DODD FRANK: 2013 The Regulators Extend Their Reach into ......Nomura Holding America Inc. where he...

Seventh Annual Capital Markets SymposiumOctober 2, 2013

DODD FRANK: 2013The Regulators Extend Their Reach into the Capital Markets

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Herrick, Feinstein LLP’s Seventh Annual Capital Markets SymposiumOctober 2, 2013

Keynote Speaker:

Jill E. SommersFormer Commissioner of the Commodity Futures Trading Commission

Symposium Faculty:

Michael OttenExecutive Director, Legal, Nomura Holdings America

Deborah PrutzmanChief Executive Officer, Regulatory Fundamentals Group LLC

Steven SchwartzGlobal Head of Enforcement, Chicago Mercantile Exchange

Therese DohertyPartner, Herrick, Feinstein LLP

Irwin LatnerPartner, Herrick, Feinstein LLP

Patrick SweeneyPartner, Herrick, Feinstein LLP

DODD FRANK: 2013 The Regulators Extend Their Reach into the Capital Markets

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ContentsSpeaker Bios 1

Symposium Materials

Regulation of Swap Dealers under Title VII of the Dodd-Frank Act 9By Patrick D. Sweeney and Samuel BazianHerrick, Feinstein LLP

Regulation of End Users of Swap Transactions under Dodd-Frank 23By Patrick D. Sweeney and Marc ShepsmanHerrick, Feinstein LLP

Cross Border Application of U.S. Swap Regulations: 35 Conflicts Abound at Home and AbroadBy Patrick D. Sweeney, Adam D. Wolper and Kyle ShenfeldHerrick, Feinstein LLP

What’s Happening in Enforcement? 43By Therese M. Doherty, LisaMarie F. Collins and Philip W. RaimondiHerrick, Feinstein LLP

SEC Focus Areas Regarding Investment Advisers 51By Irwin M. Latner and John D. CleaverHerrick, Feinstein LLP

Broker-Dealer Registration Issues Involving Private Funds 63 By Irwin M. Latner and Jessica D. WesselHerrick, Feinstein LLP

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Speaker Bios

Jill E. SommersFormer Commissioner of the Commodity Futures Trading Commission Jill E. Sommers was nominated by both President George W. Bush and President Barack Obama, confirmed twice by the United States Senate and served two consecutive terms as a Commissioner of the Commodity Futures Trading Commission. She ended her six years of service on July 8, 2013. During her time at the agency, Commissioner Sommers was a consistent advocate for common sense regulation that included a thorough cost benefit analysis. In November of 2011, Ms. Sommers was named senior Commissioner with respect to MF Global matters, including overseeing the enforcement division’s investigation and ultimate filing of charges against both the companies as well as senior MF Global executives. Commissioner Sommers served as Chairman and Designated Federal Official of the Commission’s Global Markets Advisory Committee (GMAC), which discussed issues of concern to exchanges, firms, market users and the Commission regarding the regulatory challenges of a global marketplace. She also had the opportunity to represent the United States throughout the world while serving as the Commission Representative to the Technical Committee meetings of the International Organization of Securities Commissions (IOSCO). Ms. Sommers has worked in the commodity futures and options industry in a variety of capacities throughout her career. She served as Policy Director and Head of GovernmentAffairs for the International Swaps and Derivatives Association, where she worked on a number of over-the counter derivatives issues. Prior to that, Ms. Sommers worked in the Government Affairs Office of the Chicago Mercantile Exchange (CME), where she was instrumental in overseeing regulatory and legislative affairs for the exchange. Ms. Sommers started her career in Washington in 1991 as an intern for Senator Robert J. Dole (R-KS). She has continued her work engaging with Members of Congress on a variety of issues over the past twenty years including three Commodity Exchange Act Reauthorizations. A native of Fort Scott, Kansas, Ms. Sommers holds a Bachelor of Arts degree from the University of Kansas. She and her husband, Mike, currently reside in the Washington, DC area and have three children ages 11, 10 and 9.

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Michael J. OttenExecutive Director in the Legal Department of Nomura Holding America Inc. Michael J. Otten is an Executive Director in the Legal Department of Nomura Holding America Inc. where he works closely with Nomura’s registered Swap Dealers, Futures Commission Merchant, Broker-Dealer, and affiliates world-wide on implementation of regulatory reforms. Prior to joining Nomura in July 2012, he spent nearly 10 years at the Commodity Futures Trading Commission (“Commission”) in Washington, DC. While at the Commission, Michael most recently served as Legal Counsel to Commissioner Jill E. Sommers, and also served as Legal Counsel to Acting Chairman Walt Lukken and Chairman Reuben Jeffery. Michael began his tenure at the Commission in the Division of Enforcement, where he served as a Chief Trial Attorney. Prior to joining the Commission, Michael was a Partner in the Litigation Division of LeClair Ryan, a Richmond, Virginia law firm. Michael began his legal career on active-duty in the United States Air Force, Judge Advocate General’s Corps, serving as a Captain from 1994 until 1998. Michael is a graduate of Boston College Law School and Manhattanville College.

Speaker Bios



Deborah PrutzmanChief Executive Officer of the Regulatory Fundamentals Group LLC Deborah Prutzman is the Chief Executive Officer of the Regulatory Fundamentals Group LLC. She has an exceptionally wide-ranging and deep background in the domestic and international financial services industry, and has hands-on experience in regulatory risk management and corporate governance. She has earned a reputation for helping financial institutions thrive despite difficult business circumstances. Ms. Prutzman has assembled a team of highly skilled experts with decades of expertise in the financial services regulatory environment. RFG’s objective is to bring its clients a level of counsel, creativity, and practical expertise that cuts across complex technical areas in a manner not readily available elsewhere. RFG offers an experienced brain trust that has more than 250 years negotiating financial services issues, particularly in the banking, payment and clearing systems, and asset management spaces. As General Counsel to the Merrill Lynch Global Bank Group, Ms. Prutzman conceived and managed the reorganization of Merrill’s U.S. banking operations to create a full service federal thrift, which enabled Merrill to offer banking services throughout its network of financial advisors. She built and recruited a 60+ person team of legal and compliance professionals. Her team handled regulatory and product issues with a unique focus on “knowledge management” systems designed to assure both quality and consistency of results and business partner understanding of key issues. As part of this process, Ms. Prutzman designed the compliance infrastructure and recruited the compliance team professionals for the ML banks in the United States. In addition, she was able to obtain favorable regulatory rulings in a variety of circumstances, including the handling of “brokered deposits.” Ms. Prutzman has also served as General Counsel of CLS Services, the world’s foreign exchange netting system, during its start-up stages. In the absence of precedent, she developed rules and contracts that satisfied the laws and regulations of 13 jurisdictions and allowed 63 of the world’s largest financial institutions to clear foreign exchange transactions on a real-time, continuously linked basis. She recruited and staffed the legal and compliance function. Earlier in her career, Ms. Prutzman was General Counsel for the New York Clearing House Association. Also, Ms. Prutzman served as Senior Vice President and Deputy General Counsel of Chemical Bank. Ms. Prutzman has been a partner at Paul, Weiss, Rifkind, Wharton & Garrison and Arnold & Porter. She earned her law degree from Columbia University.



Speaker Bios

Steven M. SchwartzExecutive Director, Global Head of Enforcement, CME Group Steven M. Schwartz serves as Executive Director, Global Head of Enforcement of CME Group. He is responsible for oversight of the company’s Market Regulation Department enforcement function. Prior to his role as Global Head of Enforcement, he joined the company in 2011 as the Regional Head of Enforcement for New York. Prior to joining the company, he had over 20 years of litigation experience at various law firms. Most recently he was a partner at Winston & Strawn where he litigated complex commercial cases in the futures, securities and bankruptcy areas. He also worked for Hertzog, Calamari & Gleason and Webster & Sheffield where he litigated complex commercial cases, including some involving securities and futures trading, bankruptcy matters and product liability actions. He earned a bachelor’s degree in business management from the State University of New York at Binghamton and a J.D. from Cornell Law School where he graduated Magna Cum Laude and Order of the Coif. He also served as an Editor on the Cornell Law Review.

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Therese M. DohertyPartner and Co-Chair of the Securities and Commodities Litigation and Regulatory Practice Group, Herrick, Feinstein Therese M. Doherty is a senior partner in Herrick’s Litigation Department, and Co-Chair of its Securities and Derivatives Litigation and Regulatory Practice Group. Therese’s practice is focused on derivatives, futures and securities in civil litigations and regulatory enforcement proceedings. She regularly defends and advises broker-dealers, futures commission merchants, banks and other global financial institutions. Clients also rely upon Therese to lead internal investigations. Therese is ranked in the U.S. Legal 500 Legal Directory in the area of securities ligation, which notes that her “depth of industry knowledge, and the ferocity with which she represents clients make her my go-to litigator for significant matters.” Therese has extensive trial and arbitration experience and appears in federal and state courts around the country and different arbitration forums, including FINRA, the NFA and various commodity and security exchanges. Therese’s practice regularly involves complex claims of fraud, violations of commodities and securities laws, RICO violations, and accounting improprieties. Therese’s regulatory practice includes defending firms and individuals in investigations and enforcement proceedings initiated by the CFTC, SEC, U.S. Attorney’s Offices, Attorneys General, self-regulatory organizations, including the NFA and FINRA, and various commodity and security exchanges. She also represents financial institutions in employment related matters, including recruitment disputes, restrictive covenants and issues involving Forms U-4, U-5 and 8T.



Irwin M. Latner Partner and Chair of the Hedge Fund Group, Herrick, Feinstein Irwin Latner has a broad based practice that focuses on representing hedge fund and private equity fund managers in the establishment of private investment funds and their ongoing operations. Irwin represents both domestic and offshore managers who employ varied investment strategies and need assistance with fund set up and structuring, SEC registration and reporting, agreements with strategic investors, developing effective compliance programs, marketing and advertising practices, employment and compensation arrangements, portfolio investment transactions, derivatives, and compliance with the myriad of federal and state securities and commodities laws applicable to their business. In addition to representing investment advisers and fund managers, Irwin represents U.S. and non-U.S. based broker dealers, placement agents, commodity trading advisers, seeding and incubation firms, family offices and other types of financial service companies and alternative investment firms. Irwin regularly speaks at hedge fund industry seminars and is frequently quoted in the press on current hedge fund industry issues. Irwin graduated magna cum laude from Brooklyn Law School.

Speaker Bios



Patrick D. SweeneyPartner and Chair of the Investment Management Group, Herrick, Feinstein Patrick D. Sweeney is Chairperson of Herrick’s Investment Management Practice Group. He represents investment managers, investment funds and investment fund fiduciaries in a wide range of corporate, regulatory and transactional matters. Pat also represents major institutional investors in corporate debt restructuring and non-U.S. investors in inbound investments. Prior to joining Herrick, Pat practiced investment management law in-house for more than 10 years, first as senior investment counsel for Merrill Lynch Asset Management and then as General Counsel to Nomura Corporate Research and Asset Management. He began practicing law in association with Shearman & Sterling in the 1980’s, where he represented financial institutions in corporate, securities and finance transactions. Pat is an active member of the New York City Bar Investment Management Committee and the Investment Company and Investment Adviser Subcommittee of the American Bar Association’s Business Law Section, and has participated for many years in committees, conferences and panel presentations of the Investment Company Institute, the Loan Syndications and Trading Association, the Mutual Fund Directors Forum and many other investment management industry organizations.


DODD FRANK: 2013 Regulation of Swap Dealers under Title VII of the Dodd-Frank Act

By Patrick D. Sweeney and Samuel Bazian


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Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets


Regulation of Swap Dealers under Title VII of the Dodd-Frank ActBy Patrick D. Sweeney and Samuel Bazian1

Title VII of Dodd-Frank imposes a comprehensive regulatory framework on swaps transactions andtheir participants, including swap dealers, major swap participants, and end-users. Title VII containstwo key components. First, it establishes regulations requiring that most swaps be cleared by aregistered derivatives clearing organization (DCO).2 Second, the statute creates rules that parties to aswap must follow, including reporting and disclosure requirements, business conduct standards, andcapital and margin requirements. Finally, Title VII divides regulatory authority over swapstransactions between the U.S. Commodity Futures Trading Commission (CFTC) and the Securitiesand Exchange Commission (SEC).3 Specifically, the CFTC has primary authority over the regulationof swaps, while the SEC has primary authority to regulate security-based swaps. This article willdiscuss solely the CFTC regulations and focus on the rules governing swap dealers.

What is a “Swap Dealer”?Title VII defines a “swap dealer” as “any person who—(i) holds itself out as a dealer in swaps; (ii)makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course ofbusiness for its own account; or (iv) engages in any activity causing the person to be commonlyknown in the trade as a dealer or market maker in swaps, provided however, in no event shall aninsured depository institution be considered a swap dealer to the extent it offers to enter into a swapwith a customer in connection with a originating a loan with that customer.”4 Furthermore, “[a] personmay be designated as a swap dealer for a single type or single class or category of swap or activitiesand considered not to be a swap dealer for other types, classes, or categories of swaps or activities.”5

The term “swap dealer” only applies, however, to a person that enters into swaps as part of his regularbusiness. Thus, if that person engages in swaps transactions for his own account, he or she will not beconsidered a swap dealer. Importantly, there are certain swaps that are not considered in determiningwhether a person or an entity is considered a swap dealer. These include: (1) swaps in which onecounterparty directly or indirectly owns a majority interest in the other; (2) swaps entered into by a“cooperative with a member of such cooperative” if the cooperative has policies requiring themonitoring and reporting of swaps; (3) swaps entered into for the purpose of hedging physicalpositions; and (4) swaps entered into by floor traders.6

Moreover, a person will not be considered a swap dealer as a result of its swap dealing activityinvolving counterparties, so long as the swap positions connected with those dealing activities intowhich the person enters over the preceding 12 months have an aggregate notional amount of no morethan $3 billon, subject to a phase in7 level of an aggregate gross notional amount of no more than $8

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Patrick D. Sweeney is a partner and Samuel Bazian is a summer associate at Herrick, Feinstein LLP.2

See Dodd-Frank Act § 723.3

See Dodd-Frank Act § 712.4

Id. at § 721(49)(A).5

Id. at § 721(49)(B).6

CFTC Regulation § 1.3(6)(ii)(A).7

Pursuant to CFTC regulations, the phase-in termination date is no later than 39 months after “the date that a swap datarepository first receives swap data” from the swap dealer or, in the case where the CFTC terminates this set phase-in period

Seventh Annual Capital Markets Symposium

12 Herrick, Feinstein LLP

billion. This is referred to as the “de minimis exception.” For a swap dealer that enters into swaps with“Special Entities,”8 the de minimis notional threshold amount is $25 million.9

Swap Dealers RegulationsAs of October 12, 2012, a swap dealer is required to register with the CFTC. A dealer that surpassesthe de minimis exception level after that date is required to register with the CFTC within two monthsfollowing the last day of the month in which it exceeds the de minimis threshold amount. 10 Onceregistered, a swap dealer must comply with the voluminous regulations of the CFTC.

Designating a Chief Compliance OfficerA swap dealer is required to designate a chief compliance officer (CCO) who is generally responsiblefor developing “appropriate policies and procedures to fulfill the duties set forth in [Title VII] and[CFTC regulations].” Specifically, the CCO’s duties include administering the registrant swapdealer’s policies and procedures, resolving conflicts of interest, taking reasonable steps to ensurecompliance with CFTC rules, and establishing procedures for the remediation of noncomplianceissues.

Furthermore, the CCO must file an annual report that: describes the registrant’s written code of ethicsand conflicts of interest policies and procedures; reviews the policies in place that are designed toensure compliance with Title VII and CFTC regulations and whether improvements to those policiesare needed; lists any material changes to the policies and procedures in the prior year; describes theresources devoted to compliance; and discusses any noncompliance issues addressed. The CCO orCEO must certify that the report is accurate and complete and file the report electronically with theCFTC within 90 days after the end of the registrant’s fiscal year.

Recordkeeping and Daily Trading Records RequirementsA swap dealer must retain all records relating to swaps activities and the documents on which thetransaction information is originally recorded.11 These records must be kept in a form that issearchable by transaction and counterparty. These records include transaction records, positionrecords, and records of transactions executed on a swap execution facility or designated contractmarket, or cleared by a DCO.

Additionally, a swap dealer must keep full business and financial records, records of complaintsreceived concerning any member of the organization, marketing and sales materials, records of datareported to a swap data repository, and real-time reporting data. Moreover, the regulations require thata swap dealer keep detailed records of its daily trading activities. These records must be sufficientlydetailed so as to make possible a “comprehensive and accurate trade reconstruction for each swap.”12

A swap dealer must also retain all pre-execution trade information that leads to the execution of aswap, including oral and written communications concerning quotes, solicitations, bids, and offers,

and has not published a new phase-in termination date, “five years after the date that a swap repository first receives swapdata.”8

See section below entitles “Swaps and Special Entities.”9

See CFTC Regulation § 1.3(ggg)(iv)((4).10

See http://www.cftc.gov/PressRoom/PressReleases/pr6348-12.11

See CFTC Regulation § 23.201.12

See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/bcs_qas_final.pdf.



regardless of communication media; execution trade information, including the terms upon which aswap is made, the trade ticket for each swap, the unique swap identifier,13 the date and time of theexecution, the name of the counterparty, price of the swap, fees and commissions, and all otherrelevant information; and post-execution trade information, such as post-trade processing and events.

A swap dealer is further required to maintain ledgers listing: payments received; moneys borrowedand loaned; daily calculations relating to the value of each outstanding swap, the current and potentialfuture exposure of each counterparty, initial and variation margin payable to or receivable from eachcounterparty, and the value of all collateral; transfers of collateral; and charges against and credits toeach counterparty’s account. Finally, a swap dealer must keep daily trading records of all cash orforward transactions it executes. All of the records listed above must be kept at the swap dealer’sprincipal place of business. They must be retained for a period of five years from the date the recordwas made and made accessible during the first two years.14

Risk Management and Supervision RequirementsEvery swap dealer must implement a risk management program that identifies risks and sets risktolerance limits based on various factors such as market risk, credit risk, liquidity risk, foreigncurrency risk, legal risk, operational risk, and settlement risk. Every quarter—as well as any time amaterial risk to the entity is detected—the risk management unit of each swap dealer must submit tothe dealer’s governing body a “Risk Exposure Report” detailing the applicable risk exposures. Thereport must consider whether there should be changes to the risk management program and the timeframe for implementing those changes. These reports must be submitted to the CFTC within five daysof the time they are submitted to the governing body.

Before a swap dealer may engage in a transaction involving a new product, the dealer must include inthe Risk Exposure Report a new product policy that considers the product’s characteristics andcounterparty involved, identifies the relevant risks, and assesses whether the product would materiallyalter the overall entity-wide risk profile. Furthermore, a swap dealer must establish policies mandatingthe use of central counterparties when clearing is required and must monitor compliance with the riskmanagement program.

A swap dealer must also establish policies for its business trading unit that require: (1) all tradingpolicies be approved by the entity’s governing body; (2) all counterparties to have an establishedcredit limit; (3) specific quantitative or qualitative limits on the ability of traders to commit the capitalof the swap dealer; and (4) the monitoring, documentation, and auditing of traders’ transactions.

CFTC regulations also require a swap dealer to maintain a system of diligent supervision over allactivities relating to its business performed by all members or agents of the entity to ensurecompliance with all regulations. A dealer must design a business continuity and disaster recovery planthat would enable the entity to resume business activities by the next day following a disaster oremergency.

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See section below entitled “Unique Identifiers.”14

CFTC Regulation § 23.203(b).



Conflicts of Interest Policies and ProceduresThe CFTC has published final rules addressing conflicts of interest.15 Non-research personnel areprohibited from impacting a research analyst’s research report. Similarly, research analysts may notbe supervised or controlled by any employee of the swap dealer, business trading unit, or clearing unit.Moreover, non-research personnel may only review a swap dealer's research reports before publicationwhen necessary to verify the factual accuracy of the report, provide non-substantive editing, oridentify potential conflicts of interest. Even when this minimal level of review is permitted, thereview must be made through authorized legal or compliance personnel of the swap dealer, regardlessof whether it is written or oral. In reviewing a research analyst’s compensation, a swap dealer may notconsider the analyst’s contributions to the swap dealer’s trading or clearing business.

The regulations include significant requirements mandating disclosure of any financial interests that aresearch analyst may have in a derivative that the analyst follows or any other material conflicts ofinterest that the analyst or swap dealer may have. Further, the regulations forbid a swap dealer fromretaliating against a research analyst for an adverse research report.

Additionally, a swap dealer is prohibited from retaliating against any research analyst as a result of theanalyst writing—in good faith—an unfavorable research report that may adversely affect the swapdealer’s pricing, trading, or clearing activities.

Finally, a swap dealer may not interfere with or influence the decision of a clearing unit of anyaffiliated clearing member of a DCO to provide clearing services or to make other decisions relating toa particular customer. Accordingly, a swap dealer must keep separate all information between theswap dealer’s business trading unit and the employees of an affiliated clearing member of a DCO.This partition should ensure that employees of the swap dealer do not influence or control activities ofthe clearing unit in any way.

“Know Your Counterparty”Prior to entering into a swap, a swap dealer must gather basic identification information of acounterparty whose identity is known to it, including the counterparty’s true name and address, as wellas its principal business. The swap dealer must also obtain any facts necessary for implementing itscredit and operational risk management policies, and complying with any laws, rules, or regulations. Aswap dealer “may rely on the written representations of a counterparty to satisfy its due diligencerequirements… unless it has information that would cause a reasonable person to question theaccuracy of the representation.”16

Prohibition on FraudThe CFTC regulations generally prohibit a swap dealer from engaging in fraud. They do, however,provide for affirmative defenses to allegations of fraudulent activity if the swap dealer actedunintentionally or complied with the relevant policies and procedures in good faith. The regulationsalso prohibit a swap dealer from disclosing to anyone information provided by a counterparty to theswap dealer or using the confidential information for its own purposes in a way that is materiallyadverse to the counterparty’s interests.

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CFTC Regulation § 23.605.16

CFTC Regulation § 23.402(d).



Verification of Counterparty EligibilityBefore a swap dealer may enter into a swap with a counterparty, the dealer must verify whether thecounterparty is an “eligible contract participant”17 and whether the counterparty is a Special Entity.18

The swap dealer must verify whether the counterparty is eligible to elect to be a Special Entity, and ifso, it must notify the counterparty of that fact. In fulfilling these requirements, the dealer may rely onthe counterparty’s written representations.

Disclosure RequirementsBefore entering into a swap, a swap dealer must disclose to its counterparty any information necessaryto allow its counterparty to assess the material risks, characteristics, incentives, and conflicts ofinterest relating to the transaction. If the swap is one that is not made available for trading on adesignated contract market (DCM) or swap execution facility (SEF), the swap dealer is additionallyrequired to notify its counterparty that the counterparty may request and consult on the design of ascenario analysis to allow the counterparty to assess the potential risk exposure if it were to enter intothe swap. These disclosure requirements, however, do not apply to swaps that are initiated on a DCMor SEF, or to swaps in which the swap dealer does not know the identity of the counterparty prior toexecution.

For uncleared swaps, the swap dealer is required to provide the counterparty with the mid-marketmark of the swap, which excludes amounts for profit, credit reserve, hedging, funding, liquidity, andany other costs or adjustments. It must also provide the methodology and assumptions used to preparethe daily mark and any material changes during the term of the swap, as long as that information isneither confidential nor proprietary. With respect to cleared swaps, however, a swap dealer need onlynotify the counterparty that is has a right to receive the daily mark from the appropriate DCO. Thisdaily mark must be provided to the counterparty during the term of the swap as of the close ofbusiness or such other time as the parties agree in writing.

For swaps that are required to be cleared, a swap dealer must notify its counterparty that thecounterparty has the sole right to choose the DCO at which the swap will be cleared. If the swap is notrequired to be cleared, the swap dealer must inform the counterparty that it may elect to requireclearing of the swap and the right to choose the DCO at which the swap will be cleared.

Institutional SuitabilityA swap dealer that recommends a swap or trading strategy involving a counterparty must: (1)undertake reasonable diligence to understand the potential risks and rewards associated with therecommended swap or trading strategy involving a swap; and (2) have a reasonable basis to believe

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Title VII provides that it is unlawful for any person other than an Eligible Contract Participant (“ECP”) as defined

in the CEA, to enter into a swap unless executed on a DCM. There are multiple definitions for an ECP, but the twothat are most germane are: (1) a corporation, partnership, proprietorship, trust, or other entity that (i) has totalassets exceeding $10 million, or (ii) has a net worth exceeding $1 million and enters into an agreement inconnection with the conduct of the entity’s business or to manage the risk associated with an asset owned orincurred or reasonably likely to be owned or incurred by the entity; or (2) an individual who has amounts investedin excess of (i) $10 million, or (ii) $5 million and who enters into an agreement to manage the risk associated withan asset owned or incurred or reasonably likely to be owned or incurred by the individual.18

See section on Swaps and Special Entities.



that the recommended swap or trading strategy involving a swap is suitable for the counterparty.19 Aswap dealer must reasonably base its recommendations on information about the counterparty,including the counterparty’s investment profile, trading objectives, and ability to absorb losses. A safeharbor for the swap dealer regarding this “suitability” requirement exists if: (1) the dealer reasonablydetermines that the counterparty has delegated decision-making authority and is capable of evaluatinginvestment risks regarding the swap; (2) the counterparty or its agent represents in writing that it isexercising independent judgment in evaluating the swap dealer’s recommendations; (3) the swapdealer informs the counterparty that it has not assessed the suitability of the swap for the counterparty;or (4) if the counterparty is a Special Entity, the swap dealer complies with the requirements fordealing with a Special Entity.

Swaps and Special EntitiesThe CFTC has enacted special rules for a swap dealer that acts as an advisor or counterparty to SpecialEntities. A Special Entity is defined as: (1) a federal agency; (2) a state, state agency, city, county,municipality, other political subdivision of a state, or any instrumentality, department, or a corporationof or established by a state or political subdivision of a State; (3) any employee benefit plan subject toTitle I of ERISA20; (4) any governmental plan as defined in Section 3 of ERISA; (5) any endowment,including an endowment that is an organization described in Section 501(c)(3) of the Internal RevenueCode; or (6) any employee benefit plan defined in ERISA not otherwise defined as a Special Entity,that elects to be a Special Entity by notifying a swap dealer or major swap participant of its electionprior to entering into a swap with the particular swap dealer or major swap participant.21

A swap dealer acts as an advisor to a Special Entity when it recommends a swap or trading strategythat is tailored to the Special Entity’s specific needs. When a swap dealer advises Special Entities,22 ithas a duty to determine that its recommendations are in the best interests of the Special Entity andmust make reasonable efforts to obtain the necessary information to make this determination,including: (1) financial and tax statuses; (2) hedging, investment, and financing objectives; (3)experience of the Special Entity in entering into swaps; (4) and other facts and circumstances relevantto the Special Entity, market conditions, and the type of swap strategy involved.

On the other hand, there are separate regulations for a swap dealer that acts as a counterparty toSpecial Entities. The first requirement is that the swap dealer must have a reasonable basis to believe

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CFTC Regulation § 23.434.20

ERISA is the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002).21

CFTC Regulation § 23.401(c).22

CFTC Regulation § 23.440(b) provides that a swap dealer does not act as advisor to a Special Entity that is an employeebenefit plan if the Special Entity represents in writing that it has a fiduciary—as defined in Section 3 of ERISA—that isresponsible for representing the Special Entity in connection with the swap transaction, the fiduciary represents in writingthat it will not rely on the swap dealer’s recommendations, and the Special Entity represents in writing that it will complyin good faith with the written policies and procedures designed to ensure that the swap dealer’s recommendation to theSpecial Entity is evaluated by a fiduciary prior to the transaction. In addition, a swap dealer does not act as an advisor toany Special Entity when: the swap dealer does not express an opinion as to whether the Special Entity should enter into aswap or trading strategy involving a swap that is tailored to the particular need of the Special Entity; the Special Entityrepresents in writing that it will not rely on the swap dealer’s recommendations, and instead, it will rely on advice from aqualified independent representative; and the swap dealer discloses to the special entity that it is not undertaking to act inthe best interests of the Special Entity.



that the Special Entity23 has a representative that: (1) has sufficient knowledge to evaluate thetransaction and risks involved; (2) is not subject to a statutory disqualification; (3) is independent ofthe swap dealer; (4) undertakes the duty to act in the best interest of the Special Entity; (5) makesappropriate and timely disclosures to the Special Entity; and (6) evaluates fair pricing and theappropriateness of the swap. A swap dealer dealing with Special Entities defined under Section23.451(c)(2) or (4) must also ensure that the Special Entity’s representative is subject to certainrestrictions on the political contributions that he or she may make.24

Finally, to prevent fraud, the CFTC regulations prohibit a swap dealer from offering to enter orentering into a swap or trading strategy with a governmental Special Entity within two years after anycontribution to an official of that government Special Entity was made by the swap dealer or by acovered associate of the swap dealer.25 Moreover, a swap dealer and its covered associates may not:(1) provide any payment to anyone for the purposes of soliciting a government Special Entity to offerto enter into or to enter into a swap with that swap dealer, unless that person is a regulated person;26 or(2) coordinate or solicit any person or political action committee to contribute to an official of agovernmental Special Entity or a political party of a state or locality with which the swap dealer isoffering to enter into or has entered into a swap.

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The requirements set forth in the paragraph that follows does not apply to employee benefit plans subject to Title I ofERISA. When acting as a counterparty to these Special Entities, a swap dealer must reasonably believe that the entity hasa representative that is a fiduciary as defined by ERISA.24

See CFTC Regulation § 23.450(b)(1)(vii).25

CFTC Regulation § 23.451 defines a “covered associate” as “(i) any general partner, managing member, or other personwith a similar status or function; (ii) any employee who solicits a governmental Special Entity for the swap dealer and anyperson who supervises, directly or indirectly, such employee; and (iii) any political action committee controlled by theswap dealer or by [anyone listed in the above sections].”26

CFTC Regulation § 23.451 defines a “regulated person” as “(i) A person that is subject to restrictions on certain politicalcontributions imposed by the Commission, the Securities and Exchange Commission, or a self-regulatory agency subject tothe jurisdiction of the Commission or the Securities and Exchange Commission; (ii) A general partner, managing member,or executive officer of such person, or other individual with a similar status or function; or (iii) An employee of suchperson who solicits a governmental Special Entity for the swap dealer and any person who supervises, directly orindirectly, such employee.”



Proposed Capital and Margin RequirementsThe CFTC has proposed capital and margin requirements for swap dealers.27 First, a swap dealerwould be required to maintain tangible net equity28 of at least $20 million plus an amount that wouldcover its market risk exposure and its over-the-counter derivatives credit risk associated with swappositions and hedge positions, or the minimum amount of capital required by a registered futuresassociation of which the swap dealer is a member, whichever is greater.29

If the swap dealer is a subsidiary of a U.S. bank holding company, the swap dealer must maintain thegreatest amount of: (1) $20 million of Tier 1 capital; (2) the swap dealer’s minimum risk-based ratiorequirements as if the swap dealer itself was a U.S. bank-holding company; or (3) the amount ofcapital required by a futures association of which the swap dealer is a member.30

Second, the proposed regulations provide detailed margin requirements for uncleared swaps that differbased on whether the swap is between a covered swap entity31 and swap dealer,32 a covered swapentity and financial entity,33 or a covered swap entity and non-financial entity.34 These rules wouldgenerally require each covered swap entity to require its counterparty to post initial margin calculatedunder the credit support arrangements with the counterparty that are consistent with proposed Section23.155.35

It is also important to note that Title VII provides that a swap dealer is required to notify thecounterparty at the beginning of the transaction that “the counterparty has the right to requiresegregation of the funds or other property supplied to margin, guarantee, or secure the obligations ofthe counterparty.”36 If the counterparty requests that the funds be segregated, the account must becarried out by an independent third-party custodian and designated as a segregated account for thecounterparty. If the counterparty does not require segregation, the swap dealer must report on aquarterly basis to the counterparty that the procedures relating to margin and collateral requirementscomply with the parties’ agreement.

Reporting RequirementsOne of the most important regulations with which a swap dealer must comply is the swap datareporting requirement. As a threshold matter, the regulations provide that only one party to a swapmust report the swap data; the regulations set rules by which the parties may determine who is

_______________________________________________________________________________________________________________27

The proposed CFTC capital requirements discussed here do not apply to a registered swap dealer that is already subjectto minimum capital requirements established by a prudential regulator or to a swap dealer that also is a registered futurescommission merchant that is subject to certain other capital requirements.28


CFTC Regulation § 23.101(a)(1).30

CFTC Regulation § 23.101(a)(2).31

A “covered swap entity” is a swap dealer or major swap participant for which there is no prudential regulator. ProposedCFTC Regulation § 23.150.32

See Proposed CFTC Regulation § 23.152.33



Proposed CFTC Regulation § 23.152.36

Title VII, § 724(c).



obligated to be the “reporting party.”37 Any instance in which a swap dealer is a party to a swap—andwhen one of the counterparties will be required to report the swap data38—the swap dealer will be thereporting party.39 The swap dealer must report all of the data related to a swap to a single swap datarepository.40 A swap data repository is defined as “any person that collects and maintains informationor records with respect to transactions or positions in, or the terms and conditions of, swaps enteredinto by third parties for the purpose of providing a centralized recordkeeping facility for swaps.’’41 Allreporting parties must report the swap data electronically to a swap data repository as soon astechnologically practicable and within specified time frames.

Creation DataA swap dealer must report information relating to the swap at two separate times: as soon as possibleafter execution of the swap and during the life of the swap. The first event that triggers the reportingrequirement is the execution of a swap. At that time, a swap dealer must report the swap “creationdata.” Swap creation data is the confirmation data and the primary economic terms data of the swap.42

The rules that a swap dealer must follow with regard to reporting differs based on whether the swap is:(1) executed on an SEF or DCM and subject to mandatory clearing; (2) executed on an SEF or DCMand not subject to mandatory clearing; (3) not executed on an SEF or DCM and subject to mandatoryclearing; or (4) not executed on an SEF or DCM and not subject to mandatory clearing. First, if theswap is executed on an SEF or DCM and must be cleared, the swap dealer is not required to report anyinformation; instead, the SEF/DCM must report the primary economic terms data, and the DCO mustreport the confirmation data. Second, if the swap is executed on an SEF/DCM and not subject tomandatory clearing, the SEF/DCM must report the primary economic terms data, and the swap dealermust report the confirmation data. Third, if the swap is not executed on or pursuant to the rules of anSEF or DCM—this is referred to as an off-facility swap—but is required to be cleared, the swap dealermust report the primary economic terms, and the DCO must report the confirmation data. Finally, ifthe swap is neither executed on an SEF or DCM nor required to be cleared, the swap dealer mustreport all of the creation data.43 In general, if the swap is not subject to mandatory clearing but theswap is submitted voluntarily to and accepted by a DCO for clearing, the swap dealer is excused fromreporting swap creation data.

_______________________________________________________________________________________________________________37


As discussed below, there are certain instances in which neither party will be required to report the swap data and,instead, an SEF, DCM, or DCO will be required to report the data.39

If both parties are swap dealers, the parties must agree which of them will report the swap data. See CFTC Regulation §45.8(d).40

Id. at § 45.10.41

7 U.S.C. 1a(48).42

See CFTC Regulation § 45.3(a)(1). The regulations define “confirmation data” as “all of the terms of the swap matchedand agreed upon by the counterparties in confirming the swap. For cleared swaps, confirmation data also includes theinternal identifiers assigned by the automated systems of the [DCO] to the two transactions resulting from the novation tothe clearing house.” In addition, “primary economic terms” is defined as “all of the terms of a swap matched or affirmedby the counterparties in verifying the swap…” CFTC Regulation § 45.1.43

It is important to note that the deadlines for reporting this creation data following the execution of a swap varies basedon these four scenarios, as well. For specific rules regarding the reporting timeframe that a swap dealer, SEF or DCM, andDCOs must comply with, see CFTC Regulation §§ 45.3-45.4.



Continuation and Valuation DataIn addition to reporting creation data after the swap is executed, a swap dealer must also report swap“continuation data” to a swap data repository throughout the swap’s existence until its expiration ortermination. The regulations allow reporting parties to fulfill this requirement by reporting either “lifecycle event data” or “state data,” as long as the method chosen ensures that the swap data provided tothe swap data repository remains accurate. Moreover, a swap dealer must report “valuation data.”Life cycle event data is information relating to a change in primary economic terms previouslyreported to an SDR, and state data is “the data necessary to provide a snapshot view, on a daily basis,of all of the primary economic terms of a swap… including any change to any primary economic termor to any previously-reported primary economic terms data since the last snapshot.”44 Valuation datais used to describe the daily mark of the transaction.

Like the reporting of creation data, the party that must report the continuation and valuation datadepends on whether the swap is cleared by a DCO. If it is cleared by a DCO, the DCO—and not theswap dealer—will be required to report the continuation data, and both the DCO and swap dealer mustreport the valuation data; if the swap is not cleared, the swap dealer must report the continuation andvaluation data. If the swap dealer elects to submit life cycle event data, it must report the informationon the same day that the event occurs.45 State data, on the other hand, must be reported daily.Furthermore, the swap dealer must report daily the valuation data relating to the swap.

Finally, the CFTC has adopted final rules requiring parties to a swap to report any publiclyreportable46 swap transaction and pricing data to a swap data repository in real-time.47 Real-timepublic reporting is defined as the “reporting of data relating to a swap transaction, including price andvolume, as soon as technologically practicable after the time at which the swap transaction has beenexecuted.”48 The swap data repository, in turn, is required to disseminate the swap transaction andpricing data to the public.

Like the other reporting regulations, if the swap is executed on or pursuant to an SEF or DCM, theSEF/DCM must report the transaction data. If the swap is an off-facility swap and one of the parties toa swap is a swap dealer, the swap dealer will be the party required to report the real-time transactiondata.49

Unique IdentifiersTo enable regulators to aggregate and link data together across counterparties, asset classes, andtransactions, the regulations provide that reporting parties must create unique identifiers for all swap

_______________________________________________________________________________________________________________44

Id. at § 45.1.45

If the life cycle event relates to a corporate event of the non-reporting counterparty, the swap dealer must report the lifecycle event within two business days. Id. at § 45.4(c)(1)(i)(A).46

A publicly reportable swap transaction is: (1) any executed swap that is an arm’s length transaction that results in acorresponding change in market risk position between the two parties; or (2) any termination, assignment, novation,exchange, transfer, amendment, conveyance, or extinguishing of rights or obligations of a swap that changes the price of aswap. Id. at § 43.2.47

The reporting party must provide the swap data repository with the data listed in Appendix A to Part 43. See id. at §43.4(a).48

Id. at § 43.2.49

Id. at § 43.3(a).



data. These identifiers include a unique swap identifier (USI), legal entity identifier (LEI), and uniqueproduct identifier (UPI).50 The parties and transactions that are required to be identified depend onwhether the swap is executed on an SEF or DCM. For swaps executed on an SEF or DCM, the USIcontains codes assigned to the SEF or DCM and to the swap. For off-facility swaps, the USI containscodes assigned to the swap dealer and the swap. The SEF/DCM or swap dealer must create the USIand transmit the identifier to the swap data repository to which the reporting counterparty reportscreation data, the non-reporting counterparty, and the DCO, if applicable.

LEIs—currently referred to as CFTC Interim Compliant Identifiers51— identify the counterparties to aswap. The goal of LEIs is to establish a standard global identifier by which regulators may identifycounterparties to a swap. Last, the UPI is used to categorize the swap asset class and the underlyingproduct for the swap.

Historical Swap Data ReportingA swap dealer is required to report data on “historical swaps,” which includes “pre-enactment swaps”and “transition swaps.”52 Pre-enactment swaps are swaps that the counterparties entered into prior toDodd-Frank’s enactment53 and which still existed as of April 25, 2011. Transition swaps are swapsthat were executed after Dodd-Frank was enacted but before the regulations’ compliance date, andwere still in existence as of April 25, 2011.

The reporting party to a historical swap is required to submit an initial data report (IDR) to a swap datarepository—or to the CFTC if no swap database for swaps in the asset class in question exists—containing: the minimum primary economic terms data;54 the swap dealer’s LEI; the identifier used toidentify the non-reporting counterparty; and the internal identifier used to identify the swap. Inaddition, the reporting party to a historical swap must report continuation data in the same way as ifthe swap were not a historical swap. If the pre-enactment swap expired or was terminated before April25, 2011, the swap dealer must report such information relating to the terms of the transaction that theswap dealer had in its possession as of October 14, 2010. For transition swaps that expired orterminated prior to April 25, 2011, the swap dealer must report such information relating to thetransaction that was in its possession as of December 17, 2010.

ISDA ProtocolsBecause of the onerous burden of complying with the CFTC’s disclosure and reporting regulations,the International Swaps and Derivatives Association (ISDA) issued protocols on August 13, 2012, andMarch 22, 2013, with the aim of facilitating compliance with these rules. The Protocols simplify theprocess of amending existing swap relationship documentation so that parties to a swap may complywith new CFTC regulations and, in turn, engage in swaps transactions. The ISDA Protocols allowparties to a swap to amend their swaps documentation quickly and avoid the difficulties and

_______________________________________________________________________________________________________________50

Id. at § 45.5-45.7.51

See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/leiamendedorder.pdf.52


Dodd-Frank was enacted on July 21, 2010.54

See Appendix 1 to 17 CFR 46.



inefficiencies associated with lengthy bilateral negotiations and disruptions to their regular tradingactivities.55

The Protocols function by providing swap participants with a standard set of amendments that aredesigned to ensure compliance with Title VII. Parties to a swap that utilize the ISDA Protocols havethe ability to: “(i) supplement the terms of existing master agreements under which parties mayexecute Swaps or (ii) enter into an agreement to apply selected Dodd-Frank compliance provisions totheir trading relationship in respect of Swaps.”56 In addition, ISDA plans to issue additional protocolsthat amend swap participants’ existing documentation so that they may comply with futureregulations.

The ISDA August 2012 and March 2013 DF ProtocolsThe ISDA August 2012 Dodd-Frank Protocol was implemented to address CFTC regulationsregarding: (1) business conduct standards for swap dealers and major swap participants withcounterparties; (2) large trader reporting for physical commodities swaps; (3) position limits forfutures and swaps; (3) real-time public reporting; (4) recordkeeping and reporting requirements, chiefcompliance officer rules, and conflicts of interest; and (5) historical swaps. These requirements alsoinclude the “know your counterparty” and verification of counterparty eligibility rules. The protocolcovers existing agreements between parties to a swap and adds notices, representations, and covenantsregarding the new CFTC regulations that must be satisfied before a swap transaction may be executed.

ISDA has also issued the March 2013 DF Protocol, which is referred to as the “DF Protocol 2.0.” ThisProtocol is intended to address new CFTC final regulations regarding: (1) confirmation, portfolioreconciliation, portfolio compression, and swap trading relationship documentation requirements forswap dealers and major swap participants; (2) the end-user exception to the clearing requirement forswaps; and (3) the clearing requirement determination under section 2(h) of the CEA.

These Protocols enable counterparties to make single, comprehensive data disclosures to a universe ofswap dealers. Parties that wish to supplement their swap documentation with the Protocols mustcomplete an adherence letter agreeing to the terms of the Protocol Agreement,57 a questionnaire thatmust be submitted to the other Protocol participant, and other documentation. Once the parties to aswap complete these steps, the Protocol amendments apply to their master agreements.

_______________________________________________________________________________________________________________55

See http://www2.isda.org/functional-areas/protocol-management/faq/8/.56

See ISDA August DF Protocol, available at http://www2.isda.org/functional-areas/protocol-management/protocol/8.57

Note that there is a one-time adherence fee of $500.

DODD FRANK: 2013 Regulation of End Users of Swap Transactions under Dodd-Frank

By Patrick D. Sweeney and Marc Shepsman





Regulation of End Users of Swap Transactions under Dodd-FrankBy Patrick D. Sweeney and Marc Shepsman 1

IntroductionTitle VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)amends the Commodity Exchange Act (“CEA”) and the Securities Exchange Act of 1934 (the“Exchange Act”) to implement a new and comprehensive regulatory regime for previouslyunregulated over-the-counter (“OTC”) swaps and security-based swaps. In response to the 2007financial crisis, Congress enacted Title VII to reduce systemic risk, increase transparency, andpromote market integrity, by regulating swap dealers (“SDs”) and major swap participants (“MSPs”)and by creating sweeping new clearing, reporting, recordkeeping, and execution requirements forswap transactions. The clearing requirement, according to the CFTC, is “at the heart of Dodd-Frank,”and the new legislation makes it unlawful for any person to engage in most swap transactions unlessthat person submits the swap for clearing to a derivatives clearing organization (“DCO”). Certain end-users are eligible to avoid the clearing requirement. However, end-users will be subject to a number ofrequirements under Title VII regardless or whether their swaps are cleared.

The Clearing RequirementThe core of Title VII’s regulatory overhaul is the clearing requirement. Title VII now makes itunlawful for any person to enter into a swap transaction unless that person submits the swap forclearing to a registered DCO, or a DCO exempt from registration. The clearing requirement, however,does not apply to any particular swap until that type of swap has been determined by the CFTC to beeligible for clearing. When a swap is cleared, futures commission merchants (“FCMs”) act as clearingbrokers for the original swap counterparties, and bring the swap to the DCO for clearing. The DCOinterposes itself into the swap transaction, thus creating two swap transactions, each of them betweenthe DCO and one of the clearing brokers. The premise for the clearing requirement is that DCOs willhelp eliminate or diminish counterparty credit risk if they are mandated to: (1) collect initial andvariation margin associated with swap positions; (2) mark these positions regularly and issue margincalls; (3) adjust margin requirements; and (4) close out swap positions of a customer that does notmeet the margin calls. In the event that a FCM defaults, the DCO has a number of tools at its disposalto help manage and mitigate the associated risks, including transferring the defaulted swap position,and covering the losses of the default.

The DCO must provide for non-discriminatory clearing of a swap executed bilaterally or through therules of an unaffiliated designated contract market (“DCM”) or swap execution facility (“SEF”). Allpersons executing a non-exempted swap must submit each swap to any eligible DCO as soon astechnologically practicable, but in any event by the end of the day of execution. Counterparties to aswap transaction must either execute the transaction on the DCM, or on a registered or exempt SEF.Such execution is mandatory if the swap is required to be cleared, and made available to trade by aSEF or DCM. Each person must take reasonable efforts to verify whether the CFTC has made adetermination requiring clearing of the type of swaps in which such person engages.

In December 2012, the CFTC made a determination to require clearing of interest rate swaps andcredit default swaps. The CFTC has mandated compliance dates for clearing of interest rate swaps and

_______________________________________________________________________________________________________________1

Patrick D. Sweeney is a partner and Marc Shepsman is a summer associate at Herrick, Feinstein LLP.



credit default swaps. Category One entities, which include SDs, security-based SDs, MSPs, security-based MSPs, and active funds, which are funds that execute 200 or more swaps per month, had untilApril 26, 2013, to comply with the clearing requirement. Category Two entities, which include acommodity pool, private fund, or persons predominantly engaged in the business of banking, had untilJuly 25, 2013, to comply. All market participants must comply by October 23, 2013.

The End-User ExceptionTitle VII provides an exception to the clearing requirement for certain end-users of swap products. Theclearing requirement shall not apply if one of the counterparties to a swap: (i) is not a financial entity;(ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission how itgenerally meets its financial obligations associated with entering into non-cleared swaps.

Financial EntityA financial entity includes: (I) an SD; (II) a MSP; (III) a commodity pool; (IV) a private fund; (V) anemployee benefit plan; and (VI) a person predominantly engaged in the business of banking. Thesepersons thus cannot avail themselves of the end-user exception.

However, the Commission has permitted certain financial entities to rely upon the end-user exceptionunder the small financial institution (“SFI”) exemption. A financial entity will qualify for thisexemption if it: (i) is organized as a bank, the deposits of which are insured; a savings association,similarly insured; a farm credit system institution; or insured federal credit union or state-charteredcredit union; and (ii) has assets of $10 billion or less on the last day of such person’s most recent fiscalyear.

Moreover, the financial entity exclusion will not cover an entity whose primary business is providingfinancing, provided that it uses derivatives for the purpose of hedging underlying commercial risksrelated to interest rate and foreign currency exposures, ninety percent or more of which arise fromfinancing that facilitates the purchase or lease of products, ninety percent or more of which aremanufactured by the parent company or another subsidiary of the parent company.

Hedge or Mitigate Commercial RiskIn order to qualify for the end user exception, Title VII requires that one of the counterparties to theswap use the swap to hedge or mitigate commercial risk. The CFTC has clarified that a swap will beconsidered as used to hedge or mitigate commercial risk if the swap is economically appropriate to thereduction of risks of the conduct and management of a commercial enterprise, where the risks arisefrom: (A) the potential change in value of assets a person owns, produces, manufactures, processes, ormerchandises, or reasonably anticipates owning, producing, manufacturing, processing ormerchandising, in the ordinary course of business; (B) the potential change in value of liabilities that aperson has incurred or reasonably expects to incur; (C) the potential change in value of services that aperson provides or anticipates providing; (D) the potential change in the value of assets, services,inputs, products, or commodities that a person owns, produces, manufactures, processes,merchandises, leases, or sells, or reasonably anticipates the same; (E) any potential change in valuerelated to the foregoing arising from interest, currency, or foreign exchange rate movements; or (F)any fluctuation in interest, currency, or foreign exchange rate exposures arising from that person’sassets or liabilities.



In addition to the foregoing, the swap must not be “in the nature of speculation, investing, or trading”or used to hedge or mitigate the risk of another swap position, unless that position is itself used tohedge or mitigate commercial risk as defined above.

Notification of How End User Meets Financial ObligationsA counterparty which elects the end-user exception must notify the CFTC of its identity, and indicatewhether the counterparty is a financial entity, and, if so, the basis for relying upon the exception. Thecounterparty must further notify the Commission whether the swap is being used to hedge or mitigatecommercial risk. Finally, an electing counterparty must notify the Commission how it generally meetsits financial obligations by identifying one, or more, of the following categories: (1) a written creditsupport agreement; (2) pledged or segregated assets; (3) a written third-party guarantee; (4) thecounterparty’s available financial resources; or (5) means other than categories (1) through (4). Anelecting counterparty with publicly traded securities must also include its SEC Central Index Keynumber, and indicate whether an “appropriate committee” of that counterparty’s board of directors hasreviewed and approved the decision to elect the end-user exception.

In anticipation of electing the exception, an entity that qualifies for the end-user exception mayannually report all of the aforementioned information. Such reporting remains effective for 365 days,during which the electing counterparty must amend any information as necessary to “reflect anymaterial changes to the information reported.” In lieu of filing the notice itself, the end-user may relyupon the SD counterparty to report the necessary information to the CFTC on a transaction-by-transaction basis.

Treatment of AffiliatesAn affiliate of a person who qualifies for the end-user exception, including affiliate entitiespredominantly engaged in providing financing for the purchase of the merchandise or manufacturedgoods of the person, may qualify for the end-user exception if the affiliate, acting on behalf of theperson as an agent, uses the swap to hedge or mitigate the commercial risk of the person or otheraffiliate of the person that is not a financial entity. However, this affiliate rule does not apply toaffiliates which are: (1) SDs; (2) MSPs; (3) an issuer that is an investment company as defined bysection 3 of the Investment Company Act, but for paragraph (1) or (7) of subsection (c); (4) acommodity pool; or (5) a bank holding company with over $50 billion in consolidated assets.

Clearing vs. TradingThe end-user exception may excuse an end-user from the clearing requirement, but the end-user willcontinue to have an obligation to trade its swap on a DCM, unless the end-user is an “eligible contractparticipant” (“ECP”). To the extent that a DCM requires swaps traded thereon to be cleared, ECPstatus becomes a fourth condition to the availability of the end-user exception.

Segregation and Bankruptcy TreatmentTitle VII provides for the protection of collateral posted by swaps customers for cleared swaps, byimposing segregation and non-commingling requirements on FCMs. Moreover, Title VII grants tocleared swaps the protections accorded to counterparties to “commodity contracts” in the event of theliquidation of a FCM or DCO under the Bankruptcy Code.



Segregation Requirements for Cleared SwapsThe CFTC has required that an FCM must segregate all “Cleared Swaps Customer Collateral that itreceives. There are two permitted methods of segregation: (1) the FCM may deposit the collateral intoa Cleared Swaps Customer Account held at a Permitted Depository; or (2) the FCM may hold thecollateral itself, in which case it must (i) physically separate such collateral from its own property; (ii)clearly identify each physical location in which it holds such collateral as a “Location of ClearedSwaps Customer Collateral” (the “FCM Physical Location”); (iii) ensure that the FCM PhysicalLocation provides appropriate protection for such collateral; and (iv) record in its books and recordsthe amount of such Cleared Swaps Customer Collateral separately from its own funds. A FCM maycommingle Cleared Swaps Customer Collateral that it receives on, for, or on behalf of multipleCleared Swaps Customers, but it may not commingle such collateral with funds belonging to theFCM, or other categories of funds belonging to the Cleared Swaps Customers of the FCM.Furthermore, an FCM is prohibited from using the Cleared Swaps Customer Collateral of one ClearedSwaps Customer to purchase, margin, or settle the Cleared Swaps of any person other than suchCustomer.

Notwithstanding the foregoing prohibition, an FCM may: (1) invest money, securities or otherproperty constituting Cleared Swaps Customer Collateral; and (2) withdraw such share of the ClearedSwaps Customer Collateral as is necessary in the normal course of business to margin, guarantee,secure, transfer, adjust or settle a Customer’s Cleared Swaps with a DCO, or with a Collecting FCM,and may also apply such share to the payment of commissions, brokerage, interest, taxes, storage, andother charges in connection with such Cleared Swaps. The CFTC subjects DCOs to similarsegregation and non-commingling requirements.

Segregation Requirements for Uncleared SwapsFor swaps not required to be cleared, Title VII requires that an SD or MSP notify the counterparty tothe swap transaction that the counterparty has the right to require segregation of funds or otherproperty supplied to margin, guarantee, or secure the obligations of the counterparty. Furthermore, atthe request of a counterparty that provides such funds to a SD or MSP, the SD or MSP must: (1)segregate the funds for the benefit of the counterparty; and (2) maintain the funds in a segregatedaccount, separate from the assets and other interests of the SD or MSP. If the counterparty does electto require segregation, the SD or MSP must report to the counterparty on a quarterly basis that theback office procedures of the SD or MSP relating to the margin and collateral requirements are incompliance with the agreement of the counterparties.

It should be noted that although the rule has not yet been finalized, the CFTC has proposed rulesmandating SDs and MSPs to require end-users to post initial margin and variation margin as neededpursuant to the credit support agreement between them before execution of the swap, and prior to itsliquidation.

Commodity ContractsSection 724(b) of the Dodd-Frank Act amended the Bankruptcy Code to clarify that cleared swaps are“commodity contracts.” Accordingly, in the event of an FCM or DCO liquidation, customers areentitled to certain protections, including the ability to close out cleared swaps and transfer cleared



swaps and collateral. If cleared swaps are subject to liquidation, customers will receive preferentialtreatment of the remaining collateral. For bankruptcy purposes, customer collateral in cleared swapsaccounts is treated analogously to collateral in customer futures accounts.

Recordkeeping and Reporting Requirements

Recordkeeping17 C.F.R. § 45.2 provides that each SEF, DCM, DCO, SD, and MSP must keep “full, complete, andsystematic records, together with all pertinent data and memoranda, of all activities relating to thebusiness of such entity or person with respect to swaps” that fall within the jurisdiction of the CFTC.End-users are subject to a less onerous standard. They are required to keep “full, complete, andsystematic records” with respect to each swap to which they are a counterparty, including all recordsdemonstrating that they are entitled to elect the end-user exception. End-users must keep all recordsrequired to be kept throughout the life of the swap, and for a period of at least five years followingfinal termination of the swap. End-users are permitted to keep required information in either electronicor paper form, so long as the record is retrievable, and the information contained therein is reportable.The CFTC requires records to be retrievable within five business days throughout the period duringwhich the records are required to be kept.

For pre-enactment and transition swaps (“historical swaps”) in existence after April 25, 2011, eachcounterparty to the swap must keep: (1) the minimum primary economic terms of the swap; and (2)any additional records that a counterparty has in its possession at any time on or after April 25, 2011,including: (a) confirmation data; (b) any master agreement governing the swap; and (c) any creditsupport agreement. For pre-enactment swaps that have been terminated by April 25, 2011, eachcounterparty must keep all of the documents relating to the terms of the swap that were possessed onor after October 14, 2010. For transition swaps that have been terminated by April 25, 2011, eachcounterparty to the swap must have retained the information and documents relating to the terms of theswap that were possessed on or after December 17, 2010.

ReportingTitle VII requires all swaps, whether cleared or uncleared, to be reported to newly created swap datarepositories (“SDRs”). Data reporting helps increase transparency by making swap data electronicallyavailable to regulators and publicly available in real time. Thus, the CFTC believes that the reportingrequirement will “enable regulators to better understand swaps in the context of allocation, and tomore accurately assess their associated systemic risk, by enabling regulators to see the full record ofeach swap all the way back to both the original transaction and the actual counterparties.”

Swap Data RepositoriesSDRs are new entities created under Title VII. SDRs: (1) accept swap data; (2) confirm that data withboth counterparties to a swap; (3) maintain the swap data; (4) provide direct electronic access to theCFTC; (5) provide any information required by the CFTC to comply with the public reportingrequirements; (6) establish automated systems for monitoring, screening, and analyzing swap data,including the frequency of end-user exemption claims; (7) maintain the privacy of any and all swaptransaction information that the SDR receives; (8) make available, upon request and on a confidentialbasis, information required by the CFTC; and (8) establish and maintain emergency procedures,backup facilities, and a plan for disaster recovery.



IdentifiersEach swap must be identified with a unique swap identifier. For swaps executed on an SEF or DCM,the SEF or DCM must create and transmit the unique swap identifier. For swaps that have not beenexecuted on an SEF or DCM with an SD or MSP reporting counterparty, it is the SD or MSP that shallcreate and transmit the unique swap identifier. Finally, for swaps that have not been executed on aSEF or DCM with a non-SD/MSP reporting counterparty, the SDR to which the primary economicterms data is reported shall create and transmit the unique swap identifier.

Each counterparty to a swap, including end-users, must be identified in all recordkeeping and swapdata reporting by a single legal entity identifier. Each entity within a corporate organization or groupstructure that acts as a counterparty to any swap must have its own legal entity identifier. Before alegal entity identifier system has been designated by the CFTC, each registered entity and swapcounterparty must use a substitute counterparty identifier created and assigned by an SDR in allrecordkeeping and swap data reporting.

Content of ReportsSwap reporting requirements vary by reporting counterparty. The reporting counterparty may have toreport one or both of the following: (1) creation data; and (2) continuation data. Creation data consistsof primary economic terms, and confirmation data. Section 45.1 defines primary economic terms asall of the terms of a swap matched or affirmed by the counterparties in verifying the swap, including ata minimum each of the terms included in the most recent Federal Register release by the Commissionlisting minimum primary economic terms for swaps in the swap asset class in question. Confirmationdata means all of the terms of a swap matched and agreed upon by the counterparties in confirming aswap. For cleared swaps, this term will also include the internal identifiers assigned by the automatedsystems of the DCO to the two transactions resulting from novation to the clearing house.

Continuation data includes all changes to the primary economic terms of the swap occurring duringthe existence of the swap. The reporting counterparty must report either life cycle event data or statedata.

Life cycle event is defined in by the CFTC to include “any event that would result in either a change toa primary economic term of a swap or to any primary economic terms data previously reported to aSDR in connection with a swap. Examples of such events include, without limitation, a counterpartychange resulting from an assignment or novation; a partial or full termination of the swap; a change tothe end date for the swap; a change in the cash flows or rates originally reported; availability of a legalentity identifier for a swap counterparty previously identified by name or by some other identifier; or acorporate action affecting a security or securities on which the swap is based (e.g., a merger, dividend,stock split, or bankruptcy).”

State data means all of the data elements necessary to provide a snapshot view, on a daily basis, of allof the primary economic terms of a swap in the swap asset class of the swap in question, including anychange to any primary economic term or to any previously-reported primary economic terms datasince the last snapshot. At a minimum, state data must include each of the terms included in the mostrecent Federal Register release by the Commission listing minimum primary economic terms forswaps in the swap asset class in question.



Timing of Reporting

(i) Creation Data

For swaps that are executed on an SEF or DCM, the SEF or DCM must report all required creationdata as soon as technologically practicable. If the swap is accepted for clearing by a DCO, the DCOmust report all of the confirmation data for the swap as soon as technologically practicable afterclearing.

For swaps that are subject to mandatory clearing, and not executed on an SEF or DCM, the reportingcounterparty must report all primary economic terms data for the swap, within the applicable timeline.If the reporting counterparty is an SD or MSP, it must report all primary economic terms data as soonas technologically practicable after execution, but no later than 30 minutes after execution during thefirst year following the compliance date, and 15 minutes thereafter. If the reporting counterparty is anon-SD/MSP, the reporting counterparty must report all primary economic terms as soon astechnologically practicable after execution, but no later than 4 business hours after execution duringthe first year following the compliance date, 2 business hours during the second year, and 1 businesshour thereafter. If the swap is accepted for clearing by the DCO, it is the DCO that must report allconfirmation data as soon as technologically practicable, including the internal identifiers assigned bythe automated systems of the DCO. If the swap is not accepted for clearing, the reporting counterpartymust report within the applicable reporting deadline. If the reporting counterparty is an SD or MSP,the reporting counterparty must report as soon as technologically practicable, but no later than 30minutes after confirmation if confirmation occurs electronically, or 24 hours business hours ifconfirmation does not occur electronically. If the reporting counterparty is a non-SD/MSP, thereporting counterparty must report as soon as technologically practicable, but no later than the end ofthe second business day after the date of confirmation during the first year following the compliancedate, and the end of the first business day thereafter.

For swaps which are neither executed on an SEF or DCM, nor cleared, there are comparable reportingrequirements for reporting counterparties. Reporting deadlines are extended, however, reflecting thelikelihood that they have less technological support in place for these reporting requirements.

For historical swaps in existence on or after April 25, 2011, the reporting counterparty must reportelectronically to an SDR on the compliance date all of the minimum primary economic terms andrelevant identifiers.

(ii) Continuation Data

Every reporting counterparty is required to ensure that all data in the SDR concerning the swaptransaction remains current and accurate, and includes all changes to the primary economic terms ofthe swap during the existence of such swap transaction. Reporting counterparties fulfill this obligationby reporting either life cycle event data or state data.

If the swap transaction is cleared, the DCO must report to the SDR all life cycle event data for theswap, reported on the same day that any life cycle event occurs, or all state data for the swap reporteddaily. In addition, the DCO to which the swap transaction was submitted for clearing is required to



report valuation data for a swap; end-users are not required to report this information for clearedswaps.

For swaps that are not cleared, the reporting counterparty must report either the life cycle data or statedata to the SDR. If the reporting counterparty is a SD or MSP, all life cycle event data must bereported on the same day that any life cycle event occurs, with the sole exception that life cycle eventdata relating to a corporate event of the non-reporting counterparty must be reported no later than thesecond business day after the day on which such event occurs. State data must be reported daily. If thereporting counterparty is a non-SD/MSP counterparty, life cycle event must reported no later than theend of the second business day following the date of any life cycle event during the first year after thecompliance date, and the first business day thereafter, with the sole exception that life cycle event datarelating to a corporate event of the non-reporting counterparty must be reported no later than the endof the third business day following the date of such event during the first year after the compliancedate, and no later than the end of the second business day thereafter.

If the reporting counterparty is an SD or MSP, the reporting counterparty must report all valuationdata for the swap daily. If the reporting counterparty is a non-SD/MSP, the non-SP/MSP must reportthe current daily mark of the transaction as of the last day of each fiscal quarter. This report must betransmitted to the SDR within thirty calendar days of the end of each fiscal quarter. If such daily markis not available for the swap, the non-SD/MSP must report the current valuation of the swap recordedon its books.

For each uncleared historical swap in existence on or after April 25, 2011, the reporting counterpartymust report all required swap continuation data, with the exception that when a reporting counterpartyreports changes to minimum primary economic terms for a historical swap, the reporting counterpartyis only required to report changes in the minimum primary economic terms listed in Appendix 1 topart 46. For historical swaps that have terminated prior to April 25, 2011, the reporting counterpartymust report to an SDR on the compliance date, such information relating to the terms of thetransaction as was in the reporting counterparty’s possession on or after October 14, 2010.

Determination of Reporting CounterpartyIn swaps involving commercial end-users, the end-user generally would not be determined to be thereporting counterparty. In a swap with an SD or MSP, the SD or MSP would be the reportingcounterparty. If the commercial end-user’s counterparty is a financial entity, the financial entity wouldbe the counterparty. Only in the case of two commercial end-users would the counterparties need toagree upon which would be the reporting counterparty. It should be noted that regardless of the end-user’s reporting obligations, end-users are required to obtain a legal entity identifier.

Business Conduct StandardsTitle VII requires new business conduct standards between counterparties to swap transactions bycreating anti-fraud, counterparty eligibility verification, and disclosure requirements. SDs and MSPsare required to implement policies and procedures to obtain and retain a record of the essential factsconcerning each counterparty whose identity is known to the SD prior to the execution of thetransaction, including: (i) facts required to comply with all applicable laws, regulations, and rules; (ii)facts required to implement the SD’s credit and operational risk management policies; and (iii)information regarding the authority of any person acting for such counterparty. SDs and MSPs arefurther required to obtain and retain a record showing the true name and address of each counterpartywhose identity is known to the SD or MSP prior to the execution of the swap transaction.



The CFTC has made it unlawful for any SD or MSP to engage in any act, practice, or course ofbusiness that is fraudulent, deceptive, or manipulative. It is similarly unlawful for any SD or MSP to:(i) disclose to any other person any material confidential information provided by or on behalf of acounterparty to the SD or MSP; or (ii) use confidential information for its own purposes in any waythat would tend to be materially adverse to the interests of a counterparty. Notwithstanding theforegoing prohibition, SDs or MSPs may disclose or use material confidential information if thedisclosure is authorized in writing by the counterparty, or it is necessary: (i) for the effective executionof any swap for or with the counterparty; (ii) to hedge or mitigate any exposure created by such swap;or (iii) to comply with a request of the CFTC, Department of Justice, any self-regulatory organizationdesignated by the CFTC, a prudential regulator, or as required by law.

Prior to entering into the swap transaction, an SD or MSP must disclose to any counterparty to theswap material information concerning the swap in a manner reasonably designed to allow thecounterparty to assess: (1) the material risks of that particular swap; (2) the material characteristics ofthe swap; (3) the material incentives and conflicts of interest that the SD or MSP may have inconnection with a particular swap, including: (i) the price of the swap and the mid-market mark of theswap; and (ii) any compensation or other incentive from any source other than the counterparty thatthe SD or MSP may receive.

For swaps with end-users that are not made available to trade on a DCM or SEF, SDs are required to:(1) notify the end-user that it can request and consult on the design of a scenario analysis to allow theend-user to assess its potential exposure in connection with the swap; (2) provide a scenario analysis,which is designed in consultation with the end-user and at its request, and done over a range ofassumptions include severe downside stress scenarios that would result in significant loss; (3) discloseall material assumptions and explain the calculation methodologies used to perform any requestedscenario analysis, provided that the SD is not required to disclose confidential, proprietary informationabout any model it may use to prepare the scenario analysis; and (4) in designing any requestedscenario analysis, consider any relevant analyses that the swap dealer undertakes for its own riskmanagement purposes. These requirements are not applicable if the swap is initiated on a DCM orSEF, or if the SD or MSP does not know the identity of the counterparty prior to the execution of theswap.

SDs and MSPs must notify an end-user of its right to receive, upon request, the daily mark from theappropriate DCO if the swap has been submitted for clearing. For uncleared swaps, SDs and MSPsmust provide the end-user with a daily mark that must be the mid-market mark of the swap, andcannot include amounts for profit, credit reserve, hedging, funding, liquidity, or any other costs oradjustments. Furthermore, for uncleared swaps, the SD or MSP must provide: (i) the methodology andassumptions used to prepare the daily mark, and any material changes during the term of the swap; (ii)additional information concerning the daily mark to ensure a fair and balanced communication,including, as appropriate that: (A) the daily mark may not necessarily be a price at which either theend-user or the SD or MSP would agree to replace or terminate the swap; (B) depending on theagreement, calls for margin may be based on considerations other than the daily mark provided to theend-user; and (C) the daily mark may not necessarily be the value of the swap that is marked in thebooks of the SD or MSP.

For swaps that are not required to be cleared, an SD or MSP must notify the end-user with which itenters into a swap that it is not subject to the mandatory clearing requirements of the CEA, and that the



end-user: (1) may elect to require clearing of the swap; and (2) has the sole right to select the DCO atwhich the swap will be cleared.

The CFTC requires that any communication between a SD or MSP and any counterparty becommunicated in a fair and balanced manner based on principles of fair dealing and good faith.An SD that recommends a swap or trading strategy involving a swap to a counterparty, other than anSD or MSP, must: (1) undertake reasonable diligence to understand the potential risks and rewardsassociated with the recommended swap or trading strategy; and (2) have a reasonable basis to believethat the recommended swap or trading strategy is suitable for the counterparty, which it does byobtaining information from the counterparty, including the counterparty’s investment profile, tradingobjectives, and ability to absorb potential losses associated with the swap or strategy.

ConclusionThe new clearing requirement will fundamentally change the dynamics of the swap market. End-userswho are eligible for, and properly elect to utilize, the exception may be able to avert clearingrequirements and mitigate the costs of clearing. Regardless of the exception, end-users will continue tohave recordkeeping and reporting obligations. End-users will have to cooperate with SDs and MSPs inorder to enable them to discharge their new duties.

DODD FRANK: 2013 Cross Border Application of U.S. Swap Regulations: Conflicts Abound at Home and Abroad

By Patrick D. Sweeney, Adam D. Wolper and Kyle Shenfeld





Cross Border Application of U.S. Swap Regulations:Conflicts Abound at Home and AbroadBy Patrick D. Sweeney, Adam D. Wolper and Kyle Shenfeld1

Title VII of the Dodd-Frank Act2 amends the Securities Exchange Act of 1934 (the “Exchange Act”)and the Commodity Exchange Act of 1936 (“CEA”) in order to bring over-the-counter swaps (andthose persons who trade, and facilitate trades, in such swaps) under the regulation of the Security andExchange Commission (“SEC”) (in the case of “security-based swaps”), the SEC and the CommodityFutures Trading Commission (“CFTC” and, collectively with the SEC, the “Commissions”) (in thecase of mixed swaps), and the CFTC (in the case of all other regulated swaps). Title VII – whichsubjects “swap dealers” (“SDs”)3 and “major swap participants” (“MSPs”)4 to reporting,recordkeeping, and execution requirements – is broad in scope and is not limited to the boundaries ofthe United States. While its potential extraterritorial reach could conceivably come into conflict withcompeting non-U.S. regulatory schemes, Title VII nevertheless endorses transparency and cooperationamong international regulators and affirms the need to achieve international harmonization between itsregulatory framework and that of competing jurisdictions. In addition to potential conflict between theCommissions and foreign regulatory commissions (and the extent to which “substituted compliance”is permissible), there are also disparities between the proposed cross-border application of swapregulations by the CFTC and SEC, respectively. It remains to be seen what level of cooperation isactually possible, both between the Commissions in their approach to cross-border derivativesregulation, and with comparable foreign oversight commissions.

CFTC’s Final GuidanceWhile the CEA and its concomitant regulations detail how to comply with the new swap rules, they arerather vague on the subject of who and what (and the geographic location of such who and what) mustcomply. The statute and regulations make clear that only a “person” can be an SD or MSP, andSection 2(i) of the CEA provides, in part, that the swaps regulatory regime “shall not apply toactivities outside the United States unless those activities have a direct and significant connection withactivities in, or effect on, commerce of the United States . . .” However, the statute and existingregulations do not explain that nebulous standard. Instead of a clarifying regulation, on July 12, 2013,the CFTC took a step toward answering this question when it adopted its final Interpretative Guidanceand Policy Statement Regarding Compliance with Certain Swap Regulations (the “Final Guidance”).5

The Final Guidance is just what it says: guidance. As stated by the CFTC: “[u]nlike a binding rule

_______________________________________________________________________________________________________________1

Mr. Sweeney is a partner; Mr. Wolper is an associate; and Mr. Shenfeld was a summer associate at Herrick, FeinsteinLLP.2

The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).3

The CFTC defines a “swap dealer” as an entity that: (1) holds itself out as a dealer in swaps; (2) makes a market inswaps; (3) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (4)engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.4

The CFTC defines a “Major Swap Participant” as: (1) a person that maintains a “substantial position” in any of the majorswap categories, aside from positions held for hedging or mitigating commercial risk and positions maintained by certainemployee benefit plans for hedging or mitigating risks in the operation of the plan; (2) a person whose outstanding swapscreate substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S.banking system or financial markets; or (3) any financial entity that is highly leveraged relative to the amount of capitalsuch entity holds and that is not subject to capital requirements established by an appropriate federal banking agency andthat maintains a substantial position in any of the major swap categories.5

78 Fed. Reg. 45,292 (July 26, 2013).



adopted by the Commission, which would state with precision when particular requirements do and donot apply to particular situations, this [Final] Guidance is a statement of the Commission’s generalpolicy regarding cross-border swap activities . . .”. This section sets forth some of the pertinentaspects of the Final Guidance.

The CFTC’s Broad Reach: Definition of “U.S. person”The scope of jurisdiction contemplated in the Final Guidance largely hinges on the CFTC’s definitionof “U.S. person.” This term does not appear in Title VII or the CEA and its accompanyingregulations; rather, it is a creature of the Final Guidance, and is meant as a guide to assist the CFTC indetermining who is covered by the CFTC’s new swap regulations. The CFTC defines “U.S. person”(and please note that this is a non-exclusive list) as follows:

(i) any natural person who is a resident of the United States;

(ii) any estate of a decedent who was a resident of the United States at the time of death;

(iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund, or any form of enterprise similar to any of the foregoing (other than an entitydescribed in prongs (iv) or (v) below) (a “legal entity”), in each case that is organized or incorporatedunder the laws of a state or other jurisdiction in the United States or having its principal place ofbusiness in the United States;

(iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii),unless the pension plan is primarily for foreign employees of such entity;

(v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court withinthe United States is able to exercise primary supervision over the administration of the trust;

(vi) any commodity pool, pooled account, or other collective investment vehicle that is not describedin prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv),or (v), except any commodity pool, pooled account, investment fund, or other collective investmentvehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons;

(vii) any legal entity (other than a limited liability company, limited liability partnership or similarentity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s)bears unlimited responsibility for the obligations and liabilities of the legal entity; and

(viii) any individual account or joint account (discretionary or not) where the beneficial owner (or oneof the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv),(v), (vi), or (vii).

The Final Guidance further provides that “[u]nder this interpretation, the term ‘U.S. person’ generallymeans that a foreign branch of a U.S. person would be covered by virtue of the fact that it is a part, oran extension, of a U.S. person.”

Thus, the Final Guidance makes clear that the CFTC will regulate all “U.S. persons” (regardless ofwhere they are located in the world) if they surpass the thresholds warranting registration as an SD or



MSP. And for U.S. persons, all swaps (not just those entered into with other U.S. persons) areconsidered in determining whether the SD or MSP threshold is met.

Registration of Non-U.S. Persons as SDs or MSPs Regardless of LocationThe sole fact that a “person” does not meet the definition of “U.S. person” does not mean that such“non-U.S. person” is exempt from the CFTC’s swap regulations. This is because a non-U.S. personcan still meet the definition of “swap dealer” or “major swap participant,” thus requiring registrationwith the CFTC.

Projecting the CFTC’s expansive jurisdictional reach, the Final Guidance indicates that those swapdealers who exceed the de minimis threshold (set forth in CFTC Rule 1.3(ggg)(4)) are required toregister with the CFTC as SDs, regardless of whether they are a U.S. person. The Final Guidanceprovides that all of the swap dealing activities of a non-U.S. person who is a “guaranteed affiliate” of aU.S. person, or who is an “affiliate conduit” of a U.S. person, must be counted toward the de minimisthreshold for swap dealer registration. Conversely, a non-U.S. person who is not a guaranteed affiliateor affiliate conduit only has to count its swap dealing transactions with U.S. persons (other thanforeign branches of swap dealers that are registered with the CFTC) or guaranteed affiliates of U.S.persons (with three exceptions), toward the de minimis threshold for swap dealer registration.

There is a similar analysis in connection with “major swap participants.” The Final Guidance providesthat in connection with non-U.S. persons who are guaranteed or conduit affiliates of a U.S. person, “incalculating whether the applicable MSP threshold is met, [such guaranteed or conduit affiliate] wouldbe expected to include . . . the notional value of: (1) [a]ll swaps with U.S. and non-U.S. counterparties,and (2) any swaps between another non-U.S. person and a U.S. person or guaranteed affiliate, if thepotential non-U.S. MSP guarantees the obligations of the other non-U.S. person thereunder.”

Finally, the CFTC interprets Title VII’s clearing requirements to apply to any swap where one of thecounterparties is a U.S. person, regardless of where the transaction actually takes place. Given theCFTC’s expansive definition of U.S. person, the amount of transactions that have to clear, even fornon-U.S. persons, may be voluminous.

SEC’s Proposed Rules and Interpretive GuidanceIn its May 1, 2013, proposed rules and interpretive guidance6 (the “SEC Proposal”), the SEC took adifferent stance on the reach of Title VII beyond the borders of the United States, specifically throughits proposed definition of the term “U.S. person” (which, unlike the CFTC, the SEC proposes toincorporate into a rule).

Narrowed Scope of “U.S. Person” Definition is in Line with Concept of TerritorialityIn line with its overall “territorial” approach, the SEC defined “U.S. person” as one of the following:

_______________________________________________________________________________________________________________6

Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relatingto the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-69490(May 1, 2013).



(i) Any natural person resident in the United States;

(ii) Any partnership, corporation, trust, or other legal person organized or incorporated under thelaws of the United States or having its principal place of business in the United States; or

(iii) Any account (whether discretionary or non-discretionary) of a U.S. person.

If a U.S. person otherwise meets the definition of “security-based swap dealer’ or “major security-based swap participant” then they are subject to SEC regulation.

The SEC’s definition of “U.S. person” stems from the concept of territoriality, meaning that personsand activities in the international security-based swaps market should be regulated by the SEC basedon whether their situs is in the United States. Given the reality that many security-based swaps arenegotiated between entities subject to varying regulatory regimes, the SEC Proposal intends to limitSEC regulation on foreign market participants in order to relieve much of the burden associated withsimultaneous or conflicting regulations.

Non-U.S. Security-Based Swap DealersAs does the Final Guidance, the SEC Proposal explains when a non-U.S. person is required to registerwith the SEC as a “security-based swap dealer.” Furthering the territoriality concept, for purposes ofdetermining whether the de minimis threshold has been reached, non-U.S. persons are required toinclude in their calculations security-based swaps that are either: (1) entered into with U.S. persons; or(2) conducted “within the U.S.” They would not be required to include: (1) foreign branches of U.S.banks; or (2) non-U.S. persons, even if the swap is guaranteed by a U.S. person.

Non-U.S. Major Security-Based Swap ParticipantsFor purposes of determining whether a non-U.S. person exceeds the defined substantial position orcounterparty exposure threshold in the definition of “major security-based swap participant,” the SECProposal provides that non-U.S. persons need only consider transactions with U.S. persons (includingswaps with foreign branches of U.S. banks). Further, if a non-U.S. person guarantees a U.S. person’ssecurity-based swaps, all guaranteed security-based swaps are attributed to the guarantor; but if a non-U.S. person guarantees a non-U.S. person’s security-based swaps, then only the security-based swapswith a U.S. person counterparty will be attributed to the guarantor.

Analysis of Differences between CFTC and SECGiven the difference between the SEC’s and CFTC’s proposals, the SEC’s situs approach may allowmore oversight in some regards yet be narrower in others. The SEC’s reach is narrower in that itsdefinition of “U.S. person” contains fewer prongs than the CFTC’s. However, the SEC approach isbroader in that it includes transactions by any parties conducted within the U.S., a concept based onphysical presence in the U.S. that the CFTC does not recognize. Being territorial in nature, the SECdefinition could bring transactions under jurisdiction that involved no U.S. persons. The differencesturn on how the Commissions interpret what will have a “direct and significant effect” on commerceof the United States.



Reconciliation of Regulatory StructuresGiven the global nature of the swap and derivative markets, Congress felt it was necessary to providethe Commissions with the ability to implement formulae to facilitate international cooperation. It hasbeen the responsibility of both the CFTC and the SEC to implement the concept of substitutedcompliance (i.e., where a person’s compliance with the laws of their home jurisdiction constitutescompliance with SEC or CFTC rules as well). The CFTC has already begun such efforts, asevidenced by its accord with the European Commission (“EC”). The SEC hopes to address cross-border cooperation as well, though its approach to substituted compliance is slightly different.

Substituted Compliance: CFTC’s VersionUnder the Final Guidance, and subject to the next sentence of this paragraph, non-U.S. person SDs andMSPs (as well as (i) U.S. banks that are SDs or MSPs with respect to their foreign branches, and (ii)non-U.S. non-registrants that are guaranteed or conduit affiliates, as applicable) will be allowed tocomply with the entity-level and transaction-level requirements of their home jurisdictions’ (or in thecase of a foreign branch of a bank, the foreign location of the branch’s) laws and regulations, insteadof obligating such SDs and MSPs to comply with the requirements of Dodd-Frank. This “substitutedcompliance” will only be permissible if the CFTC first finds that the home jurisdictions requirements“are comparable with and as comprehensive as the corollary area(s) of regulatory obligationsencompassed by the CFTC’s Entity- and Transaction-Level Requirements.”7 The CFTC states that itscomparability determinations may be made on a requirement-by-requirement basis, rather than on thebasis of the foreign regime as a whole. One possible ramification of this analytical approach would bea “checkerboard” of U.S. and non-U.S. regulations applicable to non-U.S. persons.

Substituted Compliance: SEC’s VersionThe SEC, on the other hand, approaches substituted compliance on a more holistic level. Theproposed rules would permit SBS market participants to substitute compliance with comparable rulesfrom non-U.S. jurisdictions for compliance with U.S. rules, provided certain conditions are met. Ifthe SEC determines that a foreign regulatory regime’s requirements are comparable to the SEC’s, aforeign market participant is allowed to substitute compliance with its home country’s regime forcompliance with Title VII of Dodd-Frank.

The SEC plans to separately assess the comparability of the foreign swaps regulatory regime usingfour different categories. If a foreign regime is “comparable to Title VII in only one category, onlyrules from the foreign regime that address that category may be substituted for compliance with theanalogous Title VII rules. If the rules from the foreign regime are comparable to Title VII in twocategories, rules from the foreign regime for those two categories may be substituted for compliancewith Title VII, and so on.” The categories for consideration are: (1) requirements applicable toregistered non-U.S. SBSDs; (2) requirements relating to regulatory reporting and public disseminationof SBS data; (3) requirements relating to mandatory clearing for SBS; and (4) requirements relating to

_______________________________________________________________________________________________________________7

The entity level requirements are based on: (1) capital adequacy; (2) chief compliance officer; (3) risk management; (4)recordkeeping; and (5) SDR reporting. The transaction-level requirements are: (1) clearing and swap processing; (2)margin and segregation for uncleared swaps; (3) trade execution; (4) swap trading relationship; (5) portfolio reconciliationand compression; (6) real-time public reporting; (7) trade confirmation; (8) daily trading records; and (9) external businessconduct standards for SDs and MSPs.



mandatory trade execution for SBS. The SEC will examine the categories on a holistic level, so thatdifferences in particular rules or regulations will not necessarily render a foreign SBS regulatoryregime unsuitable for compliance.

EC and CFTC HarmonizationOn July 16, 2013, the EC and the CFTC came to a cross-border accord on derivative regulation withregards to the CFTC’s extraterritorial reach under Dodd-Frank. Additionally, the CFTC grantedtemporary relief to non-U.S. firms from compliance with Dodd Frank rules governing SDs and MSPthat were set to apply on July 12, 2013. The agreement circumvented a disturbance of cross-borderderivative transactions that would likely have stemmed from the CFTC’s proposal: (1) to force allswaps involving at least one U.S. entity to be cleared in the U.S.; and (2) to subject several non-U.S.entities entering into swaps with U.S. entities to two or more sets of redundant or even conflictingregulations.

Generally speaking, the EC and CFTC have agreed to abide by and defer to the regulatoryrequirements of the other jurisdiction wherever such compliance is “justified.” The agreement allowsnon-U.S. banks as well as other major swap traders to postpone compliance with various provisions ofTitle VII until the CFTC decides whether the analogous EU rules are subject to comparable U.S. rules,and whether to allow such entities to with their respective jurisdictional rules rather than U.S. rules.

More specifically, the highlights of the EC and CFTC agreement and proposed guidance suggest that:(1) a non-U.S. SD that is not affiliated with or guaranteed by a U.S. person will likely only be subjectto the CFTC’s transaction-level requirements in transactions with U.S. persons and guaranteedaffiliates of U.S. persons; (2) for trade executions, the CFTC will permit foreign boards of trade toreceive no-action relief to list swap contracts for trading via direct access, to avoid market andliquidity disruption; (3) where a swap is executed on an anonymous and cleared basis on a registereddesignated contract market or swap execution facility, the parties will be deemed to have met theirtransaction-level requirements; (4) the EC and CFTC have several identical requirements formandatory clearing obligations, and will continue to work as one to unify international rules onmargins for uncleared swaps; (5) CFTC and EMIR rules regarding DCOs are based on internationalminimum standards, as clearinghouses’ and central counterparties’ initial margin coverage is the keydifference between them; (6) the EU and CFTC recognize that they have essentially the same ruleswith regards to risk mitigation for the largest counterparty swap market participants; and finally (7) thedefinition of “U.S. person” should encompass offshore hedge funds as well as other collectiveinvestment vehicles that are either owned by a majority of U.S. persons or that have their principalplace of business within the U.S.

Further clarification may be expected from the CFTC prior to year end 2013, when the currenttemporary relief period expires.

DODD FRANK: 2013 What’s Happening in Enforcement?

By Therese M. Doherty, LisaMarie F. Collins and Philip W. Raimondi


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What’s Happening in Enforcement?By Therese M. Doherty

Introduction

The industry continues to evolve from trades placed and executed by humans to electronic tradingthrough automated trading systems and high-speed trading firms using high frequency tradingalgorithms. This article will examine the Commission’s increased focus with respect to automatedtrading systems and high frequency trading. For example, Commissioner Bart Chilton recentlyquestioned whether exchanges such as CME were adequately monitoring high-speed trading firmsgiven the high volume of wash trades occurring in connection with high-frequency trading. TheCommission also recently released a 137 page “concept release” that poses questions to industryparticipants focusing on increased risk controls for automated trading systems (“ATS”) and high-speedtrading firms.

Also, for the last few years, industry participants, lawyers, and compliance professionals have kept awatchful eye on how the Commission applies its broadened enforcement authority provided by Dodd-Frank relating to anti-fraud, anti-manipulation and anti-disruptive trading practices. While commentperiods have come and gone, guidance has been issued, and rules implemented, the Commission hasused its new enforcement authority sparingly. The Commission has alleged Rule 180.1 violations inan anti-fraud context, but we have yet to see any enforcement proceedings or actions allegingmanipulation under the Commission’s broadened authority. This article analyzes the proceedings todate where the Commission has used its new anti-fraud, anti-manipulation and anti-disruptive tradingpractice enforcement authority.

Automated Trading Systems and High Frequency Trading

In early 2013, the Commission began examining whether high-speed trading firms were violatingCommission rules and regulations by using wash trades to artificially inflate volume and distortmarkets in futures contracts. A wash trade occurs when a party enters into, or purports to enter into, atransaction to give the appearance that purchases and sales have been made, without incurring marketrisk or changing the trader’s market position. In other words, a party is the buyer and seller tradingwith itself, taking no risk but creating the impression that a legitimate market trade has occurred.Section 4(c) of the Act expressly prohibits wash trading as do various exchange rules.

The Commission’s examination focused on suspected wash trades by high-speed firms in futurescontracts tied to the value of crude oil, precious metals, agricultural commodities and the Standard &Poor’s 500-stock index, among other underlying instruments. In addition to scrutinizing highfrequency trading firms, the Commission’s examination focused also on two primary exchanges, CMEGroup Inc. (“CME”) and the Intercontinental Exchange, Inc. (“ICE”). With respect to the CME andICE, the Commission expressed concern that the exchanges’ systems were not sophisticated enough toprevent wash trades.

The CME’s Proposed Guidance Regarding Wash Trading

On June 17, 2013, the CME issued Regulation Advisory Notice RA1308-5 (“RA1308-5”) seeking toprovide updated guidance regarding compliance with CME Rule 543 (“Wash Trades Prohibited”).Specifically, RA1308-5 sought to draw a more distinct line between intentional and unintentionalwash trading. RA1308-5 also provided information regarding the introduction of CME’s “Self-Match

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By Therese M. Doherty, LisaMarie F. Collins and Philip W. Raimondi



Prevention” functionality (“SMP”), an optional electronic functionality that, when employed,automatically blocks the matching of buy and sell orders that are submitted to CME Globex with thesame executing firm ID and the same self-match prevention ID. The CME intended to implementRA1308-5 on July 1, 2013.

Commissioner Chilton gave a keynote address at the Trading Show of Chicago a week later.Commissioner Chilton’s speech focused on the high volume of wash trades occurring in connectionwith high frequency trading. Commissioner Chilton complained that the high volume of highfrequency related wash trades were creating “fantasy liquidity” because traders were not taking marketrisk. Commissioner Chilton warned that the Commission was “watching” high frequency traders andthat the Commission will “come into your dens and look and analyze with experts your algo programsto see if you are violating the law.” Commissioner Chilton raised concerns about the CME’selectronic prevention system and proposed RA1308-5, stating that the proposal required a lengthierreview by the Commission to understand how it played into the regulator’s own efforts to policetrading.

Following a dialogue with the Commission’s Division of Market Oversight, the CME withdrew theself-certification of RA1308-5 and reinstated its previous advisory notice from 2009 relating to washtrades. By letter dated July 9, 2013, the CME, on behalf of the CBOT, NYMEX, COMEX, and KCBT(collectively, the “Exchanges”) requested Commission approval to issue RA1308-5 to themarketplace. The CME thus abandoned its effort to update guidelines on wash trades without priorCommission approval. Pending Commission approval, the Exchanges planned to make RA1308-5effective on September 9, 2013. The Commission has not yet approved RA1308-5.

Similarly, on September 9, 2013 the Commission published a Concept Release on Risk Controls andSystem Safeguards for Automated Trading Environments, 78 Fed. Reg. 56,542 (Sept. 12, 2013)[hereinafter “Concept Release”] available athttp://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2013-22185a.pdf. TheConcept Release sets forth the Commission’s views regarding risks involved with automated trading,and preventative measures taken to date to mitigate such risks. In light of new market structuresfocused on automated and high frequency trading, traditional risk controls and safeguards, whichlargely rely on human judgment and intervention, must be reevaluated. Thus, the Concept Release isintended as “a high-level enunciation of potential measures intended to reduce the likelihood of marketdisrupting events and mitigate their impact when they occur.” Id. at 56551. The Concept Releasealso provides a comprehensive discussion and poses 124 questions related to the further potentialmitigation of such risks for which it seeks comment from the industry. Presumably, the ConceptRelease will serve as a framework for forthcoming rules, restrictions, and trading limits relating toautomated and high frequency trading.

“The Concept Release provides an overview of the automated trading environment, including itsprincipal actors, potential risks, and responsive measures taken to date by the Commission or industryparticipants. The Concept Release also discusses a series of (1) pre-trade risk controls; (2) post-tradereports and other measures; (3) system safeguards related to the design, testing and supervision ofautomated trading systems (ATSs); and (4) additional protections designed to promote safe andorderly markets.” Press Release, CFTC Release: PR 6683-13 (Sept. 9, 2013). In each case, theCommission seeks extensive public comment regarding these measures.



Rule 180.1: The Commission’s New Anti-Fraud, Anti-Manipulation andAnti-Disruptive Trading Practices Authority

With respect to Dodd-Frank enforcement, a significant augmentation of the Commission’senforcement capabilities created by Dodd-Frank is the amendment to the statutory definition offraudulent and manipulative conduct. Section 753 of Dodd-Frank amends § 6(c) of the CommodityExchange Act (the “Act”) to lessen the intent required for manipulative or fraudulent conduct --closely mirroring § 10(b) of the Securities and Exchange Act of 1934. See 7 U.S.C. § 9(1).Previously, there was a scienter requirement of specific intent to create an artificial market price.Dodd-Frank changed the intent requirement so that a violator need only act in “reckless disregard” forthe illicit conduct to be deemed unlawful. Id.

CFTC Rule 180.1 (which mirrors SEC Rule 10b-5) implements § 6(c)(1) of the Act. Rule 180.1further broadens the Commission’s previous anti-fraud authority by permitting enforcement even inthe “absence of any market or price effect” related to the alleged conduct. 76 Fed. Reg. at 41401. TheCommission interprets its new authority broadly -- Rule 180.1 prohibits certain behavior “inconnection with” swaps, commodities contracts or futures contracts. The Commission interprets thewords “in connection with” to reach all fraudulent conduct in connection with the purchase, sale,solicitation, execution, pendency, or termination of any swap, futures contract or contract for the saleof any commodity, including payment obligations under a swap. Hence, this expansion is alsodistinguishable from prior authority by extending the Commission’s enforcement power to allcommodity-related transactions regardless of the contract type.

While the Commission has brought claims asserting Rule 180.1 violations in an anti-fraud context, thederivatives community has yet to see Rule 180.1 challenged or otherwise put to the fullest use of itsenforcement power by the Commission. To date, the Commission has generally alleged violations ofnew Rule 180.1 in recent actions concerning Ponzi schemes1 or retail commodity transactions2. Thesecases have resulted in consent orders, default judgments or remain pending. The derivatives

_______________________________________________________________________________________________________________1

See e.g. Commodity Futures Trading Commission v. Atlantic Bullion & Coin, et al., No. 12-cv-1503-JMC (D.S.C.June 6, 2012) (charging a purported silver brokerage firm and its president with fraud in connection withoperating an alleged $90 million Ponzi scheme, in violation of the Act and Commission regulations); CommodityFutures Trading Commission v. Schiller, No. 12-cv-4043 (N.D. Ill. May 24, 2012) (alleging that a floor brokermade material misstatements to investors, misappropriated investor accounts to support a “lavish lifestyle,”(Compl. ¶ 2) and issued fraudulent account statements to investors. Invoking Rule 180.1, the complaint allegedthat the defendant committed the unlawful acts “knowingly or with reckless disregard for the truth); CommodityFutures Trading Commission v. Schmickle, No. 12-CV-0971 (E.D. Wis. Sept. 24, 2012) (alleging violations ofRule 180.1 against an unregistered commodity trading adviser (“CTA”) and its operator in an alleged Ponzischeme and claiming that the manipulative and/or deceptive statements used to induce investors were made“intentionally or recklessly.”

2See e.g. Commodity Futures Trading Commission v. Leighton, No. 12-cv-4012-PSG-SS (C.D. Cal. May 8, 2012)(alleging violations or Rule 180.1 where that the defendant is alleged to have deceived at least 42 pool participantsto invest in his pool by making material misstatements about his trading performance history, among other things.The defendant allegedly perpetrated the scheme by transmitting fabricated account statements to poolparticipants.); Commodity Futures Trading Commission v. Smithers, No. 12-CV-81165-KAM (S.D. Fl. Oct. 22,2012) (alleging violations of Rule 180.1 where the defendant fraudulently represented to several FCMs thatsomeone other than himself had opened and controlled certain commodity trading accounts related to retailcommodity investments he solicited. The Commission alleged that, besides the misstatements made to certainFCMs, the defendant also made false statements to investors about his performance history and misappropriatedinvestor monies.).



community has not seen substantive application of the “reckless disregard” standard, arguably themost significant element of the new rule. Nor has the derivatives community seen Rule 180.1 appliedin an anti-manipulation context.

Anti-Disruptive Trading Actions and Guidance

In addition, Section 747 of Dodd-Frank amended § 4c(a) of the Act to add a new section (§ 4c(a)(5))that authorizes the Commission to prosecute specific instances of anti-disruptive trading practices. See7 U.S.C. § 6c(5). Section 4c(a)(5) makes it unlawful for industry participants to (i) fail to honor bidsor offers placed in the open market, (ii) exhibit intentional or reckless disregard for the orderlyexecution of orders during a market’s closing period, or (iii) engage in improper bid/offer cancellingconduct known as “spoofing (bidding or offering with the intent to cancel the bid or offer beforeexecution).” Id. The Commission interprets the prohibitions in § 4c(a)(5) of the Act to be distinctstatutory provisions from the anti-manipulation provisions in Section 753 of Dodd Frank.

The Commission’s ability to bring enforcement actions for certain types of anti-disruptive tradingactivity did not begin here. For example, in March 2011, the Commission filed and simultaneouslysettled charges against a proprietary trading firm for engaging in activity resembling “spoofing” on thesoybean futures market. In the Matter of Bunge Global Markets, Inc., CFTC Docket No. 11-10 (Mar.22, 2011). The Commission alleged that the traders at issue placed contract orders during the pre-opening session, but had no intention of actually executing the orders and cancelled them prior to theopen. Id. Without any direct “spoofing” authority, the Commission successfully alleged a violation of§ 4c(a)(2)(B) of the Act which makes it unlawful to cause a non-bona fide price to be reported. Id. at4-5.

Now, in addition to limited prior authority, the Commission has new statutory authority specificallyaimed at anti-disruptive trading tactics. See 7 U.S.C. § 6c(5). The Commission issued proposedguidance in 2011 (Antidisruptive Practices Authority, 76 Fed. Reg. 14943 [March 18, 2011]) andrecently finalized its guidance on May 28, 2013. See Antidisruptive Practices Authority, 78 Fed. Reg.31890 (May 28, 2013). The Commission clarifies that the scope of the new rules applies to “anytrading, practices, or conduct” on a regulated exchange and there is no separate “manipulative intentrequirement.” 78 Fed. Reg. at 31892. However, the Commission states that the new rules do notapply to block trades or exchanges for related positions (“EFRPs”). Id.

The finalized guidance addresses each of the three specific anti-disruptive rules separately. TheCommission clarifies that the first rule, prohibiting bid and offer violations, does not contain anyintent requirement. 78 Fed. Reg. at 31893. Rather, engaging in such conduct is a “per se” ruleviolation resulting in strict liability for each offense. Further, violations of this nature are highly factspecific and a single instance could result in an enforcement action. The rule prohibits the purchase ofa contract at a price higher than the lowest available price offered or the sale of a contract at a pricelower than the highest available price bid. Id. The Commission clarifies that the second rule prohibitsintentionally or recklessly engaging in any transactions that disrupt the orderly execution of tradesduring the closing period of the applicable market. 78 Fed. Reg. at 31895. Attempts to “bang” or“mark the close” are deemed intentional violations of this rule. Id. Lastly, the third new anti-disruptive trading rule prohibits “spoofing” or the intentional cancelling of a bid or offer beforeexecution. 78 Fed. Reg. at 31896. While the Commission will evaluate “market context” and patternsof trading activity prior to making an enforcement determination, “even a single instance of tradingactivity” can violate this rule. Id.



Within two months after releasing this finalized guidance, the Commission (in conjunction with theUK’s Financial Conduct Authority) filed, and simultaneously settled, its first enforcement actionapplying the new anti-disruptive trading rules. In the Matter of Panther Energy Trading LLC, et al.,CFTC Docket No. 13-26 (Jul. 22, 2013). Here, the Commission fined a high-frequency trading firmand its owner $2.8 million for engaging in the entry of algorithmic bids and offers that wereintentionally cancelled prior to execution. Id. The alleged purpose of this illicit conduct was to createenough interest on one side of the market to increase the likelihood that the firm’s legitimate orderswould be filled on the opposite side of the market. See id. at 3. The Commission found that therespondents used an algorithm designed to cancel orders prior to execution. As a result of thisconduct, the Commission fined the firm the exact amount of its disgorged profits, and presented awarning to the high-frequency trading community that their algorithms are not outside the scope ofregulatory scrutiny.

In a related context, FINRA and several equities-based exchanges recently fined a large brokeragefirm $9.5 million for failing to supervise certain direct-market high-frequency trading customers thatallegedly engaged in certain manipulative and disruptive trading activities in the markets at issue. Inre Newedge USA, LLC, FINRA Letter of Acceptance, Waiver, and Consent, No. 20090186944 (July10, 2013). Specifically, FINRA found that the brokerage firm did not have adequate surveillance toolsto detect the illicit actions of certain customers. Accordingly, even brokerage houses are not immunefrom the obligation to prevent the harmful effects of anti-disruptive trading activity.

Conclusion

In light of the Commission’s comments, efforts and broadened authority under Dodd-Frank, thederivatives community certainly has some insight into Commission’s focus with respect toenforcement priorities. While the derivatives community has not yet seen Rule 180.1 invoked in ananti-manipulation context, one can only assume such a proceeding is on the horizon. Similarly, wecan expect to see the Commission crack down on high-speed trading firms that violate Commissionrules and regulations by way of high frequency trading algorithms.

DODD FRANK: 2013 SEC Focus Areas Regarding Investment Advisers

By Irwin M. Latner and John D. Cleaver


Latner1 Cover.indd 1 9/24/2013 11:43:53 AM



SEC Focus Areas Regarding Investment AdvisersBy Irwin M. Latner and John D. Cleaver

IntroductionInvestment advisers should be aware of the SEC’s “hot button” issues in order to successfully undergoSEC compliance exams or avoid them for as long as possible. In a series of recent speeches, releasesand enforcement actions, the SEC has amplified its broad effort to improve compliance, prevent fraud,inform policy and monitor systemic risk. As always, the SEC may select any registered investmentadviser for examination for any reason or no reason at all. Recently, however, the SEC has morespecifically targeted those investment advisers whose operations raise certain red flags. In early 2013,the SEC published its examination priorities in order to set forth the main risk areas the SEC perceivesas posing threats to investors. These stated priorities, along with an analysis of recent enforcementactions brought by the SEC, provide a growing rubric for investment advisers to consult to determinetheir likelihood of being selected for an SEC examination and how best to prepare for one.

How Does the SEC Arrive at the Door?

The National Examination Program InitiativeIn October 2012, the SEC Office of Compliance Inspections and Examinations (“OCIE”) released anindustry letter to executives and principals of fund management firms that sets forth the SEC’s“Presence Exam Initiative.” This initiative is directed to all investment advisers that were required toregister due to the repeal of the “private adviser exemption” in the Investment Advisers Act of 1940(the “Advisers Act”) by Section 402 of the Dodd-Frank Wall Street Reform and Consumer ProtectionAct (the “Dodd-Frank Act”). Pursuant to this new initiative, the SEC intends to conduct “focused,risk-based examinations” of newly registered advisers to private funds over the following two years.The exams will be conducted through the SEC’s National Exam Program (“NEP”), which is a divisionof the OCIE. This initiative consists of three phases:

• Engagement Phase: Nationwide outreach to inform newly registered firms about theirobligations under the Advisers Act.

• Examination Phase: Examination of newly registered private fund advisers which is theprimary focus of this article.

• Reporting Phase: At the conclusion of the two-year initiative, the NEP will report its findingsto the SEC and the public, describing common issues, problems, and trends that were identifiedthrough its presence exams of newly registered private fund advisers.

Types of SEC ExamsAn SEC examination of a firm, though unpleasant, is almost inevitable, and thus should be viewed asan opportunity to make sure the firm is fully compliant. All SEC examinations are performed by theOCIE and generally focus on the risks specific to a firm. In addition to presence exams targeted atprivate fund advisers, the SEC conducts other types of exams of all registered investment advisers.The following additional types of exams conducted by the SEC are triggered by different factors andinvolve different levels of rigor.

Routine ExamsOnce upon a time, the SEC had a stated goal of inspecting all investment advisers on a regularschedule. While this goal is no longer feasible due to the SEC’s limited resources and the volume and



complexity of the newly registered investment advisers resulting from the Dodd-Frank Act, “routine”exams still occur, though with less frequency than in the past. These routine exams simply mean that afirm’s “number has come up.” Generally, these exams are preceded by approximately two weeks’ ofwarning time, with the SEC informing the firm in writing of the documents it would like to see and thequestions it would like to ask. These exams are generally performed without any prior suspicion ofviolations or high risk activities, and generally examine the structure of the firm, its assets undermanagement and the documentation kept by the firm in marketing its services and supporting itspurported track record.

“For Cause” ExamsSince the goal of subjecting every investment adviser to a routine exam has proved too ambitious, theSEC has begun targeting its examinations based on tips, complains and referrals (“TCR”). OCIE hasembarked on surprise “for cause” exams (i.e., exams that are conducted without any advance notice oron very short notice) in large part as a response to a perceived lack of attention to tips about Ponzischemes such as the Madoff scandal. A tip, referral or complaint may come from an individualreporting a securities law violation, a media report or from the SEC’s own routine exam. The TCRapproach complements, but does not replace, the other exams that the SEC has at its disposal. Theadvent of the TCR surprise examination system has had tangible consequences for firms that, underthe prior system of announced examinations, took compliance seriously only once they received anSEC letter of examination.

“Sweep” ExamsThese exams typically target a number of firms at the same time in order to review a certaincompliance issue that the SEC considers a broad-based risk. These exams (usually in the form ofdocument requests) can result from data gleaned in routine or for cause exams where the SEC learnsof certain prevalent compliance problems affecting the investment advisory industry.

“Higher Risk” ExamsThe SEC seeks to examine “higher risk” advisers every three years. Often, these exams are precededby a routine exam in order to determine whether the firm warrants a “higher risk” exam. The factorsthat determine whether a firm poses a “higher risk” are manifold, including assets under management,employees with disciplinary histories, having an affiliated broker-dealer or several affiliatedbusinesses, an incomplete Form ADV and significant indicia of non-compliance in prior exams. Onceat the door, the examiner will likely focus on the most typically troublesome areas for firms, includingconflicts of interest, valuation, portfolio management, advertising and asset verification. Fundmanagers and other advisers flagged as high risk firms can generally expect more frequentexaminations and more extensive scrutiny by SEC examiners.

Aberrational PerformanceAs part of the SEC’s recent focus on private fund managers, the SEC has targeted certain managers forexamination based on the SEC’s belief that the manager has exhibited “aberrational performance.”Although indicia of non-compliance with other “hot button” focus areas (e.g. non-compliance with thecustody rule, violation of marketing and performance rules, or any of the other areas discussed in PartTwo below) could also raise red flags, aberrational performance alone can trigger an exam withoutnecessarily requiring the SEC to look further. The SEC, via its aberrational performance review, hassophisticated tools to analyze a fund’s returns vs. the returns of the market and may target a fundmanager for investigation if the fund consistently beats industry indices. Compliance exams triggered



by the SEC’s aberrational performance review of hedge funds, private equity funds and mutual fundshas resulted in numerous enforcement actions by the SEC. For example, the SEC charged New York-based hedge fund ThinkStrategy Capital Management LLC and its managing director with fraud,alleging deceptive conduct to bolster the track record, size and credentials of the two funds theymanaged. The proprietary risk analytics employed by the SEC targeted these two funds and eventuallyled to charges that ThinkStrategy overstated its assets and longevity and obscured the volatility of itsinvestments. On January 3, 2013, the U.S. District Court for the Southern District of New Yorkordered ThinkStrategy and the fund’s manager to jointly and severally pay disgorgement ofapproximately $4 million and a civil penalty of $1 million.

What should an investment adviser do if it has a legitimate run of market beating returns? Though theinvestment adviser may still be targeted by the SEC’s aberrational performance initiative, the advisercan rebut any SEC suspicions by demonstrating compliance with all underlying rules regardingmarketing, performance advertising, asset valuation, recordkeeping, and other applicable SEC rulesand regulations that pertain to accurately calculating and marketing the fund’s performance returns.

Once at Your Door, What is the Examiner Looking For?

Compliance GenerallyUpon registration with the SEC, private fund advisers must comply with all of the applicableprovisions of the Advisers Act and SEC rules thereunder. Some of these compliance requirementsinclude:

• Compliance Rule. Registered advisers must adopt and implement written policies andprocedures to prevent violations of the Advisers Act, conduct an annual review of the policiesand procedures and designate a chief compliance officer responsible for implementing andadministering the policies and procedures.

• Books and Records Rule. Registered advisers must keep accurate and current books andrecords related to the advisory business.

• Form ADV. Registered advisers must file an annual Form ADV, including at least Parts 1Aand 2A. Advisers must also amend the Form ADV annually within 90 days of the fiscal yearend of the advisory business and promptly upon any information in the Form ADV becominginaccurate.

• Code of Ethics Rule. Registered advisers must adopt a code of ethics which sets forth what isexpected of all employees of the adviser and the rules regarding personal trading of securitiesby adviser personnel.

• Advertising Rule. All investment advisers are prohibited from making any false or misleadingstatements in their offering documents or marketing materials.

In an example of a registered adviser running afoul of its compliance obligations, the SEC tookenforcement action earlier this year against IMC Asset Management, Inc. for a failure to have writtenpolicies and procedures in place that were reasonably designed to prevent violations of the AdvisersAct. The SEC alleged that the adviser’s written policies were outdated and concerned the adviser’spredecessor, which was a registered broker-dealer. Additionally, the SEC alleged that the firm’s chiefcompliance officer performed no compliance-related functions at all and had no prior complianceexperience.



Further, investment advisers are fiduciaries to their clients, and, accordingly, must act in the bestinterests of their clients in dispensing investment advice. The fiduciary duties of loyalty and good faithare woven into virtually all of the discussion below regarding the SEC focus areas.

In a particularly flagrant case of a violation of fiduciary duty, the SEC brought an action againstMartin Currie, a Scotland-based fund management group, for steering a U.S. publicly-traded fund intoan investment in order to bolster another client’s fund business in the midst of the 2008 financialcrisis. In this case, the U.S. fund’s board was led to believe that its investment was a routine one, whenit was in fact a direct ploy to alleviate another client’s illiquidity problems. Commenting on the action,Robert Khuzami, then director of the SEC’s Division of Enforcement, summarized an investmentadviser’s fiduciary duty as requiring “an undivided and disinterested loyalty [with] full and fairdisclosure of all material conflicts of interest.”

Custody Rule RequirementsThe custody rule (Rule 206(4)-2) is one of the most critical rules in the Advisers Act. Specifically,Rule 206(4)-2(d)(2) provides that all investment advisers must comply with the custody rule if it or itsrelated person holds, directly or indirectly, client funds or securities or has any authority to obtainpossession of them. The following are key features of the custody rule:

• Qualified Custodian. An adviser with custody of a client’s assets generally must keep clientfunds with a qualified custodian. See Rule 206(4)-2(a)(1).

• Client Notices. When an adviser opens an account with a qualified custodian, it must providenotice to the client in writing with specific information. See Rule 206(4)-2(a)(2).

• Client Account Statements. An adviser must have at least a reasonable basis for believingthat the qualified custodian sends quarterly, or more frequent, account statements to the client.See Rule 206(4)-2(a)(3).

• Annual Surprise Exams. An adviser with custody of client assets must undergo an annualsurprise examination by an independent public accountant which is registered with and subjectto regular inspection by the PCAOB. See Rule 206(4)-2(a)(4) and 206(4)-2(a)(6)(i). Advisersthat use a related person as a custodian of client assets must also obtain a written internalcontrol report at least annually. See Rule 206(4)-2(a)(6)(ii).

Through the custody rule, the SEC emphasizes the importance of ensuring that clients are protectedfrom theft or misuse of their assets. OCIE has cited significant custody rule deficiencies in about one-third of funds examined, including failures to recognize that the firm has custody at all, to meet thecustody rule’s surprise examination obligations and to satisfy the custody rule’s qualified custodianrequirements. Firms facing more lenient penalties for violating the custody rule may be required tobolster their written compliance procedures. Harsher penalties include referral to the SEC’s Divisionof Enforcement.

The SEC has brought numerous enforcement actions for violations of the custody rule. Mostprominently, the Madoff case demonstrated the most egregious kind of fraudulent conductsurrounding the misappropriation of client assets. More recently, in In re Gerasimowicz, the SECinstituted administrative and cease-and-desist proceedings against a registered adviser due to variousviolations of the custody rule, including the lack of an annual surprise examination of the adviser andthe failure to timely distribute annual audited financial statements prepared in accordance with GAAP(thus failing to satisfy the “audit approach” discussed below).



The Custody Rule “Audit Approach”An adviser to a private fund can avoid the client notices and client account statement requirements(Rule 206(4)-2(a)(2)-(3)), and is deemed to have satisfied the surprise exam requirement (Rule 206(4)-2(a)(4)), if the adviser distributes, at least annually, audited financial statements to investors in thefund. This “audit approach” is relied on by many fund advisers, but many advisers trip up by failing tocomply in the following ways:

• The accounting firm that conducted the audit was not “independent” under Regulation S-X.• The audited financial statements were not prepared in accordance with GAAP.• Audited financial statements were only made available upon request, rather than distributed to

all fund investors.• Audited financial statements were not sent to investors within 120 days of the private fund’s

fiscal year end (or 180 days for a fund of funds).• The auditor was not PCAOB-registered and examined.• A final audit was not performed upon the liquidation of the fund.• The adviser requested investor approval to waive the annual financial audit and did not obtain

a surprise examination. Many advisers seek such a waiver in connection with a fund’sliquidation or when assets under management are small. However, the SEC has stated that anadviser must either undergo a surprise examination or comply with the audit approach in itsentirety, including a final audit upon liquidation of the fund.

Marketing and PerformanceThe investment management industry is a highly competitive one which is uniquely prone toinaccuracy or fraud in performance marketing. Often, aberrational performance, as discussed above,can be primarily linked to misstatements in a firm’s marketing of its track record. The SEC will lookclosely at the accuracy of the advertised performance, both hypothetical and back-tested, as well as allmethodologies and assumptions used by the firm. The SEC may also examine any changes to themarketing practices of the firm in response to the SEC’s new rule, which implemented the JOBS Actmandate by eliminating the prohibition on general solicitation in connection with private offeringsunder Regulation D. The new SEC rule becomes effective September 22, 2013.

In the Matter of GMB Capital Management LLC, the SEC alleged that the investment adviser solicitedinvestors with marketing materials containing material misrepresentations, including citations ofperformance purportedly based on actual trades but actually based on back-tested hypothetical trades.The SEC also found that the investment adviser had misrepresented its utilization of qualitative pricingmodels in driving investment decisions. Further, earlier this year, the SEC announced the settlement ofa civil enforcement action against Oppenheimer Asset Management Inc. and one of its affiliates,which alleged that the firms distributed marketing materials containing misleading disclosuresregarding valuation methodologies and the internal rate of return of one of the funds that Oppenheimeradvised.

Last year, the SEC alleged that the executives of Miami-based hedge fund adviser Quantek AssetManagement LLC misrepresented to investors that they had personally invested in a Latin America-focused hedge fund. The SEC found that Quantek made repeated misrepresentations in marketingmaterials, side letters, and other fund documents about its executives having “skin in the game” along



with the investors, when, in fact, Quantek’s executives never invested their own money in the fund.Bruce Karpati, then co-chief of the SEC Enforcement Division’s Asset Management Unit, cautionedthat “private fund investors are entitled to the unvarnished truth about material information such asmanagement’s skin in the game or the adviser’s handling of related-party transactions” when thoseinvestors are making an investment decision.

Investment Adviser and Broker-Dealer RegistrationAs an initial matter, failing to register as an investment adviser when required to under Section202(a)(11) of the Advisers Act could result in harsh consequences such as civil lawsuits, an SECenforcement action or disgorgement of any profits. Absent the availability of an exemption, anyperson that, for compensation, is engaged in the business of providing advice to others or issuingreports or analyses regarding securities must register with the SEC as an investment adviser. Further,the nature of the marketing practices of an investment adviser may trigger an SEC inquiry intowhether the investment adviser should also register as a broker-dealer. Section 3(a)(4)(A) of theSecurities Exchange Act broadly defines a “broker” as “any person engaged in the business ofeffecting transactions in securities for the account of others” and Section 3(a)(5)(A) defines a “dealer”as “any person engaged in the business of buying and selling securities for his own account, through abroker or otherwise.” If, absent an exemption, an investment adviser is either a broker or a dealer, itmust register as such with the SEC. A current industry hot button issue is whether in-house marketingdepartments of private funds need to separately register with the SEC as a broker-dealer as a result oftheir marketing practices. In most cases, an external fund marketing firm which receives success-based fees is typically required to register with the SEC as a broker-dealer.

The SEC enforcement action in In the Matter of Ranieri demonstrates the SEC’s focus on prohibitingunregistered individuals from having substantive communications with prospective investors. In thiscase, a hired consultant of Ranieri Partners solicited investors and provided them with key investmentdocumentation, falling far outside the scope of a simple “finder’s” role. Ranieri Partners paid asizeable penalty for employing a consultant that performed broker-dealer services but failed toproperly register with the SEC.

Conflicts of InterestThe SEC has identified conflicts of interest as a key area of concern in its risk-based analysis ofinvestment advisers. In fact, this area is so broad that virtually any unsavory investment adviserbehavior can be explained in terms of a conflict of interest. As one example in the context of broker-dealers, the SEC released a public report of FINRA, NEP and NYSE examinations regarding broker-dealer compliance with Exchange Act Section 15(g), which requires broker-dealers to “establish,maintain and enforce written policies and procedures reasonably designed . . . to prevent the misuse . .. of material non-public information” by the firm or its associates. This report also highlighted thenecessity of mitigating the misuse of material non-public information by documenting potentialconflicts in this area, monitoring certain individuals or groups and implementing physical barriers. Thelesson to be gleaned from this report is that investment advisers should have clear policies andprocedures regarding their handling of material non-public information and the related conflicts ofinterest.

Other more specific conflicts that the SEC may focus on include:



• Valuation (discussed below): Incentives to provide high valuations for illiquid positions andinflating asset values to attract investors and charge more fees.

• Compensation-Related Conflicts and Incentives: Incentives to place investors in accountswith higher fees relative to the services provided.

• Portfolio Management-Related Conflicts: Incentives to give preferential treatment to certainclients over others in side-by-side account situations or investing client assets in securities thathave a higher risk than the stated risk appetite of the client.

• Transfer Agent Conflicts: Incentives of persons who are both principals of transfer agentsand owners or affiliates of issuers or vendors.

• Investment Adviser/Broker-Dealer Affiliations: Incentives associated with putting the clientinto an affiliated investment adviser or a broker-dealer account.

Conflicts of interest can also be conceptualized in general terms depending on the “stage” in which theprivate fund finds itself. For example, the fund-raising stage could present unique conflicts of interestin the form of preferential terms in side-letters (e.g., redemption rights) or marketing decisionsregarding use of past performance results. Funds in the investment stage may face conflicts of interestin the form of insider trading, investment allocation and fee allocation (e.g. shifting fees to a lessfavored fund or investor). Funds in the management stage may face valuation conflicts of interests.Finally, funds in the exit stage may be incentivized to drag-out the divestment of the fund in order tocontinue to collect a management fee.

The SEC has propounded three major ways in which a private fund adviser can mitigate conflicts ofinterest. First, the adviser should have an effective compliance program which is led by a dynamicteam that understands all of the material conflicts of interest inherent in the fund’s business model.Conflicts must be identified, controlled, and reviewed periodically to make sure the risks are beingcontinuously managed and mitigated. This process must also respond to the evolving business modelof the firm.

Second, the compliance and ethics program should be robust and tailored to the specific firm. Thefederal securities laws require every broker-dealer and investment adviser to have written policies andprocedures to prevent violations of the securities laws (see Rule 206(4)-7 of the Advisers Act). TheU.S. Federal Sentencing Guidelines set forth key elements of an effective compliance and ethicsprogram, including educating and training leadership and employees about the program, standards,and procedures to prevent criminal or illegal conduct, oversight via an organization’s board or seniormanagement, leadership that embodies the ethical guidelines of the program, auditing and monitoringthe effectiveness of the program, incentivizing persons to comply with the program and discipliningthem for non-compliance, taking all reasonable steps to respond to any criminal conduct, and tailoringthe compliance and ethics program to address any deficiencies.

Third, the above process for mitigating conflicts should be part of the firm’s culture and fully woveninto the firm’s overall risk management strategy. Ultimately, the firm’s senior management needs tobe engaged in the conflict of interest mitigation process by considering risks inherent in the firm’sbusiness processes. Although leaders of the firm are tasked with establishing this culture, leadersshould repeatedly emphasize the importance of all members of a firm assessing and mitigatingconflicts.

Examples of SEC enforcement actions concerning conflicts of interest are myriad. In re MatthewCrisp, the SEC alleged that an investment adviser to a private equity fund usurped investment



opportunities from the adviser’s funds while failing to disclose this conflict of interest. This not onlyviolated the adviser’s code of ethics, but it also violated the anti-fraud provisions of the federalsecurities laws.

Further, in September 2012, the SEC instituted an administrative proceeding against Focus Point, anOregon-based investment advisory firm, for its failure to disclose compensation through a revenue-sharing agreement and other conflicts of interest. The SEC cited a serious conflict of interest in thatFocus Point did not disclose to customers that it was receiving revenue-sharing payments from abrokerage firm that managed mutual funds being recommended to clients. As the SEC stated,“[b]ecause Focus Point received a percentage of every dollar that its clients invested in these mutualfunds, there was an incentive to recommend these funds over other investment opportunities in orderto generate additional revenue for the firm.”

Allocation of InvestmentsAlthough this area could be included in the conflicts of interests section, it is important enough tohighlight separately. The SEC often focuses on procedures by which registered advisers allocate tradesamong its clients, particularly if a potential conflict of interest exists (such as when a principal of theadviser is invested in a particular investment vehicle but not others managed by the adviser). Also, forexample, if a firm manages side-by-side accounts or manages performance-based and non-performance based fee accounts, the SEC will focus on whether the firm has controls in place to avoidpreferential treatment of certain investors or allocation of investments to higher fee accounts. The SECmay also focus on issues pertaining to order aggregation or order allocation of customer andproprietary trades to purchase and sell securities. The SEC may also key in on issues such as “partialfills” (when an order to purchase or sell securities exceeds the amount of securities purchased or sold)or “split fills” (when an order for securities is placed but cannot be filled at once). A partial fill couldresult in an investment adviser allocating the purchased securities or sale proceeds among investors ina manner different from the investors’ original orders. A split fill could result in different prices anddifferent brokerage fees caused by executing the investors’ orders in more than one transaction. Thesesituations may be monitored closely by the SEC as they are rife with potential favoritism of certaininvestors over others.

In December 2012, the SEC filed an action against Aletheia Research and Management, Inc., and itsCEO, alleging the unfair allocation of profitable trades to trading accounts of Aletheia employees, theCEO, and other favored clients to the detriment of other non-favored investors. The SEC alleged thatthis practice of “cherry-picking” amounted to a breach of the fiduciary duty owed to all advisoryclients. The SEC also alleged that Aletheia failed to properly implement policies and procedures thatcould have prevented this cherry-picking scheme in the first place.

ValuationThe SEC has also put much focus on valuation risks, an area that poses a veritable minefield foradvisers that manage less liquid or hard-to-value portfolios. Such risks include the inconsistentapplication of pricing procedures, accuracy of advertised performance (whether hypothetical or back-tested), third-party pricing agents assigning inaccurate values, and use of flawed assumptions andmethodologies. Further, a private fund adviser may implement improper compilation methods orreceive inflated fees based on all of the foregoing valuation missteps.



In order to avoid an SEC enforcement action, private fund managers with less liquid portfolios shouldestablish a valuation committee and should ensure that the committee meets as often as necessarygiven the nature of the fund’s valuation risks. Valuation committees should review the firm’svaluation policies and procedures at least annually and should ensure that these policies andprocedures are accurately disclosed in Part 2 of Form ADV, in the fund’s offering documents and inall marketing and investor due diligence materials.

Recent violations that have resulted in SEC enforcement actions include writing up assets to boostfees, increase fundraising, and improve reporting to databases, and writing down assets after a fundwinds down. Most SEC enforcement actions brought in the past couple of years have involved simplefraud as to the value of assets. For example, in 2011, the SEC agreed to a $200 million settlement withMorgan Keegan & Company and Morgan Asset Management in an enforcement action involving thefraudulent valuation of subprime mortgage-backed securities during the 2008 financial crisis. Then, in2012, the SEC brought an enforcement action against three top executives at KCAP Financial Inc.,alleging that the executives overstated the fund’s assets by ignoring certain market-based activitiesstemming from the financial crisis. Specifically, the SEC alleged that KCAP valued its two largestcollateralized loan obligations at cost, rather than at the “exit price” as required by applicableaccounting standards.

In SEC v. Yorkville Advisors, the SEC alleged that a fund adviser “overvalue[d] assets undermanagement and exaggerate[d] the reported returns of hedge funds they managed in order to hidelosses and increase the fees collected from investors.” The SEC alleged that Yorkville did not adhereto its own valuation policies, withheld adverse information provided by its auditors about the fund’sinvestments and illiquidity, and attracted more than $280 million in investments from pension fundsand funds of funds by virtue of its valuation misstatements. The SEC stated that Yorkville’s returnswere inconsistent with its investment strategy, putting the fund “front and center on [the] radarscreen.”

Other Focus AreasThere are various other areas that the SEC may focus on in an examination of an advisory firm. Forexample, the SEC may focus on asset verification even when custodial arrangements do not presentobvious risks of misappropriation. The SEC also considers governance, or the “tone at the top”, as akey component in assessing risk. An examiner may investigate whether an adviser is making full andaccurate disclosures to the fund’s board and whether the fund’s directors (including the directors of anoffshore private fund) are conducting sufficient reviews of service providers, contract approvals,expenses, viability of the fund, and valuation procedures.

Practical GuidelinesIn order to “pass” an SEC compliance exam, or avoid a “for cause” exam altogether, a firm shouldheed the following guidelines:

• Consider having a third party firm that specializes in SEC examinations conduct a “mockexam” to gauge its compliance and preparedness.

• Review past deficiency letters and ensure all deficiencies have been addressed.• Prepare employees and senior management for SEC staff interviews.• Be proactive about identifying and managing conflicts.



• Segregate privileged information.• Remediate conflicts with strong policies and risk controls.• Have evidence of testing policies and procedures.• Be forthcoming about any potential problems.• Be courteous and cooperative.

DODD FRANK: 2013 Broker-Dealer Registration Issues Involving Private Funds

By Irwin M. Latner and Jessica D. Wessel


Latner2 Cover.indd 1 9/24/2013 11:35:59 AM



Broker-Dealer Registration Issues Involving Private FundsBy Irwin M. Latner and Jessica D. Wessel

IntroductionIn recent years, the Securities Exchange Commission (“SEC”) has increased its enforcement focus oninvestment advisers and broker-dealers.1 Several of these enforcement actions have resulted from theSEC’s investment adviser compliance initiative, which focuses on registered investment advisers thatlack effective compliance programs designed to prevent securities laws violations.2 Theseenforcement actions have involved abnormal performance returns by private funds, misleadingdisclosures to investors, and improper fee arrangements.

Most notably, the SEC has increased its focus on the issue of whether private fund adviser personnel(i.e., marketing employees or independent consultants) are acting as unregistered brokers in violationof Section 15(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). In March 2013, theSEC imposed sanctions on, and issued a cease-and-desist order to, Ranieri Partners LLC (“Ranieri”),the private equity firm founded by mortgage bond pioneer Lewis S. Ranieri, in connection with theactivities of an unregistered independent consultant (the “Ranieri Order”). Shortly thereafter, DavidW. Blass, Chief Counsel of the SEC’s Division of Trading and Markets, delivered remarks at anAmerican Bar Association meeting (the “Blass Speech”) in which he indicated his views with respectto broker-dealer registration concerns raised by (i) sales of interests in private funds and the role of in-house marketing departments and (ii) fees paid to private equity fund managers related to portfoliocompany transactions.

The Ranieri Order and the Blass Speech build upon the SEC’s historical, expansive interpretation ofthe definition of a “broker” under the Exchange Act, and reflect the SEC’s current thinking andenforcement approach in the private fund area. That is, the Ranieri Order and the Blass Speechreiterate the SEC’s view that the receipt of transaction-based compensation in connection with the saleof securities is a “hallmark” of broker-dealer activity. Recently, however, a United States DistrictCourt has rejected the SEC’s view that transaction-based compensation alone would require a personto register as a broker-dealer.3 In SEC v. Kramer, the court rejected a single-factor approach, holdingthat the determination of whether a person acts as an unregistered broker in violation of Section 15(a)of the Exchange Act is a multi-faceted exercise, which is based on several factors.

In light of the SEC’s recent enforcement efforts, private fund advisers should be mindful of ExchangeAct implications when entering into marketing arrangements (whether involving in-house or externalmarketers) in connection with the sale of private fund interests. In particular, private fund advisers

_______________________________________________________________________________________________________________1

This is due, in part, to the SEC’s creation of an Asset Management Unit (the “Unit”) within its Division of Enforcement.The Unit is a national specialized unit, which focuses on misconduct by investment advisers, investment companies andprivate funds. Julie M. Riewe and Marshall S. Sprung are the Co-Chiefs of the Unit.2

The SEC also filed several enforcement actions against hedge funds which were triggered by investigations of abnormalperformance returns reported by the funds. Other actions against investment advisers included cases against (A) UBSFinancial Services of Puerto Rico and two executives for misleading disclosures relating to certain proprietary closed-endmutual funds; (B) Morgan Stanley Investment Management for an improper fee arrangement; and (C) OppenheimerFundsfor misleading investors in two funds suffering significant losses during the financial crisis. UBS paid more than $26million to settle the SEC’s charges while OppenheimerFunds paid more than $35 million for its violations.3

See SEC v. Kramer, 778 F. Supp. 2d 1320 (M.D. Fla. 2011) (rejecting the argument that the receipt of transaction-basedcompensation, without more, caused Stephens to be a “broker” under the Exchange Act).



should be aware of the legal and practical implications of structuring marketing arrangements withtheir in-house personnel.

Regulatory Framework for Broker-Dealer RegistrationSection 15(a)(1) of the Exchange Act makes it unlawful for any “broker” or “dealer” to make use ofthe mails or means of instrumentalities of interstate commerce to effect transactions in any security, orto induce or attempt to induce the purchase or sale of any security, unless that broker or dealer isregistered with the SEC pursuant to the Exchange Act. The Exchange Act defines the term (i) “broker”to mean any person engaged in the business of effecting transactions in securities for the account ofothers and (ii) “dealer” to mean any person engaged in the business of buying and selling securities forhis own account; provided, however, that this definition does not include any person insofar as he buysor sells securities not as a part of a regular business.4 Brokers and dealers are generally required toregister with the SEC if they use the mails or any means or instrumentality of interstate commerceeither to effect transactions or to attempt to induce the purchase or sale of any security.

Generally, issuers sell their own securities through their officers and employees without SECregistration by taking advantage of the “Issuer Exemption” under the Exchange Act. Historically, theSEC has stated that an issuer generally does not meet the definitions of “broker” or “dealer” under theExchange Act because the securities are not being sold for the account of others, nor is the issuer bothbuying and selling its securities.5 In turn, the associated persons of an issuer relying on the IssuerExemption typically rely on the registration safe harbor contained in Exchange Act Rue 3a4-1.Pursuant to Rule 3a4-1, an associated person of an issuer shall not be deemed to be a broker solely byreason of his participation in the sale of the securities of such issuer if the associated person (i) is notsubject to a statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act,at the time of his participation; (ii) is not compensated in connection with his participation by thepayment of commissions or other remuneration based either directly or indirectly on transactions insecurities; (iii) is not at the time of his participation an associated person of a broker or dealer; and (iv)(A) limits the offering and selling of the issuer’s securities only to broker-dealers and other specifiedtypes of financial institutions; (B) performs substantial duties for the issuer other than in connectionwith transactions in securities, was not a broker-dealer or an associated person of a broker-dealerwithin the preceding 12 months, and does not participate in selling an offering of securities for anyissuer more than once every 12 months; or (C) limits activities to delivering written communication bymeans that do not involve oral solicitation by the associated person of a potential purchaser.

If a person cannot rely on the Issuer Exemption, it may nevertheless be exempt from SEC registrationpursuant to a limited “Finder’s Exception” that was developed by the SEC staff in the early 1990s.6

However, since that time, the SEC has voiced its disapproval with the Finder’s Exception.7 In a 2010no-action letter, the SEC staff denied no-action relief to Brumberg, Mackey & Wall, P.L.C. (“BMW”),a law firm, in connection with BMW’s proposed fundraising activities for an energy technology

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See Sections 3(a)(4) and 3(a)(5) of the Exchange Act.5

The SEC has noted that “the [Exchange] Act has customarily been interpreted not to require the issuer itself to register aseither a broker or a dealer.” See Exchange Act Release No. 34-13195, 1977 WL 174110, Jan. 21, 1977.6

See Paul Anka, SEC No-Action Letter (available July 24, 1991).7

See Record of Proceedings of 2008 Annual SEC Government-Business Forum on Small Business Capital Formation(Nov. 20, 2008).



company.8 In its letter denying no-action relief, the SEC staff stated that the receipt of compensationdirectly tied to the sale of securities would give BMW a “salesman’s stake” and, in turn, would createa heightened incentive for BMW to engage in sales efforts. Accordingly, the SEC staff declined toissue the requested no-action relief and would not refrain from taking enforcement action if the firmproceeded with its proposed compensation plan without registering as a broker-dealer.9

Notwithstanding this historical approach, a United States District Court recently rejected the SEC’sposition that the receipt of transaction-based compensation, absent any other indicia of broker-dealeractivity, is enough to require a person to register with the SEC as a broker-dealer.10 In SEC v.Kramer, the court noted that the distinction between a finder and a broker-dealer remains largelyunexplored, and both the case law and the SEC’s informal, “no-action” letter advice is highlydependent on the facts of a particular arrangement.11

In Kramer, Kenneth R. Kramer (“Kramer”) and Bruce Baker (“Baker”) entered into a writtenagreement whereby Kramer and Baker promised to cooperate in presenting to each other prospectivemerger and acquisition candidates, potential sources of investment and venture capital funding, andother forms of business opportunities, and to share any fee or compensation resulting from thesuccessful conclusion of a business arrangement. Prior to this agreement, Skyway Aircraft (“Skyway”)agreed to pay Baker a 5% commission (i) on capital raised on behalf of the company; (ii) on thepurchase price of any acquisition or merger resulting from Baker’s introducing Skyway and a thirdparty; and (iii) on the total value of any contract brought to Skyway by Baker. The evidence at trialshowed that Kramer received transaction-based compensation in two instances.12

In its analysis, the Kramer court stated that while the factors developed in SEC v. Hansen areinstructive for finding broker-dealer activity, they are not exclusive.13 Rather, the evidence of broker-dealer activity must demonstrate involvement at “key points in the chain of distribution,” such asparticipating in the negotiation, analyzing the issuer’s financial needs, discussing the details of thetransaction, and recommending an investment.”14 Thus, the court concluded that Kramer’sinvolvement was not enough to make him a broker-dealer. The court found that Kramer told a smallbut close group about Skyway and opined that Skyway seemed like a good investment. The courtstated that the broker analysis under Section 15(a) of the Exchange Act permits examination of a wide

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See Brumberg, Mackey & Wall, P.L.C., SEC No-Action Letter (available May 17, 2010). In its incoming letter, BMWstated that the company “would engage BMW to assist them in the acquisition of funding for financing to fund theoperations and development of [the company].” The letter also stated that BMW’s proposed role would be limited to theintroduction of BMW’s contacts who may have an interest to the company. Further, BMW stated it would not (i) engage innegotiations with potential investors; (ii) provide any information about the company to potential investors that may beused as a basis for negotiations; (iii) recommend any investment in the company; or (iv) provide any assistance to potentialinvestors.9

Id.10

See footnote 3.11

See SEC v. Kramer, 778 F. Supp. 2d at 1336-37.12

Kramer arranged a meeting between Nick Talib, a registered broker-dealer, Baker and Skyway. Following this meeting,Talib raised a substantial amount of financing for Skyway by selling shares to investors, and both Baker and Kramerreceived a payment from Skyway based on the success of the introduction. Kramer also received compensation from Bakerbased on Kramer’s reporting to Baker of certain purchases of Skyway shares.13

Id. at 1334.14

Id. at 1336 (quoting Cornhusker Energy Lexington, LLC v. Prospect St. Ventures, 2006 WL 2620985, at *6(D.Neb.2006).



array of factors, including those factors already identified in applicable precedent. In the absence of astatutory definition of “effecting securities transactions” or “engaged in the business” in the definitionof “broker” under the Exchange Act, the court stated that certain factors determine whether a personqualifies as a broker. Further, the court stated that one factor may evidence broker activity whileanother may support the absence of broker activity. However, one factor alone (e.g., transaction-basedcompensation) is not determinative. Therefore, in the absence of a statutory definition enunciatingotherwise, the court found that the test for broker activity must remain cogent, multi-faceted, andcontrolled by the Exchange Act.

Accordingly, the court held that neither applicable precedent nor statutory language permits theconclusion, based on the admissible evidence, that Kramer acted as an unregistered broker in violationof Section 15(a) of the Exchange Act. Further, the court found that the SEC failed to show by apreponderance of the evidence that Kramer engaged in the business of effecting transactions insecurities for the accounts of others.

The Kramer decision is encouraging in that a court has rejected the SEC’s position that the receipt oftransaction-based compensation alone is enough to cause a person to be considered a broker-dealerunder the Exchange Act. Yet, while this decision is persuasive authority in the Middle District ofFlorida, it is not binding on the SEC in other jurisdictions. Nevertheless, the SEC seems to be takingan aggressive approach to long-standing practices in the private fund industry, especially in light of theRanieri Order and the Blass Speech, both of which emphasize transaction-based compensation as a“hallmark” of broker-dealer activity.

The Ranieri OrderIn the Ranieri Order, the SEC found that the independent consultant, William M. Stephens(“Stephens”), operated as an unregistered broker in violation of Section 15(a) of the Exchange Actbecause he actively solicited investors on behalf of private funds managed by Ranieri’s affiliates and,in return, received transaction-based compensation totaling approximately $2.4 million. The SECfurther found that Ranieri and Donald W. Phillips (“Phillips”), Ranieri’s then Senior ManagingPartner, did not take adequate steps to prevent Stephens from having substantive contacts withpotential investors. Accordingly, the SEC imposed sanctions on, and issued a cease-and-desist order toRanieri Partners in connection with the activities of its independent consultant, Stephens.15 The SECfound that Stephens operated as an unregistered broker because he actively solicited investors onbehalf of Selene Residential Mortgage Opportunity Fund L.P. (“Selene I”) and Selene ResidentialMortgage Opportunity Fund II L.P. (“Selene II”) (collectively, the “Selene Funds”), private fundsmanaged by Ranieri’s affiliates. Based on the following actions, the SEC found that Stephens engagedin the business of effecting transactions in securities in violation of Section 15(a) of the Exchange Act:

• Stephens distributed private placement memoranda (“PPMs”), supplemental PPMs,subscription documents, presentation, and other marketing materials to potential investors inthe Selene Funds.

• Stephens attended meetings with Phillips and potential investors.

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The terms of Stephens’ engagement with Ranieri were reflected in consulting services agreements prepared by outsidecounsel to Ranieri Partners. Ranieri Partners agreed to pay Stephens a fee equal to 1% of all capital commitments made tothe Selene Funds by investors introduced by Stephens.



• Stephens communicated directly with investors, including providing details about the SeleneFunds’ respective investment strategies.

• Stephens met with, and provided diligence materials to, a potential investor’s outsideconsultant for money manager selection and retention.

• Stephens described the investment to a potential investor as a “rare opportunity to earn abovemarket returns,” and encouraged the investor to consider the investment.

• Stephens sent a potential investor a list of current and prospective investors for Selene I, whichincluded a list of expected dates and amounts of the investors’ respective capital commitments.

• Stephens drafted correspondence for Phillips’s signature that addressed key questions raised bya potential investor whom Stephens had contacted and met with.

• Stephens told a potential investor that “returns to [Selene I] have been strong and the outlookfor [Selene II] looks real positive with Ranieri Partners taking on the role of market leader inthis space.” In the same email, Stephens stated that investor would pay a lower managementfee if it made a commitment before the first closing for Selene II.

Based on the foregoing, the SEC found that Stephens actively solicited investors on behalf of theSelene Funds and, in return, received transaction-based compensation totaling approximately $2.4million.

The SEC further found that Ranieri and Phillips, Ranieri’s then Senior Managing Partner, did not takeadequate steps to prevent Stephens from having substantive contacts with potential investors. Forexample:

• Phillips sent Stephens copies of the Selene Funds’ executive summaries, which summarizedtheir respective investment strategies, and provided Ranieri’s view of the distressed mortgagemarketplace and the firm’s competitive advantages in such marketplace.

• Ranieri’s personnel provided Stephens with copies of PPMs, supplemental PPMs, subscriptiondocuments, presentation, and other marketing materials for the Selene Funds.

• Stephens attended meetings with Phillips and potential investors.• Ranieri reimbursed Stephens for travel and entertainment expenses incurred on trips both with

and without Phillips in connection with capital raising for the Selene Funds.

The Ranieri Order imposed sanctions on Ranieri, Philips and Stephens.16 As a result of the conductdescribed above, the SEC found that (i) Ranieri caused Stephens’ violations of Section 15(a) of the

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The Ranieri Order required Ranieri Partners to cease and desist from committing or causing any further violations ofSection 15(a) of the Exchange Act, and to pay a civil money penalty of $375,000. Further, the Ranieri Order required thatPhillips (i) cease and desist from committing or causing any further violations of Section 15(a) of the Exchange Act; (ii) besuspended from association in a supervisory capacity with any broker, dealer, investment adviser, municipal securitiesdealer municipal adviser, transfer agent, or nationally recognized statistical rating organization for a period of nine (9)months; and (iii) pay a civil money penalty of $75,000.

The Ranieri Order also provided that Stephens (i) is barred from association with any broker, dealer, investment adviser,municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; (ii) isprohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser ordepositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser,depositor, or principal underwriter; and (iii) is barred from participating in any offering of a penny stock, including: actingas a promoter, finder, consultant, agent or other person who engages in activities with a broker, dealer or issuer forpurposes of the issuance or trading in any penny stock, or inducing or attempting to induce the purchase or sale of any



Exchange Act; (ii) Phillips willfully aided and abetted and caused Stephens’ violations of Section15(a) of the Exchange Act; and (iii) Stephens willfully violated Section 15(a) of the Exchange Act.

Speech by David W. Blass, Chief Counsel of the SEC’s Division of Trading andMarketsOn April 15, 2013, David W. Blass, Chief Counsel of the SEC’s Division of Trading and Marketsdelivered a speech to the American Bar Association’s Trading and Markets Subcommittee in which hediscussed broker-dealer registration in the context of private fund advisers. Blass stated that the SECstaff is increasingly focused on examining private fund advisers, both due to new regulatoryrequirements and the SEC’s own observations in the private fund space, particularly related to (i) salesof interests in private funds and (ii) fees related to portfolio company transactions.

More specifically, Mr. Blass focused on two issues in his remarks: (i) the payment of transaction-based compensation by a private fund adviser to its personnel for selling interests in a fund and thehiring of personnel whose only or primary functions are to sell interests in the fund; and (ii) the receiptof transaction-based compensation by the private fund adviser, its personnel or its affiliates forpurported investment banking or other broker activities relating to one or more of the fund’s portfoliocompanies. The second issue is more common among private equity fund advisers that executeleveraged buyout strategies.

With respect to the sale of fund interests, Mr. Blass provided the following examples of activities, orfactors, that might require private fund adviser personnel to register with the SEC as a broker-dealer:(i) marketing securities (shares or interests in a private fund) to investors; (ii) soliciting or negotiatingsecurities transactions; or (iii) handling customer funds and securities. Moreover, Mr. Blass stated thatthe importance of the above activities is heightened where the employee receives compensation basedon the outcome or size of the securities transaction (i.e., transaction-based compensation). Thus, itappears that, in light of the Kramer case and the Ranieri Order, the SEC and its staff consider thereceipt of transaction-based compensation to be a “hallmark” of broker activity, which will cause themto scrutinize private fund adviser personnel arrangements more closely for other indicia of broker-dealer activity.17

In addition, Mr. Blass addressed the unique issues that arise in the context of securities offerings bycertain private equity fund advisers, particularly those whose funds follow a leveraged buyoutstrategy. In such circumstances, private fund advisers may collect other types of fees in addition toadvisory fees, which Mr. Blass remarked may call into question whether such advisers are engaging inactivities that require broker-dealer registration. Examples of these additional fees include fees that theprivate fund adviser directs a portfolio company of the fund to pay directly or indirectly to the adviseror one of its affiliates in connection with the acquisition or disposition (including an IPO) of aportfolio company or a recapitalization of a portfolio company. These fees are often described as

penny stock. Any reapplication by Stephens to be an associated person of a broker-dealer will be subject to the applicablelaws and regulations governing the reentry process.16 Stephens was ordered to pay disgorgement of $2,418,379.20 andprejudgment interest of $410,248.75, but payment of such amount was waived based upon his sworn representations in hisStatement of Financial Condition dated January 28, 2013 and other documents submitted to the SEC.17

Mr. Blass also provided a list of key questions private fund advisers should ask in connection with their internalmarketing arrangements: (1) how does the adviser solicit and retain investors?; (ii) do employees who solicit investors haveother responsibilities?; and (iii) how are the personnel who solicit investors compensated?



compensation for “investment banking activity,” including negotiating transactions, identifying andsoliciting purchasers or sellers, or structuring transactions.

Practical Implications for Private Fund Advisers

In light of the SEC’s recent enforcement efforts, private fund advisers should be mindful of ExchangeAct implications when entering into marketing arrangements (whether involving in-house or externalmarketers) in connection with the sale of their private fund interests. A private fund adviser mayengage SEC-registered broker-dealers (“Placement Agents”) pursuant to written agreements, whichwill alleviate concerns about independent consultants engaging in unregistered broker activity inconnection with the offering of private fund interests.

However, a private fund adviser may desire to hire employees or engage independent consultants thatare not registered with the SEC as broker-dealers. In our experience, private fund advisers generallydo not rely on the Issuer Exemption for such arrangements because they do not fit within itsparameters. First, an independent consultant normally does not come within the Issuer Exemptionbecause it would generally not qualify as an “associated person of an issuer” for purposes of theexemption. With respect to the fund manager’s employees, they would also normally not be eligiblefor the Issuer Exemption because the employee is typically compensated, directly or indirectly, basedon transactions in securities (i.e., based on their successful capital raising efforts). Also, since privatefund managers are frequently, if not continuously, engaging in capital raising activities, theirmarketing personnel have likely participated in selling one or more offerings of securities within thepreceding 12 months.

Notwithstanding the difficulties in structuring in-house marketing personnel arrangements to complywith the Issuer Exemption, a private fund adviser utilizing internal personnel to market its funds(either in lieu of or in addition to arrangements with Placement Agents) should attempt to stay withinspirit of the Issuer Exemption even if they cannot meet all of its requirements. Thus, an adviser shouldseek to structure its marketing arrangement as an employer-employee relationship that is mindful ofthe factors enumerated in SEC v. Hansen and SEC v. Kramer for determining the presence of brokeractivity. Accordingly, a private fund adviser should make a good faith effort to ensure that therelationship with its marketing employees satisfies as many of these factors as possible. For example,a private fund adviser might structure a marketing arrangement so that the employee performssubstantial duties for or on behalf of a private fund other than in connection with the sale of itsinterests. This may include investor relations, marketing, strategic planning, deal structuring, assistingwith regulatory and investor reporting and disclosures or other non-sales related responsibilities.Similarly, the employee’s compensation can be based on overall firm performance and other factors inlieu of the success of the employee’s individual sales efforts.

With respect to portfolio company transaction fees paid to private fund advisers that advise privateequity funds with a leveraged buyout strategy or other private equity strategy, factors weighing againstthe determination of broker status may include (i) the fact that an adviser normally has “skin in thegame” or a substantial equity investment in the issuer and often plays a major role in the issuer’sdecision-making, (ii) the fact that full disclosure of the adviser’s ancillary portfolio company activitiesand related fees is normally made in the fund’s offering documents and in the relevant portfoliocompany transaction documents, (iii) the portfolio company transactions that generate the feesnormally involve sophisticated institutional counterparties, and (iv) in many cases, the adviser isalready registered as an investment adviser with the SEC and subject to substantial regulation and



fiduciary duties. Interestingly, Mr. Blass stated that a private equity fund adviser would likely not beconsidered to be engaged in broker activities where 100% of such portfolio company transaction feespaid to the adviser are used to offset or reduce the amount of management fees otherwise payable byfund investors. In other words, this arrangement could be viewed as an alternative method of payingthe manager its management fee.

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PRINCETON210 Carnegie Center Princeton, NJ 08540 t 609.452.3800 f 609.520.9095

Herrick, Feinstein LLP

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