The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Securities and Exchange Commission (collectively, the Agencies) released on January 5 a final statement with respect to complex structured finance activities of financial institutions (the Statement). The Statement, which states that the transactions it covers are an “essential part of U.S. and international capital markets,” represents supervisory “guidance” for institutions supervised by the four banking agencies and a policy statement for institutions supervised by the Securities and Exchange Commission. The guidance and statement are the culmination of efforts to prevent banks and other financial institutions from committing, aiding, or abetting violations of applicable laws, regulations and accounting principles in connection with complex structured financial transactions (CSFTs). The Agencies stated that “in some cases, certain CSFTs appear to have been used in illegal schemes that misrepresented the financial condition of public companies to investors and regulatory authorities.”
The Agencies believe that it is important for a financial institution engaged in CSFTs to have policies and procedures that are designed to allow the institution to effectively manage and address the full range of risks associated with its CSFT activities, including the elevated legal or reputational risks that may arise in connection with elevated risk CSFTs. For this reason, the Final Statement describes the types of risk management principles that the Agencies believe may help a financial institution to identify elevated risk CSFTs and to evaluate, manage, and address these risks within the institution’s internal control framework. The Statement provides examples of transactions that may warrant additional scrutiny by an institution. These examples include, among other things, transactions that appear to the institution to:
- Lack economic substance or business purpose;
- Be designed or used primarily for questionable accounting, regulatory, or tax objectives, particularly when the transactions are executed at year-end or at the end of a reporting period for the customer; or Raise concerns that the client will report or disclose the transaction in its public filings or financial statements in a manner that is materially misleading or inconsistent with the substance of the transaction or applicable regulatory or accounting requirements.
The Statement continues to provide that a financial institution should decline to participate in an elevated risk CSFT if, after conducting appropriate due diligence and taking appropriate steps to address the risks from the transaction, the institution determines that the transaction presents unacceptable risks to the institution or would result in a violation of applicable laws, regulations or accounting principles. The Statement also describes the types of risk management systems and internal controls that may help a financial institution engaged in CSFTs to identify those CSFTs that may pose heightened legal or reputational risk to the institution, and to evaluate, manage, and address those risks. Additionally, the Statement provides that the board of directors and senior management of an institution should establish a “tone at the top” through both actions and formalized policies that sends a strong message throughout the financial institution about the importance of compliance with the law and overall good business ethics.
Another section of the Statement also describes the types of training, reporting mechanisms, and audit procedures that institutions should have in place with respect to elevated risk CSFTs. The Statement also provides that a financial institution should conduct periodic independent reviews of its CSFT activities to verify and monitor that its policies and controls relating to elevated risk CSFTs are being implemented effectively and that elevated risk CSFTs are accurately identified and receive proper approvals.
While careful to state that the Statement does not impose a binding legal requirement on financial institutions because it is guidance, institutions should thoughtfully consider the guidance recognizing that failure to comply could lead to supervisory difficulties.