Fair, Balanced Communication in Security-based Swap Market Pushed

Jack Humphrey, Regulatory journalist
July 07, 2011 /

Security-based swap dealers and major security-based swap participants are called to communicate in a fair and balanced manner and make certain disclosures as the Securities and Exchange Commission (SEC) has proposed business conduct standards for them.

To promote accountability and transparency, the Dodd-Frank Act, from which the rules stem, establishes a comprehensive framework that regulates the over-the-counter swaps markets.

Dodd-Frank specifically establishes business conduct standards for security-based swap dealers and major security-based swap participants whenever those entities 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 as defined under the Employee Retirement Income Security Act of 1974 (ERISA), governmental plans, and endowments.

SEC chairperson Mary Schapiro said: “The rules we are proposing would level the playing field in the security-based swap market by bringing needed transparency to this market and by seeking to ensure that customers in these transactions are treated fairly.

“The standards we propose are intended to establish a framework that protects investors and also promotes efficiency, competition, and capital formation.”

The proposed rules seek to 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.

They are also required to 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 and the ability to require clearing of the security-based swap; communicate with ; establish a supervisory and compliance infrastructure; and designate a chief compliance officer that is required to fulfill the described duties and provide an annual compliance report.

The proposed rules also would require security-based swap dealers to determine that any recommendations they make regarding security-based swaps are suitable for their counterparties (this proposal is similar to the FINRA rule regarding suitability, including institutional suitability); 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; and comply with rules designed to prevent “pay-to-play.”

The proposed rules also defined “act as an advisor” as 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, the proposed rules would require security-based swap dealers and major security-based swap participants acting as counterparties to special entities 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; 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 disclosures of material information concerning the security-based swap; and provides written representations to the special entity regarding 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, the independent representative would be required to be a fiduciary under ERISA.

The proposal has been a collaboration between the SEC and the CFTC that also has proposed rules with respect to the external business conduct standards of swap dealers and major swap participants.

The SEC seeks public comment until August 29 and data about a broad range of issues relating to the proposed rules, including the costs and benefits associated with the proposal.


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