As part of implementing new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the Commodity Futures Trading Commission (the "CFTC") is proposing rules that would (i) establish conflict of interest systems and procedures for futures commission merchants (each, an "FCM") and introducing brokers (each, an "IB") for the purpose of ensuring that such registrants implement certain policies and procedures in compliance with the Commodity Exchange Act, as amended by the Dodd-Frank Act (the "CEA"); (ii) require each FCM, swap dealer and major swap participant to designate a chief compliance officer ("CCO"), as well as prescribe qualities and duties of the CCO and require the CCO to prepare, certify and furnish to the CFTC an annual report containing an assessment of the applicable entity's compliance activities; (iii) establish a process for registering swap dealers and major swap participants; and (iv) set forth certain duties for swap dealers and major swap participants who are registered with the CFTC. We have set forth below a brief summary of these rulemaking proceedings.
Proposed Rules for Implementation of Conflicts of Interest Policies and Procedures By FCMs and IBs
Conflicts of Interest in Research or Analysis
This proposed rulemaking relates to the conflicts of interest provisions added in Section 4d of the CEA. Specifically, Section 4d(c) authorizes the CFTC to require FCMs and IBs to implement conflict of interest systems and procedures that 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 are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of personnel whose involvement in trading or clearing activities might potentially bias the judgment or supervision of such personnel; and address such other issues as the CFTC determines to be appropriate. Accordingly, the CFTC is proposing to adopt a new Rule 1.71 to address potential conflicts of interest in the preparation and release of research reports by FCMs and IBs and the establishment of "appropriate informational partitions" within such firms, as well as certain other issues. 75 Fed. Reg. 70152 (November 17, 2010). Comments on this proposed rule are due by January 18, 2011.
Although Section 732 of the Dodd-Frank Act could be interpreted differently, this proposed rule reflects the CFTC's view that the purpose of the conflict of interest provisions added by the Dodd-Frank Act is primarily to prevent undue influence by persons involved in 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 within the firms. Thus, Rule 1.71 would impose specific restrictions on the interaction and communications between persons within an FCM or IB involved in research or analysis of the price or market for any derivative and persons involved in trading or clearing activities. This proposed rule also would restrict communications between personnel involved in research or analysis in an FCM or IB affiliate and FCM or IB personnel involved in trading or clearing activities. Given the varying size and business operations of FCMs and IBs, it is unclear how this proposed rule would be applied in practice to the firms and whether any exemptions or exceptions would be available.
Conflicts of Interest Relating to Clearing Activities
As proposed, Rule 1.71 also would address potential conflicts of interest that may arise between an FCM providing clearing services to customers and the business trading unit personnel of an affiliated swap dealer or major swap participant. Specifically, this proposed rule would preclude an FCM from permitting an affiliated swap dealer or major swap participant to interfere with, or attempt to influence, the decision of the clearing unit personnel of the FCM with regard to the provision of clearing services and activities. In this regard, each FCM would be required to create and maintain appropriate informational partitions between its clearing unit personnel and business trading units of an affiliated swap dealer or major swap participant. Also, each affected FCM and IB would be required to implement policies and procedures mandating the disclosure to its customers of any material conflicts of interest that relate to a customer's decision on the execution or clearing of a transaction.
It is unclear how the proposed restrictions relating to clearing activities would affect the clearing activities of FCMs and their swap dealer affiliates. In that connection, decisions by an FCM to provide clearing services to a customer may often be influenced by existing relationships between the customer and the FCM's affiliates, including one or more swap dealers. Such business interactions and pragmatic commercial considerations have never previously been thought to present regulatory concerns.
Designation of Chief Compliance Officer; Required Compliance Policies; and Annual Report of an FCM, Swap Dealer or Major Swap Participant
Chief Compliance Officers
The Dodd-Frank Act requires each FCM, swap dealer, and major swap participant to designate an individual to serve as its CCO. However, while the Dodd-Frank Act establishes duties of the CCO of a swap dealer or major swap participant, it does not set forth specific duties for the CCO of an FCM. Rather, the Dodd-Frank Act states that the CCO of an FCM shall "perform such duties and responsibilities as shall be set forth in regulations to be adopted by the [Commission]." In this regard, the CFTC is proposing to require that the CCO of an FCM have the same duties and responsibilities as are required under the Dodd-Frank Act for the CCO of a swap dealer or a major swap participant. Among other things, the proposed rules would (i) require the CCO of any such registrant to prepare, sign and certify an annual report discussing its compliance policies and activities that is filed with the CFTC; (ii) clarify that a CCO of a registrant is a "principal" as defined in Rule 3.1(a); and (iii) apply the CFTC's recordkeeping and inspection requirements to the annual report and any related records. The proposed rules also would require that each FCM, swap dealer and major swap participant provide the CCO with the responsibility and authority, in consultation with the registrant's board of directors and senior officer, to develop and enforce policies and procedures to fulfill the assigned duties of the CCO position. Comments on this proposed rule are due by January 18, 2011.
The proposed rules would codify the duties to be performed by a CCO of a swap dealer, major swap participant, or FCM, including the following: (i) establishing, in consultation with the board of directors or the senior officer, compliance policies; (ii) in consultation with the board of directors or the senior officer, resolving any conflicts of interest that may arise; (iii) reviewing and ensuring compliance with the compliance policies and applicable laws, rules and regulations; (iv) establishing procedures, in consultation with the board of directors or the senior officer, for remediation of any noncompliance issues identified by the CCO through a compliance officer review, look-back, internal or external audit finding, self-reported error or validated complaint; (v) establishing procedures, in consultation with the board of directors or the senior officer, for the handling, management response, remediation, retesting and closing of any noncompliance issues; and (vi) preparing, signing and certifying the required annual report. The CFTC also would require the CCO to meet annually with the board of directors or the senior officer to discuss the effectiveness of the firm's compliance policies, as well as the CCO's administration of the policies. For this purpose, the term "compliance policies" would include all the written policies and procedures required to be adopted or established by the registrant under the CEA and the CFTC's rules.
Consistent with the foregoing, only the board of directors or the senior officer would be permitted to designate the CCO or determine the compensation of the CCO.
Annual Report
The Dodd-Frank Act requires that the CCO of a swap dealer or major swap participant annually prepare, sign and certify a report containing a description of the registrant's compliance with the CEA and CFTC's regulations and a description of each policy and procedure of the registrant, including the code of ethics and conflicts of interest policies. This report would be furnished to the CFTC simultaneously with each annual financial report that is required to be furnished to the CFTC and include a certification by the CCO that, to the best knowledge and reasonable belief of the CCO and under penalty of law, the information contained in the annual report is accurate and complete. The CFTC is proposing to apply these requirements to FCMs as well, so the annual report for FCMs would be filed simultaneously with the FCM's Form 1–FR–FCM or FOCUS report.
The CFTC is proposing that the annual report must contain a number of items, including an assessment as to the effectiveness of the compliance policies, recommendations for changes or improvements to the compliance program and resources devoted to compliance, any material changes to compliance policies during the applicable period, a description of the resources set aside for compliance, including any deficiencies in such resources and any non-compliance issues and the corresponding action taken. Also, the proposed rules would require that the annual report include a certification of compliance under Sections 619 and 716 of the Dodd-Frank Act. Section 619 of the Dodd-Frank Act (the "Volcker Rule") generally prohibits banking entities, as defined in that section, from engaging in proprietary trading or maintaining an ownership interest in a private investment fund (e.g., a hedge fund or private equity fund). Section 716 of the Dodd-Frank Act (the "push-out" provision) generally prohibits any swap dealer or major swap participant (other than any major swap participant that is an insured depository institution) from receiving any federal assistance.
The proposed rules would permit a registrant to request an extension of time to file the annual report and require that any material error or omission in a previously filed annual report be promptly corrected. The annual report and any related records would be subject to the recordkeeping and inspection requirements of CFTC Rule 1.31.
Registration of Swap Dealers and Major Swap Participants
The CFTC is proposing to adopt rules that would establish a process for registering swap dealers and major swap participants in accordance with Section 4s of the CEA, which was added to the CEA by the Dodd-Frank Act. As with other CFTC registrants, the proposed rules would require swap dealers and major swap participants to become and remain members of the National Futures Association ("NFA"), a futures industry self-regulatory organization, and NFA would process applications for registration pursuant to delegated authority. 75 Fed. Reg. 71379 (November 23, 2010). Comments on these proposed rules are due by January 24, 2011.
The CFTC is proposing a provisional registration procedure for the transitional period between the July 21, 2011 date by which regulations establishing a process for registration must be in place and the effective dates of other rulemakings which will establish specific criteria with respect to the swap dealer and major swap participant definitions that determine who must register, as well as various other requirements for those who must register. Also, to allow sufficient processing time for the initial set of applicants, persons would be able to begin applying for registration voluntarily prior to July 21, 2011, beginning on April 15, 2011. This process would permit an entity that anticipates that it may be required to register as a swap dealer or major swap participant to apply for and obtain registration on a provisional basis.
Swap dealers and major swap participants, like other registrants, would be required to review and update at least annually the information provided to NFA in their application. Similarly, swap dealers and major swap participants would be required to review and update at least annually the information provided to the CFTC.
The CFTC is requesting comment on a number of issues, including whether it should by regulation restrict associated persons of swap dealers and major swap participants to natural persons as with associated persons of existing CFTC registrants. On a related issue, the CFTC is requesting comment on implementing the statutory prohibition against swap dealers and major swap participants permitting persons subject to a statutory disqualification to be associated with them. In this regard, possible alternatives include voluntary or required submission of identification information and fingerprint cards to NFA for the types of fitness review NFA conducts for existing registrants. The CFTC is also requesting comment on the extraterritorial application of the registration requirements, including what level of swap dealing activity outside the United States should qualify as having a significant connection with activities in, or effect on commerce of, the United States, thereby requiring a person outside the United States to register as a swap dealer and on interpretative issues relating to the definition of a major swap participant.
Required Duties of Swap Dealers and Major Swap Participants
The CFTC is proposing rules that would specify certain duties with which swap dealers and major swap participants who must register with the Commission would be required to comply to maintain their registrations pursuant to the new statutory framework outlined in Section 4s(j) of the CEA. These duties relate to business conduct standards and include the duty to: (i) monitor trading to prevent violations of applicable speculative position limits; (ii) establish adequate risk management procedures; (iii) disclose to the CFTC and other regulators general information relating to the terms and conditions of their swaps, their swaps trading operations, mechanisms and practices, financial integrity and risk management protections relating to swaps; (iv) establish and enforce internal systems and procedures to obtain information necessary to perform the duties imposed under CFTC regulations; (v) implement conflict of interest systems and procedures (see supra at 1-2); and (vi) refrain from taking any action that would result in an unreasonable restraint of trade or impose a material anti-competitive burden on swaps trading or clearing. 75 Fed. Reg. 71397 (November 23, 2010). Comments on these proposed rules are due by January 24, 2011.
Accordingly, the CFTC is proposing to add new Rules 23.600, 23.601, 23.602, 23.603, 23.606 and 23.607 which would elucidate the duties set forth above. In this regard, these proposed rules would, among other things, prescribe the elements of an acceptable risk management program; require position limit procedures; impose a duty of diligent supervision analogous to Rule 166.3 for existing CFTC registrants; require a written business continuity and disaster recovery plan; mandate the availability of all information required by, or related to, the CEA and CFTC regulations in accordance with the record retention requirements in Rule 1.31; and the adoption of policies and procedures to address antitrust considerations. In view of the need for firms to have some flexibility in implementing specific policies and procedures, these proposed rules are designed so that the specific elements of a risk management program may vary, depending on the size and complexity of a swap dealer's or major swap participant's business operations.
Proposed Rule 26.00 would require that a swap dealer's or major swap participant's risk management program (i) be codified in written policies and procedures which are approved by the governing body of the swap dealer or major swap participant and provided to the CFTC; and (ii) incorporate a risk management unit that is independent from the business trading unit to administer the risk management program. The proposed rule also would require swap dealers and major swap participants to establish policies and procedures (i) to require the use of central counterparties when required pursuant to CFTC regulation or order, and (ii) to use central clearing as a means of mitigating counterparty credit risk.
Proposed Rule 23.601 would require swap dealers and major swap participants to establish policies and procedures to monitor, detect and prevent violations of applicable position limits established by the CFTC, a designated contract market or a swap execution facility. In order to prevent violations, each swap dealer and major swap participant would, among other things, be required to provide training to all relevant personnel on applicable position limits, actively monitor trading, implement an early warning system, test the effectiveness of its policies and procedures, and report quarterly to its senior management and governing body on compliance with applicable limits.
Proposed Rule 23.602 requires each swap dealer and major swap participant to conform to CFTC regulations regarding the diligent supervision of the business of the swap dealer or major swap participant, respectively, which as noted above, is analogous to Rule 166.3 for existing CFTC registrants.
Proposed Rule 23.603 would require swap dealers and major swap participants to establish and maintain a written business continuity and disaster recovery plan designed to enable the swap dealer or major swap participant to resume operations within one business day of a disruption. In that connection, swap dealers and major swap participants would be required to provide the CFTC with emergency contacts and identify essential documents, data, facilities, infrastructure, and personnel, and also maintain sufficient back-up facilities in a separate geographic location.
Proposed Rule 23.606 would require each swap dealer and major swap participant to make available for disclosure and inspection by the CFTC and its prudential regulator, as applicable, all information required by the CEA and CFTC regulations, and to establish and maintain reliable systems sufficient to capture, process, record, store and produce such information to satisfy its duties under the CEA and CFTC regulations. Finally, Rule 23.607 addresses various antitrust considerations.
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