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Dodd-Frank Focus: Proposed Business Conduct Rules for Swap Dealers and Participants

July 1, 2011

On June 29th, the SEC published for comment proposed rules that would impose business conduct standards upon security-based swap dealers and major security-based swap participants whenever they engage in security-based swap transactions with counterparties, including those that are “special entities.” Special entities include federal agencies, states and political subdivisions, employee benefit plans, governmental plans, and endowments.


Among other things, the proposed rules would require security-based swap dealers and major security-based swap participants to: (i) verify whether a counterparty is an eligible contract participant and whether it is a special entity; (ii) disclose to the counterparty material information about the security-based swap; (iii) communicate with counterparties in a fair and balanced manner; (iv) establish a supervisory and compliance infrastructure; and (v) make suitability determinations.

Special Entities

The proposed rules also define what it means to “act as an advisor” to a special entity, and would require that a security-based swap dealer who acts as an advisor to a special entity act in the “best interests” of the special entity.

Security-based swap dealers and major security-based swap participants acting as counterparties to special entities must reasonably believe that the counterparty has an independent representative who: (i) has sufficient knowledge to evaluate the transaction; (ii) is not subject to a statutory disqualification; (iii) is independent; (iv) undertakes a duty to act in the best interests of the special entity; (v) makes appropriate disclosures; (vi) provides written representations to the special entity regarding fair pricing and appropriateness of the security-based swap; and (vii) is subject to pay-to-play regulations, and if the special entity is an ERISA plan, the independent representative would be required to be a fiduciary under ERISA.

Commissioner Concerns

Although the SEC Commissioners voted unanimously in favor of proposing the business conduct rules, Commissioners Troy A. Paredes and Luis A. Aguilar voiced a number of concerns about the proposal. Commissioner Paredes noted that the proposed business conduct obligations exceed those required by the Dodd-Frank Act. For example, the “know your counterparty” requirements and “suitability” standards are not mandated by the Dodd-Frank Act.

While they may not exist in the Dodd-Frank Act, the “know your counterparty” and “suitability” requirements do appear in the Commodity Futures Trading Commission’s business conduct rules proposal, which was published for comment last December. Those requirements were not well received. Commenters noted that the additional duties would, in effect, regulate the institutional swap markets more restrictively than the retail futures and securities markets.

Commissioner Paredes also seems to suggest that a security-based swap dealer should have to do more than make a recommendation to a special entity before it is required to act in the special entity’s best interest.

Commissioner Aguilar asks whether the proposal’s suitability rule for security-based swap dealers provide adequate protection for all counterparties and establish a level playing field. He notes the differences between the SEC’s proposed suitability rule and that of the Financial Industry Regulatory Authority (“FINRA”). Under FINRA’s suitability rule, a broker-dealer cannot avoid the suitability requirement by relying on the customer’s own ability to evaluate investment risks, unless a customer has at least $50 million in assets. Under the SEC’s proposed rule a security-based swap dealer could avoid the application of the suitability requirement by relying on a counterparty’s representation that it can evaluate the transaction, even when the counterparty has assets as low as $1 million.

Comments on the SEC’s proposal should be submitted on or before August 29, 2011. View the proposing release and text here.

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