March 2, 1998 Jonathan G. Katz Secretary Securities and Exchange Commission Mail Stop 6-9 450 Fifth Street, N.W. Washington, D.C. 20549 Re: File No. S7-30-97 OTC Derivatives Dealers Dear Mr. Katz: On behalf of the Legal and Regulatory Committee of the End-Users of Derivatives Association ("EUDA"), I appreciate the opportunity to comment on the Securities and Exchange Commission's ("SEC's") proposed rule affecting OTC derivatives dealers. EUDA was organized in 1994 as a District of Columbia nonprofit corporation to promote the interests of end-users of derivatives. It is to be an independent end-user resource, disseminating information and providing a forum for end-users to share their ideas and concerns about this growing and important financial market. EUDA's membership includes banks, utilities, energy companies, insurance and investment companies, manufacturing companies, and government-sponsored enterprises. EUDA is supportive of the articulated broad objectives of the SEC proposal, namely to reduce any unnecessary regulatory incentives for U.S. firms to conduct a portion of their OTC derivatives activities offshore and to permit such firms to conduct all of their OTC derivatives activities through a single entity. These objectives are consistent with (i) reducing legal risk that arises when American firms are compelled to enter into agreements with non-U.S. affiliates of U.S. derivatives dealers and (ii) reducing counterparty credit risk through more comprehensive netting arrangements. EUDA's basic criteria in evaluating regulatory changes is to assess whether they will better ensure the integrity of the derivatives markets and enhance end-user protections and safeguards. As discussed below, EUDA is not yet in a position to fully evaluate the proposal from this broader perspective. Due to the length and complexity of the SEC proposal, few of our end-users members have had the time fully to study the proposal and its implications. There are a number of aspects of the proposal that may be of substantial interest to end-users and several of these are noted briefly in this letter. One area of particular interest to EUDA which does not appear to be discussed in the SEC's proposal relates to Federal anti-fraud authority over the OTC derivatives markets. EUDA has consistently taken the position that a Federal regulator (or Federal regulatory bodies) with expertise in the OTC derivatives markets and resources to monitor those markets should have the clear anti-fraud authority. We understand that the SEC has anti-fraud authority only with respect to those transactions described in the proposed rule as "securities" OTC derivatives transactions (e.g., OTC options on equity securities or on U.S. government securities). SEC anti-fraud authority does not extend to what we understand to constitute the large majority of OTC derivatives transactions (e.g., interest rate swaps, currency swaps, commodity swaps) covered by the CFTC swaps exemption, which are described in the SEC proposal as "non-securities" OTC derivatives transactions. It is not clear to us what the implications of the new regulatory structure would be for the CFTC in terms of enforcing the anti-fraud provisions which it specifically reserved when it adopted the swaps exemption for OTC derivatives transactions. Would the CFTC, for example, be entitled to have access to the books and records required to be maintained by the derivatives dealer under the SEC rules? Would the CFTC have input into (and access to) the internal controls of derivatives dealers that are related to monitoring and managing the risks associated with the "non-securities" derivatives activities. Before EUDA takes any definitive position with respect to the SEC proposal, we believe our members should have an opportunity to review and consider the comments submitted to the SEC by the CFTC on matters affecting the CFTC's jurisdiction over "non-securities" OTC derivatives. EUDA also believes that it would be helpful to have a better understanding of certain other aspects of the SEC proposal in order to be in a position to offer constructive comments. These include the following: 1. It would assist in our understanding of the proposal if the SEC could be more specific in defining "securities" OTC derivatives and "non-securities" OTC derivatives. As a result of the Gibson Greetings and Procter and Gamble regulatory enforcement actions and the ruling of Judge Feikens in the Procter and Gamble civil litigation, there continues to be uncertainty as to whether certain swap transactions may in fact be treated as "securities" OTC derivatives. This has important implications for both dealers and end-users and additional guidance from the SEC in this matter would be helpful. 2. With respect to "non-securities" OTC derivatives, the SEC proposal appears to contain no sales practice requirements for OTC derivatives dealers. Given the clear decision of the SEC to ensure that purchasers of "securities" OTC derivatives would continue to enjoy the full investor protections accorded customers under the Federal securities laws, EUDA is interested in understanding why the SEC concluded that no such protections were warranted with respect to "non-securities" OTC derivatives. 3. There appears to be a suggestion in the SEC Supplementary Information that as a general rule counterparties in OTC derivatives transactions that enter into collateral support agreements permit their counterparties free use of posted collateral (e.g., permit the secured party to sell or rehypothecate the collateral). Our understanding is that permitting such use of posted collateral may expose the pledging party to significant additional credit risk and, for that reason, it is not uncommon for end-users to deny such rights to the party holding posted collateral. (For a recent discussion of the risks associated with permitting rehypothecation of collateral see Johnson, "Derivatives and Rehypothecation Failure: It's 3:00 p.m., Do You Know Where Your Collateral Is?" 39 Arizona Law Review 949 (1997)). While EUDA understands that the SEC's proposal is designed to permit parties to agree upon rehypothecation rights, it was uncertain whether the SEC intended the granting of such rights to be the general rule for such agreements. 4. EUDA understands that the flexible capital requirements proposed by the SEC are intended to "protect the customers of a broker-dealer from losses that can be incurred upon a broker-dealer's failure" and "to reflect international efforts to standardize capital requirements." We assume that "customer" in this context includes all the counterparties to the broker-dealer's OTC derivatives transactions (e.g., those engaging in both "securities" and "non-securities" OTC derivatives transactions). In order to address the credit concerns of end-user counterparties, a number of securities firms have established so-called "AAA subsidiaries" to act as counterparties in certain OTC derivatives transactions. Other dealers have offered parent company guarantees or other credit support provisions to address concerns of their end-user counterparties. EUDA would like to have a better understanding of how such existing arrangements will or will not be affected by the new regulatory regime contemplated by the SEC proposal. EUDA would certainly be supportive of efforts to ensure that dealer counterparties are adequately capitalized. At the same time, we assume that it is not the intention of the SEC to encourage end-users to rely solely on regulatory capital requirements in seeking appropriate credit support for their transactions with dealer counterparties. Additional discussion and clarification in this area would be helpful. Because the SEC's proposal does not address some of the important issues identified above, we believe the SEC should consider holding open the record in this matter or reproposing the rule in order to afford EUDA members and other interested parties the opportunity to better understand the proposal and provide additional input to the SEC. Again, we appreciate the opportunity to share some of the preliminary thoughts of our members concerning this significant SEC proposal. If you would like to discuss any of these matters further, or if you have any questions, pleasecontact the undersigned through EUDA at (202) 383-0639. EUDA's e-mail address is EUDA@AOL.COM. Sincerely, Dana Yealy Chairman, EUDA Legal and Regulatory Committee Member, EUDA Board of Directors