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COVINGTON & BURLING
July 19, 2004
Office of the Comptroller of the Currency
250 E Street, S.W.
Public Reference Room
Mail Stop 1-5
Washington, D.C. 20219
Board of Governors
of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, D.C. 20551
Attention: Jennifer J. Johnson, Secretary
Regulation Comments
Chief Counsel's Office
Office of Thrift Supervision
1700 G Street, N.W.
Washington, D.C. 20552
Federal Deposit Insurance Corporation
550 17th Street, N.W.
Washington, D.C. 20429
Attention: Robert E. Feldman,
Executive Secretary, Comments/OES
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Attention: Jonathan G. Katz, Secretary
Re: OCC Docket No. 04-12
OTS No. 2004-27
Federal Reserve Docket No. OP-1189
FDIC Reference Comments/OES
SEC File No. S7-22-04
Proposed Policy Statement: Interagency Statement on Sound Practices
Concerning Complex Structured Finance Activities (69 Fed. Reg. 28980
(May 19, 2004))
Ladies and Gentlemen:
Covington & Burling is pleased to respond to the request of the
Office of the Comptroller of the Currency, the Office of Thrift
Supervision, the Board of Governors of the Federal Reserve System, the
Federal Deposit Insurance Corporation and the Securities and Exchange
Commission (collectively, the "Agencies") for comments on the Agencies'
joint Proposed Policy Statement concerning complex structured finance
activities cited above (including the supplemental information included
therewith, the "Statement").1
We support the Agencies' objective of ensuring that financial
institutions subject to supervision by one or more of the Agencies
develop and maintain adequate internal control and risk management
procedures related to complex structured finance activities. We also
agree with the Agencies that in the vast majority of cases, structured
finance transactions, even those of great complexity, serve the
legitimate business needs of customers and achieve beneficial results
for the capital markets.2 We further believe that the vast
majority of corporations that engage in complex structured finance
transactions do so for valid business purposes, and account for, and
disclose the financial impacts of, such transactions appropriately,
despite recent and troubling examples to the contrary.
The purpose of this comment letter is to respectfully suggest that
certain recommendations contained in the Statement as proposed may prove
to be unworkable in practice, at least to the extent that complex
structured finance transactions involve companies that are required to
file periodic and other reports with the Securities and Exchange
Commission pursuant to Sections 13(a) and 15(d) of the Securities
Exchange Act of 1934. If the Agencies adopt these recommendations as
best practices for financial institutions subject to their supervision,
we believe that this could lead these financial institutions to adopt
practices that unnecessarily impair the ability of their customers to
execute such a transaction, either by delaying execution or by
unnecessarily raising the cost of doing so such that the transaction is
no longer economically attractive. In the worst case, the Statement, if
adopted as proposed, could prevent otherwise valid structured finance
transactions from occurring, or could unnecessarily impose additional
legal risks on financial institutions subject to supervision by one or
more of the Agencies. These risks could impair the vibrancy of our
capital markets by forcing participants to execute transactions offshore
or by artificially reducing the range of options available to companies
seeking to select the optimal financing alternative. We believe that
these risks can be addressed without impairing the ability of the
Statement to provide meaningful guidance to financial institutions as
they evaluate their internal control and risk management procedures
related to complex structured finance activities.3
Accounting and Disclosure by Customers
The Statement suggests that a financial institution should inquire as
to a customer's (i) business purpose in entering into a complex
structured finance transaction, (ii) accounting for the transaction, and
(iii) disclosure of the transaction. This recommendation is expressed
repeatedly throughout the Statement, in many instances inconsistently,
and this inconsistency makes it difficult to understand precisely what
the Agencies believe to be the best practice in this area. This
uncertainty could lead to the creation of overly broad internal policies
by financial institutions that seek in good faith to follow the letter
and the spirit of the Statement. However, even if these inconsistencies
are remedied, we believe that there are substantive issues with the
second and third components of this recommendation that could render it
unworkable, and could even create additional legal risk for the
financial institutions as they seek to rely on the Statement as a means
of limiting that risk. We discuss each of these concerns below.
Review of a Customer's Accounting Treatment of a Complex
Structured Finance Transaction.
The Statement recommends in several instances that a financial
institution should understand how a customer intends to account for a
complex structured finance transaction upon completion of the
transaction. Some references clearly limit this to the customer's
proposed accounting treatment, but in other instances the Statement
refers to review of a customer's accounting treatment unmodified by the
word "proposed." Some of these references arise in the context of the
identification by the financial institution of a situation involving an
unusually high degree of risk, suggesting that in these higher risk
transactions, the financial institution would be expected to review
final rather than proposed accounting treatment. One such reference even
suggests that the customer be required to provide a written
representation and warranty to the financial institution as to its
accounting treatment.4
We believe that the Statement should only recommend that a financial
institution inquire as to a client's proposed accounting treatment for
the transaction in question. It is entirely appropriate to expect that
the customer have a basic understanding of how it would expect to
account for the transaction in its audited financial statements for the
fiscal year in which the transaction is consummated. Implicit in this
expectation is that the customer will have discussed the accounting
treatment for the transaction with its independent public accounting
firm prior to entering into the transaction, and we agree that the
financial institution that is the primary counterparty to the customer
in the transaction should, as a matter of basic diligence, be aware of
this proposed accounting treatment and satisfy itself that there are no
material differences between the customer, its Audit Committee and its
independent auditors. The Statement also contemplates that a financial
institution could retain a public accounting firm to evaluate the
accounting treatment of a complex structured finance transaction.5
However, we do not believe that it is plausible to expect the customer
to be in a position to commit to definitive accounting treatment at any
time prior to the completion of the preparation of the customer's
financial statements for the fiscal year in question and of their
independent public accounting firm's audit of those financial
statements.
There are several reasons for this concern. First, any transaction
will be executed prior to the preparation of the audited financial
statements for the fiscal year in question, or of the unaudited
financial statements for the fiscal quarter in question. We expect that
any attempt by the customer to "lock in" such treatment in advance of
the completion of the audit would almost certainly be resisted by its
auditors. In turn, since the financial statements are prepared by the
company, not by its auditors, the auditors cannot definitively recommend
any presentation until they have had an opportunity to perform their
audit on the financial statements as prepared by the company.
We also believe efforts by any third party to compel a publicly-held
company to adopt a particular accounting treatment or presentation would
usurp the Audit Committee's authority and responsibility to oversee the
work of the company's auditors for the purpose of preparing an audit
report, and to resolve disagreements, if any, between management and the
auditors regarding financial reporting. This statutorily-imposed duty6
cannot be delegated to any other individual or institution.
In addition, the growing complexity of United States generally
accepted accounting principles has created uncertainty as to the
appropriate treatment of certain transactions and structures. Companies
and auditors, struggling in good faith with these shifting sands, are
increasingly finding themselves revising previous views as to accounting
treatment as they prepare the financial statements and complete the
audit. Such a change could occur for any number of reasons, including a
change in analysis on the part of the company's auditors, publication of
a new interpretation by the entities that promulgate the literature that
constitutes GAAP in the United States, or issuance of a statement by an
accounting regulator that calls into question standards that were
accepted at the time the transaction in question was consummated.
Finally, regardless of what one may think of the long-term merits of the
potential shift to principles-based accounting, it is reasonable to
expect that if this shift occurs, uncertainty as to accounting
treatments and presentations will increase in the short term, perhaps
dramatically. None of these events would in any way challenge the good
faith expectation of the company and its auditors at the time the
complex structured finance transaction was being executed, but could
cause the proposed accounting treatment or presentation to shift,
perhaps materially. The result would still be consistent with U.S. GAAP,
but it may not be consistent with undertakings made by the customer to
the financial institution at the time the complex structured finance
transaction was entered into.
Finally, a publicly-held company could receive SEC comments as a
result of a review of its periodic and other reports filed under the
Exchange Act, or of a review of a registration statement filed under the
Securities Act of 1933, that could result in a change in accounting
treatment or presentation of a previously consummated complex structured
finance transaction.
These factors would render any undertaking by a customer as to
definitive accounting treatment of a complex structured finance
transaction at best illusory. It is also unclear what benefit to the
process would be achieved by requiring the customer to enter into some
undertaking or to provide some form of certification, both with implicit
remedies if the undertaking or certification proves to be incorrect, if
the change results from any of the events described above. Rather than
try to negotiate ever-more complex contractual provisions or
certifications attempting to anticipate each such potential situation,
we believe that the financial institution should be encouraged to
undertake a reasonable inquiry regarding the customer's proposed
accounting treatment of the complex structured finance transaction, but
to do so with the understanding that it is not possible for the customer
(or its auditors) to provide any binding assurances as to the ultimate
accounting treatment to be adopted.
Because of these concerns, we would consider it inadvisable for any
SEC registrant to enter into a contractual undertaking, or provide a
written certification, as to what it believes the definitive accounting
treatment of a complex structured finance transaction would be at any
time prior to completion of the relevant financial statements and audit
(or, in the case of quarterly financial statements, auditor review),
because of the unacceptably high potential that subsequent events out of
the company's control could require it to adopt a different approach. We
fear that if the Statement as adopted could be read to require customers
to commit or certify in a legally binding manner to a particular
accounting treatment or presentation, this could lead financial
institutions to insist on such a commitment as a condition to their
participation in the transaction, which could lead well-advised
companies to refrain from entering into otherwise beneficial complex
structured finance transactions.
Review of a Customer's Disclosures Regarding a Complex Structured
Finance Transaction
The Release as proposed also recommends in several instances that the
financial institution review a customer's disclosures regarding the
complex structured finance transaction. While we are in no way
suggesting that improper or misleading disclosures regarding such a
transaction are acceptable, we believe that any mandated involvement by
financial institutions in the preparation of a registrant's financial
statements or related disclosures is inadvisable and unworkable for the
reasons discussed below.7
Drafting Disclosure Relating to a Complex Structured Finance
During the Transaction Would Be Premature. In many instances
involving complex structured finance transactions, the client will be
many months away from preparing its annual financial statements and
drafting its related disclosure documents. For example, assume that a
public company that is an accelerated filer and has a fiscal year ending
on December 31 entered into a complex structured finance transaction in
February of 2004. It will not have to file its Form 10-K for that fiscal
year until March 1, 2005. Thus, at the time the company enters into the
transaction, it will be 13 months away from filing disclosure containing
audited financial statements and related disclosures regarding the
transaction.8 Of course, the company was required to file its
quarterly report on Form 10-Q much sooner (by May 10, 2004 in the above
hypothetical). However, any disclosure of the transaction in this
quarterly report will be included in unaudited financial statements that
will be reviewed, but not audited, by the company's independent
auditors. Also, MD&A disclosure in the Form 10-Q of a complex structured
finance transaction may well be different from disclosure in the Form
10-K. Disclosure in the quarterly report is likely to focus on the
specific transaction that occurred in that quarter and as such will be a
more deal-specific description of that particular transaction.9
By contrast, a company that may have entered into various complex
structured finance transactions during its fiscal year should aggregate
MD&A disclosure of these transactions in its Form 10-K to the extent
that aggregation makes the disclosure more meaningful and provide
information in an efficient and understandable manner.10
The Statement as proposed implies that these timing issues ought not
to be relevant in that the parties can review proposed disclosure during
the execution of the complex structured finance transaction. We do not
believe that this is a workable approach. Financial and related
disclosures can only be effectively drafted in the context of the
company's overall results. Any attempt to draft disclosure (whether in
the notes to the financial statements or in MD&A or related disclosures)
creates disclosure in the absence of context, which may prove to be
inappropriate when the time comes to insert it into the company's
overall disclosures for the period in question. The staff of the SEC has
consistently stressed that MD&A disclosure should emphasize the major
themes underlying the company's results of operations, financial
condition and liquidity. Simply dropping in an isolated and
independently created disclosure relating to a complex structured
finance transaction (or stringing together independently created
disclosures of multiple such transactions) will fail to provide the
interrelated analysis that underlies effective disclosure.
Permitting Financial Institutions to Participate in the
Preparation of Disclosure Documents would be Inadvisable.
Alternatively, the Statement as proposed could be read to suggest that
the financial institution should negotiate the right to review and
comment upon a customer's disclosures regarding a complex structured
finance transaction at the time the relevant disclosure or other
document is being prepared. As described below, we believe it would be
inadvisable for the customer to agree to this sort of third party review
of its non-public disclosures, and also for the financial institution to
accept an invitation of this nature if one were offered.
Registrants and their Management and Directors Bear Significant
Liability for their Disclosures and will be Unwilling to Cede Control to
Third Parties. Companies required to file periodic and other reports
with the SEC, and their officers and directors, bear significant
liability for the accuracy of their disclosures, whether in periodic
reports filed pursuant to the Exchange Act or in Registration Statements
filed pursuant to the Securities Act.11 In addition, the
Sarbanes-Oxley Act has introduced rigorous certification requirements
that must be complied with by CEOs and CFOs of reporting companies.12
These certifications carry potential civil and criminal liability.
Similarly, it is the company that bears the ultimate responsibility
for its financial statements. This remains true even if the company's
auditors make suggestions as to the form or content of the financial
statements, or even if they draft them in whole or in part. While these
are audited (or, in the case of quarterly reports, reviewed) by the
company's independent public accountants, the accounting literature (as
well as the audit opinion delivered in respect of audited financial
statements) makes clear that the financial statements are the
responsibility of management. Under the Securities Act, the issuer is
strictly liable for all of the information contained in the registration
statement, including the financial statements.13
The Statement as proposed suggests that publicly-held companies agree
to review disclosures with financial institutions. As noted above, in
one instance the Statement proposes that companies deemed to pose higher
than normal risks should be required to commit contractually to such an
arrangement. We believe it would be inadvisable for a publicly held
company to enter into any arrangement whereby an unaffiliated third
party has rights to participate in, or review, disclosures made by the
company to its security holders. The interests of the parties may very
well diverge in this situation for any number of reasons.
We also believe that this approach implies that the liability
provisions of the federal securities laws provide inadequate incentive
to publicly held companies to provide clear and accurate disclosure to
their security holders. While there have doubtless been examples of
disclosure that has failed to meet the standards set by the securities
laws in recent years, we believe that the vast majority of public
companies that have engaged in complex structured finance transactions,
with the assistance of their independent public accountants and other
advisors, prepare disclosure documents that meet the standards imposed
by the federal securities laws.14 Any suggestion that
financial institutions must provide an additional level of scrutiny to
ensure that adequate disclosures are made is, we believe, inconsistent
with the policy underlying the securities laws, unless the financial
institution is prepared to undertake liability for the disclosure in
question. We discuss this question below.
Financial Institutions That Actively Participate In the
Preparation of a Registrant's Disclosures Could be Deemed to Have
Assumed Liability For Those Disclosures. As noted above, the federal
securities laws impose significant liabilities on public companies, and
their officers and directors, for the accuracy of disclosure documents.
The securities laws can also impose liability on third parties that
actively participate in the preparation or review of a registrant's
disclosures.15 While the precise parameters of this form of liability
vary across the various federal judicial districts, it is clear that
plaintiff's lawyers, in search of the deepest possible pockets, will
leap at any opportunity to include a large financial institution as
defendant in any action alleging improper disclosure. Therefore, while
the Statement is intended to suggest best practices designed to reduce
the liabilities faced by financial institutions that participate in
complex structured finance transactions, any suggestion that these
institutions participate in the preparation of disclosure documents of
public companies relating to these transactions may in fact expose the
financial institutions to increased liabilities.
Other Miscellaneous Comments
Reputational and Legal Risk
The Statement recommends that financial institutions adopt policies
and procedures designed to ensure that reputational and legal risks
associated with a complex structured finance transaction are understood
by both the financial institution and by the client. In particular, the
Statement as proposed, in the second paragraph under this heading,
suggests that financial institutions should ensure that the customer
understands the risk and return profile of the transaction, and that
disclosures made by the financial institution include an adequate
description of the risks and other factors that the customer should be
aware of. We believe this is an appropriate recommendation, but are
concerned that practice may be inconsistent with this goal.
Our experience in complex structured finance transactions is it is
becoming increasingly common for financial institutions to require
customers to agree by way of contract, or attempt to deem customers to
have agreed, that the customer has not relied upon any communication
(written or oral) it has received from the financial institution related
to the transaction. In some cases, these non-reliance representations
provide that the customer has not relied upon such communications as
investment advice or as a recommendation to enter into the transaction.16
In other cases, the scope of the non-reliance is broader. It is also
possible that foreign regulators could also recommend or require similar
provisions in transactions implicating their jurisdiction. Non-reliance
representation may usefully allocate risks between parties and are not
necessarily inconsistent with the disclosure goal as enunciated in the
Statement. However, the Agencies may want to consider whether such
disclosure achieves that goal if the customer is expressly prohibited
from relying upon it.
Documentation Standards
We note the suggestion under this caption in the Standard that
financial institutions should include in their documentation of a
complex structured finance transaction minutes of critical meetings with
the client. Our experience is that it would be highly unusual for
minutes to be taken in any meeting relating to a complex structured
finance transaction. We also believe that the formal taking of minutes
should be discouraged, for the reasons described below.
If the minutes are to have any relevance, they would have to be
reviewed and agreed by all parties to the meeting. Otherwise, they are
merely the uncorroborated views of the minute taker, but not necessarily
consistent with the views of the other parties in the meeting. To the
extent that the meeting in question is an early-stage meeting with
senior management to discuss the proposal, we doubt that senior
management will be willing to expend the time necessary to review the
minutes. To the extent that the meeting is at a later stage of the
transaction, there are likely to be many participants, so achieving an
agreed-upon set of minutes is likely to be a very time consuming task.
We believe that this aspect of the Statement as proposed would be
unworkable solely on this basis.
Of greater import, if all parties know that minutes are being taken
and will be retained, this could very well chill, rather than encourage,
discussion. Anything that impairs the free flow of ideas and discussion
will increase the risk of mistake or misunderstanding, which is exactly
what the Standard's proposed documentation standards are designed to
prevent.
Finally, we believe that a well-advised company would refuse to
permit the taking of formal minutes in any transactional meeting.
Litigation counsel typically recommends that handwritten notes, as well
as drafts and other non-final documents, be discarded as a matter of
course at the conclusion of any transaction. This is based on experience
in defending against frivolous lawsuits that may be subsequently
brought, when preliminary documents, notes and similar remnants of the
evolution of the transaction may be taken out of context by opposing
counsel and used in inappropriate ways. We believe that minutes of
meetings, preserved post-closing, would be discoverable in any
subsequent litigation and would pose precisely this risk for all parties
to the transaction.
* * *
We appreciate the opportunity to comment on the Statement. If you
have any questions with respect to this letter or require any further
information, please to not hesitate to contact the undersigned
(212.841.1060; bbennett@cov.com).
COVINGTON & BURLING
Bruce C. Bennet
1330 Avenue of the Americas
New York, NY 10019
1 The Agencies extended the deadline for comments on the
Proposed Statement from June 18, 2004 to July 19, 2004. 69 Fed. Reg.
34354 (June 21, 2004).
2 See Annette L. Nazareth, Director, Division of Market
Regulation of the Securities and Exchange Commission, Testimony
Concerning Transparent Financial Reporting for Structured Finance
Transactions, December 11, 2002 (http://www.sec.gov/news/testimony/121102tsan.htm)
("Nazareth Testimony") ("When used properly, [structured finance] can
provide needed liquidity and funding sources, investment opportunities,
and can facilitate risk dispersion.").
3 While we are not submitting this comment letter on behalf
of specific clients, we have discussed the issues addressed herein with
senior management of several publicly-held clients.
4 See the third paragraph under the caption "Accounting and
Disclosure by Customers" in the Statement.
5 We note that AICPA Statement on Auditing Standards No. 50
imposes specific obligations on an accounting firm when rendering an
oral or written report on the application of accounting principles to a
particular transaction. In addition, SAS 50 was amended by Statement on
Auditing Standards No. 97 to preclude the issuance of such a report
regarding "hypothetical transactions." See Nazareth Testimony for a
discussion of SAS 50 and SAS 97; see also Comment Letter, dated June 18,
2004, of Deloitte & Touche LLP regarding the Statement.
6 See Section 10A(m)(2) of the Exchange Act
7 While the Statement as proposed is not entirely clear on
this point, we interpret the disclosure review contemplated by the
Statement as proposed to encompass both the customer's presentation of
the complex structured finance transaction in its financial statements
(including the notes thereto) as well as the customer's disclosures
regarding the impact of the complex structured finance transaction on
its results of operations, financial condition and liquidity in the
accompanying Management's Discussion and Analysis or elsewhere in the
disclosure document or registration statement. As has been repeatedly
noted by the SEC, MD&A disclosure must interpret the information
conveyed by the financial statements, so any review by the financial
institution of a client's financial statement disclosure will of
necessity affect disclosures in the MD&A and perhaps other portions of
the document in question.
8 This assumes that the transaction would not otherwise
require disclosure on Form 8-K under the SEC's new rules for that form,
which take effect on August 23, 2004.
9 According to SEC guidance, material changes to items
disclosed in annual reports should be discussed in the quarter in which
they occur. See Interpretation: Commission Guidance Regarding
Management's Discussion and Analysis of Financial Condition and Results
of Operations, Release No. 33-8350 (December 19, 2003) at Section
III.B.2.
10 See Final Rule: Disclosure in Management's Discussion
and Analysis about Off-Balance Sheet Arrangements and Aggregate
Contractual Obligations, Release No. 33-8182 (January 28, 2003) at
Section III.C.
11 For example, see Sections 11, 12 and 17 of the Securities
Act and Sections 10 and 18 of the Exchange Act and Rule 10b-5 thereunder.
Controlling persons (as defined in both Acts) may also bear liability on
a joint and several basis for inadequate disclosure and other violations
of these Acts. See Section 15 of the Securities Act and Section 20 of
the Exchange Act.
12 See Rules 13a-14 and 15d-14 under the Exchange Act.
13 The Securities Act provides that directors and officers
are subject to a lesser standard of liability in respect of information,
such as audited financial statements, that is "expertised." A company's
public accountants take on this expert liability in respect of audited
financial statements when they have expressly consented to the
assumption of such liability. See Section 11(a)(3)(C) of the Securities
Act. See also PAUL MUNTER & THOMAS A. RATCLIFFE, APPLYING GAAP AND GAAS
§ 24.02 (37th Release 2003).
14 We note that generally accepted accounting principles and
generally accepted auditing standards also require auditors to perform
reviews that in many ways overlap with steps that the Standard proposes
to impose on financial institutions. For example, AICPA Statement on
Auditing Standards No. 1 states:The auditor has a responsibility to plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement, whether caused
by error or fraud.
The AICPA subsequently adopted Statement on Auditing Standards No. 99 to
establish standards and provide guidance to auditors in fulfilling their
responsibilities under SAS No. 1 as it relates to fraudulent
misstatements. In particular, paragraph 66 of SAS No. 99 states:
During the course of the audit, the auditor may become aware of
significant transactions that are outside the normal course of business
for the entity .... The auditor should gain an
understanding of the business rationale for such transaction and whether
that rationale (or the lack thereof) suggests that the transactions may
have been entered into to engage in fraudulent financial reporting or
conceal misappropriation of assets.
Finally, the AICPA adopted Statement on Auditing Standards No. 54 to
establish standards and provide guidance to auditors relating to
detecting misstatements resulting from illegal acts.
15 The SEC, in a letter from Annette L. Nazareth, Director,
Division of Market Regulation, Securities and Exchange Commission, to
Richard Spillenkothen, Director, Division of Banking Supervision and
Regulation of the Board of Governors of the Federal Reserve System, and
Douglas W. Roeder, Senior Deputy Comptroller, Large Bank Supervisor of
the Office of the Comptroller of the Currency, dated December 4, 2003,
gave the following guidance regarding a financial institution's
potential liability for securities law violations arising from deceptive
structured finance products and transactions:
Depending on the facts and circumstances, a financial institution could
be liable for securities law violations when it offers deceptive
structured finance products to, or participates in deceptive structured
finance transactions with, a U.S. publicly traded company. A financial
institution could have primary liability for antifraud violations. More
commonly, it could be liable for aiding and abetting antifraud,
reporting, recordkeeping, and internal controls violations. It could
also be liable for causing such violations.
In Central Bank of Denver N.A. v. First Interstate Bank of Denver,
NA., 511 US. 164, 191, (1994), the Supreme Court held that a private
plaintiff may not maintain an aiding and abetting suit under Section
10(b) of the Exchange Act. However, the Supreme Court went on to state:
[t]he absence of § 10(b) aiding and abetting liability does not mean
that secondary actors in the securities markets are always free from
liability under the securities Acts. Any person or entity, including a
lawyer, accountant, or bank, who employs a manipulative device or makes
a material misstatement (or omission) on which a purchaser or seller of
securities relies may be liable as a primary violator under 10b-5,
assuming all of the requirements for primary liability under Rule 10b-5
are met.
Following the Supreme Court's ruling in Central Bank, the lower
courts have formulated various standards to determine when the conduct
of a secondary actor makes it a primary violator under the Exchange Act.
Two divergent standards, the "bright line" test and the "substantial
participation" test, have emerged. (Enron Corp. Sec. Derivative &
ERISA Litig., 235 F. Supp. 2d 549, 583 (S.D. Tex. 2002)). The
federal court in the Enron case went on to quote, and adopt, the
rule that the SEC had proposed for primary liability of a secondary
party under Section 10(b) of the Exchange Act in its amicus curiae
brief:
when a person, acting alone or with others, creates a misrepresentation
[on which the investor-plaintiffs relied], the person can be liable as a
primary violator . . . if ... he acts with the requisite scienter.
SEC amicus curiae brief at 18. The court went on to state:
Moreover it would not be necessary for a person to be the initiator of a
misrepresentation in order to be a primary violator. Provided that a
plaintiff can plead and prove scienter, a person can be a primary
violator if he or she writes misrepresentations for inclusion in a
document to be given to investors, even if the idea for those
misrepresentations came from someone else.
Enron, 235 F. Supp. 2d 546 at 587-590.
16 This formulation has become standard in derivatives
documentation, particularly those transactions executed on International
Swaps and Derivatives Association forms. This dates back to the
promulgation by ISDA and the Federal Reserve Bank of New York of the
Principles and Practices for Wholesale Financial Market Transactions.
This document, which was issued in 1996, included non-reliance
representations as a means to reduce the risk to derivatives dealers of
being deemed to be a guarantor of the outcome of complex structured
derivatives transactions that did not perform as a customer might have
hoped. While the Principles never attained widespread adherence,
non-reliance representations have become a standard, and in our
experience virtually non-negotiable, part of derivatives documentation.
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