By James Hamilton, J.D., LL.M.
The SEC and the federal banking regulators have issued their final guidance for banks and securities firms that engage in complex structured finance transactions. The final statement takes a risk-based and principles-based approach to addressing the risks that these complex transactions may pose to institutions and focuses on those transactions that may present elevated levels of legal or reputational risk to financial institutions.
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 year-end or at the end of a reporting period for the customer.
Some commenters, notably a consortium of law professors, contended that these examples of elevated risk transactions contained in the statement have characteristics that are signals, if not conclusive proof, of fraudulent activity. Consequently, they 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. That was pretty strong language. The law professors actually asked the agencies to withdraw their statement because it could be read to encourage illegal conduct
While the agencies believe that financial institutions should conduct due diligence commensurate with identified risks, they do not believe it 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, reasoned the agencies, may determine that the transaction does not, in fact, have the characteristics that initially triggered the review. Or, the financial institution may take steps to address the risks that initially triggered the review.
But the agencies did give the law professors some solace by advising financial institutions to decline to participate in an elevated risk transaction if, after conducting due diligence and taking appropriate steps to address the transactional risks, they determine that the transaction presents unacceptable risks or would result in a violation of applicable laws, regulations or accounting principles.