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AMERICAN BANKERS ASSOCIATION July 19, 2004
Communications Division
Mailstop 1–5
Office of the Comptroller of the
Currency
250 E Street, SW
Washington, DC 20219
Re: Docket No. 04–12
Ms. Jennifer J. Johnson, Secretary,
Board of Governors of the
Federal Reserve System
20th Street & Constitution Avenue, NW
Washington, DC 20551
Re: Docket No. OP–1189
Robert E. Feldman, Executive Secretary
Attention: Comments/OES
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20429
Regulation Comments
Chief Counsel’s Office
Office of Thrift Supervision
1700 G Street, NW
Washington, DC 20552
Re: Docket No. 2004–27
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW.
Washington, DC 20549–0609
Re: Release No. 34–4969
Re: Proposed Interagency Statement on Sound Practices Concerning
Complex
Structured Finance Activities; OCC Docket No. 04–12; OTS No. 2004–27;
FRB
Docket No. OP–1189; FDIC (no docket number given); SEC Release No.
34–4969;
Federal Register 28980; May 14, 2004
Ladies and Gentlemen:
The Federal Deposit Insurance Corporation, the Board of Governors of
the Federal Reserve System, the Office of the Comptroller of the
Currency; the Office of Thrift Supervision, and the Securities and
Exchange Commission have requested comments on a proposed Interagency
Statement on Sound Practices Concerning Complex Structured Finance
Activities (Statement). The Agencies state in the preamble to the
Statement that it was developed largely in response to investigations
into certain transactions conducted by Enron Corporation. The Statement
describes a number of internal controls and risk management procedures
that the Agencies believe are particularly useful in assisting financial
institutions to ensure that their complex structured financial
activities are conducted in accordance with applicable law and that
institutions effectively manage the full range of risks associated with
these activities, including legal and reputational risks. The Statement
would be of importance to any commercial bank or savings association
participating in any way in a complex structured finance transaction.
The American Bankers Association (ABA) brings together all categories of
banking institutions to best represent the interests of this rapidly
changing industry. Its membership - which includes community, regional
and money center banks and holding companies, as well as savings
associations, trust companies and savings banks - makes ABA the largest
banking trade association in the country.
General Comments
The American Bankers Association appreciates that the Agencies
granted a 30-day extension in the comment period. We joined in that
request for additional time after a surprising number of financial
institutions expressed to us serious concerns about the proposed
Statement. It is clear from the proposal that the Agencies are seeking
to provide helpful assistance and guidance to bankers in order to avoid
legal, reputational and regulatory problems with complex structured
finance activities.
We begin by noting that the American Bankers Association and bankers
support the Agencies’ efforts to provide guidance to financial
institutions about the risks and the necessary internal controls that
financial institutions need in order to avoid the legal, regulatory and
reputational risks associated with complex structured finance
activities. We concur with the Agencies that complex structured finance
activities require rigorous and disciplined analysis, internal controls,
risk management and corporate governance, executed by professionals in
multiple disciplines and involving senior management throughout the
process. Implementation of such best practices and fostering an
unambiguous culture of professionalism, responsibility and integrity are
essential. We understand that the Agencies intend the Statement to be of
assistance to financial institutions, and we support that goal. However,
ABA believes that the proposed Statement needs material revision before
it can achieve that purpose.
In the final analysis, bankers are concerned that the Statement
actually imposes additional risk on financial institutions, if it is
adopted as proposed. They suggest that the Statement creates obligations
and responsibilities that do not currently exist in law, regulation or
practice. In many ways, the Statement appears to be making new law. We
believe that the imposition, or even suggestion, of new obligations and
responsibilities beyond the requirements of existing law, regulation or
best practice gives rise to two related but distinct areas of concern –
both of which increase rather than diminish the risk to financial
institution participants in complex structured finance.
First, inevitably the Guidance will be viewed as a standard of care –
both substantively and
procedurally – one which is different than that which has evolved
through decades of legislation, jurisprudence and best practice. From
the perspective of plaintiffs, prosecutors, examiners and courts,
financial institution providers of complex structured finance will
assume a measure of responsibility, and hence liability, which has
heretofore been the province of a customer's board and management – as
well as its professional advisors. Second, by requiring significantly
greater inquiry and involvement in the deliberations and processes of
the customer, the financial institution's degree of involvement will
bring it within the ambit of at least some of the existing tests for
liability under the securities, accounting and fiduciary laws. The
result will be that litigants will use the Statement as
a new, additional basis for claims against financial institutions,
increasing rather than decreasing legal and reputational risk to
financial institutions.
Our members also are concerned that the Statement is unclear in
important particulars: it appears to be overly broad in its application,
potentially covering many transactions that the Agencies do not intend
to cover. It also appears to not distinguish among the distinct roles
financial institutions play in these transactions, roles that have
differing responsibilities as well as risks. It also appears to fail to
adjust its requirements for varying degrees of participation and risk
with complex structured finance transactions.
Specific Comments
The Statement suggests obligations that do not currently exist in
law, regulation or practice
ABA believes that the primary cause of all of these concerns is the
Statement’s insistent subtext that financial institutions must, shall,
and/or should insert themselves into their customers’ business dealings
and corporate governance in ways not necessary or even supported by
current law. We believe that the Statement should more appropriately
provide guidance on necessary internal controls rather than expect banks
to engage in policing the knowledge and intentions of a customer. By
doing so, banks risk exposing themselves to much legal uncertainty and
the possibility of increased, rather than reduced, reputational and
litigation risk. In particular, when coupled with the detailed
obligations on banks to seek assurances from customers, their auditors
and third party advisors, the approach risks inflicting upon
institutions and their executives the danger of being characterized as
actively engaging in the management of the customer and thus becoming
legally liable for the actions of the customer.
We believe that this result arises from the Statement’s apparent
assumption that the securities law relating to the issues presented in
the Enron collapse is settled and clear. We believe that is not the
case. To use just one issue as an example, we refer you to the law on
the liability in securities sales of secondary actors for
misrepresentations.1 In the latest issue of The Business
Lawyer, author A. J. Frumento argues that the SEC has sought to
impose liability in such cases of major participation by the secondary
actor, as an aider or abettor. However, the Circuits are divided between
the “bright line” test of the Second, Tenth and Eleventh Circuits and
the looser “significant participation” test of the Ninth Circuit. “Under
the bright line test, only a person who both makes a misrepresentation
and is publicly identified as the author can be liable under Rule
10b-5(b). Under the Ninth Circuit
rule, persons who ‘substantially participate’ or play a ‘significant
role’ in making a misrepresentation, even if not publicly identified as
authors, can also be liable.”2
The legal situation has now been confused further with the decision
in In re Enron, in which Judge Harmon adopted a “creation” test,
which appears to owe much of its own creation to an amicus brief filed
by the SEC. Frumento argues that this approach is in contradiction of
the U. S. Supreme Court’s ruling in Central Bank of Denver, N.A. v.
First Interstate Bank of Denver, N.A.,3 in which the
Supreme Court repudiated the SEC’s assertion that the terms “directly or
indirectly” in Section 10b established liability for aiders and
abettors: “the text of the 1934 Act does not itself reach those who aid
and abet a Section 10(b) violation.” Our point here is not that we know
what the law is, rather our point is that the law on secondary actor
liability is still unsettled. With that in mind, we now need to review
the implied statement of the law on secondary actors found in the
Agencies’ (including the SEC) Statement.
The Statement imposes (on a financial institution, since the
Statement is Guidance for financial institutions under the jurisdiction
of the four banking agencies) extensive obligations and responsibilities
in connection with a customer’s or counterparty's tax, regulatory and
accounting treatment of a specific transaction without regard to the
financial institution's role in the transaction or conduct in connection
with it.4 The Statement provides that financial institutions should:
•obtain and document complete and accurate information regarding
a customer's proposed
accounting treatment and financial disclosure relating to a
transaction, as well as the
customer's objectives;
•assess the customer's business objectives for entering into a
transaction;
•evaluate the appropriateness of the transaction;
•obtain acknowledgment from a customer that a transaction has been
reviewed and approved
by higher levels of the customer's management if circumstances
warrant;
•conduct a comprehensive review of the financial institution's
entire relationship with a
customer when necessary;
•ensure that the customer understands the risk and return profile of
a transaction; and
•analyze and document customer-related accounting, regulatory or tax
issues.
What concerns us is that this appears to be a roadmap for a financial
institution to “substantially participate” in the structured finance
transaction, as that analysis would be used under the Enron creation
test to establish liability, in the event the transaction was fraudulent
or even if it was not, but it was used for a fraudulent purpose by the
customer. Under current law, financial institutions are not (and we
believe should not) be responsible for the disclosure, tax and
accounting obligations or risk assessments of their customers and
counterparties, unless the financial institution is directly
participating in the transaction. Nor are they responsible for
appraising the suitability of a particular transaction for a customer or
counterparty. These are the responsibility of the customer’s management,
board of directors, accountants and lawyers. However, by requiring a
level of participation beyond industry practice, the Agencies appear to
be establishing as settled law the “creation test” decision in Enron. We
believe this is a premature and inappropriate making of law by the
Agencies.
Many bankers read the Statement as extending the obligations of
financial institutions considerably beyond the existing obligations. The
Statement seems to impose in all cases a duty to police customer
accounting, disclosure and tax practices, and to assure the suitability
of a transaction for a customer, when the institution participates in or
facilitates a complex structured financial transaction.5 We
agree, and we view the Statement as writing new law, with attendant,
serious additional consequences:
• greatly increased potential liability and exposure to loss;
• new costs and burdens as financial institutions take steps to
minimize their liability and exposure;
• diminished responsibility and accountability on the part of the
customer; and
• reduction in the economic viability of some structured finance
transactions.
The Statement is Overly Broad in Scope and Requirements
a. The definitions of covered transactions appear overly broad
The key terms specifying the scope of the Statement, “complex
structured finance activities,”
“complex structured finance transactions” and “heightened risk,” are
defined by the Statement by a series of “non exclusive” general and
ambiguous criteria. The Statement mentions financial derivatives for
market and credit risk, asset-backed securities with customized cash
flow features, and specialized financial conduits that manage pools of
purchased assets, specifically, but the Statement’s broad listing of
criteria has raised concerns with some bankers that even common
financial transactions could be pulled into examiners’ scrutiny. The
Statement provides that financial institutions will need to supplement
and modify these criteria to identify transactions that fall within
their scope. Some bankers have even expressed concern that larger loan
participations might fall within the scope of the Statement.
If the Statement were just an explication of the risk considerations
and the applicable law, then such general criteria are manageable – the
financial institution would use the criteria in the institution’s
internal analysis of how to structure its risk management. If the
Statement were clear that the determination of which transactions or
categories of transactions increase risk and, therefore, require special
attention, is entirely within the province of the financial institution
in the exercise of its business judgment, reviewable only under the
fabric of existing law, such an approach seems to be workable. However,
when the Statement seems to adduce new law and impose significant new
obligations, bankers find the potential scope of these definitions
intimidating.
b. The Statement should distinguish the roles in which a financial
institution assumes special
obligations or responsibilities with respect to its customer.
A financial institution may play a number of different roles with
respect to a particular complex structured finance transaction,
including:
• a formal advisory role;
• an ongoing and integral role in the finances or other aspects of the
customer or its business;
• a role in which the financial institution has structured or marketed
the transaction as
providing a particular accounting or tax result;
• an arm's-length provider of credit;
• a fiduciary, agency or other arm’s-length service provider role;
• participant but not lead institution in a financing transaction; or
• a purchaser or seller of securities or other assets in the secondary
market.
Each of these roles creates a different network of substantive and
procedural responsibilities for that particular role. Under existing
law, the obligations associated with the respective roles are distinct.
For example, the obligations of an institution which has undertaken an
advisory role are surely different from one that is an arm's-length
provider of financing. And, an institution that markets the desirable
regulatory, tax or accounting results expected from a complex financial
product may assume different responsibilities, especially in the case of
a relatively unsophisticated counterparty.
However, we believe that the Statement fails to properly distinguish
among the multiple roles a financial institution may play in a complex
financial transaction. We believe that the Agencies could significantly
improve the proposal appropriately reflecting such distinctions in any
final Statement. For example, when a financial institution structures
and touts a transaction or strategy for a particular tax, accounting or
disclosure effect, the institution may also assume an elevated level of
responsibility. Existing law and regulatory regimes, ranging from the
Investment Advisors Act of 1940 to governance of broker-dealers, as well
as multiple theories of common law, address these duties and
responsibilities. Without adding to existing law or the regulatory
framework, it is clearly impermissible now to knowingly participate in a
transaction or strategy the purpose of which is to deceive investors,
regulators or tax authorities. Equally clearly, a financial institution
could not
prudently proceed with a transaction if it becomes aware of evidence
indicating such intention, unless the institution, through additional
review and careful consideration, determines that the transaction does
not entail inappropriate risk or violate applicable laws or regulations.
At a minimum, the Agencies should reduce the scope of the Statement to
those roles in which a financial institution can reasonably be expected
to assume some responsibility for a customer's tax, accounting or
disclosure matters under current law.
c. The Statement imposes new documentation standards in excess of
current law.
The new documentation standards in the Statement suggest affirmative
substantive duties that are inappropriate and beyond the dictates of
existing law, regulation or best practice. We find them overly broad and
believe that they would impose significant costs and potential risk on
financial institutions for activities that do not involve heightened
legal or reputational risk. In particular, the documentation
requirements for transactions that did not go forward appear excessive.
The Statement would require documentation of transactions that are not
approved, if such transactions involve controversial elements. This
obligation is burdensome and unnecessary and appears to be designed to
aid some of the Agencies in enforcement actions against other parties
rather than the financial institution. A transaction may fail to close
for any number of reasons, most of which are not problematic and do not
relate to deceptive practices. Retaining extensive documentation
regarding such transactions would require a significant commitment of
staff time and storage expense, but would not yield any meaningful
benefit in terms of managing legal or reputational risk.
If a transaction is abandoned in its early stages, the proposed
documentation requirement would impose an obligation on a financial
institution to create a paper trail that is unnecessary for business
purposes. Even if the failed transaction would have involved
controversial elements had it been completed, such a requirement could
needlessly and inappropriately involve the financial institution in
third-party litigation and create potential exposure to the customer.
The Statement also proposes that financial institutions document and
retain any formal or informal analysis or opinions, whether prepared
internally or by others, that relate to legal considerations, tax and
accounting matters, market viability and regulatory capital
requirements. This obligation, particularly the requirement to retain
records of informal communications, does not exist in current law and
could have an unintended chilling effect on open discussions between
financial institutions and their customers or counterparties. If any
final Statement does require retention of analysis or opinions, only
significant and formal materials should be covered.
Similarly, the proposal in the Statement that financial institutions
maintain “minutes of critical meetings with clients” will hamper or
prevent legitimate business negotiations and other discussions and could
impede the completion of routine transactions. Creating such minutes
would be impractical or impossible in the context of a fast-paced and
complex transaction involving multiple parties and advisers, and
customers would oppose such intrusive documentation of meetings in many,
if not most, circumstances.
Conclusion and Recommendations
Given the revelations of corporate misbehavior in the last few years,
ABA concurs with the
Agencies that complex structured finance activities require rigorous and
disciplined analysis, internal controls, risk management and corporate
governance, executed by professionals in multiple disciplines and
involving senior management throughout the process. And a primary line
of defense against wrongdoing is an unambiguous culture of
professionalism, responsibility and integrity. Any additional guidance
from the Agencies that assists financial institutions in complying with
the law and managing the reputational, legal and regulatory risks of
banking is appreciated. However, ABA believes that the proposed
Statement needs considerable revision before it becomes this additional
valuable guidance.
Our greatest concern is that the Statement appears to impose new
obligations beyond current law that thrust financial institutions into
participation with the customer in the transaction. Instead of this, the
final Statement must present a comprehensive picture of the complex body
of law, regulation and practice that has evolved with respect to the
myriad of transactions and business activities apparently covered by the
Statement. As the Statement is currently structured, we believe that by
forcing financial institutions to intrude themselves into their
customers’ businesses, the Statement actually increases the potential
for liability for financial institutions offering complex structured
finance transactions, a very counterproductive result. We note that we
are not alone in this concern, as the British Bankers Association in
their comments on the Statement express similar concerns about
differences between existing law applicable to their members and the
assumptions of
the Statement. As the BBA wrote in its letter of June 18, 2004, “[The
Statement] is insufficiently sensitive to the fact that banks coming to
the US from elsewhere will have to implement the guidelines in banking
structures and a legal framework which may be considerably different
from typical US banking structures and legal frameworks. Our members
foresee significant difficulty with regard to this legal consistency
issue if the statement was to be applied to banks in different European
jurisdictions. It may also bring them into procedural conflict with
their home regulators. This issue is only one of several which arise
from the implication that this policy initiative can and will be applied
with ease on an extra-territorial basis.”
We strongly recommend that the Agencies rewrite that Statement more
in the form of an analysis of the existing law and potential risks,
perhaps in a case study approach of specific examples, rather than as a
guidance of mandated actions.
We recommend that the Agencies make clear that they do not intend the
Statement to create new law or regulation or to impose standards of care
and practice beyond the standards of current law.
We recommend that the Agencies rewrite the Statement so as to reflect
the multiple roles of financial institutions in complex structured
finance transactions and their differing obligations with respect to
customer and counterparty disclosure under those different roles.
We urge the Agencies to discuss the significant body of law (i.e.,
the Sarbanes-Oxley Act) and regulation (including the stock exchange
rules) on corporate governance that has sprung into existence since the
collapse of Enron. Integrating these laws, regulations and best
practices into the discussion could be of considerable assistance to
smaller institutions.
We note that the Statement gives little recognition to the
differences in the obligations and
responsibilities with respect to transactions involving individuals and
private companies from those associated with public companies and from
transactions with the public at large. We recommend that the Statement at least acknowledge these
differences.
We support the recommendation of the BBA that the Agencies “discuss the
guidelines with European authorities such as the EU Commission and the
Committee of European Banking Supervisors before finalizing them - with
a view to seeking to avoid potential divergences of regulatory approach
between the US and the EU. In this regard we note the recent CESR/SEC
initiative to try and work together to produce common regulatory
solutions which can operate in both a US and a European environment.”
If any finally adopted Statement adds any of the additional
documentation requirements or enlarges the responsibilities of financial
institutions beyond existing law, as we have shown that the present
Statement does, then we recommend that any such Statement should
expressly provide for an implementation period of at least six to nine
months to allow financial institutions time to modify internal policies
and procedures in order to comply.
Finally, we recommend that any revised Statement must be published
with a request for comments, as the complexities of the Statement
clearly require such additional review.
If the staff of the Agencies have any questions about these comments,
please call the undersigned.
Sincerely,
Paul Smith
Senior Counsel
American Bankers Association
1120 Connecticut Avenue, NW
Washington, DC 20036
1 Frumento, Aegis J., “Misrepresentations of Secondary Actors in the
Sale of Securities: Does In re Enron Square with Central Bank?”, 59
Business Lawyer 975 et seq. (May, 2004).
2 Id at 976.
3 Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A,
511 U.S. 164, 188-91 (1994).
4 Financial institutions may take on significant additional
responsibilities in certain circumstances, such as when a customer
formally and intentionally retains and compensates a financial
institution for undertaking an advisory or other fiduciary role with
respect to the customer. In those alternate roles, the financial
institution assumes addition liability. However, even then, final
determination of tax, accounting and disclosure issues may fall beyond
the specific scope or time span of the financial institution's
engagement.
5 The Statement appears to us to exceed the obligations set out in
recent settlements that the Agencies state form some of the basis of the
Statement – the recent Citigroup, JP Morgan and Merrill Lynch orders.
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