WASHINGTON — Market participants are urging the Commodity Futures Trading Commission to clarify, in its proposed business-conduct standards for swap dealers, that dealers should not be required to put a state or local government issuer’s interests ahead of their own.
“The proposed rules ask, 'Should swap dealers be subject to an explicit fiduciary duty when making a recommendation to a counterparty?’ ” the Committee on Capital Markets Regulation, an independent, nonprofit research organization dedicated to improving regulation of the U.S. capital markets, wrote in a comment letter recently filed with the CFTC. “The short answer is no.”
The committee’s three-page, May 3 letter was signed by co-chairs R. Glenn Hubbard, dean of the Columbia Business School, and John Thornton, chairman of the board of trustees of the Brookings Institution, as well as Hal Scott, the committee’s director and the director of the program on international financial systems at Harvard Law School.
It was sent in response to the proposed business-conduct standards for swap dealers and major swap participants, or MSPs, that the CFTC proposed in December. The commission asked for comments on whether swap dealers should be held to “an explicit fiduciary duty” when recommending swaps.
The Committee on Capital Markets Regulation’s comments come as Republican lawmakers have pressured regulators, including the CFTC and the Securities and Exchange Commission, to slow down derivatives rulemaking under the Dodd-Frank Wall Street Reform and Consumer Protection Act, and trim the scope of the proposed rules.
Three Republicans — Rep. Spencer Bachus of Alabama, chairman of the House Financial Services Committee, Rep. Frank Lucas of Oklahoma, chairman of the House Agriculture Committee, and Rep. John Kline of Minnesota, chairman of the House Committee on Education and the Workforce — urged the regulators in March to coordinate their Dodd-Frank rulemaking on “the proper standards of care for providing personalized investment advice.”
The House Financial Services Committee recently approved a bill introduced by Bachus and four congressional Republicans in April that would delay by 18 months — until as late as December 2012 — the timetable for issuing Dodd-Frank derivatives rules. The bill also would require the CFTC and the SEC to hold public hearings and take testimony from market participants about the compliance burdens of any proposed rules.
Also in April, the CFTC voted to grant the public an additional 30 days to comment on its proposed Dodd-Frank derivatives rules, before it plunged into final rulemaking. The extended comment period on the agency’s proposed business-conduct standards closed on June 3.
In an interview, a swap dealer echoed the committee’s concerns, saying it would be inappropriate to subject swap dealers to an express fiduciary duty because their interests inherently conflict with those of counterparties, including state and local governments.
“This is a sophisticated buyer-beware market,” said Peter Shapiro, managing director of Swap Financial Group LLC in South Orange. “Things can and do go wrong.”
The remedy, he said, is not to label swap dealers as fiduciaries, but rather to have state and local governments work with swap advisers.
“Arm yourself accordingly,” Shapiro said.
Dodd-Frank gave the CFTC rulemaking authority to impose business-conduct requirements on swap dealers and MSPs in their dealings with counterparties, including “special entities,” such as state and local governments and public-sector retirement plans.
The act authorized the CFTC to establish duties for swap dealers who enter into swaps with state and local issuers and public-sector pensions, but stopped short of imposing an explicit fiduciary duty — generally, the obligation to put a client’s interests ahead of one’s own.
Still, Dodd-Frank imposes heightened burdens on swap dealers. It requires a swap dealer who acts as an adviser to a state or local government or public pension plan to promote the entity’s best interests and make reasonable efforts to determine that a recommended swap is in its best interests.
It also requires a swap dealer, when executing a swap with governmental issuers or public-sector pensions, to have a reasonable basis to believe the issuer or plan has an independent representative, generally understood — though not defined — to mean a swap adviser.
In addition, a swap dealer must have a reasonable basis to believe that an issuer’s swap adviser meets certain criteria of competence and independence.
In its December rule proposal, the CFTC took an expansive view of the Dodd-Frank language, saying swap dealers act as advisers by making swap recommendations to issuers or public pension plans, but not by merely providing general transactional, financial, or market information.
In its comment letter, the Committee on Capital Markets Regulation said Dodd-Frank and the proposed rules contain enough protections for state and local government issuers, making a fiduciary standard for swap dealers unnecessary, particularly if issuers work with a swap adviser.
Issuers have sounded a similar theme.
“It seems to me [swap] dealers ought to be held to some sort of standard of fair dealing,” said Frank Hoadley, Wisconsin’s capital finance director and a member of the Government Finance Officers Association’s governmental debt management committee. “You can’t lie, cheat, or steal when you’re dealing with an issuer on a swap.”
Issuers and other market participants say a fiduciary standard for swap dealers is unneeded and even counterproductive because Dodd-Frank essentially requires an issuer to hire a swap adviser — by compelling a swap dealer to have a reasonable basis to believe the issuer has one. In addition, they note, under Dodd-Frank, swap advisers must register with the SEC and the MSRB as muni advisers, treat issuer clients as fiduciaries and place those issuers’ interests ahead of their own.
In a comment letter filed with the CFTC in February, Susan Gaffney, the director of GFOA’s federal liaison center, made this very point. “The swap adviser already has a fiduciary duty to the state and local government,” Gaffney wrote. “As the counterparty, it is unlikely that the swap dealer can act in the best interest of the government. That duty of care is fundamentally at odds with an arm’s length, counterparty relationship.”
In addition, she urged the CFTC to reconsider the proposed “best interests” standard, warning it could cause swap dealers to stop executing over-the-counter swaps with state and local governments, effectively barring issuers from the swap market.
“This would be particularly harmful for governments with swap contracts outstanding who may need to revise or restructure existing transactions,” Gaffney added.
Another concern raised by the Committee on Capital Markets Regulation in its comment letter is that the CFTC’s proposed business-conduct rules require swap dealers to investigate an issuer’s swap adviser.
As proposed, the rules would bar a swap dealer from relying on an issuer’s written representations about its swap adviser’s qualifications unless the dealer had a reasonable basis to believe the representations were reliable and sufficiently detailed for the swap dealer to reasonably conclude the swap adviser met the criteria.
Once an issuer or pension plan has evaluated and selected its swap adviser, the committee said, a swap-dealer counterparty should be able to rely on the issuer’s written claims that the adviser is qualified unless the dealer believes those representations are inaccurate.
“There is no need for the rules to go any further,” the committee wrote.
Again, an issuer agreed, saying the requirement to probe a swap adviser’s competency had caused consternation among swap dealers. “It seems to me it’s one of those things the regulators have to let go,” said Hoadley.
Under Dodd-Frank, the CFTC has authority to regulate swaps, swap dealers, and MSPs, including most muni-bond related swaps. The SEC has oversight over security-based swaps, security based-swap dealers, and major security-based swap participants.
