Wednesday, September 21, 2011

The SEC's Newly Proposed Rules on Derivative "Swaps"

This Wednesday, the Securities and Exchange Committee (SEC) voted to propose rules that would impose certain business conduct standards on banks and other firms that deal in complex financial instruments known as “swaps.”  For the uninitiated, swaps are derivatives in which parties exchange the benefits of one financial instrument for another in order to trade the cash flow streams of the particular assets.  Swaps are typically used either to insure against market risks such as interest rate fluctuations or to make speculative investments based upon expected changes in the prices of the financial benchmarks underlying the instruments. 

This effort to regulate conduct in the derivative swap market by the SEC emerges out of the Dodd-Frank Act's comprehensive framework for monitoring over-the-counter swaps and the activities of “security-based swap dealers” and “major security-based swap participants” that engage in security-based swap transactions with counterparties (including “special entities” such as federal agencies, states and political subdivisions, employee benefit plans, governmental plans, and endowments).  The rules the SEC advanced this week would require swap dealers to disclose to their buyers the risks associated with transactions, the potential conflicts of interests involved, and the day-to-day values of their swaps, which would aid purchasers in assessing the overall worth of specific deals.&nbs p; The rules would also mandate that swap dealers doing business with special entities ensure that their counterparts use independent financial advisers to assist with transactions.  Additionally, dealers would be prohibited from participating in a wide range of “pay to play” practices.

Under these new pay to play rules, securities-based swap dealers and their “covered associates” would specifically be barred from engaging in swap transactions with a “municipal entity” for a two-year period if they choose to make certain types of political contributions to officials of that municipal entity. This Proposed Rule 15Fh-6 is modeled on, and intended to complement, existing restrictions on pay to play practices under Advisers Act Rule 206(4)-5, which imposes restrictions on political contributions by investment advisers providin g or seeking to provide investment advisory services to public pensio n plans and other government investors, and MSRB Rules G-37 and G-38, which impose such restrictions on municipal securities dealers and broker-dealers engaging or seeking to engage in the municipal securities business. The pay to play restrictions are also similar to rules the Commodity Futures Trading Commission (CFTC) recently proposed for non-securities-based swaps.


According to SEC Chairwoman Mary L. Schapiro, these new pay to play provisions and the other business conduct standards in the proposed rules will work to “level the playing field in the securities-based swap market by bringing needed transparency to this market and by seeking to ensure that customers in these transactions are treated fairly.” That is yet to be seen, but all five SEC commissioners nevertheless voted unanimously to propose the rules and introduce them through formal public notice. The proposed rules will remain open for public comment until August 29, at which point the SEC will take any submitted remarks under advisement and make a final vote as to their implementation.

It will be interesting to see how business leaders and public officials alike react to the SEC’s proposal during the upcoming notice and comment period. Businesses, and in particular investment firms, have had to adjust to a litany of newly proposed regulations and pay to pay rules in the wake of the passage of the Dodd-Frank Act. As such, it has left companies universally unsure as to what types of activities are permitted and prohibited in their day-to-day business. Public officials, however, have been quick to applaud any and all efforts by the federal government and its numerous business regulatory bodies to restrain “unsavory” corporate practices – practices that the SEC, MSRB, CFTC, and other entities assert have contributed to the current economic downturn and led to the misappropriation of billions upon billions of dollars in taxpayer money. Over the next few months, we shall see if both trends continue and if the movement toward increas ed federal regulation of business conduct and political speech persists.

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