The SEC has proposed regulations implementing Dodd-Frank provisions requiring business conduct standards for security-based swap dealers and major security-based swap participants. The proposed rules would impose know your counterparty and suitability obligations on swap dealers They would also require security-based swap dealers and major security-based swap participants to communicate in a fair and balanced manner and disclose conflicts of interest and material incentives to potential counterparties. Additional requirements would be imposed for dealings with special entities, which include municipalities, pension plans, and endowments. Security-based swap dealers and major security-based swap participants would also have to designate a chief compliance officer. Public comments on the proposals are invited until Aug. 29, 2011.
The chief compliance officer designated by security-based swap dealers and major security-based swap participants would report directly to the board of directors and must establish policies and procedures reasonably designed to achieve compliance by the swap dealer or participant. Also, the chief compliance officer would, in consultation with the board of directors, resolve conflicts of interest that may arise.
While Dodd-Frank does not require security-based swap entities to be members of SROs, and no SRO has authority to regulate their activities, the SEC was informed by SRO business conduct rules, especially FINRA and the NFA, in developing business conduct rules for security-based swap entities. At the same time, the SEC recognizes that the security-based swap has a different dynamic, what with its wide range of counterparty sophistication and greater participation of institutional investors, and has struck a balance with that in mind.
Security-based swap dealers and major security-based swap participants would be required to verify whether a counterparty is an eligible contract participant and whether it is a special entity and disclose to the counterparty material information about the security-based swap, including risks, characteristics, incentives and conflicts of interest. Counterparties would have to be given information concerning the daily mark of the security-based swap and the ability to require clearing of the security-based swap, with any communications with counterparties to be conducted in a fair and balanced manner based on principles of fair dealing and good faith. More broadly, swap dealers and participants would have to establish a supervisory and compliance infrastructure.
The regulations would impose a suitability regime on security-based swap dealers such that they would have to determine that any recommendations they make regarding security-based swaps are suitable for their counterparties. The regime would be similar to the FINRA rule regarding suitability, including institutional suitability.
Similarly, the know your counterparty obligations under the proposed regulations are a modified version of the know your customer obligations imposed on broker-dealers when dealing with customers The swap dealers would also have to 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, including facts necessary to comply with applicable laws and regulations and rules, facts necessary to effectuate the swap dealer’s credit and operational risk management policies in connection with transactions entered into with a counterparty, information regarding the authority of any person acting for such counterparty, and if the counterparty is a special entity, such background information regarding the independent representative as the swap dealer reasonably deems appropriate.
The SEC proposes that all security-based swap dealers and major participants be required to determine if a counterparty is a special entity, which is defined as a federal of state agency, an ERISA-defined employee benefit plan, an IRC 501(c)(3) endowment.
The regulations would define what it means to “act as an advisor” to a special entity, and would require that a security-based swap dealer who acts as an advisor to a special entity act in the best interests of the special entity and make reasonable efforts to obtain information that it needs to determine that the recommendation is in the best interests of the special entity. In addition, security-based swap dealers and major security-based swap participants acting as counterparties to special entities would have to reasonably believe that the counterparty has an independent representative who has sufficient knowledge to evaluate the transaction and risks, is not subject to a statutory disqualification, and is independent of the swap dealer or participant. The swap dealer and swap participant would also have a duty to act in the best interests of the special entity, disclose material information concerning the security-based swap, and provides written representations on fair pricing and appropriateness of the security-based swap. In addition, the independent representative would be subject to pay-to-play regulations, and if the special entity is an ERISA plan, would be required to be a fiduciary under ERISA.
The regulations would require security-based swap dealers and major participants to verify that a counterparty meets the eligibility standards for an eligible contract participant before entering into a security-based swap transaction. The verification requirement could be satisfied by obtaining a written representation from the counterparty. The SEC set out two alternative approaches when it would not be appropriate to rely on the counterparty’s representation without further inquiry. The first approach would permit reliance on a representation unless the swap dealer or participant knows that the representation is not accurate.
The second would permit reliance on a representation unless the dealer has information that would cause a reasonable person to question the accuracy of the representation. Under either approach, a swap dealer or participant could not ignore information in its possession as a result of which it would know that a representation is inaccurate. The Commission’s approach to reliance on a counterparty representation is similar to a suggestion from SIFMA and ISDA that swap dealers and participants 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 dealer on notice.
Similarly, under Regulation R, a bank or a broker-dealer satisfies its customer eligibility requirements if it has a reasonable basis to believe that the customer is an institutional customer or high net worth customer. 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.