WASHINGTON (CN) – The Securities and Exchange Commission plans to adopt business conduct standards for security-based swap dealers similar to existing standards used by self regulatory organizations, such as stock exchanges, because it expects most such swap dealers to be members of a self regulatory organization.
Security based swaps are options traded between counterparties based on the value of an underlying security, which may include debt, assets, futures contracts and other financial instruments whose value might change over the course of the swap.
The Dodd-Frank Wall Street Reform and Consumer Protection Act authorizes the SEC to define and regulate security-based swaps because the relatively new and not widely understood financial products often were overvalued by buyers and sellers alike, contributing to the financial collapse in 2008.
The proposed standards would require security-based swap dealers and major participants in the markets for security-based swaps to designate a chief compliance officer to audit the dealer’s compliance with the new rules, which are based on principles of “fair dealing” and “good faith.”
In action, dealers and participants would have to disclose material information about any swaps they propose, including material risks, characteristics, incentives and conflicts of interest that either party may have.
More specifically, dealers would have to make a formal determination, which would become part of the record of a swap, that any recommendations they make regarding security-based swaps are suitable for their counterparties.
Even tighter standards apply for dealers when they act advisor to the investment arms of federal agencies, states and political subdivisions, employee benefit plans, governmental plans, and endowments – so called “special entities.” In such cases, the new rules create a duty for the advisor to act in the “best interests: of the special entity.
Dealers and other market participants can only engage special entities as counterparties if they reasonably believe that the special entity is represented by someone who has sufficient knowledge to evaluate the transaction and the inherent risks, has no connection to any other party in the transaction and has taken on the duty to act in the best interest of the entity.
The strict rules for dealing with special entities follow SEC investigations, which revealed that people responsible for investing government pensions and trust funds frequently did not understand the nature of the security-based swaps and, in some cases, stood to gain from the transactions.
The agency is accepting public comment on the proposed business standards until August 29, 2011.