The Consumer Federation of America (CFA) is leading a coalition of groups that wants federal regulators to make the rules governing swaps involving pension plans and endowments as strict as possible.

The American Benefits Council, Washington, recently visited the Commodity Futures Trading Commission (CFTC) to make the case that use of provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that are meant to help pension fund managers avoid risky swap arrangements could do more harm than good, by making it difficult or impossible for pension plans to buy the swaps needed to manage plan risk.

But representatives from the CFA, Washington, and allied groups, such as Better Markets, Washington, and Americans for Financial Reform, Washington, visited the CFTC earlier this month to say they think the CFTC and the U.S. Securities and Exchange Commission should be strict about applying the “special entity” rules in the Dodd-Frank Act swap provisions.

A swap is an arrangement that one party can use to trade an income stream with another party.

Investors, speculators and others use swaps to manage risk from variations in, or speculate on, changes in, interest rates, exchange rates and the likelihood that debtors will default on their obligations.

Because of concerns that sophisticated swap dealers and swap market participants had fooled unsophisticated pension fund managers and endowment managers into using complicated, unexpectedly risky swaps in the years leading up to the financial crisis that started in 2007, Congress included Dodd-Frank Act provisions that require swap dealers to take special precautions when doing business with special entities, such as pension plans governed by the Employee Retirement Income Security Act (ERISA), that might have less sophisticated managers and advisors than banks or insurers.

Swap dealers and other swap market participants, such as counterparties, are supposed to verify that special entities have independent advisors that understand swaps and the risks the entities will be assuming if they enter into specific swap arrangements.

The Dodd-Frank Act has given the SEC and the CFTC joint responsibility for overseeing swaps, and the agencies have been working on regulations implementing the provisions. The regulatory efforts come under the heading Business Conduct Standards with Counterparties.

“The American Benefits Council argued that ERISA plans are supposed to be advised by prudent experts who are putting the plans’ interests first and that, if fiduciaries put any faith in the kindness of counterparties, that would be a violation of fiduciary responsibilities.

Strict application of the rule also could make it difficult for swap dealers to enter into swap arrangements with special entities, because, technically, the dealers and other would-be counterparties could never act both as plan advisors and as swap counterparties.

Consumer representatives such as Barbara Roper of CFA and colleagues visited the CFTC offices to say they like the approach the CFTC has taken to special entity standards and hate the SEC approach.

The consumer reps talked about points they made in comment letters they sent to the SEC and forwarded to the CFTC, CFTC officials say.

The SEC draft is so vague that “independent representatives” could really be working for swap market players, and the SEC definition of “act as an advisor” is so vague that swap market players could easily make special entities “sign away their right to best interest recommendations,” the consumer reps say in the letter, which was submitted in August.

The SEC and the CFTC should “provide guidance with regard to the best interest standard” and “make clear that the best interest standard is intended to provide protections that go beyond those of a suitability standard,” the consumer reps say. “In addition, guidance should clarify that the best interest standard is consistent with various different methods of compensation and with proprietary trades, but that it requires the full disclosure of any conflicts of interest.”

Swap dealers claim strict rules could keep special entities from entering into useful swaps, but, in many cases, “derivatives dealers have lured these unsophisticated players into the derivatives markets when they would have been better served by more traditional debt instruments,” the consumer reps say.

“The practice of recommending products to hedge risks that actually expose the special entities to risks that are greater than those they are hedging” should be eliminated, the reps say. “Recommending customized swaps when the special entity would be better off in a standardized swap should also be eliminated. In other words, the goal is not to preserve access to these markets on the same terms that access exists today, but to preserve access to these markets when it is in the best interests of the special entity to do so and on terms that promote their interests.”

A swap market participant should not be able to decide that a special entity is sophisticated enough to use swaps by simply getting the advisor to sign a form saying the special entity is sophisticated, the consumer reps say.

Instead, the SEC and the CFTC should require that the swap dealer “document the basis on which it reached its conclusion, to do so in sufficient detail to allow a third-party to evaluate the validity of the conclusion, and to make those records available” for inspection, the reps say.

The SEC and the CFTC also should guard against making the advisor rules so loose that requirements that advisors should act in the best interests of the special entities would never come into play, the reps say.

If any special entity rules make beneficial swap arrangements impossible to complete, regulators should eliminate the conflict by creating U.S. Labor Department prohibited transaction exemptions rather than by weakening overall special entity protections, the reps say.

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