Wall Street's biggest firms are considering the suitability of selling opaque financial products to governments, endowments and not-for-profits after the contracts magnified credit market losses that plunged the U.S. into a recession.

"There is no distinction among very different groups of investors, and this is where things might change," said Dino Kos, a managing director at Portales Partners LLC in New York and former head of the Federal Reserve Bank of New York's open market operations. "Wall Street cannot pretend anymore that the treasurer of a small town in the Midwest on a civil service salary and no analytical support has the same level of sophistication as a specialized hedge fund."

Any restrictions on the sale of derivatives, which are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather, would "at least initially" reduce earnings because "it would be harder to sell higher-margin products to some customers," said Kos, who worked at the New York Fed for 22 years beginning in 1985 before a nine-month stint at Morgan Stanley.

While securities laws differentiate between the financial transactions companies can sell to individuals and to institutions, there's growing recognition that local governments and endowments should not be equated with hedge funds, according to four Wall Street executives who spoke on the condition of anonymity because their firms have not made any decisions.

U.S. securities laws differentiate between investment advisers, who operate under a "fiduciary duty" toward their clients, and brokers, who are required only to determine whether an investment is "suitable." While the fiduciary duty obliges advisers to put clients' interests ahead of their own, the suitability standard entails ascertaining that customers are able to understand and withstand the risks.

The key assessment in determining suitability is the amount of money controlled by the client. Customers with more than $1 million of investable assets are deemed more sophisticated than those with less. Above $100 million, there's little distinction between institutions, whether they're city governments or investment companies.

The financial reform bill that passed the Senate last month attempts to address sales of swaps. The legislation, which needs to be reconciled with a version passed by the House in December, would require swaps dealers to adopt a fiduciary duty in dealings with state or local governments, endowments and pension or retirement plans.

Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who has served as treasurer of Morgan Stanley and chief financial officer of Lehman Brothers, said imposing such a fiduciary duty on brokers would mean they would stop doing business with "protected" clients in the over-the-counter market, where most derivatives are traded and higher fees are charged.

"It's very unlikely that an OTC derivatives desk will ever deal with a client as a fiduciary in an OTC market," Hintz said. "A fiduciary is expected to owe the duty of loyalty to his or her client and must not profit from the fiduciary position."

Wall Street executives say the industry's behavior will change. Firms are going to be more careful determining which institutions can undertake the detailed analysis required to understand investments, they said.

Attempts to define which investors are more sophisticated than others can be fraught with difficulty and may restrict investors' choices unfairly, said Russell Sacks, a partner at the law firm Shearman & Sterling LLP in New York.

"There are some very sophisticated and professional municipal and pension fund managers and some less sophisticated hedge fund managers," Sacks said. "At some point you run out of tests for sophistication, and you have to rely on the representations of the person in front of you, the qualifications of the person in front of you and, as imperfect as it is, the assets under management of the person in front of you."

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