Over the past several months, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have been actively seeking public comment and proposing rules as part of the regulatory overhaul of the derivatives markets mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). As we await final rules to be published in 2011, which will implement and (hopefully) clarify uncertainties in the statutory provisions of Dodd-Frank, we summarize below the principal actions taken by the regulators during the last half of the year.
On August 13, 2010, the CFTC kicked off its rulemaking initiatives by issuing an advance notice of rulemaking seeking public comment on various definitions.
Acting on its statutory mandate to further define certain definitions, the CFTC sought industry comments with respect to the following definitions: "swap," "swap dealer," "major swap participant," "security-based swap," "security-based swap dealer," "major security-based swap participant" and "eligible contract participant." Joint proposed rules further defining the dealer and participant definitions were approved by the CFTC on December 1, 2010, and by the SEC on December 7, 2010, as discussed below. Neither the CFTC nor the SEC has yet proposed rules with respect to the definition of "swap" or "security-based swap," respectively.
Click here for the CFTC advance notice.
On August 26, 2010, the CFTC issued final rules with respect to the regulation of off-exchange retail foreign exchange transactions and intermediaries.
Largely based on the proposed rules that the CFTC issued six months prior to Dodd-Frank, the final rules represent a comprehensive regulatory scheme for off-exchange transactions in foreign currency with members of the retail public. Comprised of both new rules and amendments to existing rules, the final rules establish requirements for, among other things, registration, disclosure, recordkeeping, financial reporting, minimum capital, and other operational standards relating to retail forex transactions.
Click here for the final rules.
On October 1, 2010, the CFTC adopted an interim final rule on reporting of pre-enactment swaps, and on October 13, 2010, the SEC adopted the corollary interim final rule on reporting of pre-enactment security-based swaps.
The CFTC and the SEC adopted interim final rules for reporting pre-enactment swaps that had not expired as of July 21, 2010 (pre-enactment swaps). Under those rules, certain information concerning pre-enactment swaps 2 Attorney Advertisement
must be reported to a swap data repository (SDR) or, in the absence of one, to the CFTC or SEC, as applicable, by the earlier of the compliance date established in the yet-to-be finalized reporting rules established under Section 2(h)(5) of the CEA and 60 days after a SDR becomes registered with the CFTC or SEC, as applicable, and commences operations to receive and maintain data related to the swaps. Each of the interim final rules contains an interpretive note that requires counterparties to retain all information and documents, to the extent and in the form that they presently exist, relating to the terms of their pre-enactment unexpired swaps.
Click here for the CFTC interim final rule and here for the SEC interim final rule.
On October 1, 2010, the CFTC issued proposed rules on financial resources requirements for derivatives clearing organizations.
The proposed rules would implement Core Principle B, as amended by Dodd-Frank, which requires a derivatives clearing organization (DCO) to maintain a minimum amount of financial resources that would enable the DCO to meet its financial obligations to its members in the event of a default by a clearing member and to cover its operating costs for one year.
Consistent with Core Principle B, the proposed rules would require a DCO to maintain financial resources sufficient to cover its exposures with a high degree of confidence and to enable it to perform its functions in compliance with the core principles under the Commodity Exchange Act (CEA). Specifically, a DCO would be required to maintain financial resources that would enable it to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions. (In the case of a systemically important derivatives clearing organization (SIDCO), the SIDCO would be required to maintain financial resources that could withstand a default by the two clearing members creating the largest combined financial exposure to it in extreme but plausible market conditions.) The DCO's financial resources also must enable it to cover its operating costs for at least one year, calculated on a rolling basis. The proposed rules specify the types of financial resources that a DCO may use to satisfy its financial resources requirements, including any applicable haircuts for purposes of valuing those financial resources. A SIDCO, however, may only count the value of potential member assessments, after a 30% haircut, to meet up to 20% of the obligations arising from a default by a clearing member creating the second highest financial exposure to the SIDCO.
The proposed rules would require a DCO, on a monthly basis, to perform stress testing that would allow it to make a reasonable calculation of the financial resources needed to meet the requirement in the case of a defaulting clearing member (or two clearing members, in the case of a SIDCO) and to make a reasonable calculation of its projected operating costs over a 12-month period.
Click here for the proposed rules.
On October 1, 2010, the CFTC issued proposed rules with respect to requirements for derivatives clearing organizations, designated contract markets, and swap execution facilities regarding the mitigation of conflicts of interest. On October 14, 2010, the SEC also issued similar proposed rules intended to mitigate conflicts of interest applicable to clearing agencies that clear security-based swaps, security-based swap execution facilities, and national securities exchanges.
The proposed CFTC rules would impose limits on voting equity ownership and the exercise of voting power in DCOs, designated contract markets (DCMs), and swap execution facilities (SEFs) in order to address any perceived conflicts of interest. Note that the proposed rules would not impose any limitations on non-voting equity ownership. The proposed rules also would impose structural governance requirements on DCOs, DCMs, and SEFs, with a particular focus on those entities' boards of directors and board committees. 3 Attorney Advertisement
With respect to DCMs and SEFs, the proposed rules would prohibit any DCM or SEF member (together with any related persons of such member) from beneficially owning more than 20% of any class of voting equity in the entity or directly or indirectly voting any interest that exceeds 20% of the voting power of any class of equity interest in the entity.
With respect to DCOs, the proposed rules permit DCOs to choose between two sets of limitations, absent a waiver. The First Alternative would, similar to the limitations for DCMs and SEFs, prohibit any DCO member (together with any related persons of such member) from beneficially owning more than 20% of any class of voting equity in the DCO or directly or indirectly voting any interest that exceeds 20% of the voting power of any class of equity interest in the DCO. It also would contain an aggregate test by prohibiting "enumerated entities" (e.g., bank holding companies with total consolidated assets of $50 billion or more, nonbank financial companies supervised by the Federal Reserve, affiliates of either type of entity, swap dealers, or major swap participants), regardless of whether they are DCO members (together with any related persons of such enumerated entities), collectively, from beneficially owning more than 40% of any class of voting equity in the DCO or directly or indirectly voting any interest that exceeds 40% of the voting power of any class of equity interest in the DCO. The Second Alternative would prohibit any DCO member or enumerated entity, regardless of whether it is a DCO member (together with any related persons in each case thereof), from beneficially owning more than 5% of any class of voting equity in the DCO or directly or indirectly voting any interest that exceeds 5% of the voting power of any class of equity interest in the DCO. Unlike the First Alternative, there would be no aggregate test in the Second Alternative.
Proposed Regulation MC is the SEC's comparable ownership limitation and governance requirements for clearing agencies that clear security-based swaps (SBS CAs), security-based swap execution facilities (SB SEFs), and national securities exchanges (NSEs). The ownership and voting limitations for SB SEFs and NSEs under proposed Regulation MC are essentially the same as for SEFs and DCMs under the CFTC's proposed rules. However, the SEC diverges in its treatment of SBS CAs from the CFTC's treatment of DCOs in two respects. First, the SEC would apply the 40% aggregate test in the First Alternative and the 5% test in the Second Alternative only to SBS CA participants and would not include the "enumerated entity" concept from the CFTC's proposed rules. Accordingly, Proposed Regulation MC's ownership and voting limitations may be narrower than the CFTC's. Second, the SEC would apply different governance requirements for SBS CAs depending on which alternative is selected. Specifically, Regulation MC would require higher percentages of independent directors and committee members under the Second Alternative.
Click here for the CFTC proposed rules and here for the SEC proposed rules.
On October 19, 2010, the CFTC issued a proposed rule defining the term "agricultural commodity."
In its proposed definition of "agricultural commodity," the CFTC started with the list of enumerated agricultural commodities in the statutory definition of "commodity" and included additional elements to further define the term. For example, the proposed definition would include commodity-based contracts based wholly or principally on a single underlying agricultural commodity, such as an index made up of more than 50% of any single agricultural commodity.
Click here for the proposed rule.
On October 19, 2010, the CFTC issued proposed rules with respect to the privacy of consumer financial information.
The proposed rules would expand the scope of Part 160 of the CFTC's rules to apply to swap dealers and major swap participants (MSPs) and would change all references to the Federal Trade Commission in Part 160 to the Bureau of Consumer Financial Protection, which was created under Dodd-Frank. 4 Attorney Advertisement
Click here for the proposed rules.
On October 19, 2010, the CFTC issued proposed rules with respect to marketing by business affiliates and disposal of consumer information.
As authorized under Title X of Dodd-Frank, the proposed rules would implement sections 624 and 628 of the Fair Credit Reporting Act. Specifically, the proposed rules would require futures commission merchants (FCMs), retail foreign exchange dealers, commodity trading advisors, commodity pool operators, introducing brokers, swap dealers, and MSPs (collectively, CFTC Registrants) to provide consumers with the opportunity to prohibit affiliates from using certain information to make marketing solicitations to consumers. The proposed rules also would require CFTC Registrants that possess or maintain consumer report information in connection with their business activities to develop and implement a written program for the proper disposal of such information.
Click here for the proposed rules.
On October 19, 2010, the Department of the Treasury issued a notice and request for comments on whether to exclude foreign exchange swaps or foreign exchange forwards, or both, from the definition of "swap" under Dodd-Frank.
Under Dodd-Frank, foreign exchange swaps and foreign exchange forwards are expressly included in the definition of swap. However, the Secretary of the Department of the Treasury (Treasury) may make a written determination that either foreign exchange swaps or foreign exchange forwards, or both, should not be regulated as swaps under the CEA. The Treasury solicited comments on whether, and to what extent, it should make any such determination and on the application of the statutory factors required in making any such determination.
Click here for our client alert and here for the Department of the Treasury notice.
On October 19, 2010, the CFTC issued proposed rules with respect to position reports for physical commodity swaps.
Under Dodd-Frank, the CFTC is required to promulgate, as appropriate, position limits for listed commodity futures and option contracts in exempt and agricultural commodities and position limits, including aggregate limits, for swaps that are economically equivalent to those futures and option contracts. The proposed rules list a broad set of futures and option contracts that may be subject to CFTC-set position limits. The proposed rules also introduce the terms "paired swap" and "paired swaption" that define a subset of swaps that may qualify as economically equivalent to the DCM swaps listed in the proposed rules. Clearing organizations, clearing members, and swap dealers would be required to report certain data regarding paired swaps and paired swaptions to the CFTC, subject to the CFTC finding, via an order, that swap data repositories (SDRs) are processing positional data and that such processing will enable the CFTC to effectively surveil trading in paired swaps and paired swaptions and the markets therefor.
Click here for the proposed rules.
On October 26, 2010, the CFTC issued proposed rules with respect to provisions common to registered entities.
The proposed rules would apply to DCMs, DCOs, SEFs, and SDRs and largely would relate to new product certification and approval, as well as rulemaking procedures for those entities. For example, the proposed rules would provide for the tolling of the CFTC's review period, pending a jurisdictional determination between the CFTC and the SEC, for any proposal to list, trade, or clear an agreement, contract, transaction, or swap having elements of both a security and a derivative. The proposed rules also would provide for self-certification of certain 5 Attorney Advertisement
rules but would require a SIDCO to provide the CFTC with 60 days' notice of any change in its rules, procedures, or operations that could materially affect the nature or level of risks presented by the SIDCO.
Click here for the proposed rules.
On October 26, 2010, the CFTC issued an advance notice of proposed rulemaking and request for comments with respect to disruptive trading practices.
Dodd-Frank amends the CEA to expressly prohibit certain trading practices deemed disruptive of fair and equitable trading. Specifically, Dodd-Frank makes it unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that (1) violates bids or offers, (2) demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period, or (3) is of the character of, or is commonly known to the trade as, "spoofing" (bidding or offering with the intent to cancel the bid or offer before execution). The advance notice requests comments to assist the CFTC in its rulemaking with respect to the amended provision.
Click here for the notice.
On October 26, 2010, the CFTC issued proposed rules with respect to the process for the review of swaps for mandatory clearing.
The proposed rules would implement the statutory provisions under Dodd-Frank regarding the CFTC's mandate to determine which swaps are required to be cleared. Under the proposed rules, a DCO would be presumed to be eligible to accept for clearing any swap that is within a group, category, type, or class of swaps that it already clears. Any such presumption, however, is subject to CFTC review. To the extent that a DCO wishes to accept any other swap for clearing, the DCO must request the CFTC to determine the DCO's eligibility to clear such swap.
Once eligibility is established, a DCO would be required to submit to the CFTC each swap, or any group, category, type, or class of swaps, that it plans to accept for clearing. The proposed rules would require, among other things, information regarding the requested swap, or group, category, type, or class of swaps, that would be sufficient to provide the CFTC a reasonable basis to make a quantitative and qualitative assessment of certain enumerated factors (e.g., product specifications; the existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data; and the effect on the mitigation of systemic risk). DCO submissions would be subject to a 30-day public comment period, and the CFTC would be required to make its determination not later than 90 days after receipt of a complete submission, subject to any extension agreed to by the DCO.
The proposed rules also would require the CFTC, on an ongoing basis, to review swaps that have not been accepted for clearing and determine whether such swaps should be required to be cleared. Notices of any such determination would be subject to a 30-day public comment period. If no DCO has accepted for clearing a particular swap, group, category, type, or class of swaps that the CFTC finds would otherwise by subject to a clearing requirement, the CFTC would be required to investigate the relevant facts and circumstances, issue a public report containing the results of the investigation within 30 days of completion, and take such actions as the CFTC determines to be necessary and in the public interest. Such actions may include requiring the retaining of adequate margin or capital by parties to the swap, group, category, type, or class of swaps.
After making any determination with respect to mandatory clearing, the CFTC may stay the application of such clearing requirement upon its own initiative or upon the application of a counterparty to an affected swap, pending a 90-day review period (subject to any extension agreed to by the DCO).
Click here for the proposed rules.
On October 26, 2010, the CFTC issued proposed rules with respect to the investment of customer funds and funds held in accounts for foreign futures and foreign option transactions.
The proposed rules would amend Regulations 1.25 and 30.7 with respect to investment of customer segregated funds and, among other things, would remove provisions setting forth credit rating requirements. By narrowing the scope of investment choices in Regulation 1.25 (e.g., removing foreign sovereign debt as a permitted investment), the CFTC seeks to eliminate the potential use of instruments that may pose an unacceptable level of risk. It also seeks to increase the safety of Regulation 1.25 investments by promoting diversification through new asset-based and repurchase agreement counterparty concentration limits. The proposed rules also would replace the current requirement that an investment be "readily marketable" with a new "highly liquid" standard and would harmonize Regulation 30.7 with the investment limitations of Regulation 1.25.
Click here for the proposed rules.
On October 26, 2010, the CFTC issued, and on November 3, 2010, the SEC similarly issued, proposed rules on the prohibition of fraud, manipulation, and deception in connection with swaps and security-based swaps, respectively.
The CFTC proposed rules broaden the scope of existing prohibitions on price manipulation. The SEC proposed Rule 9j-1 expands the language of 10b-5 as specifically applied to security-based swaps to capture instances of fraud and manipulation in connection with ongoing obligations arising under security-based swaps, such as cash flow payments. The anti-fraud and anti-manipulation provisions of Dodd-Frank will be effective, in the case of the CFTC's rules, on the date on which the related implementing rules take effect and, in the case of those provisions in the Securities Exchange Act of 1934 (Exchange Act), not less than 60 days after publication of the final related rules.
Click here for our client alert, here for the CFTC proposed rules, and here for the SEC proposed rules.
On October 27, 2010, the CFTC issued proposed rules removing references to or reliance on credit ratings and proposed alternatives in replace thereof.
The proposed rules apply to FCMs, DCOs, and commodity pool operators and are part of the CFTC's effort, as required under Dodd-Frank, to remove references to or reliance on credit ratings in its rules.
Click here for the proposed rules.
On November 10, 2010, the CFTC issued a proposed rule with respect to the implementation of conflicts of interest policies and procedures by futures commission merchants and introducing brokers.
The proposed rule would address potential conflicts of interest in the preparation and release of research reports by FCMs and introducing brokers (IBs) and, among other things, the establishment of appropriate informational partitions within those firms. The CFTC adapted many elements of the proposed rule from National Association of Securities Dealers (NASD) Rule 2711.
Under the proposed rule, non-research personnel (and, in particular, any employee of the business trading unit or clearing unit of the FCM or IB or of any affiliate thereof that performs or is involved in any pricing, trading, sales, marketing, advertising, solicitation, structuring, or brokerage activities on behalf of a FCM or IB or that performs or is involved in any proprietary or customer clearing activities on behalf of a FCM ) would be prohibited from influencing the content of a research report of the FCM or IB. Note, however, that the term "research report" would exclude, among other things, internal communications that are not given to current or prospective 7 Attorney Advertisement
customers. FCMs and IBs also would be prohibited from directly or indirectly offering favorable research to, or threatening to change research for, an existing or prospective customer in return for business or compensation.
The proposed rule would prohibit non-research personnel, other than the board of directors or any board committee, from reviewing or approving any research report prior to its publication, other than non-substantive reviews or editing, such as verifying its factual accuracy or formatting its layout. Furthermore, no research analyst could be subject to the supervision or control of any employee of the FCM's or IB's business trading unit or clearing unit, no personnel engaged in trading or clearing activities could have any influence or control over the evaluation or compensation of a research analyst, and no FCM or IB could consider as a factor in any research analyst's compensation the contribution of the research analyst to the FCM's or IB's trading or clearing business.
The proposed rule would require each FCM to create and maintain an appropriate informational partition between business trading units of an affiliated swap dealer or MSP and the FCM's clearing unit personnel. In addition, the proposed rule would prohibit FCMs from permitting any affiliated swap dealer or MSP to directly or indirectly interfere with, or attempt to influence, the decision of the FCM's clearing unit personnel with regard to the provision of clearing services or activities.
With respect to disclosure of any conflicts of interest, the proposed rule would require FCMs and IBs to disclose in research reports, and research analysts to disclose in public appearances, whether the research analyst maintains a financial interest in any derivative of a type that he or she follows and the general nature of that interest.
Click here for the proposed rule.
On November 10, 2010, the CFTC issued proposed rules with respect to registration of foreign boards of trade.
The proposed rules would establish a registration requirement and related registration procedures and conditions for foreign boards of trade (FBOTs) that wish to provide their members or other participants located in the United States with direct access to their electronic trading and order matching systems. The proposed registration process would replace the CFTC's current policy of accepting and reviewing requests by FBOTs for such direct access via the no-action process. According to the CFTC, a formal registration procedure would provide more legal certainty for registered FBOTs than the no-action process and would be more consistent with other countries' treatment of U.S. DCMs providing direct access internationally. For FBOTs currently operating under existing no-action relief, the proposed rules would provide for a limited application process.
Click here for the proposed rules.
On November 10, 2010, the CFTC issued proposed rules with respect to the designation of a chief compliance officer, required compliance policies, and an annual report of a futures commission merchant, swap dealer, or major swap participant.
The proposed rules implement the Dodd-Frank provisions that require each FCM, swap dealer, and MSP to designate a chief compliance officer and set forth a non-exclusive list of the chief compliance officer's duties. Foremost among those duties would be the preparation, signing and certifying of an annual compliance report, which, among other things, at a minimum would (1) contain a description of the entity's compliance with respect to the CEA and CFTC regulations and each of the entity's compliance policies, (2) describe any non-compliance issues identified and the corresponding action taken, and (3) provide a statement of certification of compliance with sections 619 (the Volcker Rule) and 716 (the Lincoln Push-Out Provision) of Dodd-Frank and any rules adopted pursuant thereto. As a general matter, the chief compliance officer would be required to certify that, to the best of his or her knowledge and reasonable belief, and under penalty of law, the information contained in the annual compliance report is accurate and complete.
Click here for the proposed rules.
On November 10, 2010, the CFTC issued proposed rules with respect to the registration of swap dealers and major swap participants.
The proposed rules would impose a registration process for swap dealers and MSPs that is similar to that for FCMs. Applicants for registration as a swap dealer or MSP would be required to file a Form 7-R with the National Futures Association and demonstrate compliance, or the ability to comply, with various sections added to the CEA by Dodd-Frank that relate to swap dealers and MSPs. To the extent that a swap dealer or MSP is also an FCM, the proposed rules would require such a dual status entity to register in both capacities. Swap dealers and MSPs also would be required to become and remain members of at least one registered futures association.
Of particular note, the proposed rules provide for a provisional registration process for the transitional period between adoption of the swap dealer and MSP registration regulations and the latest date by which applicants must comply with the other final rulemakings relating to swap dealers and MSPs (e.g., capital and margin requirements, reporting and recordkeeping requirements, business conduct standards). Under the proposed rules, applicants may apply for provisional registration as a swap dealer or MSP beginning April 15, 2011. As the other rulemakings become effective, provisionally registered swap dealers and MSPs would be required to demonstrate compliance within the timeframe required by each such rulemaking. Once all of the relevant rulemakings have become effective and a provisionally registered swap dealer or MSP has demonstrated full compliance with those rules, the applicant would be notified that its provisional registration has become a full registration.
Click here for the proposed rules.
On November 10, 2010, the CFTC issued proposed rules with respect to the implementation of conflicts of interest policies and procedures by swap dealers and major swap participants.
The proposed rules governing conflicts of interest policies for swap dealers and MSPs are essentially the same as those that the CFTC proposed for FCMs and IBs on November 10, 2010 (see above). However, one difference is that the proposed rules add pricing to the list of activities prohibited for personnel having influence or control over a research analyst's evaluation or compensation (i.e., "no personnel engaged in pricing, trading or clearing activities may have any influence or control over the evaluation or compensation of a research analyst"). In addition, the proposed rules would require broader disclosure of conflicts of interest in research reports and public appearances. Specifically, swap dealers, MSPs, and research analysts would be required to also disclose any other actual, material conflicts of interest of the research analyst or swap dealer or MSP of which the research analyst has knowledge at the time of publication of the research report or at the time of the public appearance.
Click here for the proposed rules.
On November 10, 2010, the CFTC issued proposed rules establishing and governing the duties of swap dealers and major swap participants.
The proposed rules set forth the duties that would be imposed on each swap dealer and MSP with respect to establishing and maintaining a risk management program; monitoring for and preventing violations of applicable position limits; diligently supervising all activities relating to its business performed by its partners, members, officers, employees, and agents; establishing and maintaining a business continuity and disaster recovery plan; making information available for disclosure and inspection by the CFTC and its prudential regulator, if any; and not adopting any process or engaging in any action that would result in any unreasonable restraint of trade or impose any material anticompetitive burden on trading or clearing, unless necessary or appropriate to achieve the purposes of the CEA.
Click here for the proposed rules.
On November 10, 2010, the CFTC issued proposed rules implementing the whistleblower provisions of Section 23 of the CEA.
The proposed rules would establish a whistleblower program that would enable the CFTC to pay an award to eligible whistleblowers who voluntarily provide the CFTC with original information about a violation of the CEA that leads to successful enforcement of a covered judicial or administrative action. The proposed rules also would provide public notice of the prohibition on retaliation by employers against individuals who provide the CFTC with information pertaining to potential violations.
Click here for the proposed rules.
On November 19, 2010, the CFTC issued a notice requesting comments on the study regarding the oversight of existing and prospective carbon markets.
Dodd-Frank established an interagency working group to conduct a study on the oversight of existing and prospective carbon markets, including spot and derivative markets. A report on the results of the study is due no later than 180 days after enactment of Dodd-Frank. In its notice, the CFTC solicits public comment on a list of topics and questions relating to the study.
Click here for the proposed rules.
On November 19, 2010, the CFTC issued an advanced notice of proposed rulemaking and request for comments with respect to possible models for implementing new statutory provisions concerning the protection of cleared swaps customers before and after commodity broker bankruptcies.
The advance notice of proposed rulemaking requests comments on whether the CFTC should adopt a model for protecting swaps customer collateral similar to the current model for protecting futures customer collateral, which mutualizes loss among all of a defaulting FCM's customers, or whether another model is appropriate.
Click here for the proposed rules.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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