Derivatives Practice Alert
December 2010
Author:
Anthony R.G. Nolan
Anthony.nolan@klgates.com
+1.212.536.4843
The author acknowledges the
assistance of associate Lloyd H.
Johnson in the preparation of this
Alert.
K&L Gates includes lawyers practicing out
of 36 offices located in North America,
Europe, Asia and the Middle East, and
represents numerous GLOBAL 500,
FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies, entrepreneurs,
capital market participants and public
sector entities. For more information,
visit www.klgates.com.
CFTC Proposes Rules to Implement Conflict
of Interest Requirements of Swap Dealers and
Major Swap Participants Under Section 731 of
the Dodd-Frank Act
On November 23, 2010, the Commodity Futures Trading Commission (“CFTC”)
proposed a rule to implement requirements relating to conflicts of interest for swap
dealers (“SDs”) and major swap participants (“MSPs”) that are contained in Section
4s(j)(5) of the Commodity Exchange Act (“CEA”), which was added pursuant to
Section 731 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(the “Dodd-Frank Act”).1
Proposed Rule 23.605 would generally address conflicts of interest that arise as a
result of (1) research reports prepared and/or released by SDs and MSPs, (2) certain
clearing determinations made by persons in the clearing arms of SDs and MSPs, and
(3) disclosures made to customers of SDs and MSPs regarding potential derivatives
transactions.
Public comment on the proposed rule must be received on or before January 24,
2011.
Background
Section 4s(j)(5) to the CEA directs each SD and MSP to implement conflicts of
interest systems and procedures that establish safeguards within the firm to ensure
that any persons researching or analyzing the price or market for any commodity or
swap are separated by “appropriate informational partitions” within the firm from
review, pressure, or oversight of persons whose involvement in pricing, trading or
clearing activities might potentially bias the judgment or supervision of such
research personnel. The statute emphasizes that pricing, trading and clearing
activities should comply with open access and business conduct standards set forth
elsewhere in the Dodd-Frank Act, and mandates that the required conflicts of interest
systems and procedures “address such other issues as the [CFTC] determines to be
appropriate.”
The Proposing Release notes that the statutory conflict-of-interest requirement
described above generally mirrors the conflict-of-interest provision in Section 15D of
the Securities Exchange Act of 1934 (the “Exchange Act”).2 However, the
Proposing Release observes that Section 4s(j)(5) is potentially broader than
1
Implementation of Conflicts of Interest Policies and Procedures by Swap Dealers and Major Swap
Participants, 75 Fed. Reg. 71391 (November 23, 2010) (the “Proposing Release”).
2
Section 15D(a) of the Exchange Act generally would require the Securities and Exchange
Commission, registered security organizations or national security exchanges to adopt policies and
procedures regarding security analyst recommendations and “appropriate informational partitions”
between analysts and brokers or dealers.
Derivatives Practice Alert
personnel” from influencing the content of
research reports and would prohibit research
analysts from being subject to the “supervision
or control” of any employee in an SD or MSP’s
business trading unit or clearing unit.4
Subsection (c)(1) also would prohibit personnel
engaged in pricing, trading or clearing activities
from influencing or controlling the evaluation
or compensation of research analysts.
Additionally, non-research personnel (other
than the board of directors or a committee of
the board of directors) would not be permitted
to review or approve the research reports before
publication, except for verifying “factual
accuracy,” performing “non-substantive
editing,” general formatting, or to “identify any
potential conflicts of interest” so long as
communications between research analysts and
non-research personnel made in connection
with such review or approval are conducted
through authorized legal or compliance
personnel of the SD or MSP.
Exchange Act Section 15D because it 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 but 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.
Conflicts Related to Research -Proposed Rule 23.605(c)
Proposed Rule 23.605(c) sets forth several
restrictions that are intended to prevent conflicts of
interest that may arise as a result of research reports
prepared and/or released by research analysts of a
SD or MSP by creating informational partitions
between the research and trading functions of SDs
and MSPs, as well as by implementing other
requirements that are intended to remove any
influence that employees in the trading function
might have over research analysts.3
Notwithstanding the breadth of the statutory
provision, the CFTC has expressed concern in the
Proposing Release 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,” considering
that the 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. For that
reason, the primary thrust of Proposed Rule
23.605(c) is to prevent undue influence.
•
Subsection (c)(2) would require that any
“written or oral communication by a research
analyst to a current or prospective counterparty,
or to any employee of the [SD] or [MSP],
relating to any derivative must not omit any
material fact or qualification that would cause
the communication to be misleading to a
reasonable person.”
•
Subsection (c)(3) states that SDs or MSPs may
not consider a research analyst’s contributions
to their trading or clearing businesses when
determining such research analyst’s
compensation, and that no employees of the SD
or MSP’s business trading or clearing units may
“influence the review or approval of a research
analyst’s compensation.”
•
Subsection (c)(4) would prohibit SDs or MSPs
from directly or indirectly offering “favorable
research,” or from threatening or changing
research, “to an existing or prospective
The proposed rule would seek to foster the CFTC’s
policy objective of preventing undue influence by
SDs or MSPs in the following ways:
•
3
Subsection (c)(1) would prohibit “non-research
The CFTC notes that specific elements of the proposed rule
have been adapted from National Association of Securities
Dealers (“NASD”) Rule 2711.
4
Pursuant to Proposed Rule 23.605(a), “non-research
personnel” would be defined as any employee of the business
trading unit or clearing unit, or any other employee of the SD
or MSP who is not directly responsible for, or otherwise
involved with, research concerning a derivative, other than
legal or compliance personnel.
December 2010
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Derivatives Practice Alert
counterparty as consideration or inducement for
the receipt of business or compensation.”
•
•
Subsection (c)(5) would require SDs and MSPs
to disclose clearly, conspicuously and
prominently in their research reports and public
appearances: (i) whether the research analyst
that created the report “maintains, from time to
time, a financial interest in any derivative of any
type that the research analyst follows, and the
general nature of the financial interest”; and
(ii) “any other actual, material conflicts of
interest of the research analyst or [SD] or [MSP]
of which the research analyst has knowledge at
the time of the publication of the research report
or at the time of the public appearance.”5
Finally, subsection (c)(6) would prohibit SDs
and MSPs or their employees that are involved
in pricing, trading or clearing activities from
directly or indirectly retaliating or threatening to
retaliate against any research analyst employed
by the SD or MSP or its affiliates “as a result of
an adverse, negative, or otherwise unfavorable
research report or public appearance written or
made, in good faith, by the research analyst that
may adversely affect the [SD]’s or [MSP]’s
present or prospective pricing, trading or
clearing activities.”
Proposed Rule 23.605(c) would define the term
“research report” generally to mean any written
communication (including electronic) that includes
an analysis of the price or market for any derivative,
and that provides information reasonably sufficient
upon which to base a decision to enter into a
derivatives transaction. The term would be subject
to certain exceptions that 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.
Under these exceptions, the following types of
communications would not be considered “research
reports”: (i) communications that are distributed to
5
SDs or MSPs would also be required to make available
research reports produced by third parties and to require that a
SD or MSP also provide a web address that gives any reader
of such report the same disclosures required by subsection (c).
SDs and MSPs would not have to provide such disclosures for
third party reports if such reports are provided at the
customer’s request or if such reports are made available
“through a website maintained by the [SD] or [MSP].”
fewer than 15 persons; (ii) periodic reports or other
communications prepared for investment company
shareholders or commodity pool participants that
discuss individual derivatives positions in the
context of a fund’s past performance or the basis for
previously made discretionary decisions; (iii) any
communication generated by an employee of the
business trading unit that is conveyed as a
solicitation for entering into a derivatives
transaction, and is conspicuously identified as such;
and (iv) internal communications that are not given
to current or prospective customers.
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
would restrict communications with research
analysts employed by an affiliate. An affiliate would
be defined for this purpose as an entity controlling,
controlled by, or under common control with, a SD
or MSP.
Conflicts Related to Clearing -Proposed Rule 23.605(d)
Proposed Rule 23.605(d) sets forth restrictions that
are intended to “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 Dodd-Frank Act.”
The CFTC has stated in the Proposing Release that
it interprets the statutory conflict-of-interest
provision related to clearing to require informational
partitions between (1) persons making clearing
determinations and (2) persons involved in pricing
and trading swaps, what it describes as “risk-taking
units.” It has further stated that it believes this
interpretation would protect against potential bias or
interference in relation to the provision of clearing
activities.
Paragraph (1) of Proposed Rule 23.605(d) would
prohibit any SD or MSP from directly or indirectly
December 2010
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Derivatives Practice Alert
interfering with or attempting to influence the
decision of any affiliated clearing member of a
derivatives clearing organization with regard to the
provision of clearing services and activities. Such
services and activities would include, without
limitation, decisions regarding: “(i) whether to offer
clearing services and activities to customers;
(ii) whether to accept a particular customer for the
purposes of clearing derivatives; (iii) whether to
submit a transaction to a particular derivatives
clearing organization; (iv) setting risk tolerance
levels for particular customers; (v) determining
acceptable forms of collateral from particular
customers; or (vi) setting fees for clearing services.”
Subsection (d)(2) would require each SD and MSP
to create and maintain an “appropriate informational
partition” between business trading units of the SD
or MSP and the “clearing member personnel of any
affiliated member of a derivatives clearing
organization.”6 Subsection (d)(2) states that such
informational partition would be required to at least
prohibit business trading unit employees from
supervising, controlling or influencing employees of
a clearing member of a derivatives clearing
organization.
Conflicts Relating to SD or MSP
Influence over Customers -- Proposed
Rule 23.605(e)
The CFTC has proposed Rule 23.605(e), which sets
forth restrictions intended to address the potential
influence an SD or MSP might have on its
customers. This is in response to new Section
4s(j)(5) of the CEA, which, in addition to mandating
the establishment of appropriate informational
partitions within SDs and MSPs, requires SDs and
MSPs to implement conflict-of-interest systems and
procedures that address such other issues as the
CFTC determines to be appropriate.
Pursuant to subsection (e), each SD and MSP would
be required to implement policies and procedures
that “mandate the disclosure to its counterparties of
any material incentives and any material conflicts of
interest regarding the decision of a counterparty:
(1) whether to execute a derivative on a swap
execution facility or designated contract market, or
(2) whether to clear a derivative through a
derivatives clearing organization.” The CFTC
noted that Proposed Rule 23.605(e) might be
particularly helpful in addressing questions
counterparties may have regarding entering into and
clearing trades with an SD or MSP.7
Conclusion
The CFTC’s proposed rule addressing conflicts of
interest is part of an interrelated set of proposed new
rules that will impose registration requirements and
a wide array of substantive regulation on SDs and
MSPs. The proposed rule will have a pervasive
effect on research by SDs and MSPs, determinations
by the clearing arms of SDs and MSPs, and
disclosures by SDs and MSPs to their clients
regarding potential derivatives transactions.
7
6
Proposed Rule 23.605(a)(1) states that “affiliates” means,
with respect to a person, a person controlling, controlled by, or
under common control with, such person.
The CFTC specifically noted that the proposed rules may
address questions such as: “(1) whether to enter into a
cleared or uncleared trade, (2) whether to refer a counterparty
to a particular futures commission merchant for clearing, or
(3) whether to send a cleared trade to a particular derivatives
clearing organization.”
December 2010
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Derivatives Practice Alert
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©2010 K&L Gates LLP. All Rights Reserved.
December 2010
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