Peggy A. Heeg, Michael Loesch, Brandon Byrne and Craig Oliver
November 23, 2010 view as PDF
Whistleblower and Swap Dealer Business Conduct Rules Proposed
On November 10, 2010, the Commodity Futures Trading Commission (“CFTC”) held its fourth public meeting to consider proposed rules under the Dodd–Frank Wall Street Reform and Consumer Protection Act. The CFTC approved for public comment proposed rules addressing:
- whistleblower incentives and protections;
- registration of swap dealers and major swap participants;
- business conduct standards for swap dealers and major swap participants;
- the designation of chief compliance officers for swap dealers, major swap participants, and futures commission merchants;
- conflict of interest policies for swap dealers, major swap participants, and futures commission merchants; and
- registration of foreign boards of trade.
Although all rules proposed were approved for publication, several proposed rules received opposition from one or more Commissioners. Several Commissioners expressed concern that the proposed rules regarding key definitions had not yet been issued by the Commission, which makes it difficult for the public to comment on other rules. Chairman Gensler indicated during the meeting that he expected proposals regarding entity and product definitions to be considered in December. Commissioners also expressed concern that the CFTC’s rulemaking is trending away from principles-based regulation to a more prescriptive, rules-based approach.
The following summary is based on the discussion at the CFTC’s public meeting and related materials. As of the preparation of this briefing, only a portion of the proposed rules have been published in the Federal Register.
The CFTC proposed rules to implement the Dodd-Frank whistleblower provisions, which establish a new whistleblower program to provide incentives and protections for eligible individuals who supply the Commission with information about potential violations of the Commodity Exchange Act (“CEA”).
The proposed whistleblower rules are designed to implement Dodd-Frank Section 748 and seek public comment on a number of questions regarding the operation of the whistleblower program. Dodd-Frank Section 748 requires the CFTC to reward individuals who provide “original information” that leads to a successful enforcement action resulting in monetary sanctions exceeding $1 million. The Act prescribes that the awards range from 10% to 30% of the sanctions collected but gives broad discretion to the CFTC in deciding the exact award amounts. The Act also contains a number of specific provisions addressing whistleblower eligibility, exclusions for persons with particular responsibilities, protections against retaliation, and the operation of a new CFTC customer protection fund.
During the meeting, the CFTC staff confirmed that whistleblowers may receive an award based upon violations that occurred prior to Dodd-Frank enactment and that whistleblowers who submit information prior to the effective date of the proposed rules may also be eligible for an award provided they comply with the appropriate procedures within 120 days of the effective date. Several Commissioners noted with approval the provisions authorizing the CFTC to use penalties collected in connection with the proposed rule to fund consumer education initiatives as well as whistleblower awards. The Commission also discussed the need to ensure that the proposed whistleblower rules were appropriately consistent with the programs operated by other federal agencies, such as the Securities Exchange Commission. Comments on the proposed rules are due within 60 days of publication in the Federal Register.
Rules Concerning Swap Dealers and Major Swap Participants
The CFTC approved proposed rules governing the registration of swap dealers and major swap participants, as required under Dodd-Frank Section 731. Because the Commission has not yet issued proposed rules defining key terms, it is uncertain which entities will be swap dealers or major swap participants. Accordingly, the proposed rules include a provisional registration process under which entities that believe they meet the Act’s definition of swap dealer or major swap participant would be permitted, but not required, to register with the CFTC starting April 15, 2011. Registration would become mandatory once the rules defining “swap dealer” and “major swap participant” become effective. Chairman Gensler hinted during the meeting that proposed rules providing entity definitions may be considered by the Commission in December.
Dodd-Frank Section 731 adds new Section 4s to the CEA and subjects all registered swap dealers and major swap participants to several conduct requirements, including capital and margin requirements and business conduct standards. The swap dealer requirements will be addressed by separate Commission rulemakings. To accommodate the ongoing rulemaking process, under the proposed registration rules, swap dealers and major swap participants would be registered only on a “provisional” basis until all of the rules implementing the Section 4s requirements become effective. Provisionally registered swap dealers and major swap participants would be subject only to those Section 4s rules effective at the time of their provisional registration, and would be required to come into compliance with other Section 4s rules as they become effective.
The proposed rules also (i) require swap dealers and major swap participants to become members of a registered futures association (e.g., the National Futures Association) and (ii) prohibit swap dealers and major swap participants from associating with a person subject to a statutory disqualification. The Commission also seeks comment on who should perform swap dealer and major swap participant oversight and examination functions. Specifically, the Commission requests comment on three options as to who should be responsible for determining whether an entity is in compliance with the various requirements of registration: (i) the CFTC; (ii) the National Futures Association (subject to CFTC oversight); or (iii) the CFTC and National Futures Association (depending on the oversight activity involved).
During the meeting, the Commission debated the timing of the proposal and why registration could occur before effectiveness of all of the requirements under new Section 4s. The staff explained that provisional registration permits, but does not require, swap dealer registration and fulfills the mandates of the Act. The staff indicated that the provisional registration process would help expedite the final registration process by permitting entities to fulfill many of the administrative tasks in advance of effectiveness. Commissioner Sommers disagreed with this approach and feared that the provisional registration process would increase confusion among market participants and strain the already limited resources of the CFTC. Comments on the proposed rules are due within 60 days of publication in the Federal Register.
The CFTC approved proposed rules relating to the duties of swap dealers and major swap participants, as set forth in new CEA Section 4s(j). These proposed rules, which establish internal business conduct standards, would, among other things, require swap dealers and major swap participants to:
- establish a risk management program designed to manage day-to-day business risks, including all relevant risks (e.g., market, credit, liquidity, foreign currency, legal, and settlement risk);
- establish polices for monitoring traders for compliance with the firm’s trading limits;
- require traders to follow procedures for executing and confirming transactions;
- diligently supervise traders;
- separate traders from the risk management unit;
- establish procedures to monitor and prevent violations of the position limits of the CFTC, a designated contract market, or a swap execution facility, including:
- annual training;
- supervision of trading;
- early warning systems;
- testing and auditing of position limit procedures; and
- quarterly documentation of compliance;
- establish a supervisory system over its partner, member, officer, employee, and agent activities;
- establish a plan designed to enable the resumption of operations by the next business day following an emergency or other disruption;
- promptly disclose all information required by the CFTC or a prudential regulator; and
- adopt policies and procedures to prohibit any action that results in any unreasonable restraint of trade or imposes any material anticompetitive burden on trading or clearing (unless necessary or appropriate to achieve the purposes of the CEA).
At the meeting, the CFTC staff clarified that, with respect to the required risk management program, swap dealers and major swap participants would set risk tolerance levels for themselves. The staff also explained that the risk management duties embodied in the proposed rules are generally standard industry practice. Comments on the proposed rules are due within 60 days of publication in the Federal Register.
Chief Compliance Officer and Annual Compliance Report
The CFTC also approved proposed rules concerning (i) the designation, qualification, and duties of Chief Compliance Officers (“CCOs”) of swap dealers, major swap participants, and futures commission merchants and (ii) the preparation of required annual compliance reports to the Commission. Under the proposed rules, which implement and generally track the provisions of new CEA Section 4s(k), swap dealers, major swap participants, and futures commission merchants1 must designate a CCO whose responsibilities include:
- establishing and administering compliance policies;
- reviewing and ensuring the registrant’s compliance with the CEA and CFTC regulations;
- resolving conflicts of interest;
- identifying and establishing procedures for remediation of non-compliance issues; and
- preparing, signing, and certifying an annual report that contains, among other things:
- a description of the registrant’s compliance with the CEA, CFTC regulations, and the registrant’s own compliance policies;
- an assessment of the effectiveness of the registrant’s policies;
- a discussion of areas for improvement;
- a description of the resources set aside for compliance; and
- a description of any non-compliance issues identified and addressed.
Under the proposal, these duties must be undertaken by the CCO in consultation with the board of directors or the senior officer of the registrant, and the CCO must be considered a listed principal of the registrant. The proposal also requires that CCOs have an appropriate background and the skills needed to fulfill the responsibilities, though the CCO is not intended to act as a substitute for audit staff, back-office staff, external auditors, or the chief financial officer.
The CFTC specifically seeks comment on the degree of flexibility in the CCO reporting structure and whether limitations should be placed on persons who may be designated as a CCO (e.g., should the CFTC restrict the CCO position from being held by an attorney who represents the registrant or its board of directors, such as an in-house or general counsel).2 During the meeting, the CFTC Staff indicated that most entities already have an individual who fits the role of the CCO. Chairman Gensler indicated that he was interested in hearing how the rule would impact smaller entities. Commissioner Sommers opposed the proposed CCO rules, questioned why futures commission merchants were included and whether the requirements could be delegated to others. Comments on the proposed rules are due by January 18, 2010.3
Conflicts of Interest
The CFTC approved proposed rules to establish conflict of interest requirements for swap dealers, major swap participants, futures commission merchants, and introducing brokers. The proposed rules, which implement Dodd-Frank Section 731 (for swap dealers and major swap participants) and Section 732 (for futures commission merchants and introducing brokers), would require information barriers between a firm’s commodity research functions and its trading and clearing functions and other safeguards designed to prevent research-related conflicts of interest. Specifically, the proposed rules require swap dealers, major swap participants, futures commission merchants, and introducing brokers to establish conflict-of-interest systems, including procedures that:
- establish appropriate informational partitions, or “firewalls,” between:
- persons researching or analyzing the price or market for any commodity or swap and persons whose involvement in pricing, trading, or clearing activities might potentially bias the judgment or supervision of persons engaged in research; and
- persons acting in a role of providing clearing activities or making determinations as to accepting clearing customers from persons involved in pricing, trading, or clearing activities;
- prohibit certain trading and clearing personnel from supervising research analysts;
- prohibit contributions to the trading or clearing business to be considered when setting a research analyst’s compensation;
- prohibit offering favorable research, or threatening to change research, for existing or prospective counterparties in exchange for business or compensation;
- require disclosure in research reports (and disclosure in public appearances by research analysts) whether a research analyst maintains a financial interest in any derivative of a type followed by that analyst; and
- prohibit retaliation against any research analyst who produces a research report that may adversely impact the firm’s business activities.
The proposal would prohibit swap dealers and major swap participants from interfering with decisions related to the provision of clearing and require swap dealers and major swap participants to erect partitions between trading personnel and the personnel of any affiliated clearing members.
The CFTC specifically seeks comment on whether there are alternative approaches to address the potential conflicts of interest that may arise between a futures commission merchant providing clearing services to customers and the trading unit personnel of an affiliated swap dealer or major swap participant. Commissioner Sommers opposed the proposed conflict of interest rules as applied to futures commission merchants and introducing brokers. Comments on the proposed rules are due by January 18, 2010.4
Foreign Board of Trade Registration
The CFTC issued proposed rules requiring Foreign Boards of Trade (“FBOTs”) to register with the Commission if they provide U.S. customers with “direct access” to their trading systems. Dodd-Frank Section 738 provided the CFTC with the authority to adopt rules implementing a registration system for FBOTs. Currently, there is no formal FBOT registration system. The CFTC relies on issuance of staff no-action letters to regulate FBOTs that want to grant their U.S. members the ability to enter orders directly into the exchange trade-matching system, instead of through an intermediary. The proposed registration rules prescribe: (i) registration procedures; (ii) conditions that a registered FBOT must meet to retain its registration status, including conditions that apply to contracts linked to U.S.-listed contracts; (iii) the types of entities to which direct access can be grated; and (iv) criteria for the revocation of FBOT registration, among other things. The proposed registration system would replace the current practice of issuing staff no-action letters, though many of the new registration requirements and conditions are largely consistent with the current procedures.5
While this proposal received general support for providing consistent and transparent rules in place of the current no-action process, there was some dissent and Commissioners O’Malia and Sommers voted against the proposal. Commissioner Sommers emphasized that the proposed rule lacked a “grandfather” provision exempting FBOTs already operating under the current no-action system. In her view, reaffirming the status of existing FBOTs would unnecessarily stretch the CFTC’s limited resources. Comments on the proposed rules are due by January 18, 2010. 6
This article was prepared by Peggy A. Heeg (email@example.com or 713 651 8443), Michael Loesch (firstname.lastname@example.org or 202 662 4552), Brandon Byrne (email@example.com or 214 855 7437), and
Craig Oliver (firstname.lastname@example.org or 214 855 8139) from Fulbright’s Energy Practice Group and Fulbright's Corporate Governance Practice Group.
 The Dodd–Frank Act amends Section 4d(d) of the CEA to require each futures commission merchant to designate a CCO, who is to “perform such duties and responsibilities as shall be set forth in regulations to be adopted by the Commission.”
 The CFTC also requests comment on: (i) whether it would be more appropriate for a CCO to report to the senior officer or the board of directors; (ii) whether the senior office or board of directors generally is a stronger advocate of compliance matters within an organization; (iii) whether the proposed rules allow for sufficient flexibility with regard to a registrant’s business structure; (iv) whether the proposed reporting structure should be amended to address any issues related to affiliates; and (v) whether the rule should include a provision requiring a majority of the board of directors to remove the CCO.
 75 Fed. Reg. 70881 (Nov. 19, 2010).
 75 Fed. Reg. 70152 (Nov. 17, 2010).
 For example, the proposed registration system requires FBOTs providing direct access from the United States to meet the same seven general requirements that the staff currently uses to evaluate applications for no-action relief: membership criteria, trading system, contract, settlement and clearing, regulatory authorities, rules and rule enforcement, and information sharing. Additionally, the proposed rule identifies the types of entities to which a registered FBOT could grant direct access, and these entities are consistent with those under the existing no-action structure.
 75 Fed. Reg. 70974 (Nov. 19, 2010).
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Peggy A. Heeg