OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice Disputes
Published: 1997-10-02T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO reviewed the sales practices for over-the-counter (OTC) derivatives, mortgage-backed securities (MBS), and structured notes, focusing on the: (1) federal sales practice requirements applicable to these products and the dealers marketing them; (2) extent of end-user satisfaction with sales practice, product use, and related disputes and the costs of these disputes; (3) views of end-users and dealers on the nature of their relationship and responsibilities; (4) actions dealers and end-users have taken to reduce the potential for sales practice disputes; and (5) actions regulators have taken to address sales practice issues.
section_title: What GAO Found
paragraphs: GAO noted that: (1) 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; (2) 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 the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), respectively; (3) 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; (4) 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; (5) 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; (6) when OTC derivatives are marketed by banks, they are subject to supervisory guidance issued by federal bank regulators; (7) 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 regulatory oversight, although some individual transactions may be subject to such oversight; (8) although sales practice requirements vary by product and dealer, according to GAO's survey, most end-users were generally satisfied with the sales practices of the dealers with whom they entered transactions; (9) GAO's survey also found that relatively few organizations reported using OTC derivatives; (10) 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; (11) however, the dealers and end-users involved in these cases often experienced significant costs; (12) although generally satisfied with dealer sales practices, end-users' views on the nature of counterparty relationships sometimes differed from those of dealers; (13) in addition, bank regulators have taken certain actions to address sales practice issues; and (14) 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.

section_title: Letter
paragraphs: 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.
subsections: section_title: Introduction
paragraphs: In 1994, we reported on a number of risks associated with the use of over-the-counter (OTC) derivatives, 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-user concerns about dealer sales practices. 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.
subsections: section_title: OTC Derivatives
paragraphs: 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 exchange-traded derivatives, which include futures and optionscontracts. 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).
Both OTC and exchange-traded derivatives are used by firms around the world to manage market risk 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, 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 leverage 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.
subsections: section_title: Forwards
paragraphs: 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 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.
section_title: OTC Options
paragraphs: 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.
section_title: Swaps
paragraphs: 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. 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.
section_title: Plain Vanilla OTC Derivatives
paragraphs: 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 spread—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.
section_title: More Complex OTC Derivatives
paragraphs: 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. 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 offset or unwind 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 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.
section_title: Mortgage-Backed Securities
paragraphs: 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. The process of pooling mortgages and using them to back a new issue of securities is called securitization. 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). 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 safe and stable tranches requires the creation of more risky tranches that can be highly volatile in price.
section_title: Structured Notes
paragraphs: Structured notes are debt securities that combine elements of traditional debt instruments and OTC derivatives. 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, can be attractive to investors seeking to hedge their unique risks or possibly earn greater returns than those offered by traditional debt securities. 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)corporations or government-sponsored enterprises (GSE) and, therefore, are considered by market participants to have minimal credit risk.
section_title: OTC Derivatives, MBS, and Structured Note Markets’ Growth and Participants’ Activities
paragraphs: 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.
subsections: section_title: Market Growth
paragraphs: According to the most recent global survey by the Bank for International Settlements, the notional/contract amount outstanding of OTC derivatives was estimated at $47.5 trillion worldwide and $11 trillion in the United States, as of March 31, 1995. MBS issuances 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.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.
section_title: The Nature and Extent of Issuer, Underwriter, and Dealer Activities
paragraphs: 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 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.
section_title: Various Types of Institutions Actively Market OTC Derivatives, MBS, and Structured Notes
paragraphs: 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 companies 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. 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.
section_title: Sales Practices for OTC Derivatives, MBS, and Structured Notes
paragraphs: 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 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.
section_title: Various Regulators Oversee the Dealers Marketing OTC Derivatives, MBS, and Structured Notes
paragraphs: The dealers of OTC derivatives, MBS, and structured notes may be subject to oversight by various federal or other regulatory bodies. 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 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). 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 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.
section_title: Objectives, Scope, and Methodology
paragraphs: 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 regulators 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. 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, including not only the largest organizations, which were determined on the basis of financial 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-market 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 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 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), the Government Finance Officers Association (GFOA), ISDA, and the National Association of State Auditors, Controllers and Treasurers (NASACT). 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.
section_title: Federal Sales Practice Requirements Vary by Product and Dealer
paragraphs: 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. 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.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.
subsections: section_title: Sales Practice Requirements Vary, Depending on the Product
paragraphs: 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.
subsections: section_title: Some OTC Derivatives Are Subject to the Federal Securities Laws
paragraphs: 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. 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 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. For example, NASD’s members offering securities to the public must comply with its Conduct Rules.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.
In cooperation with CFTC, SEC took action under the securities laws against Bankers Trust, 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.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.
section_title: Some OTC Derivatives Are Subject to the Federal Commodities Laws
paragraphs: 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 options 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 raised about the application of the CEA’s fraud provisions to OTC derivatives transactions.
The extent to which some OTC derivatives are subject to the CEA is uncertain. 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 options on commodities, except on certain enumerated domestic agricultural commodities, to be traded off-exchange. Forwards and certain OTC foreign-currency transactions are excluded from regulation under the CEA, 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.Without determining that swaps were futures, CFTC issued a rule that exempted eligible swaps from all but the CEA’s antifraud and antimanipulation provisions. 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 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 advisor and had violated the antifraud provisions of the CEA governing such parties’ activities.
section_title: State Statutory and Common Law Claims Would Be Asserted in Disputes Involving OTC Derivatives That Are Not Subject to Federal Laws
paragraphs: 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. These claims, which are typically advanced in suits against dealers, are either tort 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. 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.
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. 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.
section_title: MBS and Structured Notes Are Typically Subject to the Securities Laws
paragraphs: MBS and structured notes are typically considered to be securities and subject to the federal securities laws, 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 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. 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.
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. Such users are defined by the rule to include any entity other than a natural person. This interpretation provides that a dealer must, on the basis of information either supplied by the end-user or 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.
section_title: Sales Practice Requirements Vary, Depending on the Regulator of the Dealers’ Activities
paragraphs: 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.
subsections: section_title: Bank Activities Are Regulated to Protect Their Financial Condition
paragraphs: 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 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 guidancedirects 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, 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 determine lack sophistication, how transactions will achieve the counterparties’ objectives.
The Federal Reserve’s December 1993 guidance 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, 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. 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. 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 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.
section_title: Bank Regulators Adopted Additional Requirements for Dealers Marketing Securities
paragraphs: 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. 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. 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 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.
section_title: Banks Market Products From Various Legal Entities That May Be Subject to Oversight by Different Regulators
paragraphs: 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 MBS 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. 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 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.
section_title: Unregulated Affiliates Are Not Subject to Direct Federal Oversight, but Regulators May Assert Jurisdiction Over Specific Products
paragraphs: Affiliates of securities, futures, and insurance firms that market nonsecurities or nonfutures OTC derivatives are not directly regulated by SEC or CFTC. 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. 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 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.
section_title: The Working Group Concluded That the Scope of Regulators’ Authority and Sales Practice Requirements Are Adequate
paragraphs: 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. SEC and CFTC officials told us that if they believed their authority was insufficient, they would ask Congress to address the issue.
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 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.
section_title: Satisfaction With Sales Practices Was High and Disputes Were Limited, but When Disputes Occurred Losses Were Often Large
paragraphs: 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.
subsections: section_title: Most End-Users Were Generally Satisfied With Dealer Sales Practices
paragraphs: 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.
subsections: section_title: Few End-Users Reported Dissatisfaction With Dealers Used
paragraphs: 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. 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 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 percent of users reported being similarly dissatisfied; for structured note dealers used, 13 percent reported being similarly dissatisfied.
Our survey indicated that 79 percent 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. The overall level of dissatisfaction with dealers not used was 17 percent for plain vanilla OTC derivatives, 26 percent for more complex derivatives, 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 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. 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.
section_title: Respondents Provided Consistent Reasons for Their Dissatisfaction With Specific Elements of Dealer Sales Practices
paragraphs: 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. 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 percent 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.
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. 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. 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 percentreported 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 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.
section_title: Reported Product Usage Varied Across Products and by Organization Size and Type
paragraphs: 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 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.
subsections: section_title: Few Organizations Reported Using OTC Derivatives, More Reported Using MBS and Structured Notes
paragraphs: 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 percent 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.
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.
section_title: Larger Organizations Were More Likely to Be End-Users
paragraphs: 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.
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,which was about twice the estimated 21-percent usage rate across all other organizations. In addition, 35 percent 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.
section_title: Product Usage Varied by Industry
paragraphs: 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. 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.
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 entities 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 corporations did report using plain vanilla OTC derivatives to a great extent. We estimated that 66 percent 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.
section_title: More Recent Studies Generally Showed Little Change in Product Usage
paragraphs: 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. 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. 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.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.
section_title: Sales Practice Concerns Did Not Appear to Be Widespread but Involved Many Large Losses
paragraphs: 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.
subsections: section_title: Concerns About Dealer Sales Practices Were Raised in Many Publicized Losses
paragraphs: 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.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. These end-user losses totaled an estimated $11.4 billion. Sales practice concerns were raised in 209, or 58 percent, 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 period we reviewed, 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.
section_title: OTC Derivatives Losses With Sales Practice Concerns Involved Primarily One Dealer
paragraphs: 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, 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 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; 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 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.
section_title: More Sales Practice Concerns Were Raised in MBS and Structured Note Transactions, but Such Concerns Generally Involved Few Dealers
paragraphs: 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. 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.
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.
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. 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.
The bulk of the sales practice cases being reviewed by regulators involved MBS; however, one case involving structured notes has been widely 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.
section_title: When They Occurred, Sales Practice-Related Disputes Were Often Costly to Dealers and End-Users
paragraphs: 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.
subsections: section_title: Compliance and Reputation Risk Losses Can Arise From Sales Activities
paragraphs: 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. 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 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.
section_title: Some Dealers Experienced Significant Costs Associated With Sales Practice Disputes
paragraphs: 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 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. 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 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.
section_title: Some End-Users Also Experienced Significant Costs From Sales Practice Disputes
paragraphs: 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. 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.
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.
section_title: Disagreement Over Counterparty Responsibilities Increases the Potential for Disputes
paragraphs: 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.
subsections: section_title: Disputes Have Centered on Counterparty Responsibilities
paragraphs: 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. 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.
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’ 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.
section_title: The Potential for Additional Disputes Arises From the Differing Views of End-Users and Dealers
paragraphs: 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.
subsections: section_title: End-Users Attributed Some Fiduciary Responsibilities to Dealers
paragraphs: 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 involving plain vanilla OTC derivatives, and that 48 percent attributed such responsibilities to dealers in some or all transactions involving more complex OTC derivatives, as shown in figure 4.1.
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 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.
section_title: End-Users Also Indicated Reliance on Dealers for Investment Advice
paragraphs: 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.
section_title: Dealer-Issued Guidance Asserts an Arm’s-Length Relationship
paragraphs: 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. 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. 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. 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.
In August 1995, six financial industry groups, 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 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. 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. 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.
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 Thirty and others, for 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.
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.
section_title: The Dealer-Issued Guidance Differs in Some, but Not All, Respects From Regulatory Standards Applicable to Other Activities
paragraphs: To identify any significant differences between the dealer-issued voluntary guidance 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. 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 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, 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. 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 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. 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.
section_title: Reconciling the Views of End-Users and Dealers Could Be Difficult
paragraphs: 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.
subsections: section_title: Reactions to the Tenets of the Dealer-Issued Guidance Have Been Mixed
paragraphs: End-user representatives, including EUDA, GFOA, the National Association of State Treasurers (NAST), the North American Securities Administrators Association (NASAA), and the Department of Labor have criticized the tenets of the dealer guidance. 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 entities 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.
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. 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 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 Trust would be a better model for disclosing risk and ensuring that end-users understand transactions. 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.”
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 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.
section_title: The Interests of End-Users and Dealers Conflict When It Comes to Defining Their Relationship
paragraphs: 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 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, 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.
section_title: The Financial Impact of Altering the Nature of Relationships May Make Resolving Disagreements More Difficult
paragraphs: 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 the markets. 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.
section_title: A Dealer Group Proposed Contract Language to Address the Nature of Counterparty Relationships
paragraphs: 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. 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 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.
section_title: Recent Court Decisions Have Found That OTC Derivatives Dealers Have Some Responsibilities, but They Have Not Resolved Key Issues
paragraphs: 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 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.
section_title: The Need to Address Conflicting Views on the Nature of Counterparty Relationships Has Been Recognized
paragraphs: 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 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. “. . . 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.
section_title: Dealers and End-Users Acted to Reduce the Potential for Sales Practice Disputes, but Weaknesses Remain
paragraphs: 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, 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.
subsections: section_title: Corporate Governance Systems Can Address Sales Practice Issues
paragraphs: 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, and the Group of Thirty, 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 have also issued guidance that is specifically targeted to their members’ investment activities and that addresses the importance of a strong corporate governance system.
section_title: Dealers Described Sales Practice Policies and Procedures That Were Consistent With the Dealer-Issued Guidance
paragraphs: 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. 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 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 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.
section_title: Regulatory Examinations Surfaced Dealer Weaknesses
paragraphs: 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 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.
section_title: End-Users Described a Range of Controls, but Some Lacked Basic Controls
paragraphs: 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. Some described very sophisticated and involved processes, whereas others acknowledged that very few formal policies or practices existed. For 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 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. 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. This survey and one other 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, and 14 percent reported such capabilities for complex options.
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 recently begun requiring additional levels of approval. 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.
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. 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.
section_title: Reviewing Organizations Found That Weaknesses at End-Users Contributed to Losses
paragraphs: 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.
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 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.
section_title: Various Organizations Issued Guidance for End-Users
paragraphs: 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 derivatives. About 1 year later, NAST issued revised guidance 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) issued guidelines on internal controls and appropriate disclosures for end-users of derivatives. Finally, in November 1996, the Risk Standards Working Group (RSWG) issued 20 standards for managing and measuring risks. 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.
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.
section_title: Some State Governments Acted to Reduce the Risk of Loss
paragraphs: 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. These actions—which included 11 states enacting legislation and 3 states 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. 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 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.
section_title: Regulators Have Improved Sales Practice Oversight of Regulated Firms, but Some Weaknesses Remain
paragraphs: 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.
subsections: section_title: Bank Regulators’ Efforts to Oversee Sales Practices Have Increased, but Updated Federal Reserve Guidance Has Not Yet Been Issued
paragraphs: 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.
subsections: section_title: Bank Regulators Expanded Sales Practice Requirements for Banks
paragraphs: 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, the Federal Reserve indicated that banks should establish standards to ensure that counterparties are not entering into transactions in complex products 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.
section_title: Bank Regulators Generally Conducted Thorough Examinations After Sales Practice Problems Surfaced
paragraphs: 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, 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 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.
section_title: OCC Addressed Weaknesses in Its Guidance, but Updated Federal Reserve Guidance Has Not Yet Been Issued
paragraphs: 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.
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.
section_title: The Federal Reserve Placed Higher Sales Practice Requirements on One Bank
paragraphs: 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. 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 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.
section_title: Jurisdictional and Other Limitations Have Affected Oversight of Securities Firms’ Sales Practices
paragraphs: 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 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 notes 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.
subsections: section_title: SEC and CFTC Jurisdiction Is Limited, but the Regulators Receive Information on Affiliates’ Activities
paragraphs: 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 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.
section_title: SEC and CFTC Lack Information to Assess the Sales Practices of Unregulated Affiliates
paragraphs: 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.
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 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.
section_title: SEC Relies Primarily on SROs to Oversee MBS and Structured Note Dealers, but Also Conducts Examinations and Takes Enforcement Actions
paragraphs: 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.
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. 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.)
section_title: Various Factors Also Affected SROs’ Ability to Fully Assess Dealer Sales Practices
paragraphs: 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 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. 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 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.
section_title: Removal of Restrictions on NASD Oversight Should Improve Sales Practice Oversight
paragraphs: 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. 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. 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. 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.
section_title: Conclusions and Recommendations
subsections: section_title: Conclusions
paragraphs: 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 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 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.
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.
section_title: Recommendations to the President’s Working Group on Financial Markets
paragraphs: 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 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.
section_title: Recommendation to the Federal Reserve
paragraphs: 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.
section_title: Recommendation to SEC and CFTC
paragraphs: 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.
section_title: Agency and Industry Comments and Our Evaluation
paragraphs: 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 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 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 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 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 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.