STATE OF MICHIGAN

FRANK J. KELLEY, ATTORNEY GENERAL

Opinion No. 6894

April 1, 1996

INVESTMENT:

Investment of assets of state retirement systems

1965 PA 314 allows the state retirement systems (SMRS) to purchase Index Swaps based on the movements of foreign stock market indexes when the SMRS simultaneously purchases LIBOR Notes.

Honorable Greg Kaza

State Representative

The Capitol

Lansing, Michigan 48909-7514

You have asked a question that may be stated as follows:

I. THE TRANSACTIONS AT ISSUE

"Index Swaps" are one of many types of transactions called derivatives. ⁽¹⁾ This opinion confines itself to the specific transaction structure utilized by the State Treasurer set forth in the question posed. That structure has been documented by personnel in the Michigan Department of Treasury, Bureau of Investments.

In 1965 PA 314, MCL 38.1132 et seq; MSA 3.981(112) et seq, the Legislature has authorized the investment of the assets of public employee retirement systems. Under that act, the state treasurer is the investment fiduciary for the combined assets of the public school employees' retirement system, the state employees' retirement system, the judges' retirement system and the state police retirement system. These state retirement systems (SMRS) have approximately $30 billion in assets.

The SMRS has executed ten International Swap Dealers Association (ISDA) Agreements ⁽²⁾ with Goldman Sachs, Credit Suisse, Salomon Brothers and United Bank of Switzerland totalling approximately $1.015 billion, which represents less than 3% of the assets of the SMRS. Each firm, called a counterparty, is rated AAA, ⁽³⁾ which the SMRS requires. The Agreements are for a fixed term of from 2 to 5 years and cover 8 international stock markets: The United Kingdom, Germany, France, Switzerland, Netherlands, Japan, Australia and Hong Kong. At the end of the contract period the counterparty pays the SMRS the percentage increase in the international market. If, however, the market decreases the SMRS pays the counterparty the decrease and the liability of the SMRS is limited to the dollar amount of each ISDA Agreement. This kind of transaction is referred to in the industry as an Index Swap.

Upon the execution of each ISDA Agreement, the SMRS puts at least the initial amount of the contract (the notional amount) into a fixed interest rate instrument, called a LIBOR (London Interbank Offered Rate) Note. By purchasing a LIBOR Note in at least the notional amount of each ISDA Agreement, the SMRS effectively links the ISDA Agreement with the LIBOR Note. The LIBOR Note matures at the same time that the contract period ends for its linked ISDA Agreement. The SMRS retains full ownership and control over the LIBOR Note. The interest on the LIBOR Notes is received by the SMRS and, except for approximately one-half percent which the SMRS retains, is paid by it to the counterparty as a negotiated payment obligation under the ISDA Agreement.

This office has been informed that it is the policy and practice of the SMRS to always purchase a LIBOR Note in at least the same amount as the amount in the linked ISDA Agreement. This avoids a leveraged transaction in which the amount at risk exceeds the amount that is available and has been identified to cover the risk. Further, the dollar amounts of the LIBOR Notes are shown as investments in the monthly reports of the SMRS, thus enabling it to comply with legislatively imposed limits on certain types of transactions. The LIBOR Notes total approximately $1.021 billion.

The type of transaction here at issue has been studied by the Bureau of Investments in the Michigan Department of Treasury since 1986. This type of transaction was approved by the Investment Advisory Council (IAC) ⁽⁴⁾ in 1993. These transactions simulate participation in international stock markets without subjecting the SMRS to a myriad of international securities regulations and tax laws. This diversifies the SMRS investment portfolio and is intended to minimize fluctuations in investment income.

While this opinion confines itself to this specific structure and this specific fiduciary, derivatives include a broad class of investments covering hundreds of different structures. Numerous reported instances of massive losses suffered by underwriters, banks, municipalities, like Orange County, California, and others while investing in derivatives amply demonstrate the potential dangers presented by these forms of investments. In short, the news about derivative investments is that there is a risk of heavy loss. It has been observed that derivatives "became the dirtiest word on Wall Street, in corporate America and even on Main Street last year as risks associated with these complex securities wrought huge damages on reputable, sophisticated institutional investors." Migliozzi, Glenn & Corse, Elizabeth. "The Dirtiest Word on the Street." State Government News (October 1995), 12.

II. THE LEGAL ISSUES

The first issue is whether these Index Swap transactions come within the statutory definition of investment. In section 12(e) of 1965 PA 314, the Legislature has defined "investment" as follows:

Research has failed to disclose any Michigan appellate court decisions interpreting this statutory definition of "investment." Entering into an Index Swap based on the movement of a foreign stock market index and simultaneously purchasing a LIBOR Note in at least an amount equal to the amount of the ISDA Agreement involves the use of money in the expectation of future returns in the form of income or capital gain. Clearly, the expectation is that at the close of the contract period the foreign stock market index will have risen and the SMRS will receive capital gains in the form of a payment from the counterparty representing the increase in that market. Also, scholarly literature recognizes the use of derivatives as an investment. Cohen, The Challenge of Derivatives, 63 Ford L Rev 1993, 2006 and 2011, n 88 (1995).

Section 12(b) of 1965 PA 314 defines "assets" as follows:

The transactions here at issue all include the simultaneous execution of an ISDA Agreement and purchase of a LIBOR Note that are carried on the reports of the SMRS at their cost. Thus, there is a valuation basis for complying with the asset limitations on certain types of investments.

Next, we must determine whether these particular investments are permitted by 1965 PA 314. In that regard, section 13(1) of the act provides that the investment authority granted therein supersedes any investment authority "previously granted to a system under any other law of this state."

1965 PA 314 authorizes investment fiduciaries to invest in specific types of investments. In addition, the Legislature has provided for limited investment flexibility in section 20d of the statute as follows:

The legislative history of 1982 PA 55, which added section 20d to 1965 PA 314, contained the following:

House Legislative Analysis, HB 4272, November 10, 1982.

Thus, the State Treasurer, as investment fiduciary for the SMRS, may invest up to 15% of the systems' assets in "investments not otherwise qualified" under 1965 PA 314. OAG, 1989-1990, No 6597, p 198, 203 (August 24, 1989), concluded that "investments not otherwise qualified," as used in section 20d(1) of 1965 PA 314, means those types of investments which the Legislature has not otherwise specifically authorized in that act.

The amount of the ISDA Agreements, based on the value of the LIBOR Notes, is reported by the SMRS in its listing of investments under section 20d of 1965 PA 314. Thus, there is the necessary compliance with the 15% of assets investment limitation in the "basket clause."

Therefore, I am constrained to conclude that under the broad authority of the "basket clause" the ten Index Swaps represented by the ISDA Agreements and the linked purchase of LIBOR Notes in each case are permissible investments under 1965 PA 314. ⁽⁵⁾

By this opinion, I am not endorsing investment in derivatives. I want to emphasize that my opinion is based on the facts present in this situation, i.e., the State Treasurer's policy of purchasing a LIBOR Note at the time of the index swap investment in an amount equal to that investment. The Legislature may wish to review the use of derivatives instruments by public fiduciaries and clarify the basis upon which such fiduciaries may invest in these products.

Frank J. Kelley

Attorney General