United States: Interagency Statement on Sound Practices Concerning Complex Structured Finance Transactions

Last Updated: June 1 2004
Article by Andrew P. Cross

On May 14, 2004, five federal agencies requested public comment on a statement regarding risk management procedures to help financial institutions manage the full range of risks associated with complex structured finance transactions, including the risk that the transactions do not comply with applicable law (the "Statement"). There are two major themes to the Statement:

(1) Financial institutions are expected to bring a multi-disciplinary, comprehensive approach to the management of the credit, market, operational, legal and reputational risks associated with these types of transactions; and

(2) Financial institutions are expected to fully understand their customers’ business objectives for entering into a complex structured finance transaction. SEC Release No. 24-49695; File No. S7-22-04. Comments regarding the Statement should be received on or before June 18, 2004.

Scope of the Statement

The Statement applies to the following financial institutions:

  • National Banks supervised by the Office of the Comptroller of the Currency ("OCC");
  • Federal and State Savings Associations and Savings and Loan Holding Companies supervised by the Office of Thrift Supervision ("OTS");
  • State Member Banks and Bank Holding Companies supervised by the Board of Governors of the Federal Reserve System ("Board");
  • State Nonmember Banks supervised by the Federal Deposit Insurance Corporation ("FDIC");
  • U.S. Branches and Agencies of Foreign Banks supervised by the Board, the OCC and the FDIC; and
  • Registered Broker-Dealers and Investment Advisers supervised by the Securities and Exchange Commission ("SEC").

The Statement is primarily directed to those financial institutions that offer complex structured finance transactions. However, any financial institution listed above that is an end-user of complex structured finance products (for its own use or on behalf of its clients) should become familiar with the Statement since its business dealings with offering financial institutions may be affected by the proposed Statement. An "end-user" financial institution may also want to review its existing risk management guidelines, policies and procedures related to the use of complex structured finance products in light of the policies proposed in the Statement.

Definition of Complex Structured Finance Transactions

The guidance in the Statement addresses "complex structured finance transactions." The Statement indicates that the most important characteristic of these transactions is that they expose a financial institution to elevated levels of market, credit, operational, legal or reputational risks. The following are three other common characteristics that these transactions usually share:

  • The transactions typically result in a final product that is often non-standard and structured to meet the specific financial objectives of a customer.
  • The transactions often involve professionals from multiple disciplines within the financial institution and may have significant fees or high returns in relation to the market and credit risks associated with the transaction.
  • The transactions may be associated with the creation or use of one or more special purpose entities designed to address the economic, legal, tax or accounting objectives of the customer and/or the combination of cash and derivative products.
  • The Statement indicates that these criteria are not exclusive and should be modified or supplemented by a financial institution, as appropriate, to reflect business activities, as well as any marketplace changes.

Proposed Guidelines for Structured Finance Transactions

The Statement sets forth the following proposed guidelines for incorporating structured finance transactions into existing management procedures, controls and systems.

Role of Board of Directors and Senior Management

The Statement emphasizes that the board of directors of a financial institution is the focal point of the corporate governance system and that effective oversight by the directors and senior management is fundamental to preserving the integrity of capital markets. The following are specific recommendations as to the role of the board of directors and senior management with respect to the oversight of structured finance transactions:

The board should establish the financial institution’s thresholds for the risks associated with complex structured finance products and ensure that a sufficiently strong risk control framework is in place to guide the actions of the institution’s personnel.

The board should ensure that the financial institution has a risk control framework for complex structured finance products that includes comprehensive policies related to the elements described in the Statement.

Using guidance provided by the board, senior management should implement a risk control framework for complex structured finance transactions that includes comprehensive policies, defined roles and responsibilities and approval authorities, detailed management reporting, required documentation, and ongoing independent monitoring and testing of policy compliance. The Statement indicates that one approach to this guideline is to create a senior management risk-control committee to ensure that structured finance products that may expose the financial institution to higher levels of financial, legal and reputational risk are comprehensively and consistently managed and controlled on a firm-wide basis.

The board and senior management also should send a strong message to others in the financial institution about the importance of integrity, compliance with the law, and overall good business ethics. The financial institution’s culture and procedures should encourage personnel to elevate ethical concerns regarding a complex structured finance transaction to appropriate levels of management.

The board and senior management should ensure that incentive plans are not structured in a way that encourages employees to cross ethical boundaries when executing complex structured finance transactions.

Policies and Procedures

The Statement recommends that financial institutions that offer complex structured finance transactions should maintain a comprehensive set of formal, firm-wide policies and procedures related to these transactions. The purpose of these policies and procedures is to provide for the identification, documentation, evaluation, and control of the full range of credit, market, operational, legal and reputational risks that may be associated with these transactions. Therefore, an institution’s policies and procedures should define what constitutes a complex structured finance transaction and, at a minimum, address the following nine subject areas.

  • Transaction Approval—The policies should define the process that financial institution personnel must follow to obtain approval for complex structured finance transactions. The approval process should involve both transactors, such as personnel from the sales, marketing and trading areas, and independent control staff, such as personnel from risk management, accounting and legal areas. These policies should also clearly outline when third-party legal, accounting and/or tax professionals should be engaged to consult on the transactions.
  • New Product—The policies should establish a control process for the approval of all "new" complex structured finance products. A variety of factors may be considered in determining whether a transaction is "new." These factors include: any structural variations from existing products; whether the product is targeted at a new class of customers; pricing variations from existing products; whether the product raises additional or new legal, compliance or regulatory issues; and deviations from standard market practices. The New Product policy should also address the roles and responsibilities of all relevant financial institution personnel.
  • Reputational and Legal Risk Management—The policies should ensure that a financial institution identifies a complex structured finance transaction that has elevated levels of reputational and legal risks and appropriately manages these risks. A transaction that is identified as having heightened reputational and legal risks should be reviewed by the financial institution’s legal department and, where appropriate, by independent legal counsel. The Statement includes several examples of characteristics that may indicate that a transaction involves heightened legal and reputational risks. The policies should ensure that the customer understands the risk-return profile of a particular transaction and outline the responsibilities of financial institution personnel to analyze and document a customer’s objectives and customer-related accounting, regulatory and tax issues. In summary, the legal risk management policies should enable the financial institution to (i) assess a customer’s business objectives for entering into a transaction; (ii) analyze the economic substance of a transaction; (iii) evaluate the appropriateness of the transaction; and (iv) prevent the institution from participating in inappropriate transactions.
  • Accounting and Disclosure by Customers—The policies should ensure that financial institution staff appropriately reviews and documents the customers’ proposed accounting treatment of complex structured finance transactions, financial disclosures relating to the transactions, and business objectives for entering into the transactions. These policies are particularly important for transactions identified as involving elevated legal and reputational risks.
  • Documentation Standards—The polices should provide for the generation, collection and retention of appropriate documentation relating to all complex structured finance transactions. The documents retained should include standard legal documents, as well as any ancillary documents, such as notes from customer meetings and third-party opinions. The Statement also specifically states that the documentation polices should seek to ensure that all counterparty obligations are reduced to legally enforceable written contracts. This should include the use of term sheets, confirmations, master agreements, netting agreements and collateral agreements.
  • Reporting to the Board of Directors and Senior Management—The policies should ensure that the board of directors and senior management of the financial institution receive appropriate and timely reports concerning the complex structured finance activities of the institution.
  • Independent Monitoring, Analysis and Compliance with Internal Policies—The policies should provide for periodic independent reviews of the institution’s complex structured finance activities to ensure that the institution’s policies and controls are being implemented effectively and to identify potential compliance issues.
  • Audit—The policies should ensure effective internal audit coverage of the institution’s complex structured finance activities. The Statement notes that effective audit coverage requires a comprehensive independent audit program that is staffed with personnel that have the necessary skills and experience to understand the structured transactions and to identify and report on compliance with financial institution policy and procedures. Additionally, due to the complexity of many structured finance activities, the Statement suggests that it might be appropriate in some cases to retain outside consultants, accountants or lawyers to review the structured product area.
  • Training—The policies should ensure that financial institution personnel receive appropriate training concerning the institution’s policies and procedures governing its complex structured finance activities.

Summary

As noted in the Introduction to this Bulletin, there are two major themes to the Statement:

(1) Financial institutions are expected to bring a multi-disciplinary, comprehensive approach to the management of the credit, market, operational, legal and reputational risks associated with these types of transactions; and

(2) Financial institutions are expected to fully understand their customers’ business objectives for entering into a complex structured financial transaction.

The Statement is primarily directed to those financial institutions that offer complex structured finance transactions. However, any financial institution listed above that is an end-user of complex structured finance products (for its own use or on behalf of its clients) should become familiar with the Statement since its business dealings with offering financial institutions may be affected by the proposed Statement. An "end-user" financial institution may also want to review its existing risk management guidelines, policies and procedures related to the use of complex structured finance products in light of the policies proposed in the Statement.

This article is presented for informational purposes only and is not intended to constitute legal advice.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions