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SEC and Banking Agencies Issue Revised Guidance on Structured Transactions

As financial derivatives and asset-backed securities have gone from somewhat esoteric instruments to a central feature of the markets, the SEC and the federal banking regulators have developed guidance for banks and securities firms that engage in complex structured transactions. Continuing a process that began in 2004, the agencies recently issued revised guidance on managing the risk of derivatives and other instruments issued in connection with the complex transactions. Based on comments received on the initial 2004 statement, the agencies have substantially revised the guidance (Rel. No. 34-53773, May 9, 2006).  

The agencies continue to believe that 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 such transactions, including the involvement of people independent of the business lines involved in the transactions. The firm or bank also must conduct due diligence commensurate with the potential risk, the agencies said, and should obtain additional information from the customer. If needed, they should also obtain specialized advice from in-house or outside accounting and legal professionals.

If a risk evaluation reveals that participation in the complex transaction would create significant legal or reputational risks, the bank or securities firm should take steps to manage the risks, including modifying the transaction or conditioning participation on the receipt of assurances from the customer that reasonably address the heightened risks presented by the transaction. The regulators emphasized that financial institutions should decline to participate in elevated risk transactions that present unacceptable risks.

In response to comments, the agencies clarified that the guidance does not apply to structured finance transactions, such as standard public mortgage-backed securities transactions, that are familiar to participants in the financial markets and have well-established track records. They also clarified that the due diligence for an elevated risk should focus on issues creating heightened levels of risk for the bank or firm.  

The revised statement also provides that financial institutions operating in foreign jurisdictions may tailor their procedures to account for local regulations and standards. For example, U.S. branches of foreign banks should coordinate their policies with the foreign bank's group-wide policies developed in accordance with the rules of the bank's home country. In addition, the U.S. branches should implement a control infrastructure for complex structured transactions that is consistent with the overall corporate structure, as well as the bank's framework for risk management and internal controls.

The agencies also provided guidance on identifying transactions with elevated risk. Banks and securities firms should carefully examine transactions lacking in economic substance or business purpose, such as those involving a circular transfer of risks between the bank and the customer, as well as those designed primarily for questionable accounting or tax objectives. Another transaction suggesting elevated risk is one providing the bank or firm with compensation disproportionate to the services provided or the investment made.

Once a process is developed to identify elevated risk transactions, the next step is to implement procedures to conduct a heightened level of due diligence for those transactions. Generally, due diligence should be conducted at a level commensurate with the level of risk identified. A bank or securities firm that has been involved in structuring or marketing the elevated risk transaction, or has advised on such a transaction, should exercise a higher degree of care in conducting due diligence than a firm that played a more limited role in the transaction, such as acting only as a counterparty.

The agencies cautioned against concluding that an elevated risk transaction involves minimal or manageable risks solely because another financial institution will participate in the transaction or because of the size or sophistication of the customer or counterparty. Financial institutions were also warned to carefully consider whether it would be appropriate to rely on opinions prepared by the customer concerning any significant accounting or tax issues associated with an elevated risk.

The agencies also recommended the implementation of processes to manage the transaction's elevated risk on a firm-wide basis. These processes should allow for, and be consistent with, any existing informational barriers designed to manage insider trading. The regulators noted that some financial institutions have established a senior management committee involving representatives from all of the relevant control functions within the firm, including such groups as independent risk management, accounting, legal, compliance and financial control, in the oversight and approval of complex structured transactions.

The federal agencies recommended sound documentation practices. In particular, banks and securities firms should collect sufficient documentation to enforce the material obligations of the counterparties, confirm that customers have received required disclosures and allow the internal audit department to monitor compliance with the firm's procedures.

The agencies emphasized that the internal audit department should regularly audit the firm's adherence to its own control procedures relating to elevated risk transactions and further assess the adequacy of the procedures. The internal audit department should periodically validate that business lines and individual employees are complying with the standards for elevated risk transactions. This validation should include transaction testing.

James Hamilton