Who’s Holding the Bag?

Everyone knows banks are shedding more risk these days. So where does it go?

No Stinking Badges?

“A surprising number of financial institutions expressed to us serious concerns about the proposed statement,” the American Bankers Association (ABA) wrote to regulators, adding that the primary cause of all of its concerns was the “insistent subtext” that banks should “insert themselves into their customers’ business dealings and corporate governance.”

The guidelines did propose that banks “ensure that financial-institution staff appropriately reviews and documents the customer’s proposed accounting treatment of complex structured-finance transactions, financial disclosures relating to the transactions, and business objectives for entering into the transactions.” They also suggested that banks develop policies for “analyzing and documenting the customer’s objectives and customer-related accounting, regulatory, or tax issues.” Under certain circumstances, banks would also be required to seek review from “higher levels of [the] customer’s management” or even “communicate directly with the customer’s independent auditors.”

The guidelines also required extensive document retention, including minutes of “critical” meetings with clients, all client correspondence, and — particularly galling to critics — documents about transactions proposed but ultimately disapproved. “The proposed standards appear more aptly designed to affect the deputization of financial institutions as prosecutorial archivists,” complained a joint letter from three industry groups.

Regulators also urged banks to decline any transaction that might result in a customer issuing a materially misleading financial statement, or, failing that, “condition [the bank's] participation upon the customer making express and accurate disclosures” through legally binding representations and warranties. While few companies should object to agreeing to simply disclose a transaction, says Krohn, “if banks are looking for a covenant that you’ll account for it in a certain way, that creates some risk until your accountants have signed off.”

Ironically, the idea that banks demand assurance of proper accounting treatment from their customers was first proposed by Citigroup and, subsequently, JPMorgan Chase, in August 2002, in response to Enron. In a 2003 interview with CFO, then-CFO Todd Thomson reiterated this requirement, although he avoided repeated questions about whether such assurances would be required in writing. (Citigroup’s own response to the guidelines focused fairly narrowly on certain definitions and, while endorsing a letter from the Bond Market Association, did not endorse the stronger objections of the ABA.)

So strong was the industry response that the agencies withdrew the proposed guidelines. A revision, expected in August, has yet to appear. “I’d guess we’ll see some pretty significant changes,” says Krohn. “I can’t imagine they’ll just fix some typos.”

Despite the heated objections to the guidelines, says Krohn, banks are extraordinarily careful these days, particularly when corporate customers propose a transaction. “There is absolutely no interest in walking close to any line on any of these transactions,” he says, adding that he has begun to see representations and warranties about accounting disclosure “creeping in” to structured-finance contracts.

Yet, all this demonstrates just how fine the line is between legitimate and fraudulent transactions. “Structured-finance transactions will continue to be an important part of the capital markets,” says Krohn. “Banks are not responsible for customers’ financial statements. But if they know their financial product is being used to manipulate or create misleading financial statements, then the elements of aiding and abetting have been met.”

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