap market and
promoting competition ``by helping to avoid subjecting foreign
security-based swap dealers to potentially conflicting or duplicative
compliance obligations, while still achieving the policy objectives of
Title VII.'' The Commission also stated that such an approach would be
consistent with the global nature of the security-based swap market,
and may be less disruptive of business relationships than not
permitting substituted compliance.\1376\
---------------------------------------------------------------------------
\1376\ See id. at 31089-90.
---------------------------------------------------------------------------
Under the proposal, the Commission would not permit dealer
requirements to be satisfied by substituted compliance unless the
Commission determined that the foreign regime's requirements were
comparable to the otherwise applicable requirements, after taking into
account such factors as the Commission determines are appropriate,
including the scope and objectives of the relevant foreign regulatory
requirements and the effectiveness of the supervisory compliance
program administered, and the enforcement authority exercised, by the
foreign financial regulatory authority in support of its
oversight.\1377\
---------------------------------------------------------------------------
\1377\ See id. at 31086-88.
---------------------------------------------------------------------------
The Commission also stated that in making a substituted compliance
determination, it would focus on the similarities in regulatory
objectives, rather than requiring that the foreign jurisdiction's rules
be identical. Moreover, depending on the assessment of comparability,
the Commission could condition the substituted compliance determination
by limiting it to a particular class or classes of registrants in the
foreign jurisdiction.\1378\
---------------------------------------------------------------------------
\1378\ See id. at 31088. The Commission added that it intended
to take a category-by-category approach toward substituted
compliance under the proposal, and that ``certain requirements are
interrelated such that the Commission would expect to make a
substituted compliance determination for the entire group of related
requirements.'' See id. at 31088-89 (further stating that the
Commission anticipated considering substituted compliance related to
capital and margin requirements in connection with requirements
related to risk management, recordkeeping and reporting, and
diligent supervision).
---------------------------------------------------------------------------
The proposal would have required that, prior to making a
substituted compliance determination, the Commission must have entered
into a supervisory and enforcement memorandum of understanding
(``MOU'') or other arrangement with the foreign authority addressing
the oversight and supervision of security-based swap dealers subject to
the substituted compliance determination.\1379\ The proposal further
provided for the potential withdrawal of substituted compliance orders,
after notice and comment.\1380\ In addition, the proposal would have
required that a foreign security-based swap dealer could not submit a
substituted compliance request unless it is directly supervised by the
foreign financial regulatory authority, and the security-based swap
dealer provides a certification and opinion of counsel that the
security-based swap dealer can provide the Commission with prompt
access to its books and records, and that the security-based swap
dealer as a matter of law can submit to onsite inspection and
examination by the Commission.\1381\
---------------------------------------------------------------------------
\1379\ See id. at 31088.
\1380\ See id. at 31089 (citing as an example changes in the
foreign regulatory regime or a foreign regulator's failure to
exercise its supervisory or enforcement authority in an effective
manner).
\1381\ See id. at 31089 & n.1126.
---------------------------------------------------------------------------
Under the proposal, substituted compliance would not have been
available to Major SBS Participants. In this regard, the Commission
particularly noted ``the limited information currently available to us
regarding what types of foreign entities may become major security-base
swap participants, if any, and the foreign regulation of such
entities.'' \1382\
---------------------------------------------------------------------------
\1382\ See id. at 31035-36.
---------------------------------------------------------------------------
2. Comments on the Proposal
Commenters raised issues in connection with a variety of aspects
regarding the proposed substituted compliance rule:
Basis for substituted compliance. One commenter to the
Cross-Border Proposing Release questioned the Commission's authority to
grant substituted compliance,\1383\ and expressed skepticism regarding
the policy basis for permitting the use of substituted compliance to
satisfy Title VII requirements.\1384\ That commenter further suggested
that any Commission relief should be used sparingly, and should be
predicated on a finding that
[[Page 30071]]
there is an actual conflict between Title VII and foreign
requirements.\1385\
---------------------------------------------------------------------------
\1383\ See Better Markets (August 2013), supra note 7, at 24
(``Nowhere does the SEC address its authority for adopting such a
framework, nor does it explain how the possibility of `conflicting
or duplicative compliance obligations' [justifies] supplanting
Congress's determination that, to protect the American taxpayer and
economy, those subject to the Commission's jurisdiction must comply
with the actual provisions of the Dodd-Frank financial reform
law.'').
This commenter particularly described the use of substituted
compliance as constituting an impermissible exemption from the Title
VII requirements, stating: ``Had Congress intended the SEC to permit
compliance with foreign regulation to suffice for all Title VII
regulation of entities under U.S. jurisdiction, directly or by way
of anti-evasion regulations, it certainly could have done so.'' In
support, the commenter cited Exchange Act section 17A(k), 15 U.S.C.
78q-1(k), added by Dodd-Frank, which specifically permits the
Commission to exempt clearing agencies from registration when they
are subject to comparable and comprehensive oversight by the CFTC or
by foreign regulators. See Better Markets (August 2013), supra note
7, at 25.
\1384\ See Better Markets (August 2013), supra note 7, at 24-25
(``The SEC's duty is to protect investors and the public consistent
with congressional policy, not to minimize the costs, burdens, or
inconvenience that regulation imposes on industry. This is
particularly important when any claimed industry burden is not only
self-serving, but without basis and entirely speculative.''). The
commenter also alluded to potential loopholes associated with
opportunities for regulatory arbitrage, encouraging ``a race to the
regulatory bottom so that financial firms can increase profits by
avoiding regulations that protect the American people and
taxpayers,'' and that the ``financial industry is among the most
notorious business sectors for searching the globe to exploit such
loopholes.'' See id.
\1385\ See Better Markets (August 2013), supra note 7, at 26
(``Rather than following a substituted compliance approach, the SEC
should use its exemptive authority sparingly, and only upon a
finding of actual conflict with a particular foreign regulation.'').
---------------------------------------------------------------------------
Availability to U.S. persons. One commenter suggested that
substituted compliance for the dealer requirements should be available
to foreign branches of U.S. persons,\1386\ while another commenter
opposed the availability of substituted compliance to U.S.
persons.\1387\ One commenter expressed the view that substituted
compliance should be made available to U.S. persons in connection with
transactions with non-U.S. persons,\1388\ while another stated that
substituted compliance should be made available to U.S. persons in
connection with all transaction-level requirements.\1389\
---------------------------------------------------------------------------
\1386\ See SIFMA (August 2013), supra note 7, at A-33 (stating
that not allowing substituted compliance for foreign branches in
connection with confirmation requirements and certain other
requirements would put foreign branches at a competitive
disadvantage to foreign dealers, although foreign branches ``are, in
most cases, subject to extensive supervision and oversight in their
host country''; further noting that the Commission proposed to allow
substituted compliance for foreign branches in connection with
regulatory reporting, public dissemination and trade execution
requirements).
\1387\ See Better Markets (August 2013), supra note 7,
(generally opposing substituted compliance for U.S. persons,
including foreign branches, and stating that allowing substituted
compliance in those circumstances would constitute ``carve-outs''
that would ``essentially nullify U.S. law in favor of foreign
regulatory requirements'').
\1388\ See ESMA, supra note 8, at 3-4 (expressing the view that
``substituted compliance should apply when a counterparty to the
derivative transaction is established in an equivalent jurisdiction
and is a non-U.S. person. In such case, substituted compliance
should be possible whatever the status of the other party is,
including if it is a U.S. person, and whatever the place out of
which the transaction is conducted or executed.'').
\1389\ See MFA/AIMA, supra note 8 (stating the Commission should
extend substituted compliance to ``to all transaction-level
requirements that apply to U.S. and non-U.S. persons,'' and that
``by extending the scope of substituted compliance to all market
participants, irrespective of their `U.S. person' status, and to all
regulatory categories . . . the Commission would mitigate the risk
of duplicative and/or conflicting regulatory requirements, without
curtailing the reasonable application of Title VII of Dodd-Frank to
relevant market participants'').
---------------------------------------------------------------------------
Availability in connection with U.S. business. One
commenter expressed the view that substituted compliance generally
should not be available in connection with transactions involving U.S.
counterparties, or in connection with transactions that occur within
the U.S.\1390\
---------------------------------------------------------------------------
\1390\ See Better Markets (August 2013), supra note 7, at 26-27
(``The SBS activities of a U.S. person directly and immediately
impact the United States and endanger the U.S. taxpayer if
improperly regulated . . . . Substituted compliance is simply
impermissible for transactions with U.S. persons or for transactions
that occur within the United States, regardless of the status of the
counterparty.'').
---------------------------------------------------------------------------
Comparability criteria. Certain commenters opposed the
proposed holistic approach toward assessing comparability based on
regulatory outcomes, and instead expressed the view that any
assessments should be done on a requirement-by-requirement basis.\1391\
Conversely, a number of commenters supported the proposed
approach.\1392\ Some commenters requested further clarity regarding the
assessment criteria and regarding the information that should be
submitted in support of applications,\1393\ while one commenter
challenged the proposal's lack of particularized elements for assessing
comparability in connection with certain requirements.\1394\ One
commenter questioned how the Commission would be notified of material
changes to foreign law that underpins a substituted compliance
determination.\1395\ Commenters also expressed the views that
regulatory comparisons should focus on common principles associated
with shared G-20 Leaders goals,\1396\ urged the need for consistency
and coordination with the work of other regulators and IOSCO,\1397\ and
supported building on existing cooperative initiatives.\1398\
Commenters
[[Page 30072]]
also stated that the Commission should coordinate substituted
compliance determinations with the CFTC.\1399\ One commenter expressed
concern regarding operational complexities that may be associated with
``partial'' substituted compliance determinations, and suggested that
there be presumptions against such partial determinations.\1400\
---------------------------------------------------------------------------
\1391\ See AFR (stating that an ```outcomes-based' assessment of
regulation is thus likely to be far more subjective than a careful,
point-by-point comparison of the actual substance of the rules,''
and that ``a hypothesized similarity in outcomes for sets of rules
that are quite different in substance should not suffice to certify
comparability''; further stating that an outcomes-based assessment
may not be consistent with the need for different sets of
requirements to be standardized); Better Markets, supra note 7,
(August 2013) at 3, 30 (stating that the SEC must abandon the
regulatory outcomes test and must ensure that foreign regulation is
comparable in substance, form, over time, and as enforced,'' and
also questioning whether ``one can ever predict whether regulatory
outcomes will be comparable'').
A legislative comment letter to the CFTC in connection with the
CFTC's own cross-border initiative, on which the SEC Chair and
Commissioners were copied, also took the view that there should be a
presumption against comparability for substituted compliance
purposes and that any assessment be made on a requirement-by-
requirement basis. See U.S. Senators, supra note 8 (``However, the
`substituted compliance' determination must be made through a
judicious process, on a country-by-country and requirement-by-
requirement basis, and subject to a presumption that other
jurisdictions do not comply unless proven otherwise.'').
\1392\ See, e.g., SIFMA (August 2013), supra note 7, at A-30
(the proposed approach ``is consistent with the goal of
international comity and is preferable to a rule-by-rule
comparison''); IIB (August 2013), supra note 8, at 18 (``We agree
with the Commission that requirements related to internal controls
(such as risk management, recordkeeping and reporting, internal
systems and controls, diligent supervision and chief compliance
officer requirements) should generally be evaluated holistically.
These requirements are commonly overseen and administered by a
single prudential regulator.''); EC, supra note 8 (``We support the
consideration of regulatory outcomes as the standard for permitting
substituted compliance, as well as the consideration of particular
market practices and characteristics in individual jurisdictions.
This flexible approach recognises the differing approaches that
regulators and legislators may take to achieving the same regulatory
objectives in the derivatives markets.''); ABA (October 2013), supra
note 8.
\1393\ See SIFMA (August 2013), supra note 7 (requesting that
the Commission provide a ``more granular and detailed framework''
for clarity regarding the assessment process, including the factors
relevant to the determination and the method and metrics for
comparing regulatory outcomes); CDEU, supra note 8 (addressing
vagueness in criteria); ISDA (August 2013), supra note 7, at 3
(``Without a more concrete definition of the outcomes-based
standard, applicants will face uncertainty in determining what
information should be supplied in connection with an application.
ISDA proposes that the appropriate `outcomes' to guide substituted
compliance determinations should be the common principles based on
the consensus G-20 goals as described above, rather than details of
domestic legislation; in other words, a substituted compliance
determination should be an assessment that the non-US regulatory
approach under consideration adheres to the common principles.'');
FOA, supra note 8 (requesting additional detail regarding relevant
regulatory outcomes).
\1394\ See Better Markets (August 2013), supra note 7, at 30
(noting that the Commission proposed particularized comparability
elements in connection with regulatory reporting and public
dissemination requirements, and stating that the lack of such
elements for other requirements would be confusing and would create
``the opportunity for the Commission to approve much more relaxed
foreign regulations based on more vague standards''; further stating
that it would be arbitrary and capricious not to make use of
``consistently robust and publicly disclosed'' standards to guide
substituted compliance determinations for each requirement).
\1395\ See Better Markets (August 2013), supra note 7, at 29
(``Any entity making use of substituted compliance must be held
responsible for immediately informing the SEC if either the relevant
regulation or the factors that qualified the entity for substituted
compliance change in any material way.'').
\1396\ See ISDA (August 2013), supra note 7 (stating that ``the
Commission could consider and adopt a regime-based approach, whereby
comparability would exist if a jurisdiction has implemented
regulations to meet the G-20 commitments. The Commission's rejection
of this approach based on its `responsibility to implement the
specific statutory provisions . . . added by Title VII' overlooks
the principle that comity should inform the extraterritorial
application of statutory directives''; citation omitted).
\1397\ See II.F, supra note 8 (``Nevertheless, the proposed
approach (and any similar approaches used in other jurisdictions)
will be even more effective and beneficial if they are consistent
with, and coordinated with, the work and approaches of other
authorities in the same jurisdiction (particularly in the case where
multiple supervisors have responsibility for swaps regulation),
national authorities in other jurisdictions and international
standard setters such as the International Organization of
Securities Commissions (IOSCO).'').
\1398\ See JSDA, supra note 8 (noting that the CFTC and the
European Union had announced a ``Path Forward'' regarding their
joint understandings for how to approach cross-border derivatives,
and stating ``[w]e expect that the SEC and CFTC will jointly adopt
the same approach regarding application of substituted compliance to
Japan'').
\1399\ See, e.g., CDEU, supra note 8 (``The SEC should also work
closely with the CFTC when determining whether substituted
compliance is applicable with respect to a particular jurisdiction.
With respect to substituted compliance, the regulatory requirements
of end-users operating globally depend on whether the SEC has made a
comparability determination for the relevant non-U.S. jurisdiction.
Conflicting regimes will lead to increased costs and unnecessary
duplicative regulations which may be directly or indirectly imposed
on derivatives end users.''); ISDA (August 2013), supra note 7
(``Differences in the Commission's and CFTC's approaches to
derivatives regulation produce uncertainties and confusion for
market participants. Moreover, the lack of coordination severely
limits potential efficiencies in the substituted compliance process.
We note here some of the significant differences between the
Proposal and the CFTC July 2013 Guidance. We respectfully urge the
agencies to prioritize harmonization of their approaches to
substituted compliance.''). But see ISDA (August 2013), supra note 7
(commending the Commission's proposal ``to allow substituted
compliance by bona fide non-U.S. SBS dealers for external business
conduct standards and conflicts of interest duties in transactions
with U.S. persons,'' in contrast to the approach set forth in the
CFTC's cross-border guidance).
\1400\ FOA, supra note 8 (urging the Commission to be sensitive
to ``the possible consequences of `partial' substituted compliance
determination for market participants and, wherever possible, to
presume that where a significant portion of a jurisdiction's
regulatory regime is determined to be comparable to Title VII of the
Dodd-Frank Act, the remainder of the jurisdiction's regulatory
regime should also be deemed to be comparable'').
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Enforcement and supervisory practices. One commenter
expressed the view that a substituted compliance assessment must
address a foreign regime's supervisory and enforcement capabilities in
practice.\1401\ Another commenter expressed the view that differences
among the supervisory and enforcement regimes should not be assumed to
reflect flaws in one regime or another.\1402\ One commenter requested
guidance regarding how the Commission would consider such enforcement
and supervisory practices.\1403\
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\1401\ This commenter also highlighted particular factors for
analysis of foreign supervision and enforcement. See Better Markets
(August 2013), supra note 7, at 29-31 (stating that the ``foreign
regulatory regime must incorporate strong investigative tools and
meaningful penalty provisions, and the foreign regulator must have a
demonstrable commitment to enforcement and the resources to carry
out such a commitment,'' that the Commission ``must evaluate a host
of factors regarding the foreign regulatory system, including staff
expertise, agency funding, agency independence, technological
capacity, supervision in fact, and enforcement in fact,'' and that
the Commission ``must determine that there is a track record of
robust enforcement by the foreign jurisdiction before making or
renewing any such finding'').
Another commenter more generally supported the Commission's
ability to not grant substituted compliance due to the substantive
enforcement of foreign regulatory regimes. See AFR, supra note 8
(also supporting withdrawal of substituted compliance due to a
foreign regulator's failure to exercise its supervisory or
enforcement authority).
\1402\ See ISDA (August 2013), supra note 7 (``While the G-20
commitments for the reform of derivatives markets are globally
shared, supervisory practices vary significantly among
jurisdictions. Supervisory practices established in one jurisdiction
will be adapted to the facts of that jurisdiction. This lack of
commonality should not be assumed to be a defect in supervisory
standards; common objectives may be reached through differing means.
Moreover, commonality may not present meaningful benefits beyond
those already achieved by virtue of the Commission and its
counterpart regulators negotiating and entering into memoranda of
understanding, a process that is separately a predicate for
substituted compliance.'').
\1403\ See ABA, supra note 8 (``In addition, we believe that the
Commission's comparability analysis should extend to the existence
and effectiveness of the foreign jurisdiction's supervisory
examination and enforcement programs. However, we urge the
Commission to provide further guidance as to how these factors will
be analyzed in particular scenarios.'').
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Multi-jurisdictional issues. One commenter raised
questions regarding the application of substituted compliance in
connection with third-country branches of non-U.S. dealers,\1404\ while
another commenter raised issues regarding which sets of rules apply to
transactions between parties in different markets, and whether the
parties to cross-jurisdiction transactions may choose which rules
apply.\1405\ Commenters also raised issues regarding the assessment of
substituted compliance in the context of the European Union, stating
that certain rules are adopted at a European level and are applied
directly in individual member states.\1406\
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\1404\ See FOA, supra note 8 (``However, multi-jurisdictional
scenarios are quite common and the SEC must provide additional
guidance on how it intends to address substituted compliance when a
bank headquartered in one country (e.g., the UK) may have a swap
dealing branch that operates in another country (e.g., Hong Kong).
Any substituted compliance determination by the SEC must account for
the interplay of the regulatory regimes in the relevant non-U.S.
jurisdictions.'').
\1405\ See IIF, supra note 8 (``A further general observation is
that while the rule proposal provides for substituted compliance
covering significant aspects of entity-level and transaction-level
requirements, it does not seem to address the issue of whose rules
govern when the transaction is between two or more parties in
different markets. It is important that the SEC provide guidance as
to how one determines the applicable requirements in such cases. We
suggest that the final rule should clarify that if the SEC has
concluded on the basis of its outcomes-based assessment that the
rules of the host country where the counterparties are located
produce comparable outcomes to those in the United States, then
either the parties should be free to choose which rules apply or the
rules where the [transaction] occurs should be the default
position.'').
\1406\ See ESMA, supra note 8 (``ESMA considers it is important
that substituted compliance is assessed at the level of the
jurisdiction, i.e. at the level of the Union, for Europe. EMIR rules
are adopted at European level and apply directly in each Member
State''); FOA, supra note 8, at 5 (``It is not clear how the SEC
intends to approach situations where more than one non-U.S.
jurisdiction's rules may be relevant. To some extent, these risks
may be mitigated in the European Union to the extent that the SEC
makes a substituted compliance determination on an EU-wide
basis.'').
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Deference and coordination. One commenter suggested that
the Commission should defer to non-U.S. oversight when possible.\1407\
Commenters further questioned the proposed requirement that an
applicant for substituted compliance certify that the Commission can
access the firm's books and records and conduct onsite inspections of
the firm.\1408\ One commenter expressed the view that the Commission's
ability to access the books and records of, and inspect, a dealer
relying on substituted compliance should be subject to agreement with a
foreign jurisdiction.\1409\
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\1407\ See ISDA (August 2013), supra note 7, at 6-7 (``In order
to minimize the burden of duplicative inspection requests, the
Commission should defer to the maximum extent possible to oversight
by the non-U.S. regulatory authorities. Such an approach would
recognize the inherent limitations on the Commission's capability to
interpret non-U.S. regulation and determine whether conduct is
compliant.'').
\1408\ See ISDA (August 2013), supra note 7, at 6 (``ISDA
requests that the Commission articulate a clear rationale for the
inspection powers stipulated in footnote 1126 of the Proposal, as
well as a set of principles setting forth how such powers would be
used.''); ESMA, supra note 8 (``The objective of substituted
compliance and the necessary cooperation of the non-U.S. authorities
that accompany such a determination should not be pre-empted by an
invasive approach based on direct access to all books and records
and on-site inspections which are not conducted in a coordinated
manner with the home jurisdiction competent authority.''). The
underlying part of the Cross-Border Proposing Release discussed how
the proposing release for the registration requirement would require
that nonresident security-based swap dealers provide the Commission
with an opinion of counsel concurring that as a matter of law the
firm may provide the Commission with prompt access to the firm's
books and records, and submit to onsite inspection and examination
by the Commission. See Cross-Border Proposing Release, 78 FR at
31089 n.1126, supra note 6. The Commission has since adopted that
requirement. See Registration Adopting Release, 80 FR at 48981,
supra note 989.
\1409\ See FOA, supra note 8 (``The FOA believes that the SEC's
access to the books and records of, and the right to conduct on-site
examinations and inspections of, a non-U.S. security-based swap
dealer relying on a substituted compliance determination should be
subject to the terms of the relevant Memorandum of Understanding (or
other agreement) governing such substituted compliance arrangements.
The FOA therefore urges the SEC to clarify in its final cross-border
rules that, as part of a substituted compliance determination, the
SEC agrees to access books and records, and conduct on-site
examinations and inspections, of non-U.S. security-based swap
dealers through the cooperative arrangements entered into with the
relevant non-U.S. regulator(s).'').
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[[Page 30073]]
Implementation and phase-in periods. Some commenters
suggested that certain requirements be deferred pending action on
related substituted compliance determinations.\1410\ Commenters also
stated that any withdrawal or modification of a substituted compliance
determination by the Commission should also be subject to a phase-in
period.\1411\
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\1410\ See, e.g., FOA, supra note 8 (suggesting that the
Commission consider ``a phased implementation process'' for
substituted compliance, whereby the Commission would ``consider
delaying the effectiveness of the compliance obligations applicable
to non-U.S. security-based swap dealers and major security-based
swap participants until such time as the SEC has been able to make
substituted compliance determinations in respect of those
jurisdictions that are most active in the international derivatives
markets''; also supporting a ``temporary'' substituted compliance
regime whereby, following submission of a substituted compliance
request, ``market participants from that jurisdiction would be
permitted to continue to comply with home country regulations until
such time as the SEC determines that it will not permit substituted
compliance in respect of some, or all, of such home country's
regulatory requirements''); ABA, supra note 8 (``However, we
recommend that the Commission further clarify the details of its
proposed substituted compliance analysis; for example, by indicating
that it will consider deferring the application of relevant entity-
level requirements pending final action on a particular request.'');
SIFMA (August 2013), supra note 7 (``[W]e believe that Foreign SBSDs
should be provided relief from compliance with Entity-Level
Requirements until the Commission has had the opportunity to provide
substituted compliance determinations. We believe that this is
preferable to requiring Foreign SBSDs to have to build the
technological, operational and compliance systems required to comply
with U.S. law for a short, interim period. This should be the case
so long as that period of time is anticipated to be reasonably brief
and the Commission anticipates a possibility that the finalized
regulations will be sufficiently comparable.'').
\1411\ See SIFMA (August 2013), supra note 7, at A-36-37
(``[M]arket participants are likely to design systems and processes
to comply with an approved substituted regulatory regime after the
Commission has made such a determination. Withdrawal or modification
of such a determination could cause significant operational
difficulties for market participants, that may have to realign their
internal infrastructure to be in compliance with the Commission's
requirements.''); FOA, supra note 8 (``any decision by the SEC to
modify or withdraw a substituted compliance determination should be
subject to an appropriate phased timetable to permit market
participants sufficient time to adjust their systems and operations
to the new compliance obligations'').
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Availability to major participants. Two commenters
disagreed with the proposal that substituted compliance not be
available to major security-based swap participants.\1412\ In contrast,
one commenter expressed opposition to the possibility of making
substituted compliance available to major participants.\1413\
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\1412\ See SIFMA (August 2013), supra note 7, at A-34 (``Without
this allowance, MSBSPs subject to comparable regulation in their
home jurisdiction would be forced to comply with duplicative or
potentially conflicting regulatory regimes.''); IIB (August 2013),
supra note 8, at 22 (``We see no reason why such institutions, if
they exceed one of the MSBSP thresholds, should be no less eligible
for substituted compliance than a foreign SBSD.'').
\1413\ See Better Markets (August 2013), supra note 7, at 29
(supporting proposed approach, citing lack of data and limited
information, and adding that the Commission should not consider
substituted compliance for major participants ``until and unless
industry participants provide reliable and comprehensive data
proving that it would be otherwise prudent to do so'').
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Other. In response to questions posed by the Cross-Border
Proposing Release, certain commenters opposed certain potential
limitations to the availability of substituted compliance.\1414\ One
commenter supported a standard timeframe for the review of substituted
compliance applications.\1415\
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\1414\ See, e.g., ISDA (August 2013), supra note 7, at 7
(opposing potential conditions requiring that U.S. counterparties be
qualified institutional buyers or qualified investors, and opposing
any use of a threshold requirement that non-U.S. security-based swap
dealers predominantly engage in non-U.S. business); ABA, supra note
8 (opposing limiting substituted compliance to qualified
institutional buyers or qualified investors); see also Cross-Border
Proposing Release, 78 FR at 31091-92, supra note 6 (soliciting
comment on those potential limitations to the availability of
substituted compliance).
\1415\ See FOA, supra note 8 (``The FOA recognises that the
timeline for reviewing a request for substituted compliance and
reaching an informed decision will likely vary, for example due to
the nature of the regulatory regime in a given jurisdiction or the
SEC staff's lack of familiarity with a particular jurisdiction's
approach. Nevertheless, the FOA believes that it is essential that
there be a standard timeframe for the SEC to reach a substituted
compliance determination. Any uncertainty regarding the timeline for
compliance with regulatory obligations creates a significant amount
of additional complexity for market participants that are already
faced with substantial operational and compliance burdens in
preparing for the compliance dates of new regulations.'').
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3. Response to Comments and Final Rule
After considering the comments received, the Commission is adopting
Rule 3a71-6 to make substituted compliance potentially available in
connection with the business conduct requirements being adopted
today.\1416\ The final rule has been modified from the proposal in a
number of ways, including, as discussed below: Consistent with the
scope of the current rulemaking, the final rule solely addresses the
use of substituted compliance to satisfy those business conduct
requirements (rather than addressing the availability of substituted
compliance more generally in connection with section 15F requirements
other than registration requirements, as proposed); \1417\ and the
final rule makes substituted compliance potentially available to
registered Major SBS Participants (rather than limiting the potential
availability of substituted compliance to registered SBS Dealers, as
proposed).\1418\
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\1416\ The final rule has been renumbered from the proposal.
\1417\ See Section III.B.3.b, infra.
\1418\ See Section III.B.3.c, infra.
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a. Basis for Availability of Substituted Compliance in Connection With
Business Conduct Requirements
As discussed elsewhere, the security-based swap market is global,
with a prevalence of cross-border transactions within that
market.\1419\ The cross-border nature of this market poses special
regulatory challenges in connection with the rules we are adopting
today, in that the Title VII business conduct requirements applicable
to SBS Dealers or Major SBS Participants have the potential to lead to
requirements that are duplicative of or in conflict with applicable
foreign business conduct requirements, even when the two sets of
requirements implement similar goals and lead to similar results. Such
results have the potential to disrupt existing business relationships
and, more generally, to reduce competition and market efficiency.
---------------------------------------------------------------------------
\1419\ See Section VI.B.3, infra.
---------------------------------------------------------------------------
The Commission accordingly proposed to implement a substituted
compliance framework ``to address the effect of conflicting or
duplicative regulations on competition and market efficiency and to
facilitate a well-functioning global security-based swap market.''
\1420\ In the Commission's view, under certain circumstances it may be
appropriate to allow for substituted compliance whereby market
participants may satisfy certain of the Title VII business conduct
requirements by complying with comparable foreign requirements. In this
manner, registered entities could comply with a single set of
requirements where substituted compliance is deemed appropriate, while
remaining subject to robust oversight. Accordingly, substituted
compliance may be expected to help achieve the goals of Title VII in a
way that promotes market efficiency, enhances competition and
facilitates a well-functioning global security-based swap market.
---------------------------------------------------------------------------
\1420\ See Cross-Border Proposing Release, 78 FR at 31086, supra
note 6.
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In reaching this conclusion, the Commission notes that one
commenter has questioned the Commission's authority to grant
substituted compliance and has expressed skepticism regarding the
policy basis for
[[Page 30074]]
permitting the use of substituted compliance to satisfy Title VII
requirements.\1421\ In contrast to the suggestion of that comment,
however, substituted compliance does not constitute exemptive relief
and does not excuse registered SBS Entities from having to comply with
the Exchange Act business conduct requirements. Instead, substituted
compliance provides an alternative method of satisfying those
requirements under Title VII.
---------------------------------------------------------------------------
\1421\ See notes 1383 and 1384, supra.
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Moreover, the same commenter's view that substituted compliance
would lead to a lowering of regulatory standards is addressed by the
provision that any grant of substituted compliance would be predicated
on there being comparable requirements in the foreign jurisdiction.
Indeed, in the Commission's view, the potential for substituted
compliance will help to promote the effective application of Title VII
requirements, by making it less likely that certain market participants
that are complying with comparable foreign requirements will determine
that they need to choose between modifying their business conduct
systems to reflect the requirements of U.S. rules, or else limiting or
ceasing their participation in the U.S. market.\1422\
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\1422\ The Commission further notes that section 752(a) of the
Dodd-Frank Act in part requires that the Commission consult with the
foreign regulatory authorities on the establishment of consistent
regulatory standards with respect to the regulation of security-
based swaps. The use of substituted compliance to help mitigate the
impacts of inconsistent and duplicative requirements is consistent
with that statutory direction.
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This commenter also expressed the view that any Commission action
of this nature at a minimum should be predicated on a finding that
there is an actual conflict between Title VII and foreign
requirements.\1423\ In the Commission's view, however, requiring a
showing of actual conflict as a condition to substituted compliance
should not be necessary as substituted compliance is intended to
promote compliance efficiencies in connection with potentially
duplicative requirements (as well as conflicting requirements).\1424\
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\1423\ See note 1385, supra.
\1424\ In light of the benefits associated with substituted
compliance, the final rule also does not include potential
limitations, for which the proposing release solicited comment, that
would have conditioned substituted compliance on a non-U.S. entity
not transacting with U.S. counterparties that are not qualified
institutional buyers or qualified investors, or that would have
required that non-U.S. entities receiving substituted compliance
predominantly engage in non-U.S. business. See note 1414, supra.
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b. Structure and Scope of the Final Rule
i. In General
As noted, the final rule has been revised from the proposal to
reflect that until other Title VII rules are adopted, substituted
compliance will be available only with respect to the business conduct
rules. The Commission expects to assess the potential availability of
substituted compliance in connection with other requirements when the
Commission considers final rules to implement those requirements.
To implement this revised approach, paragraph (a)(1) of Rule 3a71-6
as adopted provides that the Commission may, conditionally or
unconditionally, by order, make a determination with respect to a
foreign financial regulatory system that compliance with specified
requirements under that foreign financial regulatory system by a
registered SBS Dealer and/or by a registered Major SBS Participant--
each a ``security-based swap entity'' under the rule--or class thereof,
may satisfy the corresponding requirements identified in paragraph (d)
of rule 3a71-6 that would otherwise apply.\1425\ Paragraph (d),
discussed below, is an addition from the proposal that specifies the
business conduct requirements that the Commission is adopting.\1426\
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\1425\ See Exchange Act Rule 3a71-6(a)(1). The proposed rule
would have made substituted compliance potentially available for all
of the section 15F dealer requirements other than registration
requirements. The structure of the final rule implements a more
targeted approach whereby the Commission will assess the
availability of substituted compliance when the Commission considers
the applicable substantive rules. Consistent with this approach, the
final rule does not include proposed paragraph (a)(3), which would
have specified that substituted compliance would not be available in
connection with the registration requirements of section 15F. See
generally Registration Adopting Release, 80 FR at 48972-73, supra
note 989 (determining that substituted compliance would not be
available in connection with the registration requirements for
security-based swap dealers, and stating that ``[p]ermitting a
foreign SBS Dealer to satisfy these requirements through compliance
with the relevant requirements in its home jurisdiction, even with
appropriate notice of such compliance to the Commission, may deprive
the Commission of the necessary information, including information
resulting from inspection and examination of the books and records
of a firm engaged in dealing activity at levels above the de minimis
threshold.'').
Paragraph (a)(1) of the final rule also has been modified from
the proposal to remove language limiting substituted compliance to
``foreign'' entities. Substituted compliance for the business
conduct standards at issue here will be available only to foreign
security-based swap dealers and foreign major security-based swap
participants, and the Commission expects to assess whether
substituted compliance should be limited to foreign entities in
connection with other section 15F requirements.
\1426\ Exchange Act Rule 3a71-6(d).
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Paragraph (a)(2) of the final rule provides that the Commission
will not make a substituted compliance determination unless it
determines that the foreign requirements applicable to the SBS Entity
(or class thereof), or to the activities of such entity (or class
thereof), are comparable to the otherwise applicable requirements,
after taking into account such factors as the Commission determines are
appropriate, such as the scope and objectives of the relevant foreign
regulatory requirements (taking into account applicable criteria set
forth in paragraph (d)), as well as the effectiveness of the
supervisory compliance program administered, and the enforcement
authority exercised, by the foreign authority to support its oversight
of the SBS Entity (or class thereof) or of the activities of the entity
(or class thereof). This provision has been revised from the proposal
in part to make the rule more flexible, by permitting substituted
compliance to be predicated either on foreign regulation of the entity
(or class), or, alternatively, on foreign regulation of the entity's
(or class's) activities. In this way, the rule can account for
situations in which a foreign regulatory regime does not specifically
provide for the registration of a particular category of market
participant, but nonetheless effectively regulates the activities of
members of that category.\1427\
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\1427\ In other words, for example, under the final rule the
Commission may make substituted compliance available in connection
with a foreign regulatory regime that does not make use of a
specific registration category for dealers in security-based swaps,
but that nonetheless regulates such dealers in a manner that is
comparable to the section 15F requirements.
As proposed, paragraph (a)(2) made no mention of particular
criteria associated with a substituted compliance determination.
Paragraph (a)(2) of the final rule, however, specifies that in
considering the scope and objectives of the relevant foreign
requirements, the Commission intends to consider applicable criteria
that are set forth in new paragraph (d). See Section III.B.3.e,
infra.
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Paragraph (a)(2) of the rule further provides that the Commission
will not make a substituted compliance determination unless the
Commission has entered into a supervisory and enforcement memorandum of
understanding and/or other arrangement with the relevant foreign
financial regulatory authority addressing supervisory and enforcement
cooperation and other matters arising under the substituted compliance
determination.\1428\ This provision
[[Page 30075]]
should help ensure that both regulators will cooperate with each other
within the substituted compliance framework, such that both regulators
have information that will assist them in fulfilling their respective
regulatory mandates. Moreover, the Commission may, on its own
initiative, by order, modify or withdraw a substituted compliance
determination after appropriate notice and opportunity for
comment.\1429\
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\1428\ See Exchange Act Rule 3a71-6(a)(2)(ii). Paragraph
(a)(2)'s reference to supervisory and enforcement cooperation and
other matters further has been revised from the proposal, which
addressed the ``oversight and supervision'' of applicable security-
based swap dealers. This change is to help ensure that enforcement
cooperation is encompassed within those arrangements, given the
importance of enforcement in promoting compliance with applicable
requirements. The change parallels comparable language in the
substituted compliance rules applicable to Regulation SBSR. See
Regulation SBSR 908(c)(2)(iv).
\1429\ See Exchange Act Rule 3a71-6(a)(3).
Commenters stated that any withdrawal or modification of a
substituted compliance determination by the Commission should also
be subject to a phase-in period. See note 1411, supra. The final
rule does not contain any such provision for a phase-in period,
however, given that substituted compliance is predicated on the
relevant foreign requirements being comparable to the Title VII
requirements, and on the adequacy of the relevant foreign
authority's supervision and enforcement in connection with those
foreign requirements. Subject to that principle, the Commission in
practice would expect to consider such timing and operational issues
in the event that it were to reconsider a previous grant of
substituted compliance. The particular facts and circumstances
surrounding such a reconsideration would be relevant to how long
substituted compliance would remain available after Commission
action.
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Paragraph (b) of the final rule specifies that a registered SBS
Entity may satisfy the Exchange Act requirements identified in
paragraph (d) of the rule by complying with corresponding law, rules
and regulations under a foreign financial regulatory system, provided
that: (1) The Commission has made a determination providing that
compliance with specified requirements under the foreign financial
regulatory system by such registered security-based swap entity (or a
class thereof) may satisfy the corresponding requirements, and (2) such
entity satisfies any conditions set forth in the Commission's
determination.\1430\
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\1430\ See Exchange Act Rule 3a71-6(b). This paragraph has been
changed from the proposal in certain ways consistent with the
changed scope of the rule (i.e., deleting the word ``foreign'' and
replacing ``dealer'' with ``entity'') or for clarifying purposes.
This paragraph also has been changed from the proposal, which
referred to ``legislative requirements, rules and regulations,'' to
more flexibly account for the variety of potential sources of
applicable requirements.
---------------------------------------------------------------------------
Paragraph (c) of the final rule addresses requests for substituted
compliance determinations. As discussed below, those application
provisions have been revised from the proposal in certain
respects.\1431\
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\1431\ See Section III.B.3.h, infra.
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To implement the final rule's targeted approach toward substituted
compliance, paragraph (d) of rule 3a71-6 states that substituted
compliance will be available in connection with the business conduct
and supervision requirements of sections 15F(h) and 15F(j) and rules
15Fh-3 through 15Fh-6, and the CCO requirements of section 15F(k) and
rule 15Fk-1, subject to exceptions discussed below.\1432\
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\1432\ The business conduct requirements that are the subject of
this rulemaking in large part are derived from Exchange Act section
15F(h). As discussed above, however, Exchange Act section 15F(j)
imposes on SBS Entities a series of self-executing duties with
regard to trade monitoring, risk management systems, regulatory
disclosures, information access systems and procedures, conflict-of-
interest systems and procedures, and antitrust considerations. Rule
15h-3(h)(2)(iii)(I) requires SBS Entities to adopt written policies
and procedures reasonably designed to comply with those duties. See
note 605, supra, and accompanying text.
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As discussed below, moreover, paragraph (d) specifies that prior to
making these substituted compliance determinations, the Commission
intends to consider whether the information required to be provided to
counterparties pursuant to the requirements of the foreign
jurisdiction, the counterparty protections of the foreign jurisdiction,
the mandates for supervisory systems under the requirements of the
foreign jurisdiction, the duties imposed by the foreign jurisdiction,
and the CCO requirements of the foreign jurisdiction, are comparable to
the Exchange Act requirements.\1433\ Those factors are relevant to the
comparability analysis, and their inclusion in the final rule also
responds to commenters that expressed the view that the rules should
provide more guidance regarding comparability criteria.\1434\ At the
same time, as discussed below, substituted compliance does not require
that there be requirement-by-requirement comparability between Exchange
Act requirements and foreign requirements, as the operative question is
whether there is the comparability of the associated regulatory
outcomes.\1435\
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\1433\ See note 1458, infra, and accompanying text.
\1434\ See notes 1393 and 1394, supra.
\1435\ See Section III.B.3.e, infra.
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Finally, the Commission is not persuaded by commenter requests that
we provide phase-in periods or other means to link the timing of the
substantive requirements under the Exchange Act with the availability
of substituted compliance.\1436\ The effective dates and compliance
dates for these business conduct requirements reflect the need to
implement those requirements in a timely manner, regardless of whether
the alternative route provided by substituted compliance is
available.\1437\
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\1436\ See note 1410, supra.
\1437\ Given the facts and circumstances nature of the
substituted compliance assessment, the Commission also does not
believe that it would be practicable to provide a standard timeframe
for reaching substituted compliance determinations. See note 1415,
supra.
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ii. Unavailability in Connection With Antifraud Prohibitions and
Certain Other Requirements
Paragraph (d)(1) of the final rule provides that substituted
compliance is not available in connection with Exchange Act section
15F(h)(4)(A), which in relevant part prohibits SBS Dealers from
engaging in fraudulent activities in connection with special entities
and more generally. The rule also provides that substituted compliance
is not available in connection with Exchange Act rule 15Fh-4(a), which
implements that statutory antifraud provision.
In the Commission's view, substituted compliance is not appropriate
in connection with those explicit statutory prohibitions of fraudulent
conduct, given the central role of the antifraud provisions of the
securities laws in protecting the integrity and reputation of U.S.
financial markets. The Commission also notes that concerns regarding
regulatory duplication do not arise in the context of such antifraud
prohibitions in the same way they may arise with respect to other
provisions.
Paragraph (d)(1) further provides that substituted compliance is
not available in connection with Exchange Act sections 15F(j)(3) and
(j)(4)(B). Section 15F(j)(3) requires that SBS Entities disclose, to
the Commission and the applicable prudential regulators, information
concerning: The terms and conditions of the entity's security-based
swaps; security-based swap trading operations, mechanisms and
practices; financial integrity protections relating to security-based
swaps; and other information relevant to the entity's trading in
security-based swaps. Section 15F(j)(4)(B) provides that the SBS Entity
upon request shall provide the Commission and any applicable prudential
regulator with information necessary to perform statutory functions
under Section 15F. In our view, the Commission's oversight of SBS
Entities requires that the Commission be able to directly access
relevant information from those entities. Accordingly, the Commission
does not believe that those requirements that SBS Entities provide
information to the Commission are reasonably amenable to being
satisfied
[[Page 30076]]
via compliance with the requirements of a foreign jurisdiction.\1438\
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\1438\ In addition, Exchange Act Section 15F(j)(7) authorizes
the Commission to prescribe rules governing the duties of SBS
Entities. While the Commission is not excluding that provision from
the potential availability of substituted compliance, the Commission
expects to separately consider whether substituted compliance may be
available in connection with any future rules promulgated pursuant
to that provision.
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iii. Application to Particular Requirements
It is possible that substituted compliance may be granted with
regard to some of these requirements but not others. As discussed
below, the Commission intends to assess the comparability of foreign
requirements using a holistic approach that focuses on regulatory
outcomes rather than predicating substituted compliance on requirement-
by-requirement similarity.\1439\ At the same time, however, the
business conduct requirements being adopted today encompass a range of
distinct categories (e.g., supervision, counterparty protection,
special entity protection) such that those individual categories may be
subject to differing conclusions regarding the comparability of
regulatory outcomes and/or the associated foreign enforcement and
supervisory practices. Thus, for example, it may be possible that the
Commission would make substituted compliance available with regard to a
particular foreign regulatory regime in connection with certain
counterparty protections required by these rules but not the
supervision requirements, or vice versa. Ultimately, this would depend
on the relevant facts and circumstances, and their impact upon specific
assessments of comparability,\1440\ and of supervision and enforcement.
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\1439\ See Section III.B.3.e, infra.
\1440\ As discussed below, substituted compliance is predicated
on the comparability of regulatory outcomes, and does not mandate
rule-by-rule equivalence between specific requirements under Title
VII and analogous foreign requirements.
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The Commission further anticipates that certain categories of the
requirements we are adopting today--related to ECP verification,
special entities and political contributions--will raise special issues
with regard to comparability, and with regard to whether adequate
supervision and enforcement is available under the foreign regulatory
regime. Such issues are likely to arise with regard to those particular
requirements because each of those requirements address protections
that may have no foreign law analogues, as those requirements reflect
heightened concerns under U.S. law regarding potential abuses involving
particular categories of persons. Indeed, those categories and the
protections afforded to them under U.S. law may not correspond with any
specified categories of persons or protections under relevant foreign
law. As a result, substituted compliance assessments in connection with
those categories will require inquiry regarding whether foreign
regulatory requirements adequately reflect the same particular
interests and protections.
c. Availability to Major SBS Participants
Under the proposed rule, substituted compliance would have been
available only to registered SBS Dealers, and would not have been
available to registered Major SBS Participants. In taking that proposed
position, the Commission noted a lack of information regarding the
types of entities that may become Major SBS Participants, and the
foreign regulation of those entities.\1441\
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\1441\ See note 1382, supra.
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Two commenters disagreed with that aspect of the proposal, with one
commenter expressing concern regarding major participants being forced
to comply with duplicative or potentially conflicting regulatory
regimes, and the other commenter suggesting there would be no reason to
distinguish between SBS Dealers and Major SBS Participants in this
regard.\1442\ One commenter, in contrast, opposed the possibility of
substituted compliance for Major SBS Participants by citing the lack of
relevant information, and stated that the Commission should not
consider substituted compliance for Major SBS Participants unless the
industry provided data proving that this step would be prudent.\1443\
---------------------------------------------------------------------------
\1442\ See note 1412, supra.
\1443\ See note 1413, supra.
---------------------------------------------------------------------------
After further consideration of the issues, the final rule provides
that substituted compliance is potentially available in connection with
these business conduct requirements for registered Major SBS
Participants as well as for registered SBS Dealers. This decision
reflects the fact that the business conduct standards apply to
registered Major SBS Participants as well as to registered SBS Dealers,
and recognizes that the market efficiency goals that underpin
substituted compliance also can apply when substituted compliance is
granted to registered Major SBS Participants.
To implement this approach, the final rule has been revised from
the proposal to specify that the Commission may determine that
compliance by a registered SBS Dealer and/or by a registered Major SBS
Participants--each a ``security-based swap entity'' under the rule--may
satisfy the business conduct requirements through substituted
compliance.\1444\ The remainder of the final rule refers to a security-
based swap ``entity'' rather than a security-based swap ``dealer.''
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\1444\ See Exchange Act rule 3a71-6(a)(1).
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One commenter had expressed the view that more information is
needed before substituted compliance is made available to Major SBS
Participants.\1445\ In the Commission's view, however, those concerns
are adequately addressed by the fact that any grant of substituted
compliance in connection with the business conduct requirements
applicable to Major SBS Participants would be predicated on a
determination that the Major SBS Participants is subject to comparable
regulation in a foreign jurisdiction. Absent such a determination--and
consistent with the Commission's previously noted concerns regarding
the need for information regarding the types of entities that may
become Major SBS Participants, and the foreign regulation of those
entities--the Commission would not grant substituted compliance in
connection with registered Major SBS Participants, even if the
Commission were to grant substituted compliance in connection with
registered SBS Dealers in the same jurisdiction.
---------------------------------------------------------------------------
\1445\ See note 1413, supra, and accompanying text.
---------------------------------------------------------------------------
d. Availability of Substituted Compliance With Regard to U.S. and
Foreign Entities, Counterparties and Activity
Under the final rule, substituted compliance in connection with the
business conduct requirements is not available to entities that are
U.S. persons.\1446\ On the other hand, entities that are not U.S.
persons may rely on substituted compliance to satisfy the business
conduct requirements with regard to the entirety of their security-
based swap business, regardless of whether their counterparty for a
particular transaction is a U.S. person, or whether any of the
associated activity occurs in the U.S.
---------------------------------------------------------------------------
\1446\ See Exchange Act rule 3a71-6(d). For these purposes, the
term ``U.S. person'' has the meaning set forth in Exchange Act rule
3a71-3(a)(4).
---------------------------------------------------------------------------
i. No Availability to U.S. Security-Based Swap Dealers or U.S. Major
Security-Based Swap Participants
Consistent with the proposal, the final rule does not make
substituted compliance available to U.S. security-based swap dealers or
U.S. major
[[Page 30077]]
security-based swap participants in connection with these business
conduct requirements.
Certain commenters had suggested that substituted compliance for
these dealer requirements should be available to foreign branches of
U.S. persons,\1447\ or to U.S. persons in certain circumstances in
connection with transaction-level requirements.\1448\ One commenter
further expressed the view that foreign branches of U.S. banks may be
subject to extensive host country supervision, and that concerns
regarding duplicative or inconsistent regulation may arise in
connection with the security-based swap activities of U.S. entities.
Conversely, one commenter argued that such an extension of the proposed
scope of substituted compliance would be inconsistent with the
application of U.S. law.\1449\
---------------------------------------------------------------------------
\1447\ See note 1386, supra.
\1448\ See notes 1388 and 1389, supra.
\1449\ See note 1387, supra.
---------------------------------------------------------------------------
The Commission concludes on balance that it is appropriate to limit
the availability of substituted compliance such that only entities that
are not U.S. persons may take advantage of that alternative route for
satisfying the Title VII business conduct requirements. In part, this
conclusion accounts for the fact that concerns regarding duplication
and inconsistency in connection with transaction-level business conduct
requirements should be mitigated by the amendment we are adopting to
Exchange Act rule 3a71-3, to provide an exception from the business
conduct requirements under Exchange Act section 15F(h)--other than
supervision requirements pursuant to Exchange Act section
15F(h)(1)(B)--for registered U.S. SBS Dealers in connection with
foreign business conducted through their foreign branches.\1450\
---------------------------------------------------------------------------
\1450\ See Exchange Act rule 3a71-3(c); see also Section
III.A.3.b, supra. There is a similar exception from the section
15F(h) business conduct requirements (other than supervision) for
registered U.S. Major SBS Participants with respect to security-
based swap transactions that constitute transactions through a
foreign branch of the registered U.S. Major SBS Participant, that
are either with a non-U.S. person or with a U.S.-person counterparty
that constitutes a transaction conducted through a foreign branch of
that counterparty. See Exchange Act rule 3a67-10(d)(2). These
exceptions are not available in connection with the CCO
requirements, which are promulgated pursuant to Exchange Act section
15F(k).
---------------------------------------------------------------------------
The Commission recognizes that the above exception would not
mitigate the possibility that U.S. entities may face duplication or
inconsistency in certain circumstances. For example, for non-U.S.
business that U.S. SBS Dealers and U.S. Major SBS Participants conduct
through their foreign branches, such duplication or inconsistency may
still arise in connection with the entity-level supervision and CCO
regulations being adopted today. For the other security-based swap
business of those U.S. SBS Entities, such duplication or inconsistency
potentially may arise in connection with any of the business conduct
requirements being adopted today.
The Commission nonetheless believes that substituted compliance
should not be available to registered entities that are U.S. persons.
This conclusion reflects a number of policy considerations.
Fundamentally, this approach acknowledges that dealers and major
participants that fall within the ``U.S. person'' definition have a
heightened connection to the U.S. market.\1451\ As a result of that
heightened connection, it is the Commission's judgment that a U.S. SBS
Entity's compliance with the business conduct requirements of Title
VII, and the Commission's associated oversight of that entity's
security-based swap business, should occur without the potential
availability of substituted compliance. Although substituted compliance
is predicated on there being comparability with Title VII requirements,
and does not exempt or otherwise excuse compliance with Title VII, in
the Commission's view direct compliance with the Title VII business
conduct requirements by U.S. SBS Entities will efficiently facilitate
the Commission's regulatory oversight of entities that have a
heightened connection to the U.S. market. That warrants such limits to
substituted compliance in our view, notwithstanding the general
considerations that support the availability of substituted compliance
in connection with the business conduct requirements.
---------------------------------------------------------------------------
\1451\ The definition of ``U.S. person'' is designed to
encompass persons that have a significant portion of their financial
and legal relationships within the U.S. ``[T]he definition of `U.S.
person' in [17 CFR 240.3a71-3] is intended, in part, to identify
those persons for whom it is reasonable to infer that a significant
portion of their financial and legal relationships are likely to
exist within the United States and that it is therefore reasonable
to conclude that risk arising from their security-based swap
activities could manifest itself within the United States,
regardless of the location of their counterparties, given the
ongoing nature of the obligations that result from security-based
swap transactions.'' ``Application of `Security-Based Swap Dealer'
and `Major Security-Based Swap Participant' Definitions to Cross-
Border Security-Based Swap Activities,'' Exchange Act Release No.
72472 (Jun. 25, 2014), 79 FR 47278, 47289 (Aug. 12, 2014) (``SBS
Entity Definitions Adopting Release'').
Moreover, the definition of ``U.S. person'' does not carve out
the foreign branches of U.S. persons. In part this reflects the fact
that ``a person does not hold itself out as a security-based swap
dealer as anything other than a single person even when it enters
into transactions through its foreign branch or office.'' See id.
Based on the direct nature of this link between the U.S. market
and those persons that fall within the ``U.S. person'' definition,
Title VII applies to the security-based swap activities of U.S.
persons in a manner that is more comprehensive than its application
to the activities of other persons. See generally id. at 47288-91
(addressing how dealer and major participant definitions account for
all security-based swap activity of U.S. persons because all such
activity occurs in the U.S., but account for a more limited subset
of the activity of foreign entities).
---------------------------------------------------------------------------
This conclusion also reflects our view that U.S. market
participants generally would have a reasonable expectation that the
business conduct requirements of Title VII would apply directly, and
that the activities of such U.S. persons would be subject to Commission
oversight with a degree of directness that may not be present in
connection with substituted compliance.
ii. Availability in Connection With U.S. Counterparties and U.S.
Activity
Consistent with the proposal, the final rule does not contain any
provisions that would limit the ability of foreign registered entities
to use substituted compliance to satisfy the business conduct
requirements in connection with transactions involving U.S.
counterparties or U.S. activity.
One commenter had expressed the view that substituted compliance
should not be available in connection with activities involving U.S.
persons or U.S. activity, arguing that the security-based swap activity
of U.S. persons directly and immediately impacts the U.S., and would
endanger U.S. taxpayers if improperly regulated.\1452\ We concur with
that commenter regarding the need for proper regulation of SBS Entities
in connection with their security-based swap business involving U.S.
counterparties and activity (as well as more generally). At the same
time, however, we note that substituted compliance is not an
alternative to rigorous regulation, but instead is predicated on there
being business conduct regulation comparable with the rules we are
adopting today. So long as the Commission determines that corresponding
foreign requirements are comparable with those Title VII business
conduct requirements, the use of substituted compliance accordingly
would uphold the interests associated with those Title VII
requirements.
---------------------------------------------------------------------------
\1452\ See note 1390, supra.
---------------------------------------------------------------------------
Also, following alternative approaches--such as an approach whereby
substituted compliance would not be available to a foreign SBS Entity
in connection with transactions involving U.S. counterparties or U.S.
[[Page 30078]]
activity, but would be available in connection with other
transactions--in practice may have the effect of forcing the foreign
SBS Entity to choose between modifying its business conduct systems,
including its supervisory and CCO arrangements to reflect the
requirements of U.S. rules, or else exiting the U.S. market and thereby
generally reducing competition and market efficiency.\1453\
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\1453\ Other alternative approaches for addressing the
application of substituted compliance could be, for example, to
permit substituted compliance in connection with U.S. activity that
does not involve U.S. counterparties, or allowing substituted
compliance for transaction with U.S. counterparties only so long as
no U.S. activity is involved. Reducing the availability of
substituted compliance in such a manner, however, would be expected
to be accompanied by a corresponding reduction to the competition
and market efficiency benefits associated with substituted
compliance.
---------------------------------------------------------------------------
e. Comparability Criteria
As discussed in the Cross-Border Proposing Release, the Commission
will endeavor to take a holistic approach in considering whether
regulatory requirements are comparable for purposes of substituted
compliance, and will focus on the comparability of regulatory outcomes
rather than predicating substituted compliance on requirement-by-
requirement similarity. The Commission also continues to recognize that
foreign regulatory systems differ in their approaches to achieving
particular regulatory outcomes, and that foreign requirements that
differ from those adopted by the Commission nonetheless may achieve
regulatory outcomes comparable with those of Title VII. The Commission
further continues to recognize that different regulatory systems may be
able to achieve some or all of those regulatory outcomes by using more
or fewer specific requirements than the Commission, and that in
assessing comparability the Commission may need to take into account
the manner in which other regulatory systems are informed by business
and market practices in those jurisdictions.\1454\
---------------------------------------------------------------------------
\1454\ See Cross-Border Proposing Release, 78 FR at 31085-86,
supra note 6.
---------------------------------------------------------------------------
Accordingly, in considering whether the requirements of a foreign
regulatory regime are comparable with the various categories of
requirements being adopted today (such as the supervision and
counterparty protection requirements we are adopting) the Commission
will evaluate whether the foreign requirements provide for regulatory
outcomes that are consistent with the regulatory outcomes of the
applicable category of requirements. Moreover, as noted above, in
application the Commission may determine that for a particular
jurisdiction, the prerequisites for substituted compliance have been
met in connection with certain categories of requirements but not
others.
In reaching this conclusion, the Commission notes that certain
commenters opposed the proposed holistic approach toward assessing
comparability based on regulatory outcomes, and that instead expressed
the views that any assessments should be done on a requirement-by-
requirement basis. Those views at least in part reflected the reasoning
that an outcomes-based approach would be subjective and would lead to a
``hypothesized similarity in outcomes for sets of rules that are quite
different in substance.'' \1455\ In this regard, the Commission
recognizes that a requirement-by-requirement approach would be easier
to implement and simpler to translate into objective criteria than an
alternative approach that focuses on regulatory outcomes. Such a
requirement-by-requirement approach, however, could foreclose any
grants of substituted compliance, because even highly similar
regulatory regimes are likely to have technical differences in the
implementing rules. More generally, the Commission believes that the
proper focus for analyzing substituted compliance should address
regulatory outcomes, because a standard that turns upon the
comparability of regulatory outcomes can promote regulatory efficiency
in a way that preserves the key protections associated with the
business conduct rules, and in a manner that reflects the cross-border
nature of the market and helps to curb fragmentation, while
facilitating the ability of U.S. persons to participate in the global
security-based swap market.\1456\
---------------------------------------------------------------------------
\1455\ See note 1391, supra.
\1456\ A requirement-by-requirement standard, in contrast,
similarly would promote key protections, but would not adequately
address the cross-border nature of the market and the ability of
U.S. persons to participate in the global market.
---------------------------------------------------------------------------
As noted above, the Commission foresees that there will be
difficult questions connected with comparability assessments for Dodd-
Frank requirements related to ECP verification, special entities and
political contributions, given that those particular requirements all
address activities involving certain classes of U.S. persons, and
reflect heightened concerns regarding potential abuses involving such
persons.\1457\ Recognizing that the comparability assessments will
focus on regulatory outcomes rather than rule-by-rule comparisons, the
assessments will require inquiry regarding whether foreign regulatory
requirements adequately reflect those particular interests and
protections.
---------------------------------------------------------------------------
\1457\ See Section III.B.3.b.iii, supra.
---------------------------------------------------------------------------
Moreover, paragraph (d) of the final rule (which as discussed above
has been added to the rule to specify the requirements for which
substituted compliance potentially is available), provides that prior
to making these substituted compliance determinations, the Commission
intends to consider whether the information required to be provided to
counterparties pursuant to the requirements of the foreign
jurisdiction, the counterparty protections of the foreign jurisdiction,
the mandates for supervisory systems under the requirements of the
foreign jurisdiction, the duties imposed by the foreign jurisdiction,
and the CCO requirements of the foreign jurisdiction, are comparable to
the Exchange Act requirements.\1458\ Those provisions have been
included as part of new paragraph (d) in response to commenters to the
Cross-Border Proposing Release that requested specific guidance
regarding the criteria the Commission will consider in making
comparability assessments,\1459\ or that challenged the rule's lack of
particularized elements for assessing comparability.\1460\ While
recognizing those commenters' wish for additional guidance to assist in
making applications for substituted compliance, and for assessment
criteria that are as specific and objective as possible, in this
circumstance the Commission believes that the comparability assessments
will turn upon relevant facts and circumstances in a manner such that
it would not be practicable to include more specific criteria in the
rule.
---------------------------------------------------------------------------
\1458\ See Exchange Act rule 3a71-6(d)(1). The rule further
provides that prior to making a substituted compliance determination
in connection with the CCO requirements of section 15F(k), the
Commission intends to consider whether the requirements of the
foreign jurisdiction regarding CCO requirements are comparable to
those required pursuant to the applicable Exchange Act requirements.
See Exchange Act rule 3a71-6(d)(2).
\1459\ See note 1393, supra.
\1460\ See note 1394, supra.
---------------------------------------------------------------------------
One commenter questioned how the Commission would be notified of
material changes to foreign law that underpins a substituted compliance
determination.\1461\ The Commission expects to address those issues in
connection with considering specific applications for substituted
compliance, and notes that, potentially, the requirement that the
Commission be notified of material changes in foreign law could be
incorporated as conditions
[[Page 30079]]
to substituted compliance orders, or as part of memoranda of
understanding or other arrangements between the Commission and the
relevant foreign financial regulators.\1462\
---------------------------------------------------------------------------
\1461\ See note 1395, supra.
\1462\ Substituted compliance orders further may be conditioned
on security-based swap dealers and major security-based swap
participants that rely on substituted compliance notifying the
Commission of that reliance. In that respect, the forms that the
Commission has adopted for use by applicants for registration as
security-based swap dealers or major security-based swap
participants provides for applicants to notify the Commission
regarding intended reliance on substituted compliance. See
Registration Adopting Release, 80 FR at 49049, supra note 989
(questions 3A, B and C of Form SBSE-A, addressing potential reliance
on substituted compliance determinations).
---------------------------------------------------------------------------
Commenters also expressed the views that regulatory comparisons
should focus on common principles associated with shared G-20 Leaders
goals,\1463\ urged the need for consistency and coordination with the
work of other regulators and IOSCO,\1464\ and with the CFTC,\1465\ and
also supported building on existing cooperative initiatives,\1466\ and
supported deference to non-U.S. oversight when possible.\1467\ While
the Commission intends to be mindful of those various goals and
principles as part of its comparability analyses, the decision whether
to grant substituted compliance ultimately must focus on whether a
foreign regime produces regulatory outcomes consistent with the
applicable provisions of the Exchange Act. That type of assessment
necessarily must focus on Exchange Act requirements.
---------------------------------------------------------------------------
\1463\ See note 1396, supra.
\1464\ See note 1397, supra.
\1465\ See note 1399, supra.
\1466\ See note 1398, supra.
\1467\ See note 1407, supra.
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Finally, one commenter argued that to help manage operational
complexities, the entirety of a regulatory regime should be deemed
comparable with the Exchange Act requirements if a significant portion
of that regime is found to be comparable.\1468\ In the Commission's
view, however, such an approach would be inconsistent with the
predicate for substituted compliance that there be the comparability of
regulatory outcomes. If a foreign regulatory regime does not achieve a
regulatory outcome that is comparable to the regulatory outcome
associated with particular Exchange Act requirements, then the basis
for substituted compliance will not have been satisfied. In that case,
substituted compliance would not be appropriate with regard to such
requirements, notwithstanding its potential availability in connection
with other requirements.
---------------------------------------------------------------------------
\1468\ See note 1400, supra.
---------------------------------------------------------------------------
f. Consideration of Supervision and Enforcement Practices
Assessment of a foreign regulatory regime's supervisory and
enforcement practices is expected to be a critical component of any
Commission decision to permit substituted compliance. As discussed in
the Cross-Border Proposing Release, when the Commission assesses a
foreign regulatory regime's oversight for purposes of making a
substituted compliance determination, the Commission expects to
consider not only overall oversight activities, but also oversight
specifically directed at conduct and activity that would be relevant to
the substituted compliance determination.\1469\ For example, it would
be difficult for the Commission to make a comparability determination
in support of substituted compliance if oversight is directed solely at
the local activities of foreign security-based swap dealers, as opposed
to the cross-border activities of such dealers.
---------------------------------------------------------------------------
\1469\ See Cross-Border Proposing Release, 78 FR at 31088
n.1117, supra note 6.
---------------------------------------------------------------------------
In making this consideration a prerequisite for substituted
compliance, the Commission in no way should be interpreted as
minimizing the significance of the Commission's own independent
obligation to supervise the compliance of registered entities with
Title VII requirements, even when requirements may be satisfied via
substituted compliance. Registered entities are subject to the
requirements of Title VII, and the Commission retains its full
authority to inspect, examine and supervise those entities' compliance
with Title VII, and take enforcement action as appropriate, regardless
of the availability of substituted compliance.
One comment emphasized that the assessment must address a foreign
regulatory regime's supervisory and enforcement capabilities in
practice, not merely on paper.\1470\ Another comment stated that
differences among the supervisory and enforcement regimes should not be
assumed to reflect flaws in one regime or another.\1471\ The Commission
expects that its consideration of the effectiveness of a foreign
regulatory regime's practices will account for those factors in
conjunction with other relevant factors.\1472\
---------------------------------------------------------------------------
\1470\ See note 1401, supra.
\1471\ See note 1402, supra.
\1472\ In this regard, the Commission notes that one commenter
requested further guidance regarding the Commission's consideration
of the effectiveness of foreign supervision and enforcement. See
note 1403, supra. In the Commission's view, however, consideration
of foreign supervisory and enforcement effectiveness will turn upon
relevant facts and circumstances in a manner such that it would not
be practicable to provide more specific guidance regarding specific
factors that may be included within that analysis.
---------------------------------------------------------------------------
Applying those principles here, the Commission notes that the
difficult questions noted above with respect to requirements regarding
ECP verification, special entities and political contributions also can
be expected to manifest themselves in connection with our consideration
of a foreign regulatory regime's supervisory and enforcement practices.
That is, as the Commission evaluates the foreign regulatory regime's
supervisory and enforcement practices in connection with substituted
compliance, the Commission necessarily will seek to evaluate whether
those supervisory and enforcement practices will adequately support
regulatory outcomes consistent with those particular requirements (as
well as the other business conduct requirements).
More generally, the scope of any grant of substituted compliance
may be linked to the scope of foreign regulatory regime's supervision
and enforcement practices. For example, if a foreign regulatory regime
closely oversees the security-based swap business that an SBS Entity
conducts through an office located in that non-U.S. jurisdiction, but
does not exercise the same degree of regulatory oversight over a branch
of that entity that is located in the U.S., it is possible that any
grant of substituted compliance would not extend to activities
conducted through the entity's U.S. branch.
g. Multi-Jurisdictional Issues
Commenters further have raised certain issues--that were not
addressed in the Cross-Border Proposing Release--regarding how the
substituted compliance rule would apply to certain special
circumstances involving multi-jurisdictional activities of foreign
security-based swap dealers. While recognizing the facts-and-
circumstances nature of the application of substituted compliance under
the final rule, the Commission anticipates that the final rule would
apply generally to such circumstances in the following manner:
i. Third-Country Branches
One commenter particularly raised questions regarding the
application of substituted compliance in connection with third-country
branches of foreign security-based swap dealers, and requested further
guidance regarding how substituted compliance would apply to
circumstances where an entity
[[Page 30080]]
located in one country has a branch located in another country that
engages in dealing activity.\1473\ The potential availability of
substituted compliance under the final rule will reflect the scope of
any relevant substituted compliance order, including, for instance,
whether an order for a particular jurisdiction extends to third-country
branches of entities domiciled within that jurisdiction. The scope of
any such order--and hence the potential availability of substituted
compliance for a third-country branch--necessarily will turn upon the
applicable facts and circumstances.
---------------------------------------------------------------------------
\1473\ See note 1404, supra.
---------------------------------------------------------------------------
ii. Substituted Compliance and the European Union
Commenters also raised issues regarding the assessment of
substituted compliance in the context of the European Union, stating
that certain rules are adopted at a European level and are applied
directly by individual member states.\1474\ In the Commission's view,
such issues may be expected to affect analyses of substantive
comparability in a manner that differs from the way they may apply to
consideration of the adequacy of a foreign regulatory regime's
enforcement and supervisory system. In particular, to the extent that
substantive requirements are promulgated at a multi-state level, the
Commission's analysis may consider whether those multi-state
requirements are comparable to the corresponding Exchange Act
requirements. In contrast, to the extent that the enforcement and
supervision of those requirements is conducted at the member state
level, then the Commission necessarily would assess the adequacy of a
foreign regulatory regime's enforcement and supervisory system at the
member state level. Any grant of substituted compliance necessarily
would take into account both the substantive requirements and the
adequacy of the relevant enforcement and supervisory system.
---------------------------------------------------------------------------
\1474\ See note 1406, supra.
---------------------------------------------------------------------------
iii. Additional Cross-Jurisdictional Issues
Another commenter raised issues regarding which sets of
requirements would apply to transactions between parties in different
markets, and whether the parties to cross-jurisdiction transactions may
choose which rules apply.\1475\ As discussed above, substituted
compliance is intended to help promote efficiency, enhance competition
and facilitate a well-functioning market by helping SBS Entities avoid
regulatory conflicts or duplication. Substituted compliance is not
mandatory, moreover, so when it is available a non-U.S. SBS Entity may
elect whether to rely on comparable foreign requirements with regard to
its security-based swap business or some discrete portion of that
business. However, the policies and procedures of non-U.S. SBS Entities
generally should address with particularity when the entity will rely
on substituted compliance with regard to particular requirements (e.g.,
with regard to particular portions of their security-based swap
business and/or particular counterparties).
---------------------------------------------------------------------------
\1475\ See note 1405, supra.
---------------------------------------------------------------------------
h. Applications for Substituted Compliance and Related Prerequisites
Paragraph (c)(1) of the final rule provides that a party or group
of parties that potentially would rely on substituted compliance, or
any foreign financial regulatory authority or authorities supervising
such a party or its security-based swap activities, may file an
application, pursuant to the procedures set forth in Exchange Act Rule
0-13 requesting that the Commission make a substituted compliance
determination.\1476\ Exchange Act Rule 0-13 is a procedural rule that
the Commission has adopted regarding the submission of substituted
compliance applications, and provides for the opportunity for public
comment on completed applications.\1477\ Paragraph (c)(1) has been
revised from the proposal (which only referred to applications by
security-based swap dealers) to reflect the fact that Rule 0-13
provides for applications by foreign financial authorities.\1478\ Also,
to avoid duplicating the requirements of Rule 0-13, paragraph (c)(1)
also has been revised from the proposal by removing references to the
need for the applicant to provide the reasons for the request and
provide supporting documentation as the Commission may request.
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\1476\ See Exchange Act rule 3a71-6(c)(1). The final rule
accordingly provides that a foreign financial regulatory authority
may submit a substituted compliance application if that authority
supervises a party that would rely on substituted compliance, or
supervises that party's activities. A regulatory authority that does
not possess such supervisory responsibilities would not be eligible
to submit a substituted compliance application, even if that
authority promulgates rules or other requirements applicable to such
parties' security-based swap activities.
\1477\ Among other respects, Rule 0-13 provides that
applications must include any supporting documents necessary to make
the application complete, ``including information regarding
applicable requirements established by the foreign financial
regulatory authority or authorities, as well as the methods used by
the foreign financial regulatory authority or authorities to monitor
and enforce compliance with such rules.'' Rule 0-13 further provides
that Commission staff will review the application after the filing
is complete, and that completed applications will be published for
public comment.
\1478\ See Cross-Border Adopting Release, 79 FR at 47358, supra
note 193 (concluding, in adopting Rule 0-13, that ``allowing foreign
regulators to submit such requests would promote the completeness of
requests and promote efficiency in the process for considering such
requests'').
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In addition, paragraph (c)(1) has been revised from the proposal to
provide that applications may be made by parties or groups of parties
that potentially would rely on substituted compliance, in lieu of the
proposed reference to applications by foreign security-based swap
dealers or groups of dealers ``of the same class.'' This change in part
accommodates the possibility that market participants may seek approval
to rely on substituted compliance prior to their being deemed to be
``security-based swap dealers'' or ``major security-based swap
participants'' under the applicable definitions. The final rule also
does not limit joint applications to those that come from persons ``of
the same class,'' to facilitate the Commission's ability to consider
applications jointly submitted by multiple entities notwithstanding
differences in their businesses.\1479\
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\1479\ Paragraphs (c)(1) and (c)(2) also have been changed to
reflect the possibility that the foreign regulators may supervise
the party, or the party's activities.
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In connection with applications submitted by such parties, Rule
3a71-6(c)(2)(i) states that such a party (or group of parties) may make
a substituted compliance request only if the party or the party's
activities are ``directly supervised by the foreign financial
regulatory authority or authorities with respect to the foreign
regulatory requirements relating to the applicable requirements.''
\1480\ This condition should help promote the principles that condition
substituted compliance on the effectiveness of the supervision and
enforcement exercised by the foreign authority, by reflecting the fact
that substituted compliance will not be allowed for entities that are
not subject to foreign oversight in connection with their security-
based swap business.
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\1480\ See Exchange Act rule 3a71-6(c)(2)(i). This provision has
been changed from the proposal to reflect the fact that potential
applicants will not be limited to security-based swap dealers. This
provision also has been changed from the proposal by removing a
redundant reference to the foreign authorities being ``under the
system.'' In addition, the introductory part of paragraph (c)(2) has
been modified from the proposal to refer to requests made ``pursuant
to paragraph (c)(1)'' (rather than ``pursuant to paragraph (a)(1)''
as set forth in the proposal), consistent with the revised structure
of the rule.
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The final rule further provides that to make a request for
substituted
[[Page 30081]]
compliance, each such party must provide the certification and opinion
of counsel that is described in Exchange Act rule 15Fb2-4(c), as if the
party were subject to that requirement at the time of the
request.\1481\ Rule 15Fb2-4(c) requires that nonresident security-based
swap dealers and major security-based swap participants must certify,
and provide an associated opinion of counsel, that the entity can as a
matter of law, and will, provide the Commission with prompt access to
the entity's books and records and submit to onsite inspection and
examination by the Commission.\1482\ This part of the final rule is
generally consistent with the proposal, with one change to permit an
entity to apply for substituted compliance before the entity registers
with the Commission.\1483\
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\1481\ See Exchange Act rule 3a71-6(c)(2)(ii).
\1482\ See Exchange Act rule 15Fb2-4(c). Under that rule, the
certification must state that the entity ``can, as a matter of law,
and will'' provide such access to the Commission, while the opinion
of counsel only says that the entity ``can, as a matter of law''
provide such a certification.
As noted, although commenters to the Cross-Border Proposing
Release had questioned such direct access on deference-related
grounds, the Commission subsequently adopted a final rule requiring
those certifications and opinions of counsel as prerequisites to
registration by nonresident entities. See notes 1408 and 1409,
supra. In adopting that prerequisite, we noted our belief that
``significant elements of an effective regulatory regime are the
Commission's abilities to access registered SBS Entities' books and
records and to inspect and examine the operations of registered SBS
Entities.'' See Registration Adopting Release, 80 FR at 48981, supra
note 989.
\1483\ The final rule, in contrast to the proposal, states that
the party must provide the certification and opinion of counsel ``as
if the party were subject to that requirement at the time of the
request.'' Because the requirements of rule 15Fb2-4(c) are imposed
on an entity applying for registration with the Commission, the
addition of that language should facilitate the ability of an entity
to apply for substituted compliance before the entity is required to
register with the Commission as a security-based swap dealer or as a
major security-based swap participant.
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The final rule also has been revised from the proposal to implement
an analogous requirement in connection with substituted compliance
applications by foreign financial regulatory authorities.\1484\ In
particular, the final rule provides that foreign financial regulatory
authorities may make substituted compliance requests only if each such
authority provides adequate assurances that no law or policy of any
relevant foreign jurisdiction would impede the ability of any entity
that is directly supervised by the foreign financial regulatory
authority, and that may register with the Commission as a security-
based swap dealer or major security-based swap participant, to provide
prompt access to the Commission to such entity's books and records or
to submit to onsite inspection or examination by the Commission.\1485\
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\1484\ See Exchange Act rule 3a71-6(c)(3). As noted above, the
final rule has been modified from the proposal to permit foreign
financial regulatory authorities to submit substituted compliance
applications, necessitating the addition of this prerequisite to
applications by such authorities.
\1485\ While applications by foreign financial regulatory
authorities must include such adequate assurances, the rule does not
specifically require those applications to be accompanied by
opinions of counsel (in contrast to applications submitted by
entities that seek to rely on substituted compliance). Opinions of
counsel, however, provide one possible way in which such authorities
may provide the necessary adequate assurances.
---------------------------------------------------------------------------
In general, those prerequisites to the submission of substituted
compliance applications by entities or by foreign financial authorities
should promote efficiency in the substituted compliance assessment
process. The prerequisites particularly will help focus such
assessments upon those jurisdictions that would not effectively
prohibit entities from registering as dealers or major participants as
a result of blocking statutes or other laws or policies that otherwise
would impede the Commission's ability to exercise its supervisory
authority and responsibilities over registered entities. In other
words, if a jurisdiction has blocking statutes or other laws or
policies that would preclude the registration of such dealers and major
participants with the Commission, there would be no purpose to the
Commission considering a substituted compliance application in
connection with that jurisdiction.
Exchange Act rule 0-13, which addresses the submission of
substituted compliance applications, states that the Commission will
not consider hypothetical requests for substituted compliance
orders.\1486\ Consistent with that limitation, when the Commission
reviews substituted compliance applications, it would take into account
whether particular jurisdictions contain entities that reasonably may
be expected to register with the Commission as security-based swap
dealers or major security-based swap participants based on their level
of security-based swap activity connected with U.S. persons or the U.S.
market.
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\1486\ See Exchange Act rule 0-13(e).
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IV. Explanation of Dates
A. Effective Date
These final rules will be effective 60 days following publication
in the Federal Register.
B. Compliance Date
The Commission believes it appropriate not to apply these rules
until entities are required to register as SBS Dealers or Major SBS
Participants. Therefore, with the exception of the application of
customer protection requirements described in final Rule 3a71-3(c) to
transactions described under final Rule 3a71-3(a)(8)(i)(B), the
Commission is adopting a compliance date for final Rules 15Fh-1 through
15Fh-6 \1487\ and Rule 15Fk-1 that is the same as the compliance date
of the SBS Entity registration rules (``Registration Compliance
Date'').\1488\
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\1487\ See Section II.H.9 (Certain Political Contributions by
SBS Dealers), supra, discussing, among other things, how Rule 15Fh-6
applies to contributions made before the SBS Dealer registered with
the Commission as such as well as how the rule's ``look back''
provision will not apply to contributions made before the compliance
date of the rule by newly covered associates to which the look back
applies.
\1488\ See Registration Adopting Release, supra note 989.
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In the Registration Adopting Release, the Commission provided that
the Registration Compliance Date will be the later of: Six months after
the date of publication in the Federal Register of final rules
establishing capital, margin and segregation requirements for SBS
Entities; \1489\ the compliance date of final rules establishing
recordkeeping and reporting requirements for SBS Entities; \1490\ the
compliance date of final rules establishing business conduct
requirements under Sections 15F(h) and 15F(k) of the Exchange Act; or
the compliance date for final rules establishing a process for a
registered SBS Entity to make an application to the Commission to allow
an associated person who is subject to a statutory disqualification to
effect or be involved in effecting security-based swaps on the SBS
Entity's behalf.\1491\
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\1489\ The Commission previously has proposed rules to establish
capital, margin and segregation requirements for SBS Entities. See
Capital, Margin, and Segregation Requirements for Security-Based
Swap Dealers and Major Security-Based Swap Participants and Capital
Requirements for Broker-Dealers, Exchange Act Release No. 68071
(Oct. 18, 2012), 77 FR 70213 (Nov. 23, 2012).
\1490\ The Commission previously has proposed rules to establish
recordkeeping and reporting requirements for SBS Entities. See
Recordkeeping Release, 79 FR 25193, supra note 242.
\1491\ See Registration Adopting Release, supra note 989.
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The Commission has previously noted the potential complexities
associated with identifying transactions of a dealer that it arranges,
negotiates, or executes by personnel located in the United States under
Rule 3a71-3(b)(1)(iii)(C),\1492\ which requires a non-
[[Page 30082]]
U.S.-person dealer to include such transactions in its de minimis
threshold calculations. In the U.S. Activity Adopting Release, the
Commission specified that the compliance date for that rule is ``the
later of (a) 12 months following publication in the Federal Register,
or (b) the SBS Entity Counting Date.'' \1493\ Because the Commission
believes similar potential complexities exist with respect to such
transactions that are included in ``U.S. business'' as defined in final
Rule 3a71-3(a)(8)(i)(B), the Commission is adopting a compliance date
for application of customer protection requirements described in final
Rule 3a71-3(c) to transactions described under final Rule 3a71-
3(a)(8)(i)(B) that is the later of (a) 12 months following publication
in the Federal Register, or (b) the Registration Compliance Date.
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\1492\ See U.S. Activity Adopting Release, 81 FR 8636-37.
\1493\ Id.
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The Commission believes that these timing requirements should
provide firms with adequate time to review the business conduct rules
being adopted today and make appropriate business decisions before
being required to comply with the requirements of the rules.
C. Application to Substituted Compliance
For the substituted compliance provisions of Rule 3a71-6, the
Commission similarly is adopting an effective date of 60 days following
publication in the Federal Register. There will be no separate
compliance date in connection with that rule, as the rule does not
impose obligations upon entities separate and apart from the underlying
business conduct requirements. As discussed above, security-based swap
dealers and major security-based swap participants will not be required
to comply with the business conduct requirements until they are
registered, and the registration requirement for those entities will
not be triggered until a number of regulatory benchmarks have been met.
In practice, the Commission recognizes that if the requirements of
a foreign regime are comparable to Title VII requirements, and the
other prerequisites to substituted compliance also have been satisfied,
then it may be appropriate to permit a security-based swap dealer or
major security-based swap participant to rely on substituted compliance
commencing at the time that entity is registered with the Commission.
Accordingly, the Commission would consider substituted compliance
requests that are submitted prior to the compliance date for the entity
registration requirements.
V. Paperwork Reduction Act
Certain provisions of the Rules impose new ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\1494\ In accordance with 44 U.S.C.
3507 and 5 CFR 1320.11, the Commission submitted the provisions to the
Office of Management and Budget (``OMB'') for review when it issued the
Proposing Release. The titles for these collections are ``Business
Conduct Standards for Security-Based Swap Dealers and Major Security-
Based Swap Participants,'' and ``Designation of Chief Compliance
Officer of Security-Based Swap Dealers and Major Security-Based Swap
Participants.''
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\1494\ 44 U.S.C. 3501 et seq.
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Compliance with collection of information requirements is
mandatory. 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 OMB control number. OMB assigned control number 3235-
0732 to the new collections of information.
In the Proposing Release, the Commission requested comment on the
collection of information requirements contained therein, as well as
the accuracy of the Commission's related estimates and statements
regarding the associated costs and burdens of the proposed rules. As
noted above, the Commission received 43 comment letters addressing the
Proposing Release, as well as those portions of the Cross-Border
Proposing Release that referenced the proposed rules governing business
conduct standards for security-based swap dealers. Although none of the
comment letters specifically addressed the Commission's estimates for
the proposed collection of information requirements, the views of
commenters relevant to the Commission's analysis of burdens, costs, and
benefits of the proposed rules are discussed in Section IV.C, below.
The Commission continues to believe that the methodology used for
calculating the burdens set forth in the Proposing Release is
appropriate. However, where noted, certain estimates have been
modified, as necessary, to conform to the adopted rules and to reflect
the most recent data available to the Commission. Other than these
changes, the Commission's estimates remain unchanged from those in the
Proposing Release.
As a part of this release, the Commission also is adopting Rule
3a67-10(d) and Rule 3a71-3(c), which among other things, provide an
exception to certain of the business conduct standards described in
section 15F(h) of the Act, and the rules and regulations thereunder, to
registered Major SBS Participants and registered SBS Dealers in certain
transactions conducted through the foreign branch of their U.S.-person
counterparty. As part of the process of availing themselves of this
exception, registered Major SBS Participants (in the case of Rule 3a67-
10(d)) and registered SBS Dealers (in the case of Rule 3a71-3(c)) would
be permitted to rely on certain representations provided to them by
their counterparties regarding whether a transaction is conducted
through a foreign branch. The requirements regarding those
representations are contained in Rule 3a71-3(a)(3)(ii). The Commission
previously published a notice requesting comment on the collection of
information requirements in Rule 3a71-3 as part of the Cross-Border
Proposing Release, and submitted those proposed collection of
information requirements to OMB for review in accordance with 44 U.S.C.
3507 and 5 CFR 1320.11. The title of the collection of information
related to the representation in Rule 3a71-3 is ``Reliance on
Counterparty Representations Regarding Activity Within the United
States.'' OMB has not yet assigned a control number to this collection.
The Commission also is adopting Rule 3a71-6 to provide for
substituted compliance in connection with the business conduct
requirements. As proposed, the title of the information collection
associated with that rule was ``Rule 3a71-5 Substituted Compliance for
Foreign Security-Based Swap Dealers.'' \1495\ The OMB assigned control
number 3235-0715 to the new collection of information. In the Cross-
Border Proposing Release, the Commission solicited comment on the
collection of information requirements associated with the substituted
compliance rule and on the accuracy of the Commission's related
statements. The Commission received no comments on those proposed
information collection requirements.
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\1495\ Consistent with the renumbering of the rule and the
potential availability of substituted compliance to Major SBS
Participants, the revised title of the collection of information is
``Rule 3a71-6 Substituted Compliance for Foreign Security-Based Swap
Entities.''
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[[Page 30083]]
A. Summary of Collections of Information
1. Definitions
Rule 15Fh-2(d) defines a ``special entity'' as: (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 ERISA;
(4) any employee benefit plan defined in Section 3 of ERISA, not
otherwise defined as a special entity, unless such employee benefit
plan elects not to be a special entity by notifying an SBS dealer or
Major SBS Participant of its election prior to entering into a
security-based swap; (5) any governmental plan, as defined in Section
3(32) of ERISA; or (6) any endowment, including organizations described
in Section 501(c)(3) of the Internal Revenue Code.
The proposed rule included employee benefit plans ``defined in''
ERISA within the special entity definition. The final rule similarly
includes employee benefit plans ``defined in'' ERISA that are not
otherwise ``subject to'' ERISA within the special entity definition,
although it provides such benefit plans with the ability to opt out of
special entity status.
2. Verification of Status
Rule 15Fh-3(a)(1) requires an SBS Entity to verify that a
counterparty meets the eligibility standards for ECP status before
entering into a security-based swap with that counterparty other than
with respect to a transaction executed on a registered national
securities exchange.
Rule 15Fh-3(a)(2) requires an SBS Entity to verify whether a
counterparty is a special entity before entering into a security-based
swap transaction with that counterparty, unless the transaction is
executed on a registered or exempt SEF or registered national
securities exchange, and the SBS Entity does not know the identity of
the counterparty at a reasonably sufficient time prior to the
transaction to permit the SBS Entity to comply with the obligations of
the rule.
Rule 15Fh-3(a)(3) requires an SBS Entity, in verifying the special
entity status of a counterparty pursuant to Rule 15Fh-3(a)(2), to
verify whether a counterparty is eligible to elect not to be a special
entity as provided for in the adopted special entity definition in Rule
15Fh-2(d)(4), and if so, to notify such counterparty of its right to
make such an election. An SBS Entity may satisfy these verification
requirements through any reasonable means including, among other
things, by obtaining written representations from the counterparty as
to specific facts about the counterparty.\1496\
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\1496\ The Commission separately has proposed rules regarding
recordkeeping and reporting requirements for SBS Entities that would
require an SBS Entity to keep records of its verification. See
Recordkeeping Release, 79 FR 25193, 25208 and 25217-25218, supra
note 242.
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3. Disclosures by SBS Entities
Rule 15Fh-3(b) generally requires an SBS Entity at a reasonably
sufficient time prior to entering into a security-based swap to
disclose to a counterparty (other than an SBS Entity or Swap Entity)
material information concerning the security-based swap in a manner
reasonably designed to allow the counterparty to assess: (1) The
material risks and characteristics of a particular security-based swap;
and (2) any material incentives or conflicts of interest that the SBS
Entity may have in connection with the security-based swap. These
disclosure requirements do not apply unless the identity of the
counterparty is known to the SBS Entity at a reasonably sufficient time
prior to execution of the transaction to permit the SBS Entity to
comply with the obligations of the rule. The rule also requires the SBS
Entity to make a written record of any non-written disclosures made
pursuant to this provision, and timely provide a written version of
these disclosures to counterparties no later than the delivery of the
trade acknowledgement of the particular transaction.
Rule 15Fh-3(c)(1), for cleared security-based swaps, requires an
SBS Entity to, upon request of the counterparty, disclose the daily
mark to the counterparty (other than an SBS Entity or Swap Entity). The
daily mark that the SBS Entity receives from the appropriate clearing
agency. Rule 15Fh-3(c)(2), for uncleared security-based swaps, requires
an SBS Entity to disclose the daily mark to the counterparty, which is
the midpoint between the bid and offer, or the calculated equivalent
thereof, as of the close of business, unless the parties agree in
writing to a different time, on each business day during the term of
the security-based swap. Rule 15Fh-3(c)(2) also requires disclosure of
the data sources and a description of the methodology and assumptions
used to prepare the daily mark for an uncleared security-based swap, as
well as disclosure of any material changes to such data sources,
methodology or assumptions during the term of the security-based swap.
Rule 15Fh-3(c)(1) and (2) also require an SBS Entity to provide the
daily mark without charge to the counterparty and without restrictions
on the internal use of the daily mark by the counterparty.
Rule 15Fh-3(d) requires an SBS Entity to disclose information
regarding clearing rights to its counterparties (other than an SBS
Entity or Swap Entity), so long as the identity of the counterparty is
known to the SBS Entity at a reasonably sufficient time prior to
execution of the transaction to permit the SBS Entity to comply with
the obligations of the rule. Pursuant to the rule, before entering into
a security-based swap that is subject to the clearing requirements of
Section 3C(a) of the Exchange Act, the SBS Entity shall disclose to the
counterparty the names of the clearing agencies that accept the
security-based swap for clearing, and through which of those clearing
agencies the SBS Entity is authorized or permitted, directly or through
a designated clearing member, to clear the security-based swap;
disclose to the counterparty whether any of the named clearing agencies
satisfy the standard for clearing under Section 3C(a)(1) of the
Exchange Act; and notify the counterparty that it shall have the sole
right to select which clearing agency shall be used to clear the
security-based swap. For security-based swaps, not subject to the
clearing requirements of Section 3C(a) of the Exchange Act, before
entering into a security-based swap, the SBS Entity shall determine
whether the security-based swap is accepted for clearing by one or more
clearing agencies; disclose to the counterparty the names of the
clearing agencies that accept the security-based swap for clearing, and
whether the SBS Entity is authorized or permitted, directly or through
a designated clearing member, to clear the security-based swap through
such clearing agencies; and notify the counterparty that it may elect
to require clearing of the security-based swap and shall have the sole
right to select the clearing agency at which the security-based swap
will be cleared, provided it is a clearing agency at which the SBS
Entity is authorized or permitted, directly or through a designated
clearing member, to clear the security-based swap. To the extent that
the disclosures required by Rule 15Fh-3(d) are not provided in writing
prior to the execution of the transaction, the SBS Entity is required
to make a written record of the non-written disclosures and provide the
counterparty with a written version of these disclosure no later than
the delivery of the trade acknowledgement for the transaction.
[[Page 30084]]
4. Know Your Counterparty and Recommendations
Rule 15Fh-3(e) requires an SBS Dealer to establish, maintain and
enforce written policies and procedures reasonably designed to obtain
and retain a record of the essential facts concerning each counterparty
whose identity is known to the SBS Dealer that are necessary for
conducting business with such counterparty. The essential facts are:
(1) Facts required to comply with applicable laws, regulations and
rules; (2) facts required to implement the SBS 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.
Rule 15Fh-3(f)(1) requires an SBS Dealer recommending a security-
based swap or trading strategy involving a security-based swap to a
counterparty (other than an SBS Entity or a Swap Entity) to: (i)
Undertake reasonable diligence to understand the potential risks and
rewards associated with the recommendation; and (ii) have a reasonable
basis to believe that the recommendation is suitable for the
counterparty. To establish a reasonable basis for a recommendation, an
SBS Dealer must have or obtain relevant information regarding the
counterparty, including the counterparty's investment profile, trading
objectives, and its ability to absorb potential losses associated with
the recommended security-based swap or trading strategy involving a
security-based swap.
Under Rule 15Fh-3(f)(2), an SBS Dealer may also fulfill its
suitability obligations under Rule 15Fh-3(f)(1)(ii) with respect to an
institutional counterparty (defined as a counterparty that is an
eligible contract participant as defined in clauses (A)(i), (ii),
(iii), (iv), (viii), (ix) or (x), or clause (B)(ii) (other than a
person described in clause (A)(v)) of Section 1a(18) of the Commodity
Exchange Act and the rules and regulations thereunder, or any person
(whether a natural person, corporation, partnership, trust or
otherwise) with total assets of at least $50 million) if: (i) The SBS
Dealer reasonably determines that the counterparty (or its agent) is
capable of independently evaluating the investment risks with regard to
the relevant security-based swap or trading strategy involving a
security-based swap; (ii) the counterparty (or its agent) affirmatively
represents in writing that it is exercising its independent judgment in
evaluating the recommendations of the SBS Dealer with regard to the
relevant security-based swap or trading strategy; and (iii) the SBS
Dealer discloses to the counterparty that it is acting in its capacity
as a counterparty and is not undertaking to assess the suitability of
the security-based swap or trading strategy for the counterparty. Under
Rule 15Fh-3(f)(3), an SBS Dealer will be deemed to have satisfied the
requirements of Rule 15Fh-3(f)(2)(i) if it receives written
representations, as provided in Rule 15Fh-1(b), that: (i) 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; and (ii) in the case of a
counterparty that is a special entity, satisfy the terms of the safe
harbor in Rule 15Fh-5(b).
5. Fair and Balanced Communications
Rule 15Fh-3(g) requires an SBS Entity to communicate with its
counterparties in a fair and balanced manner based on principles of
fair dealing and good faith. The rule requires that: (1) Communications
provide a sound basis for evaluating the facts with regard to a
particular security-based swap or trading strategy involving a
security-based swap; (2) communications not imply that past performance
will recur or make any exaggerated or unwarranted claim, opinion, or
forecast; and (3) any statement referring to potential opportunities or
advantages presented by a particular security-based swap be balanced by
an equally detailed statement of the corresponding risks.
6. Supervision
Rule 15Fh-3(h) requires an SBS Entity to establish and maintain a
system to supervise, and to diligently supervise, its business and the
activities of its associated persons. Such a system shall be reasonably
designed to prevent violations of the provisions of applicable federal
securities laws and the rules and regulations thereunder relating to
its business as an SBS Entity. At a minimum, the supervisory system
must: (i) Designate at least one person with authority to carry out
supervisory responsibilities for each type of business in which the SBS
Entity engages for which registration as an SBS Entity is required;
(ii) use reasonable efforts to determine all such supervisors are
qualified, either by virtue of experience or training, to carry out
their assigned responsibilities; and (iii) establish, maintain and
enforce written policies and procedures addressing the supervision of
the types of security-based swap business in which the SBS Entity is
engaged and the activities of it associated persons that are reasonably
designed to prevent violations of applicable securities laws and rules
and regulations thereunder.
Such written policies and procedures must include, at a minimum,
procedures: (a) For the review by a supervisor of transactions for
which registration as an SBS Entity is required; (b) for the review by
a supervisor of incoming and outgoing written (including electronic)
correspondence with counterparties or potential counterparties and
internal written communications relating to the SBS Entity's security-
based swap business; (c) for a periodic review, at least annually, of
the security-based swap business in which the SBS Entity engages that
is reasonably designed to assist in detecting and preventing violations
of applicable federal securities laws and regulations; (d) to conduct a
reasonable investigation regarding the good character, business repute,
qualifications, and experience of any person prior to that person's
association with the SBS Entity; (e) to consider whether to permit an
associated person to establish or maintain a securities or commodities
account or a trading relationship in the name of, or for the benefit
of, such associated person at another financial institution, and if
permitted, to supervise the trading at such institution; (f) describing
the supervisory system, including the titles, qualifications and
locations of supervisory persons and the responsibilities of each
supervisory person with respect to the types of business in which the
SBS Entity is engaged; (g) prohibiting an associated person who
performs a supervisory function from supervising his or her own
activities or reporting to, or having his or her compensation or
continued employment determined by, a person or persons he or she is
supervising; provided that if the SBS Entity determines, with respect
to any of its supervisory personnel, that compliance with this
requirement is not possible because of the firm's size or a supervisory
person's position within the firm, then the SBS Entity must document
the factors used to reach such determination and how the supervisory
arrangement otherwise complies with this rule, and include a summary of
such determination in the annual compliance report prepared by the SBS
Entity's CCO pursuant to Rule 15Fk-1(c); (h) reasonably designed to
prevent the supervisory system from being
[[Page 30085]]
compromised due to conflicts of interest that may be present with
respect to the associated person being supervised, including the
position of such person, the revenue such person generates for the SBS
Entity, or any compensation that the associated person conducting the
supervision may derive from the associated person being supervised; and
(i) reasonably designed, taking into consideration the nature of the
SBS Entity's business, to comply with the duties set forth in Section
15F(j) of the Exchange Act.
Rule 15Fh-3(h)(3) provides that an SBS Entity (or associated person
of an SBS Entity) will not be deemed to have failed to diligently
supervise another person if that person is not subject to his or her
supervision, or if: (i) The SBS Entity has established and maintained
written policies and procedures (as required in Rule15Fh-3(h)(2)(iii)),
and a documented system for applying those policies and procedures that
would reasonably be expected to prevent and detect, insofar as
practicable, any violation of the federal securities laws and the rules
and regulations thereunder relating to security-based swaps; and (ii)
the SBS Entity or associated person has reasonably discharged the
duties and obligations required by such written policies and procedures
and documented system and did not have a reasonable basis to believe
that such written policies and procedures and documented system were
not being followed.
Rule 15Fh-3(h)(4) provides that an SBS Entity must also promptly
amend its written supervisory procedures as appropriate when material
changes occur in applicable securities laws, rules, or regulations
thereunder, as well as when material changes occur in its business or
supervisory system, and promptly communicate any material amendments to
its supervisory procedures to all associated persons to whom such
amendments are relevant based on their activities and responsibilities.
7. SBS Dealers Acting as Advisors to Special Entities
Rule 15Fh-4(b)(1) imposes the duty on an SBS Dealer that acts as an
advisor to a special entity regarding a security-based swap to make a
reasonable determination that any security-based swap or trading
strategy involving a security-based swap recommended by the SBS Dealer
is in the best interests of the special entity. Paragraph (b)(2) also
requires an SBS Dealer acting as an advisor to a special entity to make
reasonable efforts to obtain such information as it considers necessary
to make a reasonable determination that a security-based swap or
related trading strategy is in the best interests of the special
entity. The information that must be obtained to make this reasonable
determination includes, but is not limited to: (i) The authority of the
special entity to enter into a security-based swap; (ii) the financial
status and future funding needs of the special entity; (iii) the tax
status of the special entity; (iv) the hedging, investment, financing
or other objectives of the special entity; (v) the experience of the
special entity with respect to security-based swaps, generally, and
security-based swaps of the type and complexity being recommended; (vi)
whether the special entity has the financial capability to withstand
changes in market conditions during the term of the security-based
swap; and (vii) such other information as is relevant to the particular
facts and circumstances of the special entity, market conditions and
the type of security-based swap or trading strategy being recommended.
However, the requirements of Rule 15Fh-4(b) do not apply to a security-
based swap if: (i) The transaction is executed on a registered or
exempt SEF or a registered national securities exchange; and (ii) the
SBS Dealer does not know the identity of the counterparty at a
reasonably sufficient time prior to execution of the transaction to
permit the SBS Dealer to comply with the obligations of this rule.
Rule 15Fh-2(a) generally provides that an SBS Dealer acts as an
advisor to a special entity when it recommends a security-based swap or
security-based swap trading strategy to that special entity. Rule 15Fh-
2(a)(1) provides a safe harbor under which an SBS Dealer will not be
deemed to act as an advisor to a special entity that is subject to
Title I of ERISA if: (i) The special entity represents in writing that
it has a fiduciary as defined in Section 3 of ERISA that is responsible
for representing the special entity in connection with the security-
based swap; (ii) the fiduciary represents in writing that it
acknowledges that the SBS Dealer is not acting as an advisor; and (iii)
the special entity 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 SBS
Dealer involving a security-based swap transaction is evaluated by a
fiduciary before it is entered into; or (b) that any recommendation the
special entity receives from the SBS Dealer involving a security-based
swap transaction will be evaluated by a fiduciary before the
transaction is entered into.\1497\
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\1497\ Rule 15Fh-2(a)(1).
---------------------------------------------------------------------------
Rule 15Fh-2(a)(2) provides a safe harbor for transactions between
an SBS Dealer and any special entity. Under this rule, an SBS Dealer
that recommends a security-based swap or security-based swap trading
strategy to any special entity (other than a special entity subject to
Title I of ERISA) will not be deemed to act as an advisor to that
special entity if the special entity represents in writing that it
acknowledges that the SBS Dealer is not acting as an advisor, and that
it will rely on advice from a qualified independent representative, as
defined in Rule 15Fh-5(a). The SBS Dealer must also disclose to the
special entity that it is not undertaking to act in the best interests
of the special entity, as otherwise required by Section 15F(h)(4) of
the Exchange Act.\1498\
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\1498\ Rule 15Fh-2(a)(2).
---------------------------------------------------------------------------
8. SBS Entities Acting as Counterparties to Special Entities
Rule 15Fh-5(a)(1) requires an SBS Entity that offers to enter into
or enters into a security-based swap with a special entity (other than
a special entity that is an employee benefit plan subject to Title I of
ERISA), to have a reasonable basis to believe that the special entity
has a qualified independent representative that meets certain specified
qualifications. For purposes of Rule 15Fh-5(a)(1), a qualified
independent representative must: (i) Have sufficient knowledge to
evaluate the transaction and related risks; (ii) not be subject to a
statutory disqualification; (iii) undertake a duty to act in the best
interests of the special entity; (iv) make appropriate and timely
disclosures to the special entity of material information concerning
the security-based swap; (iv) evaluate, consistent with any guidelines
provided by the special entity, the fair pricing and appropriateness of
the security-based swap; (v) in the case of a special entity defined in
Rule 15Fh-2(d)(2) or (5), be subject to the pay-to-play prohibitions of
the Commission, the CFTC, or a self-regulatory organization that is
subject to the jurisdiction of the Commission or the CFTC (unless the
independent representative is an employee of the special entity); and
(vii) be independent of the SBS Entity that is the counterparty to a
proposed security-based swap.\1499\
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\1499\ Rule 15Fh-5(a)(1)(vii).
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Rule 15Fh-5(a)(1) also provides that a representative of a special
entity will be ``independent'' of an SBS Entity if the
[[Page 30086]]
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.\1500\ In
addition, a special entity's representative will be deemed to be
``independent'' of an SBS Entity if: (1) The representative is not and
was not an associated person of the SBS Entity within one year of
representing the special entity in connection with the security-based
swap; (2) the representative provides timely 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 complies with
policies and procedures reasonably designed to manage and mitigate such
material conflicts of interest; and (3) the SBS Entity 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 security-based swap.\1501\
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\1500\ Rule 15Fh-5(a)(1)(vii)(A).
\1501\ Rule 15Fh-5(a)(1)(vii)(B).
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Rule 15Fh-5(a)(2) provides that an SBS Entity that offers to enter
into or enters into a security-based swap with a special entity as
defined in Rule 15Fh-2(d)(3) (any employee benefit plan that subject to
Title I of ERISA) must have a reasonable basis to believe the special
entity has a representative that is a fiduciary as defined in Section 3
of ERISA.
Rule 15Fh-5(b) provides safe harbors for SBS Dealers seeking to
form a reasonable basis regarding the qualifications of the independent
representative. Under Rule 15Fh-5(b)(1), an SBS Entity shall be deemed
to have a reasonable basis to believe that a special entity (other than
an ERISA special entity) has a representative that satisfies the
requirements of Rule 15Fh-5(a)(1) if: (i) The special entity represents
in writing to the SBS Entity 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 requirements of Rule
15Fh-5(a)(1), and that such policies and procedures provide for ongoing
monitoring of the performance of such representative consistent with
Rule 15Fh-5(a)(1); and (ii) the representative represents in writing to
the special entity and the SBS Entity that the representative: (a) Has
policies and procedures reasonably designed to ensure that it satisfies
the applicable requirements of Rule 15Fh-5(a)(1); (b) meets the
independence requirements of Rule 15Fh-5(a)(1)(vii); and (c) is legally
obligated to comply with the requirements of Rule 15Fh-5(a)(1) by
agreement, condition of employment, law, rule, regulation, or other
enforceable duty.
Under Rule 15Fh-5(b)(2), an SBS Entity shall be deemed to have a
reasonable basis to believe that an ERISA special entity has a
representative that satisfies the requirements of Rule 15Fh-5(a)(2),
provided that the special entity provides in writing to the SBS Entity
the representative's name and contact information, and represents in
writing that the representative is a fiduciary as defined in Section 3
of ERISA.
Under Rule 15Fh-5(c), before initiation of a security-based swap,
an SBS Dealer must disclose to the special entity in writing the
capacity in which the SBS Dealer is acting in connection with the
security-based swap, and, if the SBS Dealer engages in business with
the counterparty in more than one capacity, the SBS Dealer must
disclose the material differences between such capacities and any other
financial transaction or service involving the counterparty to the
special entity.
Under Rule 15Fh-5(d), formerly Rule 15Fh-5(c), the provisions of
Rule 15Fh-5 do not apply when two conditions are satisfied: (1) The
transaction is executed on an registered or exempt SEF or registered
national securities exchange; and (2) the SBS Entity is unaware of the
counterparty's identity, at a reasonably sufficient time prior to the
execution of the transaction to permit the SBS Entity to comply with
the obligations of the rule.
9. Political Contributions
Rule 15Fh-6(b) prohibits an SBS Dealer from offering to enter into,
or entering into a security-based swap, or a trading strategy involving
a security-based swap, with a municipal entity within two years after
any contribution by the SBS Dealer or its covered associates to an
official of such municipal entity, subject to certain exceptions. These
prohibitions do not apply to certain contributions made by an SBS
Dealer's covered associate if the SBS Dealer discovered the
contribution within 120 calendar days of the date of such contribution,
the contribution did not exceed $350, and the covered associate
obtained a return of the contribution within 60 calendar days of the
date of discovery of the contribution by the SBS Dealer. However, a SBS
dealer may not rely on that provision more than three times in any 12-
month period if it has more than 50 covered associated, and no more
than twice if it has 50 or fewer covered associates. The Commission may
also, upon application, exempt a security-based swap dealer from the
prohibitions of the rule after consideration of several factors.
The provisions of Rule 15Fh-6 do not apply when two conditions are
satisfied: (1) The transaction is executed on an registered or exempt
SEF or registered national securities exchange; and (2) the SBS Dealer
is unaware of the counterparty's identity, at a reasonably sufficient
time prior to the execution of the transaction to permit the SBS Dealer
to comply with the obligations of the rule.
10. Chief Compliance Officer
Rule 15Fk-1 requires an SBS Entity to designate an individual to
serve as CCO on its registration form. Under Rule 15Fk-1(b)(1) the CCO
must report directly to the board of directors or senior officer of the
SBS Entity. Under Rule 15Fk-1(b)(2), the CCO must take reasonable steps
to ensure that the SBS Entity establishes, maintains, and reviews
written policies and procedures reasonably designed to achieve
compliance with the Exchange Act and the rules and regulations
thereunder relating to its business as an SBS Entity by: (1) Reviewing
the SBS Entity's compliance with the SBS Entity requirements described
in Section 15F of the Exchange Act and the rules and regulations
thereunder (where such review shall involve preparing the SBS Entity's
annual assessment of its written policies and procedures reasonably
designed to achieve compliance with Section 15F of the Exchange Act and
the rules and regulations thereunder); (2) taking reasonable steps to
ensure the SBS Entity establishes, maintains, and reviews policies and
procedures reasonably designed to remediate non-compliance issues
identified by the CCO through any means, including any compliance
office review, look-back, internal or external audit finding, self-
reporting to the Commission and other appropriate authorities, or
complaint that can be validated; and (3) taking reasonable steps to
ensure that the SBS Entity establishes and follows procedures
reasonably designed for the handling, management response, remediation,
retesting, and resolution of non-compliance issues. Under Rule 15Fk-
1(b)(3), the CCO must take reasonable steps to resolve any material
conflicts of interest that may arise, in consultation with the board or
the senior officer of the SBS Entity. Under Rule 15Fk-1(b)(4), the CCO
must
[[Page 30087]]
administer each policy and procedure that is required to be established
pursuant to Section 15F of the Exchange Act and the rules and
regulations thereunder.
Under Rule 15Fk-1(c), the CCO must also prepare and sign an annual
compliance report that must be submitted to the Commission within 30
days following the deadline for filing the SBS Entity's annual
financial report with the Commission pursuant to Section 15F of the
Exchange Act and the rules and regulations thereunder. This annual
compliance report must contain a description of the written policies
and procedures of the SBS Entity described in Rule 15Fk-1(b), outlined
above, including the code of ethics and conflict of interest policies.
The compliance report must also include, at a minimum, a description
of: (1) The SBS Entity's assessment of the effectiveness of its
policies and procedures relating to its business as an SBS Entity; (2)
any material changes to the policies and procedures since the date of
the preceding compliance report; (3) any areas for improvement and
recommended potential or prospective changes or improvements to its
compliance program and resources devoted to compliance; (4) any
material non-compliance matters identified; and (5) the financial,
managerial, operational, and staffing resources set aside for
compliance with the Exchange Act and the rules and regulations
thereunder relating to its business as an SBS Entity, including any
material deficiencies in such resources. The report must be submitted
to the board of directors and audit committee (or equivalent bodies)
and the senior officer of the SBS Entity prior to submission to the
Commission. The report also must be discussed in one or more meetings
(addressing the obligations of this rule) that were conducted by the
senior officer with the CCO in the preceding 12 months, and must
include a certification by the CCO or senior officer that, to the best
of his or her knowledge and reasonable belief and under penalty of law,
the information contained in the compliance report is accurate and
complete in all material respects.
The final rule allows an SBS Entity to incorporate by reference
sections of a compliance report that has been submitted with the
current or immediately preceding reporting period to the Commission,
and allows an SBS Entity to request from the Commission an extension of
time to submit its compliance report, provided that the SBS Entity's
failure to timely submit the report could not be eliminated by the SBS
Entity without unreasonable effort or expense. Extensions of the
deadline will be granted at the discretion of the Commission. The final
rule also requires an SBS Entity to promptly submit an amended
compliance report if material errors or omissions in the report are
identified.
Under Rule 15k-1(d), the compensation and removal of the CCO shall
require the approval of a majority of the board of directors of the SBS
Entity.
11. Foreign Branch Exception
Rule 3a67-10(d), as adopted, provides that registered major
security-based swap participants shall not be subject to business
conduct standards described in section 15F(h) of the Act (15 U.S.C.
78o-10(h)), and the rules and regulations thereunder, other than rules
and regulations prescribed by the Commission pursuant to section
15F(h)(1)(B) of the Act, in certain transactions conducted through the
foreign branch of their U.S.-person counterparty. Rule 3a71-3(c), as
adopted, provides a similar exception for registered security-based
swap dealers. The previously adopted definition of ``transaction
conducted through a foreign branch'' permits a person to rely on its
U.S. bank counterparty's representation that the transaction ``was
arranged, negotiated, and executed on behalf of the foreign branch
solely by persons located outside the United States, unless such person
knows or has reason to know that the representation is not accurate.''
\1502\
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\1502\ See Exchange Act rule 3a71-3(a)(3)(ii).
---------------------------------------------------------------------------
12. Substituted Compliance Rule
Rule 3a71-6, as adopted, provides that the Commission may,
conditionally or unconditionally, by order, make a determination with
respect to a foreign financial regulatory system that compliance with
specified requirements under such foreign financial regulatory system
by a registered non-U.S. SBS Entity, or class thereof, may satisfy
certain business conduct requirements by complying with the comparable
foreign requirements. The availability of substituted compliance would
be predicated on a determination by the Commission that the relevant
foreign requirements are comparable to the requirements that otherwise
would be applicable, taking into account the scope and objectives of
the relevant foreign requirements,\1503\ and the effectiveness of
supervision and enforcement under the foreign regulatory regime.\1504\
The availability of substituted compliance further would be predicated
on there being a supervisory and enforcement MOU or other arrangement
between the Commission and the relevant foreign authority addressing
supervisory and enforcement cooperation and other matters arising under
the substituted compliance determination.\1505\
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\1503\ In the specific context of substituted compliance for the
business conduct requirements, prior to making any comparability
determination the Commission intends to consider whether the
information that is required to be provided to counterparties
pursuant to the requirements of the foreign jurisdiction, the
counterparty protections under the requirements of the foreign
jurisdiction, the mandates for supervisory systems under the
requirements of the foreign jurisdiction, and the CCO requirements
under the foreign jurisdiction are comparable with the applicable
Exchange Act provisions. See Exchange Act Rule 3a71-6(d).
\1504\ See Exchange Act Rule 3a71-6(a)(2)(i).
\1505\ See Exchange Act Rule 3a71-6(a)(2)(ii).
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Requests for substituted compliance may come from parties or groups
of parties that may rely on substituted compliance, or from foreign
financial authorities supervising such parties or their security-based
swap activities.\1506\ Under the final rule, the Commission would make
any determinations with regard to the applicable business conduct
requirements, rather than on a firm-by-firm basis. Once the Commission
has made a substituted compliance determination, other similarly
situated market participants would be able to rely on that
determination to the extent applicable and subject to any corresponding
conditions. Accordingly, the Commission expects that requests for a
substituted compliance determination would be made only where an entity
seeks to rely on particular requirements of a foreign jurisdiction that
has not previously been the subject of a substituted compliance
request. The Commission believes that this approach would substantially
reduce the burden associated with requesting substituted compliance
determinations for an entity that relies on a previously issued
determination, and, therefore, complying with the Commission's rules
and regulations more generally.
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\1506\ See Exchange Act Rule 3a71-6(c)(1). Such parties or
groups of parties may make requests only if each such party or its
activities is directly supervised by the foreign financial
authority. See Exchange Act Rule 3a71-6(c)(2).
---------------------------------------------------------------------------
As provided by Exchange Act Rule 0-13, which the Commission adopted
in 2014, applications for substituted compliance determinations in
connection with these requirements must be accompanied by supporting
documentation necessary for the Commission to make the determination,
including information regarding applicable requirements established by
the foreign financial regulatory
[[Page 30088]]
authority or authorities, as well as the methods used by the foreign
financial regulatory authority or authorities to monitor and enforce
compliance with such rules, and to cite to and discuss applicable
precedent.\1507\
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\1507\ See Exchange Act Rule 0-13(e). Rule 0-13 also specifies
other prerequisites for the filing of substituted compliance
applications (e.g., requirements regarding the use of English, the
use of electronic or paper requests, contact information, and public
notice and comment in connection with complete applications).
In adopting Rule 0-13, the Commission also noted that because
Rule 0-13 was a procedural rule that did not provide any substituted
compliance rights, ``collections of information arising from
substituted compliance requests, including associated control
numbers, [would] be addressed in connection with any applicable
substantive rulemakings that provide for substituted compliance.''
See SBS Entity Definitions Adopting Release, 79 FR at 47366 n.778,
supra note 1451.
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B. Use of Information
1. Verification of Status
Rule 15Fh-3(a) requires an SBS Entity to verify that a counterparty
meets the eligibility standards for ECP status before offering to enter
into or entering into a security-based swap other than with respect to
a transaction executed on a registered national securities exchange.
The SBS Entity will use this information to comply with Section 6(l) of
the Exchange Act (15 U.S.C. 78(f)(l)), which prohibits a person from
entering into a security-based swap with a counterparty that is not an
ECP other than on a registered national securities exchange. The rule
also requires the SBS Entity to verify, for non-anonymous transactions,
whether a counterparty is a special entity before entering into a
security-based swap transaction with that counterparty, unless the
transaction is executed on a registered or exempt security-based swap
execution facility or registered national securities exchange. The SBS
Entity will use this information to assess its need to comply with the
requirements applicable to dealings with special entities under Rules
15Fh-4(b) and 15Fh-5. In addition, the Commission staff may review this
information in connection with examinations and investigations.
2. Disclosures by SBS Entities
The disclosures that SBS Entities must provide to a counterparty
(other than an SBS Entity or a Swap Entity) will help the counterparty
understand the material risks and characteristics of a particular
security-based swap, as well as the material incentives or conflicts of
interest that the SBS Entity may have in connection with the security-
based swap. As a result, these disclosures will assist the counterparty
in assessing the transaction by providing them with a better
understanding of the expected performance of the security-based swap
under various market conditions. The disclosures will also give
counterparties additional transparency and insight into the pricing and
collateral requirements of security-based swaps.
Rule 15Fh-3(d) requires SBS Entities, before entering into a
security-based swap with a counterparty (other than an SBS Entity or
Swap Entity), to determine whether the security-based swap is subject
to the clearing requirements of Section 3C(a) of the Exchange Act and
to disclose its determination to counterparties, along with certain
information regarding the clearing alternatives available to them. In
addition to assisting the SBS Entity and its CCO in supervising and
assessing internal compliance with the statute and rules, the
Commission staff may also review this information in connection with
examinations and investigations.
3. Know Your Counterparty and Recommendations
These collections of information will help SBS Dealers comply with
applicable laws, regulations and rules, as well as assist SBS Dealers
in effectively dealing with counterparties. For example, these
collections of information may better enable SBS Dealers to make
appropriate recommendations for counterparties, and to gather from the
counterparty any information that the SBS Dealer needs for credit and
risk management purposes. Furthermore, these collections of information
will assist SBS Dealers in determining whether it is reasonable to rely
on various representations from a counterparty, and in evaluating the
risks of trading with that counterparty. The information will also
assist a CCO in determining whether the SBS Entity has written policies
and procedures reasonably designed to obtain and retain a record of the
essential facts concerning each known counterparty, and to make
suitable recommendations to its counterparties. The Commission staff
may also review this information in connection with examinations and
investigations.
4. Fair and Balanced Communications
The collection of information concerning the risks of a security-
based swap will assist an SBS Entity in communicating with
counterparties in a fair and balanced manner by requiring, among other
things, that communications provide a sound basis for evaluating the
facts with regard to a particular security-based swap and, if a
statement refers to potential opportunities or advantages presented by
a particular security-based swap, that statement must be balanced by an
equally detailed statement of corresponding risks. It will also help
the CCO in ensuring that the SBS Entity is communicating with
counterparties in a fair and balanced manner based on principles of
fair dealing and good faith by establishing certain express
requirements with which these communications must comply. Acting on the
basis of fair and balanced information, the counterparty will also be
better equipped to make more informed investment decisions. The
Commission staff may also review this information in connection with
examinations and investigations.
5. Supervision
The requirement to establish and maintain a reasonably designed
system to supervise, and to diligently supervise, the business and the
activities of associated persons will assist an SBS Entity in
preventing violations of the applicable securities laws, rules and
regulations related to the business of an SBS Entity. The CCO may use
this information in discharging his or her duties under Rule 15Fk-1 and
in determining whether remediation efforts are required. The collection
of information will also be useful to supervisors in understanding and
carrying out their supervisory responsibilities. The Commission staff
may also review this information in connection with examinations and
investigations.
6. SBS Dealers Acting as Advisors to Special Entities
Certain information collected under Rule 15Fh-4(b) will help SBS
Dealers that act as advisors to special entities to make a reasonable
determination that they are acting in the best interests of those
special entities.
Other information collected under Rule 15Fh-2(a) will help SBS
Dealers establish that they are not acting as advisors to special
entities.
These collections of information will also assist CCOs in
determining whether an SBS Dealer has complied with relevant provisions
of the Exchange Act, as well as the rules and regulations thereunder.
The Commission staff may also review this information in connection
with examinations and investigations.
7. SBS Entities Acting as Counterparties to Special Entities
The information collected under Rule 15Fh-5(a) will assist an SBS
Entity in
[[Page 30089]]
forming a reasonable basis to believe that a special entity has a
qualified independent representative that meets the requirements of the
rule.
The written representations required under Rule 15Fh-5(b) will
assist in, and provide a safe harbor for, an SBS Entity forming a
reasonable basis as to the qualifications of the independent
representative, including representations that: (i) The special entity
has complied in good faith with written policies and procedures
reasonably designed to ensure its representative satisfies the
requirements of Rule 15Fh-5(a)(1), and that such policies and
procedures provide for ongoing monitoring of the performance of such
representative consistent with Rule 15Fh-5(a)(1); and that (ii) the
representative has policies and procedures designed to ensure that it
satisfies the requirements of Rule 15Fh-5(a)(1); meets the requirements
of Rule 15Fh-5(a)(1)(i), (ii), (iii), (vi) and (vii); and is legally
obligated to comply with the requirements of Rule 15Fh-5(a)(1) by
agreement, condition of employment, law, rule, regulation, or other
enforceable duty.
Disclosures under Rule 15Fh-5(c) regarding the capacity in which an
SBS Dealer is acting in connection with a security-based swap will
provide additional transparency to special entities as to any material
differences between the SBS Dealer's capacities and any other financial
transaction or service involving the counterparty to the special
entity, such as when an SBS Dealer is acting as a counterparty or
principal on the other side of a transaction with potentially adverse
interests.
These collections of information will also assist a CCO in
assessing the SBS Entity's compliance with relevant provisions of the
Exchange Act. The Commission staff may also review this information in
connection with examinations and investigations.
8. Political Contributions
Rule 15Fh-6 will deter SBS Dealers from participating, even
indirectly, in pay to play practices. In addition to assisting the SBS
Dealer and its CCO in supervising and assessing internal compliance
with the pay to play prohibitions, the Commission staff may also review
this information in connection with examinations and investigations.
9. Chief Compliance Officer
The information collected under Rule 15Fk-1 will assist the CCO in
overseeing and administering an SBS Entity's compliance with the
provisions of the Exchange Act and the rules and regulations thereunder
relating to its business as an SBS Entity. The Commission staff may
also review this information in connection with examinations and
investigations.
10. Foreign Branch Exception
Under the final rules, a registered major security-based swap
participant or registered security-based swap dealer is not subject to
the requirements relating to business conduct standards described in
section 15F(h) of the Act (15 U.S.C. 78o-10(h)), and the rules and
regulations thereunder, other than the rules and regulations prescribed
by the Commission pursuant to section 15F(h)(1)(B) of the Act, in
certain transactions conducted through the foreign branch of their
U.S.-person counterparty. For these purposes, the foreign branch of a
U.S. bank must be the counterparty to the security-based swap
transaction, and the transaction must be arranged, negotiated, and
executed on behalf of the foreign branch solely by persons located
outside the United States.\1508\
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\1508\ See Exchange Act rule 3a71-3(a)(3)(i).
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As discussed in the Cross-Border Proposing Release, the Commission
acknowledges that verifying whether a security-based swap transaction
falls within the definition of ``transaction conducted through a
foreign branch'' could require significant due diligence. The
definition's representation provision would mitigate the operational
difficulties and costs that otherwise could arise in connection with
investigating the activities of a counterparty to ensure compliance
with the corresponding rules.\1509\
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\1509\ See Cross-Border Proposing Release, 78 FR at 31107, supra
note 6.
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11. Substituted Compliance Rule
The Commission would use the information collected pursuant to
Exchange Act Rule 3a71-6, as adopted, to evaluate requests for
substituted compliance with respect to the business conduct
requirements applicable to security-based swap entities. The requests
for substituted compliance determinations are required when a person
seeks a substituted compliance determination.
Consistent with Exchange Act Rule 0-13(h), the Commission will
publish in the Federal Register a notice that a complete application
has been submitted, and provide the public the opportunity to submit to
the Commission any information that relates to the Commission action
requested in the application.
C. Respondents
In the Proposing Release, the Commission stated its belief that
approximately fifty entities may fit within the definition of SBS
Dealer and that up to five entities may fit within the definition of
Major SBS Participant.\1510\ Further, the Commission understands swap
and security-based swap markets to be integrated, and continues to
estimate that approximately thirty-five firms that may register as SBS
Entities will also be registered with the CFTC as Swap Entities.\1511\
As a result, these entities will also be subject to the business
conduct standards applicable to Swap Entities, which the CFTC adopted
in 2012. In addition, the Commission continues to estimate that
approximately sixteen registered broker-dealers will also register as
SBS Dealers.\1512\ In the Proposing Release, the Commission estimated
that fewer than eight firms not otherwise registered with the CFTC or
the Commission would register as SBS Entities. Based on an analysis of
updated DTCC data, the Commission now estimates that four registrants
would not otherwise be registered with the CFTC or the
Commission.\1513\
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\1510\ Proposing Release, 76 FR at 42442, supra note 3. See also
Registration Adopting Release, 80 FR at 48990, supra note 965.
\1511\ Proposing Release, 76 FR at 42442, supra note 3. See also
Registration Adopting Release, 80 FR at 48990, supra note 989.
\1512\ Proposing Release, 76 FR at 42442, supra note 3. See also
Registration Adopting Release, 80 FR at 48990, supra note 1129.
\1513\ See Registration Adopting Release, 80 FR at 48990, supra
note 1129.
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In the Proposing Release, the Commission estimated that there were
approximately 8,500 market participants, including approximately 1,200
special entities in the security-based swap markets.\1514\ Based on an
analysis of more recent DTCC data and our understanding of security-
based swap markets, we currently believe that there are approximately
10,900 market participants in the security-based swap market, of which
1,141 are special entities.\1515\ Of the 10,900 market participants, we
estimate approximately 68% of them (7,412) are also swap
[[Page 30090]]
market participants.\1516\ Based upon the number of registered
municipal advisors, we estimate that there are approximately 385 third-
party independent representatives for special entities.\1517\ In the
Proposing Release, we estimated that approximately 95% of special
entities would use a third-party independent representative.\1518\
Based on additional data from DTCC through 2014, the Commission
currently estimates that approximately 98% of special entities would
use a third-party independent representative in their security-based
swap transactions.\1519\ For purposes of calculating reporting burdens,
in the Proposing Release, we estimated that 60 special entities (the
remaining 5% of special entities), had employees who could serve as an
in-house independent representative.\1520\ The Commission currently
estimates that the remaining 2% of special entities, or 25 special
entities, have employees who currently negotiate on behalf of and
advise the special entity regarding security-based swap transactions,
and who could likely fulfill the qualifications and obligations of the
independent representative.\1521\ Consequently, the Commission
estimates a total of 410 potential independent representatives.\1522\
We received no comments on any of the foregoing estimates or our basis
for the estimates.
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\1514\ Proposing Release, 76 FR at 42442, supra note 3.
\1515\ As discussed in the economic baseline, estimates of the
number and type of market participants are based on hand
classifications of TIW data for 2006-2014. Our classifications are
not sufficiently granular to distinguish between ERISA special
entities, and special entities defined in, but not subject to ERISA,
and our estimates include both. Therefore, our estimates reflect
both ERISA special entities, and entities that may choose to opt out
of the special entity status under these final rules. See Sections
VI.B and Section VI.C.4.i, infra.
\1516\ This estimation assumes that the proportion of single
name CDS market participants that also use index CDS is
representative of the proportion of security-based swap market
participants that are swap market participants in 2014. See Section
VI.B.6, infra.
\1517\ As of January 1, 2016 there were 665 municipal advisors
registered with the Commission (http://www.sec.gov/help/foia-docs-muniadvisorshtm.html), of which 381 indicated that they expect to
provide advice concerning the use of municipal derivatives or advice
or recommendations concerning the selection of other municipal
advisors or underwriters with respect to municipal financial
products or the issuance of municipal securities. We expect that
many of these municipal advisors will also act as independent
representatives for other special entities. The Commission therefore
estimates that approximately 385 municipal advisors will act as
independent representatives to special entities with respect to
security-based swaps.
\1518\ Proposing Release, 76 FR at 42442, supra note 3.
\1519\ The estimate is based on available market data for
November 2006-December 2014 provided by DTCC that indicates
approximately 98% of special entities used registered or
unregistered third-party investment advisers in connection with
security-based swaps transactions.
\1520\ Proposing Release, 76 FR at 42442, supra note 3.
\1521\ The estimate is based on available market data for
November 2006-December 2014 provided by DTCC.
\1522\ The estimate is based on the following calculation: 385
third-party independent representatives + 25 in-house independent
representatives.
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In the Cross-Border Proposing Release, the Commission preliminarily
estimated that 50 entities may include a representation that a
security-based swap is a ``transaction conducted through a foreign
branch'' in their trading relationship documentation.\1523\ We estimate
that, consistent with the proposal, a total of 50 entities may incur
burdens under this collection of information, whether solely in
connection with the business conduct requirements being adopted in this
release or also in connection with the application of the de minimis
exception.\1524\
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\1523\ See Cross-Border Proposing Release, 78 FR at 31108, supra
note 6.
\1524\ See id. See also Cross-Border Adopting Release, 79 FR at
47366, supra note 193.
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Under the final rule related to substituted compliance,
applications for substituted compliance may be filed by foreign
financial authorities, or by non-U.S. SBS Entities. Based on the
analysis of recent data, the Commission staff expects that there may be
approximately 22 non-U.S. entities that potentially may register as SBS
Dealers, out of approximately 50 total entities that may register as
SBS Dealers.\1525\ Potentially, all such non-U.S. SBS Dealers, or some
subset thereof, may seek to rely on substituted compliance in
connection with these business conduct requirements.\1526\
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\1525\ See U.S. Activity Adopting Release, 81 FR at 8605, supra
note 17.
\1526\ Consistent with prior estimates, the Commission staff
further believes that there may be zero to five major security-based
swap participants. See Cross-Border Proposing Release, 78 FR at
31103, supra note 6. It is possible that some subset of those
entities will be non-U.S. major security-based swap participants
that will seek to rely on substituted compliance in connection with
the business conduct requirements.
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In practice, the Commission expects that the greater portion of any
such substituted compliance requests will be submitted by foreign
financial authorities, given their expertise in connection with the
relevant substantive requirements, and in connection with their
supervisory and enforcement oversight with regard to security-based
swap dealers and their activities.
D. Total Annual Reporting and Recordkeeping Burdens
As discussed in Section I.C., above, aspects of Rules 15Fh-1 to
15Fh-6 conform, to the extent practicable, to the business conduct
standards applicable to Swap Dealers or Major Swap Participants
promulgated by the CFTC.\1527\ Therefore, to the extent an SBS Entity
already complies with the CFTC's business conduct standards, the
Commission believes there will be minimal additional burden in
complying with the requirements under the Commission's business conduct
standards, as adopted.\1528\
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\1527\ See CFTC Adopting Release, supra note 21.
\1528\ Notably, the CFTC adopted its final rules in 2012.
Current estimates reflect the fact that the CFTC rules have been in
place since that time, and that registrants will not incur a de novo
burden in complying with the Commission's rules, which largely
conform to those of the CFTC. In addition, as noted in the Proposing
Release, some banks will register as SBS Dealers. Banking agencies,
such as the Office of the Comptroller of the Currency, have issued
guidance to national banks that engage in financial derivatives
transactions regarding business conduct procedures, and,
accordingly, the banks that may register as SBS Entities are also
likely already complying with similar requirements. See e.g., Risk
Management of Financial Derivatives, Office of Comptroller of the
Currency Banking Circular No. 277 (Oct. 27, 1993).
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Furthermore, a number of these rules are based on existing FINRA
rules. Accordingly, the Commission expects that the estimated 16 SBS
Entities that are also registered as broker-dealers are already
complying with a number of these requirements in the context of their
equities businesses.
1. Verification of Status
As discussed above, the Commission estimates that approximately 55
SBS Entities (of which we expect approximately 35 will be dually
registered with the CFTC as Swap Entities) will be required to verify
whether a counterparty is an ECP or special entity, as required by Rule
15Fh-3(a). These verification requirements are the same under the
business conduct standards adopted by the CFTC.\1529\ We understand
that industry has developed protocols and questionnaires that allow the
counterparty to indicate its status, whether or not it is a special
entity and whether it elects to be treated as a special entity.\1530\
As a result of these protocols and questionnaires, the Commission
continues to believe that these dually registered SBS Entities will not
incur any start-up or ongoing burdens in complying with the rules, as
adopted, because they already adhere to the relevant protocols to
obtain the information under the CFTC's business conduct standards. The
remaining 20 SBS Entities will each incur $500 in start-up burdens to
adhere to the protocols. In addition, each
[[Page 30091]]
counterparty that does not already adhere to the protocols will incur
$500 in start-up burdens to adhere to the protocols. In addition to the
$500 fee to adhere to the protocol, in order to adhere to the protocol,
an adherence letter must also be submitted, the form of which is
provided online. Accordingly, we conservatively estimate that one hour
will be needed to input the data required to generate the adherence
letter.\1531\ We do not anticipate any ongoing burdens with respect to
this rule. We anticipate that the parties will adhere to the protocol.
We also anticipate that in connection with each transaction, SBS
Entities will require counterparties to provide a certificate
indicating that there are no changes to the representations included in
the protocol and that reliance on those representations would be
reasonable.
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\1529\ See CFTC Adopting Release, 75 FR at 80658, supra note 21.
Accordingly, the SBS Entities that would also be registered as a
Swap Dealer or Major Swap Participant with the CFTC would have
verification procedures for engaging in swaps.
\1530\ See ISDA August 2012 DF Protocol at http://www2.isda.org/functional-areas/protocol-management/protocol/8 (``ISDA August 2012
DF Protocol'').
\1531\ In lieu of adhering to the protocol, market participants
may engage in bilateral negotiations either to obtain
representations regarding the status of the counterparty or the SBS
Entity may conduct due diligence to determine the status of the
counterparty. However, given the relatively low cost and time burden
to adhere to the protocol, we estimate that market participants will
choose to adhere to the protocol rather than pay counsel to
negotiate representations or conduct the necessary due diligence in
the absence of any indications that reliance on such representations
would not be reasonable. For the purposes of this estimate, we have
assumed that reliance on the representations in the protocol would
be reasonable.
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As noted above, the Commission believes that approximately 7,412 of
the 10,900 security-based swap market participants (which include SBS
Entities and counterparties) are also swap market participants and
likely already adhere to the relevant protocol.\1532\ These 7,412
market participants would not have any start-up burdens or ongoing
burdens with respect to verification. The remaining 3,488 market
participants would incur $500 each to adhere to the protocol for an
aggregate total of $1,744,000 and one hour for the adherence letter for
an aggregate total of 3,488 hours.\1533\
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\1532\ See supra Section V.C. regarding the estimate for the
number of market participants.
\1533\ Although we understand that ISDA offers bulk pricing for
multiple entities that are part of the same corporate group or for
fund families, we do not have the data as to how many of the 3,488
market participants are related entities that would be able to take
advantage of this bulk pricing. As a result, we have conservatively
estimated that each of the 3,488 market participants would incur the
$500 fee and the hour for the adherence letter.
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2. Disclosures by SBS Entities
Pursuant to Rule 15Fh-3(b), (c), and (d), SBS Entities would be
required to provide certain disclosures to market participants. Based
on the Commission's experience with burden estimates for similar
disclosure requirements,\1534\ as well as our discussions with market
participants,\1535\ we understand that the SBS Entities that are dually
registered with the CFTC already provide their counterparties with
disclosures similar to those required under Rules 15Fh-3(b) and (c). To
the extent that the material characteristics required by Rule 15Fh-
3(b)(1) are included in the documentation of a security-based swap,
such as the master agreement, credit support annex, trade confirmation
or other documents, the Commission does not believe that any additional
burden will be required for the disclosure of material characteristics.
For other required disclosures relating to material risks required by
Rule 15Fh-3(b)(1) or disclosures relating to material incentives or
conflicts of interest required by Rule 15Fh-3(b)(2), the Commission
understands that certain market participants have developed
standardized disclosures for some of these requirements.\1536\ For
example, many SBS Dealers already provide a statement of potential
risks related to investing in certain security-based swaps to their
counterparties. However, to the extent that an SBS Entity and
counterparty engage in a highly bespoke transaction, the standardized
disclosure may not satisfy all of the SBS Entities disclosure
requirements. In those cases, the SBS Entity will likely use a
combination of standardized disclosures and de novo disclosures to
fulfill its obligations under Rules 15Fh-3(b)(1) and (2).
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\1534\ For disclosures similar to the disclosure of
methodologies and assumptions of daily mark, see Disclosure of
Accounting Policies for Derivative Financial Instruments and
Derivative Commodity Instruments and Disclosure of Quantitative and
Qualitative Information about Market Risk Inherent in Derivative
Financial Instruments, Other Financial Instruments and Derivative
Commodity Instruments, Securities Act Release No. 7386 (Jan. 31,
1997), 62 FR 6044 (Feb. 10, 1997).
\1535\ See Proposing Release n. 14, 76 FR at 42398, supra note
3. See also, supra note 19 regarding a list of Commission staff
meetings with interested parties.
\1536\ See e.g., ISDA General Disclosure Statement for
Transactions (August 2015). To the extent that disclosures of
material risks and characteristics under Rule 15Fh-3(b)(1) or
disclosures of material incentives and conflicts of interest under
Rule 15Fh-3(b)(2) are initially provided orally, the additional
burden of providing a written version of the disclosure at or before
delivery of the trade confirmation pursuant to Rule 15Fh-3(b)(3)
will be considered in connection with the overall reporting and
recordkeeping burdens of the SBS Entity. See Recordkeeping Release,
supra note 242.
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In some cases, such as disclosures about the daily mark for a
cleared security-based swap, the SBS Entity is obligated to provide the
daily mark upon request. We understand that in the current model of
clearing security-based swaps, the security-based swap between the SBS
Entity and counterparty is terminated upon novation by the clearing
agency. The SBS Entity would no longer have any obligation to provide a
daily mark to the original counterparty because a security-based swap
no longer exists between them. Therefore, there would not be any
ongoing burden on the SBS Entity. Depending on how quickly the
security-based swap is cleared, there may not be an initial burden on
the SBS Entity either. Unlike the CFTC's rule, Rule 15Fh-3(c)(1) does
not require a pre-trade daily mark. So if the security-based swap is
cleared before the end of the next day and the clearing results in
novation of the original swap, the SBS Entity would not have any daily
mark obligations for the cleared swap.
For uncleared security-based swaps, the Commission believes that
SBS Entities may need to slightly modify the models used for
calculating variation margin to calculate the daily mark. In addition,
the SBS Entity will need to provide the counterparty with a description
of the methodologies and assumptions used to calculate the daily mark.
Nevertheless, existing accounting standards and other disclosure
requirements under the Exchange Act, such as FASB Accounting Standards
Codification Topic 820, Fair Value Measurements and Disclosures, or
Item 305 of Regulation S-K, require disclosures similar to the
description of the methodologies and assumptions of the daily mark. To
the extent that the model it uses and methodologies and assumptions are
not already prepared, the SBS Entity may need to prepare the initial
description of the data sources, methodologies and assumptions. In
addition, the SBS Entity will have an ongoing burden of updating the
disclosure for any material changes to the data sources, methodologies
and assumptions.
The Commission continues to believe that SBS Entities will use
internal staff to revise existing disclosures to comply with Rules
15Fh-3(b) and (c), and to assist in preparing language to comply with
Rule 15Fh-3(d) regarding the clearing options available for a
particular security-based swap. In addition, the requirements of Rule
15Fh-3(d) are not the same as the CFTC requirements to disclose
clearing choices, so SBS Entities will need to develop new disclosures.
The Commission estimates that in 2014 there has been approximately
740,700 security-based swap transactions between an SBS Dealer and a
counterparty that is not an SBS Dealer. Of these, the Commission
estimates that approximately 428,000 were new or
[[Page 30092]]
amended trades requiring these disclosures.\1537\ In view of the
factors discussed in the Economic Analysis section and elsewhere in
this release, the Commission recognizes that the time required to
develop an infrastructure to provide these disclosures will vary
significantly depending on, among other factors, the complexity and
nature of the SBS Entity's security-based swap business, its market
risk management activities, its existing disclosure practices, whether
the security-based swap is cleared or uncleared and other applicable
regulatory requirements. Under the rule, as adopted, SBS Entities could
make the required disclosures to their counterparties through
standardized documentation, such as a master agreement or other written
agreement, if the parties so agree. The Commission recognizes that it
will likely be necessary to prepare some disclosures that are
particular to a transaction to meet all of an SBS Entity's disclosure
obligations under Rules 15Fh-3(b), (c) and (d). The Commission also
believes that, because the reporting burden will generally require
refining or revising an SBS Entity's existing disclosure processes, the
disclosures will be prepared internally.
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\1537\ Available DTCC-TIW data for 2014 indicated approximately
740,700 transactions between SBS Entities and non-SBS Entities
during that time period. Of these, approximately 240,000 were new
trades, and 188,000 were amendments. Of the approximately 240,000
new trades between likely SBS Dealers and non-dealers, only 1,000
trades or approximately 0.5% were voluntarily cleared bilateral
trades in 2014.
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Given the foregoing, the Commission continues to conservatively
estimate that on average, SBS Entities will initially require three
persons from trading and structuring, three persons from legal, two
persons from operations, and four persons from compliance, for 100
hours each, to comply with the rules.\1538\ This team will analyze the
changes necessary to comply with the new disclosure requirements,
including the redesign of current compliance systems, if necessary, as
well as the creation of functional requirements and system
specifications for any systems development work that may be needed to
automate the disclosure process.\1539\ This will amount to an aggregate
initial burden of 66,000 hours.\1540\
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\1538\ In the Proposing Release, the Commission used this
estimate and it recognizes the development of market practice to
comply with very similar CFTC rules. It also recognizes that given
the current model used for clearing security-based swaps, daily mark
disclosures in that context are unlikely to be required.
Furthermore, no comments were received on these estimates. As a
result, the Commission conservatively continues to use these
estimates.
\1539\ Some SBS Entities may choose to utilize in-house counsel
to review, revise and prepare these disclosures.
\1540\ The estimate is based on the following calculation: (55
SBS Entities) x (12 persons) x (100 hours).
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Following the initial analysis and development of specifications,
the Commission continues to estimate that half of these persons will
still be required to spend 20 hours annually to re-evaluate and modify
the disclosures and system requirements as necessary, amounting to an
ongoing annual burden of 6,600 hours.\1541\ In addition, the Commission
estimates that on average, the SBS Entities will require one burden
hour per security-based swap to evaluate whether more particularized
disclosures are necessary for the transaction and to develop the
additional disclosures for an aggregate ongoing burden of 428,000
hours.\1542\
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\1541\ The estimate is based on the following calculation: (55
SBS Entities) x (6 persons) x (20 hours).
\1542\ The estimate is based on the following calculation:
(428,000 security-based swaps that require these disclosures) x (1
hour). The Commission realizes that some assessments may take less
time and some may take more. In addition, to the extent that
additional disclosures are required, drafting the disclosure is
likely to take more than an hour, but we expect the vast majority of
transactions will not require additional disclosures so that an
average of one hour per transaction is a reasonable estimate.
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The Commission also continues to estimate that, to create and
maintain an information technology infrastructure to the specifications
identified by the team of persons from trading and structuring, legal,
operations and compliance described above, each SBS Entity will
require, on average, eight full-time persons for six months of systems
development, programming and testing, amounting to a total initial
burden of 440,000 hours.\1543\ The Commission continues to estimate
that maintenance of this system will require two full-time persons for
a total ongoing burden of 220,000 hours annually.\1544\
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\1543\ The estimate is based on the following calculation: (55
SBS Entities) x (4 persons) x (2000 hours).
\1544\ The estimate is based on the following calculation: (55
SBS Entities) x (2 persons) x (2000 hours).
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3. Know Your Counterparty and Recommendations
As noted in the Proposing Release, the estimates in this paragraph
reflect the Commission's experience with and burden estimates for
similar collections of information, as well as our discussions with
market participants.\1545\ The Commission continues to believe that
most SBS Dealers already have policies and procedures in place for
knowing their counterparties, to comply with existing CFTC and FINRA
standards. The Commission estimates that, on average, the rules will
require each SBS Dealer to initially spend approximately five hours to
review existing policies and procedures and to document the collection
of information necessary to comply with its ``know your counterparty''
obligations--for a total initial burden of 250 hours. The Commission
also continues to estimate that an SBS Dealer will spend an average of
approximately 30 additional minutes each year per unique non-SBS Dealer
counterparty to assess whether the SBS Dealer is in compliance with the
rules' know your counterparty requirements--a total ongoing burden of
approximately 11,500 hours annually,\1546\ or an average of 230 hours
annually per SBS Dealer.\1547\
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\1545\ See Proposing Release n. 14, 76 FR at 42398, supra note
3. See also supra note 19 regarding a list of Commission staff
meetings with interested parties.
\1546\ The estimate is based on the following calculation:
(23,000 unique SBS Dealer--non-dealer counterparty pairs) x 30
minutes / 60 minutes. In the Proposing Release, the Commission
estimated 47,000 unique SBS Dealer--non-dealer counterparty pairs.
Based on updated DTCC-TIW data, we now estimate 23,000 SBS Dealer--
non-dealer counterparty pairs.
\1547\ To the extent that the SBS Dealer is unfamiliar with the
counterparty, the Commission would expect a greater time burden and
as an SBS Dealer becomes more familiar with the particular
counterparty, the Commission would expect a lesser time burden. As a
result, we use 30 minutes as an average estimate.
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In addition, the Commission estimates that the counterparties will
require approximately ten hours for each counterparty or its agent to
collect and provide essential facts to the SBS Dealer for a total
initial burden of 109,000 hours.\1548\
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\1548\ The estimate is based on 10,900 market participants x 10
hours.
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The Commission expects that, given the institutional nature of the
participants involved in security-based swaps, most SBS Dealers will
obtain the representations in Rules 15Fh-3(f)(2) and (3) to comply with
Rule 15Fh-3(f).\1549\ For the 1,141 special entities, we expect SBS
Entities will not act as an advisor pursuant to Rule 15Fh-2(a) and
accordingly, the burden estimates for the SBS Entities and special
entities are included in the context of the discussion for that rule,
infra. For the 7,412 security-based swap market participants that are
also swap market participants, including the thirty-five firms that we
expect to be dually registered as Swap Dealers and SBS Dealers, most of
the requisite
[[Page 30093]]
representations have been drafted for the swaps context.\1550\ We
understand that swap market participants are currently utilizing
standardized representations that are currently in Schedule 3 of the
ISDA August 2012 DF Protocol. The $50 million institutional suitability
threshold is consistent with the institutional suitability exception in
FINRA standards, but may require SBS Dealers to obtain an additional
representation or conduct due diligence to determine the counterparty
has total assets of at least $50 million. To the extent that any
modifications are necessary to adapt those representations to the
security-based swap context, we conservatively estimate that market
participants will each require two hours to assess the necessity and
make any necessary modifications for the security-based swap context
for an aggregate initial burden of 12,542 hours for the market
participants that participate in both the security-based swaps market
and the swaps market.\1551\ We do not anticipate any ongoing burden
with respect to the requisite representations because the
representations in the swaps context are deemed repeated ``as of the
occurrence of each Swap Communication Event'' and we would anticipate a
similar construction in the security-based swap context. For the
remaining 3,488 market participants, we expect that they will draft the
requisite representations to comply with the institutional suitability
analysis in Rule 15Fh-3(f)(2). We also anticipate that these 3,488
market participants are likely to model their representations on the
representations included in the ISDA August 2012 DF Protocol because
the SBS Entity is already familiar with those particular
representations. Accordingly, we estimate that the remaining 3,488
market participants will each require five hours to review and agree to
representations similar to those included in such protocol for an
aggregate initial burden of 17,440 hours.\1552\ Again, we do not
anticipate an ongoing burden for these representations for the reasons
set forth above.
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\1549\ The Commission bases its expectation on its observation
and experience in the context of transactions by broker-dealers with
institutional clients and the use of FINRA's institutional
suitability exception in that context.
\1550\ Of the 7,412 market participants that engage in both
swaps and security-based swaps, a proportion of them will also be
special entities. This calculation assumes all of the special
entities are engaged in transactions in both markets, leaving 6,271
market participants (7,412 market participants -1,141 special
entities) to adapt the representations in the ISDA August 2012 DF
Protocol to the security-based swap context, as necessary.
\1551\ This calculation is based on the assumption that all of
the special entities are engaged in both the swaps market and the
security-based swaps market and that the special entities will
choose to comply with the safe harbor of Rule 15Fh-5(b). (7,412
market participants -1,141 special entities) x (2 hours).
\1552\ This estimate is based on the following calculation:
(3,488 market participants) x (5 hours).
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4. Fair and Balanced Communications
Rule 15Fh-3(g) requires SBS Entities to communicate with
counterparties ``in a fair and balanced manner, based on principles of
fair dealing and good faith.'' The three specific standards of Rule
15Fh-3(g) require that: (1) Communications must provide a sound basis
for evaluating the facts with respect to any security-based swap or
trading strategy involving a security-based swap; (2) communications
may not imply that past performance will recur, or make any exaggerated
or unwarranted claim, opinion, or forecast; and (3) any statement
referring to the potential opportunities or advantages presented by a
security-based swap or trading strategy involving a security-based swap
shall be balanced by an equally detailed statement of the corresponding
risks.\1553\ We expect that a discussion of material risks of the
transaction will be included in the documentation for the security-
based swap. The Commission believes that all 55 SBS Entities will be
required to comply with Rule 15Fh-3(g), and that they will likely send
their existing marketing materials to outside counsel for review and
comment. Accordingly, the Commission continues to believe that each SBS
Entity will likely incur $6,000 in legal costs, or $330,000 in the
aggregate initial burden, to draft or review statements of potential
opportunities and corresponding risks in the marketing materials for
single name and narrow based index credit default swaps, total return
swaps and other security-based swaps.\1554\
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\1553\ To the extent that the 16 registered broker-dealers that
are expected to register as SBS Entities are also FINRA members,
they are already subject to these similar FINRA requirements in the
non-security based swap context. Cf. FINRA Rule 2210(d)(1)(D)
(``Members must ensure that statements are clear and not misleading
within the context in which they are made, and that they provide
balanced treatment of risks and potential benefits. Communications
must be consistent with the risks of fluctuating prices and the
uncertainty of dividends, rates of return and yield inherent to
investments.'') The Commission believes that this requirement
addresses concerns raised by a commenter that to be fair and
balanced, communications must inform investors of both the potential
rewards and risks of their investments. See Levin, supra note 5.
\1554\ The Commission estimates that the review of marketing
materials for these three categories of security-based swaps would
require 5 hours of outside counsel time, at an average cost of $400
per hour. This estimate also assumes that each SBS Entity engages in
all three categories of security-based swaps.
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The Commission additionally believes that compliance with Rule
15Fh-3(g) would require a review of SBS Entities' other communications
to their counterparties, such as emails and Bloomberg messages.
However, we believe that such additional communications would likely be
reviewed internally, by in-house legal counsel or an SBS Entity's CCO.
We estimate that the initial internal burden hours associated with this
review would be approximately six hours, for an aggregate total of 330
hours.\1555\
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\1555\ The Commission estimates that the review of additional
communications for these three categories of security-based swaps
would require internal burden hours for each of the 55 SBS Entities.
This estimate also assumes that each SBS Entity engages in all three
categories of security-based swaps.
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For more bespoke transactions, the cost for outside counsel to
review the marketing materials will depend on the complexity, novelty
and nature of the product, but the Commission expects a higher cost
associated with the review for more novel products. The Commission
accordingly estimates an initial, aggregate compliance cost for the
marketing materials relating to bespoke single name and narrow based
index credit default swaps, total return swaps and other security-based
swaps at $462,000.\1556\
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\1556\ The Commission estimates the review of the marketing
materials for each of these categories would require seven hours of
outside counsel time at a cost of $400 per hour. This estimate also
assumes that each SBS Entity engages in all three categories of
transactions.
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As stated above in Section II.G.5, Rule 15Fh-3(g) applies to
communications made before the parties enter into a security-based
swap, and continues to apply over the term of a security-based swap.
The Commission believes that the ongoing compliance costs associated
with the rule will likely be limited to a review of SBS Entities' email
communications sent to counterparties, which we believe will likely be
done by in-house counsel. We estimate that the ongoing compliance costs
of the rule will be approximately two burden hours, for an aggregate
total of 330 hours.\1557\
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\1557\ The Commission estimates that the review of additional
communications for these three categories of security-based swaps
would require two internal burden hours for each of the 55 SBS
Entities. This estimate also assumes that each SBS Entity engages in
all three categories of security-based swaps.
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5. Supervision
As outlined above, Rule 15Fh-3(h) requires an SBS Entity to
establish and maintain a system to supervise, and to diligently
supervise, its business and the activities of its associated persons.
Such a system shall be reasonably designed to prevent violations of the
provisions of applicable federal
[[Page 30094]]
securities laws and the rules and regulations thereunder relating to
its business as an SBS Entity. The written policies and procedures
required by Rule 15Fh-3(h) must include, at a minimum, procedures for
nine specific areas of supervision.
As for the number of SBS Entities respondents, the Commission
continues to estimate that approximately 55 SBS Entities (of which we
expect approximately 35 will be dually registered with the CFTC as Swap
Entities) will be required to comply with analogous supervision rules
like those required by Rule 15Fh-3(h).\1558\ The supervision
requirements in Rule 15Fh-3(h) are largely the same under the business
conduct standards and related rules adopted by the CFTC.\1559\
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\1558\ Proposing Release, 76 FR at 42442, supra note 3. See also
Registration Adopting Release, 80 FR at 48990, supra note 1129.
\1559\ See Commodity Exchange Act Rule 23.602. See also
Commodity Exchange Act Rule 23.402(a) (policies and procedures to
ensure compliance); Commodity Exchange Act Rule 3.3(d)(1)
(administration of compliance policies and procedures). Accordingly,
the SBS Entities that would also be registered as a swap dealer or
major swap participant with the CFTC would have supervision policies
and procedures for engaging in swaps.
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The estimates in this paragraph reflect the foregoing information,
as well as the Commission's general experience with and understanding
of the burden estimates in similar contexts, including, but not limited
to, FINRA's analogous supervision rules. While each of the nine written
policies and procedures required, at a minimum, by Rule 15Fh-3(h) will
vary in cost, the Commission continues to estimate that such policies
and procedures will require, on average, 210 hours per respondent, per
policy and procedure to initially prepare written policies and
procedures in order to establish a system to diligently supervise those
policies and procedures, or an average of 1,890 burden hours per SBS
Entity--resulting in an initial aggregate burden of 103,950
hours.\1560\ The Commission also continues to expect that many SBS
Entities will primarily rely on outside counsel for the collection of
information required under this rule at a rate of $400 per hour, for an
average of 450 hours per respondent, with a minimum of nine policies
and procedures, resulting in an outside initial cost burden of $180,000
per respondent--or an aggregate initial cost of $9,900,000.\1561\ Once
these policies and procedures are established, the Commission continues
to estimate that, on average, each SBS Entity will spend approximately
540 hours (approximately 60 hours per policy and procedure) each year
to maintain these policies and procedures, yielding a total ongoing
annual burden of approximately 29,700 internal burden hours (55 SBS
Entities x 540 hours).\1562\ The Commission believes that the
maintenance of these policies and procedures will be conducted
internally.
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\1560\ See Proposing Release, 76 FR at 42446, supra note 3. The
estimate is based on the following calculation: (210 hours) x (9
policies and procedures) x (55 SBS Entities). The estimates
reflected do not include the burden and cost of actually complying
with the underlying substance of these written policies and
procedures as that is beyond the scope of the PRA analysis.
\1561\ Some SBS Entities may choose to utilize in-house counsel
to initially prepare these policy and procedure, which would
mitigate the aggregate initial cost, but the Commission's estimate
of $9,900,000 reflects a conservative assumption of SBS Entities
primarily relying on outside counsel to prepare these materials.
\1562\ See Proposing Release, 76 FR at 42446, supra note 3.
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6. SBS Dealers Acting as Advisors to Special Entities
As discussed above, Rule 15Fh-4 imposes on SBS Dealers that act as
advisors to special entities a duty to make a reasonable determination
that any security-based swap or related trading strategy that the SBS
Dealer recommends is in the ``best interests'' of the special entity.
Rule 15Fh-2(a) states that an SBS Dealer ``acts as an advisor'' to a
special entity when it recommends a security-based swap or related
trading strategy to the special entity. However, the rule provides a
safe harbor whereby an SBS Entity will not be deemed an ``advisor'' if
an ERISA special entity counterparty relies on advice from an ERISA
fiduciary, or where any special entity counterparty relies on advice
from a qualified independent representative that acts in its best
interests.\1563\
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\1563\ Rule 15Fh-2(a)(1)-(2).
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In the Proposing Release, the Commission recognized the inherent
tensions that arise where SBS Dealers recommend a security-based swap
or related transaction to special entity counterparties.\1564\ Given
the parties' incentive to transact in security-based swaps, the
Commission believes that the parties are likely to resolve these
tensions by providing the necessary representations and disclosures to
meet the requirements of the safe harbor under Rule 15Fh-2(a)(1)-(2),
such that an SBS Dealer will not be deemed to act as an advisor to a
special entity, particularly for transactions in which the SBS Dealer
is the counterparty to the transaction.
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\1564\ See Proposing Release, 76 FR at 42424, supra note 3.
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Among swap dealers operating under the CFTC's parallel safe
harbor,\1565\ parties have generally included representations in
standard swap documentation that both counterparties are acting as
principals, and that the counterparty is not relying on any
communication from the swap dealer as investment advice. We believe
that SBS Dealers and their special entity counterparties will similarly
include the requisite representations in standard security-based swap
documentation. These representations will need to be reviewed and
revised to ensure that they comply with the rules the Commission adopts
today.
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\1565\ See CFTC Regulation Sec. 23.440(b)(1)-(2).
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As stated in the Proposing Release, the Commission continues to
believe that the 50 SBS Dealers will primarily rely on in-house counsel
for compliance with this rule, each of which will need approximately
five internal burden hours to draft, review and revise the
representations in its standard security-based swap documentation to
comply with Rule 15Fh-2(a)(1)-(2), for an initial aggregate burden of
250 hours.\1566\ The Commission also believes that, once an SBS Dealer
revises the language of the representations to meet the requirements of
Rule 15Fh-2(a)(1)-(2), such language will become part of the SBS
Dealer's standard security-based swap documentation and, accordingly,
there will be no further ongoing burden associated with this rule. For
transactions in which an SBS Dealer is not a counterparty and chooses
to act as an advisor, the Commission estimates that an SBS Entity will
require approximately 20 internal burden hours to collect the requisite
information from each special entity, for an aggregate initial burden
of approximately 1,700 hours.\1567\
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\1566\ See Proposing Release, 76 FR at 42446, supra note 3. This
estimate is based on multiplying the number of SBS Dealers (50) by
the number of estimated internal burden hours (5).
\1567\ This estimate is based on available market data for
November 2006-September 2014 provided by DTCC that indicates 85
unique pairs of SBS Dealers and U.S. special entities without a
third-party investment adviser. Based on 2014 single name CDS data
in DTCC-TIW, there were 2 unique trading relationships between
likely SBS Dealers and special entities without a third party
investment adviser, which entered into 272 new trades and 200
terminations, representing 0.039% of all transactions in 2014.
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7. SBS Entities Acting as Counterparties to Special Entities
Where a special entity is a counterparty to a security-based swap,
Rule 15Fh-5(a)(1) requires an SBS Entity to have a reasonable basis for
believing that the special entity has a qualified independent
representative
[[Page 30095]]
that meets specified requirements. Where the special entity
counterparty is an ERISA plan, under Rule 15Fh-5(a)(2), the SBS Entity
must have a reasonable basis to believe that the ERISA plan is
represented by an ERISA fiduciary. The Commission believes that written
representations will likely provide the basis for establishing an SBS
Entity's reasonable belief regarding the qualifications of the
independent representative.
As stated in the Proposing Release, the Commission continues to
believe that the burden for determining whether an independent
representative is independent of the SBS Entity will depend on the size
of the independent representative, the size of the SBS Entity, and the
volume of transactions with which each is engaged. The Commission
further believes that each SBS Entity would initially require written
representations regarding the qualifications of a special entity's
independent representative, but would only require updates to the
independent representative's qualifications in subsequent dealings with
the same independent representative throughout the duration of the swap
term, provided the volume and nature of the security-based swap
transaction remain the same.
Regarding the initial burden estimates for SBS Entities, the
Commission's updated estimates reflect that each SBS Entity will
interact with and be required to form a reasonable basis regarding the
qualifications of approximately 385 independent, third-party
representatives and 25 in-house independent representatives, for a
total of 410 independent representatives. In the Proposing Release, the
Commission estimated an average internal burden of 15 hours for each
SBS Entity per independent representative. We have increased this
estimate based on changes to the representations that SBS Entities will
have to obtain and now estimate that each SBS Entity, on average, will
initially require approximately 15.5 internal burden hours from the SBS
Entity's own in-house counsel per independent representative to collect
the information necessary to comply with this requirement. This will
result in an aggregate initial burden of 349,525 internal hours (15.5
hours x 410 independent representatives x 55 SBS Entities).\1568\ We do
not believe there will be any external burdens associated with this
rule.
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\1568\ While the Commission does not believe that every SBS
Entity is likely to deal with every independent representative, we
do not have data on the average number of independent
representatives with whom each SBS Entity would deal. Accordingly,
for the purposes of these calculations, we have assumed that each
SBS Entity will deal with each independent representative.
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With regard to SBS Entities' ongoing burden, the Commission
believes that such burden would be minimal, since, once an SBS Entity
forms a reasonable basis to believe that a given independent
representative meets the qualifications of Rule 15Fh-5, the SBS Entity
will not likely need to reaffirm that independent representative's
qualifications anew, but could instead rely on past representations
regarding the representative's qualifications. We estimate that SBS
Entities will incur an ongoing, aggregate burden of 22,500 hours (1
hour x 55 SBS Entities x 410 independent representatives) per year as a
result of this rule.
In addition to the burdens imposed on SBS Entities, Rule 15Fh-
5(a)(1) will also impose a burden on special entities' independent
representatives to collect the necessary information regarding their
relevant qualifications, and provide that information to the SBS Entity
and/or the special entity. The Commission continues to believe that the
reporting burden for the independent representative will consist of
providing written representations to the SBS Entity and/or the special
entity it represents. The Commission believes that the burden
associated with an independent representative's obligation to assess
its independence from the SBS Entity will likely depend on the size of
the independent representative, the size of the SBS Entity, the
interactions between the independent representative and the SBS Entity,
the policies and procedures of the independent representative and
depend less on the number of transactions in which the independent
representative is engaged. The policies and procedures of the
independent representative will facilitate its ability to quickly
assess, disclose, manage and mitigate any potential material conflicts
of interest. We now believe the number of transactions in which the
independent representative engages is less likely to impact this
assessment. Accordingly, we have updated our estimates.
We anticipate that independent representatives will rely on in-
house counsel to collect and submit the relevant documentation and
information regarding its qualifications. The Commission also estimates
that each independent representative, on average, will initially
require approximately 16 internal burden hours from its in-house
counsel per SBS Entity to collect the information necessary to comply
with this requirement.\1569\ This will result in an aggregate initial
burden of 360,800 internal hours (16 hours x 410 independent
representatives x 55 SBS Entities).
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\1569\ While the Commission does not believe that every
independent representative is likely to deal with every SBS Entity,
we do not have data on the average number of SBS Entities with whom
each independent representative would deal. Accordingly, for the
purposes of these calculations, we have assumed that each SBS Entity
will deal with each independent representative.
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As with SBS Entities' ongoing burden associated with this rule, the
Commission believes that the ongoing burden imposed on independent
representatives would be minimal, since, once the independent
representative has provided information regarding its qualifications to
the SBS Entity, the independent representative will not likely need to
collect or provide that information again, but could instead rely on a
bring down certificate that reflects past representations regarding its
qualifications. We estimate that independent representatives will incur
an ongoing, aggregate burden of 22,500 hours (1 hour x 55 SBS Entities
x 410 independent representatives) per year as a result of this
rule.\1570\ We do not believe there will be external burdens associated
with this rule.
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\1570\ We note that, in the Proposing Release, we based our
burden estimates for evaluating an independent representative's
qualifications on the underlying assumption that representations
regarding an independent representative's qualifications must be
provided prior to every transaction, and therefore the associated
burden calculations were transaction-specific. See Proposing
Release, 76 FR 42446-7, supra note 3. However, based on the observed
practices of swap market participants, we now believe that
representations regarding an independent representative's
qualifications need only be provided in the context of each
relationship with an SBS Entity. Our revised calculations, which are
now relationship-specific, reflect this shift in our underlying
assumption.
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8. Political Contributions
As noted above, the Commission believes that there will be
approximately 50 SBS Dealers subject to these rules, and estimates that
all of them will provide, or will seek to provide, security-based swap
services to municipal entities. SBS Dealers, in order to supervise and
assess internal compliance with the pay to play rules, will need to
collect information regarding the political contributions of SBS
Dealers and their covered associates. In addition, SBS Dealers' covered
associates will also need to collect and provide the information
required by these rules to SBS Dealers.
The Commission's estimates in this paragraph take into account the
burden of the covered associates and the SBS Dealers. These estimates
also reflect the
[[Page 30096]]
Commission's experience with and burden estimates for similar
requirements, as well as our discussions with market
participants.\1571\ Based on the foregoing, the Commission estimates
that it will take, on average, approximately 185 hours per SBS Dealer--
resulting in a total initial burden of 9,250 hours \1572\ to collect
the information regarding the political contributions of SBS Dealers
and their covered associates to assist SBS Dealer in their compliance
with the rule. The Commission believes that many SBS Dealers will
primarily rely on in-house counsel for the collection of information
required under this rule.
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\1571\ See Advisers Act Pay-to-Play Release, 75 FR 41018, 41061-
65, supra note 1100. See also supra note 19 regarding a list of
Commission staff meetings with interested parties.
\1572\ The estimate is based on the following calculation: (185
hours x 50 SBS Dealers).
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Additionally, we expect some SBS Dealers to incur one-time costs to
establish or enhance current systems to assist in their compliance with
the rule. These costs will vary widely among firms. Similar to the
estimates made by the Commission in connection with the Advisers Act
pay to play rule, we have also estimated that some small and medium
firms will incur start-up costs, on average, of $10,000, and larger
firms will incur, on average, $100,000. Assuming all SBS Dealers will
be larger firms, the initial cost to establish or enhance current
systems to assist in their compliance with the rule is estimated at
$5,000,000 for all SBS Dealers.\1573\ Nevertheless, we note that some
SBS Dealers may not incur any system costs if they determine a system
is unnecessary due to their limited number of employees, or their
limited number of municipal entity counterparties. Furthermore, like
other large firms, SBS Dealers have likely devoted significant
resources to automating compliance and reporting with respect to
regulations concerning certain political contributions. This rule
could, therefore, cause them to enhance the existing systems that had
originally been designed to comply with MSRB Rules G-37 and G-38 and
Advisers Act Rule 206(4)-5.
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\1573\ The initial cost is estimated at: 50 SBS Dealers x
$100,000 = $5,000,000. See Advisers Act Pay-to-Play Release, 75 FR
at 41061, supra note 1100 (estimating that larger firms will incur,
on average, $100,000, in start-up costs).
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The final rules also allow SBS Dealers to file applications for
exemptive relief, and outline a list of items to be addressed,
including, whether the SBS Dealer has developed policies and procedures
to monitor political contributions; the steps taken after discovery of
the contribution; and the apparent intent in making the contribution
based on the facts and circumstances of each case. The incidence of
exemptive relief related to MSRB Rule G-37 and the number of
applications the Commission has received under the Advisers Act Rule
206(4)-5 may be indicative of the possible applications for exemptive
relief under these final rules. Consistent with the Commission's
estimates in connection with Advisers Act Rule 206(4)-5, we also
estimate that a firm that applies for an exemption will hire outside
counsel to prepare an exemptive request, and estimate that the number
of hours counsel will spend preparing and submitting an application
between 16 hours to 32 hours, at a rate of $400 per hour. Recognizing
that this is an estimate, we conservatively estimate that the
Commission may receive up to two applications for exemptive relief per
year with respect to pay to play rules.\1574\ at a total ongoing cost
of $25,600 per year, assuming conservatively 32 hours for outside
counsel to prepare an exemptive request.\1575\
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\1574\ FINRA has granted 17 exemptive letters related to Rule G-
37 between 1/05 and 12/15 (11 years) http://www.finra.org/industry/exemptive-letters. In addition, the Commission has received 13
applications under the Adviser's act (since the compliance date,
approximately 4 years).
\1575\ Ongoing: (Outside counsel at $400 per hour x 32 hours per
application x 2) = $25,600. See Advisers Act Pay-to-Play Release, 75
FR at 41065, supra note 1100 (making similar estimates in connection
with Advisers Act Rule 206(4)-5).
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9. Chief Compliance Officer
Under Rule 15Fk-1, an SBS Entity's CCO is responsible for, among
other things, taking reasonable steps to ensure that the SBS Entity
establishes and maintains policies and procedures reasonably designed
to ensure compliance by the SBS Entity with the Exchange Act and the
rules and regulations thereunder relating to its business as an SBS
Entity. The Commission continues to estimate that, on average, the
establishment and administration of the policies and procedures
required under Rule 15Fk-1 (e.g., preparing an annual compliance report
and the SBS Entity's annual assessment of its written policies and
procedures reasonably designed to achieve compliance with Section 15F
and the rules and regulations thereunder) will require 630 hours to
create and 180 hours to administer per year per respondent, for a total
burden of 34,650 initial hours, and 9,900 hours per year on average, on
an ongoing basis.\1576\ The Commission also continues to estimate that
a total of $60,000 in outside legal costs will be incurred to, among
other things, assist in the preparation of the annual compliance report
and the SBS Entity's annual assessment of its written policies and
procedures, as a result of this burden per respondent, for a total
initial outside cost burden of $3,300,000.\1577\
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\1576\ See Proposing Release, 76 FR at 42448, supra note 3.
\1577\ See id. This figure is the result of an estimated $400
per hour cost for outside legal services times 150 hours for 3
policies and procedures for 55 respondents. See SDR Registration
Release, supra note 1202.
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A CCO will also be required to prepare and submit annual compliance
reports to the Commission and the SBS Entity's board of directors. In
the Proposing Release, the Commission estimated that these reports
would require on average 92 hours per respondent per year for an
ongoing annual burden of 5,060 hours. As a result of additional
descriptions that some CCOs will have to include in their annual
compliance reports, we now estimate that these reports will require on
average 93 hours per respondent per year for an ongoing annual burden
of 5,115.\1578\ Because the report will be submitted by an internal
CCO, the Commission does not expect any external costs associated
therewith.
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\1578\ The estimate is based on the following calculation: (93
hours) x (55 SBS Dealers).
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10. Foreign Branch Exception
The Commission estimates the one-time paperwork burden associated
with developing representations under this collection of information
would be, for each U.S. bank counterparty that may make such
representations to its registered Major SBS Participant or registered
SBS Dealer counterparty, no more than five hours, and up to $2,000 for
the services of outside professionals, for an estimate of approximately
250 hours and $100,000 across all security-based swap counterparties
that may make such representations.\1579\ This estimate assumes little
or no reliance on standardized disclosure language.
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\1579\ See Cross-Border Proposing Release, 78 FR at 31108, supra
note 6 (explaining that the Commission estimated that 50 entities
may include a representation that security-based swap is a
``transaction conducted through a foreign branch'' in their trading
relationship documentation).
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However, as the Commission has previously noted in connection with
this collection of information, in most cases, the representations
associated with the definition of ``transaction conducted through a
foreign branch'' are likely to be made through amendments to the
parties' existing trading documentation (e.g., the schedule to a
[[Page 30097]]
master agreement).\1580\ Because these representations relate to new
regulatory requirements, the Commission anticipates that U.S. bank
counterparties may elect to develop and incorporate these
representations in trading documentation soon after the effective date
of the Commission's security-based swap regulations, rather than
incorporating specific language on a transactional basis. The
Commission believes that parties would be able to adopt, where
appropriate, standardized language across all of their security-based
swap trading relationships.
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\1580\ See Cross-Border Adopting Release, 79 FR at 47366, supra
note 193. See also Cross-Border Proposing Release, 78 FR at 31108,
supra note 6 (noting that entities may include the representation in
their trading relationship documentation). The Commission believes
that because trading relationship documentation is established
between two counterparties, the question of whether one of those
counterparties is able to represent that it is entering into a
``transaction conducted through a foreign branch'' would not change
on a transaction-by-transaction basis and, therefore, such
representations would generally be made in the schedule to a master
agreement, rather than in individual confirmations.
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The Commission expects that the majority of the burden associated
with the new disclosure requirements will be experienced during the
first year as language is developed and trading documentation is
amended. After the new representations are developed and incorporated
into trading documentation, the Commission continues to believe that
the on-going paperwork burden associated with this requirement will be
10 hours per U.S. bank counterparty for verifying representations with
existing counterparties, for a total of approximately 500 hours across
all applicable U.S. bank counterparties.\1581\
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\1581\ The Commission staff estimates that this burden would
consist of 10 hours of in-house counsel time for each security-based
swap market participant that may make such representations. See
Cross-Border Adopting Release, 79 FR 47367 (estimating 10 hours per
counterparty for verification), supra note 193; Cross-Border
Proposing Release, 78 FR 31108 (same), supra note 6.
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11. Substituted Compliance Rule
Rule 3a71-6 under the Exchange Act would require submission of
certain information to the Commission to the extent that foreign
financial authorities or security-based swap dealers or major security-
based swap participants elect to request a substituted compliance
determination with respect to the Title VII business conduct
requirements. Consistent with Exchange Act Rule 0-13, such applications
must be accompanied by supporting documentation necessary for the
Commission to evaluate the request, including information regarding
applicable foreign requirements, and the methods used by foreign
authorities to monitor and enforce compliance.
The Commission expects that registered security-based swap dealers
and major security-based swap participants will seek to rely on
substituted compliance upon registration, and that it is likely that
the majority of such requests will be made during the first year
following the effective date of this substituted compliance rule.
Requests would not be necessary with regard to applicable rules and
regulations of a foreign jurisdiction that have previously been the
subject of a substituted compliance determination in connection with
the applicable rules.
In light of the provisions of the final rule and rule 0-13,
permitting substituted compliance applications to be made by foreign
regulatory authorities, the Commission expects that the great majority
of substituted compliance applications will be submitted by foreign
authorities, and that very few substituted compliance requests will
come from SBS Entities. For purposes of this assessment, the Commission
estimates that three such SBS Entities will submit such
applications.\1582\ The Commission estimates that the total one-time
paperwork burden incurred by such entities associated with preparing
and submitting a request for a substituted compliance determination in
connection with the business conduct requirements will be approximately
240 hours, plus $240,000 for the services of outside professionals for
all three requests.\1583\
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\1582\ This estimate differs from the Cross-Border Proposing
Release estimate, that there would be no more than 50 requests for
substituted compliance determinations pursuant to proposed Rule
3a71-5. See Cross-Border Proposing Release, 78 FR at 31110, supra
note 6. The revised estimate reflects our expectation that the large
majority of substituted compliance requests will be made by foreign
regulatory authorities, rather than by market participants.
\1583\ Consistent with the per-request estimates in the Cross-
Border Proposing Release, the Commission estimates that the
paperwork burden associated with making each such substituted
compliance request would be approximately 80 hours of in-house
counsel time, plus $80,000 for the services of outside professionals
(based on 200 hours of outside time * 400). See Cross-Border
Proposing Release, 78 FR at 31110, supra note 6.
In practice, those amounts may overestimate the costs of
requests pursuant to Rule 3a71-6 as adopted, as such requests would
solely address business conduct requirements, rather than the
broader proposed scope of substituted compliance set forth in that
proposal.
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E. Collections of Information are Mandatory
With the exception of the collection of information related to the
foreign branch exception, compliance with collection of information
requirements under these rules is mandatory for all SBS Dealers and SBS
Entities. 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 OMB control number.
Compliance with the collection of information requirements
associated with rule 3a71-6, regarding the availability of substituted
compliance, is mandatory for all foreign financial authorities or non-
U.S. SBS Entities that seek a substituted compliance determination.
F. Confidentiality
The forms that the Commission has adopted for use by applicants for
registration as security-based swap dealers or major security-based
swap participants provide for applicants to notify the Commission
regarding intended reliance on substituted compliance.\1584\ Also, the
Commission generally will make requests for substituted compliance
determination public, subject to requests for confidential treatment
being submitted pursuant to any applicable provisions governing
confidentiality under the Exchange Act.\1585\
---------------------------------------------------------------------------
\1584\ See Registration Adopting Release, 80 FR at 49049, supra
note 989 (questions 3A, B and C of Form SBSE-A, addressing potential
reliance on substituted compliance determinations)
\1585\ See SBS Entity Definitions Adopting Release, 79 FR at
47359, supra note 1451 (discussing confidentiality provisions under
the Exchange Act in connection with adopting Rule 0-13, governing
applications for substituted compliance).
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The representations provided in connection with the foreign branch
exception would be provided voluntarily by certain U.S. bank
counterparties to their registered SBS Dealer counterparties;
therefore, the Commission would not typically receive confidential
information as a result of this collection of information. However, to
the extent that the Commission receives confidential information
contained in a representation document through our examination and
oversight program, an investigation, or some other means, such
information would be kept confidential, subject to the provisions of
applicable law.
G. Retention Period of Recordkeeping Requirements
SBS Dealers will be required to retain records and information
relating to
[[Page 30098]]
these rules for the required retention periods specified in Exchange
Act Rule 17a-4.
VI. Economic Analysis
A. Introduction and Broad Economic Considerations
The Commission is sensitive to the costs and benefits imposed by
its rules. This section presents an analysis of the particular economic
effects--including costs, benefits and impact on efficiency,
competition, and capital formation--that may result from our final
rules. Section 3(f) of the Exchange Act requires the Commission, when
engaging in rulemaking that requires the Commission to consider or
determine whether an action is necessary or appropriate in the public
interest, to consider, in addition to the protection of investors,
whether the action will promote efficiency, competition, and capital
formation. Further, Section 23(a)(2) of the Exchange Act requires the
Commission, when adopting rules under the Exchange Act, to consider the
impact that any new rule would have on competition and to not adopt any
rule that would impose a burden on competition that is not necessary or
appropriate in furtherance of the purposes of the Exchange Act. In the
Proposing Release, the Commission solicited comments on all aspects of
the costs and benefits associated with the proposed rules, including
any effect the proposed business conduct rules may have on efficiency,
competition, and capital formation.\1586\ The Commission has considered
these comments and has modified some of the rules being adopted as
discussed in sections I, II and III, supra.
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\1586\ See Proposing Release, supra note 3.
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The business conduct rules as adopted implement the requirements
under Sections 15F(h) and 15F(k) of the Exchange Act as added by
Section 764(a) of the Dodd-Frank Act. As discussed in Section VI.C,
infra, the final rules include both requirements expressly addressed by
Title VII of the Dodd-Frank Act, as well as discretionary rules
designed to further the principles which underlie the statutory
requirements. These discretionary rules include requirements to make
certain additional disclosures; certain ``know your counterparty''
obligations; suitability obligations for SBS Dealers; prohibitions
against certain ``pay to play'' activities; and a requirement of board
approval for decisions related to the compensation or removal of the
CCO.
SBS Entities play a central role in intermediating transactions in
complex and opaque security-based swaps, and enjoy significant
informational advantages compared to their less sophisticated
counterparties. For instance, SBS Dealers observe quote solicitations
and order flow. SBS Dealers may also act as lenders, placement agents,
underwriters, structurers or securitizers of the securities underlying
security-based swaps. As a result of operating in such additional
capacities, SBS Dealers may have superior information about the quality
of security-based swaps and of securities underlying security-based
swaps. Major SBS Participants may have lower volumes of dealing
activity than SBS Dealers, but may hold large concentrated positions in
security-based swaps,\1587\ and may have specialized expertise in
pricing and trading security-based swaps. At the same time, less
informed and less sophisticated counterparties do not observe order
flow, may have less information concerning the risks and expected
returns of security-based swaps and reference securities, and may have
less expertise in valuing complex security-based swaps.
---------------------------------------------------------------------------
\1587\ See Definitions Adopting Release, 77 FR at 30751-30756,
supra note 115.
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In addition, SBS Dealers are for-profit entities with business
incentives that may be competing with those of their counterparties.
Due to the nature of their market making and intermediation roles, SBS
Dealers purchase security-based swaps from counterparties seeking to
sell them, and sell security-based swaps to counterparties seeking to
buy them. When SBS Dealers transact as principal risk holders and do
not hedge their exposures, they benefit from directional market moves
that result in losses for their counterparties. When SBS Dealers hedge
their exposures and do not carry balance sheet risk, they may be
indifferent to directional price moves of the security-based swap, but
profit from charging high fees to their counterparties, whereas their
counterparties benefit from low fees and transaction costs. If SBS
Dealers recommend security-based swaps to counterparties, such
recommendations may be influenced by the above business incentives.
Counterparties of SBS Dealers may be aware of these competing
incentives, and SBS Dealers generally benefit from intermediating a
greater volume of trades, potentially mitigating these effects.
However, informational asymmetries between SBS Dealers and their
counterparties outlined above may limit the ability of counterparties
to decouple the potential biases and information components of SBS
Dealer recommendations, and to evaluate the merits of each security-
based swap.
Broadly, these external business conduct rules as adopted may
decrease informational asymmetries between SBS Entities and their less
sophisticated counterparties and strengthen counterparty protections.
This may enable market participants to make better informed investment
decisions, and enhance allocative efficiency in security-based swap
markets.
The baseline for our economic analysis reflects rules adopted as
part of the SBS Entity Definitions Adopting Release, the Cross-Border
Adopting Release, Regulation SBSR and SDR Rules,\1588\ as well as SBS
Entity registration rules. We also recognize that final U.S. Activity
rules have been adopted, and affect the scope of cross-border
transactions that will become subject to various substantive Title VII
requirements, including those related to business conduct standards.
While these rules are not yet in effect, to perform a meaningful
analysis of the business conduct requirements being adopted and their
cross-border application, our baseline includes the final U.S. Activity
rules.\1589\
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\1588\ 17 CFR 232.11, 232.101, 232.305, and 232.407; 17 CFR
240.13n-1 to 240.13n-12 (``SDR Rules''). See SDR Registration
Release, supra note 1202.
\1589\ See U.S. Activity Adopting Release, 81 FR at 8598.
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Title VII provides a statutory framework for the OTC derivatives
market and divides authority to regulate that market between the CFTC
(which regulates swaps) and the Commission (which regulates security-
based swaps). We note that many entities expected to register with the
Commission as SBS Entities are currently intermediating large volumes
of transactions across swap, security-based swap and reference security
markets. The Commission has previously estimated that of the total 55
entities expected to register with the Commission as SBS Entities, up
to 35 entities are registered with the CFTC as Swap Entities, and up to
16 entities are registered with the Commission as broker-dealers.\1590\
Since broker-dealers registered with the Commission and Swap Entities
registered with the CFTC are required to join an SRO, the majority of
SBS Entities may already be subject to CFTC and SRO oversight.
Therefore, we anticipate that many of the entities
[[Page 30099]]
expected to register as SBS Entities and become subject to the
Commission's final business conduct rules may have already brought
their business into compliance with CFTC business conduct requirements
and SRO rules, among others. The Commission has sought to harmonize, to
the extent practicable, the final business conduct requirements with
existing requirements applicable to SBS Dealers and broker-dealers.
Obligations imposed on SBS Entities in this rulemaking are modeled on,
and largely similar to, obligations applicable to Swap Entities and
registered broker-dealers. These obligations include disclosure, know-
your-customer, suitability, pay-to-play, supervision, and compliance
responsibilities. The Commission has also considered the implications
of certain business conduct rules regarding special entities subject to
ERISA. DOL staff has stated that the final business conduct standards
neither conflict with DOL regulations nor compel SBS Entities to engage
in fiduciary conduct, as discussed in Section II.D supra.
---------------------------------------------------------------------------
\1590\ See Registration Adopting Release, 80 FR at 49000, supra
note 989. Also see U.S. Activity Proposing Release, 80 FR at 27458,
supra note 9.
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As discussed in the economic baseline, extensive cross-market
participation of dealers and non-dealer counterparties in swap,
security-based swap and reference security markets points to a high
degree of market integration. The Commission has sought to harmonize,
to the extent practicable, final business conduct requirements with
other existing rules, which may result in efficiencies and lower
incremental economic costs for cross-registered SBS Entities and their
counterparties than might have otherwise resulted.\1591\
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\1591\ A number of commenters recommended the Commission to
harmonize external business conduct rules with those of the CFTC.
See, e.g., Barnard, supra note 5; Levin, supra note 5; APPA, supra
note 5; BlackRock, supra note 5; NABL, supra note 5; Nomura, supra
note 5; AFGI (July 2013), supra note 5; ISDA (July 2013), supra note
5; Barnard (July 2015), supra note 10; and SIFMA (August 2015),
supra note 5.
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Nonetheless, the Commission recognizes--as reflected in the
economic analysis--that the final rules establish new requirements
applicable to SBS Entities, and that complying with these requirements
will entail costs to SBS Entities. In considering the economic
consequences of these final rules we have been mindful of the direct
and indirect costs these rules will impose on market participants, as
well as the effect of various business conduct requirements on the
ability of counterparties to transact with SBS Entities. We have
considered the likely costs and benefits of the final business conduct
requirements for SBS Entities, counterparties in security-based swap
markets, investors in reference security markets, as well as
stakeholders in special entities, such as taxpayers, pension holders,
endowment beneficiaries, and investors in municipal securities. We have
also considered how various types of market participants may respond to
the obligations and safe harbors in these final rules.
Some of these final rules impose requirements on SBS Dealers only,
whereas others apply to transactions by both SBS Dealers and Major SBS
Participants. These final rules have considered potential differences
between the roles SBS Dealers and Major SBS Participants in security-
based swap markets. As discussed in the sections that follow,
registered SBS Dealers are expected to intermediate large volumes of
security-based swaps and to transact with many hundreds or thousands of
counterparties, whereas Major SBS Participants will be holding
significant positions in SBS without intermediating significant volumes
of deals.\1592\ As discussed in Regulation SBSR, SBS Dealers manage
large changes in exposure to reference entities (inventory risk).\1593\
Large CDS transactions on a particular reference entity create large
inventory positions that affect SBS Dealers' exposure to the credit
risk of reference assets. SBS Dealers may actively manage inventory
risks that they do not want to bear by entering into offsetting
contracts that diversify or hedge new risk exposures. Doing so requires
finding market participants, typically in the interdealer market, who
are willing to act as counterparties to these offsetting
contracts.\1594\ Further, as discussed above, SBS Dealers observe order
flow and may be involved in arranging or structuring security-based
swaps, enjoying informational advantages relative to their non-dealer
counterparties. In contrast, participants required to register as Major
SBS Participants will have accumulated large positions in security-
based swaps but have dealing activity below the de minimis threshold.
As a result of their substantial positions, Major SBS Participants may
be susceptible to market risks. We have considered these differences in
risks arising from the security-based swap activity of the two types of
SBS Entities.
---------------------------------------------------------------------------
\1592\ See Definitions Adopting Release, 77 FR at 30751-30756,
supra note 115.
\1593\ See Regulation SBSR Adopting Release, 80 FR at 14617,
infra note 1602.
\1594\ See ``Inventory risk management by dealers in the single-
name credit default swap market'' (October 17, 2014) at 5, available
at http://www.sec.gov/comments/s7-34-10/s73410-184.pdf. The analysis
uses DTCC-TIW data to describe how SBS Dealers manage inventory risk
by hedging. Also see FN14 citing to Hansch, Oliver, Narayan Y. Naik,
and S. Viswanathan. ``Do inventories matter in dealership markets?
Evidence from the London Stock Exchange.'' The Journal of Finance
53, no. 5 (1998): 1623-1656.
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We have also taken into account comments regarding the different
application of various business conduct requirements to SBS Dealers and
Major SBS Participants,\1595\ including one comment that imposition of
``dealer-like'' obligations on Major SBS Participants may undermine
market development, and reduce competition and counterparty
choice.\1596\ The Commission recognizes that SBS Dealers serve as the
points of connection in security-based swap markets, whereas Major SBS
Participants may have greater market impacts and risks associated with
holding larger security-based swap positions. As discussed in Section
II, these final rules are intended to provide counterparty protections
and reduce information asymmetries. The Commission is imposing
counterparty status verification, disclosure, fair and balanced
communications, supervision, antifraud, CCO rules and rules related to
counterparties of special entities on both SBS Dealers and Major SBS
Participants. The final rules limit the scope of ``know your
counterparty'', suitability, pay to play and certain special entity
rules to SBS Dealers. Therefore, counterparties of Major SBS
Participants, as well as counterparties of SBS Dealers, may benefit
from counterparty protections and information benefits of these final
rules. At the same time, Major SBS Participants will not be subject to
the full range of business conduct obligations where business conduct
requirements are not expressly addressed by the Dodd-Frank Act or the
statute applies a requirement only to SBS Dealers. We further discuss
these considerations in the sections that follow.
---------------------------------------------------------------------------
\1595\ See, e.g., MFA, supra note 5; Blackrock, supra note 5;
CFA, supra note 5.
\1596\ See MFA, supra note 5.
---------------------------------------------------------------------------
We recognize that costs of rules imposed on Major SBS Participants
may be passed on to counterparties in the form of transaction costs or
a decreased willingness to intermediate transactions with non-SBS or
Swap Entity counterparties. As reflected in the economic baseline, the
Commission estimates that of the 55 SBS Entities that may register with
the Commission, between zero and five entities may be Major SBS
Participants. The
[[Page 30100]]
Commission also estimates that non-SBS Entity counterparties may
transact with a median of three and an average of four SBS Dealers per
year. Should Major SBS Participants become less willing to transact
with non-SBS or Swap Entity counterparties, SBS Dealers are likely to
step in to intermediate OTC trades. As articulated in prior sections,
the Commission believes that imposing certain final business conduct
rules on both SBS Dealers and Major SBS Participants may reduce
information asymmetries and enhance counterparty protections in
security-based swap markets.
Final business conduct rules reflect the informational advantage of
SBS Entities relative to other market participants. SBS Dealers enjoy
informational advantages over their non-SBS Entity counterparties. As
we quantify in the economic baseline, inter-dealer transactions play a
significant role in security-based swap markets, and security-based
swap activity is highly concentrated among a small number of dealers.
SBS Dealers observe deal flow, and may act in other capacities, such as
in the capacity of underwriters or arrangers, in relation to reference
securities underlying security-based swaps. Major SBS Participants may
also be better informed about the risks and valuations of security-
based swaps due to their large positions in security-based swaps.
Therefore, compared to other counterparties, both SBS Dealers and Major
SBS Participants may be better informed and better able to assess
material risks and characteristics of security-based swaps. Final
disclosure and suitability rules are limited to security-based swap
activities between SBS Entities and counterparties that are not
themselves SBS or Swap Entities. Other external business conduct rules
explicitly address conduct of SBS Entities when they act as
counterparties or advisors to special entities, such as employee
benefit plans, municipalities and endowments.
The Commission has considered counterparty protections, information
asymmetries and risks arising from arm's length and inter-affiliate
transactions. Inter-affiliate transactions may be conducted for the
purposes of internal risk management within a commonly controlled
corporate group with generally aligned incentives and few informational
asymmetries, and may involve the same personnel acting in or on behalf
of both parties. Imposing business conduct requirements on transactions
among various control affiliates of the same SBS Entity is less likely
to result in counterparty protections, informational benefits or
improvements in allocative efficiency, but would result in additional
costs and execution delays for SBS Entities.\1597\ Similar to the
CFTC's adopted approach, the final business conduct rules 240.15Fh-
3(a)-(f), 240.15Fh-4(b), and 240.15F-5 will apply to arm's length
transactions and exclude transactions that SBS Entities enter into with
their majority-owned affiliates.
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\1597\ As discussed in Section II.A, supra, all commenters
recommended not applying these final rules to inter-affiliate
transactions. See ABA Securities Association, supra note 5; FIA/
ISDA/SIFMA, supra note 5; SIFMA (August 2015), supra note 5.
---------------------------------------------------------------------------
The Commission notes that, where possible, it has attempted to
quantify the costs, benefits, and effects on efficiency, competition,
and capital formation expected to result from adopting these rules. In
many cases, however, the Commission is unable to quantify the economic
effects. Crucially, many of the relevant economic effects, such as
counterparty protections, information asymmetry, the ability of less
informed market participants to overcome information asymmetries, and
the value of Commission enforcement and oversight, are inherently
difficult to quantify. In other cases, we lack the information
necessary to provide reasonable estimates. For example, we lack data on
business conduct practices of U.S. SBS Entities' foreign branches;
profitability of SBS Dealer and Major SBS Participant transactions at
various volume levels, by type (SEF execution versus OTC/bespoke) and
by counterparty (other SBS and Swap Entities, special entities, all
other counterparties); the magnitude of the conflicts of interest
related to the ``pay to play'' practices by SBS Entities with respect
to special entities and the degree of reliance of dually registered SBS
Entities on covered associates already subject to similar prohibitions;
and how SBS Entities, new entrants, and counterparties, including those
currently not transacting in security-based swap markets, may react to
specific business conduct rules. To the best of our knowledge, no such
data are publicly available and commenters have not provided data to
allow such quantification.
B. Baseline
To assess the economic impact of the final rules described in this
release, we are using as our baseline the security-based swap market as
it exists at the time of this release, including applicable rules we
have already adopted but excluding rules that we have proposed but not
yet finalized.\1598\ The analysis includes the statutory provisions
that currently govern the security-based swap market pursuant to the
Dodd-Frank Act, and rules adopted in the Definitions Adopting Release,
the Cross-Border Adopting Release,\1599\ the SDR Registration
Release,\1600\ the SBS Entity Registration Adopting Release,\1601\ and
the Regulation SBSR Adopting Release,\1602\ along with U.S. Activity
rules,\1603\ as these final rules--even if compliance is not yet
required--are part of the existing regulatory landscape that market
participants expect to govern their security-based swap activity.
---------------------------------------------------------------------------
\1598\ We also considered, where appropriate, the impact of
rules and technical standards promulgated by other regulators, such
as the CFTC and the European Securities and Markets Authority, on
practices in the security-based swap market.
\1599\ See Cross-Border Adopting Release, supra note 684.
\1600\ See SDR Registration Release, supra note 1202.
\1601\ See Registration Adopting Release, supra note 989.
\1602\ See ``Regulation SBSR-Reporting and Dissemination of
Security-Based Swap Information,'' Exchange Act Release No. 74244
(Feb. 11, 2015), 80 FR 14563 (Mar. 19, 2015) (``Regulation SBSR
Adopting Release'').
\1603\ See U.S. Activity Adopting Release 81 FR 8598.
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The business conduct rules include a variety of standards for
conduct by SBS Entities when they transact with counterparties. While
certain requirements apply to SBS Entity transactions with all
counterparties, some requirements will affect only SBS Entity
transactions with non-SBS or Swap Entities, others distinguish between
SBS Dealers and Major SBS Participants, and yet others offer relief for
anonymous transactions. The following sections describe current
security-based swap market activity, participants, common dealing
structures, counterparties, and patterns of cross-border and cross-
market participation.
1. Available Data Regarding Security-Based Swap Activity
Our understanding of the market is informed in part by available
data on security-based swap transactions, though we acknowledge that
limitations in the data limit the extent to which we can quantitatively
characterize the market.\1604\ Because these data do not cover the
entire market, we have developed an understanding of market activity
using a sample of transactions data that includes only certain portions
[[Page 30101]]
of the market. We believe, however, that the data underlying our
analysis here provide reasonably comprehensive information regarding
single-name CDS transactions and the composition of participants in the
single-name CDS market.
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\1604\ We also rely on qualitative information regarding market
structure and evolving market practices provided by commenters, both
in letters and in meetings with Commission staff, and knowledge and
expertise of Commission staff.
---------------------------------------------------------------------------
Specifically, our analysis of the state of the current security-
based swap market is based on data obtained from the DTCC Derivatives
Repository Limited Trade Information Warehouse (``TIW''), especially
data regarding the activity of market participants in the single-name
CDS market during the period from 2008 to 2014. According to data
published by the Bank for International Settlements (``BIS''), the
global notional amount outstanding in single-name CDS was approximately
$9.04 trillion,\1605\ in multi-name index CDS was approximately $6.75
trillion, and in multi-name, non-index CDS was approximately $611
billion. The total gross market value outstanding in single-name CDS
was approximately $366 billion, and in multi-name CDS instruments was
approximately $227 billion.\1606\ The global notional amount
outstanding in equity forwards and swaps as of December 2014 was $2.50
trillion, with total gross market value of $177 billion.\1607\ As these
figures show (and as we have previously noted), although the definition
of security-based swaps is not limited to single-name CDS, single-name
CDS contracts make up a majority of security-based swaps, and we
believe that the single-name CDS data are sufficiently representative
of the market to inform our analysis of the state of the current
security-based swap market.\1608\
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\1605\ The global notional amount outstanding represents the
total face amount used to calculate payments under outstanding
contracts. The gross market value is the cost of replacing all open
contracts at current market prices.
\1606\ See semi-annual OTC derivatives statistics at December
2014, Table 19, available at http://www.bis.org/statistics/dt1920a.pdf (accessed Jul. 29, 2015).
\1607\ These totals include both swaps and security-based swaps,
as well as products that are excluded from the definition of
``swap,'' such as certain equity forwards.
\1608\ While other repositories may collect data on transactions
in total return swaps on equity and debt, we do not currently have
access to such data for these products (or other products that are
security-based swaps). Consistent with the Cross-Border Proposing
Release, we believe that data related to single-name CDS provide
reasonably comprehensive information for purposes of this analysis,
as such transactions appear to constitute roughly 74 percent of the
security-based swap market as measured on the basis of gross
notional outstanding. See Cross-Border Proposing Release, 78 FR
31120 n.1301.
Also consistent with our approach in that release, with the
exception of the analysis regarding the degree of overlap between
participation in the single-name CDS market and the index CDS market
(cross-market activity), our analysis below does not include data
regarding index CDS as we do not currently have sufficient
information to classify index CDS as swaps or security-based swaps.
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We note that the data available to us from TIW do not encompass
those CDS transactions that both: (i) Do not involve U.S.
counterparties; \1609\ and (ii) are based on non-U.S. reference
entities. Notwithstanding this limitation, the TIW data should provide
sufficient information to permit us to identify the types of market
participants active in the security-based swap market and the general
pattern of dealing within that market.\1610\
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\1609\ Following publication of the Warehouse Trust Guidance on
CDS data access, TIW surveyed market participants, asking for the
physical address associated with each of their accounts (i.e., where
the account is organized as a legal entity). This physical address
is designated the registered office location by TIW. When an account
reports a registered office location, we have assumed that the
registered office location reflects the place of domicile for the
fund or account. When an account does not report a registered office
location, we have assumed that the settlement country reported by
the investment adviser or parent entity to the fund or account is
the place of domicile. Thus, for purposes of this analysis, we have
classified accounts as ``U.S. counterparties'' when they have
reported a registered office location in the United States. We note,
however, that this classification is not necessarily identical in
all cases to the definition of ``U.S. person'' under Exchange Act
rule 3a71-3(a)(4).
\1610\ The challenges we face in estimating measures of current
market activity stem, in part, from the absence of comprehensive
reporting requirements for security-based swap market participants.
The Commission has adopted rules regarding trade reporting, data
elements, and public reporting for security-based swaps that are
designed to, when fully implemented, provide the Commission with
additional measures of market activity that will allow us to better
understand and monitor activity in the security-based swap market.
See Regulation SBSR Adopting Release, 80 FR at 14699-14700, supra
note 1602.
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2. Security-Based Swap Market: Market Participants and Dealing
Structures
a. Security-Based Swap Market Participants
Activity in the security-based swap market is concentrated among a
relatively small number of entities that act as dealers in this market.
In addition to these entities, thousands of other participants appear
as counterparties to security-based swap contracts in our sample, and
include, but are not limited to, investment companies, pension funds,
private (hedge) funds, sovereign entities, and industrial companies. We
observe that most non-dealer users of security-based swaps do not
engage directly in the trading of swaps, but trade through banks,
investment advisers, or other types of firms acting as dealers or
agents. Based on an analysis of the counterparties to trades reported
to the TIW, there are 1,875 entities that engaged directly in trading
between November 2006 and December 2014.\1611\
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\1611\ These 1,875 entities, which are presented in more detail
in Table 1, below, include all DTCC-defined ``firms'' shown in TIW
as transaction counterparties that report at least one transaction
to TIW as of December 2014. The staff in the Division of Economic
and Risk Analysis classified these firms, which are shown as
transaction counterparties, by machine matching names to known
third-party databases and by manual classification. See, e.g.,
Cross-Border Proposing Release, 78 FR 31120, n. 1304, supra note 6.
Manual classification was based in part on searches of the EDGAR and
Bloomberg databases, the SEC's Investment Adviser Public Disclosure
database, and a firm's public Web site or the public Web site of the
account represented by a firm. The staff also referred to ISDA
protocol adherence letters available on the ISDA Web site.
---------------------------------------------------------------------------
As shown in Table 1, below, close to three-quarters of these
entities (DTCC-defined ``firms'' shown in TIW, which we refer to here
as ``transacting agents'') were identified as investment advisers, of
which approximately 40 percent (about 30 percent of all transacting
agents) were registered as investment advisers under the Advisers
Act.\1612\ Although investment advisers comprise the vast majority of
transacting agents, the transactions they executed account for only
11.5 percent of all single-name CDS trading activity reported to the
TIW, measured by number of transaction-sides (each transaction has two
transaction sides, i.e., two transaction counterparties). The vast
majority of transactions (83.7 percent) measured by number of
transaction-sides were executed by ISDA-recognized dealers.
---------------------------------------------------------------------------
\1612\ See 15 U.S.C. 80b1-80b21. Transacting agents participate
directly in the security-based swap market, without relying on an
intermediary, on behalf of principals. For example, a university
endowment may hold a position in a security-based swap that is
established by an investment adviser that transacts on the
endowment's behalf. In this case, the university endowment is a
principal that uses the investment adviser as its transacting agent.
[[Page 30102]]
Table 1--The Number of Transacting Agents by Counterparty Type and the Fraction of Total Trading Activity, From
November 2006 Through December 2014, Represented by Each Counterparty Type \1613\
----------------------------------------------------------------------------------------------------------------
Transaction
Transacting agents Number Percent share
(percent)
----------------------------------------------------------------------------------------------------------------
Investment advisers............................................. 1,425 76.0 11.5
--SEC registered............................................ 571 30.5 7.7
Banks........................................................... 252 13.4 4.3
Pension Funds................................................... 27 1.4 0.1
Insurance Companies............................................. 38 2.0 0.2
ISDA-Recognized Dealers \1614\.................................. 17 0.9 83.7
Other........................................................... 116 6.2 0.2
-----------------------------------------------
Total................................................... 1,875 99.9 100
----------------------------------------------------------------------------------------------------------------
Principal holders of CDS risk exposure are represented by
``accounts'' in the TIW.\1615\ The staff's analysis of these accounts
in TIW shows that the 1,875 transacting agents classified in Table 1
represent 10,900 principal risk holders. Table 2, below, classifies
these principal risk holders by their counterparty type and whether
they are represented by a registered or unregistered investment
adviser.\1616\ For instance, banks in Table 1 allocated transactions
across 327 accounts, of which 23 were represented by investment
advisers. In the remaining 304 instances, banks traded for their own
accounts. Meanwhile, ISDA-recognized dealers in Table 1 allocated
transactions across 75 accounts.
---------------------------------------------------------------------------
\1613\ Adjustments to these statistics reflect updated
classifications of counterparties and transactions classification
resulting from further analysis of the TIW data.
\1614\ For the purpose of this analysis, the ISDA-recognized
dealers are those identified by ISDA as belonging to the G14 or G16
dealer group during the period: JP Morgan Chase NA (and Bear
Stearns), Morgan Stanley, Bank of America NA (and Merrill Lynch),
Goldman Sachs, Deutsche Bank AG, Barclays Capital, Citigroup, UBS,
Credit Suisse AG, RBS Group, BNP Paribas, HSBC Bank, Lehman
Brothers, Soci[eacute]t[eacute] G[eacute]n[eacute]rale, Credit
Agricole, Wells Fargo and Nomura. See, e.g., http://www.isda.org/c_and_a/pdf/ISDA-Operations-Survey-2010.pdf.
\1615\ ``Accounts'' as defined in the TIW context are not
equivalent to ``accounts'' in the definition of ``U.S. person''
provided by Exchange Act rule 3a71-3(a)(4)(i)(C). They also do not
necessarily represent separate legal persons. One entity or legal
person may have multiple accounts. For example, a bank may have one
DTCC account for its U.S. headquarters and one DTCC account for one
of its foreign branches.
\1616\ Unregistered investment advisers include all investment
advisers not registered under the Investment Advisers Act and may
include investment advisers registered with a state or a foreign
authority.
Table 2--The Number and Percentage of Account Holders--by Type--Who Participate in the Security-Based Swap
Market Through a Registered Investment Adviser, an Unregistered Investment Adviser, or Directly as a Transacting
Agent, From November 2006 Through December 2014.\1617\
----------------------------------------------------------------------------------------------------------------
Represented by
Represented by an Participant is
Account holders by type Number a registered unregistered transacting
investment investment agent \1618\
adviser adviser
----------------------------------------------------------------------------------------------------------------
Private Funds................................... 3,168 1,569 50% 1,565 49% 34 1%
DFA Special Entities............................ 1,141 1,088 95% 33 3% 20 2%
Registered Investment Companies................. 800 768 96% 30 4% 2 0%
Banks (non-ISDA-recognized dealers)............. 327 17 5% 6 2% 304 93%
Insurance Companies............................. 232 150 65% 21 9% 61 26%
ISDA-Recognized Dealers......................... 75 0 0% 0 0% 75 100%
Foreign Sovereigns.............................. 72 53 74% 3 4% 16 22%
Non-Financial Corporations...................... 61 43 70% 3 5% 15 25%
Finance Companies............................... 13 6 46% 0 0% 7 54%
Other/Unclassified.............................. 5,011 3,327 66% 1,452 29% 232 5%
---------------------------------------------------------------
All......................................... 10,900 7,021 64% 3,113 29% 766 7%
----------------------------------------------------------------------------------------------------------------
Among the accounts, there are 1,141 Dodd-Frank Act-defined special
entities \1619\ and 800 investment companies registered under the
Investment Company Act of 1940.\1620\ Private funds comprise the
largest type of account holders that we were able to classify, and
although not verified through a recognized database, most of the funds
we were not able to classify appear to be private funds.\1621\
---------------------------------------------------------------------------
\1617\ Adjustments to these statistics reflect updated
classifications of counterparties and transactions classification
resulting from further analysis of the TIW data.
\1618\ This column reflects the number of participants who are
also trading for their own accounts.
\1619\ Our manual classification does not distinguish between
special entities subject to ERISA and special entities defined in,
but not subject to ERISA, and this estimate includes both groups of
entities. Therefore, our analysis includes entities that may opt out
of the special entity status under these final rules. If many such
entities opt out, this figure may overestimate the number of market
participants subject to business conduct standards with regards to
special entities. See Section VI.C.4.
\1620\ See 15 U.S.C. 80a1-80a64. There remain approximately
5,000 DTCC ``accounts'' unclassified by type. Although unclassified,
each was manually reviewed to verify that it was not likely to be a
special entity within the meaning of the Dodd-Frank Act and instead
was likely to be an entity such as a corporation, an insurance
company, or a bank.
\1621\ For the purposes of this discussion, ``private fund''
encompasses various unregistered pooled investment vehicles,
including hedge funds, private equity funds, and venture capital
funds.
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[[Page 30103]]
[GRAPHIC] [TIFF OMITTED] TR13MY16.000
b. Participant Domiciles
As depicted in Figure 1 above, domiciles of new accounts
participating in the market have shifted over time. It is unclear
whether these shifts represent changes in the types of participants
active in this market, changes in reporting or changes in transaction
volumes in particular underliers. For example, the increased percentage
of new entrants that are foreign accounts may reflect an increase in
participation by foreign account holders in the security-based swap
market, and the increased percentage of the subset of new entrants that
are foreign accounts managed by U.S. persons also may reflect more
specifically the flexibility with which market participants can
restructure their market participation in response to regulatory
intervention, competitive pressures, and other stimuli.\1623\ On the
other hand, apparent changes in the percentage of new accounts with
foreign domiciles may reflect improvements in reporting by market
participants to TIW, an increase in the percentage of transactions
between U.S. and non-U.S. counterparties, and/or increased transactions
in single-name CDS on U.S. reference entities by foreign persons.\1624\
---------------------------------------------------------------------------
\1622\ See Section VI.B.1, supra (explaining how domiciles for
firms were identified for purposes of this analysis).
\1623\ See Charles Levinson, ``U.S. banks moved billions in
trades beyond the CFTC's reach,'' Reuters (Aug. 21, 2015), available
at: http://www.reuters.com/article/2015/08/21/usa-banks-swaps-idUSL3N10S57R20150821.
\1624\ As noted above, the available data do not include all
security-based swap transactions but only transactions in single
name CDS that involve either (1) at least one account domiciled in
the United States (regardless of the reference entity) or (2)
single-name CDS on a U.S. reference entity (regardless of the U.S.-
person status of the counterparties).
---------------------------------------------------------------------------
c. Market Centers
A market participant's domicile, however, does not necessarily
correspond to where it engages in security-based swap activity. In
particular, financial groups engaged in security-based swap dealing
activity operate in multiple market centers and carry out such activity
with counterparties around the world.\1625\ Several commenters noted
that many market participants that are engaged in dealing activity
prefer to use traders and manage risk for security-based swaps in the
jurisdiction where the underlier is traded. Thus, although a
significant amount of the dealing activity in security-based swaps on
U.S. reference entities involves non-U.S. dealers, we understand that
these dealers tend to carry out much of the security-based swap trading
and related risk-management activities in these security-based swaps
within the United States.\1626\ Some dealers have explained that being
able to centralize their trading, sales, risk management and other
activities related to U.S. reference entities in U.S. operations (even
when the resulting transaction is booked in a foreign entity) improves
the efficiency of their dealing business.
---------------------------------------------------------------------------
\1625\ See U.S. Activity Proposing Release, 80 FR 27449-27452,
supra note 9.
\1626\ See id.
---------------------------------------------------------------------------
Consistent with these operational concerns and the global nature of
the security-based swap market, the available data appear to confirm
that participants in this market are in fact active in market centers
around the globe. Although, as noted above, the available data do not
permit us to identify the location of personnel in a
[[Page 30104]]
transaction, TIW transaction records indicate that firms that are
likely to be security-based swap dealers operate out of branch
locations in key market centers around the world, including New York,
London, Tokyo, Hong Kong, Chicago, Sydney, Toronto, Frankfurt,
Singapore and the Cayman Islands.\1627\
---------------------------------------------------------------------------
\1627\ TIW transaction records contain a proxy for the domicile
of an entity, which may differ from branch locations, which are
separately identified in the transaction records.
---------------------------------------------------------------------------
Given these market characteristics and practices, participants in
the security-based swap market may bear the financial risk of a
security-based swap transaction in a location different from the
location where the transaction is arranged, negotiated, or executed, or
where economic decisions are made by managers on behalf of beneficial
owners. Market activity may also occur in a jurisdiction other than
where the market participant or its counterparty books the transaction.
Similarly, a participant in the security-based swap market may be
exposed to counterparty risk from a counterparty located in a
jurisdiction that is different from the market center or centers in
which it participates.
d. Common Business Structures for Firms Engaged in Security-Based Swap
Dealing Activity
A financial group that engages in a global security-based swap
dealing business in multiple market centers may choose to structure its
dealing business in a number of different ways. This structure,
including where it books the transactions that constitute that business
and how it carries out market-facing activities that generate those
transactions, reflects a range of business and regulatory
considerations, which each financial group may weigh differently.
A financial group may choose to book all of its security-based swap
transactions, regardless of where the transaction originated, in a
single, central booking entity. That entity generally retains the risk
associated with that transaction, but it also may lay off that risk to
another affiliate via a back-to-back transaction or an assignment of
the security-based swap.\1628\ Alternatively, a financial group may
book security-based swaps arising from its dealing business in separate
affiliates, which may be located in the jurisdiction where it
originates the risk associated with the security-based swap, or,
alternatively, the jurisdiction where it manages that risk. Some
financial groups may book transactions originating in a particular
region to an affiliate established in a jurisdiction located in that
region.\1629\
---------------------------------------------------------------------------
\1628\ See U.S. Activity Proposing Release, 80 FR 27463, supra
note 9; Cross-Border Proposing Release, 78 FR 30977-78, supra note
6.
\1629\ There is some indication that this booking structure is
becoming increasingly common in the market. See, e.g., ``Regional
swaps booking replacing global hubs,'' Risk.net (Sep. 4, 2015),
available at: http://www.risk.net/risk-magazine/feature/2423975/regional-swaps-booking-replacing-global-hubs. Such a development may
be reflected in the increasing percentage of new entrants that have
a foreign domicile, as described above.
---------------------------------------------------------------------------
Regardless of where a financial group determines to book its
security-based swaps arising out of its dealing activity, it is likely
to operate offices that perform sales or trading functions in one or
more market centers in other jurisdictions. Maintaining sales and
trading desks in global market centers permits the financial group to
deal with counterparties in that jurisdiction or in a specific
geographic region, or to ensure that it is able to provide liquidity to
counterparties in other jurisdictions,\1630\ for example, when a
counterparty's home financial markets are closed. A financial group
engaged in a security-based swap dealing business also may choose to
manage its trading book in particular reference entities or securities
primarily from a trading desk that can take advantage of local
expertise in such products or that can gain access to better liquidity,
which may permit it to more efficiently price such products or to
otherwise compete more effectively in the security-based swap market.
Some financial groups prefer to centralize risk management, pricing,
and hedging for specific products with the personnel responsible for
carrying out the trading of such products to mitigate operational risk
associated with transactions in those products.
---------------------------------------------------------------------------
\1630\ These offices may be branches or offices of the booking
entity itself, or branches or offices of an affiliated agent, such
as, in the United States, a registered broker-dealer.
---------------------------------------------------------------------------
The financial group affiliate that books these transactions may
carry out related market-facing activities, whether in its home
jurisdiction or in a foreign jurisdiction, using either its own
personnel or the personnel of an affiliated or unaffiliated agent. For
example, the financial group may determine that another affiliate in
the financial group employs personnel who possess expertise in relevant
products or who have established sales relationships with key
counterparties in a foreign jurisdiction, making it more efficient to
use the personnel of the affiliate to engage in security-based swap
dealing activity on its behalf in that jurisdiction. In these cases,
the affiliate that books these transactions and its affiliated agent
may operate as an integrated dealing business, each performing distinct
core functions in carrying out that business.
Alternatively, the financial group affiliate that books these
transactions may in some circumstances, determine to engage the
services of an unaffiliated agent through which it can engage in
dealing activity. For example, a financial group may determine that
using an interdealer broker may provide an efficient means of
participating in the interdealer market in its own, or in another,
jurisdiction, particularly if it is seeking to do so anonymously or to
take a position in products that trade relatively infrequently.\1631\ A
financial group may also use unaffiliated agents that operate at its
direction. Such an arrangement may be particularly valuable in enabling
a financial group to service clients or access liquidity in
jurisdictions in which it has no security-based swap operations of its
own.
---------------------------------------------------------------------------
\1631\ We understand that interdealer brokers may provide voice
or electronic trading services that, among other things, permit
dealers to take positions or hedge risks in a manner that preserves
their anonymity until the trade is executed. These interdealer
brokers also may play a particularly important role in facilitating
transactions in less-liquid security-based swaps.
---------------------------------------------------------------------------
We understand that financial group affiliates (whether affiliated
with U.S.-based financial groups or not) that are established in
foreign jurisdictions may use any of these structures to engage in
dealing activity in the United States, and that they may seek to engage
in dealing activity in the United States to transact with both U.S.-
person and non-U.S.-person counterparties. In transactions with non-
U.S.-person counterparties, these foreign affiliates may affirmatively
seek to engage in dealing activity in the United States because the
sales personnel of the non-U.S.-person dealer (or of its agent) in the
United States have existing relationships with counterparties in other
locations (such as Canada or Latin America) or because the trading
personnel of the non-U.S.-person dealer (or of its agent) in the United
States have the expertise to manage the trading books for security-
based swaps on U.S. reference securities or entities. We understand
that some of these foreign affiliates engage in dealing activity in the
United States through their personnel (or personnel of their
affiliates) in part to ensure that they are able to provide their own
counterparties, or those of financial group affiliates in other
jurisdictions, with access to liquidity (often in non-U.S. reference
entities) during U.S. business hours, permitting them to meet
[[Page 30105]]
client demand even when the home markets are closed. In some cases,
such as when seeking to transact with other dealers through an
interdealer broker, these foreign affiliates may act, in a dealing
capacity, in the United States through an unaffiliated, third-party
agent.
e. Current Estimates of Number of SBS Dealers and Major SBS
Participants
As discussed above, security-based swap activity is concentrated in
a relatively small number of dealers, which already represent a small
percentage of all market participants active in the security-based swap
market. Based on analysis of 2014 data, our earlier estimates of the
number of entities likely to register as security-based swap dealers
remain largely unchanged.\1632\ Of the approximately 50 entities that
we estimate may potentially register as security-based swap dealers, we
believe it is reasonable to expect 22 to be non-U.S. persons.\1633\
Under the rules as they currently exist, we identified approximately
170 entities engaged in single-name CDS activity, with all
counterparties, of $2 billion or more. Of those entities, 155 would be
expected to incur assessment costs to determine whether they meet the
``security-based swap dealer'' definition. Approximately 57 of these
entities are non-U.S. persons.
---------------------------------------------------------------------------
\1632\ See Registration Adopting Release, 80 FR 49000, supra
note 989.
\1633\ These estimates are based on the number of accounts in
TIW data with total notional volume in excess of de minimis
thresholds, increased by a factor of two, to account for any
potential growth in the security-based swap market, to account for
the fact that we are limited in observing transaction records for
activity between non-U.S. persons to those that reference U.S.
underliers, and to account for the fact that we do not observe
security-based swap transactions other than in single-name CDS. See
U.S. Activity Proposing Release, 80 FR 27452, supra note 9. See also
Definitions Adopting Release, 77 FR 30725, n.1457, supra note 115.
---------------------------------------------------------------------------
Many of these dealers are already subject to other regulatory
frameworks under U.S. law based on their role as intermediaries or on
the volume of their positions in other products, such as swaps.
Available data supports our prior estimates, based on our experience
and understanding of the swap and security-based swap market that of
the 55 firms that might register as SBS Dealers or Major SBS
Participants, approximately 35 would also be registered with the CFTC
as Swap Dealers or Major Swap Participants.\1634\ Based on our analysis
of TIW data and filings with the Commission, we estimate that 16 market
participants expected to register as SBS Dealers have already
registered with the Commission as broker-dealers and are thus subject
to Exchange Act and FINRA requirements applicable to such entities.
Finally, as we discuss below, some dealers may be subject to similar
requirements in one or more foreign jurisdictions.
---------------------------------------------------------------------------
\1634\ Based on our analysis of 2014 TIW data and the list of
swap dealers provisionally registered with the CFTC, and applying
the methodology used in the Definitions Adopting Release, we
estimate that substantially all registered security-based swap
dealers would also be registered as swap dealers with the CFTC. See
U.S. Activity Proposing Release, 80 FR 27458, supra note 9;
Registration Adopting Release, 80 FR 49000, supra note 989. See also
CFTC list of provisionally registered swap dealers, available at:
http://www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer.
---------------------------------------------------------------------------
3. Security-Based Swap Market: Levels of Security-Based Swap Trading
Activity
As already noted, firms that act as dealers play a central role in
the security-based swap market. Based on an analysis of 2014 single
name CDS data in TIW, accounts of those firms that are likely to exceed
the SBS Dealer de minimis thresholds and trigger registration
requirements intermediated transactions with a gross notional amount of
approximately $8.5 trillion, over 60 percent of which was intermediated
by top 5 dealer accounts.\1635\
---------------------------------------------------------------------------
\1635\ Commission staff analysis of TIW transaction records
indicates that approximately 99 percent of single name CDS price-
forming transactions in 2014 involved an ISDA-recognized dealer.
---------------------------------------------------------------------------
These dealers transact with hundreds or thousands of
counterparties. Approximately 35 percent of accounts of firms expected
to register as SBS Dealers and observable in TIW have entered into
security-based swaps with over 1,000 unique counterparty accounts as of
year-end 2014. \1636\ Approximately 9 percent of these accounts
transacted with 500-1,000 unique counterparty accounts; another 35
percent transacted with 100-500 unique accounts, and only 22 percent of
these accounts intermediated swaps with fewer than 100 unique
counterparties in 2014. The median dealer account transacted with 453
unique accounts (with an average of approximately 759 unique accounts).
Non-dealer counterparties transact almost exclusively with these
dealers. The median non-dealer counterparty transacted with 3 dealer
accounts (with an average of approximately 4 dealer accounts) in 2014.
---------------------------------------------------------------------------
\1636\ Many dealer entities and financial groups transact
through numerous accounts. Given that individual accounts may
transact with hundreds of counterparties, we may infer that entities
and financial groups, which may have multiple accounts, transact
with at least as many counterparties as the largest of their
accounts in terms of number of counterparties.
---------------------------------------------------------------------------
Figure 2 below describes the percentage of global, notional
transaction volume in North American corporate single-name CDS reported
to the TIW between January 2008 and December 2014, separated by whether
transactions are between two ISDA-recognized dealers (interdealer
transactions) or whether a transaction has at least one non-dealer
counterparty.
Figure 2 also shows that the portion of the notional volume of
North American corporate single-name CDS represented by interdealer
transactions has remained fairly constant and that interdealer
transactions continue to represent a significant majority of trading
activity even as notional volume has declined over the past six
years,\1637\ from more than $6 trillion in 2008 to less than $3
trillion in 2014.\1638\ The high level of interdealer trading activity
reflects the central position of a small number of dealers, each of
which intermediates trades with many hundreds of counterparties. While
we are unable to quantify the current level of trading costs for
single-name CDS, those dealers appear to enjoy market power as a result
of their small number and the large proportion of order flow they
privately observe.
---------------------------------------------------------------------------
\1637\ The start of this decline predates the enactment of the
Dodd-Frank Act and the proposal of rules thereunder, which is
important to note for the purpose of understanding the economic
baseline for this rulemaking.
\1638\ This estimate is lower than the gross notional amount of
$8.5 trillion noted above as it includes only the subset of single-
name CDS referencing North American corporate documentation, as
discussed above.
---------------------------------------------------------------------------
Figure 2: Global, notional trading volume in North American
corporate single-name CDS by calendar year and the fraction of volume
that is interdealer.
[[Page 30106]]
[GRAPHIC] [TIFF OMITTED] TR13MY16.001
Against this backdrop \1639\ of declining North American corporate
single-name CDS activity, about half of the trading activity in North
American corporate single-name CDS reflected in the set of data we
analyzed was between counterparties domiciled in the United States and
counterparties domiciled abroad, as shown in Figure 3 below. Using the
self-reported registered office location of the TIW accounts as a proxy
for domicile, we estimate that only 12 percent of the global
transaction volume by notional volume between 2008 and 2014 was between
two U.S.-domiciled counterparties, compared to 48 percent entered into
between one U.S.-domiciled counterparty and a foreign-domiciled
counterparty and 40 percent entered into between two foreign-domiciled
counterparties.\1640\
---------------------------------------------------------------------------
\1639\ Adjustments to these statistics from the proposal reflect
additional analysis of TIW data. Cf. Registration Adopting Release,
80 FR 49001, supra note 989 (showing slightly different values for
2012 through 2014). For the purposes of this analysis, we assume
that same-day cleared transactions reflect inter-dealer activity.
\1640\ For purposes of this discussion, we have assumed that the
registered office location reflects the place of domicile for the
fund or account, but we note that this domicile does not necessarily
correspond to the location of an entity's sales or trading desk. See
U.S. Activity Adopting Release, 81 FR 8607.
---------------------------------------------------------------------------
If we consider the number of cross-border transactions instead from
the perspective of the domicile of the corporate group (e.g., by
classifying a foreign bank branch or foreign subsidiary of a U.S.
entity as domiciled in the United States), the percentages shift
significantly. Under this approach, the fraction of transactions
entered into between two U.S.-domiciled counterparties increases to 32
percent, and to 51 percent for transactions entered into between a
U.S.-domiciled counterparty and a foreign-domiciled counterparty.
By contrast, the proportion of activity between two foreign-
domiciled counterparties drops from 40 percent to 17 percent. This
change in respective shares based on different classifications suggests
that the activity of foreign subsidiaries of U.S. firms and foreign
branches of U.S. banks accounts for a higher percentage of security-
based swap activity than U.S. subsidiaries of foreign firms and U.S.
branches of foreign banks. It also demonstrates that financial groups
based in the United States are involved in an overwhelming majority
(approximately 83 percent) of all reported transactions in North
American corporate single-name CDS.
Financial groups based in the United States are also involved in a
majority of interdealer transactions in North American corporate
single-name CDS. Of transactions on North American corporate single-
name CDS between two ISDA-recognized dealers and their branches or
affiliates, 65 percent of transaction notional volume involved at least
one account of an entity with a U.S. parent.
In addition, we note that a significant majority of North American
corporate single-name CDS transactions occur in the interdealer market
or between dealers and non-U.S.-person non-dealers, with the remaining
(and much smaller) portion of the market consisting of transactions
between dealers and U.S.-person non-dealers. Specifically, 79.5 percent
of North American corporate single-name CDS transactions involved
either two ISDA-recognized dealers or an ISDA-recognized dealer and a
non-U.S.-person non-dealer. Approximately 20 percent of such
[[Page 30107]]
transactions involved an ISDA-recognized dealer and a U.S.-person non-
dealer.
[GRAPHIC] [TIFF OMITTED] TR13MY16.002
4. Global Regulatory Efforts
In 2009, leaders of the G20--whose membership includes the United
States, 18 other countries, and the European Union (``EU'')--addressed
global improvements in the OTC derivatives markets. They expressed
their view on a variety of issues relating to OTC derivatives
contracts. In subsequent summits, the G20 leaders have returned to OTC
derivatives regulatory reform and encouraged international consultation
in developing standards for these markets.\1641\
---------------------------------------------------------------------------
\1641\ See, e.g., G20 Leaders' Final Declaration, November 2011,
para. 24 available at: https://g20.org/wp-content/uploads/2014/12/Declaration_eng_Cannes.pdf.
---------------------------------------------------------------------------
Many SBS Dealers likely will be subject to foreign regulation of
their security-based swap activities that are similar to regulations
that may apply to them pursuant to Title VII, even if the relevant
foreign jurisdictions do not classify certain market participants as
``dealers'' for regulatory purposes. Some of these regulations may
duplicate, and in some cases conflict with, certain elements of the
Title VII regulatory framework.
Foreign legislative and regulatory efforts have focused on five
general areas: Moving OTC derivatives onto organized trading platforms,
requiring central clearing of OTC derivatives, requiring post-trade
reporting of transaction data for regulatory purposes and public
dissemination of anonymized versions of such data, establishing or
enhancing capital requirements for non-centrally cleared OTC
derivatives transactions, and establishing or enhancing margin and
other risk mitigation requirements for non-centrally cleared OTC
derivatives transactions. Foreign jurisdictions have been actively
implementing regulations in connection with each of these categories of
requirements. Regulatory transaction reporting requirements are in
force in a number of jurisdictions including the EU, Hong Kong SAR,
Japan, Australia, Brazil, Canada, China, India, Indonesia, South Korea,
Mexico, Russia, Saudi Arabia, and Singapore; other jurisdictions are in
the process of proposing legislation and rules to implement these
requirements.\1642\ In addition, a number of major foreign
jurisdictions have initiated the process of implementing margin and
other risk mitigation requirements for non-centrally cleared OTC
derivatives transactions.\1643\ Several jurisdictions have also taken
steps to implement the Basel III recommendations governing capital
requirements for financial entities, which include enhanced capital
charges for non-centrally cleared OTC derivatives transactions.\1644\
---------------------------------------------------------------------------
\1642\ Information regarding ongoing regulatory developments
described in this section was primarily obtained from progress
reports on implementation of OTC derivatives market reforms
published by the Financial Stability Board. These are available at:
http://www.financialstabilityboard.org/publications/progress-reports/?policy_area[]=17.
\1643\ In November 2015, the Financial Stability Board reported
that 12 member jurisdictions participating in its tenth progress
report on OTC derivatives market reforms had in force a legislative
framework or other authority to require exchange of margin for non-
centrally cleared transactions and had published implementing
standards or requirements for consultation or proposal. A further 11
member jurisdictions had a legislative framework or other authority
in force or published for consultation or proposal. See Financial
Stability Board, OTC Derivatives Market Reforms Tenth Progress
Report on Implementation (November 2015), available at http://www.financialstabilityboard.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf.
\1644\ In November 2015, the Financial Stability Board reported
that 18 member jurisdictions participating in its tenth progress
report on OTC derivatives market reforms had in force standards or
requirements covering more than 90% of transactions that require
enhanced capital charges for non-centrally cleared transactions. A
further three member jurisdictions had a legislative framework or
other authority in force and had adopted implementing standards or
requirements that were not yet in force. An additional three member
jurisdictions had a legislative framework or other authority in
force or published for consultation or proposal. See Financial
Stability Board, OTC Derivatives Market Reforms Tenth Progress
Report on Implementation (November 2015), available at http://www.financialstabilityboard.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf.
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[[Page 30108]]
5. Dually Registered Entities
We expect the magnitude of the above economic costs, benefits, and
effects on efficiency, competition and capital formation to depend on
the extent to which SBS Entities are already complying with similar
business conduct rules. As discussed extensively in the baseline and in
the sections that follow, most entities expected to register with the
Commission and become subject to these final business conduct standards
have registered with the CFTC as Swap Entities or with the Commission
as broker-dealers. Therefore, they have already become subject to
CFTC's adopted external business conduct rules and/or FINRA rules
related to, among others, suitability, communications with the public,
supervision, and compliance. The Commission has sought to harmonize the
regulatory regimes in recognition of swap and security-based swap
market integration and extensive cross-market participation. As a
result, some SBS Entities may have already restructured their
activities to comply with many of the substantive business conduct
standards being adopted. Dually registered SBS Entities that have
already restructured their systems and activities to comply with
parallel CFTC and FINRA rules may incur lower costs relative to non-
dually registered SBS Entities. The specific economic costs, benefits,
and effects on efficiency, competition, and capital formation of
various business conduct rules and requirements are discussed in
further detail in the sections that follow. Wherever practicable, we
also evaluate the economic effects of the various rules being adopted
against these parallel rules, and other reasonable alternatives.
6. Cross-Market Participation
As noted above, persons registered as SBS Dealers and Major SBS
Participants are likely also to engage in swap activity, which is
subject to regulation by the CFTC.\1645\ This overlap reflects the
relationship between single-name CDS contracts, which are security-
based swaps, and index CDS contracts, which may be swaps or security-
based swaps. A single-name CDS contract covers default events for a
single reference entity or reference security. Index CDS contracts and
related products make payouts that are contingent on the default of
index components and allow participants in these instruments to gain
exposure to the credit risk of the basket of reference entities that
comprise the index, which is a function of the credit risk of the index
components. A default event for a reference entity that is an index
component will result in payoffs on both single-name CDS written on the
reference entity and index CDS written on indices that contain the
reference entity. Because of this relationship between the payoffs of
single-name CDS and index CDS products, prices of these products depend
upon one another,\1646\ creating hedging opportunities across these
markets.
---------------------------------------------------------------------------
\1645\ See U.S. Activity Adopting Release, 81 FR 8609;
Registration Adopting Release, 80 FR 49000, supra note 989.
\1646\ ``Correlation'' typically refers to linear relationships
between variables; ``dependence'' captures a broader set of
relationships that may be more appropriate for certain swaps and
security-based swaps. See, e.g., Casella, George and Roger L.
Berger, ``Statistical Inference'' (2002), at 171.
---------------------------------------------------------------------------
These hedging opportunities mean that participants that are active
in one market are likely to be active in the other. Commission staff
analysis of approximately 4,500 TIW accounts that participated in the
market for single-name CDS in 2014 revealed that approximately 3,000 of
those accounts, or 67 percent, also participated in the market for
index CDS. Of the accounts that participated in both markets, data
regarding transactions in 2014 suggest that, conditional on an account
transacting in notional volume of index CDS in the top third of
accounts, the probability of the same account landing in the top third
of accounts in terms of single-name CDS notional volume is
approximately 64 percent; by contrast, the probability of the same
account landing in the bottom third of accounts in terms of single-name
CDS notional volume is only 10 percent.\1647\
---------------------------------------------------------------------------
\1647\ The Commission recently revised its methodology for
estimating cross-market participation of TIW accounts. This has
resulted in an increase in the reported number of accounts that
participated in both markets relative to previous Commission
releases.
---------------------------------------------------------------------------
Similarly, since the payoffs of security-based swaps are dependent
upon the value of underlying securities, activity in the security-based
swap market can be correlated with activity in underlying securities
markets. Security-based swaps may be used in order to hedge or
speculate on price movements of reference securities or the credit risk
of reference securities. For instance, prices of both CDS and corporate
bonds are sensitive to the credit risk of underlying reference
securities. As a result, trading across markets may sometimes result in
information and risk spillovers between these markets, with
informational efficiency, pricing and liquidity in the security-based
swap market affecting informational efficiency, pricing, and liquidity
in markets for related assets, such as equities and corporate
bonds.\1648\
---------------------------------------------------------------------------
\1648\ See the Registration Adopting Release, 80 FR 49003, supra
note 989. Empirical evidence on the direction and significance of
the CDS-bond market spillover is mixed. See also Massa and Zhang
(2012) Massa & L. Zhang, CDS and the Liquidity Provision in the Bond
Market (INSEAD Working Paper No. 2012/114/FIN, 2012), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2164675
(considering whether the presence of CDS improves pricing and
liquidity of investment grade bonds in 2001-2009); S. Das, M.
Kalimipalli & S. Nayak, Did CDS Trading Improve the Market for
Corporate Bonds?, 111 J. Fin. Econ. 495 (2014) (considering the
effects of CDS trading on the efficiency, pricing error and
liquidity of corporate bond markets); M. Oehmke & A. Zawadowski, The
Anatomy of the CDS Market, Rev. of Fin. Studies (forthcoming),
available at https://www0.gsb.columbia.edu/faculty/moehmke/papers/OehmkeZawadowski_CDS.pdf (suggesting a standardization and liquidity
role of CDS markets and documenting cross-market arbitrage links
between the CDS market and the bond market); and Boehmer, S. Chava,
& H. Tookes, Related Securities and Equity Market Quality: The Cases
of CDS, 50(3) J. Fin. & Quant. Analysis (2015), pp 509-541
(providing evidence that firms with traded CDS contracts on their
debt experience significantly lower liquidity and price efficiency
in equity markets when these firms are closer to default and in
times of high market volatility).
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7. Pay to Play Prohibitions
The baseline against which we are assessing the potential effects
of the pay to play prohibitions in these final business conduct rules
reflects MSRB Rules G-37 and G-38, SEC Rule 206(4)-5 under the Advisers
Act, as well as CFTC Regulation 23.451. First, we note that MSRB rules
G-37 and G-38 are currently effective and are part of the economic
baseline. Second, Rule 206(4)-5 prohibits an adviser and its covered
associates from providing or agreeing to provide, directly or
indirectly, payment to any third party for solicitation of advisory
business from any government entity on such adviser's behalf unless
such third party is a ``regulated person,'' defined in Rule 206(4)-5 as
(i) an SEC-registered investment adviser, (ii) a registered broker or
dealer subject to pay-to-play rules adopted by a registered national
securities association, or (iii) a registered municipal advisor that is
subject to pay-to-play rules adopted by the MSRB (``third-party
solicitor ban''). Although the compliance date for the third-party
solicitor ban was July 31, 2015, the Division of Investment Management
stated that it will not
[[Page 30109]]
recommend enforcement action to the Commission with respect to the
third-party solicitor ban until the later of (1) the effective date of
a FINRA pay-to-play rule or (2) the effective date of an MSRB pay-to-
play rule for registered municipal advisors.\1649\ Therefore, certain
parts of Rule 206(4)-5--the prohibition from receiving compensation for
advising government entities for two years after certain contributions
are made, and the prohibition from coordinating and soliciting
contributions to government officials and parties--enter into our
economic baseline.
---------------------------------------------------------------------------
\1649\ See ``Staff Responses to Questions About the Pay to Play
Rule,'' Question I.4, updated as of Jun. 25, 2015. Available at:
http://www.sec.gov/divsions/investment/pay-to-play-faq.htm, last
accessed 4/6/2016.
---------------------------------------------------------------------------
Third, Commodity Exchange Act Rule 23.451 prohibits Swap Dealers
from offering to enter or entering into a swap with governmental
special entities within two years of any contribution to an official of
such entity by the Swap Dealer or any covered associate. The CFTC has
similarly stated that the rule is intended to deter fraud and undue
influence that harms the public, and to promote consistency in the
business conduct standards that apply to financial market professionals
dealing with municipal entities. However, CFTC Letter No. 12-33
provided no-action relief from Regulation 23.451 to Swap Dealers and
their covered associates with respect to ``governmental plans'' defined
in Section 3 of ERISA, to the extent that such plans are not otherwise
covered by SEC and/or MSRB rules. The CFTC has also clarified that the
two year ``look-back'' period does not include any time period that
precedes the date on which an entity is required to register as a Swap
Dealer.\1650\
---------------------------------------------------------------------------
\1650\ See CFTC 77 FR at 9827. See also: CFTC No-Action Letter
No. 12-33 Amended, available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-33.pdf, last accessed 8/
27/2015.
---------------------------------------------------------------------------
As indicated above, we estimate that up to 35 of 55 entities
seeking to register as SBS Entities may be registered with the CFTC as
Swap Entities. Additionally, based on an analysis of 2014 TIW data on
accounts likely to trigger SBS Dealer registration requirements, we
have identified 18 entities belonging to a corporate group with at
least one MSRB registered broker-dealer or bank-dealer.\1651\ Finally,
as discussed in section V, the Commission continues to estimate that
the overwhelming majority of independent representatives of special
entities subject to these final rules are likely already registered as
municipal advisors.\1652\ As a result of the pay to play rules
currently in effect, some SBS Entities and third-party independent
advisers of special entities may have restructured their business
practices in various markets to comply with certain restrictions
imposed by pay to play rules on investment advisers, municipal
advisors, and SBS Entities discussed above.
---------------------------------------------------------------------------
\1651\ See ``Broker-Dealers and Bank Dealers Registered with the
MSRB'', available at http://www.msrb.org/BDRegistrants.aspx, last
accessed 2/8/2016.
\1652\ As of January 1, 2016 there were 665 municipal advisors
registered with the Commission (http://www.sec.gov/help/foia-docs-muniadvisorshtm.html). Of those, 381 indicated that they expect to
provide advice concerning the use of municipal derivatives or advice
or recommendations concerning the selection of other municipal
advisors or underwriters with respect to municipal financial
products or the issuance of municipal securities. We expect that
many of these municipal advisors will also act as independent
representatives for other special entities. As discussed in Section
V, the Commission estimates that approximately 385 municipal
advisors will act as independent representatives to special entities
with respect to security-based swaps.
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C. Costs and Benefits of Business Conduct Rules
1. Verification of Status and Know Your Counterparty Rules
Rule 15Fh-3(a)(1) requires an SBS Entity to verify that a
counterparty meets the standards for an eligible contract participant
before entering into a security-based swap with the counterparty,
except for transactions executed on a registered national securities
exchange. Rule 15Fh-3(a)(2) requires SBS Entities to verify whether a
known counterparty is a special entity before entering into a security-
based swap with that counterparty, except for transactions executed on
a registered or exempt SEF or registered national securities exchange,
where the SBS Entity does not know the identity of the counterparty at
a reasonably sufficient time prior to execution of the transaction to
permit compliance with obligations of the rule. Rule 15Fh-3(a)(3)
requires SBS Entities to verify whether a counterparty is eligible to
elect not to be a special entity under Rule 15Fh-2(d)(4) and, if so,
notify such counterparty of its right to make such an election.\1653\
Finally, Rule 15Fh-3(e) requires that SBS Dealers establish, maintain
and enforce written policies and procedures reasonably designed to
obtain and retain records of the essential facts concerning each known
counterparty necessary for conducting business with such
counterparties. The scope of such essential facts includes facts
required to comply with applicable laws, regulations and rules; facts
required to implement the SBS Dealer's credit and operational risk
management policies; and information regarding the authority of persons
acting for such counterparties.\1654\
---------------------------------------------------------------------------
\1653\ See Section II.H supra.
\1654\ The ability of SBS Entities to rely on representations to
comply with these and other business conduct rules is discussed in
detail in the section VI.C.4 below.
---------------------------------------------------------------------------
We recognize that many SBS Entities, in the course of business,
already may be conducting due diligence and fact gathering concerning
their security-based swap counterparties, which may reduce the economic
effects of this rule.
The scope of the ``know your counterparty'' rule reflects
differences in the roles of entities likely to register as SBS Dealers
and entities that may register as Major SBS Participants. The
Commission believes that entities that will register as SBS Dealers
will intermediate a large volume of security-based swap transactions as
both principal risk holders and agents transacting on behalf of
principal risk holders, such as special entities. As discussed in the
economic baseline, we understand that entities currently operating as
dealers in security-based swap markets play a central intermediation
role, transacting with hundreds and thousands of non-dealer
counterparties and accounting for large activity volumes. At the same
time, the Commission expects that Major SBS Participants will hold
large positions in security-based swaps, but have low volumes of
security-based swap activity. Hence, we expect Major SBS Participants
may not play the central intermediation role fulfilled by SBS Dealers.
These rules limit the scope of application of the ``know your
counterparty'' requirement to SBS Dealers, and exclude Major SBS
Participants. As a result, entities that may register as Major SBS
Participants will not bear the costs of compliance with this rule. At
the same time, SBS Dealers will be required to comply and bear related
compliance costs. We note that this approach is substantially similar
to the CFTC's final external business conduct rules, which limit the
scope of ``know your counterparty'' requirements to Swap Dealers. This
results in a consistent treatment of entities that may trigger both
Major Swap Participant and Major SBS Participant registration
requirements, and will enable Major Swap Participants to enter into
security-based swap positions without bearing additional compliance
costs to comply with our ``know your counterparty'' requirement.
[[Page 30110]]
To the extent that SBS Dealers do not already collect and retain
essential facts about their counterparties as a part of their normal
course of business, this requirement will increase the cost to SBS
Dealers of entering into security-based swaps. Specifically, SBS
dealers will incur costs of complying with the verification
requirements and costs of establishing, maintaining, and enforcing
policies and procedures reasonably designed to obtain and retain
essential facts about each known counterparty that are necessary for
conducting business with such counterparty. We note that the ability to
rely on counterparty representations to fulfill the SBS Dealer
diligence requirement partly lowers compliance burdens, as reflected in
our estimates. Further, to the extent that the majority of SBS Entities
have already cross-registered with the CFTC as Swap Entities and have
become subject to substantially similar verification and ``know your
counterparty'' requirements, and to the extent the majority of their
counterparties transact across swap and security-based swap markets and
have already benefited from existing CFTC rules, the economic effects
of these final rules may be partly mitigated.
Direct costs of compliance with verification of status requirements
related to adherence to standardized protocols by SBS Entities that are
not dually registered as Swap Entities are estimated at, approximately,
$17,600.\1655\ As discussed in Section V, these estimates include costs
related to verification of counterparty's eligibility to elect not to
be a special entity and notification of counterparties of their right
to make such an election. In addition, SBS Dealers will also be
required to comply with ``know your counterparty'' obligations, which
will require a review of existing policies and procedures and related
documentation, involving an estimated initial cost of $95,000 for all
SBS Dealers.\1656\ Further, direct ongoing costs of ``know your
counterparty'' obligations are estimated at approximately $4,370,000
per year for all SBS Dealers.\1657\
---------------------------------------------------------------------------
\1655\ Initial outside counsel cost: $500 * (20 non-CFTC
registered SBS Entities) = $10,000. Initial adherence letter burden:
(In-house attorney at $380 per hour) x 20 hours = $7,600.
\1656\ Initial cost: (In-house attorney at $380 per hour) x 250
hours = $95,000.
\1657\ (In-house attorney at $380 per hour) x 11,500 hours =
$4,370,000.
---------------------------------------------------------------------------
Increases in SBS Entity costs due to these obligations may be
reflected in the terms offered to counterparties, and increases in
counterparty costs may affect their willingness to transact in
security-based swaps. Further, counterparties of SBS Entities that are
not also participating in swap markets and relying on the above
protocols may incur costs associated with the verification of status
requirement and related adherence letters, estimated at approximately
$3,051,840.\1658\ As estimated in Section V, counterparties or their
agents will also be required to collect and provide essential facts to
the SBS Dealer to comply with the ``know your counterparty''
obligations for an initial total cost estimate of approximately
$41,420,000.\1659\
---------------------------------------------------------------------------
\1658\ Initial costs of disclosure of essential facts: $500 x
(3,468 counterparties) = $1,734,000. Initial costs of adherence
letters: (In-house attorney at $380 per hour) x 3,468 counterparties
= $1,317,840. Total initial costs: $1,734,000 + $1,317,840 =
$3,051,840.
\1659\ Initial cost: (In-house attorney at $380 per hour) x
109,000 hours = $41,420,000.
---------------------------------------------------------------------------
We note that the eligible contract participant status verification
requirement does not apply to transactions executed on a registered
national securities exchange. In addition, the special entity status
verification requirement does not apply to transactions where the SBS
Entity does not know the identity of the counterparty at a reasonably
sufficient time prior to execution of the transaction to permit
compliance. This limits the scope of the transactions covered by final
rules, therefore potentially reducing the expected benefits. However,
since anonymous transactions will not be subject to these requirements,
the rule imposes lower costs, delays and implementation challenges with
respect to anonymous trades. This approach to anonymous transactions
executed on registered exchanges or SEFs may incentivize SBS Entities
to trade through these venues, to avoid imposition of these obligations
under final business conduct rules. The compliance costs imposed on SBS
Entities by these and other business conduct requirements (excluding
anonymous transactions executed on a registered exchange or SEF) may
lead to a decrease in the volume of OTC bilateral security-based swap
trades, and an increase in the volume of transactions executed on
exchanges or SEFs. This may facilitate liquidity, price discovery and
risk mitigation in these transparent venues, which may attract greater
market participation. The overall effects will depend on the value of
disclosure and suitability requirements, customization and bilateral
relationships in OTC transactions, compared with the standardization,
liquidity and execution quality of contracts in SEFs and exchanges,
among others.
As an alternative to the approach taken in the final rules, the
Commission has considered imposing specific requirements as to the form
and manner of documentation. Specific documentation requirements could
result in greater information gathering and documentation by SBS
Entities fulfilling their status verification and ``know your
counterparty'' obligations, which may further strengthen counterparty
protections and reduce evasion. However, we recognize commenter
concerns regarding costs and loss of flexibility from imposing specific
documentation requirements, and the importance of private contractual
negotiation, as well as the need to impose effective verification and
documentation requirements to facilitate enforcement.\1660\ We
therefore declined to adopt this approach.
---------------------------------------------------------------------------
\1660\ See FIA/ISDA/SIFMA, supra note 5; CFA, supra note 5.
---------------------------------------------------------------------------
The Commission is adopting a ``know your counterparty'' requirement
based on a policies and procedures approach. However, the final rules
explicitly delineate certain items that the Commission believes are
essential facts concerning the counterparty that are necessary for
conducting business with such counterparty. The CFTC has adopted a
substantially similar requirement for swap dealers to implement
policies and procedures reasonably designed to obtain and retain a
record of the essential facts about each known counterparty that are
necessary for conducting business with such counterparty. As noted
earlier, in light of extensive cross-market participation between swap
and security-based swap markets, and expected cross-registration of SBS
Entities already complying with CFTC's business conduct rules,
harmonization with the CFTC regime may facilitate continued integration
between these markets and may potentially reduce duplicative compliance
costs for some dual registrants.
2. Disclosures and Communications
The Commission is adopting rules concerning SBS Entity disclosures
of material risks, characteristics, incentives, conflicts of interest
and daily mark of security-based swaps to their counterparties. The
final rules also require SBS Entities to make a written record of the
non-written disclosures and provide a written version of these
disclosures to counterparties no later than the delivery of the trade
acknowledgement for a particular transaction. We note that the scope of
the final disclosure requirements is
[[Page 30111]]
limited to counterparties that are not themselves SBS or Swap Entities,
the economic effects of which are discussed below.
Broadly, these disclosure rules may mitigate information
asymmetries between more informed SBS Entities and less informed
counterparties, and may allow them to make more informed decisions
about capital allocation and counterparty selection. At the same time,
SBS Entities profit from information rents \1661\ and, to the extent
that disclosures will inform their counterparties, SBS Entities may
forgo profits on security-based swaps with counterparties as a result
of these requirements. In addition, SBS Entities will incur direct
compliance costs. As discussed in Section V and consistent with our
analysis in the Proposing Release, compliance with disclosure rules
will involve an initial cost burden of which has been estimated at
approximately $25,080,000, with the ongoing burden estimated at
$2,508,000 for all SBS Entities.\1662\ Similarly, the Commission
estimates that information technology infrastructure required to comply
with final disclosure rules will require will cost approximately
$124,520,000 initially, and an additional $62,260,000 per year for all
SBS Entities.\1663\ In addition, the Commission estimates that SBS
Entities will incur costs of evaluating whether more particularized
disclosures are necessary for each transaction and of developing the
additional disclosures for an ongoing aggregate estimated cost of
$121,124,000.\1664\ These and other costs less amenable to
quantification and discussed below may be passed on to counterparties.
---------------------------------------------------------------------------
\1661\ Rents refer to profits that SBS Entities earn by trading
with counterparties who are less informed. In a market with
competitive access to information, there is no informational
premium; SBS Entities only earn a liquidity premium. The difference
between the competitive liquidity premium and the actual profits
that SBS Entities earn is the economic rent. See Cross-Border
Adopting Release, 79 FR 47283.
As the Commission articulated in other releases, transparency
stemming from the SDR Rules and Regulation SBSR should reduce the
informational advantage of SBS dealers and promote competition among
SBS dealers and other market participants. See SDR Registration
Release 80 FR at 14528, supra note 1202; Regulation SBSR Adopting
Release, supra note 1602.
\1662\ Initial cost: (In-house attorney at $380 per hour) x
66,000 hours = $25,080,000. Ongoing cost: (In-house attorney at $380
per hour) x 6,600 hours = $2,508,000.
\1663\ Initial cost: (Compliance manager at $283 per hour) x
440,000 hours = $124,520,000. Ongoing cost: (Compliance manager at
$283 per hour) x 220,000 hours = $62,260,000.
\1664\ Ongoing cost: (Compliance manager at $283 per hour) x
428,000 hours = $121,124,000.
---------------------------------------------------------------------------
These rules may enhance transparency and protect counterparties,
but may also adversely affect the willingness of SBS Entities to
intermediate OTC security-based swaps with non-SBS or Swap Entity
counterparties, and the costs of entering OTC security-based swaps for
non-SBS or Swap Entity counterparties may increase. This fundamental
tradeoff is discussed in more detail in the sections below with respect
to individual disclosure requirements, their scope and implementation.
The overall economic effects of the final disclosure requirements will
depend on the severity of informational asymmetries and conflicts of
interest in security-based swap markets, the ability of some
counterparties of SBS Entities to obtain similar information
independently without the required disclosures and the costs of doing
so,\1665\ and the information content of the required disclosures, and
the extent to which market participants have already learned from
similar disclosures pertaining to swap transactions.
---------------------------------------------------------------------------
\1665\ See Table 2 of the economic baseline, which shows the
overwhelming majority of most groups of non-dealer market
participants are represented by investment advisers in security-
based swap transactions. See also, e.g., MFA, supra note 5.
---------------------------------------------------------------------------
We note that the SBS Entities will not be required to comply with
pre-transaction disclosure requirements if the identity of the
counterparty is not known to the SBS Entity at a reasonably sufficient
time prior to execution of the transaction to permit the SBS Entity to
comply with these obligations.
a. Risks, Characteristics, and Conflicts of Interest
Rule 15Fh-3(b) requires SBS Entities to make disclosures concerning
a security based swap's material risks and characteristics, and the SBS
Entity's material incentives or conflicts of interest before entering
into a security-based swap. In addition to implementing the statutory
requirements, the rule also requires SBS Entities to make a written
record of the non-written disclosures and provide a written version of
these disclosures to counterparties in a timely manner, but no later
than the delivery of the trade acknowledgement for a particular
transaction.
In evaluating the economic effects of this rule, we note that
security-based swaps are complex products, and security-based swap
markets are more opaque than markets for regular equity or fixed income
products. Security-based swap markets are characterized by a high
degree of informational asymmetry among various groups of
counterparties. As described in the economic baseline, dealers
intermediate large volumes of security-based swaps, observe quote
solicitations and order flow. In addition, SBS Dealers may serve in a
variety of capacities such as placement agents, underwriters,
structurers, securitizers, and lenders in relation to security-based
swaps and the securities underlying them. Further, as outlined above,
SBS Dealers generally have business incentives that may be competing
with those of their counterparties as a result of taking on the
opposite side of the transactions, and may have specific conflicts of
interest due to their advisory, market making, trader and other roles.
As discussed in Section VI.A, Major SBS Participants may also be better
informed about the risks and valuations of security-based swaps due to
their large positions in security-based swaps, compared with their non-
SBS Entity counterparties.
At the same time, counterparties that are not SBS or Swap Entities
do not observe quote solicitations or order flow, and are less likely
to arrange or structure security-based swaps and their underlying
securities. Such counterparties may also be generally less informed
about the nature and risks of security-based swaps due to their low
volume of activity, as indicated by the low transaction share of non-
dealers in Table 1 of the economic baseline. Many non-dealer
counterparties transact in security-based swaps through investment
advisers; however approximately 7% transact in security-based swaps
directly. If the required disclosures are informative to non-SBS
Entities, these final rules may help less informed market participants
make more informed counterparty and capital allocation choices. The
records requirement may facilitate the implementation of the disclosure
requirement, enabling counterparties to reference the non-written
disclosures made prior to entering into the swap during the life of the
security-based swap.
As we have recognized,\1666\ informational asymmetry can negatively
affect market participation and decrease the amount of trading--a
problem commonly known as adverse selection.\1667\ When information
about security-based swap risks, liquidity, pricing and counterparty
incentives is scarce, market participants may be less willing to enter
into transactions and the overall level of trading may fall. To
[[Page 30112]]
the extent that adverse selection costs are currently present in
security-based swap markets, if market participants become better
informed as a result of these final rules, they may increase their
activity in security-based swaps, which may facilitate greater
informational efficiency and liquidity in security-based swap markets.
Disclosures may inform counterparties of SBS Entities about security-
based swap markets, and counterparties may learn from repeatedly
accessing these markets. Hence, most of the benefits are expected to be
incurred by existing participants when the first disclosures are made,
and by new market participants when they first enter the market.
However, to the extent that disclosures will contain transaction-
specific information concerning risks, incentives, pricing and clearing
of individual security-based swaps, the informational benefits
described above may persist.
---------------------------------------------------------------------------
\1666\ See, e.g., Registration Adopting Release 80 FR at 49004,
supra note 989.
\1667\ See George A. Akerlof, The Market For ``Lemons'': Quality
Uncertainty and the Market Mechanism, 84 Q.J. Econ. 488 (1970).
---------------------------------------------------------------------------
At the same time, disclosures required under these proposed rules
will involve costs to SBS Entities and their counterparties. As
discussed in Section V, SBS Entities will bear direct compliance
burdens related to the disclosures, which are reflected in our
compliance cost estimates above. In addition, since SBS Entities are
more informed about security-based swaps, they are able to extract
information rents in the form of higher markups and fees charged to
non-dealer counterparties. If SBS Entity disclosures better inform
counterparties concerning characteristics and risks of security-based
swaps, these rules may reduce the informational advantage of SBS
Entities relative to their counterparties and decrease profitability of
transactions with non-SBS Entity counterparties, which may reduce
incentives for dealers to provide liquidity to these
counterparties.\1668\
---------------------------------------------------------------------------
\1668\ For instance, Grossman and Stiglitz (1980) showed that
because information is costly, prices cannot perfectly reflect the
information which is available, since if it did, those who spent
resources to obtain it would receive no compensation. In other
words, informational efficiency reduces incentives of economic
agents to expend resources to acquire information, and there is an
equilibrium amount of ``disequilibrium''. See Sanford J. Grossman
and Joseph E. Stiglitz, On the Impossibility of Informationally
Efficient Markets, 70 American Economic Review 393-408 (1980).
---------------------------------------------------------------------------
We recognize that the above costs may be passed on to
counterparties through more adverse price and non-price terms of
security-based swaps. To the extent that SBS Entities may be unable to
recover these costs, they may become less likely to intermediate
transactions with non-SBS or Swap Entity counterparties and decrease
participation in U.S. security-based swap markets. Further, since final
business conduct rules require these disclosures to be made prior to
entering into the security-based swap, the disclosure requirements may
involve some delays in execution and may affect liquidity in security-
based swaps, to the extent that these disclosures are not already being
made in master agreements or post trade acknowledgements. We have
considered how the timing, manner and content of disclosures may affect
these competing considerations. First, we recognize that the ability to
rely on master agreements, standardized disclosures and ex post trade
acknowledgements of oral disclosures may significantly reduce ongoing
transaction specific costs and potential execution delays, as
recognized by a commenter,\1669\ but may reduce the specificity and
information content of disclosures. As the Commission discussed in the
Proposing Release,\1670\ security-based swaps are executed under master
agreements and SBS Entities may elect to make required disclosures in a
master agreement or accompanying standardized document. However, as
stated in the Proposing Release and discussed in Section II, supra,
standardized disclosures will not be sufficient in all circumstances
and certain provisions may need to be tailored to the particular
transaction, most notably pricing and other transaction-specific
commercial terms.
---------------------------------------------------------------------------
\1669\ See FIA/ISDA/SIFMA, supra note 5.
\1670\ See Proposing Release, 76 FR at 42406, supra note 3.
---------------------------------------------------------------------------
We have considered commenter concerns that oral disclosures may not
satisfy the goal of pre-trade transparency, may make enforcement more
difficult, and may allow SBS Entities to obscure conflicts of interest
and misrepresent risks until after trade confirmation.\1671\ However,
we are sensitive to the fact that alternative requirements to provide
extensive written disclosures of risks, characteristics, incentives and
conflicts of interest before an SBS Entity enters into a transaction
with a counterparty may increase transaction costs or impose execution
delays, which may be particularly significant in periods of high market
volatility. We have received comments that a requirement to provide
these disclosures ``at a reasonably sufficient time'' prior to entering
the security-based swap transaction, in writing may better inform
unsophisticated counterparties,\1672\ however it may further raise the
risks discussed above. These could result in potentially significant
execution delays, decreases in liquidity and SBS Entity willingness to
intermediate transactions with non-SBS or Swap Entity counterparties.
We also note that, as proposed, under the final rules, standardized
disclosure will not be sufficient in all circumstances: Some forms of
disclosure may be highly standardized, but certain provisions will need
to be tailored to reflect material characteristics of individual
transactions, most notably pricing and other transaction-specific
commercial terms. The CFTC's approach to manner and form of disclosures
is substantially similar to the proposed requirements and to the rule
being adopted. In the Proposing Release, the Commission interpreted the
statutory requirement to disclose material risks and characteristics of
the security-based swap itself, and not of the underlying reference
security or index.\1673\ As an alternative, the Commission could
include underliers in the scope of required disclosures. Compared to
the approach being adopted, the alternative may help better inform less
sophisticated investors and enable them to make better tailored
investment decisions. However, it may increase transactional costs and
execution delays, which are particularly costly during times of high
market volatility. Further, information about many underliers, such as
corporate, municipal and sovereign bonds, is more likely to be publicly
available.
---------------------------------------------------------------------------
\1671\ See CFA, supra note 5.
\1672\ See Better Markets (August 2011), supra note 5 and CFA,
supra note 5.
\1673\ See Proposing Release, 76 FR at 42407, supra note 3.
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We have received mixed comments on the relative balance of these
competing considerations with respect to underlier disclosures.\1674\
Under the CFTC's approach, disclosures regarding underlying assets are
not generally required, but to the extent that payments or cash-flows
of the swap are materially affected by the performance of an underlying
asset for which publicly available information is not available, the
Swap Entity is required to provide disclosure about the material risks
and characteristics of the underlying asset to enable the counterparty
to assess the material risks of the swap. As described in Section II,
our final rules require disclosure regarding the referenced security,
index, asset or issuer if it would be considered material to investors
in evaluating the
[[Page 30113]]
security-based swap, including any related payments.
---------------------------------------------------------------------------
\1674\ See, e.g., Better Markets (2011) Letter; SIFMA (2011)
Letter; FIA/ISDA/SIFMA supra note 5; Levin, supra note 5; Markit,
supra note 5; Barnard, supra note 5; CFA, supra note 5. Also see
Section II.G.2 supra.
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Finally, we have considered the alternatives of adopting more
prescriptive requirements of characteristics to be disclosed, an
explicit risk taxonomy, requirements concerning volatility and
liquidity metrics, and scenario analysis regarding political, economic
events and underlying market factors. These approaches also present a
tradeoff between informing investors and protecting counterparties, and
costs and willingness of SBS Entities to intermediate trades with non-
SBS or Swap Entity counterparties, similar to the effects described
above.
For instance, disclosure of a scenario analysis may inform
counterparties, but may be particularly costly since such analysis may
depend on the specific terms of the agreement. To the extent that the
provision of scenario analysis will impose costs on SBS Entities, a
requirement to include scenario analysis as part of mandated
disclosures may result in bundling research and advice, with SBS
intermediation functions for all affected transactions. This would
increase costs to SBS Entities, and these costs are likely to be passed
on to counterparties. Further, one commenter suggested that the
requirement to produce and disclose scenario analysis for each
transaction may delay execution and expose counterparties to market
risk in times of market volatility.\1675\
---------------------------------------------------------------------------
\1675\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
As an alternative, the CFTC's approach allows counterparties to opt
in to receive the scenario analysis for swaps that are not available
for trading on a SEF, and requires Swap Dealers to disclose to
counterparties their right to receive the scenario analysis. The CFTC's
external business conduct rules do not prescribe whether and how swap
dealers may be able to charge for such analysis and we do not have data
regarding whether any counterparties are taking advantage of the rule
provision. We understand that counterparties already privately
negotiate terms of over-the-counter derivatives with SBS Dealers, which
may also serve in advisory and other capacities. As discussed in the
economic baseline, non-dealer market participants are typically
institutional investors, the overwhelming majority of which rely on
investment advisers in their security-based swap activities. It is
unclear that a requirement to disclose the right to receive a scenario
analysis would affect the demand for such analyses or inform
counterparties.
The Commission has also considered an alternative of adopting
prescriptive risk taxonomies, and requiring disclosure of volatility
and liquidity metrics. While these requirements may reveal additional
information to counterparties, they may be less informative for
customized over-the counter security-based swaps, may fail to capture
risks of new products, and would increase costs. To the extent that
these requirements would increase SBS Entity costs of transacting with
non-SBS or Swap Entity counterparties, these costs would also adversely
affect terms of security-based swaps for non-SBS or Swap Entity
counterparties. Rule 15Fh-3(b)(2) also requires SBS Entities to
disclose any material incentives or conflicts of interest that an SBS
Entity may have in connection with the security swap, including any
compensation or other incentives from any source other than the
counterparty. As articulated in Section II, this rule will not require
SBS Entities to report all profits or expected returns from the swap or
related hedging or trading activities, but will require reporting of
incentives, such as revenue sharing arrangements, from any source other
than the counterparty in connection with the swap. To the extent that
disclosure informs counterparties regarding SBS Entity conflicts of
interest, counterparties of SBS Entities may become better able to make
informed decisions about security-based swaps and the SBS Entities they
transact with. When SBS Entity conflicts of interest are severe,
disclosure of such conflicts may lead counterparties to renegotiate the
terms of a transaction or select another counterparty with fewer
conflicts of interest, contributing to more efficient capital
allocation by non-dealer counterparties. Importantly, this requirement
does not prohibit material conflicts of interest. Instead, the rule
focuses on disclosure of material incentives and conflicts of interest,
which may help counterparties better evaluate the terms and risks of
transacting with an SBS Entity. The severity of these conflicts of
interest in security-based swaps, the awareness of non-SBS or Swap
Entity counterparties about these conflicts, the similarity between
disclosures of conflicts already made by SBS Entities cross-registered
as Swap Entities under CFTC rules with disclosures that will be made
under these final rules, and the informativeness of the newly required
disclosures will influence the magnitude of the benefits described
above.
We recognize that final external business conduct rules for Swap
Entities are already in place and include a similar set of conflict of
interest disclosure rules. Swap Entities are already disclosing
incentives and conflicts of interest in swap transactions, which enters
into our economic baseline and is reflected in current market activity.
Non-SBS or Swap Entity counterparties that are transacting with the
same dealers in both swap and security-based swap markets have
benefited from such disclosures in swap markets, and may have already
become familiar with standardized disclosures by Swap Dealer
counterparties. To the extent that disclosures by the same dealers
related to, for instance, index CDS and single name CDS may be similar,
such counterparties may enjoy fewer benefits of these final rules.
However, we note that the rules being adopted require disclosures
specific to security-based swap transactions, and certain disclosures
will need to be tailored to a particular security-based swap.
In addition to direct costs of compliance born by SBS Entities, to
the extent that disclosures will provide new and relevant information
about SBS Entity conflicts of interest, SBS Entities with significant
conflicts of interest may lose business to SBS Entities that do not
have such conflicts. While this requirement may impose costs on those
SBS Entities with the most acute conflicts, such disclosures may
benefit less conflicted SBS Entities, enhance protections of
counterparties, and improve the ability of market participants to make
informed counterparty decisions.
We have considered the costs and benefits of an alternative
requiring a disclosure of the difference in compensation between
selling a security-based swap versus another product with similar
economic terms, or expected profit of the SBS Entity from the
transaction, as suggested by some commenters.\1676\ We do not believe
that disclosure of SBS Entity profits to counterparties would protect
counterparties or improve their ability to make suitable investment
decisions, relative to the approach being adopted, and are not adopting
this alternative. SBS Entities compete for business on price, execution
quality, underlier and counterparty risks, among others. We understand
that counterparties need information about price, non-price terms and
risks of the security-based swap and conflicts of interest of the SBS
Entity to be able to assess the relative
[[Page 30114]]
merits of a particular transaction. The final business conduct rules
being adopted will require SBS Entities to disclose to their non SBS
Entity counterparties material characteristics and risks of the
transaction, as well as any compensation or incentives from any source
other than the counterparty in connection with the security-based swap.
Rules 15Fh-3(c) and 15Fh-3(d), the economic effects of which are
discussed below, will also require disclosure of the daily mark and
clearing rights. We also note that SDR Rules and Regulation SBSR
adopted by the Commission will introduce post-trade transparency to
security-based markets, and counterparties will have access to more
extensive and more accurate information upon which to make trading and
valuation determinations when compliance with these rules is required.
---------------------------------------------------------------------------
\1676\ See CFA, supra note 5; Levin, supra note 5.
---------------------------------------------------------------------------
SBS Entities are for-profit entities, buying security-based swaps
from counterparties seeking to sell them; and selling swaps to
counterparties seeking to purchase them. When SBS Entities carry
balance sheet risk, they profit from directional price moves that
result in losses for their counterparties and so, they may have an
incentive to offload security-based swaps in their inventory on less
informed non-dealer counterparties, even where such security-based
swaps are unsuitable. When SBS Entities hedge their inventory risk and
do not carry balance sheet exposure, they benefit from charging higher
costs and fees to their counterparties. SBS Entity business incentives
may, therefore, be generally competing with the interests or positions
of their counterparties. However, SBS Entities have reputational
incentives and benefit from intermediating a greater volume of trade
which, all else given, mitigates this conflict. Further, it is unclear
that market participants are generally unaware of these competing
incentives.
SBS Entities act as principal risk holders and transacting agents
effecting security-based swaps on behalf of their customers. An SBS
Entity's expected return on a security-based swap depends on, among
others, price terms of the swap, cost of funds, shorting constraints,
balance sheet exposures, costs of underlying elements of the security-
based swap, and costs of structuring the security-based swap. It is
unclear that disclosure of expected profits of an SBS Entity has any
bearing on a counterparty's expected cost of the transaction, quality
of execution or assessment of the risks of a security-based swap given
the counterparty's investment objectives, horizons, hedging needs,
financial condition etc.\1677\ As a practical consideration, the SBS
Entity's expected profit would depend on potentially proprietary data
and valuation models, and numerous assumptions about future market
factors. At the same time, such a requirement would impose direct costs
of producing disclosures and potential reputational costs on SBS
Entities; if the costs become significant, some SBS Entities may reduce
security-based swap market activity with non-SBS or Swap Entity
counterparties. We note that the rules being adopted not only require
disclosure of material characteristics, risks, conflicts of interest or
incentives, daily mark and clearing rights, but also include fair and
balanced communications, antifraud, supervision, compliance, and
conduct requirements.
---------------------------------------------------------------------------
\1677\ For instance, one commenter asserted that the best
protection for a counterparty is reviewing and selecting the best
available pricing. See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
b. Daily Mark
Rule 15Fh-3(c) requires SBS Entities to disclose the daily mark to
counterparties other than SBS or Swap Entities upon request. For
cleared security-based swaps, the rules require an SBS Entity to
disclose, upon request of the counterparty, the daily mark that the SBS
Entity receives from the appropriate clearing agency. For uncleared
swaps, Rule 15Fh-3(c) implements the statutory provision and requires
the SBS Entity make this disclosure on a daily basis for any uncleared
security-based swap by providing the midpoint between the bid and
offer, or the calculated equivalent thereof, as of the close of
business unless the parties agree in writing otherwise. The method for
computing the daily mark is not provided in the statute. For uncleared
swaps, the SBS Entity would also be able to use market quotations for
comparable security-based swaps and model implied valuations. The SBS
Entity is also required to disclose data sources, methodologies and
assumptions used to prepare the daily mark, and promptly disclose any
material changes to the above during the term of the security-based
swap.
Similar to the economic effects of disclosures concerning material
risks and characteristics of security-based swaps, the overall impact
of the daily mark disclosure depends on the severity of the
informational asymmetries between SBS Entities and counterparties
regarding market prices of security-based swaps; the amount of
disclosure unsophisticated counterparties require to become better
informed; the informativeness of the disclosures; and the direct and
indirect costs of producing such disclosures by SBS Entities. For
cleared security-based swaps, the requirement to disclose the daily
mark from clearing agencies is an explicit statutory requirement, and
provides a standardized and comparable reference point for
counterparties.\1678\ As described above, based on the current model
for clearing security-based swaps, the security-based swap between the
SBS Entity and counterparty is terminated upon novation by the clearing
agency. The SBS Entity would no longer have any obligation to provide a
daily mark to the original counterparty because a security-based swap
no longer exists between them. Therefore, there would not be any
ongoing burden on the SBS Entity.
---------------------------------------------------------------------------
\1678\ We have received comment that SBS Entities may have
direct or indirect affiliations or relationships with clearing
agencies and market data providers, which may pose conflicts of
interest. See Levin, supra note 5. Should such conflicts exist, they
may be partly mitigated by other substantive business conduct
requirements being adopted, such as the antifraud provision,
requirement to engage in fair and balanced communications, and other
statutory obligations. Further, counterparties will be able to
select the venue in which security-based swaps will be cleared and
will benefit from SBS Entities' disclosures of incentives and
conflicts of interest under these final rules.
---------------------------------------------------------------------------
The ability of SBS Entities to rely on quotes, model imputed prices
or prices of comparable security-based swaps to calculate the daily
mark for uncleared swaps may produce valuations that are potentially
superior to stale market prices on illiquid contracts. However, we
continue to recognize that SBS Entities may influence the daily mark
disclosed to their less sophisticated counterparties by varying
modeling assumptions, data sources and methodology which produce the
daily mark, as supported by some commenters.\1679\ This tradeoff is
partially mitigated by the requirement to disclose data sources and a
description of the methodology and assumptions used to prepare the
daily mark, and promptly disclose any material changes during the term
of the swap.
---------------------------------------------------------------------------
\1679\ See, e.g., Levin, supra note 5; IDC, supra note 5.
---------------------------------------------------------------------------
As we recognized in the Proposing Release,\1680\ we anticipate
significant variability in the models and data sources, methodology and
assumptions used by different SBS Entities, leading to different daily
marks being established for similar security-based swaps. As a result,
security-based swap
[[Page 30115]]
market participants that consider the daily mark as an indicator in the
reporting of their positions may report different valuations of similar
security-based swap positions. However, we continue to believe that
since, as quantified in the economic baseline, non-dealer
counterparties typically transact with multiple dealers, counterparties
may be able to observe and analyze differences in security-based swap
valuations across SBS Entities. We recognize that the daily mark may
not be a reliable reference point for estimating fair values, potential
net asset values or prices at which the security-based swap could be
executed as suggested by a commenter,\1681\ however, we continue to
believe that it may inform counterparty understanding of their
financial relationship with SBS Entities.\1682\
---------------------------------------------------------------------------
\1680\ See Proposing Release, 76 FR at 42449, supra note 3. Also
see, e.g., FIA/ISDA/SIFMA, supra note 5.
\1681\ See MFA, supra note 5.
\1682\ See Proposing Release, 76 FR at 42449, supra note 3.
---------------------------------------------------------------------------
We are sensitive to cost considerations, and recognize that costs
borne by SBS Entities as a result of the final business conduct rules
may be passed on to counterparties in the form of higher transaction
costs. Further, if these costs are significant, SBS Entities may reduce
their security-based swap activity or become less willing to
intermediate swaps with certain groups of counterparties. As a result,
liquidity, price discovery and market access of certain groups of
counterparties may be adversely affected. As articulated in the
Proposing Release, we understand that SBS Entities routinely assess
end-of-day values in the course of their business as an integral
component of risk management. We continue to believe that SBS Entities
may already be estimating values that may be used to fulfil the daily
mark disclosure requirement, and, therefore, to the extent this is the
case, direct compliance costs of this requirement to costs of producing
disclosures may be less than estimated above.
One commenter indicated that requiring Major SBS Participants to
comply with the daily mark requirement for uncleared swaps would result
in ``significant, unnecessary increased costs without any meaningful
benefit.'' \1683\ We recognize that the broader scope of this
requirement will impose costs on Major SBS Participants, as reflected
in our compliance cost estimates. To the extent that Major SBS
Participants may be better informed about the risks and valuations of
security-based swaps and more sensitive to market risk due to their
significant positions, disclosures of the daily mark may help their non
SBS Entity counterparties make more informed counterparty and valuation
determinations. We note that the rules being adopted provide all SBS
Entities significant flexibility with respect to how they may estimate
the daily mark for uncleared swaps. Specifically, similar to SBS
Dealers, Major SBS Participants will be able to rely on market quotes
for similar swaps, model based prices or some combination thereof under
Rule 15Fh-3(c). The Commission continues to believe that informing
counterparties' understanding of their financial relationship with SBS
Entities is an important benefit of these final rules.
---------------------------------------------------------------------------
\1683\ See MFA, supra note 5.
---------------------------------------------------------------------------
As discussed in Section II, supra, SBS Entities will not
necessarily be able to use the same mark for collateral purposes and
for meeting the disclosure requirement. We recognize commenter concern
that this approach may impose additional costs of estimating and
disclosing a daily mark valuation on SBS Entities with respect to
transactions where both counterparties have agreed on a basis for
margining uncleared swaps.\1684\ As discussed above, the Commission
continues to believe that the daily mark disclosure, as being adopted
for the purposes of this rule, would provide a useful and meaningful
reference point for counterparties holding positions in uncleared
security-based swaps.
---------------------------------------------------------------------------
\1684\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
Currently, entities that are likely to trigger SBS Entity
registration requirements due to their volume of dealing activity are
not required to disclose daily marks of security-based swaps, or data
sources, assumptions and methodologies used to calculate them. While
this requirement is currently effective in swap markets and some SBS
Entities may be making such security-based swap specific disclosures
voluntarily, these final rules impose mandatory disclosure requirements
on all SBS Entities in their security-based swap transactions with
counterparties that are not themselves SBS Entities or Swap Entities.
The requirement to disclose data sources, assumptions and methodology
used to calculate the value of security-based swaps may reduce the
informational advantage SBS Entities enjoy as a result of developing
superior valuation models or information, as supported by public
comments.\1685\ However, these costs are partly mitigated by the
ability to rely on standardized disclosures and a description of the
models, as opposed to disclosures of the models themselves.
---------------------------------------------------------------------------
\1685\ See, e.g., MFA, supra note 5; IDC, supra note 5.
---------------------------------------------------------------------------
c. Clearing Rights
Finally, Rule 15Fh-3(d) requires SBS Entities to make disclosures
regarding clearing rights to counterparties that are not SBS Entities
or Swap Entities before entering into the security-based swap. For
security-based swaps not subject to mandatory clearing, the SBS Entity
would be required to determine whether the security-based swap is
accepted for clearing by one or more clearing agencies, to disclose the
names of clearing agencies that accept the security-based swap for
clearing, and to notify the counterparty of their right to elect
clearing and the agency used to clear the transaction. For security-
based swaps subject to mandatory clearing, the final rules require SBS
Entities to disclose clearing agency names to the counterparty, and to
notify the counterparty of their right to select the clearing agency
subject to Section 3C(g)(5) of the Act. The rule also requires SBS
Entities to make a written record of the non-written disclosures and
provide counterparties with a written version of these disclosures no
later than the delivery of the trade acknowledgement of the
transaction.
The required disclosure of clearing rights may increase how
informed a counterparty is concerning the availability of clearing in
general, the ability to require clearing of security-based swaps, as
well as the names of clearing agencies that may accept a given
security-based swap for clearing. The reliance on standardized
disclosures may lead to more general and less transaction specific
information being communicated, reflecting information that has already
been absorbed by market participants and potentially reducing these
benefits. To the extent that the rule results in greater transparency
concerning clearing rights, the volume of cleared security-based swaps
may increase.
We note that clearing is currently voluntary and available for CDS
only.\1686\ Disclosure of the clearing
[[Page 30116]]
agencies that accept a security-based swap for clearing may inform
counterparties of the right to clear and of various clearing agencies
that are able to clear a given security-based swap, particularly
clearing agencies that have just started accepting a given security-
based swap or group of security-based swaps for clearing. This may
enhance potential competition among clearing agencies in the future,
which may lower clearing costs or improve quality of clearing services.
The above effect may be more significant if more clearing agencies
register to clear security-based swaps and clearing becomes available
for security-based swaps other than CDS, which are currently being
cleared voluntarily.
---------------------------------------------------------------------------
\1686\ Mandatory clearing is not currently in effect and we
currently do not have sufficient information to estimate the number
and volume of security-based swap transactions executed across
different trading venues and using these various execution
practices. However, the Commission staff has performed an analysis
of voluntary clearing activity in single name CDS markets, which
generally informs our analysis. See SEC Division of Economic and
Risk Analysis, Single-Name Corporate Credit Default Swaps:
Background Data Analysis on Voluntary Clearing Activity, 15 (Apr.
2015), available at http://www.sec.gov/dera/staff-papers/white-papers/voluntary-clearing-activity.pdf.
---------------------------------------------------------------------------
Currently, SBS Entities are not yet required to register and are
not subject to substantive Title VII requirements, including business
conduct rules. Therefore, SBS Entities currently are not required to
produce disclosures concerning clearing rights and a list of clearing
agencies accepting a security-based swap for clearing. Entities that
are currently registered with the CFTC as Swap Entities are required to
make clearing rights disclosures for swap transactions. Under these
final rules, all SBS Entities will bear costs of producing the clearing
rights disclosures pertaining to security-based swap transactions, and
communicating them to their counterparties other than SBS Entities and
Swap Entities, as estimated in Sections V and VI.C above. However, we
recognize that these costs may be lower for dually registered SBS
Entities that may have already adjusted their systems and practices to
comply with parallel CFTC rules. We also recognize that if, as a result
of the disclosure, some counterparties begin choosing to clear as well
as choosing the agency used to clear the transaction, SBS Entities may
lose potentially beneficial flexibility related to clearing, which may
affect the price of security-based swaps. In addition, if clearing
rights disclosures lead to a greater volume of transactions cleared
through registered clearing agencies, increases in clearing costs borne
by SBS Entities may be passed on to counterparties.
3. Suitability
SBS Dealers intermediate large volumes of security-based swaps,
buying products from counterparties seeking to sell them; and selling
swaps to counterparties seeking to purchase them. When SBS Dealer
exposure is not hedged by offsetting transactions with other dealers,
SBS Dealers act as principal risk holders, benefiting from directional
price moves that result in losses for their counterparties, and vice
versa. SBS Dealers carrying inventory may have an incentive to
recommend security-based swaps from their inventory that may be
unsuitable to their counterparties, but help to manage dealer inventory
risk. When SBS Dealers hedge the underlying risk of a transaction,
dealer profits stem from commissions and fees charged to their
counterparties in relation to the security-based swap. As a result, SBS
Dealer incentives may be generally inconsistent with, or may be
contrary to the economic interests of their counterparties.
As discussed in earlier sections, SBS Dealers are more informed
than their non-dealer counterparties as they can directly observe pre-
trade requests for quotes and order flow. Where SBS Dealers have
previously acted in other capacities, such as in the capacity of an
underwriter, arranger or structurer of a security-based swap, they may
have superior information about the quality and risk of a specific
security-based swap and its underlying assets. As a result, SBS Dealers
may have superior information about the inherent value and risk of
security-based swaps, including information concerning whether a given
security-based swap is unsuitable for a particular non-dealer
counterparty given the counterparty's horizon and ability to absorb
losses, among other things.
When SBS Dealers advise their counterparties regarding security-
based swaps, the above conflicts of interest may result in
recommendations of security-based swaps that may be unsuitable for a
given counterparty. For instance, more complex security-based swaps are
more opaque and difficult to price for less informed counterparties;
they may also be unsuitable for a greater number of non-dealer
counterparties.\1687\ At the same time, such transactions may be
profitable for the dealer. To the extent that SBS Dealers may be
recommending unsuitable security-based swaps, and to the extent
counterparties may be relying on such advice and are unable to observe
and decouple bias from the information component of the recommendation,
counterparties may be entering into security-based transactions
inconsistent with their investment objectives and risk tolerance. The
central role and high market share of a small number of SBS Dealers
described in the economic baseline may reduce the effectiveness of
reputational considerations in mitigating these effects.
---------------------------------------------------------------------------
\1687\ The Commission recognizes that complex over-the-counter
security-based swaps may benefit some market participants due to the
ability to tailor economic terms to counterparties' hedging needs or
market views.
---------------------------------------------------------------------------
Under Rule 15Fh-3(f)(1), SBS Dealers recommending security-based
swaps or trading strategies involving a security-based swap to
counterparties other than an SBS Entity or a Swap Entity are required
to (i) undertake reasonable diligence to understand potential risks and
rewards associated with the recommendation; and, (ii) have a reasonable
basis to believe that the recommended swap or strategy is suitable for
the counterparty, taking into account, among other things, the
counterparty's investment profile, trading objectives and ability to
absorb potential losses. Rule 15Fh-3(f)(2) includes an alternative for
institutional counterparties (defined as a counterparty that is an
eligible contract participant as defined in clauses (A)(i), (ii),
(iii), (iv), (viii), (ix) or (x), or clause (B)(ii) of Section 1a(18)
of the Commodity Exchange Act and the rules and regulations thereunder,
or any person (whether a natural person, corporation, partnership,
trust or otherwise) with total assets of at least $50 million) that
allows an SBS Dealer to satisfy its customer-specific suitability
obligations in Rule 15Fh-3(f)(1)(ii) if (i) the SBS Dealer reasonably
determines that the counterparty or agent with delegated authority is
capable of independently evaluating investment risks with respect to a
given security-based swap or strategy; (ii) the counterparty or agent
represents in writing that they are exercising independent judgment in
evaluating the dealer's recommendations; and (iii) the SBS Dealer
discloses that it is acting as a counterparty and not assessing
suitability. Under Rule 15Fh-3(f)(3), an SBS Dealer will be deemed to
have satisfied the requirements of the first prong of the institutional
suitability alternative in Rule 15Fh-3(f)(2)(i) if it receives written
representations that: (i) 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; and (ii) in the case of a counterparty that is a special
entity, satisfy the terms of the safe harbor in Rule 15Fh-5(b).
a. Costs and Benefits
Rule 15Fh-3(f)(1) may benefit counterparties by requiring that SBS
Dealers undertake reasonable diligence to understand the potential risk
and
[[Page 30117]]
rewards associated with recommended security-based swaps or trading
strategies involving security-based swaps and that these
recommendations are suitable for the counterparty given the
counterparty's investment profile, trading objectives, and ability to
absorb potential losses. As a result, counterparties of SBS Dealers may
become more likely to allocate capital to suitable security-based
swaps, potentially enhancing counterparty protections and allocative
efficiency.\1688\ These benefits are expected to accrue only to the
extent that some SBS Dealers otherwise may be making unsuitable
recommendations, and to the extent that non-SBS or Swap Entity
counterparties rely on such SBS Dealer recommendations in their capital
allocation decisions. If incentive conflicts or governance failures
within counterparties, or other factors unrelated to SBS Dealer
recommendations, for instance, reaching for yield in low interest rate
environments, contribute to potentially unsuitable security-based swap
choices, the benefits of these rules may be muted. The suitability
standard does not require dealers to disclose whether another suitable
security-based swap or underlier has superior material characteristics.
Therefore, some of the above counterparty protection and allocative
efficiency benefits of the suitability standard may be less. Further,
this benefit is likely to be highest for those counterparties of SBS
Dealers which do not already rely on professional asset managers or
independent advisers in security-based swap transactions.
---------------------------------------------------------------------------
\1688\ See, e.g., CFA, supra note 5; Levin, supra note 5.
---------------------------------------------------------------------------
The suitability requirement will impose costs on SBS Dealers.
First, the rule requires SBS Dealers to undertake reasonable diligence
to understand the potential risks and rewards of the security-based
swaps or trading strategy involving a security-based swap they
recommend. Second, the rule will involve direct costs required to make
an assessment of suitability of a security-based swap or asset class
for each counterparty.\1689\ As estimated in Section V, we expect that
SBS Dealers may seek to obtain representations at an estimated cost of
up to $11,393,160.\1690\ Further, the Commission recognizes that
suitability assessments under these final rules may give rise to
potential liability and litigation costs of SBS Dealers.
---------------------------------------------------------------------------
\1689\ See, e.g., FIA/ISDA/SIFMA, supra note 5.
\1690\ Initial cost: (In-house attorney at $380 per hour) x
(6,271 x 2 hours for participants active in both swaps and SBS
markets + 3,488 x 5 hours for participants active in SBS markets
only) = 380 x 29,982 = $11,393,160.
---------------------------------------------------------------------------
In considering the economic effects of this final rule, we note
that the suitability requirement does not apply to recommendations made
to SBS Dealers, Major SBS Participants, Swap Dealers, or Major Swap
Participants. Therefore, the rule may result in higher costs to SBS
Dealers in transacting with non-SBS or Swap Entity counterparties.
Additionally, costs of suitability assessments may be higher for
counterparties with which an SBS Dealer has had no prior transactions.
The rule may adversely affect counterparties of SBS Dealers that
are not themselves SBS Dealers, Major SBS Participants, Swap Dealers,
or Major Swap Participants. In addition, SBS Dealer cost increases due
to suitability assessments discussed above may be passed on to
counterparties, and, if a significant percentage of the costs cannot be
recovered, the willingness of SBS Dealers to make recommendations to
non-dealer counterparties may decrease. Further, SBS Dealers may have
superior information about the quality of security-based swaps they
intermediate, but have significantly less information about their
counterparty. This informational asymmetry may result in SBS Dealers
not recommending security-based swaps that may be potentially suitable
to the counterparty. Moreover, to the extent that customer suitability
evaluations take time and require additional due diligence, the rule
may result in execution delays, particularly during times of high
market volatility when the value of risk mitigation may be higher. We
note, however, that suitability requirements apply only with respect to
swaps being recommended by SBS Dealers, and counterparties may continue
to have access to security-based swaps intermediated without bundled
SBS Dealer advice, as well as swaps executed on SEFs or registered
exchanges.
The above benefits and costs of the suitability rule are likely to
be limited by the scope of these final rules and the institutional
suitability alternative. The suitability requirement is limited to
transactions between SBS Dealers and counterparties that are not
themselves SBS or Swap Entities. We believe that SBS Entities are
likely to be able to independently evaluate material risks, pricing,
and overall suitability of a security-based swap given, among others,
their investment objectives and risk tolerance. As shown in Figure 3,
the majority of trades and trade notional involved trades among
dealers, which substantially reduces the scope of application of the
suitability requirement. Further, as discussed below, the scope of
application of the suitability rule may be reduced if SBS Dealers are
able to take advantage of the institutional suitability alternative for
customer-specific suitability with respect to a significant fraction of
transactions.
As noted in the proposing release,\1691\ many SBS Dealers may
already have an obligation to make suitable recommendations in other
contexts. FINRA imposes a suitability requirement on recommendations by
broker-dealers and we have elsewhere estimated that up to 16 entities
registering with the Commission as SBS Entities may be already
operating as registered broker-dealers subject to Commission and FINRA
oversight.\1692\ As discussed in Section II, Swap Dealers registered
with the CFTC are also subject to reasonable basis and customer-
specific suitability requirements with respect to swap transactions
under Rule 23.434, and we have elsewhere estimated that up to 35 SBS
Entities may be cross-registered with the CFTC as Swap Entities. Some
of these cross-registered entities may have adjusted their compliance
infrastructure and recommendation practices. These considerations may
mitigate both the costs and the benefits of these final rules.
---------------------------------------------------------------------------
\1691\ See Proposing Release, 76 FR at 42450, supra note 3.
\1692\ See Registration Adopting Release, 80 FR at 49000, supra
note 989.
---------------------------------------------------------------------------
b. Institutional Suitability Alternative
Rule 15Fh-3(f)(2) includes an institutional suitability alternative
for customer-specific suitability assessments. SBS Dealers will be
deemed to have fulfilled their customer-specific suitability
obligations if they reasonably determine that the counterparty or its
agent is capable of independently evaluating the investment risks; the
counterparty or agent affirmatively represents in writing that they are
evaluating the investment independently; and the SBS Dealer discloses
that it is not undertaking to assess suitability for the counterparty.
The institutional suitability alternative for customer-specific
suitability requirements will not be available with respect to
counterparties that are not institutional counterparties (defined as a
counterparty that is an eligible contract participant as defined in
clauses (A)(i), (ii), (iii), (iv), (viii), (ix) or (x), or clause
(B)(ii) of Section 1a(18) of the Commodity Exchange Act and the rules
and regulations thereunder, or any
[[Page 30118]]
person (whether a natural person, corporation, partnership, trust or
otherwise) with total assets of at least $50 million. Recommendations
of any potentially unsuitable products could involve losses and lead to
inefficient capital allocation by non-dealer counterparties when such
counterparties lack the ability to independently assess suitability of
security-based swap transactions they enter into. Sophisticated
institutions or entities that rely on independent advisors in their
decision making may be better able to independently assess the merits
and suitability of a given security-based swap. Therefore, more
sophisticated counterparties and counterparties that rely on
independent advisers to assess disclosures and analyze the relative
merits of individual swaps are less likely to benefit from the
suitability rule. The institutional suitability alternative reflects
these considerations.
As a result of the institutional suitability alternative, SBS
Dealers will not be required to undertake customer-specific suitability
evaluations for counterparties that the rule presumes are capable of
independently evaluating investment risks with regard to the relevant
security-based swap or trading strategy involving a security-based
swap. As shown in Table 2 of the economic baseline, between November
2006 and December 2014, 99% of private funds, 100% of registered
investment companies, 72% of insurance companies, 75% of non-financial
firms and 98% of special entities were represented by investment
advisers. Hence, non-dealer counterparties generally have third-party
representation and may be able to evaluate security-based swaps
independently of SBS Dealers. Many SBS Dealers may be able to rely on
the institutional suitability alternative to fulfill their customer-
specific suitability obligations. Therefore, a large fraction of
transactions may qualify for the institutional suitability alternative,
and the economic effects of the suitability requirement above may
accrue to a small share of security-based swap market activity.
In addition, the institutional suitability alternative for
customer-specific suitability will not be available for SBS Dealers
making recommendations to counterparties that are not institutional
counterparties. The $50 million asset threshold in the institutional
counterparty definition narrows the scope of the alternative and
increases the potential counterparty protection and allocative
efficiency benefits of the final suitability rule. Our data do not
allow us to estimate how many counterparties that would not meet the
institutional counterparty definition are currently transacting in
security-based swap markets and relying on recommendations by SBS
Dealers, asset size thresholds for counterparties at which the intended
information and counterparty protection benefits of these final rules
become significant, or the extent to which asset size and counterparty
sophistication may be correlated in security-based swap markets. We
also recognize that the $50 million asset size threshold may increase
costs and diverges from the suitability safe harbor adopted by the CFTC
as part of business conduct standards for Swap Entities. As a result,
all SBS Dealers that are dually registered with the CFTC as Swap
Dealers will face a bifurcated suitability standard in swaps and
security-based swaps, such as index CDS and single name CDS, with
respect to counterparties that do not meet the institutional
counterparty definition. In response to these final rules, dually
registered SBS Dealers may choose not to rely on the institutional
suitability alternative when making recommendations to counterparties
that do not meet the institutional counterparty definition in both swap
and security-based swap markets.
Direct burdens and costs of suitability assessments have been
estimated above. The Commission also recognizes that this aspect of the
institutional suitability alternative may increase system complexity,
liability and other costs less amenable to quantification that SBS
Dealers will incur as a result of advising and transacting with small
counterparties in security-based swaps. These costs may be passed on to
counterparties of SBS Dealers, which may experience an increase in
transaction costs, decreased access to SBS Dealer advice, or decreased
willingness of SBS Dealers to intermediate over-the-counter security-
based swaps.
However, affected counterparties may continue to retain access to
anonymous SEF or exchange executed security-based swaps, which are not
subject to the suitability requirements of these final rules. Further,
while the asset threshold in the institutional suitability alternative
diverges from the CFTC's approach to suitability for Swap Dealers, it
aligns with FINRA's asset threshold for the institutional account
definition. SBS Dealers cross-registered as broker-dealers are
currently unable to rely on institutional suitability when recommending
less complex products, such as vanilla equity or fixed income
instruments, to the same group of counterparties, and may be less
affected by the institutional counterparty asset threshold for the
suitability alternative. We note that SBS Dealers will be able to avail
themselves of the institutional suitability alternative when making
recommendations to certain financial institutions, insurance companies,
registered investment companies, commodity pools with at least $5
million in assets, broker-dealers, futures commission merchants, floor
brokers, investment advisers and commodity trading advisors with less
than $50 million in assets. As discussed above, the Commission believes
that the $50 million asset threshold may enhance counterparty
protection and allocative efficiency benefits of the final suitability
rule relative to the alternative of not including an asset threshold as
part of institutional suitability.
We note that the institutional suitability alternative is not
applicable to the suitability requirement to undertake reasonable
diligence to understand the potential risks and rewards associated with
the recommended security-based swap or trading strategy involving a
security-based swap. However, when SBS Dealers rely on the alternative,
they will not be required to make customer-specific suitability
assessments with respect to individual counterparties' investment
profile, trading objectives and ability to absorb losses.
As clarified in Section II, the Commission believes that parties
should be able to make the disclosures and representations required by
Rules 15Fh-3(f)(2) and (3) on a transaction-by-transaction basis, on an
asset-class-by-asset-class basis, or in terms of all potential
transactions between the parties. As a result, SBS Dealers will not be
required to assess customer-specific suitability of whole asset classes
or all security-based swaps, if the counterparty makes appropriate
representations and other institutional suitability requirements are
met.
To the extent that security-based swaps are heterogeneous in their
risk and expected return characteristics, and since the degree of
counterparty sophistication and familiarity with various types of
security-based swaps may vary over time, such an approach to
institutional suitability may lower the benefits of the rule. However,
the ability to take advantage of the institutional suitability
alternative for groups of security-based swaps, asset classes or
counterparties as a whole mitigates the burdens imposed on SBS
Dealers,\1693\
[[Page 30119]]
particularly when such dealers intermediate multiple homogeneous
transactions with the same counterparty over a limited time period. For
instance, as we have noted in the economic baseline, based on an
analysis of DTCC-TIW data, an average unique dealer-nondealer pair
entered into approximately 32 transactions in 2014. The ability of
dealers to rely on the institutional suitability alternative for some
or all of the trades with a given counterparty would be less costly,
and may also limit execution delays facilitating market access to
security-based swaps.
---------------------------------------------------------------------------
\1693\ See, e.g., Barnard, supra note 5.
---------------------------------------------------------------------------
In addition to the above considerations concerning institutional
suitability, we note that the final suitability requirements will not
apply if an SBS Dealer does not recommend a security-based swap or
trading strategy involving a security-based swap to counterparties. As
estimated above, the suitability requirement imposes costs on SBS
Dealers, and may decrease their willingness to recommend security-based
swaps to non-SBS or Swap Entity counterparties. However, as discussed
throughout the release, we believe that the overwhelming majority of
market participants already have access to third party advice
concerning security-based swaps.
Finally, suitability obligations will also apply to transactions
with special entities, and the institutional suitability alternative
described above will be available for special entity counterparties
that meet the institutional counterparty definition (i.e., have total
assets of at least $50 million).
4. Special Entities
The business conduct rules being adopted include a number of
requirements for SBS Entities specific to their dealings with special
entities governing, among other things: (a) The scope of entities that
will be subject to the substantive special entity standards; (b) the
duty to verify and inform entities when they are eligible to elect not
to be considered a special entity for the purposes of these rules; (c)
the definition of qualified independent representative for such
purposes; (d) the conduct of SBS Entities when they act as
counterparties to special entities; (e) the conduct of SBS Dealers when
they act as advisors to special entities.
a. Scope and Verification
First, as part of verification of status requirement under Rule
15Fh-3(a)(2), SBS Entities will be required to verify whether a
counterparty is a special entity before entering into a security-based
swap, unless the transaction is executed on a registered or exempt SEF
or registered national securities exchange, and the SBS Entity does not
know the identity of the counterparty at a reasonably sufficient time
prior to execution of the transaction to permit the SBS Entity to
comply with the rule. Under Rule 15Fh-3(a)(3), an SBS Entity shall also
verify whether a counterparty is eligible to elect not to be a special
entity, and, if so, notify such counterparty of its right to make such
an election. Rule 15Fh-2(e) defines the scope of special entities to
include, among other things, federal and state agencies, States,
cities, counties, municipalities, and other political subdivisions of a
State, instrumentalities, departments or corporations of or established
by a State or political subdivision of a State, employee benefit plans
subject to Title I of ERISA, governmental plans as defined in Section
3(32) of ERISA, and endowments. Rule 15Fh-2(e) also provides that
employee benefit plans defined in Section 3 of ERISA, that are not
otherwise defined as special entities, may elect not to be treated as
special entities by notifying an SBS Entity prior to entering into a
security-based swap.
These final rules define the set of special entities that will be
able to avail themselves of the protections in these final rules. The
inclusion of entities defined in, but not subject to, ERISA into the
special entity category, subject to an opt out provision, increases the
set of market participants afforded the counterparty protections under
the final business conduct standards, relative to the exclusive
application of these rules to entities subject to ERISA.\1694\ At the
same time, as discussed below, compliance with these final rules
concerning special entities will entail direct and indirect costs for
SBS Entities. Increased costs to SBS Entities may be passed on to
special entity counterparties in the form of more adverse terms of
available security-based swaps or a decreased willingness of SBS
Entities to intermediate such swaps with special entities, which may
reduce special entities' access to such security-based swaps.\1695\ The
ability of special entities defined in, but not subject to, ERISA to
opt out of the special entity status may give such entities greater
flexibility in structuring their relationships with SBS Entities, and
allow them to trade off the benefits of counterparty protections in
these final rules against potentially greater costs and lower liquidity
in SBS Entity intermediated OTC security-based swaps.
---------------------------------------------------------------------------
\1694\ See Church Alliance (August 2011), supra note 5 and
Church Alliance (October 2011), supra note 5, suggesting that church
plans may benefit from enhanced conduct by SBS Entities in their
advisory or intermediation roles, and requesting clarification of
status of church plans for purposes of regulations under Dodd Frank.
\1695\ As we discuss in Section VI.C.4.f, special entity rules
will not apply to security-based swaps executed on registered or
exempt SEFs or registered national security exchanges, where SBS
Entities do not know the identity of the counterparty at a
reasonably sufficient time prior to execution of the transaction to
permit the SBS Entity to comply with these final obligations.
Therefore, special entities and entities defined in, but not subject
to ERISA, regardless of their opt out decision, will continue to
have access to anonymous SEF or exchange executed security-based
swaps.
---------------------------------------------------------------------------
We note that the opt out approach for special entities defined in,
but not subject to, ERISA differs from parallel CFTC business conduct
rules, which allow such entities to opt into the special entity status
instead. As discussed in the economic baseline, the Commission expects
extensive cross-registration of SBS Entities as Swap Entities, and
understands most market participants transact in both swap and
security-based swap markets. To the extent that SBS Entities have
significant bargaining power in transactions with special entities,
special entities that have selected not to opt into the special entity
status in swap markets are likely to opt out of similar protections
under these final rules. Therefore, it is unclear whether the ability
of special entities defined in, but not subject to ERISA to opt out of
special entity protections would lead to a greater number of special
entities benefiting from counterparty protections in these final rules,
relative to the opt in approach. We also recognize that under the final
rules, if a special entity chooses to opt out of the special entity
status, it would be required to provide a written notice to the SBS
Entity and would bear related costs. The overall economic effects of
this rule will, therefore, depend on the number of entities defined in,
but not subject to, ERISA that will choose to opt out of the special
entity status, the costs of producing notices, and magnitude of the
transaction cost increases in OTC security-based swaps resulting from
compliance with these final special entity rules.
Estimates of special entity market participants in our economic
baseline are based on manual account classifications, and our data is
not sufficiently granular to estimate the number of special entities
defined in but not subject to ERISA currently active in security-based
swap markets that may be scoped in by these rules. Special
[[Page 30120]]
entities represent approximately 8% of market participants in swap
markets.\1696\ Out of 3,635 special entities subscribed to the ISDA
August 2012 DF Protocol, 1,453 market participants (approximately 40%)
elected to be a special entity under the protocol. This may indicate
that a substantial number of market participants in swap markets may
have opted into the special entity treatment. However, we note that
using hand classifications of accounts in TIW data on 2006-2014, we
estimate that special entities represent approximately 10.5% of single
name CDS market participants by count (see Table 2 above). This
estimate is comparable to the 8% of all special entities adhering to
the ISDA August 2012 DF Protocol, and our hand classifications of
accounts do not distinguish between special entities subject to ERISA,
and those defined in but not subject to ERISA. Therefore, our analysis
of special entity transaction activity throughout the release likely
includes both special entities subject to ERISA, and entities defined
in but not subject to ERISA that may opt out of the special entity
protections of these final rules.
---------------------------------------------------------------------------
\1696\ This estimate is based upon data provided by ISDA as of
December 31, 2015 on the number and type of market participants
adhering to the ISDA August 2012 DF Protocol. See Memorandum from
Lindsay Kidwell to File (Feb. 18, 2016) available on the
Commission's Web site at http://www.sec.gov/comments/s7-25-11/s72511.shtml under ``Meetings with SEC Officials.'' See also Section
VI.B.
---------------------------------------------------------------------------
Special entity requirements and related costs will not apply to
security-based swaps transacted on registered national securities
exchanges and registered or exempt SEFs, if the SBS Entity does not
know the identity of the counterparty at a reasonably sufficient time
prior to execution of the transaction to permit the SBS Entity to
comply with the obligations of the rules. We recognize that some
security-based swaps executed on a SEF or exchange may be bilaterally
negotiated, which may point to potential counterparty and information
benefits of applying the business conduct rules to SEF and exchange
traded security-based swaps. However, bilateral negotiations are likely
to require an SBS Entity to know the identity of the counterparty at a
reasonably sufficient time prior to execution to permit compliance. We
also recognize that conflicts of interest may affect SBS Dealer
recommendations of security-based swaps regardless of the venue in
which these transactions are executed. It is not clear whether an SBS
Dealer would be able to make a recommendation to a counterparty whose
identity is not known at a reasonably sufficient time prior to
execution. Finally, as we discuss throughout the release, while
business conduct rules, including rules concerning special entities,
may result in significant benefits, they will impose direct and
indirect costs on SBS Entities. In the context of SEF transactions, the
application of these rules may increase transaction costs, add
complexity and delays, or require negotiation with counterparties. To
the extent that security-based swaps executed through SEFs may
represent exclusively arms-length transactions, the terms of which are
not negotiated, the imposition of the final business conduct rules on
such trades could increase costs without corresponding benefits
anticipated by these final rules. For instance, if clearing reduces
credit risk of counterparties, SBS Entities may compete on transaction
costs and quality of execution, as opposed to credit risks of the
transaction, as suggested by commenters.\1697\ These final rules
recognize these competing considerations and provide explicit relief
for transactions executed on a registered or exempt SEF or registered
national exchange, if the SBS Entity does not know the identity of the
special entity counterparty at a reasonably sufficient time prior to
execution of the transaction to permit compliance with the obligations
of the rule. Finally, the Commission continues to recognize that the
benefits of these final special entity rules are expected to primarily
accrue to entities that are less informed about security-based swap
markets. While special entities will not be able to opt out of the
protections of these final rules as discussed in section VI.C.8, SBS
Entities will be able to rely on an independent representative safe
harbor, the economic effects of which are considered in detail in the
sections that follow.
---------------------------------------------------------------------------
\1697\ See SIFMA (August 2011), supra note 5 and BlackRock,
supra note 5.
---------------------------------------------------------------------------
As discussed in Section II, the special entity definition does not
include collective investment vehicles, and the final rules do not
require SBS Dealers to determine whether any of the investors in the
collective investment vehicle counterparty qualify as special entities.
Such an approach limits the scope of application of these final rules,
reducing potential counterparty protection and allocative efficiency
benefits, but also potential costs and risks of loss of access by
special entities and entities defined in, but not subject to ERISA, to
security-based swaps.
b. SBS Entities as Counterparties to Special Entities
Under final Rule 15Fh-5(a) an SBS Entity that offers to enter or
enters into a security-based swap with a special entity must have a
reasonable basis to believe that the special entity has a qualified
independent representative. Under Rule 15Fh-5(c), before initiating a
swap, an SBS Dealer will also be required to disclose in writing the
capacity in which the dealer is acting in connection with the security-
based swap. Additionally, if the SBS Dealer or its associated persons
engage or have engaged in business with the special entity in more than
one capacity, the dealer would be required to disclose the material
differences between such capacities and any other financial
transactions or service involving the special entity. As discussed in
section II.H.7 supra, the SBS Dealer may use generalized disclosures
regarding the capacities in which the SBS Dealer and its associated
persons have acted or may act with respect to the special entity, along
with a statement distinguishing those capacities from the capacity in
which the SBS Dealer is acting with respect to the present security-
based swap. The requirements in Rule 15Fh-5 do not apply to a security-
based swap if the transaction is being executed on a registered or
exempt SEF or registered national securities exchange, and the SBS
Entity does not know the identity of the counterparty at a reasonably
sufficient time prior to execution of the transaction to permit
compliance with these obligations.
Qualified independent representatives must have sufficient
knowledge to evaluate the transaction and risks; may not be subject to
statutory disqualification; undertake a duty to act in the best
interests of the special entity; appropriately and timely disclose
material information concerning the security-based swap to the special
entity; evaluate, consistent with any guidelines provided by the
special entity, the fairness of pricing and appropriateness of the
security-based swap; and for certain types of special entities the
representative must be subject to rules for the Commission, the CFTC,
or a SRO prohibiting it from engaging in specified activities if
certain political contributions have been made, unless the
representative is an employee of the special entity. Independence
requires that a 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. A
[[Page 30121]]
representative will be deemed to be independent of an SBS Entity if,
within one year of representing the special entity in connection with
the security-based swap, the representative was not an associated
person of an SBS Entity; provides timely 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; complies with
policies and procedures reasonably designed to manage and mitigate such
material conflicts of interest; and the SBS Entity did not refer,
recommend, or introduce it to the special entity within one year of the
representative's representation of the special entity in connection
with the security-based swap. As proposed by some commenters, ERISA
plans will be able to comply with these requirements by relying on an
ERISA fiduciary.\1698\ Further, as we discuss in more detail below, the
independence requirement refers to the representative's independence of
the SBS Entity and not of the special entity and so, qualified
investment representatives that are employees or associates of the
special entity may qualify as independent representatives for the
purposes of these rules.
---------------------------------------------------------------------------
\1698\ See ABC, supra note 5 and SIFMA (August 2011), supra note
5.
---------------------------------------------------------------------------
In contrast with the final rule, the proposed rule defined
independence based on a two-prong test of (1) associated person status
within the preceding year; and (2) ten percent or greater revenue
reliance on a given SBS Entity. We are sensitive to commenter concerns
that this definition may impose undue restrictions and cost burdens on
SBS Entities, and may be difficult to implement.\1699\ Further, the
CFTC's independence formulation applicable to Swap Entities does not
include a ten percent revenue prong in the independent test with
special entities. In light of active cross-market participation and
expected SBS Entity cross-registration, adopting a substantively
different independence requirement from that required by Swap Entities
may impose costs of compliance with two different independent
representation standards. At the same time, it is unclear that such an
approach would be more beneficial to counterparty protections,
Commission oversight or enforcement in security-based swaps relative to
the approach being adopted.
---------------------------------------------------------------------------
\1699\ See, e.g., SIFMA (August 2011), supra note 5; APPA;
BlackRock, supra note 5; SIFMA (August 2011), supra note 5; ABA
Committees, supra note 5; FIA/ISDA/SIFMA, supra note 5; Blackrock,
supra note 5.
---------------------------------------------------------------------------
Under this rule, special entities transacting with more informed
and sophisticated SBS Entities will have the benefit of representation
by a qualified independent representative that has a duty to act in the
best interests of the entity. To the extent that some special entities
are less informed about security-based swaps and less able to unwind
biases that may exist in potentially conflicted recommendations than
other counterparties, this requirement may appropriately facilitate
stronger protections and superior capital allocation decisions by
special entities. Better informed special entities, such as large well-
informed pension funds that regularly transact in security-based swaps,
are likely to enjoy fewer benefits of this requirement. However, they
may also be more likely to use investment advisers in their current
security-based swap transactions, in which case they would need to make
that representation to an SBS Dealer under Rule 15Fh-5(b). In addition,
similar to our earlier discussion of suitability rules, to the extent
that special entities may be entering security-based swap transactions
with inferior risk-return characteristics as a result of internal
incentive conflicts or macro factors, such as reaching for yield in a
low interest rate environment, the benefits of these protections may be
muted.
Further, special entities that transact with the SBS Dealer in a
variety of roles, such as investment adviser or underwriter, will
benefit from greater transparency about the capacity in which the
dealer is entering the security-based swap. For instance, if an SBS
Dealer currently engages in business with a special entity in the
capacity of an investment adviser, the SBS Dealer would be required to
disclose that it is not acting in such capacity if it is seeking to
enter into a security-based swap with the special entity. This may help
counterparties better understand the nature of the incentives of an SBS
Dealer in relation to a given security-based swap transaction.
This rule will involve direct and indirect costs. SBS Entity
counterparties will incur costs of obtaining a reasonable basis to
believe that the special entity has a qualified independent
representative. Based on our estimates in Section V, all SBS Entities
acting as counterparties to special entities will incur an aggregate
initial cost of, approximately, $132,819,500.\1700\ Ongoing costs of
compliance with rules for counterparties of special entities will
involve updating representations and verifications for transactions
with third-party non-employee independent representatives, estimated at
$8,569,000.\1701\ In-house independent representatives will bear costs
of making representations to SBS Entities, which will involve an
aggregate initial compliance burden of, approximately, $137,104,000
with an ongoing cost of $8,569,000.\1702\
---------------------------------------------------------------------------
\1700\ Aggregate initial cost: (In-house attorney at $380 per
hour) x 349,525 hours = $132,819,500.
\1701\ Ongoing aggregate cost: (In-house attorney at $380 per
hour) x 22,500 hours = $8,569,000.
\1702\ Initial cost: (In-house attorney at $380 per hour) x
360,800 hours = $137,104,000. We believe that in-house investment
advisers may be compensated similarly to in-house attorneys. To the
extent that the rate of compensation for independent representatives
may be lower, these figures may overestimate the aggregate initial
burden related to these final rules.
Ongoing: (In-house attorney at $380 per hour) x 22,500 hours =
$8,569,000.
---------------------------------------------------------------------------
In addition, some special entities may be entering security-based
swaps with SBS Entities that are not in their best interest, and advice
from qualified independent representatives may help inform special
entities and enable them to make better investment decisions.
Therefore, this rule may improve allocative efficiency of security-
based swap investments. However, as noted earlier, SBS Entities are
for-profit entities, and, to the extent that SBS Entities are currently
intermediating security-based swaps that are not in the best interests
of some of their special entity counterparties, the rule may lower an
SBS Entity's profitability of intermediating security-based swaps with
special entities. SBS Entities may attempt to recoup these costs in the
form of less attractive security-based swap terms, or become less
willing to transact with special entities. As an additional
consideration, entities with activity levels below de minimis
triggering SBS Dealer registration, but with positions large enough to
require Major SBS Participant registration will bear these costs of
intermediating transactions with special entities. If the costs of
intermediated security-based swaps with special entities are
substantial, some Major SBS Participants may reduce or stop transacting
with special entity counterparties.
These costs may be lower if SBS Entities' special entity
counterparties provide representations that allow SBS Entities to take
advantage of the safe harbor in Rule 15Fh-5(b). Our data do not allow
us to estimate the number of
[[Page 30122]]
special entities currently relying on qualified independent
representatives since we cannot observe whether they have conflicts of
interest with SBS Entities that would preclude them from meeting
independence requirements of these final rules. However, we note that,
as reflected in the economic baseline, special entities represent
approximately 10.5% of account holders in DTCC TIW between 2006 and
2014. Only approximately 2% of special entities did not rely on
investment advisers in their single name CDS trades, with 85 unique
pairs of SBS Dealers and U.S. special entities transacting in single
name CDS. In 2014, there were 2 unique trading relationships between
likely SBS Dealers and special entities without a third party
investment adviser, representing approximately 0.039% of all
transactions in 2014. Therefore, the overwhelming majority of special
entities may already be relying on investment advisers in their
security-based swap transactions. However, we do not observe whether
advisors in TIW data meet the independence and qualification
requirements being adopted in these final rules. If a significant
fraction of third party representatives does not meet the qualified
independent representative requirements in these final rules, special
entity counterparties of SBS Entities may choose to replace third party
representatives with those that do have requisite qualifications and
independence, enabling continued transaction activity with SBS
Entities, or may lose access to SBS Entity intermediated OTC security-
based swaps.
As estimated above, all special entity counterparties of SBS
Entities will face costs of making representations to SBS Entities
concerning their reliance on independent advisors acting in their best
interests. To the extent SBS Entities transact with special entities
that are not already relying on representatives, or are relying on
representatives that would not meet the qualification and independence
criteria in these final rules, such special entities would incur costs
of obtaining a new representative and making necessary representations,
if they wish to facilitate the SBS Entities' reliance on the safe
harbor. This may increase demand for the services of qualified
independent representatives, and independent representatives may
require higher compensation to reflect such higher demand. Such costs
will depend on the number of third-party representatives of special
entities that do not currently meet the independence and qualification
requirements of these final rules; the resulting increase in the demand
for new representation; and the supply of investment advisers not
currently representing special entities in security-based swaps that
would be considered qualified and independent under these final rules.
We lack data to quantify these effects and commenters did not provide
information that would enable such quantification. We are, therefore,
unable to estimate these costs.
Under the final rules, SBS Entities may become counterparties of
special entities only if they have a reasonable basis to believe that
the special entity has a qualified independent representative. We note
that Rule 15Fh-1(b) allows SBS Entities to rely on written
representations of a counterparty to satisfy its due diligence
requirements. As a result, SBS Entities that can rely on
representations will not be required to conduct independent assessments
of the qualifications or independence of special entity
representatives, as proposed by some commenters.\1703\ These issues are
discussed in further detail in Section VI.C.4.iv below.
---------------------------------------------------------------------------
\1703\ See, e.g., SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------
c. SBS Dealers as Advisors to Special Entities
Rule 15Fh-2(a) introduces in a default presumption that an SBS
Dealer acts as an advisor to a special entity when it recommends a
security-based swap or a trading strategy that involves the use of a
security-based swap to the special entity. The rule provides a safe
harbor, where an SBS Dealer will not be acting as advisor when a
special entity represents that it acknowledges that the SBS Dealer is
not acting as an advisor, that the special entity will rely on advice
from a qualified independent representative, and the SBS Dealer
discloses to the special entity that it is not undertaking to act in
the best interest of the special entity. The rule also provides a safe
harbor for SBS Dealers transacting with ERISA special entities, where
the SBS Dealer will not be acting as an advisor if the special entity
represents that it has an ERISA fiduciary; the fiduciary represents in
writing that it acknowledges that the SBS Dealer is not acting as an
advisor; and the special entity represents either that it will comply
in good faith with written policies and procedures designed to ensure
that any recommendation received from the SBS Dealer involving a
security-based swap transaction is evaluated by a fiduciary, or that
any recommendation received from the SBS Dealer involving a security-
based swap transaction will be evaluated by a fiduciary.
Rule 15Fh-4(b) establishes requirements for an SBS Dealer acting as
an advisor to special entities. Rule 15Fh-4(b)(1) provides that an SBS
Dealer acting as an advisor to a special entity shall have a duty to
make a reasonable determination that any security-based swap or trading
strategy involving a security-based swap recommended by the SBS Dealer
is in the best interests of the special entity. Rule 15Fh-4(b)(2)
requires an SBS Dealer acting as an advisor to a special entity to make
reasonable efforts to obtain such information that the SBS Dealer
considers necessary to make such a determination.
The final rules except transactions executed on registered or
exempt SEFs or registered national securities exchanges if an SBS
Dealer does not know the identity of the counterparty at a reasonably
sufficient time prior to execution to permit compliance with these
final obligations.
As discussed in detail in earlier sections, SBS Dealers enjoy
informational advantages relative to their nondealer counterparties,
and are for profit entities with business interests that may conflict
with those of their counterparties in principal and/or agency
transactions. Hence, SBS Dealers may have conflicts of interest related
to the security-based swaps and the securities underlying them.\1704\
Such conflicts of interest may influence SBS Dealer recommendations to
their counterparties. The final business conduct rules may lessen the
reliance of special entities on SBS Dealer recommendations, but, they
may also limit special entities' access to security-based swap related
investment advice and OTC security-based swaps.
---------------------------------------------------------------------------
\1704\ See Sections VI.A and VI.C.2 for a more detailed
discussion of informational asymmetries and conflicts of interest
related to security-based swap dealing activity.
---------------------------------------------------------------------------
Special entity counterparties may be aware of these fundamental
incentives of SBS Dealers and of the complexity and opacity of
security-based swaps, and may be able to recognize and parse out the
potential bias in dealer recommendations. As discussed above, special
entities represent a small fraction of market participants and almost
exclusively rely on investment advisers. We also note that, to the
extent special entities are currently allocating capital inefficiently
in security-based swaps, they may be doing so for reasons unrelated to
SBS Dealer recommendations, such as reaching for yield in a low
interest rate environment,
[[Page 30123]]
or as a result of fund manager incentive conflicts. If special entity
participation in security-based swap markets is driven by these other
factors and is not a result of reliance on SBS Dealer recommendations,
the benefits of these rules may be reduced.
As we have noted in prior sections, based on TIW data for 2006
through 2014, approximately 98% of special entities transacting in
single name CDS trades in TIW rely on advisors. We lack data to
estimate how many of these advisors may be considered qualified
independent representatives for the purposes of the safe harbor.
However, we recognize that the economic effects of this rule may be
significantly reduced if many SBS Dealers avail themselves of the safe
harbor in their transactions with and recommendations to special
entities.
We note that under the final rules, when an SBS Dealer makes a
recommendation to a special entity, and obtains the representations and
makes the disclosures required by the safe harbor, the SBS Dealer will
not be required to comply with the best interest standard in Rule 15Fh-
4(b). However, if, in such cases the special entity counterparty has
less than $50 million in assets (and therefore, does not meet the
institutional counterparty definition), the SBS Dealer will still be
required to comply with its customer-specific suitability obligations
in Rule 15Fh-3(f)(1)(ii). This provision imposes customer-specific
suitability obligations on SBS Dealers who cannot take advantage of the
institutional suitability alternative in Rule 15Fh-3(f)(2). This may
enhance potential counterparty protection and allocative efficiency
benefits of the final special entity rules relative to the alternative
of not imposing customer-specific suitability obligations with respect
to special entities under the safe harbor with less than $50 million in
assets. Our data do not allow us to estimate how many special entities
would fall under the $50 million asset size threshold; asset size
thresholds for special entities at which the intended information and
counterparty protection benefits of these final rules become
significant; or the extent to which asset size and special entity
sophistication may be correlated in security-based swap markets.
We also recognize that this approach diverges from the
institutional suitability alternative adopted by the CFTC as part of
business conduct standards for Swap Entities. As a result, all SBS
Dealers that are dually registered with the CFTC as Swap Dealers will
face two different standards of care in swaps and security-based swaps
when making recommendations to special entities with less than $50
million in assets. As a result, dually registered SBS Dealers may
choose not to rely on the institutional suitability alternative when
making recommendations to special entities with less than $50 million
in both swap and security-based swap markets. This aspect of the
alternative may increase costs that SBS Dealers will incur as a result
of advising and transacting with small special entities in security-
based swaps. SBS Dealers may reduce their provision of advice to small
special entities or pass on such costs to counterparties in the form of
higher transaction costs or a decreased willingness to intermediate
over-the-counter security-based swaps. Further, as discussed above, the
Commission believes that suitability obligations for special entities
with less than $50 million in assets may increase the potential
counterparty protection and allocative efficiency benefits of the final
special entity rules. Therefore, the primary economic effects of these
rules depend on the degree to which special entities rely on conflicted
SBS Dealer recommendations in their security-based swap decisions, the
value of biased security-based swap recommendations by SBS Dealers, the
relative cost of outside investment advice concerning security-based
swaps, and the fraction of SBS Dealers that will be able to take
advantage of the qualified independent representative safe harbor.
Therefore, the primary economic effects of these rules depend on
the degree to which special entities rely on conflicted SBS Dealer
recommendations in their security-based swap decisions, the value of
biased security-based swap recommendations by SBS Dealers, the relative
cost of outside investment advice concerning security-based swaps, and
the fraction of SBS Dealers that will be able to take advantage of the
qualified independent representative safe harbor.
SBS Dealers will be unable to recommend security-based swaps that
are not in special entities' best interests, and will therefore forego
potential incremental profits from such transactions. SBS Dealer ``best
interest'' determinations concerning recommended security-based swaps
may potentially give rise to dealer liability or litigation risk if
there are differences of opinion concerning the relative merits of
different security-based swaps and counterparties incur losses. SBS
Dealer registration is not currently required, disclosure of litigation
reserves by SBS Dealers is not mandatory, and the economic magnitude of
such costs will depend on how special entities, their representatives
and SBS Dealers will respond to these final rules. Therefore, we are
unable to estimate these costs. However, we recognize that some SBS
Dealers may incur such costs. In addition, the aggregate initial costs
of revising representations and collecting requisite information from
special entities related to the requirements for SBS Dealers serving as
advisors to special entities are estimated at $741,000.\1705\
---------------------------------------------------------------------------
\1705\ Initial cost: (In-house attorney at $380 per hour) x
((250 hours to draft, review and revise the representations in
standard SBS documentation) + (1,700 hours to collect information
from each special entity) = $741,000.
---------------------------------------------------------------------------
SBS Dealers that are most affected by these costs may respond to
the final rules by ceasing to provide security-based swap
recommendations to special entities, limiting special entities' access
to such investment advice, or by decreasing their willingness to
intermediate OTC security-based swaps with special entities. However,
we note that SBS Dealers that lose the most profit as a result of the
requirement to provide advice in their counterparties' best interests
may have been issuing more conflicted recommendations that were not in
the special entities' best interests. Therefore, special entities may
lose access to such conflicted advice, but the remaining advice by SBS
Dealers should be consistent with special entities' best interest.
d. Independent Representation: Alternatives
We have considered alternatives that result in tightening of the
independence requirements for representatives, for instance, through
the imposition of a longer look back period in the associated person
prong of the independence definition. More stringent independence
requirements may mitigate potential conflicts of interest and biases in
security-based swap recommendations registered representatives make to
special entities. However, as tabulated in Table 2, the majority of
market participants rely on investment advisers for their security-
based swap transactions, and more stringent definitions will limit the
number of representatives qualified to advise special entities in
security-based swaps. A decrease in the supply of independent
representatives may increase the cost of retaining independent
representation and limit access by smaller, less sophisticated
counterparties that benefit from independent advice and representation
[[Page 30124]]
in opaque and complex security-based swap transactions. Further, more
stringent independence requirements may decrease the level of
specialized expertise of representatives. We have received mixed
comments on the relative merits of various definitions of independence,
commenters did not quantify the economic costs or benefits of the
alternatives \1706\ and no such data is available at present time. As
indicated earlier, the independence definition being adopted is
consistent with the CFTC's approach in swap markets.
---------------------------------------------------------------------------
\1706\ See, e.g., Better Markets (August 2011), supra note 5;
NAIPFA, supra note 5; CFA, supra note 5; FIA/ISDA/SIFMA, supra note
5; APPA; BlackRock, supra note 5; SIFMA (August 2011), supra note 5;
and Blackrock, supra note 5.
---------------------------------------------------------------------------
Finally, we have considered eliminating the independent
representative safe harbor from the special entity requirements, as
suggested by some commenters.\1707\ To the extent that unsophisticated
counterparties rely on independent outside advisors or professional
portfolio managers acting in their best interest, the economic effects
of potential biases in SBS Dealer recommendations may be mitigated.
Sophisticated entities and entities relying on independent advice from
qualified fiduciaries are less likely to benefit from SBS Dealer best
interest recommendations, particularly in light of the disclosures
being adopted as part of these final rules. At the same time, the costs
of SBS Entity advice under the best interest standard would be passed
on to special entities, increasing costs of security-based swaps and
potentially limiting market access for special entities. Further, SBS
Entities may have superior information about security-based swaps, but
face information asymmetries concerning the nature of financial and
business risks of their counterparties. Special entities may be better
able to assess the relative merits of a given security-based swap
transaction when relying on independent qualified representatives, as
opposed to engaging SBS Entities to make such recommendations under a
best interest standard.
---------------------------------------------------------------------------
\1707\ Better Markets (August 2011), supra note 5; CFA, supra
note 5; and AFSCME, supra note 5.
---------------------------------------------------------------------------
Similarly, prohibiting SBS Dealers from selling derivatives when
the special entity would be better served by more traditional debt
instruments, as suggested by one commenter,\1708\ will impede market
access by special entities to a potentially valuable vehicle for risk
mitigation. For some special entities, particularly for sophisticated
entities, entities relying on independent advice from qualified
advisors, and entities with risk management needs best addressed by OTC
security-based swaps, such costs are likely to be significant. Further,
this alternative would preclude special entities from accessing one of
the vehicles for trading on negative information about risks of the
underlying securities. Excluding informed and sophisticated special
entities from security-based swaps markets may decrease price
efficiency and liquidity, and fragment swap, security-based swap and
underlying reference security markets. However, if such special
entities are prohibited from accessing OTC security-based swaps, these
entities would be able to access standardized security-based swaps
traded on registered national exchanges or SEFs. This may increase the
volume of security-based swap trades transacted on these platforms.
---------------------------------------------------------------------------
\1708\ See CFA, supra note 5.
---------------------------------------------------------------------------
e. Reliance on Representations
Rule 15Fh-1(b) allows SBS Entities to rely on the written
representations of a counterparty to satisfy its due diligence
requirements, unless they have information that would cause a
reasonable person to question the accuracy of the representation. While
these final rules impose new costs on SBS Entities, Rule 15Fh-1(b) will
enable SBS Entities to rely on representations in lieu of independent
due diligence, under certain circumstances. Since SBS Entities may be
able to rely on representations to fulfil the requirements in these
final rules, we expect they will do so when the costs of reliance on
representations are lower than those of independent due diligence, to
the extent that special entities are willing and able to provide
representations that meet the requirements of the rule. This may,
therefore, provide potentially beneficial flexibility to SBS Entities
in managing their compliance obligations under these final rules.
Relying on special entities' representations concerning the
qualifications, and independence of investment representatives should
be less costly for SBS Entities than conducting independent substantive
evaluations of qualifications and independence of their counterparties'
representatives. To the extent that the best interest standard
introduces costs for SBS Entities, and to the extent that the qualified
independent representative safe harbor may mitigate these costs as
discussed in prior sections, Rule 15Fh-1(b) may enable SBS Entities to
make recommendations and serve as counterparties to special entities at
lower costs under reliance on counterparty representations than under
independent due diligence. However, if an SBS Entity has information
that would lead a reasonable person to question the accuracy of the
representation, SBS Entities will be required to perform independent
due diligence.
We have considered an ``actual knowledge'' standard as an
alternative to the reliance on representation standard. Under an
``actual knowledge'' standard, an SBS Entity can rely on a
representation unless it knows that the representation is inaccurate.
The alternative could allow SBS Entities to rely on questionable
representations insofar as they do not have actual knowledge that the
representation is inaccurate, even if they have information that would
cause reasonable persons to question their accuracy. As a result, this
alternative would reduce the benefits of the verification of status,
know your counterparty, suitability and special entity requirements and
result in weaker protections for counterparties to SBS Entities.
However, SBS Entities would be able to rely on counterparty
representations with respect to a potentially greater set of
transactions and counterparties. To the extent that reliance on
representations may lower SBS Entity costs from these final business
conduct rules, this actual knowledge standard alternative for reliance
on representations has the potential to further reduce costs.
We have received mixed comments on the relative merits of these
standards, with some commenters supporting the actual knowledge
standard,\1709\ others supporting the reasonable person reliance
standard,\1710\ and others opposing both standards as too low.\1711\
None of the commenters quantified the potential economic costs or
benefits of the proposed standards, and we lack information or data to
quantify the above economic effects. For instance, we lack information
about the number of transactions between special entities and SBS
Entities conducted in reliance on representations, the accuracy of
which reasonable persons would question but where SBS Entities lack
actual knowledge of falsehood, and the costs of independently
evaluating a representative's qualifications and independence which
will depend on an individual SBS Entity's choice to
[[Page 30125]]
perform due diligence in house and the efficiency of related internal
business processes, or to retain a third party due diligence provider
and the related choice of service provider. In addition, we have
received comment that, where SBS Dealers are required to conduct
independent due diligence, they may face potential litigation risk if
they approve a representative who is subsequently determined to be
lacking expertise, as well as potential litigation from representatives
whom they have chosen to disqualify, which may discourage SBS Dealers
from intermediating OTC security-based swaps with certain groups of
counterparties.\1712\ Commenters have not provided any information to
enable us to quantify these costs and we have no data to enable such
quantification.
---------------------------------------------------------------------------
\1709\ See, e.g., SIFMA (August 2011), supra note 5; FIA/ISDA/
SIFMA, supra note 5; CCMR, supra note 5; APPA, supra note 5;
BlackRock, supra note 5); ABC (2011); ABA Committees, supra note 5.
\1710\ See, e.g., Better Markets (2011).
\1711\ See CFA, supra note 5 and AFSCME, supra note 5.
\1712\ See ABC, supra note 5.
---------------------------------------------------------------------------
We note that under CFTC rules, Swap Entities are subject to the
reasonable person reliance standard being adopted in these final rules.
We also note that swap and security-based swap markets are
interconnected, market participants transact across these markets, and
many SBS Entities are expected to be dually-registered as Swap
Entities. If the same dealers face differential compliance costs of
transacting over the counter with the same special entities in, for
instance, single name and index CDS, dealing activity may flow to the
market with lower compliance costs, potentially fragmenting price
discovery and liquidity. Further, the standard being adopted is likely
more timely and cost effective than an approach permitting no reliance
on representations.
We have also considered alternative approaches involving a higher
standard for reliance on representations or requiring SBS Entities to
conduct an independent analysis of conflicts and qualifications of each
independent representative of a special entity, with which they may be
negotiating swaps. This approach may enhance SBS Entities' due
diligence with respect to representatives of special entity
counterparties, but may decrease the willingness or ability of SBS
Entities to provide special entities with access to security-based
swaps.\1713\ As an additional consideration, we understand that most
market participants in swap markets and Swap Entities have adopted a
multilateral protocol as a means of complying with the CFTC external
business conduct rules. While we understand that the representations
contained in the protocol only expressly address swap transactions, we
have received comment that factual matters addressed by those
representations typically do not vary between swap and security-based
swap transactions. To the extent that cross-market participation of
dealers and non-dealer counterparties is a significant feature of
security-based swap markets, requiring dually-registered SBS Entities
to obtain separate representations or conduct independent due diligence
specifically addressing security-based swaps may impose additional
costs, which may be passed on to counterparties and limit their access
to OTC security-based swaps.\1714\ In addition, as discussed above, we
have received comment that requiring SBS Dealers to conduct independent
due diligence may lead to potential litigation risk from approving
representatives subsequently determined to be lacking expertise or
representatives that are disapproved. According to the comment letter,
this may discourage SBS Dealers from intermediating OTC security-based
swaps with certain groups of counterparties.\1715\ The commenter did
not provide any estimate of such potential costs and the Commission has
no data to enable such quantification. However, we recognize that these
costs may be significant, and it is unclear that the independent due
diligence alternative is superior to the reliance on representation
approach being adopted.
---------------------------------------------------------------------------
\1713\ See, e.g., NAIPFA, supra note 5.
\1714\ See SIFMA (November 2015), supra note 5.
\1715\ See ABC, supra note 5.
---------------------------------------------------------------------------
f. Magnitude of the Economic Effects
When considering the likely magnitude of the economic effects of
special entity rules discussed above, we note that, based on data for
November 2006 through December 2014, approximately 98% of special
entities relied on investment advisors for their single name CDS trades
in DTCC-TIW, and only approximately 2% of special entities acted as a
transacting agents.\1716\ We lack data or other information to estimate
how many investment advisers currently representing special entities in
security-based swap markets will be considered qualified and
independent for the purposes of compliance with these final rules, or
how many SBS Entities would be able to rely on the independent
representative safe harbor in their transactions with special entities.
Commenters did not provide data that would enable such quantification.
In addition, we lack data on the associations of investment advisers
with SBS Entities in the past year, the extent of their advisory roles
in relationships with special entities, the existence of conflicts of
interest, and other information. Therefore, we cannot quantify how many
special entities may be able to rely on representations. However, in
light of special entities' heavy reliance on investment advisers in
security-based swap transactions, it is unclear whether a substantial
portion of special entities rely on SBS Entity recommendations in their
security-based swap transactions.
---------------------------------------------------------------------------
\1716\ Approximately 95% of special entities relied on SEC
registered investment advisers, and another 3% of special entities
used unregistered investment advisers. See Table 2 of the economic
baseline, Section VI.B supra.
---------------------------------------------------------------------------
We also recognize similarities between the CFTC's business conduct
standards, FINRA rules, and the rules being adopted, as well as
extensive cross-market participation--all of which may reduce both the
economic costs (if dually registered entities have already restructured
their compliance infrastructure to comply with similar rules) and the
benefits of these rules (if, for instance, special entities have
learned about potential biases in recommendations from new market
practices of the same dealers in other financial markets). We note that
our final business conduct standards include transaction level
requirements. Therefore, as we discuss and estimate above, some
benefits and costs related to individual security-based transactions
are still likely to accrue to special entities, their qualified
independent representatives, and SBS Entities; even those already
subject to similar rules in other markets. Further, some SBS Entities
and potential new entrants may not be cross-registered with the CFTC or
with FINRA, and may, therefore, not already be subject to similar rules
in other markets.
Finally, the rules relating to transactions with special entities
will not apply to security-based swaps executed on registered or exempt
SEFs or registered national security exchanges, where SBS Entities do
not know the identity of the counterparty at a reasonably sufficient
time prior to execution of the transaction to permit the SBS Entity to
comply with the obligations of the rules. Therefore, special entities
would not receive the benefits of additional counterparty protections
of these rules when transacting anonymously through SEFs or registered
national securities exchanges. However, as noted earlier these final
rules may increase the costs of SBS Entities and reduce their
information rents, which may lead SBS Entities to seek to recover lost
profits through more adverse terms of OTC swaps sold to special
entities, or reduced willingness to transact with special entities.
Since anonymous SEF
[[Page 30126]]
or exchange traded security-based swaps will not be subject to these
final requirements, the risk that special entities will lose access to
security-based swaps may be reduced.
5. Fraud, Fair and Balanced Communications, Supervision
a. Antifraud
The final business conduct rules include a set of antifraud
provisions covering SBS Entity transactions with all counterparties,
and with special entities. With respect to special entities, rules
15Fh-4(a)(1) and 15Fh-4(a)(2) prohibit SBS Entities from employing any
device, scheme, or artifice to defraud special entities, and from
engaging in any transaction, practice or course of business that
operates as a fraud or deceit. Rule 15Fh-4(a)(3) imposes a general ban
on SBS Entities engaging in any act, practice, or course of business
that is fraudulent, deceptive or manipulative.
To the extent fraudulent, deceptive or manipulative conduct may
affect the choice of the SBS Entity's counterparty and the decision to
enter into a given swap, antifraud protections may lead to an increased
flow of transactions to SBS Entities not engaging in fraudulent
practices. To the extent that the risk of fraud may affect the
willingness of market participants to transact in security-based swap
markets, antifraud protections may increase the willingness of non-SBS
or Swap Entity counterparties to participate in security-based swap
markets. We recognize that, as indicated by a commenter, general
antifraud and anti-manipulation provisions of existing federal
securities laws and Commission rules offer similar protections.\1717\
Therefore, the magnitude of these economic benefits relative to the
economic baseline is expected to be de minimis. Further, in light of
SBS Entities' ongoing statutory antifraud obligations, we anticipate
that entities likely to trigger SBS Entity registration requirements
have already developed policies and procedures necessary for compliance
with these final rules. Therefore, the magnitude of the economic costs
to SBS Entities from these final rules is expected to be de minimis as
well.
---------------------------------------------------------------------------
\1717\ See Barnard, supra note 5.
---------------------------------------------------------------------------
The Commission is not establishing a policies and procedures safe
harbor for non-scienter violations, or provisions regarding the
protection for counterparty confidential information. As an alternative
to these final rules, the Commission could adopt such a safe harbor.
For instance, the Commission could adopt a rule where an SBS Entity
would be able to establish an affirmative defense by demonstrating that
it did not act intentionally or recklessly, and complied in good faith
with written policies and procedures reasonably designed to meet this
particular requirement. The adoption of such a safe harbor may reduce
compliance and litigation costs related to nonscienter fraudulent,
deceptive or abusive practices or conduct that may occur despite SBS
Entities having developed and implemented all relevant policies and
procedures, acting in good faith. However, a safe harbor against fraud
may weaken counterparty protections in a market for complex and opaque
securities.
b. Fair and Balanced Communications
Under rule 15Fh-3(g), SBS Entities are required to communicate with
counterparties in a fair and balanced manner based on principles of
fair dealing and good faith. As discussed in Sections I and II, this
rule is harmonized with FINRA's communications with the public rule. To
the extent that up to 16 likely SBS Entities may be cross-registered as
broker-dealers, some SBS Entities are already complying with these
requirements with respect to securities transactions. Specifically, all
communications must provide a sound basis for evaluating a given
security-based swap or trading strategy, communications may not imply
that past performance will recur, or make exaggerated and unwarranted
claims. Rule 15Fh-3(g) clarifies the kinds of communications that would
be consistent with fair dealing or good faith communications. In
conjunction with the antifraud rules and enhanced disclosure
requirements, the fair and balanced communications rule aims to provide
transparency to market participants transacting with SBS Entities. To
the extent to which counterparties of SBS Entities may have asymmetric
information or are less sophisticated, this requirement may help
protect counterparties and improve their ability to select the most
appropriate security-based swap and counterparty.
We recognize that the requirement may impose costs on SBS Entities.
As indicated in Section V, the related initial aggregate costs are
estimated at $917,400 for the industry, with ongoing costs of
approximately $125,400.\1718\
---------------------------------------------------------------------------
\1718\ Initial internal cost: (In-house attorney $380 per hour)
x 330 = $125,400. Initial external legal counsel costs: $330,000 +
$462,000 = 792,000. Ongoing costs: (In-house attorney $380 per hour)
x 330 = $125,400.
---------------------------------------------------------------------------
c. Supervision
Rule 15Fh-3(h) requires SBS Entities to establish and maintain a
supervision system and diligently supervise their business and the
activities of their associated persons. At a minimum the supervisory
system must (1) designate at least one person with supervisory
authority for each type of a business in which the SBS Entity engages
that requires registration as an SBS Entity; (2) use reasonable efforts
to determine that all supervisors are qualified; and (3) establish,
maintain and enforce written policies and procedures addressing the
supervision of the types of security-based swap business an SBS Entity
is engaged in and the activities of its associated persons, that are
reasonably designed to prevent violations of applicable securities
laws, and rules and regulations thereunder. The rule lists specific
types of policies and procedures that must be included.
In addition, SBS Entities and their associated persons will not be
deemed to have failed to diligently supervise if (1) the SBS Entity has
certain written policies and procedures and a documented system for
applying them that would reasonably be expected to prevent and detect,
insofar as practicable, any violation of the federal securities laws
and the rules and regulations thereunder relating to security-based
swaps; and (2) the SBS Entity or its associated person has reasonably
discharged the duties and obligations required by such written policies
and procedures and system, and did not have a reasonable basis to
believe they were not being followed.
Lastly, SBS Entities have an obligation to promptly amend written
supervisory policies and procedures when there are material changes to
applicable securities laws, rules and regulations, or when there are
material changes to the SBS Entity's business or supervisory system.
SBS Entities are also required to promptly communicate any material
amendments to their supervisory procedures to all associated persons to
whom such amendments are relevant based on their activities and
responsibilities.
The Commission recognizes that these final supervision rules may
impose certain burdens and costs on SBS Entities. Specifically, SBS
Entities will be required to establish and maintain a supervision
system consistent with the minimum requirements articulated in Rule
15Fh-3(h); to diligently supervise their business and the activities of
their associated persons; and to amend their written supervisory
policies and procedures when material changes
[[Page 30127]]
occur to applicable laws, rules or regulations or to their business or
supervisory systems, and promptly communicate such amendments to all
associated persons to whom such amendments are relevant.\1719\ Based on
estimates in Section V, compliance with the supervision rules may
involve an aggregate initial cost of $39,317,850 and an ongoing cost of
$8,405,100 for all SBS Entities.\1720\ In addition, these final rules
impose new supervision requirements on SBS Entities, which may increase
the probability and related costs of responding to legal actions.
However, to the extent that these supervision rules may enhance
compliance with federal securities laws and Commission rules and
regulations thereunder, the probability and costs of responding to
regulatory inquiries and private actions may actually decrease.
---------------------------------------------------------------------------
\1719\ See Section V for an estimate of burdens and costs
related to the diligent supervision rules.
\1720\ Initial internal cost: (Compliance manager $283 per hour)
x 103,950 = $29,417,850. Initial external legal counsel costs:
$9,900,000. Ongoing costs: (Compliance manager $283 per hour) x
29,700 = $8,405,100.
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We have considered the alternative of excluding Major SBS
Participants from the scope of the supervision rules and have received
mixed comment on the issue, as discussed in Section II. One commenter
indicated that the rule may impose burdensome and costly supervisory
procedures on Major SBS Participants that are not appropriate given
their non-dealer role in the marketplace, and the potential costs of
compliance ``would be without any meaningful offsetting benefit for
other market participants or the financial markets as a whole.'' \1721\
The commenter did not provide any data to quantify potential costs or
benefits for Major SBS Participants. We recognize that these rules
impose requirements and costs on Major SBS Participants they are not
currently required to bear, as reflected in our estimates. We also note
that the Commission elsewhere estimated that only between zero and five
entities may seek to register with the Commission as Major SBS
Participants. The Commission continues to believe that due to their
large positions in security-based swaps, activities of Major SBS
Participants may pose significant risks, such as market and
counterparty risks, in security-based swap markets, as discussed in
Section II above, the Commission believes the application of the rules
is thus appropriate.
---------------------------------------------------------------------------
\1721\ See MFA, supra note 5.
---------------------------------------------------------------------------
6. CCO Rules
Rule 15Fk-1 requires an SBS Entity to designate a CCO, and imposes
certain duties and responsibilities on that CCO, including the
preparation of an annual compliance report. In addition, under Rule
15Fk-1(d), the compensation and removal of the CCO require the approval
of a majority of the board of directors of the SBS Entity. We note that
the adopted SBS Entity registration forms already require SBS Entities
to designate an individual to serve as a CCO, which enters into an
economic baseline against which we are assessing the effects of these
final rules. Therefore, the primary economic effects of these final CCO
rules stem from the annual compliance report requirement, other duties
of the CCO, and CCO compensation and removal requirements.
a. Annual Compliance Report, Conflicts of Interest, Policies and
Procedures
Rule 15Fk-1(c) requires each SBS Entity's CCO to prepare and sign
an annual compliance report containing a description of the SBS
Entity's written policies and procedures described in paragraph (b) of
the rule, including the code of ethics and conflict of interest
policies. The report must also contain a description of: the SBS
Entity's assessment of the effectiveness of its policies and procedures
relating to its business as an SBS Entity; any material changes to the
SBS Entity's policies and procedures; any areas for improvement, and
recommended potential or prospective changes or improvements to the SBS
Entity's compliance program and resources devoted to compliance; any
material non-compliance matters; and the financial, managerial,
operational, and staffing resources set aside for compliance with the
Exchange Act and the rules and regulations thereunder relating to its
business as an SBS Entity, including any material deficiencies in such
resources. Further, SBS Entities must promptly submit an amended
compliance report if material errors or omissions in the report are
identified. The submission of the annual compliance report as required
by the final rules may help the Commission assess the compliance
activities of SBS Entities.
In addition, Rule 15Fk-1(b)(2) requires the CCO to take reasonable
steps to ensure that the SBS Entity establishes, maintains and reviews
policies and procedures reasonably designed to achieve compliance with
the Act and the rules and regulations thereunder relating to its
business as an SBS Entity by: Reviewing the compliance of the SBS
Entity; and taking reasonable steps to ensure that the SBS Entity
establishes policies and procedures for the remediation and handling of
non-compliance issues. Rule 15Fk-1(b)(3) requires the CCO, in
consultation with the board of directors or senior officer, to take
reasonable steps to resolve any material conflicts of interest that may
arise; and Rule 15Fk-1(b)(4) requires the CCO to administer each policy
and procedure required to be established under Section 15F of the
Exchange Act and the rules and regulations thereunder.
Our final rules impose a set of duties and responsibilities on CCOs
of SBS Entities. As described in the economic baseline and discussed in
earlier sections, the Commission believes that a number of entities
that will seek to register as SBS Entities may be dually registered,
and may already be required to comply with some of these rules in swap
or reference security markets. However, we note that SBS Entity
registration is currently not required, and entities intermediating
security-based swaps, including dually registered entities, are not
required to comply with business conduct or CCO rules relating to their
business as an SBS Entity. Therefore, these rules impose a new set of
requirements on a population of SBS Entity registrants as they pertain
to security-based swap business. To the extent that CCO oversight may
facilitate compliance, the above rules may enhance compliance of SBS
Entities with federal securities laws and other Commission rules.\1722\
---------------------------------------------------------------------------
\1722\ The Commission has elsewhere stated that strong internal
compliance programs lower the likelihood of non-compliance with
securities rules and regulations. See SDR Registration Release, 80
FR at 14543, supra note 1202.
---------------------------------------------------------------------------
Based on our analysis in Section V, the establishment and
administration of the policies and procedures required under Rule 15Fk-
1 will involve a total initial cost of approximately $13,105,950, and
an ongoing cost of approximately $2,801,700 per year for all SBS
Entities.\1723\ Ongoing costs of preparation of an annual compliance
report by the CCO is estimated at approximately $2,480,775 for all SBS
Entities.\1724\
---------------------------------------------------------------------------
\1723\ Initial cost of policies and procedures: (Compliance
manager at $283 per hour) x 34,650 hours = $9,805,950. Initial cost
of outside counsel: $3,300,000. Total initial cost: $9,805,950 +
$3,300,000 = $13,105,950. Ongoing cost: (Compliance manager at $283
per hour) x 9,900 hours = $2,801,700.
\1724\ Ongoing cost of compliance reporting: (CCO at $485 per
hour) x 5,115 hours = $2,480,775.
---------------------------------------------------------------------------
In addition, these rules impose new requirements concerning CCO
duties. These final rules also require the annual compliance report to
include a
[[Page 30128]]
certification by the CCO or senior officer, and may increase CCO or
senior officer liability when the CCO or senior officer executes the
required certification. If SBS Entity CCOs or senior officers are risk
averse, they may require additional liability insurance, higher
compensation or lower incentive pay as a fraction of overall
compensation. To the extent that liability may be a significant
consideration for some SBS Entities, this may lower the labor supply of
senior officers or CCOs in security-based swap markets.
b. CCO Removal and Compensation
CCOs play a central role in monitoring compliance with federal
securities laws and regulations. These final rules elevate approval of
decisions regarding the compensation or removal of the CCO to the
board. As indicated in the proposing release, the Commission believes
that the approach being adopted may reduce inherent conflicts of
interest that arise when CCO compensation and removal decisions are
made by individuals whose compliance with applicable law and
regulations the CCO is responsible for monitoring.\1725\ The rule,
therefore, may mitigate CCO conflicts of interest within SBS Entities,
and may strengthen SBS Entity compliance with federal securities laws
and Commission rules, including these final business conduct rules.
---------------------------------------------------------------------------
\1725\ See Proposing Release, 76 FR at 42451, supra note 3.
---------------------------------------------------------------------------
SBS Entities are expected to be primarily large institutions and
may be part of organizational structures that include hundreds of
entities, with varying levels of business complexity. Many SBS Entities
may also be active in swap markets, while others may also perform
broker-dealer functions or have banking operations; yet others may
focus their primary business on security-based swaps. As a result,
different governance and oversight structures may be suitable for
different SBS Entities depending on their internal operations, business
complexity, and the role security-based swap transactions play in their
overall operations, among others. Therefore, the rule limits the
ability to delegate CCO compensation and removal decisions to a senior
officer, which may be optimal for some SBS Entities.
CCO compensation and removal decisions require an understanding of
security-based swap markets and the SBS Entities' business
opportunities in such markets, compliance risks related to various SBS
Entity activities and transactions, the labor market for CCOs of SBS
Entities, and an ability to infer the quality of skills and effort
exerted by the CCO from performance. To the extent SBS Entity boards
lack specific expertise necessary to approve compensation and removal
decisions, such boards may currently delegate these functions to other
officers, such as head of compliance, chief risk officer, or other
persons. As a result of the final rules, such delegation will not be
permitted, and boards of some SBS Entities may be required to gather
additional information or gain expertise necessary to approve
compensation and removal decisions.
SBS Entities that currently delegate these functions to other
officers may need to refocus board resources on the area of compliance.
As a result, SBS Entity boards may need to replace existing directors,
hire new directors, or retain the services of independent executive
search and compensation consultants that are familiar with security-
based swaps. This may detract from the time and resources SBS Entity
boards are able to invest in overseeing activities in other markets,
which may represent a larger fraction of the business and shareholder
profits for some SBS Entities. To the extent that SBS Entity boards
face time and resource constraints, they may also become less effective
at monitoring and advising SBS Entities in areas outside of compliance.
Further, the requirement that SBS Entity boards approve CCO
compensation and removal decisions, may increase the liability of SBS
Entity's directors, which may increase the costs of director liability
insurance and director compensation. Nevertheless, as discussed above,
the Commission continues to believe that these final rules may reduce
certain conflicts of interest related to CCO compensation and removal
decisions, which may strengthen SBS Entity compliance with federal
securities laws and Commission rules.
The final rules do not address the appointment of the CCO. However,
the rules require the CCO to report directly to the board or senior
officer, and require decisions regarding the compensation and removal
of the CCO to be approved by the board. As a result, some SBS Entities
may separate reporting to and appointment by the senior officer, from
compensation and removal decisions by the board. The Commission
recognizes that appointment, compensation and removal decisions may be
inextricably intertwined, requiring an informed assessment of the CCO's
talent, abilities, expertise and performance when compared against
external candidates, as well as an understanding of the CCO labor
market. Further, a senior officer may have conflicts of interest in CCO
appointment decisions similar to those present in CCO compensation or
removal decisions. A potential separation of the CCO reporting line and
appointment decisions from compensation and removal decisions may
decrease the quality of these decisions. However, the ability of some
SBS Entity boards to continue to rely on senior officers for the CCO to
report to and for appointment decisions may mitigate some of the
resource drain on boards of SBS Entities discussed above.
We have considered an alternative approach under which only
independent members of the board can approve decisions regarding the
compensation, appointment and removal of CCOs, as proposed by some
commenters,\1726\ as well as requiring certain minimum CCO
qualifications and governance practices. Independent directors may have
fewer conflicts of interest and may be less likely to be influenced by
CCOs, strengthening their oversight role, which may enhance SBS Entity
compliance with security laws, and rules and regulations thereunder. At
the same time, outside directors face an informational asymmetry with
respect to the SBS Entity's risks and investment opportunities, and may
lack an intimate understanding of the SBS Entity's business. We
understand that SBS Entities may trade off the value of specific
expertise in security-based swaps on the one hand, with the value of
independence in the face of potential conflicts of interest on the
other hand, in the context of each SBS Entity's operations. Requiring
specific CCO qualifications and other governance practices of all SBS
Entities may enhance compliance for some SBS Entities, but may also
involve potentially costly restructuring of internal governance
structures and operations while offering few benefits for other SBS
Entities as recognized by one commenter.\1727\
---------------------------------------------------------------------------
\1726\ See, e.g., Barnard, supra note 5 and Better Markets
(August 2011), supra note 5.
\1727\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------
Additionally, appropriate CCO qualifications may depend on the
CCO's functional roles and expertise, and business activities that the
SBS Entity engage in, particularly for SBS Entities that operate within
larger consolidated financial institutions with the same CCO. One-size-
fits-all qualification requirements or competency exams would restrict
the level and type of expertise of CCOs that SBS Entities are
[[Page 30129]]
able to retain, and would require some SBS Entities to remove the
current CCOs and search for new CCOs meeting the imposed qualification
requirements. Crucially, it is not clear how many SBS Entities
currently hire and retain underqualified CCOs. The Commission is not
requiring any particular level or type of competency or business
experience for a CCO as part of these final rules. However, as
discussed in Section II, the Commission believes that an SBS Entity's
CCO generally should be competent and knowledgeable regarding the
federal securities laws, empowered with full responsibility and
authority to develop appropriate policies and procedures for the SBS
Entity, as necessary, and responsible for monitoring compliance with
the SBS Entity's policies and procedures adopted pursuant to rules
under the Exchange Act. Similarly, mandatory quarterly or annual
meetings with the board or certain committees of SBS Entities, proposed
by one commenter,\1728\ may not mitigate potential conflicts of
interest involving CCOs, or facilitate compliance where such conflicts
or deficiencies stem from board or committee collective action
problems, weak monitoring or misaligned incentives, instead of a lack
of communication or information.
---------------------------------------------------------------------------
\1728\ See Better Markets (October 2013), supra note 5.
---------------------------------------------------------------------------
As discussed in Section II, commenters disagreed on the relative
merits of the approach being adopted and the alternatives above.\1729\
The above economic effects are not readily amenable to quantification.
Commenters did not provide data or other information that would
facilitate quantification of these effects; no such data is publicly
available. The overall effects of these competing considerations
regarding the CCO rules being adopted depend on internal governance
structures of SBS Entities, their organizational complexity, severity
of the conflicts of interest between SBS Entity CCOs and other
officers, reliance of existing SBS Entity boards on external executive
search and compensation consultants, importance of security-based swap
performance and compliance for SBS Entity profitability and
counterparty protections, optimal delegation of oversight, and the ways
in which SBS Entities may restructure their business in response to
these and other pending substantive Title VII rules.
---------------------------------------------------------------------------
\1729\ See, e.g., FIA/ISDA/SIFMA, supra note 5, Better Markets,
supra note 5; CFA, supra note 5. Also see Section II.I supra.`
---------------------------------------------------------------------------
7. Pay To Play
Rules 15Fh-5(a)(1)(vi) and 15Fh-6 impose a two-year time out period
after certain political contributions by security-swap dealers and
certain independent representatives. Rule 15Fh-6(b) generally prohibits
SBS Dealers from offering to enter into, or entering into, a security-
based swap or trading strategy involving a security-based swap with a
municipal entity within two years following any contribution to an
official of such municipal entity made by the SBS Dealer or any of its
covered associates. The rule also prohibits SBS Dealers and any covered
associates from providing or agreeing to provide payment to any person
to solicit a municipal entity to offer to enter into, or to enter into,
security-based swaps, unless such person is a regulated person. The
rule prohibits SBS Dealers and any covered associates from coordinating
or soliciting any person or political action committee to make
contributions to officials of a municipal entity, or to a political
party of a state or locality, with which the SBS Dealer is offering to
enter into, or has entered into, a security-based swap or a trading
strategy involving a security-based swap.
Under Rule 15Fh-6(a)(2) covered associates will include general
partners, managing members, executive officers or other persons of
similar status or function; employees who solicit municipal entities to
enter security-based swaps with an SBS dealer, and all persons directly
or indirectly supervising such employees; and political action
committees controlled by such persons or SBS Dealers.
These final rules also limit political contributions by independent
representatives in security-based swaps. Under Rule 15Fh-5(a) SBS
Entities who offer to enter into or enter into a security-based swap
with a special entity must have a reasonable basis to believe that the
special entity has a qualified independent representative. Rule 15Fh-
5(a)(1)(vi) provides that in the case of a special entity, a qualified
independent representative is a person that is subject to rules of the
Commission, the CFTC or an SRO prohibiting it from engaging in
specified activities if certain political contributions have been made,
except where the independent representative is an employee of the
special entity.
As discussed in more detail below, our economic analysis of these
final rules reflects the fact that a large majority of entities
expected to seek registration as SBS Entities are expected to be dually
registered and required to comply with similar pay to play rules in
other markets.
These final rules are intended to address pay to play relationships
that may interfere with the process by which municipal entities
allocate capital to security-based swaps to enhance returns or manage
risk on behalf of their stakeholders.\1730\ To the extent that these
final rules reduce the incidence of pay to play practices, municipal
entities may become less subject to conflicts of interest related to
political contributions by SBS Dealers. To the extent that conflicts of
interest related to political contributions may currently be affecting
capital allocation by municipal entities, resulting in inefficiencies
from conflicted counterparty or product selection, these rules may
benefit municipal entities and their stakeholders. Consistent with the
expected benefits articulated in the proposing release, these rules may
deter undue influence from SBS dealers and advisors. Therefore, these
rules may enhance counterparty protections of municipal entities and
increase allocative efficiency. In addition, these rules may also
encourage SBS Dealers to compete on the merits of the transaction.
Similarly, under Rule 15Fh-5 qualified independent representatives of
special entities in security-based swaps will be employees and
representatives subject to pay to play rules of the Commission, the
CFTC or an SRO, such as registered municipal advisors or registered
investment advisers. To the extent that some special entities may
currently rely on advisors that are not employees or registered
investment or municipal advisors, special entities may become less
affected by potential conflicts of interest of representatives, and
independent representatives may be encouraged to compete on their
qualifications, service quality, and cost. These benefits may flow
through to stakeholders of municipal entities, such as participants in
public pension plans and taxpayers.
---------------------------------------------------------------------------
\1730\ See Proposing Release, 76 FR at 42450, supra note 3.
---------------------------------------------------------------------------
To the extent that SBS Dealers are currently recovering the costs
from pay to play practices in the form of higher prices of security-
based swaps, these final rules may decrease transaction costs. We have
no data or other information on the prevalence of political
contributions of SBS Dealers, the number and contributions of their
covered associates, and transaction costs and non-price terms of
security-based swaps offered for sale to special entities. Such data is
not publicly available and commenters have not provided data to
[[Page 30130]]
enable such quantification. However, a study by Butler, Fauver and
Mortal (2009) found that negotiated bid deals had underwriter gross
spreads of 12-14 basis points (about one-seventh of the mean gross
spread) higher during the pay-to-play era.\1731\ The study concluded
that, when underwriting firms were routinely able to make political
campaign contributions to win underwriting business, gross spreads were
significantly higher, but only for those deals that were negotiated
that enable conflicted underwriter selection. This may indicate that,
absent pay to play rules, offerings subject to conflicts of interest
related to political contributions may not always be negotiated at
market rates. Pay to play rules may decrease certain costs to municipal
entities and their stakeholders, but may increase costs to dealers from
greater quality based competition.
---------------------------------------------------------------------------
\1731\ See Alexander W. Butler, Larry Fauver, and Sandra Mortal,
Corruption, Political Connections, and Municipal Finance, 22 The
Review of Financial Studies 28-73 (2009).
In a theoretical model by Cotton (2012), contributions may
increase access but not necessarily improve outcomes for some
agents, while contribution limits decrease rent extraction and may
encourage more evidence disclosure. See C. Cotton, Pay-to-play
Politics: Informational Lobbying and Contribution Limits When Money
Buys Access, 96 Journal of Public Economics 369-386 (2012).
---------------------------------------------------------------------------
Several caveats apply. While the pay to play regime considered in
the study above examines the effects of the contribution limits in the
1994 pay to play reforms, and the contribution thresholds in these
final rules are comparable in magnitude, we cannot quantify the levels
at which certain political contributions by SBS Dealers and their
covered associates may give rise to conflicts of interest. However, we
note that de minimis thresholds in the final rules have been harmonized
with existing rules to which Swap Entities and investment advisers are
subject. We also note that the effect on spreads quantified above has
been estimated around the adoption of the MSRB pay to play rule. These
final rules follow pay to play rules adopted by the MSRB, the CFTC and
the Commission. In light of extensive cross-market participation and
expected dual registration of some entities, the economic effects of
these final rules may be smaller than those discussed above, if some
SBS Dealers and other market participants have already restructured
their business practices in security-based swap markets as a result of
existing pay to play rules in other markets.
Finally, the two-year time out may disincentivize direct political
contributions to certain officials by SBS Dealers and their covered
associates. To the extent that SBS Dealers and covered associates may
increase contributions to other entities, such as 501(c) organizations
\1732\ or independent expenditure committees, which are not subject to
these final rules, and to the extent these other expenditures may
facilitate ongoing pay to play practices, the above benefits may be
reduced.
---------------------------------------------------------------------------
\1732\ See, e.g., McCutcheon v. Federal Election Commission, 134
S.Ct. 1434, 1460 (2014).
---------------------------------------------------------------------------
As a result of the pay to play rule, SBS Dealers will incur costs,
including costs of establishing and implementing policies and
procedures to monitor the political contributions made by the SBS
Dealer and its covered associates. As indicated in Section V, pay to
play rules will require collection of information regarding political
contributions of SBS Dealers and their covered associates, which may
cost up to $3,515,000 for all dealers.\1733\ Additionally, as discussed
in Section V above, SBS Dealers may incur one-time initial costs to
establish or enhance current systems to assist in their compliance with
the rule, estimated at up to $5,000,000 for all SBS Dealers.\1734\
Compliance costs imposed by the rule are expected to vary significantly
among SBS Dealers, depending on, among other things, the number of
covered associates and the supervisory structure of the SBS Dealer; the
degree to which compliance procedures are automated (such as policies
and procedures requiring pre-clearance); and the extent to which the
SBS Dealer may already have policies and procedures guiding political
contributions under ethics or compliance programs. Smaller SBS Dealers,
for example, would likely have a small number of covered associates,
and thus expend fewer resources to comply with the proposed rule.
However, to the extent that the cost of developing policies and
procedures may have a high fixed cost component, smaller SBS dealers
may incur costs that represent a higher percentage of net income.
Lastly, these costs will be greater for SBS Dealers with multiple
layers of supervision and a higher number of covered associates with
shorter tenures.
---------------------------------------------------------------------------
\1733\ Initial cost: (In-house attorney at $380 per hour) x
9,250 hours = $3,515,000. This figure may overestimate the initial
cost burden on some SBS Dealers if some of the functions are
performed by in-house compliance managers instead of in-house
attorneys.
\1734\ In the Advisers Act pay to play rule, the Commission
estimated that firms with over 15 covered associates incur, on
average, $100,000 startup costs. Assuming all SBS Dealers will have
over 15 covered associates, the initial cost is estimated at: 50 SBS
Dealers x $100,000 = $5,000,000. See Advisers Act Pay-to-Play
Release, supra note 1100 (adopting Advisers Act Rule 206(4)-5)).
---------------------------------------------------------------------------
Under the final rules, the two-year time out on SBS dealing with
municipal entities is triggered when any of the covered associates has
contributed in excess of the de minimis thresholds. While developing
and implementing policies and procedures related to political
contributions and training covered associates may mitigate this risk,
some SBS Dealers may still trigger the time out despite these measures
due to contributions by one of their covered associates.
Such SBS Dealers will incur costs from the loss of business with
municipal entities. We note that the final rules contain a safe harbor
for contributions by natural persons that predate the date of becoming
a covered associate by more than 6 months, if such associates do not
solicit municipal entities on behalf of the SBS Dealer. Further, if the
SBS Dealer discovers the triggering contribution under $350 within 4
months and secures a return of funds within 60 days, the prohibition
will not apply. In response to commenter concerns,\1735\ and consistent
with Advisers Act Rule 206(4)-5, the final rules provide up to two such
exemptions per year for dealers with 50 or fewer covered associates,
and up to three such exemptions for dealers with over 50 covered
associates. We do not have data or other information concerning the
number of general partners, managing members, executive officers or
other persons of similar status and function in SBS Entities; the
number of employees that solicit municipal entities to enter security-
based swaps with SBS Dealers; SBS Dealer supervisory structures for
such employees; or political action committees controlled by such
persons or SBS Dealers. However, the Commission has previously
estimated that as many as 423 natural persons may associate with each
SBS Dealer.\1736\ Therefore, we believe that many SBS Entities are
likely to be able to take advantage of up to 3 annual exemptions
against inadvertent violations described above.
---------------------------------------------------------------------------
\1735\ FIA/ISDA/SIFMA, supra note 5.
\1736\ See Rule of Practice 194 Proposing Release, 80 FR at
51710.
---------------------------------------------------------------------------
The final rules also allow SBS Dealers to file applications for
exemptive relief, and outline a list of items to be addressed,
including, whether the SBS Dealer has developed policies and procedures
to monitor political contributions; the steps taken after discovery of
the contribution; and the apparent intent in making the
[[Page 30131]]
contribution based on the facts and circumstances of each case. These
safe harbors, combined with the ability to apply for exemptive relief,
may partly mitigate the direct and indirect costs of SBS Dealers
triggering the timeout and being precluded from dealing with municipal
entities.
As discussed in Section V, the incidence of exemptive relief
related to MSRB Rule G-37 and the number of applications the Commission
has received under the Adviser's act pay to play rules may be
indicative of possible applications for exemptive relief under these
final rules. Recognizing that this is an estimate, we conservatively
estimate that the Commission may receive up to two applications for
exemptive relief per year with respect to pay to play rules,\1737\ at a
total ongoing cost of $25,600 per year.\1738\
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\1737\ FINRA has granted 17 exemptive letters related to Rule G-
37 between 1/2005 and 12/2015 (11 years) http://www.finra.org/industry/exemptive-letters. As of 1/2016 there were 665 SEC
registered muni advisers http://www.sec.gov/help/foia-docs-muniadvisorshtm.html. Using these figures, we obtain an estimate of
(17 applications/11 years) x (50 SBS Dealers/665) = 0.117
applications per year.
In addition, the Commission has received 13 applications under
the Adviser's act (since the compliance date, approximately 4
years). As of 2/2016 there were 11,959 registered investment
advisers filing form ADV https://www.sec.gov/foia/docs/invafoia.htm.
Using these figures, (13 applications/4 years) x (50 SBS Dealers/
11,959) = 0.014 applications per year.
\1738\ Ongoing cost: (Outside counsel at $400 per hour x 32
hours per application x 2) = $25,600.
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Costs of compliance with the final pay to play rules may be
recovered by SBS Dealers in the form of higher costs of security-based
swaps offered to municipal entities. If the costs are significant and
cannot be fully recovered from counterparties some SBS Dealers may
limit their security-based swap transactions with municipal entities
and reduce their access to OTC security-based swaps. However, the pay-
to-play rules do not apply to security-based swaps executed on national
registered exchanges or SEFs, where the security-based swap dealer does
not know the identity of the counterparty to the transaction at a
reasonably sufficient time prior to execution to permit the security-
based swap dealer to comply. Therefore, municipal entities will retain
access to more liquid and standardized security-based swaps executed on
SEFs or registered national exchanges, and will continue to be able to
rely on security-based swaps as a tool for risk mitigation.
Once SBS Dealers have to comply with the rule, to the extent that
SBS Dealers currently engaging in pay to play practices enjoy a
competitive advantage over SBS Dealers that are not, they may lose some
of their business with municipal entities and related profits. However,
other SBS Dealers that do not currently engage in pay to play practices
may win business, and SBS Dealers may begin to seek competitive
advantages through lower transaction costs, more customized security-
based swaps, or superior execution, benefitting municipal entity
counterparties.
If some SBS Dealers currently intermediating a significant volume
of transactions with municipal entities trigger the two-year time out,
it could limit the number of SBS Dealers able to offer to enter into or
enter into security-based swaps with municipal entities. However, the
lost market share is likely to be picked up by other SBS Dealers. The
presence and direction of any economic effects would depend on the
number of SBS Dealers that trigger the time outs; the market power of
the prohibited SBS Dealers; the market power of SBS Dealers that may be
able to step in; and the importance of bilateral relationships.
Further, municipal entities will continue to have unconstrained access
to security-based swaps transacted through SEFs or registered national
security exchanges.
The Commission recognizes that these rules impose restrictions on
persons that can represent special entities in security-based swap
transactions of special entities with SBS Entities. As discussed in
Section II.H.6.f, under Rule 15Fh-5(a)(1)(vi), qualified independent
representatives of special entities must be subject to pay to play
rules of the Commission, the CFTC or an SRO, except where the
independent representative is an employee of the special entity. If
special entities currently rely on advisors not subject to pay to play
rules, or do not rely on independent advisors in their transactions
with SBS Entities in security-based swaps, they will incur costs
related to retaining qualified independent representatives. These costs
will depend on the type of advisor search the special entity would
choose to perform, the special entity's ability to delegate such
functions to current employees, and labor market conditions for
qualified independent representatives. Table 2 of the economic baseline
shows that the overwhelming majority of special entities transact
through SEC registered investment advisers already subject to similar
pay to play rules under the Adviser's Act. Special entities that do not
transact through SEC registered investment advisers likely rely on
municipal advisors subject to MSRB rules or employees in their
transactions with SBS Entities. While we have no data or other
information to enable us to identify what fraction of advisors
representing special entities would meet the qualified independent
representative requirements of these final rules, the above
considerations indicate that costs of pay to play rules for independent
representatives of special entities may be mitigated.
However, the Commission recognizes that, to the extent that some
representatives currently intermediating special entity transactions
with SBS Entities would be prohibited from advising special entities
under these final rules, some representatives may incur costs related
to loss of business, and competition among qualified independent
representatives of special entities may decrease. At the same time,
representatives prohibited from such activities under these final rules
may seek to register as SEC registered investment advisers, MSRB
registered municipal advisors or special entity employees, becoming
subject to pay to play rules referenced in Rule 15Fh-5(a)(1)(vi) and
continuing to represent special entities in compliance with these final
rules. Therefore, the overall effect of pay to play rules on
competition among qualified independent representatives of special
entities is unclear.
As a result of the two-year time out and other pay to play
requirements, SBS Dealers transacting with municipal entities, as well
as covered associates of SBS Dealers, may be less likely to make
certain political contributions and payments to political parties at or
above de minimis thresholds. This may result in a decrease in funding
by SBS Dealers and their covered associates for such campaigns through
direct contributions and political action committees. However, to the
extent that the two-year time out may disincentivize direct
contributions, SBS Dealers and covered associates may turn to other
avenues of political speech, such as contributing unlimited amounts to
501(c) organizations or independent expenditure committees, which are
not required to disclose donors and are not prohibited under these
final rules.\1739\ Therefore, the overall effect of these final rules
on the aggregate volume of political contributions by SBS Dealers and
their covered associates to campaigns is unclear.
---------------------------------------------------------------------------
\1739\ See, e.g., McCutcheon v. Federal Election Commission, 134
S.Ct. 1434, 1460 (2014).
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As clarified in Section II, the Commission is adopting an approach,
under which these prohibitions will not be triggered for an SBS Dealer
or any of
[[Page 30132]]
its covered associates by contributions made before the SBS Dealer
registered with the Commission as such. We also note that these
prohibitions will not apply to contributions made before the compliance
date of the rule by newly covered associates to which the look back
applies. At the same time, if individuals who later become covered
associates make a triggering contribution on or after the compliance
date of this rule, the contribution would trigger the two-year time out
if it were made less than, as applicable, six months or two years
before the individual became a newly covered associate.
We have also considered the alternative, under which dealers would
enjoy a safe harbor where the municipal entity is represented by a
qualified independent representative, as proposed by one
commenter.\1740\ Such an alternative would lower the scope of entities
and transactions affected by the pay to play prohibitions. As discussed
in earlier sections and discussed in the economic baseline,
approximately 98% of special entities rely on investment advisers in
their CDS transactions. While we do not have data or information
allowing us to conclude whether these investment advisers would be
considered independent qualified representatives under our final rules,
this alternative has the potential to substantially reduce the scope of
application of the pay to play rules. While this may reduce direct and
indirect costs of pay to play rules for SBS Dealers, this may also
reduce their benefits, if qualified independent advisor representation
does not fully resolve conflicts of interest related to prohibited
political contributions by SBS Dealers and covered associates.
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\1740\ See SIFMA (August 2011), supra note 5.
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Finally, we have considered the alternative of increasing or
decreasing the number of exemptions for inadvertent violations. The
ability of SBS Dealers to cure reduces the risk that some SBS Dealers
may trigger a two-year timeout as a result of inadvertent violations
due to prohibited contributions by covered associates, related losses,
and potential adverse effects on competition and market liquidity. At
the same time, increasing the number of automatic exceptions available
to SBS Dealers decreases their incentives to monitor their and their
covered associates' political contributions, and may facilitate ongoing
pay to play practices. We also note that, under the rules being
adopted, in addition to such automatic exceptions, SBS Dealers would be
able to apply with the Commission for exemptive relief.
We do not have data or any other information concerning the sizes,
donors and recipients of political contributions of entities that may
trigger SBS Dealer registration and covered associates. No such
information is publicly available, and commenters did not provide data
enabling such quantification. Therefore, we cannot quantify the
magnitude of the above effects.
8. Scope
a. Inter-Affiliate Transactions
The final business conduct rules are designed to facilitate
counterparty protections, reduce information asymmetries, and enable
Commission oversight. However, as discussed in Sections V and VI above,
these final rules impose direct and indirect compliance costs, and may
erode SBS Entities' profitability of dealing in security-based swaps,
which may reduce the incentive for dealers to intermediate SBS
transactions and provide liquidity to end users. We recognize, however,
that some market participants, such as complex and diversified
corporations or institutions, may in the regular course of business
enter into inter-affiliate security-based swaps to manage risk inside a
corporate group or to transfer risk to a treasury department or central
affiliate.
When the economic interests of those affiliates are aligned
adequately, as would be found in the case of majority-ownership, such
security-based swaps serve to allocate or transfer risks within an
affiliated group, rather than to move those risks out of the group to
an unaffiliated third party. Therefore, the application of these final
business conduct rules to security-based swaps that SBS Entities enter
into with majority-owned affiliates is unlikely to yield enhanced
counterparty protections as discussed above. At the same time, SBS
Entities would incur costs related to compliance with these final rules
for such transactions. Therefore, the exclusion of such transactions
may avoid costs that are less likely to be offset by the economic
benefits considered above. Further, the CFTC excludes such swaps from
substantive business conduct requirements for Swap Entities. Imposing
these rules with respect to such security-based swaps would increase
the relative costs of transacting in security-based swap markets,
including single-name CDS, and swap markets, including index CDS. Such
an approach may fragment an otherwise integrated market and could lead
to a flight of liquidity to swap markets, with follow on effects on
market liquidity and price discovery. As indicated earlier, Rule 15Fh-
1(a) specifies that security-based swaps that SBS Entities enter into
with the majority-owned affiliates will be excluded from Rules 15Fh-
3(a) through 15Fh-3(f), 240.15Fh-4(b) and 240.15Fh-5. We note that CCO
and supervision rules will continue to apply to dealers engaging in
such swaps.
b. Opt Out
These final rules are intended to strengthen counterparty
protections, reduce informational asymmetries between SBS Entities and
their counterparties, and enhance Commission oversight over security-
based swap markets. We recognize the inherent heterogeneity in the
level of general sophistication and informedness specific to security-
based swaps of various counterparties of SBS Entities, as suggested by
some commenters.\1741\ The final rules do not allow counterparties of
SBS Entities to opt out from some or all of the substantive business
conduct requirements, such as disclosures of material characteristics,
risks, conflicts of interest, incentives and clearing rights;
suitability assessments or pay to play rules. As a result, more
sophisticated and better informed counterparties of SBS Entities may
enjoy few benefits, but may incur costs from these final rules.
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\1741\ See, e.g., CalSTRS, supra note 5.
---------------------------------------------------------------------------
The final rules reflect these competing considerations through a
reliance on representations approach, and in safe harbors and
alternatives, such as the institutional suitability alternative for
customer-specific suitability and the independent advisor safe harbor
for SBS Entities advising special entities. Further, some of the
requirements, such as pre-trade disclosures of material incentives,
risks and characteristics, will not apply to counterparties that are
themselves SBS or Swap Entities. Yet other rules impose requirements on
SBS Dealers, but not on Major SBS Participants, recognizing the central
role of dealers as intermediaries in security-based swap markets.
Finally, as discussed throughout the release, many of these final
business conduct requirements are harmonized with CFTC and FINRA
conduct rules, which do not allow counterparties to opt out of these or
similar protections.
We also note that if counterparties are able to opt-out of some or
all of the substantive requirements, SBS Entities may have an incentive
to require opt-out of these final rules prior to transacting
[[Page 30133]]
with their counterparties, or cease business with such counterparties.
This effect is more likely to be present for SBS Entity--counterparty
relationships, in which counterparties have the least bargaining power,
such as less sophisticated counterparties that do not regularly access
security-based swap markets, do not have established relationships with
multiple dealers, and engage in low volumes of security-based swap
activity. This may result in smaller, less sophisticated and less
informed counterparties, which are ex ante most likely to benefit from
the disclosures and protections in these final rules, opting out of
business conduct rules or risking the loss of access to OTC security-
based swaps if opt out was permitted. However, we recognize that the
ability of counterparties to opt out of these final rules would give
such entities greater flexibility in structuring their relationships
with SBS Entities relative to the approach being adopted, and allow
them to trade off the benefits of counterparty protections and
information benefits of these final rules against potentially greater
costs and lower liquidity in SBS Entity intermediated OTC security-
based swaps under these final business conduct standards.
Finally, these economic considerations are attenuated by the fact
that many of the final rules are not applicable to if the SBS Entity
does not know the identity of the counterparty at a reasonably
sufficient time prior to the execution of the transaction to permit the
SBS Entity to comply with the obligations of the rule and, in certain
instances, the transaction is executed on a registered national
exchange or a registered or exempt SEF.
9. Cross-Border Application
As the Commission has indicated in other releases,\1742\ security-
based swap markets are global, and market data presented in the
economic baseline demonstrates extensive cross-border participation in
security-based swap markets. For instance, Figure 1 shows that, based
on DTCC-TIW data for 2014, approximately half of all new accounts
participating in the market are accounts with a domicile outside the
U.S. Viewed from the perspective of the domiciles of the counterparties
booking credit default swap (``CDS'') transactions, approximately 48
percent of price forming North American corporate single-name CDS
transactions from January 2008 to December 2014 were cross-border
transactions between a U.S.-domiciled counterparty and a foreign-
domiciled counterparty, and an additional 40 percent of such CDS
transactions were between two foreign-domiciled counterparties (see
Figure 3). Thus, only 12 percent of the global transaction volume by
notional volume between 2008 and 2014 was between two U.S.-domiciled
counterparties, using registered office location of the TIW accounts to
identify domiciles. Together, these data indicate that cross-border
transactions are a common feature of dealing activity in the security-
based swap market.
---------------------------------------------------------------------------
\1742\ See, e.g., Cross-Border Adopting Release, 79 FR at 47280,
supra note 684; U.S. Activity Proposing Release, 80 FR at 27454.
---------------------------------------------------------------------------
Further, SBS Dealers and other counterparties are highly
interconnected, with most dealers transacting with hundreds of
counterparties, and most non-dealers transacting with several
dealers.\1743\ The global scale of the security-based swap market
allows counterparties to access liquidity across jurisdictional
boundaries, providing market participants with opportunities to share
these risks with counterparties around the world. Because dealers
facilitate the great majority of security-based swap transactions, with
bilateral relationships that extend to potentially thousands of
counterparties, deficiencies in SBS Dealer disclosures, recommendations
of unsuitable security-based swaps, and informational asymmetries may
affect a large number of counterparties and have potentially
significant cross-border implications.
---------------------------------------------------------------------------
\1743\ Based on an analysis of 2014 DTCC-TIW transaction data,
accounts likely to register with the Commission as SBS Dealers have
on average 759 unique counterparties (a median of 453 unique
counterparties). All other accounts (i.e., those more likely to
belong to non-dealers) averaged four unique counterparties (a median
of three counterparties).
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a. Scope of Application to SBS Entities
As discussed in Section III, business conduct requirements fall
into two categories: Entity-level business conduct requirements, such
as CCO rules and supervision, and transaction-level requirements, such
as disclosure and suitability. The final rules create certain
exceptions from application of the transaction-level business conduct
requirements to registered SBS Dealers and Major SBS Participants in
certain transactions. With respect to SBS Dealers, these transaction-
level requirements will apply to any transaction that constitutes an
SBS Dealer's U.S. business but not to any transaction that constitutes
its foreign business. For U.S. SBS Dealers, U.S. business includes all
of their transactions, except for certain transactions conducted
through a foreign branch. For foreign SBS Dealers, U.S. business
includes all of their transactions with U.S. persons (except for
certain transactions conducted through a foreign branch of a U.S.-
person counterparty) and transactions captured by the U.S. Activity
Test (i.e., transactions with another non-U.S. person that the foreign
SBS Dealer arranges, negotiates, or executes using personnel located in
a U.S. branch or office).
The final rule creates a slightly different exception for Major SBS
Participants. U.S. Major SBS Participants must comply with the business
conduct requirements in all their transactions, except for certain
transactions conducted through a foreign branch, and foreign Major SBS
Participants must comply with the requirements in their transactions
with U.S. persons, except for certain transactions conducted through a
foreign branch. Under the final rule, the exception for foreign Major
SBS Participants does not incorporate a U.S. Activity Test.
In considering the economic effects of this cross-border approach,
we recognize that the economic baseline reflects markets as they exist
today, in which compliance with business conduct standards for
security-based swaps is not required. Therefore, these final business
conduct rules will apply with respect to security-based swap
transactions intermediated by SBS Entities where they currently do not.
Under Exchange Act Section 15F, these requirements apply to registered
SBS Entities by virtue of their registration with the Commission and,
in the absence of any exceptions to the requirements, would apply to
all business of a registered SBS Entity. However, final Exchange Act
rules 3a71-3(c) and 3a67-10(d) create certain exceptions, as described
above, that limit the application of these requirements to a subset of
the transactions of a registered SBS Entity. For example, a foreign SBS
Dealer transacting with a foreign counterparty will not be subject to
Title VII transaction-level business conduct requirements if the
foreign SBS Dealer does not rely on personnel located in the United
States to arrange, negotiate or execute the swap, including with
respect to transactions in which the foreign SBS Dealer's counterparty
may have relied on personnel located in the United States.
However, we recognize that the inclusion of the U.S. Activity Test
in the definition of ``U.S. business'' for foreign
[[Page 30134]]
dealers may increase the set of transactions that will be required to
comply with these final business conduct rules, relative to the
alternative under which foreign dealers transacting with foreign
counterparties are not subject to these final rules. We also recognize
that capturing transactions of foreign SBS Entities with U.S. persons
may increase the set of transactions subject to the final business
conduct rules as compared to the alternative of not capturing such
transactions.
The final cross-border approach to the scope of the final business
conduct requirements may produce several benefits. First, classifying
certain rules, such as diligent supervision and CCO rules, as entity-
level requirements that apply to the entire security-based swap
business of the registered SBS Entity may facilitate Commission
oversight of registered SBS Entities and enhance compliance with
federal securities laws and Commission rules. For example, as discussed
in Section III and in the Cross-Border Proposing Release, supervision
and CCO rules are aimed at mitigating conflicts of interest and
enhancing compliance with securities laws, rules and regulations
thereunder by the entire registered SBS Entity. The Commission
continues to recognize that relevant conflicts of interest and non-
compliance may arise as a result of transactions comprising an SBS
Entity's foreign business. Further, we note that CCO duties include
establishing, maintaining, and reviewing policies and procedures
reasonably designed to ensure compliance with applicable Exchange Act
requirements that apply to the SBS Entity as a whole. As discussed in
Section III, the Commission is applying diligent supervision and CCO
duties rules at the entity level.
Second, by imposing transaction-level requirements on transactions
of SBS Entities with U.S.-person counterparties, subject to a tailored
foreign branch exception, these final rules result in disclosure,
suitability, fair and balanced communications and special entity
requirements, among others, applying to transactions that are
particularly likely to raise the types of counterparty protection and
other concerns addressed by Title VII business conduct requirements,
whether carried out by U.S. or foreign SBS Entities. Specifically, this
approach to security-based swap transactions between registered SBS
Entities and U.S. persons may potentially enhance the expected
counterparty protection, reduce information asymmetry, and facilitate
Commission oversight benefits of these final rules to the U.S.
security-based swap market.
Third, requiring registered foreign SBS Dealers (but not Major SBS
Participants) to comply with business conduct requirements with respect
to any transaction with another non-U.S.-person counterparty that the
foreign SBS Dealer arranges, negotiates, or executes using personnel
located in the United States will facilitate more uniform regulatory
treatment of the security-based swap activity of registered SBS Dealers
operating in the United States, mitigating potential competitive
distortions.\1744\ Although applying other business conduct frameworks
(such as broker-dealer regulation) to this activity may achieve similar
regulatory goals, the availability of exceptions, exclusions and safe
harbors may mean that alternative frameworks may not apply to certain
business structures used by registered SBS Dealers to carry out their
business in the United States.\1745\ Moreover, these alternative
frameworks may apply only to the U.S. intermediary of the foreign SBS
Dealer and not to the SBS Dealer itself. These final rules will avoid
these differences in application, along with the potential competitive
disparities they may create, by subjecting all registered SBS Dealers
engaged in transactions captured by the U.S. Activity test to the same
business conduct framework, including, among others, disclosure,
suitability, and fair and balanced communication rules. Applying
business conduct rules to all security-based swap trades arranged,
negotiated or executed by personnel located in the U.S. also may reduce
disparities between U.S. and foreign SBS Dealers competing for business
with the same foreign counterparties.
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\1744\ We recognize that, depending on the business structure
that a registered U.S. or foreign SBS Dealer employs, an
intermediary (such as an agent that is a registered broker-dealer)
may already be subject to certain business conduct requirements with
respect to the SBS Dealer's counterparty in the transaction.
However, we continue to believe that it may be important that
registered SBS Dealers themselves are subject to these final
business conduct requirements with respect to security-based swap
transactions that are part of their U.S. business. Because SBS
Dealers and their agents may allocate between themselves specific
responsibilities in connection with these business conduct
requirements, to the extent that these requirements overlap with
requirements applicable directly to the agent (for example, in its
capacity as a broker), and the SBS Dealer allocates responsibility
for complying with relevant requirements to its agent, we expect any
increase in costs arising from the proposed rules may be mitigated.
\1745\ For example, Exchange Act section 3(a)(4)(B) excepts
banks from the definition of ``broker'' with respect to certain
activity.
---------------------------------------------------------------------------
We recognize that foreign SBS Dealers transacting with foreign
counterparties may be subject to foreign regulations in addition to
these final rules, giving rise to potentially duplicative compliance
costs, pointed out by commenters.\1746\ However, as discussed in
Section III above, the Commission believes that requiring registered
foreign SBS Dealers to comply with the transaction-level business
conduct requirements with respect to these transactions may enhance
transparency, strengthen counterparty protections, and integrity of the
U.S. security-based swap market.
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\1746\ See, e.g., IIB (July 2015), supra note 10; ISDA (July
2015), supra note 10; SIFMA-AMG (July 2015), supra note 10; SIFMA/
FSR (July 2015), supra note 10, commenting on the U.S. Activity
Proposing Release.
---------------------------------------------------------------------------
Moreover, the Commission is adopting a framework that would
potentially permit foreign SBS Dealers to satisfy their requirements
with respect to certain of the business conduct requirements by
complying with comparable requirements of a foreign jurisdiction.
Therefore, foreign SBS Dealers engaged in U.S. Activity may be able to
comply with these final rules by complying with foreign jurisdictions'
rules and regulations, to the extent that the Commission makes
substituted compliance determinations and the other prerequisites to
substituted compliance have been satisfied. This may mitigate the
potential for conflicting requirements and duplication in compliance
costs. We recognize that there will be limits to the availability of
substituted compliance, including the possibility that substituted
compliance may be permitted with regard to some requirements and not
others, or that, in certain circumstances, substituted compliance may
not be permitted with respect to any requirements with regard to a
particular jurisdiction depending on our assessment of the
comparability of the relevant foreign requirements and the availability
of supervisory and enforcement arrangements among the Commission and
relevant foreign financial regulatory authorities. However, the
Commission does not believe it would be appropriate to permit foreign
security-based swap dealers to satisfy these final business conduct
requirements by complying with foreign requirements when the
prerequisites to substituted compliance have not been satisfied.\1747\
---------------------------------------------------------------------------
\1747\ See Section III, supra.
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As we noted earlier, these rules limit the scope of application of
these final business conduct requirements by excluding certain
transactions of registered foreign and U.S. SBS Entities from the
requirements. However, as we have also noted, relative to the baseline,
[[Page 30135]]
final Exchange Act rules 3a71-3(c) and 3a67-10(d), together with the
substantive rules being adopted in this release, should result in an
increase in costs and benefits from the baseline. Specifically, the
final approach to cross-border application of the final business
conduct rules may increase assessment and programmatic costs of
registered SBS Dealers, but may also increase related counterparty
protections, reduce informational asymmetries and enhance Commission
oversight.
With respect to assessment costs, registered SBS Entities likely
will establish systems to identify transactions that are subject to the
business conduct requirements. Foreign SBS Entities will need to
establish systems to identify transactions with U.S. persons (including
whether the transaction is conducted through a foreign branch of that
person), and foreign SBS Dealers will need to establish systems to
identify transactions falling within the U.S. Activity Test. Similarly,
U.S. SBS Entities will incur additional assessment costs related to
identifying their own transactions conducted through a foreign branch,
including such transactions with U.S.-person counterparties that
constitute transactions conducted through a foreign branch of those
U.S.-person counterparties. Most of the assessment costs with respect
to analysis and systems to track transactions have been evaluated in
connection with other Commission rules; therefore, our economic
baseline includes all registered SBS Entities have those systems in
place. For instance, in the Cross-Border Adopting Release, the
Commission estimated foreign SBS Entity assessment costs with respect
to systems tracking transactions with U.S. persons for purposes of
counting transactions toward the major security-based swap participant
position thresholds and the security-based swap dealer de minimis
thresholds.\1748\ Similarly, in the U.S. Activity Adopting Release, the
Commission evaluated the assessment costs to SBS Dealers related to
including transactions falling within the U.S. Activity Test in a non-
U.S. person's dealer de minimis requirements.\1749\ Once registered,
these SBS Entities will be able to use these systems in connection with
identifying whether a transaction is subject to the transaction-level
business conduct requirements.
---------------------------------------------------------------------------
\1748\ See Cross-Border Adopting Release, 79 FR 47332-34
(evaluating foreign SBS Dealer assessment costs with respect to
systems tracking transactions with U.S. persons); id. at 47353-54
(evaluating foreign Major SBS Participant assessment costs with
respect to systems tracking transactions with U.S. persons). In that
release, the foreign branch exception applied only to U.S. banks
that were themselves registered SBS Dealers, and our evaluation of
analysis costs borne by such persons were based on a system that
would evaluate whether a counterparty was a U.S. person, whether
that counterparty was transacting through a foreign branch, and
whether that counterparty was a registered SBS Dealer, among other
things. See, e.g., Cross-Border Adopting Release, 79 FR 47353.
Because the analysis to determine whether the transaction-level
business conduct requirements apply in a transaction by a foreign
SBS Entity with a U.S. person involve only a determination whether
the counterparty is a U.S. person and whether it is transacting
through a foreign branch, we believe that the system whose costs
were estimated in these prior releases should be sufficient for the
analysis required by foreign SBS Entities under these rules.
\1749\ See U.S. Activity Adopting Release, 81 FR 8627
(evaluating assessment costs to SBS Dealers with respect to systems
for tracking transactions arising from U.S. activity).
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However, in addition to these previously evaluated costs, U.S. SBS
Entities conducting business through a foreign branch will need to
classify their counterparties and transactions to determine whether
business conduct transaction-level requirements apply. We believe that
the costs to a U.S. SBS Entity of creating systems to identify
transactions it conducts through a foreign branch with U.S.-person
counterparties and to determine whether any such transactions are
conducted through the foreign branch of its U.S.-person counterparties
may be similar to costs associated with the systems that foreign
persons are likely to establish to perform the dealer de minimis or
major participant threshold calculations. In both cases such systems
would have to flag a person's security-based swaps against the specific
criteria embedded in the final rules. Based on the methodology set out
in the Cross-Border Adopting Release for estimating costs of systems
designed to identify similar criteria,\1750\ we estimate these
assessment costs may include one-time programming costs of $14,904 and
ongoing annual costs of $16,612 per SBS Entity.\1751\ Based on a review
of DTCC-TIW data relating to single-name CDS activity in 2014, we
estimate that up to 5 U.S. SBS Dealers conducted dealing activity
through foreign branches, and we conservatively estimate that there may
be as many as 5 U.S. Major SBS Participants. Assuming that all ten of
these U.S. SBS Entities elected to establish a system to identify
transactions conducted through a foreign branch or conducted through
the foreign branch of their U.S. counterparties, the total assessment
costs associated with our final business conduct rules would be
approximately $149,040 in one-time annual programming costs and
$166,120 in ongoing annual costs.\1752\
---------------------------------------------------------------------------
\1750\ See Cross-Border Adopting Release, 79 FR 47332, note 681.
See also Definitions Adopting Release, 77 FR 30734-35, note 107.
\1751\ In the Definitions Adopting Release, we estimated that
the one-time programming costs of $13,692 per entity and annual
ongoing assessment costs of $15,268. See Definitions Adopting
Release, 77 FR 30734-35, and accompanying text (providing an
explanation of the methodology used to estimate these costs). The
hourly cost figures in the Definitions Adopting Release for the
positions of Compliance Attorney, Compliance Manager, Programmer
Analyst, and Senior Internal Auditor were based on data from SIFMA's
Management & Professional Earnings in the Securities Industry 2010.
For purposes of the cost estimates in this release, we have
updated these figures with more recent data as follows: The figure
for a Compliance Attorney is $334/hour, the figure for a Compliance
Manager is $283/hour, the figure for a Programmer Analyst is $220/
hour, and the figure for a Senior Internal Auditor is $209/hour,
each from SIFMA's Management & Professional Earnings in the
Securities Industry 2013, modified by SEC staff to account for an
1800-hour work-year and multiplied by 5.35 to account for bonuses,
firm size, employee benefits, and overhead. We also have updated the
Definitions Adopting Release's $464/hour figure for a Chief
Financial Officer, which was based on 2011 data, with a revised
figure of $500/hour, for a Chief Financial Officer with five years
of experience in New York, that is from http://www.payscale.com,
modified by Commission staff to account for an 1800-hour work-year
and multiplied by 5.35 to account for bonuses, firm size, employee
benefits, and overhead. See http://www.payscale.com (last visited
Apr. 16, 2014).
Incorporating these new cost figures, the updated one-time
programming costs based upon our assumptions regarding the number of
hours required in the Definitions Adopting Release would be $14,904
per entity, i.e., (Compliance Attorney at $334 per hour for 2 hours)
+ (Compliance Manager at $283 per hour for 8 hours) + (Programmer
Analyst at $220 per hour for 40 hours) + (Senior Internal Auditor at
$209 per hour for 8 hours) + (Chief Financial Officer at $500 per
hour for 3 hours) = $14,904, and the annual ongoing costs would be
$16,612 per entity, i.e., ((Senior Internal Auditor at $209 per hour
for 16 hours) + Compliance Attorney at $334 per hour for 4 hours) +
(Compliance Manager at $283 per hour for 4 hours) + (Chief Financial
Officer at $500 per hour for 4 hours) + (Programmer Analyst at $220
per hour for 40 hours) = $16,612).
\1752\ One-time annual programming cost: $14,904 x 10 U.S. SBS
Entities = $149,040. Ongoing annual cost: $16,612 x 10 U.S. SBS
Entities = $166,120.
---------------------------------------------------------------------------
As recognized in Section III above, SBS Entities would be permitted
to rely on certain representations provided to them by their U.S. bank
counterparties regarding whether a transaction is conducted through a
foreign branch. Initial costs to the U.S. bank counterparties of
developing related representations are estimated at $195,000.\1753\
Aggregate ongoing costs to the U.S. bank counterparties of
representations are estimated at approximately $190,000 per year.\1754\
---------------------------------------------------------------------------
\1753\ Initial cost: Outside counsel $100,000 + ((Attorney at
$380 per hour) x 250 hours = $95,000) = $195,000).
\1754\ Ongoing cost: (In-house attorney at $380 per hour) x 500
hours = $190,000.
---------------------------------------------------------------------------
[[Page 30136]]
This scope of transactions subject to business conduct requirements
may also affect the programmatic costs incurred by participants in
security-based swap markets. For entities already required to register
as SBS Entities under current rules, this rule may increase the set of
transactions and counterparties to which they must apply business
conduct requirements, relative to the baseline under which no business
conduct requirements apply. We continue to recognize that requiring
compliance of foreign SBS Dealers transacting with foreign
counterparties where transactions were arranged, negotiated or executed
by personnel located in the United States may discourage reliance by
foreign SBS Entities on personnel located in the United States. Some
foreign SBS Dealers transacting with foreign counterparties may choose
to relocate their personnel outside of the United States, or replace
personnel located in the United States with personnel not located in
the United States to avoid compliance with these final rules. To the
extent that these final rules may increase the costs of foreign SBS
Entities, or influence competition between U.S. and foreign SBS
Dealers, the terms of security-based swaps intermediated by foreign SBS
Dealers may deteriorate and foreign SBS Dealers may become less willing
to intermediate security-based swap transactions. The approach taken in
this rule may mitigate some of the commenter concerns with the initial
proposal by focusing only on the location of the foreign dealer's or
its agent's market-facing personnel, and not the location of its
counterparties' activity.\1755\ Further, these final rules allow for
the possibility of substituted compliance for foreign SBS Dealers,
including in connection with their security-based swap activity with
foreign counterparties. Therefore, as discussed above, these costs may
be incurred primarily by foreign SBS Entities subject to less stringent
business conduct rules in their foreign jurisdictions, where the ex-
ante benefits of these final rules may be greater.\1756\
---------------------------------------------------------------------------
\1755\ See U.S. Activity Adopting Release, 81 FR 8634.
\1756\ See, e.g., SIFMA-AMG (July 2015) supra note 10 and ISDA
(July 2015), supra note 10, on the U.S. Activity Proposing Release.
---------------------------------------------------------------------------
The Commission has received comment that this approach to the
application of business conduct requirements may impose costs of
additional disclosures and representations on asset managers servicing
foreign clients.\1757\ As we noted in Section III, these final rules do
not apply directly to asset managers, and asset managers will incur no
liability under these rules. However, we recognize that SBS Entities
may have certain expectations of asset managers in connection with the
transactions involving funds. Depending on how SBS Entities and asset
managers choose to allocate these responsibilities, asset managers may
incur some fraction of the costs estimated above. The commenter also
argued that the final rules may result in asset managers separating
block trades for U.S. and non-U.S. persons, for whom business conduct
eligibility has not been verified, and obtaining assurances that the
dealer's personnel arranging, negotiating or executing block trades for
non-U.S. persons is not based in the U.S. We recognize that, to the
extent this affects the ability of asset managers to find
counterparties to block trades with non-U.S. persons or the costs of
doing so, liquidity may become fragmented and execution price of
certain block trades may be adversely affected. We note that some asset
managers may be complying with similar requirements, such as those
under the Exchange Act and FINRA rules applicable to U.S. broker-
dealers related to transactions in cash securities that these broker-
dealers intermediate on behalf of foreign brokers.
---------------------------------------------------------------------------
\1757\ See SIFMA-AMG (July 2015), supra note 10, at 4.
---------------------------------------------------------------------------
We have considered the alternative of applying business conduct
rules to all security-based swap transactions of all registered SBS
Entities. This approach would increase the scope of transactions
subject to these substantive rules, increasing programmatic costs of
compliance by registered SBS Entities--costs that are likely to be
passed on to counterparties. Under the rules being adopted, the U.S.
business of foreign SBS Dealers excludes transactions conducted through
a foreign branch. Further, the final rule provides for an exception
from the transaction-level business conduct requirements when a foreign
Major SBS Participant (or a U.S. Major SBS Participant in a transaction
conducted through its foreign branch) enters into a transaction with a
foreign branch of a U.S. person.
To the extent that potential losses on security-based swap
transactions may flow from foreign branches of U.S. persons to the U.S.
business of U.S. persons, excluding transactions of foreign SBS Dealers
with foreign branches of U.S. persons from the definition of U.S.
business may increase risks to U.S. persons and impact the integrity of
U.S. markets. However, compliance with business conduct requirements
with respect to security-based swap transactions between foreign SBS
Entities and foreign branches of U.S. persons would further increase
costs of foreign SBS Entities. Such costs may be passed along to
foreign branches of U.S. persons in the form of higher transaction
costs or reduced access to security-based swap transactions with
foreign SBS Entities.\1758\ We lack data regarding the reliance of U.S.
persons on foreign branches for their security-based swap activity with
foreign SBS Dealers, current business conduct practices of foreign SBS
Dealers in their relationships with foreign branches of U.S. persons,
and the value of bilateral relationships for this group of market
participants. Therefore, we are unable to quantify these effects.
However, the approach being adopted recognizes these competing risk and
access considerations.
---------------------------------------------------------------------------
\1758\ See Cross-Border Adopting Release, 79 FR at 47343, supra
note 684.
---------------------------------------------------------------------------
The Commission has also considered the alternative of applying
these final business conduct rules to all transactions that a U.S. SBS
Entity enters into, including any transaction conducted through its
foreign branch. Importantly, the definition of ``transactions conducted
through a foreign branch'' requires the transaction to be arranged,
negotiated or executed in the foreign branch.\1759\ The activities of
foreign branches of U.S. SBS Dealers relying on foreign personnel
transacting with foreign counterparties may not pose the same
compliance and counterparty risks in U.S. markets as those addressed by
these final business conduct requirements. As a result, this
alternative may produce fewer intended benefits associated with these
final rules, but would increase costs of U.S. SBS Dealers transacting
with foreign counterparties.
---------------------------------------------------------------------------
\1759\ See Exchange Act Rule 3a71-3(a)(3).
---------------------------------------------------------------------------
The Commission has also considered the alternative of excepting all
transactions of a foreign SBS Dealer with non-U.S. persons, including
transactions that involve U.S. activity. We recognize that the
alternative would decrease the set of transactions subject to the final
business conduct rules, reducing both assessment and programmatic costs
to foreign SBS Dealers, and expected programmatic benefits of these
final rules discussed above. Data on North American corporate single
name CDS market in Figure 3 of the economic baseline suggest that
activity among non-U.S. domiciled accounts represents as much as 17%
(if we use the domicile of a corporate group) to 40% (if we use
registered office location) of global
[[Page 30137]]
notional volume, and potentially a larger percentage if firms
restructure their business in response to such an exception. We do not
currently have data on which of those trades are arranged, negotiated
or executed by U.S. personnel of foreign SBS Dealers. However, we note
that the U.S. Activity Test in these final rules will subject some
foreign SBS Dealer transactions with foreign counterparties to these
business conduct rules. Therefore, this alternative would reduce the
scope of activity subject to the transaction-level requirements of
these final rules, and their resulting costs and benefits, relative to
the approach being adopted.
In addition, this alternative could put U.S. SBS Entities at a
competitive disadvantage due to higher direct and indirect costs
related to these final business conduct rules when dealing with foreign
counterparties. This approach may also incentivize U.S. SBS Dealers to
restructure to be considered a non-U.S. person, while continuing to
rely on personnel located in the United States to negotiate, arrange or
execute security-based swap transactions with their foreign
counterparties. As recognized above, we understand security-based swap
markets to be global, and we expect registered SBS Dealers transact
across multiple jurisdictions. This alternative may involve potentially
significant frictions to cross-border transaction activity and may lead
to fractioned liquidity and participation in otherwise globally
integrated markets. The approach being adopted may reduce incentives to
engage in such restructuring by requiring that foreign SBS Dealers
comply with transactional business conduct requirements even when
transacting with another non-U.S. person where such security-based swap
transactions are arranged, negotiated or executed by personnel located
in the United States.
Finally, we have considered an alternative approach that would
limit the scope of application of these final business conduct rules to
transactions between registered SBS Entities and U.S. person
counterparties. This alternative would exclude transactions between
U.S. as well as non-U.S. SBS Dealers and their foreign counterparties,
which may significantly decrease the scope of application and potential
economic effects of these final rules.
First, excluding transactions between U.S. SBS Dealers and their
foreign counterparties from the scope of these requirements may reduce
direct and indirect compliance costs of U.S. SBS Dealers, potentially
reducing transaction costs or improving liquidity; however, it may
reduce potential information benefits of these final rules. Second,
similar to the discussion above, excluding transactions between foreign
SBS Dealers and their foreign counterparties may mitigate incentives
for inefficient relocation by financial groups that use a non-U.S.
dealer to carry out their dealing activity in the United States.
However, to the extent compliance with these business conduct
requirements is costly and these costs are passed along to
counterparties in, for instance, more adverse pricing and lower
liquidity of available OTC security-based swaps, this alternative may
give rise to competitive disparities between U.S. and non-U.S.
counterparties of registered SBS Dealers. U.S. counterparties that are
members of financial groups may respond by restructuring their
security-based swap activity so that it is carried out by a non-U.S.
person, in which case none of its transactions with SBS Dealers would
be required to comply with transaction level business conduct
requirements and incur related costs. To the extent that counterparties
restructure their security-based swap activity in response to the
incentives created by the competitive disparities and market
fragmentation, a significant portion of that activity may occur outside
the scope of these final business conduct requirements. U.S. persons
that currently transact with SBS Dealers may have an incentive to
migrate that business to affiliated non-U.S. persons to stay
competitive with their non-U.S. competitors. The fraction of U.S.
counterparties able to perform such restructuring and related costs are
unclear. In contrast, the approach being adopted recognizes the
importance of SBS Entity conduct for counterparty protections, may
decrease incentives for such evasion, and enhance Commission oversight
of registered SBS Entities.
b. Substituted Compliance
As discussed in Section III, the final rules contemplate a
substituted compliance regime for substantive business conduct
requirements. Substituted compliance may permit the counterparty
protection, information and Commission oversight benefits of these
final business conduct rules to be achieved while avoiding potential
duplication of compliance costs that foreign SBS Entities may otherwise
incur. As indicated in the Cross-Border release,\1760\ to the extent
that our business conduct rules conflict with regulations in foreign
jurisdictions that also govern the activity of foreign SBS Entities
that are subject to Title VII business conduct requirements, these
final rules could act as a barrier to entry for foreign SBS Entities
into the U.S. security-based swap market. Allowing market participants
to comply with these final business conduct rules via substituted
compliance could facilitate participation of non-resident SBS Entities
in U.S. security-based swap markets. If foreign regulatory regimes are
comparable to these final rules requirements,\1761\ and to the extent
that such foreign regimes have adequate compliance and enforcement
capabilities, allowing substituted compliance for nonresident SBS
Entities may help promote market efficiency and enhance competition in
U.S. markets, potentially benefiting non-dealer counterparties.
---------------------------------------------------------------------------
\1760\ See Cross-Border Adopting Release, 79 FR at 47359, supra
note 684.
\1761\ See ISDA (August 2013), supra note 7.
---------------------------------------------------------------------------
At the same time, the process of making substituted compliance
requests may cause nonresident SBS Entities to incur additional costs
of applying for a substituted compliance determination. In Section V
the Commission has estimated that three security-based swap dealers
will submit substituted compliance applications, noting that the
majority of substituted compliance requests may be made by foreign
authorities. Based on our analysis of domiciles of likely SBS Entity
registrants and our understanding of the market, we believe that there
may be between four and nine substituted compliance applications with
respect to these final rules. The total cost associated with SBS
Entities preparing and submitting requests for substituted compliance
determinations in connection with the business conduct requirements are
estimated at, approximately, $406,770 \1762\ for up to
[[Page 30138]]
three requests. We also estimate that up to six foreign jurisdictions
may make substituted compliance requests in connection with these final
business conduct standards at an estimated cost of up to
$524,790.\1763\
---------------------------------------------------------------------------
\1762\ Initial internal cost of substituted compliance
applications for SBS Entity applicants: (In-house attorney at $380
per hour) x (80 hours) x 3 = $91,200. External: (External counsel at
400$ per hour) x 200 x 3 = $240,000.
Consistent with the Registration Adopting release, certification
and opinion of counsel is estimated at: (a) (In-house attorney at
$380 per hour) x 0.5 hours x 3 = $570. (b) External: (External
counsel at 400$ per hour) x 62.5 x 3 = $75,000. See Registration
Adopting Release, 80 FR at 48994
Total cost for SBS Entities: $240,000 + $75,000 + $91,200 + $570
= $406,770
As noted in Section V, those amounts may overestimate the costs
of requests pursuant to Rule 3a71-6 as adopted, as such requests
would solely address business conduct requirements, rather than the
broader proposed scope of substituted compliance set forth in that
proposal. In addition, some SBS Entities may receive a positive
substituted compliance determination and use the same certification
and opinion of counsel when filing for registration, the costs of
which were assessed in the Registration Adopting Release.
\1763\ We believe that foreign jurisdictions are less likely to
rely on outside counsel in preparing substituted compliance
determinations and adequate assurances concerning Rule 15Fb2-4(c).
In lieu of outside counsel we believe they will rely on internal
government attorneys, estimated using SEC hourly cost for management
and professional staff of $255.
Initial cost of substituted compliance applications for up to 6
foreign jurisdiction: (Government management and professional staff
at $255) x (80 + 200) x 6 = $428,400.
Initial cost of certifications and assurances concerning Rule
15Fb2-4(c): (Government management and professional staff at $255) x
(0.5 + 62.5) x 6 = $96,390.
Total cost for foreign jurisdictions: $428,400 + $96,390 =
$524,790.
---------------------------------------------------------------------------
We note that substituted compliance requests will be made on a
voluntary basis, and nonresident SBS Entities would only make such
requests when the anticipated costs of relying on substituted
compliance are lower than the costs of complying directly with these
final rules. Further, after a substituted compliance determination is
made, SBS Entities would choose substituted compliance only if their
expected private benefits from participating in U.S. security-based
swap markets exceed expected private costs, including any conditions
the Commission may attach to the substituted compliance determination.
We also recognize that these costs and the overall economic effects
of allowing substituted compliance for these final business conduct
rules will depend on, among others, whether (and to what extent)
substituted compliance requests will be granted for jurisdictions in
which some of the most active nonresident SBS Entities are currently
residing; the costs of potential relocation, business restructuring, or
direct compliance by nonresident SBS Entities in jurisdictions for
which substituted compliance is not granted; the relevant information
required to demonstrate consistency between the foreign regulatory
requirements and the Commission's business conduct rules; the relevant
information required to demonstrate the adequacy of the foreign
regime's compliance and enforcement mechanisms; and the fraction of SBS
Entities in a given jurisdiction that may rely on substituted
compliance if available.
We note that substituted compliance determinations will be made on
a jurisdiction-wide basis. As a result, after the first applicant from
a given jurisdiction receives an affirmative substituted compliance
determination, all SBS Entities from the same jurisdiction will be able
to comply with these final rules by complying with requirements of that
foreign jurisdiction without bearing the related substituted compliance
application costs. Such an approach eliminates duplication in
application costs for SBS Entities from the same jurisdictions.
However, foreign SBS Entities that are the first to make a substituted
compliance application from a given jurisdiction will also bear greater
costs, which disadvantages first movers. SBS Entities that intermediate
greater volume or hold larger positions of security-based swaps in the
United States, and SBS Entities that face greater costs of direct
compliance with these final rules compared to costs of compliance with
rules of a foreign jurisdiction may be the first SBS Entities to make
substituted compliance applications and bear application costs.
SBS Entities in foreign jurisdictions with blocking laws, privacy
laws, secrecy laws and other legal barriers inconsistent with the
Commission's authority over registered entities will be unable to take
advantage of substituted compliance. As part of these final rules, the
Commission is adopting a requirement that, in order to make a request
for substituted compliance, each party must provide the certification
and opinion of counsel that the entity can as a matter of law, and
will, provide the Commission with prompt access to the entity's books
and records and submit to onsite inspection and examination by the
Commission. Similarly, foreign financial regulatory authorities may
make substituted compliance requests only if they can provide adequate
assurances that no law or policy of any relevant foreign jurisdiction
would impede the ability of any entity that is directly supervised by
the authority and that may register as an SBS Entity to provide prompt
access to the Commission to books and records or to submit to onsite
inspection or examination. As a result of these requirements, the scope
of SBS Entities and jurisdictions able to take advantage of substituted
compliance may be reduced. However, as we have stated elsewhere,\1764\
the Commission believes that significant elements of an effective
regulatory regime are the Commission's abilities to access registered
SBS Entities' books and records and to inspect and examine the
operations of registered SBS Entities.
---------------------------------------------------------------------------
\1764\ See Registration Adopting Release, 80 FR at 48981.
---------------------------------------------------------------------------
We note that U.S. SBS Entities will not be able to rely on
substituted compliance with respect to any transactions, including
transactions with foreign counterparties. Alternatively, the Commission
could allow substituted compliance for U.S. SBS Entities. Under the
alternative, U.S. SBS Entities would be able to comply with these
substantive transaction-level requirements by complying with business
conduct requirements of a comparable regulatory regime when dealing
with counterparties domiciled in foreign countries. We recognize that
U.S. SBS Entities may be competing for foreign counterparty business
with foreign SBS Entities, and substituted compliance may reduce costs
of complying with these final business conduct requirements. Under the
alternative, the ability of U.S. SBS Entities to rely on substituted
compliance may increase the profitability of U.S. SBS Entities
transactions with foreign counterparties or may increase business for
U.S. SBS Entities seeking to intermediate security-based swaps with
foreign market participants. However, such an approach may adversely
impact counterparty protection, informational asymmetry and Commission
oversight benefits of these substantive requirements enjoyed by all
counterparties of U.S. SBS Entities as a result of potential
differences among global regulatory regimes. Since any potential costs
of compliance with these substantive requirements may be passed on to
counterparties, such an alternative may result in differential access
and security-based swap terms of U.S. and foreign counterparties of
U.S. SBS Entities.
Under the approach being adopted, foreign SBS Entities will be able
to comply with these final business conduct requirements by complying
with comparable foreign requirements. We have considered an alternative
approach, under which the availability of substituted compliance is
predicated on a finding of a direct conflict between Title VII and
foreign regulatory requirements. Under this alternative, foreign SBS
Entities that are currently complying with comparable (though not
identical) requirements, would be required to bring their activities
into compliance with these final rules, absent a direct conflict
between Title VII requirements and their foreign regulatory regime. If
the scope of comparable regulatory regimes is broader than the scope of
regimes that are in direct conflict with the
[[Page 30139]]
requirements of Title VII, this alternative may enable SBS Entities
from fewer jurisdictions to take advantage of substituted compliance.
As a result, the economic benefits of substituted compliance discussed
above may be reduced.
Fewer foreign SBS Entities being eligible for substituted
compliance may also reduce direct application costs to the industry.
However, the burden of establishing a direct conflict may be greater
than the burden related to establishing comparability, which may
increase direct substituted compliance costs per application.
Crucially, if fewer SBS Entities are able to take advantage of
substituted compliance under this alternative, a greater number of
foreign SBS Entities would be required to incur costs of restructuring
their systems and processes to comply with these final rules.
Alternatively, foreign SBS Entities may choose relocate to another
jurisdiction, or decrease their participation in U.S. security-based
swap markets below thresholds triggering SBS Entity registration
requirements and compliance with these final rules. To the extent that
these costs may be passed on to counterparties of foreign SBS Entities
or affect liquidity provision by foreign SBS Entities, transaction
costs may increase and liquidity may be reduced. Further these costs
may create a barrier to entry for foreign SBS Entities into U.S.
security-based swap markets, and facilitate market segmentation.
Under this alternative, counterparties of foreign SBS Entities
unable to rely on substituted compliance may benefit to a greater
extent from the transparency and counterparty protections of these
final rules. Further, U.S. SBS Entities and foreign SBS Entities from
jurisdictions that are able to rely on substituted compliance may step
in to intermediate trades with counterparties impacted by foreign SBS
Entities unable to rely on substituted compliance. The Commission's
future substituted compliance determinations with respect to individual
foreign regimes will affect the scope of affected foreign SBS Entities.
Therefore, we are unable to estimate and compare the number, market
share and scope of counterparties of foreign SBS Entities that may be
able to rely on substituted compliance under the approach being
adopted, and under the alternative. However, we note that, using DTCC-
TIW data as of year-end 2014, all foreign SBS Dealers likely to trigger
registration requirements were responsible for 35% of the notional
volume of all likely SBS Entities. In addition, as we have noted
earlier in the economic analysis, in 2014 non-dealer counterparties
transacted with a median of three and an average of four SBS Dealers.
We have also considered an alternative approach under which foreign
SBS Entities would be able to rely on substituted compliance only in
their transactions with non-U.S. counterparties. This alternative would
effectively limit the scope of substituted compliance to non-U.S. SBS
Entities that are transacting with non-U.S. counterparties, but are
subject to these final rules as a result of their reliance on U.S.
personnel discussed above. Such an approach could ensure that U.S.
counterparties of all SBS Entities benefit from the same transparency
and counterparty protection benefits of these final rules, regardless
of the degree of comparability of foreign regimes. However, some
foreign SBS Entities already complying with comparable regimes would
incur additional costs of restructuring to comply with these final
rules without being able to rely on substituted compliance in their
transactions with U.S. counterparties. If such costs are significant,
non-U.S. SBS Entities may become less willing to intermediate
transactions with U.S. counterparties and transaction costs borne by
U.S. counterparties may increase. While other U.S. SBS Entities are
likely to step in and provide the necessary liquidity, this approach
may adversely impact competition and facilitate market segmentation.
D. Effects on Efficiency, Competition and Capital Formation
In adopting these final rules, we are required to consider their
effects on efficiency, competition and capital formation. As we discuss
below, these final rules may enhance transparency, and improve
informational and allocative efficiency in security-based swap markets.
Greater transparency and allocative efficiency may incentivize quality
based competition among market participants in general, and SBS Dealers
in particular. In the discussion below, we address the potential
effects of final disclosure, suitability and special entity rules on
informational and allocative efficiency, and their effects on capital
formation in security-based swap and reference security markets. We
also consider how harmonization with the CFTC external business conduct
rules facilitates ongoing market integration between swap and security-
based swap markets, and lowers informational inefficiencies. Finally,
we discuss the competitive burdens of compliance costs, their effects
on the willingness of SBS Dealers to intermediate transactions with
certain groups of counterparties, as well as competitive effects of the
cross-border approach being adopted.
The business conduct standards for SBS Entities, including
requirements to disclose material risks, characteristics, incentives
and conflicts of interest related to security-based swaps, as well as
the fair and balanced communications rule, may reduce information
asymmetries between SBS Entities and their less sophisticated
counterparties. To the extent that adverse selection costs described in
Section VI.C.2 are present in security-based swap markets, market
participants may become more informed and may increase their activity
in security-based swaps, which may improve market quality. To the
extent that security-based swap market participants consider
disclosures under these final rules informative in selecting security-
based swaps and SBS Entity counterparties, these final rules may help
market participants make more informed counterparty choices. The
increased disclosure of information regarding material risks and
characteristics, incentives and conflicts of interest may lead to
improved informational efficiency and quality-based competition among
SBS Entities to the extent that market participants rely on this
information in selecting security-based swaps and counterparties.
However, as more informed counterparties, SBS Entities are able to
extract information rents from non-dealer counterparties. To the extent
that the business conduct rules help inform counterparties, these rules
may reduce the informational advantage of SBS Entities, and may
decrease profitability of their transactions with non-dealer
counterparties. As a result of disclosures of material risks, daily
mark, conflicts of interest and other information regarding security-
based swaps, some private information of SBS Dealers about the quality
of security-based swaps and underlying reference securities may become
public. As a result, security-based swap prices and dealer profit
margins may decrease. These rules may reduce the incentives of SBS
Dealers to gather private information that is impounded into prices,
and SBS Dealer willingness to intermediate security-based swap
transactions with non-dealer counterparties.
Enhanced disclosures and counterparty protections of these Business
Conduct Standards may improve access to information, and may attract
non-dealer market participants into security-based swap markets. These
[[Page 30140]]
rules may, therefore, protect end users and other non-dealers that are
effecting security-based swaps to manage risk or trade on negative
information, which may improve their ability to make appropriate and
informed portfolio decisions. However, if these rules result in less
informed market participants playing an increasingly larger role in
security-based swap markets, informational efficiency in security-based
swap markets may decrease. This consideration is attenuated by the fact
that uninformed participants bring valuable liquidity enabling informed
traders, such as SBS Dealers, to execute informed trades with less
price impact. The overall effects of these final rules on price
discovery and informational efficiency in security-based swap markets
are, therefore, difficult to assess.
The final suitability and special entity rules would require SBS
Dealers to evaluate the suitability of trades for non-dealer
counterparties and special entities when making recommendations to such
counterparties, unless the SBS Dealer can rely on the institutional
suitability alternative to fulfill its customer-specific suitability
obligations. SBS Dealers may have superior information about security-
based swaps, but may face an informational asymmetry when analyzing the
hedging needs, risk tolerance and horizons of their counterparties.
This requirement may preclude SBS Dealers from recommending some
security-based swaps that may be truly suitable for a given
counterparty, while recommending other security-based swaps that may be
less suitable. The presence and magnitude of this economic effect
depends on the tradeoff between the severity of information asymmetry
concerning the nature of the swap and asymmetry concerning the
counterparty, and potential losses and risks of investing in unsuitable
security-based swaps relative to foregone profits from not investing in
suitable security-based swaps.
Suitability requirements and resulting costs could further increase
the costs to SBS Dealers of recommending security-based swaps to non-
dealer counterparties, particularly counterparties with which the SBS
Dealer has had no prior transactions, and counterparties that do not
meet institutional suitability requirements. We also recognize that
these rules may limit the ability of SBS Dealers to recommend some
security-based swaps to certain counterparties, which may decrease the
potential range of counterparties and products that some SBS Dealers
may intermediate. If these effects result in SBS Dealers refraining
from advising or transacting with some counterparties, and these
counterparties are otherwise unable to receive advice or enter into
security-based swaps, the suitability requirement may come at a net
cost to these counterparties and would place them at a disadvantage
relative to larger, more sophisticated competitors. To the extent that
these counterparties do not participate in the security-based swap
market as a result of these costs, adverse effects on market
participation and liquidity may follow. However, as we noted
previously, market data available to us reveal that relatively few
counterparties enter into security-based swap agreements with an SBS
Dealer without third-party representation, particularly among special
entities. As a result of this third-party representation and the SBS
Dealer's ability to fulfill its customer-specific suitability
obligations by, among other things, making the determination that a
counterparty's agent is capable of independently evaluating investment
risk, as well as the exception of anonymous SEF executed security-based
swaps, we do not believe that market access is likely to be restricted.
The final pay to play rules may reduce pay to play practices among
SBS Dealers. To the extent that political contributions may currently
be influencing counterparty and security-based swap selection, these
rules may mitigate these influences and enhance allocative efficiency
of municipal entities and facilitate greater quality-based competition
of SBS Dealers. However, if some SBS Dealers become subject to a two-
year time out due to inadvertent violations of the de minimis
thresholds by themselves or their covered associates, and are unable to
secure exemptive relief, fewer SBS Dealers may be able to transact with
municipal entities in security-based swaps, which may increase the
pricing power and decrease quality of execution of swaps offered to
municipal entities by the remaining SBS Dealers. We note that SBS
Dealers will have to keep updated records of political contributions of
their covered associates, ensure their accuracy, promptly discover
triggering contributions and seek their return. The costs of
implementing such policies and procedures related to political
contributions of covered associates will be greater for larger SBS
Dealers with multiple layers of supervision and a higher number of
covered associates with shorter tenures. While other business conduct
rules tend to impose fixed burdens, which represent a higher fraction
of net income for smaller SBS Dealers, this particular requirement may
be significantly more costly for larger SBS Dealers.
Further, under these final rules, representatives of special
entities transacting with SBS Entities are likely to be employees or
independent representatives subject to Commission, CFTC or SRO pay to
play rules. To the extent that some special entity representatives
currently intermediating transactions with SBS Entities are not
registered investment advisers, municipal advisors, other fiduciaries
or employees, they may be unable to represent special entities in
security-based swap transactions with SBS Entities unless they register
as such. This may decrease competition among qualified investment
representatives of special entities, or incentivize unregistered
representatives to register, for instance, as investment advisers with
the Commission or as municipal advisors with the MSRB.
The direct and indirect costs of compliance with these final
business conduct rules may be recovered by SBS Entities in the form of
higher transaction costs or more adverse non-price terms of security-
based swaps offered to counterparties. To the extent that these costs
cannot be recovered, incentives for some entities to operate as
registered U.S. SBS Entities may be reduced,\1765\ which may adversely
affect competition in security-based swap markets. In addition, some
counterparties may lose access to the market for OTC swaps. However, we
note that, as discussed above, anonymous SEF transactions are exempt
from some of the substantive requirements of these final rules, which
may allow such counterparties to retain access to security-based swaps.
Further, to the extent that these rules impose costs and restrictions
on non-SEF trades that are not born by SBS Entities related to SEF
trades, the volume of transactions executed on SEFs may increase. We
recognize that, as a result, these final rules may increase the
programmatic costs and benefits of pending SEF and clearing rules, with
their follow on effects on efficiency, competition and capital
formation, which will be evaluated in pending SEF and clearing rules.
We recognize similarities between CFTC external business conduct
standards for Swap Entities, FINRA rules for broker dealers and the
rules being adopted. Due to extensive cross-market participation, many
of the entities expected to register
[[Page 30141]]
as SBS Entities will have already registered with the CFTC as Swap
Entities or with the Commission as broker dealers, yet others may
already be subject to similar MSRB rules. To the extent that these
final rules involve initial compliance costs, dually registered SBS
entities may experience significantly lower initial compliance costs.
At the same time, new entrants and SBS Entities that are not dually
registered may face higher costs. Competitive effects of these final
business conduct rules primarily stem from differences in burdens
incurred by dual registrants on the one hand, and non-dually registered
SBS Entities and new entrants on the other.
---------------------------------------------------------------------------
\1765\ See U.S. Activity Adopting Release, 81 FR at 8629.
---------------------------------------------------------------------------
In addition to the competitive effects of compliance burdens above,
the cross-border approach adopted in these final rules may impact
competition between U.S. and non-U.S. SBS Entities and their U.S. and
non-U.S. personnel. A substituted compliance regime for business
conduct requirements and their application to non-U.S. persons' dealing
transactions that are arranged, negotiated, or executed using personnel
located in the United States may mitigate competitive frictions between
U.S. and non-U.S. SBS Dealers that transact with foreign
counterparties, and may promote market efficiency. The final cross-
border approach to business conduct requirements will result in a
uniform application of these requirements to U.S. and non-U.S. SBS
Dealers and their agents. If only U.S. SBS Dealers and their agents
were subject to disclosure, suitability and other requirements in these
final rules when transacting with foreign counterparties, the costs of
such disclosures would primarily be incurred by U.S. SBS Dealers, their
agents, and their counterparties. In contrast, non-U.S. SBS Dealers and
their agents, including personnel located in the United States, would
potentially have a competitive advantage over U.S. SBS Dealers in
serving non-U.S. person counterparties using personnel located in a
U.S. branch or office, were their activities not subject to the same
requirements.\1766\ Therefore, the cross-border application of these
final business conduct rules may enhance competition among these SBS
Dealers.
---------------------------------------------------------------------------
\1766\ See, e.g., Arnoud W.A. Boot, Silva Dezelan, and Todd T.
Milbourn, ``Regulatory Distortions in a Competitive Financial
Services Industry,'' Journal of Financial Services Research, Vol.
17, No. 1 (2000).
---------------------------------------------------------------------------
Access to SEC-regulated security-based swap markets increases
hedging opportunities for financial market intermediaries; such hedging
opportunities reduce risks and allow intermediaries to facilitate a
greater volume of financing activities, including issuance of equity
and debt securities, and therefore contribute to capital formation. As
we have stated in other releases,\1767\ this may be particularly true
in underlying securities markets, where potential pricing and liquidity
effects in security-based swap markets may feedback and impact the
market for reference entity securities. Security-based swap markets may
enable better risk mitigation by investors in underlying reference
securities, such as CDS hedging of the credit risk of corporate bond
investments. The possible contraction in security-based swap market
participation by SBS Entities due to costs of compliance with these
final rules may adversely impact underlying reference security markets,
including pricing and liquidity in corporate bond and equity markets.
This may have a negative effect on the ability of firms to raise debt
and equity capital to finance real investment. However, the spillover
from potential deterioration in security-based swap markets into
underlying reference security markets may also be positive.
Sophisticated institutional investors transact across CDS and bond
markets to trade on information pertaining to the credit risk of
underlying reference debt. A potential negative shock to security-based
swap market liquidity and dealing by SBS Entities with non-SBS Entity
counterparties as a result of required compliance with these final
rules may, in fact, drive sophisticated institutions to search for
liquidity pools and lower price impact of informed trades to reference
security markets. If institutions begin to trade more actively in
underlying reference security markets, such as corporate bond markets
as a result, there may be positive effects on liquidity and
informational efficiency of corporate bond and equity markets.\1768\
This may enable firms to raise more debt and equity at potentially
lower costs to finance real investment.
---------------------------------------------------------------------------
\1767\ See Registration Adopting Release, 80 FR 49008, supra
note 989.
\1768\ See Section VI.B.5.
---------------------------------------------------------------------------
VII. Regulatory Flexibility Act Certification
The Regulatory Flexibility Act (``RFA'') \1769\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. The Commission certified in the Proposing Release,
pursuant to Section 605(b) of the RFA,\1770\ that proposed Rules 15Fh-1
through 15Fh-6 and Rule 15Fk-1 would not, if adopted, have a
significant economic impact on a substantial number of ``small
entities.'' \1771\ The Commission received no comments on this
certification.
---------------------------------------------------------------------------
\1769\ 5 U.S.C. 601 et seq.
\1770\ 5 U.S.C. 605(b).
\1771\ Although Section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission has adopted definitions for the term
small entity for the purposes of Commission rulemaking in accordance
with the RFA. Those definitions, as relevant to this proposed
rulemaking, are set forth in Rule 0-10, 17 CFR 240.0-10. See
Statement of Management on Internal Control, Exchange Act Release
No. 18451 (Jan. 28, 1982), 47 FR 5215 (Feb. 4, 1982).
---------------------------------------------------------------------------
For purposes of Commission rulemaking in connection with the RFA, a
small entity includes: (i) When used with reference to an ``issuer'' or
a ``person,'' other than an investment company, an ``issuer'' or
``person'' that, on the last day of its most recent fiscal year, had
total assets of $5 million or less; \1772\ or (ii) a broker-dealer with
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared pursuant to Rule 17a-5(d) under the
Exchange Act,\1773\ or, if not required to file such statements, a
broker-dealer with total capital (net worth plus subordinated
liabilities) of less than $500,000 on the last day of the preceding
fiscal year (or in the time that it has been in business, if shorter);
and is not affiliated with any person (other than a natural person)
that is not a small business or small organization.\1774\ With respect
to investment companies in connection with the RFA, the term ``small
business'' or ``small organization'' means an investment company that,
together with other investment companies in the same group of related
investment companies, has net assets of $50 million or less as of the
end of its most recent fiscal year. Under the standards adopted by the
Small Business Administration, small entities in the finance and
insurance industry include the following: (i) For entities in credit
intermediation and related activities,\1775\ entities with $550 million
or less in assets or, (ii) for non-depository credit intermediation and
certain other activities,\1776\ $38.5
[[Page 30142]]
million or less in annual receipts; (iii) for entities in financial
investments and related activities,\1777\ entities with $38.5 million
or less in annual receipts; (iv) for insurance carriers and entities in
related activities,\1778\ entities with $38.5 million or less in annual
receipts, or 1,500 employees for direct property and casualty insurance
carriers; and (v) for funds, trusts, and other financial
vehicles,\1779\ entities with $32.5 million or less in annual
receipts.\1780\
---------------------------------------------------------------------------
\1772\ See 17 CFR 240.0-10(a).
\1773\ See 17 CFR 240.17a-5(d).
\1774\ See 17 CFR 240.0-10(c).
\1775\ Including commercial banks, savings institutions, credit
unions, firms involved in other depository credit intermediation,
credit card issuing, sales financing, consumer lending, real estate
credit, and international trade financing. 13 CFR 121.201 at
Subsector 522.
\1776\ Including firms involved in secondary market financing,
all other non-depository credit intermediation, mortgage and
nonmortgage loan brokers, financial transactions processing,
reserve, and clearing house activities, and other activities related
to credit intermediation. 13 CFR 121.201 at Subsector 522.
\1777\ Including firms involved in investment banking and
securities dealing, securities brokerage, commodity contracts
dealing, commodity contracts brokerage, securities and commodity
exchanges, miscellaneous intermediation, portfolio management,
providing investment advice, trust, fiduciary and custody
activities, and miscellaneous financial investment activities. 13
CFR 121.201 at Subsector 523.
\1778\ Including direct life insurance carriers, direct health
and medical insurance carriers, direct property and casualty
insurance carriers, direct title insurance carriers, other direct
insurance (except life, health and medical) carriers, reinsurance
carriers, insurance agencies and brokerages, claims adjusting, third
party administration of insurance and pension funds, and all other
insurance related activities. 13 CFR 121.201 at Subsector 524.
\1779\ Including pension funds, health and welfare funds, other
insurance funds, open-end investment funds, trusts, estates, and
agency accounts, real estate investment trusts and other financial
vehicles. 13 CFR 121.201 at Subsector 525.
\1780\ See 13 CFR 121.201.
---------------------------------------------------------------------------
With respect to SBS Entities, based on feedback from market
participants and our information about the security-based swap markets,
the Commission continues to believe that (1) the types of entities that
would engage in more than a de minimis amount of dealing activity
involving security-based swaps--which generally would be large
financial institutions--would not be ``small entities'' for purposes of
the RFA; and (2) the types of entities that may have security-based
swap positions above the level required to be ``major security-based
swap participants'' would not be ``small entities'' for purposes of the
RFA.\1781\
---------------------------------------------------------------------------
\1781\ See Recordkeeping Release, 79 FR 25194, 25296-97 &
n.1441, supra note 242; Further Definition of ``Swap Dealer,''
``Security-Based Swap Dealer,'' ``Major Swap Participant,'' ``Major
Security-Based Swap Participant'' and ``Eligible Contract
Participant,'' Exchange Act Release No. 66868 (Apr. 27, 2012), 77 FR
30596, 30743 (May 23, 2012) (joint Commission/CFTC final rules);
Registration Adopting Release, 80 FR 48964, 49012-49013, supra note
989.
---------------------------------------------------------------------------
For the foregoing reasons, the Commission certifies that the SBS
Entity registration rules and forms, as adopted would not have a
significant economic impact on a substantial number of small entities
for purposes of the RFA.
Statutory Basis and Text of Final Rules
Pursuant to the Exchange Act and, particularly, Sections 2, 3(b),
3C, 9, 10, 11A, 15, 15F, 17(a) and (b), 23(a) and 30(c) thereof (15
U.S.C. 78b, 78c(b), 78i(i), 78i(j), 78j, 78k-1, 78o, 78o-10, 78q(a) and
(b), 78w(a) and 78dd(c)), the Commission is adopting Rule 3a71-6, Rules
15Fh-1 through 15Fh-6, and Rule 15Fk-1, and is amending Rules 3a67-10
and 3a71-3, to address the business conduct obligations of security-
based swap dealers and major security-based swap participants,
including the cross-border application of those obligations and the
availability of substituted compliance in connection with those
obligations.
List of Subjects in 17 CFR Part 240
Brokers, Reporting and recordkeeping requirements, Securities.
Text of the Final Rules
For the reasons set forth in the preamble, the Securities and
Exchange Commission is amending Title 17, Chapter II of the Code of
Federal Regulations, as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 continues to read, and sectional
authorities for sections 240.3a71-6, 240.15Fh-1 through 240.15Fh-6, and
240.15Fk-1 are added in numerical order to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq.,
and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350;
and Pub. L. 111-203, 939A, 124 Stat. 1376, (2010), unless otherwise
noted.
* * * * *
Section 240.3a67-10, 240.3a71-3, 240.3a71-4, 240.3a71-5, and
240.3a71-6 are also issued under Pub. L. 111-203, secs. 712, 761(b),
124 Stat. 1754 (2010), and 15 U.S.C. 78dd(c).
* * * * *
Sections 240.15Fh-1 through 240.15Fh-6 and 240.15Fk-1 are also
issued under sec. 943, Pub. L. 111-203, 124 Stat. 1376.
* * * * *
0
2. Sec. 240.3a67-10 is amended by:
0
a. Adding paragraphs (a)(5) and (6); and
0
b. Adding paragraph (d).
The additions read as follows:
Sec. 240.3a67-10 Foreign major security-based swap participants.
(a) * * *
(5) U.S. major security-based swap participant means a major
security-based swap participant, as defined in section 3(a)(67) of the
Act (15 U.S.C. 78c(a)(67)), and the rules and regulations thereunder,
that is a U.S. person.
(6) Foreign major security-based swap participant means a major
security-based swap participant, as defined in section 3(a)(67) of the
Act (15 U.S.C. 78c(a)(67)), and the rules and regulations thereunder,
that is not a U.S. person.
* * * * *
(d) Application of customer protection requirements. (1) A
registered foreign major security-based swap participant shall not be
subject to the requirements relating to business conduct standards
described in section 15F(h) of the Act (15 U.S.C. 78o-10(h)), and the
rules and regulations thereunder, other than rules and regulations
prescribed by the Commission pursuant to section 15F(h)(1)(B) of the
Act (15 U.S.C. 78o- 10(h)(1)(B)), with respect to a security-based swap
transaction with a counterparty that is not a U.S. person or with a
counterparty that is a U.S. person in a transaction conducted through a
foreign branch of the U.S. person.
(2) A registered U.S. major security-based swap participant shall
not be subject to the requirements relating to business conduct
standards described in section 15F(h) of the Act (15 U.S.C. 78o-10(h)),
and the rules and regulations thereunder, other than rules and
regulations prescribed by the Commission pursuant to section
15F(h)(1)(B) of the Act (15 U.S.C. 78o-10(h)(1)(B)), with respect to a
security-based swap transaction that constitutes a transaction
conducted through a foreign branch of the registered U.S. major
security-based swap participant with a non-U.S. person or with a U.S.-
person counterparty that constitutes a transaction conducted through a
foreign branch of that U.S.-person counterparty.
0
3. Sec. 240.3a71-3 is amended by:
0
a. Adding paragraphs (a)(6) through (9); and
0
b. Adding paragraph (c).
The additions read as follows:
Sec. 240.3a71-3 Cross-border security-based swap dealing activity.
(a) * * *
(6) U.S. security-based swap dealer means a security-based swap
dealer, as defined in section 3(a)(71) of the Act (15 U.S.C.
78c(a)(71)), and the rules and regulations thereunder, that is a U.S.
person.
[[Page 30143]]
(7) Foreign security-based swap dealer means a security-based swap
dealer, as defined in section 3(a)(71) of the Act (15 U.S.C.
78c(a)(71)), and the rules and regulations thereunder, that is not a
U.S. person.
(8) U.S. business means:
(i) With respect to a foreign security-based swap dealer:
(A) Any security-based swap transaction entered into, or offered to
be entered into, by or on behalf of such foreign security-based swap
dealer, with a U.S. person (other than a transaction conducted through
a foreign branch of that person); or
(B) Any security-based swap transaction arranged, negotiated, or
executed by personnel of the foreign security-based swap dealer located
in a U.S. branch or office, or by personnel of an agent of the foreign
security-based swap dealer located in a U.S. branch or office; and
(ii) With respect to a U.S. security-based swap dealer, any
transaction entered into or offered to be entered into by or on behalf
of such U.S. security-based swap dealer, other than a transaction
conducted through a foreign branch with a non-U.S. person or with a
U.S.-person counterparty that constitutes a transaction conducted
through a foreign branch of the counterparty.
(9) Foreign business means security-based swap transactions entered
into, or offered to be entered into, by or on behalf of a security-
based swap dealer, other than the U.S. business of such person.
* * * * *
(c) Application of customer protection requirements. A registered
security-based swap dealer, with respect to its foreign business, shall
not be subject to the requirements relating to business conduct
standards described in section 15F(h) of the Act (15 U.S.C. 78o-10(h)),
and the rules and regulations thereunder, other than the rules and
regulations prescribed by the Commission pursuant to section
15F(h)(1)(B) of the Act (15 U.S.C. 78o-10(h)(1)(B)).
0
4. Add Sec. 240.3a71-6 to read as follows:
Sec. 240.3a71-6 Substituted compliance for security-based swap
dealers and major security-based swap participants.
(a) Determinations--(1) In general. Subject to paragraph (a)(2) of
this section, the Commission may, conditionally or unconditionally, by
order, make a determination with respect to a foreign financial
regulatory system that compliance with specified requirements under
such foreign financial regulatory system by a registered security-based
swap dealer and/or by a registered major security-based swap
participant (each a ``security-based swap entity''), or class thereof,
may satisfy the corresponding requirements identified in paragraph (d)
of this section that would otherwise apply to such security-based swap
entity (or class thereof).
(2) Standard. The Commission shall not make a substituted
compliance determination under paragraph (a)(1) of this section unless
the Commission:
(i) Determines that the requirements of such foreign financial
regulatory system applicable to such security-based swap entity (or
class thereof) or to the activities of such security-based swap entity
(or class thereof) are comparable to otherwise applicable requirements,
after taking into account such factors as the Commission determines are
appropriate, such as the scope and objectives of the relevant foreign
regulatory requirements (taking into account the applicable criteria
set forth in paragraph (d) of this section), as well as the
effectiveness of the supervisory compliance program administered, and
the enforcement authority exercised, by a foreign financial regulatory
authority or authorities in such system to support its oversight of
such security-based swap entity (or class thereof) or of the activities
of such security-based swap entity (or class thereof); and
(ii) Has entered into a supervisory and enforcement memorandum of
understanding and/or other arrangement with the relevant foreign
financial regulatory authority or authorities under such foreign
financial regulatory system addressing supervisory and enforcement
cooperation and other matters arising under the substituted compliance
determination.
(3) Withdrawal or modification. The Commission may, on its own
initiative, by order, modify or withdraw a substituted compliance
determination under paragraph (a)(1) of this section, after appropriate
notice and opportunity for comment.
(b) Reliance by security-based swap entities. A registered
security-based swap entity may satisfy the requirements described in
paragraph (d) of this section by complying with corresponding law,
rules and regulations under a foreign financial regulatory system,
provided:
(1) The Commission has made a substituted compliance determination
pursuant to paragraph (a)(1) of this section regarding such foreign
financial regulatory system providing that compliance with specified
requirements under such foreign financial regulatory system by such
registered security-based swap entity (or class thereof) may satisfy
the corresponding requirements described in paragraph (d) of this
section; and
(2) Such registered security-based swap entity satisfies any
conditions set forth in a substituted compliance determination made by
the Commission pursuant to paragraph (a)(1) of this section.
(c) Requests for determinations. (1) A party or group of parties
that potentially would comply with specified requirements pursuant to
paragraph (a)(1), or any foreign financial regulatory authority or
authorities supervising such a party or its security-based swap
activities, may file an application, pursuant to the procedures set
forth in Sec. 240.0-13, requesting that the Commission make a
substituted compliance determination pursuant to paragraph (a)(1) of
this section, with respect to one or more requirements described in
paragraph (d) of this section.
(2) Such a party or group of parties may make a request under
paragraph (c)(1) of this section only if:
(i) Each such party, or the party's activities, is directly
supervised by the foreign financial regulatory authority or authorities
with respect to the foreign regulatory requirements relating to the
applicable requirements described in paragraph (d) of this section; and
(ii) Each such party provides the certification and opinion of
counsel as described in Sec. 240.15Fb2-4(c), as if the party were
subject to that requirement at the time of the request.
(3) Such foreign financial authority or authorities may make a
request under paragraph (c)(1) of this section only if each such
authority provides adequate assurances that no law or policy of any
relevant foreign jurisdiction would impede the ability of any entity
that is directly supervised by the foreign financial regulatory
authority and that may register with the Commission as a security-based
swap dealer or major security-based swap participant to provide prompt
access to the Commission to such entity's books and records or to
submit to onsite inspection or examination by the Commission.
(d) Eligible requirements. The Commission may make a substituted
compliance determination under paragraph (a)(1) of this section to
permit security-based swap entities that are not U.S. persons (as
defined in Sec. 240.3a71-3(a)(4)), but not security-based swap
entities that are U.S. persons, to satisfy the following requirements
by
[[Page 30144]]
complying with comparable foreign requirements:
(1) Business conduct and supervision. The business conduct and
supervision requirements of sections 15F(h) and (j) of the Act (15
U.S.C. 78o-10(h) and (j)) and Sec. Sec. 240.15Fh-3 through 15Fh-6,
other than the antifraud provisions of section 15F(h)(4)(A) of the Act
and Sec. 240.15Fh-4(a), and other than the provisions of sections
15F(j)(3) and 15F(j)(4)(B) of the Act; provided, however, that prior to
making such a substituted compliance determination the Commission
intends to consider whether the information that is required to be
provided to counterparties pursuant to the requirements of the foreign
financial regulatory system, the counterparty protections under the
requirements of the foreign financial regulatory system, the mandates
for supervisory systems under the requirements of the foreign financial
regulatory system, and the duties imposed by the foreign financial
regulatory system, are comparable to those associated with the
applicable provisions arising under the Act and its rules and
regulations.
(2) Chief compliance officer. The chief compliance officer
requirements of section 15F(k) of the Act (15 U.S.C. 78o-10(k)) and
Sec. 240.15Fk-1; provided, however, that prior to making such a
substituted compliance determination the Commission intends to consider
whether the requirements of the foreign financial regulatory system
regarding chief compliance officer obligations are comparable to those
required pursuant to the applicable provisions arising under the Act
and its rules and regulations.
0
5. Add Sec. Sec. 240.15Fh-1 through 240.15Fh-6, and Sec. 240.15Fk-1
to read as follows:
Sec. 240.15Fh-1 Scope and reliance on representations.
(a) Scope. Sections 240.15Fh-1 through 240.15Fh-6, and 240.15Fk-1
are not intended to limit, or restrict, the applicability of other
provisions of the federal securities laws, including but not limited to
section 17(a) of the Securities Act of 1933 and sections 9 and 10(b) of
the Act, and rules and regulations thereunder, or other applicable laws
and rules and regulations. Sections 240.15Fh-1 through 240.15Fh-6, and
240.15Fk-1 apply, as relevant, in connection with entering into
security-based swaps and continue to apply, as appropriate, over the
term of executed security-based swaps. Sections 240.15Fh-3(a) through
240.15Fh-3(f), 240.15Fh-4(b) and 240.15Fh-5 are not applicable to
security-based swaps that security-based swap dealers or major
security-based swap participants enter into with their majority-owned
affiliates. For these purposes the counterparties to a security-based
swap are majority-owned affiliates if one counterparty directly or
indirectly owns a majority interest in the other, or if a third party
directly or indirectly owns a majority interest in both counterparties
to the security-based swap, where ``majority interest'' is the right to
vote or direct the vote of a majority of a class of voting securities
of an entity, the power to sell or direct the sale of a majority of a
class of voting securities of an entity, or the right to receive upon
dissolution or the contribution of a majority of the capital of a
partnership.
(b) Reliance on representations. A security-based swap dealer or
major security-based swap participant may rely on written
representations from the counterparty or its representative to satisfy
its due diligence requirements under Sec. 240.15Fh, unless it has
information that would cause a reasonable person to question the
accuracy of the representation.
Sec. 240.15Fh-2 Definitions.
As used in Sec. Sec. 240.15Fh-1 through 240.15Fh-6:
(a) Act as an advisor to a special entity. A security-based swap
dealer acts as an advisor to a special entity when it recommends a
security-based swap or a trading strategy that involves the use of a
security-based swap to the special entity, unless:
(1) With respect to a special entity as defined in Sec. 240.15Fh-
2(d)(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 security-based
swap;
(ii) The fiduciary represents in writing that it acknowledges that
the security-based swap dealer is not acting as an advisor; 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 security-based swap dealer involving a
security-based swap transaction is evaluated by a fiduciary before the
transaction is entered into; or
(B) That any recommendation the special entity receives from the
security-based swap dealer involving a security-based swap transaction
will be evaluated by a fiduciary before the transaction is entered
into.
(2) With respect to any special entity:
(i) The special entity represents in writing that:
(A) It acknowledges that the security-based swap dealer is not
acting as an advisor; and
(B) The special entity will rely on advice from a qualified
independent representative as defined in Sec. 240.15Fh-5(a); and
(ii) The security-based swap dealer discloses to the special entity
that it is not undertaking to act in the best interest of the special
entity, as otherwise required by section 15F(h)(4) of the Act.
(b) Eligible contract participant means any person as defined in
section 3(a)(65) of the Act and the rules and regulations thereunder
and in section 1a of the Commodity Exchange Act (7 U.S.C. 1a) and the
rules and regulations thereunder.
(c) Security-based swap dealer or major security-based swap
participant includes, where relevant, an associated person of the
security-based swap dealer or major security-based swap participant.
(d) 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 employee benefit plan defined in section 3 of the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1002) and not
otherwise defined as a special entity, unless such employee benefit
plan elects not to be a special entity by notifying a security-based
swap dealer or major security-based swap participant of its election
prior to entering into a security-based swap with the particular
security-based swap dealer or major security-based swap participant;
(5) Any governmental plan, as defined in section 3(32) of the
Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002(32));
or
(6) Any endowment, including an endowment that is an organization
described in section 501(c)(3) of the Internal Revenue Code of 1986.
(e) A person is subject to a statutory disqualification for
purposes of Sec. 240.15Fh-5 if that person would be subject to a
statutory disqualification, as
[[Page 30145]]
described in section 3(a)(39)(A)-(F) of the Act.
Sec. 240.15Fh-3 Business conduct requirements.
(a) Counterparty status--(1) Eligible contract participant. A
security-based swap dealer or a major security-based swap participant
shall verify that a counterparty meets the eligibility standards for an
eligible contract participant before entering into a security-based
swap with that counterparty, provided that the requirements of this
paragraph (a)(1) shall not apply to a transaction executed on a
registered national securities exchange.
(2) Special entity. A security-based swap dealer or a major
security-based swap participant shall verify whether a counterparty is
a special entity before entering into a security-based swap with that
counterparty, unless the transaction is executed on a registered or
exempt security-based swap execution facility or registered national
securities exchange, and the security-based swap dealer or major
security-based swap participant does not know the identity of the
counterparty at a reasonably sufficient time prior to execution of the
transaction to permit the security-based swap dealer or major security-
based swap participant to comply with the obligations of paragraph (a)
of this section.
(3) Special entity election. In verifying the special entity status
of a counterparty pursuant to Sec. 240.15Fh-3(a)(2), a security-based
swap dealer or major security-based swap participant shall verify
whether a counterparty is eligible to elect not to be a special entity
under Sec. 240.15Fh-2(d)(4) and, if so, notify such counterparty of
its right to make such an election.
(b) Disclosure. At a reasonably sufficient time prior to entering
into a security-based swap, a security-based swap dealer or major
security-based swap participant shall disclose to a counterparty, other
than a security-based swap dealer, major security-based swap
participant, swap dealer or major swap participant, material
information concerning the security-based swap in a manner reasonably
designed to allow the counterparty to assess the material risks and
characteristics and material incentives or conflicts of interest, as
described below, so long as the identity of the counterparty is known
to the security-based swap dealer or major security-based swap
participant at a reasonably sufficient time prior to execution of the
transaction to permit the security-based swap dealer or major security-
based swap participant to comply with the obligations of paragraph (b)
of this section.
(1) Material risks and characteristics means the material risks and
characteristics of the particular security-based swap, which may
include:
(i) Market, credit, liquidity, foreign currency, legal,
operational, and any other applicable risks; and
(ii) The material economic terms of the security-based swap, the
terms relating to the operation of the security-based swap, and the
rights and obligations of the parties during the term of the security-
based swap.
(2) Material incentives or conflicts of interest means any material
incentives or conflicts of interest that the security-based swap dealer
or major security-based swap participant may have in connection with
the security-based swap, including any compensation or other incentives
from any source other than the counterparty in connection with the
security-based swap to be entered into with the counterparty.
(3) Record. The security-based swap dealer or major security-based
swap participant shall make a written record of the non-written
disclosures made pursuant to this paragraph (b), and provide a written
version of these disclosures to its counterparties in a timely manner,
but in any case no later than the delivery of the trade acknowledgement
of the particular transaction pursuant to Sec. 240.15Fi-1.
(c) Daily mark. A security-based swap dealer or major security-
based swap participant shall disclose the daily mark to the
counterparty, other than a security-based swap dealer, major security-
based swap participant, swap dealer or major swap participant, which
shall be:
(1) For a cleared security-based swap, upon request of the
counterparty, the daily mark that the security-based swap dealer or
major security-based swap participant receives from the appropriate
clearing agency;
(2) For an uncleared security-based swap, the midpoint between the
bid and offer, or the calculated equivalent thereof, as of the close of
business, unless the parties agree in writing otherwise to a different
time, on each business day during the term of the security-based swap.
The daily mark may be based on market quotations for comparable
security-based swaps, mathematical models or a combination thereof. The
security-based swap dealer or major security-based swap participant
shall also disclose its data sources and a description of the
methodology and assumptions used to prepare the daily mark, and
promptly disclose any material changes to such data sources,
methodology and assumptions during the term of the security-based swap;
and
(3) The security-based swap dealer or major security-based swap
participant shall provide the daily mark without charge to the
counterparty and without restrictions on the internal use of the daily
mark by the counterparty.
(d) Disclosure regarding clearing rights. A security-based swap
dealer or major security-based swap participant shall disclose the
following information to a counterparty, other than a security-based
swap dealer, major security-based swap participant, swap dealer or
major swap participant, so long as the identity of the counterparty is
known to the security-based swap dealer or major security-based swap
participant at a reasonably sufficient time prior to execution of the
transaction to permit the security-based swap dealer or major security-
based swap participant to comply with the obligations of paragraph (d)
of this section:
(1) For security-based swaps subject to clearing requirement.
Before entering into a security-based swap subject to the clearing
requirement under section 3C(a) of the Act, a security-based swap
dealer or major security-based swap participant shall:
(i) Disclose to the counterparty the names of the clearing agencies
that accept the security-based swap for clearing, and through which of
those clearing agencies the security-based swap dealer or major
security-based swap participant is authorized or permitted, directly or
through a designated clearing member, to clear the security-based swap;
and
(ii) Notify the counterparty that it shall have the sole right to
select which of the clearing agencies described in paragraph (d)(1)(i)
of this section shall be used to clear the security-based swap subject
to section 3C(g)(5) of the Act.
(2) For security-based swaps not subject to clearing requirement.
Before entering into a security-based swap not subject to the clearing
requirement under section 3C(a) of the Act, a security-based swap
dealer or major security-based swap participant shall:
(i) Determine whether the security-based swap is accepted for
clearing by one or more clearing agencies;
(ii) Disclose to the counterparty the names of the clearing
agencies that accept the security-based swap for clearing, and whether
the security-based swap dealer or major security-based swap participant
is authorized or permitted, directly or through a designated clearing
member, to clear the security-based swap through such clearing
agencies; and
[[Page 30146]]
(iii) Notify the counterparty that it may elect to require clearing
of the security-based swap and shall have the sole right to select the
clearing agency at which the security-based swap will be cleared,
provided it is a clearing agency at which the security-based swap
dealer or major security-based swap participant is authorized or
permitted, directly or through a designated clearing member, to clear
the security-based swap.
(3) Record. The security-based swap dealer or major security-based
swap participant shall make a written record of the non-written
disclosures made pursuant to this paragraph (d), and provide a written
version of these disclosures to its counterparties in a timely manner,
but in any case no later than the delivery of the trade acknowledgement
of the particular transaction pursuant to Sec. 240.15Fi-1.
(e) Know your counterparty. Each security-based swap dealer shall
establish, maintain and enforce written policies and procedures
reasonably designed to obtain and retain a record of the essential
facts concerning each counterparty whose identity is known to the
security-based swap dealer that are necessary for conducting business
with such counterparty. For purposes of paragraph (e) 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 security-based 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.
(f) Recommendations of security-based swaps or trading strategies.
(1) A security-based swap dealer that recommends a security-based swap
or trading strategy involving a security-based swap to a counterparty,
other than a security-based swap dealer, major security-based swap
participant, swap dealer, or major swap participant, must:
(i) Undertake reasonable diligence to understand the potential
risks and rewards associated with the recommended security-based swap
or trading strategy involving a security-based swap; and
(ii) Have a reasonable basis to believe that a recommended
security-based swap or trading strategy involving a security-based swap
is suitable for the counterparty. To establish a reasonable basis for a
recommendation, a security-based swap dealer must have or obtain
relevant information regarding the counterparty, including the
counterparty's investment profile, trading objectives, and its ability
to absorb potential losses associated with the recommended security-
based swap or trading strategy involving a security-based swap.
(2) A security-based swap dealer may also fulfill its obligations
under paragraph (f)(1)(ii) of this section with respect to an
institutional counterparty, if:
(i) The security-based 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 security-based swap or
trading strategy involving a security-based swap;
(ii) The counterparty or its agent affirmatively represents in
writing that it is exercising independent judgment in evaluating the
recommendations of the security-based swap dealer with regard to the
relevant security-based swap or trading strategy involving a security-
based swap; and
(iii) The security-based swap dealer discloses that it is acting in
its capacity as a counterparty, and is not undertaking to assess the
suitability of the security-based swap or trading strategy for the
counterparty.
(3) A security-based swap dealer will be deemed to have satisfied
its obligations under paragraph (f)(2)(i) of this section if it
receives written representations, as provided in Sec. 240.15Fh-1(b),
that:
(i) 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
(ii) In the case of a counterparty that is a special entity,
satisfy the terms of the safe harbor in Sec. 240.15Fh-5(b).
(4) For purposes of paragraph (f)(2) of this section, an
institutional counterparty is a counterparty that is an eligible
contract participant as defined in clauses (A)(i), (ii), (iii), (iv),
(viii), (ix) or (x), or clause (B)(ii) (other than a person described
in clause (A)(v)) of section 1a(18) of the Commodity Exchange Act (7
U.S.C. 1(a)(18)) and the rules and regulations thereunder, or any
person (whether a natural person, corporation, partnership, trust or
otherwise) with total assets of at least $50 million.
(g) Fair and balanced communications. A security-based swap dealer
or major security-based swap participant shall communicate with
counterparties in a fair and balanced manner based on principles of
fair dealing and good faith. In particular:
(1) Communications must provide a sound basis for evaluating the
facts with regard to any particular security-based swap or trading
strategy involving a security-based swap;
(2) Communications may not imply that past performance will recur
or make any exaggerated or unwarranted claim, opinion or forecast; and
(3) Any statement referring to the potential opportunities or
advantages presented by a security-based swap shall be balanced by an
equally detailed statement of the corresponding risks.
(h) Supervision--(1) In general. A security-based swap dealer or
major security-based swap participant shall establish and maintain a
system to supervise, and shall diligently supervise, its business and
the activities of its associated persons. Such a system shall be
reasonably designed to prevent violations of the provisions of
applicable federal securities laws and the rules and regulations
thereunder relating to its business as a security-based swap dealer or
major security-based swap participant, respectively.
(2) Minimum requirements. The system required by paragraph (h)(1)
of this section shall, at a minimum, provide for:
(i) The designation of at least one person with authority to carry
out the supervisory responsibilities of the security-based swap dealer
or major security-based swap participant for each type of business in
which it engages for which registration as a security-based swap dealer
or major security-based swap participant is required;
(ii) The use of reasonable efforts to determine that all
supervisors are qualified, either by virtue of experience or training,
to carry out their assigned responsibilities; and
(iii) Establishment, maintenance and enforcement of written
policies and procedures addressing the supervision of the types of
security-based swap business in which the security-based swap dealer or
major security-based swap participant is engaged and the activities of
its associated persons that are reasonably designed to prevent
violations of applicable federal securities laws and the rules and
regulations thereunder, and that include, at a minimum:
(A) Procedures for the review by a supervisor of transactions for
which registration as a security-based swap dealer or major security-
based swap participant is required;
[[Page 30147]]
(B) Procedures for the review by a supervisor of incoming and
outgoing written (including electronic) correspondence with
counterparties or potential counterparties and internal written
communications relating to the security-based swap dealer's or major
security-based swap participant's business involving security-based
swaps;
(C) Procedures for a periodic review, at least annually, of the
security-based swap business in which the security-based swap dealer or
major security-based swap participant engages that is reasonably
designed to assist in detecting and preventing violations of applicable
federal securities laws and the rules and regulations thereunder;
(D) Procedures to conduct a reasonable investigation regarding the
good character, business repute, qualifications, and experience of any
person prior to that person's association with the security-based swap
dealer or major security-based swap participant;
(E) Procedures to consider whether to permit an associated person
to establish or maintain a securities or commodities account or a
trading relationship in the name of, or for the benefit of such
associated person, at another security-based swap dealer, broker,
dealer, investment adviser, or other financial institution; and if
permitted, procedures to supervise the trading at the other security-
based swap dealer, broker, dealer, investment adviser, or financial
institution;
(F) A description of the supervisory system, including the titles,
qualifications and locations of supervisory persons and the
responsibilities of each supervisory person with respect to the types
of business in which the security-based swap dealer or major security-
based swap participant is engaged;
(G) Procedures prohibiting an associated person who performs a
supervisory function from supervising his or her own activities or
reporting to, or having his or her compensation or continued employment
determined by, a person or persons he or she is supervising; provided,
however, that if the security-based swap dealer or major security-based
swap participant determines, with respect to any of its supervisory
personnel, that compliance with this requirement is not possible
because of the firm's size or a supervisory person's position within
the firm, the security-based swap dealer or major security-based swap
participant must document the factors used to reach such determination
and how the supervisory arrangement with respect to such supervisory
personnel otherwise complies with paragraph (h)(1) of this section, and
include a summary of such determination in the annual compliance report
prepared by the security-based swap dealer's or major security-based
swap participant's chief compliance officer pursuant to Sec. 240.15Fk-
1(c);
(H) Procedures reasonably designed to prevent the supervisory
system required by paragraph (h)(1) of this section from being
compromised due to the conflicts of interest that may be present with
respect to the associated person being supervised, including the
position of such person, the revenue such person generates for the
security-based swap dealer or major security-based swap participant, or
any compensation that the associated person conducting the supervision
may derive from the associated person being supervised; and
(I) Procedures reasonably designed, taking into consideration the
nature of such security-based swap dealer's or major security-based
swap participant's business, to comply with the duties set forth in
section 15F(j) of the Act.
(3) Failure to supervise. A security-based swap dealer or major
security-based swap participant or an associated person of a security-
based swap dealer or major security-based swap participant shall not be
deemed to have failed to diligently supervise any other person, if such
other person is not subject to his or her supervision, or if:
(i) The security-based swap dealer or major security-based swap
participant has established and maintained written policies and
procedures as required in Sec. 240.15Fh-3(h)(2)(iii), and a documented
system for applying those policies and procedures, that would
reasonably be expected to prevent and detect, insofar as practicable,
any violation of the federal securities laws and the rules and
regulations thereunder relating to security-based swaps; and
(ii) The security-based swap dealer or major security-based swap
participant, or associated person of the security-based swap dealer or
major security-based swap participant, has reasonably discharged the
duties and obligations required by such written policies and procedures
and documented system and did not have a reasonable basis to believe
that such written policies and procedures and documented system were
not being followed.
(4) Maintenance of written supervisory procedures. A security-based
swap dealer or major security-based swap participant shall:
(i) Promptly amend its written supervisory procedures as
appropriate when material changes occur in applicable securities laws
or rules or regulations thereunder, and when material changes occur in
its business or supervisory system; and
(ii) Promptly communicate any material amendments to its
supervisory procedures to all associated persons to whom such
amendments are relevant based on their activities and responsibilities.
Sec. 240.15Fh-4 Antifraud provisions for security-based swap dealers
and major security-based swap participants; special requirements for
security-based swap dealers acting as advisors to special entities.
(a) Antifraud provisions. It shall be unlawful for a security-based
swap dealer or major security-based 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) Special requirements for security-based swap dealers acting as
advisors to special entities. A security-based swap dealer that acts as
an advisor to a special entity regarding a security-based swap shall
comply with the following requirements:
(1) Duty. The security-based swap dealer shall have a duty to make
a reasonable determination that any security-based swap or trading
strategy involving a security-based swap recommended by the security-
based swap dealer is in the best interests of the special entity.
(2) Reasonable efforts. The security-based swap dealer shall make
reasonable efforts to obtain such information that the security-based
swap dealer considers necessary to make a reasonable determination that
a security-based swap or trading strategy involving a security-based
swap is in the best interests of the special entity. This information
shall include, but not be limited to:
(i) The authority of the special entity to enter into a security-
based swap;
(ii) The financial status of the special entity, as well as future
funding needs;
(iii) The tax status of the special entity;
(iv) The hedging, investment, financing or other objectives of the
special entity;
(v) The experience of the special entity with respect to entering
into
[[Page 30148]]
security-based swaps, generally, and security-based swaps of the type
and complexity being recommended;
(vi) Whether the special entity has the financial capability to
withstand changes in market conditions during the term of the security-
based swap; and
(vii) Such other information as is relevant to the particular facts
and circumstances of the special entity, market conditions and the type
of security-based swap or trading strategy involving a security-based
swap being recommended.
(3) Exception. The requirements of this paragraph (b) shall not
apply with respect to a security-based swap if:
(i) The transaction is executed on a registered or exempt security-
based swap execution facility or registered national securities
exchange; and
(ii) The security-based swap dealer does not know the identity of
the counterparty at a reasonably sufficient time prior to execution of
the transaction to permit the security-based swap dealer to comply with
the obligations of paragraph (b) of this section.
Sec. 240.15Fh-5 Special requirements for security-based swap dealers
and major security-based swap participants acting as counterparties to
special entities.
(a)(1) A security-based swap dealer or major security-based swap
participant that offers to enter into or enters into a security-based
swap with a special entity, other than a special entity defined in
Sec. 240.15Fh-2(d)(3), must have a reasonable basis to believe that
the special entity has a qualified independent representative. For
these purposes, a qualified independent representative is a
representative that:
(i) Has sufficient knowledge to evaluate the transaction and risks;
(ii) Is not subject to a statutory disqualification;
(iii) Undertakes a duty to act in the best interests of the special
entity;
(iv) Makes appropriate and timely disclosures to the special entity
of material information concerning the security-based swap;
(v) Evaluates, consistent with any guidelines provided by the
special entity, the fair pricing and the appropriateness of the
security-based swap;
(vi) In the case of a special entity defined in Sec. Sec.
240.15Fh-2(d)(2) or (5), is a person that is subject to rules of the
Commission, the Commodity Futures Trading Commission or a self-
regulatory organization subject to the jurisdiction of the Commission
or the Commodity Futures Trading Commission prohibiting it from
engaging in specified activities if certain political contributions
have been made, provided that this paragraph (a)(1)(vi) shall not apply
if the independent representative is an employee of the special entity;
and
(vii) Is independent of the security-based swap dealer or major
security-based swap participant.
(A) A representative of a special entity is independent of a
security-based swap dealer or major security-based swap participant if
the representative does not have a relationship with the security-based
swap dealer or major security-based swap participant, whether
compensatory or otherwise, that reasonably could affect the independent
judgment or decision-making of the representative.
(B) A representative of a special entity will be deemed to be
independent of a security-based swap dealer or major security-based
swap participant if:
(1) The representative is not and, within one year of representing
the special entity in connection with the security-based swap, was not
an associated person of the security-based swap dealer or major
security-based swap participant;
(2) The representative provides timely 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 complies with
policies and procedures reasonably designed to manage and mitigate such
material conflicts of interest; and
(3) The security-based swap dealer or major security-based 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 security-
based swap.
(2) A security-based swap dealer or major security-based swap
participant that offers to enter into or enters into a security-based
swap with a special entity as defined in Sec. 240.15Fh-2(d)(3) must
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).
(b) Safe harbor. (1) A security-based swap dealer or major
security-based swap participant shall be deemed to have a reasonable
basis to believe that the special entity, other than a special entity
defined in Sec. 240.15Fh-2(d)(3), has a representative that satisfies
the applicable requirements of paragraph (a)(1) of this section,
provided that:
(i) The special entity represents in writing to the security-based
swap dealer or major security-based 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 (a)(1) 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 (a)(1) of this section; and
(ii) The representative represents in writing to the special entity
and security-based swap dealer or major security-based swap participant
that the representative:
(A) Has policies and procedures reasonably designed to ensure that
it satisfies the applicable requirements of paragraph (a)(1) of this
section;
(B) Meets the independence test in paragraph (a)(1)(vii) of this
section; has the knowledge required under paragraph (a)(1)(i) of this
section; is not subject to a statutory disqualification under paragraph
(a)(1)(ii) of this section; undertakes a duty to act in the best
interests of the special entity as required under paragraph (a)(1)(iii)
of this section; and is subject to the requirements regarding political
contributions, as applicable, under paragraph (a)(1)(vi) of this
section; and
(C) Is legally obligated to comply with the applicable requirements
of paragraph (a)(1) of this section by agreement, condition of
employment, law, rule, regulation, or other enforceable duty.
(2) A security-based swap dealer or major security-based swap
participant shall be deemed to have a reasonable basis to believe that
a special entity defined in Sec. 240.15Fh-2(d)(3) of this section has
a representative that satisfies the applicable requirements in
paragraph (a)(2) of this section, provided that the special entity
provides in writing to the security-based swap dealer or major
security-based 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).
(c) Before initiation of a security-based swap with a special
entity, a security-based swap dealer shall disclose to the special
entity in writing the capacity in which the security-based swap dealer
is acting in connection with the security-based swap and, if the
security-based swap dealer engages in business with the counterparty in
more
[[Page 30149]]
than one capacity, the security-based swap dealer shall disclose the
material differences between such capacities and any other financial
transaction or service involving the counterparty.
(d) The requirements of this section shall not apply with respect
to a security-based swap if:
(1) The transaction is executed on a registered or exempt security-
based swap execution facility or registered national securities
exchange; and
(2) The security-based swap dealer or major security-based swap
participant does not know the identity of the counterparty at a
reasonably sufficient time prior to execution of the transaction to
permit the security-based swap dealer or major security-based swap
participant to comply with the obligations of paragraphs (a) through
(c) of this section.
Sec. 240.15Fh-6 Political contributions by certain security-based
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 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 municipal entity to enter into a
security-based swap with the security-based swap dealer and any person
who supervises, directly or indirectly, such employee; and
(iii) A political action committee controlled by the security-based
swap dealer or by a person described in paragraphs (a)(2)(i) and (ii)
of this section.
(3) The term executive officer of a security-based swap dealer
means:
(i) The president;
(ii) Any vice president in charge of a principal business unit,
division or function (such as sales, administration or finance);
(iii) Any other officer of the security-based swap dealer who
performs a policy-making function; or
(iv) Any other person who performs similar policy-making functions
for the security-based swap dealer.
(4) The term municipal entity is defined in section 15B(e)(8) of
the Act.
(5) The term official of a municipal 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 municipal entity, if the office:
(i) Is directly or indirectly responsible for, or can influence the
outcome of, the selection of a security-based swap dealer by a
municipal 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 security-based swap dealer by a municipal entity.
(6) The term payment means any gift, subscription, loan, advance,
or deposit of money or anything of value.
(7) The term regulated person means:
(i) A person that is subject to rules of the Commission, the
Commodity Futures Trading Commission or a self-regulatory organization
subject to the jurisdiction of the Commission or the Commodity Futures
Trading Commission prohibiting it from engaging in specified activities
if certain political contributions have been made, or its officers or
employees;
(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 municipal entity
for the security-based swap dealer and any person who supervises,
directly or indirectly, such employee.
(8) The term solicit means a direct or indirect communication by
any person with a municipal entity for the purpose of obtaining or
retaining an engagement related to a security-based swap.
(b) Prohibitions and exceptions. (1) It shall be unlawful for a
security-based swap dealer to offer to enter into, or enter into, a
security-based swap, or a trading strategy involving a security-based
swap, with a municipal entity within two years after any contribution
to an official of such municipal entity was made by the security-based
swap dealer, or by any covered associate of the security-based swap
dealer.
(2) The prohibition in paragraph (b)(1) of this section does not
apply:
(i) If the only contributions made by the security-based swap
dealer to an official of such municipal entity were made by a covered
associate, if a natural person:
(A) To officials for whom the covered associate was entitled to
vote at the time of the contributions, if 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, if the contributions in the
aggregate do not exceed $150 to any one official, per election;
(ii) To a security-based 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 security-based swap dealer, however, this
exclusion shall not apply if the natural person, after becoming a
covered associate, solicits the municipal entity on behalf of the
security-based swap dealer to offer to enter into, or to enter into,
security-based swap, or a trading strategy involving a security-based
swap; or
(iii) With respect to a security-based swap that is executed on a
registered national securities exchange or registered or exempt
security-based swap execution facility where the security-based swap
dealer does not know the identity of the counterparty to the
transaction at a reasonably sufficient time prior to execution of the
transaction to permit the security-based swap dealer to comply with the
obligations of paragraph (b)(1) of this section.
(3) No security-based swap dealer or any covered associate of the
security-based swap dealer shall:
(i) Provide or agree to provide, directly or indirectly, payment to
any person to solicit a municipal entity to offer to enter into, or to
enter into, a security-based swap or any trading strategy involving a
security-based swap with that security-based 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 municipal entity with which
the security-based swap dealer is offering to enter into, or has
entered into, a security-based swap or a trading strategy involving a
security-based swap; or
(B) Payment to a political party of a state or locality with which
the security-based swap dealer is offering to enter into, or has
entered into, a security-based swap or a trading strategy involving a
security-based swap.
(c) Circumvention of rule. No security-based 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 (a) or (b) of this
section.
(d) Requests for exemption. The Commission, upon application, may
conditionally or unconditionally exempt a security-based swap dealer
from the prohibition under paragraph (b)(1) of this section. In
determining whether to grant an exemption, the
[[Page 30150]]
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 security-based swap dealer:
(i) Before the contribution resulting in the prohibition was made,
adopted and 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 security-based swap
dealer, or was seeking such employment;
(4) The timing and amount of the contribution which resulted in the
prohibition;
(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 security-based swap dealer if:
(i) The security-based swap dealer discovered the contribution
within 120 calendar days of the date of such contribution;
(ii) The contribution did not exceed $350; 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 security-based swap dealer.
(2) A security-based swap dealer that has more than 50 covered
associates may not rely on paragraph (e)(1) of this section more than
three times in any 12-month period, while a security-based swap dealer
that has 50 or fewer covered associates may not rely on paragraph
(e)(1) of this section more than twice in any 12-month period.
(3) A security-based 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.
Sec. 240.15Fk-1 Designation of chief compliance officer for security-
based swap dealers and major security-based swap participants.
(a) In general. A security-based swap dealer and major security-
based swap participant shall designate an individual to serve as a
chief compliance officer on its registration form.
(b) Duties. The chief compliance officer shall:
(1) Report directly to the board of directors or to the senior
officer of the security-based swap dealer or major security-based swap
participant; and
(2) Take reasonable steps to ensure that the registrant
establishes, maintains and reviews written policies and procedures
reasonably designed to achieve compliance with the Act and the rules
and regulations thereunder relating to its business as a security-based
swap dealer or major security-based swap participant by:
(i) Reviewing the compliance of the security-based swap dealer or
major security-based swap participant with respect to the security-
based swap dealer and major security-based swap participant
requirements described in section 15F of the Act, and the rules and
regulations thereunder, where the review shall involve preparing the
registrant's annual assessment of its written policies and procedures
reasonably designed to achieve compliance with section 15F of the Act,
and the rules and regulations thereunder, by the security-based swap
dealer or major security-based swap participant;
(ii) Taking reasonable steps to ensure that the registrant
establishes, maintains and reviews policies and procedures reasonably
designed to remediate non-compliance issues identified by the chief
compliance officer through any means, including any:
(A) Compliance office review;
(B) Look-back;
(C) Internal or external audit finding;
(D) Self-reporting to the Commission and other appropriate
authorities; or
(E) Complaint that can be validated; and
(iii) Taking reasonable steps to ensure that the registrant
establishes and follows procedures reasonably designed for the
handling, management response, remediation, retesting, and resolution
of non-compliance issues;
(3) In consultation with the board of directors or the senior
officer of the security-based swap dealer or major security-based swap
participant, take reasonable steps to resolve any material conflicts of
interest that may arise; and
(4) Administer each policy and procedure that is required to be
established pursuant to section 15F of the Act and the rules and
regulations thereunder.
(c) Annual reports--(1) In general. The chief compliance officer
shall annually prepare and sign a compliance report that contains a
description of the written policies and procedures of the security-
based swap dealer or major security-based swap participant described in
paragraph (b) of this section (including the code of ethics and
conflict of interest policies).
(2) Requirements. (i) Each compliance report shall also contain, at
a minimum, a description of:
(A) The security-based swap dealer or major security-based swap
participant's assessment of the effectiveness of its policies and
procedures relating to its business as a security-based swap dealer or
major security-based participant;
(B) Any material changes to the registrant's policies and
procedures since the date of the preceding compliance report;
(C) Any areas for improvement, and recommended potential or
prospective changes or improvements to its compliance program and
resources devoted to compliance;
(D) Any material non-compliance matters identified; and
(E) The financial, managerial, operational, and staffing resources
set aside for compliance with the Act and the rules and regulations
thereunder relating to its business as a security-based swap dealer or
major security-based swap participant, including any material
deficiencies in such resources.
(ii) A compliance report under paragraph (c)(1) of this section
also shall:
(A) Be submitted to the Commission within 30 days following the
deadline for filing the security-based swap dealer's or major security-
based swap participant's annual financial report with the Commission
pursuant to section 15F of the Act and rules and regulations
thereunder;
(B) Be submitted to the board of directors and audit committee (or
equivalent bodies) and the senior officer of the security-based swap
dealer or major security-based swap participant prior to submission to
the Commission;
(C) Be discussed in one or more meetings conducted by the senior
officer with the chief compliance officer(s) in the preceding 12
months, the subject of
[[Page 30151]]
which addresses the obligations in this section; and
(D) Include a certification by the chief compliance officer or
senior officer that, to the best of his or her knowledge and reasonable
belief and under penalty of law, the information contained in the
compliance report is accurate and complete in all material respects.
(iii) Extensions of time. A security-based swap dealer or major
security-based swap participant may request from the Commission an
extension of time to submit its compliance report, provided the
registrant's failure to timely submit the report could not be
eliminated by the registrant without unreasonable effort or expense.
Extensions of the deadline will be granted at the discretion of the
Commission.
(iv) Incorporation by reference. A security-based swap dealer or
major security-based swap participant may incorporate by reference
sections of a compliance report that have been submitted within the
current or immediately preceding reporting period to the Commission.
(v) Amendments. A security-based swap dealer or major security-
based swap participant shall promptly submit an amended compliance
report if material errors or omissions in the report are identified. An
amendment must contain the certification required under paragraph
(c)(2)(ii)(D) of this section.
(d) Compensation and removal. The compensation and removal of the
chief compliance officer shall require the approval of a majority of
the board of directors of the security-based swap dealer or major
security-based swap participant.
(e) Definitions. For purposes of this section, references to:
(1) The board or board of directors shall include a body performing
a function similar to the board of directors.
(2) The senior officer shall include the chief executive officer or
other equivalent officer.
(3) Complaint that can be validated shall include any written
complaint by a counterparty involving the security-based swap dealer or
major security-based swap participant or associated person of a
security-based swap dealer or major security-based swap participant
that can be supported upon reasonable investigation.
(4) A material non-compliance matter means any non-compliance
matter about which the board of directors of the security-based swap
dealer or major security-based swap participant would reasonably need
to know to oversee the compliance of the security-based swap dealer or
major security-based swap participant, and that involves, without
limitation:
(i) A violation of the federal securities laws relating to its
business as a security-based swap dealer or major security-based swap
participant by the firm or its officers, directors, employees or
agents;
(ii) A violation of the policies and procedures relating to its
business as a security-based swap dealer or major security-based swap
participant by the firm or its officers, directors, employees or
agents; or
(iii) A weakness in the design or implementation of the policies
and procedures relating to its business as a security-based swap dealer
or major security-based swap participant.
By the Commission.
Dated: April 14, 2016.
Brent J. Fields,
Secretary.
[FR Doc. 2016-10918 Filed 5-12-16; 8:45 am]
BILLING CODE 8011-01-P