CFTC Adopts Internal Business Conduct Rules - Sullivan & Cromwell

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As required under Section 4s(j)(7) of the CEA, the Commission has adopted Subpart J of Part 23 of the regulations in Title 17 of the Code of Federal Regulations (the “CFK Regulations”), 11 as part of the Internal Business Conduct Rules, and that subpart prescribes rules and regulations governing compliance with the duties enumerated under Section 4s(j) of the CEA. The Internal Business Conduct Rules require an SD or MSP to establish written procedures and policies with respect to a risk management program. This program, which must be approved by the appropriate governing body, should monitor and manage the risks associated with swaps activities. In connection with these policies and procedures, an SD or MSP must establish a risk management unit separate from its business trading unit with sufficient authority and resources to carry out its requisite duties and functions. The risk management program of an SD or MSP must take into account and set risk tolerance limits (and review them quarterly) based on market risk, credit risk, liquidity risk, foreign currency risk, legal risk, operational risk, settlement risk and any other applicable risks. The Internal Business Conduct Rules contain detailed descriptions of these types of risk and describe how the risk management program should evaluate these risks. The risk management program must also consider risks posed by affiliates. 12 Risk management personnel of an SD or MSP must provide senior management and its governing body with written reports concerning the risk exposures of the SD or MSP and any changes to its risk management program and the SD or MSP must furnish this quarterly report to the Commission. The risk management program of an SD or MSP must include policies and procedures for evaluating the risks associated with, and approving, new products. These policies and procedures should take into account whether the new product would materially alter the overall firm-wide risk profile of an SD or MSP. If the new product would materially alter the risk profile, the governing body must approve the new product. The new product policy can allow for preliminary approval of a new product at risk levels that are not material and solely for determining risk management processes for the new product. Under the Internal Business Conduct Rules, the risk management program of an SD or MSP should also include policies and procedures that relate to its use of central counterparties. The SD or MSP must satisfy all of the capital and margin requirements established by the Commission or other prudential regulators. In connection with the risk management program, the Internal Business Conduct Rules require that an SD or MSP establish policies and procedures for its business trading unit that further the objectives of the risk management program. Moreover, the business trading personnel should be separated from the risk management personnel. Pursuant to the Internal Business Conduct Rules, an SD or MSP must adopt policies and procedures to ensure compliance with the position limits established by the Commission, a DCM or an SEF and prevent improper reliance on exemptions from the position limits. The SD or MSP will be held to a reasonableness standard in establishing and enforcing policies and procedures to this effect. An SD or MSP must provide training on position limit compliance to relevant personnel and establish an early warning system to issue alerts if applicable position limits are in danger of being breached. The Internal CFTC Adopts Internal Business Conduct Rules March 8, 2012 -4-
Business Conduct Rules require that an SD or MSP test the effectiveness of these policies and procedures quarterly, audit them annually in connection with its audit of its risk management program, and retain all records pertaining to early warnings, violations, tests and audits relating to these policies and procedures. An SD or MSP must also establish supervisory systems to monitor the swaps activities carried out by its officers, employees and agents, as well as a related supervisory structure. The Internal Business Conduct Rules require the SD or MSP to establish a business continuity and disaster recovery program, 13 programs for disclosure and inspection of general information required by the CEA or the CFTC Regulations, and policies to prevent the adoption of practices that result in the unreasonable restraint of trade. CONFLICTS OF INTEREST POLICIES AND PROCEDURES Section 732 of the Dodd-Frank Act amended the CEA to mandate that the Commission adopt rules that require FCMs and IBs to implement conflict of interest systems and procedures. Section 731 of the Dodd-Frank Act amended the CEA to require SDs and MSPs to “establish structural and institutional safeguards” and “appropriate informational partitions” to separate trading personnel and clearing personnel. In response to these two amendments to the CEA, the Commission adopted Final Rule 1.71 requiring FCMs and most IBs to adopt conflict-of-interest policies and procedures and Final Rule 23.605 requiring SDs and MSPs to do the same. 14 The Final Rules require FCMs, MSPs, SDs and most IBs to implement policies and procedures that create informational and supervisory firewalls between research personnel and non-research personnel and between trading business units and clearing units. Under the Internal Business Conduct Rules, trading business personnel at an SD or MSP are prohibited from influencing a customer’s decision (or the decision of an affiliated clearing member of a DCO to accept a customer) to use the clearing services of an affiliated clearing member of a DCO. Similarly, an FCM is prohibited from allowing an affiliated SD or MSP to influence the decision of a customer to use the clearing services of an FCM or the decision of an FCM to accept a customer. FCMs must also prohibit trading business personnel from inappropriately influencing research reports or research analysts. Separations Between Affiliated Clearing Units and Business Trading Units The Proposed Rules would have broadly defined “business trading unit” to include any person that performs or “is involved in any pricing, trading, sales, marketing, advertising, solicitation, structuring, or brokerage activities.” 15 In the Final Rules, the Commission changed this definition to exclude personnel who are not directly involved in actual trading activities, such as legal, compliance, human resources, risk management, operations and other support functions, but would include personnel who “directly perform or exercise supervisory authority over the performance” of trading activities. If legal, compliance and risk management personnel were deemed business trading personnel, these departments would not be able to interact adequately with affiliated clearing units or research departments and therefore may not be able to perform their respective functions in an integrated firm. In the Proposed Rules, the term “clearing unit” CFTC Adopts Internal Business Conduct Rules March 8, 2012 -5-
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CFTC Adopts Internal Business Conduct Rules - Sullivan & Cromwell

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