[Federal Register Volume 75, Number 245 (Wednesday, December 22, 2010)]
[Proposed Rules]
[Pages 80638-80663]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-31588]



[[Page 80637]]

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Part III





Commodity Futures Trading Commission





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17 CFR Parts 23 and 155



Business Conduct Standards for Swap Dealers and Major Swap Participants 
With Counterparties; Proposed Rule

Federal Register / Vol. 75 , No. 245 / Wednesday, December 22, 2010 / 
Proposed Rules

[[Page 80638]]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 23 and 155

RIN 3038-AD25


Business Conduct Standards for Swap Dealers and Major Swap 
Participants With Counterparties

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or 
``CFTC'') is proposing for comment new rules under Section 4s(h) of the 
Commodity Exchange Act (``CEA'') to implement provisions of Title VII 
of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 
2010 (``Dodd-Frank Act'') relating generally to external business 
conduct standards for swap dealers and major swap participants.

DATES: Written comments must be received on or before February 22, 
2011.

ADDRESSES: You may submit comments, identified by RIN number 3038-AD25, 
by any of the following methods:
    <bullet> Agency Web site, via its Comments Online process: http://comments.cftc.gov/. Follow the instructions for submitting comments 
through the Web site.
    <bullet> Mail: David A. Stawick, Secretary of the Commission, 
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st 
Street, NW., Washington, DC 20581.
    <bullet> Hand Delivery/Courier: Same as mail above.
    <bullet> Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.

Please submit your comments using only one method.

    All comments must be submitted in English, or if not, accompanied 
by an English translation. Comments will be posted as received to 
http://www.cftc.gov. You should submit only information that you wish 
to make available publicly. If you wish the Commission to consider 
information that you believe is exempt from disclosure under the 
Freedom of Information Act, a petition for confidential treatment of 
the exempt information may be submitted according to the procedures 
established in Sec.  145.9 of the Commission's Regulations.\1\
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    \1\ 17 CFR 145.9.
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    The Commission reserves the right, but shall have no obligation, to 
review, pre-screen, filter, redact, refuse or remove any or all of your 
submission from http://www.cftc.gov that it may deem to be 
inappropriate for publication, such as obscene language. All 
submissions that have been redacted or removed that contain comments on 
the merits of the rulemaking will be retained in the public comment 
file and will be considered as required under the Administrative 
Procedure Act and other applicable laws, and may be accessible under 
the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT: Phyllis J. Cela, Deputy Director and 
Chief Counsel, Division of Enforcement, or Peter Sanchez, Special 
Counsel, Division of Clearing and Intermediary Oversight, Commodity 
Futures Trading Commission, 1155 21st Street, NW., Washington, DC 
20581. Telephone number: (202) 418-7642.

SUPPLEMENTARY INFORMATION: The Commission is proposing Sec. Sec.  
23.400-402, 23.410, 23.430-434, 23.440, 23.450-451, and 155.7 under 
Section 4s(h) of the CEA. The Commission is soliciting comments on all 
aspects of the proposed rules and will carefully consider any comments 
received.

Table of Contents

I. Introduction
    A. Business Conduct Standards--Dealing With Counterparties 
Generally
    B. Business Conduct Standards--Dealing With Counterparties That 
Are Special Entities
    C. Consultations With Stakeholders
    D. Consultation and Coordination With the SEC, Prudential 
Regulators and Other Domestic and Foreign Regulatory Authorities
II. Proposed Rules for Swap Dealers and Major Swap Participants 
Dealing With Counterparties Generally
    A. Proposed Sec. Sec.  23.400, 23.401 and 23.402--Scope, 
Definitions and General Provisions
    B. Proposed Sec.  23.410--Prohibition on Fraud, Manipulation and 
Other Abusive Practices
    C. Proposed Sec.  23.430--Verification of Counterparty 
Eligibility
    D. Proposed Sec.  23.431--Disclosures of Material Risks, 
Characteristics, Material Incentives and Conflicts of Interest 
Regarding a Swap
    1. Timing and Manner of Disclosures
    2. Disclosure of Material Risks
    3. Scenario Analysis for High-Risk Complex Bilateral Swaps and 
Counterparty ``Opt-In'' for Bilateral Swaps Not Available for 
Trading on a Designated Contract Market or Swap Execution Facility
    4. Material Characteristics
    5. Material Incentives and Conflicts of Interest
    6. Daily Mark
    E. Proposed Sec.  23.432--Clearing
    F. Proposed Sec.  23.433--Communications--Fair Dealing
    G. Proposed Sec.  23.434--Recommendations to Counterparties--
Institutional Suitability
    H. Proposed Sec.  155.7--Execution Standards \2\
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    \2\ The proposed swap execution standards Sec.  155.7 would 
apply to any Commission registrant, including a swap dealer or major 
swap participant, handling an order for a swap that is available for 
trading on a designated contract market or a swap execution 
facility.
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III. Proposed Rules for Swap Dealers and Major Swap Participants 
With Special Entities
    A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)
    B. Proposed Sec.  23.440--Requirements for Swap Dealers Acting 
as Advisors to Special Entities
    1. Act as an Advisor to a Special Entity
    2. Best Interests
    3. Reasonable Efforts
    4. Reasonable Reliance To Satisfy the ``Reasonable Efforts'' 
Obligation
    C. Proposed Sec.  23.450--Requirements for Swap Dealers and 
Major Swap Participants Acting as Counterparties to Special Entities
    1. Qualifications of the Independent Representative
    2. Statutory Disqualification
    3. Independent
    4. Best Interests
    5. Makes Appropriate and Timely Disclosures
    6. Evaluates Fair Pricing and the Appropriateness of the Swap
    7. ERISA Fiduciary
    8. Restrictions on Political Contributions by Independent 
Representative of a Municipal Entity
    9. Unqualified Independent Representative
    10. Disclosure of Capacity
    11. Inapplicability
    D. Proposed Sec.  23.451--Political Contributions by Certain 
Swap Dealers and Major Swap Participants
    1. Prohibitions
    2. Exceptions
    3. Exemptions
IV. Request for Comment
    A. Generally
    B. Consistency With SEC Approach
V. Related Matters
    A. Regulatory Flexibility Act
    B. Paperwork Reduction Act
    C. Cost-Benefit Analysis

I. Introduction

    On July 21, 2010, President Obama signed the Dodd-Frank Act.\3\ 
Title VII of the Dodd-Frank Act amended the CEA \4\ to establish a 
comprehensive new regulatory framework for swaps and certain security-
based swaps. The legislation was enacted to reduce risk, increase 
transparency, and promote

[[Page 80639]]

market integrity within the financial system by, among other things: 
(1) Providing for the registration and comprehensive regulation of swap 
dealers and major swap participants; (2) imposing clearing and trade 
execution requirements on standardized derivative products; (3) 
creating robust recordkeeping and real-time reporting regimes; and (4) 
enhancing the Commission's rulemaking and enforcement authorities with 
respect to, among others, all registered entities and intermediaries 
subject to the Commission's oversight.
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    \3\ See Dodd-Frank Wall Street Reform and Consumer Protection 
Act, Public Law 111-203, 124 Stat. 1376 (2010) (``Dodd-Frank Act''). 
The text of the Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
    \4\ 7 U.S.C. 1 et seq., as amended by the Dodd-Frank Act. All 
references to the CEA are to the CEA as amended by the Dodd-Frank 
Act.
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    Section 731 of the Dodd-Frank Act amends the CEA by adding Section 
4s(h). This section provides the Commission with both mandatory and 
discretionary rulemaking authority to impose business conduct 
requirements on swap dealers and major swap participants in their 
dealings with counterparties, including ``Special Entities.'' \5\ Such 
entities are generally defined to include 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. Congress 
granted the Commission broad discretionary authority to promulgate 
business conduct requirements, as appropriate in the public interest, 
for the protection of investors, or otherwise in furtherance of the 
purposes of the CEA.\6\
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    \5\ Congress enacted a virtually identical provision in Dodd-
Frank Act Section 764 which adds Section 15F(h) to the Securities 
Exchange Act of 1934 (``Exchange Act'') (15 U.S.C. 78a et seq.). All 
references to the Exchange Act are to the Exchange Act, as amended 
by the Dodd-Frank Act. Section 712(a)(1) of the Dodd-Frank Act 
requires that the Commission consult with the Securities and 
Exchange Commission and prudential regulators in promulgating rules 
pursuant to Section 4s(h).
    \6\ See Section 4s(h)(3)(D) (``Business conduct requirements 
adopted by the Commission shall establish such other standards and 
requirements as the Commission may determine are appropriate in the 
public interest, for the protection of investors, or otherwise in 
furtherance of the purposes of this Act''); see also Sections 
4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6).
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A. Business Conduct Standards--Dealing With Counterparties Generally

    Section 4s(h)(1) grants the Commission authority to promulgate 
rules applicable to swap dealers and major swap participants related 
to, among other things: Fraud, manipulation and abusive practices 
involving swaps; diligent supervision; \7\ and adherence to position 
limits.\8\ The proposed rules incorporate the anti-fraud provision for 
swap dealers and major swap participants contained in Section 4s(h)(4), 
and also would prohibit swap dealers and major swap participants from 
disclosing confidential counterparty information, or front running or 
trading ahead of counterparty transactions. The Commission also 
proposes to adopt certain counterparty-specific supervisory and 
compliance duties including a ``know your counterparty'' requirement 
and policies and procedures to enforce these business conduct rules and 
to prevent evasion of the requirements of the CEA and Commission 
Regulations.\9\
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    \7\ See also Regulations Establishing and Governing the Duties 
of Swap Dealers and Major Swap Participants, 75 FR 71397, Nov. 23, 
2010 (proposed Sec.  23.602 imposing additional diligent supervision 
requirements on swap dealers and major swap participants).
    \8\ Id. (proposed Sec.  23.601 imposing requirements for swap 
dealers and major swap participants related to monitoring position 
limits).
    \9\ Dodd-Frank Act Sections 722(d) (amending CEA Section 2(i)), 
723(a)(3) (amending CEA Sections 2(h)(4)(A) and 2(h)(7)(F)) and 
741(b)(11) (amending CEA Section 6(e)) amend the CEA by prohibiting 
a swap dealer or major swap participant from ``knowingly or 
recklessly'' evading certain provisions of the CEA.
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    Section 4s(h)(3) directs the Commission to promulgate rules that 
would require swap dealers and major swap participants to: Verify the 
eligibility of their counterparties; disclose to their counterparties 
material information about swaps, including material risks, 
characteristics, incentives and conflicts of interest; and provide 
counterparties with information concerning the daily mark for swaps. 
The Commission also is directed to establish a duty for swap dealers 
and major swap participants to communicate in a fair and balanced 
manner based on principles of fair dealing and good faith.
    In addition, using its discretionary authority under 4s(h)(3)(D), 
the Commission is proposing to require that swap dealers and major swap 
participants comply with certain disclosure requirements based on 
certain clearing provisions of the Dodd-Frank Act and the CEA.\10\
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    \10\ See Sections 2(h)(7)(A) and (B) of the CEA.
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    The Commission proposes to use its rulemaking authority under 
Section 4s(h) to promulgate several requirements adapted from analogous 
standards and practices applicable to certain financial market 
professionals. In drafting the proposed rules, the Commission 
considered existing requirements for market intermediaries under the 
CEA, Commission Regulations and the Federal securities laws, as well as 
self-regulatory organization (``SRO'') rules.\11\ The Commission also 
considered standards adopted by prudential regulators, industry 
recommendations concerning ``best practices'' and requirements 
applicable under foreign regulatory regimes.\12\ To the extent 
practicable, the Commission has modeled the proposed rules on these 
existing rules and standards. Among the proposed requirements that are 
based on these analogous rules and standards are: An institutional 
suitability requirement for swap dealers and major swap participants 
when making recommendations to counterparties; swap execution standards 
that would apply to all Commission registrants, including swap dealers, 
for swaps available for trading on a designated contract market 
(``DCM'') or swap execution facility (``SEF''); and, as part of a swap 
dealer's or major swap participant's duty to disclose the material 
risks and characteristics of the swap, a duty to provide a scenario 
analysis of potential exposure for high-risk complex bilateral swaps, 
and on an ``opt-in'' basis scenario analysis for bilateral swaps not 
available for trading on a DCM or SEF.\13\ The Commission also is 
proposing that both swap dealers and independent representatives of 
Special Entities, including those that are registered with the 
Commission as

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commodity trading advisors (``CTAs''), be subject to certain 
restrictions with respect to political contributions to certain 
governmental Special Entities (``pay-to-play'').
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    \11\ In this regard, the Commission has looked to the 
requirements imposed by the National Futures Association (``NFA''), 
CME Group, Inc. (``CME''), IntercontinentalExchange, Inc. (``ICE''), 
Financial Industry Regulatory Authority, Inc. (``FINRA'') and the 
Municipal Securities Rulemaking Board (``MSRB''). SRO rules, in 
particular, provide a useful model because historically the 
Commission has relied on SROs to regulate conduct that is unethical 
or otherwise undesirable, but may not be fraudulent. See, e.g., NFA 
Compliance Rule 2-4, Just and Equitable Principles of Trade.
    \12\ See, e.g., International Organization of Securities 
Commissions, ``Operational and Financial Risk Management Control 
Mechanisms for Over-the-Counter Derivatives Activities of Regulated 
Securities Firms'' (Jul. 1994); Derivatives Policy Group, 
``Framework for Voluntary Oversight'' (Mar. 1995) (``DPG 
Framework''), available at http://www.riskinstitute.ch/137790.htm; 
The Counterparty Risk Management Policy Group, ``Improving 
Counterparty Risk Management Practices'' (June 1999) (CRMPG is 
composed of OTC derivatives dealers including Bank of America, BNP 
Paribas, Citigroup, Goldman Sachs, HSBC, JP Morgan and Morgan 
Stanley); The Counterparty Risk Management Policy Group, ``Toward 
Greater Financial Stability: A Private Sector Perspective--The 
Report of the Counterparty Risk Management Policy Group II'' (Jul. 
27, 2005); The Counterparty Risk Management Policy Group, 
``Containing Systemic Risk: The Road to Reform, The Report of the 
CRMPG III (Aug. 6, 2008) (``CRMPG III Report''), available at http://www.crmpolicygroup.org/.
    \13\ The CRMPG III Report identifies the characteristics of 
high-risk complex bilateral swaps to be: The degree and nature of 
leverage, the potential for periods of significantly reduced 
liquidity, and the lack of price transparency. The CRMPG III Report, 
at 54-57.
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B. Business Conduct Standards--Dealing With Counterparties That Are 
Special Entities

    Section 4s(h)(4) requires that a swap dealer who ``acts as an 
advisor to a Special Entity'' must act in the ``best interests'' of the 
Special Entity and undertake ``reasonable efforts'' to obtain 
information necessary to determine that a recommended swap is in the 
best interests of the Special Entity. The Commission proposes to 
incorporate the statutory text in a proposed rule and to specify that 
certain swaps-related conduct would be included within the meaning of 
the term ``act as an advisor to a Special Entity.''
    Section 4s(h)(5) authorizes the Commission to establish duties for 
swap dealers and major swap participants that offer swaps or enter into 
swaps with Special Entities, including requiring a swap dealer or major 
swap participant to have a reasonable basis to believe that the Special 
Entity has a representative, independent of the swap dealer or major 
swap participant, that meets certain criteria, including having 
sufficient knowledge to evaluate the transaction and risks, undertaking 
a duty to act in the ``best interests'' of the Special Entity, and 
being subject to pay-to-play restrictions. The statute requires swap 
dealers and major swap participants to disclose in writing the capacity 
in which they are acting before initiating a transaction with a Special 
Entity. The Commission is proposing to establish the duties described 
in Section 4s(h)(5) for swap dealers and major swap participants 
dealing with all categories of Special Entities.
    The Dodd-Frank Act requires the Commission to promulgate the 
mandatory rules by July 15, 2011.\14\ The Commission requests comment 
on all aspects of the proposed rules, as well as comment on the 
specific provisions and issues highlighted in the discussion below.
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    \14\ See Dodd-Frank Act Sections 712 and 754.
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C. Consultations With Stakeholders

    Commission staff held more than two dozen external consultations 
\15\ with stakeholders representing a broad spectrum of views on 
business conduct standards.\16\ Commission staff conducted many of 
these consultations jointly with Securities and Exchange Commission 
(``SEC'') staff. The consultations included discussions of the general 
nature of counterparty relationships today, counterparty practices 
unique to different types of swaps and asset classes, and interpretive 
recommendations concerning certain provisions of Section 4s(h).
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    \15\ A list of Commission staff consultations in connection with 
this proposed rulemaking is posted on the Commission's Web site, 
available at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm.
    \16\ The Commission received several written submissions from 
the public including: National Futures Association, Aug. 25, 2010 
(``NFA Letter''); Swap Financial Group, Aug. 9, 2010 (``SFG 
Letter''); Swap Financial Group, ``Briefing for SEC/CFTC Joint 
Working Group'' Aug. 9, 2010 (``SFG Presentation''); Christopher 
Klem, Ropes & Gray LLP, Sept. 2, 2010 (``Ropes & Gray Letter''); 
American Benefits Council, Sept. 8, 2010 (``ABC Letter''); American 
Benefits Council and the Committee on Investment of Employee Benefit 
Assets, Oct. 19, 2010 (``ABC/CIEBA Letter''); and Securities 
Industry and Financial Markets Association and International Swaps 
and Derivatives Association, Oct. 22, 2010 (``SIFMA/ISDA Letter''), 
available at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/OTC_3_BusConductStandardsCP.html.
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D. Consultation and Coordination With the SEC, Prudential Regulators 
and Other Domestic and Foreign Regulatory Authorities

    In compliance with Sections 712(a)(1) and 752(a) \17\ of the Dodd-
Frank Act, Commission staff has consulted and coordinated with the SEC, 
prudential regulators and foreign authorities. Commission staff has 
worked closely with SEC staff in the development of the proposed rules. 
The Commission's objective was to establish consistent requirements for 
CFTC and SEC registrants to the extent practicable given the 
differences in existing regulatory regimes and approaches. With respect 
to the prudential regulators, Commission staff consulted and considered 
certain existing business conduct standards that apply to banks. 
Commission staff also consulted informally with staff from the 
Department of Labor (``DOL'') and the Internal Revenue Service with 
respect to certain Special Entity definitions and the intersection of 
their regulatory requirements with the Dodd-Frank Act business conduct 
provisions.
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    \17\ Dodd-Frank Act Section 752(a) states in part, ``the 
Commodity Futures Trading Commission, the Securities and Exchange 
Commission, and the prudential regulators (as that term is defined 
in section 1a(39) of the [CEA]), 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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    In addition, Commission staff consulted with foreign authorities, 
specifically, European Commission and United Kingdom Financial Services 
Authority staff. Staff also considered the existing and ongoing work of 
the International Organization of Securities Commissions (``IOSCO''). 
Staff consultations with foreign authorities revealed many similarities 
in the proposed rules and foreign regulatory requirements.\18\
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    \18\ See generally European Union Markets in Financial 
Instruments Directive (``MiFID''), Directive 2004/39/EC of the 
European Parliament and of the Council of 21 April 2004 on markets 
in financial instruments, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2004L0039:20070921:EN:PDF; 
European Union Market Abuse Directive (``Market Abuse Directive''), 
Directive 2006/6/EC of the European Parliament and of the Council of 
28 January 2003 on market abuse, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2003:096:0016:0016:EN:PDF.
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II. Proposed Rules for Swap Dealers and Major Swap Participants Dealing 
With Counterparties

    The proposed business conduct rules dealing with counterparty 
relationships are contained in subpart H of new part 23 of the 
Commission's regulations.\19\ While the CEA and other provisions of the 
Commission's rules will govern swap transactions and the business of 
swap dealers and major swap participants, subpart H will contain the 
principal regulations governing sales practices and counterparty 
relationships. A section-by-section description of the proposed rules 
follows.
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    \19\ The proposed swap execution Sec.  155.7 would be 
promulgated in part 155. All the other proposed rules would appear 
in subpart H of new part 23.
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A. Proposed Sec. Sec.  23.400, 23.401 and 23.402--Scope, Definitions 
and General Provisions

    These proposed rules set out the scope, definitions and general 
provisions that apply, as appropriate, to subpart H of new part 23 of 
the Commission's regulations. The ``scope'' provision, under proposed 
Sec.  23.400, states that the rules in subpart H apply to swap dealers 
and major swap participants and that the rules do not limit the 
applicability of other provisions of the CEA, Commission Regulations or 
other laws.\20\ So, for example, in addition to the anti-fraud 
provision that would apply only to swap dealers and major swap 
participants in proposed Sec.  23.410, swap dealers and major swap 
participants will be subject to all other applicable anti-fraud 
provisions in the CEA and

[[Page 80641]]

Commission Regulations, as appropriate.\21\ The scope section also 
provides that, where appropriate, the rules also apply to swaps offered 
but not entered into. For example, the fair and balanced communications 
and fair dealing requirements in proposed Sec.  23.433 apply to swap 
dealers and major swap participants with respect to both counterparties 
and prospective counterparties.
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    \20\ In addition to its obligations under the proposed rules, to 
the extent a swap dealer or major swap participant is required to be 
a member of a registered futures association it would be required to 
comply as well with the business conduct and other requirements of 
NFA and any other applicable SROs.
    \21\ See, e.g., Section 4b of the CEA.
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    The proposed rules under subpart H will have most applicability 
when swap dealers and major swap participants have a pre-trade 
relationship with their counterparty, where that relationship includes 
discussions and negotiations that would allow a swap dealer or major 
swap participant to make appropriate disclosures and conduct due 
diligence. Indeed, when a swap is initiated on a DCM or SEF and the 
swap dealer or major swap participant does not know the counterparty's 
identity prior to execution, disclosure and due diligence obligations, 
such as the duties to verify counterparty eligibility under proposed 
Sec.  23.430, to disclose material information under proposed Sec.  
23.431, and the duty to verify that a Special Entity has a qualified 
representative under proposed Sec.  23.450, would not apply because 
there would be no basis on which to make those disclosures or 
opportunity to engage in discussions. However, when a swap dealer or 
major swap participant does not know the counterparty's identity pre-
execution, but does become aware of the counterparty's identity post-
execution of a bilateral swap, the swap dealer or major swap 
participant would still have certain specific duties such as the one to 
provide a daily mark in proposed Sec.  23.431(c)(2), (3).
    The Commission also proposes to define several terms for purposes 
of subpart H in proposed Sec.  23.401. The term ``counterparty'' would 
include ``prospective counterparty'' as appropriate in the rules. The 
terms swap dealer and major swap participant would include anyone 
acting for or on behalf of such persons, including associated persons 
as defined in Section 1a(4) of the CEA. Proposed Sec.  23.401 adopts 
the definition of Special Entity in Section 4s(h)(2). Additional terms 
are defined in the proposed rules relating to Special Entities.
    The ``general provisions'' for subpart H that are specified in 
proposed Sec.  23.402 include a requirement that swap dealers and major 
swap participants have policies and procedures reasonably designed to 
ensure compliance with the business conduct rules in subpart H and, in 
particular, to prevent a swap dealer or major swap participant from 
evading any provision of the CEA or Commission Regulations. For 
example, for a swap that is subject to mandatory clearing, a swap 
dealer or major swap participant should only be offering to enter into 
such a swap on an uncleared basis with a counterparty who has qualified 
for a valid end-user exception to the mandatory clearing of swaps.\22\ 
The Commission expects that these policies and procedures would be part 
of a swap dealer's or major swap participant's overall system of 
supervision, compliance and risk management.\23\
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    \22\ Separately, the Commission is proposing rules detailing 
when a counterparty may elect to use the exception to mandatory 
clearing under section 2(h)(7)(A)(iii) of the CEA.
    \23\ Separately, the Commission is proposing rules detailing the 
supervision, compliance and risk management obligations for swap 
dealers and major swap participants. See 75 FR 71397, Nov. 23, 2010.
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    Section 4s(h)(1)(B) gives the Commission the authority to prescribe 
rules relating to diligent supervision by swap dealers and major swap 
participants. In a separate release containing internal business 
conduct rules, the Commission has proposed comprehensive supervision 
and risk management program duties on swap dealers and major swap 
participants contained in new subpart J of part 23 of the Commission's 
Regulations.\24\ Proposed Sec.  23.402(b) would require swap dealers 
and major swap participants to diligently supervise their dealings with 
counterparties as required under subpart H in accordance with the 
diligent supervision requirements of subpart J.
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    \24\ See proposed Sec. Sec.  23.600 and 23.602, 75 FR 71397, 
Nov. 23, 2010.
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    Proposed Sec.  23.402(c) would establish a ``know your 
counterparty'' requirement on swap dealers and major swap 
participants.\25\ The proposed requirement would include the use of 
reasonable due diligence to know and retain a record of the essential 
facts concerning the counterparty, including information necessary to 
comply with the law, to service the counterparty, to implement a 
counterparty's special instructions, and to evaluate the counterparty's 
swaps experience and objectives. The proposed rule also would assist 
swap dealers and major swap participants in avoiding violations of 
Section 4c(a)(7) of the CEA which makes it ``unlawful for any person to 
enter into a swap knowing, or acting in reckless disregard of the fact, 
that its counterparty will use the swap as part of a device, scheme, or 
artifice to defraud any third party.''
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    \25\ This rule is based in part on NFA Compliance Rule 2-30, 
Customer Information and Risk Disclosure, which NFA has interpreted 
to impose ``know your customer'' duties, and has been a key 
component of NFA's customer protection regime. See NFA Interpretive 
Notice 9013.
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    Proposed Sec.  23.402(d) would require swap dealers and major swap 
participants to keep a record showing the true name and address of each 
counterparty, as well as a counterparty's address and the same 
information for any other person guaranteeing the counterparty's 
performance or controlling the counterparty's positions. This proposed 
rule is based on existing Sec.  1.37(a)(1) \26\ of the Commission's 
Regulations which applies to futures commission merchants, introducing 
brokers and members of a designated contract market.
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    \26\ 17 CFR 1.37(a)(1).
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    Another general provision, under proposed Sec.  23.402(e), states 
that swap dealers and major swap participants that seek to rely on the 
representations of their counterparties to satisfy any requirements in 
the proposed rules must have a reasonable basis to believe that the 
representations are reliable under the circumstances. In addition, the 
representations must be sufficiently detailed to enable the swap dealer 
or major swap participant to reasonably conclude that the particular 
requirement is satisfied. Proposed Sec.  23.402(e) would allow the 
parties to a swap to agree that such representations can be included in 
a master agreement \27\ or other written agreement between the parties 
and that the representations can be deemed applicable or renewed, as 
appropriate, to subsequent swaps between the parties. For example, 
particular counterparty representations about its sophistication or 
financial wherewithal relevant to the institutional suitability 
obligation imposed on swap dealers and major swap participants in 
proposed Sec.  23.434 may be contained in a master agreement, if agreed 
by the parties, and may be applied to subsequent swaps between the 
parties if the representations continue to be accurate

[[Page 80642]]

and relevant with respect to the subsequent swaps.
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    \27\ The Commission understands that swaps are generally 
governed by a master agreement and confirmation setting forth the 
relationship of the counterparties and the particulars of the 
transaction. Master agreements, which have typically been standard 
form agreements prepared by industry associations like the 
International Swaps and Derivatives Association (``ISDA''), include 
basic representations and covenants that are subject to negotiation 
by the parties and are supplemented with modifications to account 
for their specific interests. Master agreements contain terms that 
govern all succeeding swaps between the counterparties, and 
generally include provisions applicable to all swaps including: 
Payment netting, events of default, cross-default provisions, early 
termination events and closeout netting.
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    Proposed Sec.  23.402(f) would provide flexibility to swap dealers, 
major swap participants and their counterparties to agree to a reliable 
means for making disclosures of material information. Furthermore, 
proposed Sec.  23.402(g) would also allow swap dealers and major swap 
participants to use, where appropriate, standardized formats to make 
certain required disclosures of material information to their 
counterparties, and to include such standardized disclosures in a 
master or other written agreement between the parties, if agreed to by 
the parties. While standardized disclosures may be appropriate to meet 
certain disclosure obligations relating to the risks, characteristics, 
incentives and conflicts of interest related to a particular swap, it 
is unlikely that they would be adequate to meet all such disclosure 
duties. Swap dealers and major swap participants are cautioned to 
consider their disclosure obligations under the CEA and proposed rules 
with respect to each swap that they offer or enter into with a 
counterparty.
    Finally, proposed Sec.  23.402(h) would require swap dealers and 
major swap participants to create and retain a written record of their 
compliance with the requirements in subpart H. Such requirements would 
be part of the overall recordkeeping obligations imposed on swap 
dealers and major swap participants in the CEA and part 23 supbart F of 
the Commission's Regulations, would be maintained in accordance with 
Sec.  1.31 \28\ of the Commission's Regulations, and would be 
accessible to applicable prudential regulators.
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    \28\ 17 CFR 1.31.
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    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding scope, general provisions and 
definitions, and specifically on the following specific issues:
    <bullet> Should the Commission adopt any of the guidance from SRO 
rules relating to know your customer requirements? Is other guidance 
necessary in this area?
    <bullet> Are there additional terms that should be defined by the 
Commission? If so, how should such terms be defined and why?
    <bullet> Do any proposed requirements conflict with any requirement 
imposed by an SRO such that it would be impracticable or impossible for 
a swap dealer or major swap participant that is a member of an SRO to 
meet both obligations? If so, which ones and why?
    <bullet> Should the Commission specify any particular restrictions 
or prohibitions to further protect against evasion?

B. Proposed Sec.  23.410--Prohibition on Fraud, Manipulation and Other 
Abusive Practices

    Section 4s(h)(1) grants the Commission discretionary authority to 
promulgate rules applicable to swap dealers and major swap participants 
related to, among other things: Fraud, manipulation and abusive 
practices.\29\ To implement this provision the Commission proposes to 
adopt the anti-fraud provision in Section 4s(h)(4)(A) as Sec.  23.410, 
which prohibits fraudulent, deceptive and manipulative practices by 
swap dealers and major swap participants.\30\ While the heading of 
Section 4s(h)(4) states ``Special Requirements for Swap Dealers Acting 
as Advisors,'' the anti-fraud provision that follows in Section 
4s(h)(4)(A) is not so limited. The proposed rule follows the statutory 
text and applies to swap dealers and major swap participants acting in 
any capacity, e.g., as an advisor, counterparty or other market 
participant in relation to counterparties generally. The first two 
paragraphs of the rule focus on Special Entities and prohibit swap 
dealers and major swap participants from (1) employing any device, 
scheme or artifice to defraud any Special Entity; and (2) engaging in 
any transaction, practice, or course of business that operates as a 
fraud or deceit on any Special Entity. The third paragraph is not 
limited to Special Entities and prohibits swap dealers and major swap 
participants from engaging in any act, practice, or course of business 
that is fraudulent, deceptive or manipulative.\31\
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    \29\ On October 26, 2010, the Commission proposed rules to 
implement new anti-manipulation authority in Section 753 of the 
Dodd-Frank Act. The proposed rules expand and codify the 
Commission's authority to prohibit manipulation. 75 FR 67657, Nov. 
3, 2010. The same day, the Commission issued an advance notice of 
proposed rulemaking seeking comment on Section 747 of the Dodd-Frank 
Act, which amends Section 4c(a) of the CEA to expressly prohibit 
certain trading practices deemed disruptive of fair and equitable 
trading. 75 FR 67301, Nov. 2, 2010.
    \30\ In addition to the proposed anti-fraud rule, swap dealers 
and major swap participants will be subject to all other applicable 
provisions of the CEA and Commission Regulations, including those 
dealing with fraud and manipulation (e.g., Sections 4b, 6(c)(1), (3) 
and 9(a)(2) of the CEA).
    \31\ This language mirrors the language in Section 206(4) of the 
Investment Advisers Act of 1940 (``Advisers Act'') (15 U.S.C. 80b-1 
et seq.), which does not require scienter to prove liability. See 
SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992) (``[S]ection 
206(4) uses the more neutral `act, practice, or course or business' 
language. This is similar to 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 * * *.'') (citations 
omitted).
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    The Commission also proposes Sec. Sec.  23.410(b) and 23.410(c), 
which would prohibit swap dealers and major swap participants from 
disclosing confidential counterparty information and front running or 
trading ahead of counterparty swap transactions.\32\ These rules are 
based on trading standards applicable to futures commission merchants 
and introducing brokers that prohibit trading ahead of a customer and 
protect the confidentiality of customer orders.\33\ Such abuses are 
considered fraudulent practices.\34\ Viewed together, proposed 
Sec. Sec.  23. 410(b) and 23.410(c) build on the code of ethics 
requirements and informational barriers in proposed subpart J which add 
substantial protections for counterparties from abuse of their 
confidential information and business opportunities.
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    \32\ Senator Lincoln noted in a colloquy that the Commission 
should adopt rules to ensure that swap dealers maintain the 
confidentiality of hedging and portfolio information provided by 
Special Entities, and prohibit swap dealers from using information 
received from a Special Entity to engage in trades that would take 
advantage of the Special Entity's positions or strategies. 156 Cong. 
Rec. S5923 (daily ed. Jul. 15, 2010) (statement of Sen. Lincoln). In 
consultations with stakeholders, Commission staff has learned that 
these concerns apply more generally to all counterparties, rather 
than exclusively to Special Entities. Thus, the Commission proposes 
that the business conduct rules include prohibitions on these types 
of activities in all transactions between swap dealers or major swap 
participants and their counterparties.
    \33\ See, e.g., 17 CFR 155.3-4; cf. Market Abuse Directive, at 
Para. 19, Art. 1(1) (prohibiting the misuse of confidential customer 
information and front running). The proposed rule would make clear 
that the confidentiality requirements do not apply when disclosure 
is made upon request of the Commission, Department of Justice or an 
applicable prudential regulator.
    \34\ See, e.g., United States v. Dial, 757 F.2d 163, 168 (7th 
Cir. 1985).
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    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding fraud, manipulation, and abusive 
practices, and on the following specific issues:
    <bullet> Should a swap dealer or major swap participant be required 
to disclose to a counterparty its pre-existing positions in a type of 
swap prior to entering into the same type of swap with the 
counterparty?
    <bullet> Should the prohibitions on trading ahead of a counterparty 
transaction and disclosure of confidential counterparty information be 
limited in any way not already provided in the proposed rule? For 
example, if a counterparty discusses a potential swap but does not 
immediately enter into it with the swap

[[Page 80643]]

dealer or major swap participant, should there be a limit on the time 
during which the swap dealer or major swap participant must refrain 
from trading on or otherwise disclosing the counterparty's information?
    <bullet> Are there other specific fraudulent, manipulative or 
abusive practices by swap dealers and major swap participants that 
should be prohibited in these proposed rules? If so, how would they 
assist in protecting swap markets and counterparties? Are there gaps in 
the existing requirements that should be filled here?

C. Proposed Sec.  23.430--Verification of Counterparty Eligibility

    The Dodd-Frank Act makes it unlawful for any person, other than an 
eligible contract participant (``ECP''),\35\ to enter into a swap 
unless it is executed on or subject to the rules of a designated 
contract market.\36\ Section 4s(h)(3)(A) also requires the Commission 
to establish a duty for a swap dealer or major swap participant to 
verify that any counterparty meets the eligibility standards for an 
ECP. Proposed Sec.  23.430 would require swap dealers and major swap 
participants to verify that a counterparty meets the definition of an 
ECP prior to offering or entering into a swap. The proposed rule also 
would require a swap dealer or major swap participant to determine 
whether the counterparty is a Special Entity as defined in Section 
4s(h)(2) and proposed Sec.  23.401.
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    \35\ ``Eligible contract participant'' is a defined term in 
Section 1a(18) of the CEA.
    \36\ See Section 2(e) of the CEA.
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    The Commission contemplates that, in the absence of ``red flags,'' 
and as provided in proposed Sec.  23.402(e), a swap dealer or major 
swap participant would be permitted to rely on reasonable written 
representations of a potential counterparty to establish its 
eligibility as an ECP.\37\ In addition, under proposed Sec.  23.402(g), 
such written representations could be expressed in a master agreement 
or other written agreement and, if agreed by the parties, could be 
deemed to be renewed with each subsequent swap transaction, absent any 
facts or circumstances to the contrary.\38\
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    \37\ This position is consistent with industry comment. See, 
e.g., NFA Letter, at 2 (recommending the Commission adopt a rule 
modeled after NFA Compliance Rule 2-23, which permits NFA members to 
rely on information provided by the customer to satisfy the member's 
know-your-customer obligations).
    \38\ Certain industry comments support this approach. See, e.g., 
NFA Letter, at 2; SIFMA/ISDA Letter, at 12.
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    Finally, as set forth in proposed Sec.  23.430(c), a swap dealer or 
major swap participant would not be required to verify the ECP or 
Special Entity status of the counterparty for any swap initiated on a 
SEF where the swap dealer or major swap participant does not know the 
identity of the counterparty.\39\
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    \39\ This rule tracks the statutory language in Section 
4s(h)(7).
---------------------------------------------------------------------------

    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding verification of counterparties as 
ECPs and Special Entities, and on the following specific issues:
    <bullet> Should there be an ongoing, affirmative duty to verify 
eligibility? If so, how would it be met? Would the swap dealer or major 
swap participant's duty change in any way if the ECP status of the 
counterparty changes after the swap has been entered into?
    <bullet> Are there particular ``red flags'' that should indicate a 
need for a swap dealer or major swap participant to obtain additional 
information about the status of the counterparty as an ECP or Special 
Entity?

D. Proposed Sec.  23.431--Disclosure of Material Risks, 
Characteristics, Material Incentives and Conflicts of Interest 
Regarding a Swap

    Section 4(s)(h)(3)(B) requires swap dealers and major swap 
participants to disclose to their counterparties material information 
about the risks, characteristics, incentives and conflicts of interest 
regarding a swap. The requirements do not apply if both counterparties 
are any of the following: Swap dealer, major swap participant, 
security-based swap dealer or major security-based swap participant. 
Proposed Sec.  23.431 would implement the statutory disclosure 
requirements and provide specificity with respect to certain material 
information that must be disclosed under the rule. Information is 
material if there is a substantial likelihood that a reasonable 
counterparty would consider it important in making a swap related 
decision.\40\
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    \40\ Cf. CFTC v. R.J. Fitzgerald & Co., 310 F.3d 1321, 1328-29 
(11th Cir. 2002) (``A representation or omission is ``material'' if 
a reasonable investor would consider it important in deciding 
whether to make an investment.'') (citing Affiliated Ute Citizens of 
Utah v. United States, 406 U.S. 128, 153-54 (1972)).
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1. Timing and Manner of Disclosures
    The Dodd-Frank Act does not address the timing and form of the 
required disclosures. Proposed Sec.  23.431(a) would require that the 
disclosures be made before entering into a swap and in a manner 
reasonably designed to allow the counterparty to assess the 
disclosures. To satisfy its obligation, the swap dealer or major swap 
participant would also be required to make such disclosures at a time 
prior to entering into the swap that was reasonably sufficient to allow 
the counterparty to assess the disclosures. Swap dealers and major swap 
participants would have flexibility to make these disclosures using 
reliable means agreed to by the parties, as provided in proposed Sec.  
23.402(f).\41\
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    \41\ Additionally, under proposed Sec.  23.402(h), swap dealers 
and major swap participants would be required to maintain a record 
of their compliance with the proposed rules.
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    Standardized disclosure of some required information may be 
appropriate if the information is applicable to multiple swaps of a 
particular type and class.\42\ As discussed below, the Commission 
believes that most bespoke transactions, however, will require some 
combination of standardized and particularized disclosures.
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    \42\ Cf. SIFMA/ISDA Letter, at 12 (recommending the use of 
standard disclosure templates that could be adopted on an industry-
wide basis, with disclosure requirements satisfied by a registrant 
on a relationship (rather than a transaction-by-transaction) basis 
in cases where prior disclosures apply to and adequately address the 
relevant transaction).
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2. Disclosure of Material Risks
    The proposed rule tracks the statutory obligations under Section 
4s(h)(3)(B)(i) and would require the swap dealer or major swap 
participant to disclose information to enable a counterparty to assess 
the material risks of a particular swap. The Commission anticipates 
that swap dealers and major swap participants typically will rely on a 
combination of general and more particularized disclosures to satisfy 
this requirement. The Commission understands that there are certain 
types of risks that are associated with swaps generally, including 
market,\43\ credit,\44\ operational,\45\ and liquidity risks.\46\ 
Required risk disclosure would include sufficient information to enable 
a

[[Page 80644]]

counterparty to assess its potential exposure during the term of the 
swap and at expiration or upon early termination. Consistent with 
industry ``best practices,'' information regarding specific material 
risks must identify the material factors that influence the day-to-day 
changes in valuation, as well as the factors or events that might lead 
to significant losses.\47\ Appropriate disclosures should consider the 
effect of future economic factors and other material events that could 
cause the swap to experience such losses. Disclosures should also 
identify, to the extent possible, the sensitivities of the swap to 
those factors and conditions, as well as the approximate magnitude of 
the gains or losses the swap will likely experience.
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    \43\ Market risk refers to the risk to a counterparty's 
financial condition resulting from adverse movements in the level or 
volatility of market prices.
    \44\ Credit risk refers to the risk that a party to a swap will 
fail to perform on an obligation under the swap.
    \45\ Operational risk refers to the risk that deficiencies in 
information systems or internal controls, including human error, 
will result in unexpected loss.
    \46\ Liquidity risk is the risk that a counterparty may not be 
able to, or cannot easily, unwind or offset a particular position at 
or near the previous market price because of inadequate market 
depth, unique trade terms or remaining party characteristics or 
because of disruptions in the marketplace.
    \47\ See CRMPG III Report, at 60.
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    Swap dealers and major swap participants also should consider the 
unique risks associated with particular types of swaps, asset classes 
and trading venues, and tailor their disclosures accordingly.
    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding material risk disclosures for swaps 
and on the following specific issues:
    <bullet> Are there specific material risks that the Commission 
should require a swap dealer or major swap participant to disclose to a 
counterparty? Are there specific risks that should be disclosed with 
respect to particular types of swaps, asset classes and trading venues?
    <bullet> NFA and SIFMA/ISDA submitted letters that have suggested 
that the Commission develop a standard form risk disclosure statement 
for certain generic-type disclosures, similar to those used today for 
futures, options and retail foreign currency transactions.\48\ Should 
the Commission undertake such an effort? Should the Commission 
encourage the industry or SROs to develop such disclosures, in 
addition, or instead? If it would be beneficial to have such forms, why 
has the industry not developed such a standard form to date? Would 
standard form disclosure be inconsistent with the requirement that 
disclosures be based on the facts and circumstances presented by each 
swap and counterparty?
---------------------------------------------------------------------------

    \48\ See NFA Letter, at 2; SIFMA/ISDA Letter, at 12.
---------------------------------------------------------------------------

    <bullet> Are there other ways for the Commission to describe the 
risk disclosure duty required by the CEA that would provide additional 
guidance or clarify the obligation?
    <bullet> Should the rule distinguish explicitly risk disclosure 
requirements for SEF or DCM traded swaps versus bilateral swaps?
3. Scenario Analysis for High-Risk Complex Bilateral Swaps and 
Counterparty ``Opt-In'' for Bilateral Swaps Not Available for Trading 
on a Designated Contract Market or Swap Execution Facility
    The Commission is proposing that swap dealers and major swap 
participants be required to provide scenario analyses when they offer 
to enter into high-risk complex bilateral swaps to allow the 
counterparty to assess its potential exposure in connection with the 
swap.\49\ In addition, the rule would allow counterparties to elect to 
receive scenario analysis when offered bilateral swaps that are not 
available for trading on a DCM or SEF. The elective aspect of the rule 
reflects the expectation that there may be circumstances where scenario 
analysis may be helpful for certain counterparties, even for swaps that 
are not high-risk complex. Proposed Sec.  23.431(a)(1) is modeled on 
the CRMPG III industry best practices recommendation for high-risk 
complex financial instruments.\50\
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    \49\ Scenario analysis is in addition to required disclosures 
for swaps which do not qualify as high-risk complex. Such required 
disclosures include a clear explanation of the economics of the 
instrument.
    \50\ CRMPG III Report, at 60-61.
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a. High-Risk Complex Bilateral Swap: Characteristics
    The rule's mandatory scenario analysis delivery requirement would 
apply only when ``high-risk complex bilateral swaps'' are offered or 
recommended. Like the industry ``best practice'' recommendation, the 
term ``high-risk complex bilateral swap'' is not defined in the 
proposed rule; rather, certain flexible characteristics are identified 
to avoid over inclusive and under inclusive concerns. The 
characteristics are: The degree and nature of leverage,\51\ the 
potential for periods of significantly reduced liquidity, and the lack 
of price transparency.\52\ The proposed rule would require swap dealers 
and major swap participants to establish reasonable policies and 
procedures to identify high-risk complex bilateral swaps, and in 
connection with such swaps, provide the additional risk disclosure 
specified in proposed Sec.  23.431(a)(1).
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    \51\ The leverage characteristic is particularly relevant when 
the swap includes an embedded option, including one in which the 
counterparty is ``short'' or selling volatility. Such features can 
significantly increase counterparty risk exposure in ways that are 
not transparent.
    \52\ CRMPG III Report states that:
    The aforementioned characteristics are neither an exhaustive 
list nor should they be assumed to provide a strict definition of 
high-risk complex instruments, which the Policy Group believes 
should be avoided. Instead, market participants should establish 
procedures for determining, based on the key characteristics 
discussed above, whether an instrument is to be considered high-risk 
and complex and thus require the special treatment outlined in this 
section. CRMPG III Report, at 56.
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b. Market Risk Disclosures: Scenario Analysis
    Scenario analysis, as required by the proposed rule, would be an 
expression of potential losses to the fair value of the swap in market 
conditions ranging from normal to severe in terms of stress.\53\ Such 
analyses would be designed to illustrate certain potential economic 
outcomes that might occur and the effect of these outcomes on the value 
of the swap. The proposed rule would require that these outcomes or 
scenarios be developed by the swap dealer or major swap participant in 
consultation with the counterparty. In addition, the proposed rule 
would require that all material assumptions underlying a given scenario 
and its impact on swap valuation be disclosed.\54\ In requiring such 
disclosures, however, the Commission does not propose to require swap 
dealers or major swap participants to disclose proprietary information 
about any pricing models.
---------------------------------------------------------------------------

    \53\ These value changes originate from changes or shocks to the 
underlying risk factors affecting the given swap, such as interest 
rates, foreign currency exchange rates, commodity prices and asset 
volatilities.
    \54\ Material assumptions include: (1) The assumptions of the 
valuation model and any parameters applied and (2) a general 
discussion of the economic state that the scenario is intended to 
illustrate.
---------------------------------------------------------------------------

    The Commission does not propose to define the parameters of the 
scenario analysis in order to provide flexibility to the parties to 
design the analyses in accordance with the characteristics of the 
bespoke swap at issue, as well as any criteria developed in 
consultations with the counterparty. Further, the proposed rule would 
require swap dealers and major swap participants to consider relevant 
internal risk analyses including any new product reviews when designing 
the analyses.\55\ As for the format, the proposed rule would require 
both narrative and tabular expressions of the analyses.
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    \55\ The Commission has proposed that swap dealers and major 
swap participants adopt policies and procedures regarding a new 
product policy as part of the risk management system. See proposed 
Sec.  23.600(c)(3), 75 FR 71397, Nov. 23, 2010.
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    To ensure fair and balanced communications and to avoid misleading 
counterparties, swap dealers and major swap participants also would

[[Page 80645]]

be required to state the limitations of the scenario analysis, 
including cautions about the predictive value of the scenario analysis, 
and any limitations on the analysis based on the assumptions used to 
prepare it. The Commission's proposed rule is aligned with longstanding 
industry best practice recommendations,\56\ and indeed, several large 
swap dealers told Commission staff that they provide scenario analysis 
upon request and without separate charge to counterparties today.
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    \56\ See DPG Framework, at Part V(II)(G); but see SIFMA/ISDA 
Letter, at 13-14.
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    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding required scenario analysis for 
high-risk complex bilateral swaps and opt-in scenario analysis for 
swaps not available for trading on a DCM or SEF and on the following 
specific issues:
    <bullet> Regarding high-risk complex bilateral swaps, should other 
characteristics be added to the rule? Should any of the proposed high-
risk complex bilateral swap characteristics be deleted or modified?
    <bullet> Instead of high-risk complex bilateral swaps, should the 
Commission require scenario analysis for all swaps that are: (1) Not 
accepted or listed for clearing on a derivatives clearing organization 
(``DCO''), or alternatively, (2) uncleared? What are the costs/benefits 
of changing the requirement to option one or option two?
    <bullet> Regarding scenario analysis, should a swap dealer/major 
swap participant be required to provide such analysis for any swap upon 
reasonable request by any counterparty? Would there be a charge to 
counterparties that elect to ``opt-in''? How much on average would it 
cost? If the cost varies by swap type or asset class, provide an 
average cost by category. What are the costs and benefits to swap 
dealers and major swap participants and counterparties associated with 
scenario analysis?
    <bullet> Are there certain types of counterparties for which a 
scenario analysis should always be provided? If so, which ones and why?
    <bullet> Should swap dealers and major swap participants be able to 
avoid their duty to provide scenario analysis if a counterparty opts 
out of receiving it?
    <bullet> Should a Value at Risk (``VaR'') type analysis be part of 
the mandatory scenario analysis?
    <bullet> In the event that a swap dealer or major swap participant 
elects to disclose a VaR type analysis, should any minimum parameters 
apply? For instance, should there be any required confidence levels 
such as 95 percent or 99 percent? Should there be any minimum standards 
regarding the type of VaR model chosen? Should there be a required time 
horizon such as the time between payments, the expected time to 
liquidate the position, or something else?
4. Material Characteristics
    The proposed rule would require swap dealers and major swap 
participants to include in their disclosures of material 
characteristics, the material economic terms of the swap, the material 
terms relating to the operation of the swap and the material rights and 
obligations of the parties during the term of the swap. Under the 
proposed rule, the Commission intends that the material characteristics 
would include the material terms of the swap that would be included in 
any ``confirmation'' of any swap sent by the swap dealer or major swap 
participant to the counterparty upon execution.
5. Material Incentives and Conflicts of Interest
    The proposed rule tracks the statutory language under Section 
4s(h)(3)(B)(ii) and would require a swap dealer or major swap 
participant to disclose to any counterparty the material incentives and 
conflicts of interest that the swap dealer or major swap participant 
may have in connection with the particular swap. Several stakeholders 
recommended that the Commission require added transparency concerning 
the components that make up the price of a transaction. In response, 
the Commission proposes that swap dealers and major swap participants 
be required to include with the price of a swap the mid-market value of 
the swap as defined in proposed Sec.  23.431(c)(2). In addition, swap 
dealers and major swap participants would be required to disclose any 
compensation or benefit that they receive from any third party in 
connection with the swap. In connection with any recommended swap, swap 
dealers and major swap participants would be expected to disclose 
whether their compensation related to the recommended swap would be 
greater than for another instrument with similar economic terms offered 
by the swap dealer or major swap participant. With respect to conflicts 
of interest, the Commission expects such disclosure to include the 
inherent conflicts in a counterparty relationship, particularly when 
the swap dealer or major swap participant recommends the transaction. 
The Commission also expects that a swap dealer or major swap 
participant that engages in business with the counterparty in more than 
one capacity should consider whether acting in multiple capacities 
creates material incentives or conflict of interests that require 
disclosure.\57\
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    \57\ This may exist, for example, when the swap dealer or major 
swap participant acts both as an underwriter in a bond offering and 
as a counterparty to the swaps used to hedge such financing. In 
these circumstances, the swap dealer's or major swap participant's 
duties to the counterparty would vary depending on the capacities in 
which it is operating and should be disclosed.
---------------------------------------------------------------------------

    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding material incentives and conflicts 
of interest and on the following specific issues:
    <bullet> Should the Commission impose more specific requirements 
concerning the content of the required disclosures generally?
    <bullet> Should the Commission require swap dealers and major swap 
participants to disclose their profit? If so, how should a swap dealer 
or major swap participant be required to compute profitability for 
purposes of the rule?
6. Daily Mark
    Section 4s(h)(3)(B) directs the Commission to adopt rules that 
require: (1) For cleared swaps, upon request of the counterparty, 
receipt of the daily mark from the appropriate DCO; and (2) for 
uncleared swaps, receipt of the daily mark of the swap from the swap 
dealer or major swap participant. The term ``daily mark'' is not 
defined in the statute, and the Commission understands that the term 
``mark'' is used colloquially to refer to various types of valuation 
information.
a. Cleared Swaps
    For a cleared swap, proposed Sec.  23.431(c)(1) would require the 
swap dealer or major swap participant to notify a counterparty of their 
right to receive, upon request, the daily mark from the appropriate 
DCO.
b. Uncleared Swaps
    For uncleared swaps, proposed Sec.  23.431(c)(2) and (3) would 
require a swap dealer or major swap participant to provide a daily mark 
to its counterparty on each business day during the term of the swap as 
of the close of business, or such other time as the parties agree in 
writing. The Commission is proposing to define daily mark for uncleared 
swaps as the mid-market value of the swap,\58\ which shall

[[Page 80646]]

not include amounts for profit, credit reserve, hedging, funding, 
liquidity or any other costs or adjustments.\59\ Based on staff 
consultations, the consensus was that mid-market value is a transparent 
measure that would assist counterparties in calculating valuations for 
their own internal risk management purposes. Further, the Commission is 
proposing that swap dealers and major swap participants disclose both 
the methodology and assumptions used to prepare the daily mark, and any 
material changes to the methodology or assumptions during the term of 
the swap. The Commission understands that the daily mark for certain 
bespoke swaps may be generated using proprietary models. The proposed 
rule does not require the swap dealer or major swap participant to 
disclose proprietary information relating to its model.
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    \58\ Cf. SIFMA and ISDA assert that ``[b]y market convention and 
often by contract, parties generally agree to utilize a mid-market 
level for margin purposes. Counterparties understand that this level 
does not represent a valuation at which a transaction may be entered 
into or terminated and accordingly may differ from actual market 
prices. We recommend that the Commissions endorse this use of mid-
market levels for margin purposes as a uniform market practice.'' 
SIFMA/ISDA Letter, at 17.
    \59\ For a discussion of mid-market value and costs, see ISDA 
Research Notes, The Value of a New Swap, Issue 3 (2010), available 
at http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf.
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    Lastly, the Commission proposes that swap dealers and major swap 
participants provide appropriate clarifying statements relating to the 
daily mark. Such disclosures may include, as appropriate, that the 
daily mark may not necessarily be: (1) A price at which the swap dealer 
or major swap participant would agree to replace or terminate the swap; 
(2) the basis for a variation margin call; \60\ nor (3) the value of 
the swap that is marked on the books of the swap dealer or major swap 
participant.\61\
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    \60\ But see SIFMA/ISDA Letter at 17 (asserting that mid-market 
level is market convention for margin purposes and not a quote for 
entering into a transaction or terminating the swap).
    \61\ See also Trading & Capital-Markets Activities Manual, 
section 2150.1 (Bd. of Gov. Fed. Reserve Sys. Jan. 2009) (``Trading 
& Capital-Markets Activities Manual'') (``When providing a quote to 
a counterparty, institutions should be careful that the counterparty 
does not confuse indicative quotes with firm prices. Firms receiving 
dealer quotes should be aware that these values may not be the same 
as those used by the dealer for its internal purposes and may not 
represent other `market' or model-based valuations.''), available at 
http://www.federalreserve.gov/boarddocs/supmanual/trading/200901/0901trading.pdf.
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    Industry representatives have asked whether swap dealers and major 
swap participants may satisfy their obligations to provide daily marks 
for uncleared swaps by making the relevant information available to 
counterparties through password protected access to a webpage 
containing the relevant information.\62\ Proposed Sec.  23.402(f) would 
permit swap dealers and major swap participants to provide daily marks 
by any reliable means agreed to in writing by the counterparty.
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    \62\ SIFMA/ISDA Letter, at 17; NFA Letter, at 3.
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    Request for Comment: The Commission requests comments generally on 
the daily mark and on the following specific issues:
    <bullet> Should the Commission define the daily mark for uncleared 
swaps as proposed, on a different basis, or should it be subject to 
negotiation by the parties? If so, why?
    <bullet> In addition to the daily mark as defined in the proposed 
rule, should the Commission require that swap dealers or major swap 
participants provide executable quotes to counterparties upon request? 
Should this be left to negotiations between the parties?

E. Proposed Sec.  23.432--Clearing

    For swaps where clearing is mandatory,\63\ proposed Sec.  23.432(a) 
would require that a swap dealer or major swap participant notify the 
counterparty that the counterparty has the sole right to select the DCO 
that will clear the swap. For swaps that are not required to be 
cleared, under proposed Sec.  23.432(b), a swap dealer or major swap 
participant must notify a counterparty that the counterparty may elect 
to require the swap to be cleared and that it has the sole right to 
select the DCO for clearing the swap.\64\ Neither of these notification 
provisions would apply where the counterparty is a registered swap 
dealer, major swap participant, security-based swap dealer, or major 
security-based swap participant.
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    \63\ See Section 2(h) of the CEA.
    \64\ With respect to these proposed disclosure requirements, the 
Commission notes that, as between the parties, the counterparty is 
entitled to choose whether and where to clear, but that no DCM or 
SEF must make clearing available through any DCO. In other words, it 
would be up to the parties to take the swap to a DCM or SEF that 
provides for clearing through the counterparty's preferred DCO.
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    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding clearing, and on the following 
specific issues:
    <bullet> Are there additional disclosures that a swap dealer or 
major swap participant should be required to make with respect to 
clearing of swaps?

F. Proposed Sec.  23.433--Communications--Fair Dealing

    The Dodd-Frank Act requires that the Commission establish a duty 
for swap dealers and major swap participants to communicate in a fair 
and balanced manner based on principles of fair dealing and good faith. 
Proposed Sec.  23.433 would establish such a duty and, consistent with 
statutory language, would apply broadly to all swap dealer and major 
swap participant communications with counterparties. These principles 
are well established in the futures and securities markets, 
particularly through SRO rules.\65\ For example, the duty to 
communicate in a fair and balanced manner is one of the primary 
requirements of the NFA customer communication rule \66\ and is 
designed to ensure a balanced treatment of potential benefits and 
risks. In determining whether a communication with a counterparty is 
fair and balanced, the Commission expects that a swap dealer or major 
swap participant would consider factors such as whether the 
communication: (1) Provides a sound basis for evaluating the facts with 
respect to any swap; \67\ (2) avoids making exaggerated or unwarranted 
claims, opinions or forecasts; \68\ and (3) balances any statement that 
refers to the potential opportunities or advantages presented by a swap 
with statements of corresponding risks. The Commission also would 
expect that to deal fairly would require the swap dealer or major swap 
participant to treat counterparties in such a way so as not to 
advantage one counterparty or group of counterparties over another. 
Additionally, communications would be subject to the specific anti-
fraud provisions of the CEA and Commission Regulations, as well as 
applicable SRO rules, if swap dealers and major swap participants are 
required to be SRO members.
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    \65\ See, e.g., 17 CFR 170.5 (``A futures association must 
establish and maintain a program for * * * the adoption of rules * * 
* to promote fair dealing with the public.''); NFA Compliance Rule 
2-29--Communications with the Public and Promotional Material; NFA 
Interpretative Notice 9041--Obligations to Customers and Other 
Market Participants.
    \66\ See, e.g., NFA Compliance Rule 2-29(b)(2), (5); see also 
NFA Interpretive Notice 9043--NFA Compliance rule 2-29: Use of Past 
or Projected Performance; Disclosing Conflicts of Interest for 
Security Futures Products (performance must be presented in a 
balanced manner).
    \67\ See, e.g., NFA Interpretive Notice 9041, Obligations to 
Customers and Other Market Participants (``Members * * * and their 
Associates should provide a sound basis for evaluating the facts 
regarding any particular security futures product * * *'').
    \68\ See, e.g., NFA Compliance Rule 2-29(b)(4)-(5).
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    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding fair and balanced communications, 
and on the following specific issues:
    <bullet> Should the Commission specify in its final rule any 
additional

[[Page 80647]]

requirements necessary to satisfy the duty? If so, what?
    <bullet> Should the Commission specify additional considerations in 
the rule to guide compliance with the rule? Should the Commission adopt 
interpretive guidance, instead or in addition?

G. Proposed Sec.  23.434--Recommendations to Counterparties--
Institutional Suitability

    To determine whether the Commission should use its discretionary 
authority under new Section 4s(h), the Commission considered 
requirements for professionals in other markets and in other 
jurisdictions. One common requirement is a suitability obligation which 
is imposed when a market professional recommends a product to a 
customer, including institutional or sophisticated customers. For 
example, federally regulated banks acting as broker-dealers for 
government securities have an institutional suitability obligation when 
making recommendations to institutional customers.\69\ Securities 
broker-dealers are also subject to a suitability obligation when 
recommending any securities to an institutional customer.\70\ Municipal 
securities dealers have a suitability obligation for any municipal 
security offered to a ``sophisticated municipal market professional.'' 
\71\ And, in the European Union, investment services firms have a 
suitability obligation with respect to financial instruments 
recommended to ``professional clients'' under MiFID.\72\
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    \69\ See, e.g., 12 CFR 13.4; Trading & Capital-Markets 
Activities Manual, Section 2150.
    \70\ See NASD Rule 2310, Recommendations to Customers 
(Suitability); see also proposed FINRA Rule 2111 (Suitability), 75 
FR 53562, Aug. 26, 2010.
    \71\ See Municipal Securities Rulemaking Board Rule G-19, 
Suitability of Recommendations and Transactions; Discretionary 
Accounts.
    \72\ MiFID Art. 19(3). ``Professional clients'' under MiFID 
include certain financial institutions, insurance companies, pension 
funds, and other entities. See MiFID Art. 19(4), Annex II.
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    In light of its broad application in other markets and 
jurisdictions, the Commission proposes an institutional suitability 
obligation for any recommendation a swap dealer or major swap 
participant makes to a counterparty in connection with a swap or swap 
trading strategy. The Commission recognizes that futures market 
professionals have not been subject to an explicit ``suitability'' 
obligation.\73\ Instead, such professionals have been required to meet 
a variety of related requirements, including NFA ``know your customer'' 
duties,\74\ mandatory standard form risk disclosure,\75\ NFA's fair and 
balanced communication rules and just and equitable principles,\76\ and 
general anti-fraud provisions.\77\ These requirements developed to 
address the risks and characteristics of standardized exchange-traded 
futures and options contracts. Because the definition of swap includes 
a variety of different types of financial instruments and those 
instruments can be customized to have a wide range of risk/reward 
profiles, the Commission believes that standard risk disclosure, alone, 
may not be sufficient to ensure that counterparties understand their 
potential exposure. The Commission also has considered that many swap 
dealers and major swap participants already are, or will be, subject to 
institutional suitability obligations by virtue of their status as 
banks, broker-dealers or security-based swap dealers. Thus, to promote 
regulatory consistency \78\ and to take account of the nature of swaps, 
the Commission proposes to adopt an institutional suitability 
obligation for swap dealers and major swap participants, modeled, in 
part, on existing obligations for banks and broker-dealers dealing with 
institutional clients.
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    \73\ The proposed institutional suitability obligation would 
apply only to swap dealers and major swap participants, and only 
when they make swap recommendations, not futures.
    \74\ NFA Compliance Rule 2-30, Customer Information and Risk 
Disclosure; NFA Interpretive Notice 901--NFA Compliance Rule 2-30: 
Customer Information and Risk Disclosure.
    \75\ 17 CFR 1.55.
    \76\ NFA Compliance Rules 2-29, 2-36, Requirements for Forex 
Transactions.
    \77\ See, e.g., Section 4b of the CEA and Sec. Sec.  32.9, 33.10 
of the Commission's Regulations (17 CFR 32.9, 33.10).
    \78\ See, e.g., 12 CFR 13.4; Trading & Capital-Markets 
Activities Manual, section 2150.
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    Proposed Sec.  23.434 would require a swap dealer or major swap 
participant to have reasonable grounds to believe that any 
recommendation for a swap or trading strategy involving swaps is 
suitable for its counterparty.\79\ A suitability determination would be 
based upon information the swap dealer or major swap participant 
obtains regarding the counterparty's financial situation and needs, 
objectives, tax status, ability to evaluate the recommendation, 
liquidity needs, risk tolerance, ability to absorb potential losses 
related to the recommended swap or trading strategy, and any other 
information known by the swap dealer or major swap participant.
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    \79\ The rule would not apply to recommendations made to 
counterparties that are swap dealers, major swap participants, 
security-based swap dealers or major security-based swap 
participants.
---------------------------------------------------------------------------

    A swap dealer or major swap participant could rely on counterparty 
representations to satisfy its suitability obligations if: (1) It had a 
reasonable basis to believe that the counterparty was capable of 
independently evaluating relevant risks with regard to the particular 
swap or trading strategy; (2) the counterparty had affirmatively 
indicated that it was exercising independent judgment in evaluating any 
recommendations; \80\ and (3) the swap dealer or major swap participant 
had a reasonable basis to believe that the counterparty had the 
capacity to absorb potential losses related to the recommended swap or 
swap trading strategy. To the extent that a swap dealer or major swap 
participant cannot rely on a counterparty's representations as 
contemplated by proposed Sec.  23.434, it would need to undertake a 
suitability analysis as set forth in the rule.
---------------------------------------------------------------------------

    \80\ A counterparty may indicate that it is exercising 
independent judgment on one or more particular swaps or types of 
swaps, or in terms of all swaps.
---------------------------------------------------------------------------

    Whether a swap dealer or major swap participant has made a 
recommendation and thus triggered its suitability obligation would 
depend on the facts and circumstances of the particular case. A 
recommendation would include any communication by which a swap dealer 
or major swap participant provides information to a counterparty about 
a particular swap or trading strategy that is tailored to the needs or 
characteristics of the counterparty, but would not include information 
that is general transaction, financial, or market information, swap 
terms in response to a competitive bid request from the 
counterparty.\81\ In implementing the proposed institutional 
suitability rule, the Commission intends to consult relevant precedents 
and interpretive guidance under Federal securities and banking 
requirements in the United States.\82\
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    \81\ NASD Notice to Members 01-23 (April 2001); FINRA Proposed 
Suitability Rule, 75 FR 52562, 52564-69, Aug. 26, 2010.
    \82\ See, e.g., 12 CFR 13.4, 208.25(d), 368.4. In 1997, the 
Federal banking agencies offered the following guidance regarding 
recommendations in the context of government securities sales 
practices: ``While the agencies do not believe it is appropriate to 
define the term `recommendation,' they note that they would not view 
the provision of general market information, including market 
observations, forecasts about interest rates, and price quotations, 
as making a recommendation under the rule, absent other conduct.'' 
62 FR 13276, 13280, Mar. 19, 1997.
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    The Commission notes that swap dealers and major swap participants 
are likely to be acting as CTAs \83\ when they

[[Page 80648]]

make recommendations, particularly recommendations tailored to the 
needs of their counterparty. As such, they would be subject to any 
additional duties that might be applicable to CTAs under the CEA and 
Commission Regulations, including registration requirements and Section 
4o of the CEA, the anti-fraud provision that applies to CTAs and 
commodity pool operators.\84\
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    \83\ Section 1a(12) of the CEA defines a commodity trading 
advisor, in relevant part, as any person who, for compensation or 
profit, trades, or advises (either directly or through publications, 
writings, or electronic media) as to the value of, or the 
advisability of trading in, a commodity for future delivery, or 
swap. Section 1a(12)(B) of the CEA excludes from the definition of 
commodity trading advisor a variety of persons, but only if a 
person's commodity advice is solely incidental to the conduct of its 
principal business or profession. The excluded persons include (i) 
banks and trust companies and their employees, (ii) news reporters, 
news columnists, and news editors of print or electronic media, 
(iii) lawyers, accountants, and teachers, (iv) floor brokers and 
futures commission merchants, (v) publishers and producers of any 
print or electronic data of general and regular dissemination, 
including their employees, (vi) fiduciaries of defined benefit plans 
subject to ERISA, (vii) contract markets, and (viii) other persons 
that the CFTC, by rule, regulation, or order, may exclude as ``not 
within the intent of'' the definition. The revised definition does 
not exclude swap dealers whose advice is solely incidental to their 
swap dealer activities. Therefore, any ``advisory'' activities by a 
swap dealer could bring it within the statutory definition of a 
commodity trading advisor.
    \84\ Depending on the nature of the relationship, swap dealers 
might also have common law fiduciary duties to their counterparties. 
Cf. Commodity Trend Serv., Inc. v. CFTC, 233 F.3d 981, 990 (7th Cir. 
2000).
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    Request for Comment: The Commission requests comments generally on 
the proposed rules regarding recommendations and the following specific 
issues:
    <bullet> Should the Commission adopt a suitability obligation for 
swaps in the absence of such an explicit requirement for exchange 
traded futures and options? Have securities-style suitability 
obligations for institutional customers had demonstrable benefits for 
such customers? If so, provide examples.
    <bullet> Are there additional factors that swap dealers or major 
swap participants should consider in determining whether a particular 
swap is suitable for a particular counterparty?
    <bullet> Should the Commission specify additional considerations in 
the rule to guide compliance with the rule? Should the Commission adopt 
interpretive guidance, similar to that provided by the prudential 
regulators in connection with sales of government securities instead or 
in addition?
    <bullet> Should swap dealers be subject to an explicit fiduciary 
duty when making a recommendation to a counterparty?

H. Proposed Sec.  155.7--Execution Standards

    The Commission is proposing a swap execution standard rule that 
would apply to swaps available for trading on a DCM or SEF to ensure 
fair dealing and protect against fraud and other abusive practices. The 
proposed execution standard rule would require Commission registrants, 
with respect to any swap that is available for trading on a DCM or SEF, 
to execute the swap on terms that have a ``reasonable relationship'' to 
the best terms available.\85\ In addition, the registrant would be 
required, prior to execution of the order, to disclose the DCMs and 
SEFs on which the swap is available for trading, and on which markets 
the registrant has trading privileges. The swap execution standards 
would apply to all Commission registrants executing customer orders for 
swaps made available for trading on a DCM or SEF, whether execution 
occurs on or through a DCM, SEF or bilaterally.\86\ The Commission 
notes that bilateral execution of swaps available for trading on a DCM 
or a SEF would only occur pursuant to the ``end user'' exemption 
provided under Section 2(h)(7)(A) of the CEA.
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    \85\ The term ``reasonable relationship'' has been used in 
evaluating execution standards over several decades in the 
securities industry. In an early securities law case, the Second 
Circuit stated that ``[i]n its interpretation of Sec. 17(a) of the 
Securities Act, the Commission has consistently held that a dealer 
cannot charge prices not reasonably related to the prevailing market 
price without disclosing that fact.'' Charles Hughes & Co. v. SEC, 
139 F.2d 434, 437 (2d Cir. 1943). The SEC issued a release in 1987, 
``Notice to broker-dealers concerning disclosure requirements for 
mark-ups on zero-coupon securities,'' which stated that the ``duty 
of fair dealing includes the implied representation that the price a 
firm charges bears a reasonable relationship to the prevailing 
market price.'' 52 FR 15575, 15576, Apr. 21, 1987 (citing Charles 
Hughes, 139 F.2d at 437). In IM-2440-1 the former NASD stated that 
``It shall be deemed a violation of Rule 2110 [recommendations] and 
Rule 2440 [fair prices and commissions] for a member to enter into 
any transaction with a customer in any security at any price not 
reasonably related to the current market price of the security or to 
charge a commission which is not reasonable.'' Although Rule 2440 
and IM-2440-1 related to OTC transactions, FINRA expanded the 
principle to include fees charged in exchange-traded transactions. 
See FINRA Regulatory Notice 08-36.
    \86\ The duty under the proposed rule would apply whether the 
Commission registrant was acting as agent or principal in the 
transaction. This is consistent with existing duties for broker-
dealers under the Federal securities laws. See Newton v. Merrill, 
Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270 n. 1 (3d Cir. 
1988) (``[T]he best execution duty `does not dissolve when the 
broker/dealer acts in its capacity as a principal.''') (citations 
omitted). Accord E.F. Hutton & Co., Release No. 34-25887, 49 S.E.C. 
829, 832 (1988); NASD Rule 2320(e).
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    In determining what constitutes a ``reasonable relationship,'' the 
Commission registrant should consider whether the terms offered to the 
customer are fair and consistent with principles of fair dealing,\87\ 
good faith, and, when acting as an agent for the customer, the duty of 
loyalty.\88\ To have a reasonable relationship to the best terms 
available, the terms must be fair and not excessive in light of all 
other relevant circumstances. Additionally, whether the terms of any 
swap executed on behalf of a customer satisfy the ``reasonable 
relationship'' duty would be analyzed in connection with the specific 
anti-fraud provisions of the CEA and Commission Regulations and would 
be considered in connection with the course of dealing between the 
registrant and the customer.
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    \87\ Supra at footnote 85. The ``duty of fair dealing includes 
the implied representation that the price a firm charges bears a 
reasonable relationship to the prevailing market price.'' 52 FR 
15575, 15576, Apr. 21, 1987.
    \88\ See Newton, 135 F.3d at 270 (``The duty of best execution * 
* * has its roots in the common law agency obligations of undivided 
loyalty and reasonable care that an agent owes to his principal.'')
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    To satisfy its reasonable relationship obligation, a Commission 
registrant would be expected to exercise reasonable diligence to 
ascertain which DCM or SEF offers the best terms available for the 
transaction. To meet their reasonable diligence duty, Commission 
registrants would have to survey a sufficient number of DCMs or SEFs to 
be able to make a reasonable determination as to whether the terms they 
offer their clients bear a reasonable relationship to the best terms 
available. Such a survey would not necessarily be confined to markets 
on which the registrant has trading privileges and would include 
reviewing available bids and offers, requests for quotes, and real time 
reporting of trades executed within a reasonable period of time prior 
to execution of the order. In proposing this execution standard, the 
Commission notes that in separate rulemakings the Commission is 
proposing rules requiring DCMs and SEFs to provide market participants 
with open access to their trading platforms and that current pre-trade 
price and quote information will be available to all persons with 
access to DCMs and SEFs. Post-trade data also will be available to 
registrants on a real-time reporting basis. The Commission's proposed 
rule lists a number of factors that the Commission would consider in 
determining compliance with the rule which include an evaluation of the 
characteristics unique to the customer's swap order as well as the 
prevailing market conditions.
    As swaps trading transitions to and develops on DCMs and SEFs, 
technology and other innovations are

[[Page 80649]]

likely to affect how Commission registrants determine whether the terms 
they offer their customers are reasonably related to the ``best terms 
available'' for purposes of satisfying the proposed execution 
standards. For example, registrants' survey obligations may be 
satisfied by consulting, where available, information aggregators that 
facilitate the collection of information about current trading activity 
across markets. The proposed rule is intended to be sufficiently 
flexible to take account of such innovations and developments which 
should further the quality of executions.
    Request for Comment: The Commission requests comments generally on 
the proposed rules regarding the swap execution standard and the 
following specific issues:
    <bullet> For the purpose of meeting the duty to use reasonable 
diligence to determine whether the terms it offers are reasonably 
related to the best terms available for execution of a swap that is 
available for trading on a DCM or SEF, should the Commission prescribe 
a certain percentage of DCMs or SEFs that must be reviewed/considered 
by the Commission registrant? If so, what percentage is appropriate?
    <bullet> Should the Commission define what it means for the terms 
of execution to have a ``reasonable relationship to the best terms 
available''? If so, how should the Commission define the phrase?
    <bullet> Should the Commission require any additional disclosures 
to the customer, including for example, the best terms available for 
execution of the swap order and the difference between the best terms 
and the terms on which the swap was executed?

III. Proposed Rules for Swap Dealers and Major Swap Participants 
Dealing With Special Entities

    In Section 4s(h), Congress created a separate category of swap 
counterparty called Special Entities, and imposed heightened duties and 
requirements for swap dealers that act as advisors to them, and for 
swap dealers and major swap participants that are their counterparties.

A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)

    Section 4s(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; \89\ (iv) any governmental 
plan, as defined in Section 3 of ERISA; \90\ or (v) any endowment, 
including an endowment that is an organization described in Section 
501(c)(3) of the Internal Revenue Code of 1986.\91\
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    \89\ 29 U.S.C. 1002. The term ``Special Entities'' includes 
employee benefit plans defined in section 3 of ERISA. This class of 
employee benefit plans is broader than the category of plans that 
are ``subject to'' ERISA for purposes of Section 
4s(h)(5)(A)(i)(VII). Employee benefit plans not ``subject to'' 
regulation under ERISA include: (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. See 29 
U.S.C. 1003(b).
    \90\ Section 3(32) of ERISA defines ``governmental plan'' as a 
``plan established or maintained for its employees by the Government 
of the United States, by the government of any State or political 
subdivision thereof, or by any agency or instrumentality of any of 
the foregoing.'' 29 U.S.C. 1002(32).
    \91\ The term ``endowment'' is not defined in the Dodd-Frank Act 
or in the CEA.
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    The Commission has received a number of letters from stakeholders 
identifying a variety of ambiguities in the definition of Special 
Entity in Section 4s(h)(2)(C) and suggesting clarifications. For 
example, under Section 4s(h)(2)(C)(iii), the term Special Entity 
includes employee benefit plans as defined in Section 3 of ERISA.\92\ 
Industry representatives have raised issues concerning whether the 
definition requires ``looking through'' investment vehicles to 
determine whether the vehicle is a Special Entity, including master 
trusts holding the assets of one or more pension plans of a single 
employer, and collective investment vehicles in which Special Entities 
invest.\93\
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    \92\ 29 U.S.C. 1002.
    \93\ See, e.g., SIFMA/ISDA Letter, at 5 (investment vehicle 
which 25 percent or more of its equity interest is owned by benefit 
plan investors and is subject to DOL plan assets rules (29 CFR 
2510.3-101) for purposes of ERISA).
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    Stakeholders similarly have raised issues with respect to whether 
plans defined in but not subject to ERISA (unless they are covered by 
another applicable prong of the Special Entity definition) are Special 
Entities,\94\ and whether only those plans subject to the fiduciary 
responsibility provisions of ERISA should be included within the 
Special Entity definition.\95\
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    \94\ See, e.g., SIFMA/ISDA Letter, at 2.
    \95\ SIFMA/ISDA Letter, at 5 (``This would exclude such plans as 
(i) unfunded plans for highly compensated employees; (ii) foreign 
pension plans (including foreign-based governmental plans); (iii) 
church plans that have elected not to subject themselves to ERISA; 
(iv) Section 403(b) plans that accept only employee contributions; 
and (v) Section 401(a), 403(b) and 457 plans sponsored by 
governmental entities.'') (citations omitted).
---------------------------------------------------------------------------

    Under Section 4s(h)(2)(C)(v), the term Special Entity includes any 
endowment, including an endowment that is an organization described in 
Section 501(c)(3) of the Internal Revenue Code of 1986.\96\ Non-profit 
organizations that enter into swaps have asked whether they will be 
treated as Special Entities if their endowment is pledged as collateral 
or is used to make payments on those swaps or whether the definition of 
endowment is limited to those endowments that are the named 
counterparty to the swap.\97\ Others have suggested that the phrase 
``any endowment'' be limited to endowments that are non-profit 
organizations described in Section 501(c) of the Internal Revenue Code 
or are established for the benefit of such an organization.
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    \96\ 26 U.S.C. 501(c)(3). Section 501(c)(3) lists tax exempt 
organizations including: ``Corporations, and any community chest, 
fund, or foundation, organized and operated exclusively for 
religious, charitable, scientific, testing for public safety, 
literary, or educational purposes * * *.''
    \97\ SIFMA/ISDA Letter, at 6; SFG Presentation, at 8.
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    Given the range of issues surrounding the definition of Special 
Entity, the Commission is not proposing to clarify the definition at 
this time but, instead, is seeking comment on whether clarification is 
necessary.
    Request for Comment: The Commission requests comments on the 
definition of Special Entity in general and on the following specific 
issues:
    <bullet> Should the definition of State, State agency, city, 
county, municipality, or other political subdivision of a State be 
clarified in any way?
    <bullet> Should the definition ``employee benefit plans, as defined 
in Section 3 of ERISA'' be clarified in any way?
    <bullet> Should the definition ``employee benefit plans, as defined 
in Section 3 of ERISA'' be limited to plans subject to regulation under 
ERISA?
    <bullet> Should the Commission ``look through'' an entity to 
determine whether it is a Special Entity for the purposes of these 
rules? If so, why? If not, why not? If so, should the Commission 
clarify that master trusts, or similar entities, that hold assets of 
more than one pension plan from the same plan sponsor are within the 
definition of Special Entity?
    <bullet> Should the Commission clarify in any way the definition of 
governmental plan under Section 4s(h)(C)(iv)?
    <bullet> Should the Commission clarify the definition of endowment 
to include or exclude charitable organizations that enter into swaps 
but whose endowments have contractual obligations regarding that swap?
    <bullet> Should the Commission clarify the definition of endowment 
to include or exclude foreign endowments? If so, why? If not, why not?

[[Page 80650]]

B. Proposed Sec.  23.440--Requirements for Swap Dealers Acting as 
Advisors to Special Entities

    Section 4s(h)(4) provides that a swap dealer that ``acts as an 
advisor to a Special Entity'' must act in the ``best interests'' of the 
Special Entity and undertake ``reasonable efforts'' to obtain 
information necessary to determine that a recommended swap is in the 
best interests of the Special Entity. These terms are not defined in 
the statute. The Commission's proposed rules incorporate the statutory 
language and clarify that ``acts as an advisor to a Special Entity'' 
includes to make a swap recommendation to a Special Entity.
1. Act as an Advisor to a Special Entity
    With respect to what it means to ``act as an advisor to a Special 
Entity,'' the Commission proposes to clarify that a swap dealer that 
makes a recommendation to a Special Entity falls within the definition. 
The Commission also proposes to clarify that a swap dealer that merely 
provides to a Special Entity general transaction, financial, or market 
information or that provides swap terms as part of a response to a 
competitive bid request from the Special Entity does not fall within 
the definition. The proposed definition does not address what it means 
to act as an advisor in connection with any other dealings between a 
swap dealer and a Special Entity.
2. Best Interests
    The proposed rule would not define the term ``best interests.'' 
There are established principles in case law under the CEA, with 
respect to the duties of advisors which will inform the meaning of the 
term on a case-by-case basis. The Commission believes that those best 
interest principles, in the context of a recommended swap or swap 
trading strategy, would impose affirmative duties to act in good faith 
and make full and fair disclosure of all material facts and conflicts 
of interest, and to employ reasonable care that any recommendation 
given to a Special Entity is designed to further the purposes of the 
Special Entity.\98\ The Commission's proposal is guided by the 
statutory language in Sections 4s(h)(4) and (5) and Congressional 
intent that swap dealers could act both as an advisor to a Special 
Entity when recommending a swap and then as a counterparty by entering 
into the same swap with the Special Entity, where the Special Entity 
has a representative independent of the swap dealer on which it can 
rely.\99\ The proposed rules are intended to allow existing business 
relationships to continue, albeit subject to the new, higher statutory 
standards of care.\100\ Thus, the proposed rule is not intended to 
preclude, per se, a swap dealer from both recommending a swap to a 
Special Entity and entering into that swap with the same Special Entity 
where the parties abide by the requirements of Sections 4s(h)(4) and 
(5) and the Commission's proposed regulations.\101\
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    \98\ There is similar language in SEC v. Capital Gains Research 
Bureau, Inc., 375 U.S. 180, 191-94 (1963) in which the Supreme Court 
construed Advisers Act Section 206 (15 U.S.C. 80b-6) as creating an 
enforcement mechanism for violations of fiduciary duties under the 
common law. The fiduciary duty 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.
    \99\ Senator Blanche Lincoln stated in a floor colloquy that:
    [N]othing in [CEA Section 4s(h)] prohibits a swap dealer from 
entering into transactions with Special Entities. Indeed, we believe 
it will be quite common that swap dealers will both provide advice 
and offer to enter into or enter into a swap with a special entity. 
However, unlike the status quo, in this case, the swap dealer would 
be subject to both the acting as advisor and business conduct 
requirements under subsections (h)(4) and (h)(5).
    156 Cong. Rec. S5923 (daily ed. Jul. 15, 2010) (statement of 
Sen. Lincoln). However, swap dealers have an obligation to ensure 
that any Special Entity counterparty is represented by a 
sophisticated representative, independent of the swap dealer, when 
the swap dealer is acting both as an advisor and as counterparty to 
the Special Entity. (Section 4s(h)(5)).
    \100\ The Commission anticipates that swap dealers and Special 
Entities will continue to rely on representations to inform the 
nature of their relationships, including, for example, 
representations that the Special Entity: (1) Is not relying on the 
swap dealer; (2) has an independent representative that, by virtue 
of their relationship, is legally obligated to act in the best 
interests of the Special Entity; and (3) is relying on the 
independent representative's advice in evaluating any recommendation 
from a swap dealer. The parties' agreement, however, does not bind 
the Commission or override the protections granted to market 
participants under the CEA. Cf. Complaint at ] 18, SEC v. Barclays 
Bank, 07-CV-04427 (S.D.N.Y. May 30, 2007) (so-called ``Big Boy'' 
letters may not insulate parties from enforcement actions brought by 
the SEC for insider trading); SEC v. Barclays Bank, SEC Litig. 
Release No. 20132 (May 30, 2007) (Barclays Bank settles insider 
trading charges).
    \101\ The Commission staff has consulted with DOL staff, who has 
advised that any determination of status under the Dodd-Frank Act is 
separate and distinct from the determination of whether an entity is 
a fiduciary under ERISA.
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3. Reasonable Efforts
    Section 4s(h)(4)(C) requires swap dealers to undertake ``reasonable 
efforts'' to obtain information necessary to determine that a 
recommended swap is in the best interests of the Special Entity. Such 
information includes the financial and tax status of the Special Entity 
and the financing objectives of the Special Entity. The statute grants 
the Commission discretionary authority to prescribe additional types of 
information. The Commission proposes to add: (1) The authority of the 
Special Entity to enter into a swap; (2) future funding needs of the 
Special Entity; (3) the experience of the Special Entity with respect 
to entering into swaps, generally, and swaps of the type and complexity 
being recommended; (4) whether the Special Entity has a representative 
as provided in proposed Sec.  23.450 and Section 4s(h)(5) that is 
capable of evaluating the recommended swap in light of the needs and 
circumstances of the Special Entity; and (5) whether the Special Entity 
has the financial capability to withstand changes in market conditions 
during the term of the swap. The Commission believes that this non-
exclusive list would assist a swap dealer in meeting its duty to act in 
the ``best interests'' of a Special Entity in recommending a swap or 
swap trading strategy.
4. Reasonable Reliance To Satisfy the ``Reasonable Efforts'' Obligation
    Proposed Sec.  23.440(c) would allow a swap dealer to rely on the 
Special Entity's representations to satisfy its ``reasonable efforts'' 
obligations. The Commission understands from stakeholders, including a 
number of Special Entities, that Special Entities are sometimes 
reluctant to provide complete information to swap dealers about their 
investment portfolio or other information that might be relevant to the 
appropriateness of a particular recommendation. To address this 
circumstance, the Commission proposes to allow a swap dealer to meet 
its ``reasonable efforts'' duty by relying on representations of the 
Special Entity \102\ and any other information known by the swap 
dealer. In such circumstances, the swap dealer would be expected to 
make clear to the Special Entity that the recommendation is based on 
the limited information known to the swap dealer, and that the 
recommendation might be different if the swap dealer had more complete 
information as provided in Section 4s(h)(4)(C) and proposed Sec.  
23.440(b)(2).\103\
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    \102\ Certain Special Entity trade associations supported this 
approach. See ABC Letter, at 6-7; ABC/CIEBA Letter, at 3.
    \103\ In the absence of sufficient representations from the 
Special Entity, and if a swap dealer's reasonable efforts produce 
incomplete information, the swap dealer would be required to assess 
whether it is able to make a swap recommendation that is in the best 
interests of the Special Entity as required by proposed Sec.  
23.440.
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    To rely, the swap dealer must have a reasonable basis to believe 
that the representations of the Special Entity are reliable based on 
the facts and

[[Page 80651]]

circumstances of the particular swap and the Special Entity. The 
representations themselves must be detailed and include information 
regarding the Special Entity's ability to: evaluate the recommended 
transaction; exercise independent judgment; and absorb potential losses 
associated with the swap. The Special Entity also would have to have a 
representative that meets the criteria in Section 4s(h)(5) and proposed 
Sec.  23.450. This mechanism would not relieve a swap dealer of its 
duty to act in the ``best interests'' of the Special Entity.
    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding swap dealers that act as advisors 
to Special Entities, and on the following specific issues:
    <bullet> Is the proposed clarification of the term ``acts as an 
advisor to a Special Entity'' appropriate? Should the Commission 
further define the term?
    <bullet> Should the Commission define ``best interests'' in this 
context, and if so, what should the definition be?
    <bullet> Because a swap dealer has an inherent conflict of interest 
when it acts as both an advisor and a counterparty to Special Entity, 
are there additional disclosures that a swap dealer should have to make 
that could mitigate the conflicts of interest?
    <bullet> When acting as both an advisor and a counterparty to a 
Special Entity, should a swap dealer have to disclose any positions it 
holds from which it may profit should the swap in question move against 
the Special Entity?
    <bullet> Should swap dealers have to disclose to a Special Entity 
the profit it expects to make on swaps it enters into with the Special 
Entity.
    <bullet> Should swap dealers be subject to an explicit fiduciary 
duty when acting as an advisor to a Special Entity?
    <bullet> Would the proposed rule preclude swap dealers from 
continuing their current practice of both recommending and entering 
into swaps with Special Entities? If so, why?
    <bullet> Should the Commission prescribe additional information 
that would be relevant to a swap dealer's ``reasonable efforts'' and 
``best interests'' duties under the proposed rule?

C. Proposed Sec.  23.450--Requirements for Swap Dealers and Major Swap 
Participants Acting as Counterparties to Special Entities

    Section 4s(h)(5) requires that swap dealers and major swap 
participants \104\ that offer swaps to or enter into swaps with Special 
Entities comply with any duty established by the Commission that 
requires them to have a reasonable basis to believe that the Special 
Entity has an independent representative that meets certain 
criteria.\105\ The Commission interprets the statute as imposing this 
duty on swap dealers and major swap participants when they are 
counterparties to any Special Entity.\106\ In making this determination 
the Commission considered staff's consultations with staff at other 
Federal regulators, stakeholders, letters from the public,\107\ as well 
as legislative history.\108\ To meet their duties under the proposed 
rule, swap dealers and major swap participants would be able to rely on 
reasonable, detailed representations of the Special Entity concerning 
the qualifications of the independent representative.\109\
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    \104\ Although the title of Section 4s(h)(5) refers only to swap 
dealers, the specific requirements in Section 4s(h)(5)(A) are 
imposed on both swap dealers and major swap participants that offer 
to or enter into a swap with a Special Entity. Accordingly, the 
Commission proposes to apply the counterparty requirements to major 
swap participants as well as to swap dealers.
    \105\ Pursuant to Section 4s(h)(7), the duty would not apply to 
transactions initiated on a DCM or SEF where the swap dealer or 
major swap participant does not know the counterparty to the 
transaction.
    \106\ The statutory language is ambiguous as to whether the duty 
is intended to apply with respect to all types of Special Entity 
counterparties, or just a sub-group. The ambiguities arise, in part, 
from the reference to subclauses (I) and (II) of Section 
1a(18)(A)(vii) of the CEA, which include certain governmental 
entities and multinational or supranational government entities. 
Yet, multinational and supranational government entities do not fall 
within the definition of Special Entity in Section 4s(h)(2)(C), and 
State agencies, which are defined as Special Entities, are not 
included in Section 1a(18)(A)(vii)(I) and (II) but are included in 
(III).
    \107\ See, e.g., Ropes & Gray Letter, at 1; ABC/CIEBA Statement 
letter, at 2; SIFMA/ISDA Letter, at 11.
    \108\ See H.R. Rep. No. 111-517, at 869 (June 29, 2010) (Conf. 
Rep.) (``When acting as counterparties to a pension fund, endowment 
fund, or state or local government, dealers are to have a reasonable 
basis to believe that the fund or governmental entity has an 
independent representative advising them.'').
    \109\ See, e.g., ABC Letter, at 4; ABC/CIEBA Letter, at 2; 
SIFMA/ISDA Letter, at 11. Stakeholders have asserted that, even if 
Congress did intend for Section 4s(h)(5)(A) to apply to non-
governmental Special Entities, it did not intend for it to apply to 
ERISA plans. Stakeholders further assert that, even if Section 
4s(h)(5)(A) applies to ERISA plans, swap dealers and major swap 
participants should only be expected to verify that the independent 
representative satisfies the criteria of Section 
4s(h)(5)(A)(i)(VII)--that the independent representative is a 
fiduciary as defined in Section 3 of ERISA (29 U.S.C. 1002)--and not 
the criteria of Section 4s(h)(5)(A)(i)(I)-(VI). They contend that 
verification of the duty under Section 4s(h)(5)(A)(i)(VII) is the 
equivalent of verification of Section 4s(h)(5)(A)(i)(I)-(VI) and 
that to require verification of all the criteria would lead to 
regulatory conflicts under ERISA and the CEA.
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1. Qualifications of the Independent Representative
    The proposed rule would require swap dealers and major swap 
participants to have a reasonable basis to believe that a Special 
Entity has a representative that satisfies the enumerated 
criteria.\110\ The proposed rule provides that relevant considerations 
would include: (1) The nature of the Special Entity-representative 
relationship; (2) the representative's capability of making hedging or 
trading decisions; (3) use of consultants or, with respect to employee 
benefit plans subject to ERISA, use of a Qualified Professional Asset 
Manager \111\ or In-House Asset Manager; \112\ (4) the representative's 
general level of experience in the financial markets and particular 
experience with the type of product under consideration; (5) the 
representative's ability to understand the economic features of the 
swap; (6) the representative's ability to evaluate how market 
developments would affect the swap; and (7) the complexity of the swap.
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    \110\ The criteria for an independent representative based 
generally on the statute and under proposed Sec.  23.450 would be: 
(1) Sufficient knowledge to evaluate the transaction and risks; (2) 
not subject to a statutory disqualification; (3) independent of the 
swap dealer or major swap participant; (4) undertakes a duty to act 
in the best interests of the Special Entity it represents; (5) makes 
appropriate and timely disclosures to the Special Entity; (6) 
evaluates, consistent with any guidelines provided by the Special 
Entity, fair pricing and the appropriateness of the swap; (7) in the 
case of employee benefit plans subject to the ERISA, is a fiduciary 
as defined in Section 3 of ERISA (29 U.S.C. 1002); and 8) in the 
case of a municipal entity as defined in proposed Sec.  23.451, 
whether the representative is subject to restrictions on certain 
political contributions imposed by the Commission, the SEC or a 
self-regulatory organization subject to the jurisdiction of the 
Commission or the SEC. Criterion 8 is not in the statutory text 
under Section 4s(h)(5)(A)(i)(I)-(VII). The Commission is proposing 
this criterion using its discretionary authority under Section 
4s(h)(5)(B).
    \111\ See DOL Prohibited Transaction Exemption (``PTE'') 84-14, 
70 FR 49305, Aug. 23, 2005.
    \112\ See DOL PTE 96-23, 61 FR 15975, Apr. 10, 1996; Proposed 
Amendment to PTE 96-23, 75 FR 33642, June 14, 2010.
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2. Statutory Disqualification
    To guide swap dealers and major swap participants, the proposed 
rule defines ``statutory disqualification'' as grounds for refusal to 
register or to revoke, condition or restrict the registration of any 
registrant or applicant for registration as set forth in Sections 8a(2) 
and 8a(3) of the CEA.
3. Independent
    Proposed Sec.  23.450(b) would require that a swap dealer or major 
swap participant ``have a reasonable basis to believe a Special Entity 
has a

[[Page 80652]]

representative that * * * is independent of the swap dealer or major 
swap participant * * * '' \113\ This formulation of the duty is 
intended to clarify that ``independent'' as it relates to a 
representative of a Special Entity means independent of the swap dealer 
or major swap participant,\114\ not independent of the Special 
Entity.\115\
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    \113\ Section 4s(h)(5)(A)(i) provides in relevant part: 
``reasonable basis to believe that the counterparty that is a 
Special Entity has an independent representative that * * * (III) is 
independent of the swap dealer or major swap participant * * *'' By 
including the word ``independent'' twice, an ambiguity was created 
as to whether the representative had to be independent of both the 
swap dealer or major swap participant and the Special Entity. The 
legislative history indicates that was not the intent of Congress. 
Thus, the proposed rule drops the first ``independent'' to clarify 
that the representative of a Special Entity only needs to be 
independent of the swap dealer or major swap participant.
    \114\ See, e.g., ABC Letter, at 6; ABC/CIEBA Letter, at 3; Ropes 
& Gray Letter, at 2; SIFMA/ISDA Letter, at 12; NFA Letter, at 6.
    \115\ See 156 Cong. Rec. S5903 (daily ed. Jul. 15, 2010) 
(statements of Sens. Lincoln and Harkin):
    Mrs. LINCOLN Our intention in imposing the independent 
representative requirement was to ensure that there was always 
someone independent of the swap dealer or the security-based swap 
dealer reviewing and approving swap or security-based swap 
transactions. However, we did not intend to require that the special 
entity hire an investment manager independent of the special entity. 
Is that your understanding, Senator Harkin?
    Mr. HARKIN. Yes, that is correct. We certainly understand that 
many special entities have internal managers that may meet the 
independent representative requirement. For example, many public 
electric and gas systems have employees whose job is to handle the 
day-to-day hedging operations of the system, and we intended to 
allow them to continue to rely on those in-house managers to 
evaluate and approve swap and security-based swap transactions, 
provided that the manager remained independent of the swap dealer or 
the security-based swap dealer and meet the other conditions of the 
provision. Similarly, the named fiduciary or in-house asset manager-
INHAM-for a pension plan may continue to approve swap and security-
based swap transactions.
---------------------------------------------------------------------------

    As to what it means for the representative to be independent of the 
swap dealer or major swap participant, the Commission's proposed rule 
provides that a representative would be deemed to be independent if: 
(1) It is not (with a one-year look back) an associated person of the 
swap dealer or major swap participant within the meaning of Section 
1a(4) of the CEA; (2) there is no ``principal'' relationship between 
the representative and the swap dealer or major swap participant within 
the meaning of Sec.  3.1(a)\116\ of the Commission's Regulations; and 
(3) the representative does not have a material business relationship 
with the swap dealer or major swap participant. However, if the 
representative received any compensation from the swap dealer or major 
swap participant within one year of an offer to enter into a swap, the 
swap dealer or major swap participant would have to ensure that the 
Special Entity is informed of the compensation and that the Special 
Entity agrees in writing, in consultation with the representative, that 
the compensation does not constitute a material business relationship 
between the representative and the swap dealer or major swap 
participant. The proposed rule defines a material business relationship 
as any relationship with a swap dealer or major swap participant, 
whether compensatory or otherwise, that reasonably could affect the 
independent judgment or decision making of the representative.
---------------------------------------------------------------------------

    \116\ 17 CFR 3.1(a).
---------------------------------------------------------------------------

4. Best Interests
    The Commission is not proposing to define what ``best interests'' 
means in this context. As the Commission explained regarding proposed 
Sec.  23.440, the scope of the duty will be related to the nature of 
the relationship between the independent representative and the Special 
Entity. There are established principles in case law which will inform 
the meaning of the term on a case-by-case basis.\117\
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    \117\ Under the CEA, a commodity trading advisor will have a 
fiduciary duty towards its customer when it offers personalized 
advice. See Savage v. CFTC, 548 F.2d 192, 194 (7th Cir. 1977); 
Commodity Trend Serv., 233 F.3d at 990 (``the party in [Savage] 
offered personalized advice and so would be considered a fiduciary 
under the common law'') (citing Capital Gains, 375 U.S. at 194). 
Under the Advisers Act, an adviser is a fiduciary whose duty is to 
serve the best interests of its clients, which includes an 
obligation not to subrogate clients' interests to its own. 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. 
``Amendments to Form ADV,'' Release No. IA-3060 (Aug. 12, 2010) 
(citing Capital Gains, 375 U.S. at 191-94). Under ERISA, ``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'' (29 U.S.C. 1104(a)(1)(A)) and 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 * * *'' (29 U.S.C. 
1104(a)(1)(B)).
---------------------------------------------------------------------------

    We would expect that, at a minimum, the swap dealer or major swap 
participant would have a reasonable basis for believing that the 
representative could assess: (1) How the proposed swap fits within the 
Special Entity's investment policy; (2) what role the particular swap 
plays in the Special Entity's portfolio; and (3) the Special Entity's 
potential exposure to losses. The swap dealer or major swap participant 
would also need to have a reasonable basis for believing that the 
representative has sufficient information to understand and assess the 
appropriateness of the swap prior to the Special Entity's entering into 
the transaction.\118\
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    \118\ The description of the duties under Section 
4s(h)(5)(A)(i)(IV) is drawn from a description of ERISA fiduciary 
obligations in connection with the use of derivatives in the 
management of a portfolio of assets of a pension plan that is 
subject to ERISA. See Letter of Olena Berg, DOL, to Honorable Eugene 
A. Ludwig, Comptroller of the Currency (March 21, 1996), available 
at, http://www.dol.gov/ebsa/programs/ori/advisory96/driv4ltr.htm.
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5. Makes Appropriate and Timely Disclosures
    The proposed rule refines the criterion under Section 
4s(h)(5)(A)(i)(V), ``appropriate disclosures,'' to mean ``appropriate 
and timely disclosures.'' A swap dealer or major swap participant would 
have to have a reasonable basis to believe that a representative makes 
appropriate and timely disclosures to the Special Entity for the 
representative to meet the requirements of the proposed rule.
6. Evaluates Fair Pricing and the Appropriateness of the Swap
    The Commission has received a number of questions regarding the 
statutory criterion in Section 4s(h)(5)(A)(i)(VI) which states that the 
representative will provide ``written representations to the Special 
Entity regarding fair pricing and the appropriateness of the 
transaction.'' \119\ The Commission's proposed rule refines the 
statutory language to say that the representative ``evaluates, 
consistent with any guidelines provided by the Special Entity, fair 
pricing and the appropriateness of the swap.'' The Commission proposes 
to allow swap dealers and major swap participants to rely on 
appropriate legal arrangements between Special Entities and their 
independent representatives in applying this criterion. For example, 
where a pension plan has a plan fiduciary that by contract has 
discretionary authority to carry out the investment guidelines of the 
plan, the swap dealer would be able to rely, absent red flags, on the 
Special Entity's representations regarding the legal obligations of the 
fiduciary. Evidence of the legal relationship between the plan and its 
fiduciary would enable the swap dealer or major swap participant to 
conclude that the fiduciary is evaluating fair pricing and the 
appropriateness of all transactions prior to entering into such 
transactions on behalf of the plan. To comply with this criterion, the 
swap dealer or major swap participant should also have a reasonable 
basis to believe that the

[[Page 80653]]

independent representative is documenting its decisions about 
appropriateness and pricing of all swap transactions and that such 
documentation is being retained in accordance with any regulatory 
requirements that might apply to the independent representative.\120\ 
This approach would apply to in-house independent representatives as 
well.
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    \119\ See, e.g., ABC Letter, at 8; SFG Letter, at 1.
    \120\ For example, CTAs are required to maintain books and 
records for 5 years pursuant to Sec.  1.31 of the Commission's 
regulations. (17 CFR 1.31).
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7. ERISA Fiduciary
    The proposed rule tracks the statutory language that in the case of 
employee benefit plans subject to ERISA, the independent representative 
is a fiduciary as defined in Section 3 of that Act.\121\ Certain ERISA 
plans, fiduciaries and their trade associations, have urged the 
Commission to interpret the statute to mean that the independent 
representative of a plan subject to ERISA would not have to satisfy the 
additional criteria in Section 4s(h)(5)(A)(i)(I)-(VI), because such 
criteria would be duplicative of or inconsistent with ERISA 
requirements.\122\ After consultations with DOL staff, the Commission 
is inclined, at this time, to treat ERISA fiduciaries like other 
independent representatives of Special Entities with respect to the 
criteria in Section 4s(h)(5)(A)(i)(I)-(VI). The Commission would expect 
that such ERISA fiduciaries and plans would be able to provide adequate 
representations to swap dealers and major swap participants to meet the 
additional criteria without incurring significant costs. The Commission 
seeks further comment from interested parties as to this approach, 
particularly with respect to whether the additional criteria, as 
proposed in the rule, are inconsistent in any way with the requirements 
under ERISA.
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    \121\ 29 U.S.C. 1002.
    \122\  See, e.g., ABC Letter, at 4-5; ABC/CIEBA Letter, at 2-5.
---------------------------------------------------------------------------

8. Restrictions on Political Contributions by Independent 
Representative of a Municipal Entity
    As part of the process of determining the qualifications of an 
independent representative of a Special Entity that is a municipal 
entity,\123\ the Commission proposes \124\ to require swap dealers and 
major swap participants to ensure that the independent representative 
is subject to restrictions on certain political contributions, known as 
``pay-to-play'' rules.\125\ The requirement would not apply to in-house 
independent representatives of a municipal entity.\126\
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    \123\ Proposed Sec.  23.451.
    \124\ The Commission proposes this requirement pursuant to its 
discretionary authority in Section 4s(h) of the CEA, including in 
particular Section 4s(h)(5)(B).
    \125\ See, e.g., SEC Rule 206(4)-5 under the Advisers Act (17 
CFR 275.206(4)-5); MSRB Rule G-37: Political Contributions and 
Prohibitions on Municipal Securities Business. The Commission 
proposes to impose comparable requirements on swap dealers and major 
swap participants that act as advisors or counterparties to Special 
Entities. See proposed Sec.  23.432. In a separate release, the 
Commission will also propose comparable requirements on registered 
commodity trading advisors when they advise municipal entities.
    \126\ The definition of ``municipal advisor'' in Section 15B of 
the Exchange Act (15 U.S.C. 78o-4) excludes employees of a municipal 
entity.
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9. Unqualified Independent Representative
    Some stakeholders have expressed concern that the independent 
representative requirement places undue influence in the hands of the 
swap dealer or major swap participant by allowing it to use Section 
4s(h)(5)(A)(i) to control who qualifies as an independent 
representative.\127\ Thus, the proposed rule also provides that, if a 
swap dealer or major swap participant were to determine that the 
independent representative of a Special Entity did not meet the 
criteria established in this provision, the swap dealer or major swap 
participant would be required to make a written record of the basis for 
such determination and submit such determination to its Chief 
Compliance Officer for review to ensure that the swap dealer or major 
swap participant had a substantial, unbiased basis for the 
determination.
---------------------------------------------------------------------------

    \127\ E.g., ABC Letter, at 8.
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10. Disclosure of Capacity
    Section 4s(h)(5)(A)(ii) requires swap dealers and major swap 
participants to disclose in writing to Special Entities the capacity in 
which they are acting before initiation of a swap transaction. The 
Commission proposes to adopt the statutory standard in a rule, and to 
require that, if a swap dealer or major swap participant were to engage 
in business with the Special Entity in more than one capacity, the swap 
dealer or major swap participant would have to disclose the material 
differences between the capacities. This would apply, for example, when 
the swap dealer acts both as an advisor and as a counterparty to the 
Special Entity, or when firms act both as underwriters in a bond 
offering and as counterparties in swaps used to hedge such financing. 
In these circumstances, the swap dealers' or major swap participants' 
duties to the Special Entities would vary depending on the capacities 
in which they are operating.
11. Inapplicability
    Proposed Sec.  23.450 would not apply with respect to a swap that 
is initiated on a DCM or SEF where the swap dealer or major swap 
participant does not know the Special Entity's identity.
    Request for Comment: The Commission requests comment generally on 
all of the proposed rules regarding swap dealers and major swap 
participants that act as counterparties to Special Entities, and on the 
following specific issues:
    <bullet> Should the rule clarify the statutory language to give 
more guidance to the criteria in Section 4s(h)(5)(A)(i)(I)-(VI)? If, 
yes, how?
    <bullet> Are there any specific qualifications that should be 
considered in forming a reasonable basis regarding whether the 
independent representative has sufficient knowledge to evaluate the 
transaction and risks?
    <bullet> Should the criterion in Section 4s(h)(5)(A)(i)(VII) be the 
only criterion that applies to employee benefit plans subject to ERISA? 
Why or why not? Are the criteria in Section 4s(h)(5)(A)(i)(I)-(VI) 
inconsistent with a fiduciary's duties under ERISA? Do the criteria in 
Section 4s(h)(5)(A)(i)(I)-(VI) add any protections for plans subject to 
ERISA that are not otherwise provided under ERISA?
    <bullet> To resolve the ambiguity in the statutory text referenced 
in footnote 106, should the rule be limited to certain types of Special 
Entities? Why or why not? Which types should be included or excluded 
from coverage under the proposed rule?
    <bullet> Should the rule define what it means for the independent 
representative to be independent of the swap dealer or major swap 
participant? If yes, should independence be measured in relation to 
ownership and control, material business relationships, or another 
measure? Should any ``independence'' test apply to employees of the 
independent representative, as well as to the representative, itself?
    <bullet> Should the Commission specify a de minimis threshold below 
wh ich an independent representative will not be deemed to have a 
material business relationship with the swap dealer or major swap 
participant? If so, what would be an appropriate threshold?

D. Proposed Sec.  23.451--Political Contributions by Certain Swap 
Dealers and Major Swap Participants

    Using its discretionary rulemaking authority under Section 4s(h) to 
impose business conduct requirements in the

[[Page 80654]]

public interest,\128\ the Commission is proposing to prohibit swap 
dealers and major swap participants from entering into swaps with 
``municipal entities'' if they make certain political contributions to 
officials of such entities.\129\ The proposed rule is intended to 
complement existing pay-to-play prohibitions imposed by Federal 
securities regulators to deter undue influence and other fraudulent 
practices that harm the public. The Commission's proposed rule would 
promote consistency in the business conduct standards that apply to 
financial market professionals dealing with municipal entities.
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    \128\ Section 4s(h)(5)(B).
    \129\ See proposed Sec.  23.451(a)(3). The proposed definition 
of ``municipal entity'' is based on Exchange Act Section 15B(e)(8) 
(15 U.S.C. 78o-4(e)(8)) and means any State, political subdivision 
of a State, or municipal corporate instrumentality of a State, 
including--
    (A) Any agency, authority, or instrumentality of the State, 
political subdivision, or municipal corporate instrumentality;
    (B) Any plan, program, or pool of assets sponsored or 
established by the State, political subdivision, or municipal 
corporate instrumentality or any agency, authority, or 
instrumentality thereof; and
    (C) Any other issuer of municipal securities.
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    The existing restrictions on pay-to-play practices are contained in 
SEC Rule 206(4)-5 under the Investment Advisers Act of 1940,\130\ which 
prohibits certain political contributions by investment advisers 
providing or seeking to provide investment advisory services to public 
pension plans and other government investors,\131\ and under the 
Municipal Securities Rule Making Board (``MSRB'') Rules G-37 and G-
38,\132\ which impose pay-to-play restrictions on municipal securities 
dealers and broker-dealers engaging or seeking to engage in the 
municipal securities business. The proposed rule is intended to deter 
swap dealers and major swap participants from engaging in pay-to-play 
practices.
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    \130\ 17 CFR 275.206(4)-5 (``SEC Advisers Act Rule 206(4)-5'').
    \131\ See ``Political Contributions by Certain Investment 
Advisers,'' Release No. IA-3043 (Jul. 1, 2010), 75 FR 41018, Jul. 
14, 2010 (adopting a rule that prohibits certain political 
contributions by investment advisers providing or seeking to provide 
investment advisory services to public pension plans and other 
government investors).
    \132\ See MSRB Rule G-37, Political Contributions and 
Prohibitions on Municipal Securities Business; MSRB Rule G-38, 
Solicitation of Municipal Securities Business.
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1. Prohibitions
    Proposed Sec.  23.451, generally, would make it unlawful for a swap 
dealer or major swap participant to offer to enter or to enter into a 
swap with a municipal entity for a two-year period after the swap 
dealer or major swap participant or any of its covered associates makes 
a contribution to an official of the municipal entity. The proposed 
rule also would prohibit a swap dealer or major swap participant from 
paying a third-party to solicit municipal entities to enter into a 
swap, unless the third-party is a ``regulated person'' that is itself 
subject to a pay-to-play restriction under applicable law.\133\ The 
proposed rule also would ban a swap dealer or major swap participant 
from soliciting or coordinating contributions to an official of a 
municipal entity with which the swap dealer or major swap participant 
is seeking to enter into, or has entered into a swap, or payments to a 
political party of a state or locality with which the swap dealer or 
major swap participant is seeking to enter into, or has entered into a 
swap. These proposed prohibitions are similar to those contained in SEC 
Advisers Act Rule 206(4)-5 and MSRB Rules G-37 and G-38.
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    \133\ The Commission is proposing to define ``regulated 
person,'' for purposes of the rule, to mean generally a person that 
is subject to rules of the SEC, the MSRB, a self-regulatory 
organization, or the Commission prohibiting it from engaging in 
specified activities if certain political contributions have been 
made, or its officers or employees.
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    The proposed rule also includes a provision that would make it 
unlawful for a swap dealer or major swap participant to do indirectly 
or through another person or means anything that would, if done 
directly, result in a violation of the prohibitions contained in the 
proposed rule.
a. Two-Year ``Time Out''
    The proposed rule would prohibit swap dealers and major swap 
participants from offering to enter into or entering into a swap with a 
municipal entity within two years after a contribution to an official 
of such municipal entity was made by the swap dealer or major swap 
participant or any of its covered associates. The two-year time out is 
consistent with the time out provisions contained in SEC Advisers Act 
Rule 206(4)-5 and MSRB Rule G-37.
b. Covered Associates
    Political contributions made to influence the firm selection 
process are typically made not by the firm itself, but by officers and 
employees of the firm who have a stake in the business relationship 
with the municipal client. For this reason, contributions by such 
persons, which the rule defines as ``covered associates,'' would 
trigger the two-year time out. A ``covered associate'' of a swap dealer 
or major swap participant is defined as (i) any general partner, 
managing member or executive officer, or other individual with a 
similar status or function; (ii) any employee who solicits a municipal 
entity for the swap dealer or major swap participant and any person who 
supervises, directly or indirectly, such employee; and (iii) any 
political action committee controlled by the swap dealer or major swap 
participant or any of its covered associates. This definition mirrors a 
similar provision in SEC Advisers Act Rule 206(4)-5.
    Because the proposed rule attributes to a firm contributions made 
by a person even prior to becoming a covered associate of the firm, 
swap dealers and major swap participants must ``look back'' in time to 
determine whether the time out applies when an employee becomes a 
covered associate. For example, if the contribution was made less than 
two years (or six months, as applicable) before an individual becomes a 
covered associate, the proposed rule would prohibit the firm from 
entering into a swap with the relevant municipal entity until the two-
year time out period has expired.
2. Exceptions
a. De Minimis Contributions
    The proposed rule would permit 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 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. The Commission believes this two-tiered de minimis approach is 
reasonable because of the more remote interest an individual is likely 
to have in contributing to a person for whom such individual is not 
entitled to vote. This provision is similar to the one contained in SEC 
Advisers Act Rule 206(4)-5.
b. New Covered Associates
    The prohibitions of the proposed rule would not apply to 
contributions by an individual made more than six months prior to 
becoming a covered associate of the swap dealer or major swap 
participant, unless such individual solicits the municipal entity after 
becoming a covered associate.
c. Exchange and SEF Transactions
    The prohibitions of the proposed rule would not apply to a swap 
that is initiated on a DCM or SEF, for which the swap dealer or major 
swap participant does not know the identity of the counterparty.

[[Page 80655]]

3. Exemptions
    A swap dealer or major swap participant would be exempt from the 
prohibitions of the proposed rule where the contribution that was made 
by a covered associate did not exceed $150 or $350, as applicable, was 
discovered by the swap dealer or major swap participant within four 
months of the date of contribution, and was returned to the contributor 
within 60 calendar days of the date of discovery. This automatic 
exemption mirrors similar provisions contained in SEC Advisers Act Rule 
206(4)-5 and MSRB Rule G-37.
    In addition, the Commission proposes a provision under which a swap 
dealer or major swap participant 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 CEA; (ii) whether the swap dealer or major swap 
participant, before the contribution resulting in a prohibition was 
made, had adopted and implemented policies and procedures reasonably 
designed to prevent violations of the proposed rule, prior to or at the 
time of the contribution, had any actual knowledge of the contribution, 
and, after learning of the contribution, has 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 
swap dealer or major swap participant, or was seeking such employment; 
(iv) the timing and amount of the contribution; (v) the nature of the 
election (e.g., Federal, 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.\134\ This exemption is 
similar to automatic exemption provisions contained in SEC Rule 206(4)-
5 and MSRB Rule G-37.
---------------------------------------------------------------------------

    \134\ Proposed Sec.  23.451(d).
---------------------------------------------------------------------------

    Request for Comment: The Commission requests comments generally on 
the proposed rules regarding restrictions on certain political 
contributions by swap dealers and major swap participants and the 
following specific issues:
    <bullet> Is the term ``municipal entity'' appropriately defined? If 
not, should the Commission refer to ``a State, State agency, city, 
county, municipality, or other political subdivision of a State, or any 
governmental plan, as defined in Section 3 of [ERISA] (29 U.S.C. 
1002)'' within the meaning of Section 4s(h)(2)(C)? Should the 
Commission use the definition of ``government entity'' from SEC 
Advisers Act Rule 206(4)-5? \135\ Should the Commission instead follow 
the approach of MSRB Rule G-37? \136\
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    \135\ As used in SEC Advisers Act Rule 206(4)-5(f)(5) (17 CFR 
275.206(4)-5(f)(5)), the term ``government entity'' means any State 
or political subdivision of a State, including:
    (i) Any agency, authority, or instrumentality of the State or 
political subdivision;
    (ii) A pool of assets sponsored or established by the State or 
political subdivision or any agency, authority or instrumentality 
thereof, including, but not limited to a ``defined benefit plan'' as 
defined in section 414(j) of the Internal Revenue Code (26 U.S.C. 
414(j)), or a State general fund;
    (iii) A plan or program of a government entity; and
    (iv) Officers, agents, or employees of the State or political 
subdivision or any agency, authority or instrumentality thereof, 
acting in their official capacity.
    \136\ MSRB Rule G-37(g)(ii) references ``the governmental issuer 
specified in section 3(a)(29) of the [Exchange] Act'' which includes 
``a State or any political subdivision thereof, or any agency or 
instrumentality of a State or any political subdivision thereof, or 
any municipal corporate instrumentality of one more States * * *'' 
(15 U.S.C. 78c(29)).
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    <bullet> Should the proposed rule apply not to all swap dealers and 
major swap participants, but instead to only swap dealers? If so, why?

IV. Request for Comment

A. Generally

    The Commission requests comment on all aspects of the proposed 
rules. In addition, the Commission seeks comment on the following 
specific issues:
    <bullet> Should any proposed requirements be modified or deemed 
satisfied with respect to swaps that are traded and/or cleared on a 
registered entity? If so, which requirements should be modified or 
deemed satisfied, and why?
    <bullet> Should the Commission use its discretionary authority, 
where applicable, to distinguish among swap dealers depending on their 
size and the nature of their business? If so, under what circumstances 
and how?
    <bullet> Should any additional business conduct requirements be 
imposed on swap dealers and/or major swap participants? If so, which 
requirements should be imposed, and why?
    <bullet> Should the Commission delay the effective date of any of 
the proposed requirements to allow additional time to comply with the 
requirements? If so, which requirements, and what is the compliance 
burden that should merit a delay?

B. Consistency With SEC Approach

    The SEC is proposing rules related to business conduct standards 
for swap dealers and major swap participants as required under Section 
764 of the Dodd-Frank Act. Understanding that the Commission and the 
SEC regulate different products and markets and thus, appropriately may 
be proposing alternative regulatory requirements, we request comments 
generally on the impact of any differences between the Commission and 
SEC approaches to business conduct regulation in this area.
    <bullet> Do the regulatory approaches proposed by the Commission 
and the SEC result in duplicative or inconsistent business conduct 
standards for market participants subject to both regulatory regimes? 
Do the approaches result in gaps or different levels of regulation 
between those regimes? If so, in what ways do commenters believe that 
such duplication, inconsistencies, or gaps should be minimized?
    <bullet> Do commenters believe there are ways that would make the 
approaches more consistent?

V. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA)\137\ requires that agencies 
consider whether the rules they propose will have a significant 
economic impact on a substantial number of small entities and, if so, 
provide a regulatory flexibility analysis respecting the impact.\138\ 
The business conduct rules proposed by the Commission generally will 
affect swap dealers and major swap participants. Prior to Dodd-Frank, 
the Commission did not have jurisdiction over swaps, swap dealers and 
major swap participants. Thus, the Commission has not previously 
addressed the question of whether swap dealers and major swap 
participants are, in fact, ``small entities'' for purposes of the RFA.
---------------------------------------------------------------------------

    \137\ 5 U.S.C. 601 et seq.
    \138\ Id.
---------------------------------------------------------------------------

    However, the Commission has previously established certain 
definitions for small entities to be used by the Commission in 
evaluating the impact of its regulations on small entities in 
accordance with the RFA.\139\ For example, the Commission has 
previously determined that futures commission merchants (``FCMs'') are 
not small entities for the purpose of the

[[Page 80656]]

RFA\140\ based upon, among other things, the requirements that FCMs 
meet certain minimum financial requirements that enhance the protection 
of customers' segregated funds and protect the financial condition of 
FCMs generally. The analogy to FCMs is appropriate in that we 
anticipate that swap dealers and major swap participants may have to 
register as FCMs depending on the nature of their business. Moreover, 
swap dealers and major swap participants will be subject to minimum 
capital and margin requirements, and are expected to comprise the 
largest global financial firms. Entities that engage in a de minimis 
quantity of swap dealing in connection with transactions with or on 
behalf of customers are exempt from the definition of swap dealers and 
major swap participants. Accordingly, the Commission is hereby 
determining that swap dealers and major swap participants not be 
considered to be ``small entities'' for essentially the same reasons 
that FCMs have previously been determined not to be small entities.
---------------------------------------------------------------------------

    \139\ 47 FR 18618, Apr. 30, 1982.
    \140\ Id. at 18619.
---------------------------------------------------------------------------

    Similarly, the Commission has also previously determined that large 
traders are not ``small entities'' for RFA purposes.\141\ The 
Commission considered the size of a trader's position to be the only 
appropriate test for purposes of large trader reporting.\142\ Major 
swap participants maintain substantial positions in swaps, creating 
substantial counterparty exposure that could have serious adverse 
effects on the financial stability of the United States banking system 
or financial markets. Accordingly, the Commission is hereby determining 
that major swap participants not be considered ``small entities'' for 
essentially the same reasons that large traders have previously been 
determined not to be small entities. Therefore, the Chairman, on behalf 
of the Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that 
the proposed rules will not have a significant economic impact on a 
substantial number of small entities.
---------------------------------------------------------------------------

    \141\ Id. at 18620.
    \142\ Id.
---------------------------------------------------------------------------

B. Paperwork Reduction Act

    The Paperwork Reduction Act (``PRA'') provides that an agency may 
not conduct or sponsor, and a person is not required to respond to, a 
collection of information unless it displays a currently valid control 
number from the Office of Management and Budget (``OMB''). \143\
---------------------------------------------------------------------------

    \143\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    This rulemaking contains collections of information, notably the 
proposed rules that will require swap dealers and major swap 
participants to make records, document processes, and make disclosures 
to counterparties with whom they propose to enter into swaps. OMB has 
not yet assigned a control number to the new collections. OMB has not 
yet assigned a control number to the new collection.
    The collections of information contained herein overlap the 
requirements that are being proposed by the Commission in other 
rulemakings implementing the Dodd-Frank Act. The Commission is seeking 
or will seek control numbers from OMB for these collections in 
association with the other rulemakings. The other proposed rulemakings 
are being issued contemporaneously within the CFTC's Business Conduct 
Standard-Internal related rulemakings\144\ implementing the Dodd-Frank 
Act. The Commission invites public comment on the accuracy of its 
estimate that no additional recordkeeping or information collection 
requirements or changes to existing collection requirements would 
result from the rules proposed herein.
---------------------------------------------------------------------------

    \144\ The Business Conduct Standard-Internal Rulemakings are: 
Regulations Establishing and Governing the Duties of Swap Dealers 
and Major Swap Participants, 75 FR 71397, Nov. 23, 2010; Designation 
of a Chief Compliance Officer, Required Compliance Policies, and 
Annual Report of a Futures Commission Merchant, Swap Dealer, Major 
Swap Participant, 75 FR 70881, Nov. 19, 2010; and Implementation of 
Conflict-of-Interest Standards by Swap Dealers and Major Swap 
Participants, 75 FR 71391, Nov. 23, 2010. In addition, the 
Commission will be issuing proposed rules regarding recordkeeping, 
reporting and daily trading records for swap transactions consistent 
with Sec.  1.31 of the Commission's Regulations. (17 CFR Sec.  
1.31).
---------------------------------------------------------------------------

C. Cost-Benefit Analysis

    Section 15(a) of the CEA requires the Commission to consider the 
costs and benefits of its actions before issuing a rulemaking under the 
CEA. By its terms, Section 15(a) does not require the Commission to 
quantify the costs and benefits of an order or to determine whether the 
benefits of the order outweigh its costs; rather, it requires that the 
Commission ``consider'' the costs and benefits of its actions. Section 
15(a) further specifies that the costs and benefits shall be evaluated 
in light of five broad areas of market and public concern: (1) 
Protection of market participants and the public; (2) efficiency, 
competitiveness and financial integrity of futures markets; (3) price 
discovery; (4) sound risk management practices; and (5) other public 
interest considerations. The Commission may in its discretion give 
greater weight to any one of the five enumerated areas and could in its 
discretion determine that, notwithstanding its costs, a particular 
order is necessary or appropriate to protect the public interest or to 
effectuate any of the provisions or accomplish any of the purposes of 
the CEA.
    Summary of proposed requirements. The proposed regulations would 
implement Section 4s(h) which requires the Commission to promulgate 
rules to establish business conduct standards for swap dealers and 
major swap participants governing their relationships with 
counterparties including special requirements with respect to Special 
Entities. Among other things, the statute mandates that the Commission 
adopt rules requiring swap dealers and major swap participants to 
verify that counterparties meet eligibility criteria, disclose material 
information about the contemplated swaps to counterparties, including 
material risks, characteristics, incentives and conflicts of interest; 
and an ongoing duty to provide counterparties a daily mark for swaps. 
The Commission also is directed to establish a duty for swap dealers 
and major swap participants to communicate in a fair and balanced 
manner based on principles of fair dealing and good faith.
    Costs. The Commission's proposed rules implement new Section 4s(h) 
and enhance transparency, protect counterparties from fraud and abuse, 
bolster confidence in markets, reduce risk, and allow regulators to 
better monitor and manage our financial system. With respect to 
efficiency, the Commission has determined that adhering to the new 
requirements under the proposed rules will not be unduly burdensome for 
swap dealers and major swap participants. Indeed, the proposed rules, 
in part, reflect existing regulatory requirements in other markets as 
well as current industry practices in the swaps market.\145\ In 
addition, the Commission has determined that the cost to market 
participants and the public if these rules are not adopted could be 
substantial. Significantly, without these rules to promote transparency 
and fair dealing, the financial integrity and stability of the swaps 
markets could be undermined.
---------------------------------------------------------------------------

    \145\ See, e.g., Trading & Capital-Markets Activities Manual, 
Section 2150; CRMPG III Report.
---------------------------------------------------------------------------

    Benefits. With respect to benefits, the Commission has determined 
that the proposed regulations would require a swap dealer or major swap 
participant to transact with market participants according to the 
principles of fair

[[Page 80657]]

dealing and good faith in a manner intended to heighten the protection 
of market participants and the public. The additional protections for 
Special Entities reduces the overall risk to institutions critical to 
the public interest and the stability of the financial system by 
providing tools and safeguards to market participants in order to 
accurately assess risk, make informed decisions, and avoid crises. The 
proposed rules, if adopted, will result in greater certainty, reduced 
risk, increased transparency and market integrity in the swap market. 
Therefore, the Commission believes it is prudent to issue these 
business conduct requirements for swap dealers and major swap 
participants.
    The Commission invites public comment on its cost-benefit 
considerations. Commenters are also are invited to submit any data or 
other information that they may have quantifying or qualifying the 
costs and benefits of the proposed regulations with their comment 
letters.

List of Subjects in 17 CFR Part 23

    Antitrust, Commodity futures, Business conduct standards, Conflict 
of Interests, Counterparties, Information, Major swap participants, 
Registration, Reporting and recordkeeping, Special entities, Swap 
dealers, Swaps.

List of Subjects in 17 CFR Part 155

    Brokers, Commodity futures, Consumer protection, Reporting and 
recordkeeping requirements, Swaps.

    For the reasons presented above, the Commodity Futures Trading 
Commission proposes to amend part 23 (as proposed to be added by FR Doc 
2010-29024, published on November 23, 2010, 75 FR 71379) and part 155 
of Title 17 of the Code of Federal Regulations as follows:

PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS

Authority and Issuance

    1. The authority citation for part 23 shall be revised to read as 
follows:

    Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6c, 6p, 6s, 9, 9a, 12a, 
13b, 13c, 16a, 18, 19, 21 as amended by Title VII of the Dodd-Frank 
Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 
124 Stat. 1376 (Jul. 21, 2010).

    2. Add subpart H to read as follows:

Subpart H--Business Conduct Standards for Swap Dealers and Major 
Swap Participants Dealing With Counterparties, Including Special 
Entities

Sec.
23.400 Scope.
23.401 Definitions.
23.402 General provisions.
23.403-23.409 [Reserved]
23.410 Prohibition on fraud, manipulation and other abusive 
practices.
23.411-23.429 [Reserved]
23.430 Verification of counterparty eligibility.
23.431 Disclosures of material information.
23.432 Clearing.
23.433 Communications--fair dealing.
23.434 Recommendations to counterparties--institutional suitability.
23.435-23.439 [Reserved]
23.440 Requirements for swap dealers acting as advisors to special 
entities.
23.441-23.449 [Reserved]
23.450 Requirements for swap dealers and major swap participants 
acting as counterparties to special entities.
23.451 Political contributions by certain swap dealers and major 
swap participants.


Sec.  23.400  Scope.

    (a) Scope. The sections of this subpart shall apply to swap dealers 
and major swap participants. These rules are not intended to limit, or 
restrict the applicability of other provisions of the Act, and rules 
and regulations thereunder, or other applicable laws, rules and 
regulations. The provisions of this subpart shall apply in connection 
with transactions in swaps as well as in connection with swaps that are 
offered but not entered into.


Sec.  23.401  Definitions.

    Counterparty. The term ``counterparty,'' as appropriate in this 
subpart, includes any person who is a prospective counterparty to a 
swap.
    Major swap participant. The term ``major swap participant'' means 
any person defined in Section 1a(33) of the Act and Sec.  1.33(bbb) of 
this chapter and, as appropriate in this subpart, any person acting for 
or on behalf of a major swap participant, including an associated 
person defined in Section 1a(4) of the Act.
    Special Entity. The term Special Entity means:
    (1) A Federal agency;
    (2) A State, State agency, city, county, municipality, or other 
political subdivision of a State or;
    (3) Any employee benefit plan, as defined in Section 3 of the 
Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002);
    (4) Any governmental plan, as defined in Section 3 of the Employee 
Retirement Income Security Act of 1974 (29 U.S.C. 1002); or
    (5) Any endowment, including an endowment that is an organization 
described in Section 501(c)(3) of the Internal Revenue Code of 1986 (26 
U.S.C. 501(c)(3)).
    Swap dealer. The term ``swap dealer'' means any person defined in 
Section 1a(49) of the Act and Sec.  1.3(aaa) of this chapter and, as 
appropriate in this subpart, any person acting for or on behalf of a 
swap dealer, including an associated person defined in Section 1a(4) of 
the Act.


Sec.  23.402  General provisions.

    (a) Policies and Procedures to Ensure Compliance and Prevent 
Evasion of the Requirements of this Subpart.
    (1) Swap dealers and major swap participants shall have policies 
and procedures reasonably designed to:
    (i) Ensure compliance with the requirements of this subpart; and
    (ii) Prevent a swap dealer or major swap participant from evading 
or participating in or facilitating an evasion of any provision of the 
Act or any regulation promulgated thereunder.
    (2) Swap dealers and major swap participants shall implement and 
monitor compliance with such policies and procedures as part of their 
supervision and risk management requirements specified in subpart J of 
this part.
    (b) Diligent Supervision. Swap dealers and major swap participants 
shall diligently supervise their compliance with the requirements of 
this subpart in accordance with the diligent supervision requirements 
of subpart J of this part.
    (c) Know your counterparty. Each swap dealer or major swap 
participant shall use reasonable due diligence to know and retain a 
record of the essential facts concerning each counterparty and the 
authority of any person acting for such counterparty, including facts 
necessary to:
    (1) Comply with applicable laws, regulations and rules;
    (2) Effectively service the counterparty;
    (3) Implement any special instructions from the counterparty; and
    (4) Evaluate the previous swaps experience, financial wherewithal 
and flexibility, trading objectives and purposes of the counterparty.
    (d) True name and owner. Each swap dealer or major swap participant 
shall keep a record which shall show the true name and address of each 
counterparty, the principal occupation or business of such counterparty 
as well as the name and address of any other person

[[Page 80658]]

guaranteeing the performance of such counterparty and any person 
exercising any control with respect to the positions of such 
counterparty.
    (e) Reasonable Reliance on Representations. A swap dealer or major 
swap participant that seeks to rely on the written representations of a 
counterparty with respect to any requirements under this subpart must 
have a reasonable basis to believe that the representations are 
reliable taking into consideration the facts and circumstances of the 
particular relationship, assessed in the context of the particular 
transaction. The representations shall include information sufficiently 
detailed for the swap dealer or major swap participant reasonably to 
conclude that the relevant requirement is satisfied. If agreed to by 
the counterparties, such representations may be contained in a master 
or other written agreement between the counterparties and may satisfy 
the relevant requirements of this subpart for subsequent swaps offered 
to or entered into with a counterparty, unless the representations are 
inadequate to meet the requirements of this subpart with respect to any 
subsequent swap.
    (f) Manner of disclosure. A swap dealer or major swap participant 
may provide the information required by this subpart by any reliable 
means agreed to in writing by the counterparty.
    (g) Disclosures in a standard format. If agreed to by a 
counterparty, the disclosure of material information that is applicable 
to multiple swaps between a swap dealer or major swap participant and a 
counterparty, may be made in a standard format, including in a master 
or other written agreement between the counterparties.
    (h) Record Retention. Swap dealers and major swap participants 
shall create a record of their compliance with the requirements in this 
subpart and shall retain such records in accordance with subpart F of 
this part and Sec.  1.31 of this chapter and make them available to 
applicable prudential regulators, upon request.


Sec. Sec.  23.403-23.409  [Reserved]


Sec.  23.410  Prohibition on fraud, manipulation and other abusive 
practices.

    (a) It shall be unlawful for a swap dealer or major swap 
participant-
    (1) To employ any device, scheme, or artifice to defraud any 
Special Entity or prospective customer who is a Special Entity;
    (2) To engage in any transaction, practice, or course of business 
that operates as a fraud or deceit on any Special Entity or prospective 
customer who is a Special Entity; or
    (3) To engage in any act, practice, or course of business that is 
fraudulent, deceptive, or manipulative.
    (b) Confidential treatment of counterparty information. It shall be 
unlawful for any swap dealer or major swap participant to disclose to 
any other person any material confidential information obtained from a 
counterparty, unless such disclosure is necessary for the effective 
execution of any swap for or with the counterparty or to hedge any 
exposure created by such swap, and the counterparty specifically 
consents to such disclosure, or such disclosure is made upon request of 
the Commission, Department of Justice or an applicable prudential 
regulator.
    (c) Trading ahead and front running prohibited. It shall be 
unlawful for any swap dealer or major swap participant knowingly to 
enter into a transaction for its own benefit ahead of:
    (1) Any executable order for a swap received from a counterparty, 
or
    (2) Any swap that is the subject of negotiation with a 
counterparty, unless the counterparty specifically consents to the 
prior execution of such swap transaction.


Sec. Sec.  23.411-23.429  [Reserved]


Sec.  23.430  Verification of counterparty eligibility.

    (a) Eligibility. A swap dealer or major swap participant shall 
verify that a counterparty meets the eligibility standards for an 
eligible contract participant, as defined in Section 1a(18) of the Act 
and Sec.  1.3(m) of this chapter, before offering to enter into or 
entering into a swap with that counterparty.
    (b) Special Entity. In verifying the eligibility of a counterparty 
pursuant to paragraph (a) of this section, a swap dealer or major swap 
participant shall also verify whether the counterparty is a Special 
Entity.
    (c) This section shall not apply with respect to a transaction that 
is:
    (1) Initiated on a swap execution facility; and
    (2) One in which the swap dealer or major swap participant does not 
know the identity of the counterparty to the transaction.


Sec.  23.431  Disclosures of material information.

    (a) At a reasonably sufficient time prior to entering into a swap, 
a swap dealer or major swap participant shall disclose to any 
counterparty to the swap (other than a swap dealer, major swap 
participant, security-based swap dealer or major security-based swap 
participant) material information concerning the swap in a manner 
reasonably designed to allow the counterparty to assess-
    (1) The material risks of the particular swap, which may include, 
market, credit, liquidity, foreign currency, legal, operational, and 
any other applicable risks. In addition to the disclosures of material 
risks required in paragraph (a) of this section:
    (i) Prior to entering into a bilateral swap that is not available 
for trading on a designated contract market or swap execution facility, 
swap dealers and major swap participants shall notify the counterparty 
that it can request a scenario analysis as provided in paragraph (a)(1) 
of this section. Swap dealers and major swap participants shall, upon 
request of such counterparty, provide such scenario analysis.
    (ii) For a high-risk complex bilateral swap with a counterparty, a 
swap dealer or major swap participant shall provide a scenario analysis 
designed in consultation with the counterparty to allow the 
counterparty to assess its potential exposure in connection with the 
swap. The scenario analysis shall be done over a range of assumptions, 
including severe downside stress scenarios that would result in a 
significant loss.
    (iii) For the purposes of paragraph (a)(1)(ii) of this section, a 
swap dealer or major swap participant shall use reasonable policies and 
procedures to determine whether a bilateral swap is a high-risk complex 
swap based on the material characteristics of the swap including, but 
not limited to, one or more of the following criteria:
    (A) The degree and nature of leverage;
    (B) The potential for periods of significantly reduced liquidity; 
and
    (C) The lack of price transparency.
    (iv) The scenario analysis required by paragraphs (a)(1)(i) and 
(a)(1)(ii) of this section shall be provided by the swap dealer or 
major swap participant in both tabular and narrative formats. The swap 
dealer or major swap participant shall disclose all material 
assumptions and explain the calculation methodologies used to perform 
the required analysis; provided that, the swap dealer or major swap 
participant is not required to disclose confidential, proprietary 
information about any model it may use to value the swap.
    (v) In designing the scenario analysis required by paragraphs 
(a)(1)(i) and (a)(1)(ii) of this section, a swap dealer or major swap 
participant shall consider any relevant analyses that it undertakes for 
its own risk management purposes, including analyses performed as part 
of its ``New Product Policy'' specified in Sec.  23.600(c)(3);

[[Page 80659]]

    (2) The material characteristics of the particular swap, which 
shall include the material economic terms of the swap, the terms 
relating to the operation of the swap and the rights and obligations of 
the parties during the term of the swap; and
    (3) The material incentives and conflicts of interest that the swap 
dealer or major swap participant may have in connection with the 
particular swap, which shall include:
    (i) With respect to disclosure of the price of a swap, the price of 
the swap and the mid-market value of the swap as defined in paragraph 
(c)(2) of this section; and
    (ii) Any compensation or other incentive from any source other than 
the counterparty that the swap dealer or major swap participant may 
receive in connection with the swap.
    (b) Paragraph (a) of this section shall not apply with respect to a 
transaction that is:
    (1) Initiated on a designated contract market or a swap execution 
facility; and
    (2) One in which the swap dealer or major swap participant does not 
know the identity of the counterparty to the transaction.
    (c) Daily mark. A swap dealer or major swap participant shall:
    (1) For cleared swaps, notify a counterparty of the counterparty's 
right to receive, upon request, the daily mark from the appropriate 
derivatives clearing organization; and
    (2) For uncleared swaps, provide the counterparty with a daily mark 
which shall be the mid-market value of the swap. The mid-market value 
of the swap shall not include amounts for profit, credit reserve, 
hedging, funding, liquidity or any other costs or adjustments. The 
daily mark shall be provided to the counterparty on each business day 
during the term of the swap as of the close of business, or such other 
time as the parties agree in writing.
    (3) For uncleared swaps, disclose to the counterparty:
    (i) The methodology and assumptions used to prepare the daily mark 
and any material changes during the term of the swap, provided that, 
the swap dealer or major swap participant is not required to disclose 
to the counterparty confidential, proprietary information about any 
model it may use to prepare the daily mark.
    (ii) Additional information concerning the daily mark to ensure a 
fair and balanced communication, including, as appropriate:
    (A) The daily mark may not necessarily be a price at which either 
the counterparty or the swap dealer or major swap participant would 
agree to replace or terminate the swap;
    (B) Depending upon the agreement of the parties, calls for margin 
may be based on considerations other than the daily mark provided to 
the counterparty; and
    (C) The daily mark may not necessarily be the value of the swap 
that is marked on the books of the swap dealer or major swap 
participant.


Sec.  23.432  Clearing.

    (a) For swaps required to be cleared--right to select derivatives 
clearing organization. A swap dealer or major swap participant shall 
notify any counterparty (other than a registered swap dealer, 
securities-based swap dealer, major swap participant or major 
securities-based swap participant) that enters into a swap or is 
offered to enter into a swap that is subject to mandatory clearing 
under Section 2(h) of the Act, that the counterparty has the sole right 
to select the derivatives clearing organization at which the swap will 
be cleared.
    (b) For swaps not required to be cleared--right to clearing. A swap 
dealer or major swap participant shall notify any counterparty (other 
than a registered swap dealer, securities-based swap dealer, major swap 
participant or major securities-based swap participant) that enters 
into a swap that is not subject to the mandatory clearing requirements 
under Section 2(h) of the Act that the counterparty:
    (1) May elect to require clearing of the swap, and
    (2) Shall have the sole right to select the derivatives clearing 
organization at which the swap will be cleared.


Sec.  23.433  Communications--fair dealing.

    With respect to any communication between a swap dealer or major 
swap participant and any counterparty, the swap dealer or major swap 
participant shall communicate in a fair and balanced manner based on 
principles of fair dealing and good faith.


Sec.  23.434  Recommendations to counterparties--institutional 
suitability.

    (a) A swap dealer or major swap participant shall have a reasonable 
basis to believe that any swap or trading strategy involving swaps 
recommended to a counterparty is suitable for the counterparty based on 
information obtained through reasonable due diligence concerning the 
counterparty's financial situation and needs, objectives, tax status, 
ability to evaluate the recommendation, liquidity needs, risk 
tolerance, ability to absorb potential losses related to the 
recommended swap or trading strategy, and any other information known 
by the swap dealer or major swap participant.
    (b)(1) A swap dealer or major swap participant will fulfill its 
obligations under paragraph (a) of this section if:
    (i) The swap dealer has a reasonable basis to believe that the 
counterparty is capable of evaluating, independently, the risks related 
to a particular swap or trading strategy involving swaps recommended to 
the counterparty;
    (ii) The counterparty affirmatively indicates that it is exercising 
independent judgment in evaluating the recommendations; and
    (iii) The swap dealer has a reasonable basis to believe that the 
counterparty has the capacity to absorb potential losses related to the 
recommended swap or trading strategy involving swaps.
    (2) Provided that, where a counterparty has delegated discretionary 
authority to another person, such as a registered commodity trading 
advisor, the factors contained in paragraphs (b)(1)(i) and (b)(1)(ii) 
of this section shall be applied to such person.
    (c) This section shall not apply:
    (1) To any recommendations made to another swap dealer, major swap 
participant, security-based swap dealer, or major security-based swap 
participant; or
    (2) Where a swap dealer or major swap participant provides:
    (i) Information that is general transaction, financial, or market 
information; or
    (ii) Swap terms in response to a competitive bid request from the 
counterparty.


Sec. Sec.  23.435-23.439  [Reserved]


Sec.  23.440  Requirements for swap dealers acting as advisors to 
special entities.

    (a) For purposes of this section the term ``acts as an advisor to a 
Special Entity'' shall include where a swap dealer recommends a swap or 
trading strategy that involves the use of swaps to a Special Entity. 
The term shall not include where a swap dealer provides:
    (1) Information to a Special Entity that is general transaction, 
financial, or market information or
    (2) Swap terms in response to a competitive bid request from the 
Special Entity.
    (b) A swap dealer that acts as an advisor to a Special Entity 
regarding a swap shall comply with the following requirements:
    (1) Duty. Any swap dealer that acts as an advisor to a Special 
Entity shall have a duty to act in the best interests of the Special 
Entity.
    (2) Reasonable Efforts. Any swap dealer that acts as an advisor to 
a

[[Page 80660]]

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. This information shall 
include information relating to:
    (i) The authority of the Special Entity to enter into a 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 
(including review of any written derivatives, financing and investment 
policies, plans or similar documents);
    (v) The experience of the Special Entity with respect to entering 
into swaps, generally, and swaps of the type and complexity being 
recommended;
    (vi) Whether the Special Entity has an independent representative 
that meets the criteria enumerated in Sec.  23.450(b);
    (vii) Whether the Special Entity has the financial capability to 
withstand potential market-related changes in the value of the swap 
during the term of the swap; and
    (viii) Such other information as is relevant to the particular 
facts and circumstances of the Special Entity, market conditions and 
the type of swap recommended.
    (c) Reasonable reliance on representations of the Special Entity. 
The swap dealer may rely on written representations of the Special 
Entity to satisfy its requirement in paragraph (b) of this section to 
make ``reasonable efforts'' to obtain necessary information, provided 
that:
    (1) The swap dealer has a reasonable basis to believe that the 
representations are reliable taking into consideration the facts and 
circumstances of a particular swap dealer-Special Entity relationship, 
assessed in the context of a particular transaction; and
    (2) The representations include information sufficiently detailed 
for the swap dealer to reasonably conclude that the Special Entity is:
    (i) Capable of evaluating independently the material risks inherent 
in the recommendation;
    (ii) Exercising independent judgment in evaluating the 
recommendation; and
    (iii) Capable of absorbing potential losses related to the 
recommended swap; and
    (3) The swap dealer has a reasonable basis to believe that the 
Special Entity has a representative that meets the criteria enumerated 
in Sec.  23.450(b).


Sec. Sec.  23.441-23.449  [Reserved]


Sec.  23.450  Requirements for swap dealers and major swap participants 
acting as counterparties to special entities.

    (a) Definitions. For purposes of this section:
    (1) The term ``material business relationship'' means any 
relationship with a swap dealer or major swap participant, whether 
compensatory or otherwise, that reasonably could affect the independent 
judgment or decision making of the representative, provided however, 
that material business relationship does not include payment of fees by 
the swap dealer or major swap participant to the representative at the 
written direction of the Special Entity for services provided by the 
representative in connection with the swap executed between the Special 
Entity and the swap dealer or major swap participant. The term 
``material business relationship'' shall be subject to a one-year look 
back; and
    (2) The term ``principal relationship'' means where a swap dealer 
or major swap participant is a principal of the representative of a 
Special Entity or the representative of a Special Entity is a principal 
of the swap dealer or major swap participant, as the term ``principal'' 
is defined in Sec.  3.1(a) of this chapter;
    (3) The term ``statutory disqualification'' means grounds for 
refusal to register or to revoke, condition or restrict the 
registration of any registrant or applicant for registration as set 
forth in Sections 8a(2) and 8a(3) of the Act.
    (b) Any swap dealer or major swap participant that offers to or 
enters into a swap with a Special Entity shall have a reasonable basis 
to believe that the Special Entity has a representative that:
    (1) Has sufficient knowledge to evaluate the transaction and risks;
    (2) Is not subject to a statutory disqualification;
    (3) Is independent of the swap dealer or major swap participant;
    (4) Undertakes a duty to act in the best interests of the Special 
Entity it represents;
    (5) Makes appropriate and timely disclosures to the Special Entity;
    (6) Evaluates, consistent with any guidelines provided by the 
Special Entity, fair pricing and the appropriateness of the swap;
    (7) In the case of employee benefit plans subject to the Employee 
Retirement Income Security Act of 1974, is a fiduciary as defined in 
Section 3 of that Act (29 U.S.C. 1002); and
    (8) In the case of a municipal entity as defined in Sec.  23.451, 
is subject to restrictions on certain political contributions imposed 
by the Commission, the Securities and Exchange Commission or a self-
regulatory organization subject to the jurisdiction of the Commission 
or the Securities and Exchange Commission, provided that, this 
paragraph shall not apply if the representative is an employee of the 
Special Entity.
    (c) For purposes of paragraph (b)(3) of this section, a 
representative of a Special Entity will be deemed to be independent of 
the swap dealer or major swap participant if:
    (1) The representative is not and, within one year, 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.
    (d) Reasonable reliance on representations of the Special Entity. A 
swap dealer may rely on written representations of a Special Entity to 
satisfy its obligation to have a reasonable basis to believe that the 
Special Entity has a representative that satisfies the criteria in 
paragraph (b) of this section provided that:
    (1) The swap dealer has a reasonable basis to believe that the 
representations are reliable taking into consideration the facts and 
circumstances of a particular Special Entity-representative 
relationship, assessed in the context of a particular transaction;
    (2) The representations include information sufficiently detailed 
for the swap dealer reasonably to conclude that the representative 
satisfies the criteria in paragraph (b) of this section. Relevant 
considerations would include:
    (i) The nature of the relationship between the Special Entity and 
the representative and the duties of the representative, including the 
obligation of the representative to act in the best interests of the 
Special Entity;
    (ii) The representative's capability to make hedging or trading 
decisions, and the resources available to the

[[Page 80661]]

representative to make informed decisions;
    (iii) The use by the representative of one or more consultants;
    (iv) The general level of experience of the representative in 
financial markets and specific experience with the type of instruments, 
including the specific asset class, under consideration;
    (v) The representative's ability to understand the economic 
features of the swap involved;
    (vi) The representative's ability to evaluate how market 
developments would affect the swap; and
    (vii) The complexity of the swap or swaps involved.
    (e) Unqualified representative. If a swap dealer or major swap 
participant determines that the representative of a Special Entity does 
not meet the criteria established in this section, the swap dealer or 
major swap participant shall make a written record of the basis for 
such determination and submit such determination to its Chief 
Compliance Officer for review to ensure that the swap dealer or major 
swap participant has a substantial, unbiased basis for the 
determination.
    (f) Before the initiation of a swap, a swap dealer or major swap 
participant shall disclose to the Special Entity in writing:
    (1) The capacity in which it is acting in connection with the swap; 
and
    (2) If the swap dealer or major swap participant engages in 
business with the Special Entity in more than one capacity, the swap 
dealer or major swap participant shall disclose the material 
differences between such capacities in connection with the swap and any 
other financial transaction or service involving the Special Entity.
    (g) This section shall not apply with respect to a transaction that 
is:
    (1) Initiated on a designated contract market or swap execution 
facility; and
    (2) One in which the swap dealer or major swap participant does not 
know the identity of the counterparty to the transaction.


Sec.  23.451  Political contributions by certain swap dealers and major 
swap participants.

    (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 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 for the swap 
dealer or major swap participant and any person who supervises, 
directly or indirectly, such employee; and
    (iii) Any political action committee controlled by the swap dealer 
or major swap participant or by any person described in paragraphs 
(a)(2)(i) and (a)(2)(ii) of this section.
    (3) The term ``municipal entity'' means any State, political 
subdivision of a State, or municipal corporate instrumentality of a 
State, including--
    (i) Any agency, authority, or instrumentality of the State, 
political subdivision, or municipal corporate instrumentality;
    (ii) Any plan, program, or pool of assets sponsored or established 
by the State, political subdivision, or municipal corporate 
instrumentality or any agency, authority, or instrumentality thereof; 
and any other issuer of municipal securities.
    (4) 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 swap dealer or major swap participant 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 swap dealer or major swap participant by a municipal 
entity.
    (5) The term ``payment'' means any gift, subscription, loan, 
advance, or deposit of money or anything of value.
    (6) The term ``regulated person'' means:
    (i) A person that is subject to restrictions on certain political 
contributions imposed by the Commission, the Securities and Exchange 
Commission or a self-regulatory agency subject to the jurisdiction of 
the Commission or the Securities and Exchange Commission;
    (ii) A general partner, managing member or executive officer of 
such person, or other individual with a similar status or function; or
    (iii) An employee of such person who solicits a municipal entity 
for the swap dealer or major swap participant and any person who 
supervises, directly or indirectly, such employee.
    (7) The term ``solicit'' means a direct or indirect communication 
by any person with a municipal entity for the purpose of obtaining or 
retaining an engagement related to a swap.
    (b) Prohibitions and Exceptions.
    (1) As a means reasonably designed to prevent fraud, no swap dealer 
or major swap participant shall offer to enter into or enter into a 
swap or a trading strategy involving a swap with a municipal entity 
within two years after any contribution to an official of such 
municipal entity was made by the swap dealer or major swap participant, 
or by any covered associate of the swap dealer or major swap 
participant, provided however, that:
    (2) This prohibition does not apply:
    (i) If the only contributions made by the swap dealer or major swap 
participant to an official of such municipal entity were made by a 
covered associate:
    (A) To officials for whom the covered associate was entitled to 
vote at the time of the contributions, provided that the contributions 
in the aggregate do not exceed $350 to any one official per election; 
or
    (B) To officials for whom the covered associate was not entitled to 
vote at the time of the contributions, provided that the contributions 
in the aggregate do not exceed $150 to any one official, per election;
    (ii) To a swap dealer or major swap participant as a result of a 
contribution made by a natural person more than six months prior to 
becoming a covered associate of the swap dealer or major swap 
participant, provided that this exclusion shall not apply if the 
natural person, after becoming a covered associate, solicits the 
municipal entity on behalf of the swap dealer or major swap participant 
to offer to enter into or to enter into a swap or trading strategy 
involving; or
    (iii) With respect to a swap that is initiated on a designated 
contract market or swap execution facility if the swap dealer or major 
swap participant does not know the identity of the counterparty to the 
transaction at the time of the transaction.
    (3) No swap dealer or major swap participant or any covered 
associate of the swap dealer or major swap participant 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 swap with that swap dealer or major swap participant 
unless such person is a regulated person; or

[[Page 80662]]

    (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 swap dealer or major swap participant is offering to enter into, or 
has entered into, a swap; or
    (B) Payment to a political party of a state or locality with which 
the swap dealer or major swap participant is offering to enter into or 
has entered into a swap or a trading strategy involving a swap.
    (c) Circumvention of Rule. No swap dealer or major swap participant 
shall, directly or indirectly, through or by any other person or means, 
do any act that would result in a violation of paragraph (b) of this 
section.
    (d) Requests for Exemption. The Commission, upon application, may 
conditionally or unconditionally exempt a swap dealer or major swap 
participant from the prohibition under paragraph (b) of this section. 
In determining whether to grant an exemption, the Commission will 
consider, among other factors:
    (1) Whether the exemption is necessary or appropriate in the public 
interest and consistent with the protection of investors and the 
purposes of the Act;
    (2) Whether the swap dealer or major swap participant:
    (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 swap dealer or major 
swap participant, 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 swap dealer or major swap participant if:
    (i) The swap dealer or major swap participant discovered the 
contribution within 120 calendar days of the date of such contribution;
    (ii) The contribution did not exceed the amounts permitted by 
paragraphs (b)(2)(i)(A) or (B) of this section; and
    (iii) The covered associate obtained a return of the contribution 
within 60 calendar days of the date of discovery of the contribution by 
the swap dealer or major swap participant.
    (2) A swap dealer or major swap participant may not rely on 
paragraph (e)(1) of this section more than twice in any 12-month 
period.
    (3) A swap dealer or major swap participant may not rely on 
paragraph (e)(1) of this section more than once for any covered 
associate, regardless of the time between contributions.

PART 155--TRADING STANDARDS

Authority and Issuance

    3. The authority citation for part 155 shall be revised to read as 
follows:

    Authority: 7 U.S.C. 6b, 6c, 6g, 6j, 6s, and 12a as amended by 
Title VII of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act, Pub. L. 111-203, 124 Stat. 1376 (Jul. 21, 2010).

    4. Add Sec.  155.7 to read as follows:


Sec.  155.7  Execution standards.

    (a) In connection with any customer order to enter into a swap 
where such swap is available for trading on one or more designated 
contract markets or swap execution facilities, a Commission registrant 
shall:
    (1) Prior to execution of the swap, disclose to the customer:
    (i) The designated contract markets and swap execution facilities 
on which the swap is available for trading; and
    (ii) The designated contract markets and swap execution facilities 
on which the registrant has trading privileges.
    (2) Execute the order on terms that have a reasonable relationship 
to the best terms available for such swap on designated contract 
markets or swap execution facilities trading such swap.
    (b) As part of the execution requirements in paragraph (a) of this 
section, the registrant shall use reasonable diligence to ascertain the 
best terms available. Among the factors that will be considered in 
determining whether a Commission registrant has used ``reasonable 
diligence'' are:
    (1) The character of the market for the swap, including price, 
volatility, speed, certainty of execution, and liquidity;
    (2) The size and type of transaction;
    (3) The number of markets checked;
    (4) Accessibility of quotations; and
    (5) The terms and conditions of the order which results in the 
transaction, as communicated to the Commission registrant.

    By the Commission, this 9th day of December 2010.
David A. Stawick,
Secretary.

Appendices to Business Conduct Standards for Swap Dealers and Major 
Swap Participants With Counterparties--Commission Voting Summary and 
Statements of Commissioners

    Note: The following appendices will not appear in the Code of 
Federal Regulations.

Appendix 1--Commission Voting Summary

    On this matter, Chairman Gensler and Commissioners Dunn, 
Sommers, Chilton and O'Malia voted in the affirmative; no 
Commissioner voted in the negative.

Appendix 2--Statement of Chairman Gary Gensler

    I support the proposed rulemaking to establish business conduct 
standards for swap dealers and major swap participants in their 
dealings with counterparties. Today's proposal implements important 
new authorities that Congress granted the Commission to establish 
and enforce robust sales practices in the swap markets. The proposed 
rule will level the playing field and bring needed transparency. It 
will strengthen confidence in the market to benefit hedgers and 
other market participants.
    The proposed rule would prohibit fraud and certain abusive 
practices. It also would implement requirements for swap dealers and 
major swap participants to deal fairly with customers, provide 
balanced communications and disclose conflicts of interest and 
material incentives before entering into a swap. The rule also would 
implement the Dodd-Frank heightened duties on swap dealers and major 
swap participants when they deal with certain entities, such as 
pension plans, governmental entities and endowments.
    The proposed rule is intended to ensure that swaps customers get 
fair treatment in the execution of their transactions. It would 
require swap dealers to disclose what access they have to swap 
execution facilities and designated contract markets. These rules 
also prohibit a swap dealer from defrauding a customer by executing 
a transaction on terms that have no ``reasonable relationship'' to 
the market. The proposed rule provides flexibility to accommodate 
developments in

[[Page 80663]]

the swaps markets while also protecting customers.

[FR Doc. 2010-31588 Filed 12-21-10; 8:45 am]
BILLING CODE 6351-01-P