AFR in the News: Protect Public Entities and Pension Funds From Abuses

AFR in the News: State Auditor, Consumer Groups, Unions Seek To Defend Swaps Market Rules That Protect Public Entities and Pension Funds From Abuse

The Consumer Federation of America, Americans for Financial Reform, and the AFL-CIO, hosted a conference call with reporters and bloggers on Tuesday, December 6th to discuss threats to a key Dodd-Frank provision designed to protect municipalities, pensions and other vulnerable swaps market participants from predatory industry practices of the kind that just last month drove Jefferson County, Alabama to declare the nation¹s largest ever municipal bankruptcy.

The call featured Pennsylvania Auditor General Jack Wagner, Heather Slavkin, Senior Legal and Policy Advisor, AFL-CIO Office of Investment, Barbara Roper, Director of Investor Protection, Consumer Federation of America, and Marcus Stanley, Policy Director, Americans for Financial Reform.

Excerpts of remarks from participants:

Marcus Stanley, Policy Director, Americans for Financial Reform

The most prominent case of abuse in the derivatives markets is of course Jefferson County, whose recent bankruptcy was the largest municipal bankruptcy in American history. But that is just the tip of the iceberg. There are dozens of other lawsuits and a great deal of evidence of pervasive overcharging across hundreds of municipal entities. Swaps can be useful market instruments in particular cases. But the complexity of derivatives contracts makes it easy to use them to hide embedded risks and price gouging. These issues become especially problematic where you have less experienced market participants who are sold a “free lunch” story about risk reduction through aggressive sales efforts by banks.

The Dodd-Frank Act put in place new legal protections against these kinds of abuses. The details of these protections can get complex but the basic idea is simple. Swaps customers will need to retain an outside advisor in deals, and swaps dealers must provide detailed disclosures to customers. Furthermore, in cases where banks provide detailed recommendations or advice to their customers such recommendations must be suitable for the client’s needs, not simply aimed at maximizing the profits for the banks. Unfortunately these protections are under attack. We are seeing now is that these protections may be undermined in the rulemaking process through lobbying efforts. This is a very important time for these rules, as the CFTC is about to release their revised rule in this area.

Pennsylvania Auditor General Jack Wagner

We have looked into a number of different swaps. And we have found that at least 20% of school districts are involved in swaps, probably thousands of public authorities in Pennsylvania, and many, many local governments and even state government such as at the Pennsylvania Turnpike Commission. We are very concerned with interest-rate swaps because it is impossible to measure the risk they pose.

Generally speaking, the entities that were sold swaps were enticed by monies up front, without really knowing the obligation going forward, the variables involved and the risk involved.

Due to the fact that all of the entities that we looked at are dealing with public money, we are extremely concerned that these deals may cost the public more than financing would with a conventional rate borrowing. On these deals, a lot of people are making money off of the taxpayers.

Consequently, we have taken a position that swaps are very dangerous fiscally and where a public entity can get out of swaps, it should be getting out of those swaps. And we have gone so far as to recommend legislation to the General Assembly to prohibit the use of swaps by school districts and other local governments. That legislation has not passed. I believe the influence by the financial sector has been very strong. Therefore, we need federal and state regulation.

Heather Slavkin, Senior Legal and Policy Advisor, AFL-CIO Office of Investment

The AFL-CIO is the largest labor federation in the United States and represents 12.2 million union members. Union-sponsored pension and employee-benefit plans hold more than $480 billion in assets. We are deeply concerned with protecting the pension benefits of our members.

Pension funds have been under heavy pressure to make up for the losses of the financial crisis. While pension returns have been sufficient in some cases to do that, we can expect heavy pressure to amplify returns to continue due to the retirement of the baby boomers.

We don’t know exactly what products will be touted as providing low-risk but high returns. But from past experience we know that derivatives will be used to structure those products, and the complexity of derivatives will be used to conceal their risks. Some pension funds are sophisticated players but not all are, and we can anticipate that less sophisticated funds will be targeted by derivatives dealers in some of the same ways we’ve seen with municipalities.

In this context, it’s important to see Dodd-Frank reforms implemented. We believe these reforms strike a good balance in allowing full market access for the ordinary use of derivatives, while holding banks to higher standards for their recommendations and advice around complex customized products.

The rules (including the CFTC proposed rules) don’t affect arms-length transactions, just those instances where swaps dealers step out of that arms-length, counterparty relationship and act as an adviser.  Also, DOL has indicated that compliance with the business conduct rules would not, in and of itself, trigger fiduciary status under its revised fiduciary definition – laying to rest one major concern and showing that regulators are following congressional intent.  As a result, there is simply no basis for the argument that pensions would lose access to this market if tough new rules protecting their interests are imposed.

But since dealers often make their biggest profits on highly complex customized products that are not well understood by clients, they are fighting these changes. In many cases dealers have been going to less sophisticated pension counterparties and threatening them that if Dodd-Frank reforms are passed they will cut off market access all together.  These kinds of threats have muddied the political waters around what should be very straightforward and common-sense rules.

Barbara Roper, CFA Director of Investor Protection:  

Last month’s largest ever municipal bankruptcy filing by Jefferson County, Alabama provides a stark reminder of what is at stake when swaps dealers prey on the relative lack of sophistication of certain swap market participants … and why the provisions of Dodd-Frank designed to prevent such abuses are so important.  While the Jefferson County case is complicated by bribery and corruption, the underlying conduct – in which the county was sold swaps to hedge its interest rate risks that exposed the county to costs and risks far greater than those it was seeking to hedge – is emblematic of precisely the sort of predatory conduct that led Congress to grant the SEC and CFTC broad new authority to protect municipalities, endowments, pension funds and other similar entities from such practices in the future.

Congress was concerned both that these so-called “special entities” often lacked the high degree of financial sophistication needed to protect themselves in this market … and that workers, taxpayers, and other vulnerable groups bore the brunt of the harm when they failed to do so.  Based on these concerns, Congress directed the SEC and CFTC to adopt rules requiring, among other things, that swaps dealers act in the best interests of their special-entity customers when acting as an advisor to those customers … and to further protect special entities by requiring them to have independent advisers with the requisite expertise looking out for their interests when conducting such transactions.

This belt-and-suspenders approach recognized that, while it is appropriate to try to constrain swap dealer conduct and limit their ability to prey on the vulnerable, it is foolish to put too much faith in swaps dealers’ willingness to put their customers’ interests first – thus the need for the independent representatives.  By the same token, it is equally foolish to assume that special entities’ independent representatives will, in all cases, match the financial sophistication of the swaps dealers themselves.  Thus, other aspects of the rules – such as those that govern the disclosures swaps dealers are required to provide regarding conflicts, risks, and other material characteristics of the swaps – take on added importance.  It all has to work together to be effective.

As with so much of Dodd-Frank, whether the legislation achieves its goal will depend largely on the effectiveness of the implementing rules, and Wall Street is doing its best to see that the rules are as weak as possible.  With the CFTC reportedly on the brink of finalizing its rules in this area, a handful of issues will determine how well they fulfill the intent of the legislation to bring about fundamental reform.  Two of the most important are: how they define “acting as an advisor” and how they determine the independence of the independent representatives.


  1. Wall Street wants a “get out of jail free” card that would allow swaps dealers to provide individualized recommendations to special entities – and customize swaps on their behalf – without triggering their best interest obligations.  While we recognize that swaps dealers need a degree of legal certainty regarding when they are subject to that best interest standard, it must not be obtained by creating a mechanism that allows them to escape that duty entirely.  We are concerned that some of the approaches under consideration by regulators would have precisely that effect.  If the SEC’s proposed approach were adopted, for example, swaps dealers could simply make it a condition of doing business with special entities that they sign away their right to best interest recommendations.  That would leave the independent representative as their only source of protection.
  1. With so much riding on the independent representatives’ ability to protect special entities, it is essential that these advisers be both expert and truly independent – and the more regulators narrow the best interest standards, the more important it becomes.  Here again, however, some of the approaches being considered by regulators – in order to expand the pool of representatives with the requisite expertise – would allow these representatives to have more extensive financial ties to the swaps dealers on the other side of the transaction than they do to the special entities whose interests they are supposed to represent.  That is simply not an acceptable trade-off.  Without strong independence requirements, this requirement becomes all but meaningless.

The good news is that the CFTC’s original rule proposal got a lot of these issues right, and only relatively minor adjustments would be needed to address industry’s legitimate concerns.  The bad news is that the swaps dealers have been lobbying for much more extensive revisions, and, if the SEC proposed rule is any measure, have been extremely successful in getting even their most exaggerated and unfounded criticisms of the CFTC’s proposed rule addressed.  Not surprisingly, the CFTC has come under intense pressure to modify its rules accordingly.

Of course, proposed rules are just proposals.  And the Commissions still have a chance to get the final rules right.  It is essential that they do so before new Jefferson Counties and Orange Counties and Pennsylvania school districts … and the taxpayers who stand behind them … suffer the consequences of a weak and ineffective regulatory response.

Press Coverage:

Consumer groups warn about weakening financial regulations
Tim Darragh (The Morning Call – PA)
December 6, 2011

“A team of consumer groups warned Tuesday that lobbying by Wall Street could weaken proposed regulations designed to guard against the kind of abusive investment practices that crushed the Bethlehem Area School District in recent years. Speaking at a teleconference, representatives of the Consumer Federation of America, the AFL-CIO, Americans for Financial Reform and Pennsylvania Auditor General Jack Wagner said well-financed lobbies are working to disarm regulations initially designed to rein them in. In some cases, the consumer groups said, opponents of stronger limitations on the use of derivatives by local governments want to make it too easy for the financially overmatched local agencies to sign away their protections.” Click here for more.

Replay Instructions:

Please contact John Carey at to listen to the audio recording of this conference call.