The examination of the over-the-counter swaps market following the 2008 financial crisis revealed that certain public institutions were either misled or received unsound advice when they decided to participate in investments where they had little-to-no understanding of the potential for substantial negative liability. In response to these discoveries, Congress included provisions in the Dodd-Frank Act [link] designed to protect public institutions (deemed “Special Entities”) that enter into swaps and created new responsibilities for certain market participants who transact with public institutions.
The CFTC regulations implementing these Dodd-Frank protections expand the definition of a Special Entity originally laid out in the Act, thereby increasing the spectrum of entities afforded additional protections. While the statute defines a Special Entity as “a State, State agency, city, county, municipality, or other political subdivision of a State,” the CFTC regulation broadens the definition to encompass “any instrumentality, department, or a corporation of or established by a State or political subdivision of a State.” The rule further requires Swap Dealers and Major Swap Participants to utilize heightened business conduct standards when transacting with Special Entities to ensure clarity and transparency, to reduce risk, and to promote market integrity. The CFTC regulations also provide swap transactional thresholds with Special Entities, above which a counterparty must register as a Swap Dealer or Major Swap Participant.
The expanded CFTC definition of a Special Entity, and the special responsibilities of Swap Dealers and Major Swap Participants when transacting with these entities, embrace Congress’ increased awareness of the particular attributes of the beneficiaries and the ultimate liability to the taxpayer of these public institutions.
In its discussion of the new Special Entity definition, the CFTC recognizes that “Special Entities play an important public interest role by virtue of their responsibility for managing taxpayer funds, the assets of public and private employee pension plans and endowments of charitable institutions. The Special Entity rules implement the congressional mandate to establish a higher standard of care for swap dealers that act as advisors to Special Entities and to ensure that Special Entities are represented by knowledgeable, independent advisors when dealing with swap dealers and major swap participants.”
The CFTC also notes that “the Special Entity rules protect U.S. taxpayers, the retirement savings of U.S. private and public employees and pensioners, and beneficiaries of charitable endowments (‘Special Entity beneficiaries’). Losses to a company that assumes significant risk through swaps are typically limited to its investors and creditors. However, Special Entities that assume risk through the use of swaps also expose Special Entity beneficiaries to such risks. When a Special Entity suffers losses in connection with a swap, the Special Entity beneficiaries ultimately bear such losses.”
Finally, the CFTC “views § 23.401(c)(2) to apply broadly to State and local governmental entities that are entrusted with public funds, including public corporations.”