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

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Start Preamble Start Printed Page 29960

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

In accordance with Section 764 of Title VII (“Title VII”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Securities and Exchange Commission (“SEC” or “Commission”) is adopting new rules under the Securities Exchange Act of 1934 (“Exchange Act”) that are intended to implement provisions of Title VII relating to business conduct standards and the designation of a chief compliance officer for security-based swap dealers and major security-based swap participants. The final rules also address the cross-border application of the rules and the availability of substituted compliance.

DATES:

Effective Date: July 12, 2016.

Compliance Date: The compliance dates are discussed in Section IV.B of this release.

Start Further Info

FOR FURTHER INFORMATION CONTACT:

Lourdes Gonzalez, Assistant Chief Counsel—Sales Practices, Joanne Rutkowski, Senior Special Counsel, Cindy Oh, Special Counsel, Lindsay Kidwell, Special Counsel, Stacy Puente, Special Counsel, Devin Ryan, Special Counsel, Office of Chief Counsel, Division of Trading and Markets, at (202) 551-5550, at the Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549. For further information on cross-border application of the rules, contact: Carol McGee, Assistant Director, Richard Gabbert, Senior Special Counsel, Joshua Kans, Senior Special Counsel, and Margaret Rubin, Special Counsel, Office of Derivatives Policy, Division of Trading and Markets, at (202) 551-5550, at the Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549.

End Further Info End Preamble Start Supplemental Information

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Summary of Final Rules

B. Cross-Border Application of the Final Rules

C. Consistency With CFTC Rules

D. Department of Labor ERISA Fiduciary Regulations

E. Investment Adviser and Municipal Advisor Status

F. Intersection With SRO Rules

II. Discussion of Rules Governing Business Conduct

A. Scope, Generally

B. Exceptions for Anonymous SEF or Exchange-Traded Transactions

C. Application of the Rules to SBS Dealers and Major SBS Participants

D. Reliance on Representations

E. Policies and Procedures Alternative

F. Definitions

G. Business Conduct Requirements

1. Counterparty Status

2. Disclosure

a. Disclosure Not Required When the Counterparty Is an SBS Entity or a Swap Entity

b. Timing and Manner of Certain Disclosures and Scope of Disclosure Rules

c. Material Risks and Characteristics of the Security-Based Swap

d. Material Incentives or Conflicts of Interest

e. Daily Mark

f. Clearing Rights

3. Know Your Counterparty

4. Recommendations by SBS Dealers

5. Fair and Balanced Communications

6. Obligation Regarding Diligent Supervision

H. Rules Applicable to Dealings With Special Entities

1. Scope of Definition of “Special Entity”

2. “Acts as an Advisor” to a Special Entity

3. Definition of “Best Interests”

4. Antifraud Provisions

5. SBS Entities Acting as Counterparties to Special Entities

6. Qualifications of the Independent Representative

a. Written or Other Representations Regarding Qualifications

b. Sufficient Knowledge To Evaluate Transaction and Risks

c. No Statutory Disqualification

d. Undertakes a Duty To Act in the Best Interests of the Special Entity

e. Makes Appropriate and Timely Disclosures to Special Entity

f. Pricing and Appropriateness

g. Subject to “Pay To Play” Prohibitions

h. ERISA Fiduciary

i. Safe Harbor

7. Disclosure of Capacity

8. Exceptions for Anonymous, Special Entity Transactions on an Exchange or SEF

9. Certain Political Contributions by SBS Dealers

I. Chief Compliance Officer

J. Prime Brokerage Transactions

K. Other Comments

III. Cross-Border Application and Availability of Substituted Compliance

IV. Explanation of Dates

A. Effective Date

B. Compliance Date

C. Application to Substituted Compliance

V. Paperwork Reduction Act

VI. Economic Analysis

A. Introduction and Broad Economic Considerations

B. Baseline

1. Available Data Regarding Security-Based Swap Activity

2. Security-Based Swap Market: Market Participants and Dealing Structures

a. Security-Based Swap Market Participants

b. Participant Domiciles

c. Market Centers

d. Common Business Structures for Firms Engaged in Security-Based Swap Dealing Activity

e. Current Estimates of Number of SBS Dealers and Major SBS Participants

3. Security-Based Swap Market: Levels of Security-Based Swap Trading Activity

4. Global Regulatory Efforts

5. Dually Registered Entities

6. Cross-Market Participation

7. Pay To Play Prohibitions

C. Costs and Benefits of Business Conduct Rules

1. Verification of Status and Know Your Counterparty Rules

2. Disclosures and Communications

a. Risks, Characteristics, and Conflicts of Interest

b. Daily Mark

c. Clearing Rights

3. Suitability

a. Costs and Benefits

b. Institutional Suitability Alternative

4. Special Entities

a. Scope and Verification

b. SBS Entities as Counterparties to Special Entities

c. SBS Dealers as Advisors to Special Entities

d. Independent Representation: Alternatives

e. Reliance on Representations

f. Magnitude of the Economic Effects

5. Fraud, Fair and Balanced Communications, Supervision

a. Antifraud

b. Fair and Balanced Communications

c. Supervision

6. CCO Rules

a. Annual Compliance Report, Conflicts of Interest, Policies and Procedures

b. CCO Removal and Compensation

7. Pay To Play

8. Scope

a. Inter-Affiliate Transactions

b. Opt Out

9. Cross-Border Application

a. Scope of Application to SBS Entities

b. Substituted Compliance

D. Effects on Efficiency, Competition and Capital Formation

VII. Regulatory Flexibility Act Certification

Statutory Basis and Text of Final Rules

I. Introduction

The Commission is adopting Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1 to implement the business conduct standards and chief compliance officer (“CCO”) requirements for security-based swap dealers (“SBS Dealers”) and major security-based swap participants (“Major SBS Participants” and, together with SBS Start Printed Page 29961Dealers, “SBS Entities”) as set forth in Title VII of the Dodd-Frank Act.[1] The Commission is also amending Rules 3a67-10 and 3a71-3 and adopting Rule 3a71-6 with respect to the cross-border application of the rules and the availability of substituted compliance.

The Dodd-Frank Act was enacted, among other reasons, to promote the financial stability of the United States by improving accountability and transparency in the financial system.[2] The 2008 financial crisis highlighted significant issues in the over-the-counter derivatives markets, which experienced dramatic growth in the years leading up to the financial crisis and are capable of affecting significant sectors of the U.S. economy. Title VII of the Dodd-Frank Act provides for a comprehensive new regulatory framework for swaps and security-based swaps by, among other things: (1) Providing for the registration and comprehensive regulation of SBS Entities, swap dealers (“Swap Dealers”), and major swap participants (“Major Swap Participants” and, together with Swap Dealers, “Swap Entities”); (2) imposing clearing and trade execution requirements for swaps and security-based swaps, subject to certain exceptions; (3) creating recordkeeping, regulatory reporting, and public dissemination requirements for swaps and security-based swaps; and (4) enhancing the rulemaking and enforcement authorities of the Commission and the Commodity Futures Trading Commission (“CFTC”).

The Commission initially proposed Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1 in June 2011.[3] In May 2013, the Commission re-opened the comment period for all of its outstanding Title VII rulemakings, including the external business conduct rulemaking.[4]

The Commission received 40 comments on the Proposing Release, of which 9 were comments submitted in response to the Reopening Release.[5] Of the comments directed at the Cross-Border Proposing Release,[6] five referenced the proposed external business conduct standards specifically,[7] while others addressed cross-border issues generally, such as the application of substituted Start Printed Page 29962compliance,[8] without specifically referring to the Proposing Release. Of the comments submitted in response to the U.S. Activity Proposing Release,[9] eight addressed the proposed cross-border application of the business conduct standards.[10]

The Commission is now adopting Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1, with certain revisions suggested by commenters or designed to clarify the rules and conform them to the rules adopted by the CFTC. The principal aspects of the rules are briefly described immediately below. A detailed discussion of each rule follows in Sections II.A.-II.J, below.[11]

A. Summary of Final Rules

Rule 15Fh-1, as adopted, defines the scope of Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1, and provides that an SBS Entity can rely on the written representations of a counterparty or its representative to satisfy its due diligence requirements under the rules, unless it has information that would cause a reasonable person to question the accuracy of the representation.

Rule 15Fh-2, as adopted, sets forth the definitions used throughout Rules 15Fh-1 through 15Fh-6. The defined terms are discussed in connection with the rules in which they appear.

Rule 15Fh-3, as adopted, defines the business conduct requirements generally applicable to SBS Entities with respect to: (1) Verification of counterparty status as an eligible contract participant (“ECP”) or special entity; (2) disclosure to the counterparty of material information about the security-based swap, including material risks, characteristics, incentives, and conflicts of interest; (3) disclosure of information concerning the daily mark of the security-based swap; (4) disclosure regarding the ability of the counterparty to require clearing of the security-based swap; (5) communication with counterparties in a fair and balanced manner based on principles of fair dealing and good faith; and (6) the establishment of a supervisory and compliance infrastructure. Rule 15Fh-3, as adopted, additionally requires an SBS Dealer to: (1) Establish, maintain and enforce written 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 that counterparty; and (2) comply with certain suitability obligations when recommending a security-based swap, or trading strategy involving a security-based swap, to a counterparty.

Rule 15Fh-4(a), as adopted, provides that it shall be unlawful for an SBS Entity to: (i) Employ any device, scheme, or artifice to defraud any special entity or prospective customer who is a special entity; (ii) engage in any transaction, practice, or course of business that operates as a fraud or deceit on any special entity or prospective customer who is a special entity; or (iii) to engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative.

Rule 15Fh-4(b), as adopted, sets forth particular requirements for SBS Dealers acting as advisors to special entities.[12] Specifically, an SBS Dealer that acts as an advisor to a special entity must 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.[13]

Rule 15Fh-5, as adopted, sets forth particular requirements for SBS Entities acting as counterparties to special entities. Under the rule, those SBS Entities must have a reasonable basis to believe that the counterparty has a qualified representative who: (1) Has sufficient knowledge to evaluate the transaction and risks; (2) is not subject to a statutory disqualification; (3) is independent of the SBS Entity; (4) undertakes a duty to act in the best interests of the special entity; (5) makes appropriate and timely disclosures to the special entity of material information concerning the security-based swap; and (6) provides written representations regarding fair pricing and the appropriateness of the security-based swap. If the special entity is an employee benefit plan that is subject to regulation under Title I of ERISA (“ERISA plan”), these requirements are satisfied if the independent representative is a “fiduciary” under ERISA. In addition, the independent representative must be subject to pay-to-play regulation if the special entity is a “municipal entity” or a “governmental plan” as defined in Section 3 of ERISA.

Rule 15Fh-6, as adopted, imposes certain pay-to-play restrictions on SBS Dealers. The rule generally prohibits an SBS Dealer from engaging in security-Start Printed Page 29963based swap transactions with a “municipal entity” within two years after certain political contributions have been made to officials of the municipal entity. As with other pay-to-play rules, Rule 15Fh-6 does not prohibit political contributions.

Rule 15k-1, as adopted, requires an SBS Entity to designate a CCO and imposes certain duties and responsibilities on that CCO.

B. Cross-Border Application of the Final Rules

Rule 3a71-3(c) and related amendments to Rule 3a71-3(a), as adopted, define the scope of application of the business conduct standards described in Section 15F(h) of the Exchange Act, and the rules and regulations thereunder (other than the rules and regulations prescribed by the Commission pursuant to Section 15F(h)(1)(B)) to SBS Dealers. As adopted, these rules require a registered U.S. SBS Dealer to comply with transaction-level business conduct requirements with respect to all of its transactions, except for certain transactions conducted through such dealer's foreign branch. The rules further require a registered foreign SBS Dealer to comply with transaction-level business conduct requirements with respect to any transaction with a U.S. person (except for a transaction conducted through a foreign branch of the U.S. person) and any transaction that the SBS Dealer arranges, negotiates, or executes using personnel located in the United States.

Rule 3a67-10(d) and related amendments to Rule 3a67-10(a), as adopted, define the scope of application of the business conduct standards described in Section 15F(h) of the Exchange Act, and the rules and regulations thereunder (other than the rules and regulations prescribed by the Commission pursuant to Section 15F(h)(1)(B)) to registered Major SBS Participants. As adopted, these rules, like those applicable to registered SBS Dealers, require a registered U.S. Major SBS Participant to comply with transaction-level business conduct requirements with respect to all of its transactions, except for certain transactions conducted through such participant's foreign branch. The rules further require a registered foreign Major SBS Participant to comply with transaction-level business conduct requirements with respect to any transaction with a U.S. person (except for a transaction conducted through a foreign branch of the U.S. person) but not any transaction with a non-U.S. person.

Finally, Rule 3a71-6, as adopted, provides a framework under which foreign SBS Dealers and foreign Major SBS Participants may seek to satisfy certain business conduct requirements under Title VII by means of substituted compliance.

In developing these final rules, including their cross-border application, we have consulted and coordinated with the CFTC and the prudential regulators [14] in accordance with the consultation mandate of the Dodd-Frank Act.[15] The Commission also has consulted and coordinated with foreign regulatory authorities through Commission staff participation in numerous bilateral and multilateral discussions with foreign regulatory authorities addressing the regulation of OTC (over-the-counter) derivatives.[16] Through these discussions and the Commission staff's participation in various international task forces and working groups,[17] we have gathered information about foreign regulatory reform efforts and their impact on and relationship with the U.S. regulatory regime. The Commission has taken and will continue to take these discussions into consideration in developing rules, forms, and interpretations for implementing Title VII of the Dodd-Frank Act.[18]

C. Consistency With CFTC Rules

The Commission and CFTC staffs, prior to the proposal of rules by their respective agency, held approximately 30 joint meetings with interested parties regarding the agencies' respective business conduct rules to solicit a variety of views.[19] As discussed in Section I.D. below, the agencies' staffs also consulted with Department of Labor (“DOL”) representatives on this rulemaking. In the Proposing Release, the Commission solicited comment on the impact of any differences between the Commission's and CFTC's approaches to business conduct regulations, and whether the Commission's proposed business conduct regulations should be modified to conform to the proposals made by the CFTC.[20] Subsequently, in February 2012, the CFTC adopted final rules with respect to the external business conduct standards of Swap Entities that are generally consistent with the Commission's proposed rules.[21] In addition, in April 2013, the CFTC adopted final rules with respect to internal business conduct standards regarding, among other things, the obligation of a Swap Entity to diligently supervise its business.[22] These rules also require each Swap Entity to designate a CCO, prescribe qualifications and duties of the CCO, and require that the CCO prepare, sign, and furnish the annual report containing an assessment of the Start Printed Page 29964registrant's compliance activities to either the board of directors or the senior officer.[23] The rules further require the annual report to be furnished to the CFTC.[24]

In May 2013, in the Reopening Release, the Commission sought comment on certain specific issues, including: (1) The relationship of the proposed rules to any parallel requirements of other authorities, including the CFTC and relevant foreign regulatory authorities; and (2) with respect to the CFTC rules, whether and to what extent the Commission, in adopting its own rules, should emphasize consistency with the CFTC rules versus adopting rules that are more tailored to the security-based swap market, including any specific examples where consistency or tailoring of a particular rule or rule set is more critically important.[25]

The Commission received numerous comments regarding consistency with the CFTC's external business conduct rules both before and after the CFTC adopted its final rules.[26] Comments specific to individual rules are addressed in the discussions of the respective rules below. As a general matter, these comments had, as an overarching theme, that the Commission should coordinate with the CFTC to achieve consistent regulations.[27] Commenters stressed that differences between the regulatory regimes would, among other things, increase regulatory burdens and costs for market participants, delay execution of transactions, and lead to confusion.[28]

Before the CFTC adopted its final external business conduct rules, commenters were divided as to whether they preferred the Commission's [29] or the CFTC's [30] proposed approach to specific issues, in instances in which the CFTC's proposed approach differed from the Commission's proposed rules. However, the comments received by the Commission in response to the Reopening Release, which was issued after the CFTC adopted its final rules, overwhelmingly urged the Commission to harmonize its external business conduct rules with those of the CFTC because the CFTC's rules have already been implemented by the industry.[31] A number of these comments have suggested specific and detailed modifications. Where we believe the external business conduct rules, if modified in accordance with these suggestions, will continue to provide the protections (as explained in the context of the particular rule) that the rules are intended to accomplish, we have modified the proposed rules to harmonize with CFTC requirements to create efficiencies for entities that have already established infrastructure for compliance with analogous CFTC requirements.[32]

D. Department of Labor ERISA Fiduciary Regulations

Section 15F(h)(2)(C) of the Exchange Act defines the term “special entity” to include “an employee benefit plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974.” [33]

Prior to proposing the business conduct standards rules, the Commission received submissions from commenters concerning the interaction with ERISA, DOL's proposed fiduciary rule, and current regulation regarding the definition of ERISA fiduciaries.[34] As noted above, the Commission, CFTC and DOL staffs consulted on issues regarding the intersection of ERISA fiduciary status with the Dodd-Frank Act business conduct provisions, prior to the Commission's proposing rules in this area.[35]

The Commission received numerous comments concerning the interaction of ERISA and existing fiduciary regulation with the business conduct standards under the Exchange Act and the Commission's proposed rules.[36] Commenters, including ERISA plan sponsors, dealers and institutional asset managers, stated that although ERISA plans currently use security-based swaps as part of their overall hedging or investment strategy, the statutory and regulatory intersections of ERISA and the external business conduct standards under Title VII of the Dodd-Frank Act could prevent ERISA plans from participating in security-based swap markets in the future, and the proposed business conduct standards rules, if adopted without clarification, could have unintended consequences for SBS Entities dealing with ERISA plans.[37]

Commenters were primarily concerned that compliance with the business conduct standards under the Exchange Act or the Commission's proposed rules would cause an SBS Entity to be an ERISA fiduciary to an ERISA plan and thus, subject to ERISA's prohibited transaction provisions.[38] If an SBS Entity were to become an ERISA fiduciary to an ERISA plan, it would be prohibited from entering into a security-based swap with that ERISA plan absent an exemption.[39] One commenter Start Printed Page 29965asserted that the penalties for violating ERISA's prohibited transaction provisions would discourage SBS Entities from dealing with ERISA plans.[40] Other commenters asserted that compliance by SBS Entities with the following obligations could cause an SBS Entity to be an ERISA fiduciary: (1) Providing information regarding the risks of the security-based swap; (2) providing the daily mark; (3) reviewing the ability of the special entity's advisor to advise the special entity with respect to the security-based swap; and (4) acting in the best interests of the special entity.[41] Accordingly, commenters requested that the Commission and DOL coordinate the respective rules to clarify that compliance with the business conduct standards rules will not make an SBS Entity an ERISA fiduciary.[42]

DOL staff reviewed the CFTC's final business conduct standards rules for Swap Entities and provided the CFTC with the following statement:

The Department of Labor has reviewed these final business conduct standards and concluded that they do not require swap dealers or major swap participants to engage in activities that would make them fiduciaries under the Department of Labor's current five-part test defining fiduciary advice 29 CFR 2510.3-21(c). In the Department's view, the CFTC's final business conduct standards neither conflict with the Department's existing regulations, nor compel swap dealers or major swap participants to engage in fiduciary conduct. Moreover, the Department states that it is fully committed to ensuring that any changes to the current ERISA fiduciary advice regulation are carefully harmonized with the final business conduct standards, as adopted by the CFTC and the SEC, so that there are no unintended consequences for swap dealers and major swap participants who comply with these business conduct standards.[43]

Thereafter, in April 2015, the DOL reproposed a change to the definition of fiduciary under ERISA.[44] The DOL noted that its staff had “consulted with staff of the SEC.” [45]

On April 6, 2016, DOL issued its final rule.[46] We understand that DOL's revised definition of “fiduciary” in its final rule is intended to allow SBS Entities to avoid becoming ERISA fiduciaries when acting as counterparties to a swap or security-based swap transaction. For example, DOL makes the following statement in the preamble to its final rule:

The Department has provided assurances to the CFTC and the SEC that the Department is fully committed to ensuring that any changes to the current ERISA fiduciary advice regulation are carefully harmonized with the final business conduct standards, as adopted by the CFTC and the SEC, so that there are no unintended consequences for swap and security-based swap dealers and major swap and security-based swap participants who comply with the business conduct standards. See, e.g., Letter from Phyllis C. Borzi, Assistant Secretary, Employee Benefits Security Administration, U.S. Department of Labor, to The Hon. Gary Gensler et al., CFTC (Jan. 17, 2012). In this regard, we note that the disclosures required under the business conduct standards, including those regarding material information about a swap or security-based swap concerning material risks, characteristics, incentives and conflicts of interest; disclosures regarding the daily mark of a swap or security-based swap and a counterparty's clearing rights; disclosures necessary to ensure fair and balanced communications; and disclosures regarding the capacity in which a swap or security-based swap dealer or major swap participant is acting when a counterparty to a special entity, do not in the Department's view compel counterparties to ERISA-covered employee benefit plans, other plans or IRAs to make a recommendation for purposes of paragraph (a) of the final rule or otherwise compel them to act as fiduciaries in swap and security-based swap transactions conducted pursuant to section 4s of the Commodity Exchange Act and section 15F of the Securities Exchange Act. This section of this Notice discusses these issues in the context of the express provisions in the final rule on swap and security-based swap transactions and on transactions with independent fiduciaries with financial expertise.[47]

Furthermore, DOL's final rule establishes a “swap and security-based swap transactions” exclusion [48] which, in DOL's view, is intended to establish conditions under which persons acting as SBS Entities, among others, “do not become investment advice fiduciaries as a result of communications and activities conducted during the course of swap or security-based swap transactions regulated under the Dodd-Frank Act provisions in the Commodity Exchange Act or the Securities Exchange Act of 1934 and applicable CFTC and SEC implementing rules and regulations.” [49] In addition, DOL has stated that its exclusion for “transactions with independent plan fiduciaries with financial expertise” has been significantly adjusted and expanded in the final rule and gives an alternative avenue for parties involved in swap, security-based swap, or other investment transactions to conduct the transaction in a way that would ensure they do not become investment advice fiduciaries under the final rule.[50]

The Commission staff has continued to coordinate with DOL staff to ensure that the final business conduct standards rules are appropriately harmonized with ERISA and DOL regulations. DOL staff has provided the Commission with a statement that:

It is the Department's view that the draft final business conduct standards do not require security-based swap dealers or major security-based swap participants to engage in activities that would make them fiduciaries under the Department's current five-part test defining fiduciary investment advice. 29 CFR 2510.3-21(c). The standards neither conflict with the Department's existing regulations, nor compel security-based swap dealers or major security-based swap participants to engage in fiduciary conduct. Moreover, the Department's recently published final rule amending ERISA's fiduciary investment advice regulation was carefully harmonized with the SEC's business conduct standards so that there are no unintended consequences for security-based swap dealers and major security-based swap participants who comply with the business conduct standards. As explained in the preamble to the Department's final rule, the disclosures required under the SEC's business conduct rules do not, in the Department's view, compel counterparties to ERISA-covered employee benefit plans to make investment advice recommendations within the meaning of the Department's final rule or otherwise compel them to act as ERISA fiduciaries in Start Printed Page 29966swap and security-based swap transactions conducted pursuant to section 4s(h) of the Commodity Exchange Act and section 15F of the Securities Exchange Act of 1934.[51]

Finally, the Commission has modified its proposed treatment of special entities to take into account the comprehensive regulatory scheme established under ERISA. In particular, as discussed more fully in Section II.H below, if the special entity is an ERISA plan, our rules deem certain requirements satisfied if the plan has an independent representative that is a fiduciary under ERISA.

E. Investment Adviser and Municipal Advisor Status

In addition to questions about ERISA fiduciary status, commenters also questioned whether compliance with the business conduct standards might cause an SBS Entity to be deemed an investment adviser or, when transacting with a special entity that meets the definition of municipal entity, a municipal advisor.[52] Two commenters expressed concern more generally that compliance with the daily mark requirement (in Rule 15Fh-3(c)) might raise questions as to whether an SBS Entity has advisory or fiduciary responsibilities under applicable common law, state law or federal law (e.g., DOL regulations, provisions of the Investment Advisers Act of 1940 (“Advisers Act”), or the Dodd-Frank Act's municipal advisor provisions).[53]

As we noted in the Proposing Release, the duties imposed on an SBS Dealer (or Major SBS Participant) under the business conduct rules are specific to this context, and are in addition to any duties that may be imposed under other applicable law.[54] Thus, an SBS Entity must separately determine whether it is subject to regulation as a broker-dealer, an investment adviser, a municipal advisor or other regulated entity.[55] For example, an SBS Dealer that acts as an advisor to a special entity may fall within the definition of “investment adviser” under Section 202(a)(11) of the Advisers Act.[56]

We further stated in the Proposing Release that an SBS Dealer that acts as an advisor to a municipal entity also may be a “municipal advisor” under Section 15B(e) of the Exchange Act.[57] We note, however, that we subsequently adopted rules in 2013 that interpret the statutorily defined term “municipal advisor” and provide a regulatory exemption for persons engaging in municipal advisory activities in circumstances in which a municipal entity or obligated person is otherwise represented by an independent registered municipal advisor with respect to the same aspects of a municipal financial product or an issuance of municipal securities so long as the following requirements are satisfied: (1) The independent registered municipal advisor is registered pursuant to Section 15B of the Exchange Act and the rules and regulations thereunder, and is not, and within at least the past two years was not, associated with the person seeking to rely on the exemption; (2) the person seeking to use the exemption receives from the municipal entity or obligated person a representation in writing that it is represented by, and will rely on the advice of, the independent registered municipal advisor, and such person has a reasonable basis for relying on the representation; and (3) the person seeking to use the exemption provides written disclosure to the municipal entity or obligated person, with a copy to the independent registered municipal advisor, stating that such person is not a municipal advisor and is not subject to the fiduciary duty to municipal entities that the Exchange Act imposes on municipal advisors, and such disclosure is made at a time and in a manner reasonably designed to allow the municipal entity or obligated person to assess the material incentives and conflicts of interest that such person may have in connection with the municipal advisory activities.[58] We explained that if a municipal entity or obligated person is represented by a registered municipal advisor, parties to the municipal securities transaction and others who are not registered municipal advisors should be able to provide advice to the municipal entity or obligated person without being deemed themselves to be municipal advisors, so long as the responsibilities of each person are clear.[59]

F. Intersection With SRO Rules

Under the framework established in the Dodd-Frank Act, SBS Entities are not required to be members of self-regulatory organizations (“SROs”). Some commenters have, however, urged us to harmonize Title VII business conduct requirements applicable to SBS Entities with relevant SRO requirements applicable to the SRO's members to avoid unnecessary differences, which they argue could create duplication and conflicts when an SBS Entity is also registered as a broker-dealer, or when an SBS Entity uses a registered broker-dealer to intermediate its transactions.[60]

The rules we proposed were designed to implement the business conduct requirements enacted by Congress regarding security-based swap activity of SBS Entities. At the same time, in proposing these rules, we were mindful that an SBS Entity also may engage in activity that will require it to register as a broker-dealer, and thus become subject to SRO rules applicable to registered broker-dealers that may impose similar business conduct requirements.[61] As we noted in the Proposing Release, the existing rules of various SROs served as an important point of reference for our proposed Start Printed Page 29967business conduct rules.[62] For example, a number of the proposed rules, including those regarding “know your counterparty,” [63] suitability,[64] fair and balanced communications,[65] supervision,[66] and designation of a CCO,[67] were patterned on standards that have been established by SROs for their members. However, we tailored the proposed rules to the specifics of the regulatory scheme for security-based swaps under Title VII.[68]

We recognize, as the commenters noted, that the security-based swap and other securities activities of certain entities may require them to register both as broker-dealers and as SBS Dealers or Major SBS Participants.[69] To the extent an entity will be subject to regulation both as a broker-dealer and as an SBS Entity, there may be overlapping regulatory requirements applicable to the same activity. The Commission is mindful of potential regulatory conflicts or redundancies and has sought in adopting these final rules to avoid such conflicts and minimize redundancies, consistent with the statutory business conduct requirements for SBS Entities. As discussed throughout this release, the rules we are adopting today take into account the comments received, both comments specific to the application of the proposed rules to the security-based swap market and the role that the SBS Entities play in that market, and comments asking us to modify the proposed rules to more closely align with the similar SRO rules applicable to broker-dealers.[70] Overall, we believe that the business conduct rules we are adopting today are generally designed to be consistent with the relevant SRO requirements, taking into account the nature of the security-based swap market and the statutory requirements for SBS Entities.[71]

On July 1, 2011, the Commission issued a separate order granting temporary exemptive relief (the “Temporary Exemptions”) from compliance with certain provisions of the Exchange Act in connection with the revision, pursuant to Title VII of the Dodd-Frank Act, of the Exchange Act definition of “security” to encompass security-based swaps.[72] Consistent with the Commission's action, on July 8, 2011, FINRA filed for immediate effectiveness FINRA Rule 0180, which, with certain exceptions, is intended to temporarily limit the application of FINRA rules with respect to security-based swaps, thereby helping to avoid undue market disruptions resulting from the change to the definition of “security” under the Act.[73]

The Commission, noting the need to avoid a potential unnecessary disruption to the security-based swap market in the absence of an extension of the Temporary Exemptions, and the need for additional time to consider the potential impact of the revision of the Exchange Act definition of “security” in light of recent Commission rulemaking efforts under Title VII of the Dodd-Frank Act, issued an order that extended and refined the applicable expiration dates of the previously granted Temporary Exemptions.[74] In the Temporary Exemptions Extension Release, the Commission extended the expiration date of the expiring Temporary Exemptions that are not directly linked to pending security-based swap rulemakings until the earlier of such time as the Commission issues an order or rule determining whether any continuing exemptive relief is appropriate for security-based swap activities with respect to any of these Exchange Act provisions or until three years following the effective date of the Start Printed Page 29968Temporary Exemptions Extension Release.[75] The Commission further extended the expiration date for many expiring Temporary Exemptions directly related to pending security-based swap rulemakings until the compliance date for the related security-based swap-specific rulemaking.[76]

In establishing Rule 0180, and in extending the rule's expiration date,[77] FINRA noted its intent, pending the implementation of any Commission rules and guidance that would provide greater regulatory clarity in relation to security-based swap activities, to align the expiration date of FINRA Rule 0180 with the termination of relevant provisions of the Temporary Exemptions provided by the Commission, so as to avoid undue market disruptions resulting from the change to the definition of “security” under the Exchange Act.

II. Discussion of Rules Governing Business Conduct

A. Scope, Generally

1. Proposed Rule

Proposed Rule 15Fh-1 would provide that Rules 15Fh-1 through 15Fh-6 (governing business conduct) and Rule 15Fk-1 (requiring designation of a CCO) are not intended to limit, or restrict, the applicability of other provisions of the federal securities laws, including but not limited to Section 17(a) of the Securities Act, Sections 9 and 10(b) of the Exchange Act, and the rules and regulations thereunder. Additionally, it would provide that Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1 would not only apply in connection with entering into security-based swaps but also would continue to apply, as appropriate, over the term of executed security-based swaps.

In the Proposing Release, the Commission solicited comment on the scope of the business conduct rules, including whether the rules should apply to transactions between an SBS Entity and its affiliates, whether any of the rules should apply to security-based swaps that were entered into prior to the effective date of the rules, and to the extent that any of the rules were intended to provide additional protections for a particular counterparty, whether the counterparty should be able to opt out of those protections.[78]

2. Comments on the Proposed Rule

a. General

Eleven commenters addressed the general scope of the proposed business conduct standards.[79] One commenter recommended that the Commission apply the proposed rules to security-based swaps that are offered as well as those that are executed.[80] The other commenters addressed: The application of the rules to inter-affiliate transactions, the application of the rules to security-based swaps entered into prior to the effective date, and whether counterparties should be able to opt out of the protections provided by the rules.

b. Application to Security-Based Swaps Entered Into Prior to the Effective Date

Seven commenters addressed the application of the rules to security-based swaps that were entered into prior to the compliance date of the rules, and all seven recommended that the rules not apply to such transactions.[81] Three further indicated that the rules should not generally apply to amendments to, or other lifecycle events arising under, a security-based swap that was executed before the compliance date of the rules.[82] Another commenter also specifically argued that the rules should not apply to either partial or full terminations of security-based swaps executed prior to the compliance date, or the exercise of an option on a security-based swap where the option was executed prior to the compliance date.[83]

One commenter argued that amendments to existing transactions typically do not alter the risk and other characteristics of a transaction sufficiently to merit application of the rules and that application of the rules in these cases may frustrate their purpose.[84] Others believed that any potential retroactive application would be burdensome, noting that it would undermine the expectations that the parties had when entering into the security-based swap.[85]

c. Application to Inter-Affiliate Transactions

Three commenters discussed the application of the rules to inter-affiliate transactions.[86] All three recommended that the rules generally not apply to security-based swap transactions between affiliates,[87] but one recognized that entity-level requirements (such as CCO and supervision responsibilities) will necessarily apply.[88] One commenter asserted that the rules are intended to protect investors in arm's length transactions and therefore, would be irrelevant in inter-affiliate transactions.[89] The second commenter similarly argued that because affiliates are not “external clients” of the SBS Entity, the protections afforded by the rules are inapposite.[90] The second commenter also suggested that the Commission define “affiliate” to mean an entity that is “under common control and that reports information or prepares its financial statements on a consolidated basis” with another entity, and opined that the definition should be consistently applied across Title VII rulemakings.[91] The third commenter also advocated for a common control standard, arguing that the rules should not apply to transactions between an SBS Entity and “a person controlling, controlled by, or under common control with the [SBS Entity].” [92]

d. Counterparty Opt-Out

Nine commenters addressed whether to permit counterparties to opt out of certain protections provided by the Start Printed Page 29969rules.[93] Six commenters were in favor of allowing an opt out in at least some circumstances,[94] and three were against it.[95]

Three commenters suggested that the Commission permit institutional or “sophisticated investors” to opt out of provisions intended to protect counterparties.[96] Specifically, one endorsed allowing “qualified institutional buyers” as defined in Rule 144A under the Securities Act and institutions with total assets of $100 million or more to opt out, asserting that the costs, delays in execution, and requirements to make detailed representations and disclosure to the SBS Entity may outweigh the benefits that such counterparties would receive.[97] Another asserted that “sophisticated” counterparties should be able to opt out of receiving “material information” disclosures and the written disclosures related to clearing rights to lower their hedging costs and avoid potential trading delays and inefficiencies.[98]

Three other commenters suggested an opt out for specific types of counterparties.[99] One suggested that an ERISA plan should be permitted to opt out because SBS Entities might use the information they receive as a result of compliance with the business conduct standards to disadvantage the ERISA plan.[100] A second asserted that pension funds acting as end users should be allowed to opt out of any rules that impose “heightened fiduciary duties” on SBS Dealers because pension funds do not need extra protection, and compliance with the fiduciary duties would only increase costs for SBS Dealers, leading them to either pass the costs along or refrain from entering into transactions with pension funds.[101] A third suggested that any entity advised by a qualified independent representative should be able to waive the protections of the rules to avoid execution delays and administrative costs.[102]

Three commenters opposed allowing counterparties to opt out of the special protections in the rules.[103] One commenter noted that a “theoretically optional opt out would likely become mandatory” because SBS Dealers would make it a condition of doing business, and that an opt-out approach could be used to perpetuate abuses the rules are intended to prevent.[104] Another commented that an opt-out would “only add confusion to an already complex regulatory framework and create opportunities for market participants to evade compliance with the much-needed business conduct standards.” [105] A third specifically opposed allowing counterparties to opt out of the disclosure requirements, noting that even sophisticated investors may be misled.[106]

3. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-1, predesignated as Rule 15Fh-1(a), with certain modifications.

a. General

The Commission is adopting, as proposed, the provision in final Rule 15Fh-1(a) specifying that Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1 apply “in connection with entering into security-based swaps” and also will continue to apply, as appropriate, over the term of executed security-based swaps. Many of the rules impose obligations on an SBS Entity with respect to its “counterparty” that must be satisfied before the SBS Entity has actually entered into a security-based swap with that counterparty (e.g., Rule 15Fh-3(a) (verification of counterparty status) and Rule 15Fh-3(b) (disclosure of material risks and characteristics, and material incentives or conflicts of interest)). This is consistent with the language specifying that the rules apply “in connection with entering into security-based swaps” in Rule 15Fh-1(a). Accordingly, when the rules refer to a “counterparty” of the SBS Entity, the term “counterparty” includes a potential counterparty where compliance with the obligation is required before the SBS Entity and the “counterparty” has actually entered into the security-based swap.[107]

b. Application to Security-Based Swaps Entered Into Prior to the Effective Date

To address concerns raised by commenters,[108] the Commission is clarifying that the business conduct rules generally will not apply to any security-based swap entered into prior to the compliance date of the rules, and generally will apply to any security-based swap entered into after the compliance date of these rules, including a new security-based swap that results from an amendment or modification to a pre-existing security-based swap.[109]

In response to commenters' concerns about applying the business conduct rules to amendments to and other lifecycle events of a security-based swap entered into before the compliance date of these rules,[110] the Commission is clarifying that the business conduct rules generally will not apply to amendments or modifications to a pre-existing security-based swap unless the amendment or modification results in a new security-based swap (and occurs after the compliance date of these rules). The Commission has previously determined that if the material terms of a security-based swap are amended or modified during its life based on an exercise of discretion and not through predetermined criteria or a predetermined self-executing formula, the amended or modified security-based swap is viewed as a new security-based swap.[111] Thus, if there is such a material amendment or modification, which could include a change in the economic terms of the transaction that the parties would not have provided for when entering into the security-based swap contract, the Commission will consider the amended or modified security-based swap to be a new Start Printed Page 29970security-based swap for purposes of the business conduct rules. If that material amendment or modification occurs after the compliance date of these rules, these rules will apply to the resulting new security-based swap.

In response to concerns raised by a commenter, the Commission also is clarifying that the rules generally will not apply to either a partial or full termination of a pre-existing security-based swap.[112] In these instances we anticipate that the expectations of the parties will be governed by the pre-existing terms of the original security-based swap, and so the business conduct requirements generally will not apply. If, however, the partial termination involves a change in the material terms of the original security-based swap “based on an exercise of discretion and not through predetermined criteria or a predetermined self-executing formula” the business conduct rules will apply.

As requested by a commenter,[113] we are clarifying that the business conduct rules generally will not apply to a new security-based swap that results from the exercise of an option on a security-based swap (whether or not the exercise occurs before or after the compliance date of these rules), as long as the terms upon which a party can exercise the option and the terms of the underlying security-based swap that will result upon the exercise of the option are governed by the terms of the pre-existing option. If, however, the material terms of either the option or the resulting security-based swap are amended or modified based on an exercise of discretion and not through predetermined criteria or a predetermined self-executing formula, our business conduct rules will apply to the amended or modified option or security-based swap resulting from the exercise of the option (assuming that such amendment or modification occurs after the compliance date of these rules).

We believe it appropriate to apply the rules in this manner to help to ensure that counterparties receive the benefits of the rules in circumstances where they are warranted, while providing firms adequate time to review the business conduct rules being adopted today and make appropriate changes to their operations before they have to begin complying with those rules.

The Commission emphasizes that the above clarifications relate to the business conduct rules that by their terms apply when an SBS Entity offers to enter into or enters into a security-based swap, such as verification of status (Rule 15Fh-3(a)), certain disclosures (Rule 15Fh-3(b) and (d)), requirements for special entities as counterparties (Rule 15Fh-5), and pay-to-play (Rule 15Fh-6)). Other rules being adopted today are broader in their application, such as those relating to know your counterparty (Rule 15Fh-3(e)), recommendations of security-based swaps or trading strategies (Rule 15Fh-3(f)), fair and balanced communications (Rule 15Fh-3(g)), supervision (Rule 15Fh-3(h)), antifraud (Rule 15Fh-4(a)), requirements when an SBS Dealer is acting as an advisor to a special entity (Rule 15Fh-4(b)), and the CCO (Rule 15Fk-1). Thus, if an SBS Entity takes an action after the compliance date that independently implicates one of the business conduct rules, it will need to comply with the applicable requirements. For example, if an SBS Dealer makes a recommendation of a trading strategy that involves termination of a pre-existing security-based swap, the SBS Dealer would need to comply with the suitability requirements of Rule 15Fh-3(f) regarding such recommendation. In addition, an SBS Entity will need to comply with “entity level” rules relating to supervision and CCO after the compliance date of those rules for all of its security-based swap business.

c. Application to Inter-Affiliate Transactions

The Commission agrees with the concerns raised by commenters regarding the treatment of inter-affiliate transactions.[114] As the Commission noted in the Definitions Adopting Release (defined below), market participants may enter into inter-affiliate security-based swaps for a variety of purposes, such as to allocate risk within a corporate group or to transfer risks within a corporate group to a central hedging or treasury entity.[115] As discussed below, we believe that transactions by SBS Entities with certain of their affiliated persons do not implicate the concerns that the business conduct requirements regarding verification of counterparty status (Rule 15Fh-3(a)), disclosures regarding the product and potential conflicts of interest, daily mark and clearing rights (Rule 15Fh-3(b), (c) and (d)), “know your counterparty” and suitability obligations (Rules 15Fh-3(e) and (f)), and obligations when advising or acting as counterparty to a special entity (Rules 15Fh-4(b) and 15Fh-5) are intended to address (referred to as “transaction specific obligations”).[116] We therefore are providing in Rule 15Fh-1(a) as adopted that Rules 15Fh-3(a) through (f), 15Fh-4(b) and 15Fh-5 are not applicable to security-based swaps that SBS Entities enter into with certain affiliates.

We are not, however, extending the exception to transactions with all affiliates, as requested by some commenters.[117] Rather, the Commission is limiting the exception from the business conduct requirements to security-based swap transactions between majority-owned affiliates. The rule defines “majority-owned affiliates” consistent with the Definitions Adopting Release such that, for these purposes, the counterparties to a security-based swap are majority-owned affiliates if one counterparty directly or indirectly owns a majority interest in the other, or if a third party directly or indirectly owns a majority interest in both counterparties to the security-based swap, where “majority interest” is the right to vote or direct the vote of a majority of a class of voting securities of an entity, the power to sell or direct the sale of a majority of a class of voting securities of an entity, or the right to receive upon dissolution or the contribution of a majority of the capital of a partnership.[118]

The transaction-specific obligations outlined above and included in Rule 15Fh-1(a) generally are designed to provide an SBS Entity counterparty with certain information in connection with the security-based swap transaction that would help reduce potential information asymmetries, and to help ensure that the SBS Entity knows its counterparty and acts in a fair manner towards that counterparty, even in the face of potential conflicts of interest. The Commission does not believe that these objectives and Start Printed Page 29971concerns are implicated in the same manner or to the same extent when there is an alignment of economic interests between the SBS Entity and a counterparty, such as is the case when the counterparty is a majority-owned affiliate. However, absent majority ownership, we cannot be confident that there would be an alignment of economic interests that is sufficient to eliminate the concerns that underpin the need for regulation in this area.[119] Accordingly, the Commission is modifying Rule 15Fh-1(a) to provide that Rules 15Fh-3(a)-(f), 15Fh-4(b) and 15Fh-5 are not applicable to security-based swaps that SBS Entities enter into with their majority-owned affiliates. These generally are the transaction specific exceptions requested by a commenter.[120]

Further, consistent with the commenter's request, we are not granting an exception for transactions with affiliates with respect to the antifraud requirements of Rule 15Fh-4(a) or the requirements of Rule 15Fh-3(g) (fair and balanced communications).[121] The exception for inter-affiliate transactions from the transaction specific obligations discussed above is generally predicated on the assumption that entities with aligned economic interests have an incentive to act fairly when dealing with each other. However, we believe it important to continue to provide the protections of the antifraud and fair and balanced communication rules in situations where an SBS Entity acts in a manner contrary to this assumption. We also are not granting exceptions to the entity-level requirements regarding supervision (Rule 15Fh-3(h)) and CCO obligations (Rule 15Fk-1), which are intended to help to ensure the compliance of SBS Entities in their security-based swap transactions.

d. Counterparty Opt-Out

The Commission has considered the concerns raised by commenters [122] and determined, on balance, not to permit counterparties generally to opt out of the protections provided by the business conduct rules. As discussed throughout the release in the context of specific rules, the rules being adopted today are intended to provide certain protections for counterparties, including certain heightened protections for special entities. We think it is appropriate to apply the rules so that counterparties receive the benefits of those protections and so do not think it appropriate to permit parties generally to elect to “opt out” of the benefits of those provisions.[123]

While we are not adopting a general opt-out provision, as discussed below in connection with the relevant rules, the Commission has determined to permit means of compliance with the final rules that should promote efficiency and reduce costs (e.g., Rule 15Fh-1(b) (reliance on representations)) and, where appropriate, allow SBS Entities to take into account the sophistication of the counterparty (e.g., Rule 15Fh-3(f) (regarding recommendations of security-based swaps or trading strategies)).

B. Exceptions for Anonymous SEF or Exchange-Traded Transactions

Section 15F(h)(7) of the Exchange Act provides a statutory exception “from the requirements of this subsection” for security-based swap transactions that are: “(A) initiated by a special entity on an exchange or security-based swaps execution facility; and (B) the security-based swap dealer or major security-based swap participant does not know the identity of the counterparty to the transaction.” [124] More generally, commenters have asked the Commission to provide exceptions to the application of our rules in situations in which an SBS Entity does not know the identity of its counterparty, or where a security-based swap transaction is executed on a registered national securities exchange or security-based swap execution facility (“SEF”), without regard to whether the counterparty is a special entity.[125]

1. Proposal

Noting that there may be circumstances in which it may be unclear which party “initiated” the communications that resulted in the parties entering into a security-based swap transaction on a registered SEF or registered national securities exchange, the Commission proposed to interpret Section 15F(h)(7) to apply to any transaction with a special entity on a registered SEF or registered national securities exchange, where the SBS Entity does not know the identity of its counterparty at any time up to and including execution of a transaction.

The Commission further proposed to interpret Section 15F(h)(7) to apply with respect to requirements specific to dealings with special entities. Proposed Rule 15Fh-4(b)(3) would provide an exception from the special requirements for SBS Dealers acting as advisors to special entities, including the requirement that an SBS Dealer act in the best interests of a special entity for whom it acts as an advisor, if the transaction is executed on a registered exchange or SEF and the SBS Dealer does not know the identity of the counterparty at any time up to and including execution of the transaction. Under the same circumstances, proposed Rule 15Fh-5(c) would similarly provide an exception from the special requirements for SBS Entities acting as counterparties to special entities, including the qualified independent representative and disclosure requirements of proposed Rule 15Fh-5.[126] Proposed Rule 15Fh-6(b)(2)(iii) would provide an exception from the pay to play rules with respect to transactions on a registered exchange or SEF where the SBS Dealer does not know the identity of the counterparty at any time up to and including execution of the transaction.[127]

Consistent with Section 15F(h)(7), we also proposed to limit the application of certain other requirements to situations in which the identity of a counterparty (whether a special entity or not) is known to the SBS Entity. The rules as proposed would limit the verification of counterparty status obligations (proposed Rule 15Fh-3(a)),[128] and know your counterparty obligations (proposed Rule 15Fh-3(e)) to transactions with Start Printed Page 29972counterparties whose identity is known to the SBS Entity.[129]

2. Comments on the Proposal

The Commission received five comment letters that addressed the exception for anonymous, exchange or SEF-traded security-based swaps in the context of special entity-specific requirements,[130] and four comment letters that addressed more broadly the issue of an exception for anonymous or SEF and exchange-traded security-based swaps.[131] The comment letters that address the exception in the context of the special entity requirements are discussed infra in Sections II.H.8 and II.H.9. The comment letters that address the broader issue of an exception from business conduct requirements for anonymous or SEF and exchange-traded security-based swaps are discussed below.

Two commenters asserted that, where a security-based swap is cleared (through registered clearing organizations) and SEF or exchange-traded, the transaction should not be subject to the requirements of the proposed rules—regardless of whether the identity of the counterparty is known at the time of execution.[132] The commenters argued that knowledge or identification of a counterparty's identity should not compel compliance with the business conduct standards.[133] The commenters further argued that the concerns addressed by business conduct standards were largely inapplicable to security-based swaps entered into through registered SEFs, swap execution facilities or registered national securities exchanges.[134] The commenters asserted that compliance with the proposed rules would result in delay, additional complexity, individual negotiation and potentially less transparency, which the trading and clearing requirements of the Dodd-Frank Act sought to avoid.[135]

However, one of the commenters acknowledged that some security-based swaps executed on a SEF or exchange might be bilaterally negotiated, and the SEF or exchange subsequently used to process the trade, in which case it might be appropriate to apply the business conduct standards.[136]

After adoption of the CFTC's business conduct standards, one commenter urged the Commission to adopt an exception for exchange-traded security-based swaps that are intended to be cleared if: (1)(a) The transaction is executed on a registered or exempt SEF or registered national securities exchange; and (b) is of a type that is, as of the date of execution, required to be cleared pursuant to Section 3C of the Exchange Act; or (2) the SBS Entity does not know the identity of the counterparty, at any time up to and including execution of the transaction.[137] The commenter argued that these changes would harmonize the scope of the Commission's requirements with the scope of the parallel requirements under the relief provided by CFTC No-Action Letter 13-70.[138] The commenter argued that the considerations on which the CFTC staff based its no-action relief would also apply to the security-based swap market, namely: “(i) the impossibility or impracticability of compliance with certain rules by a Swap Entity when the identity of the counterparty is not known prior to execution; (ii) the likelihood that swaps initiated anonymously on a designated contract market or swap execution facility will be standardized and, thus, information about the material risks and characteristics of such swaps is likely to be available from the designated contract market or swap execution facility or other widely available source (including the product specifications of a derivatives clearing organization where the swaps are accepted for clearing); and (iii) the likelihood that such relief would provide an incentive to transact on designated contract markets and swap execution facilities, thus enhancing transparency in the swaps market.” [139]

3. Response to Comments and Final Rules

After considering the comments, the Commission has determined to adopt two sets of exceptions from the business conduct requirements. As discussed in Sections II.H.8 and II.H.9, infra, we are adopting exceptions from the requirements of Rules 15Fh-4(b), 15Fh-5 and 15Fh-6 (collectively, “special entity exceptions”) for anonymous transactions executed on a registered national securities exchange or a registered or exempt SEF, where the identity of the special entity is not known to the SBS Entity at a reasonably sufficient time prior to execution of the transaction to permit the SBS Entity to comply with the obligations of the rule.[140]

In addition to the special entity exceptions, the Commission is adopting a second set of exceptions that are not limited to transactions with special entities, under which certain of the business conduct standards rules will apply only where the SBS Entity knows the identity of the counterparty at a reasonably sufficient time prior to execution of the transaction to permit the SBS Entity to comply with the obligations of the rule.[141] These exceptions are intended to address the impracticalities and potential business disruption that could result if an SBS Entity were required to comply with the disclosure requirements in Rule 15Fh-3(b) (requiring an SBS Entity to disclose material risks and characteristics of a security-based swap and material incentives or conflicts in connection with a security-based swap, prior to entering into that security-based swap with a counterparty) and Rule 15Fh-3(d) (requiring certain pre-transaction disclosures to counterparties regarding clearing rights), before learning the identity of its counterparty.[142] By only applying these rules' requirements to situations where the counterparty's identity is known “at a reasonably sufficient time prior to” the execution of a transaction, the rules' requirements are limited to situations where an SBS Start Printed Page 29973Entity has sufficient time before the execution of the transaction to comply with its obligations under the rules. For this reason, we decline to adopt language, suggested by a commenter, which would apply the exception to circumstances where the identity of the counterparty “is not known at any time up to and including execution of the transaction.” [143]

We are not, however, accepting the commenter's suggestion that we revise our exceptions to provide an exception for transactions intended to be cleared so long as the transaction is either executed on a registered national securities exchange or registered or exempt SEF and required to be cleared pursuant to Section 3C of the Exchange Act, regardless of whether or not the transaction is anonymous.[144] Similarly, we reject commenters' more general assertions that the exceptions should apply to all SEF or exchange-traded transactions, even where the identity of the counterparty is known,[145] and that the protections provided by the business conduct standards are unnecessary for security-based swaps that are entered into through registered SEFs, swap execution facilities or registered national securities exchanges.[146] The rules being adopted today are intended to provide certain protections for counterparties, and we think it is appropriate to apply the rules, to the extent practicable, so that counterparties receive the benefits of those protections. We have determined not to apply those rules where it may not be possible or practical to do so, specifically where a transaction is executed on a registered exchange or SEF and the identity of the counterparty is not known to the SBS Entity at a reasonably sufficient time prior to execution of the transaction to permit the SBS Entity to comply with the obligations of the rule. However, where the identity of the counterparty is known in a timely manner, we believe that it is appropriate to apply the rules so that the counterparty receives the benefits of the protections provided by the rules, including the assistance of an advisor or qualified independent representative acting in the best interests of a counterparty that is special entity.

C. Application of the Rules to SBS Dealers and Major SBS Participants

1. Proposal

As noted in the Proposing Release, in general, where the Dodd-Frank Act imposes a business conduct requirement on both SBS Dealers and Major SBS Participants, we proposed rules that would apply to SBS Dealers and Major SBS Participants.[147] Where, however, a business conduct requirement is not expressly addressed by the Dodd-Frank Act, the proposed rules generally applied only to SBS Dealers.[148] We solicited comment on whether this approach was appropriate. Specifically, where the Dodd-Frank Act requires that a business conduct rule apply to all SBS Entities, we asked if the rule should impose the same requirements on Major SBS Participants as on SBS Dealers, and where we proposed rules for SBS Dealers that are not expressly addressed by the Dodd-Frank Act, we asked if any of those rules should also apply to Major SBS Participants.

2. Comments on the Proposal

Three commenters addressed the general application of the rules to SBS Dealers and Major SBS Participants.[149] One commenter agreed it may be appropriate, “in light of their somewhat different roles,” to adopt different approaches to rules governing SBS Dealers and Major SBS Participants in certain areas.[150] The commenter asserted that absent an affirmative reason to adopt a different approach for SBS Dealers and Major SBS Participants, the Commission should seek to promote consistency and adopt uniformly strong rules.[151] The commenter argued that the determining factor should be whether Major SBS Participants are likely to be engaged in conduct that would appropriately be regulated under the relevant standard.[152]

In contrast, another commenter urged the Commission to consider separate regulatory regimes for SBS Dealers and Major SBS Participants, arguing that they are different, and there are “different reasons why the Dodd-Frank Act requires additional oversight of each.” [153] The commenter recommended that the Commission focus regulation of Major SBS Participants on reducing default risk, and focus regulation of SBS Dealers on market making and pricing and sales practices in addition to reducing default risk.[154] The commenter argued that to the extent Major SBS Participants transact at arm's-length, they will not be advising counterparties and therefore, neither fiduciary duties nor “dealer-like obligations” (regarding “know your counterparty,” suitability and “pay-to-play” restrictions, for example) should be imposed on them.[155]

A third commenter generally supported our proposed approach in not applying certain business conduct requirements to Major SBS Participants where the Dodd-Frank Act does not expressly impose such standards.[156] In the alternative, if the Commission determines to require Major SBS Participants to disclose “material information” and to provide daily marks to their counterparties, the commenter asked that we make these requirements inapplicable to transactions between a Major SBS Participant and an SBS Dealer, and to allow all other parties to opt out of receiving such disclosures in their dealings with a Major SBS Participant.[157]

3. Response to Comments and Final Rules

After considering the comments, the Commission has determined to apply the rules to SBS Dealers and Major SBS Participants as proposed. To that end, as discussed below, where a statutory provision encompasses both SBS Dealers and Major SBS Participants,[158] Start Printed Page 29974we are adopting rules that would apply equally to SBS Dealers and Major SBS Participants.[159] We think this is important to ensure that counterparties of Major SBS Participants, as well as counterparties of SBS Dealers, receive the protections the rules are intended to provide. For example, to the extent that Major SBS Participants may be better informed about the risks and valuations of security-based swaps due to information asymmetries, disclosures may help inform counterparties concerning the material risks and characteristics of security-based swaps, and material conflicts of interest of Major SBS Participants entering into security-based swaps.[160]

Where, however, a business conduct requirement is not expressly addressed by the Dodd-Frank Act or we read the statute to apply a requirement only to SBS Dealers,[161] the adopted rules generally would not apply to Major SBS Participants.[162] Thus, the obligations under Rules 15Fh-3(e) (know your counterparty), 15Fh-3(f) (recommendations of security-based swaps or trading strategies), 15Fh-4(b) (special obligations when acting as an advisor to a special entity) and 15Fh-6 (pay to play rules) do not apply to a Major SBS Participant. In addition, our rules provide exceptions to Major SBS Participants, as discussed in Section II.G.2.a, from certain disclosure requirements when entering into security-based swaps with an SBS Dealer, another Major SBS Participant, a swap dealer or a swap participant.

In determining whether or not to apply certain requirements to Major SBS Participants, as explained in the Proposing Release, we have considered how the differences between the definitions of SBS Dealer and Major SBS Participant may be relevant in formulating the business conduct standards applicable to these entities. The Dodd-Frank Act and our rules define “security-based swap dealer” in a functional manner, by reference to the way a person holds itself out in the market and the nature of the conduct engaged in by that person, and how the market perceives the person's activities.[163] Unlike the definition of “security-based swap dealer,” which focuses on those persons whose function is to serve as the points of connection in those markets, the definition of “major security-based swap participant” focuses on the market impacts and risks associated with an entity's security-based swap positions.[164] Despite the differences in focus, however, the Dodd-Frank Act applies substantially the same statutory standards to SBS Dealers and Major SBS Participants.[165] We explained in the Proposing Release that, in this way, the statute applies comprehensive regulation to entities (i.e., Major SBS Participants) whose security-based swap activities do not cause them to be dealers, but nonetheless could pose a high degree of risk to the U.S. financial system generally.

We are mindful, as noted by a commenter, that there are “different reasons why the Dodd-Frank Act requires additional oversight of each.” [166] We have attempted to take into account these differing definitions and regulatory concerns in considering whether the business conduct requirements that we proposed, and that we are adopting, for SBS Dealers should or should not apply to Major SBS Participants as well. Accordingly, as noted, in general, where the Dodd-Frank Act imposes a business conduct requirement on both SBS Dealers and Major SBS Participants, the rules will apply equally to SBS Dealers and Major SBS Participants, and where a business conduct requirement is not expressly addressed by the Dodd-Frank Act, the rules generally will not apply to Major SBS Participants. We believe this approach addresses the concern of the commenter who argued that the determining factor should be the conduct in which a Major SBS Participant is likely to be engaged.[167]

The external business conduct requirements promulgated under Section 15F(h) are intended to provide certain protections for counterparties, and we believe the rules we are adopting today appropriately apply those requirements to SBS Dealers and Major SBS Participants so that counterparties receive the benefit of those protections. At the same time, mindful of the different role to be played by Major SBS Participants (which, by definition, are not SBS Dealers), we have not sought to impose the full range of business conduct requirements on Major SBS Participants. We note that our approach in this regard largely mirrors that of the CFTC, under whose rules Swap Dealers and Major Swap Participants have operated for some time. We believe that this consistency will result in efficiencies for entities that have already established infrastructure to comply with the CFTC standard.

We proposed and are adopting limited exceptions (as discussed in connection with the applicable rules) from the disclosure requirements in Rules 15Fh-3(b), 15Fh-3(c) and 15Fh-3(d) for transactions with an SBS Entity or a Swap Entity.[168] We are not, however, adopting the suggestion that we broaden the exceptions to permit other types of counterparties to opt out of the disclosures and other protections provided under the rules when entering into a transaction with a Major SBS Participant. As noted above, the external business conduct requirements promulgated under Section 15F(h) are intended to provide certain protections for counterparties, and we believe the rules we are adopting today appropriately tailor those requirements so that counterparties receive the benefit of those protections.

D. Reliance on Representations

1. Proposal

The Proposing Release solicited input on whether the rules adopted by the Commission should include a standard addressing the circumstances in which an SBS Entity may rely on representations to establish compliance with the business conduct rules.[169] We sought comment on two alternative approaches.[170] One approach would permit an SBS Entity to rely on a representation from a counterparty Start Printed Page 29975unless it knows that the representation is not accurate (“actual knowledge standard”).[171] The other would permit an SBS Entity to rely on a representation unless the SBS Entity has information that would cause a reasonable person to question the accuracy of the representation (“reasonable person standard”).[172] After the Commission issued its proposed rules, the CFTC in its final rules adopted a “reasonable person standard” that generally permits a Swap Entity to rely on written representations to satisfy its due diligence obligations unless it has information that would cause a reasonable person to question the accuracy of the representation.[173]

2. Comments on the Proposal

Twelve commenters generally addressed the proposed standards for reliance on counterparty representations.[174] With one exception,[175] these comments predate the 2012 adoption of the CFTC rules.

In 2011, seven commenters supported the actual knowledge standard.[176] One asserted its view that the actual knowledge standard would offer greater legal certainty to SBS Entities when making required subjective judgments under the rules (for example, judgments regarding the qualifications of a special entity's independent representative).[177] Another commenter argued that the actual knowledge standard is preferable because the reasonable person standard would require an assessment of what a reasonable person would conclude if such person had the same information as the SBS Entity, which could cause uncertainty and additional cost for market participants.[178]

One commenter, writing after the CFTC rules were adopted, asked the Commission to adopt a “reasonable person standard” that is “consistent with the parallel CFTC EBC Rules,” which generally permit a Swap Entity to rely on written representations to satisfy its due diligence obligations unless it has information that would cause a reasonable person to question the accuracy of the representations.[179] Additionally, two other commenters supported the reasonable person standard in 2011.[180] One commenter asserted that the reasonable person standard would help to ensure that SBS Entities are acting on reliable information because of the duty it would impose to verify the accuracy of a representation if the SBS Entity had some reason to question it.[181] The commenter also argued that the reasonable person standard would be easier to monitor and enforce because it would be objective rather than subjective.[182]

Some commenters suggested that the Commission require detailed representations.[183] One commenter asked the Commission to clarify that, for purposes of “red flags,” the knowledge test should apply only to individuals with knowledge of the security-based swap transaction; information that may be available to other parts of the SBS Entity organization should not be imputed to those individuals.[184] Another commenter requested that the Commission clarify that any representations made by a special entity or its representative to satisfy the rules do not give any party any additional rights, such as rescission or monetary compensation (e.g., if the representations turn out to be incorrect).[185] Additionally, the commenter asserted that an SBS Dealer should be permitted to rely on a single set of representations made by a special entity at the beginning of a trading relationship, rather than requiring the SBS Dealer to obtain a new representation with each transaction, if the special entity represents that it will notify the SBS Dealer when the representations become inaccurate.[186]

More generally, another commenter recommended allowing representations to be contained in counterparty relationship documentation if agreed to by the counterparties, and requiring counterparties to undertake to update such representations with any material changes.[187] The commenter also suggested that an SBS Entity that is also registered with the CFTC as a Swap Entity should be permitted to rely on a counterparty's written representations with respect to the CFTC's business conduct rules to satisfy its due diligence requirements under the Commission's business conduct rules provided that the SBS Entity provides notice of such reliance to the counterparty and the counterparty does not object.[188] The commenter argued that this would speed implementation and lower costs without reducing counterparty protections.[189] Finally, the commenter recommended including both a general reliance on representations provision and also specific reliance on representations safe harbors in the individual rules that specify what representations the SBS Entity should obtain to satisfy the safe harbor.[190]

3. Response to Comments and Final Rule

The Commission is adopting new Rule 15Fh-1(b), which provides that an SBS Entity may rely on written representations to satisfy its due diligence requirements under the business conduct rules unless it has information that would cause a reasonable person to question the accuracy of the representation. Under this standard, if an SBS Entity has in its possession information that would cause a reasonable person to question the accuracy of the representation, it will need to make further reasonable inquiry to verify the accuracy of the representation.[191]

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We understand that this is a market in which parties rely heavily on representations both with respect to relationship documentation and the transactions themselves. While both standards we proposed for comment could be workable in this context, we recognize that neither provides the absolute certainty sought by some commenters. As we explained in the Proposing Release, under either approach an SBS Entity could not ignore information in its possession as a result of which the SBS Entity would know that a representation is inaccurate.[192] Under an “actual knowledge” standard, however, an SBS Entity can rely on a representation unless it knows that the representation is inaccurate. This alternative could allow SBS Entities to rely on questionable representations insofar as they do not have actual knowledge that the representation is inaccurate, even if they have information that would cause reasonable persons to question their accuracy. As a result, this alternative could potentially reduce the benefits of the verification of status, know your counterparty, suitability and special entity requirements and result in weaker protections for counterparties to SBS Entities. In contrast, the “reasonable person” standard under the rule as adopted should help ensure that SBS Entities do not disregard facts that call into question the validity of the representation.[193]

Further, this standard also is consistent with the standard adopted by the CFTC under which a Swap Entity cannot rely on a representation if the Swap Entity has information that would cause a reasonable person to question the accuracy of the representation.[194] This consistency will result in efficiencies for entities that have already established infrastructure to comply with the CFTC standard.

The rule as adopted would permit an SBS Entity to reasonably rely on the representations of a counterparty or its representative to satisfy its due diligence obligations under the business conduct rules, including Rules 15Fh-2(a) and (d), 15Fh-3(a), (e) and (f), 15Fh-4 and 15Fh-5. We are not requiring a specified level of detail for these representations but note that they should be detailed enough to permit the SBS Entity to form a reasonable basis for believing that the applicable requirement is satisfied.[195]

Nothing in our rules would prohibit an arrangement under which the parties agree that representations will be provided in counterparty relationship documentation, and that they will update such representations with any material changes, as suggested by commenters.[196]

We are not accepting the commenter's suggestion that we provide that in every instance an SBS Entity that is also registered with the CFTC as a Swap Entity will be permitted to rely on a counterparty's pre-existing written representations with respect to the CFTC's business conduct rules to satisfy its due diligence requirements under the Commission's business conduct rules, provided that the SBS Entity provides notice of such reliance to the counterparty and the counterparty does not object.[197] Rule 15Fh-1(b) as adopted sets out the standard pursuant to which an SBS Entity can rely on representations to satisfy its due diligence obligations, and does not speak to the process the SBS Entity will need to undertake to meet the standard. The question of whether reliance on the representations that had been obtained with respect to the CFTC business conduct rules, including the process by which the SBS Entity makes that determination, would satisfy an SBS Entity's obligations under our business conduct rules will depend on the facts and circumstances of the particular matter.[198]

We are not adopting the suggestion of one commenter that “the knowledge test should be applied only to individuals with knowledge of the SBS transaction.” [199] In some instances it may be appropriate to look only to the knowledge of persons involved in a security-based swap transaction for purposes of determining whether an SBS Entity reasonably relied on representations. However, the determination whether to impute to the individuals that are involved in a securities-based swap transaction knowledge that may be available in other parts of the SBS Entity will depend on the facts and circumstances of the particular matter. At a minimum, an SBS Entity seeking to rely on representations cannot ignore information that would cause a reasonable person to question the accuracy of those representations.

E. Policies and Procedures Alternative

1. Proposal

The Commission solicited comment on whether an SBS Entity should be deemed to have complied with a requirement under the proposed rules if it has: (1) Established and maintained written policies and procedures, and a documented system for applying those policies and procedures, that are reasonably designed to achieve compliance with the requirement; and (2) reasonably discharged the duties and obligations required by the written policies and procedures and documented system, and did not have a reasonable basis to believe that the written policies and procedures and documented system were not being followed.[200]

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2. Comments on the Proposal

One commenter addressed the policies and procedures alternative.[201] The commenter opposed the alternative, arguing that it would reward the process of achieving compliance more than actually achieving compliance.[202] However, the commenter asserted that SBS Entities should be required to establish, maintain, document and enforce appropriate policies and procedures, and that the Commission should take them into account when determining the sanctions for violations.[203] The commenter argued that the requirement regarding policies and procedures should supplement the requirements or prohibitions in the rules, not supplant them.[204]

3. Response to Comments and Final Rule

After taking into consideration the comment, the Commission is not adopting a general policies and procedures safe harbor. The Commission acknowledges the importance of policies and procedures as a tool to achieving compliance with applicable regulatory and other requirements but agrees with the commenter that a general policies and procedures safe harbor could have the unintended effect of rewarding the process towards achieving compliance more than the result of actually achieving compliance.[205]

As discussed more fully herein, Rule 15Fh-3(h) requires that an SBS Entity establish, maintain and enforce written policies and procedures that are reasonably designed to prevent violations of applicable securities laws, and rules and regulations thereunder. Rule 15Fh-3(h) also provides an affirmative defense to a charge of failure to supervise diligently based, in part, on the establishment and maintenance of these policies and procedures, where the entity has reasonably discharged the duties and obligations required by the written policies and procedures and documented system, and did not have a reasonable basis to believe that the written policies and procedures and documented system were not being followed. In addition, consistent with the approach of the CFTC, we are providing targeted representations-based safe harbors,[206] which should result in efficiencies for entities that have already established infrastructure to comply with the CFTC rules.

F. Definitions

1. Proposed Rule

Proposed Rules 15Fh-2(a), (c), (e) and (f), which would define “act as an advisor to a special entity,” “independent representative of a special entity,” “special entity,” and “subject to a statutory disqualification,” respectively are discussed in Section II.H below in the context of the special entity requirements.

Proposed Rule 15Fh-2(b) would define “eligible contract participant” to mean any person defined in Section 3(a)(66) of the Exchange Act.

Proposed Rule 15Fh-2(d) would provide that “security-based swap dealer or major security-based swap participant” would include, where relevant, an associated person of the SBS Dealer or Major SBS Participant.

2. Comments on the Proposed Rule

a. Definitions Relating to the Rules Applicable to Dealings With Special Entities

Comments on paragraphs (a), (c), (e) and (f) of proposed Rule 15Fh-2 defining “act as an advisor,” “independent representative of a special entity,” “special entity” and “subject to a statutory disqualification,” respectively are addressed below in Section II.H.

b. Eligible Contract Participant

One commenter addressed proposed Rule 15Fh-2(b) defining “eligible contract participant.” [207] The commenter pointed out an error in the cross-reference in the rule to the Exchange Act definition and recommended adding a reference to applicable rules and interpretations of the Commission and the CFTC.[208]

c. SBS Dealer or Major SBS Participant

Three commenters addressed proposed Rule 15Fh-2(d) defining SBS Dealer or Major SBS Participant.[209] Two commenters suggested that the Commission adopt a broader definition that would apply the business conduct rules to any person acting on behalf of the SBS Entity, including an associated person, consistent with the CFTC business conduct rules.[210] One commenter asserted that this would prevent SBS Entities from “evad[ing] the business conduct rules by doing through third parties what they would not be permitted to do directly.” [211] The commenter also discouraged the Commission from seeking to identify all of the requirements that would apply to an associated person of an SBS Entity, suggesting that the rules should apply in any circumstance where an SBS Entity acts through or by means of an associated person or other party.[212]

A third commenter recommended that the Commission clarify that associated persons of an SBS Entity should only be directly responsible for complying with the disclosure rules and rules involving interactions with counterparties, and should not be responsible for complying with internal business conduct standards, such as the rules relating to supervision and requiring designation of a CCO.[213] The commenter also suggested that the Commission define “associated person” as “an associated person of an [SBS Dealer] or [Major SBS Participant] through whom the [SBS Dealer] or [Major SBS Participant] acts.” [214]

3. Response to Comments and Final Rule

The Commission is moving the definition of “independent representative of a special entity” from Rule 15Fh-2 to Rule 15Fh-5 and accordingly, re-designating paragraphs (d) through (f) of Rule 15Fh-2 as paragraphs (c) through (e). The definition of “independent representative of a special entity” and paragraphs (a), (d) and (e) of Rule 15Fh-2 (defining “act as an advisor,” “special entity” and “subject to a statutory disqualification,” respectively) are addressed below in Section II.H.

The Commission is adopting Rule 15Fh-2(b) with two modifications. In response to a suggestion from a commenter,[215] the Commission is correcting a typographical error in the cross-reference to the Exchange Act definition of “eligible contract participant” in the proposed rule. The proposed rule referenced “Section 3(a)(66)” of the Exchange Act, but should have referenced Section 3(a)(65) of the Exchange Act, which defines an Start Printed Page 29978eligible contract participant. Section 3(a)(65) of the Exchange Act, in turn, provides that the term eligible contract participant “has the same meaning as in section 1a of the Commodity Exchange Act.” We have also revised the definition in response to the same commenter's request that we add a reference to applicable rules and interpretations of the Commission and the CFTC to incorporate the joint SEC-CFTC rulemaking adopted in May 2012.[216] In this regard, we note that the Commission and the CFTC jointly further defined the term eligible contract participant by adopting rules and regulations under the Commodity Exchange Act.[217] Thus, as adopted, the definition of “eligible contract participant” in Rule 15Fh-2(b) refers to: “any person as defined in Section 3(a)(65) of the Act and the rules and regulations thereunder and in Section 1a of the Commodity Exchange Act and the rules and regulations thereunder.”

After considering the comments, the Commission is adopting Rule 15Fh-2(d) as proposed, re-designated as Rule 15Fh-2(c). The statute defines the term “associated person of a security-based swap dealer or major security-based swap participant” to include “any person directly or indirectly controlling, controlled by, or under common control with” an SBS Dealer or Major SBS Participant.[218] While the SBS Entity remains ultimately responsible for compliance with the business conduct standards, to the extent that an SBS Entity acts through, or by means of, an associated person of that SBS Entity, the associated person must comply as well with the applicable business conduct standards.

The Commission declines to modify the definition, as requested by some commenters, to apply to persons acting on behalf of the SBS Entity.[219] We believe it unnecessary to expand the definition because, as noted above, the SBS Entity remains ultimately responsible for compliance with the business conduct standards, whether the SBS Entity is acting through, or by means of, an associated person or other person.

In response to the commenter that raised concerns that associated persons should not be responsible for complying with “internal” business conduct standards,[220] the Commission notes that Rule 15Fh-2(c) provides that the definition of an SBS Entity includes associated persons of the SBS Entity “where relevant.” Certain rules, including the so-called “internal” business conduct rules (e.g., Rule 15Fh-3(h) (supervision) and Rule 15Fk-1 (designation of CCO)) may apply to some but not all associated persons of an SBS Entity, and the registrant remains ultimately responsible for compliance with all of the business conduct rules that are the subject of this rulemaking.

G. Business Conduct Requirements

1. Counterparty Status

a. Proposed Rule

Section 15F(h)(3)(A) of the Exchange Act directs that business conduct requirements adopted by the Commission shall establish a duty for an SBS Entity to verify that any counterparty meets the eligibility standards for an ECP.[221]

Proposed Rule 15Fh-3(a)(1) would require an SBS Entity to verify that a counterparty whose identity is known to an SBS Entity prior to the execution of the transaction meets the eligibility standards for an ECP, before entering into a security-based swap with that counterparty other than on a registered national securities exchange or SEF.[222] Proposed Rule 15Fh-3(a)(2) would require an SBS Entity to verify whether a counterparty whose identity is known to the SBS Entity prior to the execution of the transaction is a special entity before entering into a security-based swap with that counterparty, no matter where the transaction is executed.[223]

b. Comments on the Proposed Rule

Three commenters addressed proposed Rule 15Fh-3(a).[224] One opposed limiting the application of the rule to known counterparties, noting that this would invite SBS Entities to promote anonymous off-exchange transactions that would allow them to avoid obligations otherwise owed to special entities.[225] The commenter asserted that the only exemption from the verification requirement should be for transactions on a registered exchange or SEF, and that for such transactions, if the SBS Entity knows the identity of the counterparty prior to the transaction and has reason to believe it may not be an ECP, the SBS Entity should be required to undertake an additional inquiry to verify the counterparty's status.[226] The commenter also recommended that verification take place before the SBS Entity offers to enter into a transaction, rather than before execution.[227]

Two commenters recommended that the exception for transactions on a registered exchange or SEF be broadened to apply to the verification of special entity status in addition to the verification of ECP status.[228] One commenter also recommended expanding the exception to include exempt SEFs, such as a foreign SEF that the Commission determines to be subject to a comparable home country regime.[229] Additionally, as part of a series of recommendations to harmonize with the CFTC's treatment of employee benefit plans defined in Section 3 of ERISA, the commenter suggested requiring an SBS Entity to verify whether a counterparty is eligible to Start Printed Page 29979elect to be a special entity, and if so, to notify such counterparty.[230]

The other commenter also recommended further narrowing the application of the rule by excluding transactions in which the identity of the counterparty is known just prior to execution, arguing that an SBS Entity would have insufficient time to exchange representations with the counterparty or otherwise verify the counterparty's status in those situations.[231] Alternatively, the commenter requested that the Commission require SEFs to adopt rules that would permit verification of the counterparty's status.[232] The commenter also opposed establishing specific documentation requirements regarding counterparty status, asserting that it would not allow for flexible risk management and investment decisions through private contractual negotiation.[233]

c. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(a) with certain modifications.

Rule 15Fh-3(a)(1), as adopted, requires an SBS Entity to verify the ECP status of a counterparty before entering into a security-based swap with that counterparty other than a transaction executed on a registered national securities exchange. We are not adopting the further provision of the proposed rule that would have limited the application of the verification requirement to a counterparty “whose identity is known to the SBS Entity prior to the execution of the transaction.” We also are not adopting the provision of the proposed rule that would have provided that the verification requirement does not apply to transactions executed on a SEF. These changes reflect the Commission's further consideration of the regulatory framework provided by the Dodd-Frank Act.

In particular, Section 6(l) of the Exchange Act makes it unlawful to effect a transaction in a security-based swap with or for a person that is not an ECP, unless the transaction is effected on a registered national securities exchange.[234] Section 6(l) of the Exchange Act does not provide an exception for transactions effected on SEFs, or for transactions where the identity of a counterparty is not known to the SBS Entity prior to the execution of the transaction. Thus, upon further consideration of the proposed rule in the context of the statute, we are not providing an exception for transactions executed other than on a registered national securities exchange, and we are not limiting the requirement to known counterparties because Section 6(l) of the Exchange Act does not contain a similar exception or limitation, and we do not wish to suggest to SBS Entities that Section 6(l) is similarly limited. In this regard, we note that, even with these modifications, the scope of Section 6(l) of the Exchange Act (“unlawful to effect a transaction in a security-based swap”) is broader than the activity covered by Rule 15Fh-3(a)(1) (“before entering into a security-based swap”), and that SBS Entities, and other market participants, have an independent obligation under Section 6(l) for any action covered by that section.[235]

As noted in the Proposing Release, an SBS Entity that has complied with the requirements of Rule 15Fh-3(a)(1) concerning a counterparty's eligibility to enter into a particular security-based swap fulfills its obligations under the rule for that security-based swap, even if the counterparty subsequently ceases to meet the eligibility standards for an ECP during the term of that security-based swap.[236] However, an SBS Entity will need to verify the counterparty's status for any subsequent action covered by Rule 15Fh-3(a)(1), (which it could do by relying on written representations from the counterparty, as described above). An SBS Entity could satisfy this obligation by relying on a representation in a master or other agreement that is renewed or “brought down” as of the date of the subsequent action covered by 15Fh-3(a)(1). In this manner, counterparties will be able to make representations about their status at the outset of a relationship, and can undertake to “bring down” that representation for each relevant action involving a security-based swap. In addition, as noted above, market participants have an independent obligation under Section 6(l) of the Exchange Act for any action covered by that section.

Rule 15Fh-3(a)(2), as adopted, requires an SBS Entity to verify whether a counterparty is a special entity before entering into a security-based swap transaction with that counterparty, unless the transaction is executed on a registered or exempt SEF or registered national securities exchange and the SBS Entity does not know the identity of the counterparty at a reasonably sufficient time prior to execution of the transaction to permit the SBS Entity to comply with the obligations of the rule. The rule as proposed would have limited the verification of special entity status to counterparties whose identity is known to the SBS Entity prior to the execution of the security-based swap transaction. Because the question of special entity status figures most significantly in connection with the application of the special entity rules (Rules 15Fh-4, 15Fh-5 and 15Fh-6), we have modified the special entity verification rule to track the exceptions to those rules.[237] Accordingly, the verification of special entity status requirements will not apply where the transaction is executed on a registered or exempt SEF or registered national securities exchange, and the SBS Entity does not know the identity of the counterparty at a reasonably sufficient time prior to execution of the transaction to permit the SBS Entity to comply with the obligations of the rule.

An SBS Entity that has complied with the requirements of Rule 15Fh-3(a)(2) concerning verification whether a counterparty is a special entity before entering into a particular security-based swap with that counterparty fulfills its obligations under the rule for that security-based swap.[238] However, an SBS Entity will need to verify the counterparty's status for any subsequent action covered by Rule 15Fh-3(a)(2) (which it could do by relying on written representations from the counterparty, as described above). An SBS Entity could satisfy this obligation by relying on a representation in a master or other agreement that is renewed or “brought down” as of the date of the subsequent action covered by 15Fh-3(a)(2). In this manner, counterparties will be able to make representations about their status at the outset of a relationship, and can undertake to “bring down” that Start Printed Page 29980representation for each relevant action involving a security-based swap.

Additionally, the Commission is adding a new paragraph (a)(3), special entity election, which requires an SBS Entity, in verifying the special entity status of a counterparty pursuant to Rule 15Fh-3(a)(2), to verify whether a counterparty is eligible to elect not to be a special entity as provided for in the adopted special entity definition in Rule 15Fh-2(d)(4), and if so, notify such counterparty. This change is intended to provide the greatest protections to the broadest categories of special entities, while still allowing them the flexibility to elect not to avail themselves of special entity protections.[239]

Although the Dodd-Frank Act does not specifically require an SBS Entity to verify whether a counterparty is a special entity or is eligible to elect not to be a special entity, the Commission believes that such verification will help to ensure the proper application of the business conduct rules that apply to SBS Entities dealing with special entities.[240]

The Commission is not revising the rule, as suggested by a commenter,[241] to require that verification of special entity counterparty status take place before an SBS Entity “offers” to enter into a transaction. We agree with the commenter that it is important for an SBS Entity to verify special entity status “as soon as possible . . . to ensure timely compliance with the other obligations that accompany transactions with these entities.” As explained in Section II.A, when the rules refer to a “counterparty” of the SBS Entity, the term “counterparty” includes a potential counterparty where compliance with the obligation is required before the SBS Entity and the “counterparty” have actually entered into the security-based swap.

The Commission is not specifying the manner of documentation or procedures required for compliance with Rule 15Fh-3(a).[242] Among other things, an SBS Entity could rely on representations in accordance with Rule 15Fh-1(b). For example, an SBS Entity could verify that a counterparty is an ECP by obtaining a written representation from the counterparty as to specific facts about the counterparty (e.g., that it has $100 million in assets) to conclude that the counterparty is an ECP, unless the SBS Entity has information that would cause a reasonable person to question the accuracy of the representation. Similarly, an SBS Entity could seek to verify that a counterparty is not a special entity by obtaining a written representation from the counterparty that it does not fall within any of the enumerated categories of persons that are “special entities” for purposes of Section 15F of the Exchange Act. The SBS Entity also could seek to obtain a representation in writing from the counterparty if it elects not to be a special entity, as provided for in the special entity definition in Rule 15Fh-2(d)(4). Consistent with Rule 15Fh-1(b), however, an SBS Entity cannot disregard information that would cause a reasonable person to question the accuracy of the representation.

2. Disclosure

Section 15F(h)(3)(B) of the Exchange Act broadly requires that business conduct requirements adopted by the Commission require disclosures by SBS Entities to counterparties of information related to “material risks and characteristics” of the security-based swap, “material incentives or conflicts of interest” that an SBS Entity may have in connection with the security-based swap, and the “daily mark” of a security-based swap.[243]

a. Disclosure Not Required When the Counterparty is an SBS Entity or a Swap Entity

i. Proposed Rules

Section 15F(h)(3)(B) provides that disclosures under that section are not required when the counterparty is “a security-based swap dealer, major security-based swap participant, security-based swap dealer, or major security-based swap participant.” [244] As explained in the Proposing Release, the Commission believes that the repetition of the terms “security-based swap dealer and major security-based swap participant” in this Exchange Act provision is a drafting error, and that Congress instead intended an exclusion identical to that found in the Commodity Exchange Act, which provides that these general disclosures are not required when the counterparty is “a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant.” [245] Accordingly, proposed Rule 15Fh-3(b) (information about material risks and characteristics, and material incentives or conflicts of interests), proposed Rule 15Fh-3(c) (the daily mark), and proposed Rule 15Fh-3(d) (clearing rights) would not apply whenever the counterparty is an SBS Entity or Swap Entity.

ii. Comments on the Proposal

Two commenters submitted comments on the application of the disclosure requirements when the counterparty is an SBS Entity or Swap Entity.[246] One commenter asserted that the disclosure requirements should apply even when the counterparty is also an SBS Entity.[247] Another commenter agreed with the Commission's interpretation that Congress intended the exclusion to apply to transactions with other SBS Entities and Swap Entities.[248] However, in response to a specific request for comment, the commenter asserted that the Commission should not exempt transactions with other entities (such as banks or broker-dealers) from the disclosure requirements, or otherwise subject them to different disclosure standards, because while more sophisticated banks or brokers may benefit, less sophisticated parties would be left without adequate protections.[249]

Additionally, as discussed in Section II.B, a commenter advocated for adding exceptions to the disclosure requirements in Rules 15Fh-3(b) and (d) to cover security-based swaps that are intended to be cleared and that are either (1) executed on a registered national securities exchange or registered or exempt SEF and required to be cleared pursuant to Section 3C of the Exchange Act, or (2) anonymous.[250] The commenter argued that this would harmonize the scope of the Commission's disclosure requirements with no-action relief provided by the Start Printed Page 29981CFTC with respect to its parallel requirements.[251]

iii. Response to Comments and Final Rules

After considering the comments, the Commission is adopting, as proposed, the exceptions from the disclosure requirements under Rule 15Fh-3(b) (information about material risks and characteristics, and material incentives or conflicts of interests), Rule 15Fh-3(c) (the daily mark), and Rule 15Fh-3(d) (clearing rights) for transactions in which the counterparty is an SBS Entity or Swap Entity. We are not adopting the suggestion that disclosure requirements apply even when the counterparty is an SBS Entity or Swap Entity. We believe that an SBS Entity would be well-positioned to negotiate with another SBS Entity, and nothing in our rules precludes an SBS Entity from requesting such disclosures.

In addition, the exceptions under the rules as adopted parallel the exceptions in the analogous CFTC rules. This consistency will result in efficiencies for entities that have already established infrastructure to comply with the CFTC standard.

For the reasons discussed in Section II.B, we are not providing additional exceptions for transactions that are intended to be cleared.[252]

b. Timing and Manner of Certain Disclosures and Scope of Disclosure Rules

i. Proposed Rules

Proposed Rule 15Fh-3(b) would require that disclosures regarding material risks and characteristics and material incentives or conflicts of interest be made to potential counterparties before entering into a security-based swap, but would not mandate the specific manner in which those disclosures are made as long as they are made “in a manner reasonably designed to allow the counterparty to assess” the information being provided.[253] Proposed Rule 15Fh-3(d) similarly would require that disclosures regarding certain clearing rights be made before entering into a security-based swap, but would not mandate the manner of disclosure. To the extent such disclosures were not otherwise provided to the counterparty in writing prior to entering into a security-based swap, proposed Rules 15Fh-3(b)(3) and 15Fh-3(d)(3) would require an SBS Entity to make a written record of the non-written disclosures made pursuant to proposed Rules 15Fh-3(b) and 15Fh-3(d), respectively, and provide a written version of these disclosures to the counterparty in a timely manner, but in any case no later than the delivery of the trade acknowledgement of the particular transaction.

ii. Comments on Proposed Rules

Timing and Manner of Certain Disclosures

Five commenters addressed the timing and manner of required disclosures.[254] One commenter recommended allowing disclosure requirements to be satisfied by the execution of a master agreement and provision of a trade acknowledgment.[255] Similarly, another commenter urged the Commission to permit all required disclosures to be made upfront at the beginning of a trading relationship, rather than on a transaction-by-transaction basis.[256]

Alternatively, if the Commission requires disclosure beyond the master agreement and trade acknowledgment, the first commenter encouraged the Commission to permit the use of standardized disclosures.[257] The commenter also recommended that the Commission not dictate the timing of required disclosures and permit SBS Entities to make required disclosures in advance, as opposed to immediately prior to the execution of a trade, so as not to interfere with the parties' desired timing.[258] However, the commenter noted that advance disclosure requirements would be infeasible for transactions executed on a SEF or exchange, or where the counterparty is known only immediately prior to or after execution.[259]

In contrast, two commenters advocated for more specific requirements with respect to the timing and manner of disclosure.[260] Both recommended that disclosure be required in writing and at a “reasonably sufficient time” prior to the execution of the transaction to allow counterparties to evaluate the information before deciding whether to enter the transaction.[261] One commenter also asserted that disclosure should be in a clear and intelligible format that permits comparison between derivatives offered by different market participants.[262] The other commenter opposed allowing SBS Entities to satisfy disclosure requirements through entry into a master agreement and provision of a trade acknowledgement, arguing that key information could be lost in the fine print of legal documents.[263] At a minimum, if a master agreement is used, the commenter recommended that the required disclosures regarding material risks and characteristics and material incentives or conflicts of interest be provided in a clearly labeled, separate narrative incorporated into the overall document, and that all key issues be disclosed before the trade is executed and not in a post-trade acknowledgement.[264]

Another commenter also recommended that disclosure regarding material risks and characteristics and material incentives or conflicts of interest be required at a “reasonably sufficient time” prior to the execution of the transaction to harmonize with the CFTC's disclosure requirements.[265] Additionally, as discussed in Section II.B, the commenter advocated for adding exceptions to the disclosure requirements in Rules 15Fh-3(b) and (d) to cover security-based swaps that are intended to be cleared and that are either: (1) Executed on a registered national securities exchange or registered or exempt SEF and required to be cleared pursuant to Section 3C of the Exchange Act, or (2) anonymous.[266]

Written Records of Non-Written Disclosure

One commenter addressed the written record requirements in proposed Rules 15Fh-3(b)(3) and 15Fh-3(d)(3).[267] The commenter opposed permitting SBS Entities to make required disclosures orally, asserting that oral disclosure fails to promote pre-trade transparency and makes enforcement more difficult, and that SBS Entities may minimize disclosure of conflicts of interest when making them orally.[268] The commenter also argued that the Commission's approach to permitting oral disclosure “doesn't even have the benefit of saving Start Printed Page 29982labor, since the Commission proposes to require after-the-fact written disclosures of any information not made in writing prior to the transaction.” [269]

Scope of Disclosure Rules

If the Commission requires disclosure beyond the master agreement and trade acknowledgment, one commenter encouraged the Commission to exclude from such requirements counterparties that are regulated entities such as banks, broker-dealers, and investment advisers.[270] Two other commenters argued that Major SBS Participants should not be subject to the disclosure requirements because they will be transacting with counterparties at arm's length.[271] Alternatively, one commenter suggested exempting transactions between Major SBS Participants and SBS Dealers from the disclosure requirements, and allowing all other counterparties to opt out of certain disclosure requirements, in particular receiving written records of non-written disclosure.[272] Similarly, another commenter suggested that ECPs should have the option of opting-out of disclosures.[273]

iii. Response to Comments and Final Rules

After considering the comments, the Commission is adopting the rules substantially as proposed, with certain modifications. In response to commenters' concerns, the Commission is requiring that an SBS Entity make the disclosures required by Rule 15Fh-3(b) regarding material risks and characteristics and material incentives or conflicts of interest at a reasonably sufficient time prior to entering into a security-based swap to allow the counterparty to assess the disclosures. This will also be consistent with the CFTC's timing requirement for its parallel disclosures rules, resulting in efficiencies for entities that have already established infrastructure to comply with the CFTC standard.

With respect to the manner of disclosure, we are not adopting the commenters' suggestion that we impose more specific requirements with respect to the timing and manner of disclosure.[274] Instead, the Commission continues to believe it is appropriate to require only that disclosures regarding material risks and characteristics and material incentives or conflicts of interest be made “in a manner reasonably designed to allow the counterparty to assess” the information being provided pursuant to Rule 15Fh-3(b). As noted in the Proposing Release, this provision is intended to require that disclosures be reasonably clear and informative as to the relevant material risks or conflicts that are the subject of the disclosure, and is not intended to impose a requirement that disclosures be tailored to a particular counterparty or to the financial, commercial or other status of that counterparty.[275]

After considering the comments, the Commission is also adopting as proposed the requirements in Rules 15Fh-3(b)(3) and 15Fh-3(d)(3) that an SBS Entity make a written record of any non-written disclosures made pursuant to Rules15Fh-3(b) and 15Fh-3(d), respectively, and provide a written version of these disclosures to the counterparty in a timely manner, but in any case no later than the delivery of the trade acknowledgement [276] of the particular transaction. As noted in the Proposing Release and suggested by commenters, the Commission understands that security-based swaps generally are executed under master agreements, with much of the transaction-specific disclosure provided over the telephone, in instant messages or in confirmations.[277] The Commission believes that parties should have the flexibility to make disclosures by various means, including master agreements and related documentation, telephone calls, emails, instant messages, and electronic platforms.[278] Similarly, while we acknowledge the commenter's concern that SBS Entities may minimize disclosure of conflicts of interest when making them orally, we are not persuaded that requiring all disclosures be provided in writing prior to the parties' entering into a security-based swap would be necessary to provide protections under the rule as adopted. We further note that Rule 15Fh-3(b)(3), discussed in Section II.G.2.c, separately requires that an SBS Entity provide a written record of non-written disclosures no later than the delivery of the trade acknowledgement of the particular transaction. Accordingly, the Commission anticipates that SBS Entities may elect to make certain required disclosures of material information to their counterparties in a master agreement or other written document accompanying such agreement. While certain forms of disclosure may be highly standardized, certain provisions may need to be tailored to the particular transaction, most notably pricing and other transaction-specific commercial terms. As noted in the Proposing Release, the Commission believes this approach is generally consistent with the use of standardized disclosures suggested by industry groups and commenters.[279]

We do believe, however, that is it is important that the required disclosures be made at a reasonably sufficient time before the execution of the transaction to allow the counterparty to assess the disclosures. While this time may vary depending on the product and the counterparty, we do not believe, as suggested by some commenters, that SBS Entities should be able to rely on trade acknowledgements alone to satisfy certain disclosure requirements.[280] As noted in the Proposing Release, however, SBS Entities could rely on trade acknowledgements to memorialize non-written disclosures they made prior to entering into the proposed transaction.[281]

As discussed in Section II.B above, the Commission is limiting the disclosure requirements in Rules 15Fh-3(b) and (d) to circumstances where the identity of the counterparty is known to the SBS Entity at a reasonably sufficient time prior to execution of the transaction to permit the SBS Entity to comply with the obligations of the rule. The disclosure requirements in Rules 15Fh-3(b) and (d) will not apply where the identity of the counterparty is not discovered until after the execution of the transaction, or where the SBS Entity learns the identity of the counterparty Start Printed Page 29983with insufficient time to be able to provide the necessary disclosures to satisfy its obligations under the rule without disrupting or delaying the execution of the transaction. Similarly, for the reasons discussed in Section II.A.3.d, we are not providing additional exceptions or “opt-out” rights.

Finally, we are not adopting the suggestion of one commenter that the Commission exclude from the disclosure requirements transactions with counterparties that are regulated entities such as banks, broker-dealers, and investment advisers.[282] Because information asymmetries exist in a market for opaque and complex products, even for regulated entities, such disclosures may help inform counterparties concerning the valuations and material risks and characteristics of security-based swaps in the sometimes rapidly changing market environment.[283] In this regard, the external business conduct requirements promulgated under Section 15F(h) are intended to provide certain protections for counterparties, including information regarding the material risks and characteristics of the security-based swap, any material incentives or conflicts of interest that the SBS Entity may have, and the daily mark of the security-based swap. We believe the rules we are adopting today appropriately apply those requirements so that counterparties receive the benefit of those protections, and so are not providing counterparty exclusions beyond the exception for transactions with SBS Entities and Swap Entities discussed in Section II.G.2.a, infra.

c. Material Risks and Characteristics of the Security-Based Swap

i. Proposed Rule

Proposed Rule 15Fh-3(b)(1) would require an SBS Entity to disclose the material risks and characteristics of the particular security-based swap, including, but not limited to, the material factors that influence the day-to-day changes in valuation, the factors or events that might lead to significant losses, the sensitivities of the security-based swap to those factors and conditions, and the approximate magnitude of the gains or losses the security-based swap would experience under specified circumstances. In the Proposing Release, the Commission also solicited comment regarding whether SBS Entities should be specifically required to provide scenario analysis disclosure.[284]

ii. Comments on the Proposed Rule

General

Seven commenters addressed the disclosure of material risks and characteristics of security-based swaps.[285] One commenter expressed support for the proposed disclosure requirements, agreeing that the disclosure should include any information for which there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision.[286]

Two commenters argued that the Commission should adopt different or modified disclosure requirements.[287] One commenter requested that the Commission clarify in the rule that: (1) The rule only requires disclosure about the material risks and characteristics of the security-based swap itself and not with respect to the underlying reference security or index, and (2) the rule does not require disclosure in relation to any particular counterparty.[288] The commenter also asked the Commission to eliminate the proposed requirement that risk disclosures set forth the approximate magnitude of the gains or losses the security-based swap will experience under specified circumstances because this is the functional equivalent of a requirement to provide a scenario analysis, which the commenter does not support (discussed below).[289] Additionally, the commenter noted its view that the Commission should not require an SBS Entity to disclose the absence of certain material provisions typically contained in master agreements for security-based swap transactions because master agreements differ and what is “typical” is not clear.[290] A second commenter requested a clarification that only material information is required to be disclosed.[291]

Three commenters argued for additional or modified requirements.[292] One asserted that the proposed disclosure obligations are too limited in terms of scope, form, and content.[293] The commenter suggested that the disclosure provisions should require “more complete, timely, and intelligible disclosure of all the risks, costs, and other material information relating to [security-based swap] transactions,” including disaggregated prices and risks, listed hedge equivalents, scenario analysis (discussed below), and embedded financing costs.[294] Similarly, another commenter requested clarification regarding what material risks and characteristics must be disclosed, arguing that the disclosure should include liquidity risks, the details of (and separate prices for) the standardized component parts of any customized security-based swap, any features of the security-based swap that could disadvantage the counterparty (such as differences in interest rates paid versus those received), and where credit arrangements are built into security-based swaps through forbearance of collateral posting, the embedded credit and its price.[295] A third commenter also suggested that the Commission clarify what material risks and characteristics must be disclosed, proposing that SBS Entities be required to disclose any material risk related to the source of a security-based swap's assets and any negative view by the SBS Entity itself of the assets' riskiness.[296] The commenter also recommended that SBS Entities be required to disclose the material risks and characteristics not just of the security-based swap itself, but also of any reference securities, indices, or other assets, noting that this disclosure would be particularly important when the security-based swap references unique pools of assets arranged by the SBS Entity.[297]

Another commenter, writing after the CFTC adopted its final rules, recommended that the Commission harmonize with the CFTC's requirement to disclose material risks and characteristics.[298] Specifically, the commenter requested that, like the CFTC, the Commission describe the material risks and characteristics to be disclosed as including “market, credit, liquidity, foreign currency, legal, operational, and any other applicable risks,” and “the material economic terms of the security-based swap, the terms relating to the operation of the Start Printed Page 29984security-based swap, and the rights and obligations of the parties during the term of the security-based swap.” [299] The commenter argued that harmonization with the CFTC would help support the continued development of standard disclosures, reducing compliance costs and preventing undue delays in execution, and would reduce the likelihood of inconsistent disclosures for similar products and resulting counterparty confusion.[300]

Scenario Analysis

We sought comment on whether we should require scenario analysis and, if so, what standards should apply. Eight commenters addressed the disclosure of scenario analysis.[301] Four commenters supported requiring scenario analysis disclosure to some degree.[302] Of these commenters, one suggested that the analysis include specific information about the security-based swap's liquidity and volatility.[303] Another recommended only requiring scenario analysis disclosure for “high-risk complex security-based swaps,” and suggested that the Commission provide additional clarification or a definition for determining what security-based swaps are high-risk and complex.[304] A third commenter advocated requiring SBS Entities to notify counterparties of their right to receive a scenario analysis and to provide a scenario analysis at the request of a non-SBS Entity counterparty.[305] To reduce the costs associated with providing scenario analyses and to mitigate the disclosure of SBS Entities' proprietary information, the commenter suggested that the Commission permit SBS Entities to delegate the provision of scenario analyses to qualified third-parties.[306] The commenter explained that requiring scenario analysis disclosure on a transaction-by-transaction basis would not be necessary because SBS Entity counterparties are generally sophisticated enough to create their own, more meaningful, portfolio-based analyses, but that scenario analyses could help a less sophisticated counterparty understand the dynamics and potential exposure of security-based swaps on a portfolio-level.[307] The commenter also noted that the Commission should encourage all market participants to create or obtain a portfolio-level scenario analysis, in keeping with industry best practices.[308]

Four commenters opposed requiring disclosure of scenario analysis.[309] One noted that requiring scenario analysis disclosure would have potentially significant adverse consequences for special entities and other counterparties, and urged the Commission to refrain from requiring it.[310] Specifically, the commenter explained that requiring scenario analysis would likely delay execution of transactions and expose counterparties to market risk for potentially extended periods of time (including at critical times when the counterparty is seeking to hedge its positions in volatile markets) because the development of scenario analyses depends upon the specific terms agreed by the parties and therefore, cannot be performed until full agreement on the material terms is reached.[311] Additionally, the commenter noted that the development of such analyses would cause SBS Entities to incur substantial costs, which ultimately would be passed on to counterparties.[312] Another commenter opposed a requirement to provide scenario analysis and asserted that, if a scenario analysis is required, it should only be at the request of the counterparty and only with respect to scenarios based on parameters selected by the counterparty.[313] The commenter also expressed concern that providing a scenario analysis could be viewed as a “recommendation” that triggers other requirements under the proposed rules (e.g., suitability requirements).[314]

A third commenter, writing after the CFTC adopted final rules,[315] stated that, in its experience, the CFTC's scenario analysis requirement has complicated the ability of SBS Dealers to provide different pricing scenarios, either voluntarily or at the request of a counterparty, because it creates “uncertainty as to when those scenarios must satisfy the requirements for scenario analysis set forth in the CFTC EBC rules.” [316]

A fourth commenter recommended that, to the extent a Major SBS Participant is transacting with an ECP at arm's-length, the Commission should explicitly exclude scenario analysis from the information that the Major SBS Participant is required to disclose pursuant to Rule 15Fh-3(b).[317] The commenter asserted that scenario analysis disclosure would be costly and redundant since the rule would already require Major SBS 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.[318]

iii. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(b)(1) with some modifications requested by commenters to more closely align the requirements of our rules with those of the CFTC.

We have revised the descriptions in Rule 15Fh-3(b)(1) of the required disclosures of material risks and characteristics of a security-based swap to harmonize with the descriptions in the parallel CFTC disclosure requirement. As adopted, Rule 15Fh-3(b)(1) requires an SBS Entity to disclose material information in a manner reasonably designed to allow the counterparty to assess the material risks and characteristics of the particular security-based swap, which may include (1) market risk,[319] credit risk,[320] liquidity risk,[321] foreign Start Printed Page 29985currency risk, legal risk,[322] operational risk[323] and any other applicable risks, and (2) the material economic terms of the security-based swap, and the rights and obligations of the parties during the term of the security-based swap. These changes are intended to provide an illustrative list of material risks and characteristics. In addition, these changes will harmonize our rule with the requirements of the CFTC rule, which should result in efficiencies for SBS Entities that have already established infrastructure to comply with the CFTC rules, while still achieving the objectives of the rule to provide information to a counterparty to help them assess whether, and under what terms, they want to enter into the transaction.

The rule as adopted requires disclosure of “material” information regarding material risks and characteristics and material incentives or conflicts of interests. We believe that this modification will provide for an appropriate level of disclosure by requiring disclosure of “material” information, that is, the information most relevant to a counterparty's assessment of whether and under what terms to enter into a security-based swap. In addition, it will harmonize with the CFTC approach, promoting regulatory consistency across the swap and security-based swap markets, particularly among entities that transact in both markets and have already established infrastructure to comply with existing CFTC regulations. In response to comment, the Commission believes that for purposes of evaluating the material risks and characteristics of the particular security-based swap, including its economic terms, material information about the referenced security, index, asset or issuer should be disclosed.[324] As one commenter suggested, this disclosure would be particularly important when, for example, the security-based swap references unique pools of assets arranged by the SBS Entity.[325]

The Commission anticipates that SBS Entities may provide these disclosures through various means, including by providing a scenario analysis, as noted in the Proposing Release.[326] We are not, however, adopting any requirements that would require an SBS Entity to provide scenario analysis. Although scenario analysis may prove a valuable analytic tool, it is one means by which information may be conveyed, and we acknowledge the concerns of commenters that a scenario analysis may not be necessary or appropriate in every situation to ensure that appropriate disclosures are made. We note, however, that nothing in our rules would preclude parties from requesting such analysis, even if a security-based swap is “made available for trading.” In this regard, our approach differs from that of the CFTC which requires a Swap Dealer to provide scenario analysis when requested by a counterparty for any swap that is not “made available for trading” on a designated contract market or swap execution facility. We believe, however, that the approaches are consistent because, as noted above, the Commission is not prohibiting counterparties from requesting scenario analysis disclosure.

As noted in the Proposing Release, these disclosures are intended to pertain to the material risks and characteristics of the security-based swap, and not the material risks and characteristics of the security-based swap with respect to a particular counterparty.[327]

d. Material Incentives or Conflicts of Interest

i. Proposed Rule

Proposed Rule 15Fh-3(b)(2) would require the SBS Entity to disclose any material incentives or conflicts of interest that it may have in connection with the security-based swap, including any compensation or other incentives from any source other than the counterparty in connection with the security-based swap to be entered into with the counterparty.[328] We explained in the Proposing Release that we preliminarily believed that the term “incentives”—which is used in Section 15F(h)(3)(b)(ii) of the Dodd-Frank Act—refers not to any profit or return that the SBS Entity would expect to earn from the security-based swap itself, or from any related hedging or trading activities of the SBS Entity, but rather to any other financial arrangements pursuant to which an SBS Entity may have an incentive to encourage the counterparty to enter into the transaction. This disclosure would include, among other things, information concerning any compensation (e.g., under revenue-sharing arrangements) or other incentives the SBS Entity receives from any source other than the counterparty in connection with the security-based swap to be entered into with the counterparty, but would not include, for example, expected cash flows received from a transaction to hedge the security-based swap or that the security-based swap is intended to hedge.[329]

ii. Comments on the Proposed Rule

Seven commenters addressed the disclosure of material incentives or conflicts of interest.[330] One commenter expressed strong support for the proposed rule.[331] A second commenter also supported the proposed rule, noting that it is consistent with the CFTC's parallel requirement, except for the CFTC's requirement to disclose a pre-trade mid-market mark, which the commenter argued is of limited benefit and delays execution of transactions.[332] Three other commenters expressed support for the proposed rule but also suggested certain revisions to the rule.[333] One recommended modifying the rule to include specific disclosures by SBS Entities of any affiliations or material business relationships they may have with any provider of security-based swap valuation services.[334] Another noted that an SBS Entity's biggest conflict of interest would likely be the difference in compensation between selling a security-based swap (and in particular, a customized security-based swap) versus another Start Printed Page 29986product with similar economic terms.[335] Accordingly, the commenter recommended that SBS Entities be required to include any differential compensation in their disclosure.[336] Additionally, the commenter asserted that if an SBS Entity is entering a trade as part of a trading strategy to move a position off its books, the SBS Entity should be required to disclose that particular conflict of interest and that the security-based swap is recommended to effect that strategy.[337] A third commenter suggested coordinating the proposed rule with the conflict of interest prohibitions in Sections 619 and 621 of the Dodd-Frank Act to clarify that those prohibitions cannot be circumvented through application of the business conduct disclosure requirements.[338] The commenter also recommended including in these required disclosures any otherwise hidden profits or returns that the SBS Entity expects to make from a security-based swap, related agreement or arrangement, or related hedging or trading activity.[339]

One commenter objected to any requirement that an SBS Entity disclose its anticipated profit for the security-based swap.[340] The commenter asserted that the best protection for a counterparty is reviewing and selecting the best available pricing.[341]

iii. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(b)(2) as proposed.

As noted in the Proposing Release, the Commission believes that the term “incentives”—which is used in Section 15F(h)(3)(b)(ii) of the Dodd-Frank Act—refers not to any profit or return that the SBS Entity would expect to earn from the security-based swap itself, or from any related hedging or trading activities of the SBS Entity, but rather to any other financial arrangements pursuant to which an SBS Entity may have an incentive to encourage the counterparty to enter into the transaction.[342] Accordingly, the disclosure required pursuant to Rule 15Fh-3(b)(2) generally should include information concerning any compensation (for example, under revenue-sharing arrangements) or other incentives the SBS Entity receives from any source other than the counterparty in connection with the security-based swap to be entered into with the counterparty but will not include, for example, expected cash flows received from a transaction to hedge the security-based swap or that the security-based swap is intended to hedge.

As discussed above, whether a conflict or incentive is material depends on the facts and circumstances of the particular matter. Although we are not expressly requiring disclosure of differential compensation as requested by the commenter, the difference in compensation an SBS Entity may receive for selling a security-based swap versus another product with similar economic terms may create a material incentive or conflict of interest that would need to be disclosed under the framework discussed above. Similarly, an SBS Entity would need to disclose material information concerning affiliations or material business relationships it may have with any provider of security-based swap valuation providers if those relationships create a material incentive or conflict of interest. Regarding the commenter's concern that the conflict of interest prohibitions in Sections 619 and 621 of the Dodd-Frank Act might be circumvented through application of the business conduct disclosure requirements,[343] nothing in our rules limits or restricts the applicability of other relevant laws.[344]

e. Daily Mark

Exchange Act Section 15F(h)(3)(B)(iii) directs that business conduct requirements adopted by the Commission require an SBS Entity to disclose to a counterparty (other than to another SBS Entity or Swap Entity): (i) For cleared security-based swaps, upon request of the counterparty, the daily mark from the appropriate derivatives clearing organization;[345] and (ii) for uncleared security-based swaps, the daily mark of the transaction.

i. Proposed Rule

Proposed Rule 15Fh-3(c) would require an SBS Entity to disclose to its counterparty (other than to another SBS Entity or Swap Entity): (1) For a cleared security-based swap, upon the request of the counterparty, the daily end-of-day settlement price that the SBS Entity receives from the appropriate clearing agency, and (2) for an uncleared security-based swap, the midpoint between the bid and offer, or the calculated equivalent thereof, as of the close of business, unless the parties agree in writing to a different time, on each business day during the term of the security-based swap. Proposed Rule 15Fh-3(c)(2) would specify that the daily mark for an uncleared security-based swap may be based on market quotations for comparable security-based swaps, mathematical models or a combination thereof. Proposed Rule 15Fh-3(c)(2) also would require disclosure of the data sources and a description of the methodology and assumptions used to prepare the daily mark for an uncleared security-based swap, as well as any material changes to such data sources, methodology or assumptions during the term of the security-based swap.

ii. Comments on Proposed Rule

Ten comment letters addressed the requirement for SBS Entities to provide a daily mark.[346]

One commenter suggested modifications to the daily mark requirement to harmonize with the CFTC's parallel requirement.[347] Specifically, for cleared security-based swaps, the commenter recommended that an SBS Entity simply be required to notify a counterparty of its right to receive the daily mark from the appropriate clearing agency upon request.[348] The commenter also argued that the CFTC's description of the clearinghouse's mark is less Start Printed Page 29987prescriptive.[349] Additionally, the commenter recommended that the Commission provide guidance clarifying that an SBS Entity will be deemed to satisfy the daily mark requirement for cleared security-based swaps if the counterparty has agreed to receive its daily mark from its clearing member.[350]

One commenter asserted that requiring SBS Entities to provide daily marks would not further the goal of providing helpful transparency because in most transactions marks are typically either based on internal models or derived from indices with which the transactions are not perfectly matched.[351] Another commenter asked the Commission to carefully review and consider the costs of such a requirement before imposing any obligation to provide daily marks, other than those agreed upon for collateral purposes or for which midmarket quotations are observable.[352] The commenter also requested that “sophisticated counterparties” be permitted to opt out of this requirement, and recommended that the Commission clarify that where parties have agreed upon a basis for margining uncleared security-based swaps, providing the daily mark used to make the related margin calculation should satisfy the SBS Entity's daily mark disclosure obligations.[353]

One commenter suggested that the data sources, methodology and assumptions used to prepare the daily mark should be required to constitute a complete and independently verifiable methodology for valuing each security-based swap entered into between the parties, noting that this would promote objectivity and transparency, and aid in the resolution of disputes.[354] In this regard, a second commenter also expressed support for requiring the provision of a daily mark and specifically for requiring disclosure of any material changes to the data sources, methodology and assumptions used to prepare the daily mark, noting that this should include disclosing if the data sources become unreliable or unavailable and any resulting changes to the valuations.[355]

A third commenter recommended requiring disclosure as to how the daily mark is calculated, including such information as whether the daily mark was calculated based on inputs related to actual trade activity, using mathematical models, quotes and prices of other comparable securities, and whether those inputs came from third-party valuation service providers.[356] The commenter added, however, that the proposed disclosure of the data sources and the description of the methodology and assumptions used were not likely to require the disclosure of proprietary information and that a general description of key valuation inputs should be sufficient.[357] Likewise, another commenter also recommended that the Commission clarify in rule text that an SBS Entity is not required to disclose confidential, proprietary information about any model it may use to prepare the daily mark.[358]

This commenter also recommended that an SBS Entity should disclose additional information concerning its daily mark to ensure a fair and balanced communication, including that: (1) The daily mark may not necessarily be a price at which the SBS Entity or counterparty would agree to replace or terminate the security-based swap; (2) calls for margin may be based on considerations other than the daily mark; and (3) the daily mark may not necessarily be the value of the security-based swap that is marked on the books of the SBS Entity.[359] Additionally, this commenter advocated for eliminating the proposed requirement for the SBS Entity to disclose its data sources used to prepare the daily mark to harmonize more closely with the CFTC rule, which requires disclosure of assumptions and methodologies but not data sources.[360]

One commenter noted that Major SBS Participants, unlike SBS Dealers, will not always have access to sufficient market information to provide a daily mark, particularly if the security-based swap is not actively traded or if there are no current bid and offer quotes.[361] The commenter expressed concern that this could cause Major SBS Participants to have to reveal proprietary information about their trading book positions, particularly when providing the methodology and inputs that they used to prepare the daily mark.[362] The commenter suggested permitting sophisticated counterparties to opt out of receiving daily marks.[363] Another commenter suggested either not requiring Major SBS Participants to provide the daily mark to its counterparties or in the alternative, to exempt transactions between Major SBS Participants and SBS Dealers and allow all other counterparties to opt out of receiving such disclosures.[364]

Several commenters raised potential conflicts of interest concerns in connection with providing the daily mark for uncleared security-based swaps. Two commenters recommended requiring SBS Entities to use third-party quotations whenever possible to calculate the daily mark for uncleared security-based swaps.[365] One commenter suggested allowing use of the midpoint between an SBS Entity's bid and offer prices only when the SBS Entity's internal book value falls within the same price range.[366] Additionally, this commenter suggested that the Commission consider requiring the SBS Entity to provide clients with actionable quotes or prices at which the SBS Entity would terminate the swap or allow the client to buy more, and with actionable quotes at a significant size as a means to ensure accuracy.[367] Another commenter noted its view that defining the daily mark for uncleared security-based swaps as the midpoint between the bid and offer prices, or the calculated equivalent thereof, could be problematic because it may present a conflict of interest for SBS Entities, particularly when the security-based swaps are not actively traded or do not have consistent or up-to-date bid and offer quotes.[368] This commenter also suggested requiring SBS Entities and their counterparties to have a clearly defined process for resolving any potential valuation disputes.[369]

Two commenters addressed the communication of daily marks, supporting the use of web-based methods of communication.[370] One commenter advocated for web-based systems to be the preferred method of communication, but noted that since some market participants prefer more traditional methods of communication, web-based systems should not be required.[371] The commenter recommended requiring SBS Entities to have policies and procedures in place that reasonably ensure that any non-electronic means of communication is safe and secure and is otherwise Start Printed Page 29988comparable to web-based systems.[372] Additionally, the commenter generally requested that the Commission provide greater clarity on permissible methods for delivering daily mark disclosures, establish minimum requirements for the communication of daily marks (for instance, that the interfaces used provide counterparties with appropriate tools to initiate, track and close valuation disputes), and require SBS Entities to ensure that the method of communication is designed to protect the confidentiality of the data and prevent any unintentional or fraudulent addition, modification or deletion of a valuation record.[373] The second commenter suggested that the use of a secure Web site or electronic platform should be required to enhance data security.[374] The commenter noted that such a platform could also be used to provide transparency into the inputs used to determine the daily mark and to initiate inquiries or challenges to the daily mark.[375] The commenter also recommended that the Commission require daily mark information to be provided without charge.[376]

iii. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(c) as proposed, with modifications.

Cleared Security-Based Swaps

In response to concerns raised by a commenter,[377] the Commission is modifying the requirement in Rule 15Fh-3(c)(1) concerning delivery of the daily mark for cleared security-based swaps. For cleared security-based swaps, the proposed rule would have required the SBS Entity upon the request of the counterparty to provide the counterparty with the end-of-day settlement price the SBS Entity received from the clearing agency. As adopted, for cleared security-based swaps, Rule 15Fh-3(c)(1) requires an SBS Entity upon the request of the counterparty to provide to the counterparty the daily mark that the SBS Entity receives from the appropriate clearing agency.

In response to comments, the Commission is clarifying that to fulfill its obligation to provide the daily mark upon request, the SBS Entity may agree with the clearing agency, a clearing member or another agent, for such clearing agency, clearing member or other agent to provide the daily mark directly to the counterparty.[378] The SBS Entity, however, would retain the regulatory responsibility to provide the daily mark upon request. We understand that current market practice is for a clearing agency to provide access to end-of-day settlement prices to the counterparty. We believe that this flexibility is appropriate, as we believe errors in transmission are less likely to occur if the counterparty receives the information directly from the appropriate clearing agency, which is the source of the daily mark for cleared security-based swaps. In addition, these changes will align our rule more closely with the comparable CFTC rule, which allows for the counterparty to receive the daily mark for a cleared swap from access to the derivatives clearing organization or futures commodities merchant or from the Swap Entity, which should result in efficiencies for SBS Entities that have already established infrastructure to comply with the CFTC rule.[379] We note that an SBS Entity's obligation to provide the daily mark, if requested by the counterparty, exists for the life of the security-based swap between the SBS Entity and the counterparty. Depending on the form of clearing that is used to clear the security-based swap, the security-based swap between the SBS Entity and the counterparty may be terminated upon clearing by the clearing agency.[380]

Rule 15Fh-3(c)(1), as adopted, also requires that the SBS Entity provide the daily mark (as opposed to the end-of-day settlement price) upon request to the counterparty to allow clearing agencies the flexibility to provide a different calculation of the mark in the future. As noted above, we understand that current market practice is for the clearing agency to provide an end-of-day settlement price as its mark. In addition, this change will conform our rule more closely to the parallel CFTC rule described above.

Uncleared Security-Based Swaps

The Commission is adopting Rule 15Fh-3(c)(2) as proposed. The Commission agrees with commenters [381] that the daily mark for uncleared security-based swaps will provide helpful transparency to counterparties during the lifecycle of a security-based swap by providing a useful and meaningful reference point against which to assess, among other things, the calculation of variation margin for a security-based swap or portfolio of security-based swaps, and otherwise inform the counterparty's understanding of its financial relationship with the SBS Entity.[382] We continue to believe that even if the mark is calculated based on internal models or such indices, its provision by the SBS Entity will further the goal of providing helpful transparency into the SBS Entity's pricing and valuation of the security-based swap by providing a helpful reference point that the SBS Entity's counterparty can take into account when evaluating the pricing and valuation of the SBS. Thus, we disagree with the commenter [383] who believes that providing the daily mark will not enhance transparency.

As noted in the Proposing Release, though the daily mark may be used as an input to compute the variation margin between an SBS Entity and its counterparty, it is not necessarily the sole determinant of how such margin is computed. Differences between the daily mark and computations for variation margin may result from adjustments for position size, position direction, credit reserve, hedging, funding, liquidity, counterparty credit quality, portfolio concentration, bid-ask spreads, or other costs. Moreover, we understand that the actual computations may be highly negotiated between the parties. Therefore, we decline to implement the commenter's suggestion that the basis for margining uncleared security-based swaps would satisfy the daily mark disclosure obligations.

For uncleared security-based swaps, Rule 15Fh-3(c)(2) as adopted defines the daily mark as the midpoint between the bid and offer prices for a particular uncleared security-based swap, or the calculated equivalent thereof, as of the close of business unless the parties otherwise agree in writing to a different time.[384] The Commission continues to believe that, absent specific agreement by the parties otherwise, the rule will Start Printed Page 29989result in a daily mark that reflects daily changes in valuation and that is: (a) The same for all counterparties of the SBS Entity that have a position in the uncleared security-based swap, (b) not adjusted to account for holding-specific attributes such as position direction, size, or liquidity, and (c) not adjusted to account for counterparty-specific attributes such as credit quality, other counterparty portfolio holdings, or concentration of positions.[385]

As noted in the Proposing Release, for actively traded security-based swaps that have sufficient liquidity, computing a daily mark as the midpoint between the bid and offer prices for a particular security-based swap, known as a “midmarket value,” would be consistent with Rule 15Fh-3(c)(2).[386] For security-based swaps that are not actively traded, or do not have up-to-date bid and offer quotes, the SBS Entity may calculate an equivalent to a midmarket value using mathematical models, quotes and prices of other comparable securities, security-based swaps, or derivatives, or any combination thereof. In this regard, the rule as adopted requires that the SBS Entity disclose its data sources and a description of the methodology and assumptions used to prepare the daily mark, and promptly disclose any material changes to such data sources, methodology and assumptions during the term of the security-based swap. One commenter suggested that the disclosures should include how the daily mark is calculated, including whether the daily mark is calculated based on inputs related to actual trade activity or using mathematical models, quotes and prices of other comparable securities, and whether those inputs came from third-party valuation service providers.[387] We believe that the requirement in the rule to disclose data sources, methodologies and assumptions encompasses this commenter's suggestion. On the other hand, another commenter has expressed concern that disclosure of data sources, methodology and assumptions would require the SBS Entity to disclose confidential, proprietary information about its models.[388] We believe achieving the benefits underlying the statutory daily mark requirement require that each counterparty knows the data sources, methodology and assumptions used to calculate the mark. This information is critical for a counterparty to properly understand how the daily mark was calculated. The Commission believes that such disclosures will provide the counterparty useful context with which it can assess the quality of the mark received.[389] The Commission further agrees with the commenter that these disclosures would promote objectivity and transparency.[390] This commenter also suggested that this description of data sources, methodologies and assumptions should be required to constitute a complete and independently verifiable methodology for valuing each security.[391] To satisfy the duty to disclose the data sources, methodology and assumptions used to prepare the daily mark, SBS Entities may choose to provide to counterparties methodologies and assumptions sufficient to independently validate the output from a model generating the daily mark. The Commission does not foresee that these disclosures would require SBS Entities to disclose confidential, proprietary information about any model it may use to prepare the daily mark.[392] With these disclosures, counterparties should not be misled or unduly rely on the daily mark provided by the SBS Entities. Therefore, the Commission's final rule requires disclosure of the data sources, methodology and assumptions underlying the daily mark for uncleared security-based swaps.

A commenter suggested that the daily mark disclosures would assist in resolving valuation disputes during the term of the security-based swap.[393] Another commenter suggested requiring SBS Entities and their counterparties to have a clearly defined process for resolving any potential valuation disputes about daily marks for both cleared and uncleared security-based swaps.[394] The Commission notes that many market participants separately negotiate a dispute resolution mechanism for disagreements regarding valuations or include standardized language regarding dispute resolution in their agreements. At this time, the Commission declines to require parties to have a process for resolving valuation disputes and leaves the parties the flexibility to include such dispute resolution mechanisms in their negotiations if desired.

Two commenters suggested that Major SBS Participants should not be required to provide the daily mark for uncleared security-based swaps.[395] We believe that the benefits of Rule 15Fh-3(c), as discussed above, would inure equally to counterparties that transact with SBS Dealers as well as those that transact with Major SBS Participants. As we have noted above, even with the use of proprietary models to calculate the daily mark, we do not believe that the level of detail required to be disclosed would require an SBS Entity to disclose confidential proprietary information, whether the SBS Entity is an SBS Dealer or a Major SBS Participant. The commenter that expressed concerns regarding the reliability of the daily mark illustrates the necessity of the disclosure of the data sources, methodologies and assumptions underlying the calculation. Counterparties may evaluate the Start Printed Page 29990calculation and reliability of the daily mark calculation and determine for themselves whether or not to rely on the calculation. Furthermore, we do not find the arms-length nature of relationships with counterparties to be a persuasive argument to eliminate the daily mark requirement. To the extent that Major SBS Participants may be better informed about the valuations of security-based swaps due to significant information asymmetries in a market for opaque and complex products, disclosures may help inform counterparties concerning the valuations and material risks and characteristics of security-based swaps in the sometimes rapidly changing market environment.[396] The commenter also states that the vast majority of transactions by a Major SBS Participant would be with an SBS Dealer, in which circumstance, the disclosure is not required. As a result, we are not adopting the commenters' suggestions to exclude Major SBS Participants from the requirement of providing the daily mark disclosure at this time.

The Commission has considered the rationale raised by commenters and decided not to allow counterparties, even “sophisticated counterparties,” to opt-out of the protections afforded by the daily mark disclosures. It is our understanding that counterparties have a range of sophistication and some are unlikely to have their own modeling capabilities or access to relevant data to calculate a daily mark themselves. We think it is appropriate to apply the rule so that counterparties receive the benefits of the daily mark and related disclosures, and do not think it appropriate to permit parties to “opt out” of the benefits of those provisions.

A commenter suggested modifying the rule text for uncleared security-based swaps to require that the SBS Entity disclose additional information concerning the daily mark to ensure a fair and balanced communication, including, as appropriate, that: (A) The daily mark may not necessarily be a price at which either the counterparty or the SBS Entity would agree to replace or terminate the security-based swap; (B) depending upon the agreement of the parties, calls for margin may be based on considerations other than the daily mark provided to the counterparty; and (C) the daily mark may not necessarily be the value of the security-based swap that is marked on the books of the SBS Entity.[397] While the Commission declines to modify the rule text in this way, it does note that Rule 15Fh-3(g) as adopted requires an SBS Entity to communicate with its counterparty in a fair and balanced manner.[398] As a result, an SBS Entity may generally wish to consider disclosing this information.

Against this background, the Commission is not prescribing the means by which an SBS Entity determines the daily mark for an uncleared security-based swap. Commenters have made various suggestions as to additional requirements as to the inputs used for the daily mark calculation, such as requiring independent third-party quotes or limiting the context in which an SBS Entity can use its own bid and offer prices or requiring the daily mark to be an actionable quote.[399] At this time, the Commission declines to adopt these additional requirements. We believe that the rule as adopted will provide appropriate flexibility for SBS Entities to determine how to calculate the daily mark while providing disclosure of sufficient information—data sources, methodologies and assumptions, which are designed to allow the counterparty to assess the quality of the marks it receives from the SBS Entity. One of these commenters also suggested that using its own bid and offer prices for the calculation of the daily mark may present a conflict of interest for the SBS Entity.[400] If the SBS Entity is presented with a conflict of interest, we believe that the SBS Entity likely would disclose the conflict to the counterparty pursuant to Rule 15Fh-3(b)(2) if the conflict is material. After receiving such disclosures, the counterparty will be able to factor that information into its assessment of the quality of the marks it receives. Consistent with the considerations outlined above, an SBS Entity may choose to do these calculations in-house or to use independent third-party valuation services, as suggested by a commenter.[401]

As noted above, Rule 15Fh-3(c)(2) requires an SBS Entity to disclose to the counterparty its data sources and a description of the methodology and assumptions used to prepare the daily mark for an uncleared security-based swap. Additionally, Rule 15Fh-3(c)(2) requires an SBS Entity to promptly disclose any material changes to the data sources, methodology, or assumptions during the term of the security-based swap. As noted in the Proposing Release, an SBS Entity is not required to disclose the data sources or a description of the methodology and assumptions more than once unless it materially changes the data sources, methodology or assumptions used to calculate the daily mark.[402] For the purposes of this rule, a material change would generally include any change that has a material impact on the daily mark provided, such as if the data sources become unreliable or unavailable, as requested by one commenter.[403]

A commenter has requested that we eliminate the requirement to disclose data sources to harmonize more closely with the CFTC.[404] We believe that the requirement to disclose data sources is important for the counterparty to understand and assess the mark being provided. Therefore, we decline to eliminate this requirement.

Applicable to Both Cleared and Uncleared Security-Based Swaps

Rule 15Fh-3(c) as adopted, does not mandate the means by which an SBS Entity must make the required disclosures and the Commission declines to mandate any particular means at this time. The Commission believes that SBS Entities are best positioned to determine the most appropriate means of communication of the disclosures. Commenters have made several specific suggestions for additional requirements regarding the means of communication of the daily mark.[405] One commenter suggested that we require the use of a secure Web site or electronic platform.[406] Another commenter requested web-based systems to be the preferred method of communication, but noted that since some market participants prefer more traditional methods of communication, web-based systems should not be required.[407] The commenter recommended requiring SBS Entities to have policies and procedures in place that reasonably ensure that any non-Start Printed Page 29991electronic means of communication is safe and secure and is otherwise comparable to web-based systems.[408] Additionally, the commenter generally requested that the Commission provide greater clarity on permissible methods for delivering daily mark disclosures, establish minimum requirements for the communication of daily marks (for instance, that the interfaces used provide counterparties with appropriate tools to initiate, track and close valuation disputes), and require SBS Entities to ensure that the method of communication is designed to protect the confidentiality of the data and prevent any unintentional or fraudulent addition, modification or deletion of a valuation record.[409] The Commission continues to believe that such a method of communication would be an appropriate way for SBS Entities to discharge their obligations with respect to daily marks.[410]

One commenter suggested that we require an SBS Entity to have policies and procedures to reasonably ensure the safety and security of non-electronic means of communication.[411] To provide SBS Entities with flexibility in the manner of disclosure, we have not specified requirements with respect to the safety and security of either electronic or non-electronic communication of the daily mark.[412]

In the Proposing Release, the Commission stated that the daily mark for both cleared and uncleared security-based swaps should be provided without charge and with no restrictions on internal use by the counterparty, although restrictions on dissemination to third parties are permissible.[413] One commenter supported the requirement that the daily mark disclosure be provided free of charge.[414] The daily mark disclosures are relevant to a counterparty's ongoing understanding and management of its security-based swap positions. We believe that counterparties to whom the SBS Entity provides the daily mark should have the opportunity to effectively use, retain, and analyze the information with respect to such management. Therefore, the Commission continues to believe that effective access to the daily mark information is necessary to ensure a counterparty's ability to manage its security-based swap positions over the life of the security-based swaps. Charging for provision of the daily mark, or allowing restrictions on the internal use of the daily mark by the counterparty with respect to managing their security-based swap positions, could undermine this objective. Thus, the Commission continues to believe that the daily mark for both cleared and uncleared security-based swaps should be provided without charge and with no restrictions on internal use by the counterparty, although restrictions on dissemination to third parties are permissible.[415] Accordingly, the Commission has included these requirements in a new paragraph (3) to Rule 15Fh-3(c), as adopted.

f. Clearing Rights

Section 15F(h)(1)(D) of the Exchange Act authorizes the Commission to prescribe business conduct standards that relate to “such other matters as the Commission determines to be appropriate.” [416] When an SBS Entity enters into a security-based swap with a counterparty that is not an SBS Entity or a Swap Entity, Section 3C(g) of the Exchange Act establishes a right for the counterparty: (i) To select the clearing agency at which the security-based swap will be cleared, if the security-based swap is subject to the mandatory clearing requirement under Section 3C(a); [417] and (ii) to elect to require the clearing of the security-based swap, and to select the clearing agency at which the security-based swap will be cleared, if the security-based swap is not subject to the mandatory clearing requirement.[418]

i. Proposed Rule

Proposed Rule 15Fh-3(d) would require an SBS Entity, before entering into a security-based swap with a counterparty, other than an SBS Entity or Swap Entity, to disclose to the counterparty its rights under Section 3C(g) of the Exchange Act concerning submission of a security-based swap to a clearing agency for clearing. The counterparty's rights, and thus the proposed disclosure obligations, would differ depending on whether the clearing requirement of Section 3C(a) applies to the relevant transaction.[419]

When the clearing requirements of Section 3C(a) apply to a security-based swap, proposed Rule 15Fh-3(d)(1)(i) would require the SBS Entity to disclose to the counterparty the clearing agencies that accept the security-based swap for clearing and through which of those clearing agencies the SBS Entity is authorized or permitted, directly or through a designated clearing member, to clear the security-based swap. Under proposed Rule 15Fh-3(d)(1)(ii), the SBS Entity would also be required to notify the counterparty of the counterparty's sole right to select which clearing agency is to be used to clear the security-based swap, provided it is a clearing agency at which the SBS Entity is authorized or permitted, directly or through a designated clearing member, to clear the security-based swap.

For security-based swaps that are not subject to the clearing requirement under Exchange Act Section 3C(a), proposed Rule 15Fh-3(d)(2) would require the SBS Entity to determine whether the security-based swap is accepted for clearing by one or more clearing agencies and, if so, to disclose to the counterparty the counterparty's right to elect clearing of the security-based swap. Proposed Rule 15Fh-3(d)(2)(ii) would require the SBS Entity to disclose to the counterparty the clearing agencies that accept the security-based swap for clearing and whether the SBS Entity is authorized or permitted, directly or through a designated clearing member, to clear the security-based swap through such Start Printed Page 29992clearing agencies. Proposed Rule 15Fh-3(d)(2)(iii) would require the SBS Entity to notify the counterparty of the counterparty's sole right to select the clearing agency at which the security-based swap would be cleared, provided it is a clearing agency at which the SBS Entity is authorized or permitted, directly or through a designated clearing member, to clear the security-based swap.

ii. Comments on Proposed Rule

Four commenters addressed the required disclosure regarding clearing rights.[420] One commenter requested confirmation that a counterparty's clearing elections could affect the price of the security-based swap so long as this is disclosed to the counterparty at the time of the other disclosures regarding clearing.[421] Additionally, the commenter asked for clarification that standardized disclosure could be used to satisfy this requirement.[422] Another commenter recommended that the Commission not impose the clearing rights disclosure requirement on Major SBS Participants transacting with counterparties at arm's length, or alternatively, that the Commission allow ECP counterparties to opt out of receiving such disclosures.[423]

An additional commenter advocated for harmonizing the clearing rights disclosure requirement with the CFTC's parallel requirement.[424] Specifically, the commenter recommended eliminating the proposed requirements to disclose the names of the clearing agencies that accept the security-based swap for clearing, and through which the SBS Entity is authorized to clear the security-based swap.[425] The commenter argued that given the limited number of security-based swap clearing agencies, such additional disclosure is unlikely to be necessary, and that the Commission could always require it at a future date if the number increases.[426] Additionally, as discussed in Section II.B, the commenter advocated for adding an exception to the requirements regarding the disclosure of clearing rights to include security-based swaps that are intended to be cleared and that are either (1) executed on a registered national securities exchange or registered or exempt SEF and required to be cleared pursuant to Section 3C of the Exchange Act, or (2) anonymous.[427]

iii. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(d) largely as proposed, but with modifications. First, as discussed above in Section II.B, we are limiting an SBS Entity's disclosure obligations regarding clearing rights pursuant to Rule 15Fh-3(d) to counterparties whose identity is known to the SBS Entity at a reasonably sufficient time prior to the execution of the transaction.

The Commission is also making a second modification to the proposed rule. We also added the phrase “subject to Section 3C(g)(5) of the Act,” to Rule 15Fh-3(d)(1)(ii) to clarify the source of the counterparty's right to select which of the clearing agencies described in paragraph (d)(1)(i) shall be used to clear the security-based swap.

A commenter suggested that, due to the limited number of security-based swap clearing agencies, disclosure of clearing agencies by name was unnecessary.[428] Regardless of the current limited number of clearing agencies for security-based swaps, not every security-based swap will be accepted for clearing at every clearing agency, so the Commission believes that it is still useful for the counterparty to know whether the particular security-based swap is able to be cleared at a particular clearing agency.

Rule 15Fh-3(d) requires that disclosure be made before a transaction occurs. As noted in the Proposing Release, the Commission believes that it would be appropriate for a counterparty to exercise its statutory right to select the clearing agency at which its security-based swaps will be cleared on a transaction-by-transaction basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions the counterparty may execute with the SBS Entity.[429] While Rule 15Fh-3(d) does not require an SBS Entity to become a member or participant of a specific clearing agency, an SBS Entity could not enter into security-based swaps that are subject to a mandatory clearing requirement without having some arrangement in place to clear the transaction.[430]

Consistent with the discussion regarding manner of disclosures above in Section II.G.2.b, the Commission agrees with the commenter that SBS Entities could use standardized disclosure to satisfy Rule 15Fh-3(d).

The Commission also recognizes that a counterparty's clearing elections could affect the price of the security-based swap and recognizes that counterparties may wish to receive disclosures about the effect of clearing on the price. Although the rule does not explicitly require that the SBS Entity provide specific disclosures regarding the effect of clearing on the price of the security-based swap, the SBS Entity may wish to consider whether their obligations under Rule 15Fh-3(b)(1) to disclose the material risks and characteristics of the particular security-based swap, as well as their obligation pursuant to Rule 15Fh-3(g) to communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith (including providing a sound basis for evaluating the facts with regard to any particular security-based swap or trading strategy involving a security-based swap) may require such disclosure given their particular facts and circumstances.

One commenter recommended that the Commission not impose the clearing rights disclosure requirement on Major SBS Participants transacting with counterparties at arm's length or as an alternative allow ECP counterparties to opt out of receiving the clearing rights disclosure.[431] As explained in the Proposing Release, the required disclosure is intended to promote that, wherever possible and appropriate, derivatives contracts formerly traded exclusively in the OTC market are cleared through a regulated clearing agency.[432] The Commission has considered the concerns raised by commenters and determined that it is appropriate to require Major SBS Participants to provide such disclosures, and to not to permit counterparties to opt out of the protections provided by the business conduct rules. We believe that the benefits of Rule 15Fh-3(d), as discussed above, would inure equally to counterparties that transact with SBS Dealers as well as those that transact with Major SBS Participants.[433] We further believe that allowing counterparties to effectively opt out of the rule would deprive them of the express protections that the rules were intended to provide. As a result, we are not adopting the commenters' suggestions to allow counterparties to opt out of the clearing rights disclosure Start Printed Page 29993requirement when transacting with a Major SBS Participant nor to exclude Major SBS Participants from the requirement of providing the clearing rights disclosure at this time.

3. Know Your Counterparty

Section 15F(h)(1)(D) of the Exchange Act authorizes the Commission to prescribe business conduct standards that relate to “such other matters as the Commission determines to be appropriate.” [434]

a. Proposed Rule

Proposed Rule 15Fh-3(e) would establish a “know your counterparty” requirement under which an SBS Dealer would be required to establish, maintain and enforce policies and procedures reasonably designed to obtain and retain a record of the essential facts that are necessary for conducting business with each counterparty that is known to the SBS Dealer. For purposes of the proposed rule, “essential facts” would be defined as: (i) Facts required to comply with applicable laws, regulations and rules; (ii) facts required to implement the SBS Dealer's credit and operational risk management policies in connection with transactions entered into with such counterparty; (iii) information regarding the authority of any person acting for such counterparty; and (iv) if the counterparty is a special entity, such background information regarding the independent representative as the SBS Dealer reasonably deems appropriate.[435]

b. Comments on the Proposed Rule

Four commenters addressed the proposed know your counterparty requirement.[436] Two commenters generally supported the proposed rule.[437] However, one requested clarification that since the requirement only applies to “known” counterparties, it would not apply to an SBS Dealer transacting on a SEF or other electronic execution platform where such SBS Dealer only learns the identity of the counterparty immediately before the execution and must execute the transaction within a limited time frame after learning the counterparty's identity.[438] The other commenter asserted that the requirement should apply to Major SBS Participants in addition to SBS Dealers.[439]

A third commenter expressed concern that the proposed rule would inappropriately empower SBS Dealers to adopt and enforce rules and to collect information about independent representatives.[440] The commenter asserted that the use of the word “enforce” in the proposed rule suggests that the rule would improperly empower SBS Dealers to adopt policies and procedures that have the force of law with respect to their counterparties.[441] Specifically, the commenter asserted that the proposed rule authorizes SBS Dealers to collect unlimited information about the representatives of special entities, as well as proprietary information, which would give dealers an unfair competitive advantage.[442] The commenter argued that SBS Dealers should be required to adopt policies that comply with the law, and that these policies should not be binding to the extent they require more than the law requires.[443]

A fourth commenter recommended eliminating the proposed requirement to collect background information regarding the independent representative of a special entity.[444] First, the commenter asserted that this change would harmonize the Commission's rule with the parallel CFTC requirement.[445] Second, the commenter stated that the proposed requirement would be duplicative of the requirements imposed on SBS Entities acting as counterparties to special entities pursuant to Rule 15Fh-5.[446] Additionally, as discussed in Section II.B, the commenter advocated for adding an exception to the know your counterparty requirement to cover security-based swaps that are intended to be cleared, executed on a registered national securities exchange or registered or exempt SEF, and of a type that is, as of the date of execution, required to be cleared pursuant to Section 3C of the Exchange Act.[447]

c. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(e) with two modifications. First, in response to a specific suggestion from a commenter,[448] the Commission is eliminating the proposed requirement that an SBS Dealer obtain background information regarding the independent representative of a special entity counterparty, as the SBS Dealer reasonably deems appropriate. The Commission agrees with the commenter that the proposed requirement would have been duplicative of the requirements imposed on SBS Entities acting as counterparties to special entities pursuant to Rule 15Fh-5 (discussed below in Section II.H).

Second, the Commission is adding the word “written” before policies and procedures in the rule text to clarify that the policies and procedures required by the rule must be written. The Commission believes that this change clarifies the proposal and reflects the requirement in Rule 15Fh-3(h), discussed in Section II.G.6 below, that an SBS Dealer establish, maintain and enforce written policies and procedures that are reasonably designed to prevent violations of the applicable federal securities laws and rules and regulations thereunder. Thus, as adopted, Rule 15Fh-3(e) requires SBS Dealers to “establish, maintain and enforce written policies and procedures reasonably designed to obtain and retain a record of the essential facts concerning each counterparty.”

In response to concerns raised by a commenter,[449] the Commission is clarifying that the provision stating that an SBS Dealer shall “establish, maintain and enforce” policies and procedures does not vest such policies and procedures with force of law with respect to their counterparties. An SBS Dealer would, however, have an obligation to enforce (i.e., follow) its internal policies and procedures.

We have determined, as proposed, not to apply the rule where an SBS Dealer does not know the identity of its counterparty. We are not adopting the suggestion of one commenter that we provide an additional exception to cover security-based swaps that are intended to be cleared, executed on a registered national securities exchange or registered or exempt SEF, and of a type that is, as of the date of execution, required to be cleared pursuant to Section 3C of the Exchange Act, even if not anonymous.[450] However, we note that Rule 15Fh-3(e) requires SBS Dealers to establish policies and procedures that are “reasonably designed to obtain and retain a record of the essential facts concerning each Start Printed Page 29994[known counterparty] that are necessary for conducting business with such counterparty.” Reasonably designed policies and procedures established pursuant to Rule 15Fh-3(e) may address situations in which there are few, if any, essential facts that are necessary for conducting business with a counterparty. For example, if the only security-based swaps that an SBS Dealer enters into with a counterparty are intended to be cleared security-based swaps that are executed on a registered exchange or SEF and of a type that is, as of the date of execution, required to be cleared pursuant to Section 3C of the Exchange Act, then there may be few, if any, essential facts that the SBS Dealer needs to know about such counterparty in that circumstance.

In response to a commenter's request for clarification that since the requirement only applies to “known” counterparties, it would not apply to an SBS Dealer transacting on a SEF or other electronic execution platform where such SBS Dealer only learns the identity of the counterparty immediately before the execution and must execute the transaction within a limited time frame after learning the counterparty's identity,[451] the Commission notes that Rule 15Fh-3(e) does not contain a specific timing requirement. Rule 15Fh-3(e) requires SBS Dealers to establish policies and procedures that are “reasonably designed to obtain and retain a record of the essential facts concerning each [known counterparty] that are necessary for conducting business with such counterparty.” To be “reasonably designed” such policies and procedures generally should provide for the collection of counterparty information prior to execution of a transaction with that counterparty. However, if the SBS Dealer does not learn a counterparty's identity until immediately prior to or subsequent to execution, then it would be reasonable for collection to occur within a reasonable time after the SBS Dealer learns the identity of the counterparty.[452]

As noted in the Proposing Release, the “know your counterparty” obligations under Rule 15Fh-3(e) are a modified version of the “know your customer” obligations imposed on other market professionals, such as broker-dealers, when dealing with customers.[453] Although the statute does not require the Commission to adopt a “know your counterparty” standard, the Commission continues to believe that such a standard is consistent with basic principles of legal and regulatory compliance, and operational and credit risk management.[454] Further, the Commission continues to believe that entities that currently operate as SBS Dealers typically would already have in place, as a matter of their normal business practices, policies and procedures that could potentially satisfy the requirements of the rule.[455]

The Commission is applying the requirements in Rule 15Fh-3(e) to SBS Dealers but declines to apply them to Major SBS Participants, as suggested by a commenter.[456] As discussed above in Section II.C, the Commission has determined that where a business conduct requirement is not expressly addressed by the Dodd-Frank Act, the rules generally will not apply to Major SBS Participants.

4. Recommendations by SBS Dealers

Section 15F(h)(1)(D) of the Exchange Act authorizes the Commission to prescribe business conduct standards that relate to “such other matters as the Commission determines to be appropriate.” [457] Additionally, Section 15F(h)(3)(D) of the Exchange authorizes the Commission to establish “such other standards and requirements as the Commission may determine are appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of this Act.” [458]

a. Proposed Rule

i. General

Proposed Rule 15Fh-3(f) generally would require an SBS Dealer that recommends a security-based swap or trading strategy involving a security-based swap to a counterparty, other than an SBS Entity or Swap Entity, to have a reasonable basis for believing that the recommended security-based swap or trading strategy is suitable. Specifically, proposed Rule 15Fh-3(f)(1)(i) would require an SBS Dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommended security-based swap or trading strategy is suitable for at least some counterparties. Additionally, proposed Rule 15Fh-3(f)(1)(ii) would require an SBS Dealer to have a reasonable basis to believe that the recommended security-based swap or trading strategy is suitable for the particular counterparty that is the recipient of the SBS Dealer's recommendation (“customer-specific suitability”). Under proposed Rule 15Fh-3(f)(1)(ii), to establish a reasonable basis to believe that a recommendation is suitable for a particular counterparty, an SBS Dealer would need to have or obtain relevant information regarding the counterparty, including the counterparty's investment profile, trading objectives, and its ability to absorb potential losses associated with the recommended security-based swap or trading strategy.

ii. Institutional Suitability Alternative

Proposed Rule 15Fh-3(f)(2) would provide an alternative to the general suitability requirements, under which an SBS Dealer could fulfill its suitability obligations with respect to a particular counterparty if: (1) The SBS Dealer reasonably determines that the counterparty (or its agent) is capable of independently evaluating investment risks with regard to the relevant security-based swap or trading strategy involving a security-based swap; (2) the counterparty (or its agent) affirmatively represents in writing that it is exercising independent judgment in evaluating the recommendations by the SBS Dealer; and (3) the SBS Dealer discloses that it is acting in the capacity of a counterparty, and is not undertaking to assess the suitability of the security-based swap or trading strategy for the counterparty.

The Commission sought comment on whether different categories of ECPs should be treated differently for purposes of suitability Start Printed Page 29995determinations.[459] The Proposing Release noted that, under our proposed rules, an SBS Dealer could rely on the institutional suitability alternative when entering into security-based swaps with any person that qualified as an ECP, a category that includes persons with $5 million or more invested on a discretionary basis that enter into the security-based swap “to manage risks.” [460] In contrast, under FINRA rules, in order to apply an analogous institutional suitability alternative, a broker-dealer must be dealing with a person (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million.[461] The Proposing Release asked whether the Commission should apply a different standard of suitability depending on whether the counterparty would be protected as a retail investor under FINRA rules when the SBS Dealer is also a registered broker-dealer.[462] More generally, the Commission sought comment on whether the institutional suitability alternative available under proposed Rule 15Fh-3(f)(2) should be limited to counterparties that would not be protected as retail investors under FINRA rules or another category of counterparties.

iii. Special Entity Suitability Alternative

Proposed Rule 15Fh-3(f)(3) would provide another alternative to the general suitability requirements for SBS Dealers transacting with special entity counterparties. Under proposed Rule 15Fh-3(f)(3), an SBS Dealer would be deemed to satisfy its suitability obligations with respect to a special entity counterparty if the SBS Dealer either is acting as an advisor to the special entity and complies with proposed Rule 15Fh-4(b),[463] or is deemed not to be acting as an advisor to the special entity pursuant to proposed Rule 15Fh-2(a).

b. Comments on the Proposed Rule

i. General

Six commenters addressed the suitability requirements.[464] Three commenters recommended expanding the suitability requirements.[465] One commenter suggested two changes to the rule: (1) Clarifying that SBS Dealers would be prohibited from recommending to investors financial products that the dealers believe will fail; and (2) requiring that an SBS Dealer making recommendations regarding a certain product or type of product have the background necessary to understand the product.[466] Another commenter urged the Commission to consider developing suitability standards for the types of financial products that can be sold to state and local governments, including those products in the swaps arena.[467] A third commenter suggested that the Commission conform its requirements to the CFTC's proposal, noting that the CFTC proposal would have required the dealer to obtain information through reasonable due diligence concerning the counterparty's financial situation and needs, objectives, tax status, ability to evaluate the recommendation, liquidity needs, risk tolerance or other relevant information.[468] The commenter also recommended explicitly requiring SBS Dealers to: (1) Gather information sufficient to make the suitability assessment; and (2) maintain sufficient documents to allow the Commission to effectively enforce compliance.[469] Additionally, the commenter asserted that the suitability requirement should apply to all SBS Entities, not just SBS Dealers, noting that the suitability obligation would only be imposed on a Major SBS Participant if the Major SBS Participant makes a recommendation to a non-SBS Entity.[470] While the commenter supported the exclusion from the suitability requirement for recommendations to other SBS Entities, it strongly opposed any additional exclusions (e.g., for recommendations to broker-dealers or other market intermediaries who are not SBS Entities). Finally, the commenter also strongly opposed limiting the requirement to recommendations to retail investors.[471]

Two other commenters recommended narrowing the suitability requirements.[472] One commenter suggested that any suitability standard for SBS Dealers be applied at the least granular level (e.g., on a transaction-by-transaction basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions between the parties, as appropriate).[473] The second commenter opposed the suitability requirement more broadly, stating that Congress did not impose such a requirement.[474] The commenter suggested, as an alternative to the proposed rule, that any suitability requirement for recommendations to counterparties other than special entities be imposed through a requirement to adopt and enforce policies and procedures reasonably designed to assess the suitability of recommendations, and that the proposed rule be incorporated as guidance establishing a safe harbor for whether an SBS Dealer's policies are reasonable.[475] The commenter also asserted that the proposed rule could conflict with the specific suitability rules of other (unidentified) regulators, and accordingly, urged the Commission to clarify that an SBS Dealer that complies with suitability requirements of another qualifying regulator will also be deemed to have adopted and enforced reasonable suitability policies under the Commission's rule.[476] Finally, the commenter recommended allowing sophisticated counterparties to opt out of suitability protection, noting that some counterparties will find the suitability analysis burdensome and intrusive, and that the costs of the Start Printed Page 29996proposed suitability rule for those counterparties will likely outweigh any benefits.[477]

Finally, a sixth commenter advocated for harmonizing the suitability requirement in proposed Rule 15Fh-3(f)(1)(i) with the CFTC's parallel requirement.[478] Specifically, the commenter recommended changing the wording of the suitability requirement in proposed Rule 15Fh-3(f)(1)(i) to “undertake reasonable diligence to understand the potential risks and rewards associated with the recommended security-based swap or trading strategy involving a security-based swap.” [479]

ii. Institutional Suitability Alternative

Three commenters submitted comments regarding the institutional suitability alternative in proposed Rule 15Fh-3(f)(2).[480] Two commenters expressed concerns regarding the proposed alternative.[481] One commenter expressed concern that the counterparty representations upon which the SBS Dealer would rely may become outdated or boilerplate language that is inappropriate for the counterparty to which it is directed.[482] Accordingly, the commenter suggested requiring SBS Dealers to conduct routine audits to ensure that these institutional level suitability determinations are not over-utilized, that they are appropriate for the particular counterparties involved, and that the appropriate written documentation was provided and signed in applicable transactions.[483] Additionally, the commenter recommended that as part of that audit process, and to prevent inaccurate determinations, SBS Dealers should be required to test, perhaps on an annual basis, whether counterparties continue to have the personnel and expertise needed to conduct independent evaluations of the security-based swap products being marketed.[484]

The second commenter strongly opposed the institutional suitability alternative, asserting that the complexity and opacity of structured finance products has made them impenetrable to all but the most sophisticated industry experts.[485] At a minimum, the commenter recommended that if the Commission adopts the institutional suitability alternative, it should require an SBS Dealer to have a reasonable basis to believe its counterparty has the capacity to absorb potential losses related to the security-based swap or trading strategy being recommended.[486]

A third commenter advocated for harmonizing the institutional suitability alternative with the CFTC's parallel provision, citing potential counterparty confusion.[487] Specifically, the commenter recommended that the Commission: (1) Clarify that the institutional suitability alternative only satisfies an SBS Dealer's customer-specific suitability obligation in proposed Rule 15Fh-3(f)(1)(ii), not its suitability obligation in proposed Rule 15Fh-3(f)(1)(i); and (2) add a safe harbor providing that an SBS Dealer can satisfy its requirement to make a reasonable determination that the counterparty is capable of independently evaluating investment risks with regard to the security-based swap if the SBS Dealer receives written representations from the counterparty regarding the counterparty's compliance with appropriate policies and procedures.[488]

iii. Special Entity Suitability Alternative

Four commenters submitted comments regarding the suitability alternative for special entity counterparties in proposed Rule 15Fh-3(f)(3).[489] Three commenters supported the proposed rule.[490] Another commenter recommended adding a requirement to the institutional suitability alternative, in lieu of the special entity suitability alternative, that the SBS Dealer comply with the requirements of Rule 15Fh-4(b) (regarding acting as an advisor to a special entity) if the SBS Dealer's recommendation to a special entity would cause it to be acting as an advisor to the special entity.[491]

c. Response to Comments and Final Rule

i. General

After considering the comments, the Commission is adopting Rule 15Fh-3(f)(1) with two modifications. The first modification is to rephrase the suitability obligation in proposed Rule 15Fh-3(f)(1)(i), in response to a specific suggestion from a commenter,[492] to make it consistent with the CFTC's parallel suitability requirement in Commodity Exchange Act Rule 23.434(a)(1), which explicitly requires SBS Dealers to understand the risk-reward tradeoff of their recommendations. We believe that our proposed formulation and the CFTC's formulation would have achieved the same purpose. However, to alleviate concerns among commenters that compliance with the two rules would require anything different, we are harmonizing the wording of our rule with the CFTC's parallel suitability obligation.[493] As adopted, Rule 15Fh-3(f)(1)(i) requires an SBS Dealer that recommends a security-based swap or trading strategy involving a security-based swap to a counterparty, other than an SBS Entity or Swap Entity, to “undertake reasonable diligence to understand the potential risks and rewards associated with the recommended security-based swap or trading strategy involving a security-based swap.” Consistency with the CFTC standard will result in efficiencies for entities that have already established infrastructure to comply with the CFTC standard. Consistent wording will also allow SBS Entities to more easily analyze compliance with the Commission's rule against their existing activities to comply with the CFTC's parallel suitability rule for Swap Entities.

The second modification the Commission is making is to add the phrase “involving a security-based swap” to the final line of the customer-specific suitability obligation in proposed Rule 15Fh-3(f)(1)(ii) to modify “trading strategy.” Accordingly, Rule 15Fh-3(f)(1)(ii), as adopted, requires an SBS Dealer that recommends a security-based swap or trading strategy involving a security-based swap to a counterparty, other than an SBS Entity or Swap Entity, to have a reasonable basis to believe that a recommended security-based swap or trading strategy involving a security-based swap is suitable for the counterparty, and to establish a Start Printed Page 29997reasonable basis for a recommendation, to have or obtain relevant information regarding the counterparty, including the counterparty's investment profile, trading objectives, and its ability to absorb potential losses associated with the recommended security-based swap or trading strategy “involving a security-based swap.” The Commission does not believe that this is a substantive change. It simply clarifies that the term trading strategy as used in the final line of the rule is the same as recommended trading strategy involving a security-based swap that is referenced earlier in the rule.

As noted in the Proposing Release, although suitability is not expressly addressed in Section 15F(h) of the Exchange Act, the obligation to make only suitable recommendations is a core business conduct requirement for broker-dealers and other financial intermediaries.[494] Municipal securities dealers also have a suitability obligation when recommending municipal securities transactions to a customer.[495] Depending on the scope of its activities, an SBS Dealer may be subject to one of these other suitability obligations, in addition to those under Rule 15Fh-3(f). In particular, an SBS Dealer that also is a registered broker-dealer and a FINRA member, would be subject to FINRA's suitability requirements in connection with the recommendation of a security-based swap or trading strategy involving a security-based swap.[496] Rule 15Fh-3(f) is intended to ensure that all SBS Dealers that make recommendations are subject to this obligation, tailored as appropriate in light of the nature of the security-based swap markets.[497]

The Commission continues to believe that the determination of whether an SBS Dealer has made a recommendation that triggers suitability obligations should turn on the facts and circumstances of the particular situation and, therefore, whether a recommendation has taken place is not susceptible to a bright line definition.[498] This follows the FINRA approach to what constitutes a recommendation for purposes of FINRA's suitability rule.[499] In the context of the FINRA suitability rule, factors considered in determining whether a recommendation has taken place include whether the communication “reasonably could be viewed as a `call to action' ” and “reasonably would influence an investor to trade a particular security or group of securities.” [500] We note that this could include a call to action regarding buying, selling, materially amending or early termination of a security-based swap. The more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a “recommendation.” The Commission continues to believe that this approach to determining whether a recommendation has taken place should apply in the context of Rule 15Fh-3(f) as well.[501]

As noted in the Proposing Release, an SBS Dealer typically would not be deemed to be making a recommendation solely by reason of providing general financial or market information, or transaction terms in response to a request for competitive bids.[502] Again, this follows the FINRA approach to determining whether a recommendation has occurred.[503] Furthermore, compliance with the requirements of the other business conduct rules, in particular, Rules 15Fh-3(a) (verification of counterparty status), 15Fh-3(b) (disclosures of material risks and characteristics, and material incentives or conflicts of interest), 15Fh-3(c) (disclosures of daily mark), and 15Fh-3(d) (disclosures regarding clearing rights) would not, in and of itself, result in an SBS Dealer being deemed to be making a “recommendation.” [504]

We believe that the suitability obligation in Rule 15Fh-3(f)(1)(i) should address one commenter's concerns about the possibility that an SBS Dealer will recommend a financial product that it believes will fail or that it does not have the necessary background to understand.[505] When making recommendations, SBS Dealers are always required to meet their suitability obligation in Rule 15Fh-3(f)(1)(i), regardless of whether they avail themselves of the institutional suitability alternative to meet their customer-specific suitability obligations. In that respect, SBS Dealers will always be required to undertake reasonable diligence to understand the risks and rewards behind any recommended security-based swap.

With respect to another commenter's concerns about SBS Dealers' gathering sufficient information to make the customer-specific suitability assessment,[506] the Commission notes that Rule 15Fh-3(f)(1)(ii) requires an SBS Dealer to “have a reasonable basis to believe” that a recommended security-based swap or trading strategy is suitable for the counterparty. To establish that reasonable basis, the rule requires the SBS Dealer to “have or obtain relevant information regarding the counterparty, including the counterparty's investment profile, trading objectives, and its ability to Start Printed Page 29998absorb potential losses associated with the recommended security-based swap or trading strategy.” The list of “relevant information” in the rule is exemplary, not exhaustive. Whether an SBS Dealer has a reasonable basis to believe that a recommended security-based swap or trading strategy is suitable for the counterparty is a determination that depends on the facts and circumstances of the particular situation.

The Commission declines to apply Rule 15Fh-3(f) to Major SBS Participants, as suggested by one commenter.[507] As discussed above in Section II.C, where a business conduct requirement is not expressly addressed by the Dodd-Frank Act, the Commission is generally not applying such a rule to Major SBS Participants. The Commission continues to believe that it is appropriate not to impose suitability obligations on Major SBS Participants, given that, by definition, Major SBS Participants are not engaged in security-based swap dealing activity at levels above the de minimis threshold.[508] However, if a Major SBS Participant is, in fact, recommending security-based swaps or trading strategies involving security-based swaps to a counterparty, this would indicate that the Major SBS Participant is actually engaged in security-based swap dealing activity.[509] If a Major SBS Participant engages in such activity above the de minimis threshold in Exchange Act Rule 3a71-2, it would need to register as an SBS Dealer and, as such, would need to comply with the suitability obligations imposed by Rule 15Fh-3(f).

Further, Rule 15Fh-3(f) will not impose suitability obligations on an SBS Dealer transacting with an SBS Entity or Swap Entity. The Commission continues to believe that these types of counterparties, which are professional intermediaries or major participants in the swaps or security-based swaps markets, would not need the protections that would be afforded by this rule. However, taking into account the concerns of one commenter,[510] the Commission is not adopting any additional exclusions to the rule at this time, nor is the Commission applying the suitability obligations at the least granular level (e.g., on a transaction-by-transaction basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions between the parties), as suggested by another commenter.[511] The Commission is also not, as suggested by one commenter,[512] providing an opt out from the rule or a policies and procedures alternative. As discussed above in Sections II.A.3.d and II.E, the Commission believes that it is appropriate to apply the suitability rule so that counterparties receive the benefits of the protections provided by the rule; permitting parties to “opt out” of the benefits of the rule or providing a policies and procedures alternative would undermine its core purpose of protecting counterparties. However, while we are not adopting an opt out provision or a policies and procedures alternative, the Commission has determined to permit means of compliance with Rule 15Fh-3(f) that should promote efficiency and reduce costs (e.g., reliance on representations pursuant to Rule 15Fh-1(b)) and allowing SBS Dealers to take into account the sophistication of the counterparty by way of the institutional suitability alternative in Rule 15Fh-3(f)(2) (described below).

The Commission is not adopting one commenter's suggestion to impose additional standards for the types of financial products that can be sold to state and local governments, including security-based swaps.[513] We have determined that additional standards are not needed and that the rules we are adopting appropriately regulate the business conduct of the professional market intermediaries selling these products. We also note that the MSRB is developing a regulatory framework for municipal advisors, including detailed standards of conduct that municipal advisors owe to municipal entities.[514]

ii. Institutional Suitability Alternative and Special Entity Suitability Alternative

After considering the comments, the Commission is adopting Rules 15Fh-3(f)(2)-(4) with a number of modifications. First, in response to a specific suggestion from a commenter,[515] the Commission is correcting a typographical error in proposed Rule 15Fh-3(f)(2). The institutional suitability alternative in proposed Rule 15Fh-3(f)(2) was intended to provide SBS Dealers with an alternative method to fulfill their customer-specific suitability obligations described in proposed Rule 15Fh-3(f)(1)(ii), not their suitability obligations described in proposed Rule 15Fh-3(f)(1)(i). Accordingly, the cross-reference in the proposed rule should have been to “paragraph (f)(1)(ii),” not to “paragraph (f)(1).” The Commission is correcting this cross-reference in the final rules.

Second, in response to concerns raised by a commenter,[516] the Commission is also limiting the availability of the institutional suitability alternative to recommendations made to “institutional counterparties.” This is a change from the proposed rule under which the institutional suitability alternative would have been available with respect to recommendations made to any counterparty. Rule 15Fh-3(f)(4), as adopted, defines the term “institutional counterparty” for these purposes to mean a counterparty that is an eligible contract participant as defined in clauses (A)(i), (ii), (iii), (iv), (viii), (ix) or (x), or clause (B)(ii) (other than a person described in clause (A)(v)) of Section 1a(18) of the Commodity Exchange Act and the rules and regulations thereunder, or any person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million. This more closely aligns the treatment of the persons who may most need the protections of the suitability requirements with their treatment under FINRA rules, which limit the application of FINRA's analogous institutional suitability alternative to recommendations to persons (whether a natural person, corporation, partnership, trust or otherwise) with Start Printed Page 29999total assets of at least $50 million.[517] Rule 15Fh-3(f)(2), as adopted, generally provides that an SBS Dealer may rely on the institutional suitability alternative when making recommendations to institutional counterparties. For a counterparty that is not an institutional counterparty, an SBS Dealer will need to have or obtain relevant information regarding the counterparty to establish a reasonable basis to believe that a recommended security-based swap or trading strategy involving a security-based swap is suitable for the counterparty.[518]

Third, in response to specific suggestions from a commenter, the Commission is making changes to harmonize the institutional and special entity suitability alternatives with the CFTC's parallel provisions.[519] Specifically, the Commission is eliminating the separate special entity suitability alternative. Accordingly, an SBS Dealer may satisfy its customer-specific suitability obligations in Rule 15Fh-3(f)(1)(ii) with respect to any institutional counterparty, including a special entity counterparty that meets the $50 million asset threshold described above, by complying with the requirements of the institutional suitability alternative in Rule 15Fh-3(f)(2). Having a single institutional suitability alternative will result in greater consistency with the CFTC's parallel rule, which will result in efficiencies for entities that have already established infrastructure to comply with the CFTC standard.[520] However, the Commission is not adopting the commenter's suggestion to add a new fourth prong to Rule 15Fh-3(f)(2) that requires an SBS Dealer to comply, in addition to the requirements of the first three prongs (as outlined below), with the requirements of Rule 15Fh-4(b) if the SBS Dealer's recommendation to a special entity would cause it to be acting as an advisor to the special entity.[521] The Commission is not making this change because the rules impose independent requirements, and the Commission believes that SBS Dealers should comply with each rule to the extent applicable.

The proposed special entity suitability alternative would have provided that an SBS Dealer would be deemed to satisfy its suitability obligations with respect to a special entity counterparty if the SBS Dealer either (1) is acting as an advisor to the special entity and complies with proposed Rule 15Fh-4(b), or (2) is deemed not to be acting as an advisor to the special entity pursuant to proposed Rule 15Fh-2(a).[522] With respect to the former, the Commission believes that when an SBS Dealer is acting as an advisor to a special entity, it is appropriate for both the best interests requirements of Rule 15Fh-4(b) and the suitability requirements of Rule 15Fh-3(f) to apply. As discussed in Section II.H.3 below, there is some overlap between the requirements, so an SBS Dealer's efforts to satisfy one set of requirements may result in satisfaction of the other. With respect to the latter, the Commission continues to believe, as noted in the Proposing Release, that the standards for determining that an SBS Dealer is not acting as an advisor under Rule 15Fh-2(a) are substantially the same as the standards that an SBS Dealer must satisfy to qualify for the institutional suitability alternative under Rule 15Fh-3(f)(2) (with the exception of the new institutional counterparty limitation described above).[523] However, the Commission agrees with the commenter that having a single institutional suitability alternative more consistent with the CFTC's rule will result in efficiencies and a lower likelihood of counterparty confusion.[524] Additionally, as we note above, the rules being adopted today are intended to provide certain protections for counterparties, including certain heightened protections for special entities. In this regard, we believe it is important that the rules impose both sets of requirements on SBS Dealers that make recommendations to special entities so that special entities receive the full range of benefits that the rules are intended to provide.

Fourth, the Commission is adding the words “with regard to the relevant security-based swap or trading strategy involving a security-based swap” to modify “recommendations of the [SBS Dealer]” in the second prong of the institutional suitability alternative to match the language used in the first prong and clarify that those are the only recommendations to which the rule refers. The Commission is adopting the other two prongs of the institutional suitability alternative as proposed. Accordingly, as adopted, Rule 15Fh-3(f)(2) provides that when an SBS Dealer makes a recommendation, it may fulfill its customer-specific suitability obligations under Rule 15Fh-3(f)(1)(ii) with respect to an institutional counterparty, if: (1) The SBS Dealer reasonably determines that the counterparty (or its agent) is capable of independently evaluating investment risks with regard to the relevant security-based swap or trading strategy involving a security-based swap; (2) the counterparty (or its agent) affirmatively represents in writing that it is exercising independent judgment in evaluating the recommendations of the SBS Dealer with regard to the relevant security-based swap or trading strategy involving a security-based swap; and (3) the SBS Dealer discloses that it is acting in the capacity of a counterparty, and is not undertaking to assess the suitability of the security-based swap or trading strategy for the counterparty. If an SBS Dealer cannot rely on the institutional suitability alternative provided by Rule15Fh-3(f)(2), it would need to make an independent determination that the recommended security-based swap or trading strategy involving security-based swaps is suitable for the counterparty.

The Commission believes that the SBS Dealer reasonably could determine that the counterparty (or its agent) is capable of independently evaluating investment risks with regard to the relevant security-based swap or trading strategy for purposes of Rule 15Fh-3(f)(2)(i) through a variety of means. However, in response to specific suggestions from a commenter [525] and to provide additional clarity, the Commission is adding a safe harbor in Rule 15Fh-3(f)(3) providing that an SBS Dealer can satisfy its requirement under the first prong of the institutional suitability alternative in Rule 15Fh-3(f)(2) to make a reasonable determination that the counterparty (or Start Printed Page 30000its agent) is capable of independently evaluating investment risks with regard to the relevant security-based swap or trading strategy if the SBS Dealer receives appropriate written representations from its counterparty. As discussed above in Section II.D, an SBS Dealer can rely on a counterparty's written representations unless the SBS Dealer has information that would cause a reasonable person to question the accuracy of the representation. Under Rule 15Fh-3(f)(3)(i),if the counterparty is not a special entity, the representations must provide that the counterparty has complied in good faith with written policies and procedures reasonably designed to ensure that the persons evaluating the recommendation and making trading decisions on behalf of the counterparty are capable of doing so. Under Rule 15Fh-3(f)(3)(ii), if the counterparty is a special entity, the representations must satisfy the terms of the safe harbor in Rule 15Fh-5(b).[526] If an SBS Dealer chooses not to take advantage of the safe harbor provided by Rule 15Fh-3(f)(3), the Commission believes that the SBS Dealer reasonably could determine that the counterparty (or its agent) is capable of independently evaluating investment risks with regard to the relevant security-based swap or trading strategy for purposes of Rule 15Fh-3(f)(2)(i) through a variety of means. For example, an SBS Dealer could comply with this requirement by having a counterparty indicate in a signed agreement or other document that the counterparty is capable of independently evaluating investment risks with respect to recommendations or an SBS Dealer could call its counterparty, have that discussion, and (if it chooses or circumstances require) document the conversation to evidence the counterparty's affirmative indication.

The Commission continues to believe that parties should be able to make the disclosures and representations required by Rules 15Fh-3(f)(2) and (3) on a transaction-by-transaction basis, on an asset-class-by-asset-class basis, or broadly in terms of all potential transactions between the parties.[527] However, where there is an indication that a counterparty is not capable of independently evaluating investment risks, or does not intend to exercise independent judgment regarding, all of an SBS Dealer's recommendations, the SBS Dealer necessarily will have to be more specific in its approach to complying with the institutional suitability alternative. For instance, in some cases an SBS Dealer may be unable to determine that a counterparty is capable of independently evaluating investment risks with respect to any security-based swap. In other cases, the SBS Dealer may determine that a counterparty is generally capable of evaluating investment risks with respect to some categories or types of security-based swaps, but that the counterparty may not be able to understand a particular type of security-based swap or its risk. Additionally, the requirements of Rule 15Fh-1(b) will apply when an SBS Dealer is relying on representations from a counterparty or its representative.[528]

We are not adopting one commenter's suggestions to require SBS Dealers to conduct routine audits to ensure that the institutional suitability alternative is used appropriately.[529] The Commission does not believe that routine audits are the sole means through which an SBS Dealer could supervise its associated persons' use of the institutional suitability alternative. The Commission thinks that the totality of the supervisory requirements in Rule 15Fh-3(h) (discussed below) are appropriate to promote effective supervisory systems and believes that SBS Dealers should have the flexibility to determine what means they will use to supervise their associated persons' use of the institutional suitability alternative. The Commission notes that in supervising the use of the institutional suitability alternative, SBS Dealers should generally consider whether their associated persons' reliance on representations from counterparties is reasonable. As discussed above and in Section II.D, an SBS Dealer (or its associated person) can rely on a counterparty's written representations unless the SBS Dealer has information that would cause a reasonable person to question the accuracy of the representation. In this context, information that might be relevant to this determination includes whether the counterparty has previously invested in the type of security-based swap or been involved in the type of trading strategy that the SBS Dealer is now recommending, and whether the counterparty (or its representative) appreciates what differentiates the recommended security-based swap from a less complex alternative. If the associated person knows that the recommended security-based swap or trading strategy represents a significant change from the counterparty's prior investment strategy or knows that the counterparty (or its representative) lacks an appreciation of what differentiates the recommended security-based swap from a less complex alternative, the associated person should generally consider whether it can reasonably rely on the counterparty's representation that it is capable of independently evaluating the investment risks.[530]

The Commission is also not adopting another commenter's suggestion to add a requirement to the institutional suitability alternative that an SBS Dealer have a reasonable basis to believe its counterparty has the capacity to absorb potential losses related to the recommended security-based swap or trading strategy.[531] The Commission believes that the requirement in Rule 15Fh-3(f)(2)(i) that an SBS Dealer “have a reasonable basis to believe” that the counterparty is capable of evaluating investment risks independently is appropriate to support the objectives of the institutional suitability alternative, and does not believe it is necessary to specifically require an SBS Dealer to have a reasonable basis to believe its counterparty has the capacity to absorb potential losses related to the recommended security-based swap or trading strategy.

5. Fair and Balanced Communications

Section 15F(h)(3)(C) of the Exchange Act requires the Commission to adopt rules establishing a duty for SBS Entities to communicate in a fair and balanced manner based on principles of fair dealing and good faith.[532]

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a. Proposed Rule

Proposed Rule 15Fh-3(g) would require SBS Entities to communicate with counterparties in a fair and balanced manner based upon principles of fair dealing and good faith. In particular, the rule would require: (1) Communications to provide a sound basis for evaluating the facts with regard to any particular security-based swap or trading strategy involving a security-based swap; (2) communications not to imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast; and (3) any statement referring to the potential opportunities or advantages presented by a security-based swap to be balanced by an equally detailed statement of the corresponding risks.[533]

b. Comments on the Proposed Rule

Three commenters addressed the fair and balanced communications requirement.[534] Two commenters expressed support for the proposed rule,[535] and one was opposed.[536] One of the commenters supporting the proposed rule stated that there should not be any exceptions to the proposed fair and balanced communications requirement.[537] The other commenter asserted that to be fair and balanced, communications must inform investors of both the potential rewards and risks of their investments, and also the SBS Entity's involvement and interests in the investments, in specific terms.[538] Specifically, the commenter noted that all material adverse interests should be disclosed, and that the rule should clarify that it is not enough to inform a customer that the SBS Entity “may” have an adverse interest if that adverse interest already exists.[539]

The commenter in opposition to the proposed rule asserted that a fair and balanced communications requirement is unnecessary.[540] The commenter explained that the proposed rule is not relevant in the context of SBS Entities' legacy portfolios since the proposed rule would generally prohibit puffery used to induce a counterparty to enter into new transactions.[541] Additionally, the commenter noted that due to the sophisticated nature of counterparties in the security-based swaps market, the fair and balanced communications requirement is not critical, particularly where all SBS Entities' communications are already subject to the antifraud provisions of the Dodd-Frank Act and the Exchange Act.[542]

c. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(g) as proposed. The rule applies in connection with entering into security-based swaps, and will continue to apply over the term of a security-based swap.[543]

The Commission does not believe any changes to the rule are necessary to address a commenter's concern that to be fair and balanced, communications must inform investors of both the potential rewards and risks of their investments because Rule 15Fh-3(g)(3) already provides that “[a]ny statement referring to the potential opportunities or advantages presented by a security-based swap shall be balanced by an equally detailed statement of the corresponding risks.” [544] With respect to the commenter's assertion that fair and balanced communications should also include information regarding the SBS Entity's involvement and interests in the investments,[545] the Commission notes that although specific disclosure regarding conflicts of interest is not required by Rule 15Fh-3(g), it is required by Rule 15Fh-3(b)(2) (disclosure of material incentives or conflicts of interest).

The standard set forth in Rule 15Fh-3(g) is consistent with the similarly worded requirement in the FINRA rule on communications.[546] Rule 15Fh-3(g) also includes three specific standards, drawn from the FINRA rule, which should clarify the rule requirement. The standards are: (1) Communications must provide a sound basis for evaluating the facts with respect to any security-based swap or trading strategy involving a security-based swap; [547] (2) communications may not imply that past performance will recur, or make any exaggerated or unwarranted claim, opinion, or forecast; [548] and (3) any statement referring to the potential opportunities or advantages presented by a security-based swap or trading strategy involving a security-based swap shall be balanced by an equally detailed statement of the corresponding risks.[549] As noted in the Proposing Release, these standards do not represent an exclusive list of considerations that an SBS Entity must take into account in determining whether a communication with a counterparty is fair and balanced.[550] In addition to complying with Rule 15Fh-3(g), SBS Entities should also keep in mind that all their communications with counterparties will be subject to the specific antifraud provisions added to the Exchange Act under Title VII of the Dodd-Frank Act,[551] as well as general antifraud provisions under the federal securities laws.[552] The Commission declines to eliminate the fair and balanced communications requirement, as suggested by a commenter,[553] because we believe the requirement promotes investor protection by prohibiting SBS Entities from overstating the benefits or understating the risks to inappropriately Start Printed Page 30002influence counterparties' investment decisions.

6. Obligation Regarding Diligent Supervision

Section 15F(h)(1)(B) of the Exchange Act authorizes the Commission to adopt rules for the diligent supervision of the business of SBS Entities.[554]

a. Proposed Rule

Proposed Rule 15Fh-3(h)(1) would require an SBS Entity to establish, maintain and enforce a system to supervise, and to diligently supervise, its business and associated persons, with a view to preventing violations of applicable federal securities laws, rules and regulations relating to its business as an SBS Entity. Proposed Rule 15Fh-3(h)(2) would require an SBS Entity's supervisory system to be reasonably designed to achieve compliance with applicable securities laws, rules and regulations, and would establish minimum requirements for the supervisory system. Specifically, proposed Rule 15Fh-3(h)(2)(i) would require an SBS Entity to designate at least one person with authority to carry out the supervisory responsibilities of the SBS Entity for each type of business in which it engages for which registration as an SBS Entity is required. Proposed Rule 15Fh-3(h)(2)(ii) would require an SBS Entity to use reasonable efforts to determine that all supervisors are qualified and meet standards of training, experience, and competence necessary to effectively supervise the security-based swap activities of the persons associated with the SBS Entity.

Proposed Rule 15Fh-3(h)(2)(iii) would require an SBS Entity to establish, maintain and enforce written policies and procedures addressing the supervision of the types of security-based swap business in which the SBS Entity is engaged. The policies and procedures would need to be reasonably designed to achieve compliance with applicable securities laws, rules and regulations,[555] and include, at a minimum: (1) Procedures for the review by a supervisor of transactions for which registration as an SBS Entity is required; [556] (2) procedures for the review by a supervisor of incoming and outgoing written (including electronic) correspondence with counterparties or potential counterparties and internal written communications relating to the SBS Entity's business involving security-based swaps; [557] (3) procedures for a periodic review, at least annually, of the security-based swap business in which the SBS Entity engages that is reasonably designed to assist in detecting and preventing violations of, and achieving compliance with, applicable federal securities laws and regulations; [558] (4) procedures to conduct a reasonable investigation regarding the character, business repute, qualifications, and experience of any person prior to that person's association with the SBS Entity; [559] (5) procedures to consider whether to permit an associated person to establish or maintain a securities or commodities account in the name of, or for the benefit of such associated person, at another SBS Dealer, broker, dealer, investment adviser, or other financial institution, and if permitted, procedures to supervise the trading in such account, including the receipt of duplicate confirmations and statements related to such account; [560] (6) a description of the supervisory system, including the titles, qualifications and locations of supervisory persons and the specific responsibilities of each person with respect to the types of business in which the SBS Entity is engaged; [561] (7) procedures prohibiting supervisors from supervising their own activities or reporting to, or having their compensation or continued employment determined by, a person or persons they are supervising; [562] and (8) procedures preventing the standards of supervision from being reduced due to any conflicts of interest of a supervisor with respect to the associated person being supervised.[563] Additionally, proposed Rule 15Fh-3(h)(2)(iv) would require an SBS Entity to include written policies and procedures reasonably designed, taking into consideration the nature of the SBS Entity's business, to comply with the duties set forth in Section 15F(j) of the Exchange Act.[564]

Under proposed Rule 15Fh-3(h)(3), the Commission proposed two mechanisms under which an SBS Entity or associated person would not be deemed to have failed to diligently supervise any other person. The SBS Entity or associated person could demonstrate that: (1) Such person is not subject to his or her supervision, or (2) it meets the terms of a safe harbor. The safe harbor would require the SBS Entity or associated person to satisfy two conditions. The first condition would be that the SBS Entity has established and maintained written policies and procedures, and a documented system for applying those policies and procedures, that would reasonably be expected to prevent and detect, insofar as practicable, any violation of the federal securities laws and the rules and regulations thereunder relating to security-based swaps.[565] The second condition would be that the SBS Entity or associated person has reasonably discharged the duties and obligations required by such written policies and procedures and documented system and did not have a reasonable basis to believe that such written policies and procedures and documented system were not being followed.[566]

Finally, proposed Rule 15Fh-3(h)(4) would require an SBS Entity to promptly amend its written supervisory procedures as appropriate when material changes occur in either applicable securities laws, rules or regulations, or in the SBS Entity's business or supervisory system, and to promptly communicate any material amendments to its supervisory procedures throughout the relevant parts of its organization.

b. Comments on the Proposed Rule

Five commenters addressed the proposed supervision rule.[567] One commenter supported the requirement in proposed Rule 15Fh-3(h)(2)(iv) that SBS Entities adopt written policies and procedures reasonably designed to ensure compliance with the duties set forth in Section 15F(j) of the Exchange Act.[568] The commenter noted that this approach, which does not mandate the inclusion of specific elements or prohibitions, will provide SBS Entities flexibility in establishing compliance policies appropriate for their management and organizational structure.[569]

Another commenter argued for additional diligent supervision requirements.[570] The commenter recommended requiring supervisory personnel to report to upper management or the board, as appropriate, if they have reason to believe the SBS Entity's supervisory procedures are not proving effective in Start Printed Page 30003preventing violations.[571] The commenter also suggested requiring SBS Entities to reevaluate their supervisory procedures when they fail to detect or deter significant violations, and determine whether revisions are needed.[572]

In contrast, a third commenter requested that the Commission narrow the proposed supervision requirements.[573] The commenter suggested that the Commission clarify that when an SBS Entity is already subject to, and complies with, comparable requirements of another “qualifying regulator” (such as risk management standards imposed by a prudential regulator), the SBS Entity's supervisory policies and procedures will be deemed to be reasonably designed for purposes of the proposed rule.[574] The commenter also requested that the Commission clarify that a person committing a violation will not be viewed as being subject to the supervision of another person unless the putative supervisor knew or should have known that he or she had the authority and responsibility to exercise control over the other person that could have prevented the violation.[575]

A fourth commenter opposed the application of the proposed rule to Major SBS Participants.[576] The commenter asserted that the proposed rule imposes burdensome and costly supervisory procedures on Major SBS Participants that are not appropriate given their non-dealer role in the marketplace, and that the potential costs of compliance would be without any meaningful offsetting benefit for other market participants or the financial markets as a whole.[577]

A fifth commenter recommended harmonizing the Commission's supervision requirements with FINRA Rule 3110 to enable SBS Entities that are also broker-dealers to make use of their existing supervisory systems and to minimize confusion.[578] Specifically, the commenter suggested eliminating the proposed requirements in proposed Rule 15Fh-3(h)(1) to “enforce” a system to supervise and to diligently supervise “the business” (as opposed to the associated persons) of the SBS Entity, and changing the description of the supervisory system from “with a view to preventing violations of” to “reasonably designed to ensure compliance with” the provisions of applicable federal securities laws and the rules and regulations thereunder relating to its business as an SBS Entity.[579] The commenter also recommended eliminating the redundant description of the supervisory system in proposed Rule 15Fh-3(h)(2), and making a number of changes to the wording of the minimum requirements listed in sub-section (h)(2) to align them with FINRA Rule 3110.[580] The commenter also asked that the Commission modify the rule text to reflect that security-based swaps are not necessarily traded in an “account” but rather pursuant to a bilateral trading relationship.[581] Additionally, the commenter recommended adding a provision allowing an SBS Entity that cannot comply with the requirement in proposed Rule 15Fh-3(h)(2)(iii)(G) (preventing a supervisor from supervising his or her own activities or reporting to a person he or she is supervising) to document its determination that compliance is not possible because of the firm's size or a supervisory person's position within the firm and document how the supervisory arrangement otherwise complies with proposed Rule 15Fh-3(h)(1).[582] The commenter also requested that the Commission provide guidance regarding risk-based reviews that is consistent with FINRA supplementary material on the topic.[583] Finally, the commenter recommended wording changes to the maintenance of written supervisory procedures requirement in proposed Rule 15Fh-3(h)(4) to harmonize with FINRA Rule 3110, including eliminating the proposed requirement to update the written supervisory procedures when material changes occur to the “business,” as opposed to the supervisory system.[584]

c. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-3(h) With certain modifications. In response to commenters' concerns regarding SBS Entities that will also be registered as broker-dealers or Swap Entities being subject to overlapping requirements with respect to their supervisory systems,[585] the modifications (discussed below) are primarily intended to make the final rule more consistent with FINRA Rule 3110 and the CFTC's supervision rule for Swap Entities while continuing to provide protections intended to help ensure that SBS Entities have effective supervisory systems.[586] While, as discussed throughout this release, we are making changes to many of the business conduct rules that are intended to make the final rules more consistent with the parallel CFTC requirements, for the supervision and CCO rules, in particular, we agree with a commenter that consistency with the parallel FINRA rules is also important because many SBS Entities have already established infrastructure to comply with those rules in the context of broader supervisory and compliance programs across their security-based swap and related securities and swaps businesses.[587] This consistency will result in efficiencies for SBS Entities that have already established supervisory systems to comply with the FINRA and/or CFTC standards. Consistent wording will also allow SBS Entities to more easily analyze compliance with the Commission's rule against their existing activities to comply with FINRA Rule 3110 and the CFTC's supervision rule for Swap Entities.

First, in response to a specific suggestion made by a commenter,[588] the Start Printed Page 30004Commission is making several wording changes to the description of the general requirement to establish a supervisory system in Rule 15Fh-3(h)(1). The Commission is deleting the words “and enforce” from the description and adding the modifying language “the activities of” before associated persons so that it requires an SBS Entity to “establish and maintain a system to supervise, and [to] diligently supervise, its business and the activities of its associated persons.” [589] Rule 15Fh-3(h)(2)(iii) (discussed below) includes an express requirement to enforce supervisory policies and procedures, making the additional language regarding enforcing the system to supervise unnecessary. Accordingly, the Commission believes that the rule, as adopted with these wording changes, will continue to establish requirements to help ensure that SBS Entities have effective supervisory systems, consistent with the proposed rule. At the same time, the changes will make the wording of the rule more consistent with the corresponding FINRA and CFTC requirements, as requested by a commenter. This consistency will result in efficiencies for SBS Entities that have already established supervisory systems to comply with the FINRA and/or CFTC standards, as discussed above.

Second, the Commission is making further wording changes to the descriptions of the required supervisory system in Rule 15Fh-3(h)(1) and (2) in response to concerns raised by a commenter regarding the redundancy of the descriptions.[590] Proposed Rule 15Fh-3(h)(1) would require SBS Entities to “establish . . . a system to supervise . . . with a view to preventing violations of the provisions of applicable federal securities laws and the rules and regulations thereunder relating to its business [as an SBS Entity],” and proposed Rule 15Fh-3(h)(2) would specify that the required system be “reasonably designed to achieve compliance with applicable securities laws and the rules and regulations thereunder.” The Commission does not believe that the two descriptions (“prevent violations” and “achieve compliance”) are substantively different, nor did we intend to give the appearance of creating two different standards for what is essentially the same requirement. Accordingly, the Commission is changing and consolidating the description of the supervisory system in Rule 15Fh-3(h)(1) to state that an SBS Entity's supervisory system “shall be reasonably designed to prevent violations of applicable federal securities laws and the rules and regulations thereunder relating to its business [as an SBS Entity],” and eliminating the redundant description in Rule 15Fh-3(h)(2).[591] Additionally, the Commission is making parallel changes to Rules 15Fh-3(h)(2)(iii) and 15Fh-3(h)(2)(iii)(C). Specifically, the Commission is changing the requirement in Rule 15Fh-3(h)(2)(iii) that the supervisory system provide for the establishment, maintenance and enforcement of certain written policies and procedures from policies and procedures that are “reasonably designed to achieve compliance with” to policies and procedures that are “reasonably designed to prevent violations of applicable federal securities laws and the rules and regulations thereunder.” The Commission is also changing the requirement in Rule 15Fh-3(h)(2)(iii)(C) that an SBS Entity's supervisory policies and procedures include procedures for a periodic review of the SBS Entity's security-based swap business by eliminating the redundant requirement that the review be reasonably designed to assist in “achieving compliance with” applicable federal securities laws and regulations and conforming the remaining language. Accordingly, as adopted, Rule 15Fh-3(h)(2)(iii)(C) requires an SBS Entity's written supervisory policies and procedures to include “[p]rocedures for a periodic review, at least annually, of the security-based swap business in which the [SBS Entity] engages that is reasonably designed to assist in detecting and preventing violations of applicable federal securities laws and the rules and regulations thereunder.”

Third, in response to concerns raised by a commenter,[592] the Commission is changing the wording of the minimum requirements for a supervisory system listed in Rule 15Fh-3(h)(2) to more closely align the requirements of our rule with those of FINRA Rule 3110, and to reflect the fact that security-based swaps are not necessarily traded in an “account” but rather pursuant to a bilateral trading relationship. Specifically, the Commission is: (1) Changing the description of the requirement that supervisors be qualified in Rule 15Fh-3(h)(2)(ii) from “qualified and meet standards of training, experience, and competence necessary to effectively supervise the security-based swap activities of the persons associated with the [SBS Entity]” to “qualified, either by virtue of experience or training, to carry out their assigned responsibilities;” [593] (2) adding “and the activities of its associated persons” to the policies and procedures requirement in Rule 15Fh-3(h)(2)(iii) so that it requires “written policies and procedures addressing the supervision of the types of security-based swap business in which the [SBS Entity] is engaged and the activities of its associated persons;” [594] (3) adding “good” to the description of the requirement to have procedures for background investigations on associated persons in Rule 15Fh-3(h)(2)(iii)(D) so that it requires “procedures to conduct a reasonable investigation regarding the good character” of an associated person; [595] (4) adding “or a trading relationship” to the description of the requirement to have procedures for considering whether to allow an associated person to conduct trading for his or her own benefit at another financial institution in Rule 15Fh-3(h)(2)(iii)(E) so that it requires “procedures to consider whether to permit an associated person to establish or maintain a securities or commodities account or a trading relationship;” and (5) changing the description of the Start Printed Page 30005requirement to have conflicts of interest procedures in Rule 15Fh-3(h)(2)(iii)(H) from “procedures preventing the standards of supervision from being reduced due to any conflicts of interest of a supervisor with respect to the associated person being supervised” to “procedures reasonably designed to prevent the supervisory system required by paragraph (h)(1) from being compromised due to the conflicts of interest that may be present with respect to the associated person being supervised, including the position of such person, the revenue such person generates for the [SBS Entity], or any compensation that the associated person conducting the supervision may derive from the associated person being supervised.” [596] The Commission believes that the rule, as adopted with these changes, will continue to provide protections intended to help ensure that SBS Entities have effective supervisory systems, consistent with the proposed rule. At the same time, the changes will make the wording of the rule more consistent with the parallel FINRA requirement, resulting in efficiencies for SBS Entities that have already established supervisory systems to comply with the FINRA standard, as discussed above.

In addition to the wording changes described above, the Commission is making two other sets of changes to the minimum requirements for a supervisory system listed in Rule 15Fh-3(h)(2). First, the Commission is eliminating the specific requirement in proposed Rule 15Fh-3(h)(2)(iii)(E) that the supervision of trading in an associated person's securities or commodities account at another financial institution “includ[e] the receipt of duplicate confirmations and statements related to such accounts.” This change is intended to more closely align our requirement with the analogous FINRA rule, which was amended after our proposal.[597] The amended FINRA rule replaced the requirement to receive duplicate confirmation and statements with a more flexible standard by which firms can determine the data source(s) that are the most effective means to review trading activity. Likewise, this change is also intended to provide SBS Entities reasonable flexibility to craft appropriate supervisory policies and procedures relevant to their business model and to ascertain the means to obtain the necessary data for effective supervision. The Commission notes that the rule, in permitting flexibility, does not limit the SBS Entity's discretion to request from the associated person such transaction and account information as the SBS Entity deems necessary to fulfill its supervisory obligations (including confirmations and statements related to the account or trading relationship), and SBS Entities may consider the availability of such information and whether activity in the account can be properly monitored when determining whether to provide consent to an associated person to open or maintain an account or trading relationship at another financial institution.

Second, in response to concerns raised by a commenter,[598] the Commission is modifying Rule 15Fh-3(h)(2)(iii)(G) to address circumstances where an SBS Entity is unable to comply with the supervisory requirements due to the SBS Entity's size or supervisor's position within the SBS Entity. Pursuant to final Rule 15Fh-3(h)(2)(iii)(G), an SBS Entity that cannot comply with the requirement in Rule 15Fh-3(h)(2)(iii)(G) (preventing a supervisor from supervising his or her own activities or reporting to a person he or she is supervising) will be required to document its determination that compliance is not possible because of the firm's size or a supervisory person's position within the firm, document how the supervisory arrangement otherwise complies with Rule 15Fh-3(h)(1), and include a summary of such determination in the annual compliance report prepared by the SBS Entity's CCO pursuant to Rule 15Fk-1(c). This change is designed to address concerns raised by a commenter that due to the size or structure of some SBS Entities, it may not always be possible to prohibit an associated person who performs a supervisory function at an SBS Entity from supervising his or her own activities or reporting to a person whom he or she is supervising.[599] The Commission believes adding the provision described above will make the supervisory requirements more operationally workable by providing flexibility, in particular for supervision of very senior SBS Entity personnel, while still maintaining appropriate investor protection through the requirement to document how the supervisory arrangement otherwise complies with Rule 15Fh-3(h)(1). The Commission notes that SBS Entities relying on this provision will also be subject to the other requirements of Rule 15Fh-3(h), including the requirement in Rule 15Fh-3(h)(2)(iii)(H) to have procedures reasonably designed to prevent the supervisory system from being compromised due to the conflicts of interest that may be present with respect to the associated person being supervised, including the position of such person, the revenue such person generates for the SBS Entity, or any compensation that the associated person conducting the supervision may derive from the associated person being supervised.

The Commission notes that the minimum requirements for a supervisory system listed in Rule 15Fh-3(h)(2) are not an exhaustive list. SBS Entities should keep in mind their overarching obligation in Rule 15Fh-3(h)(1) to establish and maintain a supervisory system that is reasonably designed to prevent violations of applicable federal securities laws and the rules and regulations thereunder relating to the SBS Entity's business as an SBS Entity. For instance, although Rule 15Fh-3(h)(2)(iii)(B) only requires procedures “for the review by a supervisor of incoming and outgoing written (including electronic) correspondence with counterparties or potential counterparties and internal written communications relating to the [SBS Entity's] business involving security-based swaps,” if an SBS Entity records oral communications with counterparties or potential counterparties, the SBS Entity generally should consider providing for the supervisory review of such communications.[600] Similarly, if an SBS Start Printed Page 30006Entity chooses to provide certain disclosures required by Rule 15Fh-3(b) orally, the SBS Entity should consider how it will supervise these oral communications.

In response to a specific suggestion made by a commenter,[601] the Commission is modifying the maintenance of written supervisory procedures requirement in Rule 15Fh-3(h)(4) to harmonize with FINRA Rule 3110. Specifically, we are changing the requirement to promptly communicate material amendments to an SBS Entity's supervisory procedures from “throughout the relevant parts of its organization” to “to all associated persons to whom such amendments are relevant based on their activities and responsibilities.” [602] We believe that the new formulation will be more effective at achieving its intended result by targeting the communications to the associated persons to whom such amendments are relevant. The Commission believes that under the proposed formulation, potential interpretations of the phrase “relevant parts of its organization” may have resulted in communications to a broader than necessary group. The Commission declines to adopt the commenter's suggestion to eliminate the proposed requirement in Rule 15Fh-3(h)(4)(i) for an SBS Entity to update its written supervisory procedures when material changes occur to its “business,” in addition to its supervisory system.[603] Rule 15Fh-3(h)(1) requires an SBS Entity to diligently supervise its business. Implicit in that obligation is a requirement that the SBS Entity update its supervisory system as necessary to accommodate changes to its business. The Commission does not want to create confusion regarding this obligation by eliminating the explicit requirement in Rule 15Fh-3(h)(4)(i) for an SBS Entity to update its supervisory procedures when material changes occur to its business.

In addition to the modifications discussed above, the Commission is making several clarifying changes to the rule. First, the Commission is correcting a typographical error in Rule 15Fh-3(h)(2). The cross-reference in the proposed rule should have been to “paragraph (h)(1),” not to “paragraph (g)(1).” The Commission is correcting this cross-reference in the final rule.

Second, the Commission also is making two other changes to the rule to clarify that Rule 15Fh-3(h) does not require multiple sets of written supervisory policies and procedures. Specifically, the Commission is: (1) Re-designating proposed Rule 15Fh-3(h)(2)(iv) as Rule 15Fh-3(h)(2)(iii)(I); and (2) clarifying that the written policies and procedures referred to in Rule 15Fh-3(h)(3) are those required by Rule 15Fh-3(h)(2)(iii) by adding the modifying language “as required in § 240.15Fh-3(h)(2)(iii)” after “written policies and procedures” in Rule 15Fh-3(h)(3)(i), and by changing the references in Rule 15Fh-3(h)(3)(ii) from “the written policies and procedures” to “such written policies and procedures.”

Rule 15Fh-3(h) establishes supervisory obligations that incorporate principles from both Exchange Act Section 15(b) and existing SRO rules. The concept of diligent supervision in these rules is consistent with business conduct standards for broker-dealers that have historically been established by SROs for their members, subject to Commission approval. As with diligent supervision by a broker-dealer, the Commission believes that it generally would be appropriate for an SBS Entity to use a risk-based review system to satisfy its supervisory obligations under Rule 15Fh-3(h) instead of conducting detailed reviews of every transaction or every communication, so long as the SBS Entity uses a risk-based review system that is reasonably designed to provide the entity with sufficient information to allow it to focus on the areas that pose the greatest risks of federal securities law violations.[604] Use of a risk-based system allows SBS Entities the flexibility to establish their supervisory systems in a manner that reflects their business models, and based on those models, focus on areas where heightened concern may be warranted.

Rule 15Fh-3(h)(2)(iii)(I), as adopted, requires an SBS Entity to adopt written policies and procedures reasonably designed, taking into consideration the nature of such SBS Entity's business, to comply with the duties set forth in Section 15F(j) of the Exchange Act. Section 15F(j) of the Exchange Act requires an SBS Entity to comply with obligations concerning: (1) Monitoring of trading to prevent violations of applicable position limits; (2) establishing sound and professional risk management systems; (3) disclosing to regulators information concerning its trading in security-based swaps; (4) establishing and enforcing internal systems and procedures to obtain any necessary information to perform any of the functions described in Section 15F of the Exchange Act, and providing the information to regulators, on request; (5) implementing conflict-of-interest systems and procedures; and (6) addressing antitrust considerations such that the SBS Entity does not adopt any process or take any action that results in any unreasonable restraint of trade or impose any material anticompetitive burden on trading or clearing.[605] While the requirements of Section 15F(j) are self-executing, we highlight in particular the duty of an SBS Entity under Section 15F(j)(2) to “establish robust and professional risk management systems adequate for managing the day-to-day business” of the SBS Entity. Any risk management system established by an SBS Entity should be effective to manage the risks of the SBS Entity within the risk tolerance limits to be determined for each type of risk. We have separately proposed a rule regarding the requirement for an SBS Entity for which there is not a prudential regulator to establish, document, and maintain controls to assist it in managing the risks associated with its business activities, including market, credit, leverage, liquidity, legal, and operational risks.[606]

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We are not adopting a commenter's [607] suggestion that when an SBS Entity is already subject to, and complies with, comparable requirements of another “qualifying regulator” (such as risk management standards imposed by a prudential regulator), the SBS Entity's supervisory policies and procedures will be deemed to be reasonably designed for purposes of Rule 15Fh-3(h). Exchange Act Section 15F(h)(1)(B) directs the Commission to adopt rules relating to the diligent supervision of SBS Entities' business. Although we have closely conformed our supervision rule to parallel SRO requirements and believe it is also consistent with parallel CFTC requirements, we do not believe it is appropriate to defer to other regulators' rules, other than as discussed below in Section III. In addition, we are not excluding Major SBS Participants from the scope of the rule, as one commenter suggested.[608] We note that Exchange Act Section 15Fh(1)(B) explicitly contemplates that Major SBS Participants, as well as SBS Dealers, will have obligations to supervise diligently their security-based swap business. As discussed above in Section II.C, where the Dodd-Frank Act imposes a business conduct requirement on both SBS Dealers and Major SBS Participants, the rules will apply to both entities.

Rule 15Fh-3(h)(3), as adopted, provides that SBS Entities and associated persons will not be liable for failure to supervise another person if either the other person is not subject to the SBS Entity's or associated person's supervision, or if the safe harbor described in the rule is satisfied.[609] The safe harbor contains two conditions. First, the SBS Entity must have established policies and procedures, and a system for applying those policies and procedures, which would reasonably be expected to prevent and detect, to the extent practicable, any violation of the federal securities laws and the rules and regulations thereunder relating to security-based swaps. Second, the SBS Entity or associated person must have reasonably discharged the duties and obligations incumbent on it by reason of such procedures and system without a reasonable basis to believe that such procedures were not being followed.[610] Both conditions must be met in order for an SBS Entity to satisfy the safe harbor. However, as noted in the Proposing Release, the inability to rely on the safe harbor would not necessarily mean that an SBS Entity or associated person failed to diligently supervise any other person.[611]

H. Rules Applicable to Dealings With Special Entities

Sections 15F(h)(4) and (5) of the Exchange Act provide certain additional protections for “special entities”—such as municipalities, federal and state agencies, pension plans, and endowments [612] —in connection with security-based swaps.[613]

Special entities, like other market participants, may use swaps and security-based swaps for a variety of purposes, including risk management and portfolio adjustment. In adopting the special entity provisions of the Exchange Act, the Commission seeks to implement the statute, while not impeding special entities' access to security-based swaps.

1. Scope of Definition of “Special Entity”

a. Proposed Rule

Exchange Act Section 15F(h)(2)(C) defines a “special entity” as: (i) A Federal agency; (ii) a State, State agency, city, county, municipality, or other political subdivision of a State; (iii) any employee benefit plan, as defined in Section 3 of ERISA; (iv) any governmental plan, as defined in Section 3 of ERISA; or (v) any endowment, including an endowment that is an organization described in Section 501(c)(3) of the Internal Revenue Code of 1986.[614] Proposed Rule 15Fh-2(e) defines a “special entity” as: (i) A Federal agency; (ii) a State, State agency, city, county, municipality, or other political Start Printed Page 30008subdivision of a State; (iii) any employee benefit plan, as defined in Section 3 of ERISA; (iv) any governmental plan, as defined in Section 3(32) of ERISA; or (v) any endowment, including an endowment that is an organization described in Section 501(c)(3) of the Internal Revenue Code of 1986.

The Proposing Release noted that commenters had raised questions about the scope of the “special entity” definition. The Commission requested comment regarding: (1) Whether to interpret the phrase “employee benefit plan, as defined in Section 3” of ERISA to mean a plan that is subject to regulation under ERISA; (2) whether the phrase “governmental plan” should include government investment pools or other plans, programs or pools of assets; (3) the definition of the term “endowment;” (4) the treatment of collective investment vehicles in which one or more special entities are invested; (5) the treatment of foreign entities; and (6) the treatment of master trusts holding the assets of one or more funded plans of a single employer and its affiliates.

b. Comments on the Proposed Rule

One commenter argued that the term “special entity” was adequately defined in the Exchange Act, and that it “should not require extensive clarification.” [615] However, most commenters requested that the Commission exclude or include specific groups from the “special entity” designation. These comments are addressed below.

i. Federal Agency

We received no comments regarding the inclusion of federal agencies within the special entity definition. In the Proposing Release, we noted that the definition of “security-based swap” excludes an “agreement, contract or transaction a counterparty of which is a Federal Reserve bank, the Federal Government, or a Federal agency that is expressly backed by the full faith and credit of the United States.” [616]

ii. State and Municipal Entities

One commenter suggested that we modify the description of state and municipal entities to include “any instrumentality, department, or a corporation of or established by a State or political subdivision of a State.” [617] According to the commenter, this modification would harmonize the SEC's definition of “special entity” with that of the CFTC.[618]

iii. Employee Benefit Plans and Governmental Plans

As stated above, Exchange Act Section 15F(h)(2)(C)(iii) defines “special entity” to include “any employee benefit plan, as defined in Section 3 of [ERISA].” [619] Section 15F(h)(2)(C)(iv) separately adds “any governmental plan, as defined in Section 3 [ERISA]” to the special entity definition. Section 3 of ERISA defines the term “employee benefit plan” to include plans, such as most private sector employee benefit plans, that are subject to regulation under Title I of ERISA.[620] However, Section 3 of ERISA also defines the following additional categories of employee benefit plans that are not subject to” ERISA regulation: (1) Governmental plans; (2) church plans; (3) plans maintained solely for the purpose of complying with applicable workmen's compensation laws or unemployment compensation or disability insurance laws; (4) plans maintained outside the U.S. primarily for the benefit of persons substantially all of whom are nonresident aliens; or (5) unfunded excess benefit plans.[621] These latter categories of employee benefit plans, including governmental plans, are therefore “defined in” ERISA, but not “subject to” regulation under ERISA.

Commenters asked the Commission at the proposing stage to limit the scope of Section 15F(h)(2)(C)(iii) to employee benefit plans that are subject to regulation under ERISA, and not to extend the definition of “special entity” to plans that are merely “defined in” ERISA, “unless they are covered by another applicable prong of the “special entity” definition (e.g., governmental plans).” [622] As the commenters noted, Exchange Act Section 15F(h)(2)(C)(iv) separately defines “special entity” to include any governmental plan, as defined in Section 3 of ERISA. Mindful of the redundancy that would result if the statute were interpreted to include governmental plans twice in the definition of “special entity,” the Commission therefore requested comment regarding whether to interpret the phrase “employee benefit plan, as defined in Section 3 of [ERISA]” in Exchange Act Section 15F(h)(2)(C)(iii), or to mean a plan that is “subject to” regulation under ERISA.[623]

Seven comment letters addressed this issue. One commenter argued that the expansive language of the statute suggested that any employee benefit plan “defined in” ERISA, including a church plan, should be treated as a special entity, and that, as a matter of policy, church plans should not be treated differently than ERISA or governmental plans when entering into security-based swaps with SBS Entities.[624] This commenter recommended that the Commission revise the proposed special entity definition to clarify that church plans are special entities, or that the Commission permit church plans to “opt in” to special entity status, since opting in would provide potential counterparties greater certainty regarding whether a church plan was, in fact, a special entity.[625] Another commenter recommended that the Commission cover plans “defined in” ERISA.[626]

A collective group of three commenters argued that the definition of special entity should include only employee benefit plans that are “subject to” ERISA.[627] This group asserted that, “[s]ince Congress included a separate `governmental plans' prong in the definition of special entity, the `employee benefit plan' prong necessarily excludes governmental plans (both domestic and foreign) and should be read narrowly to include only employee benefit plans “subject to” ERISA.” [628] However, one of these commenters later independently submitted a comment after the CFTC adopted business conduct rules, and expressed its support for an “opt in” approach.[629] This commenter asserted that the special entity definition should be limited to employee benefit plans that are “subject to” ERISA, although other employee benefit plans defined in ERISA, such as church plans, should be allowed to opt in to special entity status. According to this commenter, these modifications would harmonize the SEC and CFTC special entity definitions.

One commenter suggested treating plans subject to ERISA and government plans subject to ERISA similarly, so long as both are acting as end-users and are Start Printed Page 30009otherwise complying with their fiduciary obligations.[630] Another commenter suggested including governmental plans as special entities, arguing that “the taxpayers and government workers who stand behind government pensions are precisely the sort of constituents Congress sought to protect through the heightened protections of special entities.” [631]

More broadly, one commenter recommended that the business conduct standards should only apply to certain governmental special entities, and that they should not apply to ERISA plans—since these plans already have similar or greater protections under ERISA.[632] The commenter argued that, by applying these standards to all special entities, the SEC “has extended its regulatory reach significantly beyond the scope of the statute,” resulting in “redundant” or “overlapping” regulations.[633] The commenter recommended that the proposed rules be modified to exclude ERISA plans with security-based swap advisors that are “already sufficiently regulated.” [634]

iv. Master Trusts

The Commission additionally requested comment regarding whether to include a master trust that holds the assets of one or more funded plans of a single employer and its affiliates within the special entity definition. Three commenters supported the treatment of master trusts as special entities.[635]

One comment letter suggested that the term “special entity” should be modified to include master trusts holding the assets of one or more funded plans of a single employer.[636] Another comment letter urged the Commission to clarify that master trusts would be treated as special entities, noting that, by making this clarification, the SEC would harmonize the interpretation of its rules with that of the CFTC.[637]

One commenter urged the Commission to include church benefit boards that hold the assets of multiple church plans, church endowments, and other church-related funds on a commingled basis within the special entity definition, arguing that the functions of church benefit boards are similar to those of tax-exempt trusts, or master trusts established by several multiple-employer pension plans, and that such a definition would reflect the close relationship—recognized in ERISA—between church benefit boards and their constituent church plans.[638]

v. Collective Investment Vehicles

The Commission requested comment regarding whether to interpret “special entity” to include a collective investment vehicle in which one or more special entities had invested. All eight commenters that commented on this question opposed the designation of collective investment vehicles as special entities, even where such collective investment vehicles have special entity investors.[639]

Commenters generally argued that requiring SBS Entities to investigate or “look through” their collective investment vehicle counterparties to determine whether they held special entity investments would create uncertainty in the market, increase compliance costs, disrupt the gains of special entity investors, and restrict special entities' access to security-based swaps—since collective investment vehicle managers may either limit or reject investments by special entities to avoid limitations on their security-based swap trading activities.[640]

One commenter asked the Commission to clarify that it would not “look through” collective investment vehicles to align its interpretation of the special entity definition with that of the CFTC.[641]

Two commenters argued to exclude collective investment vehicles because these vehicles are almost always passive investors, and that including them within the adopted rules would serve no regulatory purpose, since Congress' intent was to protect special entities as defined within the statute.[642]

Lastly, two commenters urged the Commission to exclude hedge funds, even where a special entity invests in that hedge fund.[643]

vi. Endowments

The Commission requested comment regarding how to apply the special entity definition to endowments, and whether certain organizations that qualify as endowments should be included in that definition. The five commenters addressing this issue suggested that the Commission limit the definition of endowments in the special entity context, with various caveats.[644]

Three commenters suggested limiting the definition of “endowments” to endowments that, themselves, enter into swaps.[645] Two of these commenters urged the Commission to clarify that the term “endowments” would not include non-profit organizations whose assets might include funds designated as an endowment,[646] while another asked that the Commission exclude organizations that use endowment assets to pledge, maintain, enhance or support the organization's collateral obligations.[647] Another commenter similarly requested that the Commission interpret the definition of endowment to exclude charitable organizations that enter into security-based swaps for which their counterparties have recourse to the organizations' endowment.[648] The commenter noted that, by making this clarification, the SEC would bring its interpretation of the rules into harmony with that of the CFTC.[649]

The last commenter requested clarification that private foundations would not be included within the special entity definition.[650] The commenter argued that these foundations are, by statute, non-profit organizations that are not publicly supported, and that “no evidence” exists that Congress intended to treat private foundations as “endowments” under Dodd-Frank.[651]

Similarly, this same commenter suggested that “institutional investor organizations” (such as large non-profits and “sophisticated” endowments) with over $1 billion of net assets under management should be excluded from the special entity definition, since large “sophisticated” endowments employ professional money managers already subject to oversight and review.[652] The commenter argued that a special entity designation for these organizations could reduce the number of SBS Entities willing to trade in security-based swaps, Start Printed Page 30010given the increased compliance costs associated with evaluating the qualifications of an independent representative.

vii. Foreign Plans, Foreign Entities

The Commission requested comment on whether to exclude from the definition of “special entity” any foreign entity. Six commenters responded to this issue.[653] All six commenters asserted that foreign entities should not be deemed special entities, although one commenter recommended that the U.S. reserve the right to extend application of its business conduct standards to foreign entities if international regulatory efforts fail.[654]

Four other commenters objected to the inclusion of foreign pension and employee benefit plans within the special entity definition on the grounds that the statutory language reflected a lack of Congressional intent to provide special protection for such plans under Dodd-Frank, and that extending the SEC's authority outside the United States would create the potential for conflict with other nations' regulatory regimes.[655] These commenters requested that the Commission revise the proposed definition of “special entity” to specifically exclude foreign entities.[656]

c. Response to Comments and Final Rule

After consideration of all comments, the Commission has determined to modify the scope of the special entity definition as described below.

i. Federal Agency

As noted above, the Commission did not receive any comments on the inclusion of federal agencies within the special entity definition. The Commission continues to believe it is appropriate to include federal agencies within the special entity definition, and is therefore adopting Rule 15Fh-2(e)(1) as proposed, renumbered as Rule 15Fh-2(d)(1).

ii. State and Municipal Special Entities

After further consideration and in light of the comment received, the Commission is modifying proposed Rule 15Fh-2(e)(2), adopted as Rule 15Fh-2(d)(2), to further define state and municipal entities to include “any instrumentality, department, or a corporation of or established by a State or political subdivision of a State.” [657] As the Commission explained in another context, states may delegate powers to their political subdivisions, including the power to create corporate instrumentalities.[658] Similarly, the Commission believes a department or a corporation organized as a municipal corporate instrumentality of a state's political subdivision should be considered a municipal corporate instrumentality of a state. Corporate instrumentalities, departments, or corporations created by states or their political subdivisions are therefore taxpayer-backed institutions. Consequently, the Commission believes it is important to include “any instrumentality, department, or a corporation of or established by a State or political subdivision of a State” within the special entity definition to provide heightened protections for taxpayer-backed institutions that transact in security-based swaps.

In addition, the inclusion of this language will conform the special entity definition to that of a “municipal entity” in the Exchange Act, as well as to the CFTC's definition of State and municipal special entities, thereby providing all categories of municipal entities with heightened protections,[659] as well as addressing the commenter's concern regarding the need for a consistent definition across the security-based swaps and swaps markets.[660] This consistency should result in efficiencies for entities that transact in security-based swaps, particularly where such entities have already established a compliance infrastructure that satisfies the requirements of the existing CFTC business conduct standards.

iii. Employee Benefit Plans and Governmental Plans

Upon further consideration and in light of the comments received, the Commission is modifying proposed Rule 15Fh-2(e)(3), which stated “any employee benefit plan defined in Section 3 of [ERISA]” to state in adopted Rule 15Fh-2(d)(3) “any employee benefit plan subject to Title I of [ERISA].” Under this modification, Rule 15Fh(2)(d)(3) only includes employee benefit plans that are subject to regulation under Title I of ERISA. Furthermore, proposed Rule 15Fh-2(e)(4), renumbered as Rule 15Fh-2(d)(5), is being adopted as proposed, to include “any governmental plan, as defined in section 3(32) of [ERISA].”

In reaching this determination, we believe that Exchange Act Sections 15F(h)(2)(C)(iii) (employee benefit plans defined in Section 3 of ERISA) and 15F(h)(2)(C)(iv) (governmental plans defined in Section 3 of ERISA) should be read together “to avoid rendering superfluous” any statutory language of the Exchange Act.[661] As discussed above in Section II.H.1.b.3, Exchange Act Section 15F(h)(2)(C)(iii), read literally as any employee benefit plan “defined in” Section 3 of ERISA, would render Section 15F(h)(2)(C)(iv) superfluous, since governmental plans “defined in” ERISA are specifically designated as special entities under Section 15F(h)(2)(C)(iv). The Commission therefore agrees with the commenter that Congress' separate inclusion of governmental plans within the special entity definition supports a narrower reading of Section 15F(h)(2)(C)(iii), such that the definition only includes employee benefit plans “subject to” regulation under ERISA.[662]

We recognize that this interpretation of “special entity” would exclude other types of employee benefit plans “defined in” Section 4(b) of ERISA, including church plans and workmen's compensation plans. Therefore, upon further consideration, and in response to commenters who support a broader interpretation of the term “special entity,” including those commenters who assert that a church plan should be treated as a special entity, the Start Printed Page 30011Commission has determined to include an additional prong to the special entity definition.[663] Specifically, Rule 15Fh-2(d)(4), as adopted, defines a special entity to include “[a]ny employee benefit plan defined in Section 3 of [ERISA] and not otherwise defined as a special entity, unless such employee benefit plan elects not to be a special entity by notifying a security-based swap dealer or major security-based swap participant of its election prior to entering into a security-based swap with the particular security-based swap dealer or major security-based swap participant.” The Commission believes that the inclusion of this additional provision appropriately resolves any tension between Exchange Act Sections 15F(h)(2)(C)(iii) and (iv), while granting broad coverage under the enhanced business conduct protections for special entities provided by the Dodd Frank Act.

Under Rule 15Fh-2(d)(4), as adopted, an employee benefit plan that is “defined in” Section 3 of ERISA but not “subject to” regulation under ERISA is included within the special entity definition, although it may elect to opt out of special entity status by notifying an SBS Entity counterparty of its election to opt out prior to entering into a security-based swap. Therefore, for example, under Rule 15Fh-2(d)(4), any church plan, as defined in Section 3(33) of ERISA, would be considered a special entity unless it elected to opt out of special entity status.[664] It is also consistent with Rule 15Fh-3(a)(3), which requires an SBS Entity to verify whether a counterparty is eligible to elect not to be a special entity, and if so, to notify the counterparty of its right to make such an election.[665] Further, by requiring employee benefit plans to notify SBS Entities of their decision to opt out, the provision will provide SBS Entities greater clarity regarding their counterparty's election to be treated as a special entity, as requested by a commenter.[666]

We note that the special entity definition the Commission is adopting today differs from the CFTC's special entity definition, which instead includes an opt-in provision for plans “defined in” ERISA.[667] While we agree with the CFTC's objective of “providing protections broadly,” [668] we have determined that inclusion of an opt-out provision will afford the maximum protections to the broadest categories of special entities, while still allowing them the flexibility to elect not to be special entities when they do not wish to avail themselves of those protections. In making this determination, we acknowledge the commenter's request that we conform our special entity definition to that of the CFTC.[669] However, we believe that the practical effect of an opt-out versus an opt-in regime should be minimal since, in either case, the SBS Entity will need to advise the counterparty of its option to be treated as a special entity. The result should be greater clarity for SBS Entities regarding the regulatory status of their counterparties.

Lastly, we disagree with the commenter's assertions that the SEC “has extended its regulatory reach” beyond the statute by applying the business conduct rules to ERISA plans, and that the resulting regulations would overlap with the preexisting regulations established under ERISA.[670] As noted above, the plain language of Exchange Act Section 15F(h)(2)(C)(iii) includes ERISA plans within the special entity definition, and we continue to believe that such plans are deserving of the heightened protections of the business conduct rules specific to special entities. Moreover, wherever practical, we have adopted bifurcated rules that acknowledge the existing federal regulatory framework for ERISA plans, thereby minimizing the tension that may arise between that framework and the business conduct standards adopted today.[671]

iv. Master Trusts

The Commission agrees with commenters that master trusts should be treated as special entities, where a master trust holds the assets of more than one ERISA plan, sponsored by a single employer or by a group of employers under common control.[672] In this regard, the Commission clarifies that, if a master trust holds the assets of an ERISA plan, the SBS Entity may satisfy the business conduct requirements being adopted today by treating the master trust as a special entity, rather than applying the business conduct rules to each underlying ERISA plan in a master trust. The Commission understands that a single employer or a group of employers under common control may sponsor multiple ERISA plans that are combined into a master trust to achieve economies of scale and other efficiencies. In such cases, the Commission does not believe that any individual ERISA plan within the master trust would receive any additional protection if the SBS Dealer or Major SBS Participant had to separately comply with the final rules with respect to each ERISA plan whose assets are held in the master trust.

The Commission similarly agrees with the commenter that, where a church benefit board holds the assets of multiple church plans as defined in Section 3(33) of ERISA, the function of the church benefit board is similar to that of a master trust.[673] Because church plans are recognized in ERISA, and a church benefit board holds only the assets of constituent church plans,[674] a church benefit board that holds the assets of church plans will be deemed a special entity under final Rule 15Fh-2(d)(4), although it will have the ability to opt out of special entity protections.

Lastly, this clarification addresses the commenter's request that the Commission interpret the special entity definition in harmony with the CFTC, as the CFTC also includes master trusts as special entities where a master trust holds the assets of more than one ERISA plan, sponsored by a single employer or by a group of employers under common control.[675] Such uniformity will help establish regulatory consistency across the security-based swap and swap markets, thereby creating efficiencies for SBS entities that transact in security-based swaps and swaps.

v. Collective Investment Vehicles

The Commission requested comment on whether to interpret “special entity” to include collective investment vehicles in which one or more special entities had invested. After Start Printed Page 30012consideration of the comments, the Commission has determined not to interpret “special entity” in that way. The Commission agrees with commenters that uniformly urged the Commission not to treat a collective investment vehicle as a special entity, solely because the collective investment vehicle may have one or more special entity investors.[676]

Unlike master trusts, formed for the purpose of holding assets of ERISA plans, a collective investment vehicle may be formed for a variety of reasons and only incidentally accept investments from special entities. We share the concerns of commenters that requiring SBS Entities to investigate or “look through” their collective investment vehicle counterparties to determine whether they held special entity investments could create uncertainty in the market, and could potentially increase compliance costs, disrupt the gains of special entity investors, and restrict special entities' access to security-based swaps—since collective investment vehicle managers may either limit or reject investments by special entities to avoid application of the special entity requirements.[677]

At the same time, we recognize the potential benefits of applying heightened protections to special entities that have invested in collective investment vehicles, either by applying those protections to the collective investment vehicle itself or requiring the SBS Entity to “look through” the collective investment vehicle. After further consideration, we have determined that it would neither be appropriate to treat the entire collective investment vehicle as a special entity, nor to require an SBS Dealer to “look through” the collective investment vehicle to determine whether any of its investors qualify as special entities. While the special entity has made the decision to invest in the collective investment vehicle, it is the collective investment vehicle that enters into the security-based swap—not the special entity. In light of the foregoing, we do not believe that collective investment vehicles should be included within the special entity definition.

Lastly, our decision not to include collective investment vehicles in the special entity definition will address the commenter's suggestion that we harmonize the Commission's special entity definition with that of the CFTC to increase regulatory consistency across the security-based swap and swap markets.[678]

vi. Endowments, Non-Profit Organizations, and Private Foundations

The Commission requested comment regarding application of the special entity definition to endowments. After taking into consideration the comments, the Commission has determined to interpret the term “endowment,” as used in Section 15F(h)(2)(C)(v) of the Exchange Act, not to include entities or persons other than the endowment itself. The Commission therefore agrees with commenters that special entity status should be limited to endowments that are, themselves, counterparties to security-based swaps.[679] Accordingly, the Commission does not interpret the term “endowment” to include organizations that use endowment assets to pledge, maintain, enhance or support the organization's collateral obligations, or situations where a counterparty has recourse to the organization's endowment.[680]

For clarification, and in response to comment,[681] a private foundation will be subject to special entity protections where the private foundation qualifies as an endowment under applicable state laws, rules, or regulations, including the Uniform Prudent Management of Institutional Funds Act. Although we acknowledge the commenter's assertion that private foundations typically derive their financial support through private donations,[682] we do not agree that public funding is a prerequisite to special entity status, or that private funding should necessarily exclude a foundation from qualifying for special entity status.

As noted above in Section II.G.1.b, Rule 15Fh-3(a)(2) generally requires an SBS Entity to verify whether its counterparty is a special entity before entering into the security-based swap with that counterparty. Such verification should generally include a determination whether the counterparty may be deemed an endowment under applicable state law, as described above. However, as discussed in Section II.G.1.b, supra, counterparties may make representations about their status as special entities at the outset of a relationship with an SBS Entity, and can “bring down” that representation for each relevant action involving a security-based swap.

Also, as with collective investment vehicles, we believe that a more expansive interpretation of the special entity definition would require a burdensome “look through” process to determine whether endowment funds had, for instance, been invested or used as collateral in a particular security-based swap, and could ultimately restrict the ability of entities that are neither themselves endowments nor special entities (such as organizations described in section 501(c)(3) of the Internal Revenue Code of 1986 whose assets merely include funds designated as an endowment) to transact in security-based swaps.

By making the foregoing clarifications, the Commission more closely aligns its interpretation of the term “endowment” with that of the CFTC.[683] This consistency in the definition will address the commenter's concern regarding the need to promote regulatory clarity, and result in operational efficiencies for entities that have been operating under the CFTC's business conduct regime since 2012.[684]

Lastly, as discussed in more detail above in Section II.A.2.d., we decline the commenter's suggestion to permit endowments to opt out of special entity status.[685] As stated in the Proposing Release, Congress created heightened protections to mitigate the potential for abuse in SBS transactions with special entities, as the financial sophistication of special entities varies greatly.[686] As discussed above in Section II.A, the rules being adopted today are intended to provide certain protections for counterparties, including certain Start Printed Page 30013heightened protections for special entities. We think it is appropriate to apply the rules so that counterparties receive the benefits of those protections and do not think it is appropriate to permit parties to “opt out” of those provisions. Furthermore, we note that the CFTC's adopted rules do not contain such an opt-out provision, and that Swap Entities and their special entity counterparties have been operating under this regime since 2012. For all of the foregoing reasons, and to achieve regulatory consistency across the security-based swap and swap markets, we decline to adopt an opt-out provision for endowments in the final rules.

vii. Foreign Plans and Foreign Entities

The Commission requested comment on whether to exclude from the definition of “special entity” any foreign entity. After considering the comments, all of which asserted that foreign entities should not be deemed special entities, the Commission is declining to include foreign entities within the definition of “special entity.” The Commission believes that, as stated in the Cross-Border Adopting Release, the term “special entity” applies to “legal persons organized under the laws of the United States.” [687] This reading addresses the concerns raised by commenters regarding the need for clarification concerning the application of the rules as they relate to special entity-specific provisions.[688]

2. “Acts as an Advisor” to a Special Entity

a. Proposed Rule

As discussed below in Section II.H.3, Section 15F(h)(4)(B) of the Exchange Act imposes a duty on an SBS Dealer acting “as an advisor” to a special entity to act in the best interests of the special entity.[689] The Dodd-Frank Act does not define the term “advisor,” nor does it establish specific criteria for determining when an SBS Dealer is acting as an advisor within the meaning of Section 15F(h)(4).

The Commission proposed Rule 15Fh-2(a), which states that an SBS Dealer “acts as an advisor to a special entity when it recommends a security-based swap or a trading strategy that involves the use of a security-based swap to the special entity.” We explained in the Proposing Release that, for these purposes, to “recommend” has the same meaning as that discussed in connection with Rule 15Fh-3(f).[690]

While the Dodd-Frank Act does not preclude an SBS Dealer from acting as both advisor and counterparty, the Commission recognized in the Proposing Release that it could be impracticable for an SBS Dealer acting as a counterparty to a special entity to meet the “best interests” standard imposed by Section 15F(h)(4) if it were deemed to be acting as an advisor to the special entity.[691] Proposed Rule 15Fh-2(a) would therefore provide a three-pronged safe harbor for an SBS Dealer to establish that it is not acting as an advisor. To qualify for the safe harbor, the SBS Dealer's special entity counterparty must first represent in writing that it will not rely on the SBS Dealer's recommendations, but that it will instead rely on advice from a “qualified independent representative.” [692] Second, the SBS Dealer must have a “reasonable basis” to conclude that the special entity is being advised by a qualified independent representative.[693] Toward this end, the SBS Dealer could rely on the special entity's written representations unless the SBS Dealer has information that would cause a reasonable person to question the accuracy of the representation.[694] Third, the SBS Dealer must disclose that it is not undertaking to act in the special entity's best interests, as would otherwise be required under Section 15F(h)(4).[695]

b. Comments on the Proposed Rule

The Commission received numerous comments in response to the definition of “acts as an advisor” to a special entity in proposed Rule 15Fh-2(a). One commenter asserted that the meaning of the phrase “acts as an advisor to a special entity” was critical to several regulatory rulemakings, and that this term should be applied as consistently as possible.[696] That commenter and another recommended that, in developing recommendations for the final rules, the Commission staff coordinate with the Commission staff working on rules regarding municipal advisors, as well as the MSRB and the CFTC.697 The commenter urged the Commission to work with the CFTC and the MSRB to make the definition as consistent as possible across regulatory regimes.

However, the majority of comment letters addressing proposed Rule 15Fh-2(a) related to: (1) The use of the term “recommends” when defining the phrase “acts as an advisor to a special entity;” and (2) the safe harbor from acting as an advisor to a special entity set forth in proposed Rule 15Fh-2(a)(1)-(3). These comments are summarized below.

i. “Recommends” an SBS or Related Trading Strategy to a Special Entity

Eight comment letters addressed whether an SBS Dealer should be deemed to act as an advisor if it “recommends” a security-based swap or trading strategy to a special entity.[698]

One commenter argued that the definition of “acting as an advisor” was too narrow, and should be expanded to include not only making recommendations, but also providing “more general information and opinions.” [699] That commenter and another recommended that the definition of “act as an advisor” should parallel that of an “investment adviser,” such that the definition would encompass advising special entities as to the value of a security-based swap or as to the advisability of a security-based swap or trading strategies involving security-based swaps.[700] The second commenter asserted that this definition would more closely conform the definition of “act as an advisor” to the definition of “investment adviser” under the Advisers Act, as well as to the definition of “commodity trading Start Printed Page 30014advisor” under the CEA, while preserving the benefits of the Commission's proposed safe harbor.[701]

A third commenter generally supported our proposed approach, noting that “defining recommendations as advice is consistent . . . with congressional intent.” [702] The commenter, however, would narrow the definition of advice to “recommendations related to a security-based swap or a security-based swap trading strategy that are made to meet the objectives or needs of a specific counterparty after taking into account the counterparty's specific circumstances.” [703] Another commenter suggested that the term “recommendation” exclude communications to groups of customers or to investment managers with multiple clients, unless the communication was tailored to a member of the group or to a specific client known to the SBS Dealer.[704] According to the commenter, the Commission should clarify that a recommendation must be tailored to the circumstances of a known special-entity counterparty before giving rise to advisor status, because, without this clarification, general communications to investment advisers (that potentially have special entity clients) might result in the SBS Dealer unknowingly “acting as an advisor.” [705] In 2015, after the CFTC adopted its final business conduct rules, a commenter similarly proposed that the Commission narrow the scope of the definition of “act as an advisor to a special entity” to include only recommendations that are “tailored to the particular needs or characteristics of the special entity.” [706]

Another commenter argued that a definition premised on an SBS Dealer's “recommend[ing]” a security-based swap or related trading strategy was “overly broad and unwise,” and that acting as an advisor “requires a more formal, acknowledged agency, as part of a relationship of trust and confidence.” [707] This commenter expressed concern that a definition based on recommendations could chill communications, including informal “market chatter.” [708] Two other commenters similarly urged the Commission to adopt a bright line, objective standard, where an explicit agreement by the parties would determine whether the SBS Dealer acts as advisor to the special entity.[709] Under this approach, unless the special entity and SBS Dealer agree that information provided by the SBS Dealer would form the primary basis for an investment decision, the SBS Dealer's communications would not be considered a “recommendation” under proposed Rule 15Fh-2(a).[710]

Several commenters requested that the Commission clarify whether certain communications constitute “acting as an advisor.” One commenter was concerned that an SBS Dealer could provide a counterparty with data, analysis, and opinions that constituted recommendations in fact, but were not labeled or characterized as such.[711] A second commenter suggested the Commission clarify that the phrase “acting as an advisor” does not include providing general transaction, financial or market information to the special entity.[712] A third commenter recommended the final rule clarify that an SBS Dealer's “customary product explanations and marketing activities, provision of general market information, quotes in response to requests, and information pursuant to requirements in the business conduct rules would not constitute `acting as an advisor' to a special entity.” [713]

ii. Safe Harbor

The Commission received a number of comment letters on the proposed rule's safe harbor provisions. Ten comment letters generally supported the safe harbor, subject to various suggestions or objections.[714] Three commenters objected to the safe harbor.[715]

Commenters supporting the adoption of safe harbor provisions that would protect an SBS Dealer from being deemed an advisor to a special entity, argued that market participants would benefit from greater certainty provided by the safe harbor, which would enable contracting parties to specify the nature of their relationship.[716]

A number of commenters, however, expressed concern about the possible interaction of the proposed safe harbor with ERISA. One commenter, for example, generally agreed with the proposed safe harbor but expressed concern that requiring an SBS Dealer to have a “reasonable basis” to believe a special entity was being advised by a qualified independent representative could allow the SBS Dealer's opinion of an ERISA plan representative to “trump” that of the ERISA plan fiduciary.[717] For these reasons, the commenter urged the Commission to prohibit an SBS Dealer that acts as a counterparty to an ERISA plan from vetoing the plan's choice of representative.[718]

Another commenter suggested the proposed safe harbor be revised to provide that either: (1) The special entity will rely on advice from a qualified independent representative, or (2) if the special entity or its representative is relying on the Qualified Professional Asset Manager (“QPAM”) or In-House Asset Manager (“INHAM”) Exemption, the decision to enter into the transaction will be made by a QPAM or INHAM.[719] One commenter expressed concern with the proposed safe harbor's requirement that the special entity represent it is not Start Printed Page 30015“relying” on recommendations from the SBS Dealer.[720] As the commenter explained, since reliance is one of the essential elements of a securities fraud action, an SBS Dealer could seek to rely on the special entity's representation that it did not “rely” on the SBS Dealer's recommendation in defense of a subsequent securities fraud action against the SBS Dealer.[721] Instead, the commenter suggested “as a purely technical matter” that the safe harbor instead require a special entity to acknowledge that the SBS Dealer is not acting as advisor to the special entity.[722]

In August 2015, another commenter suggested modifying the proposed rule to harmonize with the CFTC's approach by creating a second separate safe harbor for employee benefit plans subject to Title I of ERISA that “recognizes the unique fiduciary regime already applicable to such special entities.” [723] In addition to recommending a safe harbor for ERISA plans, the commenter requested two changes to the non-ERISA safe harbor: (1) Adding a requirement that an SBS Dealer may not express an opinion as to whether a special entity should enter into the recommended security-based swap or related trading strategy; and (2) eliminating the safe harbor condition that an SBS Dealer have a reasonable basis to believe that the special entity is advised by a qualified independent representative.[724] The commenter noted that the “reasonable basis” provision is absent from the parallel CFTC business conduct rule, and argued that the provision is unnecessary in light of the fact that the SBS Dealer will already receive a written representation that the special entity will rely on advice from the independent representative.[725] The commenter explained that its suggested modifications were generally intended to bring the Commission's safe harbor provisions into conformity with those of the CFTC.[726] The same commenter subsequently urged the Commission to either (i) permit SBS Entities to reasonably rely on written representations that satisfy the CFTC's safe harbor, or (ii) adopt a parallel safe harbor.[727]

Three commenters opposed the proposed safe harbor, arguing that it would erode the statutory protections for special entities. For instance, one commenter argued that the safe harbor would effectively allow SBS Dealers to give advice that might not be in the best interests of the special entity.[728] A second commenter opposed the safe harbor on the grounds that it would cause special entities to waive their right to “best interest” recommendations as a condition of transacting with SBS Dealers, and force them to rely solely on an independent representative that might be “financially beholden to the security-based swap industry.” [729] The commenter also expressed concern that “in any transaction involving a customized swap, the special entity will by definition be relying on the swap dealer's assertion that the customization was designed with the particular needs of the special entity in mind,” and if the SBS Dealer knows or has reason to know that the swap is not in the best interests of the special entity, the SBS Dealer “should be precluded from doing the transaction regardless of what representations the special entity provides about who it may be relying on.” [730]

Similarly, a third commenter characterized the safe harbor as permitting “an SBS Dealer to escape the critical responsibilities associated with ‘acting as an advisor’ by having Special Entities waive this right,” and expressed concern that special entities would be forced to sign “boilerplate” waivers to enter into a security-based swap.[731]

c. Response to Comments and Final Rule

As stated above, proposed Rule 15Fh-2(a) defined what it means for an SBS Dealer to act as an advisor to a special entity, and proposed Rule 15Fh-4 imposed certain requirements on SBS Dealers acting as advisors. Thus, the proposed rules would not impose these obligations on Major SBS Participants.[732] One commenter stated its view that it is appropriate to impose Rule 15Fh-4(b)'s heightened standards of conduct on professional market participants that are likely to be acting as advisors to special entities,[733] and another commenter stated that the “dealer-like obligations” of Rule 15Fh-4(b) should not be imposed on Major SBS Participants, transacting at arm's-length, as they will not likely advise special entities with respect to security-based swap transactions.[734] The Commission continues to believe that it is appropriate not to impose the heightened obligations when acting as an advisor to a special entity on Major SBS Participants, given the nature of their participation in the security-based swap markets.[735] However, if a Major SBS Participant is, in fact, recommending security-based swaps or trading strategies involving security-based swaps to a special entity, this could indicate that the Major SBS Participant is actually engaged in security-based swap dealing activity.[736] A Major SBS Participant that engages in such activity above the de minimis threshold in Exchange Act Rule 3a71-2 would need to register as an SBS Dealer and comply with the obligations imposed on SBS Dealers, including the obligations imposed by Rule 15Fh-4(b) when an SBS Dealer is acting as an advisor to a special entity.

Upon review and consideration of the comments, the Commission is adopting Rule 15Fh-2(a) as described below.

i. “Recommends” an SBS or Related Trading Strategy to a Special Entity

We are adopting, as proposed, Rule 15Fh-2(a), under which an SBS Dealer is defined to “act as an advisor to a special entity” when it recommends a security-based swap or a trading strategy that involves a security-based swap to a special entity.[737] For these purposes, to “recommend” has the same meaning as discussed in connection with Rule 15Fh-3(f).[738] The determination of whether an SBS Dealer has made a “recommendation” turns on the facts and circumstances of the particular situation and, therefore, whether a Start Printed Page 30016recommendation has taken place is not susceptible to a bright line definition.[739]

The Commission is not expanding the definition of “recommendation” to encompass “more general information and opinions,” as suggested by a commenter.[740] Such a broad definition could have the unintended consequence of chilling commercial communications, restricting customary commercial interactions, and generally reducing market information shared with special entities regarding security-based swaps.[741] As we discussed in Section II.G.4, the Commission continues to believe that the meaning of the term “recommendation” is well-established and familiar to intermediaries in the financial services industry, including broker-dealers that rely on institutional suitability determinations, and we believe that the same meaning should be ascribed to the term in this context.

As explained in Section II.G.4, the factors considered in determining whether a recommendation has taken place include whether the communication “reasonably could be viewed as a ‘call to action’ ” and “reasonably would influence an investor to trade a particular security or group of securities.” [742] The more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a “recommendation.” [743] Thus, in response to commenters' requests for clarification, an SBS Dealer typically would not be making a recommendation—and would therefore not be “acting as an advisor” to a special entity with a duty to act in the “best interests” of a special entity—solely by reason of providing general financial or market information or transaction terms in response to a request for competitive bids.[744] Furthermore, provision of information pursuant to the requirements of the business conduct rules will not, in and of itself, result in an SBS Dealer being viewed as making a “recommendation,” as suggested by one commenter.[745] Rather, as stated above, the determination of whether providing information about the valuation of a security-based swap, or concerning the advisability of a security-based swap or a trading strategy, involving a security-based swap constitutes a “recommendation” turns on the particular facts and circumstances.

To avoid unnecessarily narrowing the definition of “recommendation,” we decline to limit the definition of “act as an advisor” to recommendations that are designed to meet the needs of a specific counterparty after taking into account the counterparty's individual circumstances.[746] We also decline to exclude from the definition of “recommendation” communications to groups of customers or to investment managers with multiple clients.[747] We believe that such an exclusion could unnecessarily deprive groups or special entity investors of the intended protections of the rules when there are communications regarding a particular security-based swap or trading strategy to a targeted group of special entities that share common characteristics, e.g., school districts. As stated above, such communications should be evaluated based on whether, in light of all the facts and circumstances, the communications could “reasonably could be viewed as a `call to action' ” and “reasonably would influence an investor to trade a particular security or group of securities.” [748] We also note that the number of recipients of a given communication does not necessarily change the characteristics of the communication.

Furthermore, we are not limiting the definition of “act as an advisor” to a special entity to situations in which parties affirmatively contract or otherwise establish “more formal, acknowledged agency relationships that are part of a relationship of trust and confidence” [749] We believe this could limit the scope of the obligations and corresponding protections for special entities when an SBS Dealer “acts as an advisor” in a manner that is not consistent with the intended objectives of the rule. In short, the rule could be stripped of its intended protections if those protections only applied when the regulated entity agreed to be regulated.[750]

For the same reason, SBS Dealers may not avoid making a “recommendation” as defined in this context through disclaimer, or simply by not characterizing or labeling a recommendation as such.[751] An interpretation that would permit an SBS Dealer to disclaim its “best interests” duty, irrespective of the SBS Dealer's conduct, could essentially relieve SBS Dealers of their obligations and deprive special entities of the corresponding protections intended by Rule 15Fh-4. Rather than require the affirmative agreement of the parties to establish an advisory relationship, we are providing a safe harbor, as described in Section II.H.2.c.ii, infra, by which the parties can agree that an SBS Dealer is not “acting as an advisor” to a special entity where certain conditions are met—specifically, where the special entity agrees to rely on the advice of an ERISA fiduciary or other qualified, independent representative with respect to a security-based swap transaction.

We reject the commenters' suggestion that we conform the definition of an SBS Dealer that “acts as an advisor” to a special entity to the definition of “investment adviser” under the Advisers Act, or to the definition of “commodity trading advisor” under the CEA.[752] We do not agree that either definition is necessarily tailored to the specific attributes of security-based swap transactions or the unique relationships between SBS Dealers and their special entity counterparties; therefore we believe that those definitions would not necessarily provide special entities that trade in security-based swaps with the protections the business conduct rules are intended to provide.

The Commission continues to believe that the duties imposed on an SBS Dealer that “acts as an advisor” (as well as the definition of “act as an advisor” under Rule 15Fh-2(a)) are supplemental to any duties that may be imposed under other applicable law.[753] In particular, we acknowledge the commenter's suggestion that the Commission coordinate with the MSRB regarding the definition of “acts as an advisor.” [754] As explained in Section Start Printed Page 30017I.E, supra, we have adopted rules that provide an exemption from “municipal advisor” status for persons providing advice with respect to municipal financial products or the issuance of municipal securities where certain conditions are met, such as where the municipal entity is represented by an independent registered municipal advisor.[755] More generally, as discussed in Section I.E, supra, the duties imposed on an SBS Dealer under the business conduct rules are specific to this context, and are in addition to any duties that may be imposed under other applicable law. Thus, an SBS Dealer must separately determine whether it is subject to regulation as a broker-dealer, an investment adviser, a municipal advisor or other regulated entity.

Lastly, the Commission considered and agrees with the comment that the definition of “acting as an advisor” to a special entity should be applied as consistently as possible across various rulemakings, and that the Commission should coordinate with the CFTC with respect to this definition.[756] As noted in Section I.C, the staffs of the Commission and the CFTC extensively coordinated and consulted in connection with their respective rulemakings in an effort to establish a consistent rule regime across the swap and security-based swap markets. These efforts are reflected in the rules adopted today.

We note that the Commission's definition of “acts as an advisor” to a special entity under Rule 15Fh-2(a) differs slightly from the CFTC's parallel rule, under which a swap dealer is deemed to be an advisor when it “recommends a swap or trading strategy involving a swap that is tailored to the particular needs or characteristics of the Special Entity.” [757] While we agree that the more individually tailored the communication to a specific counterparty or a targeted group of counterparties about a swap, group of swaps or trading strategy involving the use of a swap, the greater the likelihood that the communication may be viewed as a “recommendation,” we do not agree that a security-based swap communication must be so tailored to constitute a recommendation for purposes of Rule 15Fh-2(a). In adopting this more expansive definition of “acts as an advisor” to a special entity, the Commission believes that it will better provide the intended protections of the statute to groups of special entity investors that may be treated similarly by SBS Dealers, such as school districts.

ii. Safe Harbor

After the Commission issued the Proposing Release, the CFTC adopted final rules that provide two safe harbors from the definition of “acts as an advisor to a special entity.” The first provides a safe harbor for communications between a swap dealer and an ERISA plan that has an ERISA fiduciary, and the second provides a safe harbor for communications between a swap dealer and any special entity (including a special entity that is an ERISA plan). Qualifying for either safe harbor requires specified representations in writing by the swap dealer and special entity. In response to requests from commenters, and upon further consideration, we are adopting an approach that similarly recognizes the use of ERISA fiduciaries by ERISA plans, thereby avoiding the potential conflict or confusion that may result where the existing ERISA rules intersect with the business conduct rules adopted today.[758]

In adopting a separate safe harbor for ERISA plans, we recognize that Congress has already established a comprehensive federal regulatory framework for ERISA plans. Such recognition of the existing federal regulatory framework for ERISA plans maintains statutory protections for ERISA plans, while addressing the potential conflict, recognized by commenters, between the ERISA rules and the business conduct standards we are adopting today.[759] Lastly, in adopting a bifurcated approach that provides a safe harbor specifically for ERISA plans and another that is available with respect to all special entities, we are responding to the commenter's request that we more closely align the Commission's rules with those of the CFTC to promote regulatory consistency and operational efficiency for entities that have been operating under the CFTC's business conduct regime since 2012.[760]

Under Rule 15Fh-2(a)(1), as adopted, an SBS Dealer may establish that it is not acting as an advisor to a special entity that is an ERISA plan if the special entity is represented by a qualified independent representative that meets the standard for an ERISA fiduciary. Specifically, the rule provides that an SBS Dealer will not be acting as an advisor to an ERISA special entity if: (i) The ERISA plan represents in writing that it has an ERISA fiduciary; (ii) the ERISA fiduciary represents in writing that it acknowledges that the SBS Dealer is not acting as an advisor; and (iii) the ERISA plan represents in writing that: (A) It will comply in good faith with written policies and procedures reasonably designed to ensure that any recommendation the special entity receives from the SBS Dealer involving a security-based swap transaction is evaluated by an ERISA fiduciary before the transaction is entered into; or (B) any recommendation the special entity receives from the SBS Dealer involving a security-based swap transaction will be evaluated by an ERISA fiduciary before that transaction is entered into.

Allowing the ERISA plan to either make written representations about its policies and procedures or represent in writing that the security-based swap transaction will be evaluated by an ERISA fiduciary provides the ERISA plan greater flexibility in structuring its relationship with the SBS Dealer. Moreover, these requirements, taken together, are designed to ensure that the ERISA fiduciary, not the SBS Dealer, is evaluating the security-based swap transaction on behalf of the ERISA plan. As an ERISA fiduciary is already required by statute to, among other things, act with prudence and loyalty when evaluating a transaction for an ERISA plan,[761] the Commission believes it is appropriate to provide the safe harbor for when an SBS Dealer would not be deemed to be acting as an advisor to the ERISA plan for purposes of this rule.

Under Rule 15Fh-2(a)(2), as adopted, an SBS Dealer can establish it is not acting as an advisor to any special entity (including a special entity that is an ERISA plan) when the special entity is relying on advice from a qualified independent representative that satisfies specific criteria. An SBS Dealer will not be “acting as an advisor” to any special entity (including a special entity that is an ERISA plan) if: (i) The special entity represents in writing that it acknowledges that the SBS Dealer is not acting as an advisor, and that the special entity will rely on advice from a qualified independent representative; and (ii) the SBS Dealer discloses that it Start Printed Page 30018is not undertaking to act in the best interests of the special entity.[762]

In adopting the safe harbor, the Commission agrees with commenters that the provisions in Rule 15Fh-2(a)(1)-(2) will reduce uncertainty regarding the role of an SBS Dealer when transacting with a special entity.[763] Requiring special entities (or their fiduciaries) to affirm in writing that they acknowledge the SBS Dealer is not acting as an advisor, and that they will instead obtain advice from a qualified independent representative, will help ensure that the parties are aware of their respective rights and obligations regarding a security-based swap transaction. While our rules would permit an SBS Dealer to rely on the special entity's (or its fiduciary's) written representations, the SBS Dealer's reliance must still be reasonable, as required under Rule 15Fh-1(b). Specifically, the SBS Dealer may not rely on a representation if the SBS Dealer has information that would cause a reasonable person to question the accuracy of the representation.[764] The requirement that a special entity or its fiduciary represents in writing that it acknowledges the SBS Dealer is not acting as an advisor differs from the proposed safe harbor, which would have required the special entity to represent that it would not rely on the SBS Dealer's recommendations. The Commission is making this change in response to a commenter's concern.[765] The Commission does not intend to affect the rights of parties in private actions.

The safe harbor under 15Fh-2(a)(2), as adopted, also differs from the proposed rule, which would have required that an SBS Dealer must have a reasonable basis to believe that the special entity is advised by a qualified independent representative. Rather, under adopted Rule 15Fh-2(a)(2)(i), the safe harbor requires written representations from the special entity that it will rely on advice from a qualified independent representative.[766] The Commission agrees with the commenter that requiring special entities to make representations to SBS Dealers in writing that they are relying on advice from a qualified independent representatives addresses the proposed rule's underlying policy concern—i.e., that the special entity is represented by a qualified independent representative.[767] Moreover, we believe that requiring special entities to effectively confirm that they have qualified independent representatives addresses the commenter's concern that the proposed rule would allow SBS Dealers to evaluate the qualifications of a special entity's independent representative and vest SBS Dealers with the authority to “trump” the special entity's choice of representative.[768] An SBS Dealer could rely on the special entity's written representations unless the SBS Dealer has information that would cause a reasonable person to question the accuracy of the representation, including the representation that the special entity is relying on advice from a qualified independent representative.

While we acknowledge commenters' concerns that the safe harbor might erode the statutory protections for special entities,[769] we also have considered the inherent tensions that arise where SBS Dealers have concurrent, potentially conflicting roles as advisor and counterparty to special entities. On the one hand, the SBS Dealer as advisor is subject to a duty to act in the “best interests” of the special entity. On the other hand, a broad application of the “best interests” standard could have the unintended consequences of chilling commercial communications, restricting customary commercial interactions, reducing market information shared with special entities, as well as reducing the ability of special entities to engage in security-based swaps. In adopting the safe harbor, we acknowledge the tension between the SBS Dealer's potentially conflicting roles as advisor and counterparty by recognizing that the special entity may be separately advised by a fiduciary or other qualified independent representative, who will act in the special entity's best interests.

We disagree with commenters that adoption of the safe harbor could cause special entities to waive their right to “best interests” standards or sign “boilerplate agreements” as a condition of transacting with SBS Entities.[770] Rather, the safe harbor reflects an approach that is conditioned upon the involvement of an ERISA fiduciary or other qualified independent representative that is otherwise required to act in the best interests of the special entity.

Although the safe harbor the Commission is adopting today largely aligns with that of the CFTC, it differs from that of the CFTC in four respects: (1) Rules 15Fh-2(a)(1)(ii) and 15Fh-2(a)(2)(i)(A) require the special entity or its fiduciary to represent in writing that it acknowledges the SBS Dealer is not acting as an advisor, whereas the CFTC requires the special entity or its fiduciary to represent it will not rely on the SBS Dealer's recommendations; [771] (2) Rules 15Fh-2(a)(1)(iii)(A) and (B) apply to any recommendation the special entity receives from the security-based swap dealer “involving” a security-based swap transaction, while the parallel CFTC rules apply to recommendations “materially affecting” a security-based swap transaction; [772] (3) Rule 15Fh-2(a)(1)(iii) requires a security-based swap transaction to be evaluated by a fiduciary before the transaction “is entered into,” whereas the CFTC's safe harbor requires a swap transaction to be evaluated by fiduciary before the transaction “occurs”; [773] and (4) the safe harbor in Rule 15Fh-2(a) does not prohibit an SBS Dealer acting as an advisor from expressing an opinion as to whether a special entity should enter into a recommended security-based swap or trading strategy.[774] The Commission believes it is appropriate to differ from the CFTC in these three discrete areas for the following reasons.

First, as discussed above, the Commission believes that replacing the requirement that the special entity or its fiduciary represent it will not “rely” on the SBS Dealer's recommendations with the requirement that the special entity or its fiduciary represent in writing that it acknowledges that the SBS Dealer is not “acting as an advisor” will afford special entities the same statutory protections. As noted above, the Commission is making this change in response to a commenter's concern.[775] The Commission does not intend to affect the rights of parties in private actions.

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Second, the Commission has determined to replace the phrase “materially affecting” with the word “involving” in relation to the recommendations that a special entity receives from an SBS Dealer. We believe that further clarification is needed in the context of Rule 15Fh-2(a)(1) to make clear that all recommendations made by the SBS Dealer are covered by this provision.

Third, the Commission has determined to use the phrase “is entered into,” as it is consistently used throughout the business conduct rules being adopted today.[776] However, because we also believe that the CFTC's usage of the word “occurs” was intended to have the same meaning as the phrase “is entered into,” we expect the practical effect of CFTC Regulation 23.440(b)(1)(iii) to be substantially the same as Rule 15Fh-2(a)(1)(iii).[777]

Fourth, the Commission declines to adopt the provision in CFTC Regulation 23.440(b)(2)(i), under which Swap Dealers seeking to avail themselves of the safe harbor would be precluded from “expressing an opinion” as to whether the special entity should enter into a recommended security-based swap or trading strategy. Under the rules adopted today, the determination of whether an SBS Dealer has provided advice to a special entity turns on whether a communication is considered a “recommendation,” not whether the SBS Dealer has “expressed an opinion.” Unlike the word “recommendation,” the phrase “express an opinion” is not defined or described in the federal securities laws in this context, and therefore may have other meanings that could cause confusion. Further, we also believe the concern that underlies the CFTC's provision (i.e., that the special entity obtain advice regarding a security-based swap from an ERISA fiduciary or other qualified independent representative) is sufficiently addressed by the requirement in Rules 15Fh-2(a)(1)-(2) that the special entity or its fiduciary represent that it acknowledges that the SBS Dealer is not acting as an advisor. It is therefore the Commission's view that prohibiting SBS Dealers from “expressing an opinion” would neither increase regulatory clarity regarding whether an SBS Dealer's conduct falls within the safe harbor, nor provide a corresponding increase in protection for special entities.

3. Definition of “Best Interests”

Exchange Act Section 15F(h)(4)(B) imposes on an SBS Dealer that “acts as an advisor” to a special entity a duty to act in the “best interests” of the special entity. In addition, Section 15F(h)(4)(C) requires the SBS Dealer that “acts as an advisor” to a special entity to make “reasonable efforts to obtain such information as is necessary to make a reasonable determination” that any swap recommended by the SBS Dealer is in the “best interests” of the special entity.[778] The term “best interests” is not defined in the Dodd-Frank Act, and the Commission did not propose to define “best interests.” In the Proposing Release, we noted that the “best interests” duty for an SBS Dealer acting as an advisor to a special entity “goes beyond and encompasses the general suitability requirement of proposed Rule 15Fh-3(f).” We sought comment on whether we should define the term “best interests,” and if so, whether such definition should use formulations based on the standards applied to investment advisers,[779] municipal advisors,[780] ERISA fiduciaries,[781] or some other formulation.

a. Proposed Rules

Proposed Rule 15Fh-4(b)(1) would generally require an SBS Dealer that acts as an advisor regarding a security-based swap to a special entity to act in the “best interests” of the special entity.

Proposed Rule 15Fh-4(b)(2) would require the SBS Dealer to make “reasonable efforts” to obtain the information necessary to make a reasonable determination that a security-based swap or trading strategy involving a security-based swap is in the best interests of the special entity, and that such information shall include but not be limited to: (i) The authority of the special entity to enter into a security-based swap; (ii) the financial status of the special entity, as well as future funding needs; (iii) the tax status of the special entity; (iv) the investment or financing objectives of the special entity; (v) the experience of the special entity with respect to entering into security-based swaps, generally, and security-based swaps of the type and complexity being recommended; (vi) whether the special entity has the financial capability to withstand changes in market conditions during the term of the security-based swap; and (vii) such other information as is relevant to the particular facts and circumstances of the special entity, market conditions and the type of security-based swap or trading strategy involving a security-based swap being recommended.Start Printed Page 30020

b. Comments on the Proposed Rules

The Commission received six comment letters on the imposition of a “best interests” standard.[782] One commenter argued that the Commission should define what it means to act in the “best interests,” and proposed that the definition must “be at least as strong as the concept of `best interest' [that] has evolved under the fiduciary principles applicable to investment [advisers].” [783] The commenter additionally requested that the Commission acknowledge “that the best interest standard intended by Congress is a fiduciary concept that goes well beyond suitability.” [784]

Similarly, a second commenter supporting a best interests standard stated it did not believe it was “necessary, or even appropriate,” to strictly define best interests.[785] The commenter asked the Commission to provide guidance on how to apply the standard in particular circumstances. This commenter asserted that Congress did not intend to apply the ERISA fiduciary standard, and argued that the intended model for the “heightened standard” was the Advisers Act fiduciary duty.[786] The commenter stated that Congress did not seek to eliminate all conflicts of interest but to ensure that such conflicts of interest would be appropriately managed and fully disclosed.[787] The commenter urged that in providing guidance in this area, it is important for the Commission to clarify that not all suitable recommendations would satisfy a best interest standard and that the best interest standard would impose a “heightened duty beyond mere suitability” and would require SBS Dealers to “recommend from among the various suitable options the approach they believe to be best for the special entity.” [788] In addition, the commenter stated that the guidance should “clarify that the best interest standard is consistent with various different methods of compensation and with proprietary trades, but that it requires the full disclosure of any conflicts of interest.” In the context of an SBS Dealer acting as an advisor and serving as a counterparty, the commenter suggested that the Commission clarify that it would not be inconsistent with the SBS Dealer's duty to act in the best interests of the special entity if the SBS Dealer, as principal, earned a reasonable profit or fee from transacting with the special entity.[789]

A third commenter asserted that Congress rejected the imposition of a fiduciary duty on SBS Dealers as incompatible with their role as market makers and asked the Commission to “respect Congressional intent” to protect the ability of end users and pension plans to transact in security-based swaps in a cost-effective manner by rejecting such a duty.[790]

Two additional commenters argued that an SBS Dealer that “acts as an advisor to a special entity” and complies with the “best interest” requirements might become an ERISA fiduciary under the DOL's proposed redefinition of the term “fiduciary.” [791] Accordingly, one of these commenters requested that the Commission clarify that compliance with the business conduct standards would not transform an SBS Dealer into a fiduciary under ERISA or under the final DOL regulation.[792]

One of these commenters also opposed the best interest requirement, and recommended that it be omitted from the final rules.[793] The commenter expressed its concern that “[r]equiring that an SBS Dealer act in the best interests of a counterparty who is a special entity would confuse the roles of the parties and have an adverse impact on the flow of information regarding investment and trading strategies.” [794] Additionally, if the requirement is retained, the commenter recommended that the term “best interests” be defined as complying with proposed Rule 15Fh-3(g) (fair and balanced communications),[795] and NASD Rule 2010(d), which would require that communications be based on principles of fair dealing and good faith, be fair and balanced, and provide a sound basis for evaluating the transaction.[796]

After the CFTC adopted its rules in 2012, one commenter asserted that “to promote legal certainty and the ability of SBS dealers to continue to trade with special entities, the SEC should provide guidance clarifying the nature of an SBS Dealer's `best interests' duty.” [797] Specifically, the commenter asserted that, to harmonize with CFTC guidance, the Commission should clarify that the best interest duty is not a fiduciary duty, but is rather a duty for the SBS Dealer to: (1) Comply with the requirement to make a reasonable effort to obtain necessary information; (2) act in good faith and make full and fair disclosure of all material facts and conflicts of interest with respect to the recommended security-based swap or related trading strategy; and (3) employ reasonable care that any recommendation made to the special entity be designed to further the special entity's stated objectives.[798] The commenter also suggested that, consistent with the CFTC's guidance, a recommendation need not represent the best of all possible alternatives to meet the best interest standard. Additionally, the commenter stated that the determination whether a recommendation is in a special entity's best interest should be based on the information known to the SBS Dealer at the time a recommendation was made.[799] Furthermore, according to the commenter, the best interest duty should not impede an SBS Dealer from negotiating the terms of a transaction in its own interests, or from making a reasonable profit in a transaction; nor should it impose an ongoing obligation on the SBS Dealer to act in the best interest of the special entity.[800] This commenter also suggested deleting the requirement under Rule 15Fh-4(b)(i) that the SBS Dealer “make reasonable efforts to obtain information regarding `the authority of the special entity to enter into a security based swap.' ” [801] Toward this end, the commenter argued that the CFTC eliminated this requirement as it was “duplicative” of the know your customer requirement under the CFTC's business conduct rules. As the commenter stated: “Since proposed Rule 15Fh3(e)(3) would require an SBS dealer to obtain this information, we believe the same considerations support eliminating that requirement here.” [802] Moreover, the commenter proposed a bifurcated treatment of ERISA and non-ERISA special entities under Rule 15Fh-5(a) to recognize the “unique fiduciary regime” already applicable to ERISA special entities, as well as to “reduce costs for special entities since most of them have Start Printed Page 30021already conformed their relationships with their representatives to satisfy the CFTC's qualification criteria.” [803]

c. Response to Comments and Final Rules

Upon consideration of commenters' views, the Commission is adopting Rules 15Fh-4(b)(1) and (2), regarding the “best interests” obligation for an SBS Dealer that acts as an advisor to a special entity regarding a security-based swap, with certain modifications.

Under Rule 15Fh-4(b)(1), as adopted, an SBS Dealer that acts as an advisor to a special entity will have a “duty to make a reasonable determination that any security-based swap or trading strategy involving a security based swap recommended by the security based swap dealer is in the best interests of the special entity.” We believe that this language, suggested by a commenter,[804] appropriately interprets the statutory requirements imposed on an SBS Dealer that is acting as an advisor to a special entity.[805] While the Commission is not specifically defining the term “best interests,” it is providing further guidance below regarding how an SBS Dealer that acts as an advisor to a special entity can comply with the duty to make a reasonable determination that a security-based swap or security-based swap trading strategy is in the “best interests” of the special entity.

Under Rule 15Fh-4(b)(2), as adopted, the advisor will be obligated to “make reasonable efforts to obtain such information that the security-based swap dealer considers necessary to make a reasonable determination that a security-based swap or trading strategy involving a security-based swap is in the best interests of the special entity.” Whether a recommended security-based swap or trading strategy is in the best interests of the special entity is based on information known to the advisor (after it has employed its reasonable efforts under Rule 15Fh-4(b)(2)) at the time the recommendation is made.

Various commenters questioned whether the “best interest” duty was tantamount to, or would give rise to, a “fiduciary duty.” [806] The Commission has considered commenters' views and the legislative history in regard to whether Section 15Fh-4 imposes a fiduciary duty.[807] As noted above, Rule 15Fh-4(b)(1), as adopted, requires that an SBS Dealer “make a reasonable determination that any security-based swap or trading strategy involving a security based swap recommended by the security based swap dealer is in the best interests of the special entity.” In response to comments, and for clarification, the determination whether a recommended security-based swap or trading strategy is in the “best interests” of the special entity will turn on the facts and circumstances of the particular recommendation and particular special entity. In response to a commenter, and as stated in the Proposing Release, we continue to believe that the “best interests” obligation for an SBS Dealer acting as an advisor to a special entity goes beyond and encompasses the general suitability requirements of Rule 15Fh-3(f).[808] The Commission generally believes that it would be difficult for an SBS Dealer acting as an advisor to a special entity to fulfill its obligations under Rule 15Fh-4(b)(1), as adopted, unless the SBS Dealer, at a minimum: (1) Complies with the requirement of Rule 15Fh-4(b)(2) that it make a reasonable effort to obtain necessary information to make a reasonable determination that a security-based swap or related trading strategy is in the best interests of the special entity; [809] (2) acts in good faith and makes full and fair disclosure of all material risks and characteristics of and any material incentives or conflicts of interest with respect to the recommended security-based swap; [810] and (3) employs reasonable care that any recommendation made to a special entity is suitable taking into account the information collected by the SBS Dealer pursuant to Rules 15Fh-3(f)(1)(ii) and 15Fh-4(b)(2), including the special entity's objectives.[811] In taking reasonable care that any recommendation made to a special entity is suitable, an SBS Dealer acting as an advisor to a special entity should consider, among other things, the fair pricing and appropriateness of the security-based swap or trading strategy, and must act without regard to its own financial or other interests in the security-based swap transaction or trading strategy.[812] As discussed below, this does not prevent an SBS Dealer from negotiating commercially reasonable terms or earning a profit.

In response to commenters' requests for clarification, we do not believe that, to act in the best interests of a special entity, an SBS Dealer acting as an advisor would be required to recommend the “best” of all possible alternatives that might exist.[813] The Start Printed Page 30022determination whether a recommended security-based swap is in the “best interests” of the special entity must be based on information known to the SBS Dealer, acting as an advisor, (after it has employed its reasonable efforts under Rule 15Fh-4(b)(2)) at the time the recommendation is made. We believe that a broader requirement could introduce legal uncertainty into the determination of what an SBS Dealer must do to fulfill its obligation under the rule, given the broad range of objectives for which a security-based swap might be used, and how such objectives may vary for different transactions. The Commission believes, however, that generally an SBS Dealer should consider, based on the information about existing alternatives known to the SBS Dealer, any reasonably available alternatives in fulfilling its best interests obligations.

For further clarification in response to comments, we believe that the “best interests” duty would not necessarily preclude an SBS Dealer from acting as a counterparty.[814] However, an SBS Dealer acting in both capacities would be required to comply with the full range of requirements under Rules 15Fh-4 and 15Fh-5, applicable to SBS Dealers acting as advisors and as counterparties to special entities. In addition to the substantive requirements, Rule 15Fh-5(c) would require that the SBS Dealer disclose to the special entity in writing the capacities in which is it acting, and the material differences between its capacities as advisor and counterparty to the special entity.

We also do not believe that the “best interests” duty would prevent an SBS Dealer from negotiating commercially reasonable security-based swap terms in its own interest,[815] or that it would preclude an SBS Dealer from making a reasonable profit or fee from a transaction with a special entity.[816] We do not believe that the profit motive inherent in any security-based swap transaction necessarily precludes an SBS Dealer, acting as an advisor, from fulfilling its “best interests” duty to a special entity, although it raises the potential for material conflicts that would need to be disclosed—particularly when the SBS Dealer is acting as both an advisor and a counterparty to the special entity. A prohibition on receipt of reasonable profits or fees would likely reduce SBS Dealers' willingness to act as advisors to and transact with special entities at the same time, and therefore could limit special entities' access to security-based swap transactions that might be necessary to their particular objectives.

As additional guidance in response to comments,[817] the “best interests” duty would not require the SBS Dealer acting as an advisor to undertake an ongoing obligation to act in the “best interests” of the special entity, unless such obligation is established through contract or other arrangement or understanding (e.g., a course of dealing). As noted above, Rule 15Fh-4(b), as adopted, requires an SBS Dealer to make a reasonable determination, after making reasonable efforts to obtain the necessary information, that a recommended security-based swap or related trading strategy is in the best interests of the special entity. Thus, the “best interests” duty applies only to recommendations by the SBS Dealer. For example, if an SBS Dealer makes a recommendation in connection with a material amendment to a security-based swap or a recommendation to terminate a security-based swap early, the “best interests” duty would apply. However, we note that an SBS Dealer would have an ongoing “best interests” duty if it were to assume the additional responsibility of monitoring a special entity's security-based swap transaction on an ongoing basis.

Commenters have suggested that we apply principles applicable to investment advisers under the Advisers Act in the “best interests” standard of Rule 15Fh-4(b).[818] As noted above in Section II.H.2.c.i., we believe that the protections included in the business conduct rules address the relationships between SBS Dealers and their special entity counterparties for which they act as advisors, so long as their activities are limited to those that would not, under the facts and circumstances, implicate other applicable law. However, as discussed in Section I.E, supra, the duties imposed on an SBS Dealer under the business conduct rules are specific to this context, and are in addition to any duties that may be imposed under other applicable law. Thus, an SBS Dealer must separately determine whether it is subject to regulation as a broker-dealer, an investment adviser, a municipal advisor or other regulated entity. We also decline to adopt a commenter's suggestion that we either omit the term “best interests” from the final rules, or state that “best interests” means complying with the fair and balanced communications requirements of Rule 15Fh-3(g) and FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade).[819] We do not believe that either approach would be consistent with the statute, which uses the terms “fair and balanced communications,” “fair dealing,” and “good faith” in separate provisions, indicating that they impose duties separate and apart from “best interests.” [820]

The Commission also has modified the information that an SBS Dealer must “make reasonable efforts to obtain” and consider in making its reasonable determination that a security-based swap or security-based swap strategy is in the “best interests of the special entity.” Specifically, Rule 15Fh-4(b)(2) now includes the special entity's hedging, investment, financing, or other stated objectives as information that shall be considered by the SBS Dealer in making this determination. The addition of “hedging” and “other” objectives in Rule 15Fh-4(b)(2)(iii) addresses a commenter's suggestion that these terms be included,[821] and recognizes that there may be a broader set of objectives for a special entity to enter into a security-based swap. The added language expressly recognizes special entities' use of security-based swaps to mitigate risk, as well as other possible uses for security-based swaps that might be necessary for a special entity to achieve these objectives. We believe that requiring an SBS Dealer to make reasonable efforts to obtain information about a wider array of possible investment objectives of special entities will allow SBS Dealers to more accurately determine a special entity's Start Printed Page 30023objectives in entering into a security-based swaps, which is one of the factors it must consider when making a best interest determination (as discussed above). Furthermore, as requested by a commenter, this change conforms the obligation under our rules with that under the rules of the CFTC.[822] Such conformity promotes regulatory consistency across the swap and security-based swap markets, particularly among entities that transact in both markets and have already established infrastructure to comply with existing CFTC regulations.

Furthermore, we reject the commenter's request to delete the requirement under proposed Rule 15Fh-4(b)(2)(i) that an SBS Dealer make reasonable efforts to obtain “information regarding the authority of the special entity to enter into a security-based swap.” [823] In so doing, we disagree with the commenter's assertion that the requirement under Rule 15Fh-4(b)(2)(i) is “duplicative” of the “know your counterparty” requirement of Rule 15Fh-3(e)(3), which, according to the commenter, already imposes an obligation on SBS Dealers to obtain information about the authority of the special entity to enter into a security-based swap. To the contrary, the know your customer requirements of Rule 15Fh-3(e)(3) require an SBS Dealer to learn “information regarding the authority of any person acting for such counterparty.” A determination regarding the authority of any person acting for a counterparty (under Rule 15Fh-3(e)(3)) is different from a determination regarding the authority of the counterparty itself to enter into a security-based swap itself (under Rule 15Fh-4(b)(2)(i)). The SBS Dealer's duty to act in the best interests of a special entity would encompass the requirement to ensure that a special entity has the requisite authority to enter into an SBS transaction. Moreover, the “know your counterparty” requirements of Rule 15Fh-3(e)(3) only apply to known counterparties.[824] Also, the “know your counterparty” requirements apply only to counterparties, whereas the requirements imposed on SBS Dealers that “act as an advisor” to special entities are not limited to special entities that are counterparties. Accordingly, we continue to believe that requiring SBS Dealers to obtain information regarding the authority of a special entity to enter into a security-based swap is not duplicative, but is necessary to achieving the overarching purpose of the rule: Determining whether a recommended security-based swap or related trading strategy is in the best interests of the special entity.

Lastly, as noted above, commenters requested that we clarify that an SBS Dealer that “acts as an advisor to a special entity” and complies with the “best interests” requirements of these business conduct standards will not necessarily become an ERISA fiduciary under the DOL's proposed (now final) redefinition of the term “fiduciary.” [825] As discussed in Section I.D, supra, DOL staff has provided the Commission with a statement that:

It is the Department's view that the draft final business conduct standards do not require security-based swap dealers or major security-based swap participants to engage in activities that would make them fiduciaries under the Department's current five-part test defining fiduciary investment advice. 29 CFR 2510.3-21(c). The standards neither conflict with the Department's existing regulations, nor compel security-based swap dealers or major security-based swap participants to engage in fiduciary conduct. Moreover, the Department's recently published final rule amending ERISA's fiduciary investment advice regulation was carefully harmonized with the SEC's business conduct standards so that there are no unintended consequences for security-based swap dealers and major security-based swap participants who comply with the business conduct standards. As explained in the preamble to the Department's final rule, the disclosures required under the SEC's business conduct rules do not, in the Department's view, compel counterparties to ERISA-covered employee benefit plans to make investment advice recommendations within the meaning of the Department's final rule or otherwise compel them to act as ERISA fiduciaries in swap and security-based swap transactions conducted pursuant to section 4s(h) of the Commodity Exchange Act and section 15F of the Securities Exchange Act of 1934.[826]

4. Antifraud Provisions

a. Proposed Rule 15Fh-4(a)

Proposed Rule 15Fh-4(a) would track the language of Section 15F(h)(4)(A) of the Exchange Act, and prohibit an SBS Entity from: (1) Employing any device, scheme, or artifice to defraud any special entity or prospective customer who is a special entity; (2) engaging in any transaction, practice, or course of business that operates as a fraud or deceit on any special entity or prospective customer who is a special entity; or (3) engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative. The first two provisions are specific to an SBS Entity's interactions with special entities, while the third applies more generally.

b. Comments on the Proposed Rule

The Commission received two comment letters on this issue.[827] The first commenter argued that the antifraud provisions of proposed Rule 15Fh-4(a) would be duplicative in light of the general antifraud and anti-manipulation provisions of the existing federal securities laws and proposed Rule 9j-1.[828]

The second commenter argued that, because the antifraud prohibitions of proposed Rule 15Fh-4(a)(3) were modeled on language in the Advisers Act applicable to conduct by investment advisers, and SBS Entities do not typically act as advisers to their counterparties, the SEC should include an affirmative defense against alleged violations of the antifraud prohibitions in its final rules.[829] Specifically, the commenter suggested that the Commission establish an affirmative defense for an SBS Entity that: (1) Did not act intentionally or recklessly in connection with such alleged violation; and (2) complied in good faith with written policies and procedures reasonably designed to meet the particular requirement that is the basis for the alleged violation.[830] The commenter noted that the CFTC included such a provision in its parallel business conduct rules, and urged the Commission to rely on the same considerations that led the CFTC to adopt its affirmative defense.[831]

c. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-4(a) as proposed. However, we are re-titling Rule 15Fh-4 “Antifraud provisions and Start Printed Page 30024special requirements for security-based swap dealers acting as advisors to special entities. We also are re-titling Rule 15Fh-4(a) “Antifraud provisions” and Rule 15Fh-4(b) “Special requirements for security-based swap dealers acting as advisors to special entities.”

Rule 15Fh-4(a) codifies the statutory requirements of Exchange Act Section 15F(h)(4)(A).[832] Inclusion of the rule in the business conduct standards will provide SBS Entities and their counterparties with easy reference to the antifraud provisions that Congress expressly provided under Section 15F(h)(4) of the Exchange Act. These requirements, which by their terms are applicable to all SBS Entities, apply in addition to those prohibitions imposed by Section 9(j) of the Exchange Act—along with any rules the Commission may adopt thereunder, and any other applicable provisions of the federal securities laws and related rules and regulations. The Commission is not adopting the commenter's recommendation that the final rules incorporate an affirmative “policies and procedures defense.” We recognize that the CFTC adopted an express, affirmative defense in its parallel antifraud rules, in part in response to concerns that the statute may impose non-scienter liability for fraud in private rights of action.[833] The Exchange Act, however, does not contain a parallel provision.[834] Moreover, the Commission has considered the concerns raised by commenters and determined not to provide a similar safe harbor from liability for fraud on behalf of SBS Entities. As discussed throughout the release in the context of specific rules, the rules being adopted today are intended to provide certain protections for counterparties, including certain heightened protections for special entities. We think it is appropriate to apply the rules so that counterparties receive the benefits of those protections, and therefore we do not think it would be appropriate to provide the safe harbor requested by the commenter from liability for fraud. While we are not adopting a safe harbor from liability for fraud, as discussed below in connection with the relevant rules, the Commission has adopted rules that permit reasonable reliance on representations (e.g., Rule 15Fh-1(b)) and, where appropriate, allow SBS Entities to take into account the sophistication of the counterparty (e.g., Rule 15Fh-3(f) (regarding recommendations of security-based swaps or trading strategies)).

5. SBS Entities Acting as Counterparties to Special Entities

a. Scope of Qualified Independent Representative Requirement

i. Proposed Rules

Under Exchange Act Section 15F(h)(5)(A), an SBS Entity that offers to enter into or enters into a security-based swap with a special entity must comply with any duty established by the Commission requiring the SBS Entity to have a “reasonable basis” to believe the special entity has an “independent representative” that meets certain qualifications. Proposed Rules 15Fh-2(c) and 15Fh-5(a) would implement this provision. In particular, proposed Rule 15Fh-2(c) would define an “independent representative,” and proposed Rule 15Fh-5(a) would require an SBS Entity that “offers to enter into” or enters into a security-based swap with a special entity to have a “reasonable basis” to believe that the special entity has a “qualified independent representative.”

ii. Comments on the Proposed Rule

Application to SBS Dealers and Major SBS Participants

Under proposed Rule 15Fh-5(a), an SBS Dealer or a Major SBS Participant that offers to enter into or enters into an SBS with a special entity must have a reasonable basis to believe that the special entity has a qualified independent representative. Although Exchange Act Section 15F(h)(2)(B) only imposes an express obligation on SBS Dealers to comply with the requirements of Section 15F(h)(5), we proposed to apply the qualified independent representative requirement to Major SBS Participants as well as SBS Dealers because the specific requirements under Section 15F(h)(5)(A) apply by their terms to both a “security-based swap dealer and major security-based swap participant that offers to or enters into a security-based swap with a special entity.” [835]

The sole commenter on this issue supported the proposed Rule, and agreed that it should apply to both SBS Dealers and Major SBS Participants.[836]

Application to Any Special Entity

In proposed Rule 15Fh-5(a), we proposed to apply the qualified independent representative requirements to transactions with all special entities. In the Proposing Release, we explained that while Exchange Act Section 15F(h)(5)(A) provides broadly that an SBS Entity that offers to or enters into a security-based swap with a special entity must comply with the requirements of that section, Section 15F(h)(5)(A)(i) on its face would apply these requirements only to dealings only with “a counterparty that is an eligible contract participant within the meaning of subclause (I) or (II) of clause (vii) of section 1a(18) of the Commodity Exchange Act.” A reliance on Section 15Fh(5)(A)(i) read in isolation would lead to an anomalous result in which special entity obligations could apply with respect to entities such as multinational and supranational government entities, which are ECPs “within the meaning of subclause (I) or (II) of clause (vii) of section 1a(18) of the Commodity Exchange Act,” but that do not fall within the definition of special entity in Section 15F(h)(2)(C). Conversely, Section 15Fh(5)(A)(i) read in isolation could lead to special entity obligations not being applied with respect to dealings with state agencies, which are special entities as defined in Section 15Fh(2)(C) but are not ECPs as defined in Section 1a(18)(A)(vii)(I) and (II) of the CEA.[837]

To resolve the ambiguity in the statutory language, we proposed to apply the qualified independent requirement under Section 15F(h)(5) to Start Printed Page 30025security-based swap transactions or offers to enter into security-based swap transactions between an SBS Entity and any counterparty that is a “special entity” as defined in Section 15F(h)(1)(C). This approach would address the statutory ambiguity by including dealings with a special entity that is an ECP within the meaning of subclause (I) or (II) of clause (vii) of Commodity Exchange Act Section 1a(18).[838] The Proposing Release noted that this reading would be consistent with the categories of special entities mentioned in the legislative history.[839] It also would give meaning to the requirement of Section 15F(h)(5)(A)(i)(VII) concerning “employee benefit plans subject to ERISA,” that are not ECPs within the meaning of subclause (I) or (II) of clause (vii) of section 1a(18) of the Commodity Exchange Act but are included in the category of retirement plans identified in the definition of special entity.[840]

The Commission received one comment letter that addressed the question of whether proposed Rule 15Fh-5(a) should apply to security-based swap transactions with any special entity.[841] According to the commenter, proposed Rule 15Fh-5(a) was overly broad in scope and ignored the limiting language of Section 15F(h)(5)(A). This commenter suggested interpreting the requirement as applying to only those referenced governmental entities that are special entities.” [842]

Application to “Offers”

As stated above, proposed Rule 15Fh-5(a) would apply to an SBS Dealer or Major SBS Participant that “offers to enter into” or enters into a security-based swap with a special entity. The Commission requested comment regarding whether the phrase “offers to enter into” a security-based swap was sufficiently clear, and if not, how the requirement should be clarified.[843] Three commenters responded to this request.[844]

One commenter suggested that the “offer” stage of a security-based swap transaction would often be too early for the counterparty to ensure that the independent representative requirement was satisfied.[845] Instead, the commenter argued that the independent representative requirement should be satisfied if the counterparty had an independent representative at the time the transaction was executed.[846] A second commenter recommended that the Commission exclude preliminary negotiations from the definition of “offer,” and that the communication of an interest in trading a security-based swap should only be viewed as an “offer” when, based on the relevant facts or circumstances, the communication was “actionable” or “firm.” [847] A third commenter asked that the Commission, like the CFTC, clarify the term “offer” to mean an “offer to enter into an SBS that, if accepted, would result in a binding contract under applicable law.” [848]

“Reasonable Basis”

The Commission additionally sought comment regarding the degree of inquiry required for an SBS Entity to form a “reasonable basis” to believe the special entity was represented by a qualified independent representative. Three commenters expressed concern with the additional duties of inquiry and diligence imposed on SBS Entities under proposed Rule 15Fh-5(a).[849] One of these commenters argued that the CFTC's proposed requirement that a Swap Dealer perform substantial diligence to confirm a swap advisor's qualifications could pose a serious conflict of interest, give the Swap Dealer too much power, and ultimately interfere with, prove more costly for, and be problematic to state or local governments.[850] Another commenter similarly argued that an inherent conflict of interest existed in granting one party to a transaction the authority to effectively determine who has the requisite qualifications to represent the other party.[851] The second commenter would impose additional due diligence obligations on SBS Entities before they could rely on special entities' representations regarding the qualifications of representatives, even where the SBS Entity does not have information that would cause a reasonable person to question the accuracy of the representations.[852] The commenter conceded that requiring such additional diligence might limit the willingness or ability of SBS Entities to provide special entities with access to security-based swaps. However, it argued that, in the absence of such diligence, special entities' access to security-based swaps should be limited to the extent suitability is in question.[853]

Other commenters expressed a range of views in response to our request for comment on whether an SBS Entity should be able to rely on representations to form the necessary “reasonable basis” for believing that a special entity counterparty is represented by a qualified independent representative. One commenter argued that no particular level of specificity should be required in the representations, and that the SBS Dealer should not be required to conduct further diligence before relying on the special entity's representations, as “any such diligence would interfere with the relationship between the special entity and its independent advisor and could result in the SBS Dealer second-guessing the special entity's choice of representative.” [854] Another commenter argued that an SBS Dealer should be required to rely on the representations of a special entity concerning the qualifications of its independent representative, absent actual knowledge of facts that clearly contradict material aspects of the representative's purported qualifications.[855]

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One commenter suggested adopting a presumption that the special entity's selection of independent representative was acceptable if the special entity represents to the SBS Entity that the representative satisfies the criteria in Exchange Act Section 15F(h)(5)(A)(i).[856]

Two other commenters supported the actual knowledge standard because they believe the reasonable person standard in practice could require an SBS Entity to perform substantial due diligence to rely on representations.[857] One commenter noted that this additional due diligence could reduce the number of SBS Entities willing to contract with special entities, and could increase the cost of security-based swaps for those persons.[858] The other expressed concern that additional due diligence, in the context of the qualifications of a special entity's independent representative, would be intrusive, time consuming and unnecessary, and would “come very close to having the SBS Dealer `approve' the special entity's representative.” [859] A third commenter expressed similar concerns, noting that absent actual knowledge that a representation is incorrect, SBS Dealers should not be able to second-guess a special entity's selection of a representative.[860]

Another commenter supported permitting an SBS Dealer to rely on a special entity's representation that its independent representative met the statutory and regulatory requirements, unless the SBS Dealer had reason to believe that the special entity's representations with respect to its independent representative were inaccurate.[861]

After the adoption of the CFTC's final rules, one commenter urged the Commission to adopt the CFTC's reasonable person approach, under which an SBS Entity would be deemed to have a reasonable basis to believe the special entity has a qualified independent representative when it relies on written representations that the special entity's representative meets the criteria for a qualified independent representative.[862] Alternatively, in the ERISA context, the commenter suggested that an SBS Entity be deemed to have a reasonable basis to believe a special entity subject to ERISA has a representative that satisfies the requirements for a qualified independent representative when it relies on written representations that the representative is a fiduciary as defined in Section 3 of ERISA.[863] The commenter's suggested modifications were intended to harmonize the SEC's standard with that adopted by the CFTC.[864]

Another commenter requested that the Commission clarify that any representations made by a special entity or its representative to satisfy the rules do not give any party any additional rights, such as rescission or monetary compensation (e.g., if the representations turn out to be incorrect).[865]

iii. Response to Comments and Final Rule

After consideration of the comments, we are adopting Rule 15Fh-5(a), subject to the modifications described below.

Application to SBS Dealers and Major SBS Participants

As a preliminary matter, we continue to believe and agree with the commenter that Rule 15Fh-5(a) should apply to both SBS Dealers and Major SBS Participants.[866] As discussed in Section II.C. above, in making this determination, the Commission recognizes that the statutory language of the business conduct standards generally does not distinguish between SBS Dealers and Major SBS Participants. Where the statute does make that distinction, the Commission also makes that distinction in the corresponding rule.[867] Here, we believe Congress intended to impose the independent representative requirement equally with respect to SBS Dealers and Major SBS Participants, since the specific requirements under Section 15F(h)(5)(A) of the Exchange Act apply by their terms to both “security-based swap dealer[s] and major security-based swap participant[s] that offer[ ] to or enter[ ] into a security-based swap with a special entity.” [868] We also believe that the protections of Rule 15Fh-5 should inure equally to those special entities that transact with SBS Dealers as well as those that transact with Major SBS Participants.

Application to Any Special Entity

Moreover, the Commission continues to believe that the qualified independent representative requirements in Rule 15Fh-5 should apply whenever an SBS Entity acts as a counterparty to any special entity. We acknowledge the commenter's suggestion that the Commission “give appropriate effect to the limiting language in Exchange Act Section 15F(h)(5)(A)” regarding the types of special entities to which the independent representative requirement applies.[869] However, given the ambiguity between the language of Sections 15F(h)(2)(C) and 15F(h)(5)(A)(i), we believe that our interpretation is appropriate and promotes a more consistent reading of both provisions of the statute, providing protections to all special entities.[870]

This interpretation also gives meaning to the requirement of Section 15F(h)(5)(A)(i)(VII) concerning “employee benefit plans subject to ERISA.” Although these benefit plans are not ECPs within the meaning of subclause (I) or (II) of clause (vii) of section 1a(18) of the Commodity Exchange Act, they are included in the category of plans identified as special entities in Exchange Act section 15F(h)(2)(C). For these reasons, we believe Rule 15Fh-5(a) should apply to any special entity as counterparty.Start Printed Page 30027

Application to Offers

The Commission continues to believe that, consistent with statutory language, the independent representative requirement of the business conduct rules should be triggered when an “offer” to enter into a security-based swap is made. We disagree with the commenter that applying Rule 15Fh-5(a) at the offer stage is premature.[871] The rules are intended to provide benefits to special entities by, among other things, requiring that a special entity has a qualified independent representative that undertakes a duty to act in its best interests in determining whether to enter into a security-based swap. The benefits of these protections could be lost if the rule were to require only that the special entity counterparty have an independent representative at the time the transaction is executed.[872]

Some commenters argued that the appropriate definition of the term “offer” should be consistent with contract law, and that a communication should only be considered an offer when, based on the relevant facts and circumstances, it is “actionable” or “firm.” [873] The Commission agrees with the commenter that the term “offer” for purposes of the independent representative requirement of these business conduct rules means an “offer to enter into a security-based swap that, if accepted, would result in a binding contract under applicable law.” [874] Given that the relationship between the SBS Entity and the counterparty is defined and shaped by contract (e.g., generally a master agreement and credit documents), we believe that the contractual interpretation is the appropriate interpretation in this context. This interpretation is also the same as the CFTC's interpretation of an offer to enter into a swap and would harmonize the scope of the term offer for purposes of the independent representative requirement of these business conduct rules.[875] We believe that this harmonization will result in efficiencies for entities that have already established infrastructure to comply with the CFTC standard.

Whether preliminary negotiations would be deemed an “offer” will depend upon the facts and circumstances and details of the communication.[876] For example, if the preliminary communication contains enough details (or if taken in the context of several communications) that, if accepted, would result in a binding contract, it likely may be an “offer” under the rule.

Reasonable Basis

The Commission recognizes and believes it appropriate that Rule 15Fh-5(a) imposes on SBS Entities a duty of inquiry to form a reasonable basis to believe the special entity has a qualified independent representative. The amount of due diligence the SBS Entity must perform to form a reasonable basis to believe the independent representative meets a particular qualification will depend upon the particular facts and circumstances. For example, if the SBS Entity has no prior dealings or familiarity with the particular independent representative, it will likely require more diligence on the part of the SBS Entity than a transaction with an independent representative that the SBS Entity has had numerous recent dealings in various different contexts. Furthermore, if the SBS Entity has dealt with the independent representative in other contexts, but not necessarily in the context of a security-based swap, it may require some limited diligence to form a reasonable basis regarding the requisite qualifications.

The Commission agrees, however, with the concerns of commenters that requiring SBS Entities to perform substantial due diligence regarding the qualifications of independent representatives may provide SBS Entities with the ability to second guess or negate the special entity's choice of independent representative, which may generally increase transaction costs for security-based swaps with special entities, and allow SBS Entities to exert undue influence over the special entity's selection of an independent representative.[877] To address these concerns, final Rule 15Fh-1(b), as discussed in Section II.D, allows SBS Entities to reasonably rely on written representations regarding the qualifications and independence of special entities' representatives.[878] This generally comports with an SBS Entity's heightened standard of care when transacting with special entities, while avoiding the potential conflict of interest and increased transaction costs that could result if SBS Entities effectively second-guessed special entities' choice of independent representatives. In addition, we are adopting safe harbors as discussed below, pursuant to which an SBS Entity will be deemed to have a reasonable basis to believe that the special entity has a representative that meets the qualification and independence requirements of Rule 15Fh-5(a). We believe the availability of the safe harbor also addresses the concerns of certain commenters that SBS Entities not exert undue influence on the special entity's selection of representative.[879]

The Commission acknowledges one commenter's recommended approach that would permit a special entity to choose between either: (1) Relying on the Commission's proposed framework regarding a reasonable basis to believe the qualifications of the independent representative; or (2) relying on an alternative approach under which it would be permitted to enter into off-exchange security-based swap transactions with an SBS Entity if the special entity had a representative, whether internal or a third party, that had been certified as able to evaluate security-based swap transactions. The commenter contemplated that the certification process would involve the development and implementation of a proficiency examination by the Commission or FINRA “or another recognized testing organization,” and that a certified independent representative would be required to complete periodic continuing education.[880] We do not believe that this suggested alternative would appropriately provide the protections to special entities that the statute and our proposed Rule 15Fh-5 were designed to provide. First, we believe that this alternative would effectively permit special entities to opt out of the express protections that the rules are intended to provide. In addition, we are not aware of the existence of a certification process as described by the commenter, and we did not propose and are not adopting such a process.[881]

As with final Rule 15Fh-2(a), we have determined to adopt Rule 15Fh-5(a) in a bifurcated format to avoid potential conflict with ERISA and DOL regulations, as well as to more closely harmonize with existing CFTC business conduct rules. Rule 15Fh-5(a)(1), as adopted, requires an SBS Entity that offers to enter into or enters into a security-based swap with a special entity other than an ERISA special entity to form a reasonable basis to believe that the special entity has a Start Printed Page 30028qualified independent representative. Rule 15Fh-5(a)(2), as adopted, requires an SBS Entity that offers to enter into or enters into a security-based swap with an ERISA special entity to have a reasonable basis to believe that the special entity has a fiduciary, as defined in Section 3 of ERISA. By adopting separate criteria for the independent representatives of ERISA and non-ERISA special entities, the Commission is addressing the concerns of numerous commenters that the business conduct standards, if adopted without regard for the potential regulatory intersections of ERISA, could cause confusion and unintended consequences for SBS Entities dealing with ERISA plans.[882] In addition, this change will provide greater consistency with the parallel CFTC rule, which will result in efficiencies for SBS Entities that have already established infrastructure to comply with the CFTC rule.

The newly bifurcated rule, detailing the requisite criteria for an SBS Entity to form a reasonable basis to believe that ERISA and non-ERISA special entities have qualified independent representatives, is discussed in greater detail below.

b. Qualified Independent Representative

i. Proposed Rule

Proposed Rule 15Fh-5(a)(6) would require an SBS Entity to have a reasonable basis to believe that, in the case of a special entity that is an employee benefit plan subject to ERISA, the independent representative was a “fiduciary” as defined in section 3(21) of that Act (29 U.S.C. 1002).[883] The proposed rule was not intended to limit, restrict, or otherwise affect the fiduciary's duties and obligations under ERISA.[884]

The Proposing Release solicited feedback regarding any specific requirements that should be imposed on SBS Entities with respect to this obligation, as well as what other independent representative qualifications might be deemed satisfied if an independent representative of an employee benefit plan subject to ERISA, is a fiduciary as defined in section 3 of ERISA.

ii. Comments on the Proposed Rule

The Commission received six comment letters advocating a presumption of qualification for ERISA plan fiduciaries, since ERISA already imposes fiduciary duties upon the person who decides whether to enter into a security-based swap on behalf of an ERISA plan, and imposes on this person a statutory duty to act in the best interests of the plan and its participants, thereby prohibiting certain self-dealing transactions.[885] According to these commenters, the Commission's proposed standards would be unnecessary, redundant, would overlap with ERISA's standards, and would only serve to increase the administrative burden and cost on SBS Entities without any corresponding benefit.[886]

To address the potential conflict with ERISA standards, one commenter suggested that the Commission's definition of “independent representative” should be inapplicable to ERISA plans, and that the Commission should merely cross-reference the requirements under ERISA for ERISA representatives.[887]

Another commenter supported the presumptive qualification for ERISA plan fiduciaries, provided that the plan satisfied a minimum $1 billion net asset requirement for institutional investor organizations.[888] The commenter asserted that no public policy objective would be achieved by permitting an SBS Entity to reject a risk manager fiduciary selected by a sophisticated institutional investor organization with over $1 billion in net assets, which did not require the protections of the rules.[889]

Since the adoption of the CFTC's final rules, another commenter recently advocated for the separate treatment of independent representatives of special entities subject to ERISA.[890] Under this commenter's proposal, an SBS Entity that transacts with a special entity subject to Title I of ERISA must have a reasonable belief that the qualified independent representative is a fiduciary, as defined in Section 3 of ERISA.[891] An SBS Entity that transacts with a non-ERISA special entity would be required to form a reasonable belief that the special entity has a qualified independent representative, defined by specific criteria. The commenter's proposed modification recognizes “the unique fiduciary regime already applicable to such special entities,” and harmonizes the Commission's criteria for qualified independent representatives with those of the CFTC.[892]

iii. Response to Comments and Final Rule

After consideration of the comments, the Commission is reformulating the rules to reflect a separate treatment for transactions with special entities subject to ERISA, and transactions with special entities other than those subject to ERISA. Toward this end, we have bifurcated Rule 15Fh-5(a) into parts (a)(1) (applicable to dealings with special entities other than those subject to ERISA), and (a)(2) (applicable to dealings with special entities subject to ERISA).

Under Rule 15Fh-5(a)(1), as adopted, an SBS Entity that transacts with a special entity that is not subject to ERISA must have a reasonable basis to believe that the special entity has a qualified independent representative. As defined in the rule, a qualified independent representative is a representative who: Has sufficient knowledge to evaluate the transaction and risks; is not subject to a statutory disqualification; 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; will provide written representations to the special entity regarding fair pricing and the appropriateness of the security-based swap; in the case of a special entity defined in 15Fh-2(2) or (5), is subject to pay to play rules of the Commission, the CFTC, or a SRO subject to the jurisdiction of the Commission or the CFTC; and is independent of the SBS Entity. These qualifications are addressed, separately, in Section II.H.7, infra.

Under new Rule 15Fh-5(a)(2), (formerly proposed Rule 15Fh-5(a)(6)), an SBS Entity that transacts with a special entity subject to ERISA must have a reasonable basis to believe that the special entity has a representative that is a fiduciary, as defined in Section 3 of ERISA.[893] In this regard, the SBS Entity need not undertake further inquiry into the ERISA fiduciary's qualifications. Such a presumption is based on the pre-existing, Start Printed Page 30029comprehensive federal regulatory regime governing ERISA fiduciaries.[894]

The Commission agrees with commenters that ERISA fiduciaries should be presumptively deemed qualified as special entity representatives,[895] particularly because an ERISA fiduciary is already required by statute and regulations to, among other things, act with prudence and loyalty when evaluating a transaction for an ERISA plan.[896] Moreover, as several commenters noted, to overlap existing ERISA standards with the business conduct standards would be unnecessary, redundant, and would unnecessarily increase administrative costs for SBS Entities.[897]

This bifurcated rule is designed to address the commenter's concerns regarding the need to align the Commission's treatment of ERISA plans with that of the CFTC,[898] and will reflect the potential intersection of the business conduct rules with the comprehensive framework of regulation under ERISA. Specifically, as discussed above in Section I.D., supra, the bifurcated format of the rule addresses the concerns of numerous commenters that the intersection between ERISA's existing fiduciary regulation and the business conduct standards could lead to conflict and unintended consequences for SBS Entities transacting with ERISA special entities, up to and including the preclusion of ERISA plans from participating in security-based swap markets in the future.[899] By providing separate means for SBS Entities to comply with the rules when transacting with ERISA and non-ERISA special entities, the final rule will avoid the potential conflict between the comprehensive framework of regulation under ERISA and business conduct rule regimes.

However, the Commission declines the commenter's suggestion to exclude ERISA plans with a minimum net asset requirement from the requirements of the rule.[900] Rule 15Fh-5 is designed to ensure that special entities are represented by a qualified independent representative pursuant to the statutory requirement. The Commission does not believe that it is appropriate in this context to provide an exception to ERISA plans from the protections of representation by a qualified and independent representative based on a net asset threshold. Different entities will have differing levels of understanding of the security-based swap market, which may or may not be impacted by the amount of their net assets. More generally, the rules are intended to provide certain protections to special entities, and we think it appropriate to apply the rules so that special entities receive the benefits of those rules.

c. Definition of “Independent Representative”

i. Proposed Rule

As noted above, an SBS Entity must have a reasonable basis to believe that a special entity has a “qualified independent representative.” Proposed Rule 15Fh-2(c) would establish parameters for the term “independent representative” of a special entity.

For instance, proposed Rule 15Fh-2(c)(1) would generally require that a representative of a special entity be “independent” of the SBS Entity that is the counterparty to a proposed security-based swap. Proposed Rule 15Fh-2(c)(2) would provide that a representative of a special entity is “independent” of an SBS Entity if the representative does not have a relationship with the SBS Entity, whether compensatory or otherwise, that reasonably could affect the independent judgment or decision-making of the representative. In the Proposing Release, the Commission noted that the SBS Entity should obtain the necessary information to determine if, in fact, a relationship existed between the SBS Entity and the independent representative that could impair the independence of the representative in making decisions that affect the SBS Entity.

Proposed Rule 15Fh-2(c)(3) would deem a representative of a special entity to be independent of an SBS Entity where two conditions are satisfied: (i) The representative is not and, within one year, was not an associated person of the SBS Entity; and (ii) the representative had not received more than ten percent of its gross revenues over the past year, directly or indirectly, from the SBS Entity. This latter restriction would apply, for example, with respect to revenues received as a result of referrals by the SBS Entity. It was intended to encompass situations where a representative was hired by the special entity as a result of a recommendation by the SBS Entity. The restriction would also apply to revenues received, directly or indirectly, from associated persons of the SBS Entity.

In order for an SBS Entity to reasonably believe that the independent representative received less than ten percent of its gross revenue over the past year from the SBS Entity, the Commission noted that the SBS Entity would likely need to obtain information regarding the independent representative's gross revenues from either the special entity or independent representative.

ii. Comments on the Proposed Rule Independence From the Special Entity

The Commission requested comment on whether an independent representative must be independent of the special entity entering into the security-based swap, or whether the representative need only be independent of the SBS Entity. All five commenters agreed that the independent representative need only be independent from the SBS Entity, and emphasized that the intent of the proposed rule was to ensure a special entity received advice from someone in no way affiliated with an SBS Entity.[901]

One commenter, representing two trade associations for municipal power producers, argued that the intended benefit of the proposed independent representative requirement was to ensure that a special entity receives security-based swap advice from a person other than the SBS Entity—not to force special entities to hire third-parties as independent representatives.[902] The commenter noted that although many municipal power producers rely on third-party advisors when entering interest-rate swaps, they have internal experts to advise them on energy contracts.

Another commenter asserted that the legislative history for Dodd-Frank indicated that a representative's “independence” referred to its independence from the dealer or broker—not its independence from the special entity.[903] The commenter pointed out that Congress specifically recognized the possibility that special entities would use an in-house risk specialist, and that the proposed rules Start Printed Page 30030seemed to incorporate this assumption.[904]

Standards for “Independence”

The Commission solicited comment regarding whether to adopt a different test for a representative's independence, or whether the definition of “independent representative” should exclude certain categories of associated persons. Eleven comment letters addressed the independence test in proposed Rule 15Fh-2(c)(2)-(3).[905]

Four commenters argued that the proposed rule would not sufficiently ensure a representative's independence.[906] For instance, one commenter suggested that the one-year prohibition on a representative being an associated person of the SBS Entity be extended to two years.[907] This commenter also recommended that representatives who receive any compensation of any kind, directly or indirectly, from an SBS Entity during the prior year be disqualified.[908] According to this commenter, representatives and associated persons should be barred from, directly or indirectly, working for or receiving compensation from any SBS Entities for one year to act as an independent representative for any special entity.[909]

Another commenter argued that under the proposed rule, a representative might be deemed to be independent even if he or she “worked with the SBS Entity as recently as a year ago, was recommended by the SBS Entity, has a direct business relationship with the SBS Entity that makes the representative highly financially dependent on that entity, and earns more of its revenues from the SBS Entity than from the Special Entity he or she purports to represent.” [910] This commenter also noted that, under the proposed rule, a representative could earn virtually all of its gross revenues from various SBS Entities, so long as no more than ten percent originated from the entity on the other side of the transaction. For these reasons, the commenter urged the Commission to adopt instead the version of the independence standard proposed by the CFTC, under which a representative would be deemed to be independent if: “(1) the representative is not and, within one year, was not an associated person of the swap dealer or major swap participant, within the meaning of Section 1a(4) of the Act; (2) there is no principal relationship between the representative of the Special Entity and the swap dealer or major swap participant; and (3) the representative does not have a material business relationship with the swap dealer or major swap participant, provided however, that if the representative received any compensation from the swap dealer or major swap participant, the swap dealer or major swap participant must ensure that the Special Entity is informed of the compensation and the Special Entity agrees in writing, in consultation with the representative, that the compensation does not constitute a material business relationship.” [911]

Similarly, since the adoption of the CFTC's final business conduct rules, one commenter has argued that the Commission should harmonize its standards of independence with those of the CFTC, replacing the SEC's restriction on revenues received by the independent representative from the SBS Entity with the following qualifications: (1) The representative is not, and within one year of representing the special entity in connection with the security-based swap, was not an associated person of the SBS Entity; (2) there is no principal relationship between the special entity's representative and the SBS Entity; (3) the representative provides timely and effective disclosures to the special entity of all material conflicts of interest, complies with policies and procedures designed to mitigate conflicts of interest, is not directly or indirectly controlled by the SBS Entity, and does not receive referrals, recommendations, or introductions from the SBS Entity within one year of representing the special entity in connection with the security-based swap.[912] As the commenter asserted, “the CFTC's standard has, in our members' experiences, proved sufficient to ensure the independence of special entity representatives and mitigate possible conflicts of interest, while also establishing an objective standard that special entities can apply in practice. As a result, we believe harmonization would achieve the proposed rules' intended objective while also minimizing the extent to which SBS Entities and special entities need to incur significant additional costs.” [913]

A third commenter suggested that the Commission revise the independence test for special entity representatives by: (1) Using ERISA standards in assessing the independence of a representative (but rejecting the DOL's fiduciary standard, under which a fiduciary may not derive more than 1% of its annual income from a party in interest and its affiliates); (2) considering a representative's relationships with an SBS Entity on behalf of multiple special entities, including the representative's relationships with an SBS Entity outside of the security-based swap transaction at issue; (3) including the revenues of an independent representative's affiliates in applying the gross revenues test; (4) decreasing the ten-percent gross revenue threshold; and (5) adopting a two-year timeframe (rather than one year) to determine whether a representative is independent of the SBS Entity.[914] The commenter argued that an independent representative should be permitted to receive compensation from the proceeds of a security-based swap, so long as the compensation was authorized by, and paid at the written direction of, the special entity.[915] However, the commenter did not believe that a special entity should be allowed to consent to an independent representative's conflicts of interest, even if fully disclosed, as such conflicts might still affect the independence of the representative.[916]

The sole commenter that supported the independence test as proposed did so on the grounds that market participants would benefit from the certainty of its safe harbor.[917]

Another commenter argued that the proposed rules' definition of “independent representative” should not apply to ERISA plans, as ERISA already defines the criteria for “independence” of a representative.[918] According to this commenter, if a plan's representative is not independent of the plan's counterparty, the transaction violates the prohibited transaction rules under ERISA section 406(b). Rather than Start Printed Page 30031adopt such overlapping regulations, the commenter suggested cross-referencing the independence requirements under ERISA. Otherwise, the prohibition on investment managers who receive revenues from SBS Dealers from serving as independent representatives could cause plans to lose their best investment managers and counterparties. Moreover, the commenter argued that “the administrative burden of applying the gross revenue test could in many cases be enormous at best and simply unworkable at worst.” [919]

However, the majority of commenters urged the Commission to modify the proposed independence standards. For instance, while one commenter supported the Commission's one-year prohibition on associated persons of SBS Entities serving as special entity representatives, the commenter suggested four changes to the gross revenues component of the proposed rule: (1) Only payments by or on behalf of the SBS Entity (not by or on behalf of any affiliates or other associated persons) should be taken into account; (2) the revenue computations should be based on the representative's prior fiscal year rather than a rolling twelve-month look-back to simplify the calculations and reduce compliance costs; (3) payments to any affiliate (other than a wholly-owned subsidiary) of the representative should not be taken into account for purposes of this test; and (4) an SBS Entity should be able to rely on representations from the representative as to its gross revenues and whether payments that have been made to the representative equal or exceed the ten percent threshold.[920]

Another commenter proposed reducing the one year disqualification period for association with the SBS Entity to six months.[921] This commenter also suggested excluding from the gross revenue test: (1) Income from referrals from the gross revenue test, because referrals “can be difficult to track;” and (2) income paid by an SBS Entity on behalf of the special entity.[922]

A third commenter generally opposed the proposed rule on the basis that it was unclear, would require costly enhancements to compliance systems, and “would be particularly problematic in instances where a corporate transaction changes the identity of associated persons during the look-back year.” [923] With respect to the first prong of the proposed rule, this commenter supported eliminating the one-year look back period, as it believed the costs of compliance with that provision would outweigh any benefits. Instead, the commenter argued that “independence” should be established if the representative is not an associated person of an SBS Entity at the time of the transaction.[924] With respect to the gross revenue test, the commenter argued that the term “indirect compensation” was vague, and that “determining what would comprise indirect compensation and establishing a compliance system to track that indirect compensation represents a significant and time consuming burden,” the expense of which would likely be passed on to special entities.[925] The commenter therefore suggested limiting the gross revenue test to direct revenue received by the representative from the SBS Dealer—and not its affiliates.[926]

A fourth commenter objected to the compliance burdens raised by the proposed rule, as well as various implementation concerns on the grounds that both prongs of the test were “moving targets” that would substantially complicate compliance and impose additional burdens and costs on advisors and special entities.[927] The commenter recommended that the Commission eliminate the twelve-month “look-back” provision altogether, but argued that if the Commission retained this provision, it should apply only where a continuing agreement exists between the representative and the SBS Entity (such as an ongoing corporate services agreement), that the one-year period be defined as a calendar year rather than a rolling twelve-month period, and that it should only be triggered by the SBS Entity and the representative—not by any associated persons of the SBS Entity or the representative.[928] This commenter additionally urged the Commission to eliminate the gross revenue test on the grounds that it was unduly restrictive and difficult to apply. However, if the Commission retained the gross revenue test, the commenter requested that the final rule clarify how gross revenues are to be calculated.[929]

Another commenter argued that the final version of proposed Rule 15Fh-2(c) clarify that the ten percent gross revenue test would not apply to any independent representative employed by the special entity, as such a prohibition would be inappropriate.[930] The commenter also suggested that the prohibition on independent representatives who have worked for an SBS Entity within the past year should not apply if the independent representative is an employee of the special entity, who owes the special entity a fiduciary duty.[931] The commenter asserted that if an independent representative is an employee of and owes a fiduciary duty to an institutional investor organization, an SBS Entity should have no authority to assess the representative's qualifications. The commenter pointed out that, as a fiduciary, the employee's prior employment by an SBS Entity would be irrelevant—since any actual breach of fiduciary duty would be governed by the special entity's charter, state law or other applicable legal requirements, rather than the Dodd-Frank Act.[932]

iii. Response to Comments and Final Rule

After consideration of the comments, the Commission is adopting Rule 15Fh-2(c), with certain modifications. First, we moved the rule defining the “independence” of a special entity's representative from Rule 15Fh-2 to Rule 15Fh-5 in an effort to minimize confusion, and to consolidate the requirements of the qualified independent representative into Rule 15Fh-5. Specifically, the Commission is renumbering proposed Rule 15Fh-2(c) as Rule 15Fh-5(a)(1)(vii). In doing so, we have subsumed the requirement that a representative be independent of the SBS Entity under the criteria for a special entity's qualified independent representative.

Consistent with our proposal and with comments received, we continue to believe that a qualified independent representative should be independent of the SBS Entity, but need not be independent of the special entity itself.[933] We do not believe that special entities would receive any greater protection by being required to incur the cost of retaining a representative that was independent of the special entity; in fact, the special entity may be better served by someone who has an ongoing relationship with it and is more familiar with the uses of the proceeds of the swap and other needs of the special entity. Although the Dodd-Frank Act is Start Printed Page 30032silent concerning the question of independence from the special entity, nothing in the Dodd-Frank Act precludes the use of a qualified independent representative that is affiliated with the special entity. Accordingly, Rule 15Fh-5(a)(1) only requires that the independent representative be independent of the SBS Entity to be a qualified independent representative.

We are adopting Rule 15Fh-5(a)(1)(vii) (formerly proposed Rules 15Fh-2(c)(1) and (2)) with one modification. Proposed Rule 15Fh-2(c)(1) defined an independent representative of a special entity, in part, as “independent of the security-based swap dealer or major security-based swap participant that is the counterparty to a proposed security-based swap.” Rule 15Fh-5(a)(1)(vii) as adopted eliminates the phrase “that is the counterparty to a proposed security-based swap” from the definition. As described immediately below, this change is intended to reconcile the use of the term “qualified independent representative” in Rules 15Fh-5(a)(1) and 15Fh-2(a)(2) as adopted.

Specifically, Rule 15Fh-2(a)(2) as proposed and as adopted, under which an SBS Dealer may seek to establish that it is not acting as an advisor to a special entity, refers to the definition of “qualified independent representative” as defined in Rule 15Fh-5(a).[934] However, although the relevant part of the definition of the term “independent representative of a special entity” in proposed Rule 15Fh-2(c)(1) included the phrase “that is a counterparty to a proposed security-based swap,” the requirements in Rule 15Fh-2(a)(2) (as proposed and as adopted) are not limited to transactions in which the SBS Dealer is a counterparty to the special entity with respect to the security-based swap. Thus, as noted, we are eliminating the phrase “that is the counterparty to a proposed security-based swap” in Rule 15Fh-5(a)(1)(vii) as adopted to reconcile the cross reference to the term “qualified independent representative” in Rule 15Fh-2(a)(2).

This change will not alter the scope of Rule 15Fh-5(a) as adopted, because that rule is only applicable to an SBS Entity acting as counterparty to a special entity. It will, however, align the definition of qualified independent representative with the scope of Rule 15Fh-2(a), which applies to recommended transactions whether or not the SBS Dealer is a counterparty to the recommended security-based swap. As a result, there must always be someone independent of the SBS Dealer reviewing any recommended security-based swap transaction on behalf of the special entity, whether or not the SBS Dealer making the recommendation is the counterparty to the transaction. Furthermore, the elimination of the phrase “that is the counterparty to a proposed security-based swap” in the rule as adopted will harmonize the rule more closely with the parallel CFTC requirement.

Under Rule 15Fh-5(a)(1)(vii)(A) as adopted, a representative of a special entity is independent of an SBS Entity if the representative does not have a relationship with the SBS Entity, “whether compensatory or otherwise, that reasonably could affect the independent judgment or decision-making of the representative.” Rule 15Fh-5(a)(1)(vii)(B) (as adopted) modifies the criteria for determining the independence of the representative that was proposed in proposed Rule 15Fh-2(c)(3) by replacing the ten percent gross revenues test with requirements for timely disclosures of all material conflicts of interest and a prohibition against referrals, recommendations or introductions by the SBS Entity within one year of the representative's representation of the special entity. Under Rule 15Fh-5(a)(1)(vii)(B) as adopted, a representative of a special entity will be deemed to be independent of an SBS Entity if three conditions are met: (1) The representative is not and, within one year of representing the special entity in connection with the security-based swap, was not an associated person of the SBS Entity; (2) the representative provides timely disclosures to the special entity of all material conflicts of interest that could reasonably affect the judgment or decision making of the representative with respect to its obligations to the special entity and complies with policies and procedures reasonably designed to manage and mitigate such material conflicts of interest; and (3) the SBS Entity did not refer, recommend, or introduce the representative to the special entity within one year of the representative's representation of the special entity in connection with the security-based swap.

Rule 15Fh-5(a)(1)(vii)(B)(1) (formerly proposed Rule 15Fh-2(c)(2)) requires that the independent representative is not and was not an associated person of the SBS Entity “within one year of representing the special entity in connection with the security-based swap.” One commenter agreed with the one-year time frame in this provision.[935] One commenter suggested that one year was not long enough and suggested a two-year look back [936] and another commenter suggested that one year was too long and suggested a six-month look back.[937] After consideration of the comments, the Commission continues to believe that an appropriate amount of time is necessary to “cool off” any association with an SBS Entity before being considered independent of the SBS Entity, and believes that a one-year period between being an associated person of an SBS Entity and functioning as an independent representative is an appropriate amount of time. We disagree with the commenter that a shorter six-month look back would be appropriate, as we believe that a one-year cooling off period provides greater assurances of independence. At the same time, we do not want to unnecessarily place lengthy restrictions on a representative's ability to work as an independent representative or unnecessarily restrict a special entity's access to qualified independent representatives. For this reason, we believe that a one year restriction strikes an appropriate balance. In addition to the comments received, we note that many market participants have established compliance policies and procedures to address a one-year look-back to comply with the CFTC rule that requires that the independent representative was not an associated person of the Swap Entity within the preceding twelve months or the independent representative complied with policies and procedures reasonably designed to manage and mitigate the conflict of being an associated person within the last twelve months.[938]

Rule 15Fh-5(a)(1)(vii)(B)(2) adds the new requirement that a representative must provide timely disclosures to the special entity of all material conflicts of interest that could reasonably affect the judgment or decision making of the representative regarding its obligations to the special entity, and the representative must comply with policies and procedures reasonably designed to manage and mitigate such material conflicts of interest. This requirement establishes a standard that is designed to support the development of an SBS Entity's reasonable belief regarding the independence of the representative advising a special entity. One commenter recommended adopting Start Printed Page 30033such a requirement, asserting that the CFTC standard, including the requirement for timely disclosures has, in their “members' experiences proved sufficient to ensure the independence of special entity representatives and mitigate possible conflicts of interest, while also establishing an objective standard that special entities can apply in practice.” [939] In addition, harmonization with the parallel CFTC rule will result in efficiencies for SBS Entities that have already established infrastructure to comply with the CFTC rule.

In the Commission's view, to be “timely,” a representative's disclosures must allow the special entity sufficient opportunity to assess the likelihood or magnitude of a conflict of interest prior to entering into the security-based swap.

To determine which conflicts of interest disclosures are required, an SBS Entity generally would need a reasonable basis to believe that the representative reviewed its relationships with the SBS Entity and its affiliates, including lines of business in which the representative solicits business. Additionally, where applicable, the SBS Entity generally would also need a reasonable basis to believe the representative reviewed the relationships of its principals and employees, who could affect the judgment or decision making of the representative on behalf of the special entity.

Lastly, Rule 15Fh-5(a)(1)(vii)(B)(3) replaces the proposed “gross revenues” test with a standard under which a representative will not be deemed independent if the SBS Entity refers, recommends, or introduces the representative to the special entity within one year of the representative's representation of the special entity in connection with the security-based swap. The change is intended to provide a simpler standard for achieving the policy goal that a special entity's choice of representative and the advice the representative provides should be made without any influence or input from the SBS Entity.

In making this modification to the rule as adopted, the Commission seeks to address commenters' concerns about cost, clarity, and practicality.[940] Commenters had expressed concerns regarding the gross revenues test and an SBS Entity's ability to accurately track the revenues.[941] One commenter suggested eliminating the gross revenues standard altogether.[942] After consideration of the comments, the Commission believes that the disclosures provided and the prohibition against referrals, recommendations or introductions adequately addresses concerns regarding independence more simply and directly than the proposed “gross revenues” test.[943] Furthermore, this prohibition harmonizes the Commission's standards for the independence of the representative with those of the CFTC.

6. Qualifications of the Independent Representative

Proposed Rules 15Fh-5(a)(1)(i)-(vii) would list the required qualifications of a special entity's independent representative. The qualifications would be that the independent representative: (1) Has sufficient knowledge to evaluate a security-based swap and its risks; (2) is not subject to statutory disqualification; (3) will undertake a duty to act in the best interests of the special entity; (4) makes appropriate and timely disclosures to the special entity of material information concerning the security-based swap; (5) will provide written representations to the special entity regarding fair pricing and the appropriateness of the security-based swap; (6) (in the case of employee benefit plans subject to ERISA) is a fiduciary as defined in ERISA; and (7) is subject to the pay to play prohibitions of the Commission, the CFTC, or an SRO that is subject to the jurisdiction of the Commission or the CFTC. Each of these proposed qualifications is discussed in turn below.

As discussed above in Section II.H.5.a.iii.B and more fully below, the rules as adopted will distinguish between transactions with special entities subject to ERISA, and transactions with special entities other than those subject to ERISA. Specifically, Rule 15Fh-5(a)(1) as adopted addresses the qualifications for the independent representatives of special entities other than those subject to regulation under ERISA, and Rule 15Fh-5(a)(2) as adopted addresses the qualifications for independent representatives of special entities subject to regulation under ERISA.

a. Written or Other Representations Regarding Qualifications

i. Proposal

In the Proposing Release, the Commission also requested comment regarding whether independent representatives must furnish written representations about their qualifications, or whether the rules should permit other means of establishing that a special entity's independent representative possessed the requisite qualifications.

ii. Comments on the Proposal

The Commission received three comment letters on this point, all in favor of a written representation requirement.[944] Although one such commenter agreed that written representations should be sufficient to ensure that a qualified independent swap advisor had been hired, the commenter proposed that the written representations include a verification that the external swap advisor had registered with and met professional standards set by the appropriate regulatory body overseeing swap advisors.[945] According to the commenter, this would provide for independent verification that was not associated with the SBS Dealer or the Start Printed Page 30034special entity, thereby minimizing any potential conflict of interests.[946]

Another commenter suggested that, in the case of an internal representative, written representations should be obtained either from the representative or from the special entity, or a combination of the two, depending on the circumstances.[947] In the case of third-party representatives, the commenter suggested that the third-party representative provide the statement either directly to the SBS Entity or to the special entity acknowledging that the statement would be relied on by SBS Entities for purposes of the business conduct rules.[948]

iii. Response to Comments and Final Rule

After considering the comments, the Commission has determined not to mandate a manner of compliance with the requirements of Rule 15Fh-5(a). As discussed above, the obligation is on the SBS Entity to have a reasonable basis for believing that an independent representative has the necessary qualifications. An SBS Entity may use various means, such as reliance on representations from the special entity or its representative or due diligence, to form its reasonable basis to believe the special entity's independent representative meets the qualifications outlined in Rule 15Fh-5(a).

When an SBS Entity is relying on representations from a special entity or its representative to satisfy the requirements of the rule, the requirements of Rule 15Fh-1(b) will apply.[949] Consistent with our approach to representations used to make institutional suitability determinations, we believe that parties should be able to make representations regarding the knowledge and qualifications of the independent representative on a transaction-by-transaction basis, on an asset-class-by-asset-class basis, or broadly in terms of all potential transactions between the parties. However, where there is an indication that the independent representative is not capable of independently evaluating investment risks, or does not intend to exercise independent judgment regarding all of an SBS Entity's recommendations, the SBS Entity necessarily will have to be more specific in its approach. For instance, in some cases, an SBS Entity may be unable to determine that an independent representative is capable of independently evaluating investment risks with respect to any security-based swap. In other cases, the SBS Entity may determine that the independent representative is generally capable of evaluating investment risks with respect to some categories or types of security-based swaps, but that the independent representative may not be able to understand a particular type of security-based swap or its risk.

b. Sufficient Knowledge To Evaluate Transaction and Risks

i. Proposed Rule

Proposed Rule 15Fh-5(a)(1) would require an SBS Entity to have a reasonable basis to believe that the independent representative has sufficient knowledge to evaluate the security-based transaction and related risks.

ii. Comments on the Proposed Rule

The Proposing Release solicited comment regarding what circumstances, if any, would give rise to a presumption of qualification for certain independent representatives other than ERISA fiduciaries.

Presumptive Qualification

Two commenters supported a finding of presumptive qualification for sophisticated, professional advisers, such as banks, Commission-registered investment advisers, registered municipal advisors, or other similarly qualified professionals.[950] The commenter stated its view that applicable federal and/or state regulations governing these entities already impose requirements that ensure a minimum qualification level, and any additional evaluation of such representatives' qualifications would add little or no value to a special entity's representative selection process.[951]

Other commenters supported the presumption of qualification for in-house representatives of a special entity, since those representatives should presumably act in the best interests of the special entity by virtue of their employment with the special entity.[952] More specifically, one commenter supported this presumption on the grounds that the representative had been hired by the special entity to perform a hedging and risk control function, that he or she would be subject to direct control by his or her employer, and that he or she would be subject to regular review.[953] Another commenter supported this presumption so long as the in-house representative met established requirements for qualification, testing and continuing education.[954]

Similarly, one commenter supported the presumption of qualification for independent representatives where a governmental entity had verified the qualifications of its independent representative employee through the hiring process.[955]

Registration of Representative as Municipal Advisor or Investment Adviser

In the Proposing Release, the Commission asked whether to require that an independent representative be registered as a municipal advisor or an investment adviser or otherwise subject to regulation, such as banking regulation.[956] Three commenters expressed some support for the proposed registration requirement for independent representatives,[957] while one commenter opposed it.[958]

The first commenter supporting the registration requirement suggested that the written representations regarding a representative's qualifications include a verification that the external swap advisor had registered with and met professional standards set by the appropriate regulatory body overseeing swap advisors.[959]

Another commenter supported the requirement that independent representatives be registered with the Commission as municipal advisors or Start Printed Page 30035investment advisers, or that they otherwise be subject to regulation, such as banking regulations, under which the independent representative would be bound by a fiduciary duty of loyalty and care at all times.[960]

The third commenter requested that the Commission establish a safe harbor permitting an SBS Entity to conclude that the special entity's representative was “qualified” (but not necessarily “independent”) if the representative was a registered municipal advisor or an SEC-registered investment adviser that provides investment advice with respect to security-based swaps (or a foreign entity having an equivalent status abroad).[961]

As noted above, one commenter opposed requiring employees of a special entity to register in any capacity, and suggested that any requirement to register third-party representatives should first be issued in the form of a notice of proposed rulemaking.[962]

Proficiency Examination

In the Proposing Release, the Commission requested comment regarding whether a proficiency examination should be developed to assess the qualifications of independent representatives. Four commenters supported the development and usage of a proficiency examination,[963] while one commenter opposed any proficiency examination for in-house representatives.[964]

One commenter, advocating for a proficiency examination, argued that such testing should be mandatory for both in-house and third-party representatives.[965] Another commenter suggested that the proficiency examination could be developed by the Commission, an SRO (e.g., FINRA), or another recognized testing organization.[966] Furthermore, after passing the examination, this commenter suggested that an independent representative be required to complete periodic continuing education.[967]

On the other hand, one commenter opposed any proficiency examination for in-house representatives, and argued that a proficiency exam for third-party representatives might provide a false sense of expertise.[968] This commenter also expressed concern that an examination requirement might, directly or indirectly, impose additional costs or burdens on special entities or SBS Entities.[969]

Periodic Re-Evaluation of Qualifications

In the Proposing Release, the Commission asked whether an SBS Entity should be required to reevaluate (or, as applicable, require a new written representation regarding) the qualifications of the independent representative on a periodic basis.

The Commission received three comment letters in response to the request for comment.[970] The first commenter viewed the reevaluation of a representative's qualifications as unnecessary if independent representatives were subject to continuing education and periodic testing requirements.[971] Another commenter suggested that the Commission permit the representations regarding a representative's qualifications to be set forth in a letter that could be relied on for the duration of a swap master agreement.[972] However, this commenter acknowledged a value in requiring periodic re-certification for third-party representatives, and recommended that such re-certification occur every two years.[973] The third commenter was concerned that trade-by-trade documentation of the independent representative criteria could reduce the speed of trade execution for special entities and add compliance burdens to each transaction.[974] This commenter requested that the Commission clarify that an SBS Dealer may meet its burden of confirming the qualifications of an independent representative through appropriate representations provided by the special entity no more frequently than annually.[975]

iii. Response to Comments and Final Rule

Upon consideration of the comments, the Commission is adopting Rule 15Fh-5(a)(1)(i) (formerly proposed Rule 15Fh-5(a)(1)), as proposed.

Rule 15Fh-5(a)(1)(i) as adopted requires that SBS Entities have a reasonable basis to believe that the independent representative has sufficient knowledge to evaluate the transaction and risks. The independent representative may be required to register by the statutes and rules of another regulatory regime, such as municipal advisor or investment adviser, and nothing in the business conduct standards modifies or otherwise alters those registration requirements. Whether or not an independent representative is otherwise registered under a different regulatory regime may inform the SBS Entity's view of the independent representative's knowledge and qualifications, but would not automatically satisfy the qualification requirements of the independent representative. For example, an independent representative registered as an investment adviser may be very knowledgeable with respect to a variety of asset classes that do not include security-based swaps.

While some commenters supported the development of a proficiency examination, we are neither developing nor requiring that a proficiency examination be developed to assess the qualifications of independent representatives.[976] As noted above, an SBS Entity may reasonably rely on written representations about the qualifications of the independent representative to satisfy this obligation. In this regard, the Commission believes that the framework of Rule 15Fh-5(a)(1) provides an appropriate criteria for assessing the qualifications of special entity representatives.[977]

As discussed below, we are separately providing in new Rule 15Fh-5(a)(2) that the qualified independent representative requirement will be satisfied if a special entity that is subject to regulation under ERISA has a representative that is a fiduciary as defined in Section 3 of ERISA. We recognize that Congress has established a comprehensive federal regulatory framework that applies to plans subject to regulation under ERISA.[978] Such recognition of the federal regulatory framework for ERISA plans maintains statutory protections for ERISA plans, while addressing the potential conflict, recognized by commenters, between the Start Printed Page 30036ERISA rules and business conduct standards adopted today.[979]

Commenters have suggested various time frames in which an independent representative's qualifications should be confirmed or recertified.[980] Whether or not an independent representative's qualifications should be periodically re-evaluated will likely be dependent on whether it is reasonable for the SBS Entity to continue to rely on the representations regarding the independent representative's qualifications. The Commission recognizes the potential benefit of requiring periodic re-evaluation, but is also mindful of the costs of doing so. The Commission has determined that it is appropriate to allow the SBS Entity to determine the necessity for a re-evaluation based on the reasonableness of its reliance on the representations it receives from the special entity regarding the qualifications of the independent representatives, which will provide the SBS Entities and the special entities with flexibility to address their particular facts and circumstances while still affording the special entities the protections of the rules.[981]

c. No Statutory Disqualification

i. Proposed Rule

Proposed Rule 15Fh-5(a)(2) would require an SBS Entity to have a reasonable basis to believe that an independent representative is not subject to a statutory disqualification. Although Exchange Act Section 15F(h) does not define “subject to a statutory disqualification,” the term has an established meaning under Section 3(a)(39) of the Exchange Act,[982] which defines circumstances that would subject a person to a statutory disqualification with respect to membership or participation in, or association with a member of, an SRO. While Section 3(a)(39) would not literally apply here, the Commission proposed to define “subject to a statutory disqualification” for purposes of proposed Rule 15Fh-5 by reference to Section 3(a)(39) of the Exchange Act.

ii. Comments on the Proposed Rule

In the Proposing Release, the Commission solicited comment regarding whether it should require an SBS Entity to check publicly available databases, such as FINRA's BrokerCheck and the Commission's Investment Adviser Public Disclosure program, to determine whether an independent representative was subject to a statutory disqualification.

The Commission received two comment letters on this issue. To minimize the degree of diligence imposed on SBS Dealers, one commenter suggested requiring third-party representatives to affirm that they are not subject to statutory disqualification, are not under investigation, and are not listed on the publicly available databases described above.[983]

After the adoption of the CFTC's final rules, the Commission received one comment letter addressing the definition of “statutory disqualification in the Proposing Release.” [984] This commenter stated that, although the statutory disqualification standards under the Exchange Act and the CEA differ somewhat, both cover comparable types of disqualifying events.[985] Therefore, requiring a dual registrant to apply different standards for statutory disqualification “would impose substantial and duplicative diligence documentation, without material countervailing benefits.” [986] To avoid this conflict, the commenter suggested including language to accommodate dually registered SBS Entities by establishing a safe harbor where they are deemed to have a reasonable basis to believe that a person is not subject to statutory disqualification under the Exchange Act if the dually registered SBS Entity has a reasonable basis to believe that the person is not subject to statutory disqualification under the CEA.[987] According to the commenter, this would allow dually registered SBS Entities to determine whether a special entity's representative is subject to statutory disqualification based on the information it obtained to ensure compliance with the parallel CFTC business conduct rule.[988]

iii. Response to Comments and Final Rule

The Commission is adopting proposed Rule 15Fh-5(a)(2), renumbered as Rule 15Fh-5(a)(1)(ii), as proposed, with one modification. The Commission is incorporating the definition of “statutory disqualification” under Section 3(a)(39)(A)-(F) of the Exchange Act, whereas the proposed rule incorporated the definition under Section 3(a)(39) of the Exchange Act.

Exchange Act Section 15F(h) does not define “subject to a statutory disqualification,” however Exchange Act Section 3(a)(39) defines the term “statutory disqualification.” As discussed in the SBS Entity Registration Adopting Release, the definition in Exchange Act Section 3(a)(39) specifically relates to persons associated with an SRO. In recognition of the fact that an independent representative of a special entity may not be associated with an SRO, we have modified the text of proposed Rule 15Fh-2(f) to reference Sections 3(a)(39)(A)-(F) of the Securities Exchange Act of 1934. This updated cross-reference incorporates the underlying issues that give rise to statutory disqualification without reference to SRO membership.[989]

In defining the phrase “subject to statutory disqualification,” the Commission declines to reference any parallel provisions of the CEA.[990] The CFTC defines “statutory disqualification” under relevant sections of the CEA, without reference to parallel provisions of the Exchange Act. Therefore the inclusion of references to the CEA might lead to greater confusion and less certainty among market participants regarding Start Printed Page 30037what persons would be subject to statutory disqualification.

The Commission declines to adopt a commenter's suggestion to require third-party representatives to provide specific affirmations that they are not subject to statutory disqualifications, are not under investigation, and are not listed on publicly available databases as subject to a statutory disqualification. We do not believe that it is necessary or appropriate to prescribe in Rule 15Fh-5(a)(1)(ii) how an SBS Entity must form its reasonable basis to believe that the independent representative is not subject to a statutory disqualification; rather, the rule provides SBS Entities the flexibility to determine how best to meet their obligation. The SBS Entity may reasonably rely on representations regarding the qualifications of the independent representative to form its reasonable basis, but it is not required to do so. Nor is it required to obtain any specific representations or affirmations.

d. Undertakes a Duty To Act in the Best Interests of the Special Entity

i. Proposed Rule

Proposed Rule 15Fh-5(a)(3) would require an SBS Entity to have a reasonable basis to believe that the independent representative would undertake a duty to act in the best interests of the special entity.

ii. Comments on the Proposed Rule

The Commission requested comment regarding what circumstances, if any, would give rise to a presumption that an independent representative was acting in the best interests of the special entity. The Commission received seven comment letters supporting the presumption that certain representatives would act in the best interests of the special entity by virtue of their employment with the special entity or their status as fiduciaries.[991] According to these commenters, in-house representatives of a special entity should presumably act in the best interests of their special entity employer, particularly where their performance would be subject to the special entity's review and evaluation.[992]

iii. Response to Comments and Final Rule

As discussed in Section I.D., supra, the Commission has modified Rule 15Fh-5 to address the intersection of Dodd-Frank and ERISA regulation by distinguishing between non-ERISA special entities and ERISA special entities. With respect to non-ERISA special entities, under Rule 15Fh-5(a)(1), an SBS Entity must have a reasonable basis for believing that a non-ERISA special entity counterparty has a qualified independent representative that, among other things, undertakes a duty to act in the “best interests” of the special entity.[993] With respect to ERISA special entities, under Rule 15Fh-5(b)(2), the SBS Entity must have a reasonable basis to believe a special entity counterparty that is “subject to” regulation under ERISA has a representative that is a “fiduciary” as defined in Section 3 of ERISA. This bifurcated treatment of ERISA and non-ERISA special entities under Rule 15Fh-5(a) addresses the commenter's recommendation that the business conduct rules recognize the comprehensive federal regulatory framework that applies to plans that are subject to regulation under ERISA, as well as creates efficiencies for special entities that have already conformed their relationships with their representatives to satisfy the CFTC's qualification criteria.[994]

The Commission is adopting proposed Rule 15Fh-5(a)(3), renumbered as Rule 15Fh-5(a)(1)(iii), as proposed. The Commission agrees with commenters that an SBS Entity may rely on information about legal arrangements between the special entity and its representative to establish that the representative is obligated to act in the best interests of the special entity, including by contract, employment agreement, or other requirements under state or federal law. In addition, Rule 15Fh-5(b) provides safe harbors for forming a reasonable basis regarding the qualifications of the independent representative.[995] Specifically, part of the safe harbor is satisfied if the independent representative provides a written representation that it is legally obligated to comply with the applicable requirements in Rule 15Fh-5(a)(1) that describe the qualifications of the independent representative—including that it undertakes to act in the best interests of the special entity—by agreement, condition of employment, law, rule, or other enforceable duty. Given the relief provided by the safe harbor, at this time, the Commission does not believe a presumption is necessary regarding the reasonable belief of the SBS Entity relating to the undertaking of the independent representative to act in the best interests of the special entity.

e. Makes Appropriate and Timely Disclosures to Special Entity

i. Proposed Rule

Proposed Rule 15Fh-5(a)(4) would require an SBS Entity to have a reasonable basis to believe that the special entity's independent representative would make “appropriate and timely” disclosures to the special entity of material information concerning the security-based swap.

ii. Comments on the Proposed Rule

The Proposing Release solicited comment regarding whether to impose specific requirements with respect to the content of the disclosures in proposed Rule 15Fh-5(a)(4). The Commission received six letters addressing this provision of the proposed rule. Two commenters supported the use of specific disclosures to satisfy this requirement.[996] In contrast, two commenters argued that the Commission should not require specific content disclosures.[997] One commenter appeared to argue that the standard of the proposed rule was too low,[998] and two commenters cautioned against reading this portion of the proposed rule as requiring the disclosure of information before the execution of each trade.[999]

A commenter recommended that the final rules expressly state that the appropriate and timely disclosure requirement would be satisfied if the SBS Entity received a written representation affirming that the representative is “obligated by law and/or agreement or undertaking to provide appropriate and timely disclosures to the special entity.” [1000] However, this commenter additionally believed that, because this provision of the proposed rule could be read to mandate pre-execution disclosure on a transaction-by-transaction basis, it could cause delays in the execution of security-based swaps, interfere with special entities' ability to hedge positions and Start Printed Page 30038portfolio risks, and deprive them of trading opportunities.[1001] Another commenter requested that the Commission clarify that proposed Rule 15Fh-5(a)(4) would not require the disclosure of information before a trade is executed.[1002]

A third commenter urged the Commission not to impose specific requirements regarding the content of the disclosures.[1003] According to this commenter, there are too many types of swaps and circumstances to allow for a uniform set of mandated disclosures.[1004] After the adoption of the CFTC's final rules, a commenter argued against the specific requirement that the qualified independent representative disclose “material information concerning the security-based swap.” [1005] The commenter requested that the Commission instead make the requirement a general requirement to make appropriate and timely disclosures to the special entity to harmonize this provision with the parallel CFTC requirement, “which would reduce costs for special entities since most of them have already conformed their relationships with their representatives to satisfy the CFTC's qualification criteria.” [1006]

iii. Response to Comments and Final Rule

As noted above, the SBS Entity may reasonably rely on representations regarding the independent representative making appropriate and timely disclosures to the special entity to form its reasonable basis to believe that the independent representative will comply with Rule 15Fh-5(a)(1)(iv). As with Rule 15Fh-5(a)(1)(iii), an SBS Entity may rely on appropriate legal arrangements between a special entity and its representative to form a reasonable basis to believe the representative will make appropriate and timely disclosures to the special entity of material information regarding the security-based swap—such as an existing contract or employment agreement.

In response to the comments arguing that pre-trade disclosure should not be required, we believe the necessity of pre-trade disclosure will depend on the facts and circumstances of the particular security-based swap in the context of the special entity and independent representative. The SBS Entity is required to have a reasonable basis to believe the independent representative will provide the appropriate and timely disclosures. To the extent that any disclosures from the independent representative are necessary for the special entity to make an investment decision with respect to the security-based swap, the disclosure would not be timely if it was given after the investment decision was made. Similarly, the CFTC rule also requires that the Swap Entity have a reasonable basis to believe that the independent representative will make “appropriate and timely” disclosures. Although the language of the Commission's rule narrows the requirement found in the parallel CFTC rule to appropriate and timely disclosures of “material information concerning the security-based swap,” the timing requirement is the same.[1007]

f. Pricing and Appropriateness

i. Proposed Rule

Proposed Rule 15Fh-5(a)(5) would require an SBS Entity to form a reasonable basis to believe that the special entity's independent representative would provide written representations to the special entity regarding fair pricing and the appropriateness of the security-based swap.

ii. Comments on the Proposed Rule

Four commenters addressed this proposed rule. Two commenters supported the Commission's proposal that it “should be sufficient if the representation states that the representative is obligated, by law and/or contract, to review pricing and appropriateness with respect to any swap transaction in which the representative serves as such with respect to the plan.” [1008] Both commenters urged the Commission to incorporate this approach into the adopted rules.

The third commenter suggested that an independent representative should be required to disclose the basis on which it determined that a particular transaction was fairly priced, and that the underlying documentation should be sufficiently detailed to enable a third party to evaluate the representative's conclusion.[1009]

After the adoption of the CFTC's business conduct rules, the fourth commenter urged the Commission to harmonize with the CFTC and require that the qualified independent representative “evaluate[ ], consistent with any guidelines provided by the special entity, regarding fair pricing and the appropriateness of the security-based swap.” [1010] The commenter asserted that this harmonization would reduce compliance costs for special entities that have already conformed their relationships with their representatives to satisfy the CFTC's qualification criteria.[1011]

iii. Response to Comments and Final Rule

Upon consideration of the comments, the Commission is modifying proposed Rule 15Fh-5(a)(5), renumbered as Rule 15Fh-5(a)(1)(v). The Commission agrees with the commenter's suggestion that the Commission should harmonize with the language of the CFTC's parallel provision, which requires an SBS Entity to form a reasonable basis that the special entity's independent representative will “evaluate” fair pricing and the appropriateness of the security-based swap, “consistent with any guidelines provided by the special entity.” In the Commission's view, requiring an SBS Entity to form a reasonable basis to believe that an independent representative will evaluate, consistent with any guidelines provided by the special entity, fair pricing and the appropriateness of the security-based swap will achieve the purpose of the proposed rule to ensure the special entity receives advice specifically with respect to pricing and whether or not to enter into the security-based swap. The rule will also provide the special entity the flexibility to provide parameters to its independent representative regarding the pricing and appropriateness of its security-based swap. The Commission therefore agrees with the commenter's suggestion that the special entity's guidelines, to the extent a special entity provides them, should establish the criteria for assessing the fair pricing and appropriateness of a security-based swap. In addition, this change will harmonize the rule with the parallel CFTC rule, thus creating efficiencies for entities that have already established infrastructure to comply with the CFTC standard. In the absence of any guidelines provided by the special entity, Rule 15Fh-5(a)(1)(v) requires the SBS Entity to form a reasonable basis to believe that the independent representative will evaluate the fair pricing and appropriateness of the security-based swap.Start Printed Page 30039

An SBS Entity also could form a reasonable basis for its determination by relying on a written representation that the independent representative will document the basis for its conclusion that the transaction was fairly priced and appropriate in accordance with any guidelines provided by the plan, and that the independent representative or the special entity will maintain that documentation in its records for an appropriate period of time, and make such records available to the special entity upon request.[1012] In response to commenters' concerns, the Commission clarifies that this provision does not necessarily require that a representative provide the special entity transaction-by-transaction documentation with respect to fair pricing and appropriateness of each security-based swap. For example, where the representative is given trading authority, the representative could consider undertaking in its agreement with the special entity to ensure that the representative will evaluate the pricing and appropriateness of each swap consistent with any guidelines provided by the Special Entity prior to entering into the swap. In such a situation, the independent representative could prepare and maintain adequate documentation of its evaluation of pricing and appropriateness to enable both the representative and the special entity to confirm compliance with any such agreement.

g. Subject to “Pay to Play” Prohibitions

i. Proposed Rule

Proposed Rule 15Fh-5(a)(7) would require an SBS Entity to have a reasonable basis to believe that a special entity's independent representative is subject to rules of the Commission, the CFTC, or an SRO subject to the jurisdiction of the Commission or the CFTC that prohibit it from engaging in specified activities if certain political contributions have been made, unless the independent representative is an employee of the special entity.

While not addressed in the Dodd-Frank Act, the Commission proposed to include this “pay-to-play” provision among the qualifications for independent representatives.[1013] As discussed more fully in Section II.H.10, infra, pay-to-play practices in connection with security-based swap transactions could result in significant harm to special entities—particularly where, as here, the independent representative is intended to act in the best interests of special entities.[1014] The pay-to-play provisions of the proposed rules were intended to deter independent representatives from participating, even indirectly, in such practices.

ii. Comments on the Proposed Rule

The Commission received one comment letter addressing the inclusion of a pay-to-play restriction among the qualifications for independent representatives. This commenter supported the exception to the pay-to-play restrictions for advisors who are employees of the special entity.[1015]

iii. Response to Comment and Final Rule

The Commission is adopting proposed Rule 15Fh-5(a)(7), renumbered as Rule 15Fh-5(a)(1)(vi), as proposed. Accordingly, an SBS Entity must have a reasonable basis for believing that the independent representative is subject to rules of the Commission, the CFTC or an SRO subject to the jurisdiction of the Commission or the CFTC that prohibit it from engaging in specified activities if certain political contributions have been made, unless the independent representative is an employee of the special entity.[1016] As stated in the Proposing Release, the Commission continues to believe that an independent representative in these circumstances would likely be either a municipal advisor or an investment adviser that is already subject to the MSRB's or the Commission's pay-to-play prohibitions. The Commission does not, however, intend to prohibit other qualified persons from acting as independent representatives, so long as those persons are similarly subject to pay-to-play restrictions. The Commission believes that Rule 15Fh-5(a)(1)(vi) will sufficiently deter SBS Entities from participating, even indirectly, in such unlawful practices.

h. ERISA Fiduciary

i. Proposed Rule

Proposed Rule 15Fh-5(a)(6) would require an SBS Entity to have a reasonable basis to believe that, in the case of a special entity that is an employee benefit plan subject to ERISA, the independent representative was a “fiduciary” as defined in section 3(21) of that Act (29 U.S.C. 1002).[1017] The proposed rule was not intended to limit, restrict, or otherwise affect the fiduciary's duties and obligations under ERISA.[1018]

The Proposing Release solicited feedback regarding any specific requirements that should be imposed on SBS Entities with respect to this obligation, as well as what other independent representative qualifications might be deemed satisfied if an independent representative of an employee benefit plan subject to ERISA, is a fiduciary as defined in section 3 of ERISA.

ii. Comments on the Proposed Rule

The Commission received six comment letters advocating for a presumption of qualification for ERISA plan fiduciaries, since ERISA already imposes fiduciary duties upon the person who decides whether to enter into a security-based swap on behalf of an ERISA plan, and imposes on this person a statutory duty to act in the best interests of the plan and its participants, thereby prohibiting certain self-dealing transactions.[1019] According to these commenters, the Commission's proposed standards would be unnecessary, redundant, would overlap with ERISA's standards, and would only serve to increase the administrative burden and cost on SBS Entities without any corresponding benefit.[1020]

To address the potential conflict with ERISA standards, one commenter suggested that the Commission's definition of “independent representative” should be inapplicable to ERISA plans, and that the Commission should merely cross-Start Printed Page 30040reference the requirements under ERISA.[1021]

Another commenter supported the presumptive qualification for ERISA plan fiduciaries, provided that the plan satisfied a minimum $1 billion net asset requirement for institutional investor organizations.[1022] The commenter asserted that no public policy objective would be achieved by permitting an SBS Entity to reject a risk manager fiduciary selected by a sophisticated institutional investor organization with over $1 billion in net assets, which did not require the protections of the rules.[1023] Another commenter advocated for the separate treatment of independent representatives of special entities subject to ERISA.[1024] Under this commenter's proposal, an SBS Entity that transacts with a special entity subject to Title I of ERISA must have a reasonable belief that the qualified independent representative is a fiduciary, as defined in Section 3 of ERISA.[1025] The commenter's proposed modification for ERISA special entities was intended to recognize “the unique fiduciary regime already applicable to such special entities,” and to harmonize the Commission's criteria for qualified independent representatives with those of the CFTC.[1026]

One commenter asserted that, for ERISA plans, the determination whether a disclosure was “appropriate” and “timely” should be made with reference to ERISA.[1027] However, in the event the Commission imposed its own, separate requirements on such disclosures, the commenter requested that the Commission allow the following representations to satisfy this provision of the proposed rule: (1) That the representative shall provide the special entity with such information, at such times, as the special entity may reasonably request regarding any swap trade (either individually or in the aggregate) entered into by such representative on behalf of the special entity; and (2) that, in the absence of specific instruction to the contrary by the special entity regarding swap trade disclosure, the representative shall comply with the disclosure requirements imposed on the representative under other applicable law (e.g., ERISA) and by the special entity under the special entity's investment management agreement and investment guidelines.[1028]

iii. Response to Comments and Final Rule

As discussed in Section II.H.5.b.iii, we are adopting a new Rule 15Fh-5(a)(2) that expressly addresses dealings with special entities subject to ERISA.

Under new Rule 15Fh-5(a)(2), (formerly proposed Rule 15Fh-5(a)(6)), an SBS Entity that acts as a counterparty to an employee benefit plan subject to Title I of ERISA must have a reasonable basis to believe that the special entity has a representative that is a fiduciary as defined in Section 3 of ERISA. In this regard, an ERISA fiduciary will be presumed to be a qualified independent representative, and the SBS Entity need not undertake further inquiry into the ERISA fiduciary's qualifications. Such a presumption acknowledges the pre-existing, comprehensive federal regulatory regime governing ERISA fiduciaries and the importance of harmonizing the Dodd-Frank Act requirements with ERISA to avoid unintended consequences.[1029] This formulation also will align the Commission's treatment of ERISA plans with that of the CFTC.

i. Safe Harbor

i. Summary of Comments

Although not included in the proposed rules, after adoption of the CFTC's final rules, one commenter requested that the Commission adopt separate safe harbors for transactions with ERISA and non-ERISA special entities regarding the requirement that an SBS Entity form a reasonable basis to believe that the special entity has a qualified independent representative.[1030] According to this commenter, the adoption of separate safe harbors for ERISA and non-ERISA special entities would align the Commission's requirements with those of the CFTC by recognizing the “unique fiduciary regime already applicable to” ERISA special entities, and, for transactions with non-ERISA special entities, the safe harbor would “help speed implementation, reduce costs, and mitigate counterparty confusion, because most special entity representatives have already taken steps to ensure that they can provide the representations contained in the CFTC's safe harbor.” [1031]

ii. Response to Comments and Final Rule

After consideration of the comments, the Commission has determined to add a new bifurcated safe harbor in Rule 15Fh-5(b), similar to that adopted by the CFTC. The Commission believes the safe harbor will provide SBS Entities an efficient manner with which to comply with the requirement to have a reasonable basis to believe an independent representative meets certain enumerated qualifications while meeting the purposes of the rule.

Under Rule 15Fh-5(b)(1) as adopted, an SBS Entity shall be deemed to have a reasonable basis to believe that a non-ERISA special entity has a representative that satisfies the requirements of Rule 15Fh-5(a)(1) if: (i) The special entity represents in writing to the SBS Entity that it has complied in good faith with written policies and procedures reasonably designed to ensure that it has selected a representative that satisfies the requirements of Rule 15Fh-5(a)(1), and that such policies and procedures provide for ongoing monitoring of the performance of such representative consistent with Rule 15Fh-5(a)(1); and (ii) the representative represents in writing to the special entity and the SBS Entity that the representative: Has policies and procedures reasonably designed to ensure that it satisfies the requirements of Rule 15Fh-5(a)(1); meets the independence test of Rule 15Fh-f(a)(1)(vii); has the knowledge required under paragraph (a)(1)(i) of this section; is not subject to a statutory disqualification under paragraph (a)(1)(ii) of this section; undertakes a duty to act in the best interests of the special entity as required under paragraph (a)(1)(iii) of this section; and is subject to the requirements regarding political contributions, as applicable, under paragraph (a)(1)(vi) of this section; and is legally obligated to comply with the requirements of Rule 15Fh-5(a)(1) by agreement, condition of employment, law, rule, regulation, or other enforceable duty.[1032]

Under Rule 15Fh-5(b)(2) as adopted, an SBS Entity shall be deemed to have a reasonable basis to believe that an ERISA special entity has a representative that satisfies the requirements of Rule 15Fh-5(a)(2), provided that the special entity provides in writing to the SBS Entity the Start Printed Page 30041representative's name and contact information, and represents in writing that the representative is a fiduciary as defined in Section 3 of ERISA. Obtaining the name and contact information provides the SBS Entity with basic information to investigate further if it becomes questionable whether it can reasonably rely on the special entity's representation or if the need arises for it to further investigate any of the representatives qualifications. In addition, it is highly likely that the SBS Entity will have the information in the ordinary course of negotiating the security-based swap if the independent representative is advising or negotiating the security-based swap on behalf of the special entity.

The Commission believes that the safe harbor will better enable an SBS Entity to fulfill its obligations under Rule 15Fh-5(a), while at the same time appropriately providing protections for special entities. The Commission also agrees with commenters that the safe harbor will increase the efficiency of SBS transactions, reduce costs, and mitigate counterparty confusion. We believe that although SBS Entities will need to obtain additional representations relating to meeting certain of the standards in Rule 15Fh-5(a)(1), most SBS Entities and special entity representatives will still be able to leverage any existing compliance infrastructure established pursuant to the CFTC's safe harbor.[1033] Additionally, as discussed above, the bifurcated nature of the safe harbor appropriately recognizes existing ERISA regulations.[1034]

7. Disclosure of Capacity

a. Proposed Rule

Proposed Rule 15Fh-5(b) would require that, before initiation of a security-based swap with a special entity, an SBS Dealer must disclose in writing the capacity or capacities in which it is acting, and, if the SBS Dealer engages in business or has engaged in business within the last twelve months with the counterparty in more than one capacity, the SBS Dealer must disclose the material differences between such capacities in connection with the security-based swap and any other financial transaction or service involving the counterparty.[1035] Therefore, an SBS Dealer that is acting as a counterparty but not an advisor to a special entity would need to make clear to the special entity the capacity in which it is acting (i.e., that it is acting as a counterparty, but not as an advisor).

As noted in the Proposing Release, a firm might act in multiple capacities in relation to a special entity. For example, the firm might act as an underwriter in a bond offering, as well as a counterparty to a security-based swap used to hedge the financing transaction.[1036] Because the SBS Dealer's duty to the special entity might vary according to the capacity in which it is acting, the special entity and its independent representative should understand the SBS Dealer's roles in any transaction.[1037] The proposed rule would therefore require an SBS Dealer that engages in business, or has engaged in business within the last twelve months, with the counterparty in more than one capacity to disclose the material differences between such capacities in connection with the security-based swap and any other financial transaction or service involving the counterparty.[1038] The requirements of the proposed rule would apply to SBS Dealers, but not Major SBS Participants, because the statutory requirement, by its terms, requires disclosure in writing of “the capacity in which the security-based swap dealer is acting” (emphasis added).

b. Comments on the Proposed Rule

The Commission received five comment letters on this proposed rule. Three commenters expressed concern over the burden imposed on large institutions, which would have to identify and disclose a myriad of possible relationships with special entities.[1039] Conversely, one commenter suggested broadening the rule to apply to Major SBS Participants in addition to SBS Dealers.[1040] The last commenter suggested conforming the disclosure of capacity requirement to that of the CFTC.[1041]

The first commenter argued that the Commission's proposed capacity disclosure requirement was problematic for two reasons.[1042] First, it might conflict with some SBS Dealers' obligations to keep certain lines of business separated from one another. In this commenter's view, to comply with this requirement, large, multifaceted SBS Dealers that have different relationships with the same special entity could be forced to review activities throughout their entire organizations—in some cases, across informational walls that separate the different business lines of the firm. Second, the requirement might cause execution delays for special entities, since the SBS Dealer would need time to determine the disclosures it must make to the special entity. The commenter asked the Commission to clarify in the final rule that this disclosure requirement applied only to the SBS Dealer and the special entity, and that it would not apply to any associated persons of either the SBS Dealer or the special entity. The commenter additionally argued that the twelve-month look back period constituted a “moving target,” and suggested that the Commission define the period as a calendar year, rather than a rolling twelve-month period.[1043]

Another commenter urged the Commission to allow SBS Entities to represent the capacity in which they were acting with respect to an ERISA plan in a schedule or amendment to an ISDA Master Agreement, other transactional document, or in an annual disclosure document provided by the SBS Entity to the special entity, which could be changed if the SBS Entity were to act in a different capacity.[1044] Because ERISA plans generally deal with SBS Entities as counterparties, the commenter believed this would be an effective and non-burdensome way to make such representations. The commenter additionally asserted that it might be harmful to a special entity to require an SBS Entity to disclose the myriad different capacities in which the SBS Entity has acted with respect to the special entity—since requiring SBS Dealers with diverse global operations to disclose every relationship with a plan (which often has multiple investment managers and service Start Printed Page 30042providers), then requiring the plan manager to review such disclosures would pose a significant administrative burden and result in high costs and delayed trades. These costs would likely be passed on to special entities.

Another commenter argued that it “would be impossible for an SBS Entity to ascertain and disclose every other relationship it may have with its counterparties” because large financial institutions have multiple points of contact with counterparties, making it impossible to systematically collect and disclose the required information.[1045] This commenter argued that the Proposing Release did not include an analysis of the costs associated with the requirement to disclose capacity. The commenter recommended that the Commission narrow this requirement to cover only disclosure of the material differences between the capacities in which the SBS Entity itself (and not any of its affiliates or other associated persons) acted in connection with the relevant security-based swap transaction. In the alternative, the commenter suggested that the Commission require disclosure regarding the capacities in which the SBS Entity has acted with respect to the counterparty other than in connection with the relevant security-based swap transaction, and that the SBS Entity should be permitted to satisfy that requirement with a generic disclosure of the general types of capacities in which it may act or have acted with respect to the counterparty (along with a statement distinguishing those capacities from the capacity in which the SBS Entity is acting with respect to the present security-based swap).

One commenter suggested that the capacity disclosure requirement be applied equally to SBS Dealers and Major SBS Participants, as it would maximize the protection for special entities.[1046]

After the adoption of the CFTC's final rules, a commenter subsequently recommended deleting this twelve-month “look back” period, as well as the requirement that SBS Dealers disclose the material differences between such capacities “in connection with the security-based swap and any other financial transaction or service involving the counterparty.” [1047] According to the commenter, these modifications would harmonize the Commission's rule with the parallel CFTC rule, and reduce confusion among counterparties regarding the nature of their relationship with an SBS Dealer.[1048]

c. Response to Comments and Final Rule

Upon consideration of the foregoing comments, the Commission is adopting proposed Rule 15Fh-5(b), renumbered as Rule 15Fh-5(c), with several modifications in response to comments. Proposed Rule 15Fh-5(b) would require that, before initiation of a security-based swap with a special entity, an SBS Dealer must disclose in writing the capacity or capacities in which it is acting, and, if the SBS Dealer engages in business or has engaged in business within the last twelve months with the counterparty in more than one capacity, the SBS Dealer must disclose the material differences between such capacities in connection with the security-based swap and any other financial transaction or service involving the counterparty. As discussed below, in response to comments, the Commission is amending the first part of the rule to clarify that the disclosure of the capacity in which the SBS Dealer is acting is “in connection with the security-based swap.” The Commission also is amending the second part of the rule to clarify the capacities between which material differences must be disclosed. In addition, we are deleting the 12 month look-back period. Specifically, under the rule, as adopted (renumbered as Rule 15Fh-5(c)), before initiation of a security-based swap, an SBS Dealer must disclose to the special entity in writing the capacity in which the SBS Dealer is acting “in connection with the security-based swap,” and, if the SBS Dealer engages in business [1049] with the counterparty in more than one capacity, the SBS Dealer must disclose the material differences between the capacity in which the SBS Dealer is acting with respect to the security-based swap and the capacities in which it is acting with respect to any other financial transaction or service involving the counterparty to the special entity.

Several commenters argued that the proposed requirement that the SBS Dealer disclose the capacity in which it was acting was too broad and would require the disclosure of a myriad of possible relationships.[1050] Some commenters suggested that the relevant disclosure should be the capacity in which the SBS Dealer is acting “in connection with the security-based swap” and suggested the rule should be narrowed accordingly.[1051] A commenter also suggested that the Commission revise the disclosure of different capacities to eliminate the language that requires such disclosures to be “in connection with the security-based swap and any other financial transaction or service involving the counterparty.” [1052]

The Commission agrees with commenters that the disclosure of capacity in the first part of the rule should be limited to the capacity in which the SBS Dealer is acting in connection with the security-based swap, and has amended the rule to clarify this limitation. However, the Commission declines the commenter's suggestion to eliminate the disclosure of material differences between or among the different capacities in which the SBS Dealer is acting “in connection with the security-based swap and any other financial transaction or service involving the counterparty.” [1053] The proposed rule was designed to provide the counterparty with sufficient information about the capacity in which the SBS Dealer is acting, and any material differences between its capacity in connection with the security-based swap and any other financial transaction or service involving the counterparty, to help ensure that the counterparty understands the SBS Dealer's role in the security-based swap transaction that is being initiated, and to distinguish that role, if applicable, from its role with respect to any other services it is providing or transactions in which it is involved with the counterparty. Eliminating the requirement that the SBS Dealer disclose the material differences in the different capacities in which it is acting would not address potential counterparty confusion that could arise when a SBS Dealer changes status from transaction to transaction.

Some commenters expressed concerns regarding the burden and practical issues relating to having to apply this disclosure requirement to the activities of associated persons of the SBS Start Printed Page 30043Dealer [1054] and associated persons of the special entity.[1055] The Commission recognizes the practical and operational difficulties described in the comment letters in determining the capacity in which associated persons, including affiliates, are acting or have acted with respect to the special entity. The Commission also recognizes the role of the independent representative in advising the special entity with respect to these transactions. Given these considerations, the Commission agrees with the commenter it would be appropriate for the SBS Dealer to use generalized disclosures regarding the other capacities in which the SBS Dealer and its associated persons, including affiliates, have acted or may act with respect to the special entity and its associated persons, along with a statement distinguishing those capacities from the capacity in which the SBS Dealer is acting with respect to the present security-based swap.[1056] Such disclosure would require consideration of the SBS Dealer's business and the types of capacities in which it and its associated persons has acted or may act with respect to the particular special entity. We believe that this generalized disclosure of other capacities will help ensure that the counterparty understands the SBS Dealer's role in the security-based swap transaction that is being initiated, and to distinguish that role, if applicable, from its role with respect to any other services it is providing or transactions in which it is involved with the counterparty.

After consideration of the comments, the Commission also acknowledges the commenters' concerns regarding the workability and potential delay in execution of transactions and increased costs the twelve month look back may cause. Accordingly, the Commission has also modified the adopted rule to eliminate the 12-month look back period for business in which the SBS Dealer has engaged.

As discussed in Section II.G.2.b. above, the Commission does not prescribe the manner in which these disclosure must be made. In response to comments received,[1057] the Commission notes that the required disclosures could be made in a transactional document or an annual disclosure document, depending on the number of capacities in which the SBS Dealer is acting and whether such capacities have changed. In any event, the disclosure must be sufficient to meet the requirements of the rule, which is designed to ensure that the special entity understands the SBS Dealer's role in the security-based swap transaction that is being initiated, and to distinguish that role, if applicable, from its role with respect to any other services the SBS Dealer is providing or transactions in which it is involved with the special entity.

Finally, the Commission declines to apply Rule 15Fh-5(c) to Major SBS Participants, since the statutory requirement, by its terms, requires disclosure in writing of “the capacity in which the security-based swap dealer is acting.” Furthermore, as discussed in Section II.C., supra, we have not sought to impose the full range of business conduct requirements on these Major SBS Participants. We note that our approach in this regard largely mirrors that of the CFTC, under whose rules Swap Entities have operated for some time.

8. Exceptions for Anonymous, Special Entity Transactions on an Exchange or SEF

a. Proposed Rules

As previously discussed in Section II.B, supra, Section 15F(h)(7) of the Exchange Act provides that “[t]his subsection shall not apply with respect to a transaction that is (A) initiated by a special entity on an exchange or security-based swap execution facility; and (B) one in which the security-based swap dealer or major security-based swap participant does not know the identity of the counterparty to the transaction.” [1058] We proposed to read Section 15F(h)(7) to apply to any transaction with a special entity on a SEF or an exchange where the SBS Entity does not know the identity of its counterparty.[1059] We further proposed exceptions from the requirement of proposed Rules 15Fh-4 (special requirements for SBS Dealers acting as advisors to special entities) and 15Fh-5 (special requirements for SBS Entities acting as counterparties to special entities) for such transactions.

b. Comments on the Proposed Rules

The Commission received five comments that generally addressed the exception for anonymous or SEF and exchange-traded security-based swaps,[1060] and five comments that specifically addressed the exception for anonymous, exchange or SEF-traded security-based swaps with special entities.[1061] The comment letters that generally address this exception are discussed above, in Section II.B, supra.

In the specific context of security-based swap transactions with special entities, one commenter suggested that the business conduct standards should only apply to non-SEF and non-exchange traded transactions, regardless whether the transaction is anonymous.[1062] This commenter urged the Commission to clarify that the proposed rules would not apply to any security-based swap transaction that is entered into by a special entity on a designated contract market or SEF.[1063]

Two commenters addressed the Commission's proposal to apply the statutory exception to any anonymous transaction with a special entity on a registered exchange or SEF.[1064] One commenter supported this proposal as a “reasonable approach which is consistent with Congressional intent that the enhanced protections apply to transactions where there is a degree of reliance by the special entity on the dealer or major swap participant.” [1065] The second commenter argued that the exception in Section 15Fh(7) was intended to apply to all external business conduct requirements promulgated under subsection (h), and not merely those requirements relating to SBS Dealers acting as advisors or counterparties to special entities.[1066]

Another commenter argued that Congress did not intend for the exception to apply when SBS Entities initiate transactions on a SEF or an exchange.[1067] According to this commenter, SBS Entities seeking to conduct business on a SEF or exchange should bear the risk that their counterparties are special entities, as the risk would incentivize SBS Entities to determine the identity of their counterparties when they initiate security-based swap transactions on an SEF or exchange. The commenter recommended that the Commission adopt a “clear test” for determining when a special entity “initiates” a security-based swap transaction, and that the test differentiate between Start Printed Page 30044initiating a negotiation and initiating a transaction.[1068] After adoption of the CFTC's business conduct standards, another commenter urged the Commission to adopt an exception for exchange-traded security-based swaps that are intended to be cleared if: (1) The transaction is executed on a registered or exempt security-based swap execution facility or registered national security exchange; and (2) is of a type that is, as of the date of execution, required to be cleared pursuant to Section 3C of the Exchange Act; or (3) the SBS Dealer does not know the identity of the counterparty, at any time up to and including execution of the transaction.[1069] The commenter argued that these modifications would harmonize the scope of the SEC's special entity requirements with the parallel CFTC requirements set forth under the relief provided by CFTC No-Action Letter 13-70.[1070]

c. Response to Comments and Final Rules

After consideration of the comments, the Commission is adopting Rule 15Fh-4(b)(3) and Rule 15Fh-5(c) (the latter renumbered as 15Fh-5(d)) with several modifications. Under the rules as adopted, the business conduct requirements of Rules 15Fh-4 and 15Fh-5 will not apply to a security-based swap with a special entity if: (1) The transaction is executed on a registered SEF, exempt SEF, or registered national securities exchange; and (2) the SBS Dealer and/or Major SBS Participant does not know the identity of the counterparty at a reasonably sufficient time prior to the execution of the transaction to permit the SBS Dealer and/or Major SBS Participant to comply with the obligations of the rule.[1071] The language of these exceptions, as adopted, differs from the language of the proposed rules, which would have applied the exceptions where the SBS Dealer or Major SBS Participant did not know the identity of its counterparty “at any time up to and including” execution of the transaction, and only to transactions executed on a registered SEF or national exchange.

As discussed in Section II.B, by limiting the scope of the business conduct standards to situations where the counterparty's identity is known at a reasonably sufficient time prior to the execution of a transaction to permit the SBS Dealer and/or Major SBS Participant to comply with the obligations of the rule, the Commission seeks to relieve SBS Dealers and/or Major SBS Participants of the duty to comply with the rules' requirements where the counterparty's identity is learned immediately prior to the execution of a transaction, so that the SBS Entity would be able to comply with the requirements of the rules in a manner that would not be disruptive to the counterparties to the transaction. This change is intended to address commenters' concerns that compliance with the rules might be unreasonable or impractical where a counterparty's identity is learned immediately prior to the transaction, and compliance could result in the delay or disruption of the transaction.[1072] Such delay or disruption would negate a primary advantage of electronic trading and discourage market participants from executing security-based swaps on electronic platforms. By only applying the rules' requirements to situations where the counterparty's identity is known “at a reasonably sufficient time prior to” the execution of a transaction, the rules' requirements are limited to situations where an SBS Entity has sufficient time before the execution of the transaction to comply with its obligations under the rules. For this reason, we decline to adopt language, suggested by a commenter, which would apply the exception to circumstances where the identity of the counterparty “is not known at any time up to and including execution of the transaction.” [1073] For clarification, and in response to commenters,[1074] the exception would encompass transactions that are executed by an SBS Entity on a registered or exempt SEF or registered national securities exchange via a request for quote method, as long as the identity of the counterparty is not known to the SBS Entity at a reasonably sufficient time prior to the execution of a transaction to permit the SBS Entity to comply with the obligations of the rules.[1075]

Also, as explained in Section II.B, the exception would apply with respect to transactions on exempt as well as registered SEFs. We believe that including transactions on exempt SEFs is appropriate since, as discussed in Section II.B, the practical considerations that underlie the exception are not affected by whether a SEF is registered or not.

We believe that the exceptions under Rule 15Fh-4(b)(3) and 15Fh-5(d), as adopted, appropriately interpret the intended statutory carve-outs for SBS Entities engaged in anonymous, registered exchange-traded, registered or exempt SEF transactions with special entities, while avoiding the ambiguity inherent in determining which party “initiated” the security-based swap. The final rule therefore obviates the need to differentiate between initiating a negotiation and initiating a transaction, as one commenter had requested.[1076]

We acknowledge the commenter's suggestion that the exception should apply irrespective of which party initiates a transaction,[1077] as well as another commenter's suggestion that Congress may have intended to deny the exception in situations in which an SBS Entity initiates a transaction, so that SBS Entities would be incentivized to determine the identities of their counterparties when they initiate security-based swap transactions.[1078] As explained in Section II.B, we understand there may be practical difficulties in determining which counterparty “initiates” a transaction on a SEF or an exchange. However, we believe the rules adopted today avoid the ambiguity inherent in determining which party “initiated” the security-based swap, while appropriately interpreting the intended statutory carve-outs for SBS Entities that execute anonymous, security-based swap transactions with special entities on a registered or exempt SEF or registered national securities exchange.

We are not accepting the commenter's suggestion that we revise the exceptions under 15Fh-4(b)(3) and 15Fh-5(d) to include transactions that are intended or required to be cleared, which are either executed on a registered national securities exchange or SEF, regardless of whether the transaction is anonymous.[1079] Similarly, we reject commenters' more general assertion that Start Printed Page 30045the exceptions should apply to all SEF or exchange traded transactions, even where the identity of the counterparty is known.[1080] Rather, we agree with the commenter that it is appropriate to apply the protections of the business conduct rules to all security-based swap transactions with special entities other than anonymous transactions executed on a registered national securities exchange or SEF.[1081] The rules adopted today are intended to provide certain protections for special entities, and we think it is appropriate to apply the rules, to the extent practicable, so that special entities receive the benefits of those protections. Where the identity of the special entity is known, we believe that it is appropriate to apply the rules so that the special entity receives the benefits of the protections provided by the rules, including the assistance of an advisor or qualified independent representative acting in the best interests of that special entity.

Lastly, we acknowledge the improbability that an SBS Dealer who is acting as an advisor to a special entity and is therefore subject to the requirements of Rule 15Fh-4 would not know the identity of its special entity counterparty. Consequently, we also acknowledge that the circumstances where the exception under Rule 15Fh-4(b)(3) would apply are unlikely, and, in any event, we would question the appropriateness of an SBS Dealer making a recommendation to an unknown special entity. Nevertheless, we believe there is value is providing legal certainty for SBS Dealers that seek to transact on a registered national securities exchange or a registered or exempt SEF without regard to the regulatory status of their counterparty.

9. Certain Political Contributions by SBS Dealers

a. Proposed Rule

As proposed, Rule 15Fh-6(b)(1) would generally make it unlawful for an SBS Dealer to offer to enter into, or enter into, a security-based swap, or a trading strategy involving a security-based swap, with a “municipal entity” within two years after any “contribution” to an “official of such municipal entity” has been made by the SBS Dealer or any of its “covered associate[s].” Proposed Rule 15Fh-6(b)(3)(i) would also prohibit an SBS Dealer from paying a third party to “solicit” municipal entities to offer to enter into, or enter into, a security-based swap, unless the third party is a “regulated person” that is itself subject to a pay to play restriction under applicable law. Proposed Rule 15Fh-6(b)(3)(ii) would prohibit an SBS Dealer from coordinating or soliciting a third party, including a political action committee, to make any: (a) Contribution to an official of a municipal entity with which the SBS Dealer is offering to enter into, or has entered into, a security-based swap, or (b) payment to a political party of a state or locality with which the SBS Dealer is offering to enter into, or has entered into, a security-based swap. Finally, proposed Rule 15Fh-6(c) would make it unlawful for an SBS Dealer to do indirectly or through another person or means anything that would, if done directly, result in a violation of the prohibitions contained in the proposed rule.

As proposed, Rule 15Fh-6(b) included three main exceptions. First, proposed Rule 15Fh-6(b)(2)(i) would permit an individual who is a covered associate to make aggregate contributions without being subject to the two-year time out period, of up to $350 per election, to any one official for whom the individual was entitled to vote at the time of the contributions, and up to $150 per election, to any one official for whom the individual was not entitled to vote at the time of the contributions.[1082] Second, proposed Rule 15Fh-6(b)(2)(ii) would not apply the proposed pay to play rules to contributions made by an individual more than six months prior to becoming a covered associate of the SBS Dealer, unless such individual solicits the municipal entity after becoming a covered associate. Third, proposed Rule 15Fh-6(b)(2)(iii) would not apply the proposed pay to play rules to a security-based swap that is initiated by a municipal entity on a registered national securities exchange or SEF, for which the SBS Dealer does not know the identity of the counterparty at any time up to and including the time of execution of the transaction.

In addition to the above exceptions, proposed Rule 15Fh-6(e)(1) would provide an automatic exception to allow an SBS Dealer a limited ability to cure the consequences of an inadvertent political contribution where: (i) The SBS Dealer discovered the contribution within four months (120 calendar days) of the date of the contribution; (ii) the contribution made did not exceed $350; and (ii) the contribution was returned to the contributor within 60 calendar days of the date of discovery. However, an SBS Dealer would not be able to rely on this exception more than twice in any 12-month period, or more than once for any covered associate, regardless of the time between contributions.

Furthermore, under proposed Rule 15Fh-6(d) an SBS Dealer may apply to the Commission for an exemption from the two-year ban. In determining whether to grant the exemption, the Commission would consider, among other factors: (i) Whether the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes of the Exchange Act; (ii) whether the SBS Dealer, (a) before the contribution resulting in the prohibition was made, had adopted and implemented policies and procedures reasonably designed to prevent violations of the proposed rule, (b) prior to or at the time the contribution was made, had any actual knowledge of the contribution, and (c) after learning of the contribution, had taken all available steps to cause the contributor to obtain return of the contribution and such other remedial or preventative measures as may be appropriate under the circumstances; (iii) whether, at the time of the contribution, the contributor was a covered associate or otherwise an employee of the SBS Dealer, or was seeking such employment; (iv) the timing and amount of the contribution; (v) the nature of the election (e.g., state or local); and (vi) the contributor's intent or motive in making the contribution, as evidenced by the facts and circumstances surrounding the contribution.

b. Comments on the Proposed Rule

Six commenters addressed proposed Rule 15Fh-6.[1083] One commenter, who supported the proposal as applied to SBS Dealers, stated that pay-to-play is an appropriate area for the Commission to exercise its authority and suggested that this proposal “would help to eliminate what would otherwise be a serious gap in protections.” [1084] However, this same commenter does not believe the Commission should exempt Major SBS Participants from the proposed pay-to-play rules based on what this commenter claims “may turn out to be a false `assumption' that they Start Printed Page 30046will not be engaged in the type of activity that would make them appropriate.” [1085]

Another commenter agreed that the prohibition timeframe should be two years, consistent with proposed Rule 15Fh-6(b)(1).[1086] That same commenter also believed that there are no circumstances where an independent representative that is advising a special entity that is a State, State agency, city, county, municipality, or other political subdivision of a State, or a governmental plan, as defined in Section 3(32) of ERISA, other than an employee of the special entity, would not be subject to pay to play rules.[1087]

One commenter recommended that, with respect to the proposal that independent representatives be subject to “pay to play” limitations, an exception is needed “for advisors that are employees of the special entity, given the employer-employee relationship.” [1088] That same commenter also urged the Commission to delay imposing the proposed pay to play rule until after the “dealer” definitions are finalized.[1089]

Another commenter suggested, as a general matter, that because the Dodd-Frank Act did not mandate any restrictions on political contributions by SBS Dealers it is not clear to that commenter that the Commission needs to impose such a requirement on a discretionary basis.[1090] This same commenter, however, recommended that the Commission revise the language of the proposed rule to, at least in the commenter's view, parallel the following aspects of MSRB's regulations: (1) Replace as the triggering occasion for the application of the proposed rule an “offer to enter into or enter into a security-based swap or a trading strategy involving a security-based swap” with a term—“engage in municipal security-based swap business”—which they suggest is “more akin to the terms used in the relevant MSRB Rules”; (2) define “municipal security-based swap business” in the proposed rule to mean “the execution of a security-based swap with a municipal entity”; (3) narrow the definition of “solicit” in the proposed rule to include only “any direct communication by any person with a municipal entity for the purpose of obtaining or retaining municipal security-based swap business,” so that the term “solicit” does not “implicate communication by employees of a financial institution that do not have a role in the security-based swap business and who are already regulated by the MSRB or the SEC”; (4) clarify the definition of “solicit” in the proposed rule to “exclude[s] any communication by any person with a municipal entity for the sole purpose of obtaining or retaining any other type of business covered under pay to play restrictions, such as municipal securities business or municipal advisory business”; and (5) modify the proposed rule to allow for up to three exemptions for inadvertent contributions, depending on the number of SBS Dealer employees.[1091] The same commenter also recommended that the Commission include a provision specifying “an operative date of the rule such that it only applies to contributions made on or after its effective date.” [1092]

Finally, one commenter suggested that the Commission create a safe harbor from the pay to play rule for a special entity that is represented by a qualified independent representative that affirmatively selects the SBS Dealer.[1093] That commenter also suggests excluding state-established plans that are managed by a third-party, such as 529 college savings plans, from the pay to play provisions because otherwise, the provisions would deter SBS Dealers from transacting with the plans.

After the adoption of the CFTC's rules in 2015, this same commenter subsequently proposed that the Commission expressly except from the prohibitions of Rule 15Fh-6(b)(1) contributions that were “made before the security-based swap dealer registered with the Commission as such.” [1094] According to the commenter, these changes would be consistent with CFTC No-Action relief, which clarified that the “look back” period would not include any time period before an SBS Dealer is required to register as such, and would therefore prevent retroactive application of the rule.[1095] The commenter further suggested that the Commission modify the exception under 15Fh-6(b)(2)(B)(iii), such that it would apply to a security-based swap that was “executed” by a municipal entity on a registered national securities exchange or registered or an “exempt” security-based swap execution facility, and was of a “type that is, as of the date of execution, required to be cleared pursuant to Section 3C of the Act.” [1096] In the alternative, the commenter suggested that the exception should apply where the SBS Dealer does not know the identity of the counterparty to the transaction at any time up to and including execution of the transaction.[1097]

c. Response to Comments and Final Rule

After considering the comments, the Commission is adopting Rule 15Fh-6 with six modifications. First, after the Proposing Release was published, an inadvertent omission was identified in the definition of “contribution” in proposed Rule 15Fh-6(a)(1)(i). The Proposing Release inadvertently omitted the word “federal” in subsection (i) of the proposed definition of “contribution” in Rule 15Fh-6(a)(1). Although the Commission did not receive any comments noting this omission, we are modifying the rule text to include the word “federal” in subsection (i) of the final definition of “contribution” in Rule 15Fh-6(a)(1)).[1098] Furthermore, and as stated in the Proposing Release, the Commission explained that “Rule 15Fh-6 is modeled on, and intended to complement, existing restrictions on pay to play practices under Advisers Act Rule 206(4)-5 . . . and under MSRB Rules G-37 and G-38.” [1099] Importantly, both Advisers Act Rule 206(4)-5(f)(1)(i) and MSRB Rule G-37(g)(i)(A)(1) include the word “federal” in their largely identical definitions of the term “contribution.” The Commission is correcting this inadvertent omission to make the definition of “contribution” in Rule 15Fh-6(a)(1)(i) consistent with the Start Printed Page 30047Commission's existing definition of “contribution” under Advisers Act Rule 206(4)-5(f)(1)(i).[1100] Correcting this omission also will make the definition of “contribution” in Rule 15Fh-6(a)(1) consistent with the existing definition of “contribution” under CFTC Regulation 23.451(a)(1)(i) and, therefore, create a harmonized regulatory framework that complements and is comparable to Advisers Act Rule 206(4)-5, MSRB Rules G-37 and CFTC Regulation 23.451.[1101] Based on the foregoing, the Commission believes that correcting this inadvertent omission in a rule that was, as set forth in the Proposing Release, “modeled on, and intended to complement, existing restrictions on pay to play practices” [1102] will eliminate an unintentional gap in pay to play protections across regulatory regimes that would otherwise be created. In light of cross-market participation and expected dual registration of some entities, substantial consistency across pay to play regulatory regimes, including having largely consistent definitions of “contribution,” will also be helpful for those entities that have already established a regulatory infrastructure to comply with pay to play standards under existing rules.

Second, the Commission is correcting another inadvertent omission in the text of Rule 15Fh-6(b)(2)(i). As outlined in the Proposing Release, the de minimis contribution exception found in Rule 15Fh-6(b)(2)(i) is intended to be limited to contributions made by individuals that are covered associates to track and complement the similar de minimis contribution exception found in Advisers Act Rule 206(4)-5(b)(1), upon which this exception was modeled.[1103] Because this exception is conditioned on whether the covered associate was entitled to vote for the official at the time of the contribution, we believe it was implicit in the proposed rule text that this exception only applies to contributions made by a natural person since other legal persons are not entitled to vote. However, we are modifying the text of Rule 15Fh-6(b)(2)(i) to clarify that this exception only applies to contributions made by a natural person. With that modification, the rule text as adopted will track the explanation behind this exception, as explained in the Proposing Release, as well as the text of Advisers Act Rule 206(4)-5(b)(1). This modification will also make Rule 15Fh-6(b)(2)(i) consistent with the CFTC's analogous de minimis contribution exception, which the CFTC described as similarly intended to be limited to individuals that are covered associates.[1104]

Third, as discussed in Section II.B, the Commission is modifying the exception under Rule 15Fh-6(b)(2)(iii) so as to apply when the SBS Dealer does not know the identity of the counterparty with reasonably sufficient time prior to execution of the transaction to permit the SBS Dealer to comply with the obligations of the rule. This language differs from the language used in the proposal, which would apply the exception when the dealer does not know the identity of the counterparty “at any time up to and including execution of the transaction.” The adoption of this language will comport with the language used in the verification of counterparty status and disclosure requirements of final Rule 15Fh-3, as well as the exceptions to the special entity requirements under Rules 15Fh-4(b)(3) and 15Fh-5(d). As discussed in those sections, this language is intended to exclude situations where the identity of the counterparty is not discovered until after execution of a transaction, or where the SBS Dealer learns the identity of the counterparty with insufficient time to be able to satisfy its obligations under the rule without delaying the execution of the transaction.

Fourth, as discussed above in Section II.H.8, the Commission is also modifying the exception under Rule 15Fh-6(b)(2)(iii) to apply to all security-based swap transactions executed on a registered or exempt SEF or registered national securities exchange, rather than just with respect to transactions “initiated by a municipal entity” on such exchange or SEF (as long as the other conditions of Rule 15Fh-6(b)(2)(iii) are met). We are revising the rule to be consistent with the adopted Rules 15Fh-4(b)(3) and 15Fh-5(d), and avoid the ambiguity inherent in determining which party “initiated” the security-based swap.[1105]

Fifth, we are also modifying Rule 15Fh-6(e)(2), as one commenter suggested,[1106] to allow for up to three exemptions for inadvertent contributions per calendar year, depending on the number of natural person covered associates at the SBS Dealer. Specifically, we are modifying the text of Rule 15Fh-6(e)(2), as suggested by this same commenter,[1107] to provide that an SBS Dealers that has more than 50 covered associates would be able to rely on this exception no more than three times per calendar year, while an SBS Dealer that has 50 or fewer covered associates would be able to rely on this exception no more than two times per calendar year. This modification will parallel the provision in Advisers Act Rule 206(4)-5, which also allows “larger” investment advisers to avail themselves of three automatic exceptions, instead of two, in any calendar year. As the Commission noted when modifying its Advisers Act rule proposal to include three automatic exceptions for larger firms, we agree that inadvertent violations of the rule are more likely at firms with greater numbers of covered associates, and we believe that the twice per year limit is appropriate for smaller firms and that the three times per year limit is appropriate for larger firms.[1108] Start Printed Page 30048Although we recognize that this modification will create an additional exception not found in the CFTC's analogous rule,[1109] we believe that harmonization across the Commission's regulatory regimes will help to create regulatory efficiencies for entities that have already established a regulatory infrastructure based on the Commission's analogous exception.

Finally, the Commission is also correcting in the final rule the following typographical errors: (1) Revising an internal cross-reference in Rule 15Fh-6(a)(2)(iii) to cross-reference “paragraphs (a)(2)(i) and (a)(2)(ii) of this section” rather than “paragraphs (c)(2)(i) and (c)(2)(ii) of this section”; (2) revising an internal cross-reference in Rule 15Fh-6(d) to cross-reference “paragraph (b) of this section” rather than “paragraph (a)(1) of this section”; (3) revising Rule 15Fh-6(b)(3)(ii)(A) to delete a phrase that was inadvertently repeated “a security-based swap security-based swap”; and (4) revising Rule 15Fh-6(b)(3)(ii)(B) to also delete a phrase that was inadvertently repeated “a security-based swap security-based swap.”

With respect to the balance of Rule 15Fh-6, after considering the comments submitted, the Commission is adopting the Rule as proposed. The Commission disagrees with certain commenters' view that Rule 15Fh-6 is not an appropriate area for the Commission to exercise its authority to prescribe business conduct standards.[1110] The Commission also disagrees with one commenter's suggestion that there may not be much marginal benefit to imposing additional restrictions on SBS Dealers generally.[1111] We proposed the rule in the context of security-based swaps because pay to play practices may result in municipal entities entering into transactions not because of hedging needs or other legitimate purposes, but rather because of campaign contributions given to an official with influence over the selection process. Where pay to play exists, SBS Dealers may compete for security-based swap business based on their ability and willingness to make political contributions, rather than on their merit or the merit of a proposed transaction. We believe these practices may result in significant harm to municipalities and others in connection with security-based swap transactions, just as they do in connection with other municipal securities transactions.[1112] We note that SBS Dealers may have an incentive to participate in pay to play practices out of concern that they may be overlooked if they fail to make such contributions. These concerns, coupled with the furtive nature of pay to play practices and the inability of markets to properly address them, strongly support the need for prophylactic measures to address them in the context of security-based swaps.[1113] Furthermore, and as the same commenter concedes, there would still be a regulatory gap as only “most” SBS Dealers would be covered and, as another commenter observed, this rule would help to eliminate that gap in protection.[1114] We made this same point in the Proposing Release, noting that while Rule 15Fh-6 is consistent with and would complement the pay to play prohibition adopted by the MRSB and CFTC, there are no existing federal pay to play rules that would apply to all SBS Dealers in their dealings with municipal entities.[1115] Therefore, this rule was proposed to help eliminate that regulatory gap.

The Commission continues to believe and a commenter also agrees that the two-year time out provided for in Rule 15Fh-6 is appropriate.[1116] As explained in the Proposing Release, Rule 15Fh-6(b)(1) would prohibit an SBS Dealer from offering to enter into, or entering into, a security-based swap or a trading strategy involving a security-based swap, with a municipal entity within two years after a contribution to an official of such municipal entity has been made by the SBS Dealer or any of its covered associates. We believe the two-year time out requirement strikes an appropriate balance, as it is sufficiently long to act as a deterrent but not so long as to be unnecessarily onerous. The two-year time out is generally consistent with the time out provisions in Advisers Act Rule 206(4)-5, MSRB Rule G-37 and CFTC Regulation 23.451.

As we also explained in the Proposing Release, because the rule would attribute to an SBS Dealer those contributions made by a person even prior to becoming a covered associate of the SBS Dealer, SBS Dealers need to “look back” in time to determine whether the two-year time out applies when an employee becomes a covered associate.[1117] Given that one commenter suggested further specificity as to whether the rule applies only to contributions made on or after the rules effective date,[1118] we are interpreting the prohibition in Rule 15Fh-6(b)(1) and its exceptions in Rule 15Fh-6(b)(2), as well as the restrictions on soliciting or coordinating contributions found in Rule 15Fh-6(b)(3), to not be triggered for an SBS Dealer or any of its covered associates by contributions made before the SBS Dealer registered with the Commission as such. This interpretation is, as one commenter noted, also consistent with CFTC No-Action relief.[1119] However, such prohibitions will apply to contributions made on or after the SBS Dealer is required to register with the Commission. We also note that these prohibitions do not apply to contributions made before the compliance date of this rule by new covered associates to which the rule's “look back” applies (i.e., a person who becomes a covered associate within two years after the contribution is made). Start Printed Page 30049This interpretation is similar to the approach taken by the Commission in connection with Advisers Act Rule 206(4)-5.[1120] For example, if an individual who becomes a covered associate on or after the effective date of the rule made a contribution before the effective date of the rule, that new covered associate's contribution would not trigger the two-year time out. On the other hand, if an individual who later becomes a covered associate made the contribution on or after the compliance date of this rule, the contribution would trigger the two-year time out if it were made less than, as applicable, six months or two years before the individual became a covered associate.[1121]

With respect to the comment recommending amending the proposed rule to include Major SBS Participants in the prohibitions of Rule 15Fh-6,[1122] the Commission does not believe that it is necessary or appropriate to do so. We have considered how the differences between the definitions of SBS Dealer and Major SBS Participant may be relevant in formulating the business conduct standards applicable to these entities.[1123] The Commission does not believe it is necessary to revisit its assumption, outlined in the Proposing Release, that Major SBS Participants are unlikely to give rise to the pay-to-play concerns that this rule is intended to address.[1124] As discussed above, SBS Dealers may have an incentive to compete for security-based swap business based on their ability and willingness to participate in pay to play activity, rather than on their merit or the merit of a proposed transaction, out of concern that they may be overlooked if they fail to make such contributions. However, we believe the incentives for Major SBS Participants to engage in pay to play activity are unlikely to be as strong as the incentives for SBS Dealers given that, by definition, Major SBS Participants are not engaged in security-based swap dealing activity at levels above the de minimis threshold.[1125] As such, Major SBS Participants are less likely than SBS Dealers to be acting as dealers in the security-based swap market and, like any other person whose dealing activity does not exceed the dealer de minimis thresholds, should therefore be less susceptible to the types of competitive pressures that may create an incentive to participate in pay to play activity. We further note that, if a Major SBS Participant is, in fact, engaged in security-based swap dealing activity above the de minimis threshold, it would need to register as an SBS Dealer and, as such, would need to comply with the pay to play rules imposed by Rule 15Fh-6.

Therefore, SBS Dealers, unlike Major SBS Participants, may have an incentive to participate in pay to play practices out of concern that they may be overlooked if they fail to make such contributions which, in turn, would necessitate application of pay to play prohibitions. Furthermore, the exclusion of Major SBS Participants from Rule 15Fh-6 will also be consistent with the pay to play prohibition adopted by the CFTC.[1126] Substantial consistency across pay to play regulatory regimes will be helpful for those entities that have already established a regulatory infrastructure to comply with existing rules. One commenter suggested that, with respect to the proposal that independent representatives be subject to pay to play limitations, an exception is needed “for advisors that are employees of the special entity, given the employer-employee relationship.” [1127] However, the Commission notes that the rules already include such an exception. As explained previously, Rule 15Fh-5(a)(1)(vi) as adopted requires an SBS Entity to have a reasonable basis for believing that the independent representative is a person that is subject to rules of the Commission, the CFTC or an SRO subject to the jurisdiction of the Commission or the CFTC prohibiting it from engaging in specified activities if certain political contributions have been made, unless the independent representative is an employee of the special entity.

The same commenter also urged the Commission, in a comment letter dated August 2011, to delay imposing the proposed pay to play rule until after the “dealer” definitions are finalized.[1128] As explained in Section IV.B below, the Commission is adopting a compliance date for final Rules 15Fh-1 through 15Fh-6 and Rule 15Fk-1 that is the same as the compliance date of the SBS Entity registration rules.[1129]

The Commission declines to revise Rule 15Fh-6, as one commenter suggested, by limiting the triggering event for the application of the pay to play rules to “engag[ing] in municipal security-based swap business” or “the execution of a security-based swap with a municipal entity.” [1130] As explained in the Proposing Release, pay to play occurs when persons seeking to do business with municipal entities make political contributions, or are solicited to make political contributions, to elected officials or candidates to influence the selection process.[1131] Hence, pay to play could occur when an SBS Dealer is merely offering to enter into a security-based swap with a municipal entity, before that SBS Dealer has yet to actually enter into, engage in, or execute any such transaction. Rather, the SBS Dealer is seeking to influence the selection process to generate business. Therefore, the Commission believes that further parsing of the trigging event applicable to this rule, as suggested by the commenter, would create an unintended regulatory gap that would not capture those who offer to enter into a security-based swap transaction with a municipal entity with the hope that their contributions or payments will influence the selection process so that they may later enter into, engage in, or execute security-based swaps with that municipal entity. As one court noted,”[w]hile the risk of corruption is obvious and substantial, actors in this field are presumably shrewd enough to structure their relations rather indirectly.” [1132] Furthermore, this same suggestion was Start Printed Page 30050raised to and declined by the CFTC.[1133] As a result, the triggering event for the application of Rule 15Fh-6 is consistent with the CFTC's rule and substantially consistent with the trigging event for certain prohibitions found in the Commission's Advisers Act Rule 206(4)-5.[1134]

One commenter that addressed the definition of “solicit” in the proposed rule generally urged us to adopt a narrower definition.[1135] However, the Commission declines to revise Rule 15Fh-6 to further parse the definition of “solicit.” We believe that it is unnecessary, as the commenter suggested, for the definition to cover only direct communications or to state what communications are not covered by the term “solicit.” [1136] The proposed definition makes clear that to fall within its scope the communication, whether direct or indirect, must be “with a municipal entity for the purpose of obtaining or retaining an engagement related to a security-based swap.” Further parsing and thus narrowing of the definition of “solicit” is unwarranted given the covert and secretive nature of pay to play practices where, as noted above, “actors in this field are presumably shrewd enough to structure their relations rather indirectly.” [1137] Rule 15Fh-6 is intended to deter SBS Dealers from participating, even indirectly, in pay to play practices. The Commission believes that the definition of “solicit” is clear as to what communications are covered by the pay to play rule, and the definition is also consistent with the CFTC's rule and the Commission's definition of “solicit” in Advisers Act Rule 206(4)-5 [1138] which, as noted above, Rule 15Fh-6 was modeled on and intended to complement.

Another commenter suggested that the Commission revise Rule 15Fh-6 to create a safe harbor from the pay to play rule for a special entity that is represented by a “qualified independent representative” that affirmatively selects the SBS Dealer.[1139] However, the Commission declines to create a safe harbor as the commenter suggested. For one, the commenter's argument that such a safe harbor would “assist municipal entities and their advisors by preserving their ability to execute security-based swap transactions” is not persuasive to support this suggested modification when, for example, one of the purposes behind this rule is the need for prophylactic measures to address stealthy pay to play practices.[1140] As stated in the Proposing Release and noted above, by its nature, pay to play is covert and secretive because participants do not broadcast that contributions or payments are made or accepted for the purpose of influencing the selection of a financial services provider. The Commission believes that adopting such a safe harbor, as suggested, could create a means for would-be wrongdoers to covertly and secretively engage in pay to play practices by, among other things, using situations where the special entity, represented by a qualified independent representative, selects the SBS Dealer as a way to evade or otherwise circumvent the rule's prohibitions. The commenter's suggestion would also create a material difference between the regulatory regimes established by the Commission under the Advisers Act as well as the CFTC's rules and would decrease regulatory efficiencies for market participants.

Finally, we are not expressly excluding, as one commenter suggested, state-established plans that are managed by a third-party, such as 529 college savings plans, from the pay to play provisions.[1141] We do not find the commenter's unsupported claim that pay to play provisions will deter SBS Dealers from transacting business with such plans persuasive. More importantly, even if we were to accept this argument, the same concerns, outlined above, that we are attempting to address with these pay to play restrictions, including but not limited to the furtive nature of pay to play practices, are also applicable for state-established plans that are managed by a third-party. As noted above, we believe that SBS Dealers may have an incentive to participate in pay to play practices, even in connection with state-established plans that are managed by a third-party, out of concern that they may be overlooked for business if they fail to make such contributions. We further believe these practices may result in significant harm to municipalities and others, including state-established plans, in connection with security-based swap transactions. Rule 15Fh-6(b)(3)(i) is intended to deter SBS Dealers from participating, even indirectly, in such practices.

I. Chief Compliance Officer

Section 15F(k) of the Exchange Act requires an SBS Entity to designate a CCO, and imposes certain duties and responsibilities on that CCO.[1142]

1. Proposed Rule

a. Designation, Reporting Line, Compensation and Removal of the CCO

Proposed Rule 15Fk-1(a) would require an SBS Entity to designate a CCO on its registration form. Proposed Rule 15Fk-1(b)(1) would require that the CCO report directly to the board of directors or to the senior officer of the SBS Entity.[1143] Proposed Rule 15Fk-1(e)(1) would define “board of directors” to include a body performing a function similar to the board of directors. Proposed Rule 15Fk-1(e)(2) would define “senior officer” to mean the chief executive officer or other equivalent officer. Finally, proposed Rule 15Fk-1(d) would require that the compensation and removal of the CCO be approved by a majority of the board of directors of the SBS Entity.

b. Duties of the CCO

Proposed Rule 15Fk-1(b) would impose certain duties on the CCO. Proposed Rule 15Fk-1(b)(2) would require the CCO to review the compliance of the SBS Entity with respect to the requirements in Section 15F of the Exchange Act and the rules and regulations thereunder.[1144] Proposed Rule 15Fk-1(b)(2) would further require that, as part of the CCO's obligation to review compliance by the SBS Entity, the CCO establish, maintain, and review policies and procedures that are reasonably designed to achieve compliance by the SBS Entity with Start Printed Page 30051Section 15F of the Exchange Act and the rules and regulations thereunder.

Proposed Rule 15Fk-1(b)(3) would require that the CCO, in consultation with the board of directors or the senior officer of the organization, promptly resolve conflicts of interest that may arise.[1145] Under proposed Rule 15Fk-1(b)(4), the CCO would be responsible for administering each policy and procedure that is required to be established pursuant to Section 15F of the Exchange Act and the rules and regulations thereunder.[1146] Proposed Rule 15Fk-1(b)(5) would require the CCO to establish, maintain and review policies and procedures reasonably designed to ensure compliance with the provisions of the Exchange Act and the rules and regulations thereunder relating to the SBS Entity's business as an SBS Entity.[1147] Proposed Rule 15Fk-1(b)(6) would require the CCO to establish, maintain and review policies and procedures reasonably designed to remediate promptly non-compliance issues identified by the CCO through any compliance office review, look-back, internal or external audit finding, self-reporting to the Commission and other appropriate authorities, or complaint that can be validated.[1148] Proposed Rule 15Fk-1(e)(3) would define “complaint that can be validated” to mean any written complaint by a counterparty involving the SBS Entity or an associated person that can be supported upon reasonable investigation. Proposed Rule 15Fk-1(b)(7) would require the CCO to establish and follow procedures reasonably designed for prompt handling, management response, remediation, retesting, and resolution of non-compliance issues.[1149]

c. Annual Compliance Report

Proposed Rule 15Fk-1(c)(1) would require that the CCO annually prepare and sign a report describing the SBS Entity's compliance policies and procedures (including the code of ethics and conflicts of interest policies) and the compliance of the SBS Entity with the Exchange Act and rules and regulations thereunder relating to its business as an SBS Entity.[1150] Proposed Rule 15Fk-1(c)(2) would require that each compliance report also contain, at a minimum, a description of: (1) The SBS Entity's enforcement of its policies and procedures relating to its business as an SBS Entity; (2) any material changes to the policies and procedures since the date of the preceding compliance report; (3) any recommendation for material changes to the policies and procedures as a result of the annual review, the rationale for such recommendation, and whether such policies and procedures were or will be modified by the SBS Entity to incorporate such recommendation; and (4) any material compliance matters identified since the date of the preceding compliance report. Proposed Rule 15Fk-1(e)(4) would define “material compliance matter” to mean any compliance matter about which the board of directors of the SBS Entity would reasonably need to know to oversee the compliance of the SBS Entity, and that involves, without limitation: (1) A violation of the federal securities laws relating to its business as an SBS Entity by the SBS Entity or its officers, directors, employees or agents; (2) a violation of the policies and procedures of the SBS Entity relating to its business as an SBS Entity by the SBS Entity or its officers, directors, employees or agents; or (3) a weakness in the design or implementation of the policies and procedures of the SBS Entity relating to its business as an SBS Entity.

Proposed Rule 15Fk-1(c)(2)(ii)(D) would require the compliance report to include a certification, under penalty of law, that the compliance report is accurate and complete.[1151] Proposed Rule 15Fk-1(c)(2)(ii)(A) would require that the compliance report accompany each appropriate financial report of the SBS Entity that is required to be furnished or filed with the Commission pursuant to Exchange Act Section 15F and the rules and regulations thereunder.[1152] To allow the compliance report to accompany each appropriate financial report within the required timeframe, proposed Rule 15Fk-1(c)(2)(ii)(B) would require the compliance report to be submitted to the board of directors, the audit committee and the senior officer of the SBS Entity at the earlier of their next scheduled meeting or within 45 days of the date of execution of the certification.

Proposed Rule 15Fk-1(c)(2)(ii)(C) would require the compliance report to include a written representation that the chief executive officer(s) (or equivalent officer(s)) has/have conducted one or more meetings with the CCO in the preceding 12 months, the subject of which addresses the SBS Entity's obligations as set forth in the proposed rules and in Exchange Act Section 15F. The subject of the meeting(s) must include: (1) The matters that are the subject of the compliance report; (2) the SBS Entity's compliance efforts as of the date of such meeting; and (3) significant compliance problems and plans in emerging business areas relating to its business as an SBS Entity.[1153]

Under proposed Rule 15Fk-1(c)(2)(iii), if compliance reports are separately bound from the financial statements, the compliance reports shall be accorded confidential treatment to the extent permitted by law.

2. Comments on the Proposed Rule

a. Designation, Reporting Line, and Compensation and Removal of the CCO

Five commenters addressed the designation, reporting line and compensation and removal of the CCO.[1154] Two commenters argued for greater flexibility for SBS Entities with respect to these requirements.[1155] The first commenter objected to the mandated line of reporting of the CCO in the proposed rule (which would require the CCO to report directly to the board of directors or to the senior officer of the SBS Entity) and recommended allowing SBS Entities greater flexibility in determining the most effective reporting framework in light of their individual structure and circumstances.[1156] The commenter noted that, particularly in large institutions where security-based swap transactions are one of many lines of business, the proposed rule would prohibit the CCO from reporting to other senior management who may be more familiar with the security-based swap activities of the SBS Entity.[1157] Accordingly, the commenter recommended that the Commission Start Printed Page 30052define the term “senior officer” to include a more senior officer within the SBS Entity's compliance, risk, legal or other control function as the SBS Entity shall reasonably determine to be appropriate.[1158]

Similarly, the second commenter asked the Commission to provide guidance specifying that if a division of a larger company is an SBS Entity, then the CCO of such entity could report to the senior officer of that division.[1159] Additionally, the commenter requested guidance: (1) Regarding the supervisory liability of compliance and legal personnel employed by SBS Entities that is consistent with the guidance it has issued for broker-dealers' legal and compliance personnel; and (2) clarifying that the CCO may share additional executive responsibilities within the SBS Entity.[1160]

Both commenters objected to the proposed requirement that the compensation and removal of the CCO be approved by a majority of the SBS Entity's board of directors.[1161] The first commenter recommended eliminating the requirement, noting that the provision is not mandated by the Dodd-Frank Act, is not consistent with other requirements applicable to similarly situated employees, and would impose organizational inefficiencies and other unwarranted costs while offering minimal benefits.[1162] The second commenter recommended allowing either the board of directors or the senior officer of the SBS Entity to approve the compensation or removal of the CCO to be consistent with the parallel CFTC requirement, asserting that this change would reasonably ensure the independence and effectiveness of the CCO while providing for greater flexibility.[1163]

Three commenters argued for more stringent requirements with respect to the designation, reporting line and compensation and removal of the CCO.[1164] The first commenter asserted that ensuring market participants have CCOs with real authority and autonomy to police a firm from within is one of the most efficient and effective tools available to regulators, and accordingly, recommended adopting additional measures to protect the authority and independence of CCOs.[1165] Specifically, the commenter suggested: (1) Requiring the CCO to meet competency standards, including a lack of disciplinary history and criteria demonstrating relevant knowledge and experience; (2) prohibiting the CCO from serving as General Counsel or a member of the legal department of the SBS Entity; (3) appointing a senior CCO with overall responsibility for compliance by a group of affiliated or controlled entities; (4) vesting authority in independent board members to oversee the hiring, compensation, and termination of the CCO; (5) requiring the CCO to have direct access to the board; and (6) prohibiting attempts by officers, directors, or employees to coerce, mislead, or otherwise interfere with the CCO.[1166]

Similarly, the second commenter recommended that the authority and responsibility to appoint or remove the CCO, or to materially change its duties and responsibilities, be vested only in the independent directors and not the full board.[1167] Additionally, the commenter suggested that the CCO have only a compliance role and no other role or responsibility that could create conflicts of interest or threaten its independence, and that the CCO's compensation be designed in a way that avoids conflicts of interest.[1168]

The third commenter asserted that firms should not be permitted to allow the CCO to report to a senior officer of the firm as a substitute for reporting to the board.[1169]

b. Duties of the CCO

Three commenters addressed the duties of the CCO.[1170] The first commenter supported the Commission's approach in the proposal regarding the role and responsibilities of the CCO, but recommended the following modifications: (1) Changing the phrase “ensure compliance” in proposed Rule 15Fk-1(b)(5) to “achieve compliance,” (2) confirming that the relevant conflicts of interest under proposed Rule 15Fk-1(b)(3) would be those which are reasonably identified by the SBS Entity's policies and procedures, taking into consideration the nature of the SBS Entity's business, and (3) clarifying that a CCO's responsibility under proposed Rule 15Fk-1(b)(4) to “administer” a firm's policies and procedures is limited to coordinating supervisors' administration of the relevant policies and procedures.[1171]

The second commenter recommended harmonizing the Commission's CCO requirements with FINRA Rule 3130 and the CFTC's CCO requirements for Swap Entities to enable SBS Entities that are also broker-dealers and/or Swap Entities to make use of their existing infrastructure and to minimize confusion.[1172] Specifically, the commenter recommended a number of changes to proposed Rule 15Fk-1(b) to align the description of the duties of an SBS Entity's CCO with those of a broker-dealer CCO, as described in applicable FINRA and SEC guidance, and guidance in the Proposing Release regarding the supervisory responsibilities of an SBS Entity's CCO.[1173] In particular, the commenter sought clarification that the SBS Entity has the responsibility, and not the CCO in his or her personal capacity, to establish, maintain and review required policies and procedures.[1174] The recommended changes include: (1) Replacing the requirement in proposed Rule 15Fk-1(b)(2) to “establish, maintain and review” written policies and procedures reasonably designed to achieve compliance with Section 15F of the Act and the rules and regulations thereunder with a requirement to “prepare the registrant's annual assessment of” such policies and procedures; (2) qualifying the requirement in proposed Rule 15Fk-1(b)(3) to promptly resolve conflicts of interest in consultation with the board of directors or the senior officer of the SBS Entity with the qualifying language “take reasonable steps to” resolve; (3) clarifying that the requirement in proposed Rule 15Fk-1(b)(4) to administer required policies and procedures involves “advising on the development of, and reviewing, the registrant's processes for (i) modifying those policies and procedures as business, regulatory and legislative changes and events dictate, (ii) evidencing supervision by the personnel responsible for the execution of those policies and procedures, and (iii) testing the registrant's compliance with those policies and procedures;” (4) qualifying the requirements in proposed Rules 15Fk-1(b)(5)-(7) to establish, maintain and review certain policies and procedures with the qualifying language “take reasonable steps to ensure that the Start Printed Page 30053registrant” establishes, maintains and reviews such policies and procedures; and (5) eliminating the timing requirements in proposed Rules 15Fk-1(b)(6) and (7) that the CCO “promptly” take the required actions.[1175] Finally, the commenter requested that the Commission provide guidance explaining that resolution of a conflict of interest encompasses both elimination and mitigation of the conflict, and that the CCO's role in resolving conflicts may involve actions other than making the ultimate decision with regard to such conflict.[1176]

In contrast, the third commenter recommended mandating that CCOs have greater authority to resolve and mitigate conflicts of interest that may cause compliance problems.[1177] At a minimum, the commenter suggested requiring the CCO to highlight in the compliance report any recommendations it made with regard to resolution or mitigation of conflicts of interest that were not adopted.[1178]

c. Annual Compliance Report

Four commenters addressed the annual compliance report requirements.[1179] One commenter noted several concerns with the annual compliance report requirement.[1180] First, the commenter requested that the Commission permit the consolidation of annual compliance reporting requirements for SBS Entities under common control (including those that are also registered broker-dealers) to avoid forcing a consolidated financial institution to submit separate compliance reports for each SBS Entity and broker-dealer within the corporate structure.[1181] Second, the commenter expressed concern regarding the requirement in proposed Rule 15Fk-1(c)(1)(i) that the compliance report contain a description of the compliance of the SBS Entity, as well as a description of the SBS Entity's compliance policies and procedures, as required under proposed Rule 15Fk-1(c)(1)(ii).[1182] The commenter requested that the Commission clarify that proposed Rule 15Fk-1(c)(1)(i) would be satisfied by a description of the particular matters set forth in proposed Rule 15Fk-1(c)(2)(i), noting that a requirement to describe an SBS Entity's “compliance” in an absolute sense is so broad and so vague as to be incapable of being fulfilled in practice.[1183] Third, the commenter recommended that the Commission amend its Freedom of Information Act regulations in a manner consistent with proposed Rule 15Fk-1(c)(2)(iii), which would provide that compliance reports bound separately from financial statements shall be accorded confidential treatment to the extent permitted by law.[1184]

The commenter also had several concerns regarding the required certification of the compliance report in proposed Rule 15Fk-1(c)(2)(ii)(D).[1185] The commenter noted that the Dodd-Frank Act does not explicitly require the CCO to be the individual responsible for certifying the compliance report and recommended that the CEO or other relevant senior officer, not the CCO, be responsible for the certification.[1186] Alternatively, if the CCO is required to certify, the commenter requested that the CEO also be required to do so.[1187] Additionally, the commenter requested that the Commission clarify that the liability standard for the certification is the same as that which applies to other documents filed with the Commission, including liability under Section 32 of the Exchange Act for willfully and knowingly making false or misleading material statements or omissions to the Commission.[1188] The commenter also asserted that the certifier should, as in other contexts, be responsible solely for stating that the documents were prepared under his or her direction or supervision in accordance with a system designed to ensure that qualified personnel would properly gather and evaluate the documents, and that based on his or her inquiry of those persons who were responsible for gathering the documents, to the best of his or her knowledge, the documents are accurate in all material respects.[1189]

Similarly, the second commenter requested that the Commission provide guidance clarifying that if a certifying officer has complied in good faith with policies and procedures reasonably designed to confirm the accuracy and completeness of annual compliance report, both the SBS Entity and the certifying officer would have a basis for defending accusations of false, incomplete, or misleading statements or representations made in the report.[1190] The commenter also requested a number of changes to the annual compliance report requirements in proposed Rule 15Fk-1(c) to harmonize them with the CFTC's parallel requirements.[1191] The commenter argued that alignment of the content requirements for annual compliance reports “would allow SBS Entities to leverage the extensive and rigorous procedures they have adopted to comply with the CFTC CCO Rule and related guidance.”[1192] Specifically, the recommended changes include: (1) Eliminating the proposed requirement to include a “description of compliance” in the annual compliance report, asserting that this requirement would add unnecessary ambiguity; (2) specifying that the report need only contain a description of the “written” compliance policies and procedures of the SBS Entity; (3) changing the proposed description requirement in proposed Rule 15Fk-1(c)(2)(i)(A) from “enforcement” of the SBS Entity's policies and procedures to an “assessment of the effectiveness” of such policies and procedures; (4) specifying that the requirement to describe material changes to policies and procedures in proposed Rule 15Fk-1(c)(2)(i)(B) refers to the “registrant's” policies and procedures; (5) changing the proposed description requirement in proposed Rule 15Fk-1(c)(2)(i)(C) from “any recommendation for material changes to the policies and procedures” to “areas for improvement, and recommended potential or prospective changes or improvements to its compliance program and resources devoted to compliance;” (6) changing the proposed description requirement in proposed Rule 15F-1(c)(2)(i)(D) from “any material compliance matters” to “any material non-compliance matters” identified since the date of the preceding report (and eliminating the definition of material compliance matter); (7) aligning the deadline for filing of the compliance report with the CFTC's 90 day deadline; (8) allowing for submission of the compliance report to either the board of directors or the senior officer, as opposed to requiring submission to both the board of directors (and audit committee) and the senior officer, as proposed; (9) eliminating the proposed requirement that the report contain a written representation regarding the required annual meeting between the CEO and the CCO; (10) eliminating the proposed specifications for what topics such Start Printed Page 30054meeting must cover; (11) allowing either the CCO or the senior officer to certify the annual compliance report to the best of his or her knowledge; and (12) providing for amendments to, extensions of filing deadlines for, and incorporation of other reports by reference in the annual compliance report.[1193]

The third commenter suggested: (1) Requiring the CCO to meet quarterly with the Audit Committee in addition to annual meetings with the board of directors and senior management; and (2) requiring the board to review and comment on, but not edit, the compliance report.[1194] Similarly, the fourth commenter expressed support for requiring the audit committee to review and the CCO to certify the compliance report, and argued that the CCO should not be permitted to qualify its report.[1195]

3. Response to Comments and Final Rule

Rule 15Fk-1, as adopted, is designed to be generally consistent with the current compliance obligations applicable to CCOs of other Commission-regulated entities,[1196] as well as with the CFTC's CCO rules applicable to Swap Entities. As noted in the Proposing Release, the requirements of Rule 15Fk-1 underscore the central role that sound compliance programs play to help ensure compliance with the Exchange Act and rules and regulations thereunder applicable to security-based swaps.[1197] The Commission believes that these requirements will help foster sound compliance programs.[1198]

a. Designation, Reporting Line, and Compensation and Removal of the CCO

After considering the comments, the Commission is adopting Rule 15Fk-1(a) (designation of the CCO), Rule 15Fk-1(b)(1) (reporting line of the CCO), Rule 15Fk-1(d) (compensation and removal of the CCO), and the associated definitions of “board of directors” and “senior officer” in Rule 15Fk-1(e)(1) and (2) as proposed. To address concerns that an SBS Entity's commercial interests might have undue influence on a CCO's ability to make forthright disclosure to the board of directors or the senior officer about any compliance failures, the rule is designed to help promote CCO independence and effectiveness by establishing a direct reporting line to the board or senior officer, and by requiring compensation and removal decisions to be made by a majority of the board of directors. Accordingly, Rule 15Fk-1(b)(1) requires the CCO to report directly to the board or senior officer of the SBS Entity.[1199] In addition, pursuant to Rule 15Fk-1(d) any decision to remove the CCO from his or her responsibilities or approve his or her compensation must be made by a majority of the board. The Commission is not eliminating the requirement that only a majority of the board can approve the compensation or removal of the CCO, as suggested by one commenter,[1200] nor is the Commission broadening the rule to allow an SBS Entity's senior officer to approve the compensation and removal of the CCO, as suggested by another commenter.[1201] The Commission believes that eliminating the requirement that only a majority of the board can approve the compensation or removal of the CCO, or allowing an SBS Entity's senior officer to approve the compensation and removal of the CCO could undermine the CCO's independence and effectiveness, particularly if the CCO is responsible for reviewing the senior officer's compliance with the Exchange Act and the rules and regulations thereunder.[1202]

In promoting a CCO's independence and effectiveness, the Commission does not believe that it is necessary to adopt additional requirements suggested by commenters prohibiting a CCO from having additional roles or responsibilities outside of compliance, such as being a member of the SBS Entity's legal department or from serving as the SBS Entity's general counsel.[1203] To the extent that this poses a potential or existing conflict of interest, the Commission believes that an SBS Entity's written policies and procedures can be designed to adequately identify and mitigate any such conflict.[1204]

The Commission also is not adopting rules requiring independent board members to oversee the hiring, compensation and termination of the Start Printed Page 30055CCO or any material changes to the CCO's duties, requiring the CCO to have direct access to the board, or expressly prohibiting attempts by officers, directors, or employees to coerce, mislead or otherwise interfere with the CCO, as suggested by commenters.[1205] The Commission continues to believe that requiring a majority of the board to approve the compensation and removal of the CCO is appropriate to promote the CCO's independence and effectiveness, and believes that it is appropriate not to provide for additional requirements such as those suggested by the commenters.[1206] With this approach, the Commission intends to promote the independence and effectiveness of the CCO while also providing SBS Entities flexibility in structuring their businesses and directing their compliance resources.

One commenter suggested requiring the CCO to meet certain competency standards, including criteria demonstrating relevant knowledge and experience.[1207] Given the critical role that a CCO is intended to play in helping to ensure an SBS Entity's compliance with the Exchange Act and the rules and regulations thereunder, the Commission believes that an SBS Entity's CCO generally should be competent and knowledgeable regarding the federal securities laws, empowered with full responsibility and authority to develop appropriate policies and procedures for the SBS Entity, as necessary, and responsible for monitoring compliance with the SBS Entity's policies and procedures adopted pursuant to rules under the Exchange Act.[1208] However, we believe that such considerations are properly vested in the SBS Entity, based on the particulars of its business, and thus, the Commission is not adopting specific requirements concerning the background, training or business experience for a CCO.

Another commenter asked that the Commission provide guidance regarding the supervisory liability of compliance and legal personnel employed by SBS Entities to reflect the guidance Commission staff has issued for broker-dealers' legal and compliance personnel.[1209] The Commission recognizes that compliance and legal personnel play a critical role in efforts by regulated entities to develop and implement effective compliance systems, including by providing advice and counsel to business line personnel. As noted in the Proposing Release, the title of CCO does not, in and of itself, carry supervisory responsibilities, and a CCO does not become a “supervisor” solely because he or she has provided advice or counsel concerning compliance or legal issues to business line personnel, or assisted in the remediation of an issue. Consistent with current industry practice, the Commission generally would not expect a CCO appointed in accordance with Rule 15Fk-1 to have supervisory responsibilities outside of the compliance department.[1210] Accordingly, absent facts and circumstances that establish otherwise, the Commission generally would not expect that a CCO would be subject to a sanction by the Commission for failure to supervise other SBS Entity personnel.[1211] Moreover, a CCO with supervisory responsibilities could rely on the provisions of Rule 15Fh-3(h)(3), under which a person associated with an SBS Entity shall not be deemed to have failed to reasonably supervise another person if the conditions in the rule are met.[1212] The fact that the Exchange Act does not presume that compliance or legal personnel are supervisors solely because of their compliance or legal functions does not in any way diminish the compliance duties of the CCO pursuant to Rule 15Fk-1(b), as discussed below.

b. Duties of the CCO

After considering the comments, the Commission is adopting Rule 15Fk-1(b)(2)-(4) (duties of the CCO) with a number of modifications. In response to a commenter's concerns,[1213] the modifications (discussed below) are primarily intended to provide certainty regarding the CCO's duties under the final rule, consistent with the duties in FINRA Rule 3130 and the CFTC's CCO requirements for Swap Entities, and to clarify the role of the CCO generally. To the extent our requirements are consistent with FINRA and/or CFTC standards, this consistency should result in efficiencies for SBS Entities that have already established infrastructure to comply with the FINRA and/or CFTC standards. Consistent wording regarding expectations for CCOs will also allow such SBS Entities to more easily analyze compliance with the Commission's rule against their existing activities to comply with FINRA Rule 3130 and the CFTC's CCO rule for Swap Entities.

First, we are reorganizing Rule 15Fk-1(b)(2) to provide additional clarity and certainty as to the obligations of the CCO. Specifically, our modifications are designed to make clear that in taking reasonable steps to ensure that the SBS Entity establishes, maintains and reviews written policies and procedures reasonably designed to achieve compliance with the Exchange Act and the rules and regulations thereunder relating to its business as an SBS Entity, the CCO must satisfy the three specific obligations enumerated in Rule 15Fk-1(b)(2)(i)-(iii), discussed below.

Second, in addition to the reorganization described above, we are making some changes to the descriptions of the duties listed in Rule 15Fk-1(b)(2). As described above, we are making changes to the duty that now appears in Rule 15Fk-1(b)(2). Specifically, the Commission agrees with a commenter that it is the responsibility of the SBS Entity, not the CCO in his or her personal capacity, to establish and enforce required policies and procedures.[1214] Accordingly, to reflect that, the Commission is qualifying the proposed requirement to establish, maintain and review policies and procedures reasonably designed to ensure compliance with the Exchange Act and rules and regulations thereunder with the qualifying language Start Printed Page 30056“take reasonable steps to ensure that the registrant” establishes, maintains and reviews such policies and procedures. The Commission is also changing the requirement in Rule 15Fk-1(b)(2) from a requirement to “ensure compliance” to a requirement to “achieve compliance” with the Exchange Act and rules and regulations thereunder relating to the SBS Entity's business as an SBS Entity in response to a specific suggestion from a commenter,[1215] and adding the word “written” before policies and procedures to clarify that the policies and procedures required by the rule must be written. Similar to the qualifying language with respect to the registrant's policies and procedures, the Commission is making the change from “ensure compliance” to “achieve compliance” to clarify that it is not the role of the CCO to “ensure” compliance. The Commission believes the formulation “take reasonable steps to ensure that the registrant establishes, maintains and reviews written policies and procedures reasonably designed to achieve compliance” (as opposed to the proposed formulation of “establish, maintain and review policies and procedures reasonably designed to ensure compliance”) more appropriately describes the CCO's role. The Commission also notes that the policies and procedures referred to in Rule 15Fk-1(b)(2) include those required by Rules 15Fh-3(h)(2)(iii), 15Fk-1(b)(2)(ii) and 15Fk-1(b)(2)(iii), and any other policies and procedures the SBS Entity deems necessary to achieve compliance with the Exchange Act and the rules and regulations thereunder relating to its business as an SBS Entity.

We are also modifying the three specific obligations of the CCO now enumerated in Rule 15Fk-1(b)(2)(i)-(iii) that the CCO must perform to satisfy his or her duty to take reasonable steps to ensure that the registrant establishes, maintains and reviews policies and procedures reasonably designed to achieve compliance. As adopted, Rule 15Fk-1(b)(2)(i) requires the CCO to “revie[w] the compliance of the [SBS Entity] with respect to the [SBS Entity] requirements described in [S]ection 15F of the [Exchange Act], and the rules and regulations thereunder, where the review shall involve preparing the registrant's annual assessment of its written policies and procedures reasonably designed to achieve compliance with [S]ection 15F of the [Exchange Act] and the rules and regulations thereunder, by the [SBS Entity].” The requirement that the CCO “prepare the registrant's annual assessment of its” written policies and procedures reasonably designed to achieve compliance with Section 15F of the Exchange Act and the rules and regulations thereunder represents a change from the proposed requirement that the CCO “establish, maintain and review” such policies and procedures. We are making this change in response to a specific suggestion from a commenter.[1216] As discussed above, the Commission agrees with the commenter that it is the responsibility of the SBS Entity, not the CCO in his or her personal capacity, to establish and enforce required policies and procedures, and believes that this change clarifies that point.

As adopted, Rule 15Fk-1(b)(2)(ii) requires the CCO to “tak[e] reasonable steps to ensure that the registrant establishes, maintains and reviews policies and procedures reasonably designed to remediate non-compliance issues identified by the [CCO] through any means, including any: (A) Compliance office review; (B) Look-back; (C) Internal or external audit finding; (D) Self-reporting to the Commission and other appropriate authorities; or (E) Complaint that can be validated.” This represents a change from the proposed requirements: (1) That the CCO “establish, maintain and review” such policies and procedures, and (2) that such policies and procedures be reasonably designed to remediate “promptly” non-compliance issues. Additionally, as adopted, Rule 15Fk-1(b)(2)(iii) requires the CCO to “tak[e] reasonable steps to ensure that the registrant establishes and follows procedures reasonably designed for the handling, management response, remediation, retesting, and resolution of non-compliance issues.” This also represents a change from the proposed requirements: (1) That the CCO “establish and follow” such procedures, and (2) that such procedures be reasonably designed for the “prompt” handling, management response, remediation, retesting, and resolution of non-compliance issues.” We are making these changes in response to specific suggestions from a commenter.[1217] As discussed above, the Commission agrees with the commenter that it is the responsibility of the SBS Entity, not the CCO in his or her personal capacity, to establish and enforce required policies and procedures, and believes that the first change to each provision clarifies that point. Additionally, as discussed above, eliminating the proposed timing requirements with respect to the “prompt” remediation and handling of non-compliance issues provides greater consistency with the parallel CFTC requirements. With this change, the Commission intends to focus the CCO's efforts on the effective remediation and handling of non-compliance issues, without placing undue emphasis on speed at the expense of other factors. We believe, however, that the remediation and handling of non-compliance issues generally should occur within a reasonable timeframe.

In addition to the changes described above, the Commission is making one more modification to the duty to remediate non-compliance issues in final Rule 15Fk-1(b)(2)(ii). The proposed rule referred only to non-compliance issues “identified by the [CCO] through any: (A) Compliance office review; (B) Look-back; (C) Internal or external audit finding; (D) Self-reporting to the Commission and other appropriate authorities; or (E) Complaint that can be validated.” However, as noted above, Rule 15Fk-1(b)(2)(iii) requires that the CCO “tak[e] reasonable steps to ensure that the registrant establishes and follows procedures reasonably designed for the handling, management response, remediation, retesting, and resolution of non-compliance issues” (emphasis added). Because this requirement is not limited to non-compliance issues identified by the CCO through a specific means, the Commission believes it is appropriate to clarify that final Rule 15Fk-1(b)(2)(ii) covers non-compliance issues identified by the CCO through any means, including the means specifically listed in sub-paragraphs (A)-(E) of the rule.

Third, the Commission is modifying the duties of the CCO now enumerated in Rules 15Fk-1(b)(3) and (4). As adopted, Rule 15Fk-1(b)(3) requires the CCO to “[i]n consultation with the board of directors or the senior officer of the [SBS Entity], take reasonable steps to resolve any material conflicts of interest that may arise.” This represents a change from the proposed requirement, which would have required the CCO to “[i]n consultation with the board of directors or the senior officer of the [SBS Entity], promptly resolve any conflicts of interest that may arise.” The Commission is adding the “take reasonable steps” language and materiality qualifier to further clarify and qualify the role of the CCO in resolving conflicts of interest in response to concerns raised by commenters.[1218] Such conflicts of Start Printed Page 30057interest could include conflicts between the commercial interests of an SBS Entity and its statutory and regulatory responsibilities, and conflicts between, among, or with associated persons of the SBS Entity. As noted in the Proposing Release and consistent with the discussions of the CCO's role above, the Commission understands that the primary responsibility for the resolution of conflicts generally lies with the business units within SBS Entities because the business line personnel are those with the power to make decisions regarding the business of the SBS Entity.[1219] As a result, the Commission anticipates that the CCO's role with respect to such resolution and mitigation of conflicts of interest would include the recommendation of one or more actions, as well as the appropriate escalation and reporting with respect to any issues related to the proposed resolution of potential or actual conflicts of interest, rather than responsibility to execute the business actions that may be associated with the ultimate resolution of such conflicts. Furthermore, the Commission recognizes that a CCO typically will not exercise the supervisory authority to resolve conflicts of interest, and the revisions to the rule are intended to clarify that CCOs are not required to actually resolve such conflicts.[1220] Finally, in response to a specific suggestion made by a commenter,[1221] the Commission is eliminating the proposed timing requirement with respect to the “prompt” resolution of conflicts of interest to harmonize with the parallel CFTC requirement. With this change, the Commission intends to focus the CCO's efforts on the effective resolution of conflicts of interest, without placing undue emphasis on speed at the expense of other factors. We believe, however, that the resolution of conflicts of interest generally should occur within a reasonable timeframe.

As adopted, Rule 15Fk-1(b)(4) requires the CCO to “[a]dminister each policy and procedure that is required to be established pursuant to [S]ection 15F of the [Exchange Act] and the rules and regulations thereunder.” This represents a change from the proposed requirement that the CCO “be responsible for” administering such policies and procedures. The Commission is eliminating the words “be responsible for” because we believe they are unnecessary and could cause confusion. The CCO is responsible for complying with all of the duties listed in Rule 15Fk-1(b)(2)-(4). Commenters requested clarifications as to what the CCO's administration of the required policies and procedures would entail.[1222] The Commission recognizes that the CCO cannot be a guarantor of the SBS Entity's conduct. The Commission believes that such administration generally should involve: (1) Reviewing, evaluating, and advising the SBS Entity and its risk management and compliance personnel on the development, implementation and monitoring of the policies and procedures of the SBS Entity, including procedures reasonably designed for the handling, management response, remediation, retesting and resolution of non-compliance issues as required by Rule 15Fk-1(b)(2)(iii); and (2) reviewing, evaluating, following and reasonably responding to the development, implementation and monitoring of the SBS Entity's processes for (a) modifying its policies and procedures as business, regulatory and legislative changes dictate; (b) evidencing supervision by the personnel responsible for the execution of its policies and procedures; (c) testing the SBS Entity's compliance with, and the adequacy of, its policies and procedures; and (d) resolving, escalating and reporting issues or concerns. In carrying out this administration, the Commission believes that the CCO generally should consult, as appropriate, with business lines, management and independent review groups regarding resolution of compliance issues.

c. Annual Compliance Report

After considering the comments, the Commission is adopting Rule 15Fk-1(c) (annual compliance report) with a number of modifications, as discussed below. In response to concerns raised by a commenter,[1223] these changes are primarily intended to harmonize the annual compliance report requirements with the CFTC's parallel requirements. As discussed above, this consistency will result in efficiencies for SBS Entities that have already established infrastructure to comply with the CFTC requirements. Consistent wording regarding expectations for the annual compliance report will also allow such SBS Entities to more easily analyze compliance with the Commission's rule against their existing activities to comply with the CFTC's parallel rule for Swap Entities.

First, the Commission is making a clarifying change to Rule 15Fk-1(c)(1) to consistently refer to the annual report required by Rule 15Fk-1(c) as the “compliance report.” This wording change will not alter the substantive requirements of the rule. It is only meant to clarify that the rule refers to a single annual compliance report. Second, the Commission is eliminating the proposed requirement to include a description of “the compliance” of the SBS Entity in the annual compliance report in response to concerns raised by commenters,[1224] and specifying that the requirement to include a description of the compliance policies and procedures only requires a description of the “written” compliance policies and procedures of the SBS Entity pursuant to Rule 15Fk-1(c)(1), in response to a specific suggestion from a commenter.[1225] The Commission agrees Start Printed Page 30058with commenters that the proposed requirement to describe “the compliance” of the SBS Entity was vague and believes these clarifying changes will facilitate SBS Entities' compliance with the rule, which will still require an SBS Entity to provide information demonstrating how the SBS Entity complies with the applicable requirements of the Exchange Act and the rules and regulations thereunder in the form of the SBS Entity's written compliances policies and procedures. As adopted, Rule 15Fk-1(c)(1) requires the CCO to “annually prepare and sign a compliance report that contains a description of the written policies and procedures of the [SBS Entity] described in paragraph (b) (including the code of ethics and conflict of interest policies).” The Commission believes that SBS Entities can fulfill this requirement by either providing copies or summaries of their written compliance policies and procedures in the annual compliance report. These changes will also harmonize the annual compliance report requirements with the CFTC's parallel requirements, as discussed above.

The Commission is also making certain modifications to the required content of the annual compliance report in Rule 15Fk-1(c)(2) in response to specific suggestions from a commenter.[1226] First, the Commission is specifying that the requirement to describe material changes to policies and procedures since the date of the preceding compliance report in Rule 15Fk-1(c)(2)(i)(B) refers to the “registrant's” policies and procedures. This is a clarification and does not change the substance of the requirement. The phrase “since the date of the preceding compliance report” in the rule refers to the coverage date of the prior year's compliance report, not the date on which it was prepared. Accordingly, pursuant to Rule 15Fk-1(c)(2)(i)(B), as adopted, an SBS Entity must describe in its annual compliance report any material changes to the SBS Entity's policies and procedures for the time period covered by the report.

Second, the Commission is making a number of changes to harmonize the content requirements for the annual compliance report with the CFTC's parallel requirements for the annual compliance reports of Swap Entities. The Commission agrees with the commenter that alignment of the content requirements will allow SBS Entities that are also registered as Swap Entities to leverage the procedures they have adopted to comply with the CFTC's parallel CCO rule.[1227] Specifically, the Commission is changing the proposed requirement in Rule 15Fk-1(c)(2)(i)(A) that the annual compliance report contain a description of the “enforcement” of the SBS Entity's policies and procedures to an “assessment of the effectiveness” of such policies and procedures.[1228] The Commission believes that an “assessment of the effectiveness” of the SBS Entity's policies and procedures is a more appropriate description because the Commission is looking for a self-evaluation in the annual compliance report, not a detailed description of the mechanisms through which the SBS Entity's policies and procedures are enforced. Additionally, the Commission believes that providing consistency with the parallel CFTC requirement will allow SBS Entities to leverage any existing procedures, as discussed above.

The Commission is also changing the proposed requirement in Rule 15Fk-1(c)(2)(i)(C) that the annual compliance report contain a description of “any recommendation for material changes to the policies and procedures” to a requirement to describe “areas for improvement, and recommended potential or prospective changes or improvements to its compliance program and resources devoted to compliance.” [1229] As discussed above, this change is in response to a specific suggestion from a commenter.[1230] A description of “areas for improvement, and recommended potential or prospective changes or improvements to [an SBS Entity's] compliance program and resources devoted to compliance” is broader and would include any recommendations made by the CCO with respect to material changes to the SBS Entity's compliance policies and procedures. Accordingly, the Commission does not believe this wording change diminishes the scope of the required content of the annual compliance report. At the same time, however, this wording change makes the rule consistent with the parallel CFTC requirements and thus will allow SBS Entities to leverage any existing procedures, as discussed above.

Additionally, the Commission is changing the proposed requirement that the annual compliance report contain a description of “any material compliance matters identified since the date of the preceding compliance report” to a requirement to describe “any material non-compliance matters identified” in Rule 15Fk-1(c)(2)(i)(D).[1231] The change from “material compliance matter” to “material non-compliance matter” is in response to a specific suggestion from a commenter.[1232] It is not a substantive change and is simply intended to provide consistency with the parallel CFTC requirement to allow SBS Entities to leverage any existing procedures, as discussed above. The Commission is also otherwise adopting the definition of material non-compliance matter in Rule 15Fk-1(e)(4), as proposed.[1233] The elimination of the phrase “since the date of the preceding compliance report” in the final rule is also intended to harmonize with the parallel CFTC requirement and respond to commenters' general concerns regarding consistency with parallel CFTC requirements.[1234] Additionally, with this change, the Commission intends to clarify that the annual compliance report should describe both material non-compliance matters that are newly identified during the time period covered by the report and previously identified material non-compliance matters that have not yet been resolved as of the end of the time period covered by the report.

Finally, the Commission is adding a requirement in Rule 15Fk-1(c)(2)(i)(E) for an SBS Entity to include a description in its annual compliance report of the “financial, managerial, operational, and staffing resources set aside for compliance with the [Exchange Act] and the rules and regulations Start Printed Page 30059thereunder relating to [the SBS Entity's] business as [an SBS Entity], including any material deficiencies in such resources.” [1235] The Commission is adding this requirement to harmonize with the CFTC's parallel content requirement for the annual compliance reports of Swap Entities, and to respond to commenters' general concerns regarding consistency with parallel CFTC requirements.[1236] The Commission believes that a description of an SBS Entity's compliance resources and any deficiencies in such resources will be useful in assessing the compliance of the SBS Entity.

The Commission is also making a number of changes with respect to the submission of the annual compliance report. First, the Commission is aligning the deadline for submitting the report with the CFTC's deadline of 90 days after the end of the Swap Entity's fiscal year in response to concerns raised by a commenter.[1237] As adopted, Rule 15Fk-1(c)(2)(ii)(A) will require an SBS Entity's compliance report to “be submitted to the Commission within 30 days following the deadline for filing the [SBS Entity's] annual financial report with the Commission pursuant to Section 15F of the Act and rules and regulations thereunder.” [1238] This represents a change from the proposed requirement that the compliance report “[a]ccompany each appropriate financial report of the [SBS Entity] that is required to be furnished to or filed with the Commission pursuant to Section 15F of the Act and rules and regulations thereunder.” In response to concerns raised by a commenter, this change will provide SBS Entities with additional time to prepare their annual compliance reports after they have filed their annual financials.[1239] The Commission proposed a 60 day deadline from the end of the SBS Entity's fiscal year for the filing of an SBS Entity's annual financials, so to the extent the Commission adopts its proposed deadline for the annual financials, this change should also result in consistency with the CFTC's 90 day deadline for furnishing the annual compliance report.[1240]

Second, in connection with the change described above, the Commission is eliminating the proposed provision that “[i]f compliance reports are separately bound from the financial statements, the compliance reports shall be accorded confidential treatment to the extent permitted by law.” The Commission believes this provision is no longer necessary in light of the changes we are making to Rule 15Fk-1(c)(2)(ii)(A), discussed above, which will no longer require the compliance report to accompany the SBS Entity's financial report. SBS Entities may request confidential treatment for their annual compliance reports pursuant to Exchange Act Rule 24b-2.[1241]

Third, in response to comment,[1242] the Commission is adding a new Rule 15Fk-1(c)(2)(iii) allowing an SBS Entity to request from the Commission an extension of the deadline for submitting its annual compliance report to the Commission. The Commission agrees with the commenter that it is appropriate to establish a framework for when an SBS Entity is unable to meet the deadline. Pursuant to Rule 15Fk-1(c)(2)(iii), an SBS Entity may request an extension, provided that the SBS Entity's failure to timely submit the report could not be eliminated without unreasonable effort or expense. Extensions of the deadline will be granted at the discretion of the Commission. Rule 15Fk-1(c)(2)(iii) will also be consistent with CFTC rules regarding extensions of deadlines for compliance reports by Swap Entities.[1243]

Fourth, the Commission is changing the required timing of submission of the compliance report to the board of directors, audit committee and senior officer of the SBS Entity. The timing requirement in proposed Rule 15Fk-1(c)(3)(ii)(B) (“at the earlier of their next scheduled meeting or within 45 days of the date of execution of the required certification”) was based on the timeframe provided in the FINRA rule regarding annual certification of compliance and supervisory processes.[1244] The FINRA rule allows for submission of the compliance report to the board of directors either before or after execution of the required certification.[1245] The Commission understands, however, that prudent corporate governance generally would require submission to the board of directors and senior officer before the execution of the certification. Accordingly, as adopted, Rule 15Fk-1(c)(2)(ii)(B) requires that the compliance report be submitted to the board of directors, audit committee and senior officer of the SBS Entity “prior to submission to the Commission.” This timing requirement will be consistent with both Commission rules regarding compliance reports by SDRs and CFTC rules regarding compliance reports by Swap Entities.[1246] This consistency with CFTC requirements will allow SBS Entities to leverage any existing procedures, as discussed above.

The Commission declines to modify this provision, as suggested by a commenter, to allow for submission of the compliance report to either the board or the senior officer.[1247] The Commission believes that requiring submission to the board, audit committee and senior officer will promote an effective compliance system by ensuring that all of these groups, not just the senior officer, have the opportunity to review the report. The Commission believes it is important for the board, the audit committee and the senior officer to all have the opportunity to receive the compliance report so that they remain informed regarding the SBS Entity's compliance system in the context of their overall responsibility for governance and internal controls of the SBS Entity. However, the Commission declines to explicitly require the board to review and comment on the compliance report, require the audit committee to review the compliance report, or require the CCO to meet quarterly with the audit committee, as Start Printed Page 30060suggested by other commenters.[1248] The Commission does not think it is necessary to explicitly require the board, audit committee or senior officer to review or comment on the compliance report that they receive, or to require the CCO to meet with the audit committee because we believe the goals of the rule can be achieved without such a requirement.

Additionally, in response to concerns raised by a commenter [1249] and to harmonize with the parallel CFTC requirement and FINRA Rule 3130, the Commission is eliminating: (1) The proposed requirement that the report contain a written representation regarding the required annual meeting between the senior officer and the CCO, and (2) the proposed specifications for what topics such meeting must cover. The Commission agrees with the commenter that since the purpose of the required annual meeting between the senior officer and CCO is to discuss the annual compliance report and since the contents of the annual compliance report are already specified in Rule 15Fk-1(c)(2)(i), it is unnecessary to also specify the topics that should be discussed in the annual meeting. Additionally, this consistency with CFTC and FINRA requirements will allow SBS Entities to leverage any existing procedures, as discussed above.

To address concerns raised by commenters,[1250] we also are modifying Rule15Fk-1(c)(2)(ii)(D) to provide that either the senior officer or CCO can execute the compliance report certification and to add knowledge and materiality qualifiers to the certification requirement. The proposed rule would have required the compliance report to include a certification that, under penalty of law, the compliance report is accurate and complete, without specifying who must execute the certification. As adopted, Rule 15Fk-1(c)(2)(ii)(D) requires the compliance report to include a certification “from the senior officer or Chief Compliance Officer that, to the best of his or her knowledge and reasonable belief, under penalty of law, the compliance report is accurate and complete in all material respects.” The