On January 11, 2007, the US banking and securities regulators (Federal Reserve Board, Securities and Exchange Commission, Office of the Comptroller of the Currency, Office of Thrift Supervision and the Federal Deposit Insurance Corporation) (Agencies) completed an almost three year process to develop supervisory guidance on complex structured finance transactions (CSFTs) by issuing a final "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities" (Statement).
The interagency process began following the collapse of Enron amid regulatory concerns about financial institutions' involvement in complex transactions and whether they were adequately dealing with the heightened risks posed by some of the transaction structures. The Agencies' initial 2004 proposal was criticized for, among other things, its perceived lack of flexibility in defining CSFTs and a concern that financial institutions would be required to ensure that their customers complied with all applicable laws and other requirements (such as accurate accounting treatment). After review of the comments, the Agencies issued revised proposed guidance in May of 2006, making it more principles-based and more focused on those transactional structures that posed the most heightened risk for financial institutions. After a second comment period on the revised proposal, the Agencies finalized the guidance, which was published in the Federal Register on January 11. The final guidance differs very little from the May 2006 revised proposal. Previous articles about this initiative appeared in the June and September 2004 and May and August 2006 Updates.
As it has from the beginning of the process, the CSFT guidance is applicable to national banks, state banks, bank holding companies organized in the United States, federal and state savings associations, savings and loan holding companies, US branches and agencies of non-US banks, and SEC-registered broker-dealers and investment advisers.
The Statement focuses on the identification of CSFTs, the due diligence and approval process for engaging in them, and the appropriate documentation to maintain in the file.
- Identifying CSFTs: A financial institution should have policies and procedures in place to identify elevated risk CSFTs. The Statement does not attempt to describe every characteristic of an elevated risk CSFT, but it does list some of the more familiar aspects of such a transaction, including no apparent economic substance or business purpose, seemingly questionable accounting, regulatory or tax objectives, or transaction economics not being in conformity with usual market practice.
- Due Diligence and Approval Process: If a financial institution identifies a potential transaction as an elevated risk CSFT, it must carefully analyze the risks involved in the transactions, particularly the legal or reputational risks, and ensure that all material questions are answered. The level and amount of due diligence depends upon the risks identified. For example, if the financial institution developed and marketed the product, or acts as an adviser to a customer in connection with such a transaction, it may have additional fiduciary responsibilities and thus more risk to identify and manage than if it played a more limited role. The financial institution should not rely on the fact that another financial institution or institutions are involved in the transaction, or accept without question customer-prepared or commissioned analyses of risks such as applicable accounting, tax or legal issues.
If the due diligence process indicates that there is elevated legal or reputational risk, the financial institution should address those risks, whether that means withdrawing from the transaction, adding additional representations and warranties for more protection, or other appropriate measures.
In addition, financial institutions should have a consistent firmwide approval process to ensure that elevated risk CSFTs are reviewed and approved by "appropriate levels of control and management personnel," including by control functions independent of the business line involved in the transaction. Information necessary for an informed decision should be provided, such as material terms of the transaction, nature of the financial institution's relationships with the customer and a discussion of the specific elevated risks posed by the transaction.
- Documentation: Financial institutions should retain records that describe the transaction details and material obligations of the parties. Records should contain information that enables the financial institution to confirm that all appropriate disclosures were made to the customer and that the relevant policies and procedures were followed. The institution's internal audit function should review adherence to such policies and procedures.
The Statement can be accessed through any of the Agencies' websites, such as the Federal Reserve Board's.