Final External Business Conduct Rules for Swap Dealers and Major Swap Participants under Dodd-Frank Issued by CFTC | Practical Law

Final External Business Conduct Rules for Swap Dealers and Major Swap Participants under Dodd-Frank Issued by CFTC | Practical Law

The CFTC adopted final rules under Title VII of the Dodd-Frank Act imposing so-called "external" business conduct standards on swap dealers and major swap participants (MSPs) in dealings with their swap counterparties.

Final External Business Conduct Rules for Swap Dealers and Major Swap Participants under Dodd-Frank Issued by CFTC

by PLC Finance
Published on 19 Jan 2012 • USA (National/Federal)
The CFTC adopted final rules under Title VII of the Dodd-Frank Act imposing so-called "external" business conduct standards on swap dealers and major swap participants (MSPs) in dealings with their swap counterparties.
On January 11, 2012, the CFTC approved final rules under the Dodd-Frank Act imposing "external" business conduct standards and requirements on swap dealers (SDs) and major swap participants (MSPs) in their dealings with their swap counterparties. These rules are designed to ensure compliance by SDs and MSPs with Title VII of the Dodd-Frank Act and prevent evasion of the Act and related regulations.
The final rules establish due-diligence and disclosure obligations for SDs and MSPs entering into swaps with non-SDs/non-MSPs. For example, SDs and MSPs are required to:
  • Verify that counterparties with which they are contemplating entering into a swap are eligible contract participants (ECPs), as defined in the Commodity Exchange Act (CEA). The SD/MSP may rely on a representation from its counterparty that the counterparty is an ECP to satisfy this obligation under the rules.
  • Ascertain whether counterparties with which they are contemplating entering into a swap are "special entities," as defined in the final rules. Special entities are federal, state and local government entities in the US (but not non-US sovereigns) and employee benefit plans.
The final rules also require SDs (but not MSPs) that enter into swaps to:
  • Disclose to their swap counterparties the material risks of entering into the swap contemplated, as well any material conflicts of interest the SD may have in entering into the swap.
  • Provide a detailed "scenario analysis," if requested by the counterparty. A scenario analysis examines the potential losses to the fair value of the swap under market conditions ranging from normal stress to severe stress. A scenario analysis should illustrate potential economic outcomes that might occur and the effect of these outcomes on the value of the swap. However, a scenario analysis would likely be costly to the counterparty, a factor that is not addressed by the final rules.
  • Have a reasonable basis for believing that the swap is suitable for the counterparty, a concept referred to in the rules as "institutional suitability." To satisfy this obligation under the rules, the SD may make representations to and rely on representations from its counterparty (see Representations by the Parties in Connection with the Final Rules). Note that the SD must still reasonably determine that the counterparty is capable of independently evaluating its risk under the swap.
Most of these diligence and disclosure obligations, including the requirement to verify whether the counterparty is an ECP, do not apply when:
  • The SD or MSP enters into a swap with another SD or MSP, or with a security-based SD or major security-based swap participant.
  • The swap is executed on a swap execution facility (SEF) or designated contract market (DCM) (in either case, a registered swap exchange) and the SD or MSP does not know the identity of the counterparty before execution of the swap.
The final rules also:
  • Impose upon SDs and MSPs a duty to communicate with their swap counterparties in a fair and balanced manner based on principles of fair dealing and good faith.
  • Require SDs and MSPs to inform their swap counterparties of their right to elect to clear a swap for which clearing is not mandatory under Dodd-Frank and to select the clearinghouse to be used.
  • Require SDs and MSPs to provide their swap counterparties with daily mid-market marks of their uncleared swap positions. This requirement is applicable to swaps entered into anonymously on a SEF or DCM. A mid-market mark is a daily mark that does not include amounts for profit, credit reserve, hedging, funding, liquidity or any other costs or adjustments.
  • Require confidential treatment of counterparty information.
  • Prohibit SDs and MSPs from engaging in fraudulent, deceptive and manipulative acts or practices in dealing with their swap counterparties. The final rules do provide for an affirmative defense to non-scienter fraud violations if the SD or MSP establishes that it complied in good faith with relevant policies and procedures.
  • Impose the following additional requirements on SDs and MSPs entering into swaps with special entities:
    • in acting as an advisor to a special entity under the rules, an SD must act in the best interests of the special entity. An SD "acts as an advisor" to a special entity when it recommends a swap or swap trading strategy tailored to the needs or characteristics of the special entity. Acting as an advisor to a special entity under the rules, however, does not impose a fiduciary relationship between the special entity and the SD. MSPs may not be advisors to special entities under the rules; and
    • an SD or MSP must have a reasonable basis to believe that a non-ERISA special entity with which it enters into a swap has a knowledgeable, independent representative advising it on whether to enter into the swap, which is not subject to statutory disqualification as a representative of the non-ERISA special entity. The rules provide for an independence test for the special entity's representative, which, among other requirements, may not have been an associate or principal of the SD or MSP within one year of acting as the representative for the special entity and may not be under common control with the SD/MSP.
      If entering into a swap with an ERISA plan, the SD/MSP must have a reasonable basis for believing the ERISA plan's representative is an ERISA fiduciary.
It appears that the CFTC contemplates both private rights of action and agency rights of action under the final rules, and notes that it cannot exempt swap dealers and MSPs from private rights of action under Section 22 of the CEA. The rules note further that issues related to private rights of action are beyond the scope of the rulemaking. The rules also state that in the absence of fraud, the CFTC will consider good faith compliance with policies and procedures reasonably designed to comply with the business conduct standards rules as a mitigating factor when exercising its prosecutorial discretion for violation of the rules.
Many of the requirements in the final rules, including those relating to entering into swaps with special entities, may be addressed through representations that made be made by the parties in the swap documentation entered into between them (see Representations by the Parties in Connection with the Final Rules).

Documentational Implications of the Final Rules

Swap Disclosure Documentation under the Final Rules

Because of the disclosure obligations imposed on SDs and MSPs in the final rules, swap dealing in the US appears likely to develop some similarities to the offering of securities under the US securities laws. Most SDs and MSPs will likely need to create standard disclosure documents for standard types of swaps, which they will furnish to counterparties in satisfaction of the final rules on disclosure of swap risks to counterparties.
The final rules permit SDs and MSPs to provide this information to counterparties in a standard format. This format could end up resembling a prospectus in many ways and is likely to include risk factors involved with entering into:
  • Swaps generally.
  • The specific type of swap contemplated (for example, credit default swap, interest rate swap).
  • The particular swap contemplated, including its specified economic and other commercial terms. This disclosure will be unique to each swap, and will not be able to be standardized in most cases. The CFTC does note that not all of the information required to be furnished by SDs and MSPs to their counterparties under the final rules will be able to be provided in standard format.

Representations by the Parties in Connection with the Final Rules

As noted, SDs and MSPs may make representations to and rely on representations from their swap counterparties and other related parties to satisfy certain of their obligations under the final rules. The final rules specify that the parties may use a master agreement such as an ISDA Master Agreement for making representations that satisfy many of the obligations of SDs and MSPs under the final rules. Representations made in such an agreement are deemed renewed with each swap entered into under that master agreement. Therefore, SDs and MSPs may want to consider including the following representations in their swap documentation (in the ISDA Schedule) to accommodate the final rules:
  • A representation from its counterparty that the counterparty is an ECP under the CEA.
  • A representation from the SD/MSP that it has complied with its obligations under the final rules to inform its counterparty of its right to request that the swap be cleared and to select the clearinghouse to be used, even though it may not be required to clear the swap under Title VII of the Dodd-Frank Act.
  • A representation from the counterparty that the SD/MSP has complied with its obligation under the final rules to offer its counterparty a scenario analysis for the contemplated swap.
  • The SD/MSP party may also consider requesting that its swap counterparties represent in their swap documents that the SD/MSP has furnished it with information sufficient to permit it to:
    • make an informed decision regarding whether or not to enter into the swap;
    • make a determination that entering into the swap is in its best interests.
    Counterparties accommodating such a request may wish to modify it with a knowledge qualifier (to the best of its knowledge). Any such representation is not likely to be determinative, but may be considered out of an abundance of caution.
  • The SD/MSP may also consider including a representation to the effect that it has implemented and complied in good faith with policies and procedures reasonably designed to comply with the business conduct standards rules applicable to it under the Dodd-Frank Act.
In addition to the representations listed above, SDs may want to consider including the following representations in their swap documentation to address the institutional suitability requirement under the rules:
  • A representation from its counterparty that it is exercising independent judgement in entering into the swap.
  • A representation from its counterparty or its counterparty's agent that the counterparty is capable of independently evaluating the suitability of a swap and absorbing any losses that could result from it, and that the counterparty is exercising independent judgment in entering into the swap.
  • A representation from the SD that it is acting as a counterparty and not evaluating the suitability of the swap for the counterparty.
The final rules detail a number of representations that may be made by special entities and their representatives, or in the case of an ERISA plan, by the ERISA plan and its fiduciary, which SDs and MSPs may rely upon to satisfy certain of their obligations under the rules relating to entering into swaps with these special entities.

Compliance and Further Information

The final rules will become effective 60 days after publication in the Federal Register. SDs and MSPs will be required to comply with the final rules on the later of:
As is the case with all final rules issued by the CFTC under Dodd-Frank, these final business conduct rules cover entities in their capacity as SDs and MSPs under Title VII of the Dodd-Frank Act in their dealings in non-security-based swaps.
For more on these proposed rules, see the CFTC's fact sheet and Q&A.
To learn more about the regulation of swaps and derivatives under the Dodd-Frank Act, including further information on SDs and MSPs and their obligations under Dodd-Frank, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives. See also, Practice Note, Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: Swaps and Derivatives.