CFTC Adopts Internal Business Conduct Rules - Sullivan & Cromwell

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OPEN MEETING On February 23, the Commodity Futures Trading Commission (the “Commission” or the “CFTC”) held an open meeting at which it considered adopting five sets of proposed rules relating to the internal conduct of swap dealers (“SDs”), major swap participants (“MSPs”), futures commission merchants (“FCMs”) and introducing brokers (“IBs”) that it proposed in November and December of 2010 (such proposed rules referred to hereinafter as the “Proposed Rules”) 1 as well as promulgating a set of proposed rules on the minimum block sizes for swaps (the “Open Meeting”). At the Open Meeting, the Commission voted three to two to adopt a final version of the Proposed Rules (the “Final Rules” or the “Internal Business Conduct Rules”) with Commissioners Sommers and O’Malia dissenting. Commissioner Sommers explained in her opening statement that she would not support the Final Rules because, in her opinion, too many of the provisions do not “make sense or portend to disturbing trends.” 2 Commissioner Sommers specifically cited the Commission’s determination in the Final Rules to eschew substituted compliance for entities subject to comparable regulation by a prudential regulator. Commissioner Sommers questioned why the Commission should expend its limited resources on duplicative regulation and whether this approach would fit accordingly with the extraterritoriality issues under the Dodd-Frank Wall Street Reforms and Consumer Protection Act (the “Dodd-Frank Act”). Commissioner O’Malia dissented because, among other reasons, he strongly disapproved of the rulemaking process. His chief complaint was that the Commission did not properly conduct its costbenefit analysis. Commissioner O’Malia argued that a list of anticipated costs associated with implementing the Final Rules was necessary under the Office of Management and Budget (the “OMB”) guidelines. Commissioner O’Malia further stated that the entire Dodd-Frank Act rulemaking process suffered from the application of “weak standards to analyzing the cost and the benefits of [the Commission’s] rulemakings.” 3 To that end, Commissioner O’Malia issued a letter to Acting Director Zients of the OMB requesting that the OMB review the Commission’s cost-benefit analysis conducted in connection with the Internal Business Conduct Rules. 4 In this letter, the Commissioner explained that he believed “the Commission has failed to carefully and precisely identify a clear baseline against which the Commission measured costs and benefits and the range of alternatives under consideration in this rule.” 5 The letter referred to examples of how commenters suggested alternatives for the rules and the Commission dismissed these suggestions without specific justification or just ignored them. As discussed in detail below, Commissioner O’Malia specifically highlighted the Commission’s refusal to allow SDs and MSPs to rely on swap data repositories (“SDRs”) to meet their recordkeeping requirements under the Internal Business Conduct Rules. 6 The failure to provide acceptable reasoning for ignoring this suggested alternative showed, in Commissioner O’Malia’s opinion, that the rulemaking process for the Final Rules did not comply with the guidelines established by the OMB. 7 As of the date of this memorandum, the OMB has made no public response to the Commissioner’s request. It is unclear what effect, if any, a review by the OMB would have on the validity of the Internal Business Conduct Rules. CFTC Adopts Internal Business Conduct Rules March 8, 2012 -2-
FINAL RULES As discussed above, the Proposed Rules consisted of five sets of rules proposed in late 2010. The Commission worked with the Securities and Exchange Commission (the “SEC”); the Board of Governors of the Federal Reserve; the Office of the Comptroller of the Currency; and the Federal Deposit Insurance Corporation to finalize the Proposed Rules. The Commission also received 114 comment letters directly related to the Proposed Rules and responded accordingly to these comments. In response to the comment letters and input from the various federal agencies, the Commission determined to make certain changes between the Proposed Rules and the Final Rules. Some of these differences are highlighted in the discussion below. Many of these changes were made in an attempt to harmonize the Proposed Rules with the rules and regulations promulgated by other domestic and foreign regulators, although the success of this harmonization may be limited. Significantly, the Commission determined to adopt the term “swaps activities” in its Final Rules and to limit the applicability of the Final Rules to these activities. In particular, the Final Rules state that the term “swaps activities” shall mean “a registrant’s activities related to swaps and any product used to hedge such swaps, including, but not limited to, futures, options, other swaps or security-based swaps, debt or equity securities, foreign currency, physical commodities, and other derivatives.” 8 This term should limit the scope of the required risk management programs and recordkeeping under the Final Rules, as well as the duties of the chief compliance officer (“CCO”), discussed below. The Commission has determined not to further modify the scope of the Internal Business Conduct Rules to differentiate between SDs and MSPs and these two types of entities will be treated identically under the Final Rules. Finally, the Commission rejected “a substituted compliance regime with respect to the [Final Rules] for registrants subject to regulation by a prudential regulator.” 9 The Commission explained in the release accompanying the Final Rules (the “Adopting Release”) that, because SDs and MSPs are Commission registrants, they should all be subject to consistent regulatory regimes. Further, the Internal Business Conduct Rules are designed to work in tandem with the “external business conduct rules,” adopted on January 11, 2012, to govern the conduct of SDs and MSPs. 10 These “external business conduct rules” govern the interactions of SDs and MSPs with their counterparties. DUTIES OF SWAP DEALERS AND MAJOR SWAP PARTICIPANTS The Dodd-Frank Act added Section 4s(j) to the Commodity Exchange Act (the “CEA”) which imposes certain duties on all registered SDs and MSPs. These duties includes the following: Monitoring positions to avoid violations of applicable limits; Establishing risk management systems; Disclosing general information concerning swaps to the Commission; Implementing conflicts-of-interest procedures and polices (discussed above); and Avoiding actions that result in an unreasonable restraint on trade. CFTC Adopts Internal Business Conduct Rules March 8, 2012 -3-
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CFTC Adopts Internal Business Conduct Rules - Sullivan & Cromwell

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