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Agencies Issue Final Statement on Complex Structured Finance Activities

Five federal agencies issued a final statement on the complex structured finance activities of financial institutions. The statement describes the types of internal controls and risk management procedures that should help financial institutions identify, manage, and address the heightened legal and reputational risks that may arise from certain complex structured finance transactions. The final statement is substantially similar to the revised statement issued for comment in May 2006, but has been modified in certain respects to address comments received on the revised statement. Like the May 2006 statement, the final statement takes a risk-based and principles-based approach to addressing the risks complex structured finance transactions may pose to institutions and focuses on those transactions that may present elevated levels of legal or reputational risk to institutions.

The final statement was issued by the four banking agencies and the SEC, and represents supervisory guidance for institutions supervised by the banking regulators and a policy statement for institutions supervised by the SEC. Accordingly, it does not establish any legally enforceable requirements or obligations. It does not create any private rights of action and does not alter or expand the legal duties and obligations that a financial institution may have to a customer, its shareholders or other parties.

The agencies declined to declare that financial institutions do not have a duty to ensure the accuracy of a client's public filings or accounting, as requested by commenters. Because the statement focuses on sound practices related to elevated risk complex structured finance transactions, which are generally conducted by a limited number of large financial institutions, it will not affect or apply to the vast majority of financial institutions.

The regulators believe that financial institutions should establish policies and procedures designed to identify elevated risk complex transactions as part of their transaction or new product approval process, and ensure that these transactions or new products undergo heightened review. Financial institutions should also conduct the level and amount of due diligence for an elevated risk transaction that is commensurate with the level of identified risk.

Consistent with the principles-based guidance, the regulators refused to provide an exclusive list of transactions that would not be considered complex structured finance transactions. However, they highlighted the hallmarks of non-complex transactions, which include a well-established track record and familiarity to market participants. Standard mortgage-backed securities and hedging-type transactions involving "plain vanilla" derivatives would not be considered complex transactions for purposes of the interagency statement.

The SEC and the bank regulators believe it is important for financial institutions engaged in complex structured transactions to design procedures to effectively manage the associated risks. These procedures must be designed to allow the bank or securities firm to identify transactions that may elevate their legal or reputational risks. In addition, the procedures should provide for management review of the transactions, including the involvement of people independent of the business lines involved in the transactions. Financial institutions must ensure that new complex finance products receive the approval of all relevant control areas that are independent of the profit center before the product is offered to customers.

The final statement provides examples of transactions that may warrant additional scrutiny by a financial institution, including those lacking economic substance or business purpose, or those designed primarily for questionable accounting, regulatory or tax objectives, particularly when the transactions are executed at the end of a year or the end of a reporting period for the customer.

Some commenters contended that these examples of elevated risk transactions have characteristics that are signals, if not conclusive proof, of fraudulent activity. The commenters urged the agencies to inform financial institutions that transactions or products with any of these characteristics should be considered presumptively prohibited. They also argued that the statement encourages or condones illegal conduct by financial institutions.

The agencies believe that financial institutions should conduct due diligence commensurate with identified risks, but they do not believe it is appropriate that all transactions initially identified as potentially creating elevated risks should be considered presumptively prohibited. A financial institution, after conducting additional due diligence for a transaction initially identified as an elevated risk, may determine that the transaction does not have the characteristics that initially triggered the review, according to the statement, or the financial institution may take steps to address risks that initially triggered the review.

If, after evaluating an elevated risk transaction, a financial institution determines that its participation in the transaction would create significant legal or reputational risks, it should take appropriate steps to manage and address the risks. These steps may include modifying the transaction or conditioning the institution's participation in the transaction on the receipt of assurances from the customer that reasonably address the heightened risks presented by the transaction.

The agencies believe that a financial institution should decline to participate in an elevated risk transaction if, after conducting due diligence and taking appropriate steps to address the transactional risks, the financial institution determines that the transaction presents unacceptable risks or would result in a violation of applicable laws, regulations or accounting principles.

The final statement describes the types of risk management systems and internal controls that may help a financial institution that is engaged in complex finance transactions to identify those transactions that may pose heightened legal or reputational risk to the institution, and to manage those risks. The statement directs the board of directors and senior management to establish a tone at the top, through actions and formal policies, to send a strong message throughout the financial institution about the importance of compliance with the law and overall good business ethics.

The final statement also describes the types of training, reporting mechanisms and audit procedures that institutions should have in place with respect to elevated risk transactions. Financial institutions should conduct periodic independent reviews of their complex finance activities to verify and monitor that their policies and controls relating to elevated risk transactions are being implemented effectively and that the transactions are accurately identified and receive proper approvals.

The statement directs financial institutions to collect sufficient documentation to verify that their policies related to elevated risk transactions are being followed and allow the internal audit function to monitor compliance with those policies. When the policies require an elevated risk transaction to be submitted for approval to senior management, financial institutions should maintain the transaction-related documentation provided to senior management as well as other documentation that reflects management's approval or disapproval of the transaction, any conditions imposed by senior management and the reasons for the action. While the documentation of a transaction should reflect the factors considered by senior management in taking action, it does not have to detail every aspect of the institution's legal or business analysis.

Release No. 34-55043 will be published in a forthcoming Report.