CFTC Proposes Rules on Conflicts of Interest Policies and Procedures by Swap Dealers and Major Swap Participants
The Commodity Futures Trading Commission, or CFTC, has proposed rules to implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed regulations establish conflicts of interest requirements for swap dealers, or SDs, and major swap participants, or MSPs, for the purpose of ensuring that such persons implement adequate policies and procedures in compliance with the Commodity Exchange Act, or CEA, as amended by the Dodd-Frank Act.
Conflicts of Interest in Research or Analysis
Section 731 of the Dodd-Frank Act requires, in relevant part, that SDs and MSPs “establish structural and institutional safeguards to ensure that the activities of any person within the firm relating to research or analysis of the price or market for any commodity or swap . . . are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in pricing, trading, or clearing activities might potentially bias their judgment or supervision.”
Much of the relevant language in section 731 of the Dodd-Frank Act is similar to certain language contained in section 501(a) of the Sarbanes-Oxley Act of 2002, which amended the Securities Exchange Act of 1934 by creating a new section 15D. In relevant part, section 15D(a) mandates that the SEC, or a registered securities association or national securities exchange, adopt “rules reasonably designed to address conflicts of interest that can arise when securities analysts recommend equity securities in research reports and public appearances, in order to improve the objectivity of research and provide investors with more useful and reliable information, including rules designed . . . to establish structural and institutional safeguards within registered brokers or dealers to assure that securities analysts are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision . . . .”
Unlike section 15D of the Securities Exchange Act of 1934, section 731 of the Dodd-Frank Act does not expressly limit the requirement for informational partitions to only those persons who are responsible for the preparation of the substance of research reports; rather, section 731 could be read to require informational partitions between persons involved in pricing, trading or clearing activities and any person within a SD or MSP who engages in “research or analysis of the price or market for any commodity or swap,” whether or not such research or analysis is to be made part of a research report that may be publicly disseminated.
However, the CFTC believes that an untenable outcome could result from implementing informational partitions between persons involved in pricing, trading or clearing activities and all persons who may be engaged in “research or analysis of the price or market for any commodity or swap,” given that persons involved in pricing, trading or clearing activities are routinely—or even primarily—engaged in “research or analysis of the price or market for” commodities or swaps. Sound pricing, trading and/or clearing activities necessarily require some form of pre-decisional research or analysis of the facts supporting such determinations.
Therefore, given the untenable alternative, the proposed rules reflect the CFTC’s belief that the Congressional intent underlying section 731 with respect to “research and analysis of the price or market of any commodity or swap” is primarily intended to prevent undue influence by persons involved in pricing, trading or clearing activities over the substance of research reports that may be publicly disseminated, and to prevent pre-public dissemination of any material information in the possession of a person engaged in research and analysis, or of the research reports, to traders.
Many elements of the proposed rule, particularly those provisions relating to potential conflicts of interest surrounding research and analysis, have been adapted from National Association of Securities Dealers (NASD) Rule 2711. To construct the “structural and institutional safeguards” mandated by Congress under section 731 of the Dodd-Frank Act, the proposed rule establishes specific restrictions on the interaction and communications between persons within a SD or MSP involved in research or analysis of the price or market for any derivative and persons involved in pricing, trading or clearing activities. The proposed rules also impose duties and constraints on persons involved in the research or analysis of the price or market for any derivative. For instance, such persons will be required to disclose conspicuously during public appearances any relevant personal financial interests relating to any derivative of a type that the person follows. SDs and MSPs similarly will be obligated to make certain disclosures clearly and prominently in research reports, including third-party research reports that are distributed or made available by the SD or MSP. Further, SDs and MSPs, as well as employees involved in pricing, trading or clearing activities, will be prohibited from retaliating against any person involved in the research or analysis of the price or market for any derivative who produces, in good faith, a research report that adversely impacts the current or prospective pricing, trading or clearing activities of the SD or MSP.
To address the possibility that the proposed rules could be evaded by employing research analysts in an affiliate of a SD or MSP, the proposed rules also will restrict communications with research analysts employed by an affiliate. An affiliate will be defined as an entity controlling, controlled by, or under common control with, a SD or MSP. Moreover, the exceptions to the definition of “research report” are designed to address issues typically found in smaller firms where individuals in the trading unit perform their own research to advise their clients or potential clients. These exceptions do not in any way impact or lessen the restrictions placed on firms that prepare research reports and release them for public consumption. According to the CFTC, any attempt by such firms to move research personnel into a trading unit to attempt to avail themselves of the exception will result in insufficient “structural and institutional safeguards” and will be a violation of Section 731 of the Dodd-Frank Act and the proposed rules.
Conflicts of Interest of Swap Dealers and Major Swap Participants in Clearing
Section 4s(j)(5), as established by section 731 of the Dodd-Frank Act, requires SDs and MSPs to implement conflicts of interest systems and procedures that “establish structural and institutional safeguards to ensure that the activities of any person within the firm . . . acting in a role of providing clearing activities or making determinations as to accepting clearing customers are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in pricing, trading, or clearing activities might potentially bias their judgment or supervision and contravene the core principles of open access and the business conduct standards described in this Act.”
The CFTC interprets the conflicts of interest provision under section 4s(j)(5) to require informational partitions between:
- persons making clearing determinations; and
- persons involved in pricing and trading swaps (i.e., risk-taking units).
According to the CFTC, this interpretation would protect against potential bias or interference in relation to “providing clearing activities.”
The provision of clearing activities includes acts relating to:
- whether to offer clearing services and activities to customers;
- whether to accept a particular customer for the purposes of clearing derivatives;
- whether to submit a transaction to a particular derivatives clearing organization;
- setting risk tolerance levels for particular customers;
- determining acceptable forms of collateral from particular customers; or
- setting fees for clearing services.
However, the proposed rules are not intended to hinder the execution of sound risk management programs by SDs or MSPs, or by any affiliate of a SD or MSP.
To prevent anti-competitive discrimination in providing access to central clearing, the CFTC proposed rules that will subject SDs and MSPs to restrictions that prevent risk-taking units from interfering with decisions by any affiliated clearing member of a derivatives clearing organization regarding whether to accept a client for clearing services. Under the proposed restrictions, all such decisions regarding the acceptance of customers for clearing should be made in accordance with publicly disclosed, objective, written criteria. Risk-taking units (i.e., those persons involved in pricing and trading swaps) would also be prevented from interfering with the provision of clearing activities.
An affiliate will be defined as an entity controlling, controlled by, or under common control with, a SD or MSP. Under the term “affiliate,” in any situation where a person is dually registered as a SD or MSP, and as a futures CFTC merchant, or FCM, the restrictions on clearing activities set forth in the proposed regulations are intended to apply to the relationship between the business trading unit of the SD or MSP and the clearing unit of the FCM, even though the business trading unit and clearing unit reside within the same entity.
In addition to mandating the establishment of “appropriate informational partitions” within SDs and MSPs that focus on the activities of persons involved in the “research or analysis of the price or market for any commodity or swap,” section 731 of the Dodd-Frank Act also requires SDs and MSPs to “implement conflict-of-interest systems and procedures that . . . address such other issues as the CFTC determines to be appropriate.” Having considered the potential conflicts of interest that may arise in a SD or MSP, the CFTC proposed rules that will address the potential for undue influence on customers. The intended cumulative effect of the proposed rules is to fulfill Congress’s objective that SDs and MSPs construct “structural and institutional safeguards” to minimize the potential conflicts of interest that could arise within such firms.
The CFTC recognizes the potential development of a complex web of incentives and relationships surrounding SDs and MSPs, particularly with respect to such questions as:
- whether to enter into a cleared or uncleared trade,
- whether to refer a counterparty to a particular futures CFTC merchant for clearing, or
- whether to send a cleared trade to a particular derivatives clearing organization.
To address this issue, the CFTC is proposing to require that each SD and MSP implement policies and procedures mandating the disclosure to its customers of any material incentives or any material conflicts of interest it has that relate to a customer’s decision on the execution or clearing of a transaction. Such disclosures will enable customers to make fully-informed business decisions, thereby minimizing the potential influence of any incentives or conflicts of SDs and MSPs.
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