SBS Dealer is acting as an advisor to a special entity? If so, which
ones and why? Should such specific requirements apply only to certain
categories of special entities?
     Is there a basis for distinguishing between the types of
conflicts disclosures required to be provided by an SBS Dealer and
those required to be provided by a Major SBS Participant? If so, how
should the types of conflicts disclosures required to be provided by a
Major SBS Participant differ from those that have been proposed?
     We do not intend to require the disclosure of information
considered proprietary in nature in order for an SBS Entity to
discharge its obligation under the proposed rule. Is such disclosure a
concern under the current formulation of the rule? If so, what types of
proprietary information might be subject to disclosure under the
proposed rule? Is there other information that could adequately
substitute for purposes of meaningful disclosure? What other
mechanisms, if any, could be used to protect proprietary information
while providing adequate disclosure to counterparties?
e. Daily Mark
    Exchange Act Section 15F(h)(3)(B)(iii) directs the Commission to
adopt rules that require an SBS Entity to disclose: (i) for cleared
security-based swaps, upon request of the counterparty, the daily mark
from the appropriate derivatives clearing organization; \98\ and (ii)
for uncleared security-based swaps, the daily mark of the
transaction.\99\ We preliminarily believe that the daily mark, as
proposed for the purposes of this rule, would provide helpful
transparency to counterparties during the lifecycle of a security-based
swap. As explained below, the daily mark under the proposed rule is
intended to provide a counterparty with a useful and meaningful
reference point against which to assess, among other things, the
calculation of variation margin for a security-based swap or portfolio
of security-based swaps, and otherwise inform the counterparty's
understanding of its financial relationship with the SBS Entity.\100\
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    \98\ Although Section 15F(h)(3)(B)(iii) of the Exchange Act
refers to a ``derivatives clearing organization,'' the Commission
believes that this was a drafting error and that Congress intended
to refer to a ``clearing agency'' because the Dodd-Frank Act
elsewhere requires security-based swaps to be cleared at registered
clearing agencies, not derivatives clearing organizations. See
Section 17A(g) of the Exchange Act, Public Law 111-203, 124 Stat.
1376, 1768 (to be codified at 15 U.S.C. 78q-1(g)).
    \99\ We note that various market participants have expressed
concerns that the statutory requirement to provide a daily mark to a
pension plan would necessarily include an SBS Entity within the
definition of ``fiduciary'' for ERISA purposes under a current
Department of Labor proposal, which may then cause the security-
based swap to be a prohibited transaction under ERISA, unless it
qualifies for a Prohibited Transaction Exemption. See Definition of
the Term ``Fiduciary,'' 75 FR 65263 (Oct. 22, 2010); SIFMA/ISDA
Letter; Joint Letter from American Bankers Association, American
Benefits Council, Committee on Investment of Employee Benefit
Assets, The ERISA Industry Committee, Financial Executives
International's Committee on Corporate Treasury, Financial Services
Roundtable, Insured Retirement Institute, National Association of
Insurance and Financial Advisors, National Association of
Manufacturers, Securities Industry and Financial Markets Association
to David A. Stawick, Secretary, CFTC (Feb. 22, 2011); Letter from
Sandra Haas, Managing Director, Head of Pensions, Endowment and
Foundation Coverage, Morgan Stanley & Co., Incorporated, and Jim
McCarthy, Managing Director, Head of Retirement Services and Client
Advisory, Morgan Stanley Smith Barney LLC to Office of Regulations
and Interpretations, Employee Benefits Security Admin., Dep't of
Labor (Feb. 2, 2011); Letter from Don Thompson, Managing Director
and Assistant General Counsel, JPMorgan Chase & Co. to Office of
Regulations and Interpretations, Employee Benefits Security Admin.,
Dep't of Labor (Feb. 3, 2011). As noted in Section I.B., the staffs
of the Commission, DoL and CFTC have been consulting and will
continue to do so in order to address these concerns. See Letter
from Phyllis C. Borzi, Assistant Secretary, Employee Benefits
Security Administration, Department of Labor, to Gary Gensler,
Chairman, CFTC (April 28, 2011) (``In DOL's view, a swap dealer or
major swap participant that is acting as a plan's counterparty in an
arm's length bilateral transaction with a plan represented by a
knowledgeable independent fiduciary would not fail to meet the terms
of the counterparty exception [to the proposed revised definition of
ERISA fiduciary] solely because it complied with the business
conduct standards set forth in the CFTC's proposed regulation.'').
The Commission also solicits comments with respect to alternatives
for addressing this issue.
    In addition, as discussed infra in Section II.C.4, we do not
believe that disclosure of the daily mark would in and of itself
constitute a recommendation under proposed Rule 15Fh-3(f).
    \100\ As explained below, the daily mark under the proposed rule
would not necessarily represent the last price at which a security-
based swap traded, or a price that is executable.
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    The term ``daily mark'' is not defined in the statute and, as
explained below, we are proposing that the term have analogous meanings
for cleared and uncleared security-based swaps. For cleared security-
based swaps, proposed Rule 15Fh-3(c)(1) would require an SBS Entity,
upon the request of the counterparty, to disclose to the counterparty
in writing the daily end-of-day settlement price received by the SBS
Entity from the appropriate clearing agency. ``End-of-day settlement
price'' in this context refers to the value for any given security-
based swap used by the clearing agency that forms the basis of
subsequent margin calculations for clearing participants.\101\
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    \101\ For example, ICE Trust, a clearing agency for credit
default swaps, indicates that it ``establishes a daily settlement
price for all cleared CDS instruments, using a pricing process
developed specifically for the CDS market by ICE Trust. ICE Trust
clearing participants are required to submit prices on a daily
basis. ICE Trust conducts an auction process daily which results in
periodic trade executions between its clearing participants. This
process determines the daily settlement prices, which are validated
by the ICE Trust Chief Risk Officer and used for the daily mark-to-
market valuations.'' ICE Trust, https://www.theice.com/ice_trust.jhtml (March 14, 2011).
---------------------------------------------------------------------------

    We are not proposing to require that clearing agencies use a
particular calculation methodology for purposes of the proposed
rule.\102\ We understand

that, for a given security-based swap, a clearing agency uses the same
end-of-day settlement price for the daily valuation of positions held
by all clearing members regardless of position direction or size, and
independent of any member-specific attribute, such as credit quality,
other portfolio holdings, or concentration of positions. Accordingly,
the prices do not necessarily represent the last price at which the
security-based swap traded, or a price that is executable.
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    \102\ The Commission understands that the particular
methodologies used by clearing agencies to produce the end of day
settlement price may vary. We understand that there are various
means by which security-based swap clearing agencies calculate end-
of-day settlement prices for each product in which they hold a
cleared interest each business day. In the credit default swap
context, for example, end-of-day settlement prices may be determined
each business day for each eligible product based upon pricing data
from one or more of various sources, including prices of over-the-
counter transactions submitted for clearing; indicative settlement
prices contributed by clearing members; and pricing information
licensed from other third-party sources. See, e.g., Letter from Ann
K. Shuman, Managing Director and Deputy General Counsel, Chicago
Mercantile Exchange Inc., to Elizabeth Murphy, Secretary, Commission
(Dec. 14, 2009) (File No. S7-06-09); Letter from Kevin McClear,
General Counsel, ICE Trust, to Elizabeth Murphy, Secretary,
Commission (Dec. 4, 2009) (File No. S7-05-09).
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    Because the term ``daily mark'' is used both in the context of
cleared and uncleared security-based swaps, the Commission
preliminarily believes that the meaning of ``daily mark'' for uncleared
swaps should be analogous to that for cleared swaps, and that the
attributes of daily marks produced by clearing agencies for cleared
security-based swaps under proposed Rule 15Fh-3(c)(1) should be equally
applicable to, and provide guidance for the computation of, the daily
mark required to be provided with respect to uncleared security-based
swaps. To ensure a degree of uniformity in market practices among SBS
Entities, proposed Rule 15Fh-3(c)(2) would require an SBS Entity to
disclose the midpoint between the bid and offer prices for a particular
uncleared security-based swap, or the calculated equivalent thereof, as
of the close of business unless the parties agree in writing
otherwise.\103\ We preliminarily believe that the proposed rule would
result in a daily mark that reflects daily changes in valuation that
is: (a) The same for all counterparties of the SBS Entity that have a
position in the uncleared security-based swap, (b) not adjusted to
account for holding-specific attributes such as position direction,
size, or liquidity, and (c) not adjusted to account for counterparty-
specific attributes such as credit quality, other counterparty
portfolio holdings, or concentration of positions.\104\
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    \103\ Parties could agree that the daily mark would be computed
as of a time other than the close of business but could not agree to
waive the requirement that the daily mark be provided on a daily
basis, as required by the statute.
    \104\ SIFMA and ISDA have suggested that ``[b]y market
convention and often by contract, parties generally agree to utilize
a mid-market level for margin purposes. Counterparties understand
that this level does not represent a valuation at which a
transaction may be entered into or terminated and accordingly may
differ from actual market prices. We recommend that the Commissions
endorse this use of mid-market levels for margin purposes as a
uniform market practice.'' SIFMA/ISDA 2010 Letter at 17. For a
discussion of midmarket value and adjustments, see ISDA Research
Notes, The Value of a New Swap, Issue 3, 2010, available at http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf (``ISDA Note'')
(describing midmarket value as ``the net present value of the
transaction assuming it is priced at mid-market'').
---------------------------------------------------------------------------

    For actively traded security-based swaps that have sufficient
liquidity, computing a daily mark as the midpoint between the bid and
offer prices for a particular security-based swap, known as a
``midmarket value,'' would be consistent with the proposed Rule 15Fh-
3(c)(2). For security-based swaps that are not actively traded, or do
not have up-to-date bid and offer quotes, the SBS Entity may calculate
an equivalent to a midmarket value using mathematical models, quotes
and prices of other comparable securities, security-based swaps, or
derivatives, or any combination thereof, provided that these
calculations produce a daily mark that is consistent with the
attributes described above.\105\ Again, the daily mark is not intended
to represent the value that either an SBS Entity or its counterparty
would use for its own, internal valuation, or fair value for financial
reporting purposes for the particular security-based swap. Nor would
the daily mark necessarily represent a price at which the SBS Entity
would be willing to execute a trade.\106\
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    \105\ See ISDA Note.
    \106\ As discussed in Section II.C.4, infra, we do not believe
that compliance with the requirements of proposed Rule 15Fh-3(c), in
and of itself, should cause an SBS Dealer to be deemed to have made
a recommendation under proposed Rule 15Fh-3(f).
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    Furthermore, though the daily mark may be used as an input to
compute the variation margin between an SBS Entity and its
counterparty, it is not necessarily the sole determinant of how such
margin is computed. Differences between the daily mark and computations
for variation margin result from adjustments for position size,
position direction, credit reserve, hedging, funding, liquidity,
counterparty credit quality, portfolio concentration, bid-ask spreads,
or other costs, that may be included as part of the margin
computations. Nonetheless, the Commission believes the daily mark, as
proposed for the purposes of this rule, would provide a useful and
meaningful reference point, similar to that for cleared security-based
swaps, for counterparties holding positions in uncleared security-based
swaps.\107\
---------------------------------------------------------------------------

    \107\ See ISDA Note (``even though market participants do not
actually transact at the midmarket rate, it is nonetheless useful
because it is an objective, transparent rate that might be used as a
basis for actual pricing'').
---------------------------------------------------------------------------

    Proposed Rule 15Fh-3(c)(2) would also require that, at or before
delivery of the first disclosure of the daily mark, an SBS Entity
disclose to the counterparty its data sources and a description of the
methodology and assumptions to be used to prepare the daily mark for an
uncleared security-based swap.\108\ We preliminarily believe that such
disclosure would provide the counterparty a useful context with which
it can assess the quality of the mark received.\109\ In addition,
proposed Rule 15Fh-3(c) would also require that an SBS Entity promptly
disclose any

material changes to the data sources, methodology, or assumptions over
the term of the security-based swap. An SBS Entity would not be
required to disclose the data sources or a description of the
methodology and assumptions more than once unless it materially changes
the data sources, methodology or assumptions used to calculate the
daily mark. For the purposes of this rule, a material change would
include any change that has a material impact on the daily mark
provided. We understand that the daily mark for illiquid security-based
swaps may be generated using models that may or may not be proprietary.
The required disclosure of the data sources or description of the
methodology and assumptions used to prepare the daily mark is not
intended to require so much detail as to result in disclosure of an SBS
Entity's proprietary information.
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    \108\ Cf. Trading & Capital-Markets Manual Sec.  2150 (Bd. of
Gov. Fed. Reserve Sys. Jan. 2009), available at http://www.federalreserve.gov/boarddocs/supmanual/trading/200901/0901trading.pdf:
    When observable market prices are available for a transaction,
two pricing methodologies are primarily used--bid/offer or
midmarket. Bid/offer pricing involves assigning the lower of bid or
offer prices to a long position and the higher of bid or offer
prices to short positions. Midmarket pricing involves assigning the
price that is midway between bid and offer prices. Most institutions
use midmarket pricing schemes, although some firms may still use
bid/offer pricing for some products or types of trading. Midmarket
pricing is the method recommended by the accounting and reporting
subcommittee of the Group of Thirty's Global Derivatives Study
Group, and it is the method market practitioners currently consider
the most sound. * * *
    For many illiquid or customized transactions, such as highly
structured or leveraged instruments and more complex, nonstandard
notes or securities, reliable independent market quotes are usually
not available, even infrequently. In such instances, other valuation
techniques must be used to determine a theoretical, end-of-day
market value. These techniques may involve assuming a constant
spread over a reference rate or comparing the transaction in
question with similar transactions that have readily available
prices (for example, comparable or similar transactions with
different counterparties). More likely, though, pricing models will
be used to price these types of customized transactions.
    \109\ The Commission recognizes that different SBS Entities may
produce somewhat different marks for similar security-based swaps,
depending on the respective data sources, methodologies and
assumptions used to calculate the marks. Thus, the data sources,
methodologies and assumptions would provide a context in which the
quality of the mark could be evaluated. See Disclosure of Accounting
Policies for Derivative Financial Instruments and Derivative
Commodity Instruments and Disclosure of Quantitative and Qualitative
Information about Market Risk Inherent in Derivative Financial
Instruments, Other Financial Instruments and Derivative Commodity
Instruments, Securities Act Release No. 7386 (Jan. 31, 1997), 62 FR
6044 (Feb. 10, 1997). We understand that currently, industry
practice is often to include similar disclosures for margin calls in
swap documentation, such as a credit support annex.
---------------------------------------------------------------------------

    We preliminarily believe that, for the disclosure to the
counterparty to be meaningful, the daily mark for both cleared and
uncleared security-based swaps should be provided without charge and
with no restrictions on internal use by the recipient, although
restrictions on dissemination to third parties are permissible. The
rule would not, however, mandate the means by which an SBS Entity makes
the required disclosures. Commenters have asked if SBS Entities may
satisfy their obligations in this regard by making the relevant
information available to counterparties through password-protected
access to a website containing the relevant information.\110\ The
Commission preliminarily believes that such a method would be an
appropriate way for SBS Entities to discharge their obligations with
respect to daily marks, subject to compliance with the Commission's
guidance on the use of electronic media.\111\ In particular, the use of
electronic media should not be so burdensome that intended recipients
cannot effectively access the information provided. Further, persons to
whom information is sent or provided electronically must have the
opportunity to download directly the information, or otherwise have an
opportunity to retain and analyze the information through the selected
medium or have ongoing access equivalent to personal retention.\112\
Information of this kind is directly relevant to a counterparty's
understanding of its financial relationship under a security-based swap
and so, we preliminarily believe that access to the information as
described above is necessary to ensure a counterparty's ability to
monitor that relationship over the life of the transaction.\113\
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    \110\ SIFMA/ISDA 2010 Letter at p. 17.
    \111\ See Use of Electronic Media by Broker-Dealers, Transfer
Agents and Investment Advisers for Delivery of Electronic
Information, Securities Act Release No. 7288 (May 9, 1996), 61 FR
24644 (May 15, 1996) (``Electronic Media Release''). See also Use of
Electronic Media, Exchange Act Release No. 42728 (Apr. 28, 2000), 65
FR 25843 (May 4, 2000).
    \112\ See Electronic Media Release.
    \113\ A counterparty may also require continuing access to
satisfy recordkeeping requirements to which it may be subject.
     The Commission has proposed to require clearing agencies to
make available to the public, on terms that are fair and reasonable
and not unreasonably discriminatory, all end-of-day settlement
prices and any other prices with respect to security-based swaps
that the clearing agency may establish to calculate mark-to-market
margin requirements for its participants and any other pricing or
valuation information with respect to security-based swaps as is
published or distributed by the clearing agency to is participants.
See Clearing Agency Standards for Operation and Governance, Exchange
Act Release No. 64017 (March 2, 2011), 76 FR 14472 (March 16, 2011)
(proposed Rule 17Aj-1). As we explained in proposing Rule 17Aj-1, we
preliminarily believe that public availability of this information
would help to improve fairness, efficiency, and market competition
by making available to all market participants data that may
otherwise be available only to a limited subset of market
participants. See id.
---------------------------------------------------------------------------

    SBS Entities also should consider the need to provide appropriate
clarifying statements or disclosures relating to the daily mark. Such
statements or disclosures may include, as appropriate, that the daily
mark may not be a price at which the SBS Entity would agree to replace
or terminate the security-based swap, nor the value at which the
security-based swap is recorded in the books of the SBS Entity.\114\
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    \114\ Cf. CFTC External Business Conduct Release (proposed Rule
17 CFR 23.431(c)).
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of this
provision. In addition, we request comments on the following specific
issues:
     Is the end-of-day settlement price an appropriate ``daily
mark'' for cleared security-based swaps for purposes of this rule? If
not, how should the Commission define ``daily mark'' in this context?
     Should the Commission prescribe a method for determining
the end-of-day settlement price for cleared security-based swaps for
purposes of this rule? If so, what method and why?
     Is the midpoint between the bid and offer prices for a
particular uncleared security-based swap, or the calculated equivalent
thereof, as of the close of business unless the parties agree in
writing otherwise, an appropriate ``daily mark'' for uncleared
security-based swaps? If not, how should the Commission define ``daily
mark'' in this context, and why?
     Should the Commission prescribe a different method for
calculating the daily mark for uncleared security-based swaps for
purposes of this rule? If so, what method and why? Should valuations of
equivalent positions used by the SBS Entity for other purposes, such as
collateral valuation or the preparation of financial statements, be
taken into consideration? Why or why not, and how?
     Are there requirements under proposed Rule 15Fh-3(c) that
would cause an SBS Entity to be a fiduciary for ERISA purposes? If so,
which requirements, and is there an alternate method for calculating
the daily mark that would not cause an SBS Entity to be a fiduciary for
ERISA purposes?
     In calculating the midmarket value, should the Commission
require an SBS Entity to use third-party market quotations (i.e.,
should the Commission allow an SBS Entity to use its own market
quotations)? Why or why not? Should there be constraints or conditions
on such use? Why or why not?
     Should the Commission require an SBS Entity to provide an
executable quote or the price at which the SBS Entity would terminate
the security-based swap, in addition to the daily mark, for purposes of
comparison or other reasons? If so, should this additional information
always be required or is there a stronger rationale for the additional
information to be required for certain identifiable types of security-
based swap positions, such as security-based swaps that are highly
customized to a counterparty's requirements, or otherwise illiquid, and
for which the daily mark may be significantly different from an
executable quote?
     Should the Commission require an SBS Entity to provide a
value that would be used for purposes of variation margin, in addition
to the daily mark, for purposes of comparison or other reasons? If so,
should this additional information always be required or is there a
stronger rationale for the additional information to be required for
certain identifiable types of security-based swap positions, such as
security-based swaps that are highly customized to a counterparty's
requirements, or otherwise illiquid, and for which the daily mark may
be significantly different from a value used for variation margin?
     If the SBS Entity and a particular counterparty are
parties to more than

one security-based swap transaction with one another, should the SBS
Entity be permitted to provide a single aggregate daily mark for all of
the security-based swaps, allowing for netting between the parties? Why
or why not?
     Should the Commission require an SBS Entity to provide
additional disclosures including, as appropriate: (1) That the daily
mark may not necessarily be a price at which either the counterparty or
the SBS Entity would agree to replace or terminate the security-based
swap; (2) that, depending upon the agreement of the parties, calls for
margin may be based on considerations other than the daily mark
provided to the counterparty; and (3) that the daily mark may not
necessarily be the value of the security-based swap that is recorded in
the books of the SBS Entity? \115\ In addition to disclosing any
material changes to data sources, methodology or assumptions used,
should an SBS Entity be required to disclose the impacts of these
material changes? Are there any other disclosures that the Commission
should require the SBS Entity to provide in connection with the daily
mark?
---------------------------------------------------------------------------

    \115\ Cf. CFTC External Business Conduct Release (proposed Sec.
23.431(c)).
---------------------------------------------------------------------------

     We do not intend the proposed disclosures regarding the
data sources and description of the methodologies and assumptions used
to prepare the daily marks to require the disclosure of information
considered proprietary in nature in order for an SBS Entity to
discharge its obligations. Is such disclosure a concern under the
current formulation of the rule? If so, what types of proprietary
information might be subject to disclosure under the proposed rule? Is
there other information that could adequately substitute for purposes
of meaningful disclosure? What mechanisms, if any, could be used to
protect proprietary information implicated by the daily mark
requirement while providing adequate disclosure to counterparties?
     Should access to a Web site or electronic platform be
considered sufficient for disclosure of the daily mark? Why or why not?
Should other forms of Internet-based or electronic disclosure be
addressed, and if so, how?
     Should we require that the daily mark for both cleared and
uncleared security-based swaps should be provided without charge and
with no restrictions on internal use by the recipient, although
restrictions on dissemination to third parties are permissible? Why or
why not?
f. Clearing Rights
    Proposed Rule 15Fh-3(d) would require an SBS Entity, before
entering into a security-based swap with a counterparty, to disclose to
the counterparty its rights under Section 3C(g) of the Exchange Act
concerning submission of a security-based swap to a clearing agency for
clearing.\116\ Although they are not required by the Dodd-Frank Act, we
preliminarily believe that such disclosures would promote the
objectives of Section 3C(g).
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    \116\ See Section 15F(h)(1)(D) of the Exchange Act (authorizing
the Commission to prescribe business conduct standards that relate
to ``such other matters as the Commission determines to be
appropriate''); see also Dodd-Lincoln Letter (describing anticipated
benefits of clearing as a means of ``bringing transactions and
counterparties into a sound, conservative and transparent risk
management framework''). Public Law 111-203, 124 Stat. 1376, 1789
(to be codified at 15 U.S.C. 78o-10(h)(1)(D)).
---------------------------------------------------------------------------

    The counterparty's rights, and thus the proposed disclosure
obligations, would differ depending on whether the clearing requirement
of Section 3C(a) applies to the relevant transaction.\117\ When the
clearing requirements of Section 3C(a)(1) apply to a security-based
swap, proposed Rule 15Fh-3(d)(1)(i) would require the SBS Entity to
disclose to the counterparty the clearing agencies that accept the
security-based swap for clearing and through which of those clearing
agencies the SBS Entity is authorized or permitted, directly or through
a designated clearing member, to clear the security-based swap. The SBS
Entity would also be required to notify the counterparty of the
counterparty's sole right to select which clearing agency is to be used
to clear the security-based swap, provided it is a clearing agency at
which the SBS Entity is authorized or permitted, directly or through a
designated clearing member, to clear the security-based swap.\118\ We
note that, while proposed Rule 15Fh-3(d) would not require an SBS
Entity to become a member or participant of a specific clearing agency,
an SBS Entity could not enter into security-based swaps that are
subject to a mandatory clearing requirement without having some
arrangement in place to clear the transaction.\119\
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    \117\ Section 3C(a)(1) of the Exchange Act provides that: ``It
shall be unlawful for any person to engage in a security-based swap
unless that person submits such security-based swap for clearing to
a clearing agency that is registered under this Act or a clearing
agency that is exempt from registration under this Act if the
security-based swap is required to be cleared.'' Public Law 111-203,
124 Stat. 1376, 1762 (to be codified at 15 U.S.C. 78c-3(a)(1)).
    \118\ Proposed Rule 15Fh-3(d)(1)(ii). See Exchange Act
3C(g)(5)(A), Public Law 111-203, 124 Stat. 1376, 1766-1777 (to be
codified at 15 U.S.C. 78c-3(g)(5)(A)):
    With respect to any security-based swap that is subject to the
mandatory clearing requirement under subsection (a) and entered into
by a security-based swap dealer or a major security-based swap
participant with a counterparty that is not a swap dealer, major
swap participant, security-based swap dealer, or major security-
based swap participant, the counterparty shall have the sole right
to select the clearing agency at which the security-based swap will
be cleared.
    \119\ See Exchange Act Section 3C(a), Public Law 111-203, 124
Stat. 1376, 1762, Sec.  763(a) (to be codified at 15 U.S.C. 78c-
3(a)).
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    For security-based swaps that are not subject to the clearing
requirement under Exchange Act Section 3C(a)(1), proposed Rule 15Fh-
3(d)(2) would require the SBS Entity to determine whether the security-
based swap is accepted for clearing by one or more clearing agencies
and, if so, to disclose to the counterparty the counterparty's right to
elect clearing of the security-based swap.\120\ Proposed Rule 15Fh-
3(d)(2)(ii) would require the SBS Entity to disclose to the
counterparty the clearing agencies that accept the type, category, or
class of security-based swap transacted and whether the SBS Entity is
authorized or permitted, directly or through a designated clearing
member, to clear the security-based swap through such clearing
agencies. Proposed Rule 15Fh-3(d)(2)(iii) would require the SBS Entity
to notify the counterparty of the counterparty's sole right to select
the clearing agency at which the security-based swap would be cleared,
provided it is a clearing agency at which the SBS Entity is authorized
or permitted, directly or through a designated clearing member, to
clear the security-based swap. Once again, the proposed rule would not
require an SBS Entity to become a member or participant of a particular
clearing agency, notwithstanding the election of the counterparty to
clear the transaction.
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    \120\ See Exchange Act Section 3C(g)(5)(B), Public Law 111-203,
124 Stat. 1376, 1767, (to be codified at 15 U.S.C. 78c-3(g)(5)(B)):
    With respect to any security-based swap that is not subject to
the mandatory clearing requirement under subsection (a) and entered
into by a security-based swap dealer or a major security-based swap
participant with a counterparty that is not a swap dealer, major
swap participant, security-based swap dealer, or major security-
based swap participant, the counterparty--(i) may elect to require
clearing of the security-based swap; and (ii) shall have the sole
right to select the clearing agency at which the security-based swap
will be cleared.
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    The proposed rule would require that disclosure be made before a
transaction occurs. The Commission believes that it would be
appropriate for a counterparty to exercise its statutory right to
select the clearing agency at which its security-based swaps would be
cleared (as provided above) on a transaction-by-transaction basis, on
an asset-class-by-asset-class basis, or in terms of all

potential transactions the counterparty may execute with the SBS
Entity.
Request for Comments
    The Commission requests comments generally on all aspects of this
provision. In addition, we request comments on the following specific
issues:
     Should the Commission require SBS Entities to disclose a
counterparty's rights to select a clearing agency, as provided above?
What benefits would this requirement provide? Would the proposed
disclosure requirement impose an undue burden on SBS Entities? If so,
what would the burden be, and are there other ways to ensure that a
counterparty is aware of its rights with respect to clearing?
     Would the SBS Entity be in a position to know, in all
cases, the information that would be required to be disclosed under
proposed Rule 15Fh-3(d)? If not, why? Would the time needed to gather
the required information affect the transaction process for security-
based swaps to any material extent? If so, how?
     Should the Commission require SBS Entities to disclose any
other information to counterparties regarding their rights or
obligations in connection with the clearing of security-based swap
transactions? For example, under Section 3C(g) of the Exchange Act,
certain ``end users'' have the option not to have their security-based
swaps cleared, even if those security-based swaps have been made
subject to a mandatory clearing requirement.\121\ Should an SBS Entity
be required to disclose to such end users that they may elect not to
have their security-based swaps cleared under these circumstances? Why
or why not?
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    \121\ Exchange Act Section 3C(g), Public Law 111-203, 124 Stat.
1376, 1767, Sec.  763(a) (to be codified at 15 U.S.C. 78c-3(g)). See
End-User Exception to Mandatory Clearing of Security-Based Swaps,
Exchange Act Release No. 63556 (Dec. 15, 2010), 75 FR 79992 (Dec.
21, 2010) (proposing new Rule 3Cg-1 under the Exchange Act governing
the exception to mandatory clearing of security-based swaps
available for counterparties meeting certain conditions).
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     Should an SBS Entity be permitted to allow its
counterparties to elect the clearing agency at which its security-based
swaps would be cleared on a transaction-by-transaction basis, on an
asset-class-by-asset-class basis, or in terms of all potential
transactions? If not, what restrictions should apply to the SBS Entity
in this context?
3. Know Your Counterparty
    Proposed Rule 15Fh-3(e) would establish a ``know your
counterparty'' requirement for SBS Dealers.\122\ The proposed rule
would require an SBS Dealer to have policies and procedures reasonably
designed to obtain and retain a record of the essential facts that are
necessary for conducting business with each counterparty that is known
to the SBS Dealer.\123\ For purposes of the proposed rule, ``essential
facts'' would be: (i) Facts necessary to comply with applicable laws,
regulations and rules, (ii) facts necessary to effectuate the SBS
Dealer's credit and operational risk management policies in connection
with transactions entered into with such counterparty, (iii)
information regarding the authority of any person acting for such
counterparty, and (iv) if the counterparty is a special entity, such
background information regarding the independent representative as the
SBS Dealer reasonably deems appropriate.\124\
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    \122\ See Section 15F(h)(1)(D) of the Exchange Act, Public Law
111-203, 124 Stat. 1376, 1789, (to be codified at 15 U.S.C. 78o-
10(h)(1)(D)) (authorizing, but not explicitly mandating, the
Commission to prescribe business conduct standards that relate to
``such other matters as the Commission determines to be
appropriate'').
    \123\ The proposed rule would not apply to security-based swaps
for which the SBS Dealer does not know the identity of the
counterparty, as is the case, for example, for many security-based
swaps traded on a SEF or an exchange.
    \124\ The Commission is considering the minimum requirements for
an SBS Dealer's operational and credit risk management practices and
expects to address any such matters in a separate rulemaking.
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    The ``know your counterparty'' obligations under the proposed rule
are a modified version of the ``know your customer'' obligations
imposed on other market professionals, such as broker-dealers, when
dealing with customers.\125\ Although the statute does not require the
Commission to adopt a ``know your counterparty'' standard, we
preliminarily believe that such a standard would be consistent with
basic principles of legal and regulatory compliance, operational and
credit risk management, and authority. Further, we preliminarily
believe that entities that currently operate as SBS Dealers typically
would already have in place, as a matter of their normal business
practices, ``know your counterparty'' policies and procedures that
could potentially satisfy the requirements of the proposed rule. We are
proposing to apply the requirement in proposed Rule 15Fh-3(e) to SBS
Dealers but not to Major SBS Participants because we do not anticipate
that Major SBS Participants would serve a dealer-type role in the
market.
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    \125\ Cf. FINRA Rule 2090 (``Every member shall use reasonable
diligence, in regard to the opening and maintenance of every
account, to know (and retain) the essential facts concerning every
customer and concerning the authority of each person acting on
behalf of such customer''). Supplementary Material .01 to FINRA Rule
2090 defines the ``essential facts'' for purposes of the FINRA rule
to include certain information not required by our proposed rule.
For purposes of FINRA Rule 2090, facts ``essential'' to ``knowing
the customer'' are those required to (a) effectively service the
customer's account, (b) act in accordance with any special handling
instructions for the account, (c) understand the authority of each
person acting on behalf of the customer, and (d) comply with
applicable laws, regulations, and rules. See also 14 CFR 13.5
(requiring a bank that is a government securities broker or dealer
to make reasonable efforts to obtain information concerning the
customer's financial status, tax status and investment objectives,
and such other information used or considered to be reasonable by
the bank in making recommendations to the customer).
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Request for Comments
    The Commission requests comments generally on all aspects of
proposed 15Fh-3(e). In addition, we request comments on the following
specific issues:
     Should the Commission impose a ``know your counterparty''
requirement? If not, why not? Does the Commission need to clarify any
of the proposed requirements? If so, how? Are there any specific
categories of information that an SBS Dealer should be required to
obtain from a counterparty? Should the Commission specify how any such
information should be obtained from the counterparty?
     Should the ``know your counterparty'' obligations apply to
Major SBS Participants, as well as to SBS Dealers? If so, why?
     To what extent would the current business practices of SBS
Dealers, including their compliance procedures and their credit and
operational risk management procedures, comply with the proposed ``know
your counterparty'' requirements? To what extent would the proposed
rule require SBS Dealers to change their current business practices?
Would the proposed requirements impose any particular burdens on market
participants?
     Should SBS Dealers be required to obtain any particular or
additional information regarding their counterparty beyond what would
be required under the proposed rule? If so, what specific information
should SBS Dealers be required to obtain?
     Should the proposed requirement track more closely the
``know your customer'' requirement imposed under SRO rules? In
particular, should the proposed rule require an SBS Dealer to obtain
information necessary to effectively ``service the counterparty,'' to
implement a counterparty's ``special instructions,'' or to evaluate the
counterparty's security-based swaps experience, financial wherewithal
and

trading objectives? \126\ If so, how should such terms be interpreted
in the context of SBS Dealers and the security-based swap market?
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    \126\ Cf. Supplementary Material .01 to FINRA Rule 2090 (``For
purposes of this Rule, facts `essential' to `knowing the customer'
are those required to (a) Effectively service the customer's
account, (b) act in accordance with any special handling
instructions for the account, (c) understand the authority of each
person acting on behalf of the customer, and (d) comply with
applicable laws, regulations, and rules.'').
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     Are there any circumstances in which it would not be
appropriate to apply a ``know your counterparty'' obligation? What
circumstances and why?
     Should ``know your counterparty'' requirements apply
differently with respect to cleared and uncleared swaps? If so, how and
why?
4. Recommendations by SBS Dealers
    Proposed Rule 15Fh-3(f) would generally require an SBS Dealer that
makes a ``recommendation'' to a counterparty to have a reasonable basis
for believing that the recommended security-based swap or trading
strategy involving security-based swaps is suitable for the
counterparty.
    In determining whether to propose Rule 15Fh-3(f), a business
conduct requirement not expressly addressed by the statute, the
Commission considered the suitability obligations imposed when other
market professionals recommend a security or trading strategy to
customers, including institutional customers.\127\ The obligation to
make only suitable recommendations is a core business conduct
requirement for broker-dealers.\128\ Municipal securities dealers also
have a suitability obligation when recommending municipal securities
transactions to a customer.\129\ Federally regulated banks have a
suitability obligation as well when acting as a broker or dealer in
connection with the purchase or sale of government securities.\130\
Depending on the scope of its activities, an SBS Dealer may be subject
to one of these other suitability obligations, in addition to those
under our proposed rule. In particular, if an SBS Dealer is also a
registered broker-dealer and a FINRA member, it would be subject as
well to FINRA suitability requirements in connection with the
recommendation of a security-based swap or trading strategy involving a
security-based swap, as well as the anti-fraud provisions of the
Exchange Act.\131\ Proposed Rule 15Fh-3(f) is intended to ensure that
all SBS Dealers that make recommendations are subject to this
obligation, tailored as appropriate in light of the nature of the
security-based swap markets.\132\
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    \127\ See Section 15F(h)(1)(D) of the Exchange Act, Public Law
111-203, 124 Stat. 1376, 1789 (to be codified at 15 U.S.C. 78o-
10(h)(1)(D)) (authorizing, but not explicitly requiring, the
Commission to prescribe business conduct standards that relate to
``such other matters as the Commission determines to be
appropriate''), and Section 15F(h)(3)(D) of the Exchange Act, Public
Law 111-203, 124 Stat. 1376, 1790 (to be codified at 15U.S.C. 78o-
10(h)(3)(D)) (authorizing the Commission to establish ``such other
standards and requirements as the Commission may determine are
appropriate in the public interest, for the protection of investors,
or otherwise in furtherance of the purposes of this Act'').
    \128\ See, e.g., FINRA Rules 2090 and 2111 (effective July 9,
2012). See also Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir.
1943) (enforcing suitability obligations under the antifraud
provisions of the Exchange Act).
    \129\ MSRB Rule G-19(c) provides that:
    In recommending to a customer any municipal security
transaction, a broker, dealer, or municipal securities dealer shall
have reasonable grounds: (i) Based upon information available from
the issuer of the security or otherwise, and (ii) based upon the
facts disclosed by such customer or otherwise known about such
customer, for believing that the recommendation is suitable.
    \130\ See Trading & Capital-Markets Manual Sec.  2150 (imposing
a suitability obligation on federally regulated banks acting as a
government securities broker or government securities dealer);
Government Securities Sales Practices, 62 FR 13276 (Mar. 19, 1997)
(codified at 12 CFR parts 13, 208, 211, and 368).
    \131\ See Section II.A, supra. See also FINRA Rule 2111
(effective July 9, 2012). Under FINRA rules, unless a counterparty
had total assets of at least $50 million, he or she would be
entitled to the protections provided by retail suitability
obligations in the broker-dealer context. See FINRA Rule 2111(b)
(referring to NASD Rule 3110(c)(4)).
    \132\ Some dealers have indicated that they already apply
``institutional suitability'' principles to their swap business.
See, e.g., Letter from Richard Ostrander, Managing Director and
Counsel, Morgan Stanley, to Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission, and David A. Stawick, Secretary,
Commodity Futures Trading Commission (Dec. 3, 2010) at 5; Report of
the Business Standards Committee, Goldman Sachs (Jan. 2011), http://www2.goldmansachs.com/our-firm/business-standards-committee/report.pdf.
---------------------------------------------------------------------------

    Proposed Rule 15Fh-3(f) would only apply when an SBS Dealer makes a
``recommendation'' to a counterparty. The Commission preliminarily
believes that the determination of whether an SBS Dealer has made a
recommendation that triggers a suitability obligation should turn on
the facts and circumstances of the particular situation and, therefore,
whether a recommendation has taken place is not susceptible to a bright
line definition. This is consistent with the FINRA approach to what
constitutes a recommendation. In the context of the FINRA suitability
standard, factors considered in determining whether a recommendation
has taken place include whether the communication ``reasonably could be
viewed as a `call to action' '' and ``reasonably would influence an
investor to trade a particular security or group of securities.'' \133\
The more individually tailored the communication to a specific customer
or a targeted group of customers about a security or group of
securities, the greater the likelihood that the communication may be
viewed as a ``recommendation.'' The Commission preliminarily believes
that this approach should apply in the context of proposed Rule 15Fh-
3(e) as well.
---------------------------------------------------------------------------

    \133\ See FINRA Notice to Members 01-23 (Mar. 19, 2001), and
Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090
(Know Your Customer) and 2111 (Suitability) in the Consolidated
FINRA Rulebook, Exchange Act Release No. 62718 (Aug. 13, 2010), 75
FR 51310 (Aug. 19, 2010), as amended, Exchange Act Release No.
62718A (Aug. 20, 2010), 75 FR 52562 (Aug. 26, 2010) (discussing what
it means to make a ``recommendation'').
---------------------------------------------------------------------------

    An SBS Dealer typically would not be deemed to be making a
recommendation solely by reason of providing general financial or
market information, or transaction terms in response to a request for
competitive bids.\134\ Furthermore, compliance with the requirements of
the proposed rules, in particular, Rule 15Fh-3(a) (verification of
counterparty status), 15Fh-3(b) (disclosures of material risks and
characteristics, and material incentives or conflicts of interest),
15Fh-3(c) (disclosures of daily mark), and 15Fh-3(d) (disclosures
regarding clearing rights) would not, in and of itself, result in an
SBS Dealer being deemed to be making a ``recommendation.''
---------------------------------------------------------------------------

    \134\ Cf. Supplementary Material .03 to FINRA Rule 2090.
---------------------------------------------------------------------------

    When the suitability obligation of proposed Rule 15Fh-3(f) applies,
the SBS Dealer must, as a threshold matter, understand the security-
based swap or trading strategy that it is recommending. Proposed Rule
15Fh-3(f)(1)(i) would require an SBS Dealer to have a reasonable basis
to believe, based on reasonable diligence, that the recommendation is
suitable for at least some counterparties. In general, what constitutes
reasonable diligence will vary depending on, among other things, the
complexity of and risks associated with the security-based swap or
trading strategy and the SBS Dealer's familiarity with the security-
based swap or trading strategy. An SBS Dealer's reasonable diligence
must provide it with an understanding of the potential risks and
rewards associated with the recommended security-based swap or trading
strategy. An SBS Dealer that lacks this understanding would not be able
to meet its obligations under the proposed rule.\135\ In addition,
under

proposed Rule 15Fh-3(f)(1), in order to establish a reasonable basis
for a recommendation to a particular counterparty, the SBS Dealer would
need to have or obtain relevant information regarding the counterparty,
including the counterparty's investment profile (including trading
objectives) and its ability to absorb potential losses associated with
the recommended security-based swap or trading strategy.\136\
---------------------------------------------------------------------------

    \135\ See, e.g., Michael F. Siegel, 2007 NASD Discip. LEXIS 20
(2007), aff'd, Exchange Act Release No. 58737 (Oct. 6, 2008),
vacated in part and remanded on other grounds, 592 F.3d 147 (10th
Cir. 2010) (finding that registered representative lacked any
reasonable basis for recommending securities because he did not have
sufficient understanding of what he was recommending). See also
Distribution by Broker-Dealers of Unregistered Securities, Exchange
Act Release No. 6721 (Feb. 2, 1962) (``the making of recommendations
for the purchase of a security implies that the dealer has a
reasonable basis for such recommendations which, in turn, requires
that, as a prerequisite, he shall have made a reasonable
investigation''). Cf. Supplementary Material .03 to FINRA Rule 2090.
    \136\ Under FINRA Rule 2111(a) (effective July 9, 2012), a
customer's investment profile includes, but is not limited to, the
customer's age, other investments, financial situation and needs,
tax status, investment objectives, investment experience, investment
time horizon, liquidity needs, risk tolerance, and any other
information the customer may disclose to the member or associated
person in connection with such recommendation. See also FINRA Rule
2360(b)(19)(B) (``No member or person associated with a member shall
recommend to a customer an opening transaction in any option
contract unless the person making the recommendation has a
reasonable basis for believing, at the time of making the
recommendation, that the customer * * * is financially able to bear
the risks of the recommended position in the option contract.'').
---------------------------------------------------------------------------

    Proposed Rule 15Fh-3(f)(2) would provide an alternative to the
general suitability requirement, under which an SBS Dealer could
fulfill its obligations with respect to a particular counterparty if:
(1) The SBS Dealer reasonably determines that the counterparty (or its
agent) is capable of independently evaluating investment risks with
regard to the relevant security-based swap or trading strategy
involving a security-based swap; (2) the counterparty (or its agent)
affirmatively represents in writing that it is exercising independent
judgment in evaluating the recommendations by the SBS Dealer; and (3)
the SBS Dealer discloses that it is acting in the capacity of a
counterparty, and is not undertaking to assess the suitability of the
security-based swap or trading strategy.\137\ We preliminarily believe
that parties should be able to make these disclosures on a transaction-
by-transaction basis, on an asset-class-by-asset-class basis, or in
terms of all potential transactions between the parties.\138\
---------------------------------------------------------------------------

    \137\ As discussed in Section II.D.3, the standards for
determining that an SBS Dealer is not acting as an advisor under
proposed Rule 15Fh-2(a) would be substantially the same as the
standards that an SBS Dealer must satisfy to qualify for the
alternative to the general suitability standard under proposed Rule
15Fh-3(f). Accordingly, as described more fully below, we are also
proposing that the general suitability requirement be deemed
satisfied if an SBS Dealer is deemed not to be acting as an advisor
to a special entity in accordance with proposed Rule 15Fh-2(a).
    \138\ This approach is consistent with FINRA's approach to
institutional suitability. See Supplementary Material .07 to FINRA
Rule 2111 (effective July 9, 2012) (``With respect to having to
indicate affirmatively that it is exercising independent judgment in
evaluating the member's or associated person's recommendations, an
institutional customer may indicate that it is exercising
independent judgment on a trade-by-trade basis, on an asset-class-
by-asset-class basis, or in terms of all potential transactions for
its account.'').
---------------------------------------------------------------------------

    If an SBS Dealer cannot rely on the alternative provided by
proposed Rule 15Fh-3(f)(2), it would need to make an independent
determination that the recommended security-based swap or trading
strategy involving security-based swaps is suitable for the
counterparty.\139\
---------------------------------------------------------------------------

    \139\ This also is consistent with FINRA's approach to
institutional suitability. See id.
---------------------------------------------------------------------------

    We preliminarily believe that an SBS Dealer, for purposes of Rule
15Fh-3(f)(2), reasonably could determine that the counterparty (or its
agent) is capable of independently evaluating investment risks with
regard to the relevant security-based swap (or trading strategy
involving a security-based swap) through a variety of means, including
the use of written representations from its counterparty. For example,
absent special circumstances described below, we preliminarily believe
it would be reasonable for an SBS Dealer to rely on written
representations by its counterparty that the counterparty (or its
agent) is capable of independently evaluating investment risks with
regard to any security-based swap (or trading strategy involving a
security-based swap). Upon receiving such a representation (or the
representation required by Rule 15Fh-3(f)(2)(ii) with respect to the
counterparty's exercise of independent judgment), the SBS Dealer would
be entitled to rely on the representation without further inquiry,
absent special circumstances described below.
    To solicit input on when it would no longer be appropriate for an
SBS Dealer to rely on such representations without further inquiry, the
Commission is proposing for comment two alternative approaches. One
approach would permit an SBS Dealer to rely on a representation from a
counterparty for purposes of Rule 15Fh-3(f)(2)(i) or (ii) unless it
knows that the representation is not accurate. The second would permit
an SBS Dealer to rely on a representation unless the SBS Dealer has
information that would cause a reasonable person to question the
accuracy of the representation.
    Under either approach, an SBS Dealer could not ignore information
in its possession as a result of which the SBS Dealer would know that a
representation is inaccurate. In addition, under the second approach,
an SBS Dealer also could not ignore information that would cause a
reasonable person to question the accuracy of a representation and, if
the SBS Dealer had such information, it would need to make further
reasonable inquiry to verify the accuracy of the representation.
    We are proposing to apply the requirement in proposed Rule 15Fh-
3(f) to SBS Dealers but not to Major SBS Participants because we do not
anticipate that Major SBS Participants will serve a dealer-type role in
the market.\140\ Further, under the proposed rule, the obligation would
not apply to an SBS Dealer in dealings with an SBS Entity, swap dealer,
or major swap participant.\141\ We preliminarily believe that these
types of counterparties, which are professional intermediaries or major
participants in the swaps or security-based swap markets, would not
need the protections that would be afforded by this rule.
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    \140\ See discussion in Section I.C.4, supra. If a Major SBS
Participant is, in fact, recommending security-based swaps to
counterparties, we believe it is likely that person is engaged in
other activities that would cause it to come within the definition
of an SBS Dealer (and therefore no longer able to qualify as a Major
SBS Participant) or other regulated entity that historically has
been subject to a suitability obligation.
    \141\ See proposed Rule 15Fh-3(f).
---------------------------------------------------------------------------

    In addition, when an SBS Dealer is acting as an advisor to a
special entity, we are proposing that the suitability requirement will
be deemed satisfied by compliance with the requirements of Rule 15Fh-
4(b). Under Section 15F(h)(4), an SBS Dealer that acts as an advisor to
a special entity is required to make a reasonable determination that
its recommendations are in the best interests of the counterparty.\142\
The statute and proposed Rule 15Fh-4(b)(2) set forth specific
information that an SBS Dealer must make reasonable efforts to obtain
as necessary when making that determination. As explained more fully in
Section II.D.3, infra, the proposed rule would further

require that the SBS Dealer act in the ``best interests'' of the
special entity, which goes beyond and encompasses the general
suitability requirements of proposed Rule 15Fh-3(f). Accordingly, we
preliminarily believe that the general suitability requirement of
proposed Rule 15Fh-3(f) should be deemed satisfied by compliance with
the requirements of proposed Rule 15Fh-4(b).
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    \142\ Section 15F(h)(4)(C) (``Any security-based swap dealer
that acts as an advisor to a special entity shall make reasonable
efforts to obtain such information as is necessary to make a
reasonable determination that any security-based swap recommended by
the security-based swap dealer is in the best interests of the
special entity''). Public Law 111-203, 124 Stat. 1376, 1790-1791 (to
be codified at 15 U.S.C. 78o-10(h)(4)(C)).
---------------------------------------------------------------------------

Request for Comments
    The Commission requests comments generally on all aspects of
proposed Rule 15Fh-3(f). In addition, we request comments on the
following specific issues:
     As noted above, the term ``recommendation'' has been
interpreted in the context of the FINRA suitability requirement. Should
the Commission define or describe more fully what is a
``recommendation'' in this context, and if so, what should the
definition or description be and why? In what specific circumstances,
if any, would additional guidance as to the meaning of a
``recommendation'' be useful? Does the existing FINRA guidance provide
sufficient clarity in this regard? Why or why not? Would a different
approach be appropriate given the differences in the market for
security-based swaps? Why or why not? Should the Commission expressly
address the application of any part of the FINRA guidance in this
context? If so, how?
     Should the Commission permit an SBS Dealer to rely on the
institutional suitability alternative that would be available under
proposed Rule 15Fh-3(f)(2)? Why or why not? Should additional or
different requirements be placed upon an SBS Dealer's use of this
alternative? If so, what requirements should be added or changed and
why?
     Is FINRA's guidance regarding the customer information a
broker-dealer should have available in order to make a suitability
determination an appropriate model for security-based swap markets?
How, if at all, should that guidance be modified? Should the SBS Dealer
be required to obtain different or additional information regarding the
counterparty?
     Should the suitability obligations apply to Major SBS
Participants, as well as to SBS Dealers? Why or why not?
     Should the suitability obligations apply to
recommendations made to SBS Entities, swap dealers and major swap
participants? Why or why not?
     Should the suitability obligations apply when
recommendations are made to a counterparty that is a broker-dealer?
\143\ Another type of market intermediary? Why or why not? Are there
any other circumstances in which the proposed suitability requirement
should not apply, or should apply in a different way?
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    \143\ FINRA ``know your customer'' obligations do not apply to a
broker-dealer's dealings with another broker or dealer. See NASD
Rule 0120(g) (``[t]he term `customer' shall not include a broker or
dealer'').
---------------------------------------------------------------------------

     Are there any particular types of security-based swap
transactions for which heightened or otherwise modified suitability
requirements should apply? If so, what types of transactions? What
requirements should apply to these transactions?
     Should different categories of ECPs be treated differently
under the proposed rules for purposes of suitability determinations? If
so, how? For example, under our proposed rules an SBS Entity would be
subject to the suitability requirement of proposed Rule 15F-3(f)(2)
when entering into security-based swaps with any person that qualified
as an ECP, a category that includes persons with $5 million or more
invested on a discretionary basis that enter into the security-based
swap ``to manage risks.'' \144\ In contrast, under FINRA rules, in
order to apply an analogous suitability standard, a broker-dealer must
be dealing with an entity (whether a natural person, corporation,
partnership, trust, or otherwise) with total assets of at least $50
million.\145\ Should the Commission apply a different standard of
suitability depending on whether the counterparty would be protected as
a retail investor under FINRA rules when the SBS Dealer is also a
registered broker-dealer? \146\ If so, what should the standard be and
to whom should it apply? In what ways should the similarities and
differences between security-based swaps and the types of securities
transactions otherwise subject to FINRA rules inform the standard
applied by the Commission in this context?
---------------------------------------------------------------------------

    \144\ See Section 1a(18)(A)(xi) of the Commodity Exchange Act,
as amended by the Dodd-Frank Act.
    \145\ See FINRA Rule 2111(b) (referring to NASD Rule
3110(c)(4)).
    \146\ Under FINRA rules, a retail customer would generally be an
entity (whether a natural person, corporation, partnership, trust,
or otherwise) with total assets of less than $50 million). See NASD
Rule 3110(c)(4). An SBS Dealer that is also a broker-dealer would
need to have a reasonable basis to believe that any recommendation
of security-based swap or trading strategy to such a person is
suitable for that person, based on the information obtained through
the reasonable diligence of the member or associated person to
ascertain the counterparty's investment profile. This general
suitability obligation under current FINRA rules would apply
regardless of whether the SBS Dealer could otherwise rely on the
alternative under proposed Rule 15Fh-3(f)(2).
---------------------------------------------------------------------------

     Is it appropriate for the Commission to exclude from the
scope of the proposed rule situations in which an SBS Dealer is making
recommendations to a special entity, since recommendations to those
entities are subject to separate and heightened suitability
requirements? Why or why not?
     Should the proposed alternative available under proposed
Rule 15Fh-3(f)(2) be limited to counterparties that would not be
protected as retail investors under FINRA rules or another category of
counterparties?\147\ If not, should we require that the proposed
alternative be addressed on a transaction-by-transaction basis (i.e.,
not generally on a relationship basis or asset-class-by-asset-class)
for counterparties that would otherwise be protected as retail
investors under FINRA rules or another category of counterparties? Why
or why not?
---------------------------------------------------------------------------

    \147\ See id.
---------------------------------------------------------------------------

     Should the suitability obligation be limited to
recommendations to counterparties that would be protected as retail
investors under FINRA rules or another subset of counterparties? If so,
should these counterparties be covered by a suitability rule similar to
FINRA Rule 2360 regarding options suitability? Should this requirement
be limited to another category of counterparties? \148\ Why or why not?
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    \148\ FINRA Rule 2360(b)(19) (Suitability) provides that:
    (A) No member or person associated with a member shall recommend
to any customer any transaction for the purchase or sale of an
option contract unless such member or person associated therewith
has reasonable grounds to believe upon the basis of information
furnished by such customer after reasonable inquiry by the member or
person associated therewith concerning the customer's investment
objectives, financial situation and needs, and any other information
known by such member or associated person, that the recommended
transaction is not unsuitable for such customer.
    (B) No member or person associated with a member shall recommend
to a customer an opening transaction in any option contract unless
the person making the recommendation has a reasonable basis for
believing, at the time of making the recommendation, that the
customer has such knowledge and experience in financial matters that
he may reasonably be expected to be capable of evaluating the risks
of the recommended transaction, and is financially able to bear the
risks of the recommended position in the option contract.
---------------------------------------------------------------------------

     Should the Commission provide guidance on other methods by
which an SBS Dealer can assess a counterparty's capability to
independently evaluate investment risks and exercise independent
judgment? If so, what alternative approaches, and what would be the
advantages and disadvantages for SBS Dealers and counterparties?

     Should the Commission impose specific requirements with
respect to the level of detail that should be required for
representations? If so, what requirements and why?
     Should the Commission permit SBS Dealers to rely on
disclosures made by counterparties for purposes of proposed Rule 15Fh-
3(f)(2) on a transaction-by-transaction basis, on an asset-class-by-
asset-class basis, or in terms of all potential transactions between
the parties? Why or why not? What are the potential advantages and
disadvantages of such an approach?
     What are the advantages and disadvantages of the two
alternative proposed approaches to guidance on when an SBS Dealer may
not rely on a representation? Which alternative would strike the best
balance among the potential disadvantages to market participants, the
regulatory interest (including protecting counterparties in security-
based swap transactions) and promoting the sound functioning of the
security-based swap market? What, if any, other alternatives should the
Commission consider (e.g., a recklessness standard) and why?
     Are there particular categories of counterparties for
which an SBS Dealer should be required to undertake further review or
inquiry to establish a counterparty's capability? Should additional
information be required when, for example, a potential counterparty is
a natural person? If so, what review or inquiry should be required in
what circumstances?
     Are there other potential reasonable methods of
establishing a counterparty's capability to independently evaluate
investment risks and exercise independent judgment besides written
representations? Should the Commission consider providing guidance
regarding these other methods? If so, what methods should such guidance
address and how?
5. Fair and Balanced Communications
    Proposed Rule 15Fh-3(g) would implement the statutory requirement
that SBS Entities communicate with counterparties in a fair and
balanced manner based on principles of fair dealing and good
faith.\149\ This obligation would apply in connection with entering
into security-based swaps, and would continue to apply over the term of
a security-based swap.\150\ The standard is consistent with the
similarly worded requirement in the FINRA customer communications rule,
which is designed to ensure that any customer communications reflect a
balanced treatment of potential benefits and risks.\151\ As we
explained in Section I.C.2, supra, when a business conduct standard is
based on a similar SRO standard, we generally expect to interpret our
standard consistently with SRO interpretations of their rules,
recognizing that we may need to account for functional differences
between the security-based swap market and other securities markets.
Accordingly, we are proposing three additional standards, drawn from
FINRA regulation, to clarify the statutory requirement.\152\ These
standards do not represent an exclusive list of considerations that an
SBS Entity must make in determining whether a communication with a
counterparty is fair and balanced.
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    \149\ See Exchange Act Section 15F(h)(3)(C), Pub. L. 111-203,
124 Stat. 1376, 1790 (to be codified at 15 U.S.C. 78o-10(h)(3)(C)).
    \150\ See proposed Rule 15Fh-1.
    \151\ NASD Rule 2210(d). See IM-2210-1(1), Guidelines to Ensure
That Communications with the Public Are Not Misleading (``Members
must ensure that statements are not misleading within the context in
which they are made. A statement made in one context may be
misleading even though such a statement could be appropriate in
another context. An essential test in this regard is the balanced
treatment of risks and potential benefits.'').
    \152\ Cf. SIFMA/ISDA 2010 Letter at 4 (requesting the Commission
clarify the standards for fair and balanced communication by
reference to the existing FINRA standards for customer
communication, subject to appropriate modifications to reflect the
heightened standards for participation in the swap markets).
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    We propose to require that communications must provide a sound
basis for evaluating the facts with respect to any security-based swap
or trading strategy involving a security-based swap that the
communication is designed to cover.\153\ In addition, we propose to
prohibit communications that imply that past performance would recur,
or that make any exaggerated or unwarranted claim, opinion, or
forecast.\154\ Finally, we propose to require that any statement
referring to the potential opportunities or advantages presented by a
security-based swap or trading strategy involving a security-based swap
be balanced by a statement of the corresponding risks having the same
degree of specificity as the statement of opportunities.\155\ SBS
Entities should also avoid broad generalities in their communications,
to the extent appropriate and practicable under the circumstances.
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    \153\ Proposed Rule 15Fh-3(g)(1). Cf. NASD Rule 2210(d)(1)(A)
(``All member communications with the public shall be based on
principles of fair dealing and good faith, must be fair and
balanced, and must provide a sound basis for evaluating the facts in
regard to any particular security or type of security, industry, or
service.'').
    \154\ Proposed Rule 15Fh-3(g)(2). Cf. NASD Rule 2201(d)(1)(D)
(``Communications with the public may not predict or project
performance, imply that past performance will recur or make any
exaggerated or unwarranted claim, opinion or forecast. A
hypothetical illustration of mathematical principles is permitted,
provided that it does not predict or project the performance of an
investment or investment strategy.''). Proposed Rule 15Fh-3(e)(4)
does not constitute a blanket prohibition of communications such as
scenario or profitability analyses that are required or advisable
under other provisions of these rules.
    \155\ Proposed Rule 15Fh-3(g)(3). Cf. NASD IM-2210-1(1) (``An
essential test in this regard is the balanced treatment of risks and
potential benefits.'').
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    We note that, regardless of the scope of the rules proposed herein,
all communications by SBS Entities will be subject to the specific
anti-fraud provisions added to the Exchange Act under Title VII of the
Dodd-Frank Act, \156\ as well as general anti-fraud provisions under
the federal securities laws.\157\
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    \156\ See Sections 9(j) and 15F(h)(4)(A) of the Exchange Act,
Public Law 111-203, 124 Stat. 1376, 1777-1778 and 1790 (to be
codified at 15 U.S.C. 78i(j) and 15 U.S.C. 78o-10(h)(4)(A)). See
also Prohibition Against Fraud, Manipulation, and Deception in
Connection with Security-Based Swaps, Exchange Act Release No. 63236
(Nov. 3, 2010), 75 FR 68560 (Nov. 8, 2010) (proposing Rule 9j-1 to
implement the anti-fraud prohibitions of Section 9(j) of the
Exchange Act).
    \157\ See, e.g., 15 U.S.C. 77q and 78i, and, if the SBS Entity
is registered as a broker-dealer, 15 U.S.C. 78o.
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Request for Comments
    The Commission requests comments generally on all aspects of this
provision. In addition, we request comments on the following specific
issues:
     Should the Commission further clarify any proposed
requirements to engage in fair and balanced communications? If so, how?
Are there specific circumstances regarding the application of the
proposed requirements that the Commission should address? If so, which
circumstances, and what guidance is required?
     Should the Commission specify any additional requirements
for the duty to engage in fair and balanced communications? If so, what
requirements and why?
     Should an SBS Entity be able to rely on SRO guidance with
respect to communications for purposes of compliance with the proposed
rule? If so, how would such reliance function as both the security-
based swap market and the broader securities markets continue to
evolve?
     Should the Commission provide additional guidance with
respect to the nature of fair and balanced communications for purposes
of furthering compliance with the proposed rule and providing greater

legal certainty to market participants? If so, what guidance and why?
     What are the specific practical effects, advantages and
disadvantages that market participants identify in considering how to
comply with the proposed rules? Are there modifications or
clarifications to the proposed rules that would better balance the
advantages and disadvantages of the statutory requirement while
furthering the Commission's regulatory objectives?
     Are there any particular differences between the
traditional securities markets and the markets for security-based swaps
that need to be taken into account in clarifying the statutory
requirement to communicate in a fair and balanced manner based on
principles of fair dealing and good faith? If so, what are these
differences, and how should the Commission's proposal be modified to
take them into account?
     Should we distinguish between the fair and balanced
communication requirements applicable to an SBS Dealer and those
applicable to a Major SBS Participant? If so, how should the
requirements applicable to a Major SBS Participant differ from those
that are being proposed?
     Are there any circumstances in which the fair and balanced
communications requirements should not apply? Which circumstances, and
why?
     We preliminarily believe that proposed Rule 15F-3(g) would
provide additional investor protection beyond what would otherwise
arise by virtue of applicable anti-fraud rules. Will the proposed
communications requirements have the effect of reducing communications
between SBS Entities and their counterparties? In what respects, and
why? What alternative approaches might the Commission consider to
effectively implement the statutory requirement without unduly
discouraging effective communication between market participants?
6. Obligation Regarding Diligent Supervision
    Exchange Act Section 15F(h)(1)(B) authorizes the Commission to
adopt rules for the diligent supervision of the business of SBS
Entities. Proposed Rule 15Fh-3(h) would establish supervisory
obligations that incorporate principles from both Exchange Act Section
15(b) and existing SRO rules.\158\ As we discussed earlier, the concept
of diligent supervision is consistent with business conduct standards
for broker-dealers that have historically been established by SROs for
their members, subject to Commission approval. We anticipate that
certain SBS Entities may also be registered broker-dealers and thus
subject to substantially similar requirements under SRO rules.\159\
More generally, we believe that the SRO requirements provide a useful
point of reference that has been implemented by a wide range of firms
in the U.S. financial services industry.
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    \158\ The Commission's policy regarding failure to supervise is
well established. 15 U.S.C. 78o(b)(4)(E) and 15 U.S.C. 78o(b)(6)(A).
As we have explained in other contexts:
    The Commission has long emphasized that the responsibility of
broker-dealers to supervise their employees is a critical component
of the federal regulatory scheme. * * * In large organizations it is
especially imperative that those in authority exercise particular
vigilance when indications of irregularity reach their attention.
The supervisory obligations imposed by the federal securities laws
require a vigorous response even to indications of wrongdoing. Many
of the Commission's cases involving a failure to supervise arise
from situations where supervisors were aware only of ``red flags''
or ``suggestions'' of irregularity, rather than situations where, as
here, supervisors were explicitly informed of an illegal act.
    Even where the knowledge of supervisors is limited to ``red
flags'' or ``suggestions'' of irregularity, they cannot discharge
their supervisory obligations simply by relying on the unverified
representations of employees. Instead, as the Commission has
repeatedly emphasized, ``[t]here must be adequate follow-up and
review when a firm's own procedures detect irregularities or unusual
trading activity. * * *'' Moreover, if more than one supervisor is
involved in considering the actions to be taken in response to
possible misconduct, there must be a clear definition of the efforts
to be taken and a clear assignment of those responsibilities to
specific individuals within the firm.
    John H. Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992)
(report pursuant to Section 21(a) of the Exchange Act) (footnotes
omitted).
    \159\ See, e.g., NASD Rules 3010 and 3012.
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    Under proposed Rule 15Fh-3(h)(1), each SBS Entity would be required
to establish, maintain and enforce a system to supervise, and would be
required to supervise diligently, the business of the SBS Entity
involving security-based swaps.\160\This system would be required to be
reasonably designed to achieve compliance with applicable federal
securities laws and the rules and regulations thereunder.\161\ Proposed
Rule 15Fh-3(h) would provide a baseline requirement for an effective
supervisory system, although a particular system may need additional
elements in order to be effective. For that reason, proposed Rule 15Fh-
3(h)(2) would state that it establishes only minimum requirements; by
implication, the list would not be exhaustive. These obligations are
based on SRO standards and we generally expect to interpret these
obligations taking into account SRO interpretations of their rules,
recognizing that we are not bound by SRO interpretations and may need
to account for functional differences between the security-based swap
market and other securities markets.
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    \160\ We will consider consolidating any recordkeeping
obligations proposed as part of this rule into a separate
recordkeeping rule that we are required to adopt under the Dodd-
Frank Act. See Section 15F(f)(2) of the Exchange Act, 15 U.S.C. 78o-
10(f)(2) (``The Commission shall adopt rules governing reporting and
recordkeeping for security-based swap dealers and major security-
based swap participants.'').
    \161\ Proposed Rule 15Fh-3(h)(2). See NASD Rule 3010(a) (``Each
member shall establish and maintain a system to supervise the
activities of each registered representative, registered principal,
and other associated person that is reasonably designed to achieve
compliance with applicable securities laws and regulations, and with
applicable NASD Rules.'').
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    Proposed Rule 15Fh-3(h)(2)(i) would require an SBS Entity to
designate at least one qualified person with supervisory responsibility
for security-based swap transactions.\162\ Proposed Rule 15Fh-
3(h)(2)(ii) would require an SBS Entity to use reasonable efforts to
determine that all supervisors are qualified and have sufficient
training, experience, and competence to adequately discharge their
responsibilities.\163\ Proposed Rule 15Fh-3(h)(2)(iii) would require an
SBS Entity to adopt written policies and procedures addressing the
types of security-based swap business in which the SBS Entity is
engaged. The policies and procedures would need to be reasonably
designed to achieve compliance with applicable securities laws and the
rules and regulations thereunder,\164\ and include, at a minimum: (1)
Procedures for the review by a supervisor of all transactions for which
registration as an SBS Entity is required; \165\ (2) procedures for the

review by a supervisor of written correspondence with counterparties
and potential counterparties and internal written (including
electronic) communications relating to the securities-based swap
business; \166\ (3) procedures for a periodic review of the security-
based swap business in which it engages; \167\ (4) procedures to
conduct reasonable investigation into the background of associated
persons; \168\ (5) procedures to monitor employee personal accounts
held at another SBS Dealer, broker, dealer, investment adviser, or
other financial institution; \169\ (6) a description of the supervisory
system, including identification of the supervisory personnel; \170\
(7) procedures prohibiting supervisors from supervising their own
activities or reporting to, or having their compensation or continued
employment determined by, a person or persons they are supervising;
\171\ and (8) procedures preventing the standards of supervision from
being reduced due to any conflicts of interest that may be present with
respect to the associated person being supervised.\172\ Proposed Rule
15Fh-3(h)(4) would require SBS Entities to promptly update their
supervisory procedures as legal or regulatory changes warrant. Proposed
Rule 15Fh-3(h)(2)(iii)(F) would require SBS Entities to maintain
records identifying supervisory personnel.
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    \162\ Cf. NASD Rule 3010(a)(2) (requiring ``[t]he designation,
where applicable, of an appropriately registered principal(s) with
authority to carry out the supervisory responsibilities of the
member for each type of business in which it engages for which
registration as a broker/dealer is required'').
    \163\ Cf. NASD Rule 3010(a)(6) (requiring members to use
``[r]easonable efforts to determine that all supervisory personnel
are qualified by virtue of experience or training to carry out their
assigned responsibilities'').
    \164\ Cf. NASD Rule 3010(b)(1) (``Each member shall establish,
maintain, and enforce written procedures to supervise the types of
business in which it engages and to supervise the activities of
registered representatives, registered principals, and other
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations, and with
the applicable Rules of NASD.'').
    \165\ Proposed Rule 15Fh-3(h)(2)(iii)(A). Cf. NASD Rule 3010
(d)(1) (``Each member shall establish procedures for the review and
endorsement by a registered principal in writing, on an internal
record, of all transactions and for the review by a registered
principal of incoming and outgoing written and electronic
correspondence of its registered representatives with the public
relating to the investment banking or securities business of such
member. Such procedures should be in writing and be designed to
reasonably supervise each registered representative.'').
    \166\ Proposed Rule 15Fh-3(h)(2)(iii)(B). Cf. NASD Rule
3010(d)(2) (which provides in part that ``[e]ach member shall
develop written procedures that are appropriate to its business,
size, structure, and customers for the review of incoming and
outgoing written (i.e., non-electronic) and electronic
correspondence with the public relating to its investment banking or
securities business, including procedures to review incoming,
written correspondence directed to registered representatives and
related to the member's investment banking or securities business to
properly identify and handle customer complaints and to ensure that
customer funds and securities are handled in accordance with firm
procedures'').
    \167\ Proposed Rule 15Fh-3(h)(2)(iii)(C). Cf. NASD Rule
3010(c)(1) (``Each member shall conduct a review, at least annually,
of the businesses in which it engages, which review shall be
reasonably designed to assist in detecting and preventing violations
of, and achieving compliance with, applicable securities laws and
regulations, and with applicable NASD rules.'').
    \168\ Proposed Rule 15Fh-3(h)(2)(iii)(D). Cf. NASD Rule 3010(e)
(``Each member shall have the responsibility and duty to ascertain
by investigation the good character, business repute,
qualifications, and experience of any person prior to making such a
certification in the application of such person for registration
with this Association.'').
    \169\ Proposed Rule 15Fh-3(h)(2)(iii)(E).
    \170\ Proposed Rule 15Fh-3(h)(2)(iii)(F). Cf. NASD Rule
3010(b)(3) (``The member's written supervisory procedures shall set
forth the supervisory system established by the member pursuant to
paragraph (a) above, and shall include the titles, registration
status and locations of the required supervisory personnel and the
responsibilities of each supervisory person as these relate to the
types of business engaged in, applicable securities laws and
regulations, and the Rules of this Association.'').
    \171\ Proposed Rule 15Fh-3(h)(2)(iii)(G). Cf. NASD Rule
3012(a)(2)(A)(i) (``General Supervisory Requirement. A person who is
either senior to, or otherwise independent of, the producing manager
must perform such supervisory reviews.'').
    \172\ Proposed Rule 15Fh-3(h)(2)(iii)(H). These conflicts could
arise from the position of the associated person being supervised,
the revenue that person generates for the SBS Entity, or any
compensation that the person conducting the supervision may derive
from the associated person being supervised. Cf. NASD Rule
3012(a)(2)(C) (requiring ``procedures that are reasonably designed
to provide heightened supervision over the activities of each
producing manager who is responsible for generating 20% or more of
the revenue of the business units supervised by the producing
manager's supervisor. For the purposes of this subsection only, the
term `heightened supervision' shall mean those supervisory
procedures that evidence supervisory activities that are designed to
avoid conflicts of interest that serve to undermine complete and
effective supervision because of the economic, commercial, or
financial interests that the supervisor holds in the associated
persons and businesses being supervised.'').
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    As part of the required system reasonably designed to achieve
compliance with applicable federal securities laws and regulations,
proposed Rule 15Fh-3(h)(2)(iv) would require an SBS Entity to adopt
written policies and procedures reasonably designed, taking into
consideration the nature of such SBS Entity's business, to comply with
the duties set forth in Section 15F(j) of the Exchange Act.\173\
Section 15F(j) of the Exchange Act requires an SBS Entity to comply
with obligations concerning: (1) Monitoring of trading to prevent
violations of applicable position limits; (2) establishing sound and
professional risk management systems; (3) disclosing to regulators
information concerning its trading in security-based swaps; (4)
establishing and enforcing internal systems and procedures to obtain
any necessary information to perform any of the functions described in
Section 15F of the Exchange Act, and providing the information to
regulators, on request; (5) implementing conflict-of-interest systems
and procedures that establish structural and institutional safeguards
to ensure that the activities of any person within the firm relating to
research or analysis of the price or market for any security-based
swap, or acting in the role of providing clearing activities, or making
determinations as to accepting clearing customers are separated by
appropriate informational partitions within the firm from the review,
pressure, or oversight of persons whose involvement in pricing,
trading, or clearing activities might potentially bias their judgment
or supervision and contravene the core principles of open access and
the business conduct standards addressed in Title VII of the Dodd-Frank
Act; and (6) addressing antitrust considerations such that the SBS
Entity does not adopt any process or take any action that results in
any unreasonable restraint of trade or impose any material
anticompetitive burden on trading or clearing.
---------------------------------------------------------------------------

    \173\ Public Law 111-203, 124 Stat. 1376, 1792- 1793 (to be
codified at 15 U.S.C. 78o-10(j)).
---------------------------------------------------------------------------

    Under proposed Rule 15Fh-3(h)(3), an SBS Entity or associated
person would not have failed diligently to supervise a person that is
subject to the supervision of that SBS Entity or associated person, if
two conditions are met. First, the SBS Entity must have established
policies and procedures, and a system for applying those policies and
procedures, which would reasonably be expected to prevent and detect,
to the extent practicable, any violation of the federal securities laws
and the rules thereunder related to security-based swaps. Second, such
person must have reasonably discharged the duties and obligations
incumbent on it by reason of such procedures and system without a
reasonable basis to believe that such procedures were not being
followed. However, the absence of either or both of these conditions
would not necessarily mean that an SBS Entity or associated person
failed to diligently supervise any other person.
Request for Comments
    The Commission requests comments generally on all aspects of this
provision. In addition, we request comments on the following specific
issues:
     Should supervisory requirements be imposed on Major SBS
Participants? Why or why not?
     Should different supervisory requirements apply to SBS
Dealers and Major SBS Participants? If so, how should the requirements
differ, and why?
     Should we require a specific means by which an SBS Entity
must determine whether a supervisor is qualified and has sufficient
training, experience, and competence to adequately discharge his or her
responsibilities? If so, what means? For example, should we require
that supervisors pass exams comparable to FINRA Series 24? Should any
such requirement apply to supervisors at Major SBS Participants as
well, or only to supervisors at SBS Dealers?
     Should the Commission consider imposing a testing
requirement comparable to FINRA Series 7 for all associated persons of
an SBS Dealer or Major SBS Participant? Why or why not? Are there other
models the Commission should consider? Which models, and why?

     Would any of these proposed supervisory requirements be
more appropriately assigned to the chief compliance officer, and if so,
which ones and why?
     Should certain obligations not be imposed on a supervisor
of an SBS Entity? If so, which ones and why?
     Should an SBS Entity be able to rely on SRO guidance with
respect to supervision for purposes of compliance with the proposed
rule? Is that guidance sufficiently clear under the circumstances?
Should that guidance be adopted or modified for purposes of its
application to SBS Entities in the context of the security-based swap
markets? If so, how and why?
     Do any of these proposed supervisory obligations conflict
with current supervisory obligations, and if so, which ones and how?
     Should the Commission impose explicit supervision
obligations with respect to the requirements of Section 15F(j), and if
so, which ones and why? In particular, should the Commission impose
explicit obligations with respect to the monitoring of trading to
prevent violations of applicable position limits? Should the Commission
impose explicit obligations with respect to establishing sound and
professional risk management systems? Should the Commission impose
explicit obligations to disclose to regulators information concerning
trading in security-based swaps? Should the Commission impose explicit
obligations with respect to establishing and enforcing internal systems
and procedures to obtain any necessary information to perform any of
the functions described in Section 15F of the Act? Should the
Commission impose explicit obligations with respect to providing the
information to regulators, on request? Should the Commission impose
explicit obligations with respect to implementing conflict-of-interest
systems and procedures to ensure that activities relating to research
or analysis of the price or market for any security-based swap,
clearing activities, and determinations as to accepting clearing
customers are separated from the review, pressure, or oversight of
persons whose involvement in pricing, trading, or clearing activities
might potentially bias their judgment or supervision and contravene the
core principles of open access and the business conduct standards
addressed in the Act? Should the Commission impose explicit obligations
with respect to addressing antitrust considerations such that the SBS
Entity does not adopt any process or take any action that results in
any unreasonable restraint of trade; or impose any material
anticompetitive burden on trading or clearing?
     Should an SBS Entity be required to have policies and
procedures reasonably designed to prevent the improper use or
disclosure of counterparty information? \174\
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    \174\ As noted above, proposed Rule 15Fh-3(h)(2)(iv) would
require SBS Entities to adopt written policies and procedures
reasonably designed, taking into consideration the nature of such
SBS Entity's business, to comply with the duties set forth in
Section 15F(j) of the Exchange Act, including implementing conflict-
of-interest systems and procedures that establish structural and
institutional safeguards to ensure that the activities of any person
within the firm relating to research or analysis of the price or
market for any security-based swap, or acting in the role of
providing clearing activities, and or making determinations as to
accepting clearing customers are separated by appropriate
informational partitions within the firm from the review, pressure,
or oversight of persons whose involvement in pricing, trading, or
clearing activities might potentially bias their judgment or
supervision and contravene the core principles of open access and
the business conduct standards described in Title VII of the Dodd-
Frank Act.
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D. Proposed Rules Applicable to Dealings With Special Entities

    Congress has provided certain additional protections under Sections
15F(h)(4) and (5) of the Exchange Act for ``special entities'' in
connection with security-based swaps.\175\ Under the terms of Section
15F(h)(7) of the Exchange Act, Section 15F(h) would not apply to a
transaction that is initiated by a special entity on an exchange or SEF
and the SBS Entity does not know the identity of the counterparty to
the transaction. The statute does not define the term ``initiated''. We
preliminarily believe that there may be circumstances in which it may
be unclear which party, in fact, ``initiated'' the communications that
resulted in the parties entering into a security-based swap
transaction. Accordingly, we are proposing to read Section 15F(h)(7) to
apply to any transaction with a special entity on a SEF or an exchange
where the SBS Entity does not know the identity of its counterparty. We
recognize that, under this reading, the exemption under Section
15F(h)(7) would be available regardless of which side ``initiates'' a
transaction, so long as the other conditions are met. We are seeking
comment on whether this reading is appropriate or whether another
possible reading of this provision should be made.
---------------------------------------------------------------------------

    \175\ See discussion in Section I.C.5, supra.
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Request for Comments
    The Commission requests comments generally on all aspects of this
provision. In addition, we request comments on the following specific
issues:
     Should the Commission adopt a different interpretation of
Section 15F(h)(7)? If so, what interpretation and why?
     Should the exemption be limited to situations in which the
special entity takes specific steps, such as submitting a request for
quote or some other communication regarding a potential transaction on
an exchange or SEF? Are there other communications or circumstances of
entry into a security-based swap that should be regarded as the
``initiation'' of a transaction by a special entity? If so, which ones?
     Should the exemption continue to apply if the SBS Entity
learns the identity of the special entity? If so, under what conditions
and why?
1. Scope of the Definition of ``Special Entity''
    Exchange Act Section 15F(h)(2)(C) defines a ``special entity'' as:
(i) A Federal agency; \176\ (ii) a State, State agency, city, county,
municipality, or other political subdivision of a State; \177\ (iii)
any employee benefit plan, as defined in section 3 of ERISA; \178\ (iv)
any governmental plan, as defined in section 3 of ERISA; \179\ or (v)
any

endowment, including an endowment that is an organization described in
section 501(c)(3) of the Internal Revenue Code of 1986.\180\ Commenters
have raised a number of questions about the scope of the definition, as
to which we are soliciting further comment below.\181\
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    \176\ The definition of ``security-based swap'' excludes an
``agreement, contract or transaction a counterparty of which is a
Federal Reserve bank, the Federal Government, or a Federal agency
that is expressly backed by the full faith and credit of the United
States.'' Section 3(a)(68) of the Exchange Act, by reference to
Section 1a of the Commodity Exchange Act. Accordingly, the
Commission expects that special entities that are Federal agencies
will be a narrow category for purposes of these rules.
    \177\ Cf. Exchange Act Section 15B(e)(8), Pub. L. 111-203, 124
Stat. 1376, 1790-1791 (to be codified at 15 U.S.C. 78o-4(e)(8))
(defining ``municipal entity'' to include ``any agency, authority,
or instrumentality of the States, political subdivision, or
municipal corporate entity''); 17 CFR 275.206(4)-(5) (defining
``governmental entity'' to include ``any agency, authority, or
instrumentality of the state or political subdivision'').
    \178\ 29 U.S.C. 1002. The term ``special entity'' includes
employee benefit plans defined in section 3 of ERISA. This class of
employee benefit plans is broader than the category of plans that
are ``subject to'' ERISA for purposes of Section
15F(h)(5)(A)(i)(VII) of the Exchange Act. Employee benefit plans not
``subject to'' regulation under ERISA include: (1) Governmental
plans; (2) church plans; (3) plans maintained solely for the purpose
of complying with applicable workmen's compensation laws or
unemployment compensation or disability insurance laws; (4) plans
maintained outside the U.S. primarily for the benefit for persons
substantially all of whom are nonresident aliens; or (5) unfunded
excess benefit plans. See 29 U.S.C. 1003(b).
    \179\ Section 3(32) of ERISA defines ``governmental plan'' as a
``plan established or maintained for its employees by the Government
of the United States, by the government of any State or political
subdivision thereof, or by any agency or instrumentality of any of
the foregoing.'' 29 U.S.C. 1002(32).
    \180\ The term ``endowment'' is not defined in the Dodd-Frank
Act, or in the securities laws generally.
    \181\ See, e.g., SIFMA/ISDA 2010 Letter at 2 (requesting
confirmation that ``collective investment vehicles do not become
`Special Entities' merely as a result of the investment by Special
Entities in such vehicles,'' and asserting that ``master trusts
holding the assets of one or more funded plans of a single employer
should be considered `Special Entities' '').
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Request for Comments
    The Commission requests comment on all aspects of the definition of
``special entity.'' In particular, we are seeking comment as to what
clarifications to the definition may be required and why. Commenters
should also explain why any suggested clarification is consistent with
both the express statutory language and the policies underlying Section
764 of the Dodd-Frank Act. In addition, the Commission requests
comments on the following specific issues.
     Should the Commission interpret ``employee benefit plan,
as defined in section 3'' of ERISA to mean a plan that is subject to
regulation under ERISA? \182\ Why or why not?
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    \182\ See, e.g., id. (requesting confirmation that ``plans not
subject to the Employee Retirement Income Security Act of 1974
(`ERISA') (unless they are covered by another applicable prong of
the ``Special Entity'' definition (e.g., governmental plans)) are
not `Special Entities' ''). Section 4 of ERISA provides that the
provisions of ERISA shall not apply to an employee benefit plan that
is a governmental plan (as defined in section 1002(32) of ERISA); a
church plan (as defined in section 1002(33) of ERISA) with respect
to which no election has been made under 26 U.S.C. section 410(d); a
plan that is maintained solely for the purpose of complying with
applicable workmen's compensation laws or unemployment compensation
or disability insurance laws; a plan that is maintained outside of
the United States primarily for the benefit of persons substantially
all of whom are nonresident aliens; or a plan that is an excess
benefit plan (as defined in section 1002(36) of ERISA) and is
unfunded.
    See Letter from Daniel Crowley, Partner, K&L Gates on behalf of
the Church Alliance, to David A. Stawick, Secretary, CFTC (Feb. 22,
2011) (on file with the CFTC), http://comments.cftc.gov/PublicComments/CommentList.aspx?id=935 (requesting clarification
that church plans be included in the definition of special entity).
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     Should the Commission interpret ``government plan'' to
include government investment pools or other plans, programs or pools
of assets? Why or why not?
     Should the Commission define ``endowment''? If so, how?
What organizations should be included in or excluded from the
definition, and why? \183\ Should the Commission interpret
``endowment'' to include funds that are not separate legal entities?
Why or why not? Should the term ``endowment'' include legal entities or
funds that are not organized or located in the United States? Should
the term ``endowment'' be limited to those organizations described in
Section 501(c)(3) of the Internal Revenue Code?
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    \183\ For accounting purposes, the term ``endowment'' is defined
to mean ``[a]n established fund of cash, securities, or other assets
to provide income for the maintenance of a not-for-profit
organization. The use of the assets of the fund may be permanently
restricted, temporarily restricted, or unrestricted. Endowment funds
generally are established by donor-restricted gifts and bequests to
provide a permanent endowment, which is to provide a permanent
source of income, or a term endowment, which is to provide income
for a specified period.'' Financial Accounting Standards Board ASC
Section 958-205-20, Glossary, Non-for-Profit Entities.
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     Should the Commission interpret ``endowment'' to include
an organization that uses the assets of its endowment to pledge or
maintain collateral obligations, or otherwise enhance or support the
organization's obligations under a security-based swap? \184\ Why or
why not?
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    \184\ See Swap Financial Group Presentation at 8 (concerning the
scope of this prong of the definition of ``special entity'').
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     Should the Commission interpret ``special entity'' to
exclude a collective investment vehicle in which one or more special
entities have invested? \185\ Should a collective investment vehicle be
considered a special entity if the fund manager, for example, becomes
subject to fiduciary duties under ERISA with respect to plan assets in
the fund? Why or why not?
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    \185\ See note 181, supra.
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     Should the Commission exclude from the definition of
``special entity'' any foreign entity?
     Should the Commission interpret ``special entity'' to
include a master trust holding the assets of one or more funded plans
of a single employer and its affiliates? \186\ Why or why not?
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    \186\ See id.
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2. Best Interests
    Section 15F(h) of the Exchange Act uses the term ``best interests''
in several instances with respect to special entities. Section
15F(h)(4)(B) imposes on an SBS Dealer that ``acts as an advisor'' to a
special entity a duty to act in the ``best interests'' of the special
entity. In addition, Section 15F(h)(4)(C) requires the SBS Dealer that
``acts as an advisor'' to a special entity to make ``reasonable efforts
to obtain such information as is necessary to make a reasonable
determination'' that any swap recommended by the SBS Dealer is in the
``best interests'' of the special entity. Finally, Section 15F(h)(5) of
the Exchange Act requires an SBS Entity that is a counterparty to a
special entity to have a ``reasonable basis'' to believe that the
special entity has an independent representative that undertakes to act
in the best interests of the special entity.\187\
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    \187\ Section 15F(h)(5)(A)(i)(IV) of the Exchange Act, Public
Law 111-203, 124 Stat. 1376, 1791 (to be codified at 15 U.S.C. 78o-
10(h)(5)(A)(i)(IV)).
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    The term ``best interests'' is not defined in the Dodd-Frank Act.
The Commission is not proposing to define ``best interests'' in this
rulemaking. Instead we are seeking comment on whether we should define
that term, and if so, whether such definition should use formulations
based on the standards applied to investment advisers,\188\ municipal
advisors,\189\ or ERISA fiduciaries,\190\ or some other
formulation.\191\
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    \188\ We recently stated that, under the Advisers Act, an
adviser is a fiduciary whose duty is to serve the best interests of
its clients, which includes an obligation not to subordinate
clients' interests to its own. An adviser must deal fairly with
clients and prospective clients, seek to avoid conflicts with its
clients and, at a minimum, make full disclosure of any material
conflict or potential conflict. See Amendments to Form ADV,
Investment Advisers Act Release No. 3060 (July 28, 2010), 75 FR
49234 (Aug. 12, 2010), citing SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180, 191-194 (1963) (holding that investment advisers
have a fiduciary duty enforceable under Section 206 of the Advisers
Act, that imposes upon investment advisers the ``affirmative duty of
`utmost good faith, and full and fair disclosure of all material
facts,' as well as an affirmative obligation to `employ reasonable
care to avoid misleading' '' their clients and prospective clients).
    \189\ See, e.g., Exchange Act Section 15B(b)(2)(L), Public Law
111-203, 124 Stat. 1376, 1919 (to be codified at 15 U.S.C. 78o-
4(b)(2)(L)) (requiring the MSRB to prescribe means reasonably
designed to prevent acts, practices, and courses of conduct that are
not consistent with a municipal advisor's fiduciary duty to its
municipal entity clients). The MSRB requested comment on draft Rule
G-36 concerning the fiduciary duty of municipal advisors, and a
draft interpretive notice under Rule G-36. See MSRB Notice 2011-14
(Feb. 14, 2011).
    \190\ See, e.g., 29 U.S.C. 1104(a)(1)(A) (``a fiduciary shall
discharge his duties with respect to a plan solely in the interest
of the participants and beneficiaries and for the exclusive purpose
of: (i) Providing benefits to participants and their beneficiaries;
and (ii) defraying reasonable expenses of administering the plan'')
and 29 U.S.C. 1104(a)(1)(B) (a fiduciary must act ``with the care,
skill, prudence, and diligence under the circumstances then
prevailing that a prudent man acting in a like capacity and familiar
with such matters would use in the conduct of an enterprise of a
like character and with like aims'').
    \191\ We note that Section 913 of the Dodd-Frank Act authorizes
the Commission to promulgate rules to provide that the standard of
conduct for broker-dealers and investment advisers when providing
personalized investment advice about securities to retail customers
(and such other customers as the Commission may by rule provide)
shall be to act in the best interest of the customer without regard
to the financial or other interest of the intermediary providing the
advice. Public Law 111-203, 124 Stat. 1376, 1827-1829.

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Request for Comments
    The Commission is seeking comment generally on whether and how it
should clarify the meaning of the term ``best interests'' under Section
15F(h). In addition, we request comments on the following specific
issues:
     Should the Commission define the term ``best interests''
in this context? If so, what definitions should the Commission consider
and why? What are the advantages and drawbacks of particular
definitions in this context? What factors should be included in the
determination of a special entity's ``best interests''?
     Should the Commission adopt a definition of ``best
interests'' that is based on the fiduciary duty applicable to
investment advisers under the Investment Advisers Act of 1940
(``Advisers Act'')? \192\ Why or why not?
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    \192\ See supra note 188.
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     Should the Commission adopt a definition of ``best
interests'' that is based on the fiduciary duty applicable to municipal
advisors under the Exchange Act? \193\ Why or why not?
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    \193\ See supra note 189.
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     Should the Commission adopt a definition of ``best
interests'' that is based on the fiduciary duty applicable to
fiduciaries under ERISA? \194\ Why or why not?
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    \194\ See supra note 190.
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     Should the Commission define ``best interests'' in a
manner consistent with how it may define ``best interests'' in any
rulemaking it may choose to propose under Section 913 of the Dodd-Frank
Act, if any? Why or why not?
3. Anti-Fraud Provisions: Proposed Rule 15Fh-4(a)
    Section 15F(h)(4)(A) of the Exchange Act provides that it shall be
unlawful for an SBS Entity to: (i) Employ any device, scheme, or
artifice to defraud any special entity or prospective customer who is a
special entity; (ii) engage in any transaction, practice, or course of
business that operates as a fraud or deceit on any special entity or
prospective customer who is a special entity; or (iii) to engage in any
act, practice, or course of business that is fraudulent, deceptive, or
manipulative. Consistent with the guidance in our previous order
regarding the effective date of this provision, we are proposing a rule
to render the statutory standard effective.\195\
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    \195\ See Order Pursuant to Sections 15F(b)(6) and 36 of the
Securities Exchange Act of 1934 Granting Temporary Exemptions and
Other Temporary Relief, Together with Information on Compliance
Dates for New Provisions of the Securities Exchange Act of 1934
Applicable to Security-Based Swaps, and Request for Comment,
Securities Act Release No. 64678 (June 15, 2011), 76 FR 36287 (June
22, 2011) at note 192:
     Section 15F(h)(6) of the Exchange Act, 15 U.S.C. 78o-10(h)(6),
directs the Commission to ``prescribe rules under this subsection
[(h) of the Exchange Act, 15 U.S.C. 78o-10(h),] governing business
conduct standards.'' Accordingly, business conduct standards
pursuant to section 15F(h) of the Exchange Act, 15 U.S.C. 78o-10(h),
will be established by rule and compliance will be required on the
compliance date of the Commission rule establishing these business
conduct standards.
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4. Advisor to Special Entities: Proposed Rules 15Fh-2(a) and 15Fh-4(b)
    Exchange Act Section 15F(h)(4) imposes a duty on an SBS Dealer that
acts as an advisor to a special entity to act in the best interests of
the special entity.\196\ The Dodd-Frank Act does not define
``advisor.'' Commenters have urged us to establish a clear standard for
determining when an SBS Dealer is acting as an advisor within the
meaning of Section 15F(h)(4).\197\ These commenters have expressed
concern that compliance with the ``best interests'' standard applicable
to advisors would create significant burdens and potential legal
liability for SBS Dealers, and therefore SBS Dealers need certainty as
to when they would or would not be acting as an advisor. For example,
commenters have expressed concern that the business conduct obligations
imposed by the Dodd-Frank Act might cause an SBS Dealer to be a
``fiduciary'' under ERISA, and therefore effectively prohibit SBS
Dealers from entering into security-based swaps with pension plans that
are subject to ERISA.\198\ We recognize the importance of this issue,
both for dealers and for the pension plans that may rely on security-
based swaps to manage risk and reduce volatility. The determination
whether an SBS Dealer is acting as an advisor for purposes of Section
15F(h)(4) and proposed Rule 15Fh-4(b) is not intended to prejudice the
determination whether the SBS Entity is otherwise subject to regulation
as an ERISA fiduciary.\199\ Although each regulatory regime applies
independently, we anticipate that Commission staff will continue to
consult with representatives of the Department of Labor to facilitate a
full understanding of how the regulatory regimes interact with one
another, and to determine whether any modifications to our proposed
rules may be necessary or appropriate in light of these interactions.
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    \196\ Section 15F(h)(2)(A) of the Exchange Act requires all SBS
Entities to comply with the requirements of Section 15F(h)(4).
Public Law 111-203, 124 Stat. 1376, 1789 (to be codified at 15
U.S.C. 78o-10(h)(2)(A)). The anti-fraud prohibitions of Section
15F(h)(4)(A) apply by their terms to all SBS Entities. Sections
15F(h)(4)(B) and (C) impose certain ``best interests'' obligations
on an SBS Dealer that acts as an advisor to a special entity. See
also Section II.D.2, infra.
    \197\ See, e.g., SIFMA/ISDA 2010 Letter at 2 (``It is essential
that the Commissions articulate a clear standard for the
circumstances that give rise to `advisor' status and the
corresponding imposition of the statutory `fiduciary-like' duty to
act in the best interests of a Special Entity.'')
    \198\ As discussed in note 99, supra, the Department of Labor is
proposing amendments to the definition of a fiduciary under ERISA
that would provide a limited exception for a person that renders
``investment advice'' for compensation if that person ``can
demonstrate that the recipient of the advice knows or, under the
circumstances, reasonably should know, that the person is providing
the advice or making the recommendation in its capacity as a
purchaser or seller of a security or other property, or as an agent
of, or appraiser for, such a purchaser or seller, whose interests
are adverse to the interests of the plan or its participants or
beneficiaries, and that the person is not undertaking to provide
impartial investment advice.'' The Department of Labor in its
proposing release explained that it had determined that ``such
communications ordinarily should not result in fiduciary status * *
* if the purchaser knows of the person's status as a seller whose
interests are adverse to those of the purchaser, and that the person
is not undertaking to provide impartial investment advice.''
Definition of the Term ``Fiduciary,'' 75 FR 65263, 65267 (Oct. 22,
2010).
    \199\ See Letter from Phyllis C. Borzi, Assistant Secretary,
Employee Benefits Security Administration, Department of Labor, to
Gary Gensler, Chairman, CFTC (Apr. 28, 2011) (``In [the Department
of Labor's] view, a swap dealer or major swap participant that is
acting as a plan's counterparty in an arm's length bilateral
transaction with a plan represented by a knowledgeable independent
fiduciary would not fail to meet the terms of the counterparty
exception solely because it complied with the business conduct
standards set forth in the CFTC's proposed regulation.''), http://comments.cftc.gov/PublicComments/CommentList.aspx?id=935.
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    An SBS Dealer that is acting as an advisor must in any case comply
with the requirements of the Dodd-Frank Act. If an SBS Dealer is acting
as an advisor, then under Section 15F(h)(4) and proposed Rule 15Fh-
4(b), it must act in the best interests of the special entity. As part
of its duty to act in the best interests of the special entity, the SBS
Dealer would be required to provide suitable advice.\200\ Consistent
with Section 15F(h)(4)(C), proposed Rule 15Fh-4(b)(2) would require an
SBS Dealer in these circumstances to make reasonable efforts to obtain
the information it considers necessary to make a reasonable
determination that any recommended security-based swap or trading
strategy involving a security-based swap is in the best interests of
the special entity. The proposed rule would identify specific types of
information that the SBS Dealer should take into account in making this
determination. This information would include, but not be limited to,
the authority of the special entity to enter into a security-based
swap; the financial status of the

special entity, as well as future funding needs; the tax status of the
special entity; the investment or financing objectives of the special
entity; the experience of the special entity with respect to entering
into security-based swaps, generally, and security-based swaps of the
type and complexity being recommended; whether the special entity has
the financial capability to withstand changes in market conditions
during the term of the security-based swap; and such other information
as is relevant to the particular facts and circumstances of the special
entity, market conditions and the type of security-based swap or
trading strategy involving a security-based swap being recommended.