Under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, special requirements and business conduct rules are to be imposed on swap dealers advising or engaging in trades with pension funds or state and local government “special entities.” The Commodity Futures Trading Commission (CFTC) has now proposed such rules, which would provide that when swaps dealers interact with such special entities, including governmental pension plans, they must act in the “best interests” of the plan and have a reasonable basis to believe that it has a qualified representative meeting certain sophistication and independence criteria. Some public pension plans have concerns with the proposed regulations, and have filed comments stressing that there is an “inherent conflict of interest for one of the parties to a transaction also to be responsible for determining who might represent the other side of a transaction.” The plans urge an alternative whereby the CFTC would permit swap transactions with a special entity so long as the special entity had a representative, either internally or at a third-party, certified as able to evaluate swap transactions.
Initially, the Senate version of what ultimately became the Dodd-Frank law would have imposed a strict fiduciary duty on swap dealers advising or engaging in trades with pension funds or state and local government “special entities.” However, many protested that since swap dealer would be the “opposing” party to the transaction, as such they would therefore have a conflict of interest that would preclude them from fulfilling their fiduciary duty under the law. Thus, it was feared that the provision could have had the unintended result of discouraging swap dealers from agreeing to do business with pension plans at all.
Although unions and consumer groups just as strongly opposed any weakening of the original Senate language, claiming that there was “overwhelming evidence that most pensions and government entities lack the financial sophistication to protect their own interests in these transactions," the final bill was modified, and the law now requires that a swap dealer that acts as an advisor to a public plan regarding a swap has a duty to act "in the best interests" of the plan and to make a reasonable determination that any swap it recommends is in the best interests of the plan.
However, a swap dealer that simply enters into or offers to enter into swap, but does not offer advice, must only have a reasonable basis to believe that the plan has a representative that, among other things, is independent of the swap dealer and has a duty to act in the best interests of the plan.
In December of 2010, the Commodity Futures Trading Commission (CFTC) proposed business conduct rules to govern swap dealers and major swap participants in their dealings with counterparties. The proposed regulations would prohibit certain fraudulent and abusive practices and impose significant disclosure, diligence, suitability and transaction execution obligations on swap dealers. In particular, when a “special entity” is involved as a counterparty, including certain governmental entities, municipalities, employee and governmental benefit plans and endowments, swap dealers must act in the “best interests” of the special entity and have a reasonable basis to believe that the special entity has a qualified representative meeting certain sophistication and independence criteria.
Some public pension plans have concerns with the proposed regulations, and have filed a joint comment letter. These plans include the California Public Employees’ Retirement System (CalPERS), the Public School & Education Employees’ Retirement System of Missouri, the Missouri State Employees’ Retirement System (MOSERS), South Carolina Retirement System Investment Commission, the Pennsylvania Public School Employees’ Retirement System, the State of Wisconsin Investment Board, Colorado PERA, the Utah Retirement Systems, the New Jersey Division of Investments, and the Virginia Retirement System.
Specifically, their letter raises issues with the proposed regulation’s requirement that a swap dealer that offers to enter into, or enters into, a swap with a special entity have a reasonable basis to believe that the special entity has a representative who is independent of the swap dealer and who meets certain other requirements. According to the CIO’s of these plans, there is an “inherent conflict of interest for one of the parties to a transaction also to be responsible for determining who might represent the other side of a transaction.” They are concerned that this “would give undue influence” to a swap dealer to determine who qualifies to fill that role.
The letter also expresses concern with the vagueness of the meaning of certain terms, and concludes that the regulations pertaining to dealings with a special entity “could be wholly unworkable and adversely affect pension fund members.”
The CIOs propose an alternative that would permit off exchange swap transactions with a special entity so long as the special entity had a representative, either internally or at a third-party, certified as able to evaluate swap transactions. The certification process would include a proficiency exam to be developed by the CFTC (or by an appropriate self-regulatory organization) and periodic ethics training. This would permit persons employed by a special entity that have extensive experience in the swaps and other financial markets to qualify for the certification and thus not be blocked from serving as an independent representative by a swap dealer.
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