SEC Proposes Business Conduct Standards Under Title VII of Dodd-Frank: SEC Issues Proposed Rules Regarding Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants

Sullivan & Cromwell LLP - July 8, 2011
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On June 29, 2011, the SEC issued proposed rules (the “Proposed Rules”) in connection with its implementation of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) regarding business conduct standards for security-based swap dealers (“SBS Dealers”) and major security-based swap participants (“Major SBS Participants” and, together with SBS Dealers, “SBS Entities”).

The Proposed Rules create two categories of business standards – those applicable to both SBS Dealers and Major SBS Participants and those just applicable to SBS Dealers.

The business conduct standards applicable to both SBS Dealers and Major SBS Participants include:

  • that the SBS Entity verify that a counterparty whose identity is known to the SBS Entity meets the eligibility standards for an eligible contract participant prior to entering into a security-based swap (“SBS”) with that counterparty other than on a registered national securities exchange (“SBS Exchange”) or registered security-based swap execution facility (“SBS SEF”);
  • that the SBS Entity verify whether a counterparty whose identity is known to the SBS Entity is a “special entity” before entering into the SBS with that counterparty;
  • that the SBS Entity disclose information regarding material risks and characteristics, material incentives and conflicts of interest, and clearing rights to any non-SBS Entity counterparty;
  • that the SBS Entity disclose the daily mark for the SBS to any non-SBS Entity counterparty;
  • communications by the SBS Entity must be fair and balanced based on principles of fair dealing and good faith;
  • the establishment, maintenance and enforcement of a supervisory structure reasonably designed to achieve compliance with applicable federal securities laws, rules and regulations relating to its business as an SBS Entity;
  • that the SBS Entity has a reasonable basis to believe that a Special Entity has a “qualified independent representative”;
  • prohibiting the SBS Entity from engaging in specified fraudulent or deceitful conduct in dealing with Special Entities or any prospective customer who is a Special Entity; and
  • that the SBS Entity designate a client compliance officer.

The Proposed Rules impose a number of business conduct standards that only apply to SBS Dealers. These conduct standards apply to transactions with non-SBS Entities and include:

  • a requirement that the SBS Dealer “know its counterparty”;
  • a suitability obligation;
  • a requirement that the SBS Dealers disclose to a Special Entity, prior to the initiation of the SBS, the capacity in which it is acting;
  • special duties when the SBS Dealer acts as an adviser to a Special Entity; and
  • “pay-to-play” restrictions.