Document ID: SEC-2011-1022-0001
Agency: sec
Document Type: Proposed Rule
Title: Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants
Posted Date: 2011-07-18T04:00Z

[Federal Register Volume 76, Number 137 (Monday, July 18, 2011)]
[Proposed Rules]
[Pages 42396-42459]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-16758]

[[Page 42395]]

Vol. 76

Monday,

No. 137

July 18, 2011

Part III

Securities and Exchange Commission

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17 CFR Part 240

Business Conduct Standards for Security-Based Swap Dealers and Major 
Security-Based Swap Participants; Proposed Rule

  Federal Register / Vol. 76 , No. 137 / Monday, July 18, 2011 / 
Proposed Rules  

[[Page 42396]]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-64766; File No. S7-25-11]
RIN 3235-AL10

Business Conduct Standards for Security-Based Swap Dealers and 
Major Security-Based Swap Participants

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
proposing for comment new rules under the Securities Exchange Act of 
1934 (``Exchange Act'') that are intended to implement provisions of 
Title VII (``Title VII'') of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act of 2010 (``Dodd-Frank Act'') relating to 
external business conduct standards for security-based swap dealers 
(``SBS Dealers'') and major security-based swap participants (``Major 
SBS Participants'').

DATES: Comments should be received on or before August 29, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number S7-25-11 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-25-11. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for Web site viewing and printing in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549 on official business days between the hours of 10 a.m. and 3 p.m. 
All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly.

FOR FURTHER INFORMATION CONTACT: Lourdes Gonzalez, Acting Co-Chief 
Counsel, Joanne Rutkowski, Branch Chief, Cindy Oh, Special Counsel, 
Office of Chief Counsel, Division of Trading and Markets, at (202) 551-
5550, at the Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is proposing Rules 15Fh-1 to 
15Fh-6 and 15Fk-1 under the Exchange Act governing certain business 
conduct requirements for SBS Dealers and Major SBS Participants. 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. Statutory Framework
    B. Consultations
    C. Approach to Drafting the Proposed Rules
    1. General Objectives
    2. SRO Rules as a Potential Point of Reference
    3. Business Conduct Rules Not Expressly Addressed by the Dodd-
Frank Act
    4. Differences Between SBS Dealers and Major SBS Participants
    5. Treatment of Special Entities
II. Discussion of Proposed Rules Governing Business Conduct
    A. Scope: Proposed Rule 15Fh-1
    B. Definitions: Proposed Rule 15Fh-2
    C. Business Conduct Requirements: Proposed Rule 15Fh-3
    1. Counterparty Status
    2. Disclosure
    a. Disclosure Not Required When the Counterparty Is an SBS 
Entity or a Swap Dealer or Major Swap Participant
    b. Timing and Manner of Certain Disclosures
    c. Material Risks and Characteristics of the Security-Based Swap
    d. Material Incentives or Conflicts of Interest
    e. Daily Mark
    f. Clearing Rights
    3. Know Your Counterparty
    4. Recommendation by SBS Dealers
    5. Fair and Balanced Communications
    6. Obligation Regarding Diligent Supervision
    D. Proposed Rules Applicable to Dealings With Special Entities
    1. Scope of Definition of ``Special Entity''
    2. Best Interests
    3. Anti-Fraud Provisions: Proposed Rule 15Fh-4(a)
    4. Advisor to Special Entities: Proposed Rules 15Fh-2(a) and 
15Fh-4(b)
    5. Counterparty to Special Entities: Proposed Rule 15Fh-5
    a. Scope of Qualified Independent Representative Requirement
    b. Independent Representative--Proposed Rule 15Fh-2(c)
    c. Reasonable Basis to Believe the Qualifications of the 
Independent Representative
    i. Qualified Independent Representative--Sufficient Knowledge to 
Evaluate Transaction and Risks
    ii. Qualified Independent Representative--No Statutory 
Disqualification
    iii. Qualified Independent Representative--Acting in the Best 
Interests of the Special Entity
    iv. Qualified Independent Representative--Appropriate 
Disclosures to Special Entity
    v. Qualified Independent Representative--Written Representations
    vi. Qualified Independent Representative--ERISA Fiduciary
    vii. Qualified Independent Representative--Subject to ``Pay to 
Play'' Prohibitions
    d. Disclosure of Capacity
    6. Prohibition on Certain Political Contributions by SBS 
Dealers: Proposed Rule 15Fh-6
    a. Prohibitions
    b. Two-Year ``Time Out''
    c. Covered Associates
    d. Officials
    e. Exceptions
    i. De Minimis Contributions
    ii. New Covered Associates
    iii. Exchange and SEF Transactions
    f. Exception and Exemptions
    E. Chief Compliance Officer: Rule Proposed 15Fk-1
III. Request for Comments
    A. Generally
    B. Consistency With CFTC Approach
IV. Paperwork Reduction Act
    A. Summary of Collections of Information
    1. Verification of Status
    2. Disclosures by SBS Entities
    3. ``Know Your Counterparty'' and Recommendations
    4. Fair and Balanced Communications
    5. Supervision
    6. SBS Dealers Acting as Advisors to Special Entities
    7. SBS Entities Acting as Counterparties to Special Entities
    8. Political Contributions
    9. Chief Compliance Officers
    B. Proposed Use of Information
    1. Verification of Status
    2. Disclosures by SBS Entities
    3. ``Know Your Counterparty'' and Recommendations
    4. Fair and Balanced Communications
    5. Supervision
    6. SBS Dealers Acting as Advisors to Special Entities
    7. SBS Entities Acting as Counterparties to Special Entities
    8. Political Contributions
    9. Chief Compliance Officers
    C. Respondents
    D. Total Annual Reporting and Recordkeeping Burdens

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    1. Verification of Status
    2. Disclosures by SBS Entities
    3. ``Know Your Counterparty'' and Recommendations
    4. Fair and Balanced Communications
    5. Supervision
    6. SBS Dealers Acting as Advisors to Special Entities
    7. SBS Entities Acting as Counterparties to Special Entities
    8. Political Contributions
    9. Chief Compliance Officers
    E. Collection of Information Is Mandatory
    F. Responses to Collection of Information Will Be Kept 
Confidential
    G. Request for Comment
V. Cost-Benefit Analysis
    A. Costs and Benefits of Rules Relating to Daily Mark
    B. Costs and Benefits of Rules Concerning Verification of 
Counterparty Status, Knowing your Counterparty and Recommendations 
of Security-Based Swaps or Trading Strategies
    C. Costs and Benefits of Rules Relating to Political 
Contributions by Certain SBS Entities and Independent 
Representatives of Special Entities
    D. Costs and Benefits Relating to the Specification of Minimum 
Requirements of the Annual Compliance Report and the Requirement of 
Board Approval of Compensation or Removal of a Chief Compliance 
Officer
VI. Consideration of Burden on Competition and Promotion of 
Efficiency, Competition and Capital Formation
VII. Consideration of Impact on the Economy
VIII. Regulatory Flexibility Act Certification
    A. Market Participants in Security-Based Swaps
    B. Certification

I. Introduction

A. Statutory Framework

    On July 21, 2010, the President signed the Dodd-Frank Act into 
law.\1\ Title VII of the Dodd-Frank Act generally provides the 
Commission with authority to regulate ``security-based swaps,'' the 
Commodity Futures Trading Commission (``CFTC'') with authority to 
regulate ``swaps,'' and both the CFTC and the Commission with authority 
to regulate ``mixed swaps.'' \2\
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    \1\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Public Law 111-203, 124 Stat. 1376 (2010).
    \2\ Section 712(d) of the Dodd-Frank Act provides that the 
Commission and the CFTC, in consultation with the Board of Governors 
of the Federal Reserve System (``Federal Reserve''), shall jointly 
further define the terms ``swap,'' ``security-based swap,'' ``swap 
dealer,'' ``security-based swap dealer,'' ``major swap 
participant,'' ``major security-based swap participant,'' ``eligible 
contract participant,'' and ``security-based swap agreement.'' 
Public Law 111-203, 124 Stat. 1376, 1644-1646 (2010). These terms 
are defined in Sections 721 and 761 of the Dodd-Frank Act and, with 
respect to the term ``eligible contract participant,'' in Section 
1a(18) of the Commodity Exchange Act, 7 U.S.C. 1a(18), as re-
designated and amended by Section 721 of the Dodd-Frank Act. Section 
721(c) of the Dodd-Frank Act also requires the CFTC to adopt a rule 
to further define the terms ``swap,'' ``swap dealer,'' ``major swap 
participant,'' and ``eligible contract participant,'' and Section 
761(b) of the Dodd-Frank Act permits the Commission to adopt a rule 
to further define the terms ``security-based swap,'' ``security-
based swap dealer,'' ``major security-based swap participant,'' and 
``eligible contract participant,'' with regard to security-based 
swaps, for the purpose of including transactions and entities that 
have been structured to evade Title VII. Public Law 111-203, 124 
Stat. 1376, 1658-1672, 1754, 1759 (2010). Finally, Section 712(a) of 
the Dodd-Frank Act provides that the Commission and CFTC, after 
consultation with the Federal Reserve, shall jointly prescribe 
regulations regarding ``mixed swaps,'' as may be necessary to carry 
out the purposes of Title VII. Public Law 111-203, 124 Stat. 1376, 
1642 (2010).
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    Section 764 of the Dodd-Frank Act amends the Exchange Act by adding 
new Section 15F.\3\ Paragraph (h) of the new section authorizes and 
requires the Commission to adopt rules specifying business conduct 
standards for SBS Dealers \4\ and Major SBS Participants \5\ in their 
dealings with counterparties, including counterparties that are 
``special entities.'' ``Special entities'' are generally defined to 
include federal agencies, states and their 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.\6\ Congress granted the Commission broad 
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 Exchange Act.\7\
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    \3\ See Public Law 111-203, 124 Stat. 1376, 1789-1792, Sec.  
764(a) (adding Exchange Act Section 15F). All references to the 
Exchange Act are to the Exchange Act, as amended by the Dodd-Frank 
Act.
    \4\ Section 761 of the Dodd-Frank Act amends Section 3(a) of the 
Exchange Act to add new Exchange Act Section 3(a)(71)(A), which 
generally defines ``security-based swap dealer'' as ``any person 
who: (i) holds themself [sic] out as a dealer in security-based 
swaps; (ii) makes a market in security-based swaps; (iii) regularly 
enters into security-based swaps with counterparties as an ordinary 
course of business for its own account; or (iv) engages in any 
activity causing it to be commonly known in the trade as a dealer or 
market maker in security-based swaps.'' Public Law 111-203, 124 
Stat. 1376, 1758, Sec.  761.
    The Commission and the CFTC are jointly proposing rules and 
interpretive guidance under the Exchange Act and the Commodity 
Exchange Act to further define the terms ``swap dealer,'' 
``security-based swap dealer,'' ``major swap participant,'' ``major 
security-based swap participant,'' and ``eligible contract 
participant.'' See Further Definition of ``Swap Dealer,'' 
``Security-Based Swap Dealer,'' ``Major Swap Participant,'' ``Major 
Security-Based Swap Participant'' and ``Eligible Contract 
Participant,'' Exchange Act Release No. 63452 (Dec. 7, 2010), 75 FR 
80174 (Dec. 21, 2010) (``Definitions Release'').
    \5\ Section 761 of the Dodd-Frank Act amends Section 3(a) of the 
Exchange Act to add new Exchange Act Section 3(a)(67)(A), which 
defines ``major security-based swap participant'' as ``any person: 
(i) Who is not a security-based swap dealer; and (ii)(I) who 
maintains a substantial position in security-based swaps for any of 
the major security-based swap categories, as such categories are 
determined by the Commission, excluding both positions held for 
hedging or mitigating commercial risk and positions maintained by 
any employee benefit plan (or any contract held by such a plan) as 
defined in paragraphs (3) and (32) of Section 3 of the Employee 
Retirement Income Security Act of 1974 (29 U.S.C. 1002) for the 
primary purpose of hedging or mitigating any risk directly 
associated with the operation of the plan; (II) whose outstanding 
security-based swaps create substantial counterparty exposure that 
could have serious adverse effects on the financial stability of the 
United States banking system or financial markets; or (III) that is 
a financial entity that (aa) is highly leveraged relative to the 
amount of capital such entity holds and that is not subject to 
capital requirements established by an appropriate Federal banking 
regulator; and (bb) maintains a substantial position in outstanding 
security-based swaps in any major security-based swap category, as 
such categories are determined by the Commission.'' Public Law 111-
203, 124 Stat. 1376, 1755-1756, Sec.  761(a) (to be codified at 15 
U.S.C. 78c(a)(67)(A)).
    See also Definitions Release, supra note 4.
    \6\ Public Law 111-203, 124 Stat. 1376, 1789-1790, Sec.  764(a) 
(to be codified at 15 U.S.C. 78o-10(h)(2)(C)).
    \7\ See Public Law 111-203, 124 Stat. 1376, 1790 (to be codified 
at 15 U.S.C. 78o-10(h)(3)(D)) (``[b]usiness 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 Public Law 111-
203, 124 Stat. 1376, 1789 (to be codified at 15 U.S.C. 78o-
10(h)(1)(D)) (requiring that SBS Entities comply as well with ``such 
business conduct standards * * * as may be prescribed by the 
Commission by rule or regulation that relate to such other matters 
as the Commission determines to be appropriate'').
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    Section 15F(h)(6) of the Exchange Act directs the Commission to 
prescribe rules governing business conduct standards for SBS Dealers 
and Major SBS Participants (collectively, ``SBS Entities''). These 
standards, as described in Exchange Act Section 15F(h)(3), must require 
an SBS Entity to: verify that a counterparty meets the eligibility 
standards for an ``eligible contract participant'' (``ECP''); disclose 
to the counterparty material information about the security-based swap, 
including material risks and characteristics of the security-based 
swap, and material incentives and conflicts of interest of the SBS 
Entity in connection with the security-based swap; and provide the 
counterparty with information concerning the daily mark for the 
security-based swap. Section 15F(h)(3) also directs the Commission to 
establish a duty for SBS Entities to communicate in a fair and balanced 
manner based on principles of fair dealing and good faith. Section 
15F(h)(1) of the Exchange Act grants the Commission authority to 
promulgate rules applicable to SBS Entities that relate to, among other 
things, fraud, manipulation and abusive practices involving security-
based swaps (including security-based swaps that are offered but not 
entered into),

[[Page 42398]]

diligent supervision of SBS Entities and adherence to all applicable 
position limits.\8\
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    \8\ The Commission has proposed for comment a new Rule 9j-1 
under the Exchange Act, which is intended to prevent fraud, 
manipulation, and deception in connection with the offer, purchase 
or sale of any security-based swap, the exercise of any right or 
performance of any obligation under a security-based swap, or the 
avoidance of such exercise or performance. Prohibition against 
Fraud, Manipulation, and Deception in Connection with Security-Based 
Swaps, Exchange Act Release No. 63236 (Nov. 3, 2010), 75 FR 68560 
(Nov. 8, 2010). The Commission is separately considering the matter 
of position limits, and would propose any position limits in a 
separate rulemaking, as necessary.
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    Section 15F(h)(4) of the Exchange Act requires that an SBS 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 such information as is necessary to make a reasonable 
determination'' that a recommended security-based swap is in the best 
interests of the special entity. Section 15F(h)(5) requires that SBS 
Entities that offer to or enter into a security-based swap with a 
special entity comply with any duty established by the Commission that 
requires an SBS Entity to have a ``reasonable basis'' for believing 
that the special entity has an ``independent representative'' that 
meets certain criteria and undertakes a duty to act in the ``best 
interests'' of the special entity.\9\ This provision also requires that 
an SBS Entity disclose in writing the capacity in which it is acting 
(e.g., as principal) before initiating a transaction with a special 
entity.\10\
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    \9\ Pub. L. 111-203, 124 Stat. 1376, 1791 (to be codified at 15 
U.S.C. 78o-10(h)(5)).
    \10\ Id.
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    Section 15F(k) of the Exchange Act requires each SBS Entity to 
designate a chief compliance officer and imposes certain duties on that 
person.

B. Consultations

    In developing the rules proposed herein, the Commission staff has, 
in compliance with Sections 712(a)(2) \11\ and 752(a) \12\ of the Dodd-
Frank Act, consulted and coordinated with the CFTC and the prudential 
regulators.\13\ Commission staff also met with persons representing a 
broad spectrum of views on the proposed rules.\14\ These meetings were 
conducted jointly with CFTC staff. Among the persons who participated 
in the meetings were other regulators, broker-dealers, consumer and 
investor advocates, endowments, end-users, financial institutions, 
futures commission merchants, industry trade groups, investment fund 
managers, labor unions, pension fund managers, self-regulatory 
organizations (``SROs''), state and local governments, and swap 
dealers. We have considered standards or guidance issued by prudential 
regulators and international organizations, requirements applicable 
under foreign regulatory regimes, and recommendations for industry 
``best practices.'' \15\ We have also taken into account the more than 
70 comments received by the CFTC on its proposed business conduct rules 
for swap dealers and major swap entities.\16\
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    \11\ Section 712(a)(2) of the Dodd-Frank Act states in part, 
``the Securities and Exchange Commission shall consult and 
coordinate to the extent possible with the Commodity Futures Trading 
Commission and the prudential regulators for the purposes of 
assuring regulatory consistency and comparability, to the extent 
possible.'' Public Law 111-203, 124 Stat. 1376, 1641-1642 (to be 
codified at 15 U.S.C. 8302(a)(2)).
    \12\ Section 752(a) of the Dodd-Frank Act states in part that, 
``[i]n order to promote effective and consistent global regulation 
of swaps and security-based swaps, the Commodity Futures Trading 
Commission, the Securities and Exchange Commission, and the 
prudential regulators (as that term is defined in Section 1a(39) of 
the Commodity Exchange Act), 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.'' Public Law 111-203, 124 Stat. 1376, 
1749-1750 (to be codified at 15 U.S.C. 8325(a)).
    \13\ ``Prudential regulator,'' as explained in Section 711 of 
the Dodd-Frank Act, has the meaning given to it in section 1a of the 
Commodity Exchange Act (7 U.S.C. 1a), including any modification 
thereof under section 721(b) of the Dodd-Frank Act. Public Law 111-
203, 124 Stat. 1376, 1641 (to be codified at 15 U.S.C. 8301).
    \14\ A list of Commission staff meetings in connection with this 
rulemaking is available on the Commission's website under ``Meetings 
with SEC Officials'' at http://www.sec.gov/comments/df-title-vii/swap/swap.shtml. In addition, the Commission received several 
letters from the public, available at http://www.sec.gov/comments/df-title-vii/swap/swap.shtml.
    \15\ See, e.g., Int'l Org. of Securities Commissions, 
Operational and Financial Risk Management Control Mechanisms for 
Over-the-Counter Derivatives Activities of Regulated Securities 
Firms, (July 1994) (``IOSCO Report''); Bank for Int'l Settlements, 
Basel Committee on Banking Supervision, Risk Management Guidelines 
for Derivatives (July 1994) (``BIS Report''); Derivatives Policy 
Group, Framework for Voluntary Oversight (Mar. 1995), http://www.riskinstitute.ch/137790.htm; The Counterparty Risk Management 
Group, Improving Counterparty Risk Management Practices (June 1999) 
(``CRMPG I Report''); The Counterparty Risk Management Group, Toward 
Greater Financial Stability: A Private Sector Perspective. The 
Report of the Counterparty Risk Management Policy Group II (July 27, 
2005) (``CRMPG II Report''); The Counterparty Risk Management Group, 
Containing Systemic Risk: The Road to Reform, The Report of the 
CRMPG III (Aug. 6, 2008) (``CRMPG III Report''). In considering 
industry voluntary best practices, the Commission acknowledges that 
such best practices were not necessarily intended to establish or 
guide regulatory standards for which market participants would have 
legal liability if violated.
    \16\ See Business Conduct Standards for Swap Dealers and Major 
Swap Participants with Counterparties, 75 FR 80638 (Dec. 22, 2010) 
(``CFTC External Business Conduct Release''). Comments received by 
the CFTC are available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=935.
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    The staffs of the Commission and the CFTC have been consulting with 
the staff of the Department of Labor, and will continue to do so, 
concerning the potential interface between ERISA and the business 
conduct requirements of the Dodd-Frank Act. We recognize the importance 
of the ability of SBS Dealers to offer security-based swaps to special 
entities that are subject to ERISA, both for dealers and for the 
pension plans that may rely on security-based swaps to manage risk and 
reduce volatility.

C. Approach to Drafting the Proposed Rules

1. General Objectives
    Section 15F(h) of the Exchange Act provides the Commission with 
both mandatory and discretionary rulemaking authority. Our intent, in 
exercising this authority, is to establish a regulatory framework that 
both protects investors and promotes efficiency, competition, and 
capital formation.\17\ The Commission staff has worked closely with 
CFTC staff in consulting with the public and in developing the proposed 
rules, with a view to establishing consistent and comparable 
requirements for our respective registrants, to the extent 
possible.\18\
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    \17\ See Section 3(f) of the Exchange Act, 15 U.S.C. 78c(f).
    \18\ See Section I.B, supra.
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    The Commission understands that the proposed rules discussed 
herein, as well as other proposals that the Commission is considering 
to implement the Dodd-Frank Act, if adopted, could significantly 
affect--and be significantly affected by--the development of the 
security-based swaps market in a number of ways. If the Commission 
adopts rules that are too permissive, for example, they may not 
adequately protect investor interests or promote the purposes of the 
Dodd-Frank Act. If, however, the Commission adopts measures that are 
too onerous, they could unduly limit hedging and other legitimate 
activities by discouraging participation in security-based swap 
markets. We are aware that the further development of the security-
based swaps market, including in response to rules adopted by the 
Commission under the Dodd-Frank Act, may alter the calculus for 
regulation of business conduct of SBS Entities. We urge commenters, as 
they review the proposed rules, to consider generally the role that 
regulation may play in the development of the market for security-

[[Page 42399]]

based swaps, as well as the role that market developments may play in 
changing the nature and implications of regulation, and to focus in 
particular on this issue with respect to the proposed business conduct 
standards for SBS Entities.
2. SRO Rules as a Potential Point of Reference
    Under the framework established in the Dodd-Frank Act, SBS Entities 
are not required to be members of SROs, and no SRO has authority to 
regulate the activities of an SBS Entity, unless the SBS Entity is 
otherwise a member of that SRO. Nevertheless, we preliminarily believe 
that SRO business conduct rules provide a potential point of reference 
to inform our development of business conduct rules for SBS Entities, 
for several reasons.\19\
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    \19\ We have looked, in particular, to the requirements imposed 
by the Financial Industry Regulatory Authority, Inc., the Municipal 
Securities Rulemaking Board, and the National Futures Association.
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    First, a number of the business conduct standards in Section 15F(h) 
of the Exchange Act, including those regarding fair and balanced 
communications,\20\ supervision,\21\ and designation of a chief 
compliance officer,\22\ appear to be patterned on and are consistent 
with standards that have been established by SROs for their members, 
with Commission approval.\23\
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    \20\ Section 15F(h)(3)C) of the Exchange Act, Public Law 111-
203, 124 Stat. 1376, 1790 (to be codified at 15 U.S.C. 78o-
10(h)(3)(C)). Cf. NASD Rule 2210(d)(1)(A).
    \21\ Section 15F(h)(1)(B) of the Exchange Act, Pub. L. 111-203, 
124 Stat. 1376, 1789 (to be codified at 15 U.S.C. 78o-10(h)(1)(B)). 
Cf. NASD Rules 3010 and 3012.
    \22\ Section 15F(k) of the Exchange Act, Public Law 111-203, 124 
Stat. 1376, 1793--1794 (to be codified at 15 U.S.C. 78o-10(k)). Cf. 
FINRA Rule 3130.
    \23\ The Commission exercises oversight over SROs with respect 
to their interpretive, rulemaking and enforcement activities. See 
Section 19 of the Exchange Act, 15 U.S.C. 78s.
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    Second, business conduct standards under SRO rules have been 
developed over the course of many decades with input from market 
participants. Many market participants are familiar with these 
standards and are experienced with implementing them through existing 
compliance and supervisory controls and procedures. Indeed, if the 
Commission were to promulgate completely new business conduct standards 
that deviate in approach from established SRO rules in the same areas, 
our actions could increase uncertainty and impose burdens on the many 
market participants already familiar with SRO business conduct 
standards by requiring them to adapt to and implement a new and 
different business conduct regime for security based swap transactions.
    Third, to the extent that certain SBS Entities may also be 
registered as broker-dealers, they would be subject to the full panoply 
of SRO rules, including SRO business conduct rules, with respect to 
their activities related to security-based swaps.\24\ If the Commission 
were to adopt business conduct standards that differ materially from 
those imposed by SRO rules, these firms could be required to comply 
with two different, and potentially inconsistent, business conduct 
regimes--the Commission's and the SRO's--for the same transaction. 
Conversely, consistency between the business conduct requirements could 
reduce potential competitive disparities between SBS Entities that are 
SRO members and those that are not. Consistent regulatory requirements 
could also potentially benefit counterparties to SBS Entities, by 
providing a more uniform level of protection and limiting the confusion 
or uncertainty that might otherwise arise if substantially different 
rules were to apply to the same type of transaction based solely on 
whether the SBS Entity is an SRO member.
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    \24\ Because security-based swap transactions are ``securities'' 
within the meaning of Section 3(a)(10) of the Exchange Act, broker-
dealers would be subject to SRO business conduct and other rules 
applicable to such transactions. Public Law 111-203, 124 Stat. 1376, 
1755, Sec.  761(a)(2) (to be codified at 15 U.S.C. 78c(a)(10)).
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    At the same time, in considering the business conduct standards 
that have been developed by SROs, we are mindful that the security-
based swap market historically has been primarily an institutional 
market in which transactions are typically negotiated on a principal-
to-principal basis. While there is a wide range of counterparty 
sophistication within this market, the greater participation of 
institutional investors in the security-based swap market suggests a 
potentially different dynamic in the nature of the interactions between 
SBS Entities and their counterparties. Accordingly, it may be 
appropriate, for example, for the business conduct requirements 
applicable to SBS Entities to diverge to some extent from the 
requirements generally applicable to broker-dealers, whose activities 
may range from principal trading with institutional counterparties to 
retail brokerage on behalf of individual investors.
    In light of these considerations, the Commission is seeking to 
strike a balance in its use of SRO business conduct standards as a 
point of reference for the proposed rules. As noted above, one 
potential benefit of this approach would be to provide greater legal 
certainty and promote consistent requirements across different types of 
SBS Entities. That potential benefit would not be achieved if the 
Commission were to implement, interpret and enforce its business 
conduct standards in a manner that differs substantially from that of 
the SROs without grounding such actions in functional differences 
between the security-based swap market and other securities markets. 
Thus, absent such functional differences, when a business conduct 
standard in these proposed rules is based on a similar SRO standard, we 
would expect--at least as an initial matter--to take into account the 
SRO's interpretation and enforcement of its standard when we interpret 
and enforce our rule. At the same time, as noted above, we are not 
bound by an SRO's interpretation and enforcement of an SRO rule, and 
our policy objectives and judgments may diverge from those of a 
particular SRO. Accordingly, we would also expect to take into account 
such differences in interpreting and enforcing our rules.
    We request comment on all aspects of our approach to using business 
conduct requirements applicable to market professionals (such as 
broker-dealers and futures commission merchants) under existing SRO 
rules as a point of reference in developing the business conduct 
requirements applicable to SBS Entities.
3. Business Conduct Rules Not Expressly Addressed by the Dodd-Frank Act
    In addition to business conduct requirements expressly addressed by 
Title VII of the Dodd-Frank Act, we are proposing for comment certain 
other business conduct requirements for SBS Dealers that we 
preliminarily believe would further the principles that underlie the 
Dodd-Frank Act. These rules would, among other things, impose certain 
``know your counterparty'' and suitability obligations on SBS Dealers, 
and restrict SBS Dealers from engaging in certain ``pay to play'' 
activities.\25\
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    \25\ The CFTC has recently proposed rules that would impose 
similar requirements for swap dealers and major swap participants. 
See CFTC External Business Conduct Release, supra, note 16.
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    Know Your Counterparty--Broker-dealers are subject to ``know your 
customer'' standards that help to ensure investor protection and fair 
dealing in securities transactions, both for retail

[[Page 42400]]

and institutional investors.\26\ We preliminarily believe that a ``know 
your counterparty'' standard would be consistent with the principles 
underlying the Dodd-Frank Act. Accordingly, we are proposing, in 
addition to the rules expressly addressed by Section 15F(h) of the 
Exchange Act, certain ``know your counterparty'' requirements for SBS 
Dealers.\27\
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    \26\ See Notice of Filing of Amendment No. 1 to a Proposed Rule 
Change and Order Granting Accelerated Approval of a Proposed Rule 
Change, as Modified by Amendment No. 1, to Adopt FINRA Rules 2090 
(Know Your Customer) and 2111 (Suitability) in the Consolidated 
FINRA Rulebook, Exchange Act Release No. 63325 (Nov. 17, 2010), 75 
FR 71479 (Nov 23, 2010) (effective July 9, 2012) (``Suitability 
Order'').
    \27\ Proposed Rule 15Fh-3(e), discussed in Section II.C.3, 
infra.
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    Suitability--Broker-dealers are subject to suitability standards 
that help to ensure investor protection and fair dealing in securities 
transactions, both for retail and institutional investors.\28\ In 
addition, the Dodd-Frank Act effectively imposes a suitability 
requirement on SBS Dealers that, when acting as advisors, make 
recommendations to special entities.\29\ We preliminarily believe that 
it would be appropriate to extend these protections to certain 
situations in which an SBS Dealer is entering into a security-based 
swap with a counterparty that is not a special entity. Accordingly, we 
are proposing certain suitability requirements for SBS Dealers when 
making recommendations to counterparties.\30\
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    \28\ See Suitability Order, supra.
    \29\ Section 15F(h)(4)(C) of the Exchange Act (``Any security-
based swap dealer that acts as an advisor to a special entity shall 
make reasonable efforts to obtain such information as is necessary 
to make a reasonable determination that any security-based swap 
recommended by the security-based swap dealer is in the best 
interests of the special entity''). Pub. L. 111-203, 124 Stat. 1376, 
1790-1791 (to be codified at 15 U.S.C. 78o-10(h)(4)(C)).
    \30\ Proposed Rule 15Fh-3(f), discussed in Section II.C.4, 
infra. The suitability obligation would not apply if the 
counterparty is an SBS Entity or a swap dealer or major swap 
participant. In addition, the proposed rule would include an 
alternative similar to the FINRA ``institutional suitability'' 
exemption, as described more fully below.
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    Pay to Play--We are also proposing pay to play restrictions for SBS 
Dealers that are intended to complement the restrictions applicable to 
other market intermediaries seeking to engage in securities 
transactions with municipal entities. As explained more fully in 
Section II.D.5, pay to play practices, in which elected officials may 
allow political contributions to play a role in the selection of 
financial services providers, distort the process by which public 
contracts are awarded. Concerns about pay to play practices in the 
municipal securities and investment adviser contexts have prompted the 
promulgation of pay to play restrictions for those market 
professionals.\31\ We are concerned that similar pay to play practices 
could distort the market for securities-based swap transactions.\32\ 
These abuses encourage corrupt market practices, and can harm municipal 
entities that subsequently enter into inappropriate security-based 
swaps.\33\ Because certain SBS Dealers may not be covered by other pay 
to play rules already in effect, we are proposing for comment here pay 
to play rules intended to create a comparable regulatory framework with 
respect to those SBS Dealers. Given the similarity of pay to play 
practices across various contexts, and to facilitate compliance, we are 
proposing pay to play rules that are intended to be consistent with 
existing pay to play rules, to the extent practicable.
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    \31\ See Rule 205(4)-5 under the Investment Advisers Act of 1940 
(applying pay to play restrictions to investment advisers), and MSRB 
Rule G-37 (which seeks to eliminate pay to play practices in the 
municipal securities market through restrictions on political 
contributions and prohibitions on municipal securities business).
    \32\ For example, the Commission has brought a number of actions 
in connection with payments by J.P. Morgan Securities Inc. to local 
firms whose principals or employees were friends of Jefferson 
County, Alabama public officials in connection with $5 billion in 
County bond underwriting and interest rate swap agreement business 
awarded to the broker-dealer. The Commission has alleged that J.P. 
Morgan Securities engaged in pay to play practices in connection 
with obtaining municipal security underwriting and interest swap 
agreement business from municipalities. The Commission has alleged 
that J.P. Morgan Securities incorporated certain of the costs of 
these payments into higher swap interest rates it charged the 
County, directly increasing the swap transaction costs to the County 
and its taxpayers. See SEC v. Larry P. Langford, Litigation Release 
No. 20545 (Apr. 30, 2008) and SEC v. Charles E. LeCroy, Litigation 
Release No. 21280 (Nov. 4, 2009) (charging Alabama local government 
officials and J.P. Morgan employees with undisclosed payments made 
to obtain municipal bond offering and swap agreement business from 
Jefferson County, Alabama). See also J.P. Morgan Securities Inc., 
File No. 3-13673 (Nov. 4, 2009) (instituting administrative and 
cease-and-desist proceedings against a broker-dealer that allegedly 
was awarded bond underwriting and interest rate swap agreement 
business by Jefferson County in connection with undisclosed payments 
by employees of the firm).
    \33\ See also Political Contributions by Certain Investment 
Advisers, Investment Advisers Act Release No. 3043 (July 1, 2010), 
75 FR 41018 (July 14, 2010) (describing concerns that led to 
adoption of Advisers Act Rule 206(4)-5); Alexander W. Butler, Larry 
Fauver, and Sandra Mortal, Corruption, Political Connections, and 
Municipal Finance, 22 The Review of Financial Studies 2873 (2009) 
(describing effect of pay to play practices on greater credit risk, 
higher bond yields and underwriting premium fees in municipal bond 
sales and underwriting).
---------------------------------------------------------------------------

    We request comment on all aspects of our proposal to impose certain 
limited business conduct requirements not expressly addressed by the 
Dodd-Frank Act.
4. Differences Between SBS Dealers and Major SBS Participants
    We have also considered how the differences between the definitions 
of SBS Dealer and Major SBS Participant may be relevant in formulating 
the business conduct standards applicable to these entities. The Dodd-
Frank Act defines ``security-based swap dealer'' in a functional 
manner, by reference to the way a person holds itself out in the market 
and the nature of the conduct engaged in by that person, and how the 
market perceives the person's activities.\34\ As described in our joint 
proposal with the CFTC regarding this definition:
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    \34\ See note 4, supra (definition of ``security-based swap 
dealer'').

    [S]wap dealers can often be identified by their relationships 
with counterparties. Swap dealers tend to enter into swaps with more 
counterparties than do non-dealers, and in some markets, non-dealers 
tend to constitute a large portion of swap dealers' counterparties. 
In contrast, non-dealers tend to enter into swaps with swap dealers 
more often than with other non-dealers. The Commissions can most 
efficiently achieve the purposes underlying Title VII of the Dodd-
Frank Act--to reduce risk and to enhance operational standards and 
fair dealing in the swap markets--by focusing their attention on 
those persons whose function is to serve as the points of connection 
in those markets. The definition of swap dealer, construed 
functionally in the manner set forth above, will help to identify 
those persons.\35\
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    \35\ Definitions Release (using ``swap dealer'' to refer both to 
security-based swap dealer and to swap dealer).

The definition of ``major security-based swap participant,'' in 
contrast, focuses on the market impacts and risks associated with an 
entity's security-based swap positions.\36\ Despite the differences in 
focus, the Dodd-Frank Act applies substantially the same statutory 
standards to SBS Dealers and Major SBS Participants.\37\ We have 
attempted to

[[Page 42401]]

take into account these differing definitions and regulatory concerns 
in considering whether the business conduct requirements that we are 
proposing for SBS Dealers that are not expressly addressed by the 
statute should or should not apply to Major SBS Participants as 
well.\38\ In general, where the Dodd-Frank Act imposes a business 
conduct requirement on both SBS Dealers and Major SBS Participants, we 
have proposed rules that would apply equally to SBS Dealers and Major 
SBS Participants. Where, however, a business conduct requirement is not 
expressly addressed by the Dodd-Frank Act, the proposed rules generally 
would not apply to Major SBS Participants.\39\
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    \36\ As explained in the Definitions Release, the ``major 
security-based swap participant'' definition uses terms--
particularly ``systemically important,'' ``significantly impact the 
financial system,'' and ``create substantial counterparty 
exposure''--that denote a focus on entities that pose a high degree 
of risk through their security-based swap activities. In addition, 
the link between the ``major participant'' definition and risk was 
highlighted during the Congressional debate on the statute. See 156 
Cong. Rec. S5907 (daily ed. July 15, 2010) (dialogue between 
Senators Hagen and Lincoln, discussing how the goal of the major 
participant definition was to ``focus on risk factors that 
contributed to the recent financial crisis, such as excessive 
leverage, under-collateralization of swap positions, and a lack of 
information about the aggregate size of positions'').
    \37\ In particular, under Section 15F of the Exchange Act, SBS 
Dealers and Major SBS Participants generally are subject to the same 
types of margin, capital, business conduct and certain other 
requirements, unless an exclusion applies. In this way, the statute 
applies comprehensive regulation to entities (i.e., Major SBS 
Participants) whose security-based swap activities do not cause them 
to be dealers, but nonetheless could pose a high degree of risk to 
the U.S. financial system generally. See Public Law 111-203, 124 
Stat. 1376, 1785-1796 (to be codified at 15 U.S.C. 78o-10).
    \38\ See Section I.C.4, infra.
    \39\ There are exceptions to this principle. We are proposing 
that all SBS Entities be required to determine if a counterparty is 
a special entity. In addition, Section 3C(g)(5) of the Exchange Act 
creates certain rights with respect to clearing for counterparties 
entering into security-based swaps with SBS Entities but does not 
require disclosure. We are proposing a rule that would require an 
SBS Entity to disclose to a counterparty certain information 
relating to these rights. See Public Law 111-203, 124 Stat. 1376, 
1766-1767 (to be codified at 15 U.S.C. 78c-3(g)(5)). The proposed 
rule is intended to further the purposes of the Dodd-Frank Act to 
ensure that, wherever possible and appropriate, derivatives 
contracts formerly traded exclusively in the OTC market are cleared 
through a regulated clearing agency.
---------------------------------------------------------------------------

    We request comment on whether this approach is appropriate. Where 
the Dodd-Frank Act requires that a business conduct rule apply to all 
SBS Entities, should the rule impose the same requirements on Major SBS 
Participants as on SBS Dealers? Where we are proposing rules for SBS 
Dealers that are not expressly addressed by the Dodd-Frank Act, should 
any of these rules apply as well to Major SBS Participants? If so, 
which rules and why?
5. Treatment of Special Entities
    Congress has provided certain additional protections in the Dodd-
Frank Act for ``special entities''--including certain municipalities, 
pension plans, and endowments--in connection with security-based swaps. 
In particular, as described in Section II.D below, Sections 15F(h)(4) 
and (5) of the Exchange Act, as amended by the Dodd Frank Act, 
establish a set of additional provisions addressed solely to the 
interactions between SBS Entities and special entities in connection 
with security-based swaps.
    Some commenters have noted that special entities, like other market 
participants, may use swaps and security-based swaps for a variety of 
beneficial purposes, including risk management and portfolio 
adjustment.\40\ For example, we understand that pension plans can be 
authorized to use such instruments in order to meet the investment 
objectives of their members.\41\ At the same time, some commenters have 
also noted that the financial sophistication of these entities can vary 
greatly.\42\ Such variation in sophistication, among other factors, has 
raised concerns about potential abuses in connection with security-
based swap transactions with special entities.\43\
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    \40\ As explained by one commenter:
    ``Swaps permit [pension] plans to hedge against market 
fluctuations, interest rate changes, and other factors that create 
volatility and uncertainty with respect to plan funding. Swaps also 
help plans rebalance their investment portfolios, diversify their 
investments, and gain exposure to particular asset classes without 
direct investments. By helping to protect plan assets as part of a 
prudent long-term investment strategy, swaps benefit the millions of 
participants who rely on these plans for retirement income, health 
care, and other important benefits.''
    Letter from Mark J. Ugoretz, President and CEO, The ERISA 
Industry Committee to David A. Stawick, Secretary, CFTC (Feb. 22, 
2011).
    \41\ See, e.g., Letter from Joseph A. Dear, Chief Investment 
Officer, California Public Employees' Retirement System et al. to 
David A. Stawick, Secretary, CFTC (Feb. 18, 2011) (the ``Public 
Pension Funds Letter''):
    To fulfill obligations to our members, we invest in a wide 
variety of assets classes, including alternative investment 
management, global equity, global fixed income, inflation-linked 
assets, and real estate. As part of our investment and risk 
management policies, we have authorized the use of certain 
derivates. The authorized derivatives include futures, forward, 
swaps, structured notes and options.
    \42\ See, e.g., Letter from Barbara Roper, Director of Investor 
Protection, Consumer Federation of America, Lisa Donner, Executive 
Director, Americans for Financial Reform, Michael Greenberger, J.D., 
Founder and Director of University of Maryland Center for Health and 
Homeland Security, and Damon Silvers, Director of Policy and Special 
Counsel, AFL-CIO to David A. Stawick, Secretary, CFTC (Feb. 22, 
2011).
    \43\ See, e.g., 156 Cong. Rec. S5903 (daily ed. Jul. 15, 2010) 
(statement of Sen. Lincoln) (discussing how ``pension plans, 
governmental investors, and charitable endowments were falling 
victim to swap dealers marketing swaps and security-based swaps that 
they knew or should have known to be inappropriate or unsuitable for 
their clients. Jefferson County, AL, is probably the most infamous 
example, but there are many others in Pennsylvania and across the 
country.'').
---------------------------------------------------------------------------

    In implementing the special entity provisions of the Dodd-Frank 
Act, we have sought to give full effect to the additional protections 
for these entities contemplated by the statute, while not imposing 
restrictions on SBS Entities that would unduly limit their willingness 
or ability to provide special entities with the access to security-
based swaps that special entities may need for risk management and 
other beneficial purposes. We request comment on all aspects of the 
approach to special entities described in this release.

II. Discussion of Proposed Rules Governing Business Conduct

    The proposed rules would implement the requirements of the Dodd-
Frank Act relating to business conduct standards for SBS Entities.

A. Scope: Proposed Rule 15Fh-1

    Proposed Rule 15Fh-1 provides that proposed Rules 15Fh-1 through 
15Fh-6 and Rule 15Fk-1 are not intended to limit, or restrict, the 
applicability of other provisions of the federal securities laws, 
including but not limited to Section 17(a) of the Securities Act of 
1933 (``Securities Act''), Sections 9 and 10(b) of the Exchange Act, 
and the rules and regulations thereunder.\44\ It also provides that 
proposed Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1 would not only 
apply in connection with entering into security-based swaps but also 
would continue to apply, as relevant, over the term of executed 
security-based swaps. Specifically, as discussed more fully herein, an 
SBS Entity's obligations under proposed Rules 15Fh-3(c) (daily mark) 
and 15Fh-3(g) (fair and balanced communications) would continue to 
apply over the life of a security-based swap. In addition, SBS Entities 
would be subject to ongoing obligations under proposed Rules 15Fh-3(h) 
(supervision) and 15Fk-1 (chief compliance officer). The proposed rules 
would not, however, apply to security-based swaps executed prior to the 
compliance date of these rules.
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    \44\ Section 15F(h) of the Exchange Act does not, by its terms, 
create a new private right of action or right of rescission, nor do 
we anticipate that the proposed rules would create any new private 
right of action or right of rescission.
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of 
proposed Rule 15Fh-1 and the scope of the proposed business conduct 
rules. In addition, we request comment on the following specific 
issues:
     Should any rule proposed by this release specify in 
greater detail the manner in which its disclosure or other requirements 
apply to associated persons? \45\ If so, for which rules would such 
clarification be helpful? How should the Commission apply the 
requirements of such rules to the associated person?
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    \45\ As described below, proposed Rule 15Fh-2(d) would provide 
that the term ``security-based swap dealer or major security-based 
swap participant'' would include, ``where relevant,'' an associated 
person of the SBS Entity in question.
---------------------------------------------------------------------------

     Should the proposed rules apply to transactions between an 
SBS Entity and

[[Page 42402]]

its affiliates? If so, which rules? Why or why not?
     Should any rules proposed by this release, such as those 
relating to the daily mark or fair and balanced communications, apply 
to security-based swaps that were entered into prior to the effective 
date of these rules? If so, which rules and why?
     Should any of the proposed rules apply to amendments, made 
after the effective date of these rules, to security-based swaps that 
were entered into prior to the effective date of the rules? If so, 
which rules and why?
     Are there any specific interactions or relationships 
between the proposed rules and existing federal securities laws that 
should be addressed? Are there any specific interactions or 
relationships between the proposed rules and other regulatory 
requirements, such as SRO rules, that should be addressed? Are there 
any specific interactions or relationships between the proposed rules 
and other existing non-securities statutes and regulations (e.g., 
ERISA) that should be addressed? If so, how should those interactions 
or relationships be clarified?
     To the extent any of the rules proposed herein are 
intended to provide additional protections for a particular 
counterparty, should the counterparty be able to opt out of those 
protections? Should the ability to opt out be limited to certain types 
of counterparties? Why or why not? What criteria should determine or 
inform the decision to permit a counterparty to opt out? For example, 
should opt out be permitted when a counterparty is a regulated entity 
such as a registered broker-dealer? A registered futures commission 
merchant? A bank? Should opt out be permitted when a counterparty meets 
certain objective standards, such as being a ``qualified institutional 
buyer'' within the meaning of Rule 144A under the Securities Act? \46\ 
Why or why not? What other standards, if any, should the Commission 
consider? What would be the advantages and disadvantages of permitting 
a counterparty to opt out? What are the reasons that a counterparty 
might want to opt out of protections provided by the proposed business 
conduct standards? For example, would permitting counterparties to opt 
out lower costs? Would these reasons vary among different types of 
counterparties? Would counterparties have a meaningful opportunity to 
elect whether or not to opt out of these protections, or would they 
face commercial or other pressure from SBS Entities that could curtail 
their choice? How would permitting counterparties to opt out affect the 
protections otherwise afforded by the proposed rules to the 
counterparties of SBS Entities? How would the overall effectiveness of 
a proposed rule be affected if a substantial population of 
counterparties opts out of that rule?
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    \46\ See Rule 144A(a), 17 CFR 230.144A(a) (defining ``qualified 
institutional buyer''). See Letter from Kenneth E. Bensten, Jr., 
Executive Vice President, Public Policy and Advocacy, SIFMA, and 
Robert C. Pickel, Executive Vice Chairman, ISDA to David A. Stawick, 
Secretary, CFTC (Feb. 17, 2011) (on file with Commission) (``SIFMA/
ISDA 2011 Letter'') (recommending that Commission permit opt out by 
``sophisticated counterparties,'' including `` `qualified 
institutional buyers' as defined in Rule 144A * * * and corporations 
having total assets of $100 million or more'').
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     As discussed below in Section II.E, proposed Rule 15Fk-1 
would require an SBS Entity to have policies and procedures reasonably 
designed to achieve compliance with Section 15F and the rules and 
regulations thereunder. Should an SBS Entity be deemed to have complied 
with a requirement under the proposed rules if: (i) The SBS Entity has 
established and maintained written policies and procedures, and a 
documented system for applying those policies and procedures, that are 
reasonably designed to achieve compliance with the requirement; and 
(ii) the SBS Entity has reasonably discharged the duties and 
obligations required by the written policies and procedures and 
documented system and did not have a reasonable basis to believe that 
the written policies and procedures and documented system were not 
being followed? Why or why not? Please explain the advantages or 
disadvantages of this approach to the extent it results in rules that 
effectively require SBS Entities to maintain and enforce specified 
policies and procedures regarding certain conduct, rather than rules 
that directly require, or prohibit, that conduct. Would this approach 
be appropriate for certain specific requirements of the rules but not 
for others? Why or why not? Would such an approach encourage or 
discourage compliance with the requirements under the proposed rules? 
Would the behavior of SBS Entities or the way in which they design 
their compliance programs be different under this approach than it 
would be under the rules as proposed? How would the effectiveness of 
such an approach compare to the effectiveness of the rules as proposed 
in implementing the requirements of the Dodd-Frank Act regarding the 
business conduct of SBS Entities, especially with respect to special 
entities? Would such an approach affect the ability of the Commission 
to inspect for compliance with the rules or to bring enforcement 
actions regarding violations? If so, how?
     As discussed herein, we preliminarily believe that, absent 
special circumstances, it would be appropriate for SBS Entities to rely 
on counterparty representations in connection with certain specific 
requirements under the proposed rules. To solicit input on when it 
would no longer be appropriate for an SBS Entity to rely on such 
representations without further inquiry, the Commission is proposing 
for comment two alternative approaches. One approach would permit an 
SBS Entity to rely on a representation from a counterparty unless it 
knows that the representation is not accurate. The second would permit 
an SBS Entity to rely on a representation unless the SBS Entity has 
information that would cause a reasonable person to question the 
accuracy of the representation. Should the rules that the Commission 
ultimately adopts include a standard addressing the circumstances in 
which an SBS Entity may rely on representations to establish compliance 
with the proposed rules? Why or why not?

B. Definitions: Proposed Rule 15Fh-2

    Proposed Rule 15Fh-2(a), as discussed in Section II.D.3 below, 
would define ``act as an advisor'' for purposes of Section 15F(h)(4) of 
the Exchange Act and proposed Rule 15Fh-4(b).
    Proposed Rule 15Fh-2(b) would define ``eligible contract 
participant'' to mean any person defined in Section 3(a)(66) of the 
Exchange Act.
    Proposed Rule 15Fh-2(c), as discussed in Section II.D.4.b. below, 
would define ``independent representative of a special entity'' for 
purposes of Section 15F(h)(5) of the Exchange Act and proposed Rule 
15Fh-5.
    Proposed Rule 15Fh-2(d) would provide that ``security-based swap 
dealer or major security-based swap participant'' would include, where 
relevant, an associated person of the SBS Dealer or Major SBS 
Participant.\47\ To the extent that an SBS Entity acts through, or by 
means of, an associated person of that SBS Entity, the associated 
person must comply as well with the

[[Page 42403]]

applicable business conduct standards.\48\
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    \47\ See Section 3(a)(70) of the Exchange Act, Pub. L. 111-203, 
124 Stat. 1376, 1757-1758 (to be codified at 15 U.S.C. 78c(a)(70)) 
(defining ``Person Associated with a Security-Based Swap Dealer or 
Major Security-Based Swap Participant'').
    \48\ See Section 20(b) of the Exchange Act, 15 U.S.C. 78t(b) 
(``It shall be unlawful for any person, directly or indirectly, to 
do any act or thing which it would be unlawful for such person to do 
under the provisions of this title or any rule or regulation 
thereunder through or by means of any other person.'').
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    Proposed Rule 15Fh-2(e), as discussed in Section II.D.1 below, 
would define ``special entity.''
    Proposed Rule 15Fh-2(f), as discussed in Section II.D.4.e below, 
would define a person that is ``subject to a statutory 
disqualification'' to mean a person that would be subject to a 
statutory disqualification under the provisions of Section 3(a)(39) of 
the Exchange Act.
Request for Comments
    The Commission requests comments generally on all aspects of 
proposed Rule 15Fh-2. In addition, we request comments on the following 
specific issues:
     Are there additional terms that should be defined by the 
Commission; if so, how should such terms be defined and why? \49\
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    \49\ The Commission is proposing to define certain additional 
terms solely for purposes of proposed Rules 15Fh-6 and 15Fk-1. See 
proposed Rules 15Fh-6(a) and 15Fk-1(e).
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     Should the proposed rules expressly identify the 
requirements that apply to associated persons of an SBS Entity? If so, 
which rules and why?
     Is it possible that an associated person that is an entity 
(i.e., not a natural person) that effects or is involved in effecting 
security-based swaps on behalf of an SBS Entity would be subject to a 
statutory disqualification? If so, should the Commission consider 
excepting any such persons from the prohibition in Section 15F(b)(6)? 
Under what circumstances and why? Should the Commission except such 
persons globally or on an individual basis?
     Are there certain statutorily disqualified persons who 
should not be permitted to remain associated with an SBS Entity based 
upon the nature of the disqualification?
     Should there be any differentiation in relief based upon 
the nature of the person, e.g., a natural person or an entity? If so, 
when and why?

C. Business Conduct Requirements: Proposed Rule 15Fh-3

1. Counterparty Status
    Proposed Rule 15Fh-3(a)(1) would require an SBS Entity, as provided 
by Section 15F(h)(3)(A) of the Exchange Act, to verify that a 
counterparty whose identity is known to an SBS Entity prior to the 
execution of the transaction meets the eligibility standards for an ECP 
before entering into a security-based swap with that counterparty other 
than on a registered national securities exchange.\50\ Although the 
statute is silent concerning the timing of the verification, we believe 
it is important for an SBS Entity to verify ECP status before entering 
into a security-based swap because, among other things, Section 6(l) of 
the Exchange Act makes it unlawful to effect a transaction in a 
security-based swap with or for a person that is not an ECP, unless the 
transaction is effected on a registered national securities 
exchange.\51\ In addition, proposed Rule 15Fh-3(a)(1) would not require 
an SBS Entity to verify the ECP status of a counterparty in a 
transaction executed on a registered national securities exchange or a 
registered security-based swap execution facility (``SEF''). Such 
verification would not be necessary because, under proposed Rule 809, 
SEFs may not provide access to entities that are not ECPs, and thus an 
SBS Entity could effectively rely on the verification of ECP status by 
a SEF or any broker or SBS Dealer indirectly providing access.\52\
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    \50\ See Section 15F(h)(3)(A) of the Exchange Act (requiring the 
Commission to establish a duty for an SBS Entity to verify that its 
counterparty meets the eligibility requirements of an ECP). Public 
Law 111-203, 124 Stat. 1376, 1790 (to be codified at 15 U.S.C. 78o-
10(h)(3)(A). Under Exchange Act Section 3(a)(65), the term 
``eligible contract participant'' has the same meaning as in Section 
1a of the Commodity Exchange Act (7 U.S.C. 1a). Public Law 111-203, 
124 Stat. 1376, 1755 (to be codified at 15 U.S.C. 78c(a)(65)). See 
also Definitions Release (proposing to further define ``eligible 
contract participant'' to include, among others, swap dealers, major 
swap participants, security-based swap dealers and major security-
based swap participants).
    \51\ Public Law 111-203, 124 Stat. 1376, 1777, Sec.  764(e) (to 
be codified at 15 U.S.C. 78f(l)) (``[i]t shall be unlawful for any 
person to effect a transaction in a security-based swap with or for 
a person that is not an eligible contract participant, unless such 
transaction is effected on a [registered] national securities 
exchange''). See also Public Law 111-203, 124 Stat. 1376, 1801, 
Sec.  768(b) (to be codified at 15 U.S.C. 77e(d)) (``unless a 
registration statement meeting the requirements of section 10(a) [of 
the Securities Act] is in effect as to a security-based swap, it 
shall be unlawful for any person * * * to offer to sell, offer to 
buy or purchase or sell a security-based swap to any person who is 
not an eligible contract participant'').
    \52\ Registration and Regulation of Security-Based Swap 
Execution Facilities, Exchange Act Release No. 63825 (Feb. 2, 2011), 
76 FR 10948 (Feb. 28, 2011) (proposed Rule 809 would permit, but not 
require SEF participation ``only if such person is registered with 
the Commission as a security-based swap dealer, major security-based 
swap participant, or broker (as defined in section 3(a)(4) of the 
Act, 15 U.S.C. 78c(a)(4)), or if such person is an eligible contract 
participant (as defined in section 3(a)(65) of the Act, 15 U.S.C. 
78c(a)(65)).'').
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    Proposed Rule 15Fh-3(a)(2) would require an SBS Entity to verify 
whether a counterparty whose identity is known to an SBS Entity prior 
to the execution of the transaction is a special entity before entering 
into a security-based swap with that counterparty.\53\ Although the 
Dodd-Frank Act does not specifically require an SBS Entity to verify 
whether a counterparty is a special entity, we preliminarily believe 
that such verification would facilitate the implementation of the 
special business conduct rules under the Dodd-Frank Act that apply to 
SBS Entities dealing with special entities.\54\
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    \53\ See generally Section 15F(h)(1)(D) of the Exchange Act, 
Public Law 111-203, 124 Stat. 1376, 1789 (to be codified at 15 
U.S.C. 78o-10(h)(1)(D)) (authorizing the Commission to prescribe 
business conduct standards that relate to ``such other matters as 
the Commission determines to be appropriate'').
    \54\ See Section II.D, infra. Because proposed Rule 15Fh-3(a)(2) 
would only apply when an SBS Entity knows the identity of its 
counterparty prior to the execution of a transaction, it is 
consistent with Section 15F(h)(7) of the Exchange Act, which 
contemplates an exception to all of the various business conduct 
requirements of Section 15F(h) for any transaction that is initiated 
by a special entity on an exchange or SEF, where the SBS Entity does 
not know the identity of the counterparty to the transaction.
---------------------------------------------------------------------------

    We believe that SBS Entities may satisfy these proposed 
verification requirements through any reasonable means.\55\ For 
example, an SBS Entity could verify that a counterparty is an ECP by 
obtaining a written representation from the counterparty. We 
preliminarily believe that it would not be reasonable for an SBS Entity 
to rely on a representation that merely states that the counterparty is 
an ECP because the counterparty may not be familiar with the 
definitions of the term under the federal securities laws. However, it 
would be reasonable for an SBS Entity to rely on a written 
representation as to specific facts about the counterparty (e.g., that 
it has $10 million in assets) in order to conclude that the 
counterparty is an ECP.
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    \55\ The SBS Entity must keep records of its verification. See 
proposed Rule 15Fk-1, discussed infra at Section II.E, which would 
require an SBS Entity to have written policies and procedures and 
maintain records sufficient to enable its chief compliance office to 
verify compliance with the requirements of the proposed rules. In 
addition, the Commission is required to propose a rule regarding 
reporting and recordkeeping requirements for SBS Entities. See 
Section 15F(f)(2) of the Exchange Act, Public Law 111-203, 124 Stat. 
1376, 1788 (to be codified at 15 U.S.C. 78o-10(f)(2)) (``The 
Commission shall adopt rules governing reporting and recordkeeping 
for security-based swap dealers and major security-based swap 
participants'').
---------------------------------------------------------------------------

    Similarly, we preliminarily believe that it would not be reasonable 
for an SBS Entity to rely on a representation that merely states that 
the counterparty is not a ``special entity'' because the counterparty 
may not be familiar with the definition of the term under the federal 
securities laws. However, an

[[Page 42404]]

SBS Entity could verify that a counterparty is not a special entity by 
obtaining a written representation from the counterparty that it does 
not fall within any of the enumerated categories of persons that are 
``special entities'' for purposes of Section 15F of the Exchange Act 
(e.g., that the counterparty is not a municipality, pension plan, 
etc.). In the context of either the ECP or the special entity 
verification, an SBS Entity would be entitled to rely on a 
counterparty's written representation for purposes of compliance with 
Rule 15Fh-3(a) without further inquiry, absent special circumstances 
described below.\56\
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    \56\ An SBS Entity would not be required to obtain a 
representation from the counterparty and so could elect to verify 
the counterparty's status through any other reasonable means.
---------------------------------------------------------------------------

    To solicit input on when it would no longer be appropriate for an 
SBS Entity to rely on such representations without further inquiry, the 
Commission is proposing for comment two alternative approaches. One 
approach would permit an SBS Entity to rely on a representation from a 
special entity for purposes of Rule 15Fh-3(a) unless it knows that the 
representation is not accurate. The second would permit an SBS Entity 
to rely on a representation unless the SBS Entity has information that 
would cause a reasonable person to question the accuracy of the 
representation.
    Under either approach, an SBS Entity could not ignore information 
in its possession as a result of which the SBS Entity would know that a 
representation is inaccurate.\57\ In addition, under the second 
approach, an SBS Entity also could not ignore information that would 
cause a reasonable person to question the accuracy of a representation 
and, if the SBS Entity had such information, it would need to make 
further reasonable inquiry to verify the accuracy of the 
representation.\58\
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    \57\ As described infra, proposed Rule 15Fh-3(e) would require 
an SBS Dealer to have policies and procedures reasonably designed to 
obtain and retain certain essential facts regarding a counterparty. 
As a result, information in the SBS Entity's possession would 
include information gathered by an SBS Dealer through compliance 
with the ``know your counterparty'' provisions of proposed Rule 
15Fh-3(e), as well as any other information the SBS Entity has 
acquired through its interactions with the counterparty including 
other representations obtained from the counterparty by the SBS 
Entity.
    \58\ Cf. Rule 144A(d)(1)(iv) under the Securities Act, 17 CFR 
230.144A(d)(1)(iv) (providing that in determining whether a 
prospective purchaser is a qualified institutional buyer, a seller 
of securities is entitled to rely on a certification by an executive 
officer of the purchaser with respect to the amount of securities 
owned and invested on a discretionary basis). The Commission, in its 
release adopting Rule 144A, explained that ``[u]nless circumstances 
exist giving a seller reason to question the veracity of the 
certification, the seller would not have a duty of inquiry to verify 
the certification.'' Private Resales of Securities to Institutions, 
Securities Act Release No. 6862 (April 27, 1990), 55 FR 17933 (Apr. 
30, 1990). Cf. also Short Sales, Exchange Act Release No. 50103 
(July 28, 2004), 69 FR 48008 (Aug. 6, 2004) at n. 58 (explaining 
that a broker-dealer can rely on a customer's assurance to establish 
the ``reasonable grounds'' required by Rule 203(b)(1)(ii) unless the 
broker-dealer ``knows or has reason to know'' that a customer's 
prior assurances resulted in failures to deliver).
    Under Regulation R, a bank or a broker-dealer satisfies its 
customer eligibility requirements if the bank or broker-dealer ``has 
a reasonable basis to believe that the customer'' is an 
institutional customer or high net worth customer before the time 
specified in the rule. When adopting Regulation R, the Commission 
stated that a bank or broker-dealer would have a ``reasonable basis 
to believe'' if it obtains a signed acknowledgment that the customer 
met the applicable standards, unless it had information that would 
cause it to believe that the information provided by the customer 
was or was likely to be false. Definitions of Terms and Exemptions 
Relating to the ``Broker'' Exceptions for Banks, Exchange Act 
Release No. 56501 (Sep. 28, 2007), 72 FR 56514 (Oct. 3, 2007).
    Commenters have suggested a similar approach. See SIFMA/ISDA 
2011 Letter (suggesting that an SBS Entity should be able to rely on 
written representations by the counterparty ``absent actual notice 
of countervailing facts (or facts that reasonably should have put 
the [SBS Entity] on notice)'').
    We note that Congress used similar language in the statutory 
provisions governing registration of SBS Entities. See Section 
15F(b)(6) of the Exchange Act, Public Law 111-203, 124 Stat. 1376, 
1785 (to be codified at 15 U.S.C. 78o-10(b)(6)) (generally making it 
unlawful for an SBS Entity to permit an associated person that is 
subject to a statutory disqualification to effect or participate in 
effecting security-based swaps on behalf of the SBS Entity if the 
SBS Entity ``knew, or in the exercise of reasonable care should have 
known,'' of the statutory disqualification).
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    An SBS Entity that has complied with the requirements of proposed 
Rule 15Fh-3(a)(1) concerning a counterparty's eligibility for a 
particular security-based swap would fulfill its obligations under the 
proposed rule for that security-based swap, even if the counterparty 
subsequently ceases to meet the eligibility standards for an ECP during 
the term of that security-based swap. However, verification of a 
counterparty's status as an ECP (and, as applicable, as a special 
entity) for one security-based swap would not necessarily satisfy the 
SBS Entity's obligation with respect to other security-based swaps 
executed with that counterparty in the future. An SBS Entity would need 
to verify the counterparty's status for each subsequent security-based 
swap (which it could do by relying on written representations from the 
counterparty, as described above). An SBS Entity could satisfy this 
obligation by relying on a representation in a master or other 
agreement that is deemed to be repeated and incorporated into each 
security-based swap under that agreement as of the date on which each 
security-based swap is executed.\59\
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    \59\ See, e.g., SIFMA/ISDA 2011 Letter (suggesting that an SBS 
Entity should be able to rely on a master agreement that contains 
(1) a counterparty eligibility representation that is deemed to be 
made at the inception of each transaction and (2) a covenant that 
the counterparty will notify the SBS Entity if it ceases to be an 
ECP).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Although we are proposing to require that an SBS Entity 
verify that a counterparty is an ECP, we are not proposing at this time 
to require that the SBS Entity otherwise determine that a potential 
counterparty is ``qualified'' to engage in security-based swaps before 
entering into a security-based swap with that person.\60\ Given that 
the Dodd-Frank Act permits any ECP to engage in security-based swaps, 
would it be appropriate for the Commission to limit which ECPs may 
engage in security-based swaps? Should the Commission impose an 
additional requirement that an SBS Entity determine that an ECP is 
otherwise ``qualified'' before the SBS Entity can enter into security-
based swaps with such ECP? If so, what qualifications should be 
applied, and to which types of ECPs? For example, the definition of ECP 
includes persons with $5 million or more invested on a discretionary 
basis that enter into the security-based swap ``to manage risks.'' \61\ 
In contrast, under FINRA rules, ``retail customers'' would include 
persons (whether a natural person, corporation, partnership, trust, or 
otherwise) with total assets of up to $50 million.\62\ To what extent 
do natural persons and institutions with assets of less than $50 
million engage in security-based swap transactions? Would the ``know 
your counterparty'' and suitability obligations of an SBS Dealer under 
proposed Rule15Fh-3(e) and (f), as described more fully below, help to

[[Page 42405]]

mitigate concerns regarding these persons?
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    \60\ Cf. FINRA Rule 2360(16)(A) (providing that no member or 
person associated with a member shall accept an order from a 
customer to purchase or write an option contract unless, among other 
things, the customer's account has been approved for options 
trading).
    \61\ A natural person with $5 million or more invested on a 
discretionary basis would qualify as an ECP if he or she entered 
into a security-based swap ``to manage risks.'' See Section 
1a(18)(A)(xi) of the Commodity Exchange Act.
    \62\ Under FINRA rules, unless a person had total assets of at 
least $50 million, a broker-dealer engaging in transactions with 
that person would be subject to retail suitability obligations. See 
FINRA Rule 2111(b) (referring to NASD Rule 3110(c)(4)).
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     Are there alternative approaches that would be feasible in 
terms of market practice for determining ECP and special entity status? 
If so, what would be the advantages and disadvantages of these 
approaches for SBS Entities and counterparties? Should the Commission, 
for example, establish specific documentation requirements or 
procedures that could be used to verify ECP or special entity status? 
Should specific types of documentation be required? If so, what types 
of documentation (e.g., bank or brokerage statements, legal entity 
filings)?
     Should the Commission otherwise specify the means by which 
SBS Entities should verify the status of a counterparty? If so, what 
means should it require?
     What are the advantages and disadvantages of the two 
alternative proposed approaches for determining when an SBS Entity may 
no longer rely on counterparty representations? Which alternative would 
strike the better balance among the regulatory interest in the 
verification of ECP and special entity status, the sound functioning of 
the security-based swap market, and the potential compliance costs for 
market participants? What, if any, other alternatives should the 
Commission consider (e.g., a recklessness standard) and why?
     In light of the additional protections that are afforded 
special entities under the Dodd-Frank Act described in Section I.C.5 
above, should an SBS Entity be required to undertake diligence or 
further inquiry in ascertaining the special entity status of a 
potential counterparty before it can rely on any representation as to 
such status from the counterparty? Why or why not? If such diligence or 
inquiry is not required, should an SBS Entity be permitted to rely on 
representations as to special entity status from a counterparty only 
where the SBS Entity does not have information that would cause a 
reasonable person to question the accuracy of the representation? Why 
or why not? Would requiring such diligence or further inquiry--or 
allowing reliance on representations only in such a manner--unduly 
limit the willingness or ability of SBS Entities to provide special 
entities with the access to security-based swaps for the purposes 
described in Section I.C.5 above? Why or why not? What, if any, other 
measures should be required in connection with an SBS Entity's 
verification of a counterparty's special entity status?
     Are there particular classes of ECPs or special entities 
for which an SBS Entity should be required to undertake further review 
or inquiry, rather than rely on written representations to verify 
status? Should further review or inquiry be required when, for example, 
a potential counterparty is a natural person or a special entity? If 
so, what review or inquiry should be required and, in what 
circumstances?
     Are there other potentially reasonable means or procedures 
that an SBS Entity might use to verify ECP or special entity status, 
other than through written representations, as to which the Commission 
should consider providing guidance? If so, what means or procedures 
should such guidance address, and how?
2. Disclosure
    Section 15F(h)(3)(B) of the Exchange Act broadly requires the 
Commission to adopt rules requiring disclosures by SBS Entities to 
counterparties of information related to ``material risks and 
characteristics'' of the security-based swap, ``material incentives or 
conflicts of interest'' that an SBS Entity may have in connection with 
the security-based swap, and the ``daily mark'' of a security-based 
swap.
a. Disclosure Not Required When the Counterparty Is an SBS Entity or a 
Swap Dealer or a Major Swap Participant
    Section 15F(h)(3)(B) further provides that disclosures under that 
section are not required when the counterparty is ``a security-based 
swap dealer, major security-based swap participant, security-based swap 
dealer, or major security-based swap participant.'' \63\ We believe 
that the repetition of the terms ``security-based swap dealer and major 
security-based swap participant'' in this Exchange Act provision is a 
drafting error, and that Congress instead intended an exclusion 
identical to that found in the Commodity Exchange Act, which provides 
that these general disclosures are not required when the counterparty 
is ``a swap dealer, major swap participant, security-based swap dealer, 
or major security-based swap participant.'' \64\ Accordingly, we are 
proposing that the disclosure requirements under Rule 15Fh-3(b) 
(information about material risks and characteristics, and material 
incentives or conflicts of interests), Rule 15Fh-3(c) (the daily mark), 
and Rule 15Fh-3(d) (clearing rights) not apply whenever the 
counterparty is an SBS Dealer, a Major SBS Participant, a swap dealer 
or a major swap participant.\65\
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    \63\ Public Law 111-203, 124 Stat. 1376, 1790 (to be codified at 
15 U.S.C. 78o-10(h)(3)(B)).
    \64\ Public Law 111-203, 124 Stat. 1376, 1708 (to be codified at 
7 U.S.C. 6s(h)(3)(B)).
    \65\ But see proposed Rule 15Fh-1 (the proposed rules ``are not 
intended to limit, or restrict, the applicability of other 
provisions of the federal securities laws, including but not limited 
to, Section 17(a) of the Securities Act of 1933 and Sections 9 and 
10(b) of the Securities Exchange Act of 1934.'').
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Request for Comments

    The Commission requests comments generally on all aspects of this 
exception. In addition, we request comments on the following specific 
issues:
     Should some or all of the disclosure requirements under 
proposed Rule 15Fh-3(b) (information about material risks and 
characteristics, material incentives or conflicts of interests), Rule 
15Fh-3(c) (the daily mark), and Rule 15Fh-3(d) (clearing rights) apply 
when the counterparty is an SBS Entity, swap dealer or major swap 
participant? Why or why not? For example, we are not proposing to 
require that an SBS Entity provide a daily mark to a counterparty that 
is an SBS Entity, swap dealer or major swap participant, because we 
preliminarily believe that a counterparty that falls into one of these 
categories would be able to perform the function on its own. 
Nevertheless, would there be some advantage in requiring such 
counterparties to exchange their respective marks, on a daily basis, so 
that any discrepancies are more transparent and can be identified and 
addressed promptly? Why or why not? Would there be disadvantages to 
this approach? Why or why not? Similarly, would there be any advantage 
in requiring any of the other disclosures to be made to a counterparty 
that is an SBS Entity, swap dealer or major swap participant? Why or 
why not? Would there be disadvantages? Why or why not?
     Should the Commission instead require that disclosures be 
made upon request by a counterparty that is an SBS Entity, swap dealer 
or major swap participant? Why or why not?
     Should the Commission require a different type or amount 
of disclosure for categories of counterparties that are market 
professionals such as broker-dealers, futures commission merchants and 
banks? What criteria should determine or inform the type or amount of 
disclosure? For example, should an SBS Entity be permitted to provide 
different or less detailed disclosure to a counterparty that is a 
registered broker-dealer? A registered futures commission merchant? A 
bank?

[[Page 42406]]

b. Timing and Manner of Certain Disclosures
    Proposed Rule 15Fh-3(b) would require that disclosures regarding 
material risks and characteristics and material incentives or conflicts 
of interest be made to potential counterparties before entering into a 
security-based swap, but would not mandate the manner in which those 
disclosures are made.\66\ Proposed Rule 15Fh-3(d) similarly would 
require that disclosures regarding certain clearing rights be made 
before entering into a security-based swap, but also would not mandate 
the manner of disclosure. To the extent such disclosures were not 
otherwise provided to the counterparty in writing prior to entering 
into a security-based swap, proposed Rules 15Fh-3(b)(3) and 15Fh-
3(d)(3) would require an SBS Entity to make a contemporaneous record of 
the non-written disclosures made pursuant to proposed Rules15Fh-3(b) 
and 15Fh-3(d), respectively, and provide a written version of these 
disclosures to the counterparty in a timely manner, but in any case no 
later than the delivery of the trade acknowledgement \67\ of the 
particular transaction.\68\
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    \66\ Section 15F(h)(3)(B) of the Exchange Act is silent 
regarding both form and timing of disclosure. See Public Law 111-
203, 124 Stat. 1376, 1790 (to be codified at 15 U.S.C. 78o-
10(h)(3)(B)).
    \67\ See Trade Acknowledgement and Verification of Security-
Based Swap Transactions, Exchange Act Release No. 63727 (Jan. 14, 
2011), 76 FR 3859 (Jan. 21, 2011) (proposing Rule 15Fi-1(c)(1), 
which would require a trade acknowledgement to be provided within 15 
minutes of execution for a transaction that has been executed and 
processed electronically; within 30 minutes of execution for a 
transaction that is not electronically executed, but that will be 
processed electronically; and within 24 hours of execution for a 
transaction that the SBS Entity cannot process electronically).
    \68\ See also Section 15F(g) of the Exchange Act (requiring the 
Commission to adopt rules governing daily trading records, including 
recordings of telephone calls):
    (g) DAILY TRADING RECORDS.--
    (1) IN GENERAL.--Each registered security-based swap dealer and 
major security-based swap participant shall maintain daily trading 
records of the security-based swaps of the registered security-based 
swap dealer and major security-based swap participant and all 
related records (including related cash or forward transactions) and 
recorded communications, including electronic mail, instant 
messages, and recordings of telephone calls, for such period as may 
be required by the Commission by rule or regulation.
    (2) INFORMATION REQUIREMENTS.--The daily trading records shall 
include such information as the Commission shall require by rule or 
regulation.
    (3) COUNTERPARTY RECORDS.--Each registered security-based swap 
dealer and major security-based swap participant shall maintain 
daily trading records for each counterparty in a manner and form 
that is identifiable with each security-based swap transaction.
    Public Law 111-203, 124 Stat. 1376, 1788-1789 (to be codified at 
15 U.S.C. 78o-10(g)).
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    Because disclosures of material risks and characteristics, material 
incentives or conflicts of interests, and clearing rights include 
information that the counterparty should consider in deciding whether 
to enter into the security-based swap, we are proposing to require that 
these disclosures be provided before entry into a security-based swap.
    Concerning the manner of disclosure, however, we preliminarily 
believe that parties should have flexibility to make disclosures by 
various means, provided that the SBS Entity (1) makes an appropriate 
record of such disclosures and (2) supplies its counterparty with a 
written version of any disclosure required under these rules that was 
not made in writing prior to the transaction. Means of disclosure may 
include master agreements and related documentation, telephone calls, 
emails, instant messages, and electronic platforms.\69\ Proposed Rule 
15Fh-3(b) would require that the required disclosures regarding 
material risks and characteristics and material incentives or conflicts 
of interest be made ``in a manner reasonably designed to allow the 
counterparty to assess'' the information being provided. This provision 
is intended to require that disclosures be reasonably clear and 
informative as to the relevant material risks or conflicts that are the 
subject of the disclosure. This provision is not intended to impose a 
requirement that disclosures be tailored to a particular counterparty 
or to the financial, commercial or other status of that 
counterparty.\70\
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    \69\ For SBS Entities to rely on electronic media, however, 
their counterparties must have the capability to effectively access 
all of the information required by Rule 15Fh-3(b)(3) in a format 
that is understandable but not unduly burdensome for the 
counterparty. See Use of Electronic Media by Broker-Dealers, 
Transfer Agents and Investment Advisers for Delivery of Electronic 
Information, Securities Act Release No. 7288 (May 9, 1996), 61 FR 
24644 (May 15, 1996). See also Use of Electronic Media, Exchange Act 
Release No. 42728 (Apr. 28, 2000), 65 FR 25843 (May 4, 2000).
    \70\ SBS Entities would, of course, have an on-going obligation 
to communicate with counterparties in a fair and balanced manner 
based on principles of fair dealing and good faith. See proposed 
Rule 15Fh-3(g) (discussed infra at Section II.C.5).
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    We understand that security-based swaps generally are executed 
under master agreements, with much of the transaction-specific 
disclosure provided over the telephone, in instant messages or in 
confirmations. We anticipate that SBS Entities may elect to make 
certain required disclosures of material information to their 
counterparties in a master agreement or other written document 
accompanying such agreement.\71\
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    \71\ While certain forms of disclosure may be highly 
standardized, the Commission anticipates that even such forms of 
disclosures will require certain provisions to be tailored to the 
particular transaction, most notably pricing and other transaction-
specific commercial terms. We believe the proposed approach is 
generally consistent with the use of standardized disclosures 
suggested by industry groups and commenters. See CRMPG III Report 
(suggesting that standardized risk disclosures should be viewed as a 
supplement to, rather than a substitute for, more detailed 
disclosures); and Letter from Kenneth E. Bentsen, Jr., Executive 
Vice President, Public Policy and Advocacy, SIFMA and Robert G. 
Pickel, Executive Vice Chairman, ISDA to Elizabeth M. Murphy, 
Secretary, Commission and David A. Stawick, Secretary, Commodity 
Futures Trading Commission (Oct. 22, 2010) (on file with Commission) 
(``SIFMA/ISDA 2010 Letter'') (recommending the use of standard 
disclosure templates that could be adopted on an industry-wide 
basis, and noting that ``the process of developing standardized 
disclosure materials would * * * provide a means for identifying 
circumstances in which more tailored disclosure might be 
appropriate'').
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    Commenters have asked that we clarify the applicability of these 
disclosure requirements to SEF- and exchange-traded security-based 
swaps in which the SBS Entity may not know the identity of the 
counterparty until immediately prior to (or after) execution of a 
transaction. The Dodd-Frank Act only addresses this issue in the 
context of special entities. Specifically, Section 15F(h)(7) provides 
an exception to the requirements of Section 15F(h) for a transaction 
that is ``initiated'' by a special entity on a SEF or an exchange and 
for which the SBS Entity does not know the identity of the counterparty 
to the transaction.\72\
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    \72\ Public Law. 111-203, 124 Stat. 1376, 1792 (to be codified 
at 15 U.S.C. 78o-10(h)(7). See Section II.D, infra.
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    We are seeking comment, therefore, on whether and how the proposed 
disclosure requirements should be satisfied for security-based swap 
transactions that are executed on a SEF or exchange and for which the 
SBS Entity does not know the identity of the counterparty until 
immediately prior to (or after) the execution of the transaction. In 
particular, we seek comment on how the disclosure obligations discussed 
below under proposed Rule 15Fh-3(b) (concerning material risks and 
characteristics, and material incentives or conflicts of interest) and 
proposed Rule 15Fh-3(d) (regarding clearing rights) could be met.
    The statute requires rules adopted by the Commission to require the 
SBS Entity to make these disclosures. We believe that SBS Entities 
generally should be able to rely on means reasonably designed to 
achieve timely delivery of the required disclosures. In particular, an 
SBS Entity could cause

[[Page 42407]]

the required disclosures to be delivered through a third party or other 
indirect means (such as by contracting with a SEF to deliver the 
disclosure electronically) in circumstances in which it may not be 
practicable for an SBS Entity to directly provide the disclosures in a 
timely manner.
    Commenters have suggested that SBS Entities should be able to rely 
on trade acknowledgements to satisfy certain disclosure 
requirements.\73\ Because proposed Rule 15Fh-3(b) would require that 
disclosures be made before ``entering into'' a security-based swap, SBS 
Entities generally would not be able to rely on trade acknowledgements 
and other documents that are provided after the transaction is executed 
to satisfy the rule's disclosure obligations. SBS Entities could, 
however, rely on trade acknowledgements to memorialize disclosures they 
made, whether orally or by other means, prior to entering into the 
proposed transaction.\74\
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    \73\ See SIFMA/ISDA 2010 Letter (``We recommend that the 
Commissions clarify that, to the extent that a counterparty is in 
possession of the master documentation and confirmation specifying 
the economic and other material terms of a specific transaction, 
registrant counterparties will have satisfied this requirement.'').
    \74\ Proposed Rule 15Fk-1, discussed infra at Section II. E, 
would require an SBS Entity to have reasonable written policies and 
procedures concerning the timing and form of disclosure, and 
maintain records sufficient to enable its chief compliance officer 
to verify compliance with the disclosure requirements under the 
proposed rules.
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    Finally, although we are proposing to permit disclosure by a range 
of means, both oral and written, we may revisit whether Congress's 
objectives under Section 15F(h) and the focus here on supervision and 
compliance require some further specific obligations concerning the 
manner in which disclosures are made.
Request for Comments
    The Commission requests comments generally on all aspects of this 
approach to the timing and manner of disclosure. In addition, we 
request comments on the following specific issues:
     Should the Commission impose more specific requirements 
concerning the timing and manner of disclosures? If so, what additional 
requirements should the Commission impose, and why?
     Commenters have urged the Commission to encourage the use 
of standardized disclosure templates.\75\ Who would develop those 
templates? What would the content be? What disclosures do or do not 
lend themselves to a standardized template? How would the templates be 
updated or supplemented to respond to market developments or account 
for the characteristics of a specific transaction?
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    \75\ See, e.g., SIFMA/ISDA 2010 Letter at 3.
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     Should the Commission require that all material 
disclosures be provided in writing prior to the execution of the 
transaction? If not, does the option to memorialize the disclosure and 
provide a written version of the disclosure to the counterparty provide 
adequate safeguards to ensure that parties are complying with the 
disclosure, supervision and compliance requirements discussed more 
fully below, as well as the provisions intended to increase the 
protection of special entities? Are there any other safeguards the 
Commission should consider? How do such safeguards provide the same or 
better protection or information for counterparties than written 
disclosures in advance of a transaction?
     Should the Commission require disclosures to be made a 
certain period of time before execution of a transaction? If so, what 
would be the advantages and disadvantages of various periods?
     Should the Commission impose specific requirements 
concerning the timing and manner in which disclosures are made to 
certain counterparties, such as special entities or categories of 
special entities? If so, which counterparties, and why? What 
requirements would be appropriate for which counterparties?
     Should the Commission require that disclosures be made in 
writing prior to the execution of the transaction when the counterparty 
is a special entity? Why or why not? If so, should this requirement 
apply with respect to all special entities? If not, how should the 
Commission distinguish among special entities?
     Should the Commission permit SBS Entities to rely on 
information in trade acknowledgements to satisfy certain disclosure 
requirements? Why or why not? Are there other approaches that would be 
more effective or efficient than the Commission's proposed approach to 
disclosure?
     In which situations (or under what circumstances) would 
the SBS Entity not know the identity of the counterparty prior to 
execution of the transaction on a SEF or exchange? If the SBS Entity 
subsequently learns the identity of the counterparty, when would such 
identity typically be ascertained (e.g., before, at the time of, or 
after the execution of the transaction)? In such situations, how should 
material information be disclosed?
     The Dodd-Frank Act and the Commission's proposal with 
respect to SEFs contemplate that SEFs and exchanges will promulgate 
detailed standards for the listing and trading of security-based swaps 
that may be transacted on their markets. Should SEFs and exchanges also 
be required to provide a means to deliver the disclosures to 
counterparties required under proposed Rules 15Fh-3(b) and (d)? Would 
SEF and exchange listing and trading rules provide an adequate 
alternative means for providing the required disclosures? Why or why 
not? How would differences in rules across markets for similar products 
be addressed? What other issues may arise in connection with this 
approach and how could they be addressed?
     Should disclosures by means of a SEF or exchange require a 
standardized format? Are there specific transactions, classes of 
transactions, or types of counterparties for which this approach would 
or would not be appropriate? Are there other means by which SBS 
entities could satisfy their disclosure obligations in this context?
     Should an SBS Entity be permitted to reference publicly 
available information to comply with its disclosure requirements to its 
counterparty without having the information deemed to be adopted or 
affirmed by the SBS Entity? For example, should an SBS Entity be 
permitted to direct its counterparty to reports filed under the 
Exchange Act and publicly available on EDGAR without being considered 
to affirm or adopt the disclosure? Should an SBS Entity be permitted to 
satisfy the disclosure requirements by directing its counterparty to 
the Web site of a company underlying a credit default swap regarding 
disclosures of material risks without being considered to affirm or 
adopt the disclosure?
c. Material Risks and Characteristics of the Security-Based Swap
    Section 15F(h)(3)(B) of the Exchange Act provides that business 
conduct requirements adopted by the Commission shall require disclosure 
by the SBS Entity of information about the material risks and 
characteristics of the security-based swap.\76\ A fact is material if 
there is a substantial likelihood that a reasonable investor would 
consider the information to be important in making an investment 
decision.\77\ Disclosures should include a clear explanation of the 
material economic

[[Page 42408]]

characteristics of the security-based swap, including a discussion of 
the key assumptions that give rise to the expected pay-offs.\78\ The 
SBS Entity should consider, among other things, the complexity of each 
of the characteristics of the security-based swap in determining the 
materiality of the characteristic, as well as the related material 
risks to be disclosed.\79\
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    \76\ We read this provision to require disclosure about the 
material risks and characteristics of the security-based swap itself 
and not of the underlying reference security or index.
    \77\ Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).
    \78\ See CRMPG III Report at 61. See also SIFMA/ISDA 2010 Letter 
(stating that ``[t]here is no better description of the 
characteristics of a transaction than the contract provisions 
expressly defining its economic terms.'').
    \79\ The adequacy of such disclosures will be determined by 
reference to the ``reasonable investor'' standard above.
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    We understand that there are certain general types of risks, 
including credit risk,\80\ settlement risk,\81\ market risk,\82\ 
liquidity risk,\83\ operational risk,\84\ and legal risk \85\ that are 
commonly associated with securities-based swaps.\86\ Proposed Rule 
15Fh-3(b)(1) would require an SBS Entity to disclose the material 
factors that influence the day-to-day changes in valuation, the factors 
or events that might lead to significant losses, the sensitivities of 
the security-based swap to those factors and conditions, and the 
approximate magnitude of the gains or losses the security-based swap 
would experience under specified circumstances.\87\ SBS Entities should 
also consider the unique risks and characteristics associated with a 
particular security-based swap, class of security-based swap or trading 
venue, and tailor their disclosures accordingly.\88\
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    \80\ By ``credit risk,'' we mean the risk that a party to a 
security-based swap will fail to perform on an obligation under the 
security-based swap. IOSCO Report at 3; BIS Report at 11.
    \81\ By ``settlement risk,'' we mean the risk that a party will 
not receive funds or instruments from its counterparty at the 
expected time, either as a result of a failure of the counterparty 
to perform or a failure of the clearing agency to perform. See IOSCO 
Report at 3.
    \82\ By ``market risk,'' we mean the risk to the value of a 
security-based swap resulting from adverse movements in the level or 
volatility of market prices. See BIS Report at 12.
    \83\ By ``liquidity risk,'' we mean 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 or because of disruptions in the marketplace. See BIS 
Report at 13.
    \84\ By ``operational risk,'' we mean the risk that deficiencies 
in information systems or internal controls, including human error, 
will result in unexpected loss. See IOSCO Report at p. 3; BIS Report 
at 14.
    \85\ By ``legal risk,'' we mean the risk that agreements are 
unenforceable or incorrectly or inadequately documented. See IOSCO 
Report at p. 4; BIS Report at 16.
    \86\ See generally IOSCO Report; BIS Report.
    \87\ See CRMPG III Report at 60. These disclosures are intended 
to be disclosures concerning the material risks and characteristics 
of the security-based swap itself, not the material risks and 
characteristics of the security-based swap with respect to a 
particular counterparty. In other words, the proposed rule would not 
require an SBS Entity to disclose different material risks and 
characteristics to different counterparties solely because of the 
identity or nature of the counterparty.
     As noted previously, proposed Rule 15Fh-3(b) would require 
disclosures to be made in a manner reasonably designed to allow the 
counterparty to assess the material risks and characteristics. In 
addition, SBS Entities would have an on-going obligation to 
communicate with counterparties in a fair and balanced manner based 
on principles of fair dealing and good faith. See proposed Rule 
15Fh-3(g) (discussed infra at Section II.C.5).
    \88\ We anticipate that SBS Entities may provide these 
disclosures through various means, including scenario analysis. See, 
e.g., CRMPG III Report at 60 (recommending that disclosure include 
``rigorous scenario analyses and stress tests that prominently 
illustrate how the instrument will perform in extreme scenarios, in 
addition to more probable scenarios'').
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    An SBS Entity also should consider risks that may be associated 
specifically with uncleared security-based swaps. Among other things, 
the absence of a credit support agreement in an uncleared security-
based swap could create risks associated with the absence of a 
bilateral obligation to post initial and variation margin.\89\ An SBS 
Entity should consider whether the absence of provisions that would 
typically be associated with a cleared security-based swap, for 
example, could create a material risk that would need to be disclosed 
in connection with a transaction involving a security-based swap that 
is not submitted for clearing.\90\
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    \89\ We note that currently market participants often choose to 
use a credit support agreement or annex specifying the applicable 
valuation methodologies for the calculation of margin or collateral 
and the mechanics for the exchange of margin or collateral in 
connection with a security-based swap.
    \90\ With respect to uncleared security-based swaps, the 
Commission expects to propose rules regarding a counterparty's right 
to have any of its property received by an SBS Entity to margin, 
guarantee, or secure the obligations of the counterparty in an 
uncleared security-based swap segregated from the funds of the SBS 
Entity. See Section 3E(f)(1)(A) of the Exchange Act, Public Law 111-
203, 124 Stat. 1376, 1775-1776 (to be codified at 15 U.S.C. 78c-
5(f)(1)(A)) (requiring an SBS Entity to notify a counterparty at the 
beginning of a security-based transaction that the counterparty has 
the right to require segregation of the funds or other property 
supplied to margin, guarantee, or secure the obligations of the 
counterparty).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     The documentation governing a security-based swap 
transaction should include all of the terms agreed by the parties that 
could affect the economic and other risks of the transaction. Should 
the requirements for disclosure of material characteristics of a 
security-based swap be deemed satisfied if the SBS Entity has entered 
into a master agreement with and provided a trade acknowledgement (or 
draft trade acknowledgement) or other documentation governing the 
particular security-based swap to the counterparty? Why or why not? How 
would such an approach provide meaningful disclosure to counterparties 
regarding the risks of the transactions they are entering into? What 
types of risks might not be readily apparent to a counterparty from a 
review of the governing documentation for a transaction? Would the 
timeliness of such disclosure be a problem if information on a trade 
acknowledgement, for example, is not provided to a counterparty until 
after the parties have entered into a security-based swap?
     Are there particular material risks or characteristics 
that the Commission should specifically require an SBS Entity to 
disclose to a counterparty? If so, which ones and why?
     Are there specific material risks or characteristics that 
should be disclosed with respect to swaps that are not cleared, or are 
not SEF- or exchange-traded? If so, which ones and why?
     Are there particular material risks or characteristics 
that the Commission should specifically require an SBS Entity to 
disclose when the counterparty is a special entity or a particular 
category of special entity? If so, which ones and why? Should any such 
special disclosure requirements apply to any categories of 
counterparties other than special entities?
     Should the Commission require an SBS Entity to disclose 
its anticipated profit for the security-based swap? If so, how should 
an SBS Entity be required to compute profitability for purposes of the 
rule? \91\ If the Commission were to adopt such a requirement, should 
it be limited to transactions in which the counterparty is a special 
entity, a particular category of special entity, or another type of 
counterparty?
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    \91\ See Swap Financial Group, Dodd[hyphen]Frank Title VII: 
Business Conduct and Special Entities Briefing for SEC/CFTC Joint 
Working Group (Aug. 9, 2010) (on file with the Commission) (``Swap 
Financial Group Presentation'') at 55 (describing profit as the 
``[m]ark-up or `spread' between price charged to the client and cost 
of dealer's hedge'').
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     Should the SBS Entity disclose or identify for the 
counterparty information regarding the issuer of the underlying 
security that is publicly available, such as whether the issuer of an 
underlying security is subject to the

[[Page 42409]]

periodic reporting requirements of the Exchange Act?
     Is there a basis for distinguishing between the types of 
disclosures that should be required to be provided by an SBS Dealer and 
those that should be required to be provided by a Major SBS 
Participant? If so, how should the types of disclosures required to be 
provided by a Major SBS Participant differ from those that have been 
proposed?
     Should the Commission specifically require scenario 
analysis disclosure? Why or why not? If such analysis should be 
required, should the Commission require the disclosure for uncleared 
security-based swaps? Should the Commission limit the scenario analysis 
disclosure requirement to ``high-risk complex security-based swaps,'' 
as described in the CRMPG III Report? If so, how should the 
definitional hurdles outlined in the CRMPG III Report be addressed? 
\92\ If not, why? Is there another standard the Commission should 
consider for requiring scenario analysis?
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    \92\ See CRMPG III Report at 54-56 (``The definition of a high-
risk complex financial instrument is itself a complex subject. * * * 
[T]he definitional challenge is better framed by identifying the key 
characteristics of classes of high-risk complex financial 
instruments that warrant special treatment in terms of sales and 
marketing practices, disclosure practices, diligence standards, and, 
more broadly, the level of sophistication required for all market 
participants. * * * While issues surrounding leverage, market 
liquidity, and price transparency are the key characteristics in 
identifying high-risk complex financial instruments, other factors 
have contributed to the problems witnessed during the credit market 
crisis.'').
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     Should an SBS Entity be required to provide a scenario 
analysis for any security-based swap, upon reasonable request by any 
counterparty? What are the advantages and disadvantages to SBS Entities 
and counterparties associated with such an analysis? If the cost varies 
by type of security-based swap, please provide an average cost by 
category of security-based swap.
     Should a scenario analysis provided by an SBS Entity to a 
counterparty be required to be consistent with similar analyses 
prepared by the SBS Entity for its own internal purposes (e.g., risk 
management)? If not, how would they differ and why?
     We do not intend that the proposed rule require an SBS 
Entity to disclose any information considered proprietary in nature. 
Would disclosure of proprietary information be a concern under the 
current formulation of the rule? If so, what types of proprietary 
information might be subject to disclosure under the proposed rule? Is 
there other information that could adequately substitute for purposes 
of meaningful disclosure? What methods, if any, could be applied to 
transform specific types of proprietary information into comparable 
information suitable for a counterparty (e.g., aggregation, averaging)? 
What other mechanisms, if any, could be used to protect proprietary 
information while providing adequate disclosure to counterparties?
     As noted above, we understand that security-based swaps 
are often entered into under a master agreement that governs the 
relationship between the SBS Entity and its counterparty.\93\ In 
particular, master agreements generally contain terms that govern all 
succeeding security-based swaps and other derivatives between the 
counterparties, and include provisions such as events of default, 
cross-default provisions, additional termination events, payment 
netting and close-out netting, and information regarding rights and 
obligations as a result of particular events.\94\ Should the Commission 
require the use of a master agreement for security-based swaps? If a 
master agreement is required when parties enter into a security-based 
swap, what particular issues should be addressed in the master 
agreement? For example, should the master agreement be required to 
address whether payment netting or close-out netting rights exist? If 
the Commission does not require the use of a master agreement, should 
it require that all security-based swaps include certain provisions 
typically included in master agreements? If so, which provisions?
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    \93\ See, e.g., Thrifty Oil Co. v. Bank of America Nat'l Trust 
and Sav. Ass'n, 322 F.3d 139, 143 (9th Cir. 2003) (describing use of 
master agreements). We note that market participants may already 
look to certain master agreements that are generally considered 
covered by the swap safe harbors in the U.S. Bankruptcy Code 
(``Bankruptcy Code''). Sections 362(b)(17) and 560 of the Bankruptcy 
Code provide an exception to the automatic stay and ipso facto 
prohibitions in the Bankruptcy Code to allow for the exercise of any 
contractual right of any swap participant or financial participant 
to cause the liquidation, termination, or acceleration of one or 
more swap agreements, including netting and set-off rights. See 11 
U.S.C. 362(b)(27) and 560. The definition of ``swap agreement'' 
under Section 101(53B)(v) of the Bankruptcy Code specifically 
contemplates master agreements. See 11 U.S.C. 101(53B)(v).
    \94\ Parties may also choose to use a credit support agreement 
or annex specifying the applicable valuation methodologies for the 
calculation of margin or collateral and the mechanics for the 
exchange of margin or collateral in connection with a security-based 
swap.
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     Should an SBS Entity be required to disclose the absence 
of certain material provisions typically contained in master agreements 
for security-based swap transactions? \95\ Similarly, should an SBS 
Entity be required to disclose if the documentation includes material 
provisions that are unusual in light of typical master agreements? In 
either case, how should the ``normal'' or ``typical'' master agreement 
be defined? By reference to particular types of standardized master 
agreements? If so, which ones? To what extent would a requirement to 
provide a disclosure separate from a master agreement regarding the 
material terms of the master agreement have the effect of incentivizing 
counterparties to review their agreements less carefully (and instead 
rely on the disclosure)? To what extent might disclosures regarding the 
documentation between the parties potentially affect any interpretation 
of the terms agreed by the parties in the event of a subsequent dispute 
over such terms? How might that in turn affect the nature or usefulness 
of the disclosures that SBS Entities might provide regarding their 
documentation?
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    \95\ For example, absent provisions for payment netting or 
close-out netting, questions may arise as to whether all of the 
counterparty's trades with the particular SBS Entity would be taken 
into account in calculating (1) net periodic payments, (2) one net 
close-out amount in respect of a default by either party, and (3) 
net margin obligations.
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     Should the Commission establish certain minimum standards 
for the agreements governing security-based swaps? If so, what 
standards and why?
d. Material Incentives or Conflicts of Interest
    Proposed Rule 15Fh-3(b)(2) would require that an SBS Entity 
disclose all material incentives or conflicts it may have in connection 
with a security-based swap.\96\ We preliminarily believe that the term 
``incentives''--which is used in Section 15F(h)(3)(b)(ii) of the Dodd-
Frank Act--refers not to any profit or return that the SBS Entity would 
expect to earn from the security-based swap itself, or from any related 
hedging or trading activities of the SBS Entity, but rather to any 
other financial arrangements pursuant to which an SBS Entity may have 
an incentive to encourage the counterparty to enter into the 
transaction. This disclosure would include, among other things, 
information concerning any compensation (e.g., under revenue-sharing 
arrangements) or other incentives the SBS Entity receives from any 
source other than the counterparty in connection with the security-
based swap to be entered into with the counterparty, but would not 
include, for

[[Page 42410]]

example, expected cash flows received from a transaction to hedge the 
security-based swap or that the security-based swap is intended to 
hedge.\97\
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    \96\ See Section 15F(h)(3)(B)(ii) of the Exchange Act, Public 
Law 111-203, 124 Stat. 1376, 1790 (to be codified at 15 U.S.C. 78o-
10(h)(3)(B)(ii)) (providing that business conduct requirements 
adopted by the Commission shall require disclosure by an SBS Entity 
of ``any material incentives or conflicts of interest'' that the SBS 
Entity may have in connection with the security-based swap).
    \97\ If an SBS Entity is also registered as a broker-dealer, it 
would be subject to similar disclosure requirements under FINRA 
rules in certain circumstances. See, e.g., FINRA Rule 2269, 
Disclosure of Participation or Interest in Primary or Secondary 
Distribution (``A member who is acting as a broker for a customer or 
for both such customer and some other person, or a member who is 
acting as a dealer and who receives or has promise of receiving a 
fee from a customer for advising such customer with respect to 
securities, shall, at or before the completion of any transaction 
for or with such customer in any security in the primary or 
secondary distribution of which such member is participating or is 
otherwise financially interested, give such customer written 
notification of the existence of such participation or interest.'').
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Are there specific material incentives or conflicts that 
the Commission should require an SBS Entity to disclose to a 
counterparty? Are there specific material incentives or conflicts that 
should be disclosed with respect to security-based swaps that are not 
cleared, or are not SEF- or exchange-traded?
     Should we require an SBS Entity to disclose affiliations 
or material business relationships with a SEF or exchange? Why or why 
not?
     Should we require an SBS Entity to disclose affiliations 
or material business relationships with a clearing agency? Why or why 
not?
     Should the Commission impose other more specific 
requirements concerning the content of the required disclosures when 
the counterparty is a special entity? If so, which ones and why? Should 
such specific requirements apply only to certain categories of special 
entities?
     Should the Commission impose other more specific 
requirements concerning the content of the required disclosures when an 
SBS Dealer is acting as an advisor to a special entity? If so, which 
ones and why? Should such specific requirements apply only to certain 
categories of special entities?
     Is there a basis for distinguishing between the types of 
conflicts disclosures required to be provided by an SBS Dealer and 
those required to be provided by a Major SBS Participant? If so, how 
should the types of conflicts disclosures required to be provided by a 
Major SBS Participant differ from those that have been proposed?
     We do not intend to require the disclosure of information 
considered proprietary in nature in order for an SBS Entity to 
discharge its obligation under the proposed rule. Is such disclosure a 
concern under the current formulation of the rule? If so, what types of 
proprietary information might be subject to disclosure under the 
proposed rule? Is there other information that could adequately 
substitute for purposes of meaningful disclosure? What other 
mechanisms, if any, could be used to protect proprietary information 
while providing adequate disclosure to counterparties?
e. Daily Mark
    Exchange Act Section 15F(h)(3)(B)(iii) directs the Commission to 
adopt rules that require an SBS Entity to disclose: (i) for cleared 
security-based swaps, upon request of the counterparty, the daily mark 
from the appropriate derivatives clearing organization; \98\ and (ii) 
for uncleared security-based swaps, the daily mark of the 
transaction.\99\ We preliminarily believe that the daily mark, as 
proposed for the purposes of this rule, would provide helpful 
transparency to counterparties during the lifecycle of a security-based 
swap. As explained below, the daily mark under the proposed rule is 
intended to provide a counterparty with a useful and meaningful 
reference point against which to assess, among other things, the 
calculation of variation margin for a security-based swap or portfolio 
of security-based swaps, and otherwise inform the counterparty's 
understanding of its financial relationship with the SBS Entity.\100\
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    \98\ Although Section 15F(h)(3)(B)(iii) of the Exchange Act 
refers to a ``derivatives clearing organization,'' the Commission 
believes that this was a drafting error and that Congress intended 
to refer to a ``clearing agency'' because the Dodd-Frank Act 
elsewhere requires security-based swaps to be cleared at registered 
clearing agencies, not derivatives clearing organizations. See 
Section 17A(g) of the Exchange Act, Public Law 111-203, 124 Stat. 
1376, 1768 (to be codified at 15 U.S.C. 78q-1(g)).
    \99\ We note that various market participants have expressed 
concerns that the statutory requirement to provide a daily mark to a 
pension plan would necessarily include an SBS Entity within the 
definition of ``fiduciary'' for ERISA purposes under a current 
Department of Labor proposal, which may then cause the security-
based swap to be a prohibited transaction under ERISA, unless it 
qualifies for a Prohibited Transaction Exemption. See Definition of 
the Term ``Fiduciary,'' 75 FR 65263 (Oct. 22, 2010); SIFMA/ISDA 
Letter; Joint Letter from American Bankers Association, American 
Benefits Council, Committee on Investment of Employee Benefit 
Assets, The ERISA Industry Committee, Financial Executives 
International's Committee on Corporate Treasury, Financial Services 
Roundtable, Insured Retirement Institute, National Association of 
Insurance and Financial Advisors, National Association of 
Manufacturers, Securities Industry and Financial Markets Association 
to David A. Stawick, Secretary, CFTC (Feb. 22, 2011); Letter from 
Sandra Haas, Managing Director, Head of Pensions, Endowment and 
Foundation Coverage, Morgan Stanley & Co., Incorporated, and Jim 
McCarthy, Managing Director, Head of Retirement Services and Client 
Advisory, Morgan Stanley Smith Barney LLC to Office of Regulations 
and Interpretations, Employee Benefits Security Admin., Dep't of 
Labor (Feb. 2, 2011); Letter from Don Thompson, Managing Director 
and Assistant General Counsel, JPMorgan Chase & Co. to Office of 
Regulations and Interpretations, Employee Benefits Security Admin., 
Dep't of Labor (Feb. 3, 2011). As noted in Section I.B., the staffs 
of the Commission, DoL and CFTC have been consulting and will 
continue to do so in order to address these concerns. See Letter 
from Phyllis C. Borzi, Assistant Secretary, Employee Benefits 
Security Administration, Department of Labor, to Gary Gensler, 
Chairman, CFTC (April 28, 2011) (``In DOL's view, a swap dealer or 
major swap participant that is acting as a plan's counterparty in an 
arm's length bilateral transaction with a plan represented by a 
knowledgeable independent fiduciary would not fail to meet the terms 
of the counterparty exception [to the proposed revised definition of 
ERISA fiduciary] solely because it complied with the business 
conduct standards set forth in the CFTC's proposed regulation.''). 
The Commission also solicits comments with respect to alternatives 
for addressing this issue.
    In addition, as discussed infra in Section II.C.4, we do not 
believe that disclosure of the daily mark would in and of itself 
constitute a recommendation under proposed Rule 15Fh-3(f).
    \100\ As explained below, the daily mark under the proposed rule 
would not necessarily represent the last price at which a security-
based swap traded, or a price that is executable.
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    The term ``daily mark'' is not defined in the statute and, as 
explained below, we are proposing that the term have analogous meanings 
for cleared and uncleared security-based swaps. For cleared security-
based swaps, proposed Rule 15Fh-3(c)(1) would require an SBS Entity, 
upon the request of the counterparty, to disclose to the counterparty 
in writing the daily end-of-day settlement price received by the SBS 
Entity from the appropriate clearing agency. ``End-of-day settlement 
price'' in this context refers to the value for any given security-
based swap used by the clearing agency that forms the basis of 
subsequent margin calculations for clearing participants.\101\
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    \101\ For example, ICE Trust, a clearing agency for credit 
default swaps, indicates that it ``establishes a daily settlement 
price for all cleared CDS instruments, using a pricing process 
developed specifically for the CDS market by ICE Trust. ICE Trust 
clearing participants are required to submit prices on a daily 
basis. ICE Trust conducts an auction process daily which results in 
periodic trade executions between its clearing participants. This 
process determines the daily settlement prices, which are validated 
by the ICE Trust Chief Risk Officer and used for the daily mark-to-
market valuations.'' ICE Trust, https://www.theice.com/ice_trust.jhtml (March 14, 2011).
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    We are not proposing to require that clearing agencies use a 
particular calculation methodology for purposes of the proposed 
rule.\102\ We understand

[[Page 42411]]

that, for a given security-based swap, a clearing agency uses the same 
end-of-day settlement price for the daily valuation of positions held 
by all clearing members regardless of position direction or size, and 
independent of any member-specific attribute, such as credit quality, 
other portfolio holdings, or concentration of positions. Accordingly, 
the prices do not necessarily represent the last price at which the 
security-based swap traded, or a price that is executable.
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    \102\ The Commission understands that the particular 
methodologies used by clearing agencies to produce the end of day 
settlement price may vary. We understand that there are various 
means by which security-based swap clearing agencies calculate end-
of-day settlement prices for each product in which they hold a 
cleared interest each business day. In the credit default swap 
context, for example, end-of-day settlement prices may be determined 
each business day for each eligible product based upon pricing data 
from one or more of various sources, including prices of over-the-
counter transactions submitted for clearing; indicative settlement 
prices contributed by clearing members; and pricing information 
licensed from other third-party sources. See, e.g., Letter from Ann 
K. Shuman, Managing Director and Deputy General Counsel, Chicago 
Mercantile Exchange Inc., to Elizabeth Murphy, Secretary, Commission 
(Dec. 14, 2009) (File No. S7-06-09); Letter from Kevin McClear, 
General Counsel, ICE Trust, to Elizabeth Murphy, Secretary, 
Commission (Dec. 4, 2009) (File No. S7-05-09).
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    Because the term ``daily mark'' is used both in the context of 
cleared and uncleared security-based swaps, the Commission 
preliminarily believes that the meaning of ``daily mark'' for uncleared 
swaps should be analogous to that for cleared swaps, and that the 
attributes of daily marks produced by clearing agencies for cleared 
security-based swaps under proposed Rule 15Fh-3(c)(1) should be equally 
applicable to, and provide guidance for the computation of, the daily 
mark required to be provided with respect to uncleared security-based 
swaps. To ensure a degree of uniformity in market practices among SBS 
Entities, proposed Rule 15Fh-3(c)(2) would require an SBS Entity to 
disclose the midpoint between the bid and offer prices for a particular 
uncleared security-based swap, or the calculated equivalent thereof, as 
of the close of business unless the parties agree in writing 
otherwise.\103\ We preliminarily believe that the proposed rule would 
result in a daily mark that reflects daily changes in valuation that 
is: (a) The same for all counterparties of the SBS Entity that have a 
position in the uncleared security-based swap, (b) not adjusted to 
account for holding-specific attributes such as position direction, 
size, or liquidity, and (c) not adjusted to account for counterparty-
specific attributes such as credit quality, other counterparty 
portfolio holdings, or concentration of positions.\104\
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    \103\ Parties could agree that the daily mark would be computed 
as of a time other than the close of business but could not agree to 
waive the requirement that the daily mark be provided on a daily 
basis, as required by the statute.
    \104\ SIFMA and ISDA have suggested 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 2010 Letter at 17. For a 
discussion of midmarket value and adjustments, see ISDA Research 
Notes, The Value of a New Swap, Issue 3, 2010, available at http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf (``ISDA Note'') 
(describing midmarket value as ``the net present value of the 
transaction assuming it is priced at mid-market'').
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    For actively traded security-based swaps that have sufficient 
liquidity, computing a daily mark as the midpoint between the bid and 
offer prices for a particular security-based swap, known as a 
``midmarket value,'' would be consistent with the proposed Rule 15Fh-
3(c)(2). For security-based swaps that are not actively traded, or do 
not have up-to-date bid and offer quotes, the SBS Entity may calculate 
an equivalent to a midmarket value using mathematical models, quotes 
and prices of other comparable securities, security-based swaps, or 
derivatives, or any combination thereof, provided that these 
calculations produce a daily mark that is consistent with the 
attributes described above.\105\ Again, the daily mark is not intended 
to represent the value that either an SBS Entity or its counterparty 
would use for its own, internal valuation, or fair value for financial 
reporting purposes for the particular security-based swap. Nor would 
the daily mark necessarily represent a price at which the SBS Entity 
would be willing to execute a trade.\106\
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    \105\ See ISDA Note.
    \106\ As discussed in Section II.C.4, infra, we do not believe 
that compliance with the requirements of proposed Rule 15Fh-3(c), in 
and of itself, should cause an SBS Dealer to be deemed to have made 
a recommendation under proposed Rule 15Fh-3(f).
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    Furthermore, though the daily mark may be used as an input to 
compute the variation margin between an SBS Entity and its 
counterparty, it is not necessarily the sole determinant of how such 
margin is computed. Differences between the daily mark and computations 
for variation margin result from adjustments for position size, 
position direction, credit reserve, hedging, funding, liquidity, 
counterparty credit quality, portfolio concentration, bid-ask spreads, 
or other costs, that may be included as part of the margin 
computations. Nonetheless, the Commission believes the daily mark, as 
proposed for the purposes of this rule, would provide a useful and 
meaningful reference point, similar to that for cleared security-based 
swaps, for counterparties holding positions in uncleared security-based 
swaps.\107\
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    \107\ See ISDA Note (``even though market participants do not 
actually transact at the midmarket rate, it is nonetheless useful 
because it is an objective, transparent rate that might be used as a 
basis for actual pricing'').
---------------------------------------------------------------------------

    Proposed Rule 15Fh-3(c)(2) would also require that, at or before 
delivery of the first disclosure of the daily mark, an SBS Entity 
disclose to the counterparty its data sources and a description of the 
methodology and assumptions to be used to prepare the daily mark for an 
uncleared security-based swap.\108\ We preliminarily believe that such 
disclosure would provide the counterparty a useful context with which 
it can assess the quality of the mark received.\109\ In addition, 
proposed Rule 15Fh-3(c) would also require that an SBS Entity promptly 
disclose any

[[Page 42412]]

material changes to the data sources, methodology, or assumptions over 
the term of the security-based swap. An SBS Entity would not be 
required to disclose the data sources or a description of the 
methodology and assumptions more than once unless it materially changes 
the data sources, methodology or assumptions used to calculate the 
daily mark. For the purposes of this rule, a material change would 
include any change that has a material impact on the daily mark 
provided. We understand that the daily mark for illiquid security-based 
swaps may be generated using models that may or may not be proprietary. 
The required disclosure of the data sources or description of the 
methodology and assumptions used to prepare the daily mark is not 
intended to require so much detail as to result in disclosure of an SBS 
Entity's proprietary information.
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    \108\ Cf. Trading & Capital-Markets Manual Sec.  2150 (Bd. of 
Gov. Fed. Reserve Sys. Jan. 2009), available at http://www.federalreserve.gov/boarddocs/supmanual/trading/200901/0901trading.pdf:
    When observable market prices are available for a transaction, 
two pricing methodologies are primarily used--bid/offer or 
midmarket. Bid/offer pricing involves assigning the lower of bid or 
offer prices to a long position and the higher of bid or offer 
prices to short positions. Midmarket pricing involves assigning the 
price that is midway between bid and offer prices. Most institutions 
use midmarket pricing schemes, although some firms may still use 
bid/offer pricing for some products or types of trading. Midmarket 
pricing is the method recommended by the accounting and reporting 
subcommittee of the Group of Thirty's Global Derivatives Study 
Group, and it is the method market practitioners currently consider 
the most sound. * * *
    For many illiquid or customized transactions, such as highly 
structured or leveraged instruments and more complex, nonstandard 
notes or securities, reliable independent market quotes are usually 
not available, even infrequently. In such instances, other valuation 
techniques must be used to determine a theoretical, end-of-day 
market value. These techniques may involve assuming a constant 
spread over a reference rate or comparing the transaction in 
question with similar transactions that have readily available 
prices (for example, comparable or similar transactions with 
different counterparties). More likely, though, pricing models will 
be used to price these types of customized transactions.
    \109\ The Commission recognizes that different SBS Entities may 
produce somewhat different marks for similar security-based swaps, 
depending on the respective data sources, methodologies and 
assumptions used to calculate the marks. Thus, the data sources, 
methodologies and assumptions would provide a context in which the 
quality of the mark could be evaluated. See Disclosure of Accounting 
Policies for Derivative Financial Instruments and Derivative 
Commodity Instruments and Disclosure of Quantitative and Qualitative 
Information about Market Risk Inherent in Derivative Financial 
Instruments, Other Financial Instruments and Derivative Commodity 
Instruments, Securities Act Release No. 7386 (Jan. 31, 1997), 62 FR 
6044 (Feb. 10, 1997). We understand that currently, industry 
practice is often to include similar disclosures for margin calls in 
swap documentation, such as a credit support annex.
---------------------------------------------------------------------------

    We preliminarily believe that, for the disclosure to the 
counterparty to be meaningful, the daily mark for both cleared and 
uncleared security-based swaps should be provided without charge and 
with no restrictions on internal use by the recipient, although 
restrictions on dissemination to third parties are permissible. The 
rule would not, however, mandate the means by which an SBS Entity makes 
the required disclosures. Commenters have asked if SBS Entities may 
satisfy their obligations in this regard by making the relevant 
information available to counterparties through password-protected 
access to a website containing the relevant information.\110\ The 
Commission preliminarily believes that such a method would be an 
appropriate way for SBS Entities to discharge their obligations with 
respect to daily marks, subject to compliance with the Commission's 
guidance on the use of electronic media.\111\ In particular, the use of 
electronic media should not be so burdensome that intended recipients 
cannot effectively access the information provided. Further, persons to 
whom information is sent or provided electronically must have the 
opportunity to download directly the information, or otherwise have an 
opportunity to retain and analyze the information through the selected 
medium or have ongoing access equivalent to personal retention.\112\ 
Information of this kind is directly relevant to a counterparty's 
understanding of its financial relationship under a security-based swap 
and so, we preliminarily believe that access to the information as 
described above is necessary to ensure a counterparty's ability to 
monitor that relationship over the life of the transaction.\113\
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    \110\ SIFMA/ISDA 2010 Letter at p. 17.
    \111\ See Use of Electronic Media by Broker-Dealers, Transfer 
Agents and Investment Advisers for Delivery of Electronic 
Information, Securities Act Release No. 7288 (May 9, 1996), 61 FR 
24644 (May 15, 1996) (``Electronic Media Release''). See also Use of 
Electronic Media, Exchange Act Release No. 42728 (Apr. 28, 2000), 65 
FR 25843 (May 4, 2000).
    \112\ See Electronic Media Release.
    \113\ A counterparty may also require continuing access to 
satisfy recordkeeping requirements to which it may be subject.
     The Commission has proposed to require clearing agencies to 
make available to the public, on terms that are fair and reasonable 
and not unreasonably discriminatory, all end-of-day settlement 
prices and any other prices with respect to security-based swaps 
that the clearing agency may establish to calculate mark-to-market 
margin requirements for its participants and any other pricing or 
valuation information with respect to security-based swaps as is 
published or distributed by the clearing agency to is participants. 
See Clearing Agency Standards for Operation and Governance, Exchange 
Act Release No. 64017 (March 2, 2011), 76 FR 14472 (March 16, 2011) 
(proposed Rule 17Aj-1). As we explained in proposing Rule 17Aj-1, we 
preliminarily believe that public availability of this information 
would help to improve fairness, efficiency, and market competition 
by making available to all market participants data that may 
otherwise be available only to a limited subset of market 
participants. See id.
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    SBS Entities also should consider the need to provide appropriate 
clarifying statements or disclosures relating to the daily mark. Such 
statements or disclosures may include, as appropriate, that the daily 
mark may not be a price at which the SBS Entity would agree to replace 
or terminate the security-based swap, nor the value at which the 
security-based swap is recorded in the books of the SBS Entity.\114\
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    \114\ Cf. CFTC External Business Conduct Release (proposed Rule 
17 CFR 23.431(c)).
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Is the end-of-day settlement price an appropriate ``daily 
mark'' for cleared security-based swaps for purposes of this rule? If 
not, how should the Commission define ``daily mark'' in this context?
     Should the Commission prescribe a method for determining 
the end-of-day settlement price for cleared security-based swaps for 
purposes of this rule? If so, what method and why?
     Is the midpoint between the bid and offer prices for a 
particular uncleared security-based swap, or the calculated equivalent 
thereof, as of the close of business unless the parties agree in 
writing otherwise, an appropriate ``daily mark'' for uncleared 
security-based swaps? If not, how should the Commission define ``daily 
mark'' in this context, and why?
     Should the Commission prescribe a different method for 
calculating the daily mark for uncleared security-based swaps for 
purposes of this rule? If so, what method and why? Should valuations of 
equivalent positions used by the SBS Entity for other purposes, such as 
collateral valuation or the preparation of financial statements, be 
taken into consideration? Why or why not, and how?
     Are there requirements under proposed Rule 15Fh-3(c) that 
would cause an SBS Entity to be a fiduciary for ERISA purposes? If so, 
which requirements, and is there an alternate method for calculating 
the daily mark that would not cause an SBS Entity to be a fiduciary for 
ERISA purposes?
     In calculating the midmarket value, should the Commission 
require an SBS Entity to use third-party market quotations (i.e., 
should the Commission allow an SBS Entity to use its own market 
quotations)? Why or why not? Should there be constraints or conditions 
on such use? Why or why not?
     Should the Commission require an SBS Entity to provide an 
executable quote or the price at which the SBS Entity would terminate 
the security-based swap, in addition to the daily mark, for purposes of 
comparison or other reasons? If so, should this additional information 
always be required or is there a stronger rationale for the additional 
information to be required for certain identifiable types of security-
based swap positions, such as security-based swaps that are highly 
customized to a counterparty's requirements, or otherwise illiquid, and 
for which the daily mark may be significantly different from an 
executable quote?
     Should the Commission require an SBS Entity to provide a 
value that would be used for purposes of variation margin, in addition 
to the daily mark, for purposes of comparison or other reasons? If so, 
should this additional information always be required or is there a 
stronger rationale for the additional information to be required for 
certain identifiable types of security-based swap positions, such as 
security-based swaps that are highly customized to a counterparty's 
requirements, or otherwise illiquid, and for which the daily mark may 
be significantly different from a value used for variation margin?
     If the SBS Entity and a particular counterparty are 
parties to more than

[[Page 42413]]

one security-based swap transaction with one another, should the SBS 
Entity be permitted to provide a single aggregate daily mark for all of 
the security-based swaps, allowing for netting between the parties? Why 
or why not?
     Should the Commission require an SBS Entity to provide 
additional disclosures including, as appropriate: (1) That the daily 
mark may not necessarily be a price at which either the counterparty or 
the SBS Entity would agree to replace or terminate the security-based 
swap; (2) that, 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 (3) that the daily mark may not 
necessarily be the value of the security-based swap that is recorded in 
the books of the SBS Entity? \115\ In addition to disclosing any 
material changes to data sources, methodology or assumptions used, 
should an SBS Entity be required to disclose the impacts of these 
material changes? Are there any other disclosures that the Commission 
should require the SBS Entity to provide in connection with the daily 
mark?
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    \115\ Cf. CFTC External Business Conduct Release (proposed Sec.  
23.431(c)).
---------------------------------------------------------------------------

     We do not intend the proposed disclosures regarding the 
data sources and description of the methodologies and assumptions used 
to prepare the daily marks to require the disclosure of information 
considered proprietary in nature in order for an SBS Entity to 
discharge its obligations. Is such disclosure a concern under the 
current formulation of the rule? If so, what types of proprietary 
information might be subject to disclosure under the proposed rule? Is 
there other information that could adequately substitute for purposes 
of meaningful disclosure? What mechanisms, if any, could be used to 
protect proprietary information implicated by the daily mark 
requirement while providing adequate disclosure to counterparties?
     Should access to a Web site or electronic platform be 
considered sufficient for disclosure of the daily mark? Why or why not? 
Should other forms of Internet-based or electronic disclosure be 
addressed, and if so, how?
     Should we require that the daily mark for both cleared and 
uncleared security-based swaps should be provided without charge and 
with no restrictions on internal use by the recipient, although 
restrictions on dissemination to third parties are permissible? Why or 
why not?
f. Clearing Rights
    Proposed Rule 15Fh-3(d) would require an SBS Entity, before 
entering into a security-based swap with a counterparty, to disclose to 
the counterparty its rights under Section 3C(g) of the Exchange Act 
concerning submission of a security-based swap to a clearing agency for 
clearing.\116\ Although they are not required by the Dodd-Frank Act, we 
preliminarily believe that such disclosures would promote the 
objectives of Section 3C(g).
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    \116\ See Section 15F(h)(1)(D) of the Exchange Act (authorizing 
the Commission to prescribe business conduct standards that relate 
to ``such other matters as the Commission determines to be 
appropriate''); see also Dodd-Lincoln Letter (describing anticipated 
benefits of clearing as a means of ``bringing transactions and 
counterparties into a sound, conservative and transparent risk 
management framework''). Public Law 111-203, 124 Stat. 1376, 1789 
(to be codified at 15 U.S.C. 78o-10(h)(1)(D)).
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    The counterparty's rights, and thus the proposed disclosure 
obligations, would differ depending on whether the clearing requirement 
of Section 3C(a) applies to the relevant transaction.\117\ When the 
clearing requirements of Section 3C(a)(1) apply to a security-based 
swap, proposed Rule 15Fh-3(d)(1)(i) would require the SBS Entity to 
disclose to the counterparty the clearing agencies that accept the 
security-based swap for clearing and through which of those clearing 
agencies the SBS Entity is authorized or permitted, directly or through 
a designated clearing member, to clear the security-based swap. The SBS 
Entity would also be required to notify the counterparty of the 
counterparty's sole right to select which clearing agency is to be used 
to clear the security-based swap, provided it is a clearing agency at 
which the SBS Entity is authorized or permitted, directly or through a 
designated clearing member, to clear the security-based swap.\118\ We 
note that, while proposed Rule 15Fh-3(d) would not require an SBS 
Entity to become a member or participant of a specific clearing agency, 
an SBS Entity could not enter into security-based swaps that are 
subject to a mandatory clearing requirement without having some 
arrangement in place to clear the transaction.\119\
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    \117\ Section 3C(a)(1) of the Exchange Act provides that: ``It 
shall be unlawful for any person to engage in a security-based swap 
unless that person submits such security-based swap for clearing to 
a clearing agency that is registered under this Act or a clearing 
agency that is exempt from registration under this Act if the 
security-based swap is required to be cleared.'' Public Law 111-203, 
124 Stat. 1376, 1762 (to be codified at 15 U.S.C. 78c-3(a)(1)).
    \118\ Proposed Rule 15Fh-3(d)(1)(ii). See Exchange Act 
3C(g)(5)(A), Public Law 111-203, 124 Stat. 1376, 1766-1777 (to be 
codified at 15 U.S.C. 78c-3(g)(5)(A)):
    With respect to any security-based swap that is subject to the 
mandatory clearing requirement under subsection (a) and entered into 
by a security-based swap dealer or a major security-based swap 
participant with a counterparty that is not a swap dealer, major 
swap participant, security-based swap dealer, or major security-
based swap participant, the counterparty shall have the sole right 
to select the clearing agency at which the security-based swap will 
be cleared.
    \119\ See Exchange Act Section 3C(a), Public Law 111-203, 124 
Stat. 1376, 1762, Sec.  763(a) (to be codified at 15 U.S.C. 78c-
3(a)).
---------------------------------------------------------------------------

    For security-based swaps that are not subject to the clearing 
requirement under Exchange Act Section 3C(a)(1), proposed Rule 15Fh-
3(d)(2) would require the SBS Entity to determine whether the security-
based swap is accepted for clearing by one or more clearing agencies 
and, if so, to disclose to the counterparty the counterparty's right to 
elect clearing of the security-based swap.\120\ Proposed Rule 15Fh-
3(d)(2)(ii) would require the SBS Entity to disclose to the 
counterparty the clearing agencies that accept the type, category, or 
class of security-based swap transacted and whether the SBS Entity is 
authorized or permitted, directly or through a designated clearing 
member, to clear the security-based swap through such clearing 
agencies. Proposed Rule 15Fh-3(d)(2)(iii) would require the SBS Entity 
to notify the counterparty of the counterparty's sole right to select 
the clearing agency at which the security-based swap would be cleared, 
provided it is a clearing agency at which the SBS Entity is authorized 
or permitted, directly or through a designated clearing member, to 
clear the security-based swap. Once again, the proposed rule would not 
require an SBS Entity to become a member or participant of a particular 
clearing agency, notwithstanding the election of the counterparty to 
clear the transaction.
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    \120\ See Exchange Act Section 3C(g)(5)(B), Public Law 111-203, 
124 Stat. 1376, 1767, (to be codified at 15 U.S.C. 78c-3(g)(5)(B)):
    With respect to any security-based swap that is not subject to 
the mandatory clearing requirement under subsection (a) and entered 
into by a security-based swap dealer or a major security-based swap 
participant with a counterparty that is not a swap dealer, major 
swap participant, security-based swap dealer, or major security-
based swap participant, the counterparty--(i) may elect to require 
clearing of the security-based swap; and (ii) shall have the sole 
right to select the clearing agency at which the security-based swap 
will be cleared.
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    The proposed rule would require that disclosure be made before a 
transaction occurs. The Commission believes that it would be 
appropriate for a counterparty to exercise its statutory right to 
select the clearing agency at which its security-based swaps would be 
cleared (as provided above) on a transaction-by-transaction basis, on 
an asset-class-by-asset-class basis, or in terms of all

[[Page 42414]]

potential transactions the counterparty may execute with the SBS 
Entity.
Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission require SBS Entities to disclose a 
counterparty's rights to select a clearing agency, as provided above? 
What benefits would this requirement provide? Would the proposed 
disclosure requirement impose an undue burden on SBS Entities? If so, 
what would the burden be, and are there other ways to ensure that a 
counterparty is aware of its rights with respect to clearing?
     Would the SBS Entity be in a position to know, in all 
cases, the information that would be required to be disclosed under 
proposed Rule 15Fh-3(d)? If not, why? Would the time needed to gather 
the required information affect the transaction process for security-
based swaps to any material extent? If so, how?
     Should the Commission require SBS Entities to disclose any 
other information to counterparties regarding their rights or 
obligations in connection with the clearing of security-based swap 
transactions? For example, under Section 3C(g) of the Exchange Act, 
certain ``end users'' have the option not to have their security-based 
swaps cleared, even if those security-based swaps have been made 
subject to a mandatory clearing requirement.\121\ Should an SBS Entity 
be required to disclose to such end users that they may elect not to 
have their security-based swaps cleared under these circumstances? Why 
or why not?
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    \121\ Exchange Act Section 3C(g), Public Law 111-203, 124 Stat. 
1376, 1767, Sec.  763(a) (to be codified at 15 U.S.C. 78c-3(g)). See 
End-User Exception to Mandatory Clearing of Security-Based Swaps, 
Exchange Act Release No. 63556 (Dec. 15, 2010), 75 FR 79992 (Dec. 
21, 2010) (proposing new Rule 3Cg-1 under the Exchange Act governing 
the exception to mandatory clearing of security-based swaps 
available for counterparties meeting certain conditions).
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     Should an SBS Entity be permitted to allow its 
counterparties to elect the clearing agency at which its security-based 
swaps would be cleared on a transaction-by-transaction basis, on an 
asset-class-by-asset-class basis, or in terms of all potential 
transactions? If not, what restrictions should apply to the SBS Entity 
in this context?
3. Know Your Counterparty
    Proposed Rule 15Fh-3(e) would establish a ``know your 
counterparty'' requirement for SBS Dealers.\122\ The proposed rule 
would require an SBS Dealer to have policies and procedures reasonably 
designed to obtain and retain a record of the essential facts that are 
necessary for conducting business with each counterparty that is known 
to the SBS Dealer.\123\ For purposes of the proposed rule, ``essential 
facts'' would be: (i) Facts necessary to comply with applicable laws, 
regulations and rules, (ii) facts necessary to effectuate the SBS 
Dealer's credit and operational risk management policies in connection 
with transactions entered into with such counterparty, (iii) 
information regarding the authority of any person acting for such 
counterparty, and (iv) if the counterparty is a special entity, such 
background information regarding the independent representative as the 
SBS Dealer reasonably deems appropriate.\124\
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    \122\ See Section 15F(h)(1)(D) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1789, (to be codified at 15 U.S.C. 78o-
10(h)(1)(D)) (authorizing, but not explicitly mandating, the 
Commission to prescribe business conduct standards that relate to 
``such other matters as the Commission determines to be 
appropriate'').
    \123\ The proposed rule would not apply to security-based swaps 
for which the SBS Dealer does not know the identity of the 
counterparty, as is the case, for example, for many security-based 
swaps traded on a SEF or an exchange.
    \124\ The Commission is considering the minimum requirements for 
an SBS Dealer's operational and credit risk management practices and 
expects to address any such matters in a separate rulemaking.
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    The ``know your counterparty'' obligations under the proposed rule 
are a modified version of the ``know your customer'' obligations 
imposed on other market professionals, such as broker-dealers, when 
dealing with customers.\125\ Although the statute does not require the 
Commission to adopt a ``know your counterparty'' standard, we 
preliminarily believe that such a standard would be consistent with 
basic principles of legal and regulatory compliance, operational and 
credit risk management, and authority. Further, we preliminarily 
believe that entities that currently operate as SBS Dealers typically 
would already have in place, as a matter of their normal business 
practices, ``know your counterparty'' policies and procedures that 
could potentially satisfy the requirements of the proposed rule. We are 
proposing to apply the requirement in proposed Rule 15Fh-3(e) to SBS 
Dealers but not to Major SBS Participants because we do not anticipate 
that Major SBS Participants would serve a dealer-type role in the 
market.
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    \125\ Cf. FINRA Rule 2090 (``Every member shall use reasonable 
diligence, in regard to the opening and maintenance of every 
account, to know (and retain) the essential facts concerning every 
customer and concerning the authority of each person acting on 
behalf of such customer''). Supplementary Material .01 to FINRA Rule 
2090 defines the ``essential facts'' for purposes of the FINRA rule 
to include certain information not required by our proposed rule. 
For purposes of FINRA Rule 2090, facts ``essential'' to ``knowing 
the customer'' are those required to (a) effectively service the 
customer's account, (b) act in accordance with any special handling 
instructions for the account, (c) understand the authority of each 
person acting on behalf of the customer, and (d) comply with 
applicable laws, regulations, and rules. See also 14 CFR 13.5 
(requiring a bank that is a government securities broker or dealer 
to make reasonable efforts to obtain information concerning the 
customer's financial status, tax status and investment objectives, 
and such other information used or considered to be reasonable by 
the bank in making recommendations to the customer).
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Request for Comments
    The Commission requests comments generally on all aspects of 
proposed 15Fh-3(e). In addition, we request comments on the following 
specific issues:
     Should the Commission impose a ``know your counterparty'' 
requirement? If not, why not? Does the Commission need to clarify any 
of the proposed requirements? If so, how? Are there any specific 
categories of information that an SBS Dealer should be required to 
obtain from a counterparty? Should the Commission specify how any such 
information should be obtained from the counterparty?
     Should the ``know your counterparty'' obligations apply to 
Major SBS Participants, as well as to SBS Dealers? If so, why?
     To what extent would the current business practices of SBS 
Dealers, including their compliance procedures and their credit and 
operational risk management procedures, comply with the proposed ``know 
your counterparty'' requirements? To what extent would the proposed 
rule require SBS Dealers to change their current business practices? 
Would the proposed requirements impose any particular burdens on market 
participants?
     Should SBS Dealers be required to obtain any particular or 
additional information regarding their counterparty beyond what would 
be required under the proposed rule? If so, what specific information 
should SBS Dealers be required to obtain?
     Should the proposed requirement track more closely the 
``know your customer'' requirement imposed under SRO rules? In 
particular, should the proposed rule require an SBS Dealer to obtain 
information necessary to effectively ``service the counterparty,'' to 
implement a counterparty's ``special instructions,'' or to evaluate the 
counterparty's security-based swaps experience, financial wherewithal 
and

[[Page 42415]]

trading objectives? \126\ If so, how should such terms be interpreted 
in the context of SBS Dealers and the security-based swap market?
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    \126\ Cf. Supplementary Material .01 to FINRA Rule 2090 (``For 
purposes of this Rule, facts `essential' to `knowing the customer' 
are those required to (a) Effectively service the customer's 
account, (b) act in accordance with any special handling 
instructions for the account, (c) understand the authority of each 
person acting on behalf of the customer, and (d) comply with 
applicable laws, regulations, and rules.'').
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     Are there any circumstances in which it would not be 
appropriate to apply a ``know your counterparty'' obligation? What 
circumstances and why?
     Should ``know your counterparty'' requirements apply 
differently with respect to cleared and uncleared swaps? If so, how and 
why?
4. Recommendations by SBS Dealers
    Proposed Rule 15Fh-3(f) would generally require an SBS Dealer that 
makes a ``recommendation'' to a counterparty to have a reasonable basis 
for believing that the recommended security-based swap or trading 
strategy involving security-based swaps is suitable for the 
counterparty.
    In determining whether to propose Rule 15Fh-3(f), a business 
conduct requirement not expressly addressed by the statute, the 
Commission considered the suitability obligations imposed when other 
market professionals recommend a security or trading strategy to 
customers, including institutional customers.\127\ The obligation to 
make only suitable recommendations is a core business conduct 
requirement for broker-dealers.\128\ Municipal securities dealers also 
have a suitability obligation when recommending municipal securities 
transactions to a customer.\129\ Federally regulated banks have a 
suitability obligation as well when acting as a broker or dealer in 
connection with the purchase or sale of government securities.\130\ 
Depending on the scope of its activities, an SBS Dealer may be subject 
to one of these other suitability obligations, in addition to those 
under our proposed rule. In particular, if an SBS Dealer is also a 
registered broker-dealer and a FINRA member, it would be subject as 
well to FINRA suitability requirements in connection with the 
recommendation of a security-based swap or trading strategy involving a 
security-based swap, as well as the anti-fraud provisions of the 
Exchange Act.\131\ Proposed Rule 15Fh-3(f) is intended to ensure that 
all SBS Dealers that make recommendations are subject to this 
obligation, tailored as appropriate in light of the nature of the 
security-based swap markets.\132\
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    \127\ See Section 15F(h)(1)(D) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1789 (to be codified at 15 U.S.C. 78o-
10(h)(1)(D)) (authorizing, but not explicitly requiring, the 
Commission to prescribe business conduct standards that relate to 
``such other matters as the Commission determines to be 
appropriate''), and Section 15F(h)(3)(D) of the Exchange Act, Public 
Law 111-203, 124 Stat. 1376, 1790 (to be codified at 15U.S.C. 78o-
10(h)(3)(D)) (authorizing the Commission to establish ``such other 
standards and requirements as the Commission may determine are 
appropriate in the public interest, for the protection of investors, 
or otherwise in furtherance of the purposes of this Act'').
    \128\ See, e.g., FINRA Rules 2090 and 2111 (effective July 9, 
2012). See also Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 
1943) (enforcing suitability obligations under the antifraud 
provisions of the Exchange Act).
    \129\ MSRB Rule G-19(c) provides that:
    In recommending to a customer any municipal security 
transaction, a broker, dealer, or municipal securities dealer shall 
have reasonable grounds: (i) Based upon information available from 
the issuer of the security or otherwise, and (ii) based upon the 
facts disclosed by such customer or otherwise known about such 
customer, for believing that the recommendation is suitable.
    \130\ See Trading & Capital-Markets Manual Sec.  2150 (imposing 
a suitability obligation on federally regulated banks acting as a 
government securities broker or government securities dealer); 
Government Securities Sales Practices, 62 FR 13276 (Mar. 19, 1997) 
(codified at 12 CFR parts 13, 208, 211, and 368).
    \131\ See Section II.A, supra. See also FINRA Rule 2111 
(effective July 9, 2012). Under FINRA rules, unless a counterparty 
had total assets of at least $50 million, he or she would be 
entitled to the protections provided by retail suitability 
obligations in the broker-dealer context. See FINRA Rule 2111(b) 
(referring to NASD Rule 3110(c)(4)). 
    \132\ Some dealers have indicated that they already apply 
``institutional suitability'' principles to their swap business. 
See, e.g., Letter from Richard Ostrander, Managing Director and 
Counsel, Morgan Stanley, to Elizabeth M. Murphy, Secretary, 
Securities and Exchange Commission, and David A. Stawick, Secretary, 
Commodity Futures Trading Commission (Dec. 3, 2010) at 5; Report of 
the Business Standards Committee, Goldman Sachs (Jan. 2011), http://www2.goldmansachs.com/our-firm/business-standards-committee/report.pdf.
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    Proposed Rule 15Fh-3(f) would only apply when an SBS Dealer makes a 
``recommendation'' to a counterparty. The Commission preliminarily 
believes that the determination of whether an SBS Dealer has made a 
recommendation that triggers a suitability obligation should turn on 
the facts and circumstances of the particular situation and, therefore, 
whether a recommendation has taken place is not susceptible to a bright 
line definition. This is consistent with the FINRA approach to what 
constitutes a recommendation. In the context of the FINRA suitability 
standard, factors considered in determining whether a recommendation 
has taken place include whether the communication ``reasonably could be 
viewed as a `call to action' '' and ``reasonably would influence an 
investor to trade a particular security or group of securities.'' \133\ 
The more individually tailored the communication to a specific customer 
or a targeted group of customers about a security or group of 
securities, the greater the likelihood that the communication may be 
viewed as a ``recommendation.'' The Commission preliminarily believes 
that this approach should apply in the context of proposed Rule 15Fh-
3(e) as well.
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    \133\ See FINRA Notice to Members 01-23 (Mar. 19, 2001), and 
Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090 
(Know Your Customer) and 2111 (Suitability) in the Consolidated 
FINRA Rulebook, Exchange Act Release No. 62718 (Aug. 13, 2010), 75 
FR 51310 (Aug. 19, 2010), as amended, Exchange Act Release No. 
62718A (Aug. 20, 2010), 75 FR 52562 (Aug. 26, 2010) (discussing what 
it means to make a ``recommendation'').
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    An SBS Dealer typically would not be deemed to be making a 
recommendation solely by reason of providing general financial or 
market information, or transaction terms in response to a request for 
competitive bids.\134\ Furthermore, compliance with the requirements of 
the proposed rules, in particular, Rule 15Fh-3(a) (verification of 
counterparty status), 15Fh-3(b) (disclosures of material risks and 
characteristics, and material incentives or conflicts of interest), 
15Fh-3(c) (disclosures of daily mark), and 15Fh-3(d) (disclosures 
regarding clearing rights) would not, in and of itself, result in an 
SBS Dealer being deemed to be making a ``recommendation.''
---------------------------------------------------------------------------

    \134\ Cf. Supplementary Material .03 to FINRA Rule 2090.
---------------------------------------------------------------------------

    When the suitability obligation of proposed Rule 15Fh-3(f) applies, 
the SBS Dealer must, as a threshold matter, understand the security-
based swap or trading strategy that it is recommending. Proposed Rule 
15Fh-3(f)(1)(i) would require an SBS Dealer to have a reasonable basis 
to believe, based on reasonable diligence, that the recommendation is 
suitable for at least some counterparties. In general, what constitutes 
reasonable diligence will vary depending on, among other things, the 
complexity of and risks associated with the security-based swap or 
trading strategy and the SBS Dealer's familiarity with the security-
based swap or trading strategy. An SBS Dealer's reasonable diligence 
must provide it with an understanding of the potential risks and 
rewards associated with the recommended security-based swap or trading 
strategy. An SBS Dealer that lacks this understanding would not be able 
to meet its obligations under the proposed rule.\135\ In addition, 
under

[[Page 42416]]

proposed Rule 15Fh-3(f)(1), in order to establish a reasonable basis 
for a recommendation to a particular counterparty, the SBS Dealer would 
need to have or obtain relevant information regarding the counterparty, 
including the counterparty's investment profile (including trading 
objectives) and its ability to absorb potential losses associated with 
the recommended security-based swap or trading strategy.\136\
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    \135\ See, e.g., Michael F. Siegel, 2007 NASD Discip. LEXIS 20 
(2007), aff'd, Exchange Act Release No. 58737 (Oct. 6, 2008), 
vacated in part and remanded on other grounds, 592 F.3d 147 (10th 
Cir. 2010) (finding that registered representative lacked any 
reasonable basis for recommending securities because he did not have 
sufficient understanding of what he was recommending). See also 
Distribution by Broker-Dealers of Unregistered Securities, Exchange 
Act Release No. 6721 (Feb. 2, 1962) (``the making of recommendations 
for the purchase of a security implies that the dealer has a 
reasonable basis for such recommendations which, in turn, requires 
that, as a prerequisite, he shall have made a reasonable 
investigation''). Cf. Supplementary Material .03 to FINRA Rule 2090.
    \136\ Under FINRA Rule 2111(a) (effective July 9, 2012), a 
customer's investment profile includes, but is not limited to, the 
customer's age, other investments, financial situation and needs, 
tax status, investment objectives, investment experience, investment 
time horizon, liquidity needs, risk tolerance, and any other 
information the customer may disclose to the member or associated 
person in connection with such recommendation. See also FINRA Rule 
2360(b)(19)(B) (``No member or person associated with a member shall 
recommend to a customer an opening transaction in any option 
contract unless the person making the recommendation has a 
reasonable basis for believing, at the time of making the 
recommendation, that the customer * * * is financially able to bear 
the risks of the recommended position in the option contract.'').
---------------------------------------------------------------------------

    Proposed Rule 15Fh-3(f)(2) would provide an alternative to the 
general suitability requirement, under which an SBS Dealer could 
fulfill its obligations with respect to a particular counterparty if: 
(1) The SBS Dealer reasonably determines that the counterparty (or its 
agent) is capable of independently evaluating investment risks with 
regard to the relevant security-based swap or trading strategy 
involving a security-based swap; (2) the counterparty (or its agent) 
affirmatively represents in writing that it is exercising independent 
judgment in evaluating the recommendations by the SBS Dealer; and (3) 
the SBS Dealer discloses that it is acting in the capacity of a 
counterparty, and is not undertaking to assess the suitability of the 
security-based swap or trading strategy.\137\ We preliminarily believe 
that parties should be able to make these disclosures on a transaction-
by-transaction basis, on an asset-class-by-asset-class basis, or in 
terms of all potential transactions between the parties.\138\
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    \137\ As discussed in Section II.D.3, the standards for 
determining that an SBS Dealer is not acting as an advisor under 
proposed Rule 15Fh-2(a) would be substantially the same as the 
standards that an SBS Dealer must satisfy to qualify for the 
alternative to the general suitability standard under proposed Rule 
15Fh-3(f). Accordingly, as described more fully below, we are also 
proposing that the general suitability requirement be deemed 
satisfied if an SBS Dealer is deemed not to be acting as an advisor 
to a special entity in accordance with proposed Rule 15Fh-2(a).
    \138\ This approach is consistent with FINRA's approach to 
institutional suitability. See Supplementary Material .07 to FINRA 
Rule 2111 (effective July 9, 2012) (``With respect to having to 
indicate affirmatively that it is exercising independent judgment in 
evaluating the member's or associated person's recommendations, an 
institutional customer may indicate that it is exercising 
independent judgment on a trade-by-trade basis, on an asset-class-
by-asset-class basis, or in terms of all potential transactions for 
its account.'').
---------------------------------------------------------------------------

    If an SBS Dealer cannot rely on the alternative provided by 
proposed Rule 15Fh-3(f)(2), it would need to make an independent 
determination that the recommended security-based swap or trading 
strategy involving security-based swaps is suitable for the 
counterparty.\139\
---------------------------------------------------------------------------

    \139\ This also is consistent with FINRA's approach to 
institutional suitability. See id.
---------------------------------------------------------------------------

    We preliminarily believe that an SBS Dealer, for purposes of Rule 
15Fh-3(f)(2), reasonably could determine that the counterparty (or its 
agent) is capable of independently evaluating investment risks with 
regard to the relevant security-based swap (or trading strategy 
involving a security-based swap) through a variety of means, including 
the use of written representations from its counterparty. For example, 
absent special circumstances described below, we preliminarily believe 
it would be reasonable for an SBS Dealer to rely on written 
representations by its counterparty that the counterparty (or its 
agent) is capable of independently evaluating investment risks with 
regard to any security-based swap (or trading strategy involving a 
security-based swap). Upon receiving such a representation (or the 
representation required by Rule 15Fh-3(f)(2)(ii) with respect to the 
counterparty's exercise of independent judgment), the SBS Dealer would 
be entitled to rely on the representation without further inquiry, 
absent special circumstances described below.
    To solicit input on when it would no longer be appropriate for an 
SBS Dealer to rely on such representations without further inquiry, the 
Commission is proposing for comment two alternative approaches. One 
approach would permit an SBS Dealer to rely on a representation from a 
counterparty for purposes of Rule 15Fh-3(f)(2)(i) or (ii) unless it 
knows that the representation is not accurate. The second would permit 
an SBS Dealer to rely on a representation unless the SBS Dealer has 
information that would cause a reasonable person to question the 
accuracy of the representation.
    Under either approach, an SBS Dealer could not ignore information 
in its possession as a result of which the SBS Dealer would know that a 
representation is inaccurate. In addition, under the second approach, 
an SBS Dealer also could not ignore information that would cause a 
reasonable person to question the accuracy of a representation and, if 
the SBS Dealer had such information, it would need to make further 
reasonable inquiry to verify the accuracy of the representation.
    We are proposing to apply the requirement in proposed Rule 15Fh-
3(f) to SBS Dealers but not to Major SBS Participants because we do not 
anticipate that Major SBS Participants will serve a dealer-type role in 
the market.\140\ Further, under the proposed rule, the obligation would 
not apply to an SBS Dealer in dealings with an SBS Entity, swap dealer, 
or major swap participant.\141\ We preliminarily believe that these 
types of counterparties, which are professional intermediaries or major 
participants in the swaps or security-based swap markets, would not 
need the protections that would be afforded by this rule.
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    \140\ See discussion in Section I.C.4, supra. If a Major SBS 
Participant is, in fact, recommending security-based swaps to 
counterparties, we believe it is likely that person is engaged in 
other activities that would cause it to come within the definition 
of an SBS Dealer (and therefore no longer able to qualify as a Major 
SBS Participant) or other regulated entity that historically has 
been subject to a suitability obligation.
    \141\ See proposed Rule 15Fh-3(f).
---------------------------------------------------------------------------

    In addition, when an SBS Dealer is acting as an advisor to a 
special entity, we are proposing that the suitability requirement will 
be deemed satisfied by compliance with the requirements of Rule 15Fh-
4(b). Under Section 15F(h)(4), an SBS Dealer that acts as an advisor to 
a special entity is required to make a reasonable determination that 
its recommendations are in the best interests of the counterparty.\142\ 
The statute and proposed Rule 15Fh-4(b)(2) set forth specific 
information that an SBS Dealer must make reasonable efforts to obtain 
as necessary when making that determination. As explained more fully in 
Section II.D.3, infra, the proposed rule would further

[[Page 42417]]

require that the SBS Dealer act in the ``best interests'' of the 
special entity, which goes beyond and encompasses the general 
suitability requirements of proposed Rule 15Fh-3(f). Accordingly, we 
preliminarily believe that the general suitability requirement of 
proposed Rule 15Fh-3(f) should be deemed satisfied by compliance with 
the requirements of proposed Rule 15Fh-4(b).
---------------------------------------------------------------------------

    \142\ Section 15F(h)(4)(C) (``Any security-based swap dealer 
that acts as an advisor to a special entity shall make reasonable 
efforts to obtain such information as is necessary to make a 
reasonable determination that any security-based swap recommended by 
the security-based swap dealer is in the best interests of the 
special entity''). Public Law 111-203, 124 Stat. 1376, 1790-1791 (to 
be codified at 15 U.S.C. 78o-10(h)(4)(C)).
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of 
proposed Rule 15Fh-3(f). In addition, we request comments on the 
following specific issues:
     As noted above, the term ``recommendation'' has been 
interpreted in the context of the FINRA suitability requirement. Should 
the Commission define or describe more fully what is a 
``recommendation'' in this context, and if so, what should the 
definition or description be and why? In what specific circumstances, 
if any, would additional guidance as to the meaning of a 
``recommendation'' be useful? Does the existing FINRA guidance provide 
sufficient clarity in this regard? Why or why not? Would a different 
approach be appropriate given the differences in the market for 
security-based swaps? Why or why not? Should the Commission expressly 
address the application of any part of the FINRA guidance in this 
context? If so, how?
     Should the Commission permit an SBS Dealer to rely on the 
institutional suitability alternative that would be available under 
proposed Rule 15Fh-3(f)(2)? Why or why not? Should additional or 
different requirements be placed upon an SBS Dealer's use of this 
alternative? If so, what requirements should be added or changed and 
why?
     Is FINRA's guidance regarding the customer information a 
broker-dealer should have available in order to make a suitability 
determination an appropriate model for security-based swap markets? 
How, if at all, should that guidance be modified? Should the SBS Dealer 
be required to obtain different or additional information regarding the 
counterparty?
     Should the suitability obligations apply to Major SBS 
Participants, as well as to SBS Dealers? Why or why not?
     Should the suitability obligations apply to 
recommendations made to SBS Entities, swap dealers and major swap 
participants? Why or why not?
     Should the suitability obligations apply when 
recommendations are made to a counterparty that is a broker-dealer? 
\143\ Another type of market intermediary? Why or why not? Are there 
any other circumstances in which the proposed suitability requirement 
should not apply, or should apply in a different way?
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    \143\ FINRA ``know your customer'' obligations do not apply to a 
broker-dealer's dealings with another broker or dealer. See NASD 
Rule 0120(g) (``[t]he term `customer' shall not include a broker or 
dealer'').
---------------------------------------------------------------------------

     Are there any particular types of security-based swap 
transactions for which heightened or otherwise modified suitability 
requirements should apply? If so, what types of transactions? What 
requirements should apply to these transactions?
     Should different categories of ECPs be treated differently 
under the proposed rules for purposes of suitability determinations? If 
so, how? For example, under our proposed rules an SBS Entity would be 
subject to the suitability requirement of proposed Rule 15F-3(f)(2) 
when entering into security-based swaps with any person that qualified 
as an ECP, a category that includes persons with $5 million or more 
invested on a discretionary basis that enter into the security-based 
swap ``to manage risks.'' \144\ In contrast, under FINRA rules, in 
order to apply an analogous suitability standard, a broker-dealer must 
be dealing with an entity (whether a natural person, corporation, 
partnership, trust, or otherwise) with total assets of at least $50 
million.\145\ Should the Commission apply a different standard of 
suitability depending on whether the counterparty would be protected as 
a retail investor under FINRA rules when the SBS Dealer is also a 
registered broker-dealer? \146\ If so, what should the standard be and 
to whom should it apply? In what ways should the similarities and 
differences between security-based swaps and the types of securities 
transactions otherwise subject to FINRA rules inform the standard 
applied by the Commission in this context?
---------------------------------------------------------------------------

    \144\ See Section 1a(18)(A)(xi) of the Commodity Exchange Act, 
as amended by the Dodd-Frank Act.
    \145\ See FINRA Rule 2111(b) (referring to NASD Rule 
3110(c)(4)).
    \146\ Under FINRA rules, a retail customer would generally be an 
entity (whether a natural person, corporation, partnership, trust, 
or otherwise) with total assets of less than $50 million). See NASD 
Rule 3110(c)(4). An SBS Dealer that is also a broker-dealer would 
need to have a reasonable basis to believe that any recommendation 
of security-based swap or trading strategy to such a person is 
suitable for that person, based on the information obtained through 
the reasonable diligence of the member or associated person to 
ascertain the counterparty's investment profile. This general 
suitability obligation under current FINRA rules would apply 
regardless of whether the SBS Dealer could otherwise rely on the 
alternative under proposed Rule 15Fh-3(f)(2).
---------------------------------------------------------------------------

     Is it appropriate for the Commission to exclude from the 
scope of the proposed rule situations in which an SBS Dealer is making 
recommendations to a special entity, since recommendations to those 
entities are subject to separate and heightened suitability 
requirements? Why or why not?
     Should the proposed alternative available under proposed 
Rule 15Fh-3(f)(2) be limited to counterparties that would not be 
protected as retail investors under FINRA rules or another category of 
counterparties?\147\ If not, should we require that the proposed 
alternative be addressed on a transaction-by-transaction basis (i.e., 
not generally on a relationship basis or asset-class-by-asset-class) 
for counterparties that would otherwise be protected as retail 
investors under FINRA rules or another category of counterparties? Why 
or why not?
---------------------------------------------------------------------------

    \147\ See id.
---------------------------------------------------------------------------

     Should the suitability obligation be limited to 
recommendations to counterparties that would be protected as retail 
investors under FINRA rules or another subset of counterparties? If so, 
should these counterparties be covered by a suitability rule similar to 
FINRA Rule 2360 regarding options suitability? Should this requirement 
be limited to another category of counterparties? \148\ Why or why not?
---------------------------------------------------------------------------

    \148\ FINRA Rule 2360(b)(19) (Suitability) provides that:
    (A) No member or person associated with a member shall recommend 
to any customer any transaction for the purchase or sale of an 
option contract unless such member or person associated therewith 
has reasonable grounds to believe upon the basis of information 
furnished by such customer after reasonable inquiry by the member or 
person associated therewith concerning the customer's investment 
objectives, financial situation and needs, and any other information 
known by such member or associated person, that the recommended 
transaction is not unsuitable for such customer.
    (B) No member or person associated with a member shall recommend 
to a customer an opening transaction in any option contract unless 
the person making the recommendation has a reasonable basis for 
believing, at the time of making the recommendation, that the 
customer has such knowledge and experience in financial matters that 
he may reasonably be expected to be capable of evaluating the risks 
of the recommended transaction, and is financially able to bear the 
risks of the recommended position in the option contract.
---------------------------------------------------------------------------

     Should the Commission provide guidance on other methods by 
which an SBS Dealer can assess a counterparty's capability to 
independently evaluate investment risks and exercise independent 
judgment? If so, what alternative approaches, and what would be the 
advantages and disadvantages for SBS Dealers and counterparties?

[[Page 42418]]

     Should the Commission impose specific requirements with 
respect to the level of detail that should be required for 
representations? If so, what requirements and why?
     Should the Commission permit SBS Dealers to rely on 
disclosures made by counterparties for purposes of proposed Rule 15Fh-
3(f)(2) on a transaction-by-transaction basis, on an asset-class-by-
asset-class basis, or in terms of all potential transactions between 
the parties? Why or why not? What are the potential advantages and 
disadvantages of such an approach?
     What are the advantages and disadvantages of the two 
alternative proposed approaches to guidance on when an SBS Dealer may 
not rely on a representation? Which alternative would strike the best 
balance among the potential disadvantages to market participants, the 
regulatory interest (including protecting counterparties in security-
based swap transactions) and promoting the sound functioning of the 
security-based swap market? What, if any, other alternatives should the 
Commission consider (e.g., a recklessness standard) and why?
     Are there particular categories of counterparties for 
which an SBS Dealer should be required to undertake further review or 
inquiry to establish a counterparty's capability? Should additional 
information be required when, for example, a potential counterparty is 
a natural person? If so, what review or inquiry should be required in 
what circumstances?
     Are there other potential reasonable methods of 
establishing a counterparty's capability to independently evaluate 
investment risks and exercise independent judgment besides written 
representations? Should the Commission consider providing guidance 
regarding these other methods? If so, what methods should such guidance 
address and how?
5. Fair and Balanced Communications
    Proposed Rule 15Fh-3(g) would implement the statutory requirement 
that SBS Entities communicate with counterparties in a fair and 
balanced manner based on principles of fair dealing and good 
faith.\149\ This obligation would apply in connection with entering 
into security-based swaps, and would continue to apply over the term of 
a security-based swap.\150\ The standard is consistent with the 
similarly worded requirement in the FINRA customer communications rule, 
which is designed to ensure that any customer communications reflect a 
balanced treatment of potential benefits and risks.\151\ As we 
explained in Section I.C.2, supra, when a business conduct standard is 
based on a similar SRO standard, we generally expect to interpret our 
standard consistently with SRO interpretations of their rules, 
recognizing that we may need to account for functional differences 
between the security-based swap market and other securities markets. 
Accordingly, we are proposing three additional standards, drawn from 
FINRA regulation, to clarify the statutory requirement.\152\ These 
standards do not represent an exclusive list of considerations that an 
SBS Entity must make in determining whether a communication with a 
counterparty is fair and balanced.
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    \149\ See Exchange Act Section 15F(h)(3)(C), Pub. L. 111-203, 
124 Stat. 1376, 1790 (to be codified at 15 U.S.C. 78o-10(h)(3)(C)).
    \150\ See proposed Rule 15Fh-1.
    \151\ NASD Rule 2210(d). See IM-2210-1(1), Guidelines to Ensure 
That Communications with the Public Are Not Misleading (``Members 
must ensure that statements are not misleading within the context in 
which they are made. A statement made in one context may be 
misleading even though such a statement could be appropriate in 
another context. An essential test in this regard is the balanced 
treatment of risks and potential benefits.'').
    \152\ Cf. SIFMA/ISDA 2010 Letter at 4 (requesting the Commission 
clarify the standards for fair and balanced communication by 
reference to the existing FINRA standards for customer 
communication, subject to appropriate modifications to reflect the 
heightened standards for participation in the swap markets).
---------------------------------------------------------------------------

    We propose to require that communications must provide a sound 
basis for evaluating the facts with respect to any security-based swap 
or trading strategy involving a security-based swap that the 
communication is designed to cover.\153\ In addition, we propose to 
prohibit communications that imply that past performance would recur, 
or that make any exaggerated or unwarranted claim, opinion, or 
forecast.\154\ Finally, we propose to require that any statement 
referring to the potential opportunities or advantages presented by a 
security-based swap or trading strategy involving a security-based swap 
be balanced by a statement of the corresponding risks having the same 
degree of specificity as the statement of opportunities.\155\ SBS 
Entities should also avoid broad generalities in their communications, 
to the extent appropriate and practicable under the circumstances.
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    \153\ Proposed Rule 15Fh-3(g)(1). Cf. NASD Rule 2210(d)(1)(A) 
(``All member communications with the public shall be based on 
principles of fair dealing and good faith, must be fair and 
balanced, and must provide a sound basis for evaluating the facts in 
regard to any particular security or type of security, industry, or 
service.'').
    \154\ Proposed Rule 15Fh-3(g)(2). Cf. NASD Rule 2201(d)(1)(D) 
(``Communications with the public may not predict or project 
performance, imply that past performance will recur or make any 
exaggerated or unwarranted claim, opinion or forecast. A 
hypothetical illustration of mathematical principles is permitted, 
provided that it does not predict or project the performance of an 
investment or investment strategy.''). Proposed Rule 15Fh-3(e)(4) 
does not constitute a blanket prohibition of communications such as 
scenario or profitability analyses that are required or advisable 
under other provisions of these rules.
    \155\ Proposed Rule 15Fh-3(g)(3). Cf. NASD IM-2210-1(1) (``An 
essential test in this regard is the balanced treatment of risks and 
potential benefits.'').
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    We note that, regardless of the scope of the rules proposed herein, 
all communications by SBS Entities will be subject to the specific 
anti-fraud provisions added to the Exchange Act under Title VII of the 
Dodd-Frank Act, \156\ as well as general anti-fraud provisions under 
the federal securities laws.\157\
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    \156\ See Sections 9(j) and 15F(h)(4)(A) of the Exchange Act, 
Public Law 111-203, 124 Stat. 1376, 1777-1778 and 1790 (to be 
codified at 15 U.S.C. 78i(j) and 15 U.S.C. 78o-10(h)(4)(A)). See 
also Prohibition Against Fraud, Manipulation, and Deception in 
Connection with Security-Based Swaps, Exchange Act Release No. 63236 
(Nov. 3, 2010), 75 FR 68560 (Nov. 8, 2010) (proposing Rule 9j-1 to 
implement the anti-fraud prohibitions of Section 9(j) of the 
Exchange Act).
    \157\ See, e.g., 15 U.S.C. 77q and 78i, and, if the SBS Entity 
is registered as a broker-dealer, 15 U.S.C. 78o.
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission further clarify any proposed 
requirements to engage in fair and balanced communications? If so, how? 
Are there specific circumstances regarding the application of the 
proposed requirements that the Commission should address? If so, which 
circumstances, and what guidance is required?
     Should the Commission specify any additional requirements 
for the duty to engage in fair and balanced communications? If so, what 
requirements and why?
     Should an SBS Entity be able to rely on SRO guidance with 
respect to communications for purposes of compliance with the proposed 
rule? If so, how would such reliance function as both the security-
based swap market and the broader securities markets continue to 
evolve?
     Should the Commission provide additional guidance with 
respect to the nature of fair and balanced communications for purposes 
of furthering compliance with the proposed rule and providing greater

[[Page 42419]]

legal certainty to market participants? If so, what guidance and why?
     What are the specific practical effects, advantages and 
disadvantages that market participants identify in considering how to 
comply with the proposed rules? Are there modifications or 
clarifications to the proposed rules that would better balance the 
advantages and disadvantages of the statutory requirement while 
furthering the Commission's regulatory objectives?
     Are there any particular differences between the 
traditional securities markets and the markets for security-based swaps 
that need to be taken into account in clarifying the statutory 
requirement to communicate in a fair and balanced manner based on 
principles of fair dealing and good faith? If so, what are these 
differences, and how should the Commission's proposal be modified to 
take them into account?
     Should we distinguish between the fair and balanced 
communication requirements applicable to an SBS Dealer and those 
applicable to a Major SBS Participant? If so, how should the 
requirements applicable to a Major SBS Participant differ from those 
that are being proposed?
     Are there any circumstances in which the fair and balanced 
communications requirements should not apply? Which circumstances, and 
why?
     We preliminarily believe that proposed Rule 15F-3(g) would 
provide additional investor protection beyond what would otherwise 
arise by virtue of applicable anti-fraud rules. Will the proposed 
communications requirements have the effect of reducing communications 
between SBS Entities and their counterparties? In what respects, and 
why? What alternative approaches might the Commission consider to 
effectively implement the statutory requirement without unduly 
discouraging effective communication between market participants?
6. Obligation Regarding Diligent Supervision
    Exchange Act Section 15F(h)(1)(B) authorizes the Commission to 
adopt rules for the diligent supervision of the business of SBS 
Entities. Proposed Rule 15Fh-3(h) would establish supervisory 
obligations that incorporate principles from both Exchange Act Section 
15(b) and existing SRO rules.\158\ As we discussed earlier, the concept 
of diligent supervision is consistent with business conduct standards 
for broker-dealers that have historically been established by SROs for 
their members, subject to Commission approval. We anticipate that 
certain SBS Entities may also be registered broker-dealers and thus 
subject to substantially similar requirements under SRO rules.\159\ 
More generally, we believe that the SRO requirements provide a useful 
point of reference that has been implemented by a wide range of firms 
in the U.S. financial services industry.
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    \158\ The Commission's policy regarding failure to supervise is 
well established. 15 U.S.C. 78o(b)(4)(E) and 15 U.S.C. 78o(b)(6)(A). 
As we have explained in other contexts:
    The Commission has long emphasized that the responsibility of 
broker-dealers to supervise their employees is a critical component 
of the federal regulatory scheme. * * * In large organizations it is 
especially imperative that those in authority exercise particular 
vigilance when indications of irregularity reach their attention. 
The supervisory obligations imposed by the federal securities laws 
require a vigorous response even to indications of wrongdoing. Many 
of the Commission's cases involving a failure to supervise arise 
from situations where supervisors were aware only of ``red flags'' 
or ``suggestions'' of irregularity, rather than situations where, as 
here, supervisors were explicitly informed of an illegal act.
    Even where the knowledge of supervisors is limited to ``red 
flags'' or ``suggestions'' of irregularity, they cannot discharge 
their supervisory obligations simply by relying on the unverified 
representations of employees. Instead, as the Commission has 
repeatedly emphasized, ``[t]here must be adequate follow-up and 
review when a firm's own procedures detect irregularities or unusual 
trading activity. * * *'' Moreover, if more than one supervisor is 
involved in considering the actions to be taken in response to 
possible misconduct, there must be a clear definition of the efforts 
to be taken and a clear assignment of those responsibilities to 
specific individuals within the firm.
    John H. Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992) 
(report pursuant to Section 21(a) of the Exchange Act) (footnotes 
omitted).
    \159\ See, e.g., NASD Rules 3010 and 3012.
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    Under proposed Rule 15Fh-3(h)(1), each SBS Entity would be required 
to establish, maintain and enforce a system to supervise, and would be 
required to supervise diligently, the business of the SBS Entity 
involving security-based swaps.\160\This system would be required to be 
reasonably designed to achieve compliance with applicable federal 
securities laws and the rules and regulations thereunder.\161\ Proposed 
Rule 15Fh-3(h) would provide a baseline requirement for an effective 
supervisory system, although a particular system may need additional 
elements in order to be effective. For that reason, proposed Rule 15Fh-
3(h)(2) would state that it establishes only minimum requirements; by 
implication, the list would not be exhaustive. These obligations are 
based on SRO standards and we generally expect to interpret these 
obligations taking into account SRO interpretations of their rules, 
recognizing that we are not bound by SRO interpretations and may need 
to account for functional differences between the security-based swap 
market and other securities markets.
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    \160\ We will consider consolidating any recordkeeping 
obligations proposed as part of this rule into a separate 
recordkeeping rule that we are required to adopt under the Dodd-
Frank Act. See Section 15F(f)(2) of the Exchange Act, 15 U.S.C. 78o-
10(f)(2) (``The Commission shall adopt rules governing reporting and 
recordkeeping for security-based swap dealers and major security-
based swap participants.'').
    \161\ Proposed Rule 15Fh-3(h)(2). See NASD Rule 3010(a) (``Each 
member shall establish and maintain a system to supervise the 
activities of each registered representative, registered principal, 
and other associated person that is reasonably designed to achieve 
compliance with applicable securities laws and regulations, and with 
applicable NASD Rules.'').
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    Proposed Rule 15Fh-3(h)(2)(i) would require an SBS Entity to 
designate at least one qualified person with supervisory responsibility 
for security-based swap transactions.\162\ Proposed Rule 15Fh-
3(h)(2)(ii) would require an SBS Entity to use reasonable efforts to 
determine that all supervisors are qualified and have sufficient 
training, experience, and competence to adequately discharge their 
responsibilities.\163\ Proposed Rule 15Fh-3(h)(2)(iii) would require an 
SBS Entity to adopt written policies and procedures addressing the 
types of security-based swap business in which the SBS Entity is 
engaged. The policies and procedures would need to be reasonably 
designed to achieve compliance with applicable securities laws and the 
rules and regulations thereunder,\164\ and include, at a minimum: (1) 
Procedures for the review by a supervisor of all transactions for which 
registration as an SBS Entity is required; \165\ (2) procedures for the

[[Page 42420]]

review by a supervisor of written correspondence with counterparties 
and potential counterparties and internal written (including 
electronic) communications relating to the securities-based swap 
business; \166\ (3) procedures for a periodic review of the security-
based swap business in which it engages; \167\ (4) procedures to 
conduct reasonable investigation into the background of associated 
persons; \168\ (5) procedures to monitor employee personal accounts 
held at another SBS Dealer, broker, dealer, investment adviser, or 
other financial institution; \169\ (6) a description of the supervisory 
system, including identification of the supervisory personnel; \170\ 
(7) procedures prohibiting supervisors from supervising their own 
activities or reporting to, or having their compensation or continued 
employment determined by, a person or persons they are supervising; 
\171\ and (8) procedures preventing the standards of supervision from 
being reduced due to any conflicts of interest that may be present with 
respect to the associated person being supervised.\172\ Proposed Rule 
15Fh-3(h)(4) would require SBS Entities to promptly update their 
supervisory procedures as legal or regulatory changes warrant. Proposed 
Rule 15Fh-3(h)(2)(iii)(F) would require SBS Entities to maintain 
records identifying supervisory personnel.
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    \162\ Cf. NASD Rule 3010(a)(2) (requiring ``[t]he designation, 
where applicable, of an appropriately registered principal(s) with 
authority to carry out the supervisory responsibilities of the 
member for each type of business in which it engages for which 
registration as a broker/dealer is required'').
    \163\ Cf. NASD Rule 3010(a)(6) (requiring members to use 
``[r]easonable efforts to determine that all supervisory personnel 
are qualified by virtue of experience or training to carry out their 
assigned responsibilities'').
    \164\ Cf. NASD Rule 3010(b)(1) (``Each member shall establish, 
maintain, and enforce written procedures to supervise the types of 
business in which it engages and to supervise the activities of 
registered representatives, registered principals, and other 
associated persons that are reasonably designed to achieve 
compliance with applicable securities laws and regulations, and with 
the applicable Rules of NASD.'').
    \165\ Proposed Rule 15Fh-3(h)(2)(iii)(A). Cf. NASD Rule 3010 
(d)(1) (``Each member shall establish procedures for the review and 
endorsement by a registered principal in writing, on an internal 
record, of all transactions and for the review by a registered 
principal of incoming and outgoing written and electronic 
correspondence of its registered representatives with the public 
relating to the investment banking or securities business of such 
member. Such procedures should be in writing and be designed to 
reasonably supervise each registered representative.'').
    \166\ Proposed Rule 15Fh-3(h)(2)(iii)(B). Cf. NASD Rule 
3010(d)(2) (which provides in part that ``[e]ach member shall 
develop written procedures that are appropriate to its business, 
size, structure, and customers for the review of incoming and 
outgoing written (i.e., non-electronic) and electronic 
correspondence with the public relating to its investment banking or 
securities business, including procedures to review incoming, 
written correspondence directed to registered representatives and 
related to the member's investment banking or securities business to 
properly identify and handle customer complaints and to ensure that 
customer funds and securities are handled in accordance with firm 
procedures'').
    \167\ Proposed Rule 15Fh-3(h)(2)(iii)(C). Cf. NASD Rule 
3010(c)(1) (``Each member shall conduct a review, at least annually, 
of the businesses in which it engages, which review shall be 
reasonably designed to assist in detecting and preventing violations 
of, and achieving compliance with, applicable securities laws and 
regulations, and with applicable NASD rules.'').
    \168\ Proposed Rule 15Fh-3(h)(2)(iii)(D). Cf. NASD Rule 3010(e) 
(``Each member shall have the responsibility and duty to ascertain 
by investigation the good character, business repute, 
qualifications, and experience of any person prior to making such a 
certification in the application of such person for registration 
with this Association.'').
    \169\ Proposed Rule 15Fh-3(h)(2)(iii)(E).
    \170\ Proposed Rule 15Fh-3(h)(2)(iii)(F). Cf. NASD Rule 
3010(b)(3) (``The member's written supervisory procedures shall set 
forth the supervisory system established by the member pursuant to 
paragraph (a) above, and shall include the titles, registration 
status and locations of the required supervisory personnel and the 
responsibilities of each supervisory person as these relate to the 
types of business engaged in, applicable securities laws and 
regulations, and the Rules of this Association.'').
    \171\ Proposed Rule 15Fh-3(h)(2)(iii)(G). Cf. NASD Rule 
3012(a)(2)(A)(i) (``General Supervisory Requirement. A person who is 
either senior to, or otherwise independent of, the producing manager 
must perform such supervisory reviews.'').
    \172\ Proposed Rule 15Fh-3(h)(2)(iii)(H). These conflicts could 
arise from the position of the associated person being supervised, 
the revenue that person generates for the SBS Entity, or any 
compensation that the person conducting the supervision may derive 
from the associated person being supervised. Cf. NASD Rule 
3012(a)(2)(C) (requiring ``procedures that are reasonably designed 
to provide heightened supervision over the activities of each 
producing manager who is responsible for generating 20% or more of 
the revenue of the business units supervised by the producing 
manager's supervisor. For the purposes of this subsection only, the 
term `heightened supervision' shall mean those supervisory 
procedures that evidence supervisory activities that are designed to 
avoid conflicts of interest that serve to undermine complete and 
effective supervision because of the economic, commercial, or 
financial interests that the supervisor holds in the associated 
persons and businesses being supervised.'').
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    As part of the required system reasonably designed to achieve 
compliance with applicable federal securities laws and regulations, 
proposed Rule 15Fh-3(h)(2)(iv) would require an SBS Entity to adopt 
written policies and procedures reasonably designed, taking into 
consideration the nature of such SBS Entity's business, to comply with 
the duties set forth in Section 15F(j) of the Exchange Act.\173\ 
Section 15F(j) of the Exchange Act requires an SBS Entity to comply 
with obligations concerning: (1) Monitoring of trading to prevent 
violations of applicable position limits; (2) establishing sound and 
professional risk management systems; (3) disclosing to regulators 
information concerning its trading in security-based swaps; (4) 
establishing and enforcing internal systems and procedures to obtain 
any necessary information to perform any of the functions described in 
Section 15F of the Exchange Act, and providing the information to 
regulators, on request; (5) implementing conflict-of-interest systems 
and procedures that establish structural and institutional safeguards 
to ensure that the activities of any person within the firm relating to 
research or analysis of the price or market for any security-based 
swap, or acting in the role of providing clearing activities, or making 
determinations as to accepting clearing customers are separated by 
appropriate informational partitions within the firm from the review, 
pressure, or oversight of persons whose involvement in pricing, 
trading, or clearing activities might potentially bias their judgment 
or supervision and contravene the core principles of open access and 
the business conduct standards addressed in Title VII of the Dodd-Frank 
Act; and (6) addressing antitrust considerations such that the SBS 
Entity does not adopt any process or take any action that results in 
any unreasonable restraint of trade or impose any material 
anticompetitive burden on trading or clearing.
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    \173\ Public Law 111-203, 124 Stat. 1376, 1792- 1793 (to be 
codified at 15 U.S.C. 78o-10(j)).
---------------------------------------------------------------------------

    Under proposed Rule 15Fh-3(h)(3), an SBS Entity or associated 
person would not have failed diligently to supervise a person that is 
subject to the supervision of that SBS Entity or associated person, if 
two conditions are met. First, the SBS Entity must have established 
policies and procedures, and a system for applying those policies and 
procedures, which would reasonably be expected to prevent and detect, 
to the extent practicable, any violation of the federal securities laws 
and the rules thereunder related to security-based swaps. Second, such 
person must have reasonably discharged the duties and obligations 
incumbent on it by reason of such procedures and system without a 
reasonable basis to believe that such procedures were not being 
followed. However, the absence of either or both of these conditions 
would not necessarily mean that an SBS Entity or associated person 
failed to diligently supervise any other person.
Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should supervisory requirements be imposed on Major SBS 
Participants? Why or why not?
     Should different supervisory requirements apply to SBS 
Dealers and Major SBS Participants? If so, how should the requirements 
differ, and why?
     Should we require a specific means by which an SBS Entity 
must determine whether a supervisor is qualified and has sufficient 
training, experience, and competence to adequately discharge his or her 
responsibilities? If so, what means? For example, should we require 
that supervisors pass exams comparable to FINRA Series 24? Should any 
such requirement apply to supervisors at Major SBS Participants as 
well, or only to supervisors at SBS Dealers?
     Should the Commission consider imposing a testing 
requirement comparable to FINRA Series 7 for all associated persons of 
an SBS Dealer or Major SBS Participant? Why or why not? Are there other 
models the Commission should consider? Which models, and why?

[[Page 42421]]

     Would any of these proposed supervisory requirements be 
more appropriately assigned to the chief compliance officer, and if so, 
which ones and why?
     Should certain obligations not be imposed on a supervisor 
of an SBS Entity? If so, which ones and why?
     Should an SBS Entity be able to rely on SRO guidance with 
respect to supervision for purposes of compliance with the proposed 
rule? Is that guidance sufficiently clear under the circumstances? 
Should that guidance be adopted or modified for purposes of its 
application to SBS Entities in the context of the security-based swap 
markets? If so, how and why?
     Do any of these proposed supervisory obligations conflict 
with current supervisory obligations, and if so, which ones and how?
     Should the Commission impose explicit supervision 
obligations with respect to the requirements of Section 15F(j), and if 
so, which ones and why? In particular, should the Commission impose 
explicit obligations with respect to the monitoring of trading to 
prevent violations of applicable position limits? Should the Commission 
impose explicit obligations with respect to establishing sound and 
professional risk management systems? Should the Commission impose 
explicit obligations to disclose to regulators information concerning 
trading in security-based swaps? Should the Commission impose explicit 
obligations with respect to establishing and enforcing internal systems 
and procedures to obtain any necessary information to perform any of 
the functions described in Section 15F of the Act? Should the 
Commission impose explicit obligations with respect to providing the 
information to regulators, on request? Should the Commission impose 
explicit obligations with respect to implementing conflict-of-interest 
systems and procedures to ensure that activities relating to research 
or analysis of the price or market for any security-based swap, 
clearing activities, and determinations as to accepting clearing 
customers are separated from the review, pressure, or oversight of 
persons whose involvement in pricing, trading, or clearing activities 
might potentially bias their judgment or supervision and contravene the 
core principles of open access and the business conduct standards 
addressed in the Act? Should the Commission impose explicit obligations 
with respect to addressing antitrust considerations such that the SBS 
Entity does not adopt any process or take any action that results in 
any unreasonable restraint of trade; or impose any material 
anticompetitive burden on trading or clearing?
     Should an SBS Entity be required to have policies and 
procedures reasonably designed to prevent the improper use or 
disclosure of counterparty information? \174\
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    \174\ As noted above, proposed Rule 15Fh-3(h)(2)(iv) would 
require SBS Entities to adopt written policies and procedures 
reasonably designed, taking into consideration the nature of such 
SBS Entity's business, to comply with the duties set forth in 
Section 15F(j) of the Exchange Act, including implementing conflict-
of-interest systems and procedures that establish structural and 
institutional safeguards to ensure that the activities of any person 
within the firm relating to research or analysis of the price or 
market for any security-based swap, or acting in the role of 
providing clearing activities, and or making determinations as to 
accepting clearing customers are separated by appropriate 
informational partitions within the firm from the review, pressure, 
or oversight of persons whose involvement in pricing, trading, or 
clearing activities might potentially bias their judgment or 
supervision and contravene the core principles of open access and 
the business conduct standards described in Title VII of the Dodd-
Frank Act.
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D. Proposed Rules Applicable to Dealings With Special Entities

    Congress has provided certain additional protections under Sections 
15F(h)(4) and (5) of the Exchange Act for ``special entities'' in 
connection with security-based swaps.\175\ Under the terms of Section 
15F(h)(7) of the Exchange Act, Section 15F(h) would not apply to a 
transaction that is initiated by a special entity on an exchange or SEF 
and the SBS Entity does not know the identity of the counterparty to 
the transaction. The statute does not define the term ``initiated''. We 
preliminarily believe that there may be circumstances in which it may 
be unclear which party, in fact, ``initiated'' the communications that 
resulted in the parties entering into a security-based swap 
transaction. Accordingly, we are proposing to read Section 15F(h)(7) to 
apply to any transaction with a special entity on a SEF or an exchange 
where the SBS Entity does not know the identity of its counterparty. We 
recognize that, under this reading, the exemption under Section 
15F(h)(7) would be available regardless of which side ``initiates'' a 
transaction, so long as the other conditions are met. We are seeking 
comment on whether this reading is appropriate or whether another 
possible reading of this provision should be made.
---------------------------------------------------------------------------

    \175\ See discussion in Section I.C.5, supra.
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission adopt a different interpretation of 
Section 15F(h)(7)? If so, what interpretation and why?
     Should the exemption be limited to situations in which the 
special entity takes specific steps, such as submitting a request for 
quote or some other communication regarding a potential transaction on 
an exchange or SEF? Are there other communications or circumstances of 
entry into a security-based swap that should be regarded as the 
``initiation'' of a transaction by a special entity? If so, which ones?
     Should the exemption continue to apply if the SBS Entity 
learns the identity of the special entity? If so, under what conditions 
and why?
1. Scope of the Definition of ``Special Entity''
    Exchange Act Section 15F(h)(2)(C) defines a ``special entity'' as: 
(i) A Federal agency; \176\ (ii) a State, State agency, city, county, 
municipality, or other political subdivision of a State; \177\ (iii) 
any employee benefit plan, as defined in section 3 of ERISA; \178\ (iv) 
any governmental plan, as defined in section 3 of ERISA; \179\ or (v) 
any

[[Page 42422]]

endowment, including an endowment that is an organization described in 
section 501(c)(3) of the Internal Revenue Code of 1986.\180\ Commenters 
have raised a number of questions about the scope of the definition, as 
to which we are soliciting further comment below.\181\
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    \176\ The definition of ``security-based swap'' excludes an 
``agreement, contract or transaction a counterparty of which is a 
Federal Reserve bank, the Federal Government, or a Federal agency 
that is expressly backed by the full faith and credit of the United 
States.'' Section 3(a)(68) of the Exchange Act, by reference to 
Section 1a of the Commodity Exchange Act. Accordingly, the 
Commission expects that special entities that are Federal agencies 
will be a narrow category for purposes of these rules.
    \177\ Cf. Exchange Act Section 15B(e)(8), Pub. L. 111-203, 124 
Stat. 1376, 1790-1791 (to be codified at 15 U.S.C. 78o-4(e)(8)) 
(defining ``municipal entity'' to include ``any agency, authority, 
or instrumentality of the States, political subdivision, or 
municipal corporate entity''); 17 CFR 275.206(4)-(5) (defining 
``governmental entity'' to include ``any agency, authority, or 
instrumentality of the state or political subdivision'').
    \178\ 29 U.S.C. 1002. The term ``special entity'' 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 
15F(h)(5)(A)(i)(VII) of the Exchange Act. 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 for persons 
substantially all of whom are nonresident aliens; or (5) unfunded 
excess benefit plans. See 29 U.S.C. 1003(b).
    \179\ 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).
    \180\ The term ``endowment'' is not defined in the Dodd-Frank 
Act, or in the securities laws generally.
    \181\ See, e.g., SIFMA/ISDA 2010 Letter at 2 (requesting 
confirmation that ``collective investment vehicles do not become 
`Special Entities' merely as a result of the investment by Special 
Entities in such vehicles,'' and asserting that ``master trusts 
holding the assets of one or more funded plans of a single employer 
should be considered `Special Entities' '').
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Request for Comments
    The Commission requests comment on all aspects of the definition of 
``special entity.'' In particular, we are seeking comment as to what 
clarifications to the definition may be required and why. Commenters 
should also explain why any suggested clarification is consistent with 
both the express statutory language and the policies underlying Section 
764 of the Dodd-Frank Act. In addition, the Commission requests 
comments on the following specific issues.
     Should the Commission interpret ``employee benefit plan, 
as defined in section 3'' of ERISA to mean a plan that is subject to 
regulation under ERISA? \182\ Why or why not?
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    \182\ See, e.g., id. (requesting confirmation that ``plans not 
subject to the Employee Retirement Income Security Act of 1974 
(`ERISA') (unless they are covered by another applicable prong of 
the ``Special Entity'' definition (e.g., governmental plans)) are 
not `Special Entities' ''). Section 4 of ERISA provides that the 
provisions of ERISA shall not apply to an employee benefit plan that 
is a governmental plan (as defined in section 1002(32) of ERISA); a 
church plan (as defined in section 1002(33) of ERISA) with respect 
to which no election has been made under 26 U.S.C. section 410(d); a 
plan that is maintained solely for the purpose of complying with 
applicable workmen's compensation laws or unemployment compensation 
or disability insurance laws; a plan that is maintained outside of 
the United States primarily for the benefit of persons substantially 
all of whom are nonresident aliens; or a plan that is an excess 
benefit plan (as defined in section 1002(36) of ERISA) and is 
unfunded.
    See Letter from Daniel Crowley, Partner, K&L Gates on behalf of 
the Church Alliance, to David A. Stawick, Secretary, CFTC (Feb. 22, 
2011) (on file with the CFTC), http://comments.cftc.gov/PublicComments/CommentList.aspx?id=935 (requesting clarification 
that church plans be included in the definition of special entity).
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     Should the Commission interpret ``government plan'' to 
include government investment pools or other plans, programs or pools 
of assets? Why or why not?
     Should the Commission define ``endowment''? If so, how? 
What organizations should be included in or excluded from the 
definition, and why? \183\ Should the Commission interpret 
``endowment'' to include funds that are not separate legal entities? 
Why or why not? Should the term ``endowment'' include legal entities or 
funds that are not organized or located in the United States? Should 
the term ``endowment'' be limited to those organizations described in 
Section 501(c)(3) of the Internal Revenue Code?
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    \183\ For accounting purposes, the term ``endowment'' is defined 
to mean ``[a]n established fund of cash, securities, or other assets 
to provide income for the maintenance of a not-for-profit 
organization. The use of the assets of the fund may be permanently 
restricted, temporarily restricted, or unrestricted. Endowment funds 
generally are established by donor-restricted gifts and bequests to 
provide a permanent endowment, which is to provide a permanent 
source of income, or a term endowment, which is to provide income 
for a specified period.'' Financial Accounting Standards Board ASC 
Section 958-205-20, Glossary, Non-for-Profit Entities.
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     Should the Commission interpret ``endowment'' to include 
an organization that uses the assets of its endowment to pledge or 
maintain collateral obligations, or otherwise enhance or support the 
organization's obligations under a security-based swap? \184\ Why or 
why not?
---------------------------------------------------------------------------

    \184\ See Swap Financial Group Presentation at 8 (concerning the 
scope of this prong of the definition of ``special entity'').
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     Should the Commission interpret ``special entity'' to 
exclude a collective investment vehicle in which one or more special 
entities have invested? \185\ Should a collective investment vehicle be 
considered a special entity if the fund manager, for example, becomes 
subject to fiduciary duties under ERISA with respect to plan assets in 
the fund? Why or why not?
---------------------------------------------------------------------------

    \185\ See note 181, supra.
---------------------------------------------------------------------------

     Should the Commission exclude from the definition of 
``special entity'' any foreign entity?
     Should the Commission interpret ``special entity'' to 
include a master trust holding the assets of one or more funded plans 
of a single employer and its affiliates? \186\ Why or why not?
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    \186\ See id.
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2. Best Interests
    Section 15F(h) of the Exchange Act uses the term ``best interests'' 
in several instances with respect to special entities. Section 
15F(h)(4)(B) imposes on an SBS Dealer that ``acts as an advisor'' to a 
special entity a duty to act in the ``best interests'' of the special 
entity. In addition, Section 15F(h)(4)(C) requires the SBS Dealer that 
``acts as an advisor'' to a special entity to make ``reasonable efforts 
to obtain such information as is necessary to make a reasonable 
determination'' that any swap recommended by the SBS Dealer is in the 
``best interests'' of the special entity. Finally, Section 15F(h)(5) of 
the Exchange Act requires an SBS Entity that is a counterparty to a 
special entity to have a ``reasonable basis'' to believe that the 
special entity has an independent representative that undertakes to act 
in the best interests of the special entity.\187\
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    \187\ Section 15F(h)(5)(A)(i)(IV) of the Exchange Act, Public 
Law 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(i)(IV)).
---------------------------------------------------------------------------

    The term ``best interests'' is not defined in the Dodd-Frank Act. 
The Commission is not proposing to define ``best interests'' in this 
rulemaking. Instead we are seeking comment on whether we should define 
that term, and if so, whether such definition should use formulations 
based on the standards applied to investment advisers,\188\ municipal 
advisors,\189\ or ERISA fiduciaries,\190\ or some other 
formulation.\191\
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    \188\ We recently stated that, 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 subordinate 
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. See Amendments to Form ADV, 
Investment Advisers Act Release No. 3060 (July 28, 2010), 75 FR 
49234 (Aug. 12, 2010), citing SEC v. Capital Gains Research Bureau, 
Inc., 375 U.S. 180, 191-194 (1963) (holding that investment advisers 
have a fiduciary duty enforceable under Section 206 of the Advisers 
Act, that imposes upon investment advisers the ``affirmative duty of 
`utmost good faith, and full and fair disclosure of all material 
facts,' as well as an affirmative obligation to `employ reasonable 
care to avoid misleading' '' their clients and prospective clients).
    \189\ See, e.g., Exchange Act Section 15B(b)(2)(L), Public Law 
111-203, 124 Stat. 1376, 1919 (to be codified at 15 U.S.C. 78o-
4(b)(2)(L)) (requiring the MSRB to prescribe means reasonably 
designed to prevent acts, practices, and courses of conduct that are 
not consistent with a municipal advisor's fiduciary duty to its 
municipal entity clients). The MSRB requested comment on draft Rule 
G-36 concerning the fiduciary duty of municipal advisors, and a 
draft interpretive notice under Rule G-36. See MSRB Notice 2011-14 
(Feb. 14, 2011).
    \190\ See, e.g., 29 U.S.C. 1104(a)(1)(A) (``a fiduciary shall 
discharge his duties with respect to a plan solely in the interest 
of the participants and beneficiaries and for the exclusive purpose 
of: (i) Providing benefits to participants and their beneficiaries; 
and (ii) defraying reasonable expenses of administering the plan'') 
and 29 U.S.C. 1104(a)(1)(B) (a fiduciary must act ``with the care, 
skill, prudence, and diligence under the circumstances then 
prevailing that a prudent man acting in a like capacity and familiar 
with such matters would use in the conduct of an enterprise of a 
like character and with like aims'').
    \191\ We note that Section 913 of the Dodd-Frank Act authorizes 
the Commission to promulgate rules to provide that the standard of 
conduct for broker-dealers and investment advisers when providing 
personalized investment advice about securities to retail customers 
(and such other customers as the Commission may by rule provide) 
shall be to act in the best interest of the customer without regard 
to the financial or other interest of the intermediary providing the 
advice. Public Law 111-203, 124 Stat. 1376, 1827-1829.

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[[Page 42423]]

Request for Comments
    The Commission is seeking comment generally on whether and how it 
should clarify the meaning of the term ``best interests'' under Section 
15F(h). In addition, we request comments on the following specific 
issues:
     Should the Commission define the term ``best interests'' 
in this context? If so, what definitions should the Commission consider 
and why? What are the advantages and drawbacks of particular 
definitions in this context? What factors should be included in the 
determination of a special entity's ``best interests''?
     Should the Commission adopt a definition of ``best 
interests'' that is based on the fiduciary duty applicable to 
investment advisers under the Investment Advisers Act of 1940 
(``Advisers Act'')? \192\ Why or why not?
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    \192\ See supra note 188.
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     Should the Commission adopt a definition of ``best 
interests'' that is based on the fiduciary duty applicable to municipal 
advisors under the Exchange Act? \193\ Why or why not?
---------------------------------------------------------------------------

    \193\ See supra note 189.
---------------------------------------------------------------------------

     Should the Commission adopt a definition of ``best 
interests'' that is based on the fiduciary duty applicable to 
fiduciaries under ERISA? \194\ Why or why not?
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    \194\ See supra note 190.
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     Should the Commission define ``best interests'' in a 
manner consistent with how it may define ``best interests'' in any 
rulemaking it may choose to propose under Section 913 of the Dodd-Frank 
Act, if any? Why or why not?
3. Anti-Fraud Provisions: Proposed Rule 15Fh-4(a)
    Section 15F(h)(4)(A) of the Exchange Act provides that it shall be 
unlawful for an SBS Entity to: (i) Employ any device, scheme, or 
artifice to defraud any special entity or prospective customer who is a 
special entity; (ii) engage in any transaction, practice, or course of 
business that operates as a fraud or deceit on any special entity or 
prospective customer who is a special entity; or (iii) to engage in any 
act, practice, or course of business that is fraudulent, deceptive, or 
manipulative. Consistent with the guidance in our previous order 
regarding the effective date of this provision, we are proposing a rule 
to render the statutory standard effective.\195\
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    \195\ See Order Pursuant to Sections 15F(b)(6) and 36 of the 
Securities Exchange Act of 1934 Granting Temporary Exemptions and 
Other Temporary Relief, Together with Information on Compliance 
Dates for New Provisions of the Securities Exchange Act of 1934 
Applicable to Security-Based Swaps, and Request for Comment, 
Securities Act Release No. 64678 (June 15, 2011), 76 FR 36287 (June 
22, 2011) at note 192:
     Section 15F(h)(6) of the Exchange Act, 15 U.S.C. 78o-10(h)(6), 
directs the Commission to ``prescribe rules under this subsection 
[(h) of the Exchange Act, 15 U.S.C. 78o-10(h),] governing business 
conduct standards.'' Accordingly, business conduct standards 
pursuant to section 15F(h) of the Exchange Act, 15 U.S.C. 78o-10(h), 
will be established by rule and compliance will be required on the 
compliance date of the Commission rule establishing these business 
conduct standards.
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4. Advisor to Special Entities: Proposed Rules 15Fh-2(a) and 15Fh-4(b)
    Exchange Act Section 15F(h)(4) imposes a duty on an SBS Dealer that 
acts as an advisor to a special entity to act in the best interests of 
the special entity.\196\ The Dodd-Frank Act does not define 
``advisor.'' Commenters have urged us to establish a clear standard for 
determining when an SBS Dealer is acting as an advisor within the 
meaning of Section 15F(h)(4).\197\ These commenters have expressed 
concern that compliance with the ``best interests'' standard applicable 
to advisors would create significant burdens and potential legal 
liability for SBS Dealers, and therefore SBS Dealers need certainty as 
to when they would or would not be acting as an advisor. For example, 
commenters have expressed concern that the business conduct obligations 
imposed by the Dodd-Frank Act might cause an SBS Dealer to be a 
``fiduciary'' under ERISA, and therefore effectively prohibit SBS 
Dealers from entering into security-based swaps with pension plans that 
are subject to ERISA.\198\ We recognize the importance of this issue, 
both for dealers and for the pension plans that may rely on security-
based swaps to manage risk and reduce volatility. The determination 
whether an SBS Dealer is acting as an advisor for purposes of Section 
15F(h)(4) and proposed Rule 15Fh-4(b) is not intended to prejudice the 
determination whether the SBS Entity is otherwise subject to regulation 
as an ERISA fiduciary.\199\ Although each regulatory regime applies 
independently, we anticipate that Commission staff will continue to 
consult with representatives of the Department of Labor to facilitate a 
full understanding of how the regulatory regimes interact with one 
another, and to determine whether any modifications to our proposed 
rules may be necessary or appropriate in light of these interactions.
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    \196\ Section 15F(h)(2)(A) of the Exchange Act requires all SBS 
Entities to comply with the requirements of Section 15F(h)(4). 
Public Law 111-203, 124 Stat. 1376, 1789 (to be codified at 15 
U.S.C. 78o-10(h)(2)(A)). The anti-fraud prohibitions of Section 
15F(h)(4)(A) apply by their terms to all SBS Entities. Sections 
15F(h)(4)(B) and (C) impose certain ``best interests'' obligations 
on an SBS Dealer that acts as an advisor to a special entity. See 
also Section II.D.2, infra.
    \197\ See, e.g., SIFMA/ISDA 2010 Letter at 2 (``It is essential 
that the Commissions articulate a clear standard for the 
circumstances that give rise to `advisor' status and the 
corresponding imposition of the statutory `fiduciary-like' duty to 
act in the best interests of a Special Entity.'')
    \198\ As discussed in note 99, supra, the Department of Labor is 
proposing amendments to the definition of a fiduciary under ERISA 
that would provide a limited exception for a person that renders 
``investment advice'' for compensation if that person ``can 
demonstrate that the recipient of the advice knows or, under the 
circumstances, reasonably should know, that the person is providing 
the advice or making the recommendation in its capacity as a 
purchaser or seller of a security or other property, or as an agent 
of, or appraiser for, such a purchaser or seller, whose interests 
are adverse to the interests of the plan or its participants or 
beneficiaries, and that the person is not undertaking to provide 
impartial investment advice.'' The Department of Labor in its 
proposing release explained that it had determined that ``such 
communications ordinarily should not result in fiduciary status * * 
* if the purchaser knows of the person's status as a seller whose 
interests are adverse to those of the purchaser, and that the person 
is not undertaking to provide impartial investment advice.'' 
Definition of the Term ``Fiduciary,'' 75 FR 65263, 65267 (Oct. 22, 
2010).
    \199\ See Letter from Phyllis C. Borzi, Assistant Secretary, 
Employee Benefits Security Administration, Department of Labor, to 
Gary Gensler, Chairman, CFTC (Apr. 28, 2011) (``In [the Department 
of Labor's] view, a swap dealer or major swap participant that is 
acting as a plan's counterparty in an arm's length bilateral 
transaction with a plan represented by a knowledgeable independent 
fiduciary would not fail to meet the terms of the counterparty 
exception solely because it complied with the business conduct 
standards set forth in the CFTC's proposed regulation.''), http://comments.cftc.gov/PublicComments/CommentList.aspx?id=935.
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    An SBS Dealer that is acting as an advisor must in any case comply 
with the requirements of the Dodd-Frank Act. If an SBS Dealer is acting 
as an advisor, then under Section 15F(h)(4) and proposed Rule 15Fh-
4(b), it must act in the best interests of the special entity. As part 
of its duty to act in the best interests of the special entity, the SBS 
Dealer would be required to provide suitable advice.\200\ Consistent 
with Section 15F(h)(4)(C), proposed Rule 15Fh-4(b)(2) would require an 
SBS Dealer in these circumstances to make reasonable efforts to obtain 
the information it considers necessary to make a reasonable 
determination that any recommended security-based swap or trading 
strategy involving a security-based swap is in the best interests of 
the special entity. The proposed rule would identify specific types of 
information that the SBS Dealer should take into account in making this 
determination. This information would include, but not be limited to, 
the authority of the special entity to enter into a security-based 
swap; the financial status of the

[[Page 42424]]

special entity, as well as future funding needs; the tax status of the 
special entity; the investment or financing objectives of the special 
entity; the experience of the special entity with respect to entering 
into security-based swaps, generally, and security-based swaps of the 
type and complexity being recommended; whether the special entity has 
the financial capability to withstand changes in market conditions 
during the term of the security-based swap; and such other information 
as is relevant to the particular facts and circumstances of the special 
entity, market conditions and the type of security-based swap or 
trading strategy involving a security-based swap being recommended.
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    \200\ See Section II.C.4, infra (discussing the interaction of 
the ``best interests'' and ``suitability'' standards).
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    Proposed Rule 15Fh-2(a) would generally define ``act as an 
advisor'' in the context of an SBS Dealer to mean recommending a 
security-based swap or a trading strategy involving a security-based 
swap to a special entity.\201\ For these purposes, ``recommending'' 
would have the same meaning as that discussed above in connection with 
proposed Rule 15Fh-3(f). An SBS Dealer would not be deemed an 
``advisor'' to a special entity with a duty under Section 15F(h)(4) and 
proposed Rule 15Fh-4(b) to act in the ``best interests'' of the special 
entity if it did not make a ``recommendation'' to a special entity. 
Commenters have advised us that, in order to avoid making a 
``recommendation'' and unintentionally becoming an ``advisor'' to a 
special entity SBS Dealers may simply refrain from interacting with 
special entities--particularly to the extent that they perceive any 
uncertainty in the determination of whether a particular communication 
would constitute a ``recommendation.'' \202\
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    \201\ See Section II.C.4 regarding what would or would not 
generally be considered a recommendation.
    \202\ See, e.g., SIFMA 2011 Letter.
---------------------------------------------------------------------------

    It is important to note that the duties imposed on an SBS Dealer 
that is ``acting as an advisor''--as well as the definition of that 
phrase in proposed Rule 15Fh-2(a)--are specific to this advisory 
context, and are in addition to any duties that may be imposed under 
other applicable law. Among other things, an SBS Dealer that acts as an 
advisor to a special entity may fall within the definition of 
``investment adviser'' under Section 202(a)(11) of the Advisers Act 
unless it can rely on the exclusion provided by Section 202(a)(11)(C) 
for a broker-dealer whose advice is ``solely incidental'' to the 
conduct of its business as a broker dealer and who receives no special 
compensation therefor, or other applicable exclusion.\203\ An SBS 
Dealer that acts as an advisor to a municipal entity may also be a 
``municipal advisor'' under Section 15B(e) of the Exchange Act.\204\
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    \203\ See 15 U.S.C. 80b-2(a)(11).
    \204\ See Public Law 111-203, 124 Stat. 1376, 1921-1922 (to be 
codified at 15 U.S.C. 78o-4).
---------------------------------------------------------------------------

    Commenters have suggested that the standard established by Section 
15F(h)(4) for an SBS Dealer acting as an advisor to a special entity 
could ``have the effect of chilling a critical element of the customary 
commercial interactions'' with special entities, absent some greater 
legal certainty about when an SBS Dealer would, in fact, be deemed to 
be ``acting as advisor'' to a special entity.\205\ Accordingly, 
proposed Rule 15Fh-2(a) would provide this legal certainty by 
permitting an SBS Dealer to establish that it is not acting as an 
advisor where certain conditions are met. Under the proposed rule, the 
special entity must represent, in writing, that it will not rely on 
recommendations provided by the SBS Dealer and that it instead will 
rely on advice from a ``qualified independent representative,'' as 
defined in proposed Rule 15Fh-5(a) and discussed more fully below in 
Section II.D.4.c. In addition, the SBS Dealer must disclose to the 
special entity that by obtaining the special entity's written 
representation as described above, the SBS Dealer is not undertaking to 
act in the best interests of the special entity, as would otherwise be 
required under Section 15F(h)(4).\206\ Finally, the SBS Dealer must 
have a reasonable basis to conclude that the special entity has a 
qualified independent representative.\207\
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    \205\ SIFMA/ISDA 2011 Letter at 33.
    \206\ Proposed Rule 15Fh-2(a).
    \207\ As noted above, an SBS Dealer in these circumstances must 
separately determine whether it is subject to regulation as an 
investment adviser, a municipal advisor or other regulated entity.
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    The Commission believes that the SBS Dealer could form this 
reasonable basis through a variety of means, including relying on 
written representations from the special entity to the same extent as 
discussed below in connection with an SBS Dealer acting as a 
counterparty to a special entity.\208\ Upon receiving such 
representations, the SBS Dealer would be entitled to rely on these 
representations without further inquiry, absent special circumstances 
described below.
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    \208\ See Section II.D.4.c, infra.
---------------------------------------------------------------------------

    To solicit input on when it would no longer be appropriate for an 
SBS Dealer to rely on such representations without further inquiry, the 
Commission is proposing for comment two alternative approaches. One 
approach would permit an SBS Dealer to rely on a representation from a 
special entity for purposes of Rule 15Fh-2(a) unless it knows that the 
representation is not accurate. The second would permit an SBS Dealer 
to rely on a representation unless the SBS Dealer has information that 
would cause a reasonable person to question the accuracy of the 
representation.
    Under either approach, an SBS Dealer could not ignore information 
in its possession as a result of which the SBS Dealer would know that a 
representation is inaccurate. In addition, under the second approach, 
an SBS Dealer also could not ignore information that would cause a 
reasonable person to question the accuracy of a representation and, if 
the SBS Dealer had such information, it would need to make further 
reasonable inquiry to verify the accuracy of the representation.
    While the Dodd-Frank Act does not preclude an SBS Dealer from 
acting as both advisor and counterparty, commenters have argued that it 
could be impracticable for an SBS Dealer that is acting as a 
counterparty to a special entity to meet the ``best interests'' 
standards that would be imposed by Section 15F(h)(4) if it were also 
acting as an advisor to the special entity.\209\ We recognize the 
potential tension in the statute itself between the role of a party 
acting as a principal in a security-based swap transaction, and the 
obligation imposed by Section 15F(h)(4) for an advisor to determine 
that a transaction is in the ``best interests'' of the special entity. 
We are seeking comment on whether we should further clarify the 
obligations of an SBS Dealer that is seeking to act both as an advisor 
and a counterparty to a special entity. We also are seeking comment on 
the need to define ``best interests'' in this context. Finally, as 
noted above, we understand that there are concerns arising from the 
potential interaction between the requirements of the Dodd-Frank Act

[[Page 42425]]

(and our rules thereunder) and the requirements of other applicable 
law, including ERISA.
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    \209\ See SIFMA/ISDA 2010 Letter at 8:
    Dealers will almost certainly refuse to engage in any swap 
activity in which they could potentially be deemed an ``advisor.'' 
The actions that a Dealer acting as an ``advisor'' would be required 
to take pursuant to Dodd-Frank are the very actions that could lead 
the Dealer to be deemed a fiduciary under ERISA. The penalties that 
would result were the Dealer deemed a fiduciary under ERISA are 
draconian, including that a swap between the Dealer and the plan 
would be deemed a prohibited transaction in violation of ERISA and 
would be subject to rescission and an excise tax equal to 15% of the 
amount involved in the transaction for each year or part of a year 
that the transaction remains uncorrected (which, if not corrected 
upon notice, could escalate up to a 100% excise tax).
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Request for Comments
    The Commission requests comments generally on all aspects of 
proposed Rules 15Fh-2(a) and 15Fh-4(b). In addition, we request 
comments on the following specific issues:
     Is the proposed definition of the term ``acts as an 
advisor'' appropriate? Why or why not? What, if any, material 
inconsistencies would the proposed definition create with respect to 
any other applicable laws? What specific practical effects, advantages 
or disadvantages may arise in connection with the proposed definition? 
How, if at all, should any definition or interpretation of 
``recommendation'' in this context diverge from the meaning of the term 
for purposes of the suitability obligation under Proposed Rule 15Fh-
3(f)?
     Should the Commission instead define ``advisor'' to mean 
``any person who, for compensation, engages in the business of advising 
special entities, as to the value of security-based swaps or as to the 
advisability of security-based swaps or trading strategies involving 
security-based swaps,'' consistent with the definition of an investment 
adviser? \210\ Why or why not?
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    \210\ See Advisers Act Section 202(a)(11) (definition of 
``investment adviser'').
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     Should the Commission instead define ``act as an advisor'' 
as ``providing advice to or on behalf of a special entity with respect 
to a security-based swap or trading strategy involving a security-based 
swap,'' consistent with the definition of a municipal advisor? \211\ 
Why or why not? What other definitions should be considered by the 
Commission and why?
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    \211\ See Exchange Act Section 15B(e)(4), Public Law 111-203, 
124 Stat. 1376, 1921-1922 (to be codified at 15 U.S.C. 78o-4(e)(4)); 
see generally Registration of Municipal Advisors, Exchange Act 
Release No. 63579 (Dec. 20, 2011), 76 FR 824 (Jan. 6, 2011).
---------------------------------------------------------------------------

     When, if at all, could an SBS Dealer, in fact, act as both 
an advisor and counterparty to a special entity in a securities-based 
swap transaction, consistent with the ``best interests'' requirements 
of Section 15F(h)(4) and proposed Rule 15Fh-4(b)? \212\ In what way 
could disclosure help to address concerns about the potentially 
conflicting roles of an SBS Dealer in these circumstances? Should the 
Commission, for example, clarify that it would not be inconsistent with 
an SBS Dealer's duty to act in the best interests of the special entity 
if the SBS Dealer, as principal, were to earn a reasonable profit or 
fee from the transaction it enters into with the special entity?
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    \212\ Commenting on a parallel provision in the Commodity 
Exchange Act, Senator Lincoln stated that:
     [N]othing in [Commodity Exchange Act 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).
---------------------------------------------------------------------------

     Should the Commission instead prohibit an SBS Dealer from 
acting as both an advisor and counterparty to a special entity? \213\ 
Why or why not?
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    \213\ Recently approved amendments to MSRB Rule G-23 would 
prohibit dealer-financial advisers from switching roles and becoming 
underwriters in the same municipal securities transactions. See also 
MSRB Notice 2011-29 (May 31, 2011) (discussing rule amendment and 
interpretive notice).
---------------------------------------------------------------------------

     Should the Commission define ``acts as an advisor'' to 
require an understanding among the parties that the SBS Dealer is 
undertaking to act as an advisor to the special entity? Why or why not? 
If such a definition should be contemplated, in what circumstances, if 
any, should such an understanding not be permitted? Should a written 
agreement be required to establish that the SBS Dealer is undertaking 
to ``act as an advisor''?
     How would the proposed rules with respect to acting as an 
advisor change current practice regarding recommending and entering 
into security-based swaps with special entities?
     Should the Commission impose specific requirements with 
respect to the level of detail that should be required for written 
representations? If so, what requirements and why?
     What are the advantages and disadvantages of the two 
alternative proposed approaches regarding when it would no longer be 
appropriate to rely on written representations? Which alternative would 
strike the best balance among the potential disadvantages to market 
participants, the regulatory interest in appropriate rules for advisory 
relationships, and the sound functioning of the security-based swap 
market? What, if any, other alternatives should the Commission consider 
(e.g., a recklessness standard) and why?
     In light of the additional protections that are afforded 
special entities under the Dodd-Frank Act, as described in Section 
I.C.5 above, should an SBS Dealer be required to undertake diligence or 
further inquiry before it can rely on any representation from a special 
entity for purposes of Rules 15Fh-2(a) and 15Fh-4(b)? Why or why not? 
If such diligence or inquiry is not required, should an SBS Dealer be 
permitted to rely on representations from the special entity only where 
the SBS Dealer does not have information that would cause a reasonable 
person to question the accuracy of the representation? Why or why not? 
Would requiring such diligence or further inquiry--or allowing reliance 
on representations only in such a manner--unnecessarily limit the 
willingness or ability of SBS Dealers to provide special entities with 
the access to security-based swaps for the purposes described in 
Section I.C.5 above? Why or why not? What, if any, other measures 
should be required in connection with an SBS Dealer's satisfaction of 
the requirements of these rules?
     Are there particular circumstances under which an SBS 
Dealer should be required to obtain information or undertake further 
review or inquiry about a special entity's independent representative 
or other facts in addition to obtaining written representations from 
the special entity as described above? Are there particular categories 
of special entities for which an SBS Dealer should be required to 
undertake further review or inquiry? Which categories, and why? What 
review or inquiry should be required, and in what circumstances?
     Are there other potential reasonable methods of 
establishing the relationship between a special entity and an SBS 
Dealer, and if so, what guidance should the Commission consider 
providing with respect to such methods?
5. Counterparty to Special Entities: Proposed Rule 15Fh-5
    Under Exchange Act Section 15F(h)(5)(A), any SBS Entity that offers 
to enter into or enters into a security-based swap with a special 
entity must comply with any duty established by the Commission 
requiring that SBS Entity to have a ``reasonable basis'' for believing 
that the special entity has an ``independent representative'' that 
meets certain requirements, including that it undertakes a duty to act 
in the best interests of the counterparty it represents. Proposed Rules 
15Fh-2(c) and 15Fh-5(a) would implement this provision. In particular, 
proposed Rule 15Fh-2(c) would define an ``independent representative,'' 
and proposed Rule 15Fh-5(a) would require an SBS Entity to have a 
reasonable basis to believe that this independent representative is 
qualified to represent the special entity by virtue of satisfying 
certain specified requirements.

[[Page 42426]]

Request for Comments
    The Commission requests comments generally on all aspects of 
proposed Rule 15Fh-5. In addition, we request comments on the following 
specific issues:
     Is it sufficiently clear what is meant by ``offers to 
enter into'' a security-based swap? If not, how should the Commission 
clarify the requirement?
     Should the proposed rule apply to all transactions with 
all special entities? Why or why not? Which, if any, transactions or 
special entities should be excluded from the scope of the proposed 
rule, and why?
a. Scope of Qualified Independent Representative Requirement
    We are proposing to apply the qualified independent representative 
requirements to Major SBS Participants as well as to SBS Dealers 
because, although Section 15F(h)(2)(B) addresses only the requirement 
for SBS Dealers to comply with the requirements of Section 15F(h)(5), 
the specific requirements under Section 15F(h)(5)(A) apply by their 
terms to both SBS Dealers and Major SBS Participants that offer to or 
enter into a security-based swap with a special entity.
    We are further proposing to apply the qualified independent 
representative requirement under Section 15F(h)(5) to security-based 
swap transactions with all special entities. There is a statutory 
ambiguity concerning the scope of this requirement. Section 
15F(h)(5)(A) provides broadly that ``[a]ny security-based swap dealer 
or major security-based swap participant that offers to [enter into] or 
enters into a security-based swap with a special entity shall'' comply 
with certain requirements. These requirements are defined in Section 
15F(h)(5)(A)(i) to include ``any duty established by the Commission * * 
* with respect to a counterparty that is an eligible contract 
participant within the meaning of subclause (I) or (II) of clause (vii) 
of section 1a(18) of the Commodity Exchange Act [i.e., governmental or 
multinational or supranational entities].'' We are proposing standards 
that would apply whenever an SBS Entity is acting as counterparty to 
any special entity as defined in Section 15F(h)(1)(C), including a 
special entity that is an ECP within the meaning of subclause (I) or 
(II) of clause (vii) of Commodity Exchange Act Section 1a(18). The 
proposed rule would be consistent with categories of special entities 
mentioned in the legislative history.\214\ It also would give meaning 
to the requirement of Section 15F(h)(5)(A)(i)(VII) concerning 
``employee benefit plans subject to ERISA,'' that are not ECPs within 
the meaning of subclause (I) or (II) of clause (vii) of section 1a(18) 
of the Commodity Exchange Act but are included in the category of 
retirement plans identified in the definition of special entity.\215\
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    \214\ See H.R. Conf. Rep. 111-517 (June 29, 2010) (``When acting 
as counterparties to a pension fund, endowment fund, or state or 
local government, dealers are to have a reasonable basis to believe 
that the fund or governmental entity has an independent 
representative advising them.'') (emphasis added).
    \215\ See Section 15F(h)(1)(C)(iii) of the Exchange Act, Pub. L. 
111-203, 124 Stat. 1376, 1789 (to be codified at 15 U.S.C. 78o-
10(h)(1)(C)(iii)).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should proposed Rule 15Fh-5 apply to both SBS Dealers and 
Major SBS Participants? Why or why not?
b. Independent Representative--Proposed Rule 15Fh-2(c)
    Proposed Rule 15Fh-5(a) would require that the SBS Entity have a 
reasonable basis to believe that a special entity has as qualified 
``independent representative.'' Under proposed Rule 15Fh-2(c)(1), a 
representative of a special entity must be independent of the SBS 
Entity that is the counterparty to a proposed security-based swap. 
Proposed Rule 15Fh-2(c)(2) would provide that a representative of a 
special entity is ``independent'' of an SBS Entity if the 
representative does not have a relationship with the SBS Entity, 
whether compensatory or otherwise, that reasonably could affect the 
independent judgment or decision-making of the representative. This 
standard is similar to the ``no material relationship'' standard that 
is used or proposed in other contexts.\216\ We preliminarily believe it 
would be an appropriate standard here because the SBS Entity would 
possess the necessary facts to determine if, in fact, there exists a 
relationship with the independent representative that would be likely 
to impair the independence of the independent representative in making 
decisions that may affect the SBS Entity.
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    \216\ Proposed Rules 15Fh-2(c)(1) and (2). This proposed 
alternative standard of independence would be consistent with the 
standard for existing and currently proposed director independence 
in other contexts. See Ownership Limitations and Governance 
Requirements for Security-Based Swap Clearing Agencies, Security-
Based Swap Execution Facilities, and National Securities Exchanges 
with Respect to Security-Based Swaps under Regulation MC, Exchange 
Act Release No. 63107 (Oct. 14, 2010), 75 FR 65882, 65897 (Oct. 26, 
2010) (proposed Rule 700(l)); Security-Based Swap Data Repository 
Registration, Duties, and Core Principles, Exchange Act Release No. 
63347 (Nov. 19, 2010), 75 FR 77306, 77322 (Dec. 10, 2010); MSRB, 
Notice of Filing of Amendment No. 1 to and Order Granting 
Accelerated Approval of a Proposed Rule Change, as Modified by 
Amendment No. 1, to Amend Rule A-3, on Membership on the Board, to 
Comply with the Dodd-Frank Wall Street Reform and Consumer 
Protection Act, Exchange Act Release No. 63025 (Sep. 30, 2010), 75 
FR 61806, 61808 (Oct. 6, 2010). It also would be consistent with the 
NYSE standard for director independence and how public companies 
have addressed this standard in their policies to determine director 
independence. See NYSE Rule 303A.02(A) (``No director qualifies as 
`independent' unless the board of directors affirmatively determines 
that the director has no material relationship with the listed 
company (either directly or as a partner, shareholder or officer of 
an organization that has a relationship with the company) .
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    Proposed Rule 15Fh-2(c)(3) would provide that a representative of a 
special entity will be deemed to be independent of an SBS Entity if two 
conditions are satisfied. First, the representative is not and, within 
one year, was not an associated person of the SBS Entity and second, 
the representative has not received more than ten percent of its gross 
revenues over the past year, directly or indirectly, from the SBS 
Entity. This latter restriction would apply, for example, with respect 
to revenues received as a result of referrals by the SBS Entity, and so 
is intended to address the situation in which a representative is hired 
by the special entity as a result of a recommendation by the SBS 
Entity. This restriction would apply as well to revenues received, 
directly or indirectly, from associated persons of the SBS Entity.
    For the SBS Entity to form a reasonable basis to believe the 
percentage of the independent representative's gross revenues that is 
received directly or indirectly from the SBS Entity, the SBS Entity 
would likely need to obtain information regarding the independent 
representative's gross revenues from either the special entity or the 
independent representative. The Commission believes that an SBS Entity 
could use a variety of methods to gather this information. The SBS 
Entity may request the financial statements of the independent 
representative for the relevant periods. Another way to obtain this 
information would be to obtain written representations from the special 
entity or independent representative regarding the revenues received, 
directly or indirectly from the SBS Entity and that such revenues were 
less than ten percent of the independent representative's gross 
revenues. Upon receiving such representations, the SBS

[[Page 42427]]

Entity would be entitled to rely on them without further inquiry, 
absent special circumstances described below.
    To solicit input on when it would no longer be appropriate for an 
SBS Entity to rely on such representations without further inquiry, the 
Commission is proposing for comment two alternative approaches. One 
approach would permit an SBS Entity to rely on a representation from a 
special entity for purposes of Rule 15Fh-2(c) unless it knows that the 
representation is not accurate. The second would permit an SBS Entity 
to rely on a representation unless the SBS Entity has information that 
would cause a reasonable person to question the accuracy of the 
representation.
    Under either approach, an SBS Entity could not ignore information 
in its possession as a result of which the SBS Entity would know that a 
representation is inaccurate. In addition, under the second approach, 
an SBS Entity also could not ignore information that would cause a 
reasonable person to question the accuracy of a representation and, if 
the SBS Entity had such information, it would need to make further 
reasonable inquiry to verify the accuracy of the representation.
    An SBS Entity may obtain information from the independent 
representative as part of its efforts to form a reasonable basis for 
its determination that it is independent of the independent 
representative. In order for the basis for its determination to be 
reasonable, however, the SBS Entity could not ignore information it 
possesses concerning whether the independent representative is or has 
been, an associated person of the SBS Entity, for example, if it were 
seeking to rely on the objective standard of proposed Rule 15Fh-
2(c)(1), or whether there exists any other relationship with the SBS 
Entity that reasonably could affect the independent judgment or 
decision-making of the independent representative for purposes of 
proposed Rule 15Fh-2(c)(2).
    A number of special entities have requested that the Commission 
confirm that the representative is only required to be independent of 
the SBS Entity and not independent of the special entity itself.\217\ 
We preliminarily believe that Section 15F(h)(5)(A)(i)(III) requires 
only that the independent representative be independent of the SBS 
Entity. The Dodd-Frank Act is silent concerning the question of 
independence from the special entity, and nothing in the legislative 
history suggests that the Commission should preclude the use of a 
qualified independent representative that is affiliated with the 
special entity.\218\
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    \217\ Letter from Lynn D. Dudley, Senior Vice President, Policy, 
American Benefits Council, to Elizabeth M. Murphy, Secretary, 
Commission and David A. Stawick, Secretary, CFTC (Sept. 8, 2010) 
(``American Benefits Council Letter'') at 6.
    \218\ See also 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.
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission adopt a different definition of 
``independent representative of a special entity'' in proposed Rule 
15Fh-2(c), and if so, why? Are there other standards of independence 
that we should consider, such as standards that would be relevant to 
determining the independence of a fiduciary for ERISA purposes? Which 
standards and why? How should such standards be modified to address the 
particular concerns of Section 15F(h)(5)? Should the Commission require 
consideration of other or additional factors in determining the 
independence of the independent representative of a special entity? 
Which factors and why? Should such factors include consideration of 
relationships the independent representative may have with an SBS 
Entity on behalf of multiple special entities? Should the Commission 
also consider relationships the independent representative has entered 
into with an SBS Entity on behalf of a special entity outside of the 
security-based swap transaction context?
     Should the definition of ``independent representative of a 
special entity'' exclude certain categories of associated persons of 
the SBS Entity? Of the independent representative? Which ones and why?
     Should the gross revenues in the definition exclude the 
revenues of affiliates of the independent representative?
     Is ten percent of gross revenues an appropriate measure of 
independence? Should the percentage be increased or decreased, and why? 
Should the Commission adopt a standard that is consistent with that 
used by the Department of Labor, for example, under which the general 
standard of independence for fiduciaries in connection with prohibited 
transaction exemptions under ERISA is that no more than 1% of an 
independent fiduciary's annual income is derived from or attributable 
to the party in interest and its affiliates? \219\ Should another 
financial or other quantifiable standard be used in lieu of gross 
revenues? Why or why not?
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    \219\ See Exemption Procedures under Federal Pension Law, http://www.dol.gov/ebsa/publications/exemption_procedures.html (``While 
in certain cases the department has permitted an independent 
fiduciary to receive as much as 5% of its annual income from the 
party in interest and its affiliates, these cases have involved 
unusual circumstances, and the general standard of independence 
remains a 1% test.'').
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     Should the Commission consider a timeframe other than one 
year to determine whether a representative is independent of the SBS 
Entity? Should the timeframe be two years, consistent with the pay to 
play provisions of proposed Rule 15Fh-6? Should some other timeframe be 
used? If so, what timeframe and why?
     Should the Commission consider a different approach to 
independence based on, for example, audit committee independence 
standards under Section 10A(m)(3) \220\ and Rule 10A-3(b),\221\ or the 
concept of an ``interested person'' under Section 2(a)(1) of the 
Investment Company Act of 1940? \222\ Why or why not? Should we 
consider other approaches? If so, which approaches and why?
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    \220\ 15 U.S.C. 78j-1(m)(3).
    \221\ 17 CFR 240.10A-3(b).
    \222\ 15 U.S.C. 80a-2(a)(19).
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     Should the Commission permit an independent representative 
that receives compensation from the proceeds of a security-based swap 
so long as the compensation is authorized by, and paid at the written 
direction of, the special entity? Why or why not?
     Should the Commission adopt a different definition of 
``independent representative of a special entity'' for different types 
of special entities? For example, are there certain types of special 
entities, e.g., a State, State agency, city, county, municipality, or

[[Page 42428]]

other political subdivision of a State, or a governmental plan as 
defined in Section 3 of ERISA, for which the Commission should define 
independence to require that the independent representative is not and 
has not been an associated person of the SBS Entity within the last two 
years and has not received any of its gross revenues, directly or 
indirectly from the SBS Entity or an associated person of the SBS 
Entity within the last two years? \223\ What if the time period 
outlined in the prior sentence was limited to one year? Should this 
stricter standard apply only with respect to special entities defined 
in clause (ii)? Are there any other classes of special entities to 
which this stricter standard should apply?
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    \223\ See Exchange Act Sections 15F(h)(2)(C)(ii) (defining 
``special entity'' to include ``a State, State agency, city, county, 
municipality, or other political subdivision of a State'') and 
15F(h)(2)(C)(iv) (a governmental plan as defined in Section 3 of 
ERISA), Pub. L. 111-203, 124 Stat. 1376, 1789.
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     Are there other standards of independence that would be 
more appropriate for independent representatives for special entities 
defined in clauses (ii) and (iv) of Section 15F(h)(2)(C) of the 
Exchange Act? Which standards and why?
     Are there certain types of relationships that, so long as 
they have been fully disclosed to the special entity and the special 
entity has consented to any conflicts of interest related thereto, 
should not be deemed to affect the independence of the representative? 
What types of relationships, and why? Are there some conflicts that are 
so significant that a special entity should not be able to consent to 
them? If so, what types of conflicts, and why?
     Is the interpretation of Section 15F(h)(5)(A)(i)(III) 
appropriate? Can and should independent representatives be required to 
be independent of the special entity entering into the security-based 
swap as well as independent of the SBS Entity? Why or why not? If an 
SBS Entity is relying on written representations from a special entity 
that is represented by an internal ``independent representative,'' 
should the SBS Entity be required to also obtain such representations 
from someone other than the independent representative?
     How, if at all, should the recommendation by an SBS Entity 
of a particular independent representative or group of independent 
representatives be deemed to affect the independent judgment or 
decision-making of the representative? Please explain. If such a 
recommendation could be deemed to affect the independence of a special 
entity, are there appropriate safeguards that should be required if an 
SBS Entity maintains a ``preferred list'' of independent 
representatives? What safeguards, and why?
c. Reasonable Basis To Believe the Qualifications of the Independent 
Representative
    As noted above, proposed Rule 15Fh-5 would require the SBS Entity 
to reasonably determine that a special entity's independent 
representative is a ``qualified independent representative.'' The 
requirements for being a ``qualified independent representative'' are 
drawn primarily from the statute and are described in the following 
sections. The Commission believes that an SBS Entity could use a 
variety of methods to establish a ``reasonable basis'' to believe that 
a special entity's ``independent representative'' is ``qualified'' for 
purposes of proposed Rule 15Fh-5.\224\
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    \224\ The SBS Entity may also be provided a copy of the 
representations that the independent representative provides to the 
special entity regarding its qualifications. In the absence of 
language precluding the SBS Entity from relying on the 
representations, the Commission preliminarily believes that the SBS 
Entity could rely on the representations to form a reasonable basis 
for its determinations to the same extent it could if the special 
entity had provided the representations to the SBS Entity. 
Furthermore, we do not believe that such reliance would constitute a 
``material business relationship'' between the SBS Entity and 
independent representative.
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    We preliminarily believe that, except as specifically noted below, 
an SBS Entity could rely on written representations regarding the 
various qualifications of the independent representative to form a 
reasonable basis to believe that the independent representative is 
``qualified''.\225\ Upon receiving such representations, the SBS Entity 
would be entitled to rely on them without further inquiry, absent 
special circumstances described below.
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    \225\ In particular, absent the special circumstances described 
above, an SBS Entity would be permitted to rely on a representation 
that stated the independent representative:
    (1) Had sufficient knowledge to evaluate the transaction and 
risks;
    (2) Would undertake a duty to act in the best interests of the 
special entity;
    (3) Would make appropriate and timely disclosures to the special 
entity of material information concerning the security-based swap;
    (4) Would provide written representations to the special entity 
regarding fair pricing and the appropriateness of the security-based 
swap; and
    (5) In the case of employee benefit plans subject to the 
Employee Retirement Income Security Act of 1974, was a fiduciary as 
defined in section 3(21) of that Act (29 U.S.C. 1002(21)); and
    (6) In the case of a special entity defined in Sec. Sec.  
240.15Fh-2(e)(2) or (4), was a person that is subject to rules of 
the Commission, the CFTC or a self-regulatory organization subject 
to the jurisdiction of the Commission or the CFTC prohibiting it 
from engaging in specified activities if certain political 
contributions have been made.
    It would not be appropriate, however, for an SBS Entity to rely 
on a general representation that merely states that the counterparty 
has a ``qualified independent representative'' for purposes of 
proposed Rule 15Fh-5.
     The SBS Entity could also obtain a representation that that the 
independent representative was not subject to a statutory 
disqualification. However, as discussed below, the SBS Entity would 
also be expected to search publicly available databases such as 
BrokerCheck.
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    To solicit input on when it would no longer be appropriate for an 
SBS Entity to rely on such representations without further inquiry, the 
Commission is proposing for comment two alternative approaches. One 
approach would permit an SBS Entity to rely on a representation from a 
special entity for purposes of Rule 15Fh-5 unless it knows that the 
representation is not accurate. The second would permit an SBS Entity 
to rely on a representation unless the SBS Entity has information that 
would cause a reasonable person to question the accuracy of the 
representation.
    Under either approach, an SBS Entity could not ignore information 
in its possession as a result of which the SBS Entity would know that a 
representation is inaccurate. In addition, under the second approach, 
an SBS Entity also could not ignore information that would cause a 
reasonable person to question the accuracy of a representation and, if 
the SBS Entity had such information, it would need to make further 
reasonable inquiry to verify the accuracy of the representation.
Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Commenters have suggested that an independent 
representative should be deemed ``qualified'' if it is ``a 
sophisticated, professional adviser such as a bank, Commission-
registered investment adviser, insurance company or other qualifying 
[Qualified Professional Asset Manager (``QPAM'')] or INHAM for Special 
Entities subject to ERISA, a registered municipal advisor, or a similar 
qualified professional''.\226\ Should the Commission permit this 
presumption? If so, the Commission asks commenters to address 
specifically how regulated status would inform the determination as to 
whether an independent representative satisfies the qualification 
requirements of Section 15F(h)(5) and proposed Rule 15Fh-5. If the 
Commission were to adopt a presumption, should it apply equally for all 
regulated persons? Should the

[[Page 42429]]

presumption instead be limited to certain types of regulated persons, 
ERISA fiduciaries, for example? Why, or why not? If the Commission does 
not permit the presumption, how, if at all, should the status of an 
independent representative be taken into account for purposes of 
determining whether the requirements of the proposed rule are 
satisfied? \227\
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    \226\ SIFMA/ISDA 2011 Letter.
    \227\ See, e.g., Section II.D.4.c.iii (seeking comment on, among 
other things, whether an ERISA plan fiduciary should be deemed to 
act in the best interests of the special entity that is an employee 
benefit plan that is subject to regulation under ERISA).
---------------------------------------------------------------------------

     Are there other approaches that the Commission should 
consider in permitting an SBS Entity to rely on a special entity's 
written representation that it has a ``qualified independent 
representative''? If so, what alternative approaches, if any, would be 
feasible in terms of market practice and the advantages and 
disadvantages for SBS Entities and special entities?
     Should the Commission require that the SBS Entity obtain 
written representations regarding the qualifications of the independent 
representative directly from the independent representative? From both 
the independent representative and the special entity? Why or why not?
     Should the Commission allow an SBS Entity to rely on 
written representations the independent representative provides to the 
special entity? What constraints, if any, should be placed on such 
reliance? For example, should an explicit statement regarding the SBS 
Entity's use of the representations be required to be included in the 
documentation of the security-based swap? What are the respective 
advantages and disadvantages of the proposed approaches to guidance on 
when it would not be appropriate to rely on a special entity's written 
representations? Which alternative would strike the best balance among 
the potential disadvantages to market participants, the regulatory 
interest in appropriate independent representation for special 
entities, and the sound functioning of the security-based swap market? 
What, if any, other alternatives should the Commission consider and 
why?
     Should an SBS Entity be required to undertake further 
review or inquiry for particular categories of special entities? If so, 
what review or inquiry should be required in what circumstances?
     In light of the additional protections that are afforded 
special entities under the Dodd-Frank Act described in Section I.C.5 
above, should an SBS Entity be required to undertake diligence or 
further inquiry before it can rely on any representation from a special 
entity concerning the qualifications of its representative? Why or why 
not? If such diligence or inquiry is not required, should an SBS Entity 
be permitted to rely on representations from the special entity only 
where the SBS Entity does not have information that would cause a 
reasonable person to question the accuracy of the representation? Why 
or why not? Would requiring such diligence or further inquiry--or 
allowing reliance on representations only in such a manner--
unnecessarily limit the willingness or ability of SBS Entities to 
provide special entities with the access to security-based swaps for 
the purposes described in Section I.C.5 above? Why or why not? What, if 
any, other measures should be required in connection with an SBS 
Entity's satisfaction of the requirements of proposed Rule 15Fh-5?
     Are there other potential reasonable means of establishing 
that a special entity's independent representative has the requisite 
qualifications, other than written representations, for which the 
Commission should consider providing guidance? If so, what means should 
such guidance address and how?
i. Qualified Independent Representative--Sufficient Knowledge To 
Evaluate Transaction and Risks
    Proposed Rule 15Fh-5(a)(1) would require that the SBS Entity have a 
reasonable basis to believe that the independent representative has 
sufficient knowledge to evaluate the transaction and risks.\228\ 
Industry groups have recognized that intermediaries should assess the 
sophistication of a counterparty--or its agent--including the 
counterparty's capability to understand the risk and return 
characteristics of the instrument.\229\ The independent representative 
will play an important role in assessing and advising the special 
entity in this regard.\230\
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    \228\ See Section 15F(h)(5)(A)(i)(I) of the Exchange Act, Public 
Law 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(i)(I)). As noted above, an SBS Entity could rely on 
representations from the special entity to form this reasonable 
basis, as discussed in note 213 and related text.
    \229\ See CRMPG III Report at 57-59 (describing standards of 
sophistication for investors of high-risk complex financial 
instruments).
    \230\ See note 225, supra, and related text regarding an SBS 
Entity's reliance on a representation from the special entity to 
form this reasonable basis.
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission require the SBS Entity to reevaluate 
(or, as applicable require a new written representation regarding) the 
qualifications of the independent representative periodically? If so, 
how often? Should such reevaluation be required for specific types of 
security-based swaps or in certain circumstances? If so, with respect 
to which types and in what circumstances?
     Should the Commission specify particular facts or 
circumstances that might give rise to a requirement for further review 
or inquiry on the part of an SBS Entity, notwithstanding any 
representations from the counterparty? Why or why not? What facts or 
circumstances should be considered, if any?
     Should the Commission consider the development of a 
proficiency examination for independent representatives? \231\ Should 
such testing requirement be mandatory? Should it apply to both in-house 
and third-party independent representatives? Why or why not?
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    \231\ See Letter from Joseph A. Dear, Chief Investment Officer, 
California Public Employees' Retirement System et al., to David A. 
Stawick, Secretary, CFTC (Feb. 18, 2011) (suggesting that the CFTC 
consider an approach that would involve passage of a proficiency 
examination by the independent representative); Letter from Peter A. 
Shapiro, Managing Director, Swap Financial Group to David A. 
Stawick, Secretary, CFTC (Feb. 22, 2011); Letter from Frank Iacono, 
Partner, Riverside Risk Advisors LLC to David A. Stawick, Secretary, 
CFTC (Feb. 22, 2011). Comments submitted to the CFTC are available 
at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=935t.
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     Should the Commission require that independent 
representatives be registered with the Commission as municipal advisors 
or investment advisers, or otherwise subject to regulation, such as 
banking regulation, for example?
ii. Qualified Independent Representative--No Statutory Disqualification
    Proposed Rule 15Fh-5(a)(2) would require that the SBS Entity have a 
reasonable basis to believe that the independent representative is not 
subject to a statutory disqualification.\232\ Although Exchange Act 
Section 15F(h) does not define ``subject to a statutory 
disqualification,'' the term has an established meaning under Section

[[Page 42430]]

3(a)(39) of the Exchange Act,\233\ which defines circumstances that 
would subject a person to a statutory disqualification with respect to 
membership or participation in, or association with a member of, an 
SRO. Although Section 3(a)(39) would not literally apply here, we are 
proposing to define ``subject to a statutory disqualification'' for 
purposes of proposed Rule 15Fh-5 by reference to Section 3(a)(39) of 
the Exchange Act.
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    \232\ See Section 15F(h)(5)(A)(i)(II) of the Exchange Act, 
Public Law 111-203, 124 Stat. 1376, 1791 (to be codified at 15 
U.S.C. 78o-10(h)(5)(A)(i)(II)). As noted above, an SBS Entity could 
rely on representations from the special entity to form this 
reasonable basis, as discussed in note 213 and related text. See 
discussion above in Section II.B.
    \233\ 15 U.S.C. 78c(a)(39).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     What, if any, other ``statutory disqualification'' models 
or definitions should the Commission consider, and why?
     Should the Commission specify particular facts or 
circumstances that require further review or inquiry on the part of an 
SBS Entity, notwithstanding written representations received?
     Should the Commission require an SBS Entity to check 
publicly available databases, such as FINRA's BrokerCheck and the 
Commission's Investment Adviser Public Disclosure program, to determine 
whether an independent representative is subject to a statutory 
disqualification? \234\ Why or why not? If so, which databases should 
be required to be consulted? Should such databases include sources 
outside the Commission and self-regulatory organizations, such as 
databases maintained by other regulators or federal or state officials? 
Why or why not? If so, which outside databases should be required to be 
consulted? Should the Commission require an SBS Entity to conduct any 
other type of inquiry to determine whether an independent 
representative is subject to a statutory disqualification? Why or why 
not?
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    \234\ See, e.g., http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/index.htm, and http://www.adviserinfo.sec.gov/(S(b3d5ktvihzlhai45hknxzk45))/IAPD/Content/
Search/iapd--Search.aspx.
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iii. Qualified Independent Representative--Acting in the Best Interests 
of the Special Entity
    Proposed Rule 15Fh-5(a)(3) would require that the SBS Entity have a 
reasonable basis to believe that the independent representative 
``undertakes a duty to act in the best interests'' of the special 
entity.\235\ As discussed above, we are not proposing to define ``best 
interests.'' We also note that an independent representative may be 
subject to similar or additional obligations under other applicable law 
with respect to its activities on behalf of the special entity.\236\
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    \235\ See Section 15F(h)(5)(A)(i)(IV) of the Exchange Act, Pub. 
L. 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(i)(IV)). See note 225, supra, and related text regarding 
an SBS Entity's reliance on a representation from the special entity 
to form this reasonable basis.
    \236\ As noted above, depending on the circumstances, an 
independent representative may be an ``investment adviser'' within 
the meaning of Section 202(a)(11) of the Advisers Act, a ``municipal 
advisor'' within the meaning of Section 15B(e) of the Exchange Act, 
or a fiduciary for purposes of ERISA. A municipal advisor, for 
example, ``shall be deemed to have a fiduciary duty to any municipal 
entity for whom such municipal advisor acts as a municipal 
advisor.'' 15 U.S.C. 78o-4(c)(1).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the independent representative be required to be 
subject to some form of regulation (e.g., as an investment adviser or 
an ERISA plan fiduciary) under which the independent representative has 
a duty to act in the best interests of the special entity (or some 
similar requirement)?
     Should an in-house independent representative be deemed to 
act in the best interests of the special entity by virtue of its 
employment with the special entity? Why or why not?
     Should an ERISA plan fiduciary, as defined under Section 
3(21) of ERISA, that meets the standards of ERISA be deemed to act in 
the best interests of a special entity that is an employee benefit plan 
subject to regulation under ERISA, for purposes of the proposed rule? 
Should a QPAM? \237\ An INHAM? \238\ Why or why not?
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    \237\ See Department of Labor Prohibited Transaction Exemption 
(``PTE'') 84-14, 70 FR 49305 (Aug. 23, 2005); Amendment to PTE 84-14 
for Plan Asset Transactions Determined by Independent Qualified 
Professional Asset Managers, 75 FR 38837 (July 6, 2010).
    \238\ See Department of Labor PTE 96-23, 61 FR 15975 (Apr. 10, 
1996); Proposed Amendment to PTE 96-23 for Plan Asset Transactions 
Determined by In-House Asset Managers, 75 FR 33642 (proposed June 
14, 2010).
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iv. Qualified Independent Representative--Appropriate Disclosures to 
Special Entity
    Section 15F(h)(5)(A)(i)(V) requires that the SBS Entity comply with 
any rules promulgated by the Commission requiring the SBS Entity to 
have a reasonable basis to believe that the independent representative 
will make appropriate disclosures. The Dodd-Frank Act is silent 
concerning the content of these disclosures. Proposed Rule 15Fh-5(a)(4) 
would require that the SBS Entity have a reasonable basis to believe 
that the independent representative will make appropriate and timely 
disclosures to the special entity of material information regarding the 
security-based swap.\239\
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    \239\ See note 225, supra, and related text regarding an SBS 
Entity's reliance on a representation from the special entity to 
form this reasonable basis.
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission impose specific requirements with 
respect to this obligation, such as the content of the disclosures that 
should be made by the independent representative? If so, what 
requirements and why? Should the ``appropriate disclosures'' include 
disclosures regarding the qualifications of the independent 
representative, in addition to disclosures regarding the security-based 
swap? Why or why not? Should such disclosures address other subjects 
not directly related to the security-based swap? Which ones and why?
     If the SBS Entity is not relying on written 
representations, should the Commission allow a presumption that an in-
house independent representative, by virtue of its employment with the 
special entity, will make appropriate disclosures of material 
information to the special entity? Why or why not?
     Should the Commission also require that the SBS Entity 
have a reasonable basis to believe that the independent representative 
will make appropriate and timely disclosures to the special entity of 
any potential conflicts of interest that the representative may have in 
connection with the security-based swap transaction? Why or why not? 
Would such disclosures be considered part of the ``best interests'' 
undertaking of an independent representative? Why or why not?
v. Qualified Independent Representative--Written Representations
    Proposed Rule 15Fh-5(a)(5) would require that the SBS Entity have a 
reasonable basis to believe that the independent representative will 
provide written representations to the special entity regarding fair 
pricing and the appropriateness of the security-based

[[Page 42431]]

swap.\240\ Commenters have suggested that a written representation 
``should be sufficient if the representation states that the 
representative is obligated, by law and/or contract, to review pricing 
and appropriateness with respect to any swap transaction in which the 
representative serves as such with respect to the plan''.\241\ We are 
not proposing a specific means by which this standard must be 
satisfied. We preliminarily believe, however, the approach described 
above would be reasonable. Another way for an SBS Entity to form a 
reasonable basis for its determination would be relying on a written 
representation that the independent representative will document the 
basis for its conclusion that the transaction was fairly priced and 
appropriate for the plan, and that the independent representative or 
the special entity will maintain that documentation in its records for 
an appropriate period of time, and make such records available to the 
plan upon request.
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    \240\ See Section 15F(h)(5)(A)(i)(VI) of the Exchange Act, Pub. 
L. 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(i)(VI)). See note 225, supra, and related text regarding 
an SBS Entity's reliance on a representation from the special entity 
to form this reasonable basis.
    \241\ American Benefits Council Letter at 9.
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission impose specific requirements with 
respect to this obligation? If so, what requirements and why?
vi. Qualified Independent Representative--ERISA Fiduciary
    Proposed Rule 15Fh-5(a)(6) would require an SBS Entity to have a 
reasonable basis to believe that the independent representative, in the 
case of a special entity that is an employee benefit plan subject to 
ERISA, is a ``fiduciary'' as defined in section 3(21) of that Act (29 
U.S.C. 1002).\242\ None of the requirements set forth in the proposed 
rule is intended to limit, restrict, or otherwise affect the 
fiduciary's duties and obligations under ERISA.\243\
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    \242\ See Section 15F(h)(5)(A)(i)(VII) of the Exchange Act, Pub. 
L. 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(i)(VII)). See note 225, supra, and related text 
regarding an SBS Entity's reliance on a representation from the 
special entity to form this reasonable basis.
    \243\ See notes 99, 198 and 189, supra, regarding the Department 
of Labor's proposal to amend definition of ``fiduciary'' for 
purposes of ERISA.
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Should the Commission impose specific requirements with 
respect to this obligation? If so, what requirements and why?
     Should other independent representative qualifications 
under proposed Rule 15Fh-5(a)(1) be deemed satisfied if the independent 
representative in the case of employee benefit plans subject to ERISA, 
is a fiduciary as defined in section 3(21) of ERISA? If so, which 
requirements and why?
vii. Qualified Independent Representative--Subject to ``Pay To Play'' 
Prohibitions
    We are proposing to include an additional requirement, not 
expressly addressed by the Dodd-Frank Act, that the SBS Entity have a 
reasonable basis for believing that the independent representative is 
subject to ``pay to play'' rules if the special entity is a State, 
State agency, city, county, municipality, or other political 
subdivision of a State, or a governmental plan, as defined in Section 
3(32) of ERISA.\244\ We believe that, unless exempted or excepted, an 
independent representative in these circumstances would likely be 
either a municipal advisor, or an investment adviser.\245\ A registered 
municipal advisor would be subject to pay to play prohibitions under 
MSRB rules.\246\ An investment adviser that is registered with the 
Commission would be subject to existing Commission rules regarding 
these practices.\247\
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    \244\ See Exchange Act Section 15F(h)(1)(C), Public Law 111-203, 
124 Stat. 1376, 1789 (to be codified at 15 U.S.C. 78o-10(h)(1)(C)) 
(authorizing the Commission to prescribe business conduct standards 
that relate to ``such other matters as the Commission determines to 
be appropriate''). For a discussion of abuses associated with pay to 
play practices, see Section II.D.5 below. See note 213 above and 
related text regarding an SBS Entity's reliance on a representation 
from the special entity to form this reasonable basis.
    \245\ See 15 U.S.C. 80b-2(a)(11) (defining ``investment 
adviser''), and 15 U.S.C. 78o-4(3) (defining ``municipal advisor''). 
Exchange Act Section 15B(4)(C) excludes from the definition of 
``municipal advisor'' any investment adviser that is registered 
under the Advisers Act, and persons associated with the investment 
adviser who are providing investment advice.'' 15 U.S.C. 78o-
4(4)(C).
    \246\ See, e.g. MSRB Notice 2011-04, Request for Comment on Pay 
to Play Rules for Municipal Advisors (Jan. 14, 2011) (requesting 
comment on a draft proposal to establish ``pay to play'' and related 
rules relating to municipal advisors and to make certain conforming 
changes to existing pay to play rules for brokers, dealers and 
municipal securities dealers).
    \247\ See, e.g., 17 CFR 275.206(4)-5 (prohibiting certain 
political contributions by investment advisers providing or seeking 
to provide investment advisory services to public pension plans and 
other government investors).
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    We do not, however, intend to prohibit other qualified persons from 
acting as independent representatives so long as those persons are 
similarly subject to pay to play restrictions. As discussed in Section 
II.D.5 below, pay to play practices may result in significant harm to 
these types of special entities in connection with security-based swap 
transactions.\248\ The concern is heightened here because of the 
fiduciary role that Congress has envisaged for independent 
representatives to special entities. In the case of independent 
representatives, the concern would be that a person might make 
contributions in order to be chosen as an independent representative 
(and obtain the fees commensurate with that role), and then not act as 
an impartial advisor with respect to the transaction. The proposed rule 
is intended to deter SBS Entities from participating, even indirectly, 
in such practices. Accordingly, proposed Rule 15Fh-5(a)(7) would 
require an SBS Entity to have a reasonable basis for believing that the 
independent representative is a person that is subject to rules of the 
Commission, the CFTC or an SRO subject to the jurisdiction of the 
Commission or the CFTC prohibiting it from engaging in specified 
activities if certain political contributions have been made, unless 
the independent representative is an employee of the special 
entity.\249\
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    \248\ See note 32, supra.
    \249\ See Exchange Act Section 15B(e)(4), Public Law 111-203, 
124 Stat. 1376, 1921-1922 (to be codified at 15 U.S.C 78o-4(e)(4)) 
(defining ``municipal advisor'' as a person ``other than a municipal 
entity or an employee of a municipal entity'' that engages in the 
specified activities).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Are there circumstances in which an independent 
representative that is advising a special entity that is a State, State 
agency, city, county, municipality, or other political subdivision of a 
State, or a governmental plan, as defined in Section 3(32) of ERISA, 
other than an employee of the special entity, would not be subject to 
pay to play restrictions?
     Should the Commission consider a different requirement, 
for example, that the independent representative be

[[Page 42432]]

subject to specific prohibitions, such as those described in Advisers 
Act Rule 206(4)-5 (prohibiting investment advisers that are registered, 
or required to be registered with the Commission, from providing or 
seeking to provide investment advisory services to public pension plans 
and other government investors when certain political contributions 
have been made)?
     Should the Commission require that the independent 
representative be a registered municipal advisor or Commission 
registered investment adviser?
d. Disclosure of Capacity
    Proposed Rule 15Fh-5(b) would require that, before initiation of a 
security-based swap with a special entity, an SBS Dealer must disclose 
in writing the capacity or capacities in which it is acting.\250\ An 
SBS Dealer that is acting as a counterparty but not an advisor to a 
special entity, for example, would need to make clear to the special 
entity the capacity in which it is acting (i.e., that it is acting as a 
counterparty, but not as an advisor).
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    \250\ See Section 15F(h)(5)(A)(2)(i) of the Exchange Act, Pub. 
L. 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(2)(i)).
---------------------------------------------------------------------------

    Commenters have noted that a firm may be acting in multiple 
capacities in relation to a special entity, for example, as underwriter 
in a bond offering as well as counterparty to a security-based swap 
used to hedge the financing transaction.\251\ In these circumstances, 
the SBS Dealer's duty to the special entity could vary depending upon 
the capacity in which it is acting, and so it is important for a 
special entity and its independent representative to understand the 
roles in which the SBS Dealer is acting.\252\ The proposed rule, 
therefore, would require an SBS Dealer that engages in business, or has 
engaged in business within the last twelve months, with the 
counterparty in more than one capacity to disclose the material 
differences between such capacities in connection with the security-
based swap and any other financial transaction or service involving the 
counterparty.\253\
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    \251\ See Swap Financial Group Presentation at 55.
    \252\ In the case of special entities that are municipal 
entities, MSRB Rule G-23 generally prohibits dealer-financial 
advisors from acting in multiple capacities in the same municipal 
securities transactions. See also MSRB Notice 2011-29 (May 31, 2011) 
(discussing rule amendment and interpretive notice).
    \253\ See proposed Rule 15Fh-5(b).
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    We are proposing to apply the requirement in proposed Rule 15Fh-
5(b) to SBS Dealers but not Major SBS Participants because the 
statutory requirement, by its terms, requires disclosure in writing of 
``the capacity in which the security-based swap dealer is acting.'' 
\254\
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    \254\ We making this statement because the introductory clause 
of Section 15F(h)(5) imposes disclosure obligations on both SBS 
Dealers and Major SBS Participants and thus could be read to impose 
the capacity disclosure obligation on all SBS Entities. See Section 
15F(h)(5)(A)(2)(ii) of the Exchange Act, Public Law 111-203, 124 
Stat. 1376, 1791 (to be codified at15 U.S.C. 78o-
10(h)(5)(A)(2)(ii)). We also note that the obligation in the text of 
the statute does not require Commission rulemaking.
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Are there specific capacities in which an SBS Dealer may 
act that merit more detailed types of disclosures? If so, which 
capacities, and what types of disclosures should be required? Should 
the Commission define in further detail the specific categories of 
``capacities'' in which SBS Dealers may act that would need to be 
disclosed under the proposed rule--e.g., as advisor, counterparty, 
underwriter, etc? If so, which capacities should be identified and 
disclosed?
     Should the Commission require similar disclosures by Major 
SBS Participants? Why or why not?
     Are there certain capacities for which disclosures should 
not be required? If so, which capacities, and why?
     Should the required disclosure be limited to other 
``capacities'' within a timeframe other than twelve months? If so, what 
would be the appropriate time frame? Why?
     Should there be a de minimis exclusion from the required 
disclosure? If so, what would be an appropriate threshold? Are there 
certain ``capacities'' that should be disclosed regardless of the 
dollar amount involved?
     We understand that some SBS Dealers may utilize a single 
relationship point of contact to manage the multiple capacities in 
which they may act with regard to a special entity. Does this 
relationship management model increase the likelihood that the special 
entity would be confused as to the standard of conduct with which each 
associated person is required to comply? Should the SBS Dealer be 
required to disclose the material differences in capacities that are 
managed separate and apart from this centralized relationship point? If 
an SBS Dealer has information barriers in place between certain 
associated persons or affiliates, should the SBS Dealer still be 
required to disclose to the special entity any material differences in 
the capacities in which these associated persons are acting? Would 
these types of information barriers impair the customer service that a 
special entity might otherwise receive?
     Are there any circumstances in which an affiliate of the 
SBS Dealer should be treated as an independent entity or third party, 
for the purposes of this disclosure rule?
6. Prohibition on Certain Political Contributions by SBS Dealers: 
Proposed Rule 15F-6
    We are proposing a rule that would prohibit an SBS Dealer from 
engaging in security-based swap transactions with a ``municipal 
entity'' if certain political contributions have been made to officials 
of the municipal entity.\255\ Pay to play occurs when persons seeking 
to do business with state and municipal governments make political 
contributions, or are solicited to make political contributions, to 
elected officials or candidates in order to influence the selection 
process.\256\ In making such contributions, interested persons hope to 
benefit from officials who ``award the contracts on the basis of 
benefit to their campaign chests rather than to the governmental

[[Page 42433]]

entity.'' \257\ Pay to play practices may take a variety of forms, 
including an SBS Dealer's direct contributions to government officials, 
an SBS Dealer's solicitation of third parties to make contributions or 
payments to government officials or political parties in the state or 
locality where the SBS Dealer seeks to provide services, or an SBS 
Dealer's payments to third parties to solicit (or as a condition of 
obtaining) security-based swap business.
---------------------------------------------------------------------------

    \255\ See Section 15F(h)(1)(D) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1789, 15 U.S.C. 78o-10(h)(1)(D) 
(authorizing the Commission to prescribe business conduct standards 
that relate to ``such other matters as the Commission determines to 
be appropriate'').
     The proposed restrictions would apply to dealings with a 
``municipal entity,'' which is defined in Exchange Act Section 
15B(e)(8) (15 U.S.C. 78o-4(e)(8)) as: ``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.''
    \256\ See, e.g., Blount v. SEC, 61 F. 3d 938 (D.C. Cir. 1995), 
cert. denied, 116 S. Ct. 1351 (1996) (holding that ``underwriters' 
campaign contributions self-evidently create a conflict of interest 
in state and local officials who have power over municipal 
securities contracts and a risk that they will award the contracts 
on the basis of benefit to their campaign chests rather than to the 
governmental entity''); Testimony of Martha Mahan Haines before the 
U.S. Senate Committee on Banking, Housing, and Urban Affairs, 
Subcommittee on Securities, Insurance, and Investment (May 21, 2009) 
(stating that pay to play practices may result in an unqualified 
financial advisor being chosen because of his political 
contributions). See also Political Contributions by Certain 
Investment Advisers, supra, note 32 at notes 18 through 25, citing 
examples of more recent Commission and criminal actions against 
investment advisers and other parties for violations involving pay 
to play arrangements.
    \257\ Blount, 61 F.3d at 944-45.
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    In the context of security-based swaps, pay to play practices may 
result in municipal entities entering into transactions not because of 
hedging needs or other legitimate purposes, but rather because of 
campaign contributions given to an official with influence over the 
selection process. Where pay to play exists, SBS Dealers may compete 
for security-based swap business based on their ability and willingness 
to make political contributions, rather than on their merit or the 
merit of a proposed transaction. We believe these practices may result 
in significant harm to municipalities and others in connection with 
security-based swap transactions, just as they do in connection with 
other municipal securities transactions.\258\
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    \258\ See id. See SEC v. Larry P. Langford, Litigation Release 
No. 20545 (Apr. 30, 2008) and SEC v. Charles E. LeCroy, Litigation 
Release No. 21280 (Nov. 4, 2009) (charging Alabama local government 
officials and J.P. Morgan employees with undisclosed payments made 
to obtain municipal bond offering and swap agreement business from 
Jefferson County, Alabama). See also J.P. Morgan Securities Inc., 
Securities Act Release No. 9078 (Nov. 4, 2009) (instituting 
administrative and cease-and-desist proceedings against a broker-
dealer that the Commission alleged was awarded bond underwriting and 
interest rate swap agreement business by Jefferson County in 
connection with undisclosed payments by employees of the firm).
---------------------------------------------------------------------------

    By its nature, pay to play is covert because participants do not 
broadcast that contributions or payments are made or accepted for the 
purpose of influencing the selection of a financial services provider. 
As one court noted, ``[w]hile the risk of corruption is obvious and 
substantial, actors in this field are presumably shrewd enough to 
structure their relations rather indirectly.'' \259\ Consequently, pay 
to play practices are often hard to prove because it is difficult to 
prove that contributions were made for the purpose of obtaining 
government business, and that those contributions then drove the 
selection of a particular entity.
---------------------------------------------------------------------------

    \259\ Blount v. SEC, 61 F.3d at 945.
---------------------------------------------------------------------------

    Absent implementation of specific rules prohibiting pay to play 
practices, it is likely such practices would continue undeterred, given 
that such practices pose a ``collective action'' problem.\260\ That is, 
government officials who engage in pay to play practices may have an 
incentive to continue accepting contributions to support their 
campaigns, for fear of being disadvantaged relative to their opponents. 
In addition, SBS Dealers may have an incentive to participate out of 
concern that they may be overlooked if they fail to make contributions. 
Both the stealthy nature of these practices and the inability of 
markets to properly address them strongly support the need for a 
prophylactic measure to address them, such as proposed Rule 15Fh-
6.\261\
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    \260\ As we explained in our release adopting Advisers Act Rule 
206(4)-5, a collective action problem exists when participants who 
prefer to abstain from pay to play nonetheless feel compelled to 
participate due to concern that they will be locked out of the 
market unless they take part. See Political Contributions by Certain 
Investment Advisers, note 33, supra.
    \261\ Cf. Blount, 61 F.3d at 945 (``no smoking gun is needed 
where, as here, the conflict of interest is apparent, the likelihood 
of stealth great, and the legislative purpose prophylactic'').
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    Proposed Rule 15Fh-6 is modeled on, and intended to complement, 
existing restrictions on pay to play practices under Advisers Act Rule 
206(4)-5, which imposes pay to play restrictions on investment advisers 
providing or seeking to provide investment advisory services to public 
pension plans and other government investors,\262\ and under MSRB Rules 
G-37 and G-38, 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 would create a 
comparable regulatory framework, as there are no existing federal pay 
to play restrictions that would apply to all SBS Dealers in their 
dealings with municipal entities. The proposed rule is intended to 
deter SBS Dealers from engaging in pay to play practices.
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    \262\ 17 CFR 275.206(4)-5. See Political Contributions by 
Certain Investment Advisers, note 32, supra. (adopting Advisers Act 
Rule 206(4)-5). See also Rules Implementing Amendments to the 
Investment Advisers Act of 1940, Investment Advisers Act Release No. 
3110 (Nov. 19, 2010), 75 FR 77052 (Dec. 10, 2010) (proposing 
amendments to Investment Advisers Act Rule 206(4)-5).
---------------------------------------------------------------------------

    The proposed rule itself does not attempt to stamp out corruption 
by public officials or to regulate local elections, nor is it a ban on 
political contributions. Rather, the proposed rule would bar SBS 
Dealers from entering into contracts after they make contributions, 
with the aim of eliminating motivation to engage in pay to play.
    We have closely drawn proposed Rule 15Fh-6 to accomplish its goal 
of preventing quid pro quo arrangements while avoiding unnecessary 
burdens on the protected speech and associational rights of SBS Dealers 
and their covered employees.\263\ The proposed rule would address only 
direct contributions to officials--it is not intended in any way to 
impinge on a wide range of expressive conduct in connection with 
elections. It would be triggered only when a business relationship 
exists or will be established in the near future. It would target those 
employees of SBS Dealers whose contributions raise the greatest danger 
of quid pro quo exchanges, and it would cover only contributions to 
those government officials who would be the most likely targets of a 
quid pro quo because of their authority to influence the award of 
government contracts. Finally, the proposed rule would not prevent 
anyone from making contributions at or below a specified de minimis 
level.
---------------------------------------------------------------------------

    \263\ The proposed rule is closely modeled on the MSRB Rule G-37 
upheld by the Court of Appeals for the District of Columbia Circuit 
in Blount v. SEC, 61 F.3d at 947-48.
---------------------------------------------------------------------------

    We are proposing to apply the requirements in proposed Rule 15Fh-6 
to SBS Dealers but not to Major SBS Participants because we do not 
anticipate that Major SBS Participants would serve a dealer-type role 
in the market.\264\
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    \264\ See discussion in Section I.C.4, supra.
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a. Prohibitions
    Proposed Rule 15Fh-6(b)(1) would generally make it unlawful for an 
SBS Dealer to offer to enter or to enter into a security-based swap 
with a municipal entity for a two-year period after the SBS Dealer or 
any of its covered associates makes a contribution to an official of 
the municipal entity.\265\
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    \265\ Proposed Rule 15Fh-6(a)(5) would define the term 
``official'' of a municipal entity for purposes of the proposed rule 
to mean:
    A person (including any election committee for such person) who 
was, at the time of the contribution, an incumbent, candidate or 
successful candidate for elective office of a municipal entity, if 
the office:
    (i) Is directly or indirectly responsible for, or can influence 
the outcome of, the selection of a security-based swap dealer or 
major security-based 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 security-based swap dealer or major security-based 
swap participant by a municipal entity.
---------------------------------------------------------------------------

    Proposed Rule 15Fh-6(b)(3)(i) would prohibit an SBS Dealer from 
paying a third party to solicit municipal entities to enter into a 
security-based swap, unless the third party is a ``regulated person'' 
that is itself subject to a pay to

[[Page 42434]]

play restriction under applicable law.\266\ We are concerned that the 
adoption of a rule addressing pay to play practices by security-based 
swap dealers would lead to the use of solicitors by security-based swap 
dealers to circumvent the rule. Proposed Rule 15Fh-6(b)(3)(i) is 
intended to deter SBS Dealers from participating, even indirectly, in 
such practices.
---------------------------------------------------------------------------

    \266\ Proposed Rule 15Fh-6(a)(7) would define ``regulated 
person,'' for purposes of the rule, to mean generally a person that 
is subject to rules of the Commission, the CFTC or an SRO subject to 
the jurisdiction of the Commission or the CFTC prohibiting it from 
engaging in specified activities if certain political contributions 
have been made, or its officers or employees.
---------------------------------------------------------------------------

    Third, proposed Rule 15Fh-6(b)(3)(ii) would ban an SBS Dealer from 
soliciting or coordinating contributions to an official of a municipal 
entity with which the SBS Dealer is seeking to enter into, or has 
entered into a security-based swap, or payments to a political party of 
a state or locality with which the SBS Dealer is seeking to enter into, 
or has entered into, a security-based swap. These proposed prohibitions 
are similar to those contained in Advisers Act Rule 206(4)-5, and MSRB 
Rules G-37 and G-38.
    Proposed Rule 15Fh-6(c) would make it unlawful for an SBS Dealer to 
do indirectly or through another person or means anything that would, 
if done directly, result in a violation of the prohibitions contained 
in the proposed rule.
b. Two-Year ``Time Out''
    Proposed Rule 15Fh-6(b)(1) would prohibit an SBS Dealer from 
offering to enter into, or entering into, a security-based swap with a 
municipal entity within two years after a contribution to an official 
of such municipal entity has been made by the SBS Dealer or any of its 
covered associates. We believe the two-year time out requirement 
strikes an appropriate balance, as it is sufficiently long to act as a 
deterrent but not so long as to be unnecessarily onerous. The two-year 
time out is consistent with the time out provisions contained in 
Advisers Act Rule 206(4)-5 and MSRB Rule G-37.
c. Covered Associates
    Political contributions made to influence the selection of a firm 
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 entity.\267\ For this reason, the restrictions under 
proposed Rule 15Fh-6(b)(1) would apply to contributions by any 
``covered associate'' of an SBS Dealer, which is defined to include: 
(i) Any general partner, managing member or executive officer, or other 
person with a similar status or function; \268\ (ii) any employee who 
solicits a municipal entity to enter into a security-based swap with 
the SBS Dealer and any person who supervises, directly or indirectly, 
such employee; and (iii) any political action committee controlled by 
the SBS Dealer or any of its covered associates.\269\ This definition 
is consistent with a similar provision in Advisers Act Rule 206(4)-
5.\270\
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    \267\ See Political Contributions by Certain Investment 
Advisers, supra, note 33.
    \268\ Proposed Rule 15Fh-6(a)(3) would define ``executive 
officer'' of an SBS Dealer to mean, for purposes of the rule:
     The president;
     Any vice president in charge of a principal business 
unit, division or function (such as sales, administration or 
finance);
     Any other officer of the SBS Dealer who performs a 
policy-making function; or
     Any other person who performs similar policy-making 
functions for the SBS Dealer.
    \269\ Proposed Rule 15Fh-6(a)(2).
    \270\ 17 CFR 275.206(4)-5(f)(2).
---------------------------------------------------------------------------

    Because the proposed rule would attribute to a firm those 
contributions made by a person even prior to becoming a covered 
associate of the firm, SBS Dealers would need to ``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 security-based swap with the relevant municipal entity 
until the two-year time out period has expired.
d. Officials
    The restrictions would apply when contributions are made to an 
``official'' of a municipal entity. Proposed Rule 15Fh-6(a)(5) would 
define ``official'' to mean 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 is directly or indirectly responsible 
for, or can influence the outcome of, the selection of an SBS Dealer by 
a municipal entity; or has authority to appoint any person who is 
directly or indirectly responsible for, or can influence the outcome 
of, the selection of an SBS Dealer by a municipal entity.
e. Exceptions
i. De Minimis Contributions
    The proposed rule would permit an individual who is a covered 
associate to make aggregate contributions without being subject to the 
two-year time out period, of up to $350 per election, for any one 
official for whom the individual is entitled to vote, and up to $150 
per election, to an official for whom the individual is not entitled to 
vote.\271\ We are proposing this two-tier approach because, while we 
recognize persons can have a legitimate interest in contributing to 
campaigns of people for whom they are unable to vote, we are concerned 
that contributions by covered associates living in distant 
jurisdictions may be less likely to be made for purely civic purposes. 
Accordingly, the proposed de minimis exception for contributions to 
candidates for whom a covered associate is not entitled to vote is 
lower than the de minimis exception for candidates for whom a covered 
associate is entitled to vote. We believe that the $150 exception for 
contributions to a candidate for whom the covered associate is not 
entitled to vote is appropriate because of the more remote interest a 
covered associate is likely to have in contributing to such a person.
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    \271\ Proposed Rule 15Fh-6(b)(2)(i).
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ii. 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 SBS Dealer, unless such individual 
solicits the municipal entity after becoming a covered associate.\272\
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    \272\ Proposed Rule 15Fh-6(b)(2)(ii).
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iii. Exchange and SEF Transactions
    The prohibitions of proposed Rule 15Fh-6 would not apply to a 
security-based swap that is initiated by a municipal entity on a 
registered national securities exchange or SEF, for which the SBS 
Dealer does not know the identity of the counterparty at any time up to 
and including the time of execution of the transaction.\273\
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    \273\ Proposed Rule 15Fh-6(a)(2)(iii).
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f. Exception and Exemptions
    We are proposing a provision that would provide an SBS Dealer a 
limited ability to cure the consequences of an inadvertent political 
contribution to an official for whom the covered associate is not 
entitled to vote. The exception would apply to contributions that, in 
the aggregate, do not exceed $350 to any one official per election. The 
SBS Dealer

[[Page 42435]]

must have discovered the contribution that resulted in the prohibition 
within four months of the date of the contribution, and obtained the 
return of the contribution to the contributor within 60 calendar days 
of the date of discovery. In addition, an SBS Dealer would not be able 
to rely on this exception more than twice in any 12-month period, or 
more than once for any covered associate, regardless of the time 
between contributions.\274\ This automatic exception mirrors similar 
provisions contained in Advisers Act Rule 206(4)-5 and MSRB Rule G-37.
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    \274\ Proposed Rule 15Fh-6(e)(1).
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    The scope of this exception would be limited to the types of 
contributions we believe are less likely to raise pay to play concerns. 
The prompt return of the contribution would provide an indication that 
the contribution would not affect an official's decision to enter into 
a transaction with the SBS Dealer. The relatively small amount of the 
contribution, in conjunction with the other conditions of the 
exception, should help to mitigate concerns that the contribution was 
made for purposes of influencing the municipal entity's selection 
process. The restrictions on repeated triggering contributions should 
reinforce the need for effective compliance controls. Because the 
proposed exception would operate automatically, we preliminarily 
believe that it should be subject to conditions that are objective and 
limited in order to capture only those contributions that are less 
likely to raise pay to play concerns.
    In addition, we are proposing a provision under which an SBS Dealer 
may apply to the Commission for an exemption from the two-year ban. In 
determining whether to grant the exemption, the Commission would 
consider, among other factors: (i) Whether the exemption is necessary 
or appropriate in the public interest and consistent with the 
protection of investors and the purposes of the Exchange Act; (ii) 
whether the SBS Dealer, (a) Before the contribution resulting the 
prohibition was made, had adopted and implemented policies and 
procedures reasonably designed to prevent violations of the proposed 
rule, (b) prior to or at the time the contribution, had any actual 
knowledge of the contribution, and (c) after learning of the 
contribution, had taken all available steps to cause the contributor to 
obtain return of the contribution and such other remedial or 
preventative measures as may be appropriate under the circumstances; 
(iii) whether, at the time of the contribution, the contributor was a 
covered associate or otherwise an employee of the SBS Dealer, or was 
seeking such employment; (iv) the timing and amount of the 
contribution; (v) the nature of the election (e.g., state or local); 
and (vi) the contributor's intent or motive in making the contribution, 
as evidenced by the facts and circumstances surrounding the 
contribution.\275\ This exemption is similar to the exemption-by-
application provisions contained in Advisers Act Rule 206(4)-5 and MSRB 
Rule G-37.
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    \275\ Proposed Rule 15Fh-6(e).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Do security-based swap transactions with municipal 
entities present the same risks of pay to play abuses as other 
securities transactions involving municipal securities dealers and 
investment advisers? If not, why not?
     Do the same risks of pay to play abuses exist when a Major 
SBS Participant, rather than an SBS Dealer, is seeking to enter into a 
security-based swap with a municipal entity? If not, why not? Should 
the proposed rule apply to Major SBS Participants, as well as to SBS 
Dealers? If so, why?
     Is the term ``municipal entity'' appropriately defined? If 
not, should the definition 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 the Employee Retirement 
Income Security Act of 1974 (29 U.S.C. 1002)'' within the meaning of 
Exchange Act Section 15F(h)(2)(C)? Should the Commission use the 
definition of ``government entity'' from Advisers Act Rule 206(4)-5? 
\276\ Should the Commission instead follow the approach of MSRB Rule G-
37? \277\
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    \276\ As used in 17 CFR 275.206(4)-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.
    \277\ MSRB Rule G-37 references ``the governmental issuer 
specified in [Section 3(a)(29) of the Exchange Act]'' which would 
include ``a State or any political subdivision thereof, or any 
municipal corporate instrumentality of one more States.''
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     Should the requirements of proposed Rule 15Fh-6 be deemed 
satisfied if an SBS Dealer can establish that it is subject to other 
regulation that similarly prohibits it from engaging in security-based 
swap activities if certain political contributions have been made? 
Should an SBS Dealer's ability to rely on other regulation be 
conditioned on a Commission finding that the other regulation imposes 
substantially equivalent or more stringent restrictions than proposed 
Rule 15Fh-6 would impose on SBS Dealers, and that such other rules are 
consistent with the objectives of proposed Rule 15Fh-6? Why or why not?
     Proposed Rule 15Fh-6(b)(3)(i) is intended to prevent SBS 
Dealers from participating, even indirectly, in pay to play practices. 
What would be the advantages and disadvantages of such an approach? Is 
there another approach that the Commission should consider? Are there 
differences between the operations of SBS Dealers and other securities 
firms that would make the third-party solicitor provision unnecessary? 
If so, what are they? Would the provision impose any collection of 
information obligations? If so, what would they be? What would be the 
costs and benefits of this approach?

E. Chief Compliance Officer: Proposed Rule 15Fk-1

    Section 15F(k) of the Exchange Act requires an SBS Entity to 
designate a chief compliance officer (``CCO''), and imposes certain 
duties and responsibilities on that CCO. Proposed Rule 15Fk-1 would 
codify the provisions of Exchange Act Section 15F(k) with some 
modifications based on the current compliance obligations applicable to 
CCOs of other Commission-regulated entities. The proposed requirements 
underscore the central role that sound compliance programs play to 
ensure compliance with the Exchange Act and rules and regulations 
thereunder applicable to security-based swaps.\278\
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    \278\ See FINRA Rule 3130.
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    Proposed Rule 15Fk-1(a) would require an SBS Entity to designate a 
CCO on its registration form, and proposed Rule 15Fk-1(b) would impose 
certain duties on the CCO. Proposed Rule 15Fk-1(b)(1) would require 
that the CCO report directly to the board of directors, a body 
performing a function similar to the board, or to the senior

[[Page 42436]]

officer of the SBS Entity.\279\ Proposed Rule 15Fk-1(b)(2) would 
require the CCO to review the compliance of the SBS Entity with respect 
to the requirements in Section 15F of the Exchange Act and the rules 
and regulations thereunder.\280\ Rule 15Fk-1(b)(2) would further 
require that, as part of the CCO's obligation to review compliance by 
the SBS Entity, the CCO establish, maintain, and review policies and 
procedures that are reasonably designed to achieve compliance by the 
SBS Entity with Section 15F of the Exchange Act and the rules and 
regulations thereunder.\281\
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    \279\ See Section 15F(k)(2)(A) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(A)).
    \280\ See Section 15F(k)(2)(B) of the Exchange Act, Public Law. 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(B)).
    \281\ The requirement to establish, maintain and review policies 
and procedures reasonably designed to achieve compliance with 
Section 15F of the Exchange Act and the rules thereunder is based on 
FINRA Rule 3130, which requires certification that a member has in 
place processes to ``establish, maintain, and review policies and 
procedures reasonably designed to achieve compliance with applicable 
FINRA rules, MSRB rules and federal securities laws and 
regulations.'' Similar requirements appear in Rule 38a-1(a)(1) under 
the Investment Company Act of 1940, 17 CFR 270.38a-1(a)(1) 
(requiring registered investment companies to ``[a]dopt and 
implement written policies and procedures reasonably designed to 
prevent violation of the Federal Securities laws by the fund''); and 
Advisers Act Rule 206(4)-7(a), 17 CFR 275.206(4)-7(a) (requiring 
registered investment advisers to ``[a]dopt and implement written 
policies and procedures reasonably designed to prevent violation, by 
you and your supervised persons, of the [Advisers] Act, and the 
rules that the Commission has adopted under the [Advisers] Act'').
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    Proposed Rule 15Fk-1(b)(3) would require that the CCO, in 
consultation with the board of directors, a body performing a function 
similar to the board, or the senior officer of the organization, 
resolve conflicts of interest that may arise.\282\ We understand that 
the primary responsibility for the resolution of conflicts generally 
lies with the business units within the SBS Entities. As a result, we 
would anticipate that the CCO's role with respect to such resolution 
and mitigation of conflicts of interest would include the 
recommendation of one or more actions, as well as the appropriate 
escalation and reporting with respect to any issues related to the 
proposed resolution of potential or actual conflicts of interest, 
rather than decisions relating to the ultimate final resolution of such 
conflicts. Under proposed Rule 15Fk-1(b)(4), the CCO would be 
responsible for administering each policy and procedure that is 
required to be established pursuant to Section 15F of the Act and the 
rules and regulations thereunder.\283\ The Commission would expect that 
a CCO should be competent and knowledgeable regarding Section 15F of 
the Exchange Act and the rules and regulations thereunder, and should 
be empowered with full responsibility and authority to execute his or 
her responsibilities.
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    \282\ See Section 15F(k)(2)(C) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(C)).
    \283\ See Section 15F(k)(2)(D) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(D)).
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    Proposed Rule 15Fk-1(b)(5) would require the CCO to establish, 
maintain and review policies and procedures reasonably designed to 
ensure compliance with the provisions of the Exchange Act and the rules 
and regulations thereunder relating to the SBS Entity's business as an 
SBS Entity.\284\ The title of CCO does not, in and of itself, carry 
supervisory responsibilities. Consistent with current industry 
practice, we generally would not expect a CCO appointed in accordance 
with proposed Rule 15Fk-1 to have supervisory responsibilities outside 
of the compliance department. Accordingly, absent facts and 
circumstances that establish otherwise, we generally would not expect 
that a CCO would be subject to a sanction by the Commission for failure 
to supervise other SBS Entity personnel. Moreover, a CCO who does have 
supervisory responsibilities could rely on the provisions of proposed 
Rule 15Fh-3(h)(3), under which a person associated with an SBS Entity 
shall not be deemed to have failed to reasonably supervise another 
person if such other person is not subject to the CCO's supervision, or 
if: (i) the SBS Entity has established and maintained written policies 
and procedures, and a documented system for applying those policies and 
procedures, that would reasonably be expected to prevent and detect, 
insofar as practicable, any violation of the federal securities laws 
and the rules and regulations thereunder relating to its business as an 
SBS Entity; and (ii) the supervising person has reasonably discharged 
the duties and obligations required by the written policies and 
procedures and documented system, and did not have a reasonable basis 
to believe that the written policies and procedures and documented 
system were not being followed.\285\
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    \284\ See Section 15F(k)(2)(E) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(E)).
    \285\ Cf. Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 
17, 2003), 68 FR 74714 (Dec. 24, 2003) at note 78.
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    Proposed Rule 15Fk-1(b)(6) would require the CCO to establish, 
maintain and review policies and procedures reasonably designed to 
remediate promptly non-compliance issues identified by the CCO.\286\ 
Proposed Rule 15Fk-1(b)(7) would require the CCO to establish and 
follow procedures reasonably designed for management response and 
resolution of non-compliance issues.\287\
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    \286\ See Section 15F(k)(2)(F) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(F)).
    \287\ See Section 15F(k)(2)(G) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1793 (to be codified at 15 U.S.C. 78o-
10(k)(2)(G)).
---------------------------------------------------------------------------

    Proposed Rule 15Fk-1(c)(1) would require that the CCO annually 
prepare and sign a report describing the compliance policies and 
procedures (including the code of ethics and conflicts of interest 
policies) and compliance of the SBS Entity with the Exchange Act and 
rules and regulations thereunder relating to its business as an SBS 
Entity.\288\ Proposed Rule 15Fk-1(c)(2) would require that each 
compliance report also contain, at a minimum: A description of the SBS 
Entity's enforcement of its policies and procedures relating to its 
business as an SBS Entity; any material changes to the policies and 
procedures since the date of the preceding compliance report; any 
recommendation for material changes to the policies and procedures as a 
result of the annual review, the rationale for such recommendation, and 
whether such policies and procedures were or will be modified by the 
SBS Entity to incorporate such recommendation; and any material 
compliance matters identified since the date of the preceding 
compliance report.\289\ Proposed Rule 15Fk-1(e)(4) would define 
``material compliance matter'' to mean any compliance matter about 
which the board of directors of the SBS Entity would reasonably need to 
know

[[Page 42437]]

to oversee the compliance of the SBS Entity, and that involves, without 
limitation, a violation of the federal securities laws relating to its 
business as an SBS Entity by the SBS Entity or its officers, directors, 
employees or agents; a violation of the policies and procedures of the 
SBS Entity relating to its business as an SBS Entity; or a weakness in 
the design or implementation of the policies and procedures of the SBS 
Entity relating to its business as an SBS Entity.\290\
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    \288\ See Section 15F(k)(3)(A) of the Exchange Act, Public Law 
111-203, 124 Stat. 1376, 1794 (to be codified at 15 U.S.C. 78o-
10(k)(3)(A)). We believe that there is a drafting error in the 
reference in Section 15F(k)(3)(A) of the Exchange Act to compliance 
of the ``major swap participant'' in this provision, and are 
proposing to apply the requirement with respect to the compliance of 
the ``major security-based swap participant.''
    \289\ This requirement is modeled on a similar requirement for 
chief compliance officers under Investment Company Act Rule 38a-
1(4), 17 CFR 270.38a-1(a)(4). The report under the Investment 
Company Act, however, is not required to be filed with the 
Commission.
     The Commission is proposing a similar requirement for chief 
compliance officers of security-based swap data repositories. See 
Security-Based Swap Data Repository Registration, Duties and Core 
Principles, Exchange Act Release No. 63347 (Nov. 19, 2010), 75 FR 
77306 (Dec. 10, 2010) (``SDR Registration Release'') (proposing 
Exchange Act Rule 13n-11(d)(1)).
    \290\ This definition is modeled on the definition of ``material 
compliance matter'' in Investment Company Act Rule 38a-1(e)(2), 
270.38a-1(e)(2). The Commission proposed a similar definition in its 
rule governing chief compliance officers of security-based swap data 
repositories. See SDR Registration Release (proposing Exchange Act 
Rule 13n-11(b)(6)).
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    Proposed Rule 15Fk-1(c)(2)(ii)(D) would require the CCO to certify, 
under penalty of law, the accuracy and completeness of the report.\291\ 
Proposed Rule 15Fk-1(c)(2)(ii)(A) would require that the CCO's annual 
report accompany each appropriate financial report of the SBS Entity 
that is required to be furnished or filed with the Commission.\292\ To 
allow the annual report to accompany each appropriate financial report 
within the required timeframe, proposed Rule 15Fk-1(c)(2)(ii)(B) would 
require the CCO to provide a copy of the required annual report to the 
board of directors, the audit committee and the senior officer of the 
SBS Entity at the earlier of their next scheduled meeting or within 45 
days of the date of execution of the certification.\293\
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    \291\ See Section 15F(k)(3)(B)(ii) of the Exchange Act, Public 
Law 111-203, 124 Stat. 1376, 1794 (to be codified at 15 U.S.C. 78o-
10(k)(3)(B)(ii)).
    \292\ See Section 15F(k)(3)(B)(i) of the Exchange Act, Public 
Law 111-203, 124 Stat. 1376, 1794 (to be codified at 15 U.S.C. 78o-
10(k)(3)(B)(i)).
    \293\ Id. This timeframe is the same as that provided by FINRA 
Rule 3130(c) (regarding certification of compliance processes).
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    Proposed Rule 15Fk-1(c)(2)(ii)(C) would require that the CCO's 
annual report include a written representation that the chief executive 
officer(s) (or equivalent officers) has/have conducted one or more 
meetings with the CCO in the preceding 12 months, the subject of which 
addresses the SBS Entity's processes to comply with the obligations of 
the CCO as set forth in the proposed rules and in Exchange Act Section 
15F.\294\ To comply with the proposed rule, the subject of the 
meeting(s) between the chief executive officer and the CCO referenced 
in the written representation must include: (1) The matters that are 
the subject of the CCO's annual report; (2) the SBS Entity's compliance 
efforts with the provisions of Section 15F and the provisions of the 
Exchange Act and the rules and regulations thereunder relating to its 
business as an SBS Entity as of the date of such a meeting; and (3) 
significant compliance problems under Section 15F and plans in emerging 
business areas relating to its business as an SBS Entity.\295\ Although 
not required by the Dodd-Frank Act, we believe that an annual 
compliance meeting would help to ensure and comprehensive compliance 
policies.\296\ Under proposed Rule 15Fk-1(c)(2)(iii), if compliance 
reports are separately bound from the financial statements, the 
compliance reports shall be accorded confidential treatment to the 
extent permitted by law.
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    \294\ See FINRA Rule 3130.
    \295\ This requirement is modeled on the obligations for broker-
dealers under FINRA rules. See Supplementary Material .04 to FINRA 
Rule 3130, Content of Meetings between Chief Executive Officer and 
Chief Compliance Officer.
    \296\ See Exchange Act Sections 15F(h)(1)(B) (authorizing the 
Commission to prescribe duties for diligent supervision), and 
15F(h)(3)(D) (providing authority to prescribe business conduct 
standards). Public Law 111-203, 124 Stat. 1376, 1789 and 1790 (to be 
codified at 15 U.S.C. 78o-10(h)(1)(B) and 78o-10(h)(3)(D)).
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    Finally, proposed Rule 15Fk-1(d) would require that the 
compensation and removal of the CCO be approved by a majority of the 
board of directors of the SBS Entity. We are proposing this measure, 
which is not required by the Dodd-Frank Act, to promote the 
independence and effectiveness of the CCO. We have proposed a similar 
requirement for the CCOs of security-based swap data repositories \297\ 
and of investment companies and business development companies.\298\ As 
we explained in proposing other CCO requirements, we are concerned that 
an entity's commercial interests might discourage a CCO from making 
forthright disclosure to the board or senior officer about any 
compliance failures. To help address this potential conflict of 
interest, the Commission preliminarily believes that only the board of 
directors of the SBS Entity should be able to set the CCO's 
compensation or remove an individual from the CCO position.\299\
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    \297\ See SDR Registration Release (proposing Exchange Act Rule 
13n-11(a)).
    \298\ See 17 CFR 270.38a-1(a)(4).
    \299\ See SDR Registration Release (discussing proposed Exchange 
Act Rule 13n-11(a)).
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Request for Comments
    The Commission requests comments generally on all aspects of this 
provision. In addition, we request comments on the following specific 
issues:
     Would a CCO of an SBS Entity have difficulty discharging 
any of these obligations? If so, why?
     Should the Commission consider additional obligations to 
be imposed on a CCO of an SBS Entity? If so, which ones and why?
     Should the Commission define circumstances in which a CCO 
may report to a senior officer rather than to the board of directors? 
If so, what should those circumstances be? Why?
     Do any of the CCO obligations conflict with current 
obligations imposed on a CCO and, if so, why?
     Would the timing of the annual report create any problems 
for SBS Entities?
     Should the compliance report be furnished rather than 
filed with the Commission? Why or why not?
     Should the Commission permit a CCO to qualify its report 
by certifying, under penalty of law, that a report is accurate and 
complete ``in all material respects''? Why or why not? Is there another 
approach the Commission should consider to appropriately balance the 
practical need for SBS Entities to attract and retain qualified CCOs 
with the statutory provision to require CCOs to certify their reports 
under penalty of law?
     Should the Commission require the chief executive officer 
or another senior officer to certify the report, similar to the 
compliance certification required under FINRA Rule 3130, instead of or 
in addition to the CCO? \300\ Why or why not?
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    \300\ FINRA Rule 3130 requires the CEO to certify that:
    1. The Member has in place processes to:
    (A) Establish, maintain and review policies and procedures 
reasonably designed to achieve compliance with applicable FINRA 
rules, MSRB rules and federal securities laws and regulations;
    (B) Modify such policies and procedures as business, regulatory 
and legislative changes and events dictate; and
    (C) Test the effectiveness of such policies and procedures on a 
periodic basis, the timing and extent of which is reasonably 
designed to ensure continuing compliance with FINRA rules, MSRB 
rules and federal securities laws and regulations.
    2. The undersigned chief executive officer(s) (or equivalent 
officer(s)) has/have conducted one or more meetings with the chief 
compliance officer(s) in the preceding 12 months, the subject of 
which satisfy the obligations set forth in FINRA Rule 3130.
    3. The Member's processes, with respect to paragraph 1 above, 
are evidenced in a report reviewed by the chief executive officer(s) 
(or equivalent officer(s)), chief compliance officer(s), and such 
other officers as the Member may deem necessary to make this 
certification. The final report has been submitted to the Member's 
board of directors and audit committee or will be submitted to the 
Member's board of directors and audit committee (or equivalent 
bodies) at the earlier of their next scheduled meetings or within 45 
days of the date of execution of this certification.
    4. The undersigned chief executive officer(s) (or equivalent 
officer(s)) has/have consulted with the chief compliance officer(s) 
and other officers as applicable (referenced in paragraph 3 above) 
and such other employees, outside consultants, lawyers and 
accountants, to the extent deemed appropriate, in order to attest to 
the statements made in this certification.

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[[Page 42438]]

     How, if at all, would the proposed CCO requirements--
including those that are not expressly addressed by the Dodd-Frank Act, 
e.g., the proposed requirements that the CCO meet with the chief 
executive officer and that the compensation of the CCO be set by the 
Board--alter the role and function that CCOs may play within SBS 
Entities? Do the proposed requirements promote an effective compliance 
function while avoiding undue constraints on a firm's discretion in 
organizing its business, including that compliance function? Why or why 
not? How, if at all, could the proposed requirements be altered to 
provide SBS Entities and CCOs greater flexibility in implementing an 
effective compliance function?
     If the CCO reports to a senior officer, should the senior 
officer have the ability to remove the CCO? Should the senior officer 
have the ability to determine the compensation of the CCO? Under what 
circumstances and why? If the CCO reports to the board of directors, 
should the compliance meeting(s) required under proposed Rule 15Fk-
1(c)(2)(i)(C) be held between the CCO and the board of directors or a 
committee of independent directors instead of with the senior officer?
     Should the board or audit committee be required to review 
the annual compliance report and approve any CCO-recommended remedial 
steps? Should the board or audit committee be required to authorize 
alternative remedial steps that the board or audit committee determines 
are more appropriate than those in the annual compliance report? Should 
the Commission require the SBS Entity to report to the Commission any 
alternative remedial steps taken? Why or why not?

III. Request for Comments

A. Generally

    The Commission requests comments on all aspects of the proposed 
rules. The Commission particularly requests comment on the general 
impact the proposals would have on the market for security-based swaps 
and on the behavior of participants in that market. The Commission also 
seeks comment on the proposals as a whole, including their interaction 
with the other provisions of the Dodd-Frank Act and their advantages 
and disadvantages when considered in total. In addition, the Commission 
seeks comment on the following specific issues:
     Do the proposed rules clearly define the obligations to be 
imposed on SBS Dealers or Major SBS Participants? Are there 
clarifications or instructions to the proposed requirements that would 
be beneficial to make? If so, what are they, and what would be the 
benefits of adopting them?
     Do the proposed rules (considered individually and in 
their entirety) provide an efficient and effective way to implement the 
requirements of the Dodd-Frank Act relating to the business conduct of 
SBS Entities? Why or why not? Are the requirements under the proposed 
rules appropriately tailored so that the requirements of the Dodd-Frank 
Act can be met consistent with an SBS Entity's maintaining an 
economically viable business? Why or why not?
     Do the proposed rules (considered individually and in 
their entirety) give full effect to the additional protections for 
special entities contemplated by the statute while avoiding 
restrictions on SBS Entities that would unduly limit their willingness 
or ability to provide special entities with access to security-based 
swaps? Why or why not? How and to what extent will the proposed rules 
(considered individually and in their entirety) affect the ability of 
special entities to engage in security-based swaps? How and to what 
extent will the proposed rules (considered individually and in their 
entirety) afford special entities the protections contemplated by the 
Dodd-Frank Act in connection with their security-based swap 
transactions?
     Would the proposed rules require disclosure of information 
that that commenters believe should not, or need not, be disclosed? If 
so, what information, and what are the problems associated with its 
disclosure?
     Do any proposed requirements conflict with any existing 
requirement, including any requirement currently imposed by an SRO, 
such that it would be impracticable or impossible for an SBS Entity 
that is a member of an SRO to meet both obligations? If so, which 
one(s) and why?
     Should an SBS Entity be permitted to establish compliance 
with the proposed business conduct standards by demonstrating 
compliance with other regulatory standards that impose substantially 
similar requirements?
     Should any proposed requirements be modified with respect 
to security-based swaps that are traded on a registered SEF or on a 
registered national securities exchange? If so, which requirements 
should be modified, and why?
     Should any proposed requirements be modified with respect 
to security-based swaps that are cleared but not SEF- or exchange-
traded? If so, which requirements and why?
     Should any proposed requirements for SBS Entities be 
modified? If so, which requirements and why? Should different standards 
apply to SBS Dealers and Major SBS Participants?
     Should any additional business conduct requirements be 
imposed on SBS Entities? If so, which requirements and why? Should 
different standards apply to SBS Dealers and Major SBS Participants? 
Under what circumstances, and why?
     Should any additional proposed requirements be modified 
when the counterparty is an SBS Dealer, a Major SBS Participant, a swap 
dealer or a major swap participant? Another type of market 
intermediary?
     Are there other counterparties for which certain proposed 
SBS Entity requirements should be modified? If so, which requirements, 
in what circumstances, and why?
     Should the Commission delay the compliance date of any of 
the proposed requirements to allow additional time to comply with those 
requirements? If so, which requirements, and how much additional time?

B. Consistency With CFTC Approach

    The CFTC has proposed rules related to business conduct standards 
for swap dealers and major swap participants as required under Section 
731 of the Dodd-Frank Act.\301\ Understanding that the Commission and 
the CFTC regulate different products, participants and markets and 
thus, appropriately may take different approaches to various issues, we 
nevertheless are guided by the objective of establishing consistent and 
comparable requirements. Accordingly, we request comments generally on 
(i) The impact of any differences between the Commission and CFTC 
approaches to business conduct regulation in this area, (ii) whether 
the Commission's proposed business conduct regulations should be 
modified to conform to the proposals made by the CFTC, and (iii) 
whether any business conduct requirements proposed by the CFTC, but not 
proposed by the Commission, should be adopted by the Commission.
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    \301\ See CFTC External Business Conduct Release, supra, note 
16.

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[[Page 42439]]

Request for Comments

    The Commission requests comments generally on all aspects of the 
proposed rules as they relate to CFTC rules and regulations. In 
addition, we request comments on the following specific issues:
     Do the regulatory approaches under the Commission's 
proposed rulemaking pursuant to Section 764 of the Dodd-Frank Act and 
the CFTC's proposed rulemaking pursuant to Section 731 of the Dodd-
Frank Act result in duplicative or inconsistent obligations for market 
participants that are subject to both regulatory regimes, or result in 
gaps or different levels of regulation between those regimes? If so, in 
what ways should such duplication, inconsistencies or gaps be 
addressed?
     Are the approaches proposed by the Commission and the CFTC 
to regulate business conduct comparable? If not, why?
     Are there approaches that would make the regulation more 
comparable? If so, what?
     Would be appropriate for us to adopt any particular 
requirements proposed by the CFTC that differ from our proposal? If so, 
which ones?
     Should the Commission require SBS Entities to perform 
periodic portfolio reconciliations in which they exchange terms and 
valuations of each security-based swap with their counterparty and also 
resolve any discrepancies within a specified period of time? \302\ If 
so, how frequently should portfolio reconciliations be performed and 
within what time period should all discrepancies be resolved? Should 
any specific policies and procedures be proposed regarding the method 
of performing a portfolio reconciliation? Should the Commission require 
any specific policies and procedures regarding the method of valuing 
security-based swaps for purposes of performing a portfolio 
reconciliation? Please explain the current market practice among 
dealers for performing portfolio reconciliations.
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    \302\ The CFTC has proposed to require periodic portfolio 
reconciliations. See Confirmation, Portfolio Reconciliation and 
Portfolio Compression Requirements for Swap Dealers and Major Swap 
Participants, 75 FR 81519 (Dec. 28, 2010).
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     Should the Commission require SBS Entities to periodically 
perform portfolio compressions in which the SBS Entity wholly or 
partially terminates some or all of its security-based swaps 
outstanding with a counterparty and replaces those security-based swaps 
with a smaller number of security-based swaps whose combined notional 
value is less than the combined notional value of the original 
security-based swaps included in the exercise? \303\ If not, why not? 
Should the Commission require SBS Entities to periodically perform 
portfolio compressions among multiple counterparties? If not, why not? 
Please explain the current market practice among dealers for performing 
portfolio compressions.
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    \303\ The CFTC has proposed to require periodic portfolio 
compressions. Id.

We request commenters to provide data, to the extent possible, 
supporting any such suggested approaches.

IV. Paperwork Reduction Act

    Certain provisions of the proposed rules would impose new 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995 (``PRA'').\304\ The Commission is 
submitting the proposed collections of information to the Office of 
Management and Budget (``OMB'') for review in accordance with 44 U.S.C. 
3507(d) and 5 CFR 1320.11. The titles for these collections are 
``Business Conduct Standards for Security-Based Swap Dealers and Major 
Security-Based Swap Participants'' and ``Designation of Chief 
Compliance Officer of Security-Based Swap Dealers and Major Security-
Based Swap Participants.'' An agency may not conduct or sponsor, and a 
person is not required to respond to, a collection of information 
unless it displays a currently valid OMB control number. OMB has not 
yet assigned a control number to the proposed collections of 
information.
---------------------------------------------------------------------------

    \304\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collections of Information

1. Verification of Status
    Proposed Rule 15Fh-3(a) would require an SBS Entity to verify that 
a counterparty, whose identity is known to the security-based swap 
dealer or a major security-based swap participant prior to the 
execution of the transaction, meets the eligibility standards for an 
ECP and whether the counterparty is a special entity. We expect that in 
order to verify the status of the counterparty, an SBS Entity would 
likely obtain written representations from the counterparty, conduct 
due diligence as part of its ``diligence checklist'' or as required by 
its internal policies and procedures, or some combination thereof, 
based upon prior dealings, if any, with the counterparty.
2. Disclosures by SBS Entities
    Proposed Rule 15Fh-3(b) would require an SBS Entity to disclose to 
any counterparty (other than an SBS Entity, swap dealer, or major swap 
participant) information reasonably designed to allow the counterparty 
to assess: (1) The material risks and characteristics of a security-
based swap; and (2) any material incentives or conflicts of interest 
that the SBS Entity may have in connection with the security-based 
swap. The proposed rule would also require that to the extent that 
these disclosures are not provided in writing prior to the execution of 
the transaction, the SBS Entity would be required to provide the 
counterparty with a written version of the disclosure no later than the 
time of delivery of the trade acknowledgement for the transaction.\305\ 
Proposed Rule 15Fh-3(c) would require an SBS Entity to disclose to any 
counterparty (other than an SBS Entity, swap dealer, or major swap 
participant) the daily mark of the security-based swap. Proposed Rule 
15Fh-3(d) would require an SBS Entity, before entering into a security-
based swap with a counterparty other than an SBS Entity, swap dealer or 
major swap participant, to determine whether the security-based swap is 
subject to the mandatory clearing requirements of Section 3C(a) of the 
Exchange Act and disclose the determination to the counterparty, as 
well as clearing alternatives available to the counterparty. To the 
extent that the disclosures required by proposed Rule 15Fh-3(d) are not 
provided in writing prior to the execution of the transaction, the SBS 
Entity would be required to provide the counterparty with a written 
record of the disclosure no later than the delivery of the trade 
acknowledgement for the transaction.
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    \305\ The Commission is separately required to propose a rule 
regarding reporting and recordkeeping requirements for SBS Entities. 
See Exchange Act Section 15F(f)(2), Public Law 111-203, 124 Stat. 
1376, 1788 (to be codified at 15 U.S.C. 78o-10(f)(2)) (``The 
Commission shall adopt rules governing reporting and recordkeeping 
for security-based swap dealers and major security-based swap 
participants'').
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3. Know Your Counterparty and Recommendations
    Proposed Rule 15Fh-3(e) would require an SBS Dealer to establish, 
maintain and enforce policies and procedures reasonably designed to 
obtain and retain a record of the essential facts concerning each 
counterparty whose identity is known to the SBS Dealer prior to the 
execution of the transaction. The essential facts would be: (1) Facts 
required to comply with applicable laws, regulations and rules; (2) 
facts required to implement the SBS Dealer's credit and operational 
risk management policies in connection

[[Page 42440]]

with transactions entered into with such counterparty; (3) information 
regarding the authority of any person acting for such counterparty; and 
(4) if the counterparty is a special entity, such background 
information regarding the independent representative as the SBS Dealer 
reasonably deems appropriate.
    Proposed Rule 15Fh-3(f)(1) would require an SBS Dealer to have a 
reasonable basis to believe: (i) Based on reasonable diligence, that 
the recommended security-based swap or trading strategy involving a 
security-based swap is suitable for at least some counterparties; and 
(ii) that a recommended security-based swap or trading strategy 
involving a security-based swap is suitable for the counterparty. To 
establish a reasonable basis for a recommendation, an SBS Dealer would 
need to have or obtain relevant information regarding the counterparty, 
including the counterparty's investment profile, trading objectives, 
and its ability to absorb potential losses associated with the 
recommended security-based swap or trading strategy. Under proposed 
Rule 15Fh-3(f)(2), an SBS Dealer would fulfill its suitability 
obligation in proposed Rule 15Fh-3(f)(1) with respect to a particular 
counterparty if: (1) The SBS Dealer reasonably determines that the 
counterparty (or its agent) is capable of independently evaluating the 
investment risks related to the security-based swap or trading 
strategy; (2) the counterparty (or its agent) affirmatively represents 
that it is exercising its independent judgment in evaluating the 
recommendation; and (3) the SBS Dealer discloses to the counterparty 
that it is acting in its capacity as a counterparty and is not 
undertaking to assess the suitability of the security-based swap or 
trading strategy. The representations to document this ``institutional 
suitability'' must be in writing. The requirements of proposed Rule 
15Fh-3(f) would not apply if the counterparty is an SBS Entity, swap 
dealer or major swap participant.\306\ An SBS Dealer that is 
recommending a security-based swap or trading strategy involving a 
security-based swap to a special entity would be deemed to have 
satisfied its obligations pursuant to proposed Rule 15Fh-3(f) with 
respect to the special entity if: (1) The SBS Dealer is acting as an 
advisor to the special entity and complies with the requirements of 
proposed Rule 15Fh-4(b); or (2) the SBS Dealer is deemed not to be 
acting as an advisor to the special entity pursuant to proposed Rule 
15Fh-2(a).\307\
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    \306\ Proposed Rule 15Fh-3(f)(1).
    \307\ Proposed Rule 15Fh-3(f)(3).
---------------------------------------------------------------------------

4. Fair and Balanced Communications
    Proposed Rule 15Fh-3(g) would require that an SBS Entity 
communicate with its counterparties in a fair and balanced manner based 
on principles of fair dealing and good faith. The proposed rule would 
require, among other things, that any statement of potential 
opportunities or advantages be balanced by a statement of the 
corresponding risks with the same degree of specificity.
5. Supervision
    Proposed Rule 15Fh-3(h) would require an SBS Entity to establish, 
maintain and enforce a system to supervise, and to diligently 
supervise, its business and its associated persons with a view to 
preventing violations of the applicable federal securities laws and the 
rules and regulations thereunder relating to its business as an SBS 
Entity. The proposed rule would require the SBS Entity to designate a 
qualified person with supervisory responsibility for each type of 
business for which registration as an SBS Entity would be required. The 
SBS Entity would be required to: Designate at least one supervisor; use 
reasonable efforts to determine all supervisors are qualified; 
establish, maintain and enforce written policies and procedures that 
are reasonably designed to achieve compliance with applicable 
securities laws, rules and regulations; and establish and maintain 
written policies and procedures to comply with the duties set forth in 
Section 15F(j) of the Exchange Act. Such written policies and 
procedures would be required to include, at a minimum, procedures for: 
Review of security-based swap transactions; review of internal and 
external written communications; periodic review of the business; 
reasonable investigation of the background of associated persons; 
monitoring employee personal accounts away from the firm; a description 
of the supervisory system, including identification of the supervisory 
personnel and their scope of supervisory responsibility; preventing a 
supervisor from supervising his or her own activities or supervising an 
employee who determines the supervisor's compensation or continued 
employment; and preventing the standard of supervision from being 
reduced due to conflicts of interest with the person being supervised. 
These supervisory requirements are similar to existing supervision 
requirements for registered broker-dealers.
6. SBS Dealers Acting as Advisors to Special Entities
    Proposed Rule 15Fh-4(b) would require an SBS Dealer acting as an 
advisor to make reasonable efforts to obtain such information as it 
considers necessary to make a reasonable determination that a security-
based swap or trading strategy involving a security-based swap is in 
the best interests of the special entity. The information that would be 
required to be collected to make this determination includes, but is 
not limited to: The authority of the special entity to enter into the 
transaction; the financial status and future funding needs of the 
special entity; the tax status of the special entity; the investment or 
financing objectives of the special entity; the experience of the 
special entity with respect to security-based swap transactions 
generally and of the type and complexity being recommended; whether the 
special entity has the financial capability to withstand changes in 
market conditions during the term of the security-based swap; and other 
relevant information. In order for an SBS Dealer to establish that it 
is not acting as an advisor under proposed Rule 15Fh-2(a): (1) The 
special entity must represent in writing that the special entity will 
not rely on advice provided by the SBS Dealer and the special entity 
will rely on the advice of a qualified independent representative; (2) 
the SBS Dealer must have a reasonable basis to believe that the special 
entity has a qualified independent representative; and (3) the SBS 
Dealer must disclose to the special entity that the SBS Dealer would 
not be undertaking to act in the best interest of the special entity, 
as otherwise required by Section 15F(h)(4) of the Exchange Act. This 
proposed Rule 15Fh-4(b) would not apply if the transaction is executed 
on a SEF or an exchange and the SBS Dealer does not know the identity 
of the counterparty at the time of the transaction.
7. SBS Entities Acting as Counterparties to Special Entities
    Proposed Rule 15Fh-5 would require an SBS Entity to have a 
reasonable basis to believe that the special entity has an independent 
representative that is independent of the SBS Entity and that meets 
certain specified qualifications, including that the independent 
representative: Has sufficient knowledge to evaluate the transaction 
and related risks; is not subject to a statutory disqualification; 
undertakes a duty to act in the best interests of the special entity; 
makes appropriate and timely

[[Page 42441]]

disclosures to the special entity of material information concerning 
the security-based swap; will provide written representations to the 
special entity regarding fair pricing and appropriateness of the 
security-based swap; in the case of employee benefit plans subject to 
ERISA, is a fiduciary as defined in Section 3(21) of ERISA; and in the 
case of a State, State agency, city, county, municipality, other 
political subdivision of a State, or governmental plan, is subject to 
restrictions on certain political contributions. An SBS Entity could 
reasonably rely on written representations to form a reasonable basis 
to believe an independent representative meets certain of these 
qualifications. An SBS Entity would need to engage in reasonable due 
diligence for any qualification for which it could not reasonably rely 
on representations. In addition, with respect to the independence of 
the independent representative, the SBS Entity would need to undertake 
some additional inquiry, such as review of the SBS Entity's own books 
and records.
    Proposed Rule 15Fh-5(b) would require that, before the initiation 
of a security-based swap, an SBS Dealer disclose in writing the 
capacity in which the SBS Dealer is acting. If the SBS Dealer is acting 
in more than one capacity with respect to the counterparty or has acted 
in more than one capacity with respect to the counterparty in the last 
twelve months, it must also disclose the material differences among 
such capacities. Proposed Rule 15Fh-5 would not apply if the 
transaction is executed on a SEF or an exchange and the SBS Entity does 
not know the identity of the counterparty at any time up to and 
including execution of the transaction.\308\
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    \308\ Proposed Rule 15Fh-5(c).
---------------------------------------------------------------------------

8. Political Contributions
    Proposed Rule 15Fh-6 would prohibit an SBS Dealer from offering to 
enter into, or entering into security-based swaps with a municipal 
entity within two years after any contribution by the SBS Dealer or its 
covered associates to an official of such municipal entity, subject to 
certain exceptions. In order to determine compliance with the rule, the 
SBS Dealer would need to maintain certain records of contributions by 
the SBS Dealer and any of its covered associates.\309\ The SBS Dealer 
would also need to collect information regarding contributions by its 
covered associates made within the six months prior to becoming covered 
associates.
---------------------------------------------------------------------------

    \309\ See notes 169 and 305, supra, regarding reporting and 
recordkeeping requirements generally for SBS Entities.
---------------------------------------------------------------------------

9. Chief Compliance Officer
    Proposed Rule 15Fk-1 would require an SBS Entity to designate an 
individual to serve as CCO. Under proposed Rule 15Fk-1, the CCO would 
be responsible for, among other things: Reviewing the compliance by the 
SBS Entity with the security-based swap requirements described in 
Section 15F of the Exchange Act; promptly resolving any conflicts of 
interest, in consultation with the board or the senior officer; 
administering policies and procedures required under Section 15F of the 
Exchange Act; establishing, maintaining and reviewing policies and 
procedures reasonably designed to ensure compliance with the Exchange 
Act and the rules and regulations thereunder relating to its business 
as an SBS Entity; establishing, maintaining and reviewing policies and 
procedures reasonably designed to remediate promptly non-compliance 
issues identified by the CCO; and establishing and following procedures 
reasonably designed for the prompt handling, management response, 
remediation, retesting, and resolution of non-compliance issues. The 
CCO would also be required under proposed Rule 15Fk-1 to submit annual 
compliance reports accompanying each appropriate financial report of 
the SBS Entity that is required to be furnished to or filed with the 
Commission and the board of directors and audit committee (or 
equivalent bodies) of the SBS Entity. These annual compliance reports 
are required to include a description of: (1) The compliance by the SBS 
Entity with the Exchange Act and rules and regulations thereunder 
relating to its business as an SBS Entity; (2) each policy and 
procedure of the SBS Entity described above; (3) the SBS Entity's 
enforcement of the policies and procedures relating to its business as 
an SBS Entity; (4) any material changes to the policies and procedures 
since the date of the prior report; (5) any recommendations for 
material changes to the policies and procedures as a result of the 
annual review, the rationale for the recommendations, and whether such 
recommendations would be incorporated; and (6) any material compliance 
matters. The compliance report must also include a written 
representation that the senior officer has conducted one or more 
meetings with the CCO in the preceding 12 months, and a certification 
that the compliance report is accurate and complete.

B. Proposed Use of Information

1. Verification of Status
    Proposed Rule 15Fh-3(a) would require an SBS Entity to determine 
whether its counterparty is an ECP before the execution of a security-
based swap other than on a registered national securities exchange or 
SEF. An SBS Entity would use this information to comply with Section 
6(l) of the Exchange Act (15 U.S.C. 78(f)(l)), which prohibits a person 
from entering into a security-based swap with a counterparty that is 
not an ECP other than on a national securities exchange. We are not 
proposing to specify the means by which SBS Entities satisfy this 
requirement. The proposed rule also would require the SBS Entity to 
determine whether a counterparty is a special entity. An SBS Entity 
would use this information, in turn, to determine the need to comply 
with the requirements applicable to dealings with special entities 
under proposed Rules 15Fh-4(b) and 15Fh-5. In addition to assisting the 
CCO in determining compliance with the statute and proposed rules, this 
collection of information would be used by the Commission staff in its 
examination and oversight program.
2. Disclosures by SBS Entities
    The disclosures required to be provided by SBS Entities to a 
counterparty (other than an SBS Entity or a swap dealer or major swap 
participant) would help the counterparty understand the material risks 
and characteristics of a particular security-based swap, as well as the 
material incentives or conflicts of interest that the SBS Entity may 
have in connection with the security-based swap. As a result, these 
disclosures would assist the counterparty in assessing the transaction. 
The disclosures would provide counterparties with a better 
understanding of the expected performance of the security-based swap 
under various market conditions. They would also give counterparties 
additional transparency and insight into the pricing and collateral 
requirements of security-based swaps. Proposed Rule 15Fh-3(d) would 
require SBS Entities to notify counterparties of the clearing 
alternatives available to them. In addition to assisting the SBS Entity 
with its internal supervision and the CCO to determine compliance with 
the statute and proposed rules, this collection of information would be 
used by the Commission staff in its examination and oversight program.

[[Page 42442]]

3. Know Your Counterparty and Recommendations
    These collections of information would help an SBS Dealer to comply 
with applicable laws, regulations and rules. They would also assist an 
SBS Dealer in effectively dealing with the counterparty, including by 
making recommendations that are appropriate for the counterparty, and 
by collecting information from the counterparty necessary for the SBS 
Dealer's credit and risk management purposes. These collections of 
information would also assist an SBS Dealer in determining whether it 
would be reasonable to rely on various representations from a 
counterparty and evaluating the risks of trading with that 
counterparty. The information would also assist the CCO in determining 
that the SBS Entity had policies and procedures reasonably designed to 
obtain and retain essential facts concerning each known counterparty 
and to make suitable recommendations to its counterparties. The 
Commission staff would also use these collections of information in its 
examination and oversight program.
4. Fair and Balanced Communications
    This collection of information concerning the risks of a security-
based swap would assist an SBS Entity in communicating with 
counterparties in a fair and balanced manner. It would also assist an 
SBS Dealer in making suitable recommendations to counterparties, and 
assist the CCO in ensuring that the SBS Entity is communicating with 
counterparties in a fair and balanced manner based on principles of 
fair dealing and good faith. The receipt of information in a fair and 
balanced manner would assist the counterparty in making more informed 
investment decisions. The Commission staff would also use this 
collection of information in its examination and oversight program.
5. Supervision
    The collection of information in connection with the establishment, 
maintenance and enforcement of a supervisory system would assist an SBS 
Entity in achieving compliance with all applicable securities laws, 
rules and regulations. The CCO may use these collections of information 
in discharging his or her duties under proposed Rule 15Fk-1 and 
determining whether remediation efforts are required. The collection of 
information would also be useful to supervisors in understanding and 
carrying out their supervisory responsibilities. The Commission staff 
would also use this collection of information in its examination and 
oversight program.
6. SBS Dealers Acting as Advisors to Special Entities
    Certain information that would be collected under proposed Rule 
15Fh-4(b) would assist an SBS Dealer that is acting as an advisor to a 
special entity to act in the best interests of the special entity. 
Other information collected under proposed Rule 15Fh-2(a) could assist 
an SBS Dealer seeking to establish that it is not acting as an advisor 
to a special entity. The collections of information would assist a CCO 
in determining compliance with the provisions of the Exchange Act by 
the SBS Dealer. The Commission staff would also use this collection of 
information in its examination and oversight program.
7. SBS Entities Acting as Counterparties to Special Entities
    The information that would be collected under Proposed Rule 15Fh-
5(a) would assist an SBS Entity in forming a reasonable basis that the 
special entity has an independent representative that meets the 
requirements of the rule. Disclosures under proposed Rule 15Fh-5(b) 
regarding the capacity in which an SBS Dealer is operating would reduce 
confusion by a special entity as to whether an SBS Dealer would be 
acting in the interests of the special entity or as a counterparty or 
principal on the other side of a transaction to the special entity with 
potentially adverse interests. These collections of information would 
also assist the CCO in determining compliance with the provisions of 
the Exchange Act by the SBS Entity. The Commission staff would also use 
this collection of information in its examination and oversight 
program.
8. Political Contributions
    Proposed Rule 15Fh-6 is intended to deter SBS Dealers from 
participating, even indirectly, in pay to play practices. The 
information that would be collected under this proposed rule would 
assist the SBS Dealer and the Commission in verifying this deterrence. 
The proposed rule would also assist the chief compliance officer in 
determining compliance with the provisions of the Exchange Act by an 
SBS Dealer. The Commission staff would use this collection of 
information in its examination and oversight program.
9. Chief Compliance Officer
    The information that would be collected under proposed Rule 15Fk-1 
would assist the CCO in overseeing and administering compliance by the 
SBS Entity with the provisions of the Exchange Act and the rules and 
regulations thereunder relating to its business as an SBS Entity. The 
Commission staff would also use this collection of information in its 
examination and oversight program.

C. Respondents

    The Commission preliminarily believes, based on data obtained from 
DTCC and conversations with market participants, that approximately 50 
entities may fit within the definition of security-based swap 
dealer,\310\ and as many as 10 entities may need to determine whether 
they come within the definition of major security-based swap 
participant.\311\ The Commission does not expect that more than five 
entities will be major security-based swap participants. Accordingly, 
we are using this estimate for the purposes of calculating the 
reporting burdens. Further, because prior to the Dodd-Frank Act, market 
participants have not had to distinguish between swaps and security-
based swaps for regulatory purposes, the Commission preliminarily 
believes that the majority of firms that may register as SBS Entities 
(approximately 35) also will be engaged in the swaps business, and will 
register with the CFTC as swap dealers or major swap participants. As a 
result, these entities would also be subject to the business conduct 
standards applicable to swap dealers and major swap participants. In 
addition, a broker-dealer may seek to register as an SBS Dealer so that 
it can enter into security-based swaps as a principal with customers 
who, among other things, may be holding securities positions and may 
wish to hedge those positions with security-based swaps. The Commission 
estimates that approximately 16 registered broker-dealers will also 
register as SBS Dealers.\312\ Finally, the costs of registration and 
associated regulation may cause an entity that is not otherwise 
registered with the CFTC or the Commission to structure its business so 
as to not have to register as an SBS Entity. Consequently, the 
Commission estimates that fewer than eight firms not otherwise 
registered with the CFTC or the Commission will register as SBS 
Entities.
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    \310\ Depending on capital and other requirements for SBS 
Dealers and how businesses choose to respond to such requirements, 
the actual number of SBS Dealers may be significantly fewer. See 
also Definitions Release.
    \311\ See Definitions Release.
    \312\ Id.
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    The Commission preliminarily believes, based on information 
currently

[[Page 42443]]

available to it, that there are and would continue to be approximately 
8,500 market participants, of which approximately 1,200 are special 
entities.\313\ Based upon the number of municipal advisors that have 
registered with the Commission, we estimate there will be approximately 
325 third-party independent representatives for special entities.\314\ 
The Commission also estimates that approximately 95% of special 
entities would use a third-party independent representative in their 
security-based swap transactions.\315\ As a result, for the purposes of 
calculating reporting burdens, the Commission estimates that the 
remaining 5% of special entities, or 60 special entities, have 
employees who currently negotiate on behalf of, and advise, the special 
entity regarding security-based swap transactions and could likely 
fulfill the obligations of the independent representative.\316\ 
Consequently, the Commission estimates a total of 385 potential 
independent representatives.\317\ The Commission seeks comment on its 
estimates as to the number of participants in the security-based swap 
market that would be required to comply with the business conduct 
standards pursuant to proposed Rules 15Fh-1 through 15Fh-6 and proposed 
Rule 15Fk-1.
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    \313\ The estimate is based on available market data for 
November 2006-September 2010 provided by DTCC. Commission staff has 
identified approximately 8,567 market participants and approximately 
1,200 special entities during this time period, but we are using 
8,500 market participants and 1,200 special entities as estimates 
for these purposes to allow for market participants and special 
entities that trade less frequently, no longer trade or trade under 
multiple designations. For the purposes of these estimates, we have 
included foreign pension plans and 501(c)(3) organizations generally 
within the category of special entity. 
    \314\ As of April 15, 2011, approximately 307 entities that are 
registered as municipal advisors with the Commission indicated that 
they expected to provide advice with respect to swaps. We expect 
that many of these municipal advisors will also act as independent 
representatives for other special entities. We also expect that some 
number of these municipal swap advisors will limit their services to 
swaps and not security-based swaps. The Commission therefore 
estimates that approximately 325 municipal swap advisors will act as 
independent representatives to special entities with respect to 
security-based swaps, we solicit comments as to the accuracy of this 
information.
    \315\ The estimate is based on available market data for 
November 2006-September 2010 provided by DTCC that indicates 
approximately 95% of special entities used third-party investment 
advisers in connection with security-based swap transactions.
    \316\ Id.
    \317\ The estimate is based on the following calculation: 325 
third-party independent representatives + 60 in-house independent 
representatives
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D. Total Annual Reporting and Recordkeeping Burdens

    Proposed Rules15Fh-1 to 15Fh-6 are intended to be very similar, to 
the extent practical, to the business conduct standards that would 
apply to swap dealers or major swap participants pursuant to the CFTC's 
proposed business conduct rules.\318\ As a result, to the extent the 
SBS Entity complies with the CFTC's business conduct standards, the 
Commission expects there would be relatively little additional burden 
to comply with the requirements under the Commission's proposed 
business conduct standards.\319\ A number of these standards are based 
on existing FINRA rules and, accordingly, the Commission expects that 
the estimated 16 SBS Entities that are also registered as broker-
dealers are already complying with a number of these requirements. We 
expect that some SBS Dealers will be banks.\320\ Banking agencies, such 
as the Office of the Comptroller of the Currency, have issued guidance 
to national banks that engage in financial derivatives transactions 
regarding business conduct procedures, and, accordingly, we expect that 
the banks that may register as SBS Entities are also already complying 
with these requirements.\321\ In addition, to the extent that the 
requirements in proposed Rules 15Fh-3 and 15Fh-5 reflect industry best 
practices, a respondent that is already following industry best 
practices would already be collecting much, if not all, of this 
information, and would have systems in place to collect such 
information. We recognize that entities may need to modify existing 
practices and systems to comply with the specific requirements of the 
proposed rules. Further, while the Commission does not have information 
as to the number of SBS Entities that have already implemented these 
best practices, we understand that most of the large SBS Dealers have 
implemented many of the recommended best practices, and we have 
considered this information in developing its estimates. In addition, 
the Commission notes that regulation of the security-based swap 
markets, including by means of these proposed rules, could impact 
market participant behavior.
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    \318\ See CFTC External Business Conduct Release, supra, note 
16.
    \319\ However, because the CFTC has not yet adopted final rules, 
we are using estimates that assume the CFTC rules are not in place 
and that the registrants have incurred a de novo burden to comply 
with the Commission rules.
    \320\ The estimate is based on available market data for 
November 2006-September 2010, the Commission estimates that 
approximately 240 banks executed security-based swaps during this 
time. The Commission anticipates that some, but not all of these 
banks will likely register as SBS Dealers.
    \321\ See Risk Management of Financial Derivatives, Office of 
Comptroller of the Currency Banking Circular No. 277 (Oct. 27, 
1993).
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1. Verification of Status
    As discussed above, for the purposes of these requirements, the 
Commission estimates that approximately 55 SBS Entities would be 
required to verify whether a counterparty is an ECP or special entity, 
as required by proposed Rule 15Fh-3(a). This requirement is the same 
for the business conduct standards proposed by the CFTC.\322\ The 
Commission also believes that many SBS Entities would not incur 
significant additional expense, because they already collect this 
information as part of their ``due diligence checklists.'' Some 
respondents may simply update their existing due diligence checklists. 
The Commission expects that to the extent an SBS Entity does not have 
an existing mechanism in place to determine the eligibility of the 
counterparty and whether it is a special entity, the SBS Entity may 
engage outside counsel to prepare for collecting this information. The 
Commission conservatively estimates that SBS Entities would need to 
engage outside counsel to review existing process and develop initial 
processes, if necessary, at a cost of $400 per hour for an average of 
15 hours per respondent, resulting in a total outside initial cost 
burden of $6,000 for each of these SBS Entities.\323\ The Commission 
preliminarily believes, based on information currently available to it, 
that there are and would continue to be a total of approximately 8,500 
market participants.\324\ The Commission estimates that the SBS 
Entities would take initially 1 hour per transaction to collect the 
information for an initial aggregate burden of approximately 47,000 
hours or an average of approximately 855 hours per SBS Entity.\325\
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    \322\ See CFTC External Business Conduct Release, 75 FR at 
80658. Accordingly, the SBS Entities that would also be registered 
as a swap dealer or major swap participant with the CFTC would have 
verification procedures for engaging in swaps.
    \323\ The estimate is based on the Commission's experiences in 
similar matters such as a registrant's determination regarding 
whether an investor is an accredited investor for the purposes of 
Regulation D. The same estimate for the hourly cost for legal 
services was used by the Commission in the proposed consolidated 
audit trail rule. Consolidated Audit Trail, Exchange Act Release No. 
62174, 75 FR 32556 (June 8, 2010).
    \324\ See note 313, supra, regarding the estimate for the number 
of market participants.
    \325\ The estimate is based on the number of unique SBS Dealer 
to non-SBS Dealer trading relationships identified in the market 
data for November 2006-September 2010 provided by DTCC. This 
estimate includes each SBS Dealer affiliate with the same non-SBS 
Dealer entity as a separate trading relationship. As a result, this 
number may overestimate the actual number of trading relationships 
with non-SBS Dealers.

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[[Page 42444]]

2. Disclosures by SBS Entities
    The estimates in this paragraph reflect the Commission's experience 
with burden estimates for similar disclosure requirements and as a 
result of our discussions with market participants.\326\ Pursuant to 
proposed Rule 15Fh-3(b), (c), and (d), SBS Entities would be required 
to provide certain disclosures to market participants. It is our 
understanding that most of the large SBS Dealers already provide their 
counterparties disclosures similar to those that would be required 
under proposed Rules 15Fh-3(b) and (c). Given that the material 
characteristics are generally included in the documentation of a 
security-based swap, such as the master agreement, credit support 
annex, trade confirmation or other documents, the Commission does not 
anticipate that any additional burden will be required for the 
disclosure of material characteristics.\327\ For other required 
disclosures relating to material risks, incentives or conflicts of 
interest, the Commission anticipates that many SBS Entities would 
revise existing disclosures and tailor them to this context. For 
example, many SBS Dealers provide a statement of potential risks 
related to investing in certain security-based swaps in documents 
describing such instruments.
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    \326\ See Disclosure of Accounting Policies for Derivative 
Financial Instruments and Derivative Commodity Instruments and 
Disclosure of Quantitative and Qualitative Information about Market 
Risk Inherent in Derivative Financial Instruments, Other Financial 
Instruments and Derivative Commodity Instruments, Securities Act 
Release No. 7386 (Jan. 31, 1997), 62 FR 6044 (Feb. 10, 1997).
    \327\ To the extent that disclosure of material characteristics 
is initially provided orally, the additional burden of providing a 
written version of the disclosure at or before delivery of the trade 
confirmation will be considered in connection with the overall 
reporting and recordkeeping burdens of the SBS Entity. See notes 160 
and 305, supra.
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    In some cases, such as disclosures about the daily mark for a 
cleared security-based swap, the proposed rules contemplate receiving 
the core valuation information from an external source with only 
limited administrative handling expected to be necessary to pass the 
disclosure to counterparties. For uncleared, security-based swaps, the 
Commission preliminarily believes that the SBS Entities may need to 
slightly modify the models used for calculating variation margin to 
calculate the daily mark required by proposed Rule 15Fh-3(c) for 
uncleared security-based swaps. The Commission does not currently have 
an expectation of the proportion of security-based swaps that will be 
cleared as a result of the Dodd-Frank Act and the rules promulgated 
thereunder.\328\ Existing accounting standards and other disclosure 
requirements under the Exchange Act, such as FASB Accounting Standards 
Codification Topic 820, Fair Value Measurements and Disclosures, or 
Item 305 of Regulation S-K, already require the description of the 
methodology and assumptions with respect to models used in the 
derivatives context.
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    \328\ The Commission has obtained data from DTCC on new and 
assigned CDS trades in U.S. dollars during the month of November 
2010 for ICE Trust. Cleared CDS trades were 5.24% by notional amount 
of all new or assigned single name trades, and 20.69% by notional 
amount of all new or assigned index trades.
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    The Commission preliminarily believes that SBS Entities will use 
internal staff to revise existing disclosures to comply with proposed 
Rules 15Fh-3(b) and (c) and assist in preparing language to comply with 
proposed Rule 15Fh-3(d) regarding the clearing options available for 
the particular security-based swap. The Commission also anticipates 
that disclosures of material risks for similar types and classes of 
security-based swaps would be similar and subsequent transactions will 
require much less time to review and revise applicable disclosures.
    Because the Commission is unaware of any definitive data regarding 
how many SBS Entities currently provide these disclosures, the 
Commission has conservatively estimated that all SBS Entities would 
require additional time to provide at least some of these disclosures. 
The Commission estimates that there has been an average of 
approximately 400,000 new security-based swap contracts traded annually 
between an SBS Dealer and a counterparty that is not an SBS Dealer, and 
these security-based swaps would likely require these disclosures.\329\ 
In view of the factors discussed in the Cost-Benefit Analysis section 
and elsewhere in this release, the Commission recognizes that the time 
required to develop an infrastructure to provide these disclosures 
would vary significantly depending on, among other factors, the 
complexity and nature of the SBS Entity's security-based swap business, 
its market risk management activities, its existing disclosure 
practices, and other applicable regulatory requirements. Under the 
proposed rule, SBS Entities could use, where appropriate, standardized 
formats to make certain required disclosures of material information to 
their counterparties, and to include such disclosures in a master or 
other written agreement between the parties, if agreed by the parties. 
The Commission recognizes that some disclosures particularized to the 
transaction would likely be necessary to adequately meet all of an SBS 
Entity's disclosure obligations. The Commission also expects that 
because the reporting burden generally would require refining or 
revising existing disclosure processes, that the disclosures would be 
prepared internally.
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    \329\ Available market data for November 2006-September 2010 
provided by DTCC indicated approximately 4,000,000 transactions 
between SBS Entities and non-SBS Entities during that time period. 
Of these, approximately 40% (or 1,600,000) are new trades; the 
remaining are assignments and terminations, which may not require 
the same level of disclosure. To obtain an approximate average 
annual number of transactions, we divided 1,600,000 transactions by 
47 (months) and multiplied by 12 and rounded to 400,000.
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    As a result, the Commission estimates that SBS Entities would 
initially require three persons from trading and structuring, three 
persons from legal, two persons from operations, and four persons from 
compliance, for 100 hours each. This team would analyze the changes 
necessary to comply with the new disclosure requirements, including the 
redesign of current compliance systems if necessary, and the creation 
of functional requirements and system specifications for any systems 
development work that may be needed to automate the disclosure 
process.\330\ This would amount to an initial cost burden of 66,000 
hours.\331\ Following the initial analysis and specifications 
development effort, the Commission estimates that half of these persons 
would be required to spend 20 hours annually to re-evaluate and modify 
the disclosures and system requirements as necessary, amounting to an 
ongoing annual burden of 6,600 hours.\332\ The Commission also 
estimates that to create and maintain an information technology 
infrastructure to the specifications identified by the team above, each 
SBS Entity would require, on average, eight full-time persons for six 
months of systems development, programming and testing, amounting to a 
total initial

[[Page 42445]]

burden of 440,000 hours.\333\ The Commission further estimates that 
maintenance of the system will require two full-time persons for a 
total of ongoing burden of 220,000 hours annually.\334\
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    \330\ Some SBS Entities may choose to utilize in-house counsel 
to review, revise and prepare these disclosures. The Commission does 
not currently have an estimate as to the proportion of SBS Entities 
that would use outside counsel, but has considered the alternative 
in developing its estimates.
    \331\ The estimate is based on the following calculation: (55 
SBS Entities) x (12 persons) x (100 hours).
    \332\ The estimate is based on the following calculation: (55 
SBS Entities) x (6 persons) x (20 hours).
    \333\ The estimate is based on the following calculation: (55 
SBS Entities) x (4 persons) x (2,000 hours).
    \334\ The estimate is based on the following calculation: (55 
SBS Entities) x (2 persons) x (2,000 hours).
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3. Know Your Counterparty and Recommendations
    Proposed Rules 15Fh-3(e) and (f) are based on existing FINRA 
rules.\335\ However, the ``know your counterparty'' requirement in 
proposed Rule 15Fh-3(e) would also require an SBS Dealer to consider 
its credit and operational risk management policies in determining the 
information to collect from its counterparty. If the SBS Dealer is a 
counterparty to a special entity, proposed Rule 15Fh-3(e) would also 
require the SBS Dealer to obtain and retain a record of the relevant 
background of the independent representative.\336\ The Commission 
expects that given the institutional nature of the participants 
involved in security-based swaps, most SBS Dealers would obtain the 
representations in proposed Rule 15Fh-3(f)(2) or proposed Rule 15Fh-
3(f)(3)(ii) to comply with proposed Rule 15Fh-3(f).
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    \335\ See note 26, supra, regarding FINRA Rules 2090 and 2111 
(effective July 9, 2012).
    \336\ To the extent that an SBS Dealer is a registered broker or 
dealer, it should already have processes and procedures in place to 
comply with similar requirements with respect to other securities. 
See FINRA Rule 2090 (requiring broker-dealers to know and retain 
essential facts, ``concerning every customer and concerning the 
authority of each person acting on behalf of such customer'').
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    In addition, many SBS Dealers already collect this type of 
information in connection with their due diligence checklists. Banking 
agencies have also issued guidance to national banks regarding similar 
procedures.\337\ However, the Commission does not currently have an 
estimate of how many SBS Entities are expected to be subject to this 
banking guidance.\338\ The Commission also preliminarily believes that 
other SBS Dealers generally already create and maintain these records 
under prudent recordkeeping procedures. However, as is true in the 
broker-dealer context, because each SBS Dealer is likely to tailor its 
procedures to its particular corporate culture and existing policies 
and procedures, we expect that the practices of SBS Dealers in 
complying with the proposed rule would vary greatly. In addition, the 
SBS Dealer may collect the information required at various points in 
the relationship with its counterparty, including at the establishment 
of the account, periodic updates, or with the execution of each 
security-based swap. The Commission has considered all of the foregoing 
in preparing the estimate regarding reporting burdens.
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    \337\ See Risk Management of Financial Derivatives, Office of 
Comptroller of the Currency Banking Circular No. 277 (Oct. 27, 
1993).
    \338\ See note 320, supra, regarding banks engaged in security-
based swaps.
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    The estimates in this paragraph reflect the Commission's experience 
with and burden estimates for similar collections of information, as 
well as our discussions with market participants.\339\ The Commission 
preliminarily believes that most SBS Dealers currently have policies 
and procedures in place for knowing their counterparties, either 
through due diligence checklists or for compliance with FINRA 
standards. The Commission estimates that, on average, these records 
would require each SBS Dealer to spend approximately three to five 
hours initially to review existing policies and procedures and document 
the collection of information necessary to comply with its ``know your 
counterparty'' obligations for a total initial burden of 250 
hours.\340\ The Commission also estimates an SBS Dealer would spend an 
average of approximately 30 additional minutes each year per unique 
non-SBS Dealer counterparty to assess whether the SBS Dealer is in 
compliance with the requirements to make suitable recommendations, a 
total ongoing burden of approximately 23,500 hours annually,\341\ or an 
average of 470 hours annually per SBS Dealer.\342\ The Commission also 
believes that many SBS Dealers will not incur significant additional 
expense because they already collect this information as part of 
current practices.\343\
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    \339\ See Books and Records Requirements for Brokers and Dealers 
under the Securities Exchange Act of 1934, Exchange Act Release No. 
44992 (Oct. 26, 2001), 67 FR 58284 (Nov. 2, 2001).
    \340\ The Commission is conservatively using the high end of the 
range for the purposes of estimating these reporting burdens.
    \341\ The estimate is based on the following calculation: 
(47,000 transactions with non-SBS Dealer counterparties) x 30 
minutes/60 minutes. See note 325 regarding the number of 
transactions with non-SBS Dealer counterparties.
    \342\ To the extent that the SBS Dealer is unfamiliar with the 
counterparty, the Commission would expect a greater time burden and 
as an SBS Dealer becomes more familiar with the particular 
counterparty, the Commission would expect a lesser time burden. As a 
result, we use 30 minutes as an average estimate.
    \343\ See Sections IV.C and D.
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    The Commission expects that much of the information relating to the 
background and experience of the independent representative is already 
included in the marketing materials of the third-party independent 
representatives and as a result, would only require a minimal amount of 
time for the independent representative to provide to the special 
entity and/or SBS Dealer.
4. Fair and Balanced Communications
    Proposed Rule 15Fh-3(g)(3) would require that statements of 
potential opportunities must be balanced by an equally detailed 
statement of corresponding risks. In addition, we note that some risk 
disclosures would already be addressed in proposed Rule 15Fh-3(b) 
discussed above, which would require an SBS Entity to disclose the 
material risks of the transaction, the burden for which is discussed 
above. We expect this discussion of material risks of the transaction 
to be included in the documentation for the security-based swap. 
Furthermore, proposed Rule 15Fh-3(g) is based on existing FINRA rules 
so for the 16 registered broker-dealers that are expected to register 
as SBS Entities, they already would be subject to similar requirements 
with respect to other securities pursuant to NASD Rules 3010 and 3012. 
In addition, for the SBS Entity's own risk management purposes, 
currently for certain products, its existing marketing materials 
already include a general statement of risks that accompany a general 
description of the security-based swap. For the remaining 39 SBS 
Entities, the Commission assumes that SBS Entities would likely send 
their existing marketing materials to outside counsel for review and 
comment. As a result, the Commission estimates that each SBS Entity 
will likely incur $6,000 in legal costs, or $234,000 in the aggregate 
initial burden, to draft or review statements of potential 
opportunities and corresponding risks in the marketing materials for 
equity swaps, credit default swaps and total return swaps, which 
comprise the vast majority of security-based swaps.\344\ For more 
bespoke transactions, the cost of outside counsel to review the 
marketing materials will depend on the complexity, novelty and nature 
of the product, but the Commission would expect a much longer review 
for more novel products.
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    \344\ The Commission estimates the review of the marketing 
materials for each of these categories would require 5 hours of 
outside counsel time at a cost of $400 per hour. This estimate also 
assumes that each SBS Entity engages in all three categories of 
transactions.

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[[Page 42446]]

5. Supervision
    Proposed Rule 15Fh-3(h) is based on existing FINRA rules so to the 
extent that an SBS Entity is a registered broker-dealer, we expect that 
the SBS Entity would already be complying with similar requirements 
with respect to other securities pursuant to NASD Rules 3010 and 
3012.\345\ Broker-dealers presently maintain lists of principals or 
branch managers responsible for supervising each of their offices 
pursuant to NASD 3010 and 3012 and other applicable SRO rules, and that 
they also have lists of associated persons who operate out of each 
office location. These rules currently require a broker-dealer to have 
supervisory systems in place that include similar obligations to 
achieve compliance with applicable securities laws, regulations and 
rules.\346\ Banking agencies have also issued guidance to national 
banks regarding similar procedures.\347\
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    \345\ See Section II.C.6.
    \346\ See NASD Rule 3010.
    \347\ See Risk Management of Financial Derivatives, Office of 
Comptroller of the Currency Banking Circular No. 277 (Oct. 27, 
1993).
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    The estimates in this paragraph reflect the foregoing information 
and the Commission's experience with and burden estimates for similar 
collections of information. While each of the policies and procedures 
required by proposed Rule 15Fh-3(h) will vary in exact cost, the 
Commission estimates that such policies and procedures would require an 
average of 210 hours per respondent per policy and procedure to prepare 
and implement,\348\ or an average of 1,890 burden hours per SBS Entity, 
resulting in an aggregate initial burden of 103,950 hours.\349\ The 
Commission also expects that many SBS Entities would engage outside 
counsel to assist them in preparing for the collection of information 
required under this rule at a rate of $400 per hour \350\ for an 
average of 450 hours per respondent for a minimum of nine policies and 
procedures,\351\ resulting in an outside initial cost burden of 
$180,000 per respondent or an aggregate initial cost of $9,900,000. 
Once these policies and procedures are established, the Commission 
estimates, that on average each SBS Entity would spend approximately 
540 hours (approximately 60 hours per policy and procedure \352\) each 
year to maintain these policies and procedures, yielding a total 
ongoing annual burden of approximately 29,700 hours (55 SBS Entities x 
540 hours). Based on the Commission's experience in other contexts, the 
Commission preliminarily believes that this maintenance of policies and 
procedures will be conducted internally.\353\
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    \348\ See SDR Registration Release.
    \349\ The estimate is based on the following calculation: (210 
hours) x (9 policies and procedures) x (55 SBS Entities).
    \350\ See SDR Registration Release. The same estimate for the 
hourly cost for legal services was used by the Commission in the 
proposed consolidated audit trail rule. Consolidated Audit Trail, 
Exchange Act Release No. 62174 (May 26, 2010), 75 FR 32556 (June 8, 
2010).
    \351\ See SDR Registration Release.
    \352\ Id.
    \353\ Id.
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6. SBS Dealers Acting as Advisors to Special Entities
    Consistent with the requirements of proposed Rule 15Fh-2(a), 
parties have generally included representations in standard security-
based swap documentation that both counterparties are acting as 
principals and that the counterparty is not relying on any 
communication from the SBS Dealer as investment advice. Under proposed 
Rule 15Fh-5, the SBS Dealer is required to have a reasonable basis to 
believe that the special entity has a qualified independent 
representative. The reporting burdens for this reasonable basis belief 
requirement are analyzed below in connection with the discussion of 
reporting burdens of ``SBS Entities Acting as Counterparties to Special 
Entities.'' In addition, we believe that parties are likely to provide 
the necessary representations and disclosures under proposed Rule 15Fh-
2(a) so that the SBS Dealer would not fall within the definition of 
acting as an advisor, particularly for transactions in which the SBS 
Dealer is the counterparty to the transaction. Accordingly, we believe 
for these transactions that it is unlikely the SBS Dealer will be 
required to collect the information to determine the best interests of 
the special entity. Based on consultations by the Commission staff with 
market participants, the Commission preliminarily believes that the 50 
SBS Dealers would each need approximately five hours to revise the 
existing representations to comply with this requirement or an 
aggregate initial burden of 250 hours. The Commission preliminarily 
believes that once each of the SBS Dealers has revised the language of 
the representation, such language would become part of the standard 
security-based swap documentation and, accordingly, there would be no 
further ongoing associated burden.
    For transactions in which the SBS Dealer is not the counterparty 
and chooses to act as an advisor, the Commission estimates that an SBS 
Entity would require approximately 20 hours to collect the requisite 
information from each special entity for an aggregate initial burden of 
approximately 4,000 hours.\354\
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    \354\ The estimate is based on available market data for 
November 2006-September 2010 provided by DTCC that indicates 201 
trading relationships between SBS Dealers and special entities that 
do not have a third-party investment adviser. For the purposes of 
estimating these reporting burdens, we approximate the number of 
trading relationships between SBS Dealers and special entities at 
200. This estimate includes the following calculation: (20 hours) x 
(200 trading relationships).
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7. SBS Entities Acting as Counterparties to Special Entities
    When a special entity is a counterparty to a security-based swap, 
proposed Rule 15Fh-5 would require that an SBS Entity must have a 
reasonable basis for believing that the special entity has an 
independent representative that: (1) Has sufficient knowledge to 
evaluate the transaction and risks; (2) is not subject to a statutory 
disqualification; (3) undertakes a duty to act in the best interests of 
the special entity; (4) makes appropriate and timely disclosures to the 
special entity of material information concerning the security-based 
swap; (5) will provide written representations to the special entity 
regarding fair pricing and the appropriateness of the security-based 
swap; (6) in the case of employee benefit plans subject to ERISA, is a 
fiduciary as defined in section 3(21) of that Act (29 U.S.C. 1002(21)); 
and (7) in the case of a special entity defined in Sec. Sec.  240.15Fh-
2(e)(2) or (4) and a non-employee, third-party independent 
representative, is a person that is subject to rules of the Commission, 
the CFTC, or an SRO subject to the jurisdiction of the Commission or 
the CFTC, that prohibit it from engaging in specified activities if 
certain political contributions have been made. The Commission expects 
that written representations are likely to form much of the basis of 
the SBS Entity's belief as to the qualifications of the independent 
representative. The Commission also expects that in connection with its 
own prudent business practices the SBS Entity would confirm the status 
of whether the independent representative is subject to statutory 
disqualifications by a search on BrokerCheck or any other database 
available to it.\355\ Furthermore, the SBS Entity is likely to have 
procedures in place to determine whether any of its associated persons 
are subject to a statutory disqualification, which it

[[Page 42447]]

could likely use or modify.\356\ The Commission preliminarily believes 
that the burden to determine that the independent representative is 
independent of the SBS Entity would likely depend on the size of the 
independent representative, the size of the SBS Entity and the volume 
of transactions in which each is engaged. The estimates in this 
paragraph reflect the Commission staff's discussions with market 
participants. The Commission preliminarily believes that each SBS 
Entity initially would require written representations regarding each 
independent representative, but would only require updates with respect 
to the representations in subsequent dealings. The Commission does not 
currently have data regarding the number of independent representatives 
with which each SBS Entity interacts. As a result, for the purposes of 
these estimates the Commission has assumed that each SBS Entity would 
interact with approximately 150 third-party independent representatives 
and 30 in-house independent representatives, and that each SBS Entity, 
on average, would initially require approximately 15 hours per 
independent representative to collect the information necessary to 
comply with this requirement, or an aggregate initial burden of 148,500 
hours (15 hours x 180 independent representatives x 55 SBS Entities). 
In addition, the Commission estimates that subsequent transactions with 
third-party, non-employee independent representatives would likely 
require an average of approximately 10 hours annually to update these 
representations and verifications or an aggregate initial burden of 
82,500 hours (10 hours x 150 independent representatives x 55 SBS 
Entities). The Commission solicits comments as to the accuracy of this 
information.
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    \355\ See Section II.D.5.c.ii and solicitation for comments 
thereunder.
    \356\ See Section 15F(b)(6) of the Exchange Act, Public Law 111-
203, 124 Stat. 1376, 1785 (to be codified at 15 U.S.C. 78o-
10(b)(6)).
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    The collection of information by the SBS Entity, would also impose 
some burden on the independent representatives to collect the 
information and provide the information to the SBS Entity and/or the 
special entities. The estimates in this paragraph reflect the 
Commission staff's discussions with market participants. The Commission 
expects that the main burden for the independent representatives is 
likely providing the representations on which the SBS Entity can rely. 
As a result, the Commission conservatively estimates that the reporting 
burden will likely be approximately 1 hour for each transaction of an 
annual average of 8,300 transactions \357\ for the estimated 60 in-
house independent representatives, equivalent to an average burden of 
approximately 138 hours per year per in-house independent 
representative.
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    \357\ The estimate is based on available market data for 
November 2006-September 2010 provided by DTCC that indicates 32,521 
transactions during that time that involve special entities trading 
without an investment adviser. To obtain an approximate annual 
average number of transactions based on this data, we divided 32,521 
transactions by 47 months and multiplied by 12 months and rounded to 
8,300.
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    With respect to third-party independent representatives, the 
Commission does not expect that any additional information would need 
to be collected pursuant to proposed Rule 15Fh-5(a)(6) because the 
independent representative would have undertaken this analysis under 
ERISA to confirm that it is subject to the fiduciary standards of ERISA 
and to determine whether it falls within one of the ``prohibited 
transaction exemptions'' promulgated by the Department of Labor. 
Similarly, under proposed Rule 15Fh-5(a)(7), the independent 
representative would have already determined whether it is subject to 
pay to play prohibitions to comply with those prohibitions. With 
respect to the transaction-specific requirements in proposed Rule 15Fh-
5(a)(4) to (5), the Commission preliminarily believes that the 
reporting burden for the independent representative would likely 
consist of providing written representations to the SBS Entity and/or 
the special entity it represents. The Commission preliminarily believes 
that the burden on the independent representative to determine that it 
is independent of the SBS Entity would likely depend on the size of the 
independent representative, the size of the SBS Entity and the volume 
of transactions in which each is engaged. The estimates in this 
paragraph reflect the foregoing and the Commission staff's discussions 
with market participants. As a result, the Commission conservatively 
estimates that the reporting burden would likely average approximately 
20 hours for each of the approximately 1,000 unique trading 
relationships between SBS Entities and special entities using a third-
party independent representative for an aggregate initial burden of 
20,000 hours or an average of approximately 62 hours for each of the 
estimated 325 third party independent representatives.\358\
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    \358\ The estimate is based on available market data for 
November 2006-September 2010 provided by DTCC that indicates 
approximately 1,000 unique trading relationships between SBS 
Entities and special entities using a third-party investment adviser 
during that time.
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8. Political Contributions
    As noted above, the Commission estimates there will be 
approximately 50 SBS Dealers and has conservatively estimated that all 
of them will provide, or will seek to provide, security-based swap 
services to municipal entities. In addition, SBS Dealers' covered 
associates would also need to collect and provide the information 
required by the proposed rule to the SBS Dealer. The estimates herein 
take into account the burden of the covered associates and the SBS 
Dealers. These estimates reflect the Commission's experience with and 
burden estimates for similar requirements, as well as our discussions 
with market participants.\359\ The Commission estimates that it would 
take, on average, approximately 185 hours per SBS Dealer and a total 
initial burden of 9,250 hours \360\ to collect the information 
regarding the political contributions of the SBS Dealers and their 
covered associates.
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    \359\ See Political Contributions by Certain Investment 
Advisers, Investment Advisers Act Release No. 2910 (July 1, 2010), 
75 FR 41018, 41061-41065 (July 14, 2010).
    \360\ The estimate is based on the following calculation: (185 
hours x 50 SBS Dealers).
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    Additionally, we expect some SBS Dealers may incur one-time costs 
to establish or enhance current systems to assist in their compliance 
with the proposed rule. These costs would vary widely among firms. Some 
SBS Dealers may not incur any system costs if they determine a system 
is unnecessary due to the limited number of employees they have or the 
limited number of municipal entity counterparties they have. Like other 
large firms, SBS Dealers likely already have devoted significant 
resources to automating compliance and reporting with existing 
applicable prohibitions on certain political contributions, and the 
proposed rule could cause them to enhance their existing systems that 
had originally been designed to comply with MSRB Rules G-37 and G-38 
and Advisers Act Rule 206(4)-5. We believe that the cost of enhancing 
such a system could range from the tens of thousands of dollars for 
simple reporting systems, to hundreds of thousands of dollars for 
complex systems.\361\
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    \361\ See Political Contributions by Certain Investment 
Advisers, note 33, supra (adopting Advisers Act Rule 206(4)-5).).
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9. Chief Compliance Officer
    Under proposed Rule 15Fk-1, an SBS Entity's CCO would be 
responsible for, among other things, establishing

[[Page 42448]]

policies and procedures reasonably designed: to ensure compliance by 
the SBS Entity with the Exchange Act and the rules and regulations 
thereunder relating to its business as an SBS Entity; to remediate 
promptly noncompliance issues identified by the CCO; and for prompt 
handling, management response, remediation, retesting, and resolution 
of noncompliance issues. As described above, the Commission estimates 
that a total of 55 respondents would be subject to this requirement. 
Based on the Commission's experience with and burden estimates for 
similar collections of information,\362\ it estimates that on average 
the establishment and administration of the policies and procedures 
required under proposed Rule 15Fk-1 would require 630 hours to create 
and 180 hours to administer per year per respondent, for a total burden 
of 34,650 hours initially and 9,900 hours per year on average, on an 
ongoing basis. The Commission estimates that a total of $60,000 in 
outside legal costs will be incurred as a result of this burden per 
respondent, for a total initial outside cost burden of $3,300,000.\363\
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    \362\ See SDR Registration Release (citing Regulation NMS: Final 
Rules and Amendments to Joint Industry Plans, Exchange Act Release 
No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005)); Registration 
and Regulation of Security-Based Swap Execution Facilities, Exchange 
Act Release No. 63825 (Feb. 2, 2011), 76 FR 10948 (Feb. 28, 2011).
    \363\ This figure is the result of an estimated $400 per hour 
cost for outside legal services times 150 hours for 3 policies and 
procedures for 55 respondents. See SDR Registration Release.
---------------------------------------------------------------------------

    A CCO would also be required under proposed Rule 15Fk-1 to prepare 
and submit annual compliance reports to the Commission and the SBS 
Entity's board of directors. Based upon the Commission's estimates for 
similar annual reviews by CCOs, the Commission estimates that these 
reports would require on average 92 hours per respondent per year.\364\ 
Thus, the Commission estimates an ongoing annual burden of 5,060 
hours.\365\ Because the report will be submitted by an internal CCO, 
the Commission does not expect any external costs associated therewith. 
The Commission solicits comments as to the accuracy of this information 
and these estimates.
---------------------------------------------------------------------------

    \364\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2107, 68 FR 
7038 (Feb. 11, 2003); SDR Registration Release; Registration and 
Regulation of Security-Based Swap Execution Facilities, Exchange Act 
Release No. 63825 (Feb. 2, 2011), 76 FR 10948 (Feb. 28, 2011).
    \365\ The estimate is based on the following calculation: (92 
hours) x (55 SBS Dealers).
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E. Collection of Information Is Mandatory

    The collections of information relating to verification of the 
status of the counterparty would be mandatory for all SBS Entities. The 
collections of information relating to disclosures by SBS Entities 
would be mandatory for all SBS Entities. The collections of information 
relating to knowing the counterparty and for suitability obligations 
would be mandatory for all SBS Dealers. The collection of information 
relating to fair and balanced communications would be mandatory for all 
SBS Entities. The collections of information relating to supervision 
would be mandatory for all SBS Entities. The collection of information 
relating to acting as an advisor to a special entity would be mandatory 
for all SBS Dealers. The collection of information relating to SBS 
Entities acting as counterparties to special entities would be 
mandatory for all SBS Entities. The collection of information relating 
to pay to play restrictions would be mandatory for all SBS Dealers. The 
collection of information relating to CCO obligations would be 
mandatory for all SBS Entities.

F. Responses to Collection of Information Will Be Kept Confidential

    The Commission preliminarily believes the collection of information 
pursuant to proposed Rules 15Fh-3 to 15Fh-6 and 15Fk-1 would not be 
publicly available. To the extent that the Commission receives 
confidential information pursuant to this collection of information, 
such information would be kept confidential, subject to the provisions 
of the Freedom of Information Act (``FOIA'').

G. Request for Comment

    We invite comment on these estimates. Pursuant to 44 U.S.C. 
3506(c)(2)(B), we request comment in order to:
     Evaluate whether the proposed collection of information is 
necessary for the performance of our functions, including whether the 
information will have practical utility;
     Evaluate the accuracy of our estimates of the burdens of 
the proposed collections of information;
     Determine whether there are ways to enhance the quality, 
utility and clarity of the information to be collected; and
     Evaluate whether there are ways to minimize the burden of 
the collection of information on those who are to respond, including 
through the use of automated collection techniques or other forms of 
information technology.
    Persons wishing to submit comments on the collection of information 
requirements of the proposed rules should direct them to (1) the Office 
of Management and Budget, Attention: Desk Officer for the Securities 
and Exchange Commission, Office of Information and Regulatory Affairs, 
Washington, DC 20503; and (2) Elizabeth M. Murphy, Secretary, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-1090, with reference to File No. S7-XX-XX. Requests for materials 
submitted to OMB by the Commission with regard to this collection of 
information should be in writing, with reference to File No. S7-XX-XX, 
and be submitted to the Securities and Exchange Commission, Office of 
Investor Education and Advocacy, 100 F Street, NE, Washington, DC 
20549-0213. OMB is required to make a decision concerning the 
collections of information between 30 and 60 days after publication, so 
a comment to OMB is best assured of having its full effect if OMB 
receives it within 30 days of publication.

V. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits imposed by 
its rules. The proposed rulemaking is intended to implement the 
requirements under Section 15F(h) of the Exchange Act as added by 
Section 764(a) of the Dodd-Frank Act concerning external business 
conduct standards for SBS Entities. Section 15F of the Exchange Act 
provides the Commission with both mandatory and discretionary 
rulemaking authority to impose business conduct requirements on SBS 
Entities in their dealings with counterparties, including special 
entities. In addition to the reporting burdens associated with certain 
of the proposed rules described in Section IV.D above, the discussion 
below focuses on other potential costs and benefits of the decisions 
made by the Commission, together with the other agencies, to fulfill 
the mandates of the Dodd-Frank Act within its permitted discretion. As 
part of this analysis, we do not consider the costs and benefits of the 
mandates of the Dodd-Frank Act itself.\366\
---------------------------------------------------------------------------

    \366\ The Paperwork Reduction Act analysis in Section IV.D., 
however, describes collections of information under the proposed 
rules, regardless of whether the rules are proposed pursuant to 
mandatory or discretionary authority.
---------------------------------------------------------------------------

    As discussed in Section I.C.3, in addition to business conduct 
requirements expressly addressed by Title VII of the Dodd-Frank Act, we 
are proposing for comment certain other

[[Page 42449]]

business conduct requirements for SBS Dealers that we preliminarily 
believe further the principles that underlie the Dodd-Frank Act. These 
include details of the daily mark for uncleared security-based swaps; 
certain disclosures related to the provision of a daily mark for 
uncleared security-based swaps; certain ``know your counterparty'' and 
suitability obligations for SBS Dealers; provisions intended to prevent 
SBS Dealers and independent representatives of special entities from 
engaging in certain ``pay to play'' activities; certain minimum 
requirements for the annual compliance reports to be provided by the 
CCO; and a requirement of board approval for decisions related to 
compensation or removal of the CCO.

A. Costs and Benefits of Rules Relating to Daily Mark

    Section 15F(h)(3)(B)(iii) of the Exchange Act requires the 
Commission to adopt rules requiring the disclosure to counterparties of 
the daily mark. For cleared security-based swaps, upon request from the 
counterparty, the rule must require an SBS Entity to provide the daily 
mark, which under proposed Rule 15Fh-3(c) would be the daily end of day 
settlement price received from the appropriate clearing agency. For 
uncleared security-based swaps, the rules must require the SBS Entity 
to provide the daily mark. However, the method for computing the daily 
mark is not provided in the statute. Proposed Rule 15h-3(c)(2) would 
require that the SBS Entity meet this disclosure requirement for any 
uncleared security-based swap by providing the midpoint between the bid 
and offer, or the calculated equivalent thereof, as of the close of 
business unless the parties agree in writing otherwise. The SBS Entity 
would also be required to disclose the data sources and describe the 
methodology and assumptions used to prepare the daily mark. The 
provision of a daily mark along with the data sources, assumptions, and 
methodology used in its preparation, should provide a useful reference 
point for the counterparty.
    In the absence of current valid quotes from which to calculate the 
mid-market price, a model would be used to estimate the daily mark. 
When markets are illiquid the mark provided by a model may provide a 
better estimate of the value of the security-based swap than a stale 
market price. However, the mark would only be as good as the model from 
which it is derived and security-based swap market participants would 
need to evaluate the data sources, methodology and assumptions employed 
to fully appreciate model-derived daily marks. Further, the model price 
would not necessarily reflect the price at which the security-based 
swap could be executed. While the market-wide disclosure of these marks 
could raise the quality of the model-derived daily marks, there would 
likely be variability in the models and data sources, methodology and 
assumptions, leading to different daily marks being established for 
similar security-based swaps. As a result, security-based swap market 
participants that consider the daily mark as one indicator in the 
reporting of their positions might present different values for similar 
security-based swap market positions on their respective balance 
sheets.
    Potential limitations of a model-based daily mark notwithstanding, 
counterparties to SBS Entities will benefit from a good faith effort by 
SBS Entities to value uncleared SBS transactions. Daily marks will 
allow counterparties to better understand their financial relationships 
with SBS Entities and provide a frequently updated basis for variation 
margin requirements. And although daily marks would not necessarily 
represent a price at which at a counterparty could enter or exit the 
position, it would provide a meaningful reference point against which 
to assess, among other things, the calculation of variation margin for 
a security-based swap or portfolio of security-based swaps, and 
otherwise inform the counterparty's understanding of its financial 
relationship with the SBS Entity. Moreover, because SBS Entities would 
be required to provide the same valuation to all of their 
counterparties, and because counterparties could interact with multiple 
SBS Entities, counterparties would be assured of equal treatment and 
would have the ability to observe when valuations differ among SBS 
Entities.
    The costs to SBS Entities of providing daily marks should be 
minimal other than the disclosure burdens previously described. Proper 
risk management at SBS Entities entails assessing end-of-day values. In 
this respect, an SBS Entity would simply be passing along a valuation 
similar to one that the SBS Entity currently performs, even without a 
rule requiring disclosure.

B. Costs and Benefits of Rules Concerning Verification of Counterparty 
Status, Knowing Your Counterparty, and Recommendations of Security-
Based Swaps or Trading Strategies

    Proposed Rule 15Fh-3(a)(2) would require an SBS Entity to verify 
whether a counterparty is a special entity before entering into a 
security-based swap with that counterparty. Although the Dodd-Frank Act 
does not require an SBS Entity to verify whether a counterparty is a 
special entity, we are mindful that Congress established a set of 
additional provisions addressing solely the interactions between SBS 
Entities and special entities in connection with security-based swaps, 
and we preliminarily believe that such verification would help to 
ensure that these counterparties do, in fact, receive the benefit of 
such provisions, as well as our proposed rules thereunder. The 
verification requirement would not apply if an SBS Entity is entering 
into a transaction with a special entity on a SEF or an exchange and 
for which the SBS Entity does not know the identity of the 
counterparty.
    Proposed Rule 15Fh-3(e) would establish a ``know your 
counterparty'' requirement for SBS Dealers that would require an SBS 
Dealer to obtain and retain a record of essential facts regarding a 
counterparty that are necessary for conducting business with such a 
counterparty. The ``essential facts concerning a counterparty'' are 
those required to (1) comply with applicable laws, regulations and 
rules; (2) implement the SBS Dealer's credit and operational risk 
management policies in connection with transactions entered into with 
such counterparty; (3) information regarding the authority of any 
person acting for such counterparty; and (4) if the counterparty is a 
special entity, such background information regarding the independent 
representative as the SBS Dealer reasonably deems appropriate. To the 
extent that the SBS Dealer does not already collect and retain this 
information as a part of its normal course of business, this 
requirement would increase the cost to the SBS Dealer of entering into 
security-based swaps. The increased cost is likely to be reflected in 
the terms offered to the counterparty. To the extent that an SBS Dealer 
is unable to recover the added costs from the counterparty, the rule 
would provide a disincentive for recommending bespoke transactions.
    Proposed Rule 15Fh-3(f) would require that the SBS Dealer have a 
reasonable basis to believe: (i) Based on reasonable diligence, that 
the recommended security-based swap or trading strategy involving a 
security-based swap is suitable for at least some counterparties; and 
(ii) that a recommended security-based swap or trading strategy is 
suitable for the counterparty based on relevant information the SBS 
Dealer has or has obtained regarding the counterparty, including the 
counterparty's investment

[[Page 42450]]

profile, trading objectives and its potential to absorb losses 
associated with the recommended security-based swap or trading 
strategy. This requirement could potentially benefit counterparties by 
requiring that an SBS Dealer recommend only suitable security-based 
swaps or trading strategies. While the proposed requirement that an SBS 
Dealer know essential facts regarding its counterparties to evaluate 
the suitability of trades for its counterparties would be a 
responsibility that would go beyond disclosure of material risks and 
so, could increase the costs to SBS Dealers in transacting with 
counterparties, particularly for counterparties with which an SBS 
Dealer has had no prior transactions, we anticipate that SBS Dealers 
would seek to rely on proposed Rule 15Fh-3(f)(2), which would allow an 
SBS Dealer to fulfill its obligations with respect to a particular 
counterparty if (1) The SBS Dealer reasonably determined that the 
counterparty, or the counterparty's agent to whom the counterparty has 
delegated decision making authority, is capable of exercising 
independent judgment, (2) the counterparty or agent affirmatively 
represented that it is exercising independent judgment in evaluating 
the recommendations, and (3) the SBS Dealer disclosed that it was 
acting in its capacity as a counterparty and was not undertaking to 
assess the suitability of the security-based swap or trading strategy 
for the counterparty. This provision would benefit counterparties by 
helping to ensure that they are in fact capable of exercising 
independent judgment in evaluating security-based swaps and trading 
strategies.
    Some SBS Dealers may already have an obligation to make suitable 
recommendations of a security-based swap or trading strategy through 
other regulatory regimes to which they may be subject. For example, 
FINRA imposes a suitability requirement on recommendations by broker-
dealers. Municipal securities dealers also have a suitability 
obligation when recommending municipal securities transactions to a 
customer. Federally regulated banks have a suitability obligation as 
well when acting as broker-dealers in connection with the purchase or 
sale of government securities. Proposed rule 15Fh-3(f) would subject 
SBS Dealers to similar suitability requirements. In addition, the 
suitability obligation would not apply to an SBS Dealer in dealings 
with an SBS Entity, swap dealer, or major swap participant.
    One potential concern is that relatively unsophisticated 
counterparties would not qualify for the exception that would be 
provided by proposed Rule 15Fh-3(f)(2) and that the costs to SBS 
Dealers associated with determining suitability may be sufficiently 
large or difficult to assess given that SBS Dealers would choose not to 
engage in over-the-counter security-based swaps with certain 
counterparties, particularly less sophisticated counterparties. 
However, our analysis of the credit default swaps market over the four 
years prior to the passage of the Dodd-Frank Act finds that non-
institutional counterparties generally have third-party representation. 
In particular, as previously noted, more than 95% of all trades by 
special entities are executed through third party investment advisers, 
and the remaining trades are predominantly by large, well known 
endowments and pension plans who would generally be characterized as 
sophisticated security-based swap market participants. Moreover, all 
counterparties may nonetheless be able to enter into security-based 
swaps that are traded on a registered national securities exchange, 
even if they are unable to find a SBS Dealer to enter a bespoke 
security-based swap.

C. Costs and Benefits of Rules Relating to Political Contributions by 
Certain SBS Entities and Independent Representatives of Special 
Entities

    Proposed Rule 15Fh-6 would prohibit SBS Dealers from engaging in 
security-based swap transactions with a ``municipal entity'' if certain 
political contributions have been made to officials of such entities. 
The proposed rule is similar to rules adopted by the MSRB in Rule G-37: 
Political Contributions and Prohibitions on Municipal Securities 
Business and G-38: Solicitation of Municipal Securities Business, and 
by the Commission in Advisers Act Rule 206(4)-5: Political 
Contributions by Certain Investment Advisers.\367\
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    \367\ Political Contributions by Certain Investment Advisers, 
Investment Advisers Act Release No. 2910, 75 FR 41018, 41061-41065 
(July 14, 2010). Many of the economic issues associated with rules 
relating to political contributions by SBS entities are similar to 
those relating to investment advisers addressed in Rule 206(4)-5.
---------------------------------------------------------------------------

    Proposed Rule 15Fh-5(a)(7) would include in the list of 
qualifications for a ``qualified independent representative'' that the 
independent representative is subject to rules of the Commission, the 
CFTC, or a self-regulatory organization subject to the jurisdiction of 
the Commission or the CFTC, that prohibit it from engaging in specified 
activities if certain political contributions have been made. The 
proposed rule would not apply if the independent representative was an 
employee of the special entity.
    The proposed rules should yield several direct and indirect 
benefits. The proposed rules are intended to address pay to play 
relationships that interfere with the legitimate process by which 
``municipal entities'' and other special entities enter into security-
based swaps to mitigate risk. The proposed rules should reduce the 
occurrence of fraudulent conduct resulting from pay to play. Addressing 
pay to play practices would help protect public pension plans, 
investments by the public in government-sponsored savings and 
retirement plans and programs, and taxpayers by addressing situations 
in which the municipal entity, in part based on a conflict of interest, 
enters into a security-based swap that may be without merit or for 
which there exists a better alternative. Allocative efficiency would be 
enhanced if special entities enter into security-based swaps based on 
hedging needs or the characteristics of the security-based swap rather 
than any influence from pay to play, either from the SBS Dealer or the 
independent representative.
    These proposed rules would encourage (1) SBS Dealers to compete for 
the business of municipal entities based on the merits of the 
transaction rather than their ability or willingness to make political 
contributions, and (2) independent representatives to compete based on 
their qualifications, service, and cost. Taxpayers may benefit from the 
rule because they would enjoy the benefits of appropriate risk 
management or investment strategies that make use of security-based 
swaps, and they might otherwise bear the financial burden of bailing 
out a municipal entity that had entered into an inappropriate security-
based swap because of pay to play practices. The proposed rule may also 
lower transaction costs paid by ``municipal entities'' since it would 
not be necessary for SBS Dealers to recover expenses incurred by pay to 
play practices.\368\
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    \368\ Academic research provides evidence that gross spreads on 
negotiated bid deals for municipal bonds were reduced following 
adoption of a pay to play rule prohibiting investment houses that 
make political contributions from selling bonds from that city/state 
for two years. See Alexander W. Butler, Larry Fauver, and Sandra 
Mortal, Corruption, Political Connections, and Municipal Finance, 22 
The Review of Financial Studies 2873 (2009).
---------------------------------------------------------------------------

    Proposed Rule 15Fh-6 would require an SBS Dealer to incur costs to 
monitor contributions it and its covered associates make and to 
establish procedures to comply with the rule. The

[[Page 42451]]

initial and ongoing compliance costs imposed by the proposed rule would 
vary significantly among firms, depending on a number of factors. These 
factors include the number of covered associates of the SBS Dealer, the 
degree to which compliance procedures are automated (including policies 
and procedures that could require pre-clearance), and the extent to 
which the SBS Dealer has a preexisting policy under its code of ethics 
or compliance program. A smaller SBS Dealer, for example, would likely 
have a small number of covered associates, and thus expend fewer 
resources to comply with the proposed rule.
    An SBS Dealer subject to the proposed rule would develop compliance 
procedures to monitor the political contributions made by the SBS 
Dealer and its covered associates. We estimate that the costs imposed 
by the proposed rule would be higher initially, as firms establish and 
implement procedures and systems to comply with the rule. We expect 
that compliance expenses would then decline to a relatively constant 
amount in future years, and that annual expenses would likely be lower 
for smaller SBS Dealers as the systems and processes should be less 
complex than for larger SBS Dealers.
    An SBS Dealer with municipal entity counterparties, as well as 
covered associates of the SBS Dealer, also may be less likely to make 
contributions to government officials, including candidates, at or 
above the de minimis level, potentially resulting in less funding by 
SBS Dealers and their covered associates for these officials' 
campaigns. Under the rule, SBS Dealers and covered associates would be 
subject to new limitations regarding which campaigns they may support 
and the amounts that they may contribute. In addition, these same 
persons would be prohibited from soliciting others to contribute or 
from coordinating contributions to government officials, including 
candidates, or payments to political parties in certain circumstances. 
These limitations, and any additional prohibitions imposed by firms 
that choose to adopt more restrictive policies or procedures, could be 
perceived by the individuals subject to them as a cost in the sense 
that they limit those individuals' ability to give direct contributions 
to certain candidates above the de minimis level.
    An SBS Dealer that becomes subject to the prohibitions of the 
proposed rule would be prohibited from offering to enter into, or 
entering into, a security-based swap with a particular municipal entity 
counterparty, which would result in a direct loss to the SBS Dealer of 
revenues and profits relating to that government counterparty. However, 
this prohibition would likely result in a reallocation as to which SBS 
Dealer would generate these revenues and profits, not an overall loss 
to the market. The two-year time out could also limit the number of SBS 
Dealers able to offer to enter into or enter into security-based swap 
contracts with potential municipal entity counterparties.

D. Costs and Benefits Relating to the Specification of Minimum 
Requirements of the Annual Compliance Report and the Requirement of 
Board Approval of Compensation or Removal of a Chief Compliance Officer

    Section 15F(k) of the Exchange Act requires an SBS Entity to 
designate a CCO, and imposes certain duties and responsibilities on 
that CCO. Proposed Rule 15Fk-1 would incorporate the provisions of 
Exchange Act Section 15F(k) in addition to certain provisions that are 
based on the current and proposed compliance obligations applicable to 
CCOs of other Commission-regulated entities.
    The submission of the CCO's annual compliance report as required by 
the proposed rule would help the Commission monitor the compliance 
activities of SBS Entities. This report would also assist the 
Commission in carrying out its oversight of SBS Entities by providing 
the Commission with the information necessary to review compliance with 
rules relating to external business conduct.
    Section 15Fk-1(2)(A) of the Exchange Act requires that the CCO 
report directly to the board or the senior officer of the SBS Entity. 
Proposed Rule 15Fk-1(d) would also require that the compensation and 
removal of the CCO would require the approval of a majority of the 
board of directors of the SBS Entity. The elevation of compensation and 
termination decisions to the board should reduce the inherent conflict 
of interest that arises when such decisions are made by individuals 
whose compliance with applicable law and regulations the CCO is 
responsible for monitoring. The potential separation of general 
supervisory responsibility of the CCO, which may reside with the senior 
officer of the SBS Entity, from the responsibility for compensation 
decisions may reduce the quality of those decisions.
    In addition to the time involved with the reporting burdens, the 
direct costs of $3,300,000 in the aggregate associated with the 
submission of the annual compliance report are discussed in more detail 
in Section IV.D.9 above.
Request for Comments
    The Commission also seeks comment on the accuracy of any of the 
benefits and costs it has identified and/or described above. The 
Commission encourages commenters to identify, discuss, analyze, and 
supply relevant data, information, or statistics regarding any such 
costs or benefits. Because the structure of the security-based swaps 
market and the behavior of its market participants is likely to change 
after the effective date of the Dodd-Frank Act and implementation of 
the Commission's rules promulgated thereunder, the impact of, and the 
costs and benefits that may result from proposed Rules 15Fh-1 through 
15Fh-6 and 15Fk-1 may change over time. As commenters review the 
proposed rules, we urge them to consider generally the role that 
regulation may play in fostering or limiting the development of the 
market for security-based swaps.

VI. Consideration of Burden on Competition and Promotion of Efficiency, 
Competition and Capital Formation

    Section 3(f) of the Exchange Act requires that the Commission, 
whenever it engages in rulemaking and is required to consider or 
determine whether an action is necessary or appropriate in the public 
interest, to consider, in addition to the protection of investors, 
whether the action would promote efficiency, competition, and capital 
formation.\369\ In addition, Section 23(a)(2) of the Exchange Act 
requires the Commission, when adopting rules under the Exchange Act, 
consider the effect such rules would have on competition.\370\ Section 
23(a)(2) of the Exchange Act also prohibits the Commission from 
adopting any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act.
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    \369\ 15 U.S.C. 78c(f).
    \370\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    Security-based swaps are currently executed and traded in the OTC 
market, with five large commercial banks representing 97% of the total 
U.S. banking industry notional amounts outstanding of derivatives.\371\ 
The gross notional amount of credit default swaps as of the end of 2009 
was approximately $30 trillion.\372\
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    \371\ See Office of the Comptroller of the Currency, Quarterly 
Report on Bank Trading and Derivatives Activities, First Quarter 
2010.
    \372\ Data available at http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls.
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    Section 15F(h) of the Exchange Act as added by Section 764(a) of 
the Dodd-Frank Act provides the Commission

[[Page 42452]]

with both mandatory and discretionary rulemaking authority to impose 
business conduct requirements on SBS Entities in their dealings with 
counterparties, including special entities.\373\ The proposed rules to 
implement business conduct requirements would apply to all SBS 
Entities. Therefore the Commission preliminarily believes that the 
effect on competition among SBS Entities would be small. The Commission 
also preliminarily believes that the proposed business conduct 
standards for SBS Entities, including those for disclosure of material 
risks and for fair and balanced communications, would reduce 
information asymmetries between SBS Entities and their counterparties. 
The reduction of information asymmetries should promote price 
efficiency, promote more informed decision-making, and reduce the 
incidence of fraudulent or misleading representations.
---------------------------------------------------------------------------

    \373\ See Exchange Act Section 15F(h)(2)(C), 15 U.S.C. 78o-
10(h)(2)(C).
---------------------------------------------------------------------------

    Proposed Rule 15Fh-3(e) would require an SBS Dealer to use 
reasonable due diligence to obtain and retain a record of the essential 
facts concerning each counterparty whose identity is known to the SBS 
Dealer prior to the execution of the transaction and the authority of 
any person acting for such counterparty. Proposed Rule 15h-3(f) would 
require that the SBS Dealer have a reasonable basis to believe: (i) 
based on reasonable diligence, that the recommended security-based swap 
or trading strategy involving a security-based swap is suitable for at 
least some counterparties; and (ii) that a recommended security-based 
swap or trading strategy is suitable for the counterparty based on 
information the SBS Dealer has obtained through reasonable due 
diligence regarding the counterparty's investment profile, and the 
potential risks and rewards associated with the recommended security-
based swap or trading strategy.
    Requiring SBS Dealers to evaluate the suitability of trades for 
counterparties is a responsibility that goes beyond disclosure of 
material risks and would further increase the costs to SBS Dealers in 
transacting with counterparties, particularly for counterparties with 
which the SBS Dealer has had no prior transactions. These costs are 
likely to be largest when the SBS Dealer is dealing directly with 
small, relatively unsophisticated counterparties where a greater level 
of inquiry would be required. If these costs result in SBS Dealers 
refraining from interacting with these counterparties, and these 
counterparties are otherwise unable to enter into security-based swaps 
and lose access to risk management methods that employ security-based 
swaps, the suitability requirement may come at a net cost to these 
counterparties and would place them at a disadvantage relative to 
larger, more sophisticated competitors. To the extent that these 
counterparties do not participate in the security-based swap market as 
a result of these costs, liquidity could drop, increasing the hedging 
costs and ultimately the cost of raising capital. However, as we noted 
previously, current market practices reveal that relatively few 
counterparties enter into security-based swap agreements with an SBS 
Dealer without third-party representation, particularly among special 
entities. As a result of this third-party representation and the SBS 
Dealer's ability to fulfill its suitability obligations by making the 
determination that a counterparty's agent is capable of independently 
evaluating investment risk, we do not believe that market access is 
likely to be restricted, even for small, relatively unsophisticated 
counterparties. Rather, we believe that it is possible that suitability 
requirements would add to the integrity of, and codify, current market 
practices, which can in some circumstances enhance the protections for 
such counterparties.
    The practices that are proposed in the rules would also help 
regulators perform their functions in an effective manner. The 
resulting increase in market integrity would likely affect capital 
formation in our capital markets positively.

Request for Comments

    The Commission also seeks comment on the accuracy of any of the 
competitive effects it has identified and/or described above. The 
Commission encourages commenters to identify, discuss, analyze, and 
supply relevant data, information, or statistics regarding any such 
effects. Because the structure of the security-based swaps market and 
the behavior of its market participants is likely to change after the 
effective date of the Dodd-Frank Act and implementation of the 
Commission's rules promulgated thereunder, the impacts that may result 
from proposed Rules 15Fh-1 through 15Fh-6 and 15Fk-1 may change over 
time. As commenters review the proposed rules, we urge them to consider 
generally the role that regulation may play in fostering or limiting 
the development of the market for security-based swaps.

VII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \374\ the Commission must advise the OMB as 
to whether the proposed regulation constitutes a ``major'' rule. Under 
SBREFA, a rule is considered ``major'' where, if adopted, it results or 
is likely to result in: (1) An annual effect on the economy of $100 
million or more (either in the form of an increase or a decrease); (2) 
a major increase in costs or prices for consumers or individual 
industries; or (3) significant adverse effect on competition, 
investment or innovation. If a rule is ``major,'' its effectiveness 
will generally be delayed for 60 days pending Congressional review.
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    \374\ Public Law. 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
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    The Commission requests comment on the potential impact of proposed 
Rules 15Fh-1 through 15Fh-7 and 15Fk-1 on the economy on an annual 
basis, any potential increase in costs or prices for consumers or 
individual industries, and any potential effect on competition, 
investment or innovation. Commenters are requested to provide empirical 
data and other factual support for their view to the extent possible.

VIII. Regulatory Flexibility Act Certification

    The Regulatory Flexibility Act (``RFA'') \375\ requires Federal 
agencies, in promulgating rules, to consider the impact of those rules 
on small entities. Section 603(a) \376\ of the Administrative Procedure 
Act,\377\ as amended by the RFA, generally requires the Commission to 
undertake a regulatory flexibility analysis of all proposed rules, or 
proposed rule amendments, to determine the impact of such rulemaking on 
``small entities.'' \378\ Section 605(b) of the RFA states that this 
requirement shall not apply to any proposed rule or proposed rule 
amendment, which if adopted, would not have a significant economic 
impact on a substantial number of small entities.\379\
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    \375\ 5 U.S.C. 601 et seq.
    \376\ 5 U.S.C. 603(a).
    \377\ 5 U.S.C. 551 et seq.
    \378\ Although Section 601(b) of the RFA defines the term 
``small entity,'' the statute permits agencies to formulate their 
own definitions. The Commission has adopted definitions for the term 
small entity for the purposes of Commission rulemaking in accordance 
with the RFA. Those definitions, as relevant to this proposed 
rulemaking, are set forth in Rule 0-10, 17 CFR 240.0-10. See 
Securities Exchange Act Release No. 18451 (Jan. 28, 1982), 47 FR 
5215 (Feb. 4, 1982).
    \379\ See 5 U.S.C. 605(b).

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[[Page 42453]]

    For purposes of Commission rulemaking in connection with the RFA, a 
small entity includes: (i) When used with reference to an ``issuer'' or 
a ``person,'' other than an investment company, an ``issuer'' or 
``person'' that, on the last day of its most recent fiscal year, had 
total assets of $5 million or less,\380\ or (ii) a broker-dealer with 
total capital (net worth plus subordinated liabilities) of less than 
$500,000 on the date in the prior fiscal year as of which its audited 
financial statements were prepared pursuant to Rule 17a-5(d) under the 
Exchange Act,\381\ or, if not required to file such statements, a 
broker-dealer with total capital (net worth plus subordinated 
liabilities) of less than $500,000 on the last day of the preceding 
fiscal year (or in the time that it has been in business, if shorter); 
and is not affiliated with any person (other than a natural person) 
that is not a small business or small organization.\382\ With respect 
to investment companies in connection with the RFA, the term ``small 
business'' or ``small organization'' means an investment company that, 
together with other investment companies in the same group of related 
investment companies, has net assets of $50 million or less as of the 
end of its most recent fiscal year.
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    \380\ See 17 CFR 240.0-10(a).
    \381\ See 17 CFR 240.17a-5(d).
    \382\ See 17 CFR 240.0-10(c).
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A. Market Participants in Security-Based Swaps

    Based on the Commission's existing information about the security-
based swap market, the Commission preliminarily believes that the 
security-based swap market, while broad in scope, is largely dominated 
by large entities such as those that would be covered by the 
``security-based swap dealer'' definition and their large institutional 
customers.\383\ Under current law, all security-based swap market 
participants are effectively required to be ``eligible contract 
participants.'' \384\ The basic thresholds under the definition of 
eligible contract participant are currently $10 million in total assets 
for natural persons, and $25 million in total assets for corporations 
and other legal entities.\385\ Because the definition of ``small 
entity'' requires that issuers or persons other than broker-dealers and 
investment companies must have total assets of $5 million or less, by 
definition they cannot be eligible contract participants. Based on its 
knowledge of registered broker-dealers and feedback from industry 
participants about the security-based swap markets, the Commission 
preliminarily believes that registered broker-dealers that participate, 
or will participate after the Dodd-Frank Act becomes effective, in the 
security-based swap markets exceed the threshold defining when broker-
dealers are ``small entities'' set out above. Finally, based on its 
review of data provided by the Warehouse Trust Company, a subsidiary of 
the Depository Trust and Clearing Corporation, to the Commission, and 
feedback from industry participants, the Commission preliminarily 
believes that investment companies that participate in the security-
based swap markets exceed the threshold defining when investment 
companies are ``small businesses'' or ``small organizations'' set out 
above. Thus, the Commission preliminarily believes it is unlikely that 
the proposed business conduct standards rules would have a significant 
economic impact on a substantial number of small entities.
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    \383\ See supra notes 4 and 5.
    \384\ Otherwise, the security-based swap would either be a 
security subject to the federal securities laws, including a 
registration requirement under the Securities Act, or an illegal 
future, depending on its economic terms and the security, commodity 
or other asset that it references. In practice, this has meant that 
such transactions do not occur.
    \385\ Note that the definition of ``eligible contract 
participant'' has been amended by Congress in Section 721(a)(9) of 
the Dodd-Frank Act. See Pub. L. 111-203, 124 Stat. 1376, 1660, Sec.  
721(a)(9) (to be codified at 7 U.S.C. 1a(18)). See also Definitions 
Release at 42 (explaining that this amendment has the effect of 
``(1) raising a threshold that governmental entities may use to 
qualify as [eligible contract participants], in certain situations, 
from $25 million in discretionary investments to $50 million in such 
investments; and (2) replacing the `total asset' standard for 
individuals to qualify as [eligible contract participants] with a 
discretionary investment standard,'' but noting that for 
individuals, while the threshold remains $10 million, under the 
amended definition this amount would be based on discretionary 
investments rather than total assets).
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B. Certification

    In the Commission's preliminary view, the proposed rules would not 
have a significant economic impact on a substantial number of small 
entities. For the foregoing reasons, the Commission certifies that 
these proposed rules would not have a significant economic impact on a 
substantial number of small entities for purposes of the RFA. The 
Commission encourages written comments regarding this certification. 
The Commission requests that commenters describe the nature of any 
impact on small entities and provide empirical data to illustrate and 
support the extent of the impact.

Business Conduct Standards for Security-Based Swap Dealers and Major 
Security-Based Swap Participants

Statutory Authority

    Pursuant to the Act and, particularly, Sections 2, 3(b), 3C, 9, 10, 
11A, 15, 15F, 17(a) and (b), and 23(a) thereof (15 U.S.C. 78b, 78c(b), 
78i(i), 78i(j), 78j, 78k-1, 78o, 78o-10, 78q(a) and (b), and 78w(a)), 
the Commission is proposing a new series of rules, Rules 15Fh-1 through 
15Fh-6, and Rule 15Fk-1, to address the business conduct obligations of 
security-based swap dealers and major security-based swap participants.

List of Subjects in 17 CFR Part 240

    Brokers, Reporting and recordkeeping requirements, Securities.

Text of the Proposed Rule

    For the reasons set forth in the preamble, the Securities and 
Exchange Commission proposes to amend Title 17, Chapter II of the Code 
of Federal Regulations, as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The authority citation for part 240 is revised to read as 
follows:

    Authority:  15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78b, 78c, 78d, 78e, 78f, 78g, 
78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78o-4, 78o-10, 78p, 
78q, 78s, 78u-5, 78w, 78x, 78dd(b) and (c), 78ll, 78mm, 80a-20, 80a-
23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq.; 18 
U.S.C. 1350, and 12 U.S.C. 5221(e)(3), unless otherwise noted.

* * * * *
    Sections 240.15Fh-1 through 240.15Fh-6 and 240.15Fk-1 are also 
issued under sec. 943, Pub. L. 111-203, 124 Stat. 1376.
* * * * *

    2. Add Sec. Sec.  240.15Fh-1 through 240.15Fh-6 to read as follows:

Sec.
240.15Fh-1 Scope.
240.15Fh-2 Definitions.
240.15Fh-3 Business conduct requirements.
240.15Fh-4 Special requirements for security-based swap dealers 
acting as advisors to special entities.
240.15Fh-5 Special requirements for security-based swap dealers and 
major security-based swap participants acting as counterparties to 
special entities.
240.15Fh-6 Political contributions by certain security-based swap 
dealers.

Sec.  240.15Fh-1  Scope.

    Sections 240.15Fh-1 through 240.15Fh-6, and 240.15Fk-1 are not

[[Page 42454]]

intended to limit, or restrict, the applicability of other provisions 
of the federal securities laws, including but not limited to Section 
17(a) of the Securities Act of 1933 and Sections 9 and 10(b) of the 
Act, and rules and regulations thereunder, or other applicable laws and 
rules and regulations. Sections 240.15Fh-1 through 240.15Fh-6, and 
240.15Fk-1 apply, as relevant, in connection with entering into 
security-based swaps and continue to apply, as appropriate, over the 
term of executed security-based swaps.

Sec.  240.15Fh-2  Definitions.

    As used in Sec. Sec.  240.15Fh-1 through 240.15Fh-6:
    (a) Act as an advisor to a special entity. A security-based swap 
dealer acts as an advisor to a special entity when it recommends a 
security-based swap or a trading strategy that involves the use of a 
security-based swap to the special entity, unless:
    (1) The special entity represents in writing that:
    (i) The special entity will not rely on recommendations provided by 
the security-based swap dealer; and
    (ii) The special entity will rely on advice from a qualified 
independent representative as defined in Sec.  240.15Fh-5(a); and
    (2) The security-based swap dealer has a reasonable basis to 
believe that the special entity is advised by a qualified independent 
representative as defined in Sec.  240.15Fh-5(a); and
    (3) The security-based swap dealer discloses to the special entity 
that it is not undertaking to act in the best interest of the special 
entity, as otherwise required by Section 15F(h)(4) of the Act.
    (b) Eligible contract participant means any person as defined in 
Section 3(a)(66) of the Act.
    (c) Independent representative of a special entity means:
    (1) A representative of a special entity must be independent of the 
security-based swap dealer or major security-based swap participant 
that is the counterparty to a proposed security-based swap.
    (2) A representative of a special entity is independent of a 
security-based swap dealer or major security-based swap participant if 
the representative does not have a relationship with the security-based 
swap dealer or major security-based swap participant, whether 
compensatory or otherwise, that reasonably could affect the independent 
judgment or decision-making of the representative.
    (3) A representative of a special entity will be deemed to be 
independent of a security-based swap dealer or major security-based 
swap participant if:
    (i) The representative is not and, within one year, was not an 
associated person of the security-based swap dealer or major security-
based swap participant; and
    (ii) The representative has not received more than ten percent of 
its gross revenues over the past year, directly or indirectly from the 
security-based swap dealer or major security-based swap participant.
    (d) Security-based swap dealer or major security-based swap 
participant includes, where relevant, an associated person of the 
security-based swap dealer or major security-based swap participant.
    (e) Special entity means:
    (1) A Federal agency;
    (2) A State, State agency, city, county, municipality, or other 
political subdivision of a State;
    (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(32) of the 
Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002(32)); 
or
    (5) Any endowment, including an endowment that is an organization 
described in section 501(c)(3) of the Internal Revenue Code of 1986.
    (f) A person is subject to a statutory disqualification for 
purposes of Sec.  240.15Fh-5 if that person would be subject to a 
statutory disqualification under the provisions of Section 3(a)(39) of 
the Act.

Sec.  240.15Fh-3  Business conduct requirements.

    (a) Counterparty Status.
    (1) Eligible contract participant. A security-based swap dealer or 
a major security-based swap participant shall verify that a 
counterparty whose identity is known to the security-based swap dealer 
or a major security-based swap participant prior to the execution of 
the transaction meets the eligibility standards for an eligible 
contract participant, before entering into a security-based swap with 
that counterparty other than on a registered national securities 
exchange or registered security-based swap execution facility.
    (2) Special entity. A security-based swap dealer or a major 
security-based swap participant shall verify whether a counterparty 
whose identity is known to the security-based swap dealer or a major 
security-based swap participant prior to the execution of the 
transaction is a special entity, before entering into a security-based 
swap with that counterparty.
    (b) Disclosure. Before entering into a security-based swap, a 
security-based swap dealer or major security-based swap participant 
shall disclose to the counterparty, other than a security-based swap 
dealer, major security-based swap participant, swap dealer or major 
swap participant, information concerning the security-based swap in a 
manner reasonably designed to allow the counterparty to assess:
    (1) Material risks and characteristics. The material risks and 
characteristics of the particular security-based swap, including, but 
not limited to, the material factors that influence the day-to-day 
changes in valuation, the factors or events that might lead to 
significant losses, the sensitivities of the security-based swap to 
those factors and conditions, and the approximate magnitude of the 
gains or losses the security-based swap will experience under specified 
circumstances.
    (2) Material incentives or conflicts of interest. Any material 
incentives or conflicts of interest that the security-based swap dealer 
or major security-based swap participant may have in connection with 
the security-based swap, including any compensation or other incentives 
from any source other than the counterparty in connection with the 
security-based swap to be entered into with the counterparty.
    (3) Record. The security-based swap dealer or major security-based 
swap participant shall make a written record of the non-written 
disclosures made pursuant to paragraph (b) of this section, and provide 
a written version of these disclosures to its counterparties in a 
timely manner, but in any case no later than the delivery of the trade 
acknowledgement of the particular transaction pursuant to Sec.  
240.15Fi-1.
    (c) Daily Mark. A security-based swap dealer or major security-
based swap participant shall disclose the daily mark to the 
counterparty, other than a security-based swap dealer, major security-
based swap participant, swap dealer or major swap participant, which 
shall be:
    (1) For a cleared security-based swap, upon the request of the 
counterparty, the daily end-of-day settlement price that the security-
based swap dealer or major security-based swap participant receives 
from the appropriate clearing agency; and
    (2) For an uncleared security-based swap, the midpoint between the 
bid and offer, or the calculated equivalent thereof, as of the close of 
business,

[[Page 42455]]

unless the parties agree in writing otherwise to a different time, on 
each business day during the term of the security-based swap. The daily 
mark may be based on market quotations for comparable security-based 
swaps, mathematical models or a combination thereof. The security-based 
swap dealer or major security-based swap participant shall also 
disclose its data sources and a description of the methodology and 
assumptions used to prepare the daily mark, and promptly disclose any 
material changes to such data sources, methodology and assumptions 
during the term of the security-based swap.
    (d) Disclosure Regarding Clearing Rights. A security-based swap 
dealer or major security-based swap participant shall disclose the 
following information to a counterparty, other than a security-based 
swap dealer, major security-based swap participant, swap dealer or 
major swap participant:
    (1) For security-based swaps subject to clearing requirement. 
Before entering into a security-based swap subject to the clearing 
requirement under Section 3C(a) of the Act, a security-based swap 
dealer or major security-based swap participant shall:
    (i) Disclose to the counterparty the names of the clearing agencies 
that accept the security-based swap for clearing, and through which of 
those clearing agencies the security-based swap dealer or major 
security-based swap participant is authorized or permitted, directly or 
through a designated clearing member, to clear the security-based swap; 
and
    (ii) Notify the counterparty that it shall have the sole right to 
select which of the clearing agencies described in paragraph (d)(1)(i) 
shall be used to clear the security-based swap.
    (2) For security-based swaps not subject to clearing requirement. 
Before entering into a security-based swap not subject to the clearing 
requirement under Section 3C(a) of the Act, a security-based swap 
dealer or major security-based swap participant shall:
    (i) Determine whether the security-based swap is accepted for 
clearing by one or more clearing agencies;
    (ii) Disclose to the counterparty the names of the clearing 
agencies that accept the security-based swap for clearing, and whether 
the security-based swap dealer or major security-based swap participant 
is authorized or permitted, directly or through a designated clearing 
member, to clear the security-based swap through such clearing 
agencies; and
    (iii) Notify the counterparty that it may elect to require clearing 
of the security-based swap and shall have the sole right to select the 
clearing agency at which the security-based swap will be cleared, 
provided it is a clearing agency at which the security-based swap 
dealer or major security-based swap participant is authorized or 
permitted, directly or through a designated clearing member, to clear 
the security-based swap.
    (3) Record. The security-based swap dealer or major security-based 
swap participant shall make a written record of the non-written 
disclosures made pursuant to paragraph (d) of this section, and provide 
a written version of these disclosures to its counterparties in a 
timely manner, but in any case no later than the delivery of the trade 
acknowledgement of the particular transaction pursuant to Sec.  
240.15Fi-1.
    (e) Know Your Counterparty. Each security-based swap dealer shall 
establish, maintain and enforce policies and procedures reasonably 
designed to obtain and retain a record of the essential facts 
concerning each counterparty whose identity is known to the security-
based swap dealer, that are necessary for conducting business with such 
counterparty. For purposes of this section, the essential facts 
concerning a counterparty are:
    (1) Facts required to comply with applicable laws, regulations and 
rules;
    (2) Facts required to implement the security-based swap dealer's 
credit and operational risk management policies in connection with 
transactions entered into with such counterparty;
    (3) Information regarding the authority of any person acting for 
such counterparty; and
    (4) If the counterparty is a special entity, such background 
information regarding the independent representative as the security-
based swap dealer reasonably deems appropriate.
    (f) Recommendations of Security-Based Swaps or Trading Strategies.
    (1) A security-based swap dealer that recommends a security-based 
swap or trading strategy involving a security-based swap to a 
counterparty, other than a security-based swap dealer, major security-
based swap participant, swap dealer, or major swap participant, must 
have a reasonable basis to believe:
    (i) Based on reasonable diligence, that the recommended security-
based swap or trading strategy involving a security-based swap is 
suitable for at least some counterparties; and
    (ii) That a recommended security-based swap or trading strategy 
involving a security-based swap is suitable for the counterparty. To 
establish a reasonable basis for a recommendation, a security-based 
swap dealer must have or obtain relevant information regarding the 
counterparty, including the counterparty's investment profile, trading 
objectives, and its ability to absorb potential losses associated with 
the recommended security-based swap or trading strategy.
    (2) A security-based swap dealer may also fulfill its obligations 
under paragraph (g)(1) with respect to a particular counterparty if:
    (i) The security-based swap dealer reasonably determines that the 
counterparty, or an agent to which the counterparty has delegated 
decision-making authority, is capable of independently evaluating 
investment risks with regard to the relevant security-based swap or 
trading strategy involving a security-based swap;
    (ii) The counterparty or its agent affirmatively represents in 
writing that it is exercising independent judgment in evaluating the 
recommendations of the security-based swap dealer; and
    (iii) The security-based swap dealer discloses that it is acting in 
its capacity as a counterparty, and is not undertaking to assess the 
suitability of the security-based swap or trading strategy for the 
counterparty.
    (3) A security-based swap dealer will be deemed to have satisfied 
its obligations under paragraph (f)(1) of this section with respect to 
a special entity if:
    (i) The security-based swap dealer is acting as an advisor to the 
special entity and complies with the requirements of Sec.  240.15Fh-
4(b); or
    (ii) The security-based swap dealer is deemed not to be acting as 
an advisor to the special entity pursuant to Sec.  240.15Fh-2(a).
    (h) Fair and Balanced Communications. A security-based swap dealer 
or major security-based swap participant shall communicate with 
counterparties in a fair and balanced manner based on principles of 
fair dealing and good faith. In particular:
    (1) Communications must provide a sound basis for evaluating the 
facts with regard to any particular security-based swap or trading 
strategy involving a security-based swap;
    (2) Communications may not imply that past performance will recur 
or make any exaggerated or unwarranted claim, opinion or forecast; and
    (3) Any statement referring to the potential opportunities or 
advantages presented by a security-based swap shall be balanced by an 
equally detailed statement of the corresponding risks.
    (i) Supervision.
    (1) In general. A security-based swap dealer or major security-
based swap

[[Page 42456]]

participant shall establish, maintain and enforce a system to 
supervise, and shall diligently supervise its business and its 
associated persons, with a view to preventing violations of the 
provisions of applicable federal securities laws and the rules and 
regulations thereunder relating to its business as a security-based 
swap dealer or major security-based swap participant, respectively.
    (2) Minimum requirements. The system required by paragraph (g)(1) 
of this section shall be reasonably designed to achieve compliance with 
applicable securities laws and the rules and regulations thereunder, 
and at a minimum, shall provide for:
    (i) The designation of at least one person with authority to carry 
out the supervisory responsibilities of the security-based swap dealer 
or major security-based swap participant for each type of business in 
which it engages for which registration as a security-based swap dealer 
or major security-based swap participant is required;
    (ii) The use of reasonable efforts to determine that all 
supervisors are qualified and meet standards of training, experience, 
and competence necessary to effectively supervise the security-based 
swap activities of the persons associated with the security-based swap 
dealer or major security-based swap participant;
    (iii) Establishment, maintenance and enforcement of written 
policies and procedures addressing the supervision of the types of 
security-based swap business in which the security-based swap dealer or 
major security-based swap participant is engaged that are reasonably 
designed to achieve compliance with applicable securities laws and the 
rules and regulations thereunder, and that include, at a minimum:
    (A) Procedures for the review by a supervisor of transactions for 
which registration as a security-based swap dealer or major security-
based swap participant is required;
    (B) Procedures for the review by a supervisor of incoming and 
outgoing written (including electronic) correspondence with 
counterparties or potential counterparties and internal written 
communications relating to the security-based swap dealer's or major 
security-based swap participant's business involving security-based 
swaps;
    (C) Procedures for a periodic review, at least annually, of the 
security-based swap business in which the security-based swap dealer or 
major security-based swap participant engages that is reasonably 
designed to assist in detecting and preventing violations of, and 
achieving compliance with, applicable federal securities laws and 
regulations;
    (D) Procedures to conduct a reasonable investigation regarding the 
character, business repute, qualifications, and experience of any 
person prior to that person's association with the security-based swap 
dealer or major security-based swap participant;
    (E) Procedures to consider whether to permit an associated person 
to establish or maintain a securities or commodities account in the 
name of, or for the benefit of such associated person, at another 
security-based swap dealer, broker, dealer, investment adviser, or 
other financial institution; and if permitted, procedures to supervise 
the trading at the other security-based swap dealer, broker, dealer, 
investment adviser, or financial institution, including the receipt of 
duplicate confirmations and statements related to such accounts;
    (F) A description of the supervisory system, including the titles, 
qualifications and locations of supervisory persons and the specific 
responsibilities of each person with respect to the types of business 
in which the security-based swap dealer or major security-based swap 
participant is engaged;
    (G) Procedures prohibiting an associated person who performs a 
supervisory function from supervising his or her own activities or 
reporting to, or having his or her compensation or continued employment 
determined by, a person or persons he or she is supervising; and
    (H) Procedures preventing the standards of supervision from being 
reduced due to any conflicts of interest of a supervisor with respect 
to the associated person being supervised.
    (iv) Written policies and procedures reasonably designed, taking 
into consideration the nature of such security-based swap dealer's or 
major security-based swap participant's business, to comply with the 
duties set forth in Section 15F(j) of the Act.
    (3) Failure to supervise. A security-based swap dealer or major 
security-based swap participant or an associated person of a security-
based swap dealer or major security-based swap participant shall not be 
deemed to have failed to diligently supervise any other person, if such 
other person is not subject to his or her supervision, or if:
    (i) The security-based swap dealer or major security-based swap 
participant has established and maintained written policies and 
procedures, and a documented system for applying those policies and 
procedures, that would reasonably be expected to prevent and detect, 
insofar as practicable, any violation of the federal securities laws 
and the rules and regulations thereunder relating to security-based 
swaps; and
    (ii) The security-based swap dealer or major security-based swap 
participant, or associated person of the security-based swap dealer or 
major security-based swap participant, has reasonably discharged the 
duties and obligations required by the written policies and procedures 
and documented system and did not have a reasonable basis to believe 
that the written policies and procedures and documented system were not 
being followed.
    (4) Maintenance of written supervisory procedures. A security-based 
swap dealer or major security-based swap participant shall:
    (i) Promptly amend its written supervisory procedures as 
appropriate when material changes occur in applicable securities laws 
or rules or regulations thereunder, and when material changes occur in 
its business or supervisory system; and
    (ii) Promptly communicate any material amendments to its 
supervisory procedures throughout the relevant parts of its 
organization.

Sec.  240.15Fh-4  Special requirements for security-based swap dealers 
acting as advisors to special entities.

    (a) In general. It shall be unlawful for a security-based swap 
dealer or major security-based swap participant:
    (1) To employ any device, scheme, or artifice to defraud any 
special entity or prospective customer who is a special entity;
    (2) To engage in any transaction, practice, or course of business 
that operates as a fraud or deceit on any special entity or prospective 
customer who is a special entity; or
    (3) To engage in any act, practice, or course of business that is 
fraudulent, deceptive, or manipulative.
    (b) A security-based swap dealer that acts as an advisor to a 
special entity regarding a security-based swap shall comply with the 
following requirements:
    (1) Duty. The security-based swap dealer shall have a duty to act 
in the best interests of the special entity.
    (2) Reasonable Efforts. The security-based swap dealer shall make 
reasonable efforts to obtain such information that the security-based 
swap dealer considers necessary to make a reasonable determination that 
a security-based swap or trading strategy involving a security-based 
swap is in the best interests of the special entity.

[[Page 42457]]

This information shall include, but not be limited to:
    (i) The authority of the special entity to enter into a security-
based swap;
    (ii) The financial status of the special entity, as well as future 
funding needs;
    (iii) The tax status of the special entity;
    (iv) The investment or financing objectives of the special entity;
    (v) The experience of the special entity with respect to entering 
into security-based swaps, generally, and security-based swaps of the 
type and complexity being recommended;
    (vi) Whether the special entity has the financial capability to 
withstand changes in market conditions during the term of the security-
based swap; and
    (vii) Such other information as is relevant to the particular facts 
and circumstances of the special entity, market conditions and the type 
of security-based swap or trading strategy involving a security-based 
swap being recommended.
    (3) Exemption. The requirements of this Sec.  240.15Fh-4(b) shall 
not apply with respect to a security-based swap if:
    (i) The transaction is executed on a registered security-based swap 
execution facility or registered national securities exchange; and
    (ii) The security-based swap dealer does not know the identity of 
the counterparty, at any time up to and including execution of the 
transaction.

Sec.  240.15Fh-5  Special requirements for security-based swap dealers 
and major security-based swap participants acting as counterparties to 
special entities.

    (a) A security-based swap dealer or major security-based swap 
participant that offers to enter into or enters into a security-based 
swap with a special entity must have a reasonable basis to believe that 
special entity has a qualified independent representative. For these 
purposes, a qualified independent representative is an independent 
representative that:
    (1) Has sufficient knowledge to evaluate the transaction and risks;
    (2) Is not subject to a statutory disqualification;
    (3) Undertakes a duty to act in the best interests of the special 
entity;
    (4) Makes appropriate and timely disclosures to the special entity 
of material information concerning the security-based swap;
    (5) Will provide written representations to the special entity 
regarding fair pricing and the appropriateness of the security-based 
swap; and
    (6) 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(21) of that Act (29 U.S.C. 1002(21)); and
    (7) In the case of a special entity defined in Sec. Sec.  240.15Fh-
2(e)(2) or (4), is a person that is subject to rules of the Commission, 
the Commodity Futures Trading Commission or a self-regulatory 
organization subject to the jurisdiction of the Commission or the 
Commodity Futures Trading Commission prohibiting it from engaging in 
specified activities if certain political contributions have been made, 
provided that this paragraph (a)(7) shall not apply if the independent 
representative is an employee of the special entity.
    (b) Before initiation of a security-based swap with a special 
entity, a security-based swap dealer shall disclose to the special 
entity in writing the capacity in which the security-based swap dealer 
is acting and, if the security-based swap dealer engages in business, 
or has engaged in business within the last twelve months, with the 
counterparty in more than one capacity, the security-based swap dealer 
shall disclose the material differences between such capacities in 
connection with the security-based swap and any other financial 
transaction or service involving the counterparty.
    (c) The requirements of this Sec.  240.15Fh-5 shall not apply with 
respect to a security-based swap if:
    (1) The transaction is executed on a registered security-based swap 
execution facility or registered national securities exchange; and
    (2) The security-based swap dealer or major security-based swap 
participant does not know the identity of the counterparty, at any time 
up to and including execution of the transaction.

Sec.  240.15Fh-6  Political contributions by certain security-based 
swap dealers.

    (a) Definitions. For the purposes of this section:
    (1) The term contribution means any gift, subscription, loan, 
advance, or deposit of money or anything of value made:
    (i) For the purpose of influencing any election for state or local 
office;
    (ii) For payment of debt incurred in connection with any such 
election; or
    (iii) For transition or inaugural expenses incurred by the 
successful candidate for state or local office.
    (2) The term covered associate means:
    (i) Any general partner, managing member or executive officer, or 
other person with a similar status or function;
    (ii) Any employee who solicits a municipal entity to enter into a 
security-based swap with the security-based swap dealer and any person 
who supervises, directly or indirectly, such employee; and
    (iii) A political action committee controlled by the security-based 
swap dealer or by a person described in paragraphs (c)(2)(i) and 
(c)(2)(ii) of this section.
    (3) The term executive officer of a security-based swap dealer 
means:
    (i) The president;
    (ii) Any vice president in charge of a principal business unit, 
division or function (such as sales, administration or finance);
    (iii) Any other officer of the security-based swap dealer who 
performs a policy-making function; or
    (iv) Any other person who performs similar policy-making functions 
for the security-based swap dealer.
    (4) The term municipal entity is defined in Section 15B(e)(8) of 
the Act.
    (5) The term official of a municipal entity means any person 
(including any election committee for such person) who was, at the time 
of the contribution, an incumbent, candidate or successful candidate 
for elective office of a municipal entity, if the office:
    (i) Is directly or indirectly responsible for, or can influence the 
outcome of, the selection of a security-based swap dealer by a 
municipal entity; or
    (ii) Has authority to appoint any person who is directly or 
indirectly responsible for, or can influence the outcome of, the 
selection of a security-based swap dealer by a municipal entity.
    (6) The term payment means any gift, subscription, loan, advance, 
or deposit of money or anything of value.
    (7) The term regulated person means:
    (i) A person that is subject to rules of the Commission, the 
Commodity Futures Trading Commission or a self-regulatory organization 
subject to the jurisdiction of the Commission or the Commodity Futures 
Trading Commission prohibiting it from engaging in specified activities 
if certain political contributions have been made, or its officers or 
employees;
    (ii) A general partner, managing member or executive officer of 
such person, or other individual with a similar status or function; or
    (iii) An employee of such person who solicits a municipal entity 
for the security-based swap dealer and any person who supervises, 
directly or indirectly, such employee.
    (8) The term solicit means a direct or indirect communication by 
any person with a municipal entity for the purpose of obtaining or 
retaining an engagement related to a security-based swap.
    (b) Prohibitions and Exceptions.
    (1) It shall be unlawful for a security-based swap dealer to offer 
to enter into,

[[Page 42458]]

or enter into, a security-based swap, or a trading strategy involving a 
security-based swap, with a municipal entity within two years after any 
contribution to an official of such municipal entity was made by the 
security-based swap dealer, or by any covered associate of the 
security-based swap dealer.
    (2) The prohibition in paragraph (b)(1) does not apply:
    (i) If the only contributions made by the security-based swap 
dealer to an official of such municipal entity were made by a covered 
associate:
    (A) To officials for whom the covered associate was entitled to 
vote at the time of the contributions, if the contributions in the 
aggregate do not exceed $350 to any one official per election; or
    (B) To officials for whom the covered associate was not entitled to 
vote at the time of the contributions, if the contributions in the 
aggregate do not exceed $150 to any one official, per election;
    (ii) To a security-based swap dealer as a result of a contribution 
made by a natural person more than six months prior to becoming a 
covered associate of the security-based swap dealer, however, this 
exclusion shall not apply if the natural person, after becoming a 
covered associate, solicits the municipal entity on behalf of the 
security-based swap dealer to offer to enter into, or to enter into, 
security-based swap, or a trading strategy involving a security-based 
swap; or
    (iii) With respect to a security-based swap that is initiated by a 
municipal entity on a registered national securities exchange or 
registered security-based swap execution facility and the security-
based swap dealer does not know the identity of the counterparty to the 
transaction at any time up to and including execution of the 
transaction.
    (3) No security-based swap dealer or any covered associate of the 
security-based swap dealer shall:
    (i) Provide or agree to provide, directly or indirectly, payment to 
any person to solicit a municipal entity to offer to enter into, or to 
enter into, a security-based swap or any trading strategy involving a 
security-based swap with that security-based swap dealer unless such 
person is a regulated person; or
    (ii) Coordinate, or solicit any person or political action 
committee to make, any:
    (A) Contribution to an official of a municipal entity with which 
the security-based swap dealer is offering to enter into, or has 
entered into, a security-based swap security-based swap, or a trading 
strategy involving a security-based swap; or
    (B) Payment to a political party of a state or locality with which 
the security-based swap dealer is offering to enter into, or has 
entered into, a security-based swap security-based swap, or a trading 
strategy involving a security-based swap.
    (c) Circumvention of Rule. No security-based swap dealer shall, 
directly or indirectly, through or by any other person or means, do any 
act that would result in a violation of paragraph (a) or (b) of this 
section.
    (d) Requests for Exemption. The Commission, upon application, may 
conditionally or unconditionally exempt a security-based swap dealer 
from the prohibition under paragraph (a)(1) 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 security-based swap dealer:
    (i) Before the contribution resulting in the prohibition was made, 
adopted and implemented policies and procedures reasonably designed to 
prevent violations of this section;
    (ii) Prior to or at the time the contribution which resulted in 
such prohibition was made, had no actual knowledge of the contribution; 
and
    (iii) After learning of the contribution:
    (A) Has taken all available steps to cause the contributor involved 
in making the contribution which resulted in such prohibition to obtain 
a return of the contribution; and
    (B) Has taken such other remedial or preventive measures as may be 
appropriate under the circumstances;
    (3) Whether, at the time of the contribution, the contributor was a 
covered associate or otherwise an employee of the security-based swap 
dealer, or was seeking such employment;
    (4) The timing and amount of the contribution which resulted in the 
prohibition;
    (5) The nature of the election (e.g., state or local); and
    (6) The contributor's apparent intent or motive in making the 
contribution that resulted in the prohibition, as evidenced by the 
facts and circumstances surrounding the contribution.
    (e) Prohibitions Inapplicable.
    (1) The prohibitions under paragraph (b) of this section shall not 
apply to a contribution made by a covered associate of the security-
based swap dealer if:
    (i) The security-based swap dealer discovered the contribution 
within 120 calendar days of the date of such contribution;
    (ii) The contribution did not exceed $350; and
    (iii) The covered associate obtained a return of the contribution 
within 60 calendar days of the date of discovery of the contribution by 
the security-based swap dealer.
    (2) A security-based swap dealer may not rely on paragraph (1) of 
this section more than twice in any 12-month period.
    (3) A security-based swap dealer may not rely on paragraph (1) of 
this section more than once for any covered associate, regardless of 
the time between contributions.
    3. Add Sec.  240.15Fk-1 to read as follows:

Sec.  240.15Fk-1  Designation of Chief Compliance Officer for security-
based swap dealers and major security-based swap participants.

    (a) In General. A security-based swap dealer and major security-
based swap participant shall designate an individual to serve as a 
chief compliance officer on its registration form.
    (b) Duties. The chief compliance officer shall:
    (1) Report directly to the board of directors or to the senior 
officer of the security-based swap dealer or major security-based swap 
participant;
    (2) Review the compliance of the security-based swap dealer or 
major security-based swap participant with respect to the security-
based swap dealer and major security-based swap participant 
requirements described in Section 15F of the Act, and the rules and 
regulations thereunder, where the review shall include establishing, 
maintaining, and reviewing written policies and procedures reasonably 
designed to achieve compliance with Section 15F of the Act and the 
rules and regulations thereunder, by the security-based swap dealer or 
major security-based swap participant;
    (3) In consultation with the board of directors or the senior 
officer of the security-based swap dealer or major security-based swap 
participant, promptly resolve any conflicts of interest that may arise;
    (4) Be responsible for administering each policy and procedure that 
is required to be established pursuant to Section 15F of the Act and 
the rules and regulations thereunder;
    (5) Establish, maintain and review policies and procedures 
reasonably

[[Page 42459]]

designed to ensure compliance with the Act and the rules and 
regulations thereunder relating to its business as a security-based 
swap dealer or major security-based swap participant;
    (6) Establish, maintain and review policies and procedures 
reasonably designed to remediate promptly non-compliance issues 
identified by the chief compliance officer through any:
    (i) Compliance office review;
    (ii) Look-back;
    (iii) Internal or external audit finding;
    (iv) Self-reporting to the Commission and other appropriate 
authorities; or
    (v) Complaint that can be validated; and
    (7) Establish and follow procedures reasonably designed for the 
prompt handling, management response, remediation, retesting, and 
resolution of non-compliance issues.
    (c) Annual Reports.
    (1) In general. The chief compliance officer shall annually prepare 
and sign a report that contains a description of:
    (i) The compliance of the security-based swap dealer or major 
security-based swap participant with respect to the Act and the rules 
and regulations thereunder relating to its business as a security-based 
swap dealer or major security-based swap participant; and
    (ii) Each policy and procedure of the security-based swap dealer or 
major security-based swap participant described in paragraph (b) of 
this section, (including the code of ethics and conflict of interest 
policies).
    (2) Requirements.
    (i) Each compliance report shall also contain, at a minimum, a 
description of:
    (A) The security-based swap dealer or major security-based swap 
participant's enforcement of its policies and procedures relating to 
its business as a security-based swap dealer or major security-based 
participant;
    (B) Any material changes to the policies and procedures since the 
date of the preceding compliance report;
    (C) Any recommendation for material changes to the policies and 
procedures as a result of the annual review, the rationale for such 
recommendation, and whether such policies and procedures were or will 
be modified by the security-based swap dealer or major security-based 
swap participant to incorporate such recommendation; and
    (D) Any material compliance matters identified since the date of 
the preceding compliance report.
    (ii) A compliance report under paragraph (c)(1) of this section 
also shall:
    (A) Accompany each appropriate financial report of the security-
based swap dealer or major security-based swap participant that is 
required to be furnished to or filed with the Commission pursuant to 
Section 15F of the Act and rules and regulations thereunder;
    (B) Be submitted to the board of directors and audit committee (or 
equivalent bodies) and the senior officer of the security-based swap 
dealer or major security-based swap participant at the earlier of their 
next scheduled meeting or within 45 days of the date of execution of 
the required certification;
    (C) Include a written representation that the chief executive 
officer(s) (or equivalent officer(s)) has/have conducted one or more 
meetings with the chief compliance officer(s) in the preceding 12 
months, the subject of which addresses the obligations in this section, 
including:
    (1) The matters that are the subject of the compliance report;
    (2) The SBS Entity's compliance efforts as of the date of such a 
meeting; and
    (3) Significant compliance problems and plans in emerging business 
areas relating to its business as a security-based swap dealer or major 
security-based swap participant; and
    (D) Include a certification that, under penalty of law, the 
compliance report is accurate and complete.
    (iii) Confidentiality. If compliance reports are separately bound 
from the financial statements, the compliance reports shall be accorded 
confidential treatment to the extent permitted by law.
    (d) Compensation and Removal. The compensation and removal of the 
chief compliance officer shall require the approval of a majority of 
the board of directors of the security-based swap dealer or major 
security-based swap participant.
    (e) Definitions. For purposes of this rule, references to:
    (1) The board or board of directors shall include a body performing 
a function similar to the board of directors.
    (2) The senior officer shall include the chief executive officer or 
other equivalent officer.
    (3) Complaint that can be validated shall include any written 
complaint by a counterparty involving the security-based swap dealer or 
major security-based swap participant or person associated with a 
security-based swap dealer or major security-based swap participant 
that can be supported upon reasonable investigation.
    (4) A material compliance matter means any compliance matter about 
which the board of directors of the security-based swap dealer or major 
security-based swap participant would reasonably need to know to 
oversee the compliance of the security-based swap dealer or major 
security-based swap participant, and that involves, without limitation:
    (i) A violation of the federal securities laws relating to its 
business as a security-based swap dealer or major security-based swap 
participant, by the firm or its officers, directors, employees or 
agents;
    (ii) A violation of the policies and procedures relating to its 
business as a security-based swap dealer or major security-based swap 
participant by the firm or its officers, directors, employees or 
agents; or
    (iii) A weakness in the design or implementation of the policies 
and procedures relating to its business as a security-based swap dealer 
or major security-based swap participant.

    By the Commission.

    Dated: June 29, 2011.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-16758 Filed 7-15-11; 8:45 am]
BILLING CODE 8011-01-P