Friday, September 02, 2011

Hedge Fund Industry Comments on SEC Proposed Business Conduct Standards for Security-Based Swap Dealers and Major Participants

In a letter to the SEC, the hedge fund industry asked the Commission to clarify that the definition of special entity in the proposed business conduct standards for security-based swap dealers and major security-based swap participants does not apply to investment vehicles, such as hedge funds, in which the special entity may invest. Similarly, the Managed Funds Association asked the SEC to clarify that it will not look through an investment vehicle to its investors to determine whether the investment vehicle is a special entity.

In enacting the Dodd-Frank Act, Congress imposed a duty on certain relationships between security-based swap dealers and special entities to ensure that appropriate safeguards are in place to protect the special entities when security-based swap dealers are advising special entities. Investment vehicles that have special entities invested in them have financially sophisticated and knowledgeable investment advisers that advise and manage those investment vehicles and that owe fiduciary duties to those special entities as investors, noted the MFA. Security-based swap dealers serve as counterparties to these investment vehicles, but do not directly interact with, enter into transactions with, or serve in a position of trust and confidence with respect to those vehicles’ investors.

Thus, the MFA posited that, even if special entities invest in these investment vehicles, the relationships between the vehicles and their swap dealer counterparties do not pose the same concerns that are present with respect to direct swap dealer advice to, or interaction with, special entities. The MFA is also concerned with the possibility that the presence of an investment by a special entity in an investment vehicle may make it more costly or even impossible for that investment vehicle to secure a security-based swap as part of its desired investment strategy.

On a separate point, to the extent that major swap participants are transacting with eligible contract participants at arm’s-length, the MFA urged the Commission not to impose burdensome dealer-like obligations on major swap participants, particularly the requirements to disclose material information, to provide contemporaneous written records of oral disclosures of material information and clearing rights, and to provide daily marks for uncleared security-based s swaps.

More specifically, the proposal would require major swap participants to make written records of non-written disclosures of material information and clearing rights concerning a security-based swap and to provide these disclosures to their non-swap entity counterparties in writing no later than delivery of the trade acknowledgement. According to the MFA, this obligation will require major security-based swap participants to expend substantial resources to obtain and track this information quickly and reliably.

A major swap participant entering into an arm’s-length transaction with an eligible contract participant is entering into a contract with a sophisticated entity able to evaluate the material risks and other material characteristics of a swap for itself, noted the MFA, without receiving disclosures from its major swap participant counterparty. The MFA reasoned that there is no meaningful benefit to the eligible contract participant counterparty in an arm’s-length transaction sufficient to outweigh that cost.

To the extent that major swap participants are transacting with counterparties at arm’s-length, continued the hedge fund association, the Commission is urged not to impose the requirements to provide material information and deliver contemporaneous written records of non-written disclosures of material information and clearing rights on major security-based swap participants. Alternatively, the MFA suggested that the Commission allow eligible contract participant counterparties to opt out of receiving such disclosures to lower their hedging costs and to avoid potential trading delays and inefficiencies.

In any event, continued the MFA, at a minimum, a major security-based swap participant’s duty to provide material information should explicitly exclude the provision of swap scenario analyses. This level of disclosure is unnecessary and very costly, said the MFA, and the proposal already requires major swap participants to undertake a transaction-specific analysis and prepare tailored disclosures of a transaction’s loss sensitivities to market factors and conditions and the magnitude of gains and losses the transaction may experience under specified circumstances.

In the MFA’s view, mandating major swap participants to conduct these additional scenario analyses for the benefit of their arm’s-length counterparties effectively requires them to conduct the counterparty’s due diligence, thereby creating disincentives for the counterparty to undertake its own due diligence.

While the MFA generally supports the Commission’s proposed exception to the Qualified Representative Rule for any security-based swap transaction with a special entity that is executed on a registered execution facility or national securities exchange and the swap entity does not know the identity of the counterparty, the association believes that the exception is too limited for certain forms of swap executions where the time period between awareness of the counterparty’s identity and the execution of the transaction is too short for the swap entity to obtain the requisite factual verifications and representations to comply with the Qualified Representative Rule.