CFTC's 'Best Conduct'Rules May Not Be Best
March 21, 2011
Swap dealers and other firms executing orders for over-the-counter derivative contracts with some investment funds will soon find themselves caught up in a lot more than just operational worries about how they will process the transactions.
The Dodd-Frank Wall Street Reform Act, passed last July, charged the Commodity Futures Trading Commission and Securities and Exchange Commission with figuring out how to implement its broad guidelines when it comes to the burgeoning $700 trillion OTC derivatives market.
In addition to requiring "standardized" contracts to be cleared through a central clearinghouse and certain swaps to be executed on a regulated exchange or swap execution facility, the CFTC in December proposed "business conduct" rules for swap dealers and major swap participants. Comments came in through Feb. 22.
The CFTC suggested that swap dealers and major swap participants may have to register as commodity trading advisors and would, possibly, become fiduciaries when they make recommendations to counterparties about swaps.
The end result: Legal experts and specialists in derivatives believe the CFTC's proposals would be extremely difficult to follow. Investment funds, whose interests the CFTC is trying to protect, may be more harmed than helped. Such is particularly the case for special entities, which the Dodd-Frank financial reform legislation defined to include pension plans, governmental entities such as municipalities, and endowments. Those firms often enter into interest-rate swap contracts as a way of hedging against changing interest rates.
"In connection with its articulation of a suitability standard, the CFTC has suggested that when making a recommendation to a special entity, the dealer or major swap participant would be considered an advisor and face potential fiduciary obligations," said Georgia Bullitt, a partner in the investment management practice of Morgan, Lewis & Bockius in New York. Broker-dealers have also traditionally been subject to suitability obligations when making recommendations but have not generally been deemed to become fiduciaries as a result.
The CFTC and SEC have defined swap dealers as firms that regularly enter into swap contracts with counterparties as part of their ordinary course business.
Major swap participants are considered non-dealers-whose outstanding swaps create substantial counterparty exposure that could adversely affect financial stability or financial markets.The thresholds for "substantial counterparty exposure," are pretty high-creating over $1 billion in uncollateralized exposure to swap counterparties contracts for certain credit and commodity swaps and $3 billion in uncollateralized exposure for interest rate swaps. While most fund managers are unlikely to fall under the classification of major swap participants they must still keep track of the provisions which would affect their investment fund clients.
Just what are fiduciary obligations? Broadly speaking, a swap dealer or major swap participant must act in the "best interests" of the counterparty and avoid conflicts of interest.
"If a swap dealer recommends a swap or trading strategy to a special entity, that would make the dealer a fiduciary to the special entity under the proposed rules. However if a swap dealer simply provides general transaction, financial or market information or responds to a bid request, that would not qualify as a recommendation." said Thomas D'Ambrosio, a partner with Morgan Lewis.
Still the language used by the CFTC to describe a recommendation is far too ambiguous for some legal experts.
"Recommends is not only a much broader concept at its center but also has the potential to be vastly expansive at its margins," wrote partner Christopher Klem and associate Margaret Moore with the law firm of Ropes & Gray LLP. "Statements such as 'You might consider a derivatives contract for' or 'You should check out the following derivatives trade' often serve at the start of any marketing call or e-mail to a special entity by a swap dealer."
Because the swap business is characterized by dealers making recommendations all of the time, the proposed rule conflicts with actual business practice.
"Proposals such as this, which are inconsistent with practices in the swaps industry, are a function of not only the mandates of Dodd-Frank, but also the fact that the CFTC and SEC are now in the position of regulating an industry with which they are largely unfamiliar," said Michael Piracci, an attorney at Morgan Lewis.
Even if the counterparties agreed that their relationship was not an advisory one, any type of communication between the dealer or major swap participant and a counterparty could be considered to be a recommendation and trigger a fiduciary role. Those communications include fulfilling the CFTC's other business conduct requirements on suitability and disclosure.
"The net effect of the disclosure and reporting obligations and the lack of narrow conditions under which a swap dealer becomes an advisor would be tantamount to placing all swap dealers in an automatic fiduciary-like relationship with any special entity with whom they engage in a swap transaction," wrote Scott Kelley, executive vice chancellor for business affairs with the University of Texas System.
As a result, "swap dealers might decide not to execute orders with special entities, which would then limit or eliminate their ablity to participate in the swaps market," warned Jeffrey Koppele, a partner specializing in derivatives and taxation law with SNR Denton in New York. That is because one counterparty to a trade cannot act in the best interests of the other when it's supposed to get the best terms for itself.
Respondents to the CFTC's request for comments urged the CFTC to clarify that swap dealers and major swap participants not be considered advisors to special entities if they simply fulfill the CFTC's disclosure and suitability requirements. They should also not be considered advisors if they receive a "certification" from the special entity that they are not advisors.