One need look no further than the settlements paid by financial institutions post-Enron--over USD7 billion--to recognize that complex structured finance transactions have the potential to create enormous risk to the entities engaging in those transactions. As all regulated institutions know all too well, when high profile losses such as these occur, the regulators are sure to develop a keen interest in how the related risk is managed.
May 9, after almost two years of reconsideration, the Securities and Exchange Commission, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Office of Thrift Supervision issued and requested comment on a revised Interagency Statement on how investment advisers, broker-dealers, banks and bank holding companies should manage their complex structured finance business. The revised Interagency Statement is a substantial redraft of a proposed Interagency Statement originally published for comment May 19, 2004, that was a direct result of governmental investigations of the role of financial institutions in the Enron debacle.
When the first Interagency Statement was released for comment, it generated numerous expressions of concern from the industry. Commentators were concerned the detailed best practices specified in the statement were unworkably burdensome, inflexible and prescriptive, and did not draw appropriate distinctions between policies that should be adopted by institutions that play major roles in these transactions and institutions that play only very limited roles. Importantly, the industry expressed concern that the original Statement was far too broad and could be read to apply to plain vanilla transactions that raise few unusual risks. Finally, the industry complained loudly that far from reducing the risk to regulated institutions, the original Statement could actually become a new basis for third-party claims and could therefore significantly increase risk.
As evidenced by the two-year wait and the extent of the revisions, the regulators took the comments seriously.
As compared to the initial proposal, the revised Interagency Statement is in fact substantially shorter and more principles-based. It seeks to provide more flexibility to financial institutions based on the varying roles and levels of participation that these institutions play in these transactions. Nevertheless, it retains its primary focus on the maintenance by regulated institutions of formal policies and procedures that will "allow the institution to identify, document, evaluate and control the full range of credit, market, operational, legal, and reputational risks" arising from their participation in these transactions.
The more noteworthy aspects of the revised Interagency Statement are these:
Fundamental Principles
The revised Interagency Statement retains the initial proposal's recognition that complex structured finance transactions, or CSFTs, provide important benefits by structuring and allocating risk in more effective ways. On the other hand, the revised Interagency Statement is equally clear that these transactions have been used by some in apparently illegal schemes to misrepresent the financial condition of public companies and regulatory authorities. As such, in some cases, these transactions can raise increased legal and reputational risk for financial institutions, in addition to the usual credit and other risks typically encountered. The fundamental purpose of the revised Interagency Statement is therefore to recognize the importance for financial institutions engaged in elevated risk CSFTs to have policies and procedures that will address these risks.
These policies and procedures should allow the institution to:
* identify CSFTs that present elevated legal or reputational risks;
* ensure review of any identified CSFTs by appropriate control and management personnel, and
* ensure an appropriate level of due diligence with respect to the identified CSFTs commensurate with the CSFTs' potential risk to the institution.
If an institution determines to proceed with such a transaction, the revised Interagency Statement calls for the institution to implement steps to manage the risks. This process could involve obtaining disclosure and assurances from the financial institution's customers.
Scope
The revised Interagency Statement does not define elevated risk CSFTs. It does clarify that it is only intended to cover elevated risk CSFTs that create heightened legal or reputational risks, not typical structured finance transactions such as traditional transactions backed by mortgages, credit cards, auto loans and the like, many of which arguably would have been covered by the first Interagency Statement. In that light, the Statement notes that it will not apply to the vast majority of financial institutions, which do not participate in the types of transaction that raise these concerns.
The revised Interagency Statement does list examples of characteristics of elevated risk CSFTs. These include transactions that:
* lack economic substance;
* are designed for "questionable" accounting, regulatory or tax objectives, particularly when the transactions are executed at the end of a reporting period;
* raise concerns that the client will disclose the transaction in a misleading manner;
* involve circular transfers of risk that lack economic purpose or business substance;
* involve undocumented agreements that would have a material * impact on regulatory, tax or accounting treatment;
* contain materially off-market financial terms; or
* appear to provide disproportionate compensation to the financial institution.
These examples represent an attempt by the Agencies to focus only on transactions that present elevated risk and therefore represent somewhat extreme cases. Nevertheless, they provide a potentially useful checklist of warning signs of elevated risk.
The revised Interagency Statement also notes that internal controls adopted by financial institutions should reflect their roles. Institutions engaged in product development, structuring and advising may require more elaborate policies and procedures than institutions that play only limited roles.
In addition, the revised Interagency Statement states explicitly that it does not create any private rights of action and does not expand or alter the legal duties of financial institutions to customer, shareholders or third parties.
Policies And Procedures
The revised Interagency Statement continues to call for a set of formal policies and procedures that will permit institutions to "identify, evaluate, assess, document and control the full range of credit, market, operational, legal and reputational risks associated with these transactions." These policies should identify and require heightened review of transactions and new complex structured finance products that have any of the characteristics included in the examples listed above or that could otherwise create elevated risks.
Once identified, the revised Interagency Statement calls for heightened due diligence commensurate with the level of risks identified. The financial institution must analyze the results independently and carefully consider whether relying on analyses prepared by or for the customer is appropriate.
Upon completion of the due diligence, the revised Interagency Statement calls for a financial institution to implement an approval process that includes all appropriate levels of control and management personnel. This approval process should include review by accounting, legal, tax, and compliance personnel who will be able to bring an institution-wide perspective to a particular CSFT. If the transaction is then approved, appropriate steps should be implemented to manage the risks. Transactions that present risks that are unacceptable or cannot be effectively managed should, of course, be declined.
If a transaction is approved, the revised Interagency Statement calls for financial institutions to create documentation that:
* documents the material terms of the transaction;
* enforces the material obligations of the parties;
* confirms that any necessary disclosures have been received by customers, and
* verifies compliance with the institution's internal policies and procedures.
As customers of financial institutions are well aware, the regulatory reaction to CSFTs often results in the imposition of certain duties on them. In fact, in response to the provisions of the original Statement and related events, many financial institutions implemented detailed procedures to document how customers were using and accounting for their structured finance transactions. The revised Interagency Statement continues to emphasize an institution's due diligence responsibilities, which will likely continue to involve obtaining detailed information from customers.
Additional Provisions
Significantly, the revised Interagency Statement calls for the implementation of a so-called tone at the top about the importance of compliance with these policies and procedures and good business ethics more generally, as evidenced by effective procedures for monitoring compliance with and auditing these procedures, training personnel and reporting on these activities generally.
The Securities and Exchange Commission, the Federal Reserve Board, the FDIC, the Office of the Comptroller of the Currency and the Office of Thrift Supervision will accept comments on the revised Interagency Statement until June 15.
This week's Learning Curve was written by David Krohnand Dwight Smith, partners at law firm Alston & Birdin Washington, D.C.
