Commodity Futures Trading Commission

Office of Public Affairs

Q & A – External Business Conduct Standards for Swap Dealers and Major
Swap Participants Dealings with Counterparties Proposed Rulemaking
What is the goal of the proposed rulemaking?

The proposed rules implement the Dodd-Frank Act’s external business conduct requirements for swap dealers (“SDs”)
and major swap participants (“MSPs”) in their dealings with counterparties, including “Special Entities.”

Do the proposed rules change the ways in which swap dealers and major swap participants will
deal with their counterparties?

Based on the Dodd-Frank Act, the proposed rules would establish due diligence and disclosure obligations, as well as
outright prohibitions against certain practices. Generally, these new duties are adapted from industry “best practices”
recommendations, self regulatory organization approaches to business conduct standards, and certain existing CFTC
requirements for market professionals. The proposed due diligence and disclosure obligations, generally, would not
apply to transactions initiated by a counterparty on a designated contract market or swap execution facility where the
SD/MSP does not know the identity of the counterparty.

What are the prohibited practices for swap dealers and major swap participants?

The proposed rules adopt the antifraud prohibition applicable to SDs and MSPs in new Section 4s(h)(4) of the
Commodity Exchange Act (“CEA”). The rules also would prohibit SDs and MSPs from disclosing material confidential
counterparty information and trading ahead or front running counterparty swap transactions. SDs/MSPs would remain
subject to all other applicable provisions of the CEA and the Commission’s regulations.

What general duties will swap dealers and major swap participants have towards their
counterparties under the proposed rules?

Verification of Eligibility. SDs/MSPs would have to verify that a counterparty is an eligible contract participant
(“ECP”) as defined in Section 1a(18) of the Act and whether the counterparty is a Special Entity.

Disclosures of Material Information. SDs/MSPs would have to disclose to a counterparty (other than an SD/MSP,
security-based swap dealer or major security-based swap participant) information concerning the swap in a manner
reasonably designed to allow the counterparty to assess the material risks and characteristics of the swap and the material
incentives and conflicts of interest that the SD/MSP may have in connection with the swap.

Scenario analysis. For high-risk complex bilateral swaps, SDs/MSPs would have to provide a scenario analysis
designed in consultation with the counterparty to allow the counterparty to assess its potential exposure in connection
with the swap. The characteristics of high-risk complex swaps would include one or more of the following criteria: the
degree and nature of any leverage; the potential for periods of significantly reduced liquidity; and the lack of price
transparency. For bilateral swaps not available for trading on a designated contract market or swap execution facility that
are not high-risk complex swaps, counterparties would be able to “opt-in” to obtain a scenario analysis for such swap.

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Clearing. SDs/MSPs would have to inform any counterparty of the counterparty’s right to select a derivatives clearing
organization (“DCO”) for cleared swaps, and for swaps not subject to the mandatory clearing requirement under Section
2(h) of the Act, the counterparty’s right to elect to clear and to select the DCO.

Daily mark. For cleared swaps, the SD/MSP would have to notify the counterparty of its right to receive a daily mark
from the DCO, and for uncleared swaps, provide the counterparty on each business day during the term of the swap a
daily mark that is the mid-market value of the swap.

Other duties. SDs/MSPs would have to communicate in a fair and balanced manner based on principles of fair dealing
and good faith, have a reasonable basis to believe that any swap or trading strategy involving swaps recommended to a
counterparty is suitable for the counterparty, and abide by execution standards with respect to swaps available for trading
on a designated contract market or swap execution facility. The proposed execution standards rule would apply to all
Commission registrants, not just SDs/MSPs.

Are there any situations in which the general obligations above would not apply?

Yes. For example, the requirement to disclose material information about the risks, characteristics, incentives and
conflicts of interest regarding a swap would not apply when the counterparty is another SD/MSP or a security-based
swap dealer or major security-based swap participant. In addition, the general verification of eligibility and disclosure
duties would not apply when the transaction is initiated by a counterparty on a swap execution facility or designated
contract market and the SD/MSP does not know the counterparty’s identity.

Will swap dealers and major swap participants be able to rely on standard form disclosures to
satisfy some of their obligations?

Proposed rule 23.402(f) would provide flexibility to SDs/MSPs and their counterparties to agree to a reliable means for
making disclosures of material information. Proposed rule 23.402(g) also would allow SDs/MSPs to use, where
appropriate, standardized formats to make certain required disclosures of material information, and to include such
standardized disclosures in a master or other written agreement between the parties. While standardized disclosures may
be appropriate to meet certain disclosure obligations concerning the risks, characteristics, incentives and conflicts of
interest related to a particular swap, it is unlikely that they would be adequate to meet all such disclosure duties for any
particular customized swap.

Will swap dealers and major swap participants be able to satisfy any of their obligations by
relying on their counterparties’ representations?

Yes. For example, with respect to the verification of counterparty eligibility, SDs/MSPs would be permitted to rely on
reasonable representations of a potential counterparty to establish its eligibility as an ECP. In addition, to fulfill its
obligations to determine whether the proposed swap was suitable for the counterparty, SDs/MSPs could rely on a
counterparty’s representations, absent red flags, that the counterparty was capable of independently evaluating relevant
risks, the counterparty affirmed it was exercising independent judgment, and the counterparty could absorb potential
losses related to the recommended swap.

What is a Special Entity?

Under the proposed rules, Special Entity would have the same definition as in new Section 4s(h)(2) of the CEA: 1) a
Federal agency; 2) a State, State agency, city, county, municipality, or other political subdivision of a State; 3) an employee
benefit plan, as defined in Section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002)
(“ERISA”); 4) a governmental plan, as defined in ERISA; or 5) an endowment, including an endowment that is an
organization described in Section 501(c)(3) of the Internal Revenue Code of 1986.

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What additional duties will a swap dealer or major swap participant have to satisfy when their
counterparty is a Special Entity?

As provided, generally, in new Section 4s(h)(5) of the CEA, the proposed rule would require that any SD/MSP that
offers to or enters into a swap with a Special Entity have a reasonable basis to believe that the Special Entity has a
representative that 1) has sufficient knowledge to evaluate the transaction and risks; 2) is not subject to a statutory
disqualification; 3) is independent of the SD/MSP; 4) undertakes a duty to act in the best interests of the Special Entity it
represents; 5) makes appropriate and timely disclosures to the Special Entity; 6) evaluates the appropriateness and pricing
of any swaps, in accordance with any guidelines provided by the Special Entity; 7) in the case of employee benefit plans
subject to ERISA, is a fiduciary as defined in Section 3 of that Act; and 8) in the case of a municipal entity as defined in
proposed rule 23.460, is subject to restrictions on certain political contributions.

SDs/MSPs also would have to disclose the capacity in which they are acting when entering into a swap with a Special
Entity.

What will it mean to act as an advisor to a Special Entity?

For purposes of the proposed rules, the term “acts as an advisor to a Special Entity” would include where an SD
recommends a swap or swap trading strategy to a Special Entity. The term would not include where an SD provides:
general transaction, financial, or market information, or terms in response to a competitive bid request from the Special
Entity.

What duties will a swap dealer have to satisfy when it is acting as an advisor to a Special Entity?

Based on new Section 4s(h)(4) of the CEA, the proposed rule would require SDs “acting as an advisor to a Special
Entity” to act in the “best interests” of the Special Entity and to make “reasonable efforts” to ensure that any
recommendation made to the Special Entity is in the Special Entity’s “best interests.” SDs/MSPs would be able, as
provided, to rely on the Special Entity’s representations to meet its “reasonable efforts” requirement. The Commission
has not proposed to define “best interests” but would expect, based on case law, that SDs would act in good faith and
make full and fair disclosure of all material facts and conflicts of interest, and employ reasonable care that any
recommendation given to a Special Entity is designed to further the purposes of the Special Entity.

Will swap dealers be able to act as an advisor to a Special Entity and then enter into the same
swap for which it provided the advice?

The proposed rules are intended to permit existing business relationships between SDs and Special Entities to continue,
albeit subject to the new, higher statutory standards of care. The proposed rules are not intended to preclude, per se, an
SD from both recommending a swap to a Special Entity and entering into that swap with the same Special Entity where
the parties abide by the requirements of Sections 4s(h)(4) and (5) and the Commission’s proposed rules.

What other general obligations will swap dealers and major swap participants have to satisfy
under these proposed rules?

The Commission proposes to prohibit SDs/MSPs dealing with municipal entities from making certain political
contributions to certain officials of those municipal entities. There will be exceptions for de minimis contributions and
newly covered associates, and SDs/MSPs will be able to apply to the Commission for an exemption on an individual
basis.

Commodity Futures Trading Commission ♦ Office of Public Affairs ♦ 202-418-5080