SEC Adopts Security-Based Swap Business Conduct Standards | Practical Law

SEC Adopts Security-Based Swap Business Conduct Standards | Practical Law

The SEC has approved a set of business conduct standards and disclosure requirements for security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs).

SEC Adopts Security-Based Swap Business Conduct Standards

Practical Law Legal Update w-001-9045 (Approx. 7 pages)

SEC Adopts Security-Based Swap Business Conduct Standards

by Practical Law Finance
Published on 23 May 2016 • USA (National/Federal)
The SEC has approved a set of business conduct standards and disclosure requirements for security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs).
On April 13, 2016, the SEC approved final rules under Title VII of the Dodd-Frank Act that create a set of business conduct standards and chief compliance officer (CCO) disclosure requirements (collectively, SBS business conduct standards) for security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs and, collectively, with SBSDs, SBS Entities).
These final SBS business conduct standards are effective on June 27, 2016. However, compliance is required for SBS Entities as of the compliance date for SBS Entity registration, which has yet to be finalized (see Legal Update, SEC Adopts Registration Rules for Security-based Swap Dealers and Major Security-based Swap Participants).
In general, these rules run parallel to the business conduct standards released by the CFTC for swap dealers and MSPs. For details on these rules, see the following Practice Notes:
The final SBS business conduct rules also align with the Department of Labor's recent clarification on the definition of "fiduciary" and such fiduciary duties (see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs).
The SEC made its initial proposal on SBS business conduct standards in June 2011 and reopened the comment period with respect to all of its Title VII rulemaking activity again in May 2013. The final SBS business conduct rules incorporate several revisions suggested by commenters.

Business Conduct Standards for SBS Entities

The rules set out a broad framework of business conduct standards and include the following:
Rule 15Fh-1 (17 CFR § 240.15Fh-1), which provides that the final SBS business conduct standards (Rules 15Fh-1 through 5Fh-6) and the rule on designation of a CCO (Rule 15Fk-1) apply over the entire term of the security-based swap (SBS), not only in connection with entering into the transaction, and further:
  • Clarifies that the SBS business conduct rules do not apply to any SBS entered into prior to the compliance date for the final SBS business conduct rules nor to any amendments to pre-existing SBS unless such amendment results in a new SBS after the compliance date.
  • Creates an exemption for SBS Entities entering into transactions with majority-owned affiliates, for example, where one counterparty directly or indirectly owns a majority in the other, or if a third party owns a majority interest in both counterparties. This exemption applies to rules related to:
    • verification of counterparty status;
    • product and conflict of interest disclosures;
    • "know your costumer" obligations; and
    • obligations when advising a "Special Entity" (defined below).
  • Clarifies that SBS Entities may rely on written representations to satisfy their due diligence requirements under the final SBS business conduct rules unless such information would cause a reasonable person to question the accuracy of such representation.
Rule 15Fh-2 (17 CFR § 240.15Fh-2), which provides definitions used throughout the final rules, including:
  • "Special Entity": Special Entities include federal agencies, state and municipal special entities ("any instrumentality, department or a corporation of or established by a State or political subdivision of a State"), employee benefit plans subject to Title 1 of ERISA, master trusts (those which hold the assets of more than one ERISA plan, sponsored by a single employer or by a group of employers under common control), endowments, non-profit organizations, and private foundations (but not the entities or persons other than the endowment itself). SBSDs have special duties under the final SBS business conduct rules when entering into a swap with a Special Entity.
  • For purposes of a SBSD's duties to a Special Entity, a SBSD is deemed to have acted as an advisor to a Special Entity "when it recommends a security-based swap or a trading strategy that involves a security-based swap." The determination of when a "recommendation" occurs depends on the facts and circumstances of the particular situation. SEC has adopted the CFTC's approach for determining when an SBSD is acting as an advisor, providing safe harbors from the "advisor" definition for:
    • communications between SBSDs and an ERISA plan that has an ERISA fiduciary; and
    • communications between SBSDs and any Special Entity (including a special entity that is an ERISA plan) when that Special Entity is relying on advice from a "qualified independent representative" (defined below).
Rule 15Fh-3 (17 CFR § 240.15Fh-3), which sets out certain business conduct requirements. In general, SBS Entities are required to:
  • Verify that their counterparty is an eligible contract participant (ECP) or Special Entity.
  • Unless the counterparty is another SBS Entity or a Swap Entity (swap dealer or MSP), disclose to the counterparty material information about the SBS, including:
    • material risks and characteristics,
    • incentives or conflicts of interest,
    • the daily mark of the swap, and
    • "clearing rights." Clearing rights refer to the right of a counterparty to either (i) select the clearing agency at which the swap will be cleared if it is subject to mandatory clearing under the Commodity Exchange Act; or (ii) elect to require clearing if the swap isn't subject to mandatory clearing.
  • Communicate with counterparties in a fair and balanced manner based on principles of good faith and fair dealing over the term of the swap.
  • Establish and maintain a supervisory and compliance infrastructure, with written policies in place, intended to prevent violations of federal securities laws, rules and regulations, and designate at least one person with supervisory responsibilities for each type of business for which registration of the SBS Entity is required.
Rule 15Fh-3 also sets out additional business conduct requirements specific to SBSDs, but not applicable to MSBSPs. These rules:
  • Require SBSDs to follow a "know your costumer" requirement that requires SBSDs to establish and enforce policies reasonably designed to obtain and retain a record of essential facts necessary for conducting business with such counterparty.
  • Require an SBSD that recommends a SBS or trading strategy to a counterparty (other than another SBS Entity or Swap Entity) to have a reasonable basis for believing such SBS or trading strategy is suitable.
Rule 15Fh-4(a) (17 CFR § 240.15Fh-4(a)), which sets out a general SBS Entity antifraud provision and prohibits SBS Entities from
  • Employing any scheme or device used to defraud any Special Entity or prospective costumer that is a Special Entity.
  • Engaging in any transaction or business practice that defrauds or deceits any Special Entity or prospective costumer that is a Special Entity.
  • Engaging in any act or business practice that is fraudulent, deceptive, or manipulative.
Rule 15Fh-4(b) (17 CFR § 240.15Fh-4(b)) requires any SBSD that acts as an advisor to a Special Entity to have an additional "duty to make a reasonable determination that any security based swap recommended by the SBSD is in the best interests of the special entity".
Rule 15Fh-4(b)(2) requires the SBSD to make reasonable efforts to obtain any information needed to make this determination.
Rule 15Fh-5 (17 CFR § 240.15Fh-5) applies additional business conduct standard to any SBS Entity that acts as a counterparty to a Special Entity (17 CFR § 240.15Fh-4). This section requires:
  • A Swap Entity to have a reasonable basis (determined by the individual facts and circumstances of the transaction) to believe that the Special Entity has a qualified independent representative when offering or entering into a SBS with a Special Entity (other than an employee benefit plan subject to Title 1 of ERISA).
  • That, in the event that the Special Entity is an employee benefit plan subject to Title 1 of ERISA, the SBS Entity has a reasonable basis for believing that the ERISA Special Entity has a representative that is a "fiduciary" under Section 3 of ERISA.
  • An SBSD to first disclose to the Special Entity the capacity in which it is acting with respect to the SBS and if that SBSD engages with the counterparty in multiple capacities, an explanation of such capacities (note that this requirement to disclose capacity does not apply to MSBSPs as counterparties).
  • That, for purposes of the above requirements, a "qualified independent representative" is a representative that, among other things:
    • has sufficient knowledge to evaluate the transaction and related risks;
    • is not subject to any statutory disqualification, acts in the best interests of the Special Entity;
    • is independent of the SBS Entity; and
    • makes appropriate and timely disclosures of material information to the Special Entity.
Rule 15Fh-6 (17 CFR § 240.15Fh-6) prohibits SBSDs from offering or entering into SBS or trading strategies involving SBS with a municipal entity within two years after making any contribution to an official of such entity.

CCO Requirements

Rule 15Fk-1 (17 CFR § 240.15Fk-1) requires an SBS Entity to designate on its SEC registration form one individual to serve as its CCO. The rule also requires that the CCO:
  • Report directly to either the board of directors or senior officers of the SBS Entity.
  • Take reasonable steps ensuring that the SBS Entity establishes and maintains written policies designed to achieve compliance with the final SBS business conduct standards and other applicable regulatory schemes.
  • Take reasonable steps to ensure that the SBS Entity has sufficient policies in place to remediate non-compliance with final SBS business conduct standards and other applicable regulatory schemes.
  • Submit an annual compliance report detailing the written policies and procedures discussed above.
This provision also requires the CCO's compensation and removal to be approved by the majority of the board of directors of the SBS Entity.

Cross-Border Application of SBS Business Conduct Standards

The final SBS business conduct rules also include cross-border provisions, which require:
  • A registered foreign SBSD to comply with transaction-level business conduct requirements for all transactions that include a US business. Transaction that include a US business, for foreign SBSDs, include both transactions that are entered into with a US person and those that are arranged, negotiated, or executed by personnel of the foreign SBSD located in a US branch or personnel of its agent located in a US branch. (Rule 3a71-3 and related amendments to Rule 3a71-3(a) (17 CFR 240.3a71-3)).
  • A registered foreign MSBSP to comply with transaction-level business conduct requirements for all transactions, except those transactions that are entered into with a non-US person or those entered into with the foreign branch of a US person (Rule 3a67-10(d) and related amendments to Rule 3a67-10(a) (17 CFR 240.3a67-10)).
The cross-border provisions also include:
  • The possibility for future substituted compliance with non-US business conduct rules if an SBS Entity complies with foreign requirements the SEC deems comparable to its SBS business conduct standards (Rule 3a71-6 (17 CFR 240.3a71-6)).
  • Costumer protections that apply to foreign SBS Entities, which exempt them from these SBS business conduct standards and other regulations except the registration requirements found in 15 U.S.C. 78o-10(h)(1)(B) (which governs the de minimis threshold for registration and regulation of brokers and dealers), specifically:
    • Registered foreign MSBSPs that participate in a SBS transaction with a counterparty that is not a US person or with a counterparty that is a US person in a transaction conducted through a foreign branch of such US person. For details on the SEC's "US person" definition, see Practice Note, The Dodd-Frank Act; Cross-Border Application of Swaps Rules: SEC Cross-Border Security-Based Swaps Rules: SEC US Person Definition.
    • Registered US MSBSPs with respect to SBS transactions conducted through a foreign branch of a registered US MSBSP with a non-US person or with a US counterparty that constitutes a transaction conducted though a foreign branch of that US counterparty.
    • Registered SBSDs with respect to their foreign business.
A separate compliance date with respect to the customer protection principles applies to foreign SBSDs that enter into and negotiate SBS transactions using personnel (or agents) within a US branch or office. This compliance date is the later of:
  • April 14, 2017, or
  • the compliance date of SBS Entity registration rules.
Along with the press release announcing the final rules, the SEC released a fact sheet which is available here.
Update: On May 23, 2016, the SEC issued a correction relating to the background information included in the final rules. The correction is available here and will be effective upon publication in the Federal Register.