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MORGAN STANLEY & CO; GOLDMAN, SACHS & CO.
July 19, 2004
Mr. Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
File Number S7-22-04
Dear Mr. Katz:
Morgan Stanley & Co. Incorporated and Goldman, Sachs & Co. are
pleased to submit comments to the Securities and Exchange Commission
(the "Commission") on the proposed policy statement on sound practices
concerning complex structured finance activities (the "Policy
Statement") proposed on May 14, 2004 by 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 Commission (the "Agencies").
We fully support the view that issuers of securities in the public
markets must provide full and accurate public disclosure of transactions
affecting their financial condition and results of operations, including
appropriate disclosure of complex structured finance transactions. As a
result of abuses that have come to light in recent years, we agree that
complex structured finance transactions deserve special attention from
regulators.
We also believe that financial institutions must have proper risk
management controls in place that are tailored to their business lines,
and we further recognize that the effectiveness of such controls depends
on having a board of directors and senior management that set the proper
tone for compliance by the entire organization.
The Policy Statement highlights the unfortunate fact that certain
issuers of securities may have used complex structured finance
transactions to circumvent regulatory or financial reporting
requirements, engage in improper tax reporting or mask questionable if
not illegal behavior. We fully recognize that financial institutions may
expose themselves to substantial reputational and legal risk if they
knowingly participate in structuring and executing transactions that are
illegal or that mislead investors.
While we support the purposes and objectives of the Agencies in
drafting the Policy Statement, we are concerned that the Policy
Statement will have unintended negative consequences for entirely proper
transactions. The overwhelming majority of structured finance
transactions are productive, legitimate activities constituting a very
significant means of capital formation for the business community.
Securitization transactions involving approximately $1.1 trillion of
securities were executed in 1993 and the notional amount of outstanding
interest rate/currency swaps in that year was approximately $8.5
trillion. By 2003, the face amount of securitization transactions
totaled approximately $3.7 trillion and the notional amount of
outstanding swaps equaled approximately $145 trillion, including
transactions in entirely new asset categories, such as credit default
swaps and collateralized debt obligations.
Despite the vast size of these markets, only a small handful of
transactions were subsequently identified as fraudulent during the
investigations of the past few years. Yet, the Policy Statement subjects
all complex structured finance transactions, broadly defined, to
heightened scrutiny and record-keeping requirements that will
substantially and immediately impair bona fide financing techniques by
companies and their financial intermediaries. As one example, the Policy
Statement's requirement to create and maintain "minutes of critical
meetings" is highly cumbersome and virtually impossible to implement.
Rather than promoting a regulatory benefit, this requirement will most
likely undercut the free flow of ideas that is essential for the
implementation of existing techniques and the creation of new financial
products. U.S. leadership and competitiveness in developing and
implementing these intellectually intensive products will suffer. We
welcome the opportunity to address our concerns in the comments set
forth below.
We note that, although our concerns may overlap with concerns of
other types of financial institutions, our comments are intended to
reflect the scope of our respective firm's business lines and
activities.
We comment on the following seven subjects:
• Issuers of securities in the public markets should continue to
bear the burden of public disclosure of material matters regarding
their financial statements and results of operations. The Policy
Statement should not result in a sharing of that burden by financial
institutions engaging in complex structured finance transactions with
such issuers. Financial institutions do not and should not have the
enforcement capability to require confirmation of involvement by an
issuer/customer's senior management, to compel a customer to disclose
its business objectives or to mandate a dialogue with a customer's
outside advisors, including auditors. The focus on evaluating proposed
customer disclosure and accounting treatment places an improper burden
on financial institutions.
• The Policy Statement should oblige each financial institution to
maintain a robust risk management program that is suitable to its own
business. The Agencies should not, however, attempt to define elements
of transactions that should always require special scrutiny; decisions
on risk management should be left to the judgment of the individual
institutions.
• Certain of the suggestions in the Policy Statement regarding
minutes of customer meetings and retention of documents regarding
rejected transactions are inconsistent with normal business practices
and are impractical.
• The role of the Board of Directors in this area should be
consistent with the general duties of directors in the oversight of
internal controls. The Policy Statement should not expand the role of
the Board beyond these well-established corporate governance
principles.
• The Policy Statement should cover transactions involving U.S.
reporting companies. Extending the scope of the Policy Statement to
foreign companies that are not reporting companies under the U.S.
Securities Exchange Act of 1934 (the "Exchange Act") will unfairly
disadvantage U.S. financial institutions by driving such foreign
companies to engage in transactions with unregulated or offshore
financial intermediaries.
• The Policy Statement should not become a source of private
rights of action against financial institutions.
• The Agencies' interpretations of the Policy Statement should be
made on a consistent and coordinated basis and publicly available.
1. Relationship with the Customer
(A) Responsibility of the Customer
While we agree with the spirit of the Policy Statement and welcome
the expression of concern on the part of the Agencies that financial
institutions may assume reputational or legal risk if their customers
act in improper or illegal ways, we believe that public company
customers that enter into complex structured finance transactions, and
not the financial institutions that assist in structuring or executing
them, are in the best position to ensure their compliance with
applicable laws and regulations.
Several recent initiatives have greatly enhanced both the quality of
public company disclosure and the likelihood that disclosure of
structured finance transactions entered into by public companies will be
accurate and complete. These include (i) the Commission's recent
modifications of the events that trigger the filing of current reports
on Form 8-K, (ii) the new disclosure requirements concerning off-balance
sheet arrangements, (iii) new accounting rules on consolidation of
variable interest entities, (iv) the renewed focus generally on the
adequacy of disclosure in the Management's Discussion and Analysis of
Financial Condition and Results of Operations section of periodic
reports and registration statements, (v) the requirements concerning
disclosure controls and procedures, and (vi) the certification
requirements applicable to principal executive and principal financial
officers regarding periodic reports. The enhanced quality of reporting
company disclosure resulting from these initiatives, we believe, will go
a long way toward addressing several of the concerns that underlie the
Policy Statement. We believe the Commission should give these various
initiatives a chance to work.
We are not suggesting that financial institutions be permitted to
turn a blind eye to wrongdoing. Quite to the contrary. We agree with the
Agencies' observations that there will be circumstances in which a
financial institution should step away from a transaction or ensure that
any transaction executed by it is modified to comply with applicable
laws and regulations. But we do not believe a financial institution
should be required to substitute its judgment for that of its customer
when it does not know, or does not recklessly disregard information,
that the proposed transaction is unlawful and where the customer has a
good faith basis to assert that the transaction complies with applicable
laws and regulations. Moreover, financial institutions should be
entitled to rely fully on experts in the absence of knowledge that the
customer has misled the experts.
(B) Knowledge of the Customer
The Policy Statement calls for policies and procedures designed to
ensure that the customer understands the risks of each complex
structured finance transaction. The suggestions include, among other
things, confirmation that a customer's senior management has reviewed
and approved a transaction. The Policy Statement also suggests that
financial institutions understand the customer's business objectives for
entering into a transaction.
Financial institutions do not and should not have the enforcement
capability to require confirmation of involvement by the customer's
senior management or, in many cases, the ability to compel a customer to
fully disclose its business objectives. Effective implementation of
these concepts presumes a high level of cooperation from the customer,
which, as a practical matter, may not always be present. We note that
some of our customers are also our competitors, and they may wish to
withhold from us proprietary information relating to the transactions
that we execute for them for perfectly legitimate reasons. This lack of
transparency should not act as a bar to executing a transaction, but
often is an element in the financial institution's analysis of its legal
and reputational risks.
We believe that it is reasonable for financial institutions to make
sure that the individuals with whom they deal understand the nature and
consequences of complex structured finance transactions prior to their
completion, but it is incumbent upon the customer to know and understand
its own objectives and to ensure that such objectives are appropriate.
Each institution needs to "know its customer" in keeping with current
requirements, but we do not believe that new rules in this area are
necessary, appropriate or effective in preventing wrongdoing.
Accordingly, the Policy Statement should delete the language under the
section entitled "Reputational and Legal Risk" that states "Policies
should also articulate when a proposed transaction requires
acknowledgment by the customer that the transaction has been reviewed
and approved by higher levels of the customer's management". The same
concept should also be deleted where it appears under the last bullet
point under "Reputational and Legal Risk" and in "Documentation
Standards".
It is critical in our view that the roles and responsibilities of the
participants in complex structured finance transactions remain
arm's-length. Financial institutions should not be considered investment
advisors with respect to these transactions and should not be deemed to
have a fiduciary-type relationship with their customers. We believe that
the Policy Statement should be clear not to impose these types of duties
on financial institutions in these circumstances.
(C) Accounting and Disclosure
The Policy Statement would require financial institutions to obtain
(and document) complete and accurate information about their customer's
proposed accounting treatment and financial disclosures relating to
proposed transactions. This information would be assessed in the
approval process and considered in light of the financial, accounting
and rating agency disclosure. The Policy Statement envisions
circumstances in which the financial institution or third-party
professionals communicate with the customer's independent auditors or
advisors. We believe these requirements are overly broad and exceed what
a financial institution should properly be required to do and what it
can reasonably accomplish.
As suggested above, the Policy Statement does not adequately take
account of the fact that the customer is primarily responsible for its
own disclosure, as the party with unlimited access to its own
information. Furthermore, it will often be the case that financial
statement and MD&A disclosure will take place after, and sometimes long after,
a complex structured finance transaction is executed. Hence, there will
be a meaningful gap in time between a financial institution's
consummation of an individual transaction and the customer's preparation
of its public disclosure documents under the Exchange Act (other than
any required Form 8-K disclosure). Additionally, customers may properly
aggregate the financial impact of various transactions in their public
disclosure documents, and a financial institution may not have knowledge
of all or even most of the transactions that a customer executes with
other financial institutions in a given reporting period. As a result,
information available to a financial institution will not be sufficient
for the financial institution to make appropriate judgments about proper
and complete disclosure. In addition, even if a financial institution
were in possession of all relevant information, a financial institution
and a customer could reasonably differ as to what information is
material.
We believe that there should be no follow-on obligation of a
financial institution after a transaction is executed to make sure that
the customer properly discloses it. To impose obligations on a financial
institution in this respect would convert the financial institution into
a compliance authority, a role it would not have the legal basis or
capability to perform. The markets and regulators should rely on the
enhanced rules and regulations applicable to issuers to ensure that
material matters are disclosed properly.
Finally, financial institutions cannot force a dialogue with a
customer's outside advisors, including its independent auditors, or
require information from them. Some customers may not permit a financial
institution to be in contact with its independent auditor or other
outside advisors for any number of reasons, including confidentiality.
Additionally, some auditing and advisory firms will not enter into
conversations with financial institutions at all or without insisting on
indemnification and imposing other requirements as a precondition to
discussion. A financial institution is not in a position to dictate a
change in these practices.
In light of the foregoing, we believe that the section on "Accounting
and Disclosure by Customers" should be recast in its entirety. In
particular, we believe that a customer's proposed accounting treatment
and public disclosure of a complex structured finance transaction, to
the extent either or both are in fact communicated by the customer to
the financial institution, should be included among other factors in a
financial institution's determination of appropriate legal or
reputational risk to it. We suggest that the Policy Statement be revised
to eliminate references based on a determination "that a proposed
transaction may result in the customer filing materially misleading
financial statements", which we believe is too vague and inappropriately
shifts the burden of due diligence and liability exposure to the
financial institution. Instead, "appropriate action" should be triggered
by a determination "that a proposed transaction would raise
inappropriate legal or reputational risk to the financial institution,
based on all of the factors then known to such financial institution,
including for example, the accounting treatment or public disclosure to
the extent communicated or proposed by the customer at the time."
2. Definition of Complex Structured Finance Transactions Subject to
Scrutiny
We subscribe to the notion that each financial institution must have
a robust risk control function. We agree with the Policy Statement that
each financial institution should have the responsibility and the
discretion to determine which complex structured finance transactions
should be subject to heightened risk control procedures.
To be sure, there are common qualities of certain types of complex
structured finance transactions that may merit special scrutiny by the
risk control function. The Policy Statement should not, however, suggest
that any particular transactional element or group of elements should
require elevating a transaction to the level of special scrutiny. For
example, most swap and securitization transactions possess some of the
elements cited by the Policy Statement as necessitating heightened
scrutiny. Yet, these transactions generally pose little or no inherent
legal or reputational risk. Each financial institution must be permitted
to make its own determination as to which transactions raise meaningful
legal, regulatory or reputational risks and should be subjected to
heightened scrutiny.
Moreover, we believe that the Policy Statement would impose
unnecessary requirements relating to tax matters. The Department of the
Treasury and the Internal Revenue Service (the "IRS") recently updated
their rules requiring taxpayers to disclose transactions with "tax
shelter" indicia to the IRS, and requiring material advisors to maintain
information about such transactions. Under the IRS rules, advisors are
required to provide that information to the IRS upon request. These new
rules reflect a major effort by the IRS over the last several years to
develop rules that identify all types of transactions that are of
interest to them, in a manner that is not unduly burdensome to
taxpayers. We (and other financial institutions) have made substantial
investments to develop procedures and train personnel in order to comply
with these rules. We are not aware of any need for the adoption by the
Agencies of additional oversight requirements in this area.
3. Documentation
The Policy Statement sets standards for documenting the approval
process for complex structured finance transactions. While we recognize
the benefits of good documentation, certain aspects of the proposal
raise concerns.
We believe it is impractical to create and maintain "minutes of
critical meetings" with customers. It is not normal or customary in any
industry or business to take minutes at meetings among business
transaction participants. Generally, conversations may not have any
predetermined outcome or may be premised on confidentiality among the
parties. This is in contrast to government agency proceedings or
corporate governance bodies or committees where all parties have an
expectation that minutes are necessary to create a record of the
proceedings for record keeping and historical purposes. Secondly, the
requirement that a financial institution minute a meeting with a
customer will chill the free flow of ideas that has proven to be
essential for the creation of new financial products. As discussed
above, the immense creativity of the structured finance business has resulted in
an array of new and valuable capital raising techniques in the last ten
years. Finally, minuting meetings may not be particularly valuable
because many meetings may not have any tangible impact on whether a
transaction occurs or is terminated. Leaving aside the practicalities of
minuting every "critical" meeting, there typically is no opportunity to
determine, other than through studied hindsight, whether a meeting is
"critical" or not. Accordingly, the section on "Documentation Standards"
should delete references to the bullet point relating to minutes of
critical meetings with the client.
The Policy Statement suggests retention of documents relating to
"disapproved transactions with controversial elements (e.g., denied in
the final stages of approval or due to customer requests for particular
terms requiring additional scrutiny)." Transactions may be disapproved
or terminated for a variety of reasons – commercial issues, timing
issues and pricing issues, among others, even in the final stages.
Transactions may be rejected at early stages before they are brought to
the attention of a governance or policy oversight committee, which in
hindsight might be deemed to have involved terms requiring additional
scrutiny. Records should not have to be maintained for all transactions
that are rejected (because the burdens of doing so would be
unmanageable), and it will frequently be difficult to pinpoint what
circumstances led to the rejection of a particular transaction of the
type identified above. Frequently, transactions are rejected or
terminated for more than one reason. The retention of disapproved
transaction records should not become a significant administrative
burden in its own right, entailing meetings and additional paperwork
just to document the rejected transaction documentation. We believe that
an appropriate balance between meeting the goals of the Policy Statement
and not imposing excessive record-keeping or otherwise impractical
requirements can be best achieved through an expectation that financial
institutions would retain records of decisions by any governance or
policy oversight committee disapproving a transaction because it
presented the financial institution with an unacceptable level of legal
or reputational risk.
4. The Role of the Board and Management
We agree with the Policy Statement that the proper role of the Board
of Directors of financial institutions in this area is to (i) establish
and maintain a proper ethical and risk management tone, and (ii) engage
in oversight of activities regarding the adoption, maintenance and use
of risk management policies and procedures. Additionally, we believe
that management has principal responsibility for devising and
implementing risk control procedures relating to complex structured
finance transactions. Management is obligated to review individual
transactions, where appropriate, monitor trends in this area to the
extent possible and report to the Board as a matter of normal corporate
governance. We further believe, however, that the Policy Statement
should not be a vehicle for expanding or changing customary principles
regarding corporate governance.
5. Scope of Coverage
The Policy Statement provides that financial institutions executing
complex structured finance transactions should maintain a comprehensive
set of formal, firm-wide policies and procedures for managing and
regulating complex structured finance activities with all customers and
in all jurisdictions around the world where the institution operates.
We believe that extending the obligations of financial institutions
to encompass customer compliance on a global basis (and not just to
companies having a reporting obligation with the Commission under the
Exchange Act), would require financial institutions to address a myriad
of potentially conflicting legal and regulatory regimes, different
disclosure standards (not just the Commission's) and accounting
treatment under other accounting principles (not just U.S. generally
accepted accounting principles).
Extending the reach of the Policy Statement to non-reporting foreign
companies could place our respective firms and other U.S. financial
institutions at a competitive disadvantage with other market
participants outside the United States. To the extent that customers
find the level of risk control dictated by U.S. procedures too
intrusive, they are likely to move offshore to institutions that are not
subject to oversight by any of the Agencies. The net effect will be
negative for U.S. financial institutions and global markets.
We believe that it would be sound policy and would maintain U.S.
competitiveness to limit the reach of the Policy Statement to complex
structured finance transactions executed by companies that are required
to file reports with the Commission under the Exchange Act, including
transactions in which the financial institution counterparty is a non-U.S.
or unregulated entity. If the scope of the Policy Statement were defined
differently, customers would be driven to engage in business with
unregulated entities or offshore institutions.
6. No Private Right of Action
We believe the Policy Statement should not establish standards that
could become the basis for legal action by private third parties,
including shareholders of customers. We believe that it does not and we
respectfully suggest that the Policy Statement expressly confirm that it
is not intended to create a private right of action.
7. Interpretation of Policy Statement
We would respectfully request that the Agencies make an effort to
provide consistent and coordinated responses and interpretations to
comments on or issues raised by the Policy Statement. We would
appreciate that all requests for interpretive guidance of the Policy
Statement to each of the Agencies as well as each Agency's response be
made public.
8. Conclusion
We welcome the spirit of the Policy Statement. We believe, however,
that the Policy Statement is unduly burdensome in certain key respects
and potentially creates unwanted legal exposure for financial
institutions engaging in appropriate and good faith commercial activity.
We appreciate the opportunity to raise these comments with the
Commission and we would be pleased to discuss the matters addressed in
this letter with the Staff if you would find that to be helpful.
Very truly yours,
Goldman, Sachs & Co.
By:
David J. Greenwald
Managing Director and Deputy General Counsel
Morgan Stanley & Co. Incorporated
By: Robin Roger
Managing Director and General Counsel, Securities
cc: Office of the Comptroller of the Currency
Chief Counsel's Office, Office of Thrift Supervision
Jennifer J. Johnson, Secretary, Board of Governors of the Federal
Reserve System
Robert E. Feldman, Executive Secretary,
Attention: Comments/0ES, Federal Deposit Insurance Corporation
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