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Legislation

Market Sweats Swap Provisions

WASHINGTON — As lawmakers in the Senate and House begin to resolve the differences in their separate financial regulatory reform bills this week, market participants are hoping the finished product will exclude several controversial provisions they say could eliminate the municipal derivatives market.

Chief among municipal dealers’ and some issuers’ concerns is a provision in the Senate bill, which cleared that chamber Thursday night on a mostly partly-line vote of 59 to 39, that would impose a fiduciary duty on dealers when they advise, pitch, or enter into swaps with public entities.

Last week, the National Association of State Treasurers said in a letter to Senate Banking Committee chairman Christopher Dodd, D-Conn., that the provision is “inappropriate.” In addition, the Securities Industry and Financial Markets Association and the Regional Bond Dealers Association warned it would be legally unworkable to hold issuers’ interests ahead of their own as counterparty on such transactions.

Lobbyists at both SIFMA and RBDA said Friday that they prefer language proposed as an amendment to the Senate bill by Sens. Robert Casey, D-Pa., and Tom Harkin, D-Iowa, that would require dealers to have a reasonable basis for believing that a swap is a suitable investment and that the issuer have an independent swap adviser. The amendment was one of several hundred that never came up for a vote before the Senate passed its bill.

The House passed its own proposal in December.

Peter Shapiro, managing director at Swap Financial Group, suggested the controversial muni-related provisions would be altered during conference, which is likely to take several weeks but could be finished before Congress’ July 4 recess.

“We know that there have been detailed, serious, and good-faith discussions about making important amendments, and our expectation is that … some of the provisions which have caused concern among issuers will be taken into account,” he said.

Shapiro declined to elaborate on which provisions would likely be altered, saying he could not predict the future. But he said the concerns raised by muni market participants have been discussed with congressional leadership, key staff members, as well as the chairs and members of the four relevant committees — Senate Banking, House Financial Services, and the two agriculture committees.

Meanwhile, lawmakers involved in the conference also will have to decide which regulator will oversee currently unregulated market intermediaries, such as non-dealer financial advisers, swap advisers and investment brokers.

The Senate bill would require such advisers to register with the Securities and Exchange Commission and be subject to regulation by the Municipal Securities Rulemaking Board, while the House bill would give the SEC exclusive oversight over them — a move favored by non-dealer FAs.

In an effort to boost the profile of the municipal market among federal regulators, the Senate bill also would mandate the SEC’s office of municipal securities and require that it report directly to the SEC chairman. Currently, it is staffed by only two attorneys within the division of trading and markets. The House bill does not feature such a provision.

John McNally, a partner at Hawkins Delafield & Wood LLP, noted that the SEC’s muni chief reported directly to the chairman under Arthur Levitt, who headed the commission from 1993 to 2001.

Market participants stressed that concerns over the derivatives section are not limited to the fiduciary duty for swap dealers. Some warn lawmakers also need to clarify whether issuers that may lose their status as eligible contract participants, or ECPs, but have existing swaps, can continue to manage their contracts.

“They may never want to do another trade again, but if they have existing trades, they need to be able to manage their portfolio the way they originally intended,” said Sam Gruer, a managing director at Cityview Capital Solutions LLC.

In order to be an ECP, an issuer would have to have $50 million in “discretionary investments” or have a bank or broker-dealer as a counterparty, under the House bill. In contrast, the Senate bill would offer no flexibility around discretionary investment threshold by essentially requiring banks to spin off their derivatives subsidiaries. The spun-off units would not count as banks or broker-dealers.

Gruer said lawmakers also should clarify whether a restructuring, termination or novation — in which one counterparty replaces another entity with their position in the trade — constitutes a new trade under the law.

Though most market participants are unlikely to view a termination as a new trade, Gruer said if non-ECP issuers can not novate their position, “they could effectively be held hostage by one firm’s pricing.”

Finally, he said Congress should address whether non-ECP issuers that in the future tweak the structure of variable-rate bonds will be allowed to make corresponding changes to their related, synthetically-fixed swaps.

In some cases, Gruer said, the tax law may require them to make the changes to their swaps in order to continue to “super-integrate” them with their bonds. But the tax law requirement may conflict with the regulatory reform bill.

Super-integration generally allows the issuer to treat the bonds and swap as one fixed-rate transaction for tax purposes.

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