Regulating Fairness: the Dodd-frank Act's Fair Dealing Requirement for Swap Dealers and Major Swap Participants

• Publication year: 2021
• Citation: Vol. 93

93 Nebraska L. Rev. 31. Regulating Fairness: The Dodd-Frank Act's Fair Dealing Requirement for Swap Dealers and Major Swap Participants

Regulating Fairness: The Dodd-Frank Act's Fair Dealing Requirement for Swap Dealers and Major Swap Participants

Gregory Scopino(fn*)

TABLE OF CONTENTS

I. Introduction.......................................... 32

II. The Dodd-Frank Act and External Business Conduct Standards for Swap Entities .......................... 39
A. Congress Reshapes the Regulatory Landscape...... 39
B. Regulations Implementing External Business Conduct Standards................................42
C. The CFTC's Fair Dealing Rule.....................45
D. Relationship with Other External Business Conduct Standards.........................................47

III. Looking to NFA Guidance When Interpreting the Fair Dealing Rule..........................................51
A. Industry Familiarity with SRO "Precedents".......51
1. NFA Compliance Rules 2-2 and 2-4............56
2. NFA's Customer Communications Rule.........56
3. NFA Interpretive Notices on the Customer Communications Rule .........................57
i. Interpretive Notice 9003-Section-by-Section Analysis of the Customer Communications Rule ....................................... 57
ii. Interpretive Notice 9025-Hypothetical Performance Results ....................... 61
iii. Interpretive Notice 9038-High-Pressure Sales Practices ............................. 62

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iv. Interpretive Notice 9039-Radio and Television Advertisements..................64
v. Interpretive Notice 9043-Examples of Violative Conduct..........................65
B. Lessons from NFA Guidance for Regulation 23.433 .66

IV. Investment Bank Misconduct Detailed in the U.S. Senate's Anatomy of a Financial Collapse..............68
A. Deutsche Bank....................................70
B. Goldman..........................................71
1. Hudson........................................72
2. Anderson ......................................74
3. Timberwolf....................................75
4. Abacus........................................76

V. Potential Sources of Good Faith Principles for the Fair Dealing Rule ..........................................77
A. Contract Law's Implied Covenant of Good Faith and Fair Dealing ......................................77
B. Drawbacks to Using Contract Law Principles of Good Faith ........................................ 80
C. The "Excluder" Conceptualization of Good Faith as a Possible Model Framework for the Fair Dealing Rule .............................................. 82
D. Applying an Excluder Conceptualization to Regulation 23.433 ................................. 84

VI. Conclusion ............................................ 87

"Fairness is what justice really is."

-Potter Stewart (1915-1985), Associate Justice, U.S. Supreme Court(fn1)

I. INTRODUCTION

In the years leading up to the financial crisis of 2008, investment banks and other large financial institutions used tactics that were misleading and unfair in structuring, marketing, selling and otherwise dealing in complex over-the-counter (OTC) derivatives with names such as "swaps,"(fn2) "collateralized debt obligations,"(fn3) and "credit

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default swaps."(fn4) A derivative is a financial product whose value is derived from a specific reference asset or underlying variable, such as a commodity or an interest rate.(fn5) A financial product that is traded OTC is not traded on an organized exchange, but instead negotiated privately between counterparties.(fn6) For example, some banks that ac-

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ted as OTC derivative dealers(fn7) pulled toxic assets off their own balance sheets and put them into OTC derivatives without disclosing to counterparties that the derivatives contained underlying assets, such as residential home mortgages, which the banks wanted to get rid of because they expected those assets to perform poorly in the immediate future.(fn8) In other circumstances, derivative dealers marketed and sold OTC derivatives at inflated prices while simultaneously refusing requests from counterparties to provide information about how those prices had been determined. They would then drastically mark down the estimated value of those same derivatives almost immediately after they were sold.(fn9) Some swap dealing banks also neglected to disclose materially adverse incentives and other conflicts of interest. This included instances where banks were betting against the OTC derivatives to profit from any decreases in the value of those deriva-tives,(fn10) as well as instances where the assets underlying the OTC derivatives had been selected by parties who likely stood to profit if the derivatives performed poorly.(fn11)

In light of such conduct, congressional leaders wanted to make the country's financial markets fair to participants.(fn12) In 2010, Congress

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enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)(fn13) that, among other things, directed the U.S. Commodity Futures Trading Commission (CFTC)(fn14) and the Securities and Exchange Commission (SEC)(fn15) to promulgate rules requiring certain large financial institutions to act fairly with their counterpar-ties.(fn16) To that end, Congress directed financial regulators to impose strict ethical business conduct standards on the financial institutions that structured, marketed, and sold OTC derivatives.(fn17) Specifically,

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the statutory provisions required regulators to create rules mandating that OTC derivative dealers communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith.(fn18) The CFTC stated that its fair dealing rule incorporated existing standards of fair play from the National Futures Association (NFA) and the futures industry's self-regulatory organization (SRO), and that the rule would serve to prohibit the kind of improper sales practices mentioned above and documented in an official report by the U.S. Senate's Permanent Subcommittee on Investigations.(fn19)

The CFTC provided little more than general statements about the kind of communications that the fair dealing rule would prohibit. For example, the specific elements or mental state that would be required for a cause of action under the rule were not clarified. Although the CFTC stated that it "would consider providing further guidance" concerning the fair dealing rule,(fn20) the agency has yet to do so.

U.S. Supreme Court Associate Justice Potter Stewart once said that "[f]airness is what justice really is"-but what is fairness? One dictionary definition of the word "fair" is "free from bias, dishonesty, or injustice . . . ."(fn21) By comparison, "unfair" refers to conduct that is "not conforming to standards of justice, honesty, or the like."(fn22) Unfortunately, those definitions do not provide much help in determining the specific kind of communications that would violate a fair dealing rule for swap dealing banks.

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Legislatively mandating adherence to a vague principle like fairness may be admirable, but it runs the risk of simply adding an ambiguous edict to a regulatory landscape that already includes prohibitions against fraud and misrepresentations. Indeed, a broad-based congressional fair dealing directive is unlike existing prohibitions against fraud or various specific forms of improper conduct that are, by and large, easier to define and recognize than a concept such as "fair dealing." On the other hand, to the extent that a fair dealing rule can be given sufficient specificity and clarity, it could conceivably serve as an effective deterrent to improper conduct that existing statutory and regulatory provisions might be unable capture-a mechanism to reach unfair conduct that merits prohibition but might otherwise fall beyond the reach of existing federal laws and regulations. This Article seeks to better understand this new duty to communicate fairly as it relates to the federal regulation of entities called swap dealers(fn23) and major swap participants(fn24) (collectively, "swap en-

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tities"),(fn25) with the goal of determining, to the extent possible, the kinds of communications that the rule prohibits.

Part II of this Article provides background on the relevant portions of the Dodd-Frank Act and describes the CFTC External Business Conduct rulemaking. Part III examines the relevant NFA guidance that the CFTC indicated that it would look to in interpreting the fair dealing rule and finds, among other things, that the relevant NFA precedents prohibit high-pressure sales practices and negligent misrepresentations in promotional material. Part IV describes the improper swap dealer conduct outlined in the Senate Report that- according to the CFTC-would run afoul of the CFTC's fair dealing rule-much of which involves failures to disclose information, such as adverse interests and swap pricing methodology. Part V analyzes whether the implied covenant of good faith and fair dealing in contract law is an appropriate source for additional principles of good faith that could be used in connection with the fair dealing rule. Part V concludes that, while contract law jurisprudence is unsuitable as a source of law for the CFTC's fair dealing rule, an approach similar to the "excluder" conceptualization of good faith used in section 205 of the Restatement (Second) of Contracts...