CFTC's Message to Municipalities: Caveat Emptor

In a little noticed vote, the Commodity Futures Trading Commission (CFTC) reversed course last week on a rule that had the potential to save cities and school districts across the country billions in excess costs on the swaps they purchase to hedge their interest rate and other risks. After enduring months of intense industry lobbying, the Commission voted 4-1 in favor of a final swaps dealer business conduct rule that makes deep concessions to industry on every major issue and, as a result, offers at best modest new protections to the most vulnerable participants in the over-the-counter derivatives markets.

This is a far cry from what Congress intended when, fresh from a series of eye-opening hearings in the Senate Permanent Subcommittee on Investigations, it inserted new provisions into the Dodd-Frank Act with a goal of radically altering the way Wall Street deals with its less sophisticated customers, particularly municipalities, school districts, endowments, and pension funds (so-called "special entities").

The legislation imposed a new duty on dealers to act in the best interest of these special entities when offering them advice. And it supplemented that protection with expansive new disclosure obligations and a requirement that special entities be represented by a qualified independent representative when conducting swaps transactions. Properly implemented, the legislation had the potential to transform the market, putting an end to routine over-charging of municipalities, for example, and prohibiting recommendations of customized swaps that exposed the purchaser to risks far greater than those they were hedging.

As the regulations were developed and then revised, Consumer Federation of America and Americans for Financial Reform worked to advance a few key issues that would determine the rule's effectiveness. Chief among them were the following:

  • Would the regulators define "acting as an advisor" to encompass the full range of advisory activity that should be subject to a "best interest" standard? Would they include, for example, customizing swaps and making recommendations based on the particular needs and objectives of the special entity?
  • Would they adopt standards to ensure that the independent representatives of special entities are truly independent of swap dealer influence?
  • Would they require disclosures that ensure special entities and their independent representatives have all the information they need to assess the risks and costs of a swap they are contemplating entering as well as the conflicts of the dealer on the other side of the transaction?

The final rule's answer to all these questions is an emphatic no. The definition of advice in the final rule covers only the narrowest sliver of the dealer's advisory activities, recommendations of customized swaps where the dealer expresses an opinion as to whether the special entity should enter the transaction. (We have yet to figure out what a recommendation looks like that doesn't include such an opinion.) And, the rule also provides a safe harbor that dealers can be expected to impose as a condition of doing business for special entities, ensuring that the best interest standard rarely, if ever, applies.

At the same time, the rule places no meaningful limits on the financial entanglements that can exist between the special entity's supposedly independent representative and the swaps dealer on the other side of the transaction. There is, for example, no limit on the percentage of the "independent" adviser's revenues that can come from the dealer, as long as that conflict is disclosed to the special entity and appropriately managed.

Although the final rule retains some good disclosure provisions, requirements for conflict of interest disclosures by dealers were weakened. And, in an age when electronic media make it possible to provide instantaneous delivery of written (verifiable) disclosures at essentially no cost, the Commission indicated that, at least in some instances, oral pre-transaction disclosures will satisfy its requirement that disclosures be made in a reliable form so long as they are later confirmed in writing.

The one glimmer of hope that remains is that the Commission will use its anti-fraud, anti-evasion, and fair dealing authority to provide tougher enforcement than the rule itself suggests. But, here again, the final rule is discouraging. Peppered throughout are clauses pledging that the Commission will consider "good faith" compliance with appropriate policies and procedures when taking action against violations. The final rule even includes a similarly constructed affirmative defense in its anti-fraud provisions. Coupled with the Commission's woefully inadequate funding, the prospect of tough enforcement seems slim at best.

What is particularly remarkable about the final rule is the totality of its retreat from the strong set of provisions included in the agency's December 2010 initial rule proposal. Among other things, the proposed rule included a broad definition of advice, a strong independence standard, and a good start on disclosure requirements, not to mention a bold new idea to bring best execution concepts to the derivatives market. All these and more were weakened in the final rule, and the best execution provision was eliminated entirely.

Of course, a lot has happened since the time when the proposed rule was being drafted. In those heady days it still seemed possible that certain regulators -- not least the CFTC -- might be prepared to adopt the tough and effective rules on which the financial reform law's success depends. Since then:

  • Newly empowered congressional Republicans have demonstrated that, far from using their oversight authority to spur on the regulators, they would do everything in their power to delay, defund and defang financial reform efforts.
  • The business community has unleashed an onslaught of lobbying to weaken the regulations. In the process, they have made it clear that they are prepared to take to the courts to kill regulatory reform, and an early court decision in the proxy access case sent a chilling message about the impossibly high standard regulators would be held to when conducting the economic analysis to justify their rules.
  • The Securities and Exchange Commission (SEC) proposed its companion business conduct rules for securities-based swaps dealers in June, undercutting the CFTC by acceding to every major industry demand to neuter the regulations.

Considering the environment in which they are operating, it's easy to understand why the CFTC blinked. The best case scenario is that the Commission is choosing its battles and will hang tough when it comes to rules more central to the creation of transparent markets and the reduction in systemic threats. But the complete reversal of the CFTC on this one lower-profile but still vitally important rule suggests a more dismal prospect -- that Wall Street is firmly back in the ascendancy and that the practices that led to the worst financial crisis since the Great Depression will be allowed to continue virtually unchecked.