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Law Professors Seek Withdrawal of SEC-Banking Agencies Guidance on Structured Transactions

A consortium of law professors has asked the SEC and the federal banking agencies to withdraw their interagency statement on complex structured financial transactions because it can be read to encourage illegal conduct. The professors said that the statement barely suggests that anything is wrong with current practices or that some complex transactions have skated too close to the legal line. In their view, the policy statement lists characteristics so strongly suggestive of fraud that it is near impossible to imagine how they could signal anything else and then requires that banks and securities firms do nothing in particular to avoid marketing or participating in deals such as those listed. The comment letter was also sent to Senator Richard Shelby (R-AL), chairman of the Senate Banking Committee.

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. The agencies, continuing a process that began in 2004, recently issued revised guidance on managing the risk of derivatives and other instruments issued in connection with the complex transactions. The SEC and the banking agencies continue to believe that it is important for financial institutions engaged in complex structured transactions to design procedures effectively managing the associated risks.

The law professors concentrated on a provision in the guidance stating that a financial institution may determine that some transactions warrant additional scrutiny because they appear to have certain characteristics. According to the professors, this language seems to place the identification of transactions with elevated risk entirely within the discretion of the financial institution. To make matters worse, in their view, the list of transaction characteristics that may warrant additional scrutiny are all so indicative of fraud that to suggest that a bank or a firm might structure a transaction possessing any of the characteristics without additional scrutiny is to invite reckless participation in illegal conduct, either as a primary actor or as an aider and abettor of another's fraud.

The characteristics listed in the guidance include a lack of economic substance or business purpose, or designing the transaction primarily for questionable accounting or tax objectives. Another troubling characteristic is to provide the financial institution with compensation substantially disproportionate to the services it provides or to the investment that is made.

The law professors found it difficult to imagine how significant transactions with any of these characteristics, at a minimum, would not raise serious questions of illegality. The professors reasoned that, given how strongly suggestive of fraudulent purpose these characteristics are, the interagency guidance should clarify that financial institutions should treat transactions and new products with any of these characteristics as presumptively prohibited. At some point, the professors said that what began as a presumptive condemnation of deals with these characteristics, in the revised statement, transformed into what could be read as permission.  

The professors also cautioned that the ever-present plea of banks and firms for more flexibility in deciding for themselves what to do must be read in light of what the leading financial institutions did with the flexibility they enjoyed in their dealings with institutions like Enron. Similarly, the fear of hobbling the $3 trillion dollar structured finance industry is not a reason for inaction, according to the professors, since the economic size of an industry is no justification for failing to regulate its abusive practices.  

The professors referred to the 2004 comments of banks, which emphasized the U.S. Supreme Court's ruling in the Central Bank case, which held that there is no private right of action for aiding and abetting securities fraud. According to the professors, the comments suggested that the SEC and the banking agencies were trying to do an end-run around that decision and once again condemn mere aiders and abettors as if Central Bank had somehow legalized not just aiding and abetting securities fraud, but aiding and abetting tax, mail and wire fraud too. Central Bank did no such thing, the professors wrote. It simply limited who might sue whom for aiding securities fraud.

The professors reminded the SEC and the banking agencies that recklessly aiding and abetting securities fraud is still a crime under federal law, assuming a prosecutor can demonstrate each element beyond a reasonable doubt. In addition, knowingly aiding and abetting securities fraud is also still a civil wrong that may be pursued by the SEC. Aiding and abetting other frauds is still illegal and Central Bank did nothing to change that. What is so troubling to the professors about the comments in response to the 2004 proposal is that they proceeded as if primary liability was all that the financial institutions were bound to avoid. The comments speak as if it were the right of financial institutions to walk as close to the primary liability line as they please so long as they do not step over it, according to the professors.

The professors view the revised statement as encouraging financial institutions to continue trying to walk the line between aiding and abetting and being the primary violator. The interagency statement notes that a financial institution that acts only as a counterparty might have lower legal risk than one that structures or markets an elevated risk transaction to a customer. The professors, while acknowledging that there is less legal risk to aiding and abetting since private parties cannot sue and the government has limited resources, pointed out that, for the same reasons, it is also true that there is little legal risk for an average citizen who commits tax fraud. Regulators would not think it appropriate to issue a policy statement for taxpayers advising them to consider how small their legal risk would be in deciding whether to file a fraudulent return, the professors noted, so asked how to justify the suggestion that banks consider how unlikely they are to face legal risk for mere aiding and abetting.

 
James Hamilton