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DEUTSCHE BANK
July 19, 2004
Office of the Comptroller of the Currency
250 E Street, SW
Public Reference Room
Mail Stop 1-5
Washington, DC 20219
Attention: Docket No. 04-12
Jennifer J. Johnson
Secretary
Board of Governors of the
Federal Reserve System
20th Street and Constitution Av., NW
Washington, DC 20551
Attention: Docket No. OP-1189
Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Attention: File No. S7-22-04
Robert E. Feldman
Executive Secretary
Attention: Comments/OES
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20429
Attention: Comments/OES
Ladies and Gentlemen:
Deutsche Bank AG appreciates this opportunity to comment on the
Proposed Interagency Statement on Sound Practices Regarding Complex
Structured Finance Activities, 69 Fed. Reg. 28980 (May 19, 2004) (the
“Proposed Guidelines”). Deutsche Bank recognizes the importance of
evaluating and controlling reputational, legal and other risks
associated with structured finance transactions, and has already
established a range of policies and procedures designed to identify,
scrutinize and manage such risks at its businesses globally. While
Deutsche Bank generally supports the comments submitted by industry
trade associations, in particular those submitted on behalf of the Bond
Market Association, the International Swaps and Derivatives Association
and the Securities Industry Association, and by The Clearing House
Association, it believes that a separate comment is warranted in light
of its own experience and the importance of the Proposed Guidelines.
Deutsche Bank shares the agencies’ view that complex structured
financial transactions (“CSFTs”) are an essential part of U.S. and
international capital markets and serve legitimate needs of financial
institutions’ clients. We endorse the general purpose of the Proposed
Guidelines – to encourage regulated financial institutions to minimize
potential legal and reputational risks when entering into a CSFT.
Although it appears that the general approach of the Proposed Guidelines
is to provide each institution with necessary flexibility to manage the
risks associated with CSFTs within the context of its existing
management procedures, controls and systems, Deutsche Bank believes that
the Guidelines must more clearly reflect this principle.
Deutsche Bank believes that the Proposed Guidelines could serve as a
valuable tool for financial institutions as they seek to continually
improve their internal procedures, controls and systems to minimize
potential risk, if the clarifications and modifications suggested herein
and in the other comment letters referred to above are adopted. Deutsche
Bank’s suggestions, if adopted, would: (1) express that the Proposed
Guidelines are intended only to provide financial institutions with a
resource to assist them in minimizing legal and reputational risks, and
not to create additional duties to other parties; (2) clarify when the
Proposed Guidelines are addressing procedures applicable to CSFTs
generally, as opposed to CSFTs presenting heightened levels of risk
(which will be referred to hereinafter as “Heightened Risk Complex
Structured Finance Transactions”, or “HRCSFTs”); (3) more clearly
reflect the principle that the Guidelines would preserve the flexibility
for financial institutions to design their own procedures for
controlling risks attendant to CSFTs; and (4) clarify that a financial
institution should be responsible for ascertaining the client’s intended
accounting treatment and/or disclosures only where the institution has
actual knowledge of facts that would reasonably cause it to believe that
the customer intends to file materially misleading financial statements,
or where the institution has custom-designed a HRCSFT to address the
financial reporting or complex tax objectives of the customer, and not
for any other CSFT. In addition, it is critical that the agencies
consistently interpret the Guidelines, not only to eliminate variances
between the agencies, but also to ensure that the agencies’ supervisory
and examination personnel understand that the Guidelines are exactly
that – and not a prescriptive “checklist”.
1. No Duties to Other Persons
It is clear that the agencies were motivated to issue the Proposed
Guidelines as a result of financial institutions having recently
incurred liability in civil and administrative actions arising out of
abusive transactions by certain companies in which the institutions
participated. 69 Fed. Reg. at 28981-982.
To the extent that they encourage financial institutions to continue
to improve their policies and procedures to manage the legal and
reputational risks associated with CSFTs, the Proposed Guidelines have
the potential to assist financial institutions in minimizing those
risks. On the other hand, if courts and administrative tribunals are
left free to interpret the Guidelines as creating new duties to other
persons, the Guidelines are more likely to exacerbate institutions’
legal and reputational risks than to minimize them, for reasons set
forth below. It is unnecessary and undesirable for the Guidelines to
even potentially be seen as creating such duties to other parties. The
creation of such duties would discourage structured finance activity
that the regulators have recognized as being not only legitimate, but
also beneficial. The purpose of the Proposed Guidelines will be
fulfilled if institutions design their CSFTs in such a way as to
minimize, to the extent possible, attendant legal and reputational risks
and refrain from participating in transactions that present unacceptable
levels of risk.
Unfortunately, aspects of the Proposed Guidelines would, if adopted,
actually tend to increase rather than decrease institutions’ risk by
imposing unprecedented and unnecessary duties to third parties in the
following manner.
a. New Duties to Clients and/or Their Stakeholders
The Proposed Guidelines direct financial institutions to “ensure that
the customer understands the risk and return profile of the
transaction.” Id. at 28987 (Reputational and Legal Risk). An institution
can only give full and fair disclosure of the risks and return profile
of a transaction; it cannot ensure that the customer understands the
disclosure. If anyone has that duty, it is the customer’s advisors, and
it is inappropriate to require the institution to do more than provide
the information necessary for a reasonable customer to understand the
transaction. This concept is better described later in that same section
of the Guidelines as follows: “Ensure that the institution provides the
customer with appropriate information concerning the structure and risks
of the transaction . . . .” Id. at 28987, 28988. By implicitly requiring
the institution to act as adviser to the customer, the Guidelines would
impose duties on the institution that it would not ordinarily accept as
part of a financing transaction, and thereby create potential liability
to the customer or its shareholders or successors in interest.
Of course, it is likely to be in an institution’s best interests that
its customer understands the structure and risks of the transaction.
This concept was better expressed, however, in The Principles and
Practices for Wholesale Financial Market Transactions (1995) (the “Principles
and Practices”, available at www.newyorkfed.org/fxc/fx18.html)
developed under the coordination of the Federal Reserve Bank of New York
with the participation of the Reserve Bank and various industry trade
groups. Section 5 of the Principles and Practices relates to
relationships between participants to wholesale transactions in the
over-the-counter financial markets. Subsection 5.2 states that: “A
Participant may wish to evaluate . . . its counterparty’s
capability . . . to understand and make independent decisions about the
terms and conditions of its Transactions” and “may wish to
maintain policies and procedures for identifying . . . and addressing
exceptional situations” where its counterparty cannot understand the
transaction, takes risks disproportionate to potential benefits, or
incorrectly assumes it can rely on the institution for advice (emphasis
added). Section 5.3 contains additional steps that an institution “may
wish to” adopt to protect itself from the consequences of a
participant’s failure to understand a transaction. The “may wish to”
formulation is superior to the prescriptive language used in the
Guidelines, in that no legal duty is created.
The Principles and Practices, as stated in Section 1.2 therein,
“articulate a set of best practices that Participants should aspire to
achieve in connection with their Transactions. . . . The Principles do
not create any legally enforceable obligations, duties, rights or
liabilities.” The Guidelines should contain similar language, and, in
particular, should specifically disclaim the creation of any legally
enforceable obligations, duties, rights or liabilities.
b. Loan Syndications
The Proposed Guidelines could have unanticipated adverse effects on
the loan syndication market by implicitly imposing on agent banks new
duties to syndicate members. Under current law, agent banks generally
are not liable to syndicate members; such members are responsible for
their own diligence in determining whether or not to extend credit to
the customer.
It would be impractical, however, for a large number of syndicate
members to fulfill all of the diligence and documentation requirements
specified in the Proposed Guidelines. They would have limited or no
direct access to the customer, and no borrower would want to submit
itself to the intensive scrutiny anticipated in the Proposed Guidelines
from a multitude of syndicate members. Exacerbating this problem is the
probability that some members may have internal policies that define a
pending transaction as “complex”, while the lead bank does not.
Simply saying that each syndicate member must satisfy itself about
the acceptability of legal and reputational risks inherent in each
syndicated transaction, would impose duties on syndicate members that
they cannot practically fulfill or increase duties of agent banks to
syndicate members that they would be unlikely to accept without dramatic
changes to the pricing of syndicated loans, to the detriment of
customers with legitimate needs for syndicated structured finance
transactions. The agencies should take care not to disrupt the existing
syndication market, which provides an invaluable source of funding to
the U.S. markets
2. Distinguish More Clearly Elements Applicable Only to HRCSFTs.
The Proposed Guidelines envision the adoption by financial
institutions of processes to define CSFTs, identify HRCSFTs, and
ensuring that HRCSFTs receive “an elevated and thorough review.” Id. at
28983. Deutsche Bank believes that many elements of the Proposed
Guidelines appear controversial only because they may be misinterpreted
as applying to CSFTs in general rather than, as intended, to only
HRCSFTs. As we understand the Guidelines, the only specific procedure
that must apply to all CSFTs – apart from controls that would apply to
all transactions of the institution, such as the existence of policies
and procedures describing the responsibilities of various functions
within the institution – is that all CSFTs must be reviewed on a
consistent basis by the institution’s legal department. Id. at 28987.
Assuming that this review is intended to refer to an approval process
and not to a mandated review by internal lawyers of each document (a
task which is frequently delegated to outside counsel, under internal
counsel’s supervision), this does not impose any significant incremental
burden, as all such transactions that an institution would define for
itself as being complex, even if not currently labeled explicitly as
CSFTs, presumably already receive such review. Other mandated processes
that seem incremental to those generally contained in institutions’
existing policies and procedures are generally qualified by the modifier
“appropriate”, even if not qualified by the explicit phrase
“transactions that may pose higher levels of legal and reputational
risk” or similar language.
For example, review by control groups other than Legal is required
only as “appropriate”. Id. at 28986-987. The agencies also note that the
goal of senior-level risk control committees established by some
institutions “is to ensure that those [CSFTs] that may expose the
financial institution to higher levels of financial, legal and
reputational risk are comprehensively and consistently managed and
controlled . . .” – not all CSFTs. Id. at 28986. The Proposed Guidelines
acknowledge that it is appropriate that only the “most complicated or
controversial [CSFTs]” are generally submitted to such a committee for
approval.
Nevertheless, some passages in the Proposed Guidelines blur the
distinction between processes applicable to all CSFTs as opposed to
HRCSFTs. For example, the introduction of the 12 red flag events cited
as possible indicators of a need for heightened scrutiny blurs the
distinction between HRCSFTs and other CSFTs. The paragraph introducing
the “red flags” begins: “Careful evaluations of the consequences of a
transaction are particularly important when the transaction is designed
to achieve a customer’s financial reporting or complex tax objectives.
Policies should clearly define the types of circumstances where the
approval of transactions or patterns of transactions should be elevated
to higher levels of financial institution management for reasons
specific to legal or reputational risk.” Id. at 28987-988. This language
appropriately suggests that most HRCSFTs would involve transactions
custom-designed for customers.
We believe that, with rare exception, it would take the presence of
one or more red flag events, in conjunction with a transaction
custom-designed to meet a customer’s financial reporting or tax
objectives, to present the elevated risks sufficient to transform a CSFT
to a HRCSFT. That sensible interpretation is muddied, however, by the
inclusion of a separate red flag event for “transactions that raise
concerns about how the client will report or disclose the transaction .
. . .” We suggest taking this latter sentence out of the list of red
flags and either omitting it or including it in the paragraph preceding
the list of red flags to indicate that this is a predicate condition
that would usually need to be present before the existence of another
red flag would cause a transaction to be viewed as a HRCSFT.
The paragraph immediately following the 12 “red flag” events reads:
“Having developed a process to identify transactions that may pose
higher levels of legal and reputational risk, financial institutions
should implement procedures to address these risks. These procedures
should include, among other things: . . .” Id. at 28988 (emphasis
added). The phrase “these risks” appears to relate to the higher levels
of legal and reputational risk, but the eight bullet points that follow
seem to apply to all CSFTs, not just HRCSFTs.
Finally, the Proposed Guidelines suggest that “financial institutions
should maintain comprehensive documentation for all transactions
approved, as well as disapproved transactions with controversial
elements . . . .” No distinction is made between CSFTs and HRCSFTs,
except as noted elsewhere that retention of documents related to CSFTs
should aim at “minimizing legal and credit risks, as well as reducing
unwarranted exposures to the financial institution’s reputation.” Id. at
28989. It is difficult to imagine how a rejected transaction poses any
risks to an institution, so the purpose of the documentation standards
is blurred. The “appropriate” modifier is auspiciously missing from the
processes specified in the Documentation Standards section. Deutsche
Bank believes that such a modifier should be inserted to reinforce the
clear intent that the institution should maintain only such
documentation as is necessary to minimize its legal, credit and
reputational risks.
3. Preserve Flexibility for Institutions to Design Their Own
Appropriate Procedures and Controls
In the Summary section of the Proposed Guidelines, the agencies
assert that the purposes of the proposal are to ensure that financial
institutions have effective policies and procedures in place to identify
HRCSFTs, to ensure that HRCSFTs receive enhanced scrutiny by the
institution, and to ensure that the institution does not participate in
illegal or inappropriate transactions. Similarly, in the Supplemental
Information, the agencies state that “it is critical that financial
institutions have effective risk management and internal controls to
ensure that the institutions’ activities comply with the law and that
all of the risks associated with a transaction – including legal and
reputational risks – are identified and appropriately addressed.” Id. at
28982. These purposes are embedded in the Statement itself. Id. at
28985. Moreover, part III of the proposal is titled: “Guidelines for
Incorporating Structured Finance Transactions Into Existing Management
Procedures, Controls and Systems” (emphasis added).
Deutsche Bank applauds the agencies for permitting each institution
to adopt its own definition of CSFT, rather than imposing a
one-size-fits-all definition that would capture transactions not deemed
complex at the largest or more sophisticated institutions and
potentially excluding transactions deemed complex at smaller or less
sophisticated institutions. Id. at 28986 (Policies and Procedures). We
also believe that the agencies were astute in recognizing that each
institution must establish its own procedures to ensure appropriate
escalation of HRCSFTs, and adopt its own documentation standards
sufficient to minimize legal and reputational risks, without mandating
specific procedures. Id. at 28987, 28989.
The foregoing demonstrates that the agencies generally recognize that
a financial institution can successfully manage the legal and
reputational risks pertaining to CSFTs only if it has the flexibility to
do so within the context of its existing procedures, controls and
systems. Unfortunately, in providing factors for institutions to
consider in defining CSFTs and establishing escalation procedures and
documentation standards, the language of the Proposed Guidelines is
sufficiently vague that examiners or plaintiffs in civil litigation
could mistakenly interpret these factors as a checklist that must be
included verbatim in each institution’s policies and procedures.
The Proposed Guidelines list four factors for institutions to
consider in defining a CSFT. Id. at 28985 (Definition and Key Risks of
Complex Structured Finance Transactions). The Proposed Guidelines do not
mandate that the presence of any one or more of these specified factors
must require a transaction to be designated a CSFT. Institutions have
varying levels of sophistication and experience, and a transaction that
may be deemed “complex” by a retail-oriented institution may not be
regarded as complex by an institution more accustomed to structuring
commercial transactions. The use of SPEs in connection with asset
securitizations may be routine for an institution active in
securitization transactions, but constitute a CSFT with escalated risks
for an institution that is just commencing securitization activities.
The Proposed Guidelines should be clear that these four elements are
merely factors to be considered in creating a definition of CSFT, rather
than a checklist.
Similarly, Deutsche Bank is satisfied that the agencies recognize
that the mere presence in a proposed transaction of one or more of the
12 “red flags” listed (id. at 28988) as indicating the possible
existence of elevated risks does not automatically mean that the
transaction must be subject to the institution’s processes for HRCSFTs.
Depending on the level of experience and sophistication of the
institution and the personnel assigned to the normal transaction
approval process, the presence of some of those red flag items may not
necessarily require escalation. In fact, Deutsche Bank believes that
none of the red flag events, by itself, would necessarily transform a
CSFT to a HRCSFT without the presence of certain prerequisite
conditions. See discussion at Part 2 of this letter, supra. In any case,
the Proposed Guidelines clarify that the red flags are intended as
guidance, not as a checklist.
Finally, Deutsche Bank believes that the Proposed Guidelines are
intended to make it clear that the primary purpose of an institution’s
documentation standards should be to minimize legal and reputational
risks. It would be helpful, however, for the Proposed Guidelines to
specifically articulate that the forms of documentation listed in the
section on Documentation Standards (id. at 28989) are suggestions,
subject to the qualification that the purpose of documentation is to
minimize legal and reputational risk, and, to a lesser but significant
extent, to facilitate the ability of auditors and examiners to be able
to efficiently review and understand a transaction. It cannot be
consistent with the purposes of the Guidelines to require institutions
to maintain documentation that would be irrelevant, immaterial,
redundant, confusing, or more likely to exacerbate than to minimize
legal and reputational risks.
4. Limit the Situations in Which Institutions Are Expected to Verify
Clients’ Accounting Treatments and Disclosures.
The Proposed Guidelines are somewhat unclear regarding one
controversial element – namely, when it is appropriate for financial
institutions to verify the accounting treatment and/or disclosures to be
adopted by the customer. As we understand the section on Accounting and
Disclosure by Customers, there are only three instances in which the
Proposed Guidelines anticipate that the financial institution must
scrutinize the customer’s proposed accounting treatment and disclosures:
(1) in the case of a “transaction designed primarily to achieve
financial reporting or complex tax objectives”; (2) when the institution
has reason to believe that the customer intends to file “materially
misleading financial statements”; and (3) “to address the creation,
acquisition, and use of institution and client-sponsored SPEs.” Id. at
28988-989.
By limiting the circumstances in which an institution would be
expected to insist upon receiving information about a customer’s
anticipated accounting treatment or financial disclosures, the agencies
appropriately recognize that there are routine CSFTs that do not present
elevated risks, which can be processed through a transaction approval
process that is less intensive than the processes to be used for HRCSFTs.
In such cases, it is unlikely that the client would have any expectation
that its accounting or disclosures would be other than in accordance
with its normal practice for similar transactions.
However, the Proposed Guidelines appear to require scrutiny of
customers’ intentions regarding financial and tax reporting even in some
circumstances that do not appear to present sufficiently elevated risks.
Clients would be unlikely to be willing to respond in detail about their
anticipated disclosures in connection with every CSFT, much less make
their attorneys or accountants available to the financial institution,
almost always for legitimate reasons -- such as protection of privilege
or proprietary information; to prevent delay in effecting the
transaction that might obviate the benefits of the transaction; or
because the client’s accountants refuse to incur incremental legal risk
by providing an accounting opinion to a third party.
In keeping with the express purposes of the Proposed Guidelines, as
reiterated above, the agencies should be satisfied if a financial
institution has sufficient procedures and controls to identify and
control risks associated with CSFTs. The regulators should not seek to
substitute their judgment for that of an institution’s legal, accounting
and other professional experts by mandating specific procedures that may
inadvertently exacerbate risk, instead of mitigating it. By creating an
absolute obligation for a financial institution to abandon a proposed
transaction because of a client’s refusal or inability to make its
accountants available, the agencies put institutions at risk of losing
profitable, legitimate transactions with no commensurate risk-reduction
benefit. Therefore, the Proposed Guidelines should impose this
obligation only where necessary to protect the institution from legal
and reputational risks. The agencies should not put financial
institutions in the position of routinely assuming responsibility for
their clients’ accounting and disclosure decisions or of substituting
for the clients’ outside accounting and legal professionals. Such an
expectation would exacerbate, not minimize, the legal and reputational
risks attendant in financial institutions’ CSFTs.
Consistent with these principles, this section of the Proposed
Guidelines could be improved by making three changes. The first would be
to revise the second sentence by adding the words in bold type below, so
that it would read: “For transactions identified as involving such
elevated risks, the financial institution’s procedures should ensure
that staff approving the transactions seek to obtain and document
complete and accurate information about the customer’s proposed
accounting treatment of the transaction, financial disclosures relating
to the transaction, as well as the customer’s objectives for entering
into the transaction.” This would clarify that these requirements apply
only for “transactions designed primarily to achieve financial reporting
or complex tax objectives” – the only circumstance in which the
institution would clearly be entitled to receive such information from
its customer, and would make it clear that a financial institution
retains the discretion to accept a customer’s explanation of why it is
unwilling to share certain requested information.
The second change would be to make it clear that the institution
would be expected to verify the customer’s plans regarding financial
reporting where the institution has actual knowledge of facts that would
reasonably cause it to believe that the customer may file materially
misleading financial statements, and not merely because the opportunity
for such conduct exists. An institution possessing such knowledge would
be justified in getting a satisfactory response from the customer before
proceeding with a transaction, even if the transaction were not designed
to meet the customer’s financial and tax reporting objectives.
The third change would be to eliminate the last paragraph in the
section relating to SPEs, or to clarify that the accounting, legal and
tax issues to be evaluated by the institution’s risk control groups are
those issues pertaining to the institution itself, and not to the
customer. There is no reason to subject the customer to intrusive
questioning merely because a transaction utilizes a SPE, unless the
transaction was custom-designed to achieve the customer’s financial
reporting or tax objectives, or unless the institution has actual
knowledge of facts that reasonably lead it to believe the customer will
file materially misleading financial statements.
As an aside, we note that the Background Section to the Supplementary
Information refers to CSFTs that the agencies view as problematic
because they were used to alter a customer’s public financial statements
“in ways that are not consistent with the economic reality of the
transactions . . . .” Id. at 28981. While not part of the Proposed
Guidelines, this language should be excised when the final version of
the Guidelines is published. We do not dispute that it is important for
the financial institution to understand the economic substance of a
transaction and to refrain from entering into transactions where it is
apparent that the customer has an improper intent with respect to
financial or tax reporting. However, the test for financial reporting is
not “economic reality”; rather, the standard is whether the transaction
is accounted for in accordance with applicable accounting standards,
consistently applied. See id. at 28988, text accompanying n.7.
5. The Agencies Must Ensure Consistency in Interpreting the
Guidelines.
As noted above, the Proposed Guidelines leave financial institutions
with the flexibility to define CSFTs, specify the levels of risk that
require escalation within the institution’s managerial hierarchy, and
determine the appropriate internal procedures and controls, including
documentation standards, to be applied to CSFTs generally and to HRCSFTs.
The agencies have wisely provided factors to be considered by financial
institutions in exercising this flexibility without mandating the use of
the factors as a checklist. This flexibility creates the possibility for
varying interpretations of the Proposed Guidelines between different
agencies, different geographic offices within the same agency, and
different examiners within the same office of an agency. It is
imperative, therefore, that the agencies make the clarifications
suggested above to eliminate, to the extent possible, the potential for
significant differences of interpretation. This is particularly true for
financial organizations, such as Deutsche Bank, that manage subsidiaries
subject to regulation and supervision by two or more of the issuing
agencies pursuant to common policies and procedures. It would be
untenable for large financial organizations to be subject to varying
interpretations of the Guidelines by different agencies, or different
offices of the same agency, supervising different operating entities.
In addition to making these clarifications, it will be important that
examiners from the various agencies be trained in a uniform manner as to
the application of the Guidelines in order to ensure consistent
application of the Guidelines to all financial institutions and to
different subsidiaries or offices of the same financial organization.
We hope that you find these comments helpful as you finalize the
Guidelines. We believe that adoption of the modifications suggested
above would facilitate the fulfillment of the underlying purpose of the
Proposed Guidelines – to forge a partnership between the agencies and
their regulated institutions to improve the practices of the industry so
as to minimize legal and reputational risks and thereby maintain the
strength and integrity of the industry and each of its member
institutions. We thank you for your consideration.
Very truly yours,
Robert Khuzami
General
Counsel-Americas
Deutsche Bank A.G.
Michael L. Kadish
Senior Counsel
Deutsche Bank A.G.
60 Wall Street
New York, NY 10005
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