United States General Accounting Office

GAO Report to the Honorable

Edward J. Markey,

House of Representatives

October 1997 OTC DERIVATIVES

Additional Oversight

Could Reduce Costly

Sales Practice Disputes

GAO/GGD-98-5

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-259982 

October 2, 1997

The Honorable Edward J. Markey

House of Representatives

Dear Mr. Markey:

This report presents the results of our review of sales practices for over-the-counter (OTC)

derivatives, mortgage-backed securities, and structured notes. On the basis of your request that

we review sales practice issues related to OTC derivatives, we report on the applicable federal

requirements, extent of end-user satisfaction with dealer sales practices, end-user and dealer

views on the nature of their relationship, and actions taken by market participants and

regulators to address sales practice issues. Because disputes and concerns were also prevalent

for transactions involving mortgage-backed securities and structured notes, we included these

products in our review as well.

This report includes recommendations to the President’s Working Group on Financial Markets

to (1) develop a formal mechanism for collecting data on sales practice issues and (2) consider

assisting dealers and end-users in resolving their disagreements over the nature of their

relationship as a part of OTC derivatives transactions. Also included are recommendations that

the Federal Reserve update its guidance to better address sales practice issues and that the

Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission

(CFTC) collect information on the extent to which securities firms are following the sales

practice provisions of voluntary guidance related to OTC derivatives.

As agreed with you, unless you publicly release its contents earlier, we plan no further

distribution of this report until 7 days from its issue date. At that time, we will provide copies to

interested members of Congress, appropriate congressional committees, CFTC, the Department

of the Treasury, the Federal Reserve Board, the Office of the Comptroller of the Currency, SEC,

the National Association of Securities Dealers, and the New York Stock Exchange.

Major contributors to this report are listed in appendix X. If you have any questions, please call

me at (202) 512-8678.

Sincerely yours,

Thomas J. McCool

Director, Financial Institutions

 and Markets Issues
Executive Summary

Purpose In 1994, some users of over-the-counter (OTC) derivatives,1

mortgage-backed securities (MBS),2 and structured notes3 experienced

large and highly publicized losses. Allegations or evidence of deficient

dealer4

 sales practices were associated with some of these losses, raising

congressional concerns about whether end-users5

 were adequately

protected against such practices. In response to these concerns, the

former Chairman of the Subcommittee on Telecommunications and

Finance, House Committee Energy and Commerce, requested that GAO

determine the prevalence of disputes in the sale of OTC derivatives.

Because market participants and others also expressed concerns about

sales practices associated with MBS and structured notes, GAO expanded its

review to include these products.

To address concerns associated with sales practices for OTC derivatives,

MBS, and structured notes, GAO analyzed (1) the federal sales practice

requirements applicable to these products and the dealers marketing them;

(2) the extent of end-user satisfaction with sales practices, product use,

and related disputes and the costs of these disputes; (3) the views of

end-users and dealers on the nature of their relationship and

responsibilities; (4) the actions dealers and end-users have taken to reduce

the potential for sales practice disputes; and (5) the actions regulators

have taken to address sales practice issues.

Background Innovative and often complex financial products known as OTC derivatives

can be used to manage financial risks associated with volatility in interest

rates, foreign exchange rates, and equity and commodity prices. OTC

derivatives can also allow end-users to increase investment yields and

reduce borrowing costs. These benefits do not come without risk because

using OTC derivatives, similar to using other financial products, can result

1

OTC derivatives are privately negotiated financial contracts whose market value is determined by the

value of an underlying asset, reference rate, or index.

2

MBS are debt securities that are created from pools of residential mortgages. Investors in MBS receive

the interest and principal payments generated by the mortgage pools.

3

Structured notes are debt securities whose principal and interest payments vary according to specific

formulas or as a result of changes in exchange rates or equity and commodity prices; they may also

contain derivatives.

4

Dealers stand ready to act as buyers, sellers, counterparties, or intermediaries for end-users and other

dealers.

5

For simplicity, GAO uses the term end-user to refer to counterparties or customers of dealers in

transactions involving OTC derivatives, MBS, and structured notes.

Page 2 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

in losses from adverse market movements, credit defaults, or operations

errors.

The notional/contract amount6

 outstanding of OTC derivatives was

estimated at $47.5 trillion worldwide and $11 trillion in the United States,

as of March 1995.7

 The bulk of this volume was in “plain vanilla,” or

relatively standardized and uncomplicated, OTC derivatives contracts.

However, more complex contracts whose values can be based on more

than one underlying asset, reference rate, or index were also being used.

In addition to OTC derivatives, a wide variety of MBS and structured notes

have been issued by government-sponsored enterprises (GSE)8

 and private

companies to finance their operations. In 1996, issuances were $474 billion

for MBS and $12 billion for GSE-issued structured notes.

Dealers of OTC derivatives, MBS, and structured notes are primarily U.S. and

foreign banks, registered broker-dealers,9

 and affiliates of securities firms

and insurance companies. These dealers may receive no federal oversight

or be overseen by one or more federal regulators, including the Federal

Reserve System, the Office of the Comptroller of the Currency (OCC), the

Securities and Exchange Commission (SEC), the Commodity Futures

Trading Commission (CFTC), and various industry self-regulatory

organizations (SRO).10 The federal financial market regulators jointly

address issues related to OTC derivatives, MBS, and structured notes

through the President’s Working Group on Financial Markets. This group,

6

The notional amount is the amount upon which payments between parties to certain types of

derivatives contracts are based. When this amount is not exchanged, it is not a measure of the amount

at risk in a transaction. According to the Federal Reserve, the amount at risk, as measured by the gross

market value of OTC derivatives outstanding, was $328 billion for U.S. entities, as of March 1995, or

about 3 percent of the notional/contract amount. (The gross market value is the cost that would be

incurred if the outstanding contracts were replaced at prevailing market prices.)

7

These estimates were based on a comprehensive survey done by the Bank for International

Settlements and represent the most current data available. The Bank for International Settlements,

among other functions, provides a forum for cooperative efforts by the central banks of major

industrial countries.

8

GSEs are privately owned financial intermediaries established pursuant to federal law to facilitate

lending for purposes that the federal government has deemed socially important, such as education,

agriculture, and housing.

9

Broker-dealers are agents that handle public orders to buy and sell securities. They also act as

principals that buy and sell securities for their own accounts.

10SROs play an extensive role in the regulation of the U.S. securities and futures industries. SROs

include all of the U.S. securities and commodities exchanges, the National Association of Securities

Dealers, the National Futures Association, and the Municipal Securities Rulemaking Board. In

addition, state agencies also oversee banking, securities, and insurance activities, although this report

does not address such oversight in detail.

Page 3 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

which is chaired by the Secretary of the Treasury, considers issues

concerning the competitiveness, integrity, and efficiency of the financial

markets.

To gather information about end-users of OTC derivatives, MBS, and

structured notes, GAO sent questionnaires to the financial officers of nearly

2,400 randomly selected U.S. organizations in 1995. Designed to be

representative of U.S. public-sector and private-sector entities, the sample

was drawn from over 49,000 U.S. organizations that GAO identified as

potential end-users of one or more of the products, and the sample was

stratified by industry and organization size.11 GAO received about 1,800

responses to the survey, allowing statistically valid estimates for the

population of (1) the level of satisfaction these organizations experienced

with dealers’ sales practices and (2) the extent to which these products

were used across the organizations. In addition, GAO followed-up with

about 50 survey respondents to obtain more information about their use of

these products and satisfaction with dealer practices.

Results in Brief The extent to which OTC derivatives are subject to federal sales practice

requirements intended to protect end-users varies, depending, in part, on

whether they are considered to be securities, futures, or neither. When

they are considered to be securities or futures, their sale is covered by the

federal securities or commodities laws, and they are regulated by SEC and

CFTC, respectively. To the extent that these products are not securities or

futures, end-users with sales practice disputes would need to seek redress

against a dealer by asserting primarily state statutory or common law

claims.12 In contrast to most OTC derivatives, MBS and structured notes are

typically securities and, thereby, subject to the federal securities laws,

except when exempted from specific provisions.

The extent to which sales practice requirements apply to the dealers

marketing OTC derivatives in the United States also varies, depending on

whether the dealer offering them is regulated. When OTC derivatives are

marketed by banks, they are subject to supervisory guidance issued by

federal bank regulators. This guidance is primarily intended to ensure that

OTC derivatives activities do not adversely affect the financial condition of

banks. Securities, futures, and insurance firms, unlike banks, typically

market OTC derivatives that they consider to be neither securities nor

futures from affiliates that are not subject to any direct federal financial

11See appendix I for information on the survey sample design.

12Common law is derived from judicial decisions rather than from statute.

Page 4 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

regulatory oversight, although some individual transactions may be

subject to such oversight.

Although sales practice requirements vary by product and dealer,

according to GAO’s survey of a broad range of U.S. organizations, most

end-users were generally satisfied with the sales practices of the dealers

with whom they entered transactions. GAO’s survey also found that

relatively few organizations reported using OTC derivatives. About

10 percent reported using plain vanilla OTC derivatives, and 2 percent

reported using more complex OTC derivatives. Within each type of

industry, the larger organizations were the predominant users of these

products.

Furthermore, GAO’s review of regulatory and public records, covering 1993

through 1996, indicated that cases involving actual or alleged deficiencies

in dealer sales practices were limited in number. However, the dealers and

end-users involved in these cases often experienced significant costs.

These were primarily sales practice-related costs associated with

compliance risk—such as litigation costs and regulatory fines—and

reputation risk—such as reduced revenues and income due to a

diminished business or professional reputation.

Although generally satisfied with dealer sales practices, end-users’ views

on the nature of counterparty relationships sometimes differed from those

of dealers. According to GAO’s survey, about one-half of all end-users of

plain vanilla or more complex OTC derivatives believed that a fiduciary

relationship of some sort existed in some or all transactions between them

and their dealer. Some end-users told GAO that this meant dealers had an

obligation to provide accurate product descriptions and disclose material

risks. In comparison, two dealer groups issued guidance asserting that

such transactions are conducted on a principal-to-principal, or an

“arm’s-length,” basis unless more specific responsibilities are agreed to in

writing or otherwise provided by law. According to this guidance,

end-users would be expected to make their own decisions about a

transaction without relying on statements made by dealers.

Representatives of end-users and dealers have called for both sides to

reach agreement on this issue, with some indicating that federal financial

market regulators could play a role in resolving differences.

Notwithstanding the disagreement over the nature of their relationship,

some dealers and end-users have taken steps—individually and

collectively—to reduce the potential for sales practice-related disputes to

arise.

Page 5 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

In addition, bank regulators have taken certain actions to address sales

practice issues. In 1993 and 1994, OCC and the Federal Reserve issued

guidance for use by their examiners and the banks they regulate covering

the marketing of OTC derivatives, MBS, and structured notes. GAO also found

that these regulators had conducted examinations that were generally

thorough in addressing banks’ sales practices. However, in conducting

these examinations, regulators addressed areas that were not listed in

their guidance, including several key areas in which alleged deficiencies in

dealer practices have led to costly disputes with end-users. In 1997, OCC

updated its guidance to address these weaknesses. The Federal Reserve

has not yet issued updated guidance, but plans to do so by the end of 1997.

The revisions are to address the areas not specifically covered in its

current guidance.

Although SEC and CFTC do not directly regulate the affiliates that securities

and futures firms use to conduct their OTC derivatives activities, SEC and

CFTC worked with the most active of these firms to produce one of two

sets of voluntary guidance. This guidance presents a framework of

management systems and controls for the participating firms to follow

related to sales practices. However, the guidance does not provide for SEC

and CFTC to receive information about the extent to which participating

firms follow its sales practice provisions. Adherence to these provisions is

important to promoting market fairness and integrity.

Although GAO found that the extent to which sales practice requirements

apply to OTC derivatives and their dealers vary, end-users were generally

satisfied with the sales practices of the dealers they used and sales

practice disputes were limited in number. However, these findings must be

viewed in the context of the relatively small number of end-users and

dealers active in these markets as well as their relatively high level of

financial sophistication. If new dealers enter the markets, use of complex

products becomes more widespread, or marketing to or product use by

less sophisticated end-users increases, disputes over sales practices might

increase. This could cause the financial market regulators to reconsider

whether sales practice requirements for OTC derivatives are sufficient to

protect end-users from abusive practices.

Page 6 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

Principal Findings

Federal Sales Practice

Requirements Vary

The federal sales practice requirements intended to protect end-users of

OTC derivatives vary, depending on whether the product involved is a

security, futures contract, or neither and on whether the dealer is

regulated. OTC derivatives that fall within the definition of a security or

futures contract are generally subject to the antifraud provisions of the

federal securities or commodities laws, respectively. Their sale is also

subject to SEC and CFTC oversight.13 The antifraud provisions of the

securities and commodities laws place certain obligations on those

marketing securities or futures. For securities, these obligations include

disclosing material information about and assessing the suitability of a

product before recommending a transaction. For futures, these obligations

include disclosing product risks and obtaining information on the financial

condition of the end-user before engaging in transactions. To the extent

that a specific OTC derivative product is not covered by federal securities

and commodities laws, end-users with sales practice disputes would need

to seek redress against a dealer by asserting primarily state statutory or

common law claims, such as fraud or breach of fiduciary duty.14

Although SEC and CFTC actions can indicate whether they consider certain

types of OTC derivatives to be securities or futures, such as when the

agencies respond to inquiries about specific proprietary contracts a dealer

is developing, these actions have not covered all OTC derivatives. For

example, CFTC has exempted certain swaps15 and other OTC derivatives

from almost all provisions of the Commodity Exchange Act (CEA);

however, it did so without determining that such products were futures.16

Furthermore, CFTC did not exempt swaps from the act’s antifraud

provisions, but such provisions only apply insofar as swaps are found to

13SROs assist SEC and CFTC in implementing the federal securities and commodities laws.

14End-users could also seek redress under the federal Racketeer Influenced and Corrupt Organizations

Act. In addition, dealers may be subject to federal criminal enforcement actions under applicable mail

fraud or wire fraud statutes.

15Swaps are OTC derivatives contracts that typically require counterparties to make periodic payments

to each other for a specified period. The calculation of these payments is based on an agreed-upon

amount, called the notional amount, that is not typically exchanged.

16CFTC was granted this exemptive authority by the Futures Trading Practices Act of 1992 (P.L.

102-546). See The Commodity Exchange Act: Legal and Regulatory Issues Remain (GAO/GGD-97-50,

Apr. 7, 1997).

Page 7 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

be futures or commodity options.17 In addition, SEC and CFTC have taken a

cooperative enforcement action against one dealer, Bankers Trust,18 for

violating the antifraud provisions of the federal securities and

commodities laws in connection with OTC derivatives it marketed. In

contrast to most OTC derivatives, MBS and structured notes are typically

securities and subject to the federal securities laws, except when

exempted from specific provisions.19

The sales practice requirements applicable to OTC derivatives in the United

States also vary, depending on whether the dealer offering them is

regulated. Banks marketing these products are overseen by federal bank

regulators who are responsible for ensuring the safety and soundness of

banks. To address this responsibility, bank regulators issued guidance in

1993 and 1994 applicable to the marketing of OTC derivatives that requires

banks to take steps to ensure that such transactions are understood and

are appropriate for the end-user. Banks marketing MBS and structured

notes that are securities are also subject to the antifraud provisions of

federal securities laws. As such, they are tasked with providing risk

disclosures and assessing the suitability of these products before

recommending them to an end-user.

Although SEC oversees securities firms and CFTC oversees futures firms,

these firms typically market OTC derivatives that are not securities or

futures20 through affiliates that are not subject to either regulator’s direct

oversight. Similar to securities and futures firms, insurance firms typically

market these products from affiliates that are not subject to direct federal

or state financial regulatory oversight. Nonetheless, if SEC or CFTC

determined that a specific transaction was a security or a futures contract,

17Commodity options give the purchaser the right, but not the obligation, to buy or sell a specified

quantity of a commodity or financial asset at a particular price on or before a certain date.

18Unless otherwise indicated, Bankers Trust refers to the parent firm—Bankers Trust New York

Corporation, which is a bank holding company—and two of its wholly owned subsidiaries—Bankers

Trust Company, which is a bank, and BT Securities Corporation, which is a securities broker-dealer.

19Structured notes that are hybrid financial instruments could be futures or commodity option

contracts if they do not meet the terms and conditions of CFTC’s hybrid instrument exemption (17

C.F.R. Part 34). A hybrid financial instrument possesses, in varying combinations, characteristics of

forwards, futures, options, securities, and/or bank deposits. Unlike many other derivatives, hybrid

financial instruments generally serve a capital-raising function. For the purposes of this report, GAO

assumed that structured notes meet the conditions of CFTC’s hybrid exemption and, therefore, are

securities and not futures.

20Firms would also typically market OTC derivatives that CFTC has exempted from the CEA from

these unregulated affiliates.

Page 8 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

it would be subject to that agency’s laws and jurisdiction, absent an

agency exemption21 or a successful court challenge.

After considering the market’s characteristics, the President’s Working

Group on Financial Markets concluded that the existing authority of these

agencies as well as current sales practice requirements for OTC derivatives

are adequate to protect end-users and the financial markets. Additionally,

Working Group participants told GAO that the agencies comprising the

group do not routinely collect information on sales practice-related market

characteristics, such as changes in the number of disputes or in the types

of end-users being offered certain products. Therefore, the Working Group

has no formal mechanism for identifying changes in market characteristics

that would cause it to reassess the adequacy of existing sales practice

requirements for OTC derivatives.

Satisfaction With Sales

Practices Was High and

Disputes Were Limited, but

Losses Were Often Large

According to GAO’s 1995 survey of a broad range of U.S. organizations,

most end-users were generally satisfied with the sales practices of dealers

marketing OTC derivatives, MBS, and structured notes. For plain vanilla OTC

derivatives, 2 percent of the organizations that had used these products

reported being somewhat or very dissatisfied with the sales practices of

the dealers they used.22 For MBS, 7 percent of the end-users reported being

dissatisfied with the dealers they used; for structured notes, 13 percent of

the end-users reported being dissatisfied.

GAO’s survey found that OTC derivatives were used less frequently than

either MBS or structured notes. It found that 10 percent of the population

reported using plain vanilla OTC derivatives, while 24 percent reported

using MBS and 16 percent reported using structured notes. Also, the

reported use of these products was comparatively greater for large

organizations than for small organizations.23 Nonetheless, in certain

industries, small organizations reported active use of these products. For

example, smaller banks, credit unions, and insurance companies, as a

group, reported using MBS and structured notes at about twice the rate as

did all other organizations combined.

21SEC has not exempted any products from the antifraud provisions of the securities laws. Similarly,

except for certain energy products, CFTC has not exempted any products from the antifraud

provisions of the CEA.

22The number of survey respondents that used more complex OTC derivatives was too small to reliably

estimate dissatisfaction.

23Large organizations were usually those in the top 10 percent of their respective industry/government

grouping on the basis of their assets, revenues, or other indicators of financial size. All other

organizations were considered small.

Page 9 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

GAO’s review of complaints filed with regulators, regulatory enforcement

actions, and public records of litigation, from 1993 through 1996, also

indicated that sales practice problems involving OTC derivatives, MBS, and

structured notes were not widespread. Moreover, a majority of these

instances of alleged sales practice problems were attributable to a small

number of dealers. The specific concerns generally involved dealers

misrepresenting potential transaction risks or offering products that were

unsuitable for the end-user.

Using public information and regulatory data, GAO identified 360 end-users

losses24 that involved OTC derivatives, MBS, and structured note

transactions with U.S. dealers.25 These losses totaled over $11.4 billion,

with the earliest loss occurring in April 1987 and the latest loss occurring

in March 1997. Sales practice concerns were raised by end-users or

regulators in 209, or 58 percent,26 of these losses and were associated with

an estimated $3.2 billion in losses. Although many of these losses were

large, they involved a relatively limited number of dealers. Of the end-user

losses with sales practice concerns, 18 involved OTC derivatives, but one

dealer—Bankers Trust—was involved in 9 of these losses. MBS and

structured notes were used more often than OTC derivatives and were

associated with more sales practice concerns. For these products, GAO

identified 190 losses with sales practice concerns; however, 8 dealers were

involved in 148 of these losses. Similarly, GAO’s review showed that

regulators were investigating as many as 44 dealers from 1993 to 1996, but

only a small number of the investigations involved multiple end-users.

Given the many thousands of transactions in OTC derivatives, MBS, and

structured notes and the hundreds of billions of dollars at risk in these

transactions over the period reviewed, GAO found that sales practice

concerns were not widespread.

Although the number of reported problems was limited during the period

GAO reviewed, many of the transactions in which concerns over dealer

sales practices arose entailed serious losses for the end-users involved.

24The amount of reported losses includes not only realized losses but also unrealized losses as well as

losses for which the loss amounts were not reported. In addition, some of the losses may involve

products not covered in this report.

25The information in this database was compiled from press accounts and other public records as well

as from nonpublic regulatory data. Many of the losses are supported by multiple sources, but the

accuracy of the information generally was not confirmed.

26This percentage is not a statistically valid estimate of the actual extent to which sales practice

concerns have been raised in connection with OTC derivatives, MBS, and structured note transactions.

It is based on a compilation of losses that is not necessarily representative of the population of such

transactions.

Page 10 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

For example, Procter & Gamble reported an after tax loss of $102 million

on its complex OTC derivatives transactions with Bankers Trust. Various

organizations reported losses involving MBS that were as high as

$660 million. Additionally, in 1994, Orange County, CA, announced losses

totaling $1.7 billion on its use of various products, including structured

notes.

The dealers and end-users in these cases also frequently incurred

significant compliance and reputation risk costs. For example, Bankers

Trust’s compliance risk costs have totaled at least $400 million, including

regulatory fines, legal fees, and other costs associated with end-user

litigation settlements. The impact on its reputation was evidenced, at least

in part, by the subsequent declines in its revenues, profits, and stock price.

In addition, Orange County faces compliance losses from suits by its

investment pool participants, SEC actions against the county’s staff, and a

countersuit by a dealer, Merrill Lynch. The county’s credit rating has also

been lowered, causing it to pay higher rates of interest on the debt used to

finance its operations.

Disagreement Over

Counterparty

Responsibilities Increases

the Potential for Disputes

According to GAO’s survey, about 53 percent of end-users of plain vanilla

OTC derivatives believed that dealers had certain fiduciary responsibilities

to end-users in some or all cases. In follow-up interviews, end-users told

GAO that these responsibilities included accurately describing a product’s

function and potential performance as well as adequately disclosing

relevant risks. Responses to GAO’s survey also indicated that an estimated

59 percent of plain vanilla OTC derivatives end-users and a similar

percentage of end-users of more complex OTC derivatives relied on dealers

to provide investment advice from “some” to a “very great extent” as part

of these transactions.

Dealers viewed their responsibilities differently. Two sets of voluntary

guidance issued by dealer groups assert, unless altered by agreement

between the parties or otherwise provided for by law, that OTC derivatives

transactions are conducted at an arm’s length, meaning that each party to

the transaction—the dealer and the end-user—is responsible for ensuring

that the transaction is appropriate.27 However, some end-users and legal

scholars have questioned the reasonableness of asserting that an

27The two sets of guidance are the Framework for Voluntary Oversight, issued in 1995 by the

Derivatives Policy Group, which is comprised of representatives from the six U.S. securities firms

whose affiliates are most active in the OTC derivatives markets, and The Principles and Practices for

Wholesale Financial Market Transactions, issued in 1995 by various dealer associations under the

auspices of the New York Federal Reserve Bank.

Page 11 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

arm’s-length relationship always exists between parties to these

transactions, particularly when the end-user is unsophisticated or

inexperienced in the use of a particular product. Others expressed

concern that the dealer-issued guidance does not obligate dealers to fully

disclose the risks of the transactions they propose. For their part, dealers

told GAO that presentations to end-users are designed to explain potentially

useful products and various investment and risk management alternatives,

but should not be construed as investment advice that end-users should

accept without performing their own internal evaluations. Furthermore,

dealers indicated that they would assume more specific responsibilities,

such as acting as an investment advisor or fiduciary, if such relationships

were agreed to in writing.

Conferences and other forums have provided end-users and dealers

opportunities to hear each other’s views. However, as of June 1997, the

parties had not reached agreement on the nature of their relationship in

OTC derivatives transactions, nor did such an agreement appear imminent.

Regulators and others have called for more discussions between end-users

and dealers on this issue. In addition, some market participants have

indicated that federal financial regulators could assist end-users and

dealers in reaching agreement.

To reduce the likelihood of losses and related sales practice disputes,

some dealers and end-users have acted, individually or as part of groups,

to ensure that their internal controls and practices are prudent. Various

groups of market participants have also offered guidance and

recommended practices to dealers and end-users to address the risks of

financial products, including the risks related to the sale of these products.

The need for these efforts was demonstrated by the weaknesses in

controls and practices that regulators and others found.

Some Improvements in

Oversight of Regulated

Firms Have Been Made

In late 1993 and early 1994, the Federal Reserve and OCC issued guidance

for use by their examiners and the banks they regulate covering the

marketing of financial products, including OTC derivatives, MBS, and

structured notes. In response to publicized sales practice disputes, in 1994

and 1995, these regulators conducted focused examinations of the largest

bank dealers that addressed their sales practices. The scope of these

examinations was broader than that required by the 1993 and 1994 Federal

Reserve and OCC guidance. Using information from regulators, private

groups, and analyses of losses in which sales practice issues were raised,

GAO identified various elements that a comprehensive examination could

Page 12 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

include. Using these criteria, GAO found the bank examinations to be

generally thorough in addressing the key elements related to sales

practices.

However, GAO found that the bank regulators’ new guidance did not

address several key areas in which dealer practices led to costly disputes

with end-users in the past. For example, it did not direct examiners to

assess the adequacy of bank policies and controls related to product risk

disclosure, fiduciary or advisory responsibilities, or supervising marketing

personnel. In January 1997, OCC expanded its guidance and addressed all

of these areas. The Federal Reserve has not yet issued updated guidance.

However, Federal Reserve officials provided GAO with a draft of the

updated guidance, and the planned revisions would address the elements

we identified as missing in the existing guidance. Federal Reserve officials

said the agency expects to issue the updated guidance by the end of 1997.

To address ongoing concerns about OTC derivatives use, in 1995, the six

securities firms whose affiliates are most active in the OTC derivatives

markets cooperated with SEC and CFTC in developing the Framework for

Voluntary Oversight.

28 The Framework has resulted in SEC and CFTC

receiving information to supplement the reports they receive under prior

legislation passed in response to the risks of unregulated activities of

registered securities and futures firms. These supplements are to be

voluntarily provided and include additional reporting to the regulators,

pledges by participating firms to follow certain practices, and external

auditor verification of participating firms’ adherence to certain provisions

of the Framework.29 However, the additional reporting and the external

auditor verification do not extend to the sales practice provisions of the

Framework, which include suggestions for alternative ways of disclosing

transaction risks and providing accurate pricing information. SEC officials

told GAO that they expect participating firms to follow these provisions

because doing so is important for ensuring market fairness and integrity.

28The six firms are CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley,

and Salomon Brothers.

29Because its OTC derivatives affiliate is subject to oversight in the United Kingdom, CS First Boston is

not subject to the additional reporting requirements but has committed to adhering to the other

elements of the Framework. SEC officials told us that under SEC risk assessment rules, the agency

receives copies of quarterly financial reports that the affiliate files with its U.K. regulator.

Page 13 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

Changes in Market

Characteristics Could

Affect the Current

Regulatory Approach

Notwithstanding the variance in sales practice requirements that apply to

OTC derivatives and their dealers, end-users were generally satisfied with

the sales practices of the dealers used and sales practice disputes were

limited in number. The individual federal financial market regulators

currently monitor OTC derivatives issues as part of their oversight of the

firms they regulate, and they discuss new developments in these markets

as part of their participation in the Working Group. Although the Working

Group concluded that, on the basis of existing market characteristics, no

additional sales practice requirements are currently needed for OTC

derivatives, the characteristics that contributed to the high level of

end-user satisfaction and the limited number of sales practice disputes

experienced to date could change as the markets evolve. These changes

could include increased market participation by new dealers, more

widespread use of complex products, or increased marketing to or

product use by less sophisticated end-users. Such changes to market

characteristics could cause the Working Group to reconsider whether

current requirements are adequate to protect OTC derivatives end-users

and the financial markets. However, the Working Group’s lack of a formal

mechanism for periodically obtaining the information on relevant market

characteristics means that it could fail to detect changes that would

warrant reassessment of the adequacy of the sales practice requirements

for OTC derivatives.

The potential for additional end-user losses to spark costly sales practice

disputes could affect the soundness of the financial condition of regulated

institutions and perceptions of market fairness and integrity. The potential

for these additional disputes is heightened because dealers and end-users

have not reconciled their differing views on the nature of counterparty

responsibilities in OTC derivatives transactions. So far, the financial

regulators have not acted to assist the parties in reaching agreement.

However, such a reconciliation of views could have several benefits,

including clarifying positions about transaction risks and uncertainty

about counterparty roles and responsibilities. The Working Group could

provide regulators a forum for assisting end-users. In addition,

unaddressed weaknesses in bank guidance correspond to areas where

sales practice disputes have arisen, and SEC and CFTC lack information on

compliance of unregulated dealer affiliates with the sales practice

provisions of the Framework.

Page 14 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

Recommendations GAO recommends that the Secretary of the Treasury, as Chairman of the

President’s Working Group on Financial Markets, take the following

actions:

• Ensure that the Working Group establishes a mechanism for

systematically monitoring developments in the OTC derivatives markets to

assess whether developments warrant introducing specific federal sales

practice requirements.

• Lead the members of the Working Group in considering the extent to

which it should assist end-users and dealers in reaching agreement on the

nature of their relationship in transactions involving OTC derivatives.

GAO also recommends that

• the Federal Reserve Board Chairman implement planned revisions to the

Federal Reserve examination guidance, which are to more specifically

address the need to assess the adequacy of banks’ policies and controls

related to disclosing risks, creating advisory relationships, and supervising

marketing personnel and

• the SEC and CFTC Chairpersons establish a mechanism for determining that

participating firms are following the sales practice provisions of the

Framework for Voluntary Oversight.

Agency and Industry

Comments and GAO’S

Evaluation

GAO obtained comments on a draft of this report from the heads, or their

designees, of CFTC, the Department of the Treasury, the Federal Reserve

Board, OCC, and SEC. Comments were also obtained from the National

Association of Securities Dealers, the New York Stock Exchange, the

End-Users of Derivatives Association (EUDA); the Government Finance

Officers Association (GFOA); the International Swaps and Derivatives

Association (ISDA); and the National Association of State Auditors,

Comptrollers and Treasurers (NASACT). The comments are presented and

evaluated in chapter 7.

Overall, no consensus emerged on the benefits of implementing GAO’s

recommendations. The banking regulators and the associations that

represent primarily end-users generally concurred with GAO’s findings

and/or recommendations. The Federal Reserve also stated that this report

makes a useful contribution to assessing the current state of financial

market sales practices. OCC commented that the report is comprehensive

in evaluating sales practices from the perspectives of dealers, end-users,

and regulators. GFOA said this report will be an extremely helpful reference

Page 15 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

on derivatives, and NASACT stated that it provides an excellent study of

sales practice issues facing the OTC derivatives market. In contrast,

Treasury and ISDA generally objected to GAO’s recommendations, while

SEC’s views were mixed.

Regarding the recommendation that the Working Group establish a

mechanism for systematically monitoring developments in the OTC

derivatives markets, SEC and Treasury commented that the Working

Group’s current efforts, which generally include the principals meeting

every 6 weeks and the staff meeting every 2 weeks, are adequate to

address market developments. Similarly, ISDA commented that it is not

readily apparent that a formal monitoring mechanism would be any more

effective than the existing structure. In contrast, EUDA, GFOA, and NASACT

supported GAO’s recommendation. EUDA indicated that taking the

recommended steps—as they relate to this and GAO’s other

recommendation to the Working Group—will lead to greater market safety

and soundness, particularly concerning new dealers or end-users entering

the markets.

GAO continues to believe that the Working Group needs a formal

mechanism for monitoring the OTC derivatives markets. This report

recognizes that the federal financial market regulators monitor the OTC

derivatives activities of the firms subject to their respective oversight, and

they discuss market developments of which they become aware through

their joint participation in the Working Group. However, this report also

observes that the agencies that participate in the Working Group do not

routinely collect the information necessary to ensure that they are able to

systematically detect changes in market characteristics. Thus, the Working

Group lacks a formal mechanism for obtaining the necessary information

for monitoring market developments related to sales practices. Such a

mechanism is important because it could alert the Working Group to the

need for reassessing the adequacy of existing sales practice requirements

applicable to OTC derivatives. The information to be assessed could include

the number and types of new dealers and end-users entering the markets,

the types of complex new products being introduced, and changes in the

types or sophistication of end-users to whom products are being

marketed.

Treasury and ISDA also objected to GAO’s recommendation that the Working

Group consider the extent to which it should assist end-users and dealers

in reaching agreement on the nature of their relationship in transactions

involving OTC derivatives. Treasury was concerned that, because such

Page 16 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

relationships are contractual, no single model may be appropriate. ISDA

commented that no need exists for the Working Group to involve itself in

mediating between dealers and end-users, that the involvement of market

participants and regulators to date has been sufficient, and that the issues

involved are complex and federal involvement may not result in an

agreement that is widely accepted. SEC commented that it believes the

Working Group would be willing to hold discussions with end-users and

professional counterparties (dealers); however, it is not necessary for the

government to intervene and define contractual obligations for

professional and sophisticated counterparties. The Federal Reserve noted

that it has recognized the importance of and encouraged voluntary

industry efforts in this area, and the three end-user associations supported

GAO’s recommendation.

GAO continues to support its recommendation that the Working Group

consider assisting market participants in reaching agreement on the nature

of their relationship in OTC derivatives transactions. This report

acknowledges that the issues involved in reaching agreement between

dealers and end-users are complex and may not lend themselves to a

single, widely accepted solution. For this reason, GAO does not intend that

the Working Group impose a model that defines counterparty

relationships in OTC derivatives transactions. However, GAO’s survey

indicated that end-users and dealers do not always agree on the nature of

their relationship, as indicated by the majority of end-users reporting that

dealers had fiduciary responsibilities in some or all OTC derivatives

transactions and that they relied on dealers from some to a very great

extent as part of these transactions. To the extent that the differing views

of end-users and dealers increase the likelihood of sales practice disputes

that expose regulated institutions to material losses or that otherwise

effect the sound financial condition of regulated institutions and the

fairness and integrity of the markets, we concluded that the federal

financial market regulators have an interest in the reconciliation of these

differences.

Treasury officials commented that the draft report appeared to be critical

of establishing an arm’s-length relationship as the default model for OTC

derivatives transactions. ISDA officials supported the arm’s-length

relationship as the default model, noting that it is the appropriate starting

place for institutional market participants. This report does not reach a

conclusion on the appropriate default model for counterparty

relationships. It presents the views of both those who support and oppose

an arm’s-length relationship as the default model. GAO concludes that the

Page 17 GAO/GGD-98-5 OTC Derivatives Sales Practices
Executive Summary

type of relationship and accompanying responsibilities that should prevail

in OTC derivatives transactions should be agreed-upon by market

participants and recommends that the Working Group consider assisting

market participants in reaching agreement on these issues.

The Federal Reserve commented that it has efforts under way that would

fully respond to GAO’s recommendation that the agency revise its

examination guidance to more specifically address the need to assess the

adequacy of banks’ policies and controls related to disclosing risk,

creating advisory relationships, and supervising marketing personnel. In

addressing GAO’s recommendation that SEC and CFTC establish a mechanism

for determining that participating firms are following the sales practice

provisions of the Framework, SEC indicated that it is willing to discuss

with the affected parties the feasibility of extending the external auditor’s

role to incorporate a review of sales practice procedures. This appears to

be an appropriate first step toward implementing GAO’s recommendation.

CFTC did not comment on this recommendation.

Page 18 GAO/GGD-98-5 OTC Derivatives Sales Practices
Page 19 GAO/GGD-98-5 OTC Derivatives Sales Practices
Contents

Executive Summary 2

Chapter 1 

Introduction

26

OTC Derivatives 26

Mortgage-Backed Securities 30

Structured Notes 31

OTC Derivatives, MBS, and Structured Note Markets’ Growth and

Participants’ Activities

32

Sales Practices for OTC Derivatives, MBS, and Structured Notes 34

Various Regulators Oversee the Dealers Marketing OTC

Derivatives, MBS, and Structured Notes

35

Objectives, Scope, and Methodology 37

Chapter 2 

Federal Sales Practice

Requirements Vary by

Product and Dealer

41

Sales Practice Requirements Vary, Depending on the Product 42

Sales Practice Requirements Vary, Depending on the Regulator of

the Dealers’ Activities

49

Chapter 3 

Satisfaction With

Sales Practices Was

High and Disputes

Were Limited, but

When Disputes

Occurred Losses Were

Often Large

57

Most End-Users Were Generally Satisfied With Dealer Sales

Practices

57

Reported Product Usage Varied Across Products and by

Organization Size and Type

63

Sales Practice Concerns Did Not Appear to Be Widespread but

Involved Many Large Losses

71

When They Occurred, Sales Practice-Related Disputes Were

Often Costly to Dealers and End-Users

77

Chapter 4 

Disagreement Over

Counterparty

Responsibilities

Increases the

Potential for Disputes

82

Disputes Have Centered on Counterparty Responsibilities 82

The Potential for Additional Disputes Arises From the Differing

Views of End-Users and Dealers

84

Reconciling the Views of End-Users and Dealers Could Be

Difficult

94

Page 20 GAO/GGD-98-5 OTC Derivatives Sales Practices
Contents

Chapter 5 

Dealers and

End-Users Acted to

Reduce the Potential

for Sales Practice

Disputes, but

Weaknesses Remain

106

Corporate Governance Systems Can Address Sales Practice

Issues

106

Dealers Described Sales Practice Policies and Procedures That

Were Consistent With the Dealer-Issued Guidance

107

Regulatory Examinations Surfaced Dealer Weaknesses 109

End-Users Described a Range of Controls, but Some Lacked

Basic Controls

110

Reviewing Organizations Found That Weaknesses at End-Users

Contributed to Losses

113

Various Organizations Issued Guidance for End-Users 115

Some State Governments Acted to Reduce the Risk of Loss 120

Chapter 6 

Regulators Have

Improved Sales

Practice Oversight of

Regulated Firms, but

Some Weaknesses

Remain

122

Bank Regulators’ Efforts to Oversee Sales Practices Have

Increased, but Updated Federal Reserve Guidance Has Not Yet

Been Issued

123

Jurisdictional and Other Limitations Have Affected Oversight of

Securities Firms’ Sales Practices

127

Chapter 7 

Conclusions and

Recommendations

134

Conclusions 134

Recommendations to the President’s Working Group on Financial

Markets

137

Recommendation to the Federal Reserve 138

Recommendation to SEC and CFTC 138

Agency and Industry Comments and Our Evaluation 138

Appendixes Appendix I: Methodology for GAO Survey of End-Users 144

Appendix II: GAO Survey of Sales Practices for OTC Derivatives,

Structured Notes, and Asset-Backed Securities

176

Appendix III: Comments From the Board of Governors of the

Federal Reserve System

190

Appendix IV: Comments From the Office of the Comptroller of

the Currency

194

Appendix V: Comments From the Securities and Exchange

Commission

195

Page 21 GAO/GGD-98-5 OTC Derivatives Sales Practices
Contents

Appendix VI: Comments From the End-Users of Derivatives

Association

201

Appendix VII: Comments From the Government Finance Officers

Association

204

Appendix VIII: Comments From the International Swaps and

Derivatives Association

216

Appendix IX: Comments From the National Association of State

Auditors, Comptrollers and Treasurers

226

Appendix X: Major Contributors to This Report 230

Tables Table 3.1: Status of Investigations of Dealers by SEC, NASD, and

NYSE From 1993 Through 1996 for Cases Involving MBS and

Structured Notes

75

Table 3.2: Complaints Received by Regulators From 1993

Through 1996 Involving MBS Sales Practices and Total

Complaints for All Products

76

Table 4.1: Key Sales Practice Elements of the Dealer-Issued

Guidance

90

Table 5.1: Key Elements of Various Organizations’ Investment

Guidance for End-Users

117

Table I.1: Design of Potential End-User Sample Frame 146

Table I.2: Disposition of Survey Sample Across All Strata 156

Table I.3: Proportion of Organizations Using OTC Derivatives in

the 12 Months Preceding Receipt of Survey, by Size Category and

Industry Group

163

Table I.4: Proportion of Estimated Total Users Represented by

Each Industry Group

164

Table I.5: Proportion of Organizations Using Plain Vanilla OTC

Derivatives, by Size Category and Industry Group

165

Table I.6: Proportion of Organizations Using More Complex OTC

Derivatives, by Size Category and Industry Group

166

Table I.7: Proportion of Organizations Using MBS, by Size

Category and Industry Group

167

Table I.8: Proportion of Organizations Using Structured Notes, by

Size Category and Industry Group

168

Table I.9: Proportion of Organizations Rating Overall Sales

Practices for Dealers Used, by Product Offered

169

Table I.10: Proportion of Organizations Rating Overall Sales

Practices for Dealers Not Used, by Product Offered

169

Page 22 GAO/GGD-98-5 OTC Derivatives Sales Practices
Contents

Table I.11: Proportion of Organizations Somewhat or Very

Dissatisfied With Disclosure of Downside Risks or Suitability of

Products Proposed, by Dealers Used and Not Used

170

Table I.12: Proportion of End-Users of a Product Who Believed a

Fiduciary Relationship Exists

172

Table I.13: Proportion of End-Users of a Product Who Believed a

Fiduciary Relationship Exists in Some or All Cases, by Industry

Group

173

Table I.14: Proportion of all End-Users of a Product That Relied

on the Dealer for Investment Advice

174

Figures Figure 3.1: Overall Sales Practice Ratings Reported for Dealers

Used and Dealers Not Used, by Product

59

Figure 3.2: Extent of Reported Product Usage Across the

Potential User Population

65

Figure 3.3: Extent of Reported Product Usage, by Organization

Size

66

Figure 3.4: Extent of Reported Product Usage, by Industry 68

Figure 4.1: Extent to Which End-Users Believed Dealers Had a

Fiduciary Relationship

85

Figure 4.2: Extent to Which End-Users Relied on Dealers for

Investment Advice

87

Page 23 GAO/GGD-98-5 OTC Derivatives Sales Practices
Contents

Abbreviations

CEA Commodity Exchange Act

CFTC Commodity Futures Trading Commission

CMO collateralized mortgage obligation

EUDA End-Users of Derivatives Association

GFOA Government Finance Officers Association

GSE government-sponsored enterprise

ISDA International Swaps and Derivatives Association

LDT leveraged derivative transaction

MBS mortgage-backed security

NASAA North American Securities Administrators Association

NASACT National Association of State Auditors, Controllers and

Treasurers

NASD National Association of Securities Dealers

NAST National Association of State Treasurers

NYSE New York Stock Exchange

OCC Office of the Comptroller of the Currency

OTC over-the-counter

REMIC real estate mortgage investment conduit

RSWG Risk Standards Working Group

SEC Securities and Exchange Commission

SRO self-regulatory organization

TMA Treasury Management Association

Page 24 GAO/GGD-98-5 OTC Derivatives Sales Practices
Page 25 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

In 1994, we reported on a number of risks associated with the use of

over-the-counter (OTC) derivatives,1

 but we did not specifically address

sales practice issues. However, since the beginning of 1994, major legal

and regulatory actions have been associated with sales practices for OTC

derivatives, mortgage-backed securities (MBS), and structured notes,

suggesting that the topic deserved closer scrutiny. In addition, we found

that an estimated $11.4 billion in reported losses resulted from

transactions in such products from April 1987 through March 1997—about

$3.2 billion of which involved end-user2

 concerns about dealer3 sales

practices.4

 Federal financial market regulators have an interest in these

markets as a part of their responsibilities for ensuring the soundness of

regulated financial institutions and maintaining the efficiency and stability

of U.S. financial markets. In response to a request by the former Chairman

of the Subcommittee on Telecommunications and Finance, House

Committee on Energy and Commerce, we reviewed sales practices for OTC

derivatives. Because users of MBS and structured notes had also

experienced losses that sometimes involved sales practice disputes, we

expanded our review to include these products.

OTC Derivatives OTC derivatives contracts are privately negotiated outside of an organized

exchange and have a market value determined by the value of an

underlying asset, reference rate, or index (called the underlying).

Underlyings include stocks, bonds, agricultural and other physical

commodities, interest rates, currency exchange rates, and stock indexes.

OTC derivatives are customized to satisfy specific end-user requirements

that cannot always be met by the typically more standardized

1

See Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,

1994). We reported on the status of our recommendations in Financial Derivatives: Actions Taken or

Proposed Since May 1994 (GAO/GGD/AIMD-97-8, Nov. 1, 1996).

2

For simplicity, we use the term “end-user” to refer to counterparties or customers of dealers in

transactions involving OTC derivatives, MBS, and structured notes.

3

Dealers stand ready to act as buyers, sellers, counterparties, or intermediaries for end-users and other

dealers.

4

See chapter 3 for a discussion of how we estimated the amount of reported losses and the amount of

such losses associated with concerns about dealer sales practices.

Page 26 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

exchange-traded derivatives, which include futures5 and options6

contracts. Although the economic terms of OTC derivatives are privately

negotiated, counterparties commonly elect to use standardized contract

language contained in master agreements, such as those developed by the

International Swaps and Derivatives Association (ISDA).7

Both OTC and exchange-traded derivatives are used by firms around the

world to manage market risk8

 by transferring it from entities less willing or

able to manage it to those more willing and able to do so. In transferring

this risk, OTC derivatives counterparties, unlike their U.S. exchange-traded

counterparts,9

 typically remain subject to credit risk—the risk of

counterparty default. Derivatives can be more cost-effective for market

participants than transactions in the underlying cash markets because of

the reduced transaction costs and the leverage10 that derivatives provide.

These benefits do not come without risk because using OTC derivatives,

similar to using other financial products, can result in losses from adverse

market movements, credit defaults, or operations errors.

As discussed in the following sections, the basic types of OTC derivatives

are forwards, options, and swaps. These basic products can be combined

with each other in a multitude of ways or with other financial products to

create more complex OTC derivatives.

Forwards Forwards are OTC contracts that obligate the holder to buy or sell a

specific underlying at an agreed-upon price, quantity, and date in the

future. The price of each forward contract may be agreed upon in advance

5

Futures contracts obligate the holder to buy or sell a specific amount or value of an underlying asset,

reference rate, or index at a specified price on a specified future date.

6

Options (American-style) give the purchaser the right, but not the obligation, to buy (call option) or

sell (put option) a specified quantity of a commodity or financial asset, or to settle for its cash value, at

a particular price (the exercise or strike price) on or before a specified future date. For this right, the

purchaser pays the seller (writer) an amount called the option premium. A European-style option can

only be exercised on its expiration date. Options may be traded on an exchange or OTC.

7

ISDA is a trade association that represents 318 members worldwide. Its primary membership includes

183 dealers.

8

Market risk is the exposure to the possibility of financial loss caused by adverse changes in the values

of assets or liabilities.

9

For exchange-traded derivatives, credit risk is borne by clearinghouses that serve as intermediaries

between the parties to all transactions by becoming the buyer to every seller and the seller to every

buyer. Clearinghouses guarantee the performance of exchange-traded contracts so that parties to

these transactions do not have to evaluate the creditworthiness of each other.

10Leverage is possible when the capital needed to own, control, or receive financial gains from an

investment is less than the investment’s full value. Derivatives provide leverage because they require

less capital than that needed to directly participate in the underlying markets. Greater leverage results

in the possibility of greater gains or losses relative to capital.

Page 27 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

or determined at the time of delivery. Forward contracts exist for many

underlyings, including traditional agricultural or physical commodities, as

well as for currencies (referred to as foreign exchange forwards) and

interest rates (referred to as forward rate agreements). Market

participants can use forwards to protect their assets and liabilities against

the risks associated with rate and price movements, called hedging, or to

profit from correctly anticipating rate and price movements. Generally,

counterparties to forwards intend either to make or take delivery of the

underlying.

OTC Options OTC options are privately negotiated contracts that can be used for hedging

or to profit from correctly anticipating rate and price movements. OTC

option contracts also exist for many underlyings, including commodities,

currencies, interest rates, and equities. Like other OTC derivatives, OTC

options are designed to satisfy specific end-user requirements because

specific terms, such as the exercise price, maturity date, and type of

underlying, are negotiated.

Swaps Swaps are OTC agreements that typically require counterparties to make

periodic payments to each other for a specified period. The calculation of

these payments is based on an agreed-upon amount, called the notional

amount, that generally is exchanged only in currency swaps.11 The

periodic payments may be a fixed or floating (variable) amount. Floating

payments may change with fluctuations in interest or currency rates or

equity or commodity prices, depending on the contract terms. Swaps are

used to hedge a risk or obtain more desirable financing terms, and they

can be used to profit from correctly anticipating rate and price

movements.

Plain Vanilla OTC

Derivatives

The simplest derivatives, such as the basic forwards, options, and swaps

previously described, are generally called plain vanilla. These OTC

derivatives are typically offered by many dealers due to their relative

simplicity. As a result, dealer price quotes tend to be very

competitive—falling within a narrow range. Also, the price at which

dealers are willing to enter into plain vanilla derivatives—the bid-ask

11When the notional amount is not exchanged, it is not a measure of the amount at risk in a

transaction.

Page 28 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

spread12—tends to be narrow. Furthermore, large transactions can be

executed through one dealer at a single price. Therefore, through the

availability of dealers, liquidity is provided for plain vanilla OTC derivatives.

Although no official data are available, according to some dealers, plain

vanilla OTC derivatives account for 80 to 90 percent of all OTC derivatives

activity.

More Complex OTC

Derivatives

In contrast to plain vanilla OTC derivatives, the more complex OTC

derivatives have features that may make them more difficult to value.

Their values may be based on, or derived from, more than one underlying

asset, reference rate, or index. An example of a more complex OTC

derivative is a “rainbow call option,” whose value is based on the highest

1-year yield available from among four underlyings—cash, the 10-year U.S.

Treasury note, the 30-year U.S. Treasury bond, and the Standard & Poor’s

500 Index.13 Unlike plain vanilla interest rate swaps in which the notional

amount remains constant to maturity, this amount may change during the

life of more complex swaps. Some OTC derivatives may be complex

because they contain, or have embedded in them, other derivatives—for

example, a swap with an embedded option that grants the holder the right,

but not the obligation, to terminate the swap contract at some future time.

Complex OTC derivatives may have other features, such as a multiplier that

magnifies the effect of a price movement in the underlying.

In contrast to plain vanilla OTC derivatives, more complex OTC derivatives

are offered by fewer dealers, or they may even be the creation, or

proprietary product, of one dealer. Fewer dealers means less liquidity and

wider bid-ask spreads, making it more difficult to offset14 or unwind15 an

earlier transaction at a favorable price. Also, an end-user may find it

difficult to independently determine the price or value of a complex OTC

derivative that has very complicated terms or that is the proprietary

product of one dealer. End-users may attempt to determine the market

price of OTC derivatives on the basis of a model. However, the resulting

12The bid-ask spread is the difference between the highest price a buyer will pay and the lowest price a

seller will accept for a particular product.

13The Standard & Poor’s 500 Index measures the performance of 500 common stocks.

14Offset of an OTC derivatives contract occurs when a market participant enters into an equal but

opposite contract. Entering into an equal but opposite contract with the same counterparty eliminates

the market and credit risks associated with the original contract. Doing so with a different

counterparty eliminates the market risk but not the credit and other risks associated with carrying two

contracts.

15Unwind of an OTC derivatives contract occurs when the counterparties agree to settle or terminate

the original contract or assign one party’s contractual obligations to a new party.

Page 29 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

price may not correspond closely to what would actually occur in the

marketplace, assuming a buyer or seller could be found. The large fees

that some more complex OTC derivatives transactions generate are an

economic incentive for dealers to develop new products and refine

existing products developed by other dealers.

Mortgage-Backed

Securities

MBS are debt securities that are created from residential mortgages. They

are backed (collateralized) by pools (groups) of mortgages, most of which

are 30-year obligations.16 The process of pooling mortgages and using

them to back a new issue of securities is called securitization.17 Investors

in MBS are entitled to receive a portion of the interest and principal

payments generated by the mortgage pool. MBS provide funds to the

mortgage market by enabling mortgage lenders to sell the mortgages that

they originate, thereby replenishing their funds for additional mortgage

lending. MBS effectively expand funds available for housing by attracting

investors in mortgage loans.

MBS consist of mortgage pass-through securities (also called

mortgage-backed certificates) and collateralized mortgage obligations

(CMO).18 Mortgage pass-through securities entitle investors to share on a

pro rata basis in all principal and interest payments received from the

mortgage pool. CMOs, which are a form of multiple-class securities, entitle

investors to share in principal and interest payments in accordance with a

payment schedule. The payment schedule may divide the mortgage pool

into classes, called tranches, and specify the order in which the tranches

are to receive principal and interest payments. CMO tranches receiving the

earliest payments, by design, contain less risk than is found in simple

mortgage pass-through securities. However, the creation of these relatively

16Mortgages may be pooled according to a common characteristic such as their maturity date, as in a

pool of 30-year mortgages.

17Technically, MBS are a subset of asset-backed securities, which is a term that is used to describe

securities created from securitized assets. In addition to mortgages, other types of assets that are

securitized in creating asset-backed securities include auto loans, credit card receivables, equipment

leases, and corporate bonds. Because market participants distinguish MBS from all other asset-backed

products, this report follows that convention.

18The term “CMO” is commonly used to refer to both CMOs and real estate mortgage investment

conduits (REMIC). Unlike other CMOs, REMICs allow investors to select securities containing the

desired levels of risk. This greater selection is possible because REMIC mortgage pools are separated

by maturity and credit risk classes, while other CMO mortgage pools are separated only by maturity

class. REMIC mortgage pools may contain mortgages of lesser credit quality, while other CMO

mortgage pools generally consist of top quality mortgages. As a result, REMICs receive a range of

credit ratings, whereas other CMOs normally receive the highest ratings. The overwhelming majority

of multiple-class MBS are REMICs.

Page 30 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

safe and stable tranches requires the creation of more risky tranches that

can be highly volatile in price.

Structured Notes Structured notes are debt securities19 that combine elements of traditional

debt instruments and OTC derivatives.20 Interest payments for traditional

debt instruments are generally either a stated fixed amount or a variable

amount that is based on fluctuations in a specified interest rate. In

contrast, the interest and/or principal payments for structured notes may

be linked to two or more specified interest or currency rates, or to equity

or commodity prices. Structured notes may contain precise formulas

describing how these payments are tied to such rates and prices and how

they are to be computed. For example, a more complex type of structured

note, the inverse floater (also called an inverse floating rate note) pays

investors a rate of interest that moves in the opposite direction of a

specific market interest rate. Because its value tends to move in the

opposite direction of other debt instruments, the inverse floating rate is

often used for hedging. Inverse floating rate notes typically contain

options that effectively set maximum and minimum rates that will be paid

to holders.

Structured notes may also have OTC derivatives embedded in them, such as

forwards, options, and swaps. By combining debt and OTC derivatives into

a single product, structured notes can provide a more efficient and

economic means of managing certain risks than debt and OTC derivatives

as separate products. For example, a company can, by purchasing a

structured note, limit its credit risk to one party (the issuer) and limit its

risk management costs to one product.

Structured notes can be attractive both to investors and issuers. They can

be customized to meet investors’ preferences for risk and return. Such

customization, which is hard to replicate with traditional debt securities,

19To the extent that structured notes are hybrid financial instruments, they can be futures or

commodity option contracts if they do not meet the terms and conditions of the Commodity Futures

Trading Commission’s hybrid instrument exemption (17 C.F.R. Part 34). A hybrid financial instrument

possesses, in varying combinations, characteristics of forwards, futures, options, securities, and/or

bank deposits. Unlike many other derivatives, hybrid financial instruments generally serve a

capital-raising function. For the purpose of this report, we assume that structured notes meet the

conditions of the Commodity Futures Trading Commission’s hybrid instrument exemption and,

therefore, are securities and not futures.

20A universally accepted definition of structured notes does not exist. For example, the Federal

National Mortgage Association and the Federal Home Loan Bank (the central credit system for savings

and loan institutions) differ on the types of callable debt they consider to be structured notes. Also,

certain other market participants consider all callable debt to be structured notes because the callable

feature is an embedded call option.

Page 31 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

can be attractive to investors seeking to hedge their unique risks or

possibly earn greater returns than those offered by traditional debt

securities.21 The customization is not needed by issuers but is offered to

attract investors. Structured notes can be attractive to issuers seeking to

lower their cost of capital through access to cheaper financing sources.

However, the customized features, though attractive to investors, can

contain rate and price risks that are unwanted by the issuer. To offset such

unwanted risks, issuers can enter into swaps or options with dealers at the

time of issuance. Structured notes are generally of high credit quality

because most are issued by highly rated (AAA/Aaa or AA/Aa)22

corporations or government-sponsored enterprises (GSE)23 and, therefore,

are considered by market participants to have minimal credit risk.

OTC Derivatives,

MBS, and Structured

Note Markets’ Growth

and Participants’

Activities

Growth in the OTC derivatives market has continued since 1993 because of

the popularity of plain vanilla products, which continue to dominate the

market relative to more complex products. In contrast, the MBS market and

the largest segment of the structured note market experienced significant

declines between 1993 and 1995, but they are now showing signs of

recovery. OTC derivatives market participants include dealers and

end-users. In addition to these participants, the MBS and structured note

markets include issuers and underwriters. Various types of financial

institutions market OTC derivatives, MBS, and structured notes.

Market Growth According to the most recent global survey by the Bank for International

Settlements,24 the notional/contract amount outstanding of OTC derivatives

was estimated at $47.5 trillion worldwide and $11 trillion in the United

21Structured notes also may be preferred by some market participants over traditional debt and

derivatives because of certain accounting, regulatory, or tax considerations that are beyond the scope

of this report.

22According to major credit rating agencies—Standard & Poor’s and Moody’s—AAA/Aaa are the

highest credit ratings, indicating that the capacity to repay debt is extremely strong. AA/Aa indicate a

very strong capacity to repay, differing from AAA/Aaa by only a small degree.

23GSEs are privately owned financial intermediaries established pursuant to federal law to facilitate

lending for purposes that the federal government has deemed socially important, such as education,

agriculture, and housing.

24The Bank for International Settlements, among other functions, provides a forum for cooperative

efforts by the central banks of major industrial countries.

Page 32 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

States, as of March 31, 1995.25 MBS issuances26 grew from $371 billion in

1990 to a peak of $991 billion in 1993. MBS issuances then declined 45

percent between 1993 and 1994 to $541 billion and declined another 40

percent between 1994 and 1995 to $326 billion. However, total issuances

for 1996 grew to $474 billion.

Structured note issuances grew each year between 1990 and 1994, which is

the last year for which we were able to obtain estimates for corporations.27

Structured note issuances for both GSEs and corporations were estimated

to be $18 billion in 1990 and $92 billion in 1994. Structured note issuances

by GSEs alone were estimated to be $44 billion in 1993. In 1994, they were

estimated to be $40 billion and accounted for 43 percent of the estimated

structured note issuances for that year. However, in 1995, GSE-issued

structured notes declined by 75 percent to $10 billion. This decline was

consistent with the significant drop in overall structured note activity that

market participants told us they experienced or witnessed that year. In

1996, GSE-issued structured notes, though still below the peak reached in

1993, increased to $12 billion.

The Nature and Extent of

Issuer, Underwriter, and

Dealer Activities

MBS and structured notes are similar to other securities, such as stocks and

bonds, in that they are issued—created and sold to investors—to raise

capital. Securities underwriting is a capital-raising activity that involves

distributing newly issued stocks and bonds as well as MBS and structured

notes, and it is a major function of securities firms and some banks. Often,

individual underwriters join with other underwriters and form

underwriting groups, or syndicates, to handle a new issue. As

underwriters, these firms agree to offer the securities of the issuer to other

investors in two different ways. One way that underwriters agree to issue

securities is on a “firm commitment” basis, whereby the underwriting firm

agrees to accept all of the issued securities from the issuing entity. If all of

25Central Bank Survey of Foreign Exchange and Derivatives Market Activity 1995, Monetary and

Economic Department, Bank for International Settlements (Basle, Switzerland: May 1996). The Bank

for International Settlements conducts this comprehensive survey every 3 years and these amounts

represent the most current data available. As previously discussed, the notional amount does not

measure the amount at risk in derivatives transactions. According to the Federal Reserve, the amount

at risk, as measured by the gross market value of OTC derivatives outstanding, was $328 billion for

U.S. entities, as of March 1995, or about 3 percent of the notional/contract amount. (The gross market

value is the cost that would be incurred if the outstanding contracts were replaced at prevailing

market prices.)

26Issuances are not the same as trading volume. Issued securities are counted only once in issuance

statistics, but may be counted more than once in trading volume to reflect each change in ownership.

27The data do not include structured notes issued by foreign corporations and foreign banks,

structured certificates of deposit, structured commercial paper, or structured notes issued in the

European medium-term note market. Our data sources were Bloomberg Financial Markets and the

Journal of Applied Corporate Finance.

Page 33 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

the securities are not sold to other dealers or investors, the firms

underwriting the issue will own the unsold portion of the issuance.

Underwriters can also agree to offer securities on a “best efforts” basis,

whereby any portion of the issuance that is not purchased by other dealers

or investors is returned to the issuing entity.

Various Types of

Institutions Actively

Market OTC Derivatives,

MBS, and Structured Notes

Dealers from various industries market OTC derivatives, MBS, and

structured notes. Data on the total number of banks, securities firms, and

other dealers of OTC derivative products were not available. In the United

States, banks account for the majority of OTC derivatives volume. In 1996,

the top 10 bank holding companies28 in terms of assets, all of which

market these products, accounted for about 94 percent of the total volume

of OTC derivatives held by all banks. Regulated broker-dealers market OTC

derivatives.29 In addition, the affiliates of some securities firms actively

market nonsecurities OTC derivatives, with the affiliates of six of the

largest firms being the most active. Insurance company affiliates are also

somewhat active, with three affiliates actively marketing nonsecurities OTC

derivatives in volumes comparable to that of some of the securities firm

affiliates. Together, these dealers conduct thousands of OTC derivatives

transactions annually. Complete statistics are not available on the total

number of dealers marketing MBS and structured notes, but regulators

estimated that hundreds of financial institutions market these products.

Securities firms account for the largest volumes, but banks and bank

affiliates also market MBS and structured notes.

Sales Practices for

OTC Derivatives,

MBS, and Structured

Notes

The sales practices that dealers use to market OTC derivatives, MBS, and

structured notes can involve various activities. For example, in discussing

potential transactions, dealers may attempt to determine whether a

particular product is appropriate or suitable for the end-user by

considering several factors, such as the product’s complexity relative to

the end-user’s sophistication as well as the end-user’s risk management

needs or investment objectives. Dealers may also make disclosures about

the product’s benefits and risks, such as how the product’s value may be

favorably or adversely affected by changes in interest rates or foreign

exchange rates. This information is sometimes provided to an end-user as

part of a “term sheet” that outlines the relevant terms of the transaction,

including price, quantity, and maturity dates, and that may also be

28Bank holding companies are corporations that own one or more banks.

29Broker-dealers are agents that handle public orders to buy and sell securities. They act as principals

that buy and sell securities for their own accounts.

Page 34 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

included as a part of the confirmation materials that document the

transaction.

Another aspect of marketing these products is the establishment of the

transaction price. The transaction price is usually negotiated between the

dealer and the end-user and can be influenced by market conditions and

other factors, including whether the end-user has other business

transactions with the dealer, such as loans or securities underwriting.

After a transaction is entered into, the dealer may be asked to periodically

assist the end-user in determining the current value of the product.

End-users are less likely to need such assistance for plain vanilla OTC

derivatives that have readily available dealer price quotes or for certain

MBS products that have an active secondary market. Dealers may also be

asked to unwind an OTC derivatives contract, and this may require one

party to pay the other an amount representing any change in the contract’s

market value.

The nature of the relationship and expectations between dealers and

end-users can vary, depending on the product involved. OTC derivatives

transactions create obligations between counterparties that continue over

the life of the contracts, and thus involve counterparty credit risk. Because

of counterparty credit risk, dealers and end-users of OTC derivatives

usually seek to enter into transactions with credit-worthy counterparties.

Such creditworthiness concerns are important because the counterparties

to a swap, for example, are obligated to exchange periodic payments over

the life of the contract. Therefore, until the contract matures, each party is

at risk that the other may not fully meet its obligations. In contrast, some

securities transactions, including those in MBS and structured notes,

involve a change in ownership, and thus no additional obligations would

exist between the dealer and end-user.

Various Regulators

Oversee the Dealers

Marketing OTC

Derivatives, MBS, and

Structured Notes

The dealers of OTC derivatives, MBS, and structured notes may be subject to

oversight by various federal or other regulatory bodies.30 Bank dealers are

generally overseen by either the Federal Reserve System, which oversees

the bank holding companies and state-chartered banks that are its

members, or the Office of the Comptroller of the Currency (OCC), which

oversees nationally chartered banks. Of the 10 largest bank OTC derivatives

dealers as of 1996, 3 are overseen by the Federal Reserve and 7 are

overseen by OCC. In addition, many banks have established separate legal

30State agencies also oversee banking, securities, and insurance activities, although this report does

not address such oversight in detail.

Page 35 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

entities to conduct securities activities, including marketing MBS and

structured notes, and these entities are also subject to oversight by the

Securities and Exchange Commission (SEC). Banks can also conduct

limited securities activities—primarily in securities issued by the U.S.

government, GSEs, or certain state or local governments—from the banking

entity itself.

As previously noted, the activities of dealers marketing OTC derivatives

that are securities as well as those marketing MBS and structured notes are

overseen by SEC. The activities of dealers marketing OTC derivatives that

are determined to be futures are subject to the Commodity Futures

Trading Commission’s (CFTC) oversight. Firms that market securities must

do so from an entity registered with SEC and subject to various regulations,

such as regulations requiring minimum levels of capital. In addition, firms

offering futures and commodity options to the public must register with

CFTC and comply with the Commodity Exchange Act (CEA) and regulations

promulgated under the act, unless otherwise exempted.

Registered securities and futures firms are also required to join and

subject themselves to the rules and requirements of a self-regulatory

organization (SRO).31 Such SROs also impose sales practice-related

requirements on their members. Most OTC derivatives are not considered

to be securities or futures by the dealers offering them. Nonsecurities and

nonfutures activities may be conducted in a subsidiary separate from the

regulated entity. Consequently, securities and futures firms typically

conduct their nonsecurities and nonfutures OTC derivatives activities

outside of their registered entities in affiliates that are not subject to SEC or

CFTC regulation. CFTC has also exempted swaps and certain other OTC

derivatives from the requirement that such activities be conducted in an

affiliate subject to its regulation, but CFTC has retained the authority to

take action against fraudulent conduct involving exempted products that

are futures. (Ch. 2 discusses the regulatory framework for OTC derivatives,

MBS, and structured notes in greater detail.)

In addition to working individually, the federal financial market regulators

also work collectively to address issues relating to the financial markets.

The heads of the Department of the Treasury, CFTC, the Federal Reserve,

and SEC comprise the President’s Working Group on Financial Markets.

Staffs from OCC and other regulatory agencies also participate in this

group’s activities. The Working Group was established after the 1987

31SROs play an extensive role in the regulation of the U.S. securities and futures industries. SROs

include all of the U.S. securities and commodities exchanges, the National Association of Securities

Dealers, the National Futures Association, and the Municipal Securities Rulemaking Board.

Page 36 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

market crash to address issues concerning the competitiveness, integrity,

and efficiency of the financial markets, and it is chaired by the Secretary of

the Treasury. The Working Group meets periodically to share information

and to coordinate regulatory policies and activities, and it also meets on

those matters relating to OTC derivatives.

Objectives, Scope,

and Methodology

To address congressional concerns associated with sales practices for OTC

derivatives, MBS, and structured notes, our objectives were to analyze

(1) the federal sales practice requirements applicable to these products

and the dealers marketing them; (2) the extent of end-user satisfaction

with sales practices, product use, and related disputes and the costs of

these disputes; (3) the views of end-users and dealers on the nature of

their relationship and responsibilities; (4) the actions dealers and

end-users have taken to reduce the potential for sales practice disputes;

and (5) the actions regulators have taken to address sales practice issues.

To analyze federal sales practice requirements applicable to these

products and the dealers marketing them, we reviewed federal laws and

regulations related to sales practices and discussed them with federal

financial market regulators. We also reviewed the proposed and final rule

issued jointly by the three federal bank regulators32 regarding bank sales

of government securities, which include MBS and structured notes issued

by GSEs. In addition, we reviewed the sales practice guidance provided by

federal bank regulators for their examiners and the dealers they oversee.

To analyze the extent of end-user satisfaction with sales practices

involving OTC derivatives, MBS, and structured notes, we sent

questionnaires to the financial officers of nearly 2,400 randomly selected

U.S. organizations in 1995.33 Using the best information we could identify,

we constructed a universe of over 49,000 public-sector and private-sector

U.S. organizations that might be using these products,34 including not only

the largest organizations, which were determined on the basis of financial

32The three federal commercial bank regulators are the Federal Deposit Insurance Corporation (which

oversees state-chartered banks that are not members of the Federal Reserve System), the Federal

Reserve System, and OCC.

33Our survey also included a request for data on asset-backed securities, but because of the relative

absence of reported sales practice problems associated with these products, we do not report our

survey results for these products, except when they cannot be separated from those for MBS. See

appendix I for more details on the survey design, methodology, and results, and see appendix II for a

reprint of the survey questionnaire.

34See appendix I for a discussion of how we determined which organizations might be using OTC

derivatives, MBS, and structured notes.

Page 37 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

or other measures of size, but also the smaller organizations in each

industry. Our sample was drawn from 19 populations of such

organizations. Some of these 19 populations were divided into 2 or more

strata on the basis of an appropriate measure of organization size—such

as assets, revenues, student enrollment, or census counts. Our

questionnaire requested data on the use of these products within the 12

months preceding the survey.

Our questionnaire asked organizations to rate the sales practices of

dealers with whom they entered into contracts across the following six

dimensions: (1) disclosure of downside risks, (2) quality of transaction

documentation provided, (3) suitability of products proposed,

(4) competitiveness of pricing and fees, (5) provision of accurate

mark-to-market35 pricing information, and (6) assistance in unwinding

transactions. Our questionnaire also asked the organizations to separately

rate the sales practices of dealers that proposed contracts but who they

did not use for the three applicable dimensions listed above—(1), (3), and

(4). We developed these sales practice dimensions on the basis of reviews

of regulatory and dealer documents and discussions with regulators,

dealers, and end-users. We also asked the organizations to provide overall

ratings of sales practices both for dealers with whom the organizations

entered into contracts as well as dealers that proposed contracts but who

they did not use.

To analyze the extent of product use, we evaluated the approximately

1,800 responses received to our questionnaire. We developed statistically

valid estimates of the extent of each product’s use across all 19

populations, subject to a 95-percent confidence level, unless otherwise

indicated. We compared our results to regulatory data and 27 other recent

studies that reported rates of OTC derivatives usage. We also compared our

survey results regarding the reasons derivatives were used to studies by

other organizations.

To analyze the extent of sales practice disputes between end-users and

dealers and the costs of these disputes, we collected data on investigations

by securities regulators and on complaints these organizations received in

the 4-year period from January 1993 through December 1996. We also

reviewed reports and findings of federal regulators and state audit

departments for cases where an end-user incurred a loss and subsequently

alleged deficient dealer sales practices. Additionally, we used public and

35Marking to market is the practice of periodically adjusting the valuation of an asset or liability to

reflect current market values.

Page 38 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

nonpublic information to compile a list of entities that were known to

have incurred losses on OTC derivatives, MBS, or structured notes, and we

attempted to identify those cases where sales practice allegations had

been raised.

To analyze the views of end-users and dealers on the nature of their

relationship and responsibilities, we evaluated the responses of survey

respondents who reported being satisfied as well as those who expressed

being dissatisfied with dealer sales practices. We also interviewed by

telephone 50 survey respondents, including about one-half of whom

expressed satisfaction and about one-half of whom expressed general

dissatisfaction with dealer sales practices. The respondents were

judgmentally selected from the industries we surveyed to include large

and small organizations and users of OTC derivatives, MBS, and structured

notes as well as nonusers that had heard sales presentations. The

interviews were performed, among other reasons, to learn more about

(1) why end-users were satisfied or dissatisfied with dealer sales practices

and (2) what opinions end-users had on fiduciary relationships.

In addition, we analyzed two sets of voluntary guidance prepared by two

dealer groups that address sales practice issues. We also reviewed

comments on this voluntary guidance made by end-user associations, legal

experts, the U.S. Department of Labor, and others. Finally, we attended

industry conferences; reviewed conference documents, court cases, and

congressional testimony; and interviewed dealer, end-user, and federal and

state regulatory officials regarding the relationship and responsibilities of

dealers and end-users in OTC derivatives transactions.

To analyze the actions that dealers and end-users have taken to reduce the

potential for sales practice disputes, we interviewed 14 dealers active in

marketing OTC derivatives, MBS, and structured notes, including securities

firms, banks, and insurance companies; 15 small, medium, and large

end-users; 11 dealer and end-user associations; and 5 U.S. federal

regulators. We interviewed the end-users and dealers regarding their

internal controls and the practices they used to reduce the likelihood of

sales practice disputes. In addition, we reviewed studies by other

organizations that surveyed end-user management practices and internal

controls for OTC derivatives, MBS, and structured notes. We also

interviewed regulators and reviewed regulatory examination results

regarding weaknesses they identified in policies, procedures, and

practices that could lead to sales practice disputes. Furthermore, we

reviewed end-user association guidance to members regarding the policies

Page 39 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1 

Introduction

and practices that should be in place before using these products. Finally,

we reviewed state legislation whose goal was to minimize the risks that

OTC derivatives, MBS, and structured notes pose to governments at the state

level or lower and that was enacted by 14 states between January 1994 and

September 1996.

To analyze the actions that regulators have taken to address sales practice

issues, we interviewed federal financial market regulators. We also

reviewed the examination reports and supporting workpapers for the

special examinations of the seven largest banks marketing OTC derivatives,

MBS, and structured notes. These special examinations were conducted by

OCC and the Federal Reserve from mid-1994 through mid-1995. We

reviewed the guidance provided by federal bank regulators for their

examiners and the dealers they oversee that addresses sales practices and

overall risk management responsibilities. We also reviewed congressional

testimony, examination policies, guidance, procedures, workpapers, and

reports pertaining to the marketing of these products.

We did our work in Chicago, Cincinnati, Dallas, Los Angeles, Minneapolis,

and Washington, D.C., between June 1994 and August 1997 in accordance

with generally accepted government auditing standards. We requested

comments on a draft of this report from the heads, or their designees, of

CFTC, the Department of the Treasury, the Federal Reserve Board, OCC, SEC,

the National Association of Securities Dealers (NASD), and the New York

Stock Exchange (NYSE). We also requested comments from the End-Users

of Derivatives Association (EUDA),36 the Government Finance Officers

Association (GFOA),37 ISDA, and the National Association of State Auditors,

Controllers and Treasurers (NASACT).38 The nontechnical comments from

these organizations are presented and evaluated at the end of chapter 7

and are reprinted along with additional responses in appendixes III

through IX.

36EUDA monitors and provides educational material to members on legal, tax, regulatory, and

accounting issues affecting OTC derivatives, GSEs, and financial institutions.

37GFOA represents approximately 13,000 finance officers from federal, state, provincial, and local

governmental entities in the United States and Canada.

38The National Association of State Auditors, Comptrollers and Treasurers represents the fiscal and

auditing professionsals of state governments and provides for information sharing, training, and policy

formulation.

Page 40 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary by

Product and Dealer

The federal sales practice requirements designed to protect end-users of

OTC derivatives vary, depending, in part, on whether the specific product in

question is a security, a futures contract, or neither product. If an OTC

derivative falls within the definition of a security or futures contract, the

transaction is subject to the applicable sections of the federal laws

governing the sale of those products. Although it is not always clear which

OTC derivatives fall within these definitions, SEC and CFTC agreed that one

dealer’s sales practices related to certain OTC derivatives warranted action,

and they cooperated in taking enforcement action against the dealer. If an

OTC derivative is not covered by the federal securities or commodities

laws, an end-user with a sales practice complaint would need to seek

redress against a dealer by asserting primarily state statutory or common

law claims.1

 In contrast to OTC derivatives, MBS and structured notes are

typically securities; therefore, their sale is subject to the federal securities

laws, except when exempted from specific provisions.

The sales practice requirements that a dealer must follow when marketing

OTC derivatives in the United States also vary, depending on which

regulator, if any, oversees its activities. If the dealer is a bank, all of its

activities are subject to oversight by one of the federal regulatory agencies

responsible for ensuring that banks are appropriately managing their risks.

Unlike the requirements applicable to securities, which are intended to

protect investors, the requirements placed on banks marketing OTC

derivatives are intended primarily to limit the risk that such activities pose

to a bank. Securities and futures firms, as well as insurance companies,

that offer nonsecurities and nonfutures OTC derivatives typically do so

from affiliates that are not subject to direct regulatory oversight.2

However, should SEC or CFTC determine that a specific OTC derivatives

transaction is a security or a futures contract, the transaction would be

subject to the respective regulator’s jurisdiction, absent an agency

exemption or a successful court challenge. Members of the President’s

Working Group on Financial Markets have stated that the scope of SEC and

CFTC authority and existing sales practice requirements are adequate to

protect the markets and OTC derivatives end-users.

1

Common law is derived from judicial decisions, rather than from statute.

2

Firms would also typically market OTC derivatives that CFTC has exempted from most provisions of

the CEA from these unregulated affiliates.

Page 41 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

Sales Practice

Requirements Vary,

Depending on the

Product

The sales practice requirements designed to protect end-users of OTC

derivatives vary. Some OTC derivatives are subject to the requirements

found in the securities laws, including their antifraud provisions and SRO

rules. Some OTC derivatives may be subject to similar requirements found

in the laws applicable to futures trading in the United States. When federal

laws do not apply, disputes involving OTC derivatives would need to be

addressed by asserting primarily state statutory or common law claims,

such as fraud or breach of fiduciary duty. In comparison, dealers

marketing MBS and structured notes that are securities must comply with

the federal securities laws.

Some OTC Derivatives Are

Subject to the Federal

Securities Laws

OTC derivatives that are securities are subject to the sales practice

requirements in the federal securities laws that SEC administers. OTC

derivatives that are considered to be securities include OTC options on

securities, including options on stock indexes. However, such OTC

derivatives represent a small portion of the overall volume of these

products. According to the most recent global survey by the Bank for

International Settlements, the notional amount of equity OTC

derivatives—which would include products either previously determined

or likely considered to be securities—was $579 billion, or 1.4 percent of

the total OTC derivatives contracts outstanding (net of local and

cross-border double-counting), at the end of March 1995. The gross market

value for equity derivatives was $50 billion, or 2.8 percent of the total OTC

derivatives contracts outstanding, at the end of March 1995. Although SEC

could not provide comparable data on the extent to which U.S.

broker-dealers market OTC derivatives that are securities, an SEC official

confirmed that the percentage of such U.S. firms’ activities were likely to

be similar to those identified in the Bank for International Settlements

survey.

The sale of any OTC derivative contract that is considered to be a security

is subject to the antifraud provisions of the securities laws that are

intended to protect customers and to foster market integrity by prohibiting

fraudulent conduct in securities transactions.3

 A dealer can violate these

antifraud provisions by making material misstatements about the security

being recommended or misleading a customer by omitting information

material to the transaction. Under the authority granted by these laws, SEC

can act against dealers or their personnel for violating these provisions,

including imposing fines on them, restricting their activities, or revoking

3

As indicated in chapter 1, all of a firm’s activities in securities must be conducted in an affiliate

registered with SEC as a broker-dealer and subject to that agency’s oversight as well as to the rules

and oversight of one or more securities industry SROs.

Page 42 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

their registration. An end-user may also bring a civil action for a violation

of these laws and seek rescission (or undoing of the transaction) or

damages.

In addition to complying with the securities laws, dealers marketing OTC

derivative securities must comply with the requirements of the securities

industry SROs of which they are members.4

 For example, NASD’s members

offering securities to the public must comply with its Conduct Rules.5

These rules, among other things, require that a dealer, before

recommending a product to an end-user, obtain and evaluate information

about the end-user’s financial condition and investment objectives to

ensure that the product is suitable. (A recently issued NASD rule

interpretation that discusses dealers’ responsibilities relating to

institutional end-users is discussed below.)

The extent to which some OTC derivatives are securities and, therefore,

subject to the securities laws is not always clear. SEC officials told us that,

as a matter of policy, the agency does not limit its authority by delineating

categories of OTC derivatives that are not securities. Relative certainty

exists for options on securities, which are considered to be securities

under the securities laws. For other OTC derivative products, case-by-case

determinations are made. SEC officials said that the agency responds, when

requested, to dealer inquiries about whether SEC would consider a specific

proprietary OTC derivative contract to be a security. In other cases, dealers

independently evaluate the characteristics of individual OTC derivative

products to determine whether the products meet the definition of a

security as defined in the securities laws. However, when dealers conduct

activities in products on the basis of their own determination that the

product involved is not a security, SEC or a court may later disagree with

their determination. Even if a product meets the definition of a security,

SEC officials told us that they can exempt products from various provisions

of the securities laws, although, according to agency officials, the agency

has never exempted any product from the antifraud provisions of these

laws.6

4

These suitability requirements and SRO activities to enforce them are discussed in chapter 6.

5

Until July 1996, these Conduct Rules were known as Rules of Fair Practice.

6

Similarly, except for certain energy products, CFTC officials indicated that their agency has not

exempted any products from the antifraud provisions of the CEA.

Page 43 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

In cooperation with CFTC, SEC took action under the securities laws against

Bankers Trust,7

 in 1994, for its conduct in transactions with Gibson

Greetings, Inc., involving two OTC derivatives contracts. In acting against

Bankers Trust, SEC found that the two transactions involved were

securities because they were options on U.S. Treasury securities.8

Accordingly, SEC found that Bankers Trust violated various sections of the

securities laws, including making false statements or omissions in the sale

of securities, supplying materially inaccurate valuations of derivatives

transactions, and failing to supervise marketing personnel.9

Some OTC Derivatives Are

Subject to the Federal

Commodities Laws

Some OTC derivatives are subject to the CEA, which governs futures trading

in the United States and which is administered by CFTC. U.S. firms offering

futures and certain options10 contracts to the public must register with

CFTC and comply with the CEA and regulations promulgated under the act

as well as with applicable SRO rules. The CEA provides various sales

practice-related requirements that must be adhered to by these and other

firms offering such products, unless otherwise exempted from such

requirements. When establishing accounts, firms are required by SRO rules

to obtain certain information pertaining to their customers’ financial

condition and trading experience. CFTC generally requires that firms make

certain disclosures about the risks of products and provide customers

with a standardized risk disclosure document before engaging in

transactions. The CEA also prohibits fraudulent conduct, including material

misstatements and omissions. CFTC can bring actions against firms for

violating the CEA. In addition, the CEA allows futures and options customers

to pursue private claims against a firm for fraud, but questions have been

7

SEC’s action was taken against Bankers Trust’s securities affiliate—BT Securities—as summarized in

Securities and Exchange Act Release No. 35136, dated December 22, 1994. Unless otherwise indicated,

in this report “Bankers Trust” refers to the parent firm—Bankers Trust New York Corporation, which

is a bank holding company—and two of its wholly owned subsidiaries—Bankers Trust Company,

which is a bank, and BT Securities Corporation, which is a securities broker-dealer.

8

The basis for CFTC’s action against Bankers Trust is discussed on pages 71 and 72.

9

Although SEC acted against Bankers Trust’s registered broker-dealer affiliate, it could not have taken

these sales practice actions unless the transactions in question were securities.

10Such options include options on commodities, futures, and stock index futures traded on a board of

trade but do not include options on securities, securities indexes, or foreign currencies traded on a

national securities exchange. CEA section 2(a)(1)(B), which codified the Shad-Johnson Jurisdictional

Accord, excludes options on one or more securities from CFTC’s jurisdiction but provides CFTC with

jurisdiction over futures (and options thereon) on broadly based stock indexes. Options on securities

are regulated by SEC under federal securities laws. In addition, U.S. firms offering trade options are

not required to register with CFTC. Trade options are options that are offered to commercial

counterparties who enter into these transactions solely for purposes related to their business.

Page 44 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

raised about the application of the CEA’s fraud provisions to OTC derivatives

transactions.11

The extent to which some OTC derivatives are subject to the CEA is

uncertain.12 CFTC’s regulatory framework is focused primarily on the

oversight of exchange-traded futures and certain options and of

intermediaries engaging in such transactions on behalf of customers. CFTC

has issued regulations that allow trade options13 on commodities, except

on certain enumerated domestic agricultural commodities,14 to be traded

off-exchange. Forwards and certain OTC foreign-currency transactions are

excluded from regulation under the CEA,

15 including its antifraud

provisions. In 1992, Congress granted CFTC the authority to exempt certain

OTC derivatives, including swaps, from almost all of the CEA’s provisions.16

Without determining that swaps were futures, CFTC issued a rule that

exempted eligible swaps from all but the CEA’s antifraud and

antimanipulation provisions.17 Although CFTC’s swaps exemption preserves

the CEA’s antifraud provisions, the provisions only apply to the extent that

swaps are found to be subject to the act.

As previously discussed, CFTC took a sales practice-related action, in

cooperation with SEC, against Bankers Trust for activities involving swaps

11For example, the judge in Procter & Gamble Co. v. Bankers Trust Co. and BT Sec. Corp., 925 F. Supp.

1270 (S.D. Ohio, May 9, 1996), concluded that Procter & Gamble could not bring a claim under section

4b of the CEA, the general antifraud provision. Section 4b prohibits fraud in connection with a futures

contract made “for or on behalf of any other person.” The judge concluded that Bankers Trust could

not act “for or on behalf of” the company because both were principals; therefore, the typical

customer-broker relationship did not exist.

12See The Commodity Exchange Act: Legal and Regulatory Issues Remain (GAO/GGD-97-50, Apr. 7,

1997).

13See 17 C.F.R. § 32.4 (1996).

14On June 9, 1997, CFTC issued an advanced notice of proposed rulemaking in the Federal Register

seeking comment on whether it should lift its ban on trade options on domestic agricultural

commodities.

15The forward exclusion is set forth in CEA section 1(a)(11). The Treasury Amendment excludes

certain OTC foreign-currency transactions from the CEA; this exclusion is set forth in CEA section

2(a)(1)(A)(ii). As discussed in our April 1997 report on the CEA, the scope of the Treasury Amendment

has been unclear.

16CFTC was granted the authority to exempt swaps meeting certain criteria and other OTC derivatives

traded among appropriate persons from the CEA by the Futures Trading Practices Act of 1992. See our

April 1997 report for a more detailed discussion of CFTC’s use of its exemptive authority and related

issues.

17These provisions do not cover the standardized risk disclosures that would otherwise be required

when marketing futures and options contracts subject to the CEA. See C.F.R. Part 35 (1996). In a

similar action, CFTC exempted certain energy contracts from the CEA’s antifraud provisions but not

from its antimanipulation provisions.

Page 45 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

and other products that are subject to the CEA exemption. In taking this

action, CFTC enumerated the transactions that were involved in the

violations but did not indicate whether it considered the transactions to be

futures or options contracts subject to the CEA. Instead, it asserted that

Bankers Trust, by its conduct, had assumed the role of a commodity

trading advisor18 and had violated the antifraud provisions of the CEA

governing such parties’ activities.

State Statutory and

Common Law Claims

Would Be Asserted in

Disputes Involving OTC

Derivatives That Are Not

Subject to Federal Laws

To the extent that OTC derivatives are not covered by either the federal

securities or commodities laws, an end-user alleging sales practice

misconduct by a dealer would need to seek relief by asserting primarily

state statutory or common law claims, such as fraud or breach of fiduciary

duty.19 These claims, which are typically advanced in suits against dealers,

are either tort20 or contract based. Although similar in certain respects,

tort claims are based upon the existence of a special relationship that

creates a duty owed by the dealer to the end-user, while contract claims

are based upon the contractual relationship between the dealer and

end-user. Tort-based claims that are typically asserted by end-users

include claims of fraud and fraudulent concealment against dealers.

End-users may also assert a claim of breach of fiduciary duty. For such

claims, a derivatives dealer may have a duty to disclose material

information to an end-user if the court finds that an explicit or de facto

fiduciary relationship exists. End-users may also assert a claim that the

dealer’s alleged misstatements or omissions constitute a negligent

misrepresentation. In addition, other state law claims may be asserted. For

example, under New York law, the judge in the Procter & Gamble case

found that an implied contractual duty to disclose in business negotiations

exists when one party has superior knowledge not known to the other and

the party with superior knowledge knows that the other party is acting on

the basis of mistaken knowledge.21 In resolving these cases, the nature of

the relationship between the parties to the transaction is critical to

determining the duties that the dealer owes the end-user.

18A commodity trading advisor is an individual or firm that, for pay, issues analyses or reports

concerning commodities, including the advisability of trading in futures or commodity options.

19End-users could also seek redress under the federal Racketeer Influenced and Corrupt Organizations

Act. In addition, dealers may be subject to federal criminal enforcement actions under applicable mail

fraud or wire fraud statutes.

20A tort is a wrongful act (except for those involving a breach of contract) for which damages are

imposed.

21925 F. Supp. at 1290. The judge concluded that Bankers Trust “had a duty to disclose material

information to plaintiff before both the parties entered into the swap transactions . . . and also had a

duty to deal fairly and in good faith during the performance of the swap transactions.” Id. at 1291.

Page 46 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

Contract-based claims do not require the existence of a special duty

between the dealer and end-user. For example, an end-user may advance a

contract-based claim for rescission due to misrepresentation. This claim

would restore the parties to the positions they held before they entered

into the contract. If the end-user is a governmental entity, it may assert an

ultra vires claim.22 To support this claim, the end-user may argue that the

transaction at issue is unenforceable because it violates a provision in its

charter. An end-user may also claim that the contract is voidable because

the end-user was a victim of economic duress and, therefore, did not enter

into the contract of its own free will. Finally, an end-user may assert that

the contract is unenforceable under the applicable statute of frauds.

Although the specifics may vary from jurisdiction to jurisdiction, the

statute of frauds generally states that contracts in excess of a certain

dollar amount that cannot be performed within 1 year are unenforceable

unless in writing and signed by the party against whom the contract is

being enforced. To reduce the likelihood of the success of this claim, New

York amended this statute in 1994 to improve the enforceability of oral OTC

derivatives transactions.

MBS and Structured Notes

Are Typically Subject to

the Securities Laws

MBS and structured notes are typically considered to be securities and

subject to the federal securities laws,23 except when exempted from

specific provisions. In the United States, these products are marketed by

broker-dealers who are required to register with SEC and become subject

to various regulations, such as those requiring minimum levels of capital.

When corporations issue these securities, they are subject to the full range

of requirements applicable to other corporate securities issued to the

public. These requirements include the need to file a prospectus that

describes the financial condition of the issuer and explains the risks of

investing in the securities. In addition, the marketing of MBS and structured

notes is subject to the antifraud provisions of the securities laws

previously discussed, as well as the sales practices provisions of SRO rules.

Many MBS and structured notes are issued by GSEs and are considered to be

government securities under the federal securities laws. Although dealers

marketing these products must comply with the antifraud provisions of the

securities laws, just as they would for other securities activities, issuers of

government securities are generally exempted from the registration and

22This claim would likely be advanced only by governmental entities because corporations typically

may not rely on this doctrine to invalidate a contract.

23As noted in chapter 1, we are assuming for the purpose of this report that structured notes meet the

conditions of CFTC’s hybrid instrument exemption and are securities, not futures.

Page 47 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

issuance disclosure provisions of the laws that apply to corporate-issued

securities. As a result, GSEs are not generally required to obtain SEC

approval before offering securities publicly, and such issuances need not

be accompanied by prospectuses that identify the issuer and describe its

business operations and financial condition.24 Nevertheless, GSEs have

chosen to voluntarily follow the same practices that corporate securities

issuers are required to follow. For example, GSE securities issuances are

accompanied by prospectuses that contain the same type of disclosures as

would be required for other company securities that are registered with

SEC. GSE security issuances also typically include a discussion of the

structure and risks of the securities being offered.

As previously discussed, dealers marketing securities, including MBS and

structured notes, must comply with the requirements of the securities

industry SROs of which they are members. NYSE and NASD supervise the

majority of dealers offering MBS and structured notes, and both place

similar requirements on their members, including requiring firms to

determine the suitability of products before recommending them to their

customers. Although NASD’s suitability rule had long applied to stocks and

other securities, the provisions of this rule were not extended to its

members’ marketing of government securities, including GSE-issued MBS

and structured notes, until August 1996.25

In recognition of the significant institutional participation in the markets

for these securities, NASD also implemented an interpretation of its

suitability rule to clarify the responsibilities that dealers have to

institutional end-users.26 Such users are defined by the rule to include any

entity other than a natural person.27 This interpretation provides that a

dealer must, on the basis of information either supplied by the end-user or

24The Federal Agricultural Mortgage Corporation, commonly known as Farmer Mac, is an exception;

its security issuances are registered with SEC.

25NASD had been prohibited from applying its full complement of sales practice rules to the marketing

of government securities by a longstanding statutory restriction that was removed by subsequent

legislation. On August 22, 1996, SEC approved NASD’s proposed extension of its rules to these

securities with an associated interpretation for applying them to institutional end-users. (This

restriction and its impact on NASD’s operations are discussed in ch. 6.) Because this restriction

applied only to government securities, NASD was able to apply its full complement of sales practice

rules to the marketing of corporate-issued CMOs.

26Self-Regulatory Organizations; National Association of Securities Dealers, Inc; Order Granting

Approval to Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval to

Amendment Nos. 4 and 5 to Proposed Rule Change Relating to Application of the Rules of Fair

Practice to Transactions in Exempted Securities (Except Municipals) and an Interpretation of its

Suitability Rule, 61 Fed. Reg. 44100 (Aug. 27, 1996).

27The interpretation indicates that its tenets are most appropriately applied to institutional customers

with more than $10 million in securities holdings.

Page 48 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

otherwise known to the dealer, determine whether the end-user is capable

of evaluating the risk of the specific transaction and whether the end-user

is making an independent investment decision. The interpretation includes

a number of factors that are relevant to making this determination,

including the end-user’s employment of outside consultants or advisors,

the end-user’s general level of sophistication and level of sophistication

with respect to the particular product, the complexity of the product, and

the end-user’s ability to understand and independently assess the product.

Other relevant information might include whether the end-user had

established a pattern of accepting the dealer’s recommendations, had

access to investment suggestions from other sources, and had supplied

information about its investment portfolio to the dealer. If a dealer

determines that the end-user is capable of independently evaluating

investment risk and making its own decision about the transaction, the

dealer’s obligation regarding the end-user’s suitability is to be considered

fulfilled. The interpretation stresses that the determination can only be

made on the basis of the particular facts and circumstances of the

transaction, including the particular relationship between the dealer and

end-user.

Sales Practice

Requirements Vary,

Depending on the

Regulator of the

Dealers’ Activities

Sales practice requirements also vary, depending on which regulator, if

any, oversees the dealers’ activities. Bank OTC derivatives activities are

subject to requirements of the federal banking regulators as a part of their

oversight of all bank activities. Banks marketing MBS and structured notes

are now expected to comply with suitability rules similar to those that

apply to securities firms offering such products. Banks marketing OTC

derivatives, MBS, and structured notes may also be subject to oversight by

different regulators, depending on which legal entity within their

corporate structure conducts these activities. Securities, futures, and

insurance firms typically conduct their nonsecurities and nonfutures OTC

derivatives marketing in affiliates not subject to direct federal oversight,

although some individual transactions may be subject to oversight.

Members of the President’s Working Group on Financial Markets have

stated that the scope of SEC and CFTC authority and existing sales practice

requirements are currently adequate to protect the end-users of derivatives

and the markets.

Bank Activities Are

Regulated to Protect Their

Financial Condition

All of the activities of banks are subject to oversight by at least one federal

regulatory agency—either the Federal Deposit Insurance Corporation, the

Federal Reserve, or OCC. These regulators are responsible for ensuring the

Page 49 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

safety and soundness of banks to protect depositors and the federally

administered Bank Insurance Fund. The regulators address this

responsibility by placing various requirements on banks, including

periodic reports of financial condition, maintenance of minimum capital

levels, and periodic bank examinations. Almost all of the banks actively

marketing OTC derivatives, MBS, and structured notes are overseen by

either the Federal Reserve or OCC.

In response to the large increase in the volume of bank activity in OTC

derivatives and other financial products over the last decade, bank

regulators revised and expanded the guidance provided to examiners and

banks to more specifically address the risks that these activities pose,

including those risks related to sales practices. Previously, according to

bank regulatory officials, the only bank sales practice-related guidance

was “know your customer” rules under which regulators expected banks

to obtain sufficient information about customers’ financial condition and

business activities to prudently extend credit or engage in other financial

transactions with them.

In 1993 and 1994, OCC and the Federal Reserve each issued new guidance

that more specifically addresses sales practice issues as a part of a bank’s

overall responsibilities for managing the risks of its financial activities,

including OTC derivatives. Both sets of guidance place generally the same

requirements on examiners and banks. OCC’s October 1993 guidance28

directs the banks it oversees to assess and document the appropriateness

of transactions, as a part of managing the credit risk arising from these

transactions. In a follow-up 1994 OCC interpretation,29 OCC states that

consistent with safe and sound practices, banks should not recommend

transactions that they know, or have reason to know, would be

inappropriate for counterparties on the basis of available information.

According to the interpretation, banks should also determine whether

proposed transactions are consistent with counterparties’ policies and

procedures, as these are known to them. Specifically, banks should

understand the risks that counterparties are trying to manage or assume

through the use of derivative products. The interpretation also requires

that banks ensure counterparties understand the general market risk of

transactions and explain, particularly for those counterparties that they

28Banking Circular 277: Risk Management of Financial Derivatives, OCC (Washington, D.C.: Oct. 1993).

29Risk Management of Financial Derivatives: Questions and Answers Re: BC-277 (OCC Bulletin 94-31),

OCC (Washington, D.C.: May 1994).

Page 50 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

determine lack sophistication, how transactions will achieve the

counterparties’ objectives.30

The Federal Reserve’s December 1993 guidance31 to the banks it oversees

states that sound business practices require member banks to take steps

to ascertain the sophistication of derivatives counterparties, including

whether counterparties understand the nature and risks of transactions. If

a bank determines that its counterparty is unsophisticated, either generally

or with respect to a specific transaction, the guidance directs it to educate

the counterparty about the risks associated with the proposed transaction.

Furthermore, the guidance provides that when a bank recommends a

derivatives transaction to an unsophisticated counterparty, it should

ensure that it has adequate information about the counterparty on which

to base its recommendation. In the guidance issued to examiners,32 the

Federal Reserve indicates that banks should have established standards

for complex products to ensure that counterparties are not entering into

transactions where they fail to understand the risks. The guidance also

notes that bank management should be cognizant of the potential for

activities in these products to result in financial losses and harm the

bank’s reputation.

The goal of the guidance applicable to OTC derivatives issued by the

Federal Reserve and OCC is primarily to protect the safety and soundness

of banks rather than their counterparties or the end-users of the products

banks offer.33 The requirements banks are to follow when marketing such

products are designed to reduce their exposure to risk of loss from

end-user default or transaction disputes.34 Although the Federal Reserve’s

guidance places additional sales practice requirements on banks, its

guidance also states that end-users are ultimately responsible for their

own transactions. Regarding OCC’s guidance, a senior OCC official

30As discussed in chapter 6, OCC subsequently issued more detailed guidance in 1996 and 1997 with

additional sales practice-related expectations for the banks it oversees; however, this additional

guidance does not change the requirements described in this chapter.

31Examining Risk Management and Internal Controls for Trading Activities of Banking Organizations,

[SR 93-69 (FIS)], Division of Banking Supervision and Regulation, Board of Governors of the Federal

Reserve System (Washington, D.C.: Dec. 1993).

32Trading Activities Manual, Division of Banking Supervision and Regulation, Board of Governors of

the Federal Reserve System (Washington, D.C.: Mar. 1994).

33Bank regulatory officials indicated that bank dealers’ compliance with these requirements should

have the indirect effect of protecting counterparties and end-users from abusive practices.

34Under federal banking laws, aggrieved end-users have no right of private action or redress similar to

that provided by federal securities or commodities laws. As a result, aggrieved end-users must seek

redress under state statutory and common law.

Page 51 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

explained that it does not task banks with determining the suitability of

OTC derivatives transactions for their customers, but the guidance is meant

to ensure that the activities are being conducted in a safe and sound

manner. According to the official, a suitability rule would represent a

fundamental change in the relationship between a bank and its customers

because certain transactions, such as loans, deposits, and letters of credit,

are entered into on a principal-to-principal basis. Although intended

primarily to protect banks, bank regulator officials told us that the

interests of end-users would indirectly be protected by banks complying

with the prudent practices recommended in bank guidance.

Bank Regulators Adopted

Additional Requirements

for Dealers Marketing

Securities

Bank regulators have placed additional requirements on banks that market

securities. Banks marketing securities must now comply with substantially

the same suitability rule as securities firms that market such products. In

1994, the Federal Deposit Insurance Corporation, the Federal Reserve,

OCC, and the Office of Thrift Supervision issued a joint statement

applicable to banks and thrifts marketing nondeposit investment products,

including mutual funds and annuities, to retail customers.35 This joint

statement also applied to banks marketing government securities,

including GSE-issued MBS and structured notes to retail customers.

Although securities products have always been subject to the antifraud

provisions of the securities laws, the interagency statement tasks banks

offering nondeposit investment products—some of which are not

securities—with determining the suitability of such products before

recommending them to retail customers.

Bank regulators have also recently approved additional sales practice

rules for banks that deal in government securities. As authorized by the

Government Securities Act Amendments of 1993, the three federal bank

regulatory agencies—the Federal Reserve, the Federal Deposit Insurance

Corporation, and OCC—issued a March 1997 joint rule on bank sales of

government securities, including GSE-issued MBS and structured notes.36 In

addressing dealers’ obligations to determine suitability before making a

recommendation to institutional end-users, the rule uses language similar

to the recently approved NASD rule, as previously discussed. As of July 1,

1997, which was the effective date of the banking regulators’ rule, banks

35Interagency Statement on Retail Sales of Nondeposit Investment Products, Board of Governors of the

Federal Reserve System, Federal Deposit Insurance Corporation, OCC, and Office of Thrift

Supervision (Washington, D.C.: Feb. 15, 1994).

36Government Securities Sales Practices, Board of Governors of the Federal Reserve System, Federal

Deposit Insurance Corporation, OCC, and Office of Thrift Supervision (Washington, D.C.: Mar. 12,

1997).

Page 52 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

and securities firms marketing these securities became subject to

essentially the same rules regarding determining suitability before

recommending purchase of GSE-issued MBS and structured notes.

Banks Market Products

From Various Legal

Entities That May Be

Subject to Oversight by

Different Regulators

Banks market OTC derivatives, MBS, and structured notes from various legal

entities within their organizational structures, and this affects which

regulators, if any, oversee these activities. Regulators indicated that most

banks use bank employees to market OTC derivatives. However, some also

use their securities affiliates’ staffs to market them, depending on

corporate preferences or the extent to which securities are also being

offered to their customers. Nevertheless, any OTC derivative marketing

activities by such securities affiliate staff would not be subject to the

securities laws unless the product being marketed is a security. A bank

examiner explained that banks’ use of the same staff to market both

securities and nonsecurities OTC derivatives may reflect an effort to have

marketing staff be able to select the most appropriate product for the

specific risk management needs or investment objectives of an end-user,

regardless of the regulatory status of the individual products.

The corporate entities used by banks to market MBS and structured notes

also vary. The Banking Act of 1933, commonly known as the Glass-Steagall

Act, allows banks and their affiliates to underwrite and deal in certain

types of securities known as bank-eligible securities. These include

GSE-issued MBS and structured notes. The act generally prohibits banks

from underwriting and dealing in bank-ineligible securities, such as those

issued by corporations, including MBS37 and structured notes. Federal

regulators have provided banks with limited authority to underwrite and

deal in ineligible securities through affiliates of their holding company.

These affiliates—called Section 20 affiliates after the relevant section of

the act—are permitted to engage in securities underwriting and dealing as

long as the affiliate generates no more than 25 percent of its gross

revenues from ineligible securities.38 Regulators told us that most banks

with such affiliates market MBS and structured notes exclusively from

these entities to provide as large a revenue base as possible for conducting

activities in ineligible securities. Because these Section 20 affiliates are

also registered as broker-dealers with SEC, they are also subject to

37To distinguish them from GSE-issued securities, MBS issued by corporations are called “private label.”

38The previous limit on revenues derived from ineligible securities activities for Section 20 affiliates

was 10 percent, but the Federal Reserve raised the percentage to 25 percent, effective March 6, 1997.

However, national banks may sell their own assets in a securitized form and, therefore, may be

deemed underwriters for purposes of the securities laws, but not for purposes of the Glass-Steagall

Act.

Page 53 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

examinations by SEC and securities industry SROs to ensure that they

comply with the sales practice requirements of the federal securities laws

when selling securities.

Unregulated Affiliates Are

Not Subject to Direct

Federal Oversight, but

Regulators May Assert

Jurisdiction Over Specific

Products

Affiliates of securities, futures, and insurance firms that market

nonsecurities or nonfutures OTC derivatives are not directly regulated by

SEC or CFTC.

39 Securities and futures firms are allowed to conduct activities

in nonsecurities and nonfutures products outside of the entities that are

subject to direct SEC or CFTC oversight, respectively. Some securities firms

have established one or more separate affiliates that conduct OTC

derivatives activities. For example, because counterparties are sensitive to

the credit risk inherent in most OTC derivatives contracts, several

securities firms have created separately capitalized subsidiaries to conduct

activities in these products. These affiliates were specifically structured to

receive the highest credit ratings by rating agencies to increase their

attractiveness as counterparties to end-users of these products. SEC

officials told us that firms generally cite the stringent treatment that OTC

derivatives receive under SEC and CFTC capital requirements as the reason

firms do not conduct such activities in regulated entities, rather than a

desire to avoid sales practice requirements.

Some insurance firms also market OTC derivatives to end-users. However,

unless the products involved are subject to SEC or CFTC jurisdiction, the OTC

derivatives marketing activities of these firms are not subject to federal

regulatory oversight. The regulation of the insurance industry is primarily

a state responsibility.40 However, officials from the state insurance

regulatory commissions of the states with major insurance company

dealers of OTC derivatives, including New York, New Jersey, and Delaware,

told us that they did not directly oversee insurance firms’ marketing of

these products because such activities were conducted in noninsurance

affiliates.

As previously discussed, to the extent that nonsecurities OTC derivatives

activities are legally conducted outside of a regulated firm, they are not

subject to direct SEC or CFTC oversight. By offering these products from

39As discussed in chapter 6, the affiliates of securities and futures firms that market OTC derivatives

are subject to indirect SEC and CFTC oversight under the risk assessment authority Congress granted

to these agencies in 1990 and 1992, respectively. Also, as discussed in chapter 6, SEC and CFTC

worked with the firms most active in the OTC derivatives markets to establish a set of voluntary

guidance for participating firms to follow. The guidance presents a framework of management

controls and risk measurement practices.

40Congress has strictly limited the extent to which federal law preempts state insurance law.

Page 54 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

affiliates, dealers have, in effect, determined that these products are not

subject to the securities laws or most provisions of the CEA. However, SEC,

CFTC, or a court could determine that a product offered by an unregulated

affiliate is subject to the provisions of the federal securities or

commodities laws, respectively, and take action against the dealer when

they find violations of these laws.

The Working Group

Concluded That the Scope

of Regulators’ Authority

and Sales Practice

Requirements Are

Adequate

According to SEC and CFTC officials, the President’s Working Group on

Financial Markets has discussed the need to expand SEC and CFTC authority

over and sales practice requirements for OTC derivatives. On the basis of

these discussions and information collected on an ad hoc basis by various

members, the officials comprising the Working Group concluded that no

changes requiring legislation are currently needed to protect the financial

markets or end-users of derivatives. SEC and CFTC officials also told us that

their agencies have been able to take appropriate actions under their

existing authorities when problems have arisen. For example, as

previously discussed in this chapter, SEC and CFTC took a cooperative

action against Bankers Trust for its conduct in OTC derivatives transactions

with Gibson Greetings. The legal entity cited was BT Securities, which is a

subsidiary of Bankers Trust.41 SEC and CFTC officials told us that if they

believed their authority was insufficient, they would ask Congress to

address the issue.42

One member of the Working Group, the Chairman of the Federal Reserve,

indicated in a February 1997 speech that institutional end-users of OTC

derivatives have demonstrated their ability to protect themselves from

fraud. He noted that when dealers have engaged in deceptive practices,

end-users have been able to obtain restitution either by taking legal action

or threatening to do so. He indicated that, while the threat of legal action

by end-users may deter misconduct, dealers are motivated by the need to

stay competitive, which requires that they maintain a good reputation.

Officials familiar with the operations of the Working Group indicated that

the various members have shared information relating to OTC derivatives

sales practice issues. The members obtained this information through

special study efforts or otherwise collected it during their routine

41BT Securities is an affiliate of Bankers Trust Company and is authorized to conduct securities

activities under section 20 of the Federal Reserve Act. Both are subsidiaries of Bankers Trust New

York Corp., which is a bank holding company.

42CFTC has offered Congress legislative amendments to address technical issues to clarify its authority

under the CEA in several respects. As of , Congress had not enacted these amendments.

Page 55 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2 

Federal Sales Practice Requirements Vary

by Product and Dealer

oversight activities. However, Federal Reserve and SEC officials indicated

that data on market characteristics relevant to sales practice issues, such

as increased market participation by new dealers, more widespread use of

complex products, or increased marketing to or product use by less

sophisticated end-users, was not routinely collected by their agencies.

Furthermore, they said that no formal mechanism or expectation existed

for the members to continue collecting and sharing such information on a

periodic basis.

Page 56 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

According to our 1995 survey, end-users were generally satisfied with the

sales practices of dealers offering OTC derivatives, MBS, and structured

notes. Product use varied with end-users reporting less use of OTC

derivatives than of MBS and structured notes, and larger organizations

generally reporting more use of all of the products than smaller

organizations. Review of regulatory and other data indicated that cases

involving sales practice disputes were not widespread. However, when

disputes did arise, the losses were often large, with dealers and end-users

generally experiencing other financial impacts. These included direct costs

from litigation or regulatory fines and indirect costs, such as reduced

revenues and income.

Most End-Users Were

Generally Satisfied

With Dealer Sales

Practices

According to our 1995 survey of a wide range of U.S. organizations, most

end-users were generally satisfied with the sales practices of the dealers

that marketed OTC derivatives, MBS, and structured notes to them. The rates

of reported overall dissatisfaction with the sales practices of dealers used

ranged from as low as 2 percent to as high as 13 percent across the

products. End-users reported lower rates of dissatisfaction with the sales

practices of dealers they had used than for dealers that made

presentations to them but were not used. Finally, the respondents to our

survey provided generally consistent reasons for any dissatisfaction with

specific elements of dealer practices.

Few End-Users Reported

Dissatisfaction With

Dealers Used

When asked to rate the sales practices of the dealers with whom they had

entered into transactions, few end-users of OTC derivatives, MBS, or

structured notes reported dissatisfaction. To obtain information on how

satisfied organizations who had heard proposals were with these dealers’

sales practices, we asked the organizations we surveyed to indicate

whether they were “very satisfied,” “somewhat satisfied,” “neither satisfied

nor dissatisfied,” “somewhat dissatisfied,” or “very dissatisfied” for each of

the products included in this review.1

 They were asked to provide these

ratings for the following six individual elements of sales practices:

(1) disclosure of downside risks, (2) quality of transaction documentation

provided, (3) suitability of products proposed, (4) competitiveness of

pricing and fees, (5) provision of accurate mark-to-market pricing

information, and (6) assistance in unwinding transactions. Respondents

were also asked to provide a rating of their overall level of satisfaction or

dissatisfaction with dealer sales practices. In addition, survey respondents

were asked to provide ratings in these categories for (1) dealers they used

1

Respondents were also able to indicate that they either “did not know” or had “no opinion.”

Page 57 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

for transactions involving OTC derivatives, MBS, or structured notes and

(2) dealers that made product proposals to them but whom they did not

use for a particular product.

As shown in figure 3.1, 2 percent of the organizations across the industries

we surveyed reported being “somewhat” or “very dissatisfied” with the

overall sales practices of the dealers they used for plain vanilla OTC

derivatives contracts. For MBS dealers used, 7 percent2 of users reported

being similarly dissatisfied; for structured note dealers used, 13 percent

reported being similarly dissatisfied.

2

All the population estimates from our survey have sampling errors of plus or minus 10 percentage

points, or less, at the 95-percent confidence level, unless otherwise noted. This means that a 95-percent

probability exists that if we were to survey all of the organizations in this population, the actual result

obtained would fall within a range above and below the estimate cited of no more than the amount of

the sampling error for that particular estimate. See appendix I for the exact sampling errors for each

estimate in the report and more information about the various errors that may affect survey estimates.

For example, survey respondents may intentionally or accidentally misreport their organizations’

product usage.

Page 58 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Figure 3.1: Overall Sales Practice Ratings Reported for Dealers Used and Dealers Not Used, by Product

0

20

40

60

80

100

85

2

13

0

71

7

20

2

64

13

20

4

29

17

33

21 20

27

46

8

15

29

48

8

Percentage of satisfaction with sales practices

Plain vanilla OTC Derivatives

Satisfied

Dissatisfied

Neutral

No opinion/

Don't know

Satisfied

Dissatisfied

Neutral

No opinion/

Don't know

Satisfied

Dissatisfied

Neutral

No opinion/

Don't know

MBS Structured notes a b

Dealers used

Dealers not used c

Note 1: The categories of satisfied and dissatisfied in this figure represent the total of those

respondents that reported being somewhat or very satisfied or somewhat or very dissatisfied,

respectively, with dealers’ overall sales practices. The neutral category represents those that

reported being neither satisfied nor dissatisfied.

Note 2: Ratings may not add to 100 percent due to rounding.

aThe satisfaction ratings for dealers used relate to MBS only, but ratings for dealers not used

include other asset-backed securities because we were unable to separate out such products

from these responses.

bThe sampling error for the percentage of structured notes users who reported being satisfied

(64 percent) was plus or minus 11 percent.

Page 59 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

cDealers not used were those that made product proposals to end-users but were not used for a

particular product.

Source: GAO survey.

Our survey indicated that 79 percent3 of the end-users of more complex

OTC derivatives were somewhat or very satisfied with the dealers with

whom they did business, which was comparable to the levels of

satisfaction reported for dealers of the three product types shown in figure

3.1. Because of the small number of end-users of more complex OTC

derivatives and the even smaller number who reported being dissatisfied

with the dealers they used, we could not make a reliable estimate of the

extent of dissatisfaction with overall dealer sales practices for more

complex products. Similarly, the small number of end-users reporting

dissatisfaction with other products among our survey respondents

precluded a statistically valid analysis of dissatisfaction by the size of

organization or by industry subgroups.

As shown in figure 3.1, an analysis of our survey results indicated that

organizations reported less satisfaction with the overall sales practices of

dealers they heard presentations from but with whom they did not do

business. The percentages of organizations that were either somewhat or

very dissatisfied with the overall sales practices of dealers that they did

not use could be at least twice as high as the comparable percentages for

dealers that were used.4

 The overall level of dissatisfaction with dealers

not used was 17 percent for plain vanilla OTC derivatives, 26 percent for

more complex derivatives,5

 27 percent for MBS and/or asset-backed

securities, and 29 percent for structured notes.

Between 4 and 8 percent of the organizations not using a particular

product were contacted by at least one dealer offering that product during

the survey period. Furthermore, some evidence exists that the extent to

which dealers contacted nonusers is somewhat higher than these

percentages suggest because some nonusers contacted chose not to rate

the dealers’ presentations. These respondents reported that they generally

did not listen to the dealers’ complete presentations or thoroughly

3

Subject to a plus or minus 19-percent sampling error.

4

The differences in dissatisfaction levels between dealers used and not used were statistically

significant for plain vanilla OTC derivatives and MBS, while the differences for more complex OTC

derivatives and structured notes were not statistically significant due to the small numbers of

dissatisfied end-users of these products in our sample.

5

Subject to a plus or minus 12-percent sampling error.

Page 60 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

evaluate them because they did not find the products appropriate for their

organization or for their investment objectives.

For those end-users and nonusers who rated dealers they did not do

business with, the higher level of dissatisfaction reported with the dealers

not used suggests that potential end-users may have chosen not to do

business with dealers whose sales practices were objectionable or

appeared questionable for particular transactions.6

 Comments by some

end-users were consistent with this interpretation, as some respondents

indicated that they refused to do business with some dealers. Also, some

respondents noted that their satisfaction with dealer sales practices varied

by product at some dealers or depended on which member of a dealer’s

sales staff presented a transaction.

Respondents Provided

Consistent Reasons for

Their Dissatisfaction With

Specific Elements of

Dealer Sales Practices

Respondents who were dissatisfied with dealer sales practices provided

similar reasons for their dissatisfaction with two individual elements of

sales practices—disclosure of downside risk and suitability of products

proposed.7

 In addition to providing ratings on their overall satisfaction

with dealers’ sales practices (as shown in fig. 3.1), survey respondents also

provided ratings of individual sales practice elements. For disclosure of

downside risk, none of the estimates for the rate of dissatisfaction with

dealers used exceeded 20 percent for any of the products. End-users of

structured notes reported the highest rate of

dissatisfaction—17 percent—with thks element. However, for dealers not

used, these rates of dissatisfaction were higher. Twenty percent of the

organizations in our population reported dissatisfaciton with the risk

disclosure practices of dealers not used that offered plain vanilla OTC

derivatives, while 38 percent8 reported dissatisfaction with the risk

disclosure practices of dealers not used that offered more complex OTC

derivatives. In addition, 27 percent of the organizations reported

dissatisfaction with the risk disclosure practices of dealers they had not

used for MBS, and 31 percent reported dissatisfaction with the risk

disclosure practices of dealers they had not used for structured notes.

6

In some cases, respondents might have rated the same firm as a dealer used and as a dealer not used

because an end-user may have entered into a transaction for a product with a dealer on one occasion

but may have chosen not to do so on another occasion.

7

Because of the relatively few end-users of OTC derivatives that existed and the even fewer number

that were dissatisfied, we could not make (1) precise estimates of the extent of dissatisfaction with

these two elements of sales practices and (2) any estimates of the extent of dissatisfaction with the

other four elements of sales practices that we asked survey respondents to rate.

8

Subject to a plus or minus 13-percent sampling error.

Page 61 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

In follow-up conversations or in their written comments, some

respondents explained why they were dissatisfied with dealer risk

disclosures. Officials at 19 of the 50 judgmentally selected organizations

with which we followed up told us that they were dissatisfied in some way

with the amount of information dealers had provided.9

 For example, an

official of a money management firm said that risk disclosure was the

primary problem with dealer sales practices. For MBS and structured notes,

he said that dealers had not provided sufficient information about the

reduced market liquidity of some products and that end-users could not

rely on commercially available pricing information to determine the

market liquidity or prices that could be received for products.

Some officials at these 19 organizations commented that even dealer

personnel did not appear to understand the potential downside risks of the

products. For example, an official at a mutual fund told us that dealer staff

often provided written materials on how product use could be beneficial,

but the dealer staff could not always answer questions about how the

value of the products would change as interest rates changed. An

insurance company official wrote on the survey form that his firm’s

dissatisfaction rating reflected experiences with some of the smaller

dealers that contacted the firm. The official believed that the larger dealers

generally did a good job of explaining the merits and risks of products.

According to our survey results for another individual sales practice

element that we asked questionnaire recipients to rate, organizations were

not always satisfied with the suitability of the products dealers proposed,

and this dissatisfaction was again more significant for dealers they did not

use.10 For this particular element, all of our estimates of dissatisfaction

with dealers used fell below 10 percent. However, for dealers not used, the

estimates of dissatisfaction were higher—18 percent of end-users reported

being somewhat or very dissatisfied with the suitability of plain vanilla OTC

derivatives proposed by dealers that were not used, while 42 percent11

reported dissatisfaction with the suitability of more complex OTC

derivatives transactions proposed by dealers that were not used. Thirty-six

percent reported dissatisfaction with the suitability of MBS that were

9

We conducted follow-up telephone interviews with 50 judgmentally selected organizations that had

responded to the survey—about one-half of which had expressed dissatisfaction and one-half of which

were generally satisfied with dealer sales practices. See appendix I for more information on our

methodology.

10When rating this aspect of dealer sales practices, survey respondents were not asked to rate whether

dealers had complied with any legal requirement to determine the suitability of a recommendation.

11Subject to a plus or minus 13-percent sampling error.

Page 62 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

offered but not purchased, and 39 percent reported dissatisfaction with

the suitability of structured notes that were offered but not purchased.

Officials at 16 of the 50 organizations with which we followed up indicated

that dealers were not sufficiently considering end-user circumstances

when proposing transactions. For example, an official at a money market

mutual fund said that, although such funds should maintain fixed net asset

values, many of the transactions dealers proposed to his organization were

for products that could cause large declines in the value of the fund. A

credit union official described mixed experiences. He said some dealers

seemed interested in selling a product regardless of the credit union’s

needs and requirements, but others were more willing to describe

products and attempt to understand the organization’s needs. Officials of

at least three organizations were concerned that dealers were marketing

GSE-issued structured notes by portraying them as safe,

government-backed investments, even though the values of such products

could be quite volatile.

Although some organizations were concerned about the suitability of

products that dealers offered, other organizations generally welcomed

receiving proposals even if the product was not currently appropriate or

suitable for them. For example, officials at a hardware products

manufacturer that exported worldwide explained that their firm used OTC

derivatives for managing its foreign currency exposures and for altering

the mix of fixed and floating interest rate obligations used to finance its

operations. Although the firm had specific guidelines related to its use of

these products, it was still interested in hearing ideas that could lead to

alternative ways of meeting its needs. Similarly, officials at three large

multinational firms told us that, even though their firms receive numerous

proposals from dealers, they explore only those they considered

appropriate for them. However, they appreciated receiving the other

proposals so that they could better evaluate their own risk management

activities.

Reported Product

Usage Varied Across

Products and by

Organization Size and

Type

Our survey revealed that the extent of OTC derivatives, MBS, and structured

notes usage varied, with fewer organizations reporting use of OTC

derivatives than of MBS and structured notes. In general, larger

organizations were more likely than smaller ones to report using any of

these products, although smaller organizations were active users in some

industries, such as banking. The extent of reported product usage also

varied across industries and organizations, with more financial

Page 63 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

organizations reporting use of the products than nonfinancial

organizations, such as state and local governments. Surveys conducted by

other organizations covering periods after that of our survey indicated that

rates of usage showed little change, with some showing slight declines.

Few Organizations

Reported Using OTC

Derivatives, More

Reported Using MBS and

Structured Notes

Our end-user survey measured the usage of OTC derivatives, MBS, and

structured notes over a broad population of U.S. organizations. The survey

results indicated that relatively few public and private organizations used

an OTC derivative product, with an estimated 11 percent12 of such

organizations reporting using such a product in the 12 months before our

survey was received, beginning for most organizations in the spring of

1995. Some of these organizations had reported using either plain vanilla

or more complex OTC derivatives, and others had reported using both. We

estimated that in the period defined by our survey, approximately 5,200

end-users of OTC derivatives (plain vanilla, more complex, or both) existed

in the population of approximately 49,000 potential end-users from which

we drew our sample.13

As shown in figure 3.2, 10 percent of these organizations reported using

plain vanilla OTC derivatives, and 2 percent reported using more complex

OTC derivatives. Reported usage of other products was somewhat more

widespread—approximately 24 percent of such organizations reported

holding at least one MBS, and 16 percent reported holding at least one

structured note during the study period. We estimated the number of

end-users for these products to be approximately 11,500 for MBS and 7,700

for structured notes. Although we did not survey individual investors,

regulators and exchange officials told us that few individuals used OTC

derivatives and their usage of MBS and structured notes was small. For

example, NYSE officials estimated that individual investors accounted for

about 5 percent of the volume in the MBS market.

12Subject to a plus or minus 2-percent sampling error.

13See appendix I for a detailed description of how we defined this population and drew our survey

sample.

Page 64 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Figure 3.2: Extent of Reported Product

Usage Across the Potential User

Population

0

5

10

15

20

25

30

10

2

24

16

Percentage of use, by organization

MBS Structured

notes

Plain vanilla More

complex

OTC Derivatives Securities a

aIncludes securities OTC derivatives.

Source: GAO survey.

Larger Organizations Were

More Likely to Be

End-Users

As shown in figure 3.3, the larger organizations were more likely to

indicate that they were users of OTC derivatives, MBS, and structured

notes.14

14We grouped the organizations in each industry into one or more substrata by asset size, investment

portfolio size, revenue, sales, population, or other relevant indicators of financial size, depending on

the type of industry and the information available. However, for banks and credit unions, we obtained

additional information on past usage of certain OTC derivative products and MBS that was used to

improve the accuracy of our groupings for these firms, not just in terms of financial size, but also in

terms of the likelihood of current product usage. Therefore, the criteria for division between larger and

smaller organizations vary across industries, and although the larger subgroups are typically

comprised of the top 10 percent of the population, from 1 percent to about 33 percent of some

industries may be apportioned to the largest subgroups. See appendix I for a more thorough

description of how we defined large and small industry subgroups.

Page 65 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Figure 3.3: Extent of Reported Product

Usage, by Organization Size

0

10

20

30

40

50

14

4

37

22

9

1

19

13

MBS Structured

notes

Plain vanilla More complex

Large organizations

Small organizations

Percentage of use, by organization

OTC Derivatives Securities a

Note: See appendix I for a description of how we defined large and small organizations across

industry strata.

aIncludes securities OTC derivatives.

Source: GAO survey.

Even though large organizations were more likely to be end-users of these

products, some types of small organizations, which were aggregated in the

survey analysis because of the small sample sizes involved, reported using

MBS at higher rates. For example, small banks, credit unions, and insurance

companies—aggregated in the survey analysis because of the small sample

sizes involved—reported using MBS at a combined rate of 40 percent,15

which was about twice the estimated 21-percent usage rate across all

15Subject to a plus or minus 11-percent sampling error.

Page 66 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

other organizations. In addition, 35 percent16 of the small bank, credit

union, and insurance company subgroup reported using structured notes,

while overall 12 percent of all other organizations reported use of such

products. Similarly, OCC reported that, as of March 31, 1996, 41 percent of

the approximately 8,600 banks with less than $250 million in assets had

invested in structured notes that had a total market value of about $6.2

billion. According to OCC, the percentage of small banks using structured

notes was equal to that of the other 1,274 banks with assets exceeding

$250 million.

Product Usage Varied by

Industry

Our survey results indicated that usage of OTC derivatives, MBS, and

structured notes was generally higher among the more specialized and

perhaps more sophisticated financial services and investment

management industries.17 As shown in figure 3.4, among the various

industries we surveyed, reported use by GSEs indicated that they were the

most active users of all three of these product types. On the basis of

information provided by the 31 GSEs that responded to our survey,

71 percent of these large and generally financially sophisticated

institutions reported using OTC derivatives. About the same percentage

also reported using MBS, while 57 percent of GSEs reported using structured

notes. A group we classified as “other financial corporations”—which

included large credit-financing organizations, mortgage brokers and

lenders, and leasing agencies—also reported being active users of OTC

derivatives. In contrast, banks, credit unions, and insurance companies

reported active use of MBS and structured notes but comparatively less use

of OTC derivatives.

16Subject to a plus or minus 13-percent sampling error.

17Statistics on the rates of usage by all industry substrata are shown in appendix I, tables I.5 through

I.8.

Page 67 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Figure 3.4: Extent of Reported Product Usage, by Industry

0

20

40

60

80

71

54

27

10 10

5

10

7

4

73

23 25

33

24

55

2

16

7

57

6

12

20

5

40

3

11

9

GSEs

Banks/Credit unions/

 Insurance

Other financial

 corporations

 Mutual funds/

Commodity pools

Money managers

Nonfinancial corporations

Endowments/Colleges

State/Local governments

Financially oriented organizations Other organizations

Percentage of use, by organization

OTC Derivatives

MBS

Structured notes

Pension funds

a

Note 1: Because of the small number of respondents in some industries, small differences in

usage percentages may not be statistically significant.

Note 2: Appendix I describes the organizations that are included in the groupings in this figure.

aPension funds include both private and public (governmental) pension funds.

Source: GAO survey.

Page 68 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

In addition, the survey results from the pension fund industry indicated

differing levels of usage within certain subgroups. Although the average

usage rates reported across the overall universe of large and small public

and private pension funds were not above average, the large public

pension fund subgroup reported relatively higher usage rates. Forty-one

percent of the large public pension funds reported using plain vanilla OTC

derivatives, 33 percent reported using structured notes, and 74 percent

reported using MBS.

Our survey also showed that nonfinancial corporations (service and

manufacturing firms), endowments and colleges, and state and local

governmental entities18 did not make extensive use of any of the products.

Among nonfinancial corporations, overall reported usage rates were

average or below average for all of the products. However, the “larger

organization” subgroup of nonfinancial corporations19 did report using

plain vanilla OTC derivatives to a great extent. We estimated that

66 percent20 of the population of large U.S. nonfinancial firms used plain

vanilla OTC derivatives during the survey period. This estimate is

comparable to those of other surveys of similar organizations, many of

which reported usage rates of over 50 percent.

Although higher proportions of firms in the specialized, sophisticated

financial industries may be using OTC derivatives, MBS, and structured

notes, they often represented a smaller total number compared to the

actual number of reported end-users among some of the more populous

nonfinancial industries. For example, even though 71 percent of GSEs

reported using OTC derivatives, they made up less than 1 percent of the

entire number of estimated end-users. However, nonfinancial corporations

made up an estimated 22 percent of the total population of end-users of

OTC derivatives, even though only 10 percent of the firms in this industry

grouping reported using these products. Similarly, while 27 percent of the

aggregated industry group of mutual funds, money market funds, and

commodity pools reported using OTC derivatives, the number of such

organizations represented 39 percent of the total number of end-users for

this product type.

18Local governmental entities included state treasuries, local school districts, special districts, cities,

and counties (see app. I, table I.2).

19For publicly held corporations, we drew our sample of large organizations from the top 10 percent

(annual sales over $1.4 million) of our population of approximately 5,600 firms. For privately held

nonfinancial corporations, we designated the top 200 firms on the basis of their assets (2.5 percent of

our universe of 8,000) as large corporations.

20Subject to a plus or minus 12-percent sampling error.

Page 69 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

More Recent Studies

Generally Showed Little

Change in Product Usage

A number of publicly reported studies conducted after our survey

generally showed either no change or slight declines in the proportion of

organizations in various industries that use OTC and other derivatives. To

assess the magnitude and direction of any change in usage that may have

taken place after our survey closed in October of 1995, we reviewed

studies conducted by three external organizations that measured usage

among specific industries over a period extending to October 1995 or

beyond.21 Two of the three studies concluded that a slight decrease in

derivative product usage had occurred among certain organizations after

1995. A series of surveys conducted by Greenwich Associates estimated

that 68 percent of a selected sample of public and private nonfinancial

corporations used derivatives in 1995, while 59 percent of such

corporations used derivatives in 1996.22 The Greenwich Associates’

surveys suggest that for nonfinancial corporations, usage reached a high

point in 1995, after having increased somewhat in the preceding years.

Surveys of public and private pension plans conducted for the September

1995 and March 1997 issues of Institutional Investor Magazine concluded

that derivatives usage had declined from 52 percent to 48 percent.23

However, another set of surveys of publicly held U.S. nonfinancial

corporations in 1994 and 1995 found an increase in the proportion of

derivative product users. The Wharton School of Business estimated that

41 percent of these organizations used derivatives in October 1995, an

increase from November 1994.24

21Although we attempted to confirm that the industry populations surveyed and products specified in

these other studies were generally similar to those discussed in this report, the estimates of usage from

these other studies are usually not directly comparable to those from our survey because of the

variability of the samples selected and questions asked. Most of the recent studies we reviewed rely on

small, nonprobability convenience samples that usually represent a self-selected subset of only the

larger organizations within any particular industry. We did not assess the quality or verify the results of

any of these external studies.

22North American Treasury Services, 1996 Report, Greenwich Associates (Greenwich, CT: July 1996).

This survey obtained 588 personal interviews with senior treasury managers at a judgmental sample of

multinational corporations, large domestic companies, foreign subsidiaries, regional banks, and

government agencies in May through July of 1995 and 457 interviews in May through July of 1996.

23“Pensionforum Survey,” Institutional Investor Magazine (New York, NY: Sept. 1995 and Mar. 1997).

This survey received an unknown number of responses from a judgmental sample survey of 800

corporate and 250 public pension plan sponsors, conducted quarterly.

241995 Survey of Derivatives Usage By U.S. Non-Financial Firms, Wharton School of

Business/Canadian Imperial Bank of Commerce/Wood Gundy (Philadelphia, PA: Apr. 1996). This

survey received 530 responses in 1994 and 350 in 1995 from a sample of over 2,000 U.S. nonfinancial

firms listed on Standard & Poor’s Compustat database. The 1995 sample also included an

undetermined number of additional Fortune 500 firms that had not been included in the 1994 sample.

Page 70 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Sales Practice

Concerns Did Not

Appear to Be

Widespread but

Involved Many Large

Losses

Concerns about dealer sales practices have been raised in many of the

publicized losses incurred by end-users of OTC derivatives, MBS, and

structured notes. Although many of the losses were large, sales practice

concerns related to OTC derivatives involved primarily one dealer. More

sales practice concerns were raised for transactions involving MBS and

structured notes. However, such losses involved a relatively limited

number of dealers.

Concerns About Dealer

Sales Practices Were

Raised in Many Publicized

Losses

Combining publicly available information and regulatory data, we

compiled a list of U.S. and foreign end-users that experienced losses from

OTC derivatives, MBS, or structured note transactions with U.S. dealers.25

From this list and with the information used to compile it, we identified

losses in which sales practice concerns were raised by end-users or

regulators. Through this effort, we identified 360 end-user losses involving

OTC derivatives, MBS, and structured notes, with the earliest loss occurring

in April 1987 and the latest loss occurring in March 1997.26 These end-user

losses totaled an estimated $11.4 billion. Sales practice concerns were

raised in 209, or 58 percent,27 of these losses and were associated with an

estimated $3.2 billion in losses. However, since many disputes were

associated with a relatively limited number of dealers, and given the many

thousands of transactions in OTC derivatives, MBS, and structured notes and

the hundreds of billions of dollars at risk in these transactions over the

25Our list of end-user losses was compiled from publicly available information and regulatory data. To

identify losses, we conducted searches of periodicals, industry publications, special studies, and

litigation reporting service data. We also reviewed regulatory case data and discussed such cases and

related matters with banking, securities, and futures regulators. We limited our list to end-user losses

directly involving OTC derivatives (forwards, options, and swaps), MBS, or structured notes. We

excluded losses that dealers incurred and that foreign end-users transacting with foreign dealers

incurred. We also excluded derivatives-related losses involving the sale of mutual funds or OTC

contracts that CFTC or a court found to be illegal, off-exchange futures contracts. Although many of

the losses are supported by multiple sources, we generally did not confirm the accuracy of the

information provided by such sources.

26The number of losses and the total amount of losses may be overstated by including losses involving

products not covered in this report and unrealized losses. The number of losses and the total amount

of losses may also be understated to the extent that all losses were not publicly reported. In this

regard, we have included in the number of losses instances where the entity was reported as having a

loss, even when the loss amount was not reported and, therefore, could not be included in the total

loss amount.

27This percentage, as with similar percentages reported in this section, is not a statistically valid

estimate of the actual extent to which sales practice concerns have been raised in connection with

OTC derivatives, MBS, and structured note transactions. It is based on a compilation of losses that is

not necessarily representative of the population of transactions involving OTC derivatives, MBS, and

structured notes.

Page 71 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

period we reviewed,28 we found that sales practice concerns were not

widespread.

As indicated above, not all OTC derivatives, MBS, and structured note losses

involved sales practice disputes. For example, 42 percent of the publicly

reported losses were not accompanied by sales practice disputes, and for

OTC derivatives, 59 percent of the reported losses were not associated with

such disputes. End-users that incurred losses may not have raised sales

practice concerns if the products were used to hedge other positions that

had offsetting gains. EUDA confirmed that some end-users suffering large

derivatives losses had been using the products as hedges. In such

instances, the losses were not unexpected because the derivatives

operated as anticipated and were offset by gains in the underlying hedged

items. Alternatively, when derivatives performed differently than the way

the dealer had represented they would perform, EUDA said disputes have

arisen.

OTC Derivatives Losses

With Sales Practice

Concerns Involved

Primarily One Dealer

Our review identified 44 end-user losses that involved OTC derivatives

transactions with U.S. dealers. These losses totaled an estimated

$5.4 billion. Sales practice concerns were raised in 18 of these losses,

accounting for about 41 percent of the total OTC derivatives losses and

covering an estimated $1.7 billion in losses. The losses with sales practice

concerns involved 9 dealers; however 1 dealer, Bankers Trust, was

involved in 9 of the 18 end-user losses.

Sales practice allegations against Bankers Trust have been among the

most widely publicized and have resulted in lawsuits and regulatory

action. As noted in our 1994 report on OTC derivatives, Bankers Trust is a

major U.S. OTC derivatives dealer,29 and it had a reputation for offering

some of the most sophisticated derivatives products. In April 1994, two of

its customers, Procter & Gamble and Gibson Greetings, Inc., announced

that they faced losses on certain complex OTC derivatives transactions with

Bankers Trust. Procter & Gamble announced after-tax losses of about

$102 million on two complex swaps transactions, and Gibson Greetings

reported after-tax losses of almost $20 million in a series of complex

swaps and options transactions. Both corporations, as well as several

other Bankers Trust customers that suffered losses, filed suit against

28According to the Federal Reserve, the amount at risk, as measured by the gross market value of OTC

derivatives outstanding, was $328 billion for U.S. entities, as of March 1995, or about 3 percent of the

notional/contract amount.

29See GAO/GGD-94-133.

Page 72 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Bankers Trust alleging, among other things, fraudulent sales practices. As

discussed on page 78, Bankers Trust has settled with Procter & Gamble

and Gibson Greetings as well as with other customers.

SEC, CFTC, and the Federal Reserve investigated Bankers Trust’s conduct,

and each regulator reached a settlement or similar agreement with

Bankers Trust (the SEC and CFTC actions were discussed in ch. 2, and the

Federal Reserve’s action is discussed in ch. 6). In December 1994, SEC and

CFTC concluded their investigations with a joint settlement addressing

Bankers Trust’s dealings with Gibson Greetings. Without admitting or

denying SEC’s and CFTC’s findings, Bankers Trust agreed to the issuance of

SEC and CFTC orders finding that the bank violated antifraud provisions of

the federal securities and commodities laws and agreed to pay a

$10 million fine. During the same period, the Federal Reserve entered into

an agreement with Bankers Trust that required it to establish, among other

things, new marketing and sales practice policies that were consistent

with safe and sound banking practices.

The eight dealers involved in the remaining nine end-user losses with sales

practice concerns were largely major U.S. securities firms;30 however,

unlike the losses associated with Bankers Trust, these losses generally

involved instances where only one end-user had raised concerns about a

dealer’s conduct. The end-users incurring the losses were foreign firms,

individuals, and a state, and their losses ranged from an estimated

$8 million to $371 million. In these losses, many of which involved

lawsuits, the end-users alleged, among other things, that the dealers had

misrepresented the risks of the products or induced the end-user to enter

into unsuitable or unauthorized derivatives transactions.

Regulatory staff at SEC, NASD, and NYSE told us that they have received few,

if any, other complaints against securities firms involving OTC derivatives.

Notwithstanding the limited number of complaints and publicized OTC

derivatives losses involving sales practice concerns, the extent to which

such concerns exist may not be fully apparent. Speaking at an industry

conference, an OCC official said that the agency’s examiners identified

instances in which banks agreed to settle certain OTC derivatives

transactions for less than the amounts due after their customers expressed

concerns about the practices that the banks used to market the products.

The OCC official was not able to estimate the total number of such

occurrences or the dollar amounts involved. Furthermore, an official from

30According to press accounts and other sources, five of these cases have been settled and the other

four cases are ongoing.

Page 73 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

a financial markets consulting firm also indicated that some of its clients

have settled transactions for amounts less than due under circumstances

similar to those described by the OCC official. In addition, EUDA expressed

the view that more sales practice disputes between end-users and dealers

have arisen than were aired publicly, many of which it said probably

involved modest losses.

More Sales Practice

Concerns Were Raised in

MBS and Structured Note

Transactions, but Such

Concerns Generally

Involved Few Dealers

MBS and structured notes were used more often than OTC derivatives, and a

greater number of sales practice concerns were raised with these products

than with OTC derivatives. Our review identified 285 end-user losses

connected with MBS and/or structured note transactions. These losses

totaled an estimated $5.6 billion. Sales practice concerns were raised in

190 of these losses, accounting for 67 percent of the total losses and

covering an estimated $1.6 billion. The losses associated with sales

practice concerns involved 56 dealers, ranging from major national

securities firms to smaller regional firms. However, 8 dealers were

involved in 148 of these losses. According to press accounts and similar

articles, common sales practice allegations included the dealers

misrepresenting the risks of the products and/or omitting material

information about them.

Our review of regulatory efforts to enforce securities laws applicable to

MBS and structured notes also indicated that cases in which sales practice

concerns were raised involved a limited number of firms, with an even

smaller number of firms accounting for large numbers of disputes with

individual end-users. To assess the extent to which sales practice concerns

were associated with MBS or structured note transactions, we collected

data on investigations by securities regulators and on complaints these

organizations received in the 4-year period from January 1993 through

December 1996. The regulatory organizations included were SEC, NASD, and

NYSE.

31 In total, we found that these organizations had conducted 55 dealer

investigations during this 4-year period. However, some of these

investigations involved several personnel at individual firms, and some

dealers had been investigated by more than one regulator. Table 3.1

summarizes the status of these investigations.

31As discussed in chapter 2, NASD and NYSE together oversee most of the securities firms marketing

MBS or structured notes in the United States.

Page 74 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Table 3.1: Status of Investigations of

Dealers by SEC, NASD, and NYSE

From 1993 Through 1996 for Cases

Involving MBS and Structured Notes

Number of dealers

Investigation status SEC NASD NYSE

Dealers still under investigation 10 6 4

Dealer investigations resulting in formal

sanctions against a firm or selected personnel 0 6 8

Cases closed with no action taken 9 3 2

Cases not pursued:

Dealer out of business (e.g., bankrupt) 1 0 0

Case referred to another regulator 0 1 1

Dealers investigated for nonsales practice

violations instead 4 0 0

Total of cases not pursued 5 1 1

Total 24 16 15

Note: Forty-four dealers were subject to investigation by these regulators during this period. The

table totals to 55 as some dealers were being investigated by more than 1 regulator.

Sources: GAO analysis of data from SEC, NASD, and NYSE.

Overall, SEC, NASD, and NYSE investigated a total of 44 different dealers.

However, just a few firms accounted for a large number of the losses in

which individual end-users had raised sales practice concerns. For

example, 6 Houston firms were being investigated or considered for

investigation across more than 78 end-users. SEC and NASD staff were

investigating 1 of these dealers for its dealings with as many as 30

customers in several states. This firm consented to a regulatory

settlement, stating that it had committed various sales practice-related

violations, including making material misrepresentations of MBS risks,

failing to adequately supervise its sales representatives, and lacking

procedures to ensure that product risks were disclosed to end-users. SEC

was also investigating at least 3 other dealers for activities involving

numerous end-users, ranging from 10 to 23 end-users at each firm.

Typically, these cases involved dealers marketing GSE-issued MBS, including

some of the more volatile variations, to municipal and county governments

and colleges. For example, an end-user in one of these cases—City

Colleges of Chicago—had estimated losses of around $38 million, as of

March 1996, after purchasing about $110 million in volatile MBS from one

dealer. In at least two of the cases that SEC or the SRO staff were

investigating, the end-users had accused dealer personnel of marketing

high-risk securities by characterizing them as safe, federally insured

investments.

Page 75 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

Although the bulk of these cases involved a few smaller securities firms,

some of the largest securities firms were involved in the MBS case that had

the largest loss. In this case, Askin Capital Management, a New York-based

investment management firm, reportedly lost over $660 million after the

declines it experienced from adverse market movements led to the

April 1994 liquidation of several funds it managed. These funds had been

invested in some of the most volatile CMO tranches. Some of the fund

investors sued Askin Capital Management and at least three large

securities firms that sold Askin the volatile products.32 The investors

alleged that Askin promised them high returns without large risks, but

instead purchased high risk securities. The suit claims that the three large

securities dealers abetted Askin in these fraudulent sales because they

needed Askin and others to buy the higher risk CMO tranches before the

lower risk tranches could also be sold, thereby ensuring the profitability of

the entire issuance of securities.

Other than these cases, regulators reported that a limited number of

allegations of deficient dealer sales practices involving MBS and structured

notes were identified. Table 3.2 shows the number of complaints received

by securities industry regulatory bodies from 1993 through 1996 for MBS.

These data indicate that the total complaints involving MBS was about

1 percent of the total number of complaints received. These regulatory

bodies did not separately track complaints, if any, they had received

involving structured notes.

Table 3.2: Complaints Received by

Regulators From 1993 Through 1996

Involving MBS Sales Practices and

Total Complaints for All Products

Complaints involving MBS sales practices

Regulator 1993 1994 1995 1996 Total

Total complaints

for all products

(1993-1996)a

SEC 42 112 50 30 234 49,869

NASD 51 69 57 29 206 18,345

NYSE 71 300 405 122 898 3,984

aIncludes all products for which these regulators received complaints (including stocks, corporate

bonds, etc.). The volume of stocks, bonds, and other products being traded likely exceeds the

volumes attributable to MBS, but we did not attempt to standardize complaint information, such

as by calculating the ratio of complaints to volume traded, across products due to the lack of data

on trading volumes for all products.

Source: GAO analysis of data from NASD, NYSE, and SEC.

The bulk of the sales practice cases being reviewed by regulators involved

MBS; however, one case involving structured notes has been widely

32The three large securities dealers were Kidder Peabody; Bear Stearns; and Donaldson, Lufkin &

Jenrette.

Page 76 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

reported by the press. In 1994, Orange County, CA, filed for bankruptcy

after incurring over $1.7 billion in losses in its investment portfolio that

included GSE-issued structured notes. While about $970 million of the

losses were attributed to structured notes, the county had also used other

nonderivative products and had borrowed heavily to make additional

investments. Alleging deficient sales practices, the county filed suit against

two dealers—Merrill Lynch and Morgan Stanley—that sold it structured

notes. Other cases involving losses on structured notes have been made

public, but they did not involve allegations of deficient sales practices.

When They Occurred,

Sales Practice-Related

Disputes Were Often

Costly to Dealers and

End-Users

Transactions in OTC derivatives, MBS, and structured notes can present

significant risks to dealers and end-users. In addition to the familiar risks

arising from adverse market movements or counterparty default, dealers

with inadequate sales practices expose themselves to significant

compliance and reputation risks. We found that, in the recent losses

involving sales practice disputes, the associated dealers and end-users

frequently experienced significant costs related to these risks.

Compliance and

Reputation Risk Losses

Can Arise From Sales

Activities

Although the potential for OTC derivatives and related financial products to

produce losses from adverse market movements or counterparty default

has been widely discussed, parties to transactions in these products are

also subject to losses arising from compliance and reputation risks. These

risks are defined by OCC in December 1995 guidance and appear to aptly

describe the various potential losses and costs that can arise from sales

practice disputes.33 OCC describes compliance risk as the potential for

losses that result when an entity violates or does not comply with existing

laws, rules, regulations, prescribed practices, or ethical standards. The OCC

guidance also indicates that this risk is present when the laws or rules

governing certain products or customer activities are ambiguous or

untested—the situation that seems to have applied to the rapidly growing

markets for OTC derivatives. The actual types of losses that result from the

failure to adequately manage activities posing compliance risk include

regulatory fines, civil lawsuit penalties and damages, legal fees, and voided

contracts.

Entities entering transactions in OTC derivatives, MBS, and structured notes

without sound sales practices or adequate controls also subject

themselves to a second major risk—reputation risk. OCC defines this risk

as the potential for reduced earnings and firm value when negative public

33Comptroller’s Handbook: Large Bank Supervision—Bank Supervision and Examination Process,

OCC (Washington, D.C.: Dec. 1995).

Page 77 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

opinion affects an institution’s ability to establish new customer

relationships or maintain existing ones. Such losses can also arise if the

shareholders of a public corporation or the investors in an investment

company or mutual fund file suit or reduce their investments in the

affected institution.

Some Dealers Experienced

Significant Costs

Associated With Sales

Practice Disputes

The Bankers Trust case exemplifies the serious compliance and reputation

risks that deficient marketing of OTC derivatives, MBS, and structured notes

can pose. Bankers Trust’s OTC derivatives sales practice disputes have

already resulted in significant costs, and additional compliance and

reputation risk losses are possible. Regarding compliance risk, press

accounts reported that Bankers Trust forgave as much as $150 million of

the amount owed to it by Procter & Gamble and forgave $14 million of the

amount owed to it by Gibson Greetings to settle these customers’ suits.

Bankers Trust also settled with several other firms. In addition, it was

required to pay a $10 million fine to settle a joint SEC and CFTC investigation

of its dealings with Gibson Greetings and retain an independent consultant

to review and make recommendations concerning its OTC derivatives

activities. Overall, Bankers Trust reserved $423 million to absorb losses

and other payments relating to these derivative-related disputes. Press

accounts also indicated that Bankers Trust faced litigation with at least

one other derivatives customer—an Italian publishing firm that reported

losses on derivatives transactions with the bank in 1994. Furthermore,

Bankers Trust has likely incurred significant legal expenses in defending

itself against these and other lawsuits, including one by a shareholder.

In addition to these costs, Bankers Trust experienced effects on its

reputation or operations that are more difficult to directly measure. It

reported sharply lower revenues and profits for 1994—the year the

disputes came to light, and its stock price declined around the time its

customers were announcing losses. Analysts attributed much of this

reduced performance to Bankers Trust’s ongoing derivatives problems.

Also, according to press reports, Bankers Trust’s credit rating was

downgraded by the major credit rating services, which was expected to

increase its future borrowing costs. Finally, Bankers Trust’s chairman

resigned and was replaced by an executive from outside of the company.

Another major dealer—Merrill Lynch—was sued by Orange County. The

county alleged that Merrill Lynch employed deficient sales practices in

marketing structured notes and other financial products and has sought

over $2 billion in civil damages. In June 1997, without admitting

Page 78 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

wrongdoing, Merrill Lynch agreed to pay Orange County $27 million and to

reimburse the county and California $3 million to end a criminal probe

into the firm’s role in the county’s bankruptcy. Under the agreement,

Merrill Lynch will also implement changes in its procedures and training.

The agreement will not affect the county’s $2 billion civil damage lawsuit

against Merrill Lynch. The county also filed suit against a second major

securities dealer—Morgan Stanley—from whom it purchased structured

notes. Since initiating an investigation of this case, SEC has taken action

against the county’s treasurer and assistant treasurer.

As of June 6, 1997, SEC had not taken action against any of the dealers

involved for their conduct in marketing structured notes to Orange

County, and SEC officials advised us they do not discuss ongoing

investigations.34 However, a press account indicated that some Merrill

Lynch staff had earlier raised concerns with its management about the

potential risks involved with both marketing securities to and

underwriting the debt of Orange County, but that management had not

adequately addressed these concerns. If so, Merrill Lynch may have failed

to adequately consider the potentially serious compliance and reputation

risks of its sales practices and other dealings with Orange County.

A number of other dealers also face potential regulatory action or are

involved in litigation as a result of their sales of MBS and structured notes.

For example, Askin Capital’s loss of as much as $660 million on MBS in

1994 resulted in an SEC investigation of its fund’s activities and of the

dealers that sold it these investments. As previously discussed, investors in

its funds have also filed suit against these dealers in a New York state

court. These investors are seeking almost $700 million in restitution and an

additional $1 billion for damages from each of the three dealers named in

the suit.

Some smaller securities firms have also incurred and continue to face

additional costs from their dealings in MBS and structured notes. As

previously indicated, as many as 44 dealers are being investigated by

regulators for their sales of MBS and some have already been assessed

monetary sanctions by federal and state securities regulators or their

designated SRO. For example, Westcap Securities of Houston, TX, entered

into a consent settlement with SEC in February 1996 in which SEC found

that sales representatives had made false or misleading statements to

34However, SEC has filed complaints against one securities firm—CS First Boston—and two

individuals employed by that firm for their role in underwriting the debt securities Orange County used

to fund its investment portfolio. These complaints allege that the financial condition of the county at

the time of these issuances was not adequately disclosed to investors in these securities.

Page 79 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

customers in marketing CMOs and had excessively traded customer

accounts to maximize sales commissions. SEC found that supervision of

sales personnel had been deficient. SEC revoked the firm’s registration as a

broker-dealer and ordered it to pay over $800,000 in regulatory penalties

and customer restitution. The firm declared bankruptcy in April 1996.

Other smaller securities firms under regulatory investigation also incurred

additional losses and costs as a result of their sales practice-related

problems. For example, another Houston securities firm—Government

Securities Corporation—was fined $400,000 by NASD and has paid more

than $11 million in restitution and other costs as part of its activities with

over 30 local government and other public fund customers. The firm was

also suspended from selling certain securities to such customers for 2

years. Other end-user suits against dealers included one involving

Escambia County, FL, which sued in U.S. district court four of the dealers

that sold it volatile MBS that had declined in value by $21 million. In

another action, Odessa College of Texas settled legal proceedings under

terms that were not publicly disclosed against four dealers that had sold it

similar securities.

Some End-Users Also

Experienced Significant

Costs From Sales Practice

Disputes

In addition to the losses that end-users suffered when adverse market

movements reduced the value of their OTC derivatives, MBS, and structured

note holdings, some end-users have experienced additional costs and

losses similar to the compliance and reputation risk losses incurred by

dealers. The widely publicized case of Orange County is a primary

illustration of the additional adverse financial impacts that an end-user can

experience beyond the original investment loss.

In December 1994, the county filed for bankruptcy—the largest reported

occurrence of a governmental insolvency in the United States, according

to a 1995 statement to Congress by the SEC Chairman—as a result of losses

on the portfolio of investments it managed for itself and 187 other local

government participants. As indicated in the Chairman’s statement, the

subsequent liquidation of this portfolio produced at least a $1.7 billion

loss.35 His statement also elaborates that, as a result of the bankruptcy

filing, two major rating services downgraded Orange County’s debt to

speculative grade status.

35Although $1.7 billion was initially reported as the amount of the loss, some estimates indicated that

total losses exceeded $2 billion.

Page 80 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3 

Satisfaction With Sales Practices Was High

and Disputes Were Limited, but When

Disputes Occurred Losses Were Often Large

According to information reported by one of the rating services, when the

county issued $275 million in 30-year bonds in June 1995, it paid

$10 million to buy insurance guaranteeing repayment—4 times the normal

rate for such issues—and an additional .25 percent in interest to investors.

Later that same month, the county issued an additional $155 million in

bonds; this issuance carried interest payments that were more than 1

percent above comparably rated municipal bonds, according to this rating

service account. We calculated that the higher rates of interest paid on

these bond issues mean that the county will pay as much as $2.2 million

more in interest each year that these bonds are outstanding.

According to testimony by an Orange County official, the county also laid

off employees, reduced its operating budget, and is using revenue from

other sources to pay off its debt. This official stated that various other

California municipalities and public entities also made service cutbacks

and reduced planned expenditures as a result of the losses incurred on the

funds they invested with the county.

The experiences of other end-users that incurred investment losses and

had subsequent sales practice disputes also illustrate the potential for

additional compliance and reputation risk losses. For example, both City

Colleges of Chicago and Odessa College of Texas have faced additional

financial impacts beyond their initial losses on MBS investments. According

to a City Colleges’ official, the college reduced services and borrowed

additional money to cover its liquidity problem. Similarly, Odessa College

officials indicated that their MBS losses were a contributing factor in

raising student tuition, borrowing from reserves, and restructuring the

college’s debt.

The case of Gibson Greetings illustrates other compliance and reputation

risk impacts. After announcing losses on various derivatives transactions

with Bankers Trust, Gibson Greetings was investigated by and

subsequently settled the proceeding with SEC for filing financial statements

that materially misstated its derivatives positions. Although SEC did not

assess a monetary penalty, the regulator ordered the company to cease

and desist any additional violation of reporting and recordkeeping, which

will likely require that it improve its internal controls and accounting

practices for such products. Gibson Greetings also faced at least four

shareholder lawsuits that claimed that the company’s disclosures about its

derivatives activities and other operations were misleading.

Page 81 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

Some end-user losses involving OTC derivatives, MBS, and structured notes

have been accompanied by disputes over counterparty responsibilities

that reflect differences in dealer and end-user views on the nature of their

relationship. These differences in views could contribute to costly sales

practice disputes when end-users incur losses. However, reconciling these

differences could be difficult given the reaction of end-users to aspects of

dealer-issued guidance that address the nature of counterparty

relationships. Also, decisions about the specific responsibilities of

end-users and dealers can affect the costs of the transaction to each party.

In addition to the dealer-issued guidance, steps taken by other dealer

groups as well as judicial decisions related to sales practice issues have

not completely resolved the differences in end-user and dealer views. As a

result, some market participants have indicated that the involvement of

federal financial market regulators may be useful.

Disputes Have

Centered on

Counterparty

Responsibilities

Some of the widely publicized losses on OTC derivatives, MBS, and

structured notes have resulted in disputes between the end-users and

dealers involved over the specific roles and responsibilities that each

envisioned for the other, including whether a fiduciary relationship

existed.1

 An institution acting as a fiduciary to an end-user, whether

established by law or fact, must act in good faith and with loyalty and

honesty towards the end-user and disclose to the end-user all material

facts relevant to actions it takes within the context of the fiduciary

relationship. In one lawsuit, Procter & Gamble accused Bankers Trust of

misusing the trust and confidence it had placed in the bank by inducing

the firm to enter into swaps that were represented as being safe

investments, when instead the transactions entailed considerable

undisclosed risk. Bankers Trust countered that it acted solely as a

principal by dealing with and not on behalf of Procter & Gamble—that is,

by dealing with the firm on an arm’s-length basis. The bank also indicated

that Procter & Gamble, as with other counterparties, was responsible for

making its own assessment of the likely rewards and risks of the

transactions, although the bank contended that it had responded to any

questions posed and had provided reasonable and accurate information.

The resolution of this case is discussed on pages 102 and 103.

1

In general, a fiduciary relationship is a relationship in which one party owes a duty of trust, loyalty,

and confidence to another. These relationships include, but are not limited to, those specifically

imposed by law. The party that owes the duty of trust, loyalty, and confidence is a fiduciary and thus

may not deal at arm’s length (or on equal terms) with the other party but has a duty to provide full

disclosure of all relevant facts about transactions, including any financial benefits it receives. A

fiduciary’s loyalty must be undivided in that it has a duty not to act on behalf of a competitor and not

to advance self-interests at the expense of the other party. A fiduciary is entitled to compensation for

duties performed unless it is waived by prior agreement.

Page 82 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

In another publicized case, the treasurer of Orange County asserted that

he relied on the advice of various large securities firms when purchasing

structured notes that later incurred losses and contributed to the county’s

bankruptcy. The dealers denied having any advisory responsibilities and

stated that county officials had responsibility for the investments they

made. The lawsuit brought against various large securities firms over their

dealings in MBS with Askin Capital (see discussion in ch. 3) also alleged

that the dealers had breached their fiduciary responsibilities and failed to

act in the interests of Askin’s investors. In January 1997, the judge in this

case reduced the counts against these firms to those pertaining to fraud,

according to press accounts.

As these cases indicate, determining whether a formal fiduciary

relationship exists can be difficult. In some instances, fiduciary duties are

clearly placed on a financial institution by law when the institution agrees

to act as an agent in performing certain services. Such fiduciary duties

arise, for example, when a bank’s trust department manages the assets of

an estate or when an investment advisor manages the investments of a

pension fund. In other instances, courts have found fiduciary duties

applied to a financial institution that had not formally agreed to provide

fiduciary services, but whose past relationship with a customer showed a

pattern of reliance by the customer on the institution’s advice. The factors

that courts have considered to establish such a pattern of reliance include

the extent to which a customer followed the institution’s

recommendations, statements by the customer indicating reliance or

dependence on the institution, and the customer’s general level of

sophistication. Generally, courts have ruled that the larger and more

sophisticated the customer, the greater its responsibility to independently

assess the value and risks of a transaction and the lesser the dealer’s

responsibility to determine the suitability of a security and to fully disclose

product risks and valuations. No specific standards distinguish between

sophisticated and unsophisticated customers or degrees of sophistication.

Even when no special relationship exists between a financial institution

and an end-user, the institution may have an obligation to disclose to the

end-user information regarding a transaction about which it has superior

knowledge. Under principles defining common law fraud, superior

knowledge or access to the means of knowledge can give rise to an

affirmative duty to disclose material information, particularly when the

information is not within reasonable reach of the other party. Applying

this principle to the securities markets, federal courts have held that

securities firms have a special duty not to take advantage of customers’

Page 83 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

lack of knowledge and, therefore, firms must disclose certain material

information—such as the amount of the markup they are charging—even

when executing a transaction on a principal-to-principal basis.

The Potential for

Additional Disputes

Arises From the

Differing Views of

End-Users and

Dealers

Differences between end-users and dealers in the way they view their

responsibilities in transactions involving OTC derivatives, MBS, and

structured notes indicate that costly disputes may continue to accompany

end-user losses. Our survey indicated that a large percentage of end-users

believed that a fiduciary relationship exists when they engage in

transactions involving these products. However, additional follow-up

contacts with respondents revealed that, when end-users indicated a

fiduciary relationship existed, they were expecting dealers to accurately

describe product features, performance, and material risks. Our survey

also indicated that a significant percentage of end-users relied on dealers

for investment advice.

However, end-users’ views on counterparty relationships differed from

those reflected in voluntary guidance issued by two groups of dealer

representatives. In the guidance, transactions in OTC derivatives are

presumed to be on an arm’s-length basis—with no special responsibilities

or reliance expected of either party—unless otherwise agreed to or

provided by law. While the dealer-issued guidance is voluntary and

intended only to supplement any existing responsibilities that parties to

these transactions may have, the approaches to the nature of the

relationship, degree of reliance, and expectations for risk disclosure

between parties differed in some, but not all, respects from the way that

such issues are addressed in existing U.S. and U.K. regulatory

requirements applicable to securities, futures, and other financial

products.

End-Users Attributed

Some Fiduciary

Responsibilities to Dealers

In our survey, we asked end-users to indicate the extent to which they

believed a fiduciary relationship existed between them and dealers

offering OTC derivatives, MBS, and structured notes. However, we did not

define the term fiduciary. The responses revealed that a significant

number of end-users attributed fiduciary-like responsibilities to dealers in

at least some transactions involving these financial products. On the basis

of responses to our survey, we estimated that 53 percent of end-users

believed dealers had a fiduciary relationship in some or all transactions

Page 84 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

involving plain vanilla OTC derivatives, and that 48 percent2 attributed such

responsibilities to dealers in some or all transactions involving more

complex OTC derivatives, as shown in figure 4.1.

Figure 4.1: Extent to Which End-Users

Believed Dealers Had a Fiduciary

Relationship

0

20

40

60

80

100

53

31

48

36

60

25

58

26

Percentage of end-users indicating fiduciary relationship existed

Plain vanilla More complex MBS Structured

notes

In all cases

In some cases Never

Securities

a

OTC Derivativesb

Note: Percentages of end-users indicating no opinion are not shown.

aSubject to a plus or minus 16-percent (or less) sampling error.

bIncludes securities OTC derivatives.

Source: GAO survey.

2

Subject to a plus or minus 16-percent sampling error. See footnote 2 in chapter 3 for an explanation of

sampling errors related to estimates from our survey analysis.

Page 85 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

To better understand survey responses indicating that a fiduciary

relationship existed, we reviewed comments on returned questionnaires

and conducted follow-up telephone interviews with 50 judgmentally

selected respondents, including those that were both satisfied and

dissatisfied with dealer sales practices. In explaining their response that a

fiduciary relationship existed, most end-users told us that this meant

dealers had a duty to disclose adequate information about the products

and their risks. Many end-users also commented that dealers should be

truthful and provide accurate information. In addition, some end-users

indicated that dealers should generally have the end-users’ best interests in

mind. For example, an official at a GSE that used OTC derivatives, MBS, and

structured notes told us that, although a legal fiduciary relationship did

not exist, his organization expected dealers to be open and forthcoming

with information, and that this expectation creates responsibilities for

dealers similar to those of a fiduciary.

The percentage of end-users that believed fiduciary relationships existed

as part of transactions in these products was generally similar across OTC

derivatives, MBS, and structured notes. As discussed in chapter 1, no

specific federal sales practice requirements apply to OTC derivatives that

are not securities or subject to the CEA antifraud provisions. However, MBS

and structured notes are subject to the antifraud provisions of federal

securities laws, which require dealers to disclose risks and assess the

suitability of transactions involving such products for end-users. Because

the percentages of end-users indicating that a fiduciary relationship

existed for transactions involving OTC derivatives were not significantly

different from the percentages for securities products, it does not appear

that the different requirements afforded these products greatly influenced

the degree of responsibility that end-users placed on dealers.

However, our analysis of survey responses revealed some differences by

type of industry. Officials of state and local governments were more likely

than those from most other organizations to report believing that a

fiduciary relationship existed in some or all transactions involving OTC

derivatives, MBS, and structured notes. In contrast, GSEs were significantly

less likely than organizations in some other industries to report that such a

relationship existed between them and their dealers. Because of the small

number of respondents within some industry groups, statistically valid

comparisons between most industries could not be made. However,

overall, the responses across industries generally indicated that entities

whose primary function included operating or managing portfolios of

financial assets—such as GSEs, mutual funds, commodity pools, and

Page 86 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

money managers—were least likely to believe that a fiduciary relationship

existed. Entities whose use of these products was generally more limited,

such as state and local governments and nonfinancial corporations, were

correspondingly more likely to believe a fiduciary relationship existed.

End-Users Also Indicated

Reliance on Dealers for

Investment Advice

In addition to views regarding fiduciary responsibilities, end-users

indicated that they relied to some extent on dealers to provide investment

advice as part of these transactions. As shown in figure 4.2, the percentage

of end-users that indicated they relied on dealers to provide investment

advice from some to a very great extent ranged from 59 percent for plain

vanilla OTC derivatives to 84 percent for structured notes.

Figure 4.2: Extent to Which End-Users

Relied on Dealers for Investment

Advice

0

20

40

60

80

100

59

36

64

32

73

20

84

10

Plain vanilla MBS Structured

notes

To great or very great extent

To some or moderate extent To little or no extent

More complex a

Securities

Percentage of end-users indicating reliance

OTC Derivativesb

Note: The percentages of end-users indicating no opinion are not shown.

Page 87 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

aSubject to a plus or minus 15-percent sampling error.

bIncludes securities OTC derivatives.

Source: GAO survey.

Dealer-Issued Guidance

Asserts an Arm’s-Length

Relationship

In 1995, two dealer groups each issued guidance that addresses sales

practices, including the nature of the relationship and the specific

responsibilities of parties to transactions involving OTC derivatives. The

first set of guidance, the Framework for Voluntary Oversight (the

Framework), was issued by the Derivatives Policy Group in March 1995.

This group consists of six securities firms whose affiliates did

approximately 90 percent of all U.S. securities firm-related business in

nonsecurities OTC derivatives.3

 The Framework was issued in response to

concerns by Congress and others that the nonsecurities OTC derivatives

activities of these firms were conducted in affiliates not subject to any

direct U.S. regulation.4

 The Framework contains procedures the

participating firms have agreed to voluntarily follow in four major areas

related to OTC derivatives, including counterparty relationships, which

address dealer sales practices.5

 Specifically, the counterparty relationships

section consists of guidelines for professional intermediaries to follow in

dealing with nonprofessional counterparties. Currently, the Framework

applies only to the six firms and only to their nonsecurities OTC derivatives

activities.6

In August 1995, six financial industry groups,7 in coordination with the

Federal Reserve Bank of New York, released the Principles and Practices

for Wholesale Financial Market Transactions (the Principles). The purpose

of the Principles is to define the relationship between institutional

3

The six firms include CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan

Stanley, and Salomon Brothers.

4

See chapter 2 for more detail on the regulatory structure under which these firms operate and chapter

6 for a discussion of SEC and CFTC monitoring of these firms.

5

The other three areas are management controls, reporting, and evaluation of risk in relationship to

capital.

6

The Framework enumerates the products it covers. SEC officials told us that, in general, it addresses

OTC derivatives not otherwise subject to regulation under the securities laws.

7

The six groups included the Emerging Markets Traders Association, the Foreign Exchange Committee

of the Federal Reserve of New York, ISDA, the New York Clearing House Association, the Public

Securities Association, and the Securities Industry Association. Since being issued in August 1995, the

Principles has been endorsed by two additional associations, the Institute of International Bankers and

the Bankers Roundtable.

Page 88 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

participants and to set out sound practices to be followed as part of

transactions in OTC financial products, including OTC derivatives, MBS, and

structured notes. This guidance does not purport to apply to transactions

involving retail customers. The Principles resulted from an invitation by a

senior official at the New York Federal Reserve Bank to representatives of

the six groups to develop a code of conduct for U.S. financial markets.8

 In

contrast to the Framework, the Principles was promoted for use by all

institutional market participants and does not make distinctions in its

recommended practices on the basis of any differences in the professional

or nonprofessional nature of the parties to a transaction.

Although differences between the two sets of dealer-issued guidance exist,

we did not find these differences to be material. One of the members of

the Principles drafting committee, whose firm also served on the

committee that developed the Framework, reached the same general

conclusion. At an April 5, 1995, public meeting at which the Principles

drafting committee discussed the provisions of Principles, he stated that

the spirit of the two documents is the same and that it would be unfair to

contrast them simply because they use different language in some

sections.

Overall, we found that the two sets of dealer-issued guidance advocate a

similar approach to counterparty relationships. Both assert that the

relationship between counterparties—unless otherwise agreed to by the

parties or provided by law—is arm’s length with neither party relying on

the other, even if information is exchanged. Also, neither set of guidance

requires risk disclosure on specific transactions by either party, although

each states that the parties should consider exchanging such information

when the transaction is more complex or involves leverage. The summary

introducing the Framework also indicates that the six participating firms

have agreed to provide a generic risk disclosure document to new

counterparties.9

 In addition, both sets of guidance recommend similar

procedures for exchanging pricing information and controlling and

supervising personnel. Furthermore, both state that they are not intended

to create legally enforceable obligations; however, courts could find the

guidance useful in evaluating counterparty relationships and defining

counterparties’ respective common law responsibilities. Table 4.1

compares the major sales practice provisions of the two sets of guidance.

8

Several such codes existed for foreign market participants, but no code existed for U.S. market

participants.

9

The counterparty relationships section of the Framework states that firms “should consider

providing” these generic risk disclosure documents.

Page 89 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

Table 4.1: Key Sales Practice Elements of the Dealer-Issued Guidance

Element The Framework The Principles

Nature of the

relationship

Transactions are predominantly arm’s length in which

each party has the responsibility to review and

evaluate the terms, risks, and benefits of the

transaction.

Transactions are arm’s length and both parties should

have the capability to understand and make

independent decisions about transactions.

Reliance on the

dealer

A dealer should not create the impression that it is

acting in an advisory capacity and should take steps

to clarify the relationship if the counterparty indicates

that it believes the dealer is acting in such a role.

Absent any written agreement or applicable law or

regulation, information passed between the parties

should not be construed as investment advice or

recommendations upon which the other party may

rely.

Disclosure of risk No disclosure is required on specific transactions, but

the summary indicates participating firms have

agreed to provide a generic risk disclosure statement

that describes principal OTC derivatives risks and that

clarifies the nature of the counterparties’ relationship.

Also, when specifically requested, particularly for

more complex or leveraged transactions, dealers

should provide additional information that accurately

presents the potential transaction’s risks and benefits,

such as scenario analyses (which shows how a

product’s value may change under different market

circumstances).

No disclosure is required, and, if none is requested,

the counterparties are to assume that each has

sufficient information about transaction risks and

terms for its decisionmaking process. A written outline

of the material terms of the transaction is considered

helpful. If a transaction is particularly complex or has

significant leverage, counterparties are advised that

they may wish to share more information, such as

scenario analyses.

Disclosure of

valuation or pricing

information

When provided, such information should be prepared

in good faith and should not be misleading. Dealers

should take steps to ensure that their counterparties

understand the type of price quote or valuation they

are receiving (i.e., indicative price, firm price, or

mid-market valuation).

Counterparties are not obligated to provide valuations

but should have policies to address the specific

methodology used for calculating such information. If

unable to internally value transactions, counterparties

should seek external valuations and clearly indicate

the desired type of valuation information being sought.

Internal controls Dealers should adopt internal policies and

procedures to foster strong relationships with

counterparties. Mechanisms should be in place for

supervising activities of personnel engaged in OTC

derivatives transactions.

Counterparties should have board or senior

management-approved policies covering their use of

financial products and should maintain and enforce

controls and compliance procedures, including those

relating to supervising personnel, to ensure that such

transactions are conducted in accordance with

applicable legal and regulatory requirements, internal

policies, and other requirements.

Sources: GAO analyses of the Framework for Voluntary Oversight and the Principles and

Practices for Wholesale Financial Market Transactions.

As a part of stating that neither counterparty should rely on the other, both

the Framework and the Principles advocate that each party should be

capable of independently analyzing prospective transactions. This

expectation is generally consistent with existing risk management

guidance, such as that issued by the Group of Thirty10 and others, for

10The Group of Thirty is an international financial policy organization whose members include

representatives of central banks, international banks and securities firms, and academia.

Page 90 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

entities engaging in transactions in OTC derivatives, MBS, and structured

notes. This other risk management guidance typically recommends that

such entities have adequate risk management systems in place, including

the ability to measure and control the risks associated with using these

products. The Framework and the Principles echo this advice by

maintaining that each party is responsible for assessing the risks of a

transaction and its own risk tolerance or capability for managing such

risks. While stating that the relationship between parties is arm’s length,

both sets of guidance advocate that parties clarify their relationship or

obligations in writing. For example, the Principles states that any changes

in the assumed relationship from one of arm’s length should be agreed to

in writing.

Although the two sets of dealer guidance indicate that entities wishing to

adhere to them should implement certain practices or controls, neither

establishes any minimum responsibility for disclosing the risks of specific

transactions—although this is an area where problems and disputes have

arisen. Nonetheless, when such information is shared, both sets of

guidance offer advice on the types of disclosure that could be made and

provide suggestions for making certain kinds of disclosures. For example,

both discuss providing scenario analyses that are not misleading and that

adequately explain any assumptions made.

Both sets of guidance also indicate that all dealings should be conducted

fairly and accurately. For example, the Framework states that dealers

should conduct their OTC derivatives activities honestly, in good faith, and

in a manner consistent with the promotion of public confidence in the

integrity of the markets. It also indicates that all materials should be

accurate and reasonable and that professional intermediaries “should

consider including legends with those materials that identify various

assumptions underlying the analyses presented, describe market factors

that may affect the analysis, and/or inform the party receiving the

materials that a variety of assumptions and market factors may affect the

analysis.” Similarly, the Principles indicates that “a Participant should act

honestly and in good faith when marketing, entering into, executing and

administering Transactions.” It subsequently indicates that any

communications between the parties, either oral or written, should be

accurate and not intentionally misleading. The Framework and the

Principles also urge that any assumptions used in scenario analyses be

reasonable and that the unique market terminology and conventions of

particular transactions not be used in a misleading way.

Page 91 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

The Framework and the Principles also note that participants must be

mindful of the potential for transactions to result in disputes as well as to

expose them to compliance risk—the risk of loss from counterparty or

shareholder lawsuits, regulatory fines, and voided contracts—and

reputation risk—the risk of loss from reduced revenues and firm value.

Both sets of dealer guidance acknowledge that certain transactions pose

greater levels of these risks, such as when the transaction is more complex

or involves leverage, or when the counterparty lacks sophistication or the

capability to independently analyze the transaction. In such cases, both

indicate that participants may wish to increase the amount of information

they exchange, involve additional internal personnel or external advisors

in negotiating the transactions, or take other steps, including avoiding the

transaction. Both sets of guidance also advocate that counterparties

establish policies and procedures to assess and mitigate the extent to

which these transactions create compliance and reputation risks for each

party, such as when counterparties appear to believe that the dealer has

assumed an advisory role.

The Dealer-Issued

Guidance Differs in Some,

but Not All, Respects From

Regulatory Standards

Applicable to Other

Activities

To identify any significant differences between the dealer-issued voluntary

guidance11 and other existing sales practice standards, we compared the

major tenets of the dealer guidance to the approaches embodied in bank

supervisory guidance, a foreign code of conduct, and U.S. commodities

and securities laws.12 Differences between the dealer-issued guidance and

these other standards could generally be attributed to differences in their

purpose and intent, products covered, or entities subject to them.

The sales practice requirements placed on banks that market OTC

derivatives are largely consistent with the dealer-issued guidance,

although certain differences exist. Similar to the dealer-issued guidance,

OCC and Federal Reserve guidance each indicates that bank counterparties

are ultimately responsible for ensuring the appropriateness of transactions

with bank dealers. Similar to the dealer-issued guidance, OCC guidance

does not specifically require risk disclosure on individual transactions.

The Federal Reserve guidance appears to require risk disclosure as it

expects banks, if they determine that a counterparty is unsophisticated, to

11The drafters of the Principles intended that their guidance be applicable to all institutional financial

market transactions, not just to those involving OTC derivatives. Nonetheless, they have

acknowledged that entities adhering to the guidance are not relieved of any obligations under existing

law.

12We were aware when doing these comparisons that the dealer-issued guidance is most relevant to

transactions involving nonsecurities OTC derivatives, which currently lack a specific body of law

relevant to sales practices.

Page 92 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

take steps to ensure that the counterparty is made aware of transaction

risks. The goal of bank supervisory guidance as it relates to OTC derivatives

is to promote the safety and soundness of regulated institutions; it is not

specifically intended to protect those who engage in financial transactions

with these institutions.

The expectations for dealers set out in the dealer-issued guidance are also

similar in some, but not all, respects to the requirements applicable to

futures trading in the United States. Similar to the dealer guidance, U.S.

commodities laws do not require entities marketing futures and

exchange-traded options to determine whether such products are suitable

for their customers. However, in contrast to the Principles, U.S.

commodities laws require that the customer be apprised of the significant

risks of buying and selling these products, including disclosing that the

prices of futures and options can be volatile and that the customer may

incur losses that are larger than the amount originally invested.

The dealer-issued guidance is most similar to regulatory requirements

issued in one of the major foreign markets for OTC derivatives and foreign

exchange. In July 1995, the Bank of England issued an update to The

London Code of Conduct,

13 which was developed in conjunction with U.K.

market participants. Similar to the U.S. dealer-issued guidance, the U.K.

code establishes that the nature of the relationship for products in

institutional markets involves transactions between principals, with

end-users assumed to be capable of independently evaluating the

transaction. In addition, the U.K. code states that if the end-user wishes to

retain the other party as an adviser, it should do so in writing.14 Just as

with the U.S. dealer-issued guidance, the U.K. code also states that

participants share an interest in maintaining high standards of business

conduct and fair dealing. However, whereas compliance with the U.S.

dealer-issued guidance is voluntary, compliance with the U.K. code is

mandatory. The code indicates that the U.K. central bank—the Bank of

England—will view breaches of its provisions seriously, will investigate

complaints, and may employ a range of sanctions against violators.

The responsibilities envisioned by the dealer-issued guidance contrast

most with the SEC requirements imposed on dealers marketing securities in

13The London Code of Conduct: For Principals and Broking Firms in the Wholesale Markets, Bank of

England (London: July 1995).

14The U.K. code classifies securities firms, banks, and other financial institutions as “core” principals

and considers other institutions, companies, and governments as “noncore” principals active in these

markets. Core principals are expected to adhere to this code in their dealings and noncore principals

are expected to understand these institutions’ roles and responsibilities.

Page 93 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

the United States. Although the Framework and the Principles do not

supersede existing regulatory requirements, they vary in several major

respects from U.S. securities law requirements. Whereas the dealer-issued

guidance asserts that an arm’s-length relationship exists between

counterparties, dealers marketing securities are expected to ensure that

transactions they recommend are suitable, given the investment

objectives, financial condition, and sophistication of the end-user.

Disclosure of transaction risk, which the dealer-issued guidance makes

optional for specific transactions, is generally expected as part of

securities transactions.

The differences between the dealer-issued guidance and U.S. securities

laws may stem, in part, from differences in the types of entities to which

each applies. The dealer-issued guidance addresses transactions between

participants who tend to be large financial and commercial entities and

tend to be financially sophisticated. In addition, the dealer-issued guidance

does not apply to individual investors. In contrast, the antifraud provisions

of the U.S. securities laws apply equally to all investors and do not

distinguish between institutional and individual end-users.15 Furthermore,

the required disclosures that must be made as part of corporate securities

issuances are designed to ensure that any superior knowledge about the

financial condition and risks associated with the entity issuing the

securities are made known to prospective investors.

Reconciling the Views

of End-Users and

Dealers Could Be

Difficult

End-user and dealer reactions to the specific tenets of the Framework and

the Principles have been mixed. Such reactions may reflect the parties’

differing interests when it comes to defining the nature of their

relationship in transactions involving OTC derivatives. Part of the difficulty

arises because altering the nature of the relationship between end-users

and dealers affects the costs of the transaction to each party. In addition to

the dealer-issued guidance, actions by a dealer group to standardize

contract language as well as judicial decisions related to sales practice

issues have not completely resolved the differences in end-user and dealer

views. Therefore, various market participants have recognized the need to

resolve these differences, and some have acknowledged that the

involvement of federal financial market regulators might be necessary.

15In some cases, U.S. securities laws make distinctions between types of investors, such as the reduced

disclosure requirements pertaining to private placements of securities. NASD’s recent suitability

interpretation also addresses dealers’ responsibilities to institutional versus other end-users.

Page 94 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

Reactions to the Tenets of

the Dealer-Issued

Guidance Have Been

Mixed

End-user representatives, including EUDA, GFOA, the National Association of

State Treasurers (NAST),16 the North American Securities Administrators

Association (NASAA),17 and the Department of Labor have criticized the

tenets of the dealer guidance.18 Others, including legal experts, have also

voiced concerns about specific provisions of the guidance. In contrast,

representatives of dealers and certain other organizations have supported

the guidance.

Although public comments were not sought on the Framework, the

drafting committee of the Principles solicited comments before finalizing

the guidance. We analyzed the comment letters to identify the views of

end-users and others on the specific tenets of the dealer-issued guidance,

many of which were common to both the Principals and the Framework.

Of the 21 organizations that commented, we spoke with 9 that provided

substantive criticisms of the Principles. These nine organizations told us

that their primary criticisms had not been addressed in the final version of

this guidance.

One of the primary objections raised by commenting organizations was

that the dealer-issued guidance inappropriately assumes that an

arm’s-length relationship should prevail for all transactions. Those citing

this issue argued that the dealer guidance thus imposes a “one-size-fits-all”

model on end-users despite their varying levels of financial sophistication.

For example, in their joint comments on the final draft of the Principles,

three associations representing governmental entities19 stated that

because the guidance uses the term “participant” to refer to both dealers

and end-users, no distinction is made between their respective roles and

responsibilities. As a result, they believe that the value of most of the

document is negated. Additionally, the associations stated that end-users

are a diverse group and that assuming they all have equivalent levels of

expertise, responsibility, and access to information is erroneous.

16NAST is a 75-member association of state and territorial treasurers, deputies, and staff.

17NASAA members are the securities regulators of the 50 states, the District of Columbia, Puerto Rico,

the Canadian provinces and territories, and Mexico. It develops model codes and guidelines, facilitates

cooperative enforcement efforts, fosters information-sharing, and provides training.

18As well as reviewing journal articles and conference proceedings, we also obtained copies of critical

letters that various organizations sent to the drafting committee of the Principles. These organizations

included the Treasury Management Association, the Financial Executives Institute, NASACT, and the

New York State Bar Association.

19The three associations were GFOA, NAST, and NASAA.

Page 95 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

Another criticism has been that the Principles may reduce end-users’ legal

protections. In a May 3, 1996, letter to the Federal Reserve Bank of New

York, EUDA noted that Bankers Trust offered the Principles as

documentation of common practices for OTC derivatives transactions in

support of its litigation with Procter & Gamble. EUDA indicated that

Bankers Trust’s action affirmed the association’s original concerns that

the Principles would be used by dealers to reduce the legal protections

afforded end-users. EUDA characterized the Principles as “essentially a

unilateral effort on the part of the dealer community to shift

responsibilities from the dealers to end-users and to buttress the position

of the dealers in pending and possible future litigation.” Some have argued

that adherence to the dealer guidance may negatively affect the ability of

end-users to claim reliance on dealer representations. GFOA, NASACT, and

NAST stated in a joint issuance to their members that they might

inadvertently waive existing legal rights if they agreed to be bound by the

Principles without careful prior review.20 In their letter commenting on the

draft of the Principles, these organizations also indicated that the attempt

by the guidance to preclude reliance on a dealer was not realistic because

potential investors should be able to, and often do, rely on representations

made by dealers about products. However, the organizations stated that

the guidance would require written acknowledgement by the dealer before

any such reliance could occur.

Some of the commenting organizations also objected to the guidance

because it does not place any responsibilities on dealers to disclose

transaction risks or valuations. For example, in its November 1995

newsletter, EUDA stated that the Principles drafting committee had

“philosophically rejected the idea that dealers should have any affirmative

obligation to disclose material risks of OTC derivative transactions to

end-users, irrespective of the complexity or novelty of the transactions.”

Later in that newsletter, EUDA stated that “the final Principles make it clear

that a dealer is not obligated to provide periodic valuations to its end-user

counterparty, regardless of whether the instrument sold is a proprietary

product of the dealer for which market valuations are neither publicly

available nor readily ascertainable.” The associations representing

governments stated that the guidance should recognize a dealer’s

affirmative obligation to provide information material to a transaction

instead of requiring an end-user to request it. They believe that failing to

do so inappropriately assumes that both sides have equal information.

They also objected to the Principles’ assumption that any additional

20State and Local Government Investor Protection ALERT, GFOA, NAST, and NASACT (Washington,

D.C.: Oct. 16, 1995).

Page 96 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

transaction information, if not specifically requested, is considered

unnecessary.

In commenting on the Principles, various associations representing

governmental entities stated that the Federal Reserve’s agreement with

Bankers Trust21 would be a better model for disclosing risk and ensuring

that end-users understand transactions.22 Such a model would require

dealers to (1) provide every counterparty with information about the

material terms and risks of any applicable proposed transactions,

(2) ensure that every counterparty could understand such terms and risks,

and (3) ensure that the means by which product prices and values are

determined are reasonably clear to counterparties. Dealers would also be

required to meet specific disclosure obligations for proposed transactions.

Another criticism of the guidance was that end-users were insufficiently

involved in their development. For example, the Department of Labor

stated in its comment letter on the draft Principles that “entities which had

no involvement in the creation of the Principles, had not agreed to adhere

to the Principles, or may not even have known of its existence could be

viewed as subject to the Principles.” The agency also stated that the

Principles should only apply to entities that subscribe to them in writing.

According to EUDA, “the process followed in developing the Principles and

Practices was fundamentally flawed” because representatives of the

end-user community were excluded from the Principles Drafting

Committee. The treasurer of a major utility, who is an EUDA board member,

was quoted in an industry publication as stating that “this is probably the

only area in the finance world where a group of dealers have shaped both

the products and all of the surrounding rules and regulations, with no

input from those who are not dealers.”23

Finally, in a May 1995, letter to the Principles drafting committee, GFOA

contrasted the Framework with the Principles by stating that the

Framework “takes limited steps in advising professional intermediaries to

OTC transactions to disclose information regarding risks, clarify valuation

questions, and provide training regarding counterparty relationships.” A

GFOA official told us that, although these documents call for largely the

21The Bankers Trust-Federal Reserve agreement applied these heightened requirements only to those

transactions involving significant leverage. The agreement is discussed more fully in chapter 6.

22Comments on Principles and Practices for Wholesale Market Transactions, GFOA, NAST, and

NASAA (Washington, D.C.: May 19, 1995).

23“Resolving the Dealer-User Conflict,” Derivatives Strategy, May 1996, Vol. 1, No. 6, page 17.

Page 97 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

same practices, GFOA believed that the Framework was more balanced in

tone.

Representatives of dealers and other organizations have viewed the

Principles more positively. A member of the ISDA board told us that the

greater use of OTC derivatives has increased the need for dealers to

formally explain their products and activities, including the risks

associated with product use and the nature of their responsibilities in

these transactions. A managing director at a large U.S. securities firm said

that he disapproved of end-users who, when faced with losses, decide that

they were not fully informed about the transactions. Therefore, he saw the

guidance as valuable for describing the customary way the institutional

markets work and for clarifying that dealers, unless otherwise agreed to,

do not have fiduciary obligations as part of these transactions. An official

from the New York Federal Reserve Bank indicated that the Principles

provides a sound basis for relationships between parties conducting

activities in financial products. He said that it assumes an arm’s-length

relationship unless otherwise agreed to and acknowledged that parties can

agree to alter this assumption in writing if it does not fit their

circumstances. He also stated that the United Kingdom makes the same

assumption about the nature of counterparty relationships, and it would

be problematic for U.S. practices to be inconsistent with those of other

major markets.

The Interests of End-Users

and Dealers Conflict When

It Comes to Defining Their

Relationship

Difficult issues remain to be resolved before the differing interests of

end-users and dealers over the nature of their relationship can be

reconciled. To date, attempts to address these differences have not been

successful. The primary areas of disagreement and uncertainty between

end-users and dealers, and among the most difficult to resolve, are the

nature of their relationships in transactions involving OTC derivatives that

are not securities or futures and whether or not each party can rely on the

statements made by the other. Under the securities laws, an implied

standard of fair dealing allows end-users to rely on dealer statements and

advice about a security. Although both sets of dealer-issued guidance

indicate that neither party is presumed to be relying on the other, these

documents contain language stating that transactions and communications

between parties are expected to be accurate and made in good faith.

According to the New York Federal Reserve Bank official who sponsored

the development of the Principles, this language means that misstatements

are not permissible. An official of a U.S. securities firm that participated in

drafting the Principles said that, although neither party has the duty to

Page 98 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

advise the other about the risks of the transaction, a “buyer beware”

philosophy is not assumed because the Principles calls for honest dealings

between the parties.

Some dealer officials explained that allowing counterparties to view their

firms’ statements as investment advice as a part of these transactions can

be problematic. They said that to provide investment advice, dealers need

to understand the complete financial position of their counterparties;

however, end-users are not always willing to provide this information. A

managing director at one of the major dealer banks, who also sits on ISDA’s

board, told us that OTC derivatives contracts require performance by both

parties. As a result, it is not reasonable to hold dealers totally responsible

for the actions of the end-user.

Dealers also explained that the information they provide is not advice,

rather it describes and explains the products. Dealers told us that they

offer useful products that can meet the needs of end-users seeking to

hedge risks or to obtain an investment return. In explaining how they

marketed these products, dealers said they take time to learn end-users

needs, assess end-users’ current financial condition, and provide end-users

education or explanations about products. For example, officials at one

U.S. securities firm provided us with a sample of a presentation given to an

end-user. The 26-page document included a detailed analysis of the

end-user’s exposure to changes in interest and currency exchange rates.

However, officials representing end-users and other organizations

indicated that when the complexity or other features of some products

render their risk characteristics less obvious, then reliance on dealer

statements is sometimes necessary. An official working in the treasury of a

large end-user commented at an April 1996 conference that, although his

firm was financially sophisticated, the effort required to fully analyze the

performance of certain complex products was beyond his firm’s

capabilities. Therefore, the firm needed to be able to rely on dealer

statements about how the products would perform as market rates

changed. He said that, although the dealers’ marketing staff who explain

complex transactions are willing to allow his firm to rely on their

representations, the dealers’ legal staff advised his firm that no such

reliance can be made because such firms are seeking to avoid the resulting

legal liability. An attorney representing EUDA at a July 1996 forum on these

issues said that dealers have superior knowledge about the proprietary

products they develop and end-users find replicating the valuations of

some products very difficult. During an address to an industry conference,

Page 99 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

an SEC commissioner said that dealers sometimes are tempted to describe

products in sophisticated terms to increase their proprietary value.

Although comments on a draft of the Principles were solicited in a public

session, few meetings between end-user and dealer groups have been held.

A representative of GFOA said that members of the Principles drafting

committee met with their organization and other governmental end-user

associations just before issuing the final draft of that document. A

representative from another end-user organization told us that his

organization had been approached in early 1996 about working on a

committee to revise the Principles, but they had declined to participate at

that time because, according to this official, participation was made

contingent on endorsing the Principles. As of August 1997, no additional

meetings for the purpose of reconciling dealer and end-user views on the

nature of their relationship as part of OTC derivatives transactions had

been held.

The Financial Impact of

Altering the Nature of

Relationships May Make

Resolving Disagreements

More Difficult

Resolving disagreements about the nature of the relationship between

end-users and dealers may be more difficult because the resolution can

affect who bears what costs in transactions involving OTC derivatives, MBS,

and structured notes. As our survey and other information indicated,

end-users believe they should be able to rely on the information that

dealers provide. However, dealers and others told us that, if end-users

want to rely on the information provided, then it would be considered

investment advice and the dealers would have to increase transaction

prices or arrange separate compensation to reflect the increased legal risk

in providing such advice. A former securities regulatory official said that

reconciling the opposing views of the parties will be difficult because

neither wants to assume the likely increased costs of the transactions. He

noted that dealers, despite providing sometimes voluminous information

about a product and its function, do not wish this information to be

considered a recommendation or investment advice that can be relied

upon because they do not want to assume any related legal liability.

Conversely, he said that end-users want to obtain information from a

dealer at no cost, secure competitive price quotes from a number of

dealers, and then retain the right to sue the dealer used if the transaction

loses money.

In January 1995 testimony before Congress, the Chairman of the Board of

Governors of the Federal Reserve System also discussed how altering

dealer responsibilities could create additional costs that are detrimental to

Page 100 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

the markets.24 The Chairman testified that dealers in financial transactions

sometimes assume a role beyond that of a mere counterparty, such as

when they provide advisory services. However, if dealers are required to

ensure that an end-user’s use of a product is appropriate, such

requirements may serve as a means for end-users to shift a transaction’s

risk back to the dealer through legal actions. If such legal risks are

exacerbated, dealers may begin charging a premium to cover uncertain

future legal claims, and some dealers could move their activities overseas

or withdraw from the market altogether. He said that such an outcome

would present considerable costs to the economy because of the resulting

interference in liquid and efficient markets.

A Dealer Group Proposed

Contract Language to

Address the Nature of

Counterparty

Relationships

ISDA proposed standardized language that describes the nature of the

relationship between counterparties to OTC derivatives transactions and

that could be incorporated into OTC derivative contracts. ISDA suggests that

this language be added to the ISDA master agreement—the standardized

contract used to document the obligations of parties to OTC derivatives

transactions.25 If included as part of such contracts, each party would be

representing that

• it was not relying on the other party and was making its own decisions

about the transaction,

• it was capable on its own (or with independent professional advice) of

understanding the terms of the transaction and its risks, and

• it was not acting as a fiduciary or an advisor in the transaction.

An official from a large U.S. corporation indicated that his firm refused to

sign contracts with this provision. He said that, although his firm did not

expect dealers to act as fiduciaries, it wanted to be able to rely on

statements of fact made by the dealers about product performance under

different market conditions. He noted that, although his firm was large

enough to refuse to sign contracts that included language such as that

suggested by ISDA, smaller end-users might not have the same clout and

thus might sign as a condition of completing a transaction.

An attorney speaking on behalf of EUDA at a July 1996 industry forum said

that the organization was cautioning end-users about signing contracts

24Testimony by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System:

Committee on Banking, Housing, and Urban Affairs; United States Senate (Washington, D.C.: Jan. 5,

1995).

25Representation Regarding Relationship Between Parties, ISDA (New York, N.Y.: Mar. 6, 1996).

Page 101 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

with this language in the event that doing so waived rights they might

otherwise have, such as the ability to claim fraud on the basis of

misrepresentations or omissions of fact. Although ISDA had amended the

representation in an attempt to address this concern, the attorney told us

that she was aware of the amendment when she spoke at the conference

and that EUDA’s reservations about the representation’s language persist.

Recent Court Decisions

Have Found That OTC

Derivatives Dealers Have

Some Responsibilities, but

They Have Not Resolved

Key Issues

In two cases resolved since 1995, courts have indicated that, although OTC

derivatives dealers were not acting as fiduciaries, they were held

responsible for being accurate when disclosing transaction risks. The first

case, decided in the English Commercial Court in December 1995, was

decided in the dealer’s favor. Although a U.K. case, the decision is relevant

to U.S. OTC derivatives counterparties because many of their swaps

personnel are located in London, and the ISDA master agreement used to

document OTC derivatives contracts offers the choice of either New York

or U.K. law as the governing jurisdiction for disputes. The case concerned

two swaps transactions executed between Bankers Trust and an

Indonesian business conglomerate. The Indonesian firm claimed, among

other things, that the bank had made fraudulent misrepresentations and

had a “duty of care” to fully explain the transactions and their risks. The

judge found that Bankers Trust had not made a complete disclosure of the

risks as part of these transactions. However, he stated that “the parties’

respective skill and knowledge in the field is a very relevant, though not by

itself, decisive factor.” He also noted that officials at the Indonesian firm

had held themselves out as being financially sophisticated and had

demonstrated their ability to determine the transaction risks, even though

the bank had not fully disclosed them. Therefore, the judge determined

that Bankers Trust did not have a duty greater than the duty to present

fairly and accurately any facts and matters in the representations it made.

Another suit—filed in U.S. District Court by Procter & Gamble against

Bankers Trust—may have aided in clarifying the responsibilities of dealers

in OTC derivatives transactions, but its early settlement has left opinions

divided on its implications. Procter & Gamble filed this suit in October

1994, but the two parties settled in May 1996 before the case was

presented to a jury. Under the settlement, Bankers Trust agreed to forgive

as much as $150 million that Procter & Gamble owed. On the day of the

settlement, the presiding judge responded to an earlier motion for

summary judgment by dismissing or ruling in Bankers Trust’s favor on all

the counts against it except one count alleging fraud and two counts

requesting that the contracts be voided. The judge would have allowed

Page 102 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

these three counts to proceed to trial. Bankers Trust had argued that the

transactions in question had been conducted at an arm’s length. In the

ruling, the judge concluded that Bankers Trust had not been acting for or

on behalf of Procter & Gamble as in a typical customer-broker context, but

instead the two were principals to a contract and, therefore, no fiduciary

duties were imposed. However, he did find that, under New York law,

Bankers Trust had a duty to disclose material information about the

transaction, both before and during the transactions, and also had a duty

to deal fairly and in good faith during the performance of the transactions.

The judge’s ruling in the Procter & Gamble case did not definitively settle

the extent to which dealers, in general, have responsibilities to disclose

material information about transaction risks or the other requirements

that may apply to dealers’ marketing activities. Since the ruling was made,

several journal articles have provided conflicting views on the implications

of the judge’s ruling on dealers’ obligations. At a July 1996 conference in

Washington, D.C., representatives of dealers and end-users as well as legal

experts also offered conflicting views on the conclusions that could be

drawn from the ruling. Furthermore, in its announced settlement with an

individual Bankers Trust employee who had marketed these products to

Gibson Greetings, SEC stated that it disagreed with the Ohio judge’s ruling

in the Procter & Gamble case regarding the inapplicability of federal

securities laws to certain OTC derivative products.

The Need to Address

Conflicting Views on the

Nature of Counterparty

Relationships Has Been

Recognized

Representatives of regulators, end-users, and dealers have recognized the

need to reach agreement on the specific responsibilities of dealers as a

part of transactions in OTC derivatives, MBS, and structured notes. While

speaking at a forum for end-users about the relationship that should

prevail between end-users and dealers in institutional market transactions,

a New York Federal Reserve Bank official said that activities in these

products are important to the economy. Therefore, he said that too much

uncertainty is created by leaving these matters to be decided by the courts

on the basis of individual case facts and circumstances. Another speaker,

an SEC commissioner, called on dealers and end-users to come to common

agreement on each party’s responsibilities and duties. He cited the

inefficiency of having dealers face potentially large legal liabilities over

disputes decided by individual courts on the basis of what is usually a brief

interaction between the end-user and dealer. He said that such uncertainty

would not be tolerated in other areas of business and should not be

tolerated in the markets for these products. Thus, he concluded that

clarifying the relationship between end-users and dealers could enhance

Page 103 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

market efficiency and reduce dealers’ legal liability. Furthermore, he said

that having dealers agree on the rules regarding their responsibilities was

better than having thousands of end-users attempting to individually

negotiate the nature of their relationship with dealers. However, he also

acknowledged that when the nuances of relationships do not fit within the

generally agreed-upon framework, then changes could still be individually

negotiated.

Others have also recognized a need for end-users and dealers to agree on

the nature of their relationship. A former securities regulator said that

end-users and dealers need to agree on a set of common terms so that

each side understands what type of information the other is providing and

which statements can be relied on and which cannot. End-users and

dealers should also discuss when and how scenario analyses should be

provided. Coming to such agreement could reduce the number of

instances where legal disputes occur. In response to an end-user’s

concerns over the need to rely on the information dealers provide about

product features and performance, ISDA’s legal counsel agreed that the

parties need to discuss these issues with the goal of reaching a consensus.

In a May 1996 article, an EUDA board member remarked that the

organization hoped to continue to work with dealers to develop mutually

acceptable practices for these products.

Some market participants have observed that the involvement of one or

more federal financial market regulators may be needed to assist

end-users and dealers in resolving disagreements about dealer

responsibilities. Speaking at a June 1996 risk management forum,

representatives of a large dealer bank and a securities firm indicated that

financial regulators had a role to play in assisting the end-user and dealer

communities in reaching agreement on their responsibilities. At an

industry forum in July 1996, an attorney with futures regulatory expertise

commented that the existence of different regulatory requirements and

dealer-issued guidance creates confusion over what standards apply or

should apply to transactions in these products. He expressed the desire

that end-users and dealers jointly come to agreement and suggested that

the standards proposed by bank regulators would be a good starting point

for considering what form such agreements could take. He and other

forum participants indicated that financial market regulators, especially

SEC and CFTC, could assist in clarifying the legal standards that are

applicable to these transactions. EUDA has also acknowledged that federal

financial market regulators could play a role in this process. In a May 3,

Page 104 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 4 

Disagreement Over Counterparty

Responsibilities Increases the Potential for

Disputes

1996, letter to the New York Federal Reserve Bank, the end-user

association called for guidelines that

“. . . could be endorsed and implemented by both dealers and end-users. This would

require, however, that all sides and views be invited to the drafting table without

preconditions. If the Federal Reserve Bank of New York does not want to facilitate such a

dialogue under its auspices, we feel certain that other interested persons or government

agencies would do so.”

Although not calling for federal involvement, the Chairman of the Federal

Reserve Board provided some criteria for appropriate regulatory

intervention in the markets. In the previously cited January 1995

congressional testimony, the Chairman stated that markets function most

efficiently when both parties are free to enter transactions at their own

discretion and are unhampered by the need to serve the interests of their

counterparties. He emphasized that any consideration of regulation in this

area should adhere to the principle that parties to financial transactions

are responsible for their own decisions. However, he noted that

misrepresentation and fraud could not be tolerated. He also said that, in

some cases, end-users may not reasonably be expected to understand the

risks involved in certain complex products, and that dealers in financial

transactions sometimes act as more than just a counterparty by providing

advisory services. According to the Chairman, addressing the situation

may require limiting the use of some products to only certain

organizations, providing guidance to end-users for investment and risk

management, encouraging them to obtain independent advice, or

encouraging them to diversify their portfolios. However, he cautioned

against approaches that would allow end-users to shift a transaction’s risk

back to the dealer through legal actions, because such approaches would

likely increase transaction costs, discourage dealers from offering these

products, and interfere with currently liquid and efficient markets.

Page 105 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

Regardless of whether end-users and dealers collectively reach agreement

on the nature of their relationship, they can individually protect

themselves against sales practice disputes by having in place strong

corporate governance systems,1

 including internal controls and related

practices. In discussions with us, dealers described implementing internal

controls and sales practices that were consistent with those advocated by

the two sets of dealer-issued voluntary guidance analyzed in chapter 4.

Nonetheless, regulators identified weaknesses in sales practices that

exposed dealers to the risk of loss. Similarly, end-users described a range

of procedures for controlling investment risk; however, some lacked basic

controls. Also, reviewing organizations identified specific weaknesses in

end-user controls that contributed to losses. To help end-users better

manage their activities, professional associations have issued guidance for

their members to use in strengthening their corporate governance systems,

including their internal controls and related practices. Actions have also

been taken by various state governments to reduce the risk of loss

associated with the use of OTC derivatives, MBS, and structured notes.

Corporate

Governance Systems

Can Address Sales

Practice Issues

In our previous reports on derivatives, we stressed the importance of

organizations having strong corporate governance systems to ensure that

risk management and internal control systems are in place and functioning

as anticipated. Under an effective corporate governance system, the board

of directors approves policies and oversees the organization’s activities in

financial products, including OTC derivatives, MBS, and structured notes. In

addition to losses arising from adverse market movements or counterparty

defaults, the marketing and use of these products can expose dealers and

end-users to risks that can be similarly costly. Various entities, such as the

Federal Reserve, OCC,

2

 and the Group of Thirty,3 have issued guidance that

emphasizes the need for sound corporate governance systems to address

the risks posed by dealing in and using these products. These sets of

guidance are applicable to dealer marketing and end-user investment

activities. As discussed at the end of this chapter, various end-user groups

1

Governance systems are concerned with transactions and relationships within an organization,

including who controls which activities, who makes decisions, and who has what responsibilities for

which claims against the revenues and assets of a company. Although we refer to these systems as

corporate governance, they also apply generally to governmental entities.

2

In addition to guidance for banks acting as dealers, the Federal Reserve and OCC have issued

guidance for banks that use OTC derivatives and other financial products primarily as end-users. See

Evaluating the Risk Management and Internal Controls of Securities and Derivative Contracts Used in

Nontrading Activities, Federal Reserve Board (SR 95-17) (Washington, D.C.: Mar. 28, 1995) and

Comptrollers Handbook: Risk Management for Derivatives, OCC (Washington, D.C.: Oct. 1994).

3

Derivatives: Practices and Principles, Global Derivatives Study Group, Group of Thirty (Washington

D.C.: July 1993).

Page 106 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

have also issued guidance that is specifically targeted to their members’

investment activities and that addresses the importance of a strong

corporate governance system.

Dealers Described

Sales Practice Policies

and Procedures That

Were Consistent With

the Dealer-Issued

Guidance

The dealers we contacted described sales practice policies and procedures

for marketing OTC derivatives, MBS, and structured notes that we found to

be consistent with the Framework and the Principles that were discussed

in chapter 4.4

 Dealers indicated that the extent to which they disclosed

transaction risks depended on the product and the needs of the end-user.

In general, they explained that the amount and type of information they

disclosed about the risks of transactions in OTC derivatives, MBS, and

structured notes varied depending on the complexity of the product. For

more complex products, dealers generally indicated that they would

provide more detailed descriptions, explanations, and materials about the

product’s performance and risks. The firms also indicated that scenario

analyses were sometimes provided, particularly for more complex

transactions. The dealers explained that the amount of information they

provided also varied depending on the sophistication of the end-user. For

example, officials at one of the large securities firms told us that end-user

sophistication was key to determining how much information was

included in proposals—that is, the less sophisticated the end-user, the

more information they would include.

Although dealers of OTC derivatives, MBS, and structured notes told us that

they considered the circumstances of end-users when marketing these

products, they did not view this as necessary for all transactions. At least

four of the dealers we contacted explicitly stated that they were not

responsible for assessing the suitability of OTC derivatives transactions for

end-users. However, all of the dealers said that their firms’ policy is to

tailor transactions to end-user objectives and sophistication. For example,

officials at a major bank and a major securities firm indicated that,

although suitability determinations are not legally required for OTC

derivatives, their staff are generally protective of their relationships with

end-users and would not knowingly enter into transactions that were

inappropriate for end-users. However, officials at another major securities

firm told us that they would enter into a transaction they believed was

inappropriate for an end-user if the end-user insisted on proceeding even

after hearing the dealer’s advice against such action. Dealers also generally

4

We interviewed or obtained written responses from 14 dealers, including 5 large U.S. securities firms,

3 large U.S. banks, and 1 foreign bank—all of which marketed OTC derivatives, MBS, or structured

notes. In addition, we obtained information from two smaller banks and three smaller securities firms

that almost exclusively marketed MBS and structured notes.

Page 107 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

did not view themselves as acting as fiduciaries in these

transactions—most dealers emphasized that the end-users with whom

they transacted were generally sophisticated. Officials at one of the large

securities firms explained that, as a way of reducing their firm’s exposure

to compliance and reputation risks, sales staff are required to be alert to

indications that an end-user might be viewing the relationship as one

involving fiduciary responsibilities for the firm. Such indications could

result from observing that the end-user generally entered into all or most

of the transactions the firm proposed, or appeared to be doing so, without

independent analysis. In such cases, firm policy was for sales staff to

ensure that transactions conformed to the end-user’s objectives and to

discuss the situation with other levels of management within the firm.

Dealers of OTC derivatives, MBS, and structured notes described having

similar controls and supervision processes to oversee their marketing of

these products and to reduce the likelihood of sales practice disputes.

They told us that their primary means of overseeing the firm’s marketing

activities was by establishing multiple points of review for the

transactions. The dealers described requiring staff other than the

marketing personnel—such as trading supervisors—to review transactions

daily as well as at weekly or monthly intervals. At least four firms had

relationship managers who acted as central points of contact for the

dealers’ activities with individual end-users. In this capacity, such staff

were to review the appropriateness of all activity between the dealer and

end-users, regardless of which business line within the firm originated the

transaction. Furthermore, most of the dealers indicated that their internal

audit staff performed reviews of their marketing activities in these

products. However, one firm indicated that its internal audit staff had

never reviewed these activities.

Most of the dealers of OTC derivatives, MBS, and structured notes told us

that they had also made at least some changes to their sales practices or

oversight activities within the last few years, primarily in response to

publicized sales practice disputes. Five of the dealers indicated that they

had revised policies applicable to their marketing of these products. For

example, two firms said that they were creating more formal written

policies to better document the specific practices they expected their staff

to follow. Two other dealers said that they had made improvements to the

information they provided to end-users including, in one case, expanding

the range of possible market moves used in scenario analyses. Two of the

dealers also indicated that they had formed new groups within their firms

to review transactions and marketing of these products. One of the firms

Page 108 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

explained that a new committee within the firm would focus on assessing

the compliance and reputation risks of the firm’s activities, including how

products would be marketed and what type of end-user would be

approached.

Dealer compensation practices was another area relevant to the quality of

sales practices. The findings of regulators and others indicate that the

structure of such compensation can be influential in determining how

marketing personnel conduct their activities. For example, to the extent

that staff receive higher compensation for more risky transactions that

bring the firm greater profits, they have greater incentives to market these

types of transactions, even if they are not in the end-user’s best interests.

One dealer told us that more complex derivatives tend to offer the

potential for greater bonuses than plain vanilla OTC derivatives because of

their higher profit margin.

In general, dealers told us that their marketing staffs were not

compensated solely by commissions on individual transactions. However,

we could not determine the extent to which such commissions determined

compensation. One dealer told us that its compensation is not a

commission system tied to sales volume but a salary and bonus system

that is based on the value of business brought into the firm. The dealer

explained that, in calculating individual bonuses, overall firm profitability

and the relative performance of other departments within the firm might

be weighed more heavily than individual performance. The dealer said that

the system was designed to reduce incentives for individuals to market

high margin, risky products that are not in the end-user’s best interests.

Some firms told us that deferring portions of the compensation of their

personnel was one way they were attempting to align their marketing

staffs’ interests with those of end-users. Other firms told us that

maintaining quality end-user relationships was important to determining

compensation.

Regulatory

Examinations

Surfaced Dealer

Weaknesses

Although dealers described following sales practices that were consistent

with the dealer-issued voluntary guidance, regulatory examinations

indicated that most dealers had some areas where improvements were

warranted. As noted in chapter 3, we did not find that a large number of

dealers had deficient sales practices. In addition, in examinations

conducted from mid-1994 to mid-1995, the Federal Reserve and OCC

generally found that large bank derivatives dealers had made efforts to

implement appropriate policies, procedures, and internal controls related

Page 109 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

to sales practices. OCC concluded that the banks it examined were in

substantial compliance with its guidance and, in many cases, had

developed policies and procedures that went beyond its minimum

requirements.

However, both regulators identified weaknesses in sales practice-related

areas at these banks that could expose them to compliance and reputation

risks. Among the weaknesses identified in internal controls were

inadequacies in the risk disclosure materials provided to potential

counterparties. For example, some banks’ risk disclosure materials did not

show how a product would perform across a sufficiently wide range of

market conditions.

Regulators also identified weaknesses in the supervision of marketing

personnel, including failure to provide for supervisory approvals of the

prices quoted by marketing personnel to end-users. Some banks also

lacked comprehensive, written policies and failed to adequately document

transactions. Finally, OCC found that, in some cases, bank communications

to end-users could be construed as advisory, which could expose banks to

litigation if the transactions resulted in losses.

Banks may continue to have such weaknesses in their sales practice

policies and controls. According to a bank regulatory official who oversees

some of the major dealer banks, the examinations they have conducted

since 1995 have continued to find weaknesses like those identified above.

This official noted that banks have made improvements to their policies

and controls relating to sales practices since 1994 and 1995, but that

additional improvements are needed.

End-Users Described

a Range of Controls,

but Some Lacked

Basic Controls

Our review found that the policies and controls varied widely at the

organizations we contacted that used OTC derivatives, MBS, and structured

notes. From a judgmentally selected sample of respondents to our survey,

we obtained information through telephone interviews about the practices

and controls in place at 50 organizations that had used OTC derivatives,

MBS, or structured notes or that had only heard dealer presentations on

these products. The organizations we contacted described a range of

policies and practices governing the use of these products.5

 Some

described very sophisticated and involved processes, whereas others

acknowledged that very few formal policies or practices existed. For

5

We did not obtain complete information from every organization we contacted, therefore, totals for

individual policies or controls do not add to the total number of organizations contacted.

Page 110 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

example, one end-user reported having an extensive set of policies that it

updated every quarter. Twenty-eight respondents said that they had their

own investment guidelines. Officials of four organizations said they

followed guidelines provided by their regulator or local governmental

authority. Officials at three organizations said they did not have formal

investment policies because of their small size or lack of investment

activity.

Restrictions on using particular products also varied across the

organizations we interviewed. Although we did not obtain complete

information for all organizations, at least 30 respondents said that they

limited purchases to specific products or had formal prohibitions against

investing in certain products. However, five entities had no restrictions on

which products they could use. In addition, 22 of the organizations

described limiting their use of these products to certain situations or for

specific purposes. For example, some of these organizations said they

limited their use of OTC derivatives to adjusting exposure to changes in

interest rates.

The ability to independently price or stress test the values of products held

and the existence of a robust process for reviewing and approving

transactions are important controls over investment activities. Of the 26

organizations that provided information on their ability to price or

stress-test their holdings, 12 indicated they could independently do so. Six

others indicated that they relied on assistance from dealers or other

parties to conduct such activity. Four indicated that they did not attempt

to stress test their portfolios.

The processes respondents used to approve or review transactions also

varied. Although 31 respondents said that they required some sort of

approval before purchasing a product, the levels of review and authorizing

parties varied greatly. In some cases, portfolio managers or treasurers

approved transactions; whereas in other cases, approval was required by

an investment committee or by the company president. Twenty-two

respondents reported controlling their use of these products by entering

into transactions only with dealers that had been previously approved. To

become an approved dealer, these organizations evaluated dealers’ credit

ratings and other factors, such as their reputation. Two respondents

reported that they only approved dealers that sign an agreement

acknowledging that they understood and would follow the end-users’

investment guidelines. Five other end-users, which said they did not

Page 111 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

conduct such evaluations, indicated that they would only use dealers with

high credit ratings.

Consistent with the descriptions of the practices followed by respondents

we contacted, surveys by other organizations also found that end-user

practices and controls varied across firms.6

 For example, a 1995 survey by

the Wharton School of Business found that while 76 percent of

respondents had policies addressing their use of these products, only

3 percent reported results monthly to their boards, 25 percent reported

results quarterly, 20 percent reported results annually, and 51 percent

reported results on an as-needed basis.7

 This survey and one other8 also

found that just under one-half of the respondents conducted stress-testing

or scenario analyses on their portfolios to determine how they could be

affected by severe market changes. A 1995 survey of 75 large,

multinational corporations found that their ability to internally determine

the value of their holdings varied widely across these organizations,

depending on the products involved. Seventy-six percent reported being

capable of pricing forwards and futures contracts, but only 38 percent of

the corporations reported that they could independently price swaps and

swaptions,9

 and 14 percent reported such capabilities for complex

options.10

Other surveys also found that the controls employed by end-users varied.

Separate surveys by two financial journals of between 150 and 200 large

U.S. firms reported that the authority for entering into transactions in OTC

derivatives and similar products resided mainly with senior managers who

were responsible for the organizations’ finances, but that some firms had

6

We attempted to confirm that the organizations and products examined in these other surveys were

generally comparable to those discussed in this report; however, we did not otherwise assess the

quality or verify the results of these surveys.

7

1995 Survey of Derivatives Usage by U.S. Non-Financial Firms, Wharton School of Business/Canadian

Imperial Bank of Commerce/Wood Gundy. (Philadelphia, PA: Oct. 1995). This survey received 142

responses from end-users in a random sample of U.S. publicly held nonfinancial firms.

8

“Survey of CFOs,” Institutional Investor Magazine (June 1995). This survey received 150 responses

from chief financial officers from a judgmentally selected sample of large U.S. public and private

corporations.

9

A swaption is an option that grants the holder the right to enter into a swap with predetermined

terms.

10Emcor Fax Survey, Emcor Risk Management Consulting, Inc. (Nov. 1995). This survey received 75

responses from finance officers from a judgmentally selected sample of large, multinational

corporations.

Page 112 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

recently begun requiring additional levels of approval.11 Similarly, an

accounting firm’s survey of U.S. and international investment fund

companies reported that one-third of those surveyed who had used

derivatives had a supervisory board or risk management committee that

established limits on the use of derivatives and similar products.12

A more recent survey that addressed the practices of end-users also

showed that practices varied across organizations. In November 1996, one

of the large public accounting firms issued a survey of almost 700 financial

and nonfinancial organizations that used exchange-traded and OTC

derivatives.13 According to this survey, although these organizations

followed generally consistent practices in accounting for these

transactions, a range of practices existed for how they defined and

evaluated the risks of these activities.

Reviewing

Organizations Found

That Weaknesses at

End-Users

Contributed to Losses

Although concerns over dealer sales practices have arisen in a number of

recent losses, in some of these cases, weaknesses in the end-user’s

internal controls and practices contributed to the end-user’s losses.

Various groups have called for end-users to improve their management of

and controls over the use of products like OTC derivatives, MBS, and

structured notes to reduce the potential for losses and resulting sales

practice disputes. The types of controls advocated by these groups are

intended to reduce end-user dependence on the information provided by

dealers and the resulting vulnerability to deficient dealer sales practices.

Federal and state regulators, state audit departments, and other reviewing

organizations that examined end-user losses where sales practice disputes

existed found that the end-users involved had multiple weaknesses in their

internal controls and practices that contributed to their losses. We

reviewed the reports and findings of these organizations for nine cases

where an end-user incurred a loss and subsequently alleged deficient

dealer sales practices. Among the weaknesses identified at these end-users

were inadequacies related to investment policies, oversight of investment

activities, separation of duties, staff training and qualifications, and

internal audits.

11“Reader Survey” and “1995 Derivatives Survey,” Treasury and Risk Management Magazine (Spr. 1993

and July-Aug. 1995). This survey received 95 responses in 1993 and 201 responses in 1995 from finance

officers from a judgmentally selected sample of U.S. public and private nonfinancial corporations.

“Survey of CFOs,” Institutional Investor Magazine (June 1995).

12Derivatives Usage by Investment Funds, Ernst & Young, LLP (Oct. 1995). Ernst & Young surveyed a

judgmentally selected sample of 143 U.S. and foreign investment fund companies in 1995.

13Survey on Current Accounting for Risk Management Activities, KPMG Peat Marwick (Nov. 1996).

This survey received 139 responses from officials at a judgmentally selected sample of 700 financial

and nonfinancial organizations that used forwards, futures, swaps, and options.

Page 113 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

Regarding investment policies, regulators and others have frequently

recommended that, at a minimum, entities using OTC derivatives or

investing in financial instruments, such as MBS and structured notes,

identify their objectives for using such products, the type of products

approved for use, and the extent to which the products will be used.

However, in five of the nine cases we reviewed, the reviewing organization

found that end-users had material weaknesses in their policies addressing

product use and, in some cases, lacked formal written policies. For

example, a State of California report on Orange County’s losses noted that

the county did not have a written investment plan against which its

activities could have been compared before the losses occurred. Also, its

investment policies did not establish limits on the level of risk allowed for

the county’s investments. In 1994, a Texas community college incurred a

$3-million loss when it sold part of its portfolio of highly volatile CMO

tranches. The college had also experienced an $11-million decline in the

market value of its remaining portfolio, which originally had a book value

of over $31 million. The state auditor found that the college had no

policies related to controlling the risk of its investments, their desired level

of liquidity, or the extent to which they should be diversified.

Regarding oversight of investments, a key control identified by most

reports and other guidance on the use of OTC derivatives and products with

similar characteristics is the need to supervise the activities of staff

engaging in such transactions to ensure that guidelines are followed and

activities are prudent. Seven of the nine audit reports of end-users

incurring losses identified lack of controls for monitoring investment

activity and personnel as contributing to these losses. For example, the

treasurer at one Texas county was allowed to enter into transactions

without prior approval. He invested over 65 percent of the county’s

investment funds in long-term, high-risk CMOs. The value of the

$12.7-million portfolio later declined by as much as $4.5 million.

A related control is to adequately separate officials’ duties and

responsibilities. Internal control standards generally require that internal

auditors report to officials other than those that directly oversee the

activities they are auditing. This control was absent in one county that

experienced losses because the comptroller was responsible for making

the county’s investments and for approving any internal audit of his

activities—approval which he had never granted. An official of another

county was responsible for both executing investment transactions and

preparing the accounting records that reported their value. Because these

two duties were not assigned to separate staff, the official was able to

Page 114 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

falsify the accounting records to hide the full extent of the losses that

resulted from transactions he executed.

Federal and state regulators and state auditors also criticized some

end-users for lacking staff that were adequately trained or that possessed

sufficient understanding of the risks involved in using complex financial

products. Six of the nine audits we reviewed indicated that investment

personnel or supervisory staff did not sufficiently understand the risks

involved with the products purchased or lacked the expertise to properly

monitor complex investments. This lack of understanding is not surprising

because the treasurers of some local entities are elected officials who may

have no experience investing in sophisticated financial instruments. In

these situations, external oversight assumes even greater importance

because, as some of the reviewing authorities noted, the lack of expertise

on the part of end-user personnel led them to rely heavily on dealers for

advice.

Finally, some end-users lacked adequate internal audits. Thorough internal

audits can lead to corrective action when investment policies and

procedures are deficient or not being followed. At three end-users, the

reviewing organizations noted that audits of investment activities either

were not being done frequently enough or were not sufficiently addressing

whether investment activities were in compliance with policies or other

guidance. State auditors noted that the investment activities at one

community college had not been reviewed by county audit staff in at least

5 years.

Various Organizations

Issued Guidance for

End-Users

In response to recent reported losses, various organizations issued

guidance on recommended practices for reducing the risks of engaging in

OTC derivatives, MBS, and structured note transactions. Although most of

the recommended practices we reviewed addressed issues faced primarily

by dealers, we identified four sets of guidance issued by professional

associations or groups that address issues faced by end-users. In

June 1994, GFOA issued guidance to its members on the policies and

practices that governmental entities should have in place before using

Page 115 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

derivatives.14 About 1 year later, NAST issued revised guidance15 that

focuses on preferred practices for government-administered investment

pools in which smaller state and local government funds are pooled and

invested centrally. That same year, the Treasury Management Association

(TMA)16 issued guidelines on internal controls and appropriate disclosures

for end-users of derivatives.17 Finally, in November 1996, the Risk

Standards Working Group (RSWG)18 issued 20 standards for managing and

measuring risks.19 The GFOA and TMA guidance is written specifically for

derivatives use, while NAST and RSWG guidance is intended for all

investment products. All four sets of guidance favor explicitly written

policies and objectives that have been approved by executive management

or the board of directors.

As shown in table 5.1, the four sets of guidance also call for similar

practices, which, if not followed, can leave an end-user more vulnerable to

sales practice disputes. However, each set of guidance has a different

emphasis. The GFOA guidance emphasizes the importance of internal

controls in reducing risks, such as establishing written investment

guidelines, reporting requirements, and oversight systems. The NAST

guidance focuses on the importance of communicating with pool

participants, establishing the authorization to invest in certain types of

products, and ensuring that investment policies exist—including

borrowing and diversification policies. The RSWG guidance stresses the

importance of risk management—including setting overall risk

management objectives, valuing investments, and measuring risk-adjusted

rates of return.

14GFOA’s primary risk management guidance for end-users of derivatives was presented in GFOA

Recommended Practice: Use of Derivatives by State and Local Governments (Washington, D.C.:

June 7, 1994). GFOA also released other guidance related to these issues, including GFOA

Recommended Practice: Diversification of Investments in a Portfolio (Washington, D.C.: 1997), and

GFOA Recommended Practice: Sale of Derivative Instruments by State and Local Governments

(Washington, D.C.: 1995).

15Guidelines for Local Government Investment Pools, NAST (Washington, D.C.: July 27, 1995).

16TMA was founded in 1979 and represents 7,000 members, consisting of cash management

professionals, such as treasurers from the private sector. TMA seeks to educate, communicate, and

recognize the treasury management profession.

17Voluntary Principles and Practices Guidelines for End-Users of Derivatives, TMA (Bethesda, MD: Oct.

1995).

18RSWG was established by 11 individuals from the institutional investment community to create a set

of risk standards for institutional investment managers and institutional investors.

19Risk Standards for Institutional Investment Managers and Institutional Investors, RSWG (New York,

NY: Nov. 1996).

Page 116 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

The TMA guidance pays particular attention to end-user management

controls, calls for end-users to obtain any necessary independent

expertise, and provides an extensive list of disclosure standards and

practices. Overall, RSWG and TMA provide the most detail on implementing

their guidance.

Table 5.1: Key Elements of Various Organizations’ Investment Guidance for End-Users

Issuing organizations

Element GFOA NAST RSWG TMA

Authority to use

products

An analysis should be

conducted to ensure that

constitutional and statutory

authority to execute

derivatives contracts

exists. End-users should

also ensure that provisions

against indebtedness and

procurement statutes are

not violated.

The end-user should

prepare a written

statement that provides

legal authority for the

investment pool and that

establishes the

relationship between pool

managers and participants.

Fiduciary responsibilities

of internal and external

investment managers

should be specified in

writing and describe their

authority to make

investment decisions and

capacity to enter

agreements.

Policies should conform

with regulations. The

Procedures should

address risks arising from

derivatives use. Personnel

authorized to enter

transactions should be

designated in writing.

Written investment

policies

Purpose and objectives of

derivatives use should be

in writing. Policies should

mandate sound asset and

liability management and

adequately consider

safety, liquidity, and yield.

The risk characteristics of

products that might make

them inappropriate for use

should be considered,

including their price

volatility, liquidity,

leverage, and valuation

difficulty.

Written policies should

address investment

objectives and risks—with

safety, liquidity, and yield

as priorities. Policies

should describe eligible

products and strategies

and any restrictions on

such. They should also

specify desired product

and overall portfolio

maturities, limits on

amounts invested in each

type of security, and

extent to which borrowing

can be used.

Written and approved

policies should address

investment philosophy,

risk tolerance, and

investment guidelines.

Technical terms should be

defined in writing and risk

limits should be stated in

concrete terms and

updated as necessary.

Back-up plans in the event

of physical emergencies

or financial crisis should

be in writing. Risk policies

should be consistently

applied.

End-users should have

written, board-established

policies and objectives

related to investment

strategies, risk tolerances,

and risk philosophy.

Acceptable derivative

products and strategies

along with their objectives

and goals should be

specified.

(continued)

Page 117 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

Issuing organizations

Element GFOA NAST RSWG TMA

Suitability of

investments

Written acknowledgement

should be obtained from

dealers that they have

received, read, and

understood the end-user’s

debt and investment

policies, including whether

derivatives are authorized

and the recommended

product is suitable for the

end-user. Entities should

also be aware of when

dealers are acting as

agents or are taking a

proprietary position and

should evaluate potential

conflicts of interest before

entering transactions.

Dealers should follow the

same standards of

conduct as required for

treasurers, and treasurers

should obtain signed

agreements of

understanding from

dealers that the investment

alternatives being offered

are suitable for the

end-users’ objectives.

In determining the

appropriateness of

investment strategies and

instruments (1) investment

strategies should be

compared to the intent of

compensation incentives

and to written investment

strategies; (2)

contemplated activities

should be compared to

risk and return goals; (3)

the impact of relevant risks

on each instrument and

the overall portfolio should

be identified, measured,

and understood; and (4)

returns should be adjusted

for risk to determine an

instrument’s relative

performance.

Discussions should be

held to ensure that

employees involved with

derivatives activities

clearly understand

applicable policies and

procedures. In conducting

daily operations, a

transaction’s potential to

harm counterparty

relations should be

evaluated.

Reports on

activities

End-users should regularly

report derivatives use to

governing bodies and

make appropriate

disclosures in official

statements and other

documents. End-users

should also follow

generally accepted

accounting principles to

report on derivatives use,

hold early discussions with

public accounting

organizations on

derivatives use, and use

special reporting

procedures, if necessary.

End-users should disclose

to all pool participants and

prospective participants

their investment

objectives, pool liquidity,

and potential access limits

to invested funds.

Participants should also

receive statements that

assess and account for

pool activities, including

detailed reports of portfolio

holdings, market values,

and maturity as well as the

independent auditor’s

report and opinion.

Requirements for routine

reporting and deviation

reporting should be

defined. Also, procedures

for reporting to higher

management levels when

deviations continue should

be defined. Risk policies

should be consistently

applied and supported by

management.

Relevant risks as well as

risk management and

other reporting policies

and procedures should be

established and should

provide useful and

relevant information.

Financial statement

disclosures and

accounting should comply

with industry regulations

and standards.

Disclosures should, at a

minimum, discuss the

types of derivative

products used, the goals

and objectives of their use,

and the way their use is

controlled.

(continued)

Page 118 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

Issuing organizations

Element GFOA NAST RSWG TMA

Oversight and

monitoring of

transactions

Procedures should be

established for periodic

monitoring of derivatives

use. Recordkeeping

systems should be

sufficiently detailed to

allow governing bodies,

auditors, and examiners to

determine if use is in

accordance with

established objectives.

An independent advisory

board should monitor

investment activities of the

investment manager for

compliance with written

objectives. An external

audit of the investment

function and treasury

should be completed at

least annually.

Oversight of line

investment activities

should be independent

from oversight of

compliance with risk

policies using updated

guidelines and control

procedures. Roles, lines of

responsibility, and

reporting should be clearly

written. Separation of

responsibilities and

adequate checks and

balances should be in

place. Evaluations of the

validity and

appropriateness of

strategies, valuation

methodologies, models,

and systems should be

conducted by an

independent third party.

Systems and procedures

for oversight should be

established to (1) review

legal relationships

between counterparties to

derivatives transactions

and the derivatives

transaction process, (2)

periodically review

compliance with policies

and procedures, (3)

identify and review policy

changes, (4) identify

deviations from written

policies and procedures,

(5) ensure compliance

with accounting disclosure

standards, and (6) review

internal controls.

Pricing and

valuation of

transactions

Competitive price

comparisons should be

obtained before entering a

transaction. End-users

should be aware that little

or no standardized pricing

information is available for

some products.

The portfolio should be

marked-to-market at least

monthly. Values should

also be determined by an

independent pricing

service or by using

multiple assessments to

formulate an average. The

method of valuation should

be disclosed.

Products should be priced

daily, weekly, or whenever

feasible as well as

whenever material events

occur, using consistent

and documented

mechanisms and

methodologies. More than

one external source for

pricing information should

exist and internal pricing

should be independently

verified. Sources of

valuation should be

evaluated for incentives to

inflate or deflate prices.

Material differences in

pricing between internal or

external sources should

be reconciled and the

reasons reported and

monitored.

Procedures and methods

of valuing derivatives

exposure and measuring

current, potential, and

underlying exposures;

marking-to-market;

dictating the frequency of

valuing derivatives; and

ensuring compliance with

valuation procedures

should be approved and

established. End-users

should not rely solely on

one counterparty for

valuation information but

should have access to

adequate internal or

external expertise.

Sources: GFOA, NAST, RSWG, and TMA.

Page 119 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

Some State

Governments Acted to

Reduce the Risk of

Loss

Between 1994 and 1996, at least 14 states made changes that address the

use of OTC derivatives, MBS, and structured notes by governmental entities

within their states.20 These actions—which included 11 states21 enacting

legislation and 3 states22 making executive branch policy changes—were

taken after governmental entities in some of these states incurred

unanticipated losses from derivatives use. These actions were taken to

minimize the risk of loss that product use poses to governments in at least

one of three ways—by improving end-users’ policies, procedures, and

controls; limiting the use of certain types of products; or placing additional

requirements on dealers.

One way that state governments have sought to decrease the likelihood of

losses arising from the use of OTC derivatives, MBS, and structured notes

was by requiring governmental entities to revise their own investment

policies, procedures, and controls. Thirteen states took actions that place

additional requirements on the investing entities within their states. For

example, legislative bodies in Florida and Texas placed a similar new

requirement on governmental units within their respective states to adopt

investment plans that make the safety of investment funds a primary

objective of government investment strategies. California and Florida now

require their treasurer or unit carrying out the state’s investment activities

to follow the prudent investor/person standard.23 Eleven states imposed

requirements for strengthening internal controls on local governments.

For example, Ohio now requires treasurers in local governments to

establish and file written investment policies with the state, prepare

quarterly investment reports, and provide monthly portfolio updates.

Several states also placed restrictions on the types of products that

governmental entities could use. Ten of the 14 states now prohibit or

restrict the use of OTC derivatives, MBS, and/or structured notes. For

example, New Mexico now prohibits governmental entities in that state

from using complex financial products, including structured notes.

Wisconsin’s legislation allows its state investment board to use derivatives

20In this section, we did not attempt to obtain comparable information from all states on any actions

that may have been taken to improve investment policies, procedures, and practices. Instead, we

summarized those that received broader public attention.

21These states were California, Colorado, Florida, Illinois, Kansas, Louisiana, Minnesota, Maryland,

Ohio, Texas, and Wisconsin.

22These states were New Mexico and Oklahoma.

23The prudent person standard requires those investing on behalf of the governmental entity to act as a

prudent person would be expected to act—with discretion and intelligence to seek reasonable income,

to preserve capital, and in general, to avoid speculative investments.

Page 120 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 5 

Dealers and End-Users Acted to Reduce the

Potential for Sales Practice Disputes, but

Weaknesses Remain

only for reducing risk. In Florida, local entities can invest in derivatives if

the entity’s investment policy authorizes derivatives and if the entity’s

financial officers have sufficient expertise in managing derivatives

investments.

Finally, four states also sought to place additional responsibilities on

dealers marketing OTC derivatives, MBS, or structured notes to

governmental entities in their jurisdictions as well as to impose punitive

measures when violations are found. The four states—Colorado,

Minnesota, Ohio, and Texas—require dealers to ensure that the products

they offer are acceptable under the governmental entities’ statutes or

investment policies. For example, Texas requires broker-dealers to sign a

statement acknowledging that they reviewed the entity’s investment policy

and implemented reasonable procedures and controls in an effort to

preclude imprudent investment activities arising out of the subject

transaction. Taking a different approach, Colorado law requires that

dealers repurchase investments, for at least the original face value plus

any accrued interest, if the investments are found to be impermissible for

the governmental entity.

Page 121 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

Federal financial market regulators have improved their oversight of

dealer sales practices, but have not taken certain steps that would better

ensure dealers follow sound practices when marketing OTC derivatives,

MBS, and structured notes. To limit the risks that these activities pose to

regulated institutions, bank regulators have promulgated specific

requirements for the marketing of financial products and conducted

examinations to monitor the extent to which banks comply with them. As

a result, bank supervisory guidance addresses sales practices more

extensively than in the past. We also found that these regulators’

examinations were generally thorough in addressing issues related to

banks’ sales practices for OTC derivatives, MBS, and structured notes.

However, the Federal Reserve’s guidance does not yet adequately address

areas where weaknesses in a bank’s practices could lead to sales

practice-related losses, although agency officials told us the Federal

Reserve plans to address these areas in updated guidance that the agency

expects to issue by the end of 1997.

In contrast to banking regulators, the regulatory authority of SEC and CFTC

does not extend to the unregulated affiliates of the firms they otherwise

regulate. To address concerns about the risks these activities pose to the

regulated entity, SEC and CFTC worked with the six U.S. securities firms

whose affiliates did approximately 90 percent of all U.S. securities

firm-related business in these products on the Framework for Voluntary

Oversight. Under the Framework, the participating firms are to provide SEC

and CFTC with more information about their unregulated activities;

however, the two regulators are not to receive information that could be

used to determine the extent to which the firms are following the sales

practice provisions of the Framework. Finally, SEC relies primarily on the

securities SROs to oversee the sales practices of MBS and structured note

dealers. Although certain jurisdictional and other factors affected SROs’

ability to fully assess dealers’ sales practices, recent changes in the law

and corresponding rules removed the most serious limitation affecting one

SRO.

Page 122 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

Bank Regulators’

Efforts to Oversee

Sales Practices Have

Increased, but

Updated Federal

Reserve Guidance Has

Not Yet Been Issued

Both the Federal Reserve and OCC have taken various actions to address

sales practice issues. Both regulators issued guidance to their examiners

and the banks they oversee that address the risks of marketing OTC

derivatives, MBS, and structured notes. They subsequently conducted

targeted examinations of bank sales practices for these products,

including reviewing areas not adequately addressed in each agency’s

guidance. To ensure that subsequent examinations would also adequately

review these areas, OCC issued additional guidance to address these

weaknesses, but the Federal Reserve has not yet issued updated guidance.

Federal Reserve officials told us they expect to issue revised guidance that

will address the sales practice areas not specifically covered in their

existing guidance by the end of 1997. In addition, the Federal Reserve

placed specific sales practice-related requirements on one bank’s

transactions in certain types of complex OTC derivatives transactions as

part of a 1994 enforcement action.

Bank Regulators Expanded

Sales Practice

Requirements for Banks

In 1993 and 1994, OCC and the Federal Reserve issued guidance to the

banks they regulate. This guidance was also used by their examiners to

review banks’ activities. The two sets of supervisory guidance were

designed to address the risks associated with the increasing volume of

banks’ activities in OTC derivatives and other financial products. According

to OCC and Federal Reserve officials, before these issuances, sales

practice-related guidance generally consisted of requirements that banks

obtain sufficient information about a customer’s financial condition and

business activities before extending credit to or engaging in other financial

transactions with the customer—referred to as the “know your customer”

rule.

In expanding the treatment of sales practice issues, OCC and Federal

Reserve guidance generally contained the same requirements to be

followed by banks and used by bank examiners. Specifically, OCC guidance

required that banks not recommend transactions that they know, or have

reason to know, would be inappropriate for their customers on the basis

of available information about the end-user. The Federal Reserve required

banks to determine the sophistication of derivatives counterparties,

including whether counterparties understood the nature and risks of

transactions. In separate guidance to its examiners,1

 the Federal Reserve

indicated that banks should establish standards to ensure that

counterparties are not entering into transactions in complex products

1

Trading Activities Manual, Division of Banking Supervision and Regulation, Board of Governors of the

Federal Reserve System (Washington, D.C.: Mar. 1994).

Page 123 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

where they do not understand the risks. The guidance also noted that bank

management should be cognizant of the risks to the bank’s reputation

arising from its activities in these products. In December 1995, OCC issued

additional guidance that more extensively discussed the risks—including

compliance and reputation risks—that are associated with marketing

financial products. This guidance also provided extensive criteria to help

examiners evaluate the degree to which a bank was exposed to these risks

and how well they were being managed.

Bank Regulators Generally

Conducted Thorough

Examinations After Sales

Practice Problems

Surfaced

In response to publicized sales practice disputes, OCC and the Federal

Reserve conducted focused examinations of the largest bank dealers that

addressed sales practices associated with OTC derivatives, MBS, and

structured notes. In 1995, OCC conducted targeted examinations of several

large bank dealers to assess their practices. OCC also published a summary

of the results of these reviews, including identifying a list of best practices

followed by the banks they reviewed. Similarly, the Federal Reserve

targeted sales practices in examinations of major bank dealers conducted

from mid-1994, when Bankers Trust’s sales practice-related problems

became public, to mid-1995. The scope of both regulators’ examinations

was broader than required by their existing supervisory guidance.

We reviewed the examination reports and supporting workpapers for

seven of the targeted examinations that the two bank regulators

conducted and found that these examinations were generally thorough in

addressing key areas related to sales practices. As part of our review, we

searched various sources for information applicable to sales

practices—including securities regulators’ examination materials, private

risk management guidance, and case studies of end-user losses—and

identified six elements that could comprise a thorough examination of an

institution’s sales practices. These elements include the existence of sales

practice policies and procedures, management oversight and controls over

marketing personnel, management oversight and controls over price

quotes and valuation information, management supervision of

restructured transactions,2

 policies and procedures for assessing

counterparty sophistication and appropriateness, and adequacy of

disclosures to counterparties. We found that OCC and Federal Reserve

examiners had reviewed at least five of these six elements at each of the

banks they examined. The element examiners most commonly omitted

from review involved management supervision of restructured

2

Restructured transactions are those in which the terms or conditions of an existing contract have

been changed.

Page 124 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

transactions. Also, the Federal Reserve’s efforts focused primarily on more

complex OTC derivatives transactions because agency officials believed

that such transactions were harder for end-users to understand and value

and thus were more prone to sales practice disputes.

OCC Addressed

Weaknesses in Its

Guidance, but Updated

Federal Reserve Guidance

Has Not Yet Been Issued

Although the guidance OCC and the Federal Reserve issued through 1996

expanded sales practice-related requirements, our analysis revealed that

they did not address several sales practice areas related to compliance and

reputation risks. These areas had been noted by regulators and dealers as

among those in which sales practice disputes were likely to arise. For

example, the guidance did not task examiners with assessing whether a

bank’s marketing practices might inadvertently create an advisory

relationship with an end-user where none was intended. In addition,

neither regulator directed its examiners to ensure that the banks had

adequate internal controls in place related to supervisory review of the

price quotations and position valuation information provided to end-users.

The importance of assessing this aspect of a dealer’s sales practices was

illustrated by the Bankers Trust case, where providing incorrect price

quotations and valuation information was the primary misconduct SEC and

CFTC cited in their settlements with the bank. Finally, neither regulator’s

guidance required examiners to assess the accuracy of banks’ marketing

materials and product risk disclosures to end-users. Yet, both regulators

reviewed such materials during the targeted examinations and found

weaknesses.

In January 1997, OCC issued guidance to its examiners and the banks it

oversees that expanded its coverage of sales practice issues into the areas

where past problems were identified, thereby addressing these

weaknesses. For example, the guidance directs OCC examiners to review

any risk disclosure materials banks provide to customers and ensure that

bank policies define the types of disclosures, if any, that should be made.

Examiners are also to determine whether banks’ internal audit staff ensure

that sales presentations are clear, balanced, and reasonable. The guidance

also raises expectations for banks’ internal controls and supervision of

marketing personnel, including requiring independent reviews of

counterparty positions by other departments within the bank. Banks’

policies must also provide guidance on avoiding the implication that an

advisory relationship exists. Finally, the new guidance more specifically

addresses the way transactions are to be documented, including directing

that bank policies require the maintenance of financial statements,

investment policies, and profiles of counterparties.

Page 125 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

As of June 20, 1997, the Federal Reserve had not yet issued updated

guidance, but agency officials told us that the agency expected to do so by

the end of 1997. Federal Reserve staff provided us with a draft of the

updated guidance to review. The planned revisions to the guidance would

address the elements we identified as missing in the existing guidance.

The Federal Reserve

Placed Higher Sales

Practice Requirements on

One Bank

Separately from the guidance issued to all of the banks that it oversees, the

Federal Reserve tasked at least one bank with more stringent

requirements as a part of a 1994 supervisory agreement. As discussed in

chapter 3, some Banker’s Trust counterparties raised concerns about the

bank’s marketing of OTC derivatives, which prompted regulatory

investigations. As a result of its investigation, the Federal Reserve entered

into a supervisory agreement with Bankers Trust that imposed extensive

new requirements on some of the bank’s activities in more complex OTC

derivatives to increase the amount of information the bank provided on

product risks as well as price and valuation calculations.

Specifically, the agreement included required practices for the bank’s

marketing of leveraged derivative transactions (LDT), whose payment flows

and values are highly sensitive to changes in relevant market rates, prices,

or indexes to which they are linked.3

 The agreement required Bankers

Trust to (1) provide every counterparty with sufficient information about

the terms and risks of any LDT it entered, (2) reasonably ensure that every

counterparty has the ability to understand this information, and

(3) conduct its LDT business in a manner that ensured reasonable price and

valuation transparency to its counterparties.

The supervisory agreement also imposed specific disclosure obligations

on the bank for proposed LDT transactions, including providing a written

term sheet setting out material terms, explaining the risks, and preparing

sensitivity analyses that show a broad range of potential outcomes. Both

the term sheet and sensitivity analyses were to describe the various

assumptions Bankers Trust used to evaluate transaction risks. To achieve

reasonable price transparency, Bankers Trust was also to provide LDT

counterparties with indicative (approximate) price quotes, which were to

be updated daily for highly market sensitive LDTs and monthly for other

3

See Written Agreement By and Among Bankers Trust New York Corporation, and Bankers Trust

Company, and BT Securities Corporation, and Federal Reserve Bank of New York (FRB Docket No.

94-082), (Dec. 4, 1994). The agreement defines LDTs to include transactions where a market move of

two standard deviations in the first month would reduce the value of a counterparty’s position by the

lower of 15 percent of the notional amount or $10 million, transactions where the counterparty’s final

principal payment is at risk, coupon swaps where the coupon can drop to zero or exceed twice the

market rate, and transactions applying leverage (i.e., a multiplier) to rates or a spread between rates.

Page 126 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

LDTs. Bankers Trust’s procedures for achieving minimum risk disclosure

and price transparency were to be subject to Federal Reserve review.

In addition to implementing these sales practice-related changes, Bankers

Trust was subjected to a review of the conduct of its employees’ LDT

activities by a special counsel and was restricted from initiating any new

LDT business until the Federal Reserve determined that it had complied

with the provisions of the written agreement. On December 9, 1996, the

Federal Reserve announced that it had terminated the written agreement,

thus ending the heightened requirements and oversight placed on the

bank. According to a press account, a Bankers Trust official responded by

noting that the bank had implemented numerous policies and procedures

over the prior 2 years that increased the transparency and controls related

to activities with its derivatives customers.

Although the sales practice requirements outlined in this agreement were

binding only on Bankers Trust, some industry participants, including legal

experts and professional association officials, indicated that the

agreement may have effectively set the standard for all derivatives dealers.

However, a senior Federal Reserve official cautioned that requirements

such as those placed on Bankers Trust for its LDT activities may not be

appropriate for other OTC derivative products. This official told us that the

detailed disclosures required of Bankers Trust for its LDT customers would

be unnecessary for more experienced end-users of plain vanilla

derivatives. However, she said that as the complexity of products increase,

similar disclosures may become necessary.

Jurisdictional and

Other Limitations

Have Affected

Oversight of

Securities Firms’

Sales Practices

SEC, CFTC, and the various industry SROs have increased their sales practice

oversight of firms that deal in OTC derivatives, MBS, and structured notes.

However, the approaches used to conduct this oversight were sometimes

affected by these organizations’ lack of authority over the full range of

firms’ marketing activities. Under legislation passed in the early 1990s, the

firms under SEC and CFTC jurisdiction must provide SEC and CFTC,

respectively, with information to be used in assessing the risks that such

firms’ unregulated activities, including those in nonsecurities and

nonfutures OTC derivatives, pose to the regulated entity. To supplement

this information, SEC and CFTC worked with the securities firms whose

affiliates are most active in the OTC derivatives markets to develop

guidance that includes actions these firms will voluntarily implement to

manage their OTC derivatives risks, including those related to sales

practices. By adopting the guidance, participating firms also agreed to

Page 127 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

provide additional information about their OTC derivatives activities.

However, SEC and CFTC are not to receive information about the extent to

which these firms are following the sales practice provisions of the

guidance.

In contrast to nonsecurities OTC derivatives, SEC has jurisdiction over the

marketing of MBS and structured notes4

 and has conducted examinations

of dealers and taken enforcement actions against them for violations of

the securities laws. SROs, such as NASD and NYSE, provide most of the

routine oversight of dealers marketing these products and also have

conducted examinations of and taken enforcement actions against dealers

of these products. However, SRO efforts have sometimes been made more

difficult by limits to their authority over particular firms or products. NASD

faced the most serious restrictions, but recent changes to the law and

applicable rules have removed these restrictions.

SEC and CFTC Jurisdiction

Is Limited, but the

Regulators Receive

Information on Affiliates’

Activities

As discussed in chapter 2, SEC and CFTC direct regulatory authority is

limited to products defined as securities or futures (including certain

options), respectively, and to the firms registered with these regulators to

conduct such activities. Because nonsecurities and nonfutures OTC

derivatives activities are usually conducted in affiliates outside of the

direct oversight of these two regulators, neither regulator conducts

examinations of these firms’ sales of OTC derivatives.

To better assess the risk posed by the activities of these affiliates on the

financial condition of a regulated broker-dealer, SEC was granted authority

under the Market Reform Act of 1990 to collect certain types of

information from the entities it regulates about their unregulated activities.

CFTC was provided similar authority by the Futures Trading Practices Act

of 1992. Both regulators subsequently issued risk assessment rules that

require the firms subject to their regulation to submit additional

information about their unregulated activities. For example, firms

overseen by both SEC and CFTC provide these regulators with information

on the total notional/contract amounts, aggregated credit risk exposure,

and credit exposures concentrated by industry or counterparty arising

from their OTC derivatives activities. The two regulators were to receive

information from the regulated entities subject to these rules on a

quarterly basis beginning in 1995. Firms regulated by both SEC and CFTC

were to provide these regulators with descriptions of the systems they use

4

As previously discussed, we assume for the purposes of this report that structured notes meet the

terms and conditions of CFTC’s hybrid exemption.

Page 128 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

to manage the risks associated with transactions in nonsecurities OTC

derivatives. SEC and CFTC officials confirmed that, in general, they have

been receiving the information required under their rules.

SEC and CFTC Lack

Information to Assess the

Sales Practices of

Unregulated Affiliates

The rapid growth of the OTC derivatives market and some highly publicized

losses by end-users raised concerns by Congress and others about the

potential risks that OTC derivatives use by unregulated affiliates might pose

to the regulated entity and the financial system. SEC and CFTC responded by

working with the six securities firms whose affiliates are most active in the

OTC derivatives markets to develop the Framework, which includes a sales

practice-related section (the provisions of which are discussed ch. 3).

According to an SEC official, the affiliates of these six firms accounted for

about 90 percent of the OTC derivatives activity done by securities firm

affiliates.

To supplement the responsibilities that securities firms have under the risk

assessment rules, the Framework expands the participating firms’

commitment to taking additional voluntary steps related to their

unregulated activities. These steps include reporting additional

information to SEC and CFTC on their market and credit risk management

systems and controls, risk in relation to the capital reserved against these

activities, and credit concentrations and revenues from these activities.

The Framework also outlines management controls that the firms are to

follow. In addition, the firms have agreed to annual external audits whose

purpose is to verify their adherence to the management control provisions

of the Framework.5

Unlike the other aspects of the Framework, the provisions relating to sales

practices are less prescriptive and do not call for SEC and CFTC to receive

additional information on the firms’ activities. These provisions suggest

that participating firms (1) provide generic risk disclosure forms to new

counterparties, (2) prepare accurate marketing materials that fairly

present a transaction’s benefits and risks, and (3) adopt internal controls

sufficient to ensure that strong counterparty relationships are maintained.

SEC officials told us that the agency had worked with the participating

firms to ensure that the counterparty relationships section was included in

the Framework because they believed that fair treatment of end-users is a

prerequisite to the growth and evolution of the OTC derivatives market. In a

5

Because its OTC derivatives affiliate is subject to oversight in the United Kingdom, CS First Boston is

not subject to the additional reporting requirements but has committed to adhering to the other

elements of the Framework. SEC officials told us that under SEC risk assessment rules, the agency

receives copies of quarterly financial reports that the affiliate files with its U.K. regulator.

Page 129 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

speech to end-users, an SEC commissioner said that the financial integrity

of the OTC derivatives markets would be harmed if participants perceived

them as unfair or rampant with abuse, thus, regulators have an interest in

the sales practices used to market these products.

Although the firms agreed to external audits addressing their adherence to

certain provisions of the Framework, as planned, these audits will not

address the sales practices provisions. The Framework also does not

stipulate that the participating firms report on the extent to which they are

implementing the sales practice provisions of the Framework. For

example, the participating firms have not provided copies of their sales

practice policies—as they did as part of SEC’s risk assessment process for

their risk management systems—and descriptions of the internal controls

they have established to ensure that such policies are being followed. In

addition, the firms are not expected to periodically provide the regulators

with internal audit reports that document adherence to these policies and

controls. Without a mechanism to collect such information, SEC and CFTC

will lack sufficient data to indicate whether these firms are conducting

their OTC derivatives marketing activities in ways that foster the fairness

and integrity of these markets as was envisioned by the agencies when the

sales practice provisions were included in the Framework.

SEC Relies Primarily on

SROs to Oversee MBS and

Structured Note Dealers,

but Also Conducts

Examinations and Takes

Enforcement Actions

Although SEC relies primarily on SROs to oversee the activities of MBS and

structured note dealers, including their sales practices, it has an active

regulatory program under which it receives reports on dealers’ financial

condition, examines broker-dealers and evaluates their compliance with

laws and regulations, and conducts investigations of possible violations of

the securities laws. The goals of its oversight are to (1) ensure the quality

of SRO activities and (2) provide additional oversight of securities firms’

marketing activities. For example, SEC conducted 645 examinations of

securities firms in 1996, about 50 percent of which were to assess the

quality of examinations performed by the relevant SRO. The remaining

50 percent of SEC examinations were initiated on the basis of a specific

cause, such as a complaint by an end-user. SEC officials advised us that

almost all of these examinations include some sales practice component.

In conducting the 1996 examinations, the officials said that six

examinations identified material sales practice deficiencies involving MBS

or structured notes that were subsequently referred to SEC’s Enforcement

Division for investigation.

Page 130 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

SEC is also expanding its examination procedures to address sales practice

issues. According to officials in SEC’s Office of Compliance Inspections and

Examinations, new examination modules have been created to facilitate

their examiners’ review of products such as MBS and structured notes.

Routine sales practice modules include updated steps to address current

rules and case law regarding markups and confirmation disclosures, and

specialized modules are being created for government securities. SEC is to

use these specialized modules to review NASD’s implementation of its new

government securities rule (as discussed on p. 133).

Although SROs also conduct enforcement activities, SEC considers

enforcing the securities laws to be one of its most important missions.6

 As

discussed in chapter 3, SEC officials had initiated investigations against 24

dealers from 1993 through 1996 for deficiencies related to the sale of MBS

and structured notes. In some of these cases, SEC has taken action against

the dealer involved, including assessing monetary penalties, imposing

operating restrictions, or revoking a dealer’s license to conduct business.

In several cases, both SEC and an SRO were investigating the conduct of the

same dealer. A senior SEC Enforcement Division official explained that,

when an SRO either has an investigation under way or has sanctioned a

firm, SEC usually avoids initiating a parallel effort but sometimes will seek

additional penalties for egregious cases. Decisions to pursue such actions

also depend on the size and frequency of the violations and the dollar

value involved. (See ch. 3 for a discussion of the results of SEC

enforcement actions.)

Various Factors Also

Affected SROs’ Ability to

Fully Assess Dealer Sales

Practices

Securities industry SROs, particularly NASD and NYSE, are an integral part of

the oversight of firms marketing MBS and structured notes. However, these

organizations were not always able to review all of a dealer’s sales

activities. SROs can only review the sales activities of their members and

not the sales activities of those firms’ unregulated affiliates that are not

also members. The way that certain customers use dealers of MBS and

structured notes also reduced the SRO staffs’ ability to fully assess sales

practices for some transactions.

As part of their activities, NASD and NYSE have conducted examinations of

securities firms. In 1996, NASD conducted 2,359 examinations and NYSE

conducted 326 examinations that addressed sales practices, according to

6

Similarly, CFTC considers enforcing the CEA to be one of its most important missions. Except for the

Bankers Trust case previously discussed, we do not address CFTC enforcement actions in the OTC

markets because they typically involved the illegal marketing of off-exchange futures, which is

generally outside the scope of this report.

Page 131 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

each SRO’s statistics. SRO officials told us that the examinations generally

reviewed firms’ sales practice policies, procedures, and controls over

marketing personnel. These organizations also had conducted

enforcement investigations of possible sales practice violations, with NASD

having performed investigations of 16 dealers and NYSE having performed

investigations of 15 dealers from January 1993 through December 1996.

(See ch. 3 for additional discussion of SRO enforcement action results.)

The way in which securities industry SROs conducted their sales practice

oversight differed from the way they met their other responsibilities.

According to a NYSE official, these SROs obtain reports and conduct

examinations to ensure that their members are financially sound and in

compliance with SRO rules and relevant federal securities law

requirements. To facilitate these examinations and reduce the overlap of

SRO jurisdiction over securities firms that conduct activities on multiple

exchanges, usually just one SRO is designated to review the financial

condition of such firms.7

 However, the NYSE official said that the individual

SROs remain responsible for conducting their own examinations for sales

practice purposes, unless they contract with another SRO to have such

examinations conducted on their behalf.

Dealers’ sales practice activities relating to OTC derivatives, MBS, and

structured notes were not always subject to review by securities industry

SROs. As previously discussed, the largest securities firms generally

conduct their nonsecurities OTC derivatives activities in affiliates that are

not registered with SEC. Although a dealer conducting activities in

securities is required to join and submit to oversight by at least one

securities industry SRO, its other nonsecurities affiliates, such as those

conducting nonsecurities OTC derivatives activities, are not subject to SRO

oversight.

The way that certain end-users conduct their activities in MBS and

structured notes also affected SROs’ ability to fully assess sales practices.

NYSE officials told us that assessing the adequacy of their members’ sales

practices for MBS and structured notes could generally only be done when

the customers involved are retail end-users. However, they estimated that

such end-users account for only about 5 percent of the purchases of MBS.

The remainder of such securities are purchased by institutional end-users

that do not always maintain their holdings in accounts at NYSE-member

securities firms. Instead, some transfer their purchases to custodial

7

The SRO with responsibility for conducting the financial condition examination of a securities firm is

known as its designated examining authority.

Page 132 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 6 

Regulators Have Improved Sales Practice

Oversight of Regulated Firms, but Some

Weaknesses Remain

accounts at banks or other money managers. According to NYSE officials,

reviewing an end-user’s portfolio is an important way for them to

determine the appropriateness and suitability of transactions for the

particular end-user. However, the transfer of purchases by some

institutional end-users to other accounts generally precluded NYSE staff

from determining the appropriateness and suitability of transactions for

such end-users.

Removal of Restrictions on

NASD Oversight Should

Improve Sales Practice

Oversight

The most serious limitation on an SRO’s ability to assess sales practices

was faced by NASD. Before August 1996, NASD could not fully assess and

take appropriate actions against certain deficiencies in the sales practices

of dealers marketing GSE-issued MBS and structured notes, which

accounted for the bulk of those securities issued.8

 As noted in chapter 2,

NASD had been prohibited from applying its full complement of sales

practice rules to the marketing of government securities by a long-standing

provision in the Securities Exchange Act of 1934.9

 This restriction was

removed by the Government Securities Act Amendments of 1993, and,

after several rounds of public comment and revision, NASD obtained SEC

approval to implement the rules and an associated interpretation on

August 22, 1996.

While in effect, this restriction on NASD’s authority affected its enforcement

activities. In cases where NASD determined that dealers’ sales practices

warranted disciplinary action, the SRO was unable to pursue such cases as

violations of its Rules of Fair Practice because GSE-issued securities were

exempt from these rules.10 Instead, it had to pursue the enforcement cases

under the antifraud provisions of the securities laws. However, the burden

of proof for fraud violations was harder to meet than that for

noncompliance with SRO rules. The removal of restrictions on NASD

authority will allow the SRO to pursue cases as violations of its own rules

and should improve its ability to oversee sales practices for MBS and

structured notes.

8

NASD officials could not determine how many of their 5,000 members marketed GSE-issued securities;

however, the officials indicated that in 1994 over 300 of the firms they oversaw held such securities

and that most were probably offering them to end-users.

9

This restriction did not extend to NYSE.

10As indicated in chapter 2, these rules are now known as Conduct Rules.

Page 133 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

Conclusions Although OTC derivatives are subject to sales practice requirements that

vary, depending on the dealer or specific product involved, our survey

found that most end-users of these products were generally satisfied with

the sales practices of dealers with whom they did business. In addition,

federal financial market regulators found that few dealers in these

contracts were involved in sales practice disputes.

Certain characteristics of the OTC derivatives markets may explain the high

level of end-user satisfaction and the relatively limited number of disputes.

Specifically, our 1995 survey found that about 10 percent of a broad range

of U.S. organizations had entered into plain vanilla OTC derivatives

contracts and only 2 percent had entered into more complex OTC

derivatives contracts. In addition, product use was concentrated among

generally large, financially oriented organizations, with GSEs, finance

companies, mutual funds, and money managers reporting the highest rates

of usage.

Nonetheless, some regulators and market participants have responded to

concerns about the losses and costly disputes that can arise when OTC

derivatives sales practices are inadequate or when roles and

responsibilities are unclear. Their responses have included issuing

guidance on recommended practices and controls; strengthening sales

practice or investment policies, procedures, and practices; and increasing

internal reviews of these activities.

Although the President’s Working Group on Financial Markets has

concluded that legislation containing additional sales practice

requirements is not currently needed for OTC derivatives, the market

characteristics that contributed to the high level of end-user satisfaction

and the limited number of sales practice disputes experienced to date

could change as the markets evolve. These changes could include

increased market participation by new dealers, more widespread use of

complex products, or increased marketing to or product use by less

sophisticated end-users. Such changes in market characteristics could

cause the Working Group to reconsider whether current requirements are

adequate to protect end-users of OTC derivatives or the financial markets.

However, the federal financial market regulators that participate in the

Working Group do not routinely collect information related to changes in

market characteristics. These regulators monitor the OTC derivatives

activities of the firms subject to their respective oversight, and they

discuss any developments of which they become aware through their joint

Page 134 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

participation in the Working Group. However, the regulators do not

routinely collect the information necessary to ensure that they are able to

systematically detect changes in market characteristics. Thus, the Working

Group lacks a formal mechanism for obtaining the necessary information

for monitoring market developments related to sales practices. Such a

mechanism is important because it could alert the Working Group to the

need for reassessing the adequacy of existing sales practice laws and

regulations applicable to OTC derivatives.

Regarding MBS and structured notes, our survey found that end-user

satisfaction with dealer sales practices was somewhat lower than for OTC

derivatives. In addition, regulators identified more cases of potential sales

practice abuse for these products than for OTC derivatives. However, SEC

and the securities industry SROs have been investigating and, when deemed

necessary, taking enforcement actions against the dealers involved in

these cases. In addition, recently enacted rules subject dealers marketing

GSE-issued MBS and structured notes—which account for the bulk of such

securities—to all of NASD’s sales practice requirements. The

implementation of these rules should close what has been a major gap in

regulatory oversight of these products and improve NASD’s ability to ensure

that dealer practices in these markets are appropriate.

Although the number of cases in which sales practice concerns were

raised was relatively limited, the disputes that accompanied some of these

cases resulted in both the end-user and dealer incurring significant costs.

These costs included legal expenses, regulatory fines, reduced income,

and even bankruptcy as well as other costs related to the failure to manage

the compliance and reputation risks associated with these transactions.

Although expanded sales practice requirements to protect end-users may

not be necessary at this time due to the market characteristics previously

discussed, the seriousness of these risks justify additional action by

federal financial market regulators to better ensure the sound financial

condition of regulated institutions and the fairness and integrity of the

markets. Even actions that focus primarily on the risks posed to dealers

can help improve dealer sales practices, benefit end-users, and enhance

the overall integrity of the markets.

The Working Group could provide regulators a forum for assisting

end-users and dealers in reconciling their differing views on the nature of

their responsibilities in transactions involving OTC derivatives. According

to our survey, over 50 percent of the end-users of plain vanilla OTC

derivatives believed that dealers had certain fiduciary responsibilities to

Page 135 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

them in some or all cases. As reflected in the two sets of dealer-issued

voluntary guidance—the Framework and the Principles—dealers have

generally considered such transactions to be conducted at arm’s length,

with minimal responsibilities existing for either party beyond those of

honest and fair dealing. To the extent that the differing views of end-users

and dealers increase the likelihood of sales practice disputes that expose

regulated institutions to material losses or that otherwise could prove

disruptive to the markets, federal regulators have an interest in the

reconciliation of these differences. The reconciliation of such differences

does not entail federal regulators imposing a resolution on the markets.

Rather, the type of relationship and accompanying responsibilities that

should prevail in OTC derivatives transactions should be agreed upon by

market participants.

A clearer understanding of the nature of end-user and dealer

responsibilities may also be necessary for the voluntary standards to

receive more widespread acceptance among end-users. In addition, these

standards may be the only ones applicable to some unregulated market

participants, such as insurance company affiliates. Therefore, by assisting

market participants in reaching a clearer understanding of their

responsibilities, federal financial market regulators may enhance the

overall integrity of the markets. Reaching a clearer understanding may

also encourage product use, where appropriate, by organizations that have

limited their use because of concerns about transaction risks and

uncertainty about the roles and responsibilities of dealers and end-users.

Finally, reaching such an understanding could result in greater diligence

by both end-users and dealers in ensuring that they comprehend product

risks before entering into transactions.

Notwithstanding the potential benefits of an improved understanding

between dealers and end-users, the issues surrounding their relationships

are complex and federal involvement may not necessarily result in an

agreement that is widely accepted. Even if an increased level of

understanding between these groups could be reached, the likelihood of

legal disputes when large losses occur might not decrease. However,

federal financial market regulators would be justified in considering

whether they can help end-users and dealers reach a mutually acceptable

agreement because of the importance of these products to the financial

markets and the U.S. economy. Consultation with market participants on

this subject might assist regulators in assessing whether they should

assume such a role.

Page 136 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

Regardless of whether they decide to assist end-users and dealers in

resolving their differences, federal financial regulators can take other

specific actions to address the risks to dealers that market OTC derivatives,

MBS, and structured notes. Although the Federal Reserve has conducted

examinations of banks’ activities and issued guidance on the

responsibilities of banks that market these products, its guidance remains

incomplete. Specifically, it does not direct bank examiners to assess the

adequacy of bank policies and controls related to disclosing risk, acting in

a fiduciary or advisory capacity, or supervising marketing personnel.

Weaknesses in these areas existed in some cases where sales practice

disputes have arisen. Although we found both bank regulators’

examinations to be generally thorough, specifically addressing these areas

in the Federal Reserve’s guidance would better ensure that such areas

receive similar attention in future examinations. Federal Reserve officials

have efforts under way to update this guidance, and our review of a draft

of this updated guidance indicates that it would address the elements we

identified as missing in the existing guidance.

SEC and CFTC participation in the development of the Framework reflects

their concern with the risks posed by the sales practices and other

activities of the largely unregulated dealers in these markets. In lieu of

additional regulation of this market, the Framework is to result in SEC and

CFTC periodically receiving additional information, including the results of

external audits, on some aspects of participating dealers’ OTC derivatives

activities. This information should improve the ability of SEC and CFTC to

conduct the legislatively mandated risk assessments of the entities they

regulate. However, information on these dealers’ adherence to the sales

practice provisions of the Framework is not included in the information

these regulators are to receive. Adherence to these provisions is important

for ensuring market fairness and integrity. In the absence of a mechanism

for ensuring such adherence, SEC and CFTC cannot be sure that these firms’

commitment to voluntarily follow the sales practice provisions of the

Framework is being fulfilled, casting doubt on whether a voluntary

arrangement is an adequate substitute for direct federal oversight.

Recommendations to

the President’s

Working Group on

Financial Markets

We recommend that the Secretary of the Treasury, as Chairman of the

President’s Working Group on Financial Markets, take the following

actions:

• Ensure that the members of the Working Group establish a mechanism for

systematically monitoring developments in the OTC derivatives markets to

Page 137 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

assess whether developments warrant introducing specific federal sales

practice requirements.

• Lead the members of the Working Group in considering the extent to

which it should assist end-users and dealers in reaching agreement on the

nature of their relationship in transactions involving OTC derivatives.

Recommendation to

the Federal Reserve

We recommend that the Chairman of the Federal Reserve Board

implement planned revisions to the Federal Reserve examination

guidance, which are to more specifically address the need to assess the

adequacy of banks’ policies and controls related to disclosing risks,

creating advisory relationships, and supervising marketing personnel.

Recommendation to

SEC and CFTC

We recommend that the Chairpersons of SEC and CFTC establish a

mechanism for determining that participating firms are following the sales

practice provisions of the Framework for Voluntary Oversight.

Agency and Industry

Comments and Our

Evaluation

We requested comments on a draft of this report from the heads, or their

designees, of CFTC, the Federal Reserve Board, OCC, SEC, and Treasury. We

also requested comments from two securities industry SROs (NASD and

NYSE) and four industry associations (EUDA, GFOA, ISDA, and NASACT). Each

of these agencies/associations provided us with written comments except

CFTC, Treasury, and NASD. The Director of Treasury’s Office of Federal

Finance Policy Analysis provided oral comments on our

recommendations. Officials from CFTC provided oral, technical comments.

Our additional responses to written, nontechnical comments are contained

in appendixes III through IX. Technical comments provided by CFTC, the

Federal Reserve Board, OCC, SEC, Treasury, NASD, NYSE, EUDA, GFOA, and ISDA

were incorporated into this report as appropriate.

Overall, no consensus emerged on the benefits of implementing our

recommendations. The banking regulators and the associations that

represent primarily end-users generally concurred with our findings and/or

recommendations. The Federal Reserve also stated that this report makes

a useful contribution to assessing the current state of financial market

sales practices. OCC commented that the report is comprehensive in

evaluating sales practices from the perspectives of dealers, end-users, and

regulators. GFOA said this report will be an extremely helpful reference on

derivatives, and NASACT stated that it provides an excellent study of sales

practice issues facing the OTC derivatives market. In contrast, Treasury and

Page 138 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

ISDA generally objected to our recommendations, with both opposing

additional federal involvement in the OTC derivatives markets to address

sales practice issues. SEC’s views were mixed.

SEC, Treasury, and ISDA objected to our recommendation that the Working

Group establish a mechanism for systematically monitoring developments

in the OTC derivatives markets. Specifically, SEC and Treasury officials

commented that the Working Group’s current efforts, which generally

include the principals meeting every 6 weeks and the staff meeting every 2

weeks, are adequate to address market developments. Similarly, ISDA

commented that it is not readily apparent that a formal monitoring

mechanism would be any more effective than the existing structure. In

contrast, EUDA, GFOA, and NASACT supported this recommendation. EUDA

indicated that taking the recommended steps—as they relate to this and

our other recommendation to the Working Group—will lead to greater

market safety and soundness, particularly concerning new dealers or

end-users entering the markets. We continue to believe that the Working

Group needs a formal mechanism for monitoring the OTC derivatives

markets. As discussed in this report, the market characteristics that

contributed to the relatively high level of end-user satisfaction and the

relatively limited number of sales practice disputes could change as the

markets evolve. This report recognizes that the federal financial market

regulators monitor the OTC derivatives activities of the firms subject to

their respective oversight, and they discuss market developments of which

they become aware through their joint participation in the Working Group.

However, this report also observes that the agencies that participate in the

Working Group do not routinely collect the information necessary to

ensure that they are able to systematically detect changes in market

characteristics. Thus, the Working Group lacks a formal mechanism for

obtaining the necessary information for monitoring developments related

to sales practices. Such a mechanism is important because it could alert

the Working Group to the need for reassessing the adequacy of existing

sales practice requirements applicable to OTC derivatives. The information

to be assessed could include the number and types of new dealers and

end-users entering the markets, the types of complex new products being

introduced, and changes in the types or sophistication of end-users to

whom products are being marketed.

Treasury and ISDA also objected to our recommendation that the Working

Group consider the extent to which it should assist end-users and dealers

in reaching agreement on the nature of their relationship in transactions

involving OTC derivatives. Treasury was concerned that, because such

Page 139 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

relationships are contractual, no single model may be appropriate. ISDA

commented that no need exists for the Working Group to involve itself in

mediating between dealers and end-users, that the involvement of market

participants and regulators to date has been sufficient, and that the issues

involved are complex and federal involvement may not result in an

agreement that is widely accepted. In addition, ISDA stated that the draft

report offered no evidence suggesting that disputes among privately

negotiated derivatives contracts (that is, OTC derivatives contracts) are

more frequent than in other commercial dealings, that these markets have

been largely free of sales practice abuses, and that courts and regulators

have not had difficulty in finding remedies when necessary. For these

reasons, ISDA indicated that it did not support expanded regulatory activity.

ISDA also commented that the report does not substantiate that the OTC

derivatives market is “in any way broken and needs fixing,” that our

recommendations do not follow logically from the facts or conclusions in

the report, and that our recommendations contradict the views of market

participants and regulators.

SEC commented that in its efforts to address financial market issues, the

Working Group has had discussions with end-users and professional

counterparties (dealers) and that it believes the Working Group would be

willing to continue this dialogue. However, SEC stated that it is not

necessary for the government to intervene and define contractual

obligations for professional and sophisticated counterparties. The Federal

Reserve noted that it has recognized the importance of and encouraged

voluntary industry efforts in this area, and the three end-user associations

supported our recommendation.

We continue to support our recommendation that the Working Group

consider assisting market participants in reaching agreement on the nature

of their relationship in OTC derivatives transactions. This report

acknowledges that the issues involved in reaching agreement between

dealers and end-users are complex and may not lend themselves to a

single, widely accepted solution. For this reason, we do not intend that the

Working Group impose a model that defines counterparty relationships in

OTC derivatives transactions. In addition, we do not base our

recommendation to the Working Group on a finding that a high frequency

of sales practice abuses exists or that courts and regulators have had

difficulty in finding remedies when abuses occur. Instead, we present

evidence that end-users and dealers do not always agree on the nature of

their relationship, including their responsibilities, in OTC derivatives

transactions. Although the dealer-issued voluntary guidance asserts that

Page 140 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

the nature of the relationship is arm’s length, our survey found that a

majority of end-users believed that dealers had fiduciary responsibilities in

some or all OTC derivatives transactions, and that a majority indicated they

relied on dealers from some to a very great extent as part of these

transactions. To the extent that the differing views of end-users and

dealers increase the likelihood of sales practice disputes that expose

regulated institutions to material losses or that otherwise effect the sound

financial condition of regulated institutions and the fairness and integrity

of the markets, we concluded that the federal financial market regulators

have an interest in the reconciliation of these differences.

Regarding ISDA’s objection to additional regulatory activity, our report

concludes that no legislation or regulation is currently needed.

Nonetheless, our views on the benefits of federal regulatory involvement

in the OTC derivatives markets differ from those of ISDA. In this regard, our

recommendations address the need for the federal financial markets to

fulfill their responsibilities related to ensuring the sound financial

condition of regulated institutions and the fairness and integrity of the

markets, without creating unnecessary or costly burdens for them. We do

not recommend that the federal financial market regulators resolve the

differences between dealers and end-users by defining the nature of their

relationship for them. Rather, we recommend that they consider, as

participants in the Working Group, whether the benefits of assisting

market participants are sufficient to warrant their involvement and

whether their involvement is likely to achieve the desired result. The

Working Group’s assistance could involve facilitating discussions between

dealers and end-users that lead to agreement in key areas where they now

disagree. Regarding ISDA’s comment that our recommendations contradict

the views of market participants and regulators, this report recognizes the

varying support of these parties for our recommendations.

Treasury officials commented that the draft report appeared to be critical

of establishing an arm’s-length relationship as the default model for OTC

derivatives transactions. ISDA officials supported the arm’s-length

relationship as the default model, noting that it is the appropriate starting

place for institutional market participants. This report does not reach a

conclusion on the appropriate default model for counterparty

relationships. It presents the views of both those who support and oppose

an arm’s-length relationship as the default model. As clarified in chapter 7,

we conclude that the type of relationship and accompanying

responsibilities that should prevail in OTC derivatives transactions should

be agreed upon by market participants, and we recommend that the

Page 141 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

Working Group consider assisting market participants in reaching

agreement on these issues.

The Federal Reserve commented favorably on our recommendation to its

chairman. That is, the agency indicated that it has efforts under way that

would fully respond to our recommendation that the agency revise its

examination guidance to more specifically address the need to assess the

adequacy of banks’ policies and controls related to disclosing risk,

creating advisory relationships, and supervising marketing personnel.

In addressing our recommendation that SEC and CFTC establish a

mechanism for determining that participating firms are following the sales

practice provisions of the Framework, SEC indicated that it is willing to

discuss with the affected parties the feasibility of extending the external

auditor’s role to incorporate a review of sales practice procedures. This

appears to be an appropriate first step towards implementing our

recommendation. As indicated in chapter 6, SEC and CFTC could also

request that the participating firms provide copies of their sales practice

policies—as was done for these firms’ risk management systems as part of

SEC’s risk assessment process—and descriptions of the internal controls

these firms have established to ensure that such policies are being

followed. CFTC did not comment on this recommendation.

However, NASACT opposed this recommendation to SEC and CFTC,

contending that these agencies’ participation in a compliance program

would be recognized as an endorsement of the Framework and would

present new legal obligations without first being subject to the due

process associated with a new regulation. In place of our

recommendation, NASACT proposed that the drafters of the Framework and

end-users work with SEC and CFTC to further clarify counterparty

relationships. GFOA also expressed concern that the dealer-issued

voluntary guidance could establish legal obligations, noting that Bankers

Trust cited the Principles as support in legal actions involving Procter &

Gamble.

Our recommendation is not intended to create new legal obligations for

dealers or end-users. Regarding NASACT’s concern that SEC and CFTC

participation in a compliance program related to the Framework would

present new legal obligations (presumably for end-users), this report notes

that the Framework is not intended to apply to end-users. Instead, the

Framework specifically states that it applies only to the participating firms

and only to their nonsecurities OTC derivatives activities. Although the

Page 142 GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 7 

Conclusions and Recommendations

Framework indicates that it is not intended to create legally enforceable

obligations, this report acknowledges that the courts could find the

guidance useful in evaluating counterparty relationships and defining

common law responsibilities. To the extent that market participants find

this potential outcome objectionable, they can individually take steps to

clarify their relationship with counterparties in each transaction they

enter.

We believe that a more effective approach would be for end-users and

dealers to participate in a joint effort to reach agreement on the nature of

their relationship in OTC derivatives transactions, and we have

recommended that the Working Group consider assisting the parties in

this process. We make our recommendation to the Working Group in the

belief that a coordinated effort by the federal market regulators would be

a more effective means of reaching agreement on the nature of

counterparty relationships, including the responsibilities of counterparties

to OTC derivatives transactions. An additional advantage to this approach is

that the resulting agreement would not make distinctions between types of

dealers and end-users. That is, it would not distinguish between dealers

that are banks and dealers that are securities firm affiliates or their

end-user counterparties. As a result, should the Working Group assist

dealers and end-users in reaching an agreement on the nature of their

relationship, the resulting agreement would be applicable to all dealers

and end-users of OTC derivatives.

This report also notes that, in lieu of additional regulation, SEC and CFTC

are already participating with the drafters of the Framework in a voluntary

program that includes monitoring the nonsales practice provisions of the

Framework by external auditors. We are merely recommending that such

monitoring be extended to the sales practice provisions of the Framework.

As we conclude in this chapter, adherence to these provisions is important

for ensuring market fairness and integrity. In the absence of a mechanism

for ensuring such adherence, SEC and CFTC cannot be sure that a

participating firm’s commitment to voluntarily follow the sales practice

provisions of the Framework is being fulfilled, thereby casting doubt on

whether a voluntary arrangement is an adequate substitute for direct

federal oversight.

Page 143 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Beginning in March 1995, we sent questionnaires to 2,381 randomly

selected organizations drawn from a wide range of U.S. public and private

industries, representing a universe of approximately 49,000 organizations

that were potential end-users of plain vanilla over-the-counter (OTC)

derivatives, complex OTC derivatives, structured notes, and asset-backed

securities.1

 Our objectives in conducting the survey were to estimate for

these four product types (1) the extent of end-user satisfaction with dealer

sales practices and (2) the extent of product use.

The questionnaire requested data on the usage of specific products within

the 12 months preceding receipt of the survey. It also asked respondents

to rate the sales practices of any dealers with whom they engaged in

transactions across six dimensions: (1) disclosure of downside risks,

(2) quality of transaction documentation provided, (3) suitability of

products proposed, (4) competitiveness of pricing and fees, (5) provision

of accurate mark-to-market pricing information, and (6) assistance in

unwinding transactions. In addition, it asked the organizations to

separately rate the sales practices of dealers that proposed contracts, but

who they did not use, over the three applicable dimensions listed

above—(1), (3), and (4). We developed these sales practice dimensions on

the basis of reviews of regulatory and dealer documents and discussions

with regulators, dealers, and end-users. Lastly, the questionnaire asked

organizations to provide overall ratings of sales practices both for dealers

with whom the organizations entered into contracts as well as dealers that

proposed contracts but who they did not use.

From the returned surveys, we selected a judgmental sample of 70 of the

respondents, drawn from a wide spectrum of large and small organizations

across all of the industries surveyed. Some were end-users and others

were nonusers of the four types of products; some were satisfied with

dealer sales practices, while others were dissatisfied. We completed

telephone follow-up interviews with 50 of these respondents to learn more

about the reasons for their satisfaction or dissatisfaction with dealer sales

practices, their opinions on fiduciary relationships, and the range of

end-user sales practice-related policies, procedures, and practices.

Although the results of these follow-up interviews are not generalizable to

any larger population of potential end-users, the 50 organizations

contacted generally reflect the range of organization types and sizes,

product usage, and satisfaction levels.

1

We included mortgage-backed securities as a subset of asset-backed securities in the questionnaire.

Page 144 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Design of the Survey

Sample

To respond to a request made by the former Chairman of the

Subcommittee on Telecommunications and Finance, House Committee

Energy and Commerce, we set out to determine the extent of end-user

satisfaction with the sales practices of dealers offering OTC derivatives,

mortgage-backed securities (MBS), and structured notes across a wide

universe of U.S. public and private organizations that might be using these

products, including not only the organizations with the largest finances,

but also the smaller organizations in each industry. The former Chairman

also asked us to determine the extent of product use.

To obtain a statistically precise estimate (one with a low sampling error)

of the level of satisfaction with dealer sales practices, we needed to collect

as many survey responses as possible from current end-users, which are

more likely to have experienced sales practice presentations. Our prior

work and that of other organizations indicated that larger organizations

tend to be end-users of these products more often than smaller

organizations.

However, we were concerned that smaller organizations, which might use

these products less often and have fewer resources for managing their

financial activities, might have different sales practice experiences than

larger organizations. Any such differences would not be reflected by our

estimate of the level of satisfaction, if small organizations were excluded

from the survey. Also, we did not want to exclude from our estimate of

usage a significant number of smaller organizations that had at least some,

if limited, potential for being end-users. Therefore, to obtain unbiased

estimates of satisfaction and usage, we included proportionately more

large organizations in our sample, while still selecting some organizations

that would represent the smaller entities in the population under study.

We began by defining the populations we would survey. We identified 19

public and private industries that we concluded would thoroughly cover

potential end-users. For each of the 19 survey strata representing these

industries, we had to compile a frame, or a listing of all known

organizations in a population, ideally without duplicates or omissions. The

frames had to include mailing addresses, relevant contact names, and

enough information about the organizations to allow classification by

industry and financial size and to allow the assignment of a unique

identification number. In several of the industries we surveyed, our frames

did not cover all of the known organizations, but were restricted to

organizations above a minimum financial size, determined by the

availability of data in the lists we used. Nevertheless, the scope of each

Page 145 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

frame covered a significant proportion of the smaller organizations in that

industry and adequately comprised the population of organizations that

would have a reasonable probability of derivative product usage and

experience with dealer sales practices. See table I.1 for a description of the

19 industry strata, the scope of organizations included in those strata, and

the sources for the sample frames we developed to represent those

populations.

Table I.1: Design of Potential End-User Sample Frame

Strata (19) Population definition Frame used

Indicators of size

and/or usage

Size/Usage substratification

criteria

Cities and

counties

All 38,995 local governments,

such as counties,

municipalities, and townships,

that were identified in a 1987

census and updated by

subsequent annual surveys

(excludes states).

Directory of

Governments, 1988:

Name and Address

File (U.S. Bureau of

the Census).

Population counts

from 1990 decennial

census.

Large substratum defined as

organizations in top 5 percent,

representing 70 percent of total

population count. Small

substratum consists of all other

organizations.

Special

districts

All 32,838 local government

special districts or authorities,

such as airports, hospitals,

utilities, ports, and terminals.

Directory of

Governments, 1988:

Name and Address

File (U.S. Bureau of

the Census).

Population counts of

cities in which the

districts are located,

from 1990 decennial

census.

Large substratum defined as

the special districts (except

sewerage and water supply

districts nationwide and other

multifunction districts in Texas)

with addresses in the 30 most

populous cities. Small

substratum consists of all other

organizations.

Local school

districts

All 14,222 school districts and

systems.

Directory of

Governments, 1988:

Name and Address

File (U.S. Bureau of

the Census).

School enrollments

from the 1992-93

school year.

Large substratum defined as

organizations in the top 10

percent, representing 60

percent of total school

enrollment. Small substratum

consists of all other

organizations.

State

treasuries

Offices of all 50 state treasurers

and the District of Columbia.

Various government

directories.

Not applicable. No substratification.

Private pension

funds and union

funds

All 46,795 corporate and union

(headquarters and local)

pension funds with investment

assets of $1 million and over

that were identified in a

periodic review of Department

of Labor Form 5500 filings

(Annual Return/Report of

Employee Benefit Plan) and a

proprietary survey conducted

by Money Market Directories,

Inc.

1995 Money Market

Directory

Pensionscope

Database (Money

Market Directories,

Inc.).

Total pension assets. Large substratum defined as

organizations with $20 million in

pension assets and over,

representing approximately the

top 10 percent of organizations.

Small substratum consists of all

other organizations.

(continued)

Page 146 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Strata (19) Population definition Frame used

Indicators of size

and/or usage

Size/Usage substratification

criteria

Public pension

funds and

retirement systems

All 1,167 pension funds and

retirement systems sponsored

by state, county, and municipal

governments with investment

assets of $1 million or more,

identified and updated

periodically by Money Market

Directories, Inc.

1995 Money Market

Directory

Pensionscope

Database (Money

Market Directories,

Inc.).

Total pension assets. Large substratum defined as

organizations with $1 billion in

pension assets and over,

representing approximately the

top 10 percent of organizations.

Small substratum consists of all

other organizations.

Endowments and

foundations

All 4,855 private educational

and museum funds; private and

public charitable endowments;

and foundations with assets of

$1 million or more, identified

and updated periodically by

Money Market Directories, Inc.

1995 Money Market

Directory

Pensionscope

Database (Money

Market Directories,

Inc.).

Total assets. Large substratum defined as

organizations with $100 million

in total assets and over,

representing approximately the

top 10 percent of organizations.

Small substratum consists of all

other organizations.

College and

university

operating funds

All 3,667 2-year and 4-year U.S.

colleges, universities, technical

institutes, and vocational

programs, identified by

Department of Education

surveys, conducted annually.

Digest of Education

Statistics, 1994

(National Center for

Education Statistics).

Current-fund

revenues, as reported

for the 1991-92 period.

Large substratum defined as

organizations with $80 million

and over in current-fund

revenue for the 1991-92

reporting period, representing

approximately the top 10

percent of organizations. Small

substratum consists of all other

organizations.

Institutional money

managers

All 1,759 registered U.S.

investment advisor firms, bank

and trust departments, and

insurance companies

managing various assets of at

least $1 million, identified and

updated periodically by Money

Market Directories, Inc.

1995 Money Market

Directory

Pensionscope

Database (Money

Market Directories,

Inc.).

Total managed assets. Large substratum defined as

organizations with $1 billion in

managed assets and over,

representing approximately the

top 36 percent of organizations.

Small substratum consists of all

other organizations.

(continued)

Page 147 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Strata (19) Population definition Frame used

Indicators of size

and/or usage

Size/Usage substratification

criteria

Governmentsponsored

enterprises (GSE)

All 33 GSEs and GSE-like

organizations that we identified

as being in existence in March

of 1995, including major credit

organizations, such as the

Federal National Mortgage

Association and the Federal

Home Loan Mortgage

Association, regional Federal

Home Loan Banks, Farm Credit

Banks, and other organizations

with the Standard Industrial

Code (SIC) classification of

6111 (“Federal and Federally

Sponsored Credit”). Excludes

approximately 238 Farm Credit

Associations whose day-to-day

asset or liability management is

generally carried out at the

bank level or higher.

Ward’s Business

Directory, (1994

edition); previously

published GAO

products, and

consultation with GAO

experts.

Not applicable. No substratification.

Commodity pools Includes 844 commodity pools

with U.S. operators, with total

net asset value of $1 million or

more, as of January 1995,

according to National Futures

Association records.

National Futures

Association.

Net asset value of

pool, as of January

1995.

Large substratum defined as

organizations with $31.5 million

net asset value and over,

representing approximately the

top 33 percent of organizations.

Small substratum consists of all

other organizations.

Mutual funds All 6,358 individual equity and

bond mutual funds (except for

municipal bond funds),

identified by Lipper Analytical

Services, Inc., as of January

1995.

Lipper Analytical

Services, Inc.

Total net assets under

management.

Large substratum defined as

organizations with $450 million

in total net asset value and

over, representing

approximately the top 10

percent of organizations. Small

substratum consists of all other

organizations.

Money market

funds

All 1,237 taxable and

tax-exempt money market

mutual funds, including

municipal bond funds,

identified by Lipper Analytical

Services, Inc., as of January

1995.

Lipper Analytical

Services, Inc.

Total net assets under

management.

Large substratum defined as

organizations with $1.15 billion

net asset value and over,

representing approximately the

top 10 percent of organizations.

Small substratum consists of all

other organizations.

(continued)

Page 148 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Strata (19) Population definition Frame used

Indicators of size

and/or usage

Size/Usage substratification

criteria

Publicly held

nonfinancial

corporations

The 5,581 U.S. parent

companies with at least 500

stockholders of one class of

stock, at least $5 million in

assets, and filing reports with

the Securities and Exchange

Commission in the 18 months

before the 1994 review by

Compact Disclosure. Excludes

companies listed in Compact

Disclosure on the basis of a

debt issue and not traded on a

national or regional exchange,

or on the National Association

of Securities Dealers

Automated Quotation system,

and which had sales of less

than $25 million. Also excludes

companies with a primary SIC

in the financial industry and

foreign-based companies with

American Depository Receipts

listed on U.S. stock exchanges.

Compact Disclosure

(Disclosure, Inc.) and

the March 14, 1995,

Pink Sheets (National

Quotation Bureau,

Inc.).

Total annual sales

figure most recently

reported in Compact

Disclosure records.

Large substratum defined as

organizations with $1.4 billion

annual sales and over,

representing approximately the

top 10 percent of organizations.

Small substratum consists of all

other organizations.

Privately held

nonfinancial

corporations

The 8,204 U.S.-based

nonfinancial privately held

ultimate parent companies with

annual revenues of at least $10

million or a workforce of at least

300 people as listed in the 1994

Directory of Corporate

Affiliations, Volume 5—U.S.

Private Companies. Excludes

public organizations and

companies with a primary SIC

in the financial industry.

1994 Directory of

Corporate Affiliations,

Volume 5—U.S.

Private Companies

(National Register

Publishing) and

Ward’s 1995 Business

Directory of U.S.

Private and Public

Companies (Gale

Research, Inc.).

Total sales as

reported in Ward’s

1995 Business

Directory of U.S.

Private and Public

Companies.

Large substratum defined as

the top 200 corporations in total

1994 sales, representing

approximately the top 2 percent

of organizations in the

population. Small substratum

consists of all other

organizations.

(continued)

Page 149 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Strata (19) Population definition Frame used

Indicators of size

and/or usage

Size/Usage substratification

criteria

Largest nonbank

financial

corporations

The largest 120 firms with

assets over $100 million, as

identified by Ward’s 1995

Business Directory. Includes

financial companies other than

banks, insurance companies,

and securities firms. Includes

firms classified under the

following SICs: 6141, personal

credit institutions; 6153,

short-term business credit

firms; 6159, miscellaneous

business credit firms;

6162, mortgage bankers and

correspondents; and 6163, loan

brokers. Does not include

subsidiaries of banks or thrifts

but may include subsidiaries of

insurance or nonfinancial

companies.

Ward’s 1995 Business

Directory of U.S.

Private and Public

Companies (Gale

Research, Inc.).

Total assets as

reported in Ward’s

1995 Business

Directory of U.S.

Private and Public

Companies.

No substratification.

Banks and thrifts All 9,816 U.S. thrifts and

single-bank and multibank

holding companies or lead

banks with national or state

charters. Does not include New

York Investment Companies or

trust companies. Branches,

subsidiaries, or individual

banks that are members of

larger families of banks are also

excluded.

Holding company,

bank, and thrift data

files in June 1994

(#188) Call Report

(Federal Financial

Institutions

Examination Council).

Total assets as

reported in June 1994

Call Reports and total

dollar amount of

assets and liabilities

reported in all

categories of MBS,

either held to maturity,

available for sale, or

held in trading

accounts plus total

off-balance sheet

notional value dollar

amounts of various

interest rate and

foreign exchange

forwards, options,

and swaps.

Largest substratum defined as

those institutions with total

assets of $225 million or more

and reporting $300 million or

more in holdings of MBS and

notional amounts of forwards,

options, and swaps (3 percent

of the population). Middle

substratum defined as

institutions with total assets of

less than $225 million and

reporting $300 million or more

in holdings of MBS and notional

amounts of forwards, options,

and swaps and institutions of

any asset size and reporting up

to $300 million in holdings of

MBS and notional amounts of

forwards, options, and swaps

(33 percent of the population).

Smallest substratum defined as

institutions of any asset size

reporting no holdings of these

products (64 percent of the

population).

(continued)

Page 150 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Strata (19) Population definition Frame used

Indicators of size

and/or usage

Size/Usage substratification

criteria

Insurance

companies

The 2,523 ultimate parent

property/casualty and

life/health insurance companies

identified in the 1994 edition of

Best’s Insurance Reports.

Includes foreign-owned U.S.

subsidiaries or divisions that list

their U.S. executive

management in Best’s

Insurance Reports. Also

includes insurance companies

owned by holding companies

outside of the insurance

industry. Does not include

subsidiaries or divisions of

other U.S. insurance

companies.

Best’s Insurance

Reports, 1994 edition

(A.M. Best, Inc.).

Total assets as

reported in 1994

edition of Best’s

Insurance Reports.

Large substratum defined as

organizations with $700 million

in assets and over,

representing approximately the

top 12 percent of organizations.

Small substratum consists of all

other organizations.

Credit unions All 13,380 federally insured

corporate and natural person

credit unions in the United

States. Includes the U.S.

Central Credit Union. Natural

person credit unions primarily

serve individuals who are their

member-owners. Corporate

credit unions are cooperatively

owned by the natural person

credit unions and serve them

by investing a portion of their

assets or loaning them funds

for liquidity purposes.

Data tapes from the

National Credit Union

Administration.

Total assets in 1994.

Also, total holdings of

collateralized

mortgage obligations

(CMO) and real estate

management

investment conduits

(REMIC) in June 1994.

Largest substratum defined as

all 45 of the corporate credit

associations, 25 of which

reported holding CMOs or

REMICs as of December 1994

(less than 1 percent of the

population). Second

substratum defined as the

1,147 natural person credit

unions with any CMO or REMIC

holdings as of June 1994

(approximately 9 percent of the

population). Third substratum

defined as the 1,204 natural

person credit unions with no

CMO or REMIC holdings as of

June 1994, but with $50 million

or more in assets

(approximately 9 percent of the

population). Fourth substratum

defined as the 10,984 natural

person credit unions with no

CMO or REMIC holdings as of

June 1994 and less than $50

million in assets (approximately

82 percent of the population).a

aTotals do not sum to 100 percent due to rounding.

Source: GAO.

After identifying the 19 strata representing broad industries, we then

subdivided 16 strata into 2 or more substrata on the basis of financial size

Page 151 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

and, if available, the extent of past product usage. We did not subdivide

three strata—state treasuries, GSEs, and the largest nonbank financial

corporations—because they were already narrow industries with too few

organizations to subdivide by size. We substratified to group organizations

on the basis of how likely they were to be current end-users of OTC

derivatives, MBS, and structured notes so that we could sample them at

different rates. In each of the industry strata, we chose indicators of

financial size, such as annual revenues, assets under management, or

population in the governmental jurisdiction served. For the bank and

credit union strata, additional information identifying past users of certain

kinds of products was available from financial reports.

Typically, we defined the larger substrata in each industry as the top 10

percent of the number of organizations in the population when ranked by

size, although the cutpoints defining the large substrata varied from

approximately the top 1 percent to 33 percent of some populations,

depending on our knowledge of that particular industry or the

characteristics of the sampling frames (see table I.1). For example, we

defined the large credit union substratum as only the corporate credit

unions, which covered less than 1 percent of all credit unions. Corporate

credit unions, which tend to be large, differ in structure and function from

smaller “natural person” credit unions. In addition, we defined a cutpoint

of $1 billion in assets under management for money managers, resulting in

the large substratum covering 36 percent of the organizations in the

population, because that asset level was the highest available in the

computerized list that we used. Organizations known to have recently

used certain MBS and derivatives were included in the larger substrata of

banks, thrifts, and credit unions.

The sample was drawn from each substratum at different

rates—proportionately more organizations were drawn from the substrata

of large entities and recent users, which we expected to yield a relatively

high proportion of current users, and fewer from the substrata of smaller

entities, which we expected to yield fewer end-users. This differential rate

of sampling was necessary to obtain a sample that would meet both the

objectives of developing an acceptable estimate of overall usage and an

acceptable estimate of users’ opinions. See table I.2 for the exact

allocation of the original survey sample of 2,422 organizations2

 across the

2

Of the 2,422 organizations in the original sample, 41 were determined to be ineligible (out of business,

wrong industry, duplicate listing, and similar dispositions) before mailout. From the 2,381

questionnaires mailed out, we determined that an additional 177 organizations were ineligible during

the course of the survey. The final working sample size was 2,204 organizations.

Page 152 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

substrata and the aggregation of the 19 strata into the 9 industry groups

that we used to present our findings throughout this report.

Questionnaire Design To develop our questionnaire, we consulted representatives of the dealer

community, groups representing end-users, financial regulators, and other

finance experts. We also conducted many in-depth interviews with finance

officers from state and local governmental entities and private

corporations on subjects to be included in the questionnaire. After drafting

a questionnaire and receiving comments from the aforementioned groups,

we conducted five pretests of the questionnaire with a variety of likely

respondents drawn from several of the survey populations. The

information gathered during such tests was used to improve the structure

of the questionnaire as well as the phrasing of specific questions.

Survey Administration The mailout of questionnaires began during the last week of March 1995.

Follow-up mailings with replacement questionnaires and a renewed appeal

encouraging response were sent to nonrespondents beginning in the last

week of May 1995. In the second week of July 1995, we began to make

telephone follow-up calls to a sample of organizations that had not yet

responded to either the first or second questionnaire mailing. A random

sample of approximately 50 percent of the nonrespondents was drawn

from across all of the strata, and we administered a short telephone

interview questionnaire to that sample of 365. The follow-up interviews

determined the reason for nonresponse, prompted the return of the full

questionnaire, or collected basic data from the organization if a mail

questionnaire would not be returned by the respondent. The survey was

closed out at the end of October 1995, after which no additional responses

were included in our results. Because the questionnaire asked for product

usage and sales practice experience for the 12 months preceding the

survey, and given that respondents were filling out and returning

questionnaires from April 1995 through October 1995, the maximum

possible period of financial activity covered by the survey was from

April 1994 through October 1995.

Survey Response We attempted to collect data from every one of the organizations chosen

in our random sample. However, for a variety of reasons, such as refusals,

we did not receive usable responses from a number of entities. After

sending a replacement questionnaire to nonrespondents and following up

by telephone with a random sample of the remaining nonrespondents, we

Page 153 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

determined the final status of our entire sample (see table I.2). We

received 1,755 usable responses, for an overall response rate of 80 percent.

Although some of the survey strata exhibited higher or lower rates of

response than others, the response rates did not vary systematically by

size of stratum. Because we hypothesized that large and small

organizations would differ on key variables, a large difference in response

rates between large and small substrata could have introduced bias into

the overall survey results.

Page 154 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Page 155 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.2: Disposition of Survey Sample Across All Strata

Industry groups (9) Strata (19) Substrata (38)

Original

population

Original

sample Ineligible

State and

local government

Cities and counties Large: population ≥ 37,000

1,932 100 1

Small: population < 37,000 37,104 50 5

State and local special

districts

Large: top 30 urban areas

489 50 5

Small: all other districts 32,349 50 4

Local school districts Large: enrollment ≥ 5,250 1,426 50 0

Small: enrollment < 5,250 12,796 50 0

State treasuries All states and District of Columbia 51 51 0

Pension funds Private pension/Union funds Large: assets ≥ $20 million 4,407 100 3

Small: assets < $20 million 41,349 100 5

Public pension

funds/Retirement systems

Large: assets ≥ $1 billion

123 75 1

Small: assets < $1 billion 1,044 25 0

Endowment and

college funds

Endowments and

foundations

Large: assets ≥ $100 million

507 50 3

Small: assets < $100 million 4,348 50 1

College and university

operating funds

Large: revenue ≥ $80 million

366 50 3

Small: revenue < $80 million 3,301 50 1

Money managers Institutional money

managers

Large: assets ≥ $1 billion

637 122 0

Small: assets < $1 billion 1,122 72 3

GSE GSE All 33 33 1

Investment funds Commodity pools Large: net asset value ≥ $31.5

million 286 29 7

Small: net asset value < $31.5

million 558 26 0

Mutual funds Large: assets ≥ $450 million 636 125 3

Small: assets < $450 million 5,722 75 1

Money market mutual funds Large: assets ≥ $1.2 billion 124 75 0

Small: assets < $1.2 billion 1,113 75 5

Nonfinancial

corporations

Publicly held nonfinancial

corporations

Large: sales ≥ $1.4 billion

506 75 0

Small: sales < $1.4 billion 5,075 74 1

Privately held nonfinancial

corporations

Large: top 200, by sales

200 50 3

Small: all others 8,004 121 16

Page 156 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Respondents Nonrespondents

Follow-up

sample

Follow-up

ineligible

Follow-up

respondents

Follow-up

nonrespondents

Total

responses

Response rate

(percent)

67 32 10 6 4 0 71 76

45 0 0 0 0 0 45 100

23 22 7 5 2 0 25 63

29 17 14 5 8 1 37 90

34 16 7 0 6 1 40 80

34 16 6 1 4 1 38 78

32 19 5 1 4 0 36 72

54 43 17 3 11 3 65 69

63 32 18 4 11 3 74 81

60 14 8 2 5 1 65 90

16 9 4 2 2 0 18 78

32 15 10 3 4 3 36 82

38 11 7 1 5 1 43 90

37 10 6 1 5 0 42 91

35 14 10 4 2 4 37 82

70 52 32 12 11 9 81 74

64 5 0 0 0 0 64 93

31 1 0 0 0 0 31 97

18 4 0 0 0 0 18 82

13 13 7 4 2 1 15 68

58 64 22 5 12 5 70 60

36 38 27 3 21 3 57 80

36 39 17 0 14 3 50 67

28 42 32 15 10 7 38 69

46 29 12 3 7 2 53 74

42 31 12 2 9 1 51 72

33 14 7 5 2 0 35 83

70 35 11 4 7 0 77 76

(continued)

Page 157 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Industry groups (9) Strata (19) Substrata (38)

Original

population

Original

sample Ineligible

Other financial

corporations

Largest nonbank financial

corporations

Top 120, by assets

120 120 7

Banks/ Credit

unions/ Insurance

companies

Banks and thrifts Large/Past users: MBS and

derivative usage ≥ $300 million

and assets ≥ $225 million 309 75 2

Medium/Past users: (1) usage <

$300 million or (2) usage ≥ $300

million and assets < $225 million 3,194 75 1

Small/No past usage: $0 usage,

any asset size 6,313 50 10

Insurance companies Large: assets ≥ $700 million 299 50 3

Small: assets < $700 million 2,224 50 13

Credit unions 45 corporate credit unions 45 45 0

Natural person credit unions, past

users of MBS 1,147 54 2

Natural person credit unions, no

past usage, assets ≥ $50 million 1,204 25 0

Natural person credit unions, no

past usage, assets < $50 million 10,984 25 0

Total N/A N/A 191,447 2,422 110

Page 158 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Respondents Nonrespondents

Follow-up

sample

Follow-up

ineligible

Follow-up

respondents

Follow-up

nonrespondents

Total

responses

Response rate

(percent)

71 42 19 7 12 0 83 78

59 14 7 4 2 1 61 88

55 19 7 1 5 1 60 82

30 10 6 2 3 1 33 87

33 14 10 2 6 2 39 87

27 10 5 0 3 2 30 81

38 7 3 1 2 0 40 91

50 2 0 0 0 0 50 96

25 0 0 0 0 0 25 100

22 3 0 0 0 0 22 88

1,554 758 365 108 201 56 1,755 80

Source: GAO.

Calculation of Survey

Estimates

The overall survey statistics appearing in this report represent estimates of

the entire population of U.S. private industry and state and local

governmental entities from which the sample was drawn. To be able to

make an estimate of the entire population, each questionnaire we received

was statistically adjusted, or “weighted,” so that its influence in

determining the overall survey result was proportional to the number of

other, nonsampled entities it had to represent in its industry. Specific

weights were calculated for returned questionnaires within each of the

substrata formed by the cross-classification of industry with organizational

size and/or past usage. The weights were also adjusted to represent

different sample selection rates within substrata for the initial sample and

the follow-up sample of nonrespondents.

Not all of the sample substrata are included in the overall survey results.

Five of the “smallest” substrata were removed from the overall survey

estimates made in this report and analyzed separately. They were: small

cities and counties, small special districts, small school districts, small

private pension and union funds, and small nonuser credit unions. These

Page 159 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

five substrata represent populations that are very numerous, yet very low

in financial assets and activity. We discovered a very low rate of product

usage among these entities and, therefore, decided to separate them from

the rest of the sample. See tables I.3 and tables I.5 through I.8 for the

estimates of usage of the various products by these very small

organizations. Although the size of the entire original population, including

the 5 smallest strata, is approximately 191,000, the population to which we

project our overall survey estimates in this report, after removing the very

small organization strata and adjusting the population for ineligibles, is

approximately 49,000 organizations.

In addition to the overall estimates that are projectable to the entire

population of U.S. public and private industry from which the sample was

drawn, this report contains some estimates for more specific industry

groupings. Because the number of sampled organizations falling within

any 1 of the 19 industries was usually too small to yield precise estimates

for that individual industry, we aggregated responses from several

comparable industries to form 9 industry groups (see table I.2). For

example, we combined questionnaires received from mutual funds, money

market funds, and commodity pools into one analytical group. Although

the individual industries combined in a group generally exhibit the same

characteristics on most survey items, a great deal of variation may exist in

rates of usage and satisfaction among some of the combined industries.

This report also breaks down survey results by the size of organization

and/or past usage of certain MBS and derivative products across the entire

sample and within each industry group. As previously described, we

separated the industries into as many as four substrata. The cutpoints

separating these substrata of “larger” from “smaller” organizations in each

of the 19 industries are somewhat arbitrary and are based on different

measures across each industry. As a result, “larger” organizations in one

industry are not necessarily similar to those in another industry.

Beyond the limited breakdowns of the survey results by broad categories

of industry and size, it is not possible to make any estimates of acceptable

precision. Because the survey sample was designed to make overall

estimates across a large number of industries, an insufficient number of

sampled institutions exists within the fine categories of industry, size,

geographical location, or other subgroups. Some subgroup estimates that

are made in this report are accompanied by a note to the reader that the

small number of observations involved make calculation of sampling error

unfeasible and heighten the likelihood of significant nonsampling error.

Page 160 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

The concept of sampling errors and other survey errors is discussed in the

following sections.

Sampling Error Because we reviewed a statistical sample of organizations, each estimate

developed from the sample has a measurable precision, or sampling error.

The sampling error is the maximum amount by which the estimate

obtained from a statistical sample can be expected to differ from the true

population value we are estimating. Sampling errors are stated at a certain

confidence level—in this case 95 percent. This means that the chances are

19 out of 20 that if we surveyed all of the organizations in the population,

the true value obtained for a question on this survey would differ from the

estimate obtained from our sample by less than the sampling error for that

question. The sampling errors for all of the survey estimates made in this

report are listed in tables I.3 through I.14. For the state treasury, GSE, and

other financial institution strata, we selected all known organizations in

the population as defined, so there is technically no sampling error

associated with those estimates. However, missing observations due to the

nonresponse of some of the sampled organizations in those strata creates

statistical uncertainty similar to sampling error.

Nonsampling Errors In addition to the reported sampling errors, the practical difficulties of

conducting any survey may introduce other types of errors, commonly

referred to as nonsampling errors. For example, intentional or accidental

misreporting, differences in how a particular question is interpreted, the

level of effort a respondent makes to answer the questions accurately, or

the types of people who do not respond can introduce unwanted

variability into the survey results.

We included steps in the questionnaire design, data collection, and data

analysis stages for the purpose of reducing such nonsampling errors.

While designing the questionnaire, we solicited expert opinions on the

wording and structure of our questions and their answer categories, we

received feedback on our questions and answers during a focus group with

end-users, and we pretested the survey instrument with five organizations

from our sample.

During data collection, we checked whether some answers respondents

gave on their questionnaires were logically consistent with other answers.

While conducting an in-depth telephone follow-up with a sample of

respondents who were particularly satisfied or dissatisfied with sales

Page 161 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

practices, we attempted to verify some of their previous answers and thus

gauge the reliability of a subset of the questions.

To reduce nonresponse bias, we attempted to convert a sample of

50 percent of the nonrespondents to respondents through telephone

follow-ups. To assess the potential impact of nonresponse on our

estimates, we examined a group of respondents who may be similar to

nonrespondents in terms of characteristics that determine questionnaire

responses—those organizations that were initially nonrespondents but

were converted through telephone follow-up. When we compared the

answers of those converted nonrespondents to organizations that

responded without follow-up, we found the only material difference to be

that a smaller proportion of the converted nonrespondents used MBS and

fewer were dissatisfied with the sales practices of dealers offering MBS.

Finally, in processing and tabulating the survey data, we employed a

number of procedures to reduce errors that arise from these activities.

Sampling Errors

Associated With the

Key Survey Estimates

Cited in This Report

Page 162 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.3: Proportion of Organizations

Using OTC Derivatives (Plain Vanilla or

More Complex) in the 12 Months

Preceding Receipt of Survey, by Size

Category and Industry Group

Organizations, by size category and industry

group

Estimate

(percent)

Sampling

error (±) 

(percent)

Size category:

All organizations in the population, excluding the

five smallest strata 11% 2%

Large organizations 14 2

Small organizations, excluding the five smallest

strata 9 3

Smallest five strata (smallest local governmental

entities, smallest credit unions, and smallest

private pension funds) <1 a

Industry group:

Banks and thrifts, credit unions, and insurance

companies 5 3

Endowments, foundations, and college and

university operating funds 7 5

Other financial corporations (credit financing

firms, mortgage brokers and lenders, and

leasing agencies) 54 6

GSEs 71 3

Money managers 10 5

Mutual funds, money market funds, and

commodity pools 27 9

Public and private pension funds and retirement

systems 10 5

Publicly and privately held nonfinancial

corporations 10 5

State and local governmental entities 4 a

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 163 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.4: Proportion of Estimated

Total Users Represented by Each

Industry Group

Industry group

Estimate

(percent)

Sampling

error (±)

(percent)

Banks and thrifts, credit unions, and insurance

companies 12% 7%

Endowments, foundations, and college and

university

operating funds 11 7

Other financial corporations 1 <1

GSEs <1 <1

Money managers 3 2

Mutual funds, money market funds, and commodity

pools 39 10

Public and private pension funds and retirement

systems 9 5

Publicly and privately held nonfinancial corporations 22 10

State and local governmental entities 2 a

Total 100% N/A

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 164 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.5: Proportion of Organizations

Using Plain Vanilla OTC Derivatives,

by Size Category and Industry Group Organizations, by size category and industry

group

Estimate

(percent)

Sampling

error (±)

(percent)

Size category:

All organizations in the population, excluding the

five smallest strata 10% 2%

Large organizations 14 2

Small organizations, excluding the five smallest

strata 9 3

Smallest five strata (smallest local governmental

entities, smallest credit unions, and smallest

private pension funds) <1 a

Industry group:

Banks and thrifts, credit unions, and insurance

companies 5 3

Endowments, foundations, and college and

university operating funds 6 5

Other financial corporations (credit financing

firms, mortgage brokers and lenders, and

leasing agencies) 54 6

GSEs 68 3

Money managers 10 5

Mutual funds, money market funds, and

commodity pools 27 9

Public and private pension funds and retirement

systems 10 5

Publicly and privately held nonfinancial

corporations 10 5

State and local governmental entities 3 a

Other subgroups:

Large publicly and privately held nonfinancial

corporations 66 12

Large public pension funds and retirement

systems 41 9

Proportion of organizations that have not used

plain vanilla OTC derivatives, but have received

a proposal to enter into such a contract in the

last 12 months 8 2

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 165 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.6: Proportion of Organizations

Using More Complex OTC Derivatives,

by Size Category and Industry Group Organizations, by size category and industry

group

Estimate

(percent)

Sampling

error (±)

(percent)

Size category:

All organizations in the population, excluding the

five smallest strata 2% 1%

Large organizations 4 1

Small organizations, excluding the five smallest

strata 1 a

Smallest five strata (smallest local governmental

entities, smallest credit unions, and smallest

private pension funds) 0 0

Other subgroups:

Proportion of organizations that have not used, but

have received a proposal for more complex OTC

derivatives 6 2

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 166 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.7: Proportion of Organizations

Using MBS, by Size Category and

Industry Group Organizations, by size category and industry

group

Estimate

(percent)

Sampling

error (±)

(percent)

Size category:

All organizations in the population, excluding the

five smallest strata 24% 3%

Large organizations 37 4

Small organizations, excluding the five smallest

strata 19 4

Smallest five strata (smallest local governmental

entities, smallest credit unions, and smallest

private pension funds) 3 a

Industry group:

Banks and thrifts, credit unions, and insurance

companies 55 8

Endowments, foundations, and college and

university operating funds 16 7

Other financial corporations (credit financing

firms, mortgage brokers and lenders, and

leasing agencies) 23 4

GSEs 73 3

Money managers 33 8

Mutual funds, money market funds, and

commodity pools 25 9

Public and private pension funds and retirement

systems 24 7

Publicly and privately held nonfinancial

corporations 2 a

State and local governmental entities 7 5

Other subgroups:

Small banks and thrifts, credit unions, and

insurance companies 40 11

All other organizations except for small banks

and thrifts, credit unions, and insurance

companies 21 2

Large public pension funds and retirement

systems 74 9

Proportion of organizations that have not used

MBS, but have received a proposal to enter into

such a contract in the last 12 months 4 2

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 167 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.8: Proportion of Organizations

Using Structured Notes, by Size

Category and Industry Group Organizations, by size category and industry

group

Estimate

(percent)

Sampling

error (±)

(percent)

Size category:

All organizations in the population, excluding the

five smallest strata 16% 3%

Large organizations 22 3

Small organizations, excluding the five smallest

strata 13 4

Smallest five strata (smallest local governmental

entities, smallest credit unions, and smallest

private pension funds) 2 a

Industry group:

Banks and thrifts, credit unions, and insurance

companies 40 8

Endowments, foundations, and college and

university operating funds 11 6

Other financial corporations (credit financing

firms, mortgage brokers and lenders, and

leasing agencies) 6 <1

GSEs 57 3

Money managers 20 7

Mutual funds, money market funds, and

commodity pools 12 6

Public and private pension funds and retirement

systems 5 4

Publicly and privately held nonfinancial

corporations 3 a

State and local governmental entities 9 6

Other subgroups:

Small banks and thrifts, credit unions, and

insurance companies 35 13

All organizations except for small banks and

thrifts, credit unions, and insurance companies 12 2

Large public pension funds and retirement

systems 33 9

Proportion of organizations which have not used

structured notes, but have received a proposal

to enter into such a contract in the last 12 months 5 1

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 168 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.9: Proportion of Organizations Rating Overall Sales Practices for Dealers Used, by Product Offered

Somewhat or very

satisfied

Neither satisfied nor

dissatisfied

Somewhat or very

dissatisfied No opinion

Product

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Plain vanilla OTC

derivatives 85% 8% 13% 8% 2% a <1% a

More complex OTC

derivatives 79 19 a a a a a a

MBS 71 8 20 8 7 4 2 a

Structured notes 64 11 20 9 13 9 4 a

aNumber of cases insufficient to make an estimate.

Source: GAO.

Table I.10: Proportion of Organizations Rating Overall Sales Practices for Dealers Not Used, by Product Offered

Somewhat or very

satisfied

Neither satisfied nor

dissatisfied

Somewhat or very

dissatisfied No opinion

Product

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Plain vanilla OTC

derivatives 29% 9% 33% 9% 17% 7% 21% 10%

More complex OTC

derivatives 16 9 51 14 26 12 7 a

MBS 20 8 46 10 27 8 8 7

Structured notes 15 7 48 12 29 10 8 a

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 169 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.11: Proportion of Organizations Somewhat or Very Dissatisfied With Disclosure of Downside Risks or Suitability of

Products Proposed, by Dealers Used and Not Used

Disclosure of downside

risks

Suitability of products

proposed

Disclosure of downside

risks

Suitability of products

proposed

Dealers used Dealers not used

Product

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Plain vanilla OTC

derivatives 6% a <1% a 20% 8% 18% 7%

More complex OTC

derivatives 12 a 3 a 38 13 42 13

MBS 5 3 4 3 27 8 36 9

Structured notes 17 9 7 a 31 10 39 10

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 170 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Page 171 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.12: Proportion of End-Users of

a Product Who Believed a Fiduciary

Relationship Exists

Total of some and all cases

Product Estimate percent

Sampling error (±)

(percent)

Plain vanilla OTC derivatives 53% 10%

More complex OTC derivatives 48 16

MBS 60 7

Structured notes 58 9

Page 172 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

In all cases In some cases Never No opinion

Estimate

(percent)

Sampling error

(±) (percent)

Estimate

(percent)

Sampling error

(±) (percent)

Estimate

(percent)

Sampling error

(±) (percent)

Estimate

(percent)

Sampling error

(±) (percent)

35% 10% 18% 7% 31% 9% 16% 8%

28 15 19 10 36 16 16 15

37 7 23 6 25 6 15 6

36 9 22 7 26 9 16 6

Source: GAO.

Table I.13: Proportion of End-Users of a Product Who Believed a Fiduciary Relationship Exists in Some or All Cases, by

Industry Group

Plain vanilla OTC

derivatives MBS Structured notes

Industry group

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Estimate

(percent)

Sampling

error (±)

(percent)

Aggregated subgroup of large and small banks and thrifts,

credit unions, and insurance companies 58% 24% 63% 10% 63% 13%

Endowments, foundations, and college and university

operating funds 31 a 58 24 34 a

Other financial corporations (credit financing firms, mortgage

brokers and lenders, leasing agencies) 54 6 75 4 73 a

GSEs 27 4 38 4 41 5

Money managers 39 24 52 15 49 20

Mutual funds, money market funds, and commodity pools 42 18 52 24 47 23

Public and private pension funds and retirement systems 78 a 51 20 69 a

Publicly and privately held nonfinancial corporations 73 19 63 a 86 a

State and local governmental entities 81 a 87 a 84 a

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 173 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

Table I.14: Proportion of All End-Users

of a Product That Relied on the Dealer

for Investment Advice

To some, moderate, great, or very

great extent

Product Estimate (percent)

Sampling error (±)

(percent)

Plain vanilla OTC derivatives 59% 10%

More complex OTC derivatives 64 15

MBS 73 6

Structured notes 84 6

Page 174 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I 

Methodology for GAO Survey of End-Users

To a great or very great extent To some or a moderate extent To little or no extent No opinion

Estimate

(percent)

Sampling error

(±) (percent)

Estimate

(percent)

Sampling error

(±) (percent)

Estimate

(percent)

Sampling error

(±) (percent)

Estimate

(percent)

Sampling error

(±) (percent)

28% 10% 31% 9% 36% 10% 5% 3%

28 18 36 16 32 15 4 a

36 7 37 7 20 6 7 3

42 9 42 9 10 5 6 4

aNumber of cases insufficient to make an estimate.

Source: GAO.

Page 175 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 176 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 177 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 178 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 179 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 180 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 181 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 182 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 183 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 184 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 185 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 186 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 187 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 188 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II 

GAO Survey of Sales Practices for OTC

Derivatives, Structured Notes, and

Asset-Backed Securities

Page 189 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix III 

Comments From the Board of Governors of

the Federal Reserve System

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 190 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix III 

Comments From the Board of Governors of

the Federal Reserve System

See comment.

Page 191 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix III 

Comments From the Board of Governors of

the Federal Reserve System

Page 192 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix III 

Comments From the Board of Governors of

the Federal Reserve System

The following is GAO’s comment on the July 30, 1997, letter from the Board

of Governors of the Federal Reserve System.

GAO Comment The Federal Reserve commented that its guidance on the investment and

end-user activities of banking institutions may be helpful to end-users

generally. We agree and have added a specific citation to this guidance as

well as Office of the Comptroller of the Currency guidance for institutions

acting as end-users of OTC derivatives and other financial products.

Page 193 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IV 

Comments From the Office of the

Comptroller of the Currency

Page 194 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V 

Comments From the Securities and

Exchange Commission

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See p. 139.

Page 195 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V 

Comments From the Securities and

Exchange Commission

See p. 140.

See p. 142.

See comment 1.

Page 196 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V 

Comments From the Securities and

Exchange Commission

Now on p. 90.

See comment 2.

Now on p. 88.

See comment 3.

See comment 4.

Page 197 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V 

Comments From the Securities and

Exchange Commission

The following are GAO’s comments on the Securities and Exchange

Commission’s (SEC) August 15, 1997, letter.

GAO Comments 1. SEC commented that our draft report did not adequately discuss the

differences between the two sets of dealer-issued guidance—the

Framework for Voluntary Oversight and the Principles and Practices for

Wholesale Financial Market Transactions. First, SEC stated that, while our

draft report noted that both sets of guidance assert the relationship

between parties to nonsecurities over-the-counter (OTC) derivatives

transactions is one of arm’s length, the report provides no additional

discussion of the affirmative responsibility, under the Framework, for a

dealer to clarify the nature of the relationship when it becomes aware that

the nonprofessional counterparty (end-user) mistakenly believes that the

dealer has assumed advisory obligations. Second, SEC stated that our draft

report alluded in table 4.1, but did not discuss, that, while the Principles

recommends that policies regarding the use of financial products be

maintained, the Framework goes further by expressly recommending that

controls be established to reduce the risk of misunderstandings and

contractual disputes between parties.

Although differences between the two sets of dealer-issued guidance exist,

we did not find these differences to be material, and we did not find them

to exist in the two respects that SEC cited. Our overall analysis of the key

provisions of each set of guidance indicates that they are consistent in the

following: type of relationship they assert; the degree to which the parties

should rely on each other; and the specific responsibilities of parties

regarding the disclosure of risk, the exchange of pricing and valuation

information, and the controls that should be in place. Also, given that

adherence to each set of guidance is voluntary, the difference in

terminology used is not material. This report now notes that a member of

the Principles drafting committee, whose firm also served on the

committee that developed the Framework, reached the same general

conclusion. He stated that the spirit of the two documents is the same and

that it would be unfair to contrast them simply because they use different

language in some sections.

Regarding the first difference between the Framework and Principles that

SEC cited, table 4.1 of this report provides our summary of the key sales

practice provisions of these two sets of guidance. In this table, we state

that the Framework indicates that professional intermediaries (dealers)

should take steps to clarify the relationship if its counterparty appears to

Page 198 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V 

Comments From the Securities and

Exchange Commission

believe that the dealer has assumed an advisory role. However, this

responsibility is not unique to the Framework, as the Principles, in section

5.2, similarly states that participants may wish to maintain policies and

procedures for identifying and addressing exceptional situations that pose

relationship, reputational, or litigation (compliance) risks, including those

in which the counterparty appears to assume incorrectly that it may rely

on the participant for recommendations or investment advice. This section

of the Principles also represents the provision related to controls that SEC

cited as a second difference between the two sets of dealer-issued

guidance. The draft report summarized this aspect of both sets of

guidance.

In addition, we added text in chapter 4 that cites a situation posing

compliance and reputation risks for which both documents call for

policies and procedures—that is, when counterparties incorrectly assume

an advisory relationship exists. In summary, our report indicates that both

sets of guidance contain similar expectations for participants regarding

the need to establish controls to address the risk arising from

misunderstandings and contractual disputes between parties.

2. In identifying another difference between the two sets of dealer-issued

guidance, SEC stated that the Principles may be implemented in whole or in

part, whereas the Framework should be implemented in its entirety. We

found that this difference between the two sets of guidance results

because the firms that have agreed to voluntarily adhere to the Framework

have done so to avoid direct federal regulation. Notwithstanding this

difference, our discussion of the key provisions of the two sets of guidance

focuses primarily on the nature of the relationship and types of the

responsibilities they advocate. Differences in the extent to which each set

of voluntary guidance may be implemented is not material to this

discussion; therefore, we did not modify the report.

3. SEC stated that while our draft report correctly indicated that the

Framework applies only to six firms and only to their nonsecurities OTC

derivatives activities, this implies that a large number of firms as well as a

large amount of activity may be operating outside of the Framework. SEC

stated that the six firms that have agreed to implement the Framework are

responsible for more than 90 percent of the nonsecurities OTC derivatives

business conducted by unregistered affiliates of broker-dealers, and that

these affiliates do not conduct securities OTC derivatives activities, as these

must be conducted through an SEC registered and regulated broker-dealer.

Page 199 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V 

Comments From the Securities and

Exchange Commission

By describing the specific firms and activities covered by the Framework,

we did not intend to imply that large amounts of securities firms’ OTC

derivatives activities are not addressed by the Framework or by some

other regulatory regime. We acknowledged in the draft report that the

participating firms account for 90 percent of the OTC derivatives activities

of security firm affiliates. We revised this text to indicate that such

activities involve nonsecurities OTC derivatives. Although we indicate in

chapter 1 of this report that firms conducting securities activities must do

so in affiliates registered with and subject to regulation by SEC, we have

also added text to that effect in chapter 2.

4. SEC commented that our draft report did not always clearly distinguish

between OTC derivatives that are securities and those that are not. We

revised the text of this report and the figures appearing in chapters 3 and

4, as appropriate, to make this distinction. We also added text in chapter 2,

explaining that OTC derivatives that are considered to be securities

represent a small percentage of the overall volume of OTC derivatives.

Page 200 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VI 

Comments From the End-Users of

Derivatives Association

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 201 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VI 

Comments From the End-Users of

Derivatives Association

See comment.

See p. 74.

Page 202 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VI 

Comments From the End-Users of

Derivatives Association

The following is GAO’s comment on the End-Users of Derivatives

Association’s August 1, 1997, letter.

GAO Comment The association commented that the draft report might give the impression

that sales practice disputes are largely the result of end-users suffering

large financial losses. It elaborated that end-users have suffered large

losses without objecting to dealer conduct when derivatives that were

used as hedges operated as dealers represented. In such cases, derivatives

losses were offset by gains in the underlying hedged items.

We did not intend to imply that end-users routinely blame dealers when

they incur losses. In chapter 3, we presented estimates of the percentage

of reported losses in which sales practice concerns were raised. While we

could not determine if the products were used for hedging, the data

(which are not statistically valid) show that about 59 percent of publicized

over-the-counter derivatives losses did not result in sales practice

disputes. Nonetheless, we revised the report to further clarify that

end-users do not routinely raise sales practice concerns when they incur

losses and to describe the circumstances under which they might raise

such concerns.

Page 203 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comment 1.

Page 204 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

See p. 100.

See p. 102.

Page 205 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

See p. 52.

See comment 2.

See p. 142.

Page 206 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

See comment 3.

See comment 4.

Page 207 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

See comment 5.

See comment 6.

See p. 116.

See comment 7.

Page 208 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

See comment 8.

Page 209 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

Page 210 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

Page 211 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

Page 212 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

The following are GAO’s comments on the Government Finance Officers

Association’s July 30, 1997, letter.

GAO Comments 1. The association commented that we should recognize the role and

importance of state securities regulators in enforcing the securities laws.

We added a footnote to the executive summary and to chapter 1 to clarify

that state agencies also oversee banking and securities activities but that

this report does not assess their oversight in detail.

2. The association commented that the presentation in the draft report of

survey statistics by financially oriented organizations and other

nonfinancial organizations could be misleading. The association was

particularly concerned about the treatment of public pension funds and

state and local governments because pension funds (both public and

private) were included in the financially oriented category, while state and

local governments were included among other organizations. We clarified

this report by adding footnotes to the related text that explain the types of

organizations within each grouping. We also added a note to figure 3.4,

indicating that appendix I describes the organizations included in the

groupings.

3. The association commented that our draft report erred in relying on the

Principles and Practices for Wholesale Financial Market Transactions

when describing the participants in transactions covered by the

dealer-issued guidance. The association elaborated that participants,

including end-users, are not only large financial and commercial entities

that are more likely to be financially sophisticated, but they also include

state and local governments, churches, schools, charities, and others who,

although holding large portfolios, would not be construed as commercial

entities or would not necessarily be financially sophisticated.

The association correctly points out that participants may include

end-users that are not large or financially sophisticated. However, our

point was that the dealer-issued guidance was designed to apply to larger

entities that tend to be financially sophisticated. In addition, our

discussions with regulators and dealers as well as the results of our survey

confirmed that the predominant users of over-the-counter (OTC)

derivatives, mortgage-backed securities, and structured notes are larger

organizations, most of which are in financially oriented industries and

most of which tend to be more financially sophisticated.

Page 213 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

4. The association commented that the draft report is technically correct in

stating that the U.S. securities laws “generally” apply equally to all

investors, but noted that these laws sometimes distinguish between

institutional and individual customers. We added a footnote to chapter 4

that recognizes the securities laws and regulatory guidance that make

distinctions between institutional and individual customers and modified

the text to clarify that the antifraud provisions of U.S. securities laws do

not make such distinctions.

5. The association commented that our report should clarify that the

association’s concern regarding the ability of an end-user to rely on dealer

statements only when acknowledged in writing by the dealer was not

based on the association’s analysis of the Principles but was drawn

directly from the document itself. Our draft report quoted from the letter

the association sent to the Principles drafting committee, and that letter

correctly interprets the Principles as requiring written agreement between

the parties before one can rely on the other.

6. The association commented that the individual cited in the draft report

as asserting that dealers, unless otherwise agreed to, do not have fiduciary

obligations in OTC derivatives transactions was expressing his opinion or

that of his employer. (We referred to this individual as the managing

director of a large securities firm and the association referred to him as an

International Swaps and Derivatives Association board member.) The

association stated that this assertion has not been settled by law. We

attributed the statement in question to the official who made it, and by

doing so, indicated that it represents his opinion.

7. The association noted that an executive branch action in Connecticut

was taken between 1994 and 1996 to institute changes to investment

policies and controls in that state. We revised chapter 5 of this report to

incorporate Connecticut’s action. We also added a footnote in chapter 5 to

clarify that we did not attempt to obtain comparable information on all

state actions to improve investment policies, procedures, and practices.

8. Although generally endorsing the recommendations in our report, the

association asked that we recommend that the Federal Reserve, the

Securities and Exchange Commission, and the Commodity Futures

Trading Commission ensure that the process for coordinating the issuance

of dealer-issued guidance in any form outside of the federal regulatory

process be more inclusive of affected market participants. As the draft

report indicated in chapter 7, we envisioned that the President’s Working

Page 214 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VII 

Comments From the Government Finance

Officers Association

Group on Financial Markets might facilitate a process under which market

participants could reach agreement on the nature of their relationship,

including their responsibilities in transactions involving OTC derivatives.

Implicit in our related recommendation is that a common set of mutually

agreed-upon guidance would be issued for dealers and end-users. We

make our recommendation to the Working Group, whose membership

includes the Federal Reserve, the Securities and Exchange Commission,

and the Commodity Futures Trading Commission, in the belief that a

coordinated effort by the federal market regulators would be more

effective than individual efforts in addressing the need for end-users and

dealers to reach agreement on the nature of counterparty relationships.

Page 215 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 216 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

See p. 139.

See p. 140.

See p. 141.

See p. 140.

Page 217 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

See comment 1.

See comment 1.

See comment 2.

See comment 3.

Page 218 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

See comment 3.

See comment 3.

See p. 139.

See comment 4.

Page 219 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

See comment 4.

See comment 5.

See comment 6.

See comment 6.

Page 220 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

Page 221 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

The following are GAO’s comments on the International Swaps and

Derivatives Association’s August 15, 1997, letter.

GAO Comments 1. The association commented that the report’s consideration of sales

practice issues for mortgage-backed securities (MBS) and structured notes

in the same context as those for over-the-counter (OTC) derivatives is

intellectually and practically inappropriate, and that the report is

confusing and incomplete in differentiating between these transaction

types. The association also noted that the report found that greater losses

and more dissatisfaction existed for MBS and structured notes than for OTC

derivatives, even though the former are subject to the securities

laws—suggesting that regulation is not necessarily effective in reducing

problems.

We attempted to ensure that this report distinguishes, as appropriate,

among OTC derivatives, MBS, and structured notes. As our report states, it

addresses sales practices for the three product categories because losses

associated with each of them were receiving public and regulatory

attention at the time we began our review. Furthermore, although we

agree with the association that significant differences in the products and

their regulatory schemes exist, the products share many risk

characteristics and are frequently marketed by the same dealers and used

by many of the same market participants. As a result, by including all three

product categories, our report provides useful information to those trying

to understand the similarities and differences among the sales practice

requirements for the OTC markets.

The association’s conclusion that the higher level of disputes and

dissatisfaction associated with MBS and structured notes indicates that the

regulatory regime is not fully effective is open to question. First, the bulk

of MBS and structured notes are government securities that are issued by

government-sponsored enterprises (GSE) and marketed by broker-dealers.

However, as our report notes, the National Association of Securities

Dealers (NASD), a self-regulatory organization with oversight

responsibilities for a significant number of MBS and structured note

dealers, was limited in its ability to assess the marketing of GSE-issued

securities against its full complement of sales practice rules by a

long-standing statutory restriction. This restriction was removed by the

Government Securities Act Amendments of 1993. Nonetheless, NASD rules

governing GSE-issued securities were not approved until August 1996. As

this report states, the removal of this restriction and implementation of

Page 222 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

these rules should improve the oversight of this products, which may, over

time, lead to a reduction in sales practice-related complaints.

Second, the higher level of sales practice-related disputes and

dissatisfaction associated with MBS relative to OTC derivatives may be

partly attributable to the lower level of sophistication of MBS end-users

compared to that of OTC derivatives end-users. Also, because MBS involve

the transfer of ownership, the dealer and end-user do not have an ongoing

relationship vis-a-vis a specific transaction. As a result, an unethical dealer

may find MBS end-users more vulnerable targets when contemplating

committing fraud.

2. The association commented that the definition of losses as discussed in

the draft report may be flawed. The association noted that loss totals

included in the report were compiled from public information and

depended on end-user self-reporting. It also noted that steps to confirm

their accuracy had not always been taken. Furthermore, it noted that

actual losses may be significantly lower than those reported because of

the inclusion of unrealized losses, which may have been mitigated by

offsetting hedging transactions.

Our report now acknowledges not only the limitations and weaknesses

that exist in the loss totals but also the potential that losses may be

overstated by including unrealized losses and understated by omitting

losses that were not publicly reported. Because of these limitations, we

used this information only as one indicator of the extent of sales practice

concerns and supplemented it with data from regulators, our survey of

end-users, and discussions with market participants and regulators.

3. The association commented that while the draft report attempts to put

the level of losses in context, it obscures how small the losses are relative

to total market activity. The association provided calculations comparing

the losses we reported to the gross market value of OTC derivatives

outstanding in the United States, as of March 1995. The association

concluded that we should have emphasized the resulting relatively small

loss percentage when explaining that sales practice-related losses did not

appear to be widespread.

We added text to the loss discussion in chapter 3 that recognizes sales

practice concerns are not widespread relative to the limited number of

dealers involved in the losses that have been reported, the thousands of

transactions that have occurred over the period discussed, and the

Page 223 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

hundreds of billions of dollars at risk in these transactions. We did not use

the loss data that we developed to perform calculations such as those the

association presented due to its limitations. Doing so would have

suggested greater precision in and validity to the statistical results than is

otherwise warranted. Notwithstanding this objection, comparing the

cumulative loss total for multiple years to the amounts outstanding as of a

single later year, as the association did, is not appropriate. Because losses

on transactions initiated in one year may not be incurred until several

years later, a more relevant analysis would be to compare losses on

transactions initiated in a single year to the amount at risk in transactions

initiated during that same year. However, data to make such calculations

were not generally available.

4. The association commented that the two sets of dealer-issued guidance

served as the basis for productive discussions between dealers and

end-users for clarifying counterparty relationships and noted that the only

appropriate starting place for institutional participants in derivatives is an

arm’s-length relationship. The association stated that the parties are free

to alter such a relationship if they agree to do so, but such variations

should occur on a privately negotiated basis. Furthermore, the association

stated that the federal government does not have a role to play in bilateral

negotiations between “parties that can take care of themselves,” and that

additional regulation and the increased potential for litigation would only

result in higher transaction costs with little offsetting benefits.

We agree that the dealer-issued guidance has provided opportunities for

discussion between dealers and end-users. However, our survey results

show that end-users attribute fiduciary responsibilities to and rely on

dealers as part of OTC derivatives transactions. Also, end-users and others

have objected to the presumption of an arm’s-length relationship as

evidenced in the formal comments these groups submitted on one set of

guidance—the Principles and Practices for Wholesale Financial Market

Transactions. This evidence indicates a lack of acceptance and/or

understanding of the specific responsibilities the dealer-issued guidance

asserts for OTC derivatives transactions. Our recommendation calls for the

federal regulators that participate in the Working Group to consider

whether they can assist in bridging this lack of agreement or

understanding. We do not anticipate that the Working Group would dictate

the nature of the relationship that should prevail because this would fail to

account for the inevitable and appropriate differences in the actual

relationships between parties. Instead, the Working Group could facilitate

Page 224 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII 

Comments From the International Swaps

and Derivatives Association

discussions between dealers and end-users that might lead to agreement in

key areas where they now disagree.

5. The association asserted that in many instances our support for

proposing regulatory intervention is anecdotal. We do not rely on

anecdotal information to support our recommendations. Rather, such

information is used primarily to illustrate the results provided by our

survey and to provide insights into other data we obtained—such as

end-users’ formal comments on the Principles.

6. The association commented that the draft report should have

emphasized in its recommendations the need for universal implementation

of and adherence to the internal control and risk management

recommendations in the Group of Thirty report published in July 1993. We

recognized the importance of internal controls in two previous reports on

derivatives.3

 The May 1994 report makes three recommendations to one or

more of the federal financial market regulators on this subject. The

inclusion of chapter 5 in this report—discussing guidance to dealers and

end-users related to sales practice issues and describing dealer and

end-user efforts to implement related internal controls—reflects our

continued concern about the adequacy of market participants’ internal

controls and our support for efforts to improve them. Implementing

controls such as those advocated by the Group of Thirty and others could

significantly reduce dealer and end-user exposure to the type of

compliance and reputation risk losses that can arise from engaging in

transactions involving OTC derivatives and other financial products.

3

See Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,

1994) and Financial Derivatives: Actions Taken or Proposed Since May 1994 (GAO/GGD/AIMD-97-8,

Nov. 1, 1996.

Page 225 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IX 

Comments From the National Association of

State Auditors, Comptrollers and Treasurers

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comment.

Page 226 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IX 

Comments From the National Association of

State Auditors, Comptrollers and Treasurers

See p. 142.

Page 227 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IX 

Comments From the National Association of

State Auditors, Comptrollers and Treasurers

Page 228 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IX 

Comments From the National Association of

State Auditors, Comptrollers and Treasurers

The following is GAO’s comment on the National Association of State

Auditors, Comptrollers and Treasurers’ July 28, 1997, letter.

GAO Comment The association commented that end-users who were generally satisfied

with dealer sales practices at the time of our 1995 survey may not be

satisfied with them today due to the promulgation of the Framework for

Voluntary Oversight and the Principles and Practices for Wholesale

Financial Market Transactions. The association elaborated that no

end-users were included in the Derivatives Policy Group that issued the

Framework, and no substantive revisions were made to the Principles as a

result of the association’s input.

End-user comments on the provisions of these documents, including those

that the association discusses in its letter, are discussed in this report. Our

report also recognizes that the market characteristics that contributed to

the relatively high level of end-user satisfaction and the relatively limited

number of sales practice disputes could change as the markets evolve. For

this reason, we recommend that the President’s Working Group on

Financial Markets establish a mechanism for systematically monitoring

developments in the over-the-counter derivatives markets to assess

whether developments warrant introducing specific federal sales practice

requirements.

Page 229 GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix X 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Cecile O. Trop, Assistant Director

Cody J. Goebel, Co-project Manager

James R. Black, Senior Evaluator

Frederick T. Evans, Senior Evaluator

Rosemary Healy, Attorney

Christine J. Kuduk, Evaluator

Carl M. Ramirez, Senior Social Science Analyst

Desiree W. Whipple, Communications Analyst

Chicago Field Office David J. Diersen, Co-project Manager

Melvin Thomas, Sub-project Manager

Daniel K. Lee, Evaluator

Cristine M. Marik, Evaluator

Angela Pun, Evaluator

Richard S. Tsuhara, Senior Evaluator

Francis M. Zbylski, Senior Operations Research Analyst (Retired)

Office of Special

Investigations

Donald F. Fulwider, Deputy Director

(233441) Page 230 GAO/GGD-98-5 OTC Derivatives Sales Practices
Ordering Information

The first copy of each GAO report and testimony is free.

Additional copies are $2 each. Orders should be sent to the

following address, accompanied by a check or money order

made out to the Superintendent of Documents, when

necessary. VISA and MasterCard credit cards are accepted, also.

Orders for 100 or more copies to be mailed to a single address

are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office

P.O. Box 37050

Washington, DC 20013

or visit:

Room 1100

700 4th St. NW (corner of 4th and G Sts. NW)

U.S. General Accounting Office

Washington, DC

Orders may also be placed by calling (202) 512-6000 

or by using fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and

testimony. To receive facsimile copies of the daily list or any

list from the past 30 days, please call (202) 512-6000 using a

touchtone phone. A recorded menu will provide information on

how to obtain these lists.

For information on how to access GAO reports on the INTERNET,

send an e-mail message with "info" in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web Home Page at:

http://www.gao.gov

PRINTED ON RECYCLED PAPER
United States

General Accounting Office

Washington, D.C. 20548-0001

Official Business

Penalty for Private Use $300

Address Correction Requested

Bulk Rate

Postage & Fees Paid

GAO

Permit No. G100