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Speech by SEC Staff:
Structured Finance Activities: The Regulatory Viewpoint

by

Mary Ann Gadziala

Associate Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

International Bar Association Conference — Financial Services Section
Chicago, Illinois
September 20, 2006

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or the other members of the staff.

Thank you very much for giving me the opportunity to present my views on some of the more challenging issues associated with the structuring, sale, and marketing of structured finance products from the regulatory perspective. It is an honor to be here to address such a distinguished group of members of the international legal community. There are three different areas on which I would like to focus today: first, the rules and regulatory requirements that apply in connection with the sale of structured products, particularly to retail customers; second, the potential liability of financial institutions for securities law violations arising from deceptive structured finance products and transactions; and third, risk management principles that may assist a financial institution in managing and addressing heightened risks that may arise in connection with complex structured finance transactions.

Structured products are not specifically defined in the securities laws. They have been described as securities that may be derived from or based on a particular security or commodity, a basket of securities, an index, a debt issuance, or a foreign currency. Many involve innovative financing techniques creating customized financing and investment products to suit specific financial needs of customers. They may involve complex tranched liabilities and transfers through special purpose vehicles. Such transactions may be structured for any number of reasons — for example, for principal protection, tax minimization, accounting cosmetics, monetization, or other specific purposes. The imprecise definition and often non-public customized market for these products make it difficult to estimate the precise dollar amount of aggregate structured finance transactions. However, all research data indicate this is an important and dynamic segment of the international capital markets, experiencing dramatic growth and increased complexity in recent years. It was recently reported by the Structured Products Association (SPA) that nearly $50 billion of structured products were issued in the United States in 2005 — a 57% increase from 2004.

I. Rules and Regulatory Requirements

Recent information — including statements from SPA calling 2005 a "breakthrough year" for "penetration among retail investors" — indicates that sales of certain structured products have increasingly been targeted at retail customers. Therefore, the U.S. Securities and Exchange Commission (SEC) and the self-regulatory organizations (SROs) are focusing attention on sales of structured products. Let me now turn to some of the securities law requirements that apply to the sale of structured finance products in the United States.

A broker-dealer that does business with a public customer makes an implied representation that it will deal fairly with the customer in accordance with industry standards. This gives rise to obligations under the U.S federal securities laws, including the obligation to recommend only specific securities or investment strategies suitable for the customer. Under case law, two theories have developed — first, the reasonable basis suitability duty; and second, the customer-specific suitability obligation. Under the first theory, the broker-dealer must have an "adequate and reasonable basis" that a recommendation is suitable for some customer, rather than the specific customer to whom the recommendation is being made.¹ The customer-specific suitability requirement imposes a duty on a broker-dealer to make recommendations based upon the customer's financial situation and level of sophistication, as well as the securities and investment strategy in the context of the customer's other securities holdings. This generally assumes a duty to obtain appropriate information to allow the broker-dealer to make such recommendations.² While the SEC does not have a specific suitability rule, it recognized suitability as a doctrine that gave rise to a "legal obligation" under the federal antifraud provisions, as well as an "ethical duty" under SRO rules.³ Enforcement of these duties relies on the theory that a broker-dealer, by "hanging out its shingle" makes an implied representation that it will deal fairly with the customer.⁴ SEC enforcement actions in this area are principally brought under Securities Exchange Act 10(b) and Exchange Act Rule 10b-5 and Securities Act of 1933 Section 17(a), which I am sure you recognize as the anti-fraud provisions.⁵

Both the NASD and the New York Stock Exchange (NYSE), two key U.S. SROs, have suitability rules. Enforcement of the duty of suitability for broker-dealers under SRO rules does not have the anti-fraud requirement of "scienter" — knowledge or intent. Typical SRO rules that apply to structured products include requirements for:

providing fair and balanced disclosure on risks and benefits;
dealing fairly with customers with regard to recommendations or orders;
performing a reasonable-basis suitability determination;
performing a customer-specific suitability determination;
supervising and maintaining a supervisory control system; and
training associated persons.

In September 2005, NASD issued Notice to Members (NTM) 05-59. That NTM summarized sales practice obligations when broker-dealers sell structured products to retail customers. NASD rules noted in NTM 05-59 that apply to activities involving structured products include: Rules 2110 (Standards of Commercial Honor and Principles of Trade), 2210 (Communications with the Public), 2310 (Recommendations to Customers), 2720 (Distribution of Securities of Members and Affiliates — Conflicts of Interest), 3010 (Supervision), and 3012 (Supervisory Control Systems).

Under NASD Rule 2210, all sales materials and oral presentations with respect to structured products are required to present a fair and balanced picture regarding both the risks and benefits. Rule 2210 also prohibits exaggerated statements and the omission of any material fact or qualification that would cause a communication to be misleading. In promoting the advantages of structured products, the broker-dealer must balance its promotional materials with disclosures on attendant risks. Sales of structured products issued by a firm, or an affiliate of a firm, to discretionary accounts are required to comply with Rule 2720 (Distribution of Securities of Members and Affiliates — Conflicts of Interest). In particular, transactions in securities issued by a firm or an affiliate of a firm, or by a company with which a firm has a conflict of interest, are not allowed to be executed by the firm in a discretionary account without prior specific written approval of the customer. NASD Information Memorandum 2310-2(e) (Fair Dealing with Customers with Regard to Derivative Products or New Financial Products) emphasizes a firm's obligations to deal fairly with customers when making recommendations or accepting orders for new financial products.⁶

NASD NTMs 03-07 and 03-71 note that a firm has an obligation to perform a reasonable basis suitability determination prior to recommending a product to investors.⁷ A firm also is required to determine that its recommendation to purchase a structured product is suitable for that particular investor.⁸ NASD Rule 3010 requires members to establish written supervisory procedures that are reasonably designed to ensure that sales of securities, including structured products, comply with all applicable securities laws, and SEC and NASD rules. Under Rule 3012, firms are required to have written supervisory control systems to test and verify compliance with Rule 3010. Firms must also train registered personnel about the characteristics, risks, and rewards of each structured product before they permit registered persons to sell that product to investors.

The NYSE has similar rules. NYSE Rule 405 states that every member must use "due diligence to learn the essential facts relative to every customer, every order, and every cash or margin account accepted or carried by such organization". NYSE Rule 476(a)(6) prohibits conduct that is "inconsistent with just and equitable principles of trade." These two rules are generally used together to enforce suitability obligations by firms selling securities, including structured finance products. NYSE Rule 342 imposes an obligation on firms to establish a supervisory system reasonably designed to achieve compliance with applicable securities laws and regulations, and NYSE Rule 342.23 requires testing and verification of the system. In addition, NYSE Rule 342.17 requires firms to have written policies and procedures to review communications with the public. These are just some of the specific SRO rule requirements that apply to that sale of structured products.

II. Potential Liability

I'd like to now turn to my second topic, the guidance issued by SEC staff on the potential liability of financial institutions for securities law violations arising from deceptive structured finance products and transactions. On December 4, 2003, SEC staff provided to the Federal Reserve Board and the Office of the Comptroller of the Currency guidance on this issue.⁹ The guidance covers two main areas: (1) the principal types of securities law violations that can arise from the use of deceptive structured finance products and transactions; and (2) the manner in which financial institutions that offer such deceptive products, or participate in such transactions, may be liable for these violations.

The principal categories of securities law violations highlighted in the guidance relate to anti-fraud, reporting, and recordkeeping and internal controls.

Anti-Fraud Violations — Anti-fraud violations would arise under Securities Exchange Act Section 10(b) and Securities Act of 1933 Section 17(a). An example provided in the guidance is the case where an issuer may falsely characterize the nature of the transaction in a press release, shareholder report, on the Internet, or in reports filed with the SEC.
Reporting Violations — Reporting violations may occur under Exchange Act Section 13(a), which requires all issuers whose securities are filed with the SEC to file periodic reports with information prescribed by the SEC. Rules 13a-1, 13a-11, 13a-13, and 12b-20 under the Exchange Act are also relevant. The guidance notes that issuers that include inaccurate or misleading information concerning structured finance transactions in reports filed with the SEC may violate reporting provisions.
Recordkeeping and Internal Controls Violations — Exchange Act Sections 13(b)(2)(A) and (B) contain requirements for recordkeeping and internal controls. Paragraph (A) requires issuers to make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions of the issuer. Paragraph (B) requires issuers to devise and maintain an adequate system of internal accounting controls. As an example of a violation, the guidance states that an issuer engaging in a structured finance transaction may take steps to conceal the fraud, including manipulating books and records and bypassing controls.

The potential liabilities discussed in the guidance include primary liability, aiding and abetting liability, and liability for causing violations. These are discussed in the guidance in a little more detail as follows:

Primary Liability — The guidance states that based on the specific facts, a financial institution may have primary liability for securities fraud for offering or participating in deceptive structured finance transactions, noting that precedent supports imposition of primary liability both on persons who make fraudulent misrepresentatives and those who know of it and assist in it.¹⁰
Aiding and Abetting Liability — Aiding and abetting liability arises under Exchange Act Section 20(e) with respect to any person who knowingly provides substantial assistance to another person in violation of any provision of the Exchange Act or rules under it. The guidance notes several cases of this type in connection with Enron transactions and specifically notes that it includes any financial institution that offers a deceptive structured finance product or participates in a deceptive structured finance transaction.
Liability for Causing Violations — The final type of liability cited in the guidance falls under Rule 13b2-1, which prohibits any person from directly or indirectly, falsifying or causing to be falsified, any book, record, or account subject to Section 13(b)(2)(A) of the Exchange Act. Again, an Enron-related transaction is cited, and the guidance notes that a financial institution could be charged with causing an issuer's falsification of its books and records, for example, in connection with a structured finance transaction.

III. Risk Management Principles

The third and final area I would like to cover is risk management principles that may help a financial institution manage and address heightened risks, including the legal risks discussed earlier. These principles are particularly relevant with respect to complex structured finance transactions (CSFTs).

On May 9, 2006, the SEC together with the U.S. federal banking regulators, issued an "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities" (Interagency Statement)¹¹ The Interagency Statement provided examples of CSFTs that may expose an institution to heightened risks, and also described risk management principles the agencies believed might assist in managing heightened risks.

Among examples of CSFTs that may expose an institution to heightened legal and reputational risks noted in the Statement are transactions that appear to:

Lack economic substance or business purpose;
Be designed or used primarily for questionable accounting, regulatory, or tax objectives, particularly when executed at year-end or end of a customer reporting period;
Raise concerns the client will report or disclose the transaction in its public filings or financial statements in a manner that is materially misleading or inconsistent with the substance of the transaction or applicable regulatory or accounting requirements;
Involve circular transfers of risk (either between the financial institution and the customer or between the customer and other related parties) lacking economic substance or business purpose;
Involve oral or undocumented agreements that would have a material impact on the regulatory, tax, or accounting treatment of the related transaction or the client's disclosure obligations;
Have material economic terms inconsistent with market norms (e.g., deep "in the money" options or historic rate rollovers); or
Provide the financial institution with compensation appearing substantially disproportionate to services provided, investments made, or credit, market or operational risk assumed by the institution.

These are not illegal or inappropriate CSFTs, but rather are transactions that may have elevated risks, requiring heightened risk management controls.

The Interagency Statement also describes risk management principles the Agencies believe may help financial institutions conduct heightened internal controls and risk management for elevated risk CSFTs. Policies and procedures articulated in the Interagency Statement include:

Due diligence to evaluate and take appropriate steps to address risks commensurate with the level of risks identified, which may include additional customer information or specialized advice from qualified professionals.
Review and approval by appropriate levels of both control and management personnel; participation in CSFTs that create significant legal or reputational risks may be conditioned to address risks, or declined if risk is unacceptable or would violate a law or accounting principle.
Creation and collection of sufficient documentation to allow the institution to: document material terms; enforce material obligations of counterparties; confirm customers have received required disclosures; verify policies and procedures are being followed; and document management's approval (or disapproval).
Establishing a "tone at the top" by the board and senior management through actions and formalized policies (including compensation and incentives) sending a strong message about the importance of legal compliance and good business ethics.
Effective, independent oversight and review of activities with results provided to management.
Appropriate training of relevant personnel on policies and procedures.
Regular internal audits of adherence to controls and assessment of adequacy of policies and procedures, including transaction testing.
Provision for management and the board to receive sufficient information and reports to perform their oversight functions.

The Interagency Statement notes that it does not create any private rights of action, nor alter or expand the legal duties and obligations that a financial institution may have to a customer, its shareholders or other third parties under applicable law. It also cautions that adherence to the principles in the Interagency Statement would not necessarily insulate a financial institution from regulatory action or any liability the institution may have to third parties under applicable law.

In conclusion, there is no doubt that structured finance transactions are now imbedded as an important segment of the international capital markets. Their use has contributed to market efficiencies and improved risk management, hedging, and cash flow allocations. However, CSFTs also can raise heightened risks in connection with their structuring, sales, and marketing. This in turn, imposes heightened challenges to ensure appropriate risk management, as well as compliance with applicable laws and rules. I hope my remarks have provided some valuable insights to you with respect to regulatory concerns regarding structured products, and some precautions a firm participating in such transactions may take to reduce the likelihood of risks and ensuing violations that may be associated with their activities in the area. Thank you very much for your attention.

Endnotes

⁵ Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful for any person, in connection with the purchase or sale of any security, to employ any device, scheme, or artifice to defraud; to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. Section 17(a) of the Securities Act prohibits similar misconduct in the offer or sale of any securities. Another related rule is Exchange Act Rule 17a-3(a)(17)(i)(A), which requires that for each account with a natural person as a customer where a suitability determination is required, broker-dealers must collect the customer's name, tax identification number, address, telephone number, date of birth, employment status, annual income, net worth and investment objectives.

⁸ Under Rule 2310, members must ensure that a recommendation is suitable for a specific customer by examining (1) the customer's financial status, (2) the customer's tax status, (3) the customer's investment objectives, and (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer. NASD IM 2310-3 provides a different standard with respect to institutional customers providing that the firm's suitability obligation is defined by (1) the customer's capability to evaluate the risk independently, and (2) the extent to which the customer is exercising independent judgment in evaluating the firm's recommendation.

http://www.sec.gov/news/speech/2006/spch092006mag.htm

Speech by SEC Staff: Structured Finance Activities: The Regulatory Viewpoint

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