The US Commodity Futures Trading Commission ("CFTC") has adopted final business conduct standards ("Final Rules") for swap dealers ("SDs") and major swap participants ("MSPs"), as required by Section 731 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). While the Final Rules are couched largely in terms of the duties that an SD or MSP will owe to counterparties and others in connection with swap transactions, the Rules permit SDs and MSPs to satisfy many of these duties by obtaining specified representations in swap and customer documentation. As implementation proceeds, SDs and MSPs will be revising their existing documentation with counterparties. All counterparties of SDs or MSPs should expect requests for new representations and other changes to this documentation.

The Final Rules subject SDs and MSPs to additional requirements when dealing with "Special Entities" (defined generally to include certain governmental and related entities, certain employee benefit plans, and endowments, but not collective investment vehicles in which Special Entities participate). As a result, Special Entities and their advisors may face even greater changes to swap and customer documentation.

The Final Rules will become effective 60 days after the date of their publication in the Federal Register. SDs and MSPs must comply with the rules beginning on the later of 180 days after their effective date or the date on which SDs and MSPs are required to apply for registration under applicable CFTC rules.

General Business Conduct Provisions

The Final Rules require SDs and MSPs to have written policies and procedures reasonably designed to ensure compliance with the business conduct rules. SDs and MSPs must also create and retain records of their compliance with the Final Rules, and make the records available upon request to prudential regulators including the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation, among others. SDs and MSPs must obtain the name, address, and principal occupation or business of each counterparty, as well as the name and address of each guarantor of the counterparty and each person exercising any control with respect to positions of the counterparty. Further, SDs, but not MSPs, must comply with certain "know your counterparty" requirements. The Final Rules note that the term "counterparty" also includes any person who is a prospective counterparty to a swap.

Duties to All Counterparties

The Final Rules require SDs and MSPs to comply with the following business conduct requirements in their dealings with all counterparties.

Verification

An SD or MSP must verify that a counterparty is an "eligible contract participant" (as defined in Dodd-Frank) and determine whether it is a Special Entity.

Transaction Disclosure

Prior to entering into a swap, an SD or MSP must disclose to each counterparty (other than a counterparty that is an SD or MSP) information sufficient to allow the counterparty to assess the material risks and characteristics of the swap. The SD or MSP must also disclose any material incentives and conflicts of interests that it may have with respect to the transaction.

Daily Mark

An SD or MSP must provide daily mid-market marks to each counterparty (other than a counterparty that is an SD or MSP) or, in the case of cleared swaps, notify the counterparty of its right to receive daily marks from the appropriate derivatives clearing organization ("DCO").

Clearing Disclosure

An SD or MSP must notify each counterparty (other than a counterparty that is an SD or MSP) of its right to clear swaps that are not required to be cleared, and to select the DCO at which a swap will be cleared.

Communications and Fair Dealing

An SD or MSP must communicate with each counterparty in a fair and balanced manner based on principles of fair dealing and good faith.

Scenario Analyses (SDs Only)

An SD, but not an MSP, must offer to provide scenario analyses to a counterparty (other than a counterparty that is an SD or MSP) for swaps that are not "made available for trading" on a designated contract market ("DCM") or swap execution facility ("SEF").

Suitability (SDs Only)

An SD, but not an MSP, that recommends a swap or swap trading strategy to a counterparty (other than an SD or MSP) must have a reasonable basis to believe that the swap or strategy is suitable for the counterparty. To establish a reasonable basis for a recommendation, an SD must obtain information about the counterparty, including the counterparty's investment profile, trading objectives, and ability to absorb potential losses associated with the recommended swap or strategy.

Duties to Special Entities

The Final Rules define Special Entities to include certain governmental and related entities, employee benefit plans subject to Title I of the Employee Retirement Income Security Act of 1974 ("ERISA") ("ERISA Plan"), governmental plans, as defined in Section 3 of ERISA, any other employee benefit plan defined in Section 3 of ERISA that elects to be a Special Entity, and any endowment, but not a collective investment vehicle in which a Special Entity participates.

The following additional requirements apply to SDs and MSPs in swap transactions with Special Entities.

SD as Advisor

An SD, but not an MSP, that acts as an advisor to a Special Entity, i.e., an SD that recommends a swap or swap trading strategy tailored to the needs or characteristics of the Special Entity, must make a reasonable determination that the swap or strategy is in the best interests of the Special Entity. To comply with this duty, the SD must make reasonable efforts to obtain pertinent information regarding the Special Entity, including its financial and tax status, its hedging, investment and financing objectives, its prior experience with swap transactions, its financial capability to withstand changes in market conditions during the term of the swap, and other relevant information.

Under a safe harbor applicable in connection with all Special Entities, including ERISA Plans, an SD will not be treated as an advisor to a Special Entity if the SD discloses that it is not undertaking to act in the best interests of the Special Entity and expresses no opinion as to whether the Special Entity should enter into a recommended swap or strategy, and the parties make certain specified representations. These representations must include a representation that the Special Entity will rely on advice from a qualified independent representative, as specified in the Final Rules.

Under an alternative safe harbor applicable only in connection with ERISA Plans, an SD will be deemed not to act as an advisor to an ERISA Plan if (i) the ERISA Plan represents in writing that an ERISA fiduciary is representing it in connection with the swap transaction, and the fiduciary agrees in writing that it will not rely on recommendations provided by the SD, and (ii) the ERISA Plan further represents in writing that either (A) it will comply in good faith with written policies and procedures reasonably designed to ensure that any recommendations it receives from the SD which materially affect the swap transaction will be evaluated by an ERISA fiduciary before the swap transaction occurs or (B) any recommendation the ERISA Plan receives from the SD materially affecting a swap transaction will be evaluated by an ERISA fiduciary before the transaction occurs.

SD or MSP as Counterparty

An SD or MSP that acts as a counterparty to a Special Entity must disclose to the Special Entity the capacity in which it is acting, and must have a reasonable basis to believe that the Special Entity has a representative that meets the requirements of the Final Rules. Where the Special Entity is an ERISA Plan, the SD or MSP must have a reasonable basis to believe that the Special Entity's representative is an ERISA fiduciary. For other Special Entities, the SD or MSP must have a reasonable basis to believe that the representative:

  • has sufficient knowledge to evaluate the transaction and risks;
  • is not subject to a statutory disqualification;
  • is independent of the SD or MSP;
  • undertakes a duty to act in the best interests of the Special Entity;
  • makes appropriate and timely disclosures to the Special Entity;
  • evaluates, consistent with any guidelines provided by the Special Entity, fair pricing and the appropriateness of the swap; and
  • with respect to certain governmental-related Special Entities (including government plans), is subject to restrictions on certain political contributions, unless the representative is an employee of the governmental Special Entity.

Under a safe harbor applicable only in connection with a Special Entity other than an ERISA Plan, an SD or MSP acting as a counterparty to such a Special Entity will be deemed to have a reasonable basis to believe that the Special Entity's representative meets the above requirements if the Special Entity represents that it complied in good faith with policies and procedures to select such a representative, and the representative provides certain representations specified in the Final Rules.

Under a safe harbor applicable only in connection with of an ERISA Plan, an SD or MSP will be deemed to have a reasonable basis to believe that the Special Entity's representative meets the above requirements if the ERISA Plan provides in writing the representative's name and contact information, and represents in writing that the representative is a fiduciary under ERISA.

Department of Labor Guidance

Prior to the release of the Final Rules, many market participants were concerned that the CFTC's business conduct rules would cause an SD or MSP to become a fiduciary under ERISA if it would enter into a swap as a counterparty to an ERISA Plan. The preamble to the Final Rules addresses this issue and notes that the Department of Labor ("DOL") has agreed that the Final Rules would not require an SD or MSP to engage in activities that would make it a fiduciary under the DOL's existing definition of fiduciary. The DOL, which has proposed and recently withdrawn regulations revising the definition of fiduciary for purposes of ERISA, has stated in a letter 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."

Political Contributions (SDs Only)

An SD, but not an MSP, that makes certain political contributions to officials of a governmental Special Entity is subject to a two-year prohibition on entering into swaps with that governmental Special Entity. The Final Rules use the term governmental Special Entity, rather than municipal Special Entity, because the CFTC wanted to clarify that "the pay-to-play prohibition applies not just to municipalities, but to any contributions made for the purpose of obtaining state and/or local government business."

The CFTC excluded MSPs from the pay-to-play prohibition because MSPs, as defined in Dodd-Frank, do not "solicit" swaps business (an MSP that did so regularly could be treated as a swap dealer); as such, the CFTC indicated that it does not expect that MSPs will assume a dealer-type role in the swaps market.

The pay-to-play prohibition applies to all stages of a swaps transaction, including the solicitation and offering phase, and not just to the execution of swaps business. The CFTC notes that it is "taking steps to mitigate costs by harmonizing the final rule with both the Securities and Exchange Commission's and Municipal Securities Rulemaking Board's prohibitions on certain political contributions."

Anti-Fraud and Confidentiality Provisions

The Final Rules prohibit SDs and MSPs from engaging in fraudulent, deceptive, or manipulative acts or practices; two specific rules further prohibit fraud or deceit on any Special Entity. The Final Rules provide an affirmative defense to certain non-scienter fraud violations where an SD or MSP establishes that it complied in good faith with applicable written policies and procedures.

SDs and MSPs may not disclose material confidential information provided by a counterparty, and may not use that information for its own purposes in a way that would tend to be materially adverse to the interests of a counterparty. An SD or MSP may, however, disclose or use confidential counterparty information with written consent of the counterparty, or if necessary to effectively execute a swap with or for the counterparty, to hedge exposure from such a swap, or to comply with requests from certain regulators, or if otherwise required by law. Each SD or MSP must implement written policies and procedures to protect this confidential counterparty information from unauthorized disclosure or use.

Means of Compliance with the Final Rules

In complying with the Final Rules, an SD or MSP may:

  • reasonably rely on counterparty representations to satisfy its due diligence requirements;
  • include representations and disclosures in counterparty relationship documentation and deem them renewed for subsequent swaps;
  • provide required information by any reliable means agreed to by the counterparty; and
  • disclose material information applicable to multiple swaps in counterparty relationship documentation.

Exemption from Certain Duties

With respect to transactions initiated on either a DCM or SEF where the SD or MSP does not know the identity of the counterparty, the SD or MSP is not required to comply with verification requirements, make pre-trade disclosures of material information, provide scenario analyses, or comply with duties applicable to Special Entities as counterparties.

Existing Swaps Grandfathered

The Final Rules generally will not apply to unexpired swaps executed before the Final Rules' effective date. A material amendment to a swap after the effective date, however, will be considered to result in a new swap that is subject to the Final Rules.

Extraterritoriality

The Final Rules do not address extraterritoriality issues, including the application of external business conduct standards to non-US customers and swap dealers. The CFTC noted in the preamble to the Final Rules that it will address these issues in a separate release.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.