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

The Securities and Exchange Commission voted on April 13 to adopt final rules implementing a comprehensive set of business conduct standards and chief compliance officer requirements for security-based swap dealers and major security-based swap participants (security-based swap entities).

The final rules are adopted under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which authorizes the Commission to implement a framework for regulating the over-the-counter security-based swap markets.

“For years, the over-the-counter derivatives market operated without basic customer protections,” said SEC Chair Mary Jo White.  “These rules better protect investors by providing fundamental reforms to the conduct of security-based swap activity that are designed to address the specific issues presented by the nature of the products and relationships in the security-based swap market.”

The final rules require security-based swap entities to comply with a range of provisions designed to enhance transparency, facilitate informed customer decision-making, and heighten standards of professional conduct.  For example, security-based swap entities are required to deal fairly with potential counterparties by communicating in a fair and balanced manner, disclosing material information about the security-based swap, including material risks, characteristics, incentives and conflicts of interest, and adhering to other professional standards of conduct. Additional requirements will apply for dealings with special entities, which include municipalities, pension plans, endowments, and similar entities.  The rules also establish supervision and chief compliance officer requirements.  In addition, the rules address the cross-border application of these requirements and the potential availability of substituted compliance.

The final rules will become effective 60 days after publication in the Federal Register.  These rules also establish a separate compliance date, which generally is based on the compliance date of the registration rules for security-based swap entities.   

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FACT SHEET

SEC Open Meeting
April 13, 2016

Action

The Securities and Exchange Commission adopted final rules implementing a comprehensive set of business conduct standards and chief compliance officer requirements for security-based swap dealers and major security-based swap participants (security-based swap entities).  The rules implement the business conduct standards and chief compliance officer requirements under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The rules are designed to enhance transparency, facilitate informed customer decision-making and heighten standards of professional conduct to better protect investors.

Highlights of the Rules

Provisions Applicable to Security-Based Swap Entities

The rules, among other things, require security-based swap dealers and major security-based swap participants to:

·         Verify whether a counterparty is an eligible contract participant and whether it is a special entity

·         Disclose to the counterparty material information about the security-based swap, including material risks, characteristics, incentives and conflicts of interest

·         Provide the counterparty with information concerning the daily mark of the security-based swap, as well as concerning the ability to require clearing of the security-based swap

·         Communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith

·         Establish a supervisory and compliance infrastructure

·         Designate a chief compliance officer who is required to fulfill the described duties and prepare an annual compliance report.

Provisions Applicable to Security-Based Swap Dealers

The rules also require security-based swap dealers to:

• Determine that any recommendations they make regarding security-based swaps are suitable for their counterparties
• Establish, maintain and enforce policies and procedures reasonably designed to obtain and retain a record of the essential facts concerning each known counterparty that are necessary to conduct business with such counterparty

The final rules define what it means to “act as an advisor” to a special entity, and require security-based swap dealers who act as an advisor to a special entity to:

• Make a reasonable determination that any security-based swap or trading strategy involving a security-based swap that it recommends is in the best interests of the special entity
• Make reasonable efforts to obtain information that it considers necessary to make a reasonable determination that the recommendation is in the best interests of the special entity

The rules also provide a safe harbor under which the parties could agree that a security-based swap dealer is not acting as an advisor to a special entity.

Heightened Protections in Transactions with Special Entities and Other Requirements

The final rules require security-based swap dealers and major security-based swap participants acting as counterparties to special entities to reasonably believe that the special entity has a qualified independent representative who is either an Employee Retirement Income Security Act of 1974 (ERISA) fiduciary (if the special entity is an ERISA plan), or who meets the following requirements:

• Has sufficient knowledge to evaluate the transaction and risks
• Is not subject to a statutory disqualification
• Is independent of the security-based swap dealer or major security-based swap participant
• Undertakes a duty to act in the best interests of the special entity
• Makes appropriate and timely disclosures to the special entity of material information concerning the security-based swap
• Evaluates, consistent with any guidelines provided by the special entity, the fair pricing and appropriateness of the security-based swap
• Is subject to pay-to-play regulations

The rules also require security-based swap dealers to comply with rules designed to prevent “pay-to-play” in transactions with municipal entities.

In addition, the rules permit security-based swap entities to reasonably rely on representations to satisfy their various due diligence obligations.  In addition, the rules generally do not apply if a counterparty’s identity is not known at a reasonably sufficient time prior to execution of the transaction to permit the security-based swap dealer or major security-based swap participant to comply with the obligations of the rules.

Cross-Border Application

The final rules define the scope of application of the transaction-level business conduct requirements to security-based swap dealers and major security-based swap participants.  In particular, the final rules require U.S. security-based swap dealers to comply with transaction-level business conduct requirements with respect to all of their transactions, except for certain transactions conducted through such dealer’s foreign branch.  Foreign security-based swap dealers are required to comply with transaction-level business conduct requirements with respect to any transaction with a U.S. person (except for a transaction conducted through the foreign branch of a U.S. person) and any transaction that the security-based swap dealer arranges, negotiates, or executes using personnel located in the United States, even if the counterparty is a non-U.S. person.

The final rules also provide for the possibility of substituted compliance. The substituted compliance rule (Exchange Act rule 3a71-6) would allow the Commission to conditionally provide that non-U.S. security-based swap dealers and non-U.S. major security-based swap participants may satisfy business conduct requirements under the Exchange Act by complying with foreign requirements that the Commission has determined to be comparable.   

Background

To enhance accountability and transparency, the Dodd-Frank Act establishes a comprehensive framework for regulating the over-the-counter swaps markets.  Among other things, the Act establishes business conduct standards for “security-based swap dealers” and “major security-based swap participants” whenever those entities act as advisors to “special entities” or engage in security-based swap transactions with counterparties, including those that are “special entities.”

Special entities include federal agencies, states and political subdivisions, employee benefit plans and governmental plans as defined under the ERISA, and endowments.

Other Regulators

The SEC worked closely with the U.S. Commodity Futures Trading Commission (CFTC) at all stages of this rulemaking. The CFTC previously adopted rules with respect to the business conduct standards of swap dealers and major swap participants.  Commission staff also has consulted with representatives of the other federal financial regulators and with Department of Labor representatives on this rulemaking.

What’s Next?

The final rules become effective 60 days after publication in the Federal Register.  These rules also establish a separate compliance date, which is based on the compliance date of the registration rules for security-based swap dealers and major security-based swap participants, with two exceptions as discussed below.  

The compliance date for application of the customer protection requirements described in Rule 3a71-3(c) to any security-based swap transaction of a foreign security-based swap dealer that is arranged, negotiated, or executed by personnel of the foreign security-based swap dealer (or its agent) located in a U.S. branch or office (as described in Rule 3a71-3(a)(8)(i)(B)) is the later of (a) 12 months following publication in the Federal Register, or (b) the compliance date of the registration rules for security-based swap dealers and major security-based swap participants.  The substituted compliance rule becomes effective 60 days after publication, without a separate compliance date.