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Regulation and Compliance > Federal Regulation > SEC

Dodd-Frank: SEC Proposes More Swaps Regs

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The U.S. Securities and Exchange Commission (SEC) is promising to work with the U.S. Labor Department to address the possibility that proposed regulations could hurt pension plan operations.

SEC officials have made that promise in the preamble to a 255-page proposed rule dealing with “business conduct standards for security-based swap dealers and major security-based swap participants.”

The draft rule, posted on the SEC website, would implement some of the parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that relate to swaps, or financial transactions used to trade one income stream for another.

Congress enacted the Dodd-Frank Act swaps sections in the wake of arguments that poorly structured, poorly understood and poorly regulated swaps had been partly responsible for creating the credit market crisis that started in 2007.

Congress put the SEC in charge of “security-based swaps” – swaps tied to securities, such as stock market indices – and the Commodity Futures Trading Commission (CFTC) in charge of regulating other types of swaps.

The rule the SEC has proposed this week would help implement Dodd-Frank Act Section 764. The proposal covers matters such as disclosures, conflicts of interest, “know your counterparty rules,” and rules governing political contributions involving pension plans and security-based swaps dealers.

Sections dealing with “special entities,” or entities in need of special care when involved in swaps transactions, would apply to any employee benefit plan governed by the Employee Retirement Income Security Act (ERISA), a government entity, a government ERISA plan, or any endowment.

The rule would require security-based swap dealers and major security-based swap participants to “determine that any recommendations they make regarding security-based swaps are suitable for their counterparties,” officials say.

Dealers and major participants would have to give counterparties material information about the security-based swap, including material risks, characteristics, incentives and conflicts of interest and provide the counterparty with information concerning the daily mark of the security-based swap.

The proposed rule also would require dealers and major participants to verify whether a counterparty was an eligible contract participant and whether it was a special entity, such as a private company’s ERISA plan or a government ERISA plan.

Another section would define what it means to “act as an advisor” to a special entity, and would require that a security-based swap dealer who acts as an advisor to a special entity:

  • Act in the “best interests” of the special entity.
  • Make reasonable efforts to obtain information that it needs to determine that the recommendation is in the “best interests” of the special entity.
  • Reasonably believe that the counterparty has an independent representative who is independent, is trying to act in the best interests of the special entity, and has enough knowledge to evaluate the transaction and risks.

“Some commenters have noted that special entities, like other market participants, may use swaps and security-based swaps for a variety of beneficial purposes, including risk management and portfolio adjustment,” SEC officials say in the preamble to the proposed rule.

In a footnote, SEC officials quote an explanation given by Mark Ugoretz, president the ERISA Industry Committee, Washington:

“Swaps permit [pension] plans to hedge against market fluctuations, interest rate changes, and other factors that create volatility and uncertainty with respect to plan funding. Swaps also help plans rebalance their investment portfolios, diversify their investments, and gain exposure to particular asset classes without direct investments. By helping to protect plan assets as part of a prudent long-term investment strategy, swaps benefit the millions of participants who rely on these plans for retirement income, health care, and other important benefits.”

Other commenters have noted that the financial sophistication of special entities can vary greatly, officials say.

The SEC wants to protect the ERISA plans and other special entities without imposing restrictions on dealers and major participants that would limit the plans’ access to swaps that would be used for beneficial purposes, officials say.

“We request comment on all aspects of the approach to special entities described in this release,” officials say.

Retirement plan representatives have met often with SEC, CFTC and U.S. Labor Department officials to talk about possible conflicts between Labor Department efforts to define the term “retirement plan fiduciary” and the SEC and CFTC efforts to write swaps rules.

The SEC, for example, wants dealers and major participants to provide a daily mark, or, to swaps counterparties, so that the counterparty understands how a swap is performing.

ERISA plan representatives have suggested that simply providing daily mark information to an ERISA plan counterparty could make a swaps dealer or major participant a fiduciary.

Many financial services companies and other companies want to avoid assuming ERISA plan fiduciary responsibility, because fiduciary responsibility can expose them to significant legal risk.

If a swaps dealer arranged for a swap and then willingly assumed fiduciary responsibility by providing a daily mark to an ERISA plan, the underlying swap would then become a prohibited transaction under ERISA, unless the swap qualified for a Prohibited Transaction Exemption, ERISA plan representatives have told regulators.

Phyllis Borzi, the assistant Labor Department secretary in charge of the Employee Benefits Security Administration has told the CFTC that the department does not believe a swaps dealer or major participant would come into conflict with the proposed update of the ERISA retirement plan fiduciary definition simply by complying with the kinds of the business conduct standards the SEC an the CFTC have proposed.

ERISA plan representatives have argued that the current Labor Department assurances about lack of conflicts do not have enough legal force to give ERISA plans, swaps dealers and major participants the confidence they need to set up transactions that could possibly lead to conflicts.

The SEC “solicits comments with respect to alternatives for addressing this issue,” officials say.

Comments on the proposal are due Aug. 29.

Other swaps coverage from National Underwriter Life & Health:


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