oversight

OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice Disputes

Published by the Government Accountability Office on 1997-10-02.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               United States General Accounting Office

GAO            Report to the Honorable
               Edward J. Markey,
               House of Representatives


October 1997
               OTC DERIVATIVES
               Additional Oversight
               Could Reduce Costly
               Sales Practice Disputes




GAO/GGD-98-5
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division

      B-259982

      October 2, 1997

      The Honorable Edward J. Markey
      House of Representatives

      Dear Mr. Markey:

      This report presents the results of our review of sales practices for over-the-counter (OTC)
      derivatives, mortgage-backed securities, and structured notes. On the basis of your request that
      we review sales practice issues related to OTC derivatives, we report on the applicable federal
      requirements, extent of end-user satisfaction with dealer sales practices, end-user and dealer
      views on the nature of their relationship, and actions taken by market participants and
      regulators to address sales practice issues. Because disputes and concerns were also prevalent
      for transactions involving mortgage-backed securities and structured notes, we included these
      products in our review as well.

      This report includes recommendations to the President’s Working Group on Financial Markets
      to (1) develop a formal mechanism for collecting data on sales practice issues and (2) consider
      assisting dealers and end-users in resolving their disagreements over the nature of their
      relationship as a part of OTC derivatives transactions. Also included are recommendations that
      the Federal Reserve update its guidance to better address sales practice issues and that the
      Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission
      (CFTC) collect information on the extent to which securities firms are following the sales
      practice provisions of voluntary guidance related to OTC derivatives.

      As agreed with you, unless you publicly release its contents earlier, we plan no further
      distribution of this report until 7 days from its issue date. At that time, we will provide copies to
      interested members of Congress, appropriate congressional committees, CFTC, the Department
      of the Treasury, the Federal Reserve Board, the Office of the Comptroller of the Currency, SEC,
      the National Association of Securities Dealers, and the New York Stock Exchange.

      Major contributors to this report are listed in appendix X. If you have any questions, please call
      me at (202) 512-8678.

      Sincerely yours,




      Thomas J. McCool
      Director, Financial Institutions
        and Markets Issues
Executive Summary


             In 1994, some users of over-the-counter (OTC) derivatives,1
Purpose      mortgage-backed securities (MBS),2 and structured notes3 experienced
             large and highly publicized losses. Allegations or evidence of deficient
             dealer4 sales practices were associated with some of these losses, raising
             congressional concerns about whether end-users5 were adequately
             protected against such practices. In response to these concerns, the
             former Chairman of the Subcommittee on Telecommunications and
             Finance, House Committee Energy and Commerce, requested that GAO
             determine the prevalence of disputes in the sale of OTC derivatives.
             Because market participants and others also expressed concerns about
             sales practices associated with MBS and structured notes, GAO expanded its
             review to include these products.

             To address concerns associated with sales practices for OTC derivatives,
             MBS, and structured notes, GAO analyzed (1) the federal sales practice
             requirements applicable to these products and the dealers marketing them;
             (2) the extent of end-user satisfaction with sales practices, product use,
             and related disputes and the costs of these disputes; (3) the views of
             end-users and dealers on the nature of their relationship and
             responsibilities; (4) the actions dealers and end-users have taken to reduce
             the potential for sales practice disputes; and (5) the actions regulators
             have taken to address sales practice issues.


             Innovative and often complex financial products known as OTC derivatives
Background   can be used to manage financial risks associated with volatility in interest
             rates, foreign exchange rates, and equity and commodity prices. OTC
             derivatives can also allow end-users to increase investment yields and
             reduce borrowing costs. These benefits do not come without risk because
             using OTC derivatives, similar to using other financial products, can result



             1
              OTC derivatives are privately negotiated financial contracts whose market value is determined by the
             value of an underlying asset, reference rate, or index.
             2
              MBS are debt securities that are created from pools of residential mortgages. Investors in MBS receive
             the interest and principal payments generated by the mortgage pools.
             3
              Structured notes are debt securities whose principal and interest payments vary according to specific
             formulas or as a result of changes in exchange rates or equity and commodity prices; they may also
             contain derivatives.
             4
              Dealers stand ready to act as buyers, sellers, counterparties, or intermediaries for end-users and other
             dealers.
             5
              For simplicity, GAO uses the term end-user to refer to counterparties or customers of dealers in
             transactions involving OTC derivatives, MBS, and structured notes.



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




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

The notional/contract amount6 outstanding of OTC derivatives was
estimated at $47.5 trillion worldwide and $11 trillion in the United States,
as of March 1995.7 The bulk of this volume was in “plain vanilla,” or
relatively standardized and uncomplicated, OTC derivatives contracts.
However, more complex contracts whose values can be based on more
than one underlying asset, reference rate, or index were also being used.

In addition to OTC derivatives, a wide variety of MBS and structured notes
have been issued by government-sponsored enterprises (GSE)8 and private
companies to finance their operations. In 1996, issuances were $474 billion
for MBS and $12 billion for GSE-issued structured notes.

Dealers of OTC derivatives, MBS, and structured notes are primarily U.S. and
foreign banks, registered broker-dealers,9 and affiliates of securities firms
and insurance companies. These dealers may receive no federal oversight
or be overseen by one or more federal regulators, including the Federal
Reserve System, the Office of the Comptroller of the Currency (OCC), the
Securities and Exchange Commission (SEC), the Commodity Futures
Trading Commission (CFTC), and various industry self-regulatory
organizations (SRO).10 The federal financial market regulators jointly
address issues related to OTC derivatives, MBS, and structured notes
through the President’s Working Group on Financial Markets. This group,

6
 The notional amount is the amount upon which payments between parties to certain types of
derivatives contracts are based. When this amount is not exchanged, it is not a measure of the amount
at risk in a transaction. According to the Federal Reserve, the amount at risk, as measured by the gross
market value of OTC derivatives outstanding, was $328 billion for U.S. entities, as of March 1995, or
about 3 percent of the notional/contract amount. (The gross market value is the cost that would be
incurred if the outstanding contracts were replaced at prevailing market prices.)
7
 These estimates were based on a comprehensive survey done by the Bank for International
Settlements and represent the most current data available. The Bank for International Settlements,
among other functions, provides a forum for cooperative efforts by the central banks of major
industrial countries.
8
 GSEs are privately owned financial intermediaries established pursuant to federal law to facilitate
lending for purposes that the federal government has deemed socially important, such as education,
agriculture, and housing.
9
 Broker-dealers are agents that handle public orders to buy and sell securities. They also act as
principals that buy and sell securities for their own accounts.
10
  SROs play an extensive role in the regulation of the U.S. securities and futures industries. SROs
include all of the U.S. securities and commodities exchanges, the National Association of Securities
Dealers, the National Futures Association, and the Municipal Securities Rulemaking Board. In
addition, state agencies also oversee banking, securities, and insurance activities, although this report
does not address such oversight in detail.



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




                   which is chaired by the Secretary of the Treasury, considers issues
                   concerning the competitiveness, integrity, and efficiency of the financial
                   markets.

                   To gather information about end-users of OTC derivatives, MBS, and
                   structured notes, GAO sent questionnaires to the financial officers of nearly
                   2,400 randomly selected U.S. organizations in 1995. Designed to be
                   representative of U.S. public-sector and private-sector entities, the sample
                   was drawn from over 49,000 U.S. organizations that GAO identified as
                   potential end-users of one or more of the products, and the sample was
                   stratified by industry and organization size.11 GAO received about 1,800
                   responses to the survey, allowing statistically valid estimates for the
                   population of (1) the level of satisfaction these organizations experienced
                   with dealers’ sales practices and (2) the extent to which these products
                   were used across the organizations. In addition, GAO followed-up with
                   about 50 survey respondents to obtain more information about their use of
                   these products and satisfaction with dealer practices.


                   The extent to which OTC derivatives are subject to federal sales practice
Results in Brief   requirements intended to protect end-users varies, depending, in part, on
                   whether they are considered to be securities, futures, or neither. When
                   they are considered to be securities or futures, their sale is covered by the
                   federal securities or commodities laws, and they are regulated by SEC and
                   CFTC, respectively. To the extent that these products are not securities or
                   futures, end-users with sales practice disputes would need to seek redress
                   against a dealer by asserting primarily state statutory or common law
                   claims.12 In contrast to most OTC derivatives, MBS and structured notes are
                   typically securities and, thereby, subject to the federal securities laws,
                   except when exempted from specific provisions.

                   The extent to which sales practice requirements apply to the dealers
                   marketing OTC derivatives in the United States also varies, depending on
                   whether the dealer offering them is regulated. When OTC derivatives are
                   marketed by banks, they are subject to supervisory guidance issued by
                   federal bank regulators. This guidance is primarily intended to ensure that
                   OTC derivatives activities do not adversely affect the financial condition of
                   banks. Securities, futures, and insurance firms, unlike banks, typically
                   market OTC derivatives that they consider to be neither securities nor
                   futures from affiliates that are not subject to any direct federal financial

                   11
                     See appendix I for information on the survey sample design.
                   12
                     Common law is derived from judicial decisions rather than from statute.



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




regulatory oversight, although some individual transactions may be
subject to such oversight.

Although sales practice requirements vary by product and dealer,
according to GAO’s survey of a broad range of U.S. organizations, most
end-users were generally satisfied with the sales practices of the dealers
with whom they entered transactions. GAO’s survey also found that
relatively few organizations reported using OTC derivatives. About
10 percent reported using plain vanilla OTC derivatives, and 2 percent
reported using more complex OTC derivatives. Within each type of
industry, the larger organizations were the predominant users of these
products.

Furthermore, GAO’s review of regulatory and public records, covering 1993
through 1996, indicated that cases involving actual or alleged deficiencies
in dealer sales practices were limited in number. However, the dealers and
end-users involved in these cases often experienced significant costs.
These were primarily sales practice-related costs associated with
compliance risk—such as litigation costs and regulatory fines—and
reputation risk—such as reduced revenues and income due to a
diminished business or professional reputation.

Although generally satisfied with dealer sales practices, end-users’ views
on the nature of counterparty relationships sometimes differed from those
of dealers. According to GAO’s survey, about one-half of all end-users of
plain vanilla or more complex OTC derivatives believed that a fiduciary
relationship of some sort existed in some or all transactions between them
and their dealer. Some end-users told GAO that this meant dealers had an
obligation to provide accurate product descriptions and disclose material
risks. In comparison, two dealer groups issued guidance asserting that
such transactions are conducted on a principal-to-principal, or an
“arm’s-length,” basis unless more specific responsibilities are agreed to in
writing or otherwise provided by law. According to this guidance,
end-users would be expected to make their own decisions about a
transaction without relying on statements made by dealers.
Representatives of end-users and dealers have called for both sides to
reach agreement on this issue, with some indicating that federal financial
market regulators could play a role in resolving differences.
Notwithstanding the disagreement over the nature of their relationship,
some dealers and end-users have taken steps—individually and
collectively—to reduce the potential for sales practice-related disputes to
arise.



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




In addition, bank regulators have taken certain actions to address sales
practice issues. In 1993 and 1994, OCC and the Federal Reserve issued
guidance for use by their examiners and the banks they regulate covering
the marketing of OTC derivatives, MBS, and structured notes. GAO also found
that these regulators had conducted examinations that were generally
thorough in addressing banks’ sales practices. However, in conducting
these examinations, regulators addressed areas that were not listed in
their guidance, including several key areas in which alleged deficiencies in
dealer practices have led to costly disputes with end-users. In 1997, OCC
updated its guidance to address these weaknesses. The Federal Reserve
has not yet issued updated guidance, but plans to do so by the end of 1997.
The revisions are to address the areas not specifically covered in its
current guidance.

Although SEC and CFTC do not directly regulate the affiliates that securities
and futures firms use to conduct their OTC derivatives activities, SEC and
CFTC worked with the most active of these firms to produce one of two
sets of voluntary guidance. This guidance presents a framework of
management systems and controls for the participating firms to follow
related to sales practices. However, the guidance does not provide for SEC
and CFTC to receive information about the extent to which participating
firms follow its sales practice provisions. Adherence to these provisions is
important to promoting market fairness and integrity.

Although GAO found that the extent to which sales practice requirements
apply to OTC derivatives and their dealers vary, end-users were generally
satisfied with the sales practices of the dealers they used and sales
practice disputes were limited in number. However, these findings must be
viewed in the context of the relatively small number of end-users and
dealers active in these markets as well as their relatively high level of
financial sophistication. If new dealers enter the markets, use of complex
products becomes more widespread, or marketing to or product use by
less sophisticated end-users increases, disputes over sales practices might
increase. This could cause the financial market regulators to reconsider
whether sales practice requirements for OTC derivatives are sufficient to
protect end-users from abusive practices.




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




Principal Findings

Federal Sales Practice   The federal sales practice requirements intended to protect end-users of
Requirements Vary        OTC derivatives vary, depending on whether the product involved is a
                         security, futures contract, or neither and on whether the dealer is
                         regulated. OTC derivatives that fall within the definition of a security or
                         futures contract are generally subject to the antifraud provisions of the
                         federal securities or commodities laws, respectively. Their sale is also
                         subject to SEC and CFTC oversight.13 The antifraud provisions of the
                         securities and commodities laws place certain obligations on those
                         marketing securities or futures. For securities, these obligations include
                         disclosing material information about and assessing the suitability of a
                         product before recommending a transaction. For futures, these obligations
                         include disclosing product risks and obtaining information on the financial
                         condition of the end-user before engaging in transactions. To the extent
                         that a specific OTC derivative product is not covered by federal securities
                         and commodities laws, end-users with sales practice disputes would need
                         to seek redress against a dealer by asserting primarily state statutory or
                         common law claims, such as fraud or breach of fiduciary duty.14

                         Although SEC and CFTC actions can indicate whether they consider certain
                         types of OTC derivatives to be securities or futures, such as when the
                         agencies respond to inquiries about specific proprietary contracts a dealer
                         is developing, these actions have not covered all OTC derivatives. For
                         example, CFTC has exempted certain swaps15 and other OTC derivatives
                         from almost all provisions of the Commodity Exchange Act (CEA);
                         however, it did so without determining that such products were futures.16
                         Furthermore, CFTC did not exempt swaps from the act’s antifraud
                         provisions, but such provisions only apply insofar as swaps are found to




                         13
                           SROs assist SEC and CFTC in implementing the federal securities and commodities laws.
                         14
                           End-users could also seek redress under the federal Racketeer Influenced and Corrupt Organizations
                         Act. In addition, dealers may be subject to federal criminal enforcement actions under applicable mail
                         fraud or wire fraud statutes.
                         15
                           Swaps are OTC derivatives contracts that typically require counterparties to make periodic payments
                         to each other for a specified period. The calculation of these payments is based on an agreed-upon
                         amount, called the notional amount, that is not typically exchanged.
                         16
                          CFTC was granted this exemptive authority by the Futures Trading Practices Act of 1992 (P.L.
                         102-546). See The Commodity Exchange Act: Legal and Regulatory Issues Remain (GAO/GGD-97-50,
                         Apr. 7, 1997).



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




be futures or commodity options.17 In addition, SEC and CFTC have taken a
cooperative enforcement action against one dealer, Bankers Trust,18 for
violating the antifraud provisions of the federal securities and
commodities laws in connection with OTC derivatives it marketed. In
contrast to most OTC derivatives, MBS and structured notes are typically
securities and subject to the federal securities laws, except when
exempted from specific provisions.19

The sales practice requirements applicable to OTC derivatives in the United
States also vary, depending on whether the dealer offering them is
regulated. Banks marketing these products are overseen by federal bank
regulators who are responsible for ensuring the safety and soundness of
banks. To address this responsibility, bank regulators issued guidance in
1993 and 1994 applicable to the marketing of OTC derivatives that requires
banks to take steps to ensure that such transactions are understood and
are appropriate for the end-user. Banks marketing MBS and structured
notes that are securities are also subject to the antifraud provisions of
federal securities laws. As such, they are tasked with providing risk
disclosures and assessing the suitability of these products before
recommending them to an end-user.

Although SEC oversees securities firms and CFTC oversees futures firms,
these firms typically market OTC derivatives that are not securities or
futures20 through affiliates that are not subject to either regulator’s direct
oversight. Similar to securities and futures firms, insurance firms typically
market these products from affiliates that are not subject to direct federal
or state financial regulatory oversight. Nonetheless, if SEC or CFTC
determined that a specific transaction was a security or a futures contract,




17
 Commodity options give the purchaser the right, but not the obligation, to buy or sell a specified
quantity of a commodity or financial asset at a particular price on or before a certain date.
18
 Unless otherwise indicated, Bankers Trust refers to the parent firm—Bankers Trust New York
Corporation, which is a bank holding company—and two of its wholly owned subsidiaries—Bankers
Trust Company, which is a bank, and BT Securities Corporation, which is a securities broker-dealer.
19
  Structured notes that are hybrid financial instruments could be futures or commodity option
contracts if they do not meet the terms and conditions of CFTC’s hybrid instrument exemption (17
C.F.R. Part 34). A hybrid financial instrument possesses, in varying combinations, characteristics of
forwards, futures, options, securities, and/or bank deposits. Unlike many other derivatives, hybrid
financial instruments generally serve a capital-raising function. For the purposes of this report, GAO
assumed that structured notes meet the conditions of CFTC’s hybrid exemption and, therefore, are
securities and not futures.
20
  Firms would also typically market OTC derivatives that CFTC has exempted from the CEA from
these unregulated affiliates.
Page 8                                             GAO/GGD-98-5 OTC Derivatives Sales Practices
                             Executive Summary




                             it would be subject to that agency’s laws and jurisdiction, absent an
                             agency exemption21 or a successful court challenge.

                             After considering the market’s characteristics, the President’s Working
                             Group on Financial Markets concluded that the existing authority of these
                             agencies as well as current sales practice requirements for OTC derivatives
                             are adequate to protect end-users and the financial markets. Additionally,
                             Working Group participants told GAO that the agencies comprising the
                             group do not routinely collect information on sales practice-related market
                             characteristics, such as changes in the number of disputes or in the types
                             of end-users being offered certain products. Therefore, the Working Group
                             has no formal mechanism for identifying changes in market characteristics
                             that would cause it to reassess the adequacy of existing sales practice
                             requirements for OTC derivatives.


Satisfaction With Sales      According to GAO’s 1995 survey of a broad range of U.S. organizations,
Practices Was High and       most end-users were generally satisfied with the sales practices of dealers
Disputes Were Limited, but   marketing OTC derivatives, MBS, and structured notes. For plain vanilla OTC
                             derivatives, 2 percent of the organizations that had used these products
Losses Were Often Large      reported being somewhat or very dissatisfied with the sales practices of
                             the dealers they used.22 For MBS, 7 percent of the end-users reported being
                             dissatisfied with the dealers they used; for structured notes, 13 percent of
                             the end-users reported being dissatisfied.

                             GAO’s survey found that OTC derivatives were used less frequently than
                             either MBS or structured notes. It found that 10 percent of the population
                             reported using plain vanilla OTC derivatives, while 24 percent reported
                             using MBS and 16 percent reported using structured notes. Also, the
                             reported use of these products was comparatively greater for large
                             organizations than for small organizations.23 Nonetheless, in certain
                             industries, small organizations reported active use of these products. For
                             example, smaller banks, credit unions, and insurance companies, as a
                             group, reported using MBS and structured notes at about twice the rate as
                             did all other organizations combined.

                             21
                              SEC has not exempted any products from the antifraud provisions of the securities laws. Similarly,
                             except for certain energy products, CFTC has not exempted any products from the antifraud
                             provisions of the CEA.
                             22
                              The number of survey respondents that used more complex OTC derivatives was too small to reliably
                             estimate dissatisfaction.
                             23
                              Large organizations were usually those in the top 10 percent of their respective industry/government
                             grouping on the basis of their assets, revenues, or other indicators of financial size. All other
                             organizations were considered small.



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




GAO’s review of complaints filed with regulators, regulatory enforcement
actions, and public records of litigation, from 1993 through 1996, also
indicated that sales practice problems involving OTC derivatives, MBS, and
structured notes were not widespread. Moreover, a majority of these
instances of alleged sales practice problems were attributable to a small
number of dealers. The specific concerns generally involved dealers
misrepresenting potential transaction risks or offering products that were
unsuitable for the end-user.

Using public information and regulatory data, GAO identified 360 end-users
losses24 that involved OTC derivatives, MBS, and structured note
transactions with U.S. dealers.25 These losses totaled over $11.4 billion,
with the earliest loss occurring in April 1987 and the latest loss occurring
in March 1997. Sales practice concerns were raised by end-users or
regulators in 209, or 58 percent,26 of these losses and were associated with
an estimated $3.2 billion in losses. Although many of these losses were
large, they involved a relatively limited number of dealers. Of the end-user
losses with sales practice concerns, 18 involved OTC derivatives, but one
dealer—Bankers Trust—was involved in 9 of these losses. MBS and
structured notes were used more often than OTC derivatives and were
associated with more sales practice concerns. For these products, GAO
identified 190 losses with sales practice concerns; however, 8 dealers were
involved in 148 of these losses. Similarly, GAO’s review showed that
regulators were investigating as many as 44 dealers from 1993 to 1996, but
only a small number of the investigations involved multiple end-users.
Given the many thousands of transactions in OTC derivatives, MBS, and
structured notes and the hundreds of billions of dollars at risk in these
transactions over the period reviewed, GAO found that sales practice
concerns were not widespread.

Although the number of reported problems was limited during the period
GAO reviewed, many of the transactions in which concerns over dealer
sales practices arose entailed serious losses for the end-users involved.


24
  The amount of reported losses includes not only realized losses but also unrealized losses as well as
losses for which the loss amounts were not reported. In addition, some of the losses may involve
products not covered in this report.
25
 The information in this database was compiled from press accounts and other public records as well
as from nonpublic regulatory data. Many of the losses are supported by multiple sources, but the
accuracy of the information generally was not confirmed.
26
  This percentage is not a statistically valid estimate of the actual extent to which sales practice
concerns have been raised in connection with OTC derivatives, MBS, and structured note transactions.
It is based on a compilation of losses that is not necessarily representative of the population of such
transactions.



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




                             For example, Procter & Gamble reported an after tax loss of $102 million
                             on its complex OTC derivatives transactions with Bankers Trust. Various
                             organizations reported losses involving MBS that were as high as
                             $660 million. Additionally, in 1994, Orange County, CA, announced losses
                             totaling $1.7 billion on its use of various products, including structured
                             notes.

                             The dealers and end-users in these cases also frequently incurred
                             significant compliance and reputation risk costs. For example, Bankers
                             Trust’s compliance risk costs have totaled at least $400 million, including
                             regulatory fines, legal fees, and other costs associated with end-user
                             litigation settlements. The impact on its reputation was evidenced, at least
                             in part, by the subsequent declines in its revenues, profits, and stock price.
                             In addition, Orange County faces compliance losses from suits by its
                             investment pool participants, SEC actions against the county’s staff, and a
                             countersuit by a dealer, Merrill Lynch. The county’s credit rating has also
                             been lowered, causing it to pay higher rates of interest on the debt used to
                             finance its operations.


Disagreement Over            According to GAO’s survey, about 53 percent of end-users of plain vanilla
Counterparty                 OTC derivatives believed that dealers had certain fiduciary responsibilities

Responsibilities Increases   to end-users in some or all cases. In follow-up interviews, end-users told
                             GAO that these responsibilities included accurately describing a product’s
the Potential for Disputes   function and potential performance as well as adequately disclosing
                             relevant risks. Responses to GAO’s survey also indicated that an estimated
                             59 percent of plain vanilla OTC derivatives end-users and a similar
                             percentage of end-users of more complex OTC derivatives relied on dealers
                             to provide investment advice from “some” to a “very great extent” as part
                             of these transactions.

                             Dealers viewed their responsibilities differently. Two sets of voluntary
                             guidance issued by dealer groups assert, unless altered by agreement
                             between the parties or otherwise provided for by law, that OTC derivatives
                             transactions are conducted at an arm’s length, meaning that each party to
                             the transaction—the dealer and the end-user—is responsible for ensuring
                             that the transaction is appropriate.27 However, some end-users and legal
                             scholars have questioned the reasonableness of asserting that an

                             27
                              The two sets of guidance are the Framework for Voluntary Oversight, issued in 1995 by the
                             Derivatives Policy Group, which is comprised of representatives from the six U.S. securities firms
                             whose affiliates are most active in the OTC derivatives markets, and The Principles and Practices for
                             Wholesale Financial Market Transactions, issued in 1995 by various dealer associations under the
                             auspices of the New York Federal Reserve Bank.



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




                         arm’s-length relationship always exists between parties to these
                         transactions, particularly when the end-user is unsophisticated or
                         inexperienced in the use of a particular product. Others expressed
                         concern that the dealer-issued guidance does not obligate dealers to fully
                         disclose the risks of the transactions they propose. For their part, dealers
                         told GAO that presentations to end-users are designed to explain potentially
                         useful products and various investment and risk management alternatives,
                         but should not be construed as investment advice that end-users should
                         accept without performing their own internal evaluations. Furthermore,
                         dealers indicated that they would assume more specific responsibilities,
                         such as acting as an investment advisor or fiduciary, if such relationships
                         were agreed to in writing.

                         Conferences and other forums have provided end-users and dealers
                         opportunities to hear each other’s views. However, as of June 1997, the
                         parties had not reached agreement on the nature of their relationship in
                         OTC derivatives transactions, nor did such an agreement appear imminent.
                         Regulators and others have called for more discussions between end-users
                         and dealers on this issue. In addition, some market participants have
                         indicated that federal financial regulators could assist end-users and
                         dealers in reaching agreement.

                         To reduce the likelihood of losses and related sales practice disputes,
                         some dealers and end-users have acted, individually or as part of groups,
                         to ensure that their internal controls and practices are prudent. Various
                         groups of market participants have also offered guidance and
                         recommended practices to dealers and end-users to address the risks of
                         financial products, including the risks related to the sale of these products.
                         The need for these efforts was demonstrated by the weaknesses in
                         controls and practices that regulators and others found.


Some Improvements in     In late 1993 and early 1994, the Federal Reserve and OCC issued guidance
Oversight of Regulated   for use by their examiners and the banks they regulate covering the
Firms Have Been Made     marketing of financial products, including OTC derivatives, MBS, and
                         structured notes. In response to publicized sales practice disputes, in 1994
                         and 1995, these regulators conducted focused examinations of the largest
                         bank dealers that addressed their sales practices. The scope of these
                         examinations was broader than that required by the 1993 and 1994 Federal
                         Reserve and OCC guidance. Using information from regulators, private
                         groups, and analyses of losses in which sales practice issues were raised,
                         GAO identified various elements that a comprehensive examination could




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




include. Using these criteria, GAO found the bank examinations to be
generally thorough in addressing the key elements related to sales
practices.

However, GAO found that the bank regulators’ new guidance did not
address several key areas in which dealer practices led to costly disputes
with end-users in the past. For example, it did not direct examiners to
assess the adequacy of bank policies and controls related to product risk
disclosure, fiduciary or advisory responsibilities, or supervising marketing
personnel. In January 1997, OCC expanded its guidance and addressed all
of these areas. The Federal Reserve has not yet issued updated guidance.
However, Federal Reserve officials provided GAO with a draft of the
updated guidance, and the planned revisions would address the elements
we identified as missing in the existing guidance. Federal Reserve officials
said the agency expects to issue the updated guidance by the end of 1997.

To address ongoing concerns about OTC derivatives use, in 1995, the six
securities firms whose affiliates are most active in the OTC derivatives
markets cooperated with SEC and CFTC in developing the Framework for
Voluntary Oversight.28 The Framework has resulted in SEC and CFTC
receiving information to supplement the reports they receive under prior
legislation passed in response to the risks of unregulated activities of
registered securities and futures firms. These supplements are to be
voluntarily provided and include additional reporting to the regulators,
pledges by participating firms to follow certain practices, and external
auditor verification of participating firms’ adherence to certain provisions
of the Framework.29 However, the additional reporting and the external
auditor verification do not extend to the sales practice provisions of the
Framework, which include suggestions for alternative ways of disclosing
transaction risks and providing accurate pricing information. SEC officials
told GAO that they expect participating firms to follow these provisions
because doing so is important for ensuring market fairness and integrity.




28
 The six firms are CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley,
and Salomon Brothers.
29
  Because its OTC derivatives affiliate is subject to oversight in the United Kingdom, CS First Boston is
not subject to the additional reporting requirements but has committed to adhering to the other
elements of the Framework. SEC officials told us that under SEC risk assessment rules, the agency
receives copies of quarterly financial reports that the affiliate files with its U.K. regulator.



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




Changes in Market       Notwithstanding the variance in sales practice requirements that apply to
Characteristics Could   OTC derivatives and their dealers, end-users were generally satisfied with

Affect the Current      the sales practices of the dealers used and sales practice disputes were
                        limited in number. The individual federal financial market regulators
Regulatory Approach     currently monitor OTC derivatives issues as part of their oversight of the
                        firms they regulate, and they discuss new developments in these markets
                        as part of their participation in the Working Group. Although the Working
                        Group concluded that, on the basis of existing market characteristics, no
                        additional sales practice requirements are currently needed for OTC
                        derivatives, the characteristics that contributed to the high level of
                        end-user satisfaction and the limited number of sales practice disputes
                        experienced to date could change as the markets evolve. These changes
                        could include increased market participation by new dealers, more
                        widespread use of complex products, or increased marketing to or
                        product use by less sophisticated end-users. Such changes to market
                        characteristics could cause the Working Group to reconsider whether
                        current requirements are adequate to protect OTC derivatives end-users
                        and the financial markets. However, the Working Group’s lack of a formal
                        mechanism for periodically obtaining the information on relevant market
                        characteristics means that it could fail to detect changes that would
                        warrant reassessment of the adequacy of the sales practice requirements
                        for OTC derivatives.

                        The potential for additional end-user losses to spark costly sales practice
                        disputes could affect the soundness of the financial condition of regulated
                        institutions and perceptions of market fairness and integrity. The potential
                        for these additional disputes is heightened because dealers and end-users
                        have not reconciled their differing views on the nature of counterparty
                        responsibilities in OTC derivatives transactions. So far, the financial
                        regulators have not acted to assist the parties in reaching agreement.
                        However, such a reconciliation of views could have several benefits,
                        including clarifying positions about transaction risks and uncertainty
                        about counterparty roles and responsibilities. The Working Group could
                        provide regulators a forum for assisting end-users. In addition,
                        unaddressed weaknesses in bank guidance correspond to areas where
                        sales practice disputes have arisen, and SEC and CFTC lack information on
                        compliance of unregulated dealer affiliates with the sales practice
                        provisions of the Framework.




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




                          GAO recommends that the Secretary of the Treasury, as Chairman of the
Recommendations           President’s Working Group on Financial Markets, take the following
                          actions:

                      •   Ensure that the Working Group establishes a mechanism for
                          systematically monitoring developments in the OTC derivatives markets to
                          assess whether developments warrant introducing specific federal sales
                          practice requirements.
                      •   Lead the members of the Working Group in considering the extent to
                          which it should assist end-users and dealers in reaching agreement on the
                          nature of their relationship in transactions involving OTC derivatives.

                          GAO   also recommends that

                      •   the Federal Reserve Board Chairman implement planned revisions to the
                          Federal Reserve examination guidance, which are to more specifically
                          address the need to assess the adequacy of banks’ policies and controls
                          related to disclosing risks, creating advisory relationships, and supervising
                          marketing personnel and
                      •   the SEC and CFTC Chairpersons establish a mechanism for determining that
                          participating firms are following the sales practice provisions of the
                          Framework for Voluntary Oversight.


                          GAO obtained comments on a draft of this report from the heads, or their
Agency and Industry       designees, of CFTC, the Department of the Treasury, the Federal Reserve
Comments and GAO’S        Board, OCC, and SEC. Comments were also obtained from the National
Evaluation                Association of Securities Dealers, the New York Stock Exchange, the
                          End-Users of Derivatives Association (EUDA); the Government Finance
                          Officers Association (GFOA); the International Swaps and Derivatives
                          Association (ISDA); and the National Association of State Auditors,
                          Comptrollers and Treasurers (NASACT). The comments are presented and
                          evaluated in chapter 7.

                          Overall, no consensus emerged on the benefits of implementing GAO’s
                          recommendations. The banking regulators and the associations that
                          represent primarily end-users generally concurred with GAO’s findings
                          and/or recommendations. The Federal Reserve also stated that this report
                          makes a useful contribution to assessing the current state of financial
                          market sales practices. OCC commented that the report is comprehensive
                          in evaluating sales practices from the perspectives of dealers, end-users,
                          and regulators. GFOA said this report will be an extremely helpful reference



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




on derivatives, and NASACT stated that it provides an excellent study of
sales practice issues facing the OTC derivatives market. In contrast,
Treasury and ISDA generally objected to GAO’s recommendations, while
SEC’s views were mixed.


Regarding the recommendation that the Working Group establish a
mechanism for systematically monitoring developments in the OTC
derivatives markets, SEC and Treasury commented that the Working
Group’s current efforts, which generally include the principals meeting
every 6 weeks and the staff meeting every 2 weeks, are adequate to
address market developments. Similarly, ISDA commented that it is not
readily apparent that a formal monitoring mechanism would be any more
effective than the existing structure. In contrast, EUDA, GFOA, and NASACT
supported GAO’s recommendation. EUDA indicated that taking the
recommended steps—as they relate to this and GAO’s other
recommendation to the Working Group—will lead to greater market safety
and soundness, particularly concerning new dealers or end-users entering
the markets.

GAO  continues to believe that the Working Group needs a formal
mechanism for monitoring the OTC derivatives markets. This report
recognizes that the federal financial market regulators monitor the OTC
derivatives activities of the firms subject to their respective oversight, and
they discuss market developments of which they become aware through
their joint participation in the Working Group. However, this report also
observes that the agencies that participate in the Working Group do not
routinely collect the information necessary to ensure that they are able to
systematically detect changes in market characteristics. Thus, the Working
Group lacks a formal mechanism for obtaining the necessary information
for monitoring market developments related to sales practices. Such a
mechanism is important because it could alert the Working Group to the
need for reassessing the adequacy of existing sales practice requirements
applicable to OTC derivatives. The information to be assessed could include
the number and types of new dealers and end-users entering the markets,
the types of complex new products being introduced, and changes in the
types or sophistication of end-users to whom products are being
marketed.

Treasury and ISDA also objected to GAO’s recommendation that the Working
Group consider the extent to which it should assist end-users and dealers
in reaching agreement on the nature of their relationship in transactions
involving OTC derivatives. Treasury was concerned that, because such



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




relationships are contractual, no single model may be appropriate. ISDA
commented that no need exists for the Working Group to involve itself in
mediating between dealers and end-users, that the involvement of market
participants and regulators to date has been sufficient, and that the issues
involved are complex and federal involvement may not result in an
agreement that is widely accepted. SEC commented that it believes the
Working Group would be willing to hold discussions with end-users and
professional counterparties (dealers); however, it is not necessary for the
government to intervene and define contractual obligations for
professional and sophisticated counterparties. The Federal Reserve noted
that it has recognized the importance of and encouraged voluntary
industry efforts in this area, and the three end-user associations supported
GAO’s recommendation.


GAO  continues to support its recommendation that the Working Group
consider assisting market participants in reaching agreement on the nature
of their relationship in OTC derivatives transactions. This report
acknowledges that the issues involved in reaching agreement between
dealers and end-users are complex and may not lend themselves to a
single, widely accepted solution. For this reason, GAO does not intend that
the Working Group impose a model that defines counterparty
relationships in OTC derivatives transactions. However, GAO’s survey
indicated that end-users and dealers do not always agree on the nature of
their relationship, as indicated by the majority of end-users reporting that
dealers had fiduciary responsibilities in some or all OTC derivatives
transactions and that they relied on dealers from some to a very great
extent as part of these transactions. To the extent that the differing views
of end-users and dealers increase the likelihood of sales practice disputes
that expose regulated institutions to material losses or that otherwise
effect the sound financial condition of regulated institutions and the
fairness and integrity of the markets, we concluded that the federal
financial market regulators have an interest in the reconciliation of these
differences.

Treasury officials commented that the draft report appeared to be critical
of establishing an arm’s-length relationship as the default model for OTC
derivatives transactions. ISDA officials supported the arm’s-length
relationship as the default model, noting that it is the appropriate starting
place for institutional market participants. This report does not reach a
conclusion on the appropriate default model for counterparty
relationships. It presents the views of both those who support and oppose
an arm’s-length relationship as the default model. GAO concludes that the



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




type of relationship and accompanying responsibilities that should prevail
in OTC derivatives transactions should be agreed-upon by market
participants and recommends that the Working Group consider assisting
market participants in reaching agreement on these issues.

The Federal Reserve commented that it has efforts under way that would
fully respond to GAO’s recommendation that the agency revise its
examination guidance to more specifically address the need to assess the
adequacy of banks’ policies and controls related to disclosing risk,
creating advisory relationships, and supervising marketing personnel. In
addressing GAO’s recommendation that SEC and CFTC establish a mechanism
for determining that participating firms are following the sales practice
provisions of the Framework, SEC indicated that it is willing to discuss
with the affected parties the feasibility of extending the external auditor’s
role to incorporate a review of sales practice procedures. This appears to
be an appropriate first step toward implementing GAO’s recommendation.
CFTC did not comment on this recommendation.




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



Executive Summary                                                                                      2


Chapter 1                                                                                             26
                         OTC Derivatives                                                              26
Introduction             Mortgage-Backed Securities                                                   30
                         Structured Notes                                                             31
                         OTC Derivatives, MBS, and Structured Note Markets’ Growth and                32
                            Participants’ Activities
                         Sales Practices for OTC Derivatives, MBS, and Structured Notes               34
                         Various Regulators Oversee the Dealers Marketing OTC                         35
                            Derivatives, MBS, and Structured Notes
                         Objectives, Scope, and Methodology                                           37

Chapter 2                                                                                             41
                         Sales Practice Requirements Vary, Depending on the Product                   42
Federal Sales Practice   Sales Practice Requirements Vary, Depending on the Regulator of              49
Requirements Vary by       the Dealers’ Activities
Product and Dealer
Chapter 3                                                                                             57
                         Most End-Users Were Generally Satisfied With Dealer Sales                    57
Satisfaction With          Practices
Sales Practices Was      Reported Product Usage Varied Across Products and by                         63
                           Organization Size and Type
High and Disputes        Sales Practice Concerns Did Not Appear to Be Widespread but                  71
Were Limited, but          Involved Many Large Losses
When Disputes            When They Occurred, Sales Practice-Related Disputes Were                     77
                           Often Costly to Dealers and End-Users
Occurred Losses Were
Often Large
Chapter 4                                                                                             82
                         Disputes Have Centered on Counterparty Responsibilities                      82
Disagreement Over        The Potential for Additional Disputes Arises From the Differing              84
Counterparty               Views of End-Users and Dealers
                         Reconciling the Views of End-Users and Dealers Could Be                      94
Responsibilities           Difficult
Increases the
Potential for Disputes



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




Chapter 5                                                                                          106
                        Corporate Governance Systems Can Address Sales Practice                    106
Dealers and               Issues
End-Users Acted to      Dealers Described Sales Practice Policies and Procedures That              107
                          Were Consistent With the Dealer-Issued Guidance
Reduce the Potential    Regulatory Examinations Surfaced Dealer Weaknesses                         109
for Sales Practice      End-Users Described a Range of Controls, but Some Lacked                   110
Disputes, but             Basic Controls
                        Reviewing Organizations Found That Weaknesses at End-Users                 113
Weaknesses Remain         Contributed to Losses
                        Various Organizations Issued Guidance for End-Users                        115
                        Some State Governments Acted to Reduce the Risk of Loss                    120

Chapter 6                                                                                          122
                        Bank Regulators’ Efforts to Oversee Sales Practices Have                   123
Regulators Have           Increased, but Updated Federal Reserve Guidance Has Not Yet
Improved Sales            Been Issued
                        Jurisdictional and Other Limitations Have Affected Oversight of            127
Practice Oversight of     Securities Firms’ Sales Practices
Regulated Firms, but
Some Weaknesses
Remain
Chapter 7                                                                                          134
                        Conclusions                                                                134
Conclusions and         Recommendations to the President’s Working Group on Financial              137
Recommendations           Markets
                        Recommendation to the Federal Reserve                                      138
                        Recommendation to SEC and CFTC                                             138
                        Agency and Industry Comments and Our Evaluation                            138

Appendixes              Appendix I: Methodology for GAO Survey of End-Users                        144
                        Appendix II: GAO Survey of Sales Practices for OTC Derivatives,            176
                          Structured Notes, and Asset-Backed Securities
                        Appendix III: Comments From the Board of Governors of the                  190
                          Federal Reserve System
                        Appendix IV: Comments From the Office of the Comptroller of                194
                          the Currency
                        Appendix V: Comments From the Securities and Exchange                      195
                          Commission




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




         Appendix VI: Comments From the End-Users of Derivatives                    201
           Association
         Appendix VII: Comments From the Government Finance Officers                204
           Association
         Appendix VIII: Comments From the International Swaps and                   216
           Derivatives Association
         Appendix IX: Comments From the National Association of State               226
           Auditors, Comptrollers and Treasurers
         Appendix X: Major Contributors to This Report                              230

Tables   Table 3.1: Status of Investigations of Dealers by SEC, NASD, and            75
           NYSE From 1993 Through 1996 for Cases Involving MBS and
           Structured Notes
         Table 3.2: Complaints Received by Regulators From 1993                      76
           Through 1996 Involving MBS Sales Practices and Total
           Complaints for All Products
         Table 4.1: Key Sales Practice Elements of the Dealer-Issued                 90
           Guidance
         Table 5.1: Key Elements of Various Organizations’ Investment               117
           Guidance for End-Users
         Table I.1: Design of Potential End-User Sample Frame                       146
         Table I.2: Disposition of Survey Sample Across All Strata                  156
         Table I.3: Proportion of Organizations Using OTC Derivatives in            163
           the 12 Months Preceding Receipt of Survey, by Size Category and
           Industry Group
         Table I.4: Proportion of Estimated Total Users Represented by              164
           Each Industry Group
         Table I.5: Proportion of Organizations Using Plain Vanilla OTC             165
           Derivatives, by Size Category and Industry Group
         Table I.6: Proportion of Organizations Using More Complex OTC              166
           Derivatives, by Size Category and Industry Group
         Table I.7: Proportion of Organizations Using MBS, by Size                  167
           Category and Industry Group
         Table I.8: Proportion of Organizations Using Structured Notes, by          168
           Size Category and Industry Group
         Table I.9: Proportion of Organizations Rating Overall Sales                169
           Practices for Dealers Used, by Product Offered
         Table I.10: Proportion of Organizations Rating Overall Sales               169
           Practices for Dealers Not Used, by Product Offered




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




          Table I.11: Proportion of Organizations Somewhat or Very                    170
            Dissatisfied With Disclosure of Downside Risks or Suitability of
            Products Proposed, by Dealers Used and Not Used
          Table I.12: Proportion of End-Users of a Product Who Believed a             172
            Fiduciary Relationship Exists
          Table I.13: Proportion of End-Users of a Product Who Believed a             173
            Fiduciary Relationship Exists in Some or All Cases, by Industry
            Group
          Table I.14: Proportion of all End-Users of a Product That Relied            174
            on the Dealer for Investment Advice


Figures   Figure 3.1: Overall Sales Practice Ratings Reported for Dealers              59
            Used and Dealers Not Used, by Product
          Figure 3.2: Extent of Reported Product Usage Across the                      65
            Potential User Population
          Figure 3.3: Extent of Reported Product Usage, by Organization                66
            Size
          Figure 3.4: Extent of Reported Product Usage, by Industry                    68
          Figure 4.1: Extent to Which End-Users Believed Dealers Had a                 85
            Fiduciary Relationship
          Figure 4.2: Extent to Which End-Users Relied on Dealers for                  87
            Investment Advice




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




Abbreviations

CEA        Commodity Exchange Act
CFTC       Commodity Futures Trading Commission
CMO        collateralized mortgage obligation
EUDA       End-Users of Derivatives Association
GFOA       Government Finance Officers Association
GSE        government-sponsored enterprise
ISDA       International Swaps and Derivatives Association
LDT        leveraged derivative transaction
MBS        mortgage-backed security
NASAA      North American Securities Administrators Association
NASACT     National Association of State Auditors, Controllers and
                 Treasurers
NASD       National Association of Securities Dealers
NAST       National Association of State Treasurers
NYSE       New York Stock Exchange
OCC        Office of the Comptroller of the Currency
OTC        over-the-counter
REMIC      real estate mortgage investment conduit
RSWG       Risk Standards Working Group
SEC        Securities and Exchange Commission
SRO        self-regulatory organization
TMA        Treasury Management Association


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

Introduction


                  In 1994, we reported on a number of risks associated with the use of
                  over-the-counter (OTC) derivatives,1 but we did not specifically address
                  sales practice issues. However, since the beginning of 1994, major legal
                  and regulatory actions have been associated with sales practices for OTC
                  derivatives, mortgage-backed securities (MBS), and structured notes,
                  suggesting that the topic deserved closer scrutiny. In addition, we found
                  that an estimated $11.4 billion in reported losses resulted from
                  transactions in such products from April 1987 through March 1997—about
                  $3.2 billion of which involved end-user2 concerns about dealer3 sales
                  practices.4 Federal financial market regulators have an interest in these
                  markets as a part of their responsibilities for ensuring the soundness of
                  regulated financial institutions and maintaining the efficiency and stability
                  of U.S. financial markets. In response to a request by the former Chairman
                  of the Subcommittee on Telecommunications and Finance, House
                  Committee on Energy and Commerce, we reviewed sales practices for OTC
                  derivatives. Because users of MBS and structured notes had also
                  experienced losses that sometimes involved sales practice disputes, we
                  expanded our review to include these products.


                  OTC derivatives contracts are privately negotiated outside of an organized
OTC Derivatives   exchange and have a market value determined by the value of an
                  underlying asset, reference rate, or index (called the underlying).
                  Underlyings include stocks, bonds, agricultural and other physical
                  commodities, interest rates, currency exchange rates, and stock indexes.
                  OTC derivatives are customized to satisfy specific end-user requirements
                  that cannot always be met by the typically more standardized




                  1
                   See Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,
                  1994). We reported on the status of our recommendations in Financial Derivatives: Actions Taken or
                  Proposed Since May 1994 (GAO/GGD/AIMD-97-8, Nov. 1, 1996).
                  2
                   For simplicity, we use the term “end-user” to refer to counterparties or customers of dealers in
                  transactions involving OTC derivatives, MBS, and structured notes.
                  3
                   Dealers stand ready to act as buyers, sellers, counterparties, or intermediaries for end-users and other
                  dealers.
                  4
                   See chapter 3 for a discussion of how we estimated the amount of reported losses and the amount of
                  such losses associated with concerns about dealer sales practices.



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




           exchange-traded derivatives, which include futures5 and options6
           contracts. Although the economic terms of OTC derivatives are privately
           negotiated, counterparties commonly elect to use standardized contract
           language contained in master agreements, such as those developed by the
           International Swaps and Derivatives Association (ISDA).7

           Both OTC and exchange-traded derivatives are used by firms around the
           world to manage market risk8 by transferring it from entities less willing or
           able to manage it to those more willing and able to do so. In transferring
           this risk, OTC derivatives counterparties, unlike their U.S. exchange-traded
           counterparts,9 typically remain subject to credit risk—the risk of
           counterparty default. Derivatives can be more cost-effective for market
           participants than transactions in the underlying cash markets because of
           the reduced transaction costs and the leverage10 that derivatives provide.
           These benefits do not come without risk because using OTC derivatives,
           similar to using other financial products, can result in losses from adverse
           market movements, credit defaults, or operations errors.

           As discussed in the following sections, the basic types of OTC derivatives
           are forwards, options, and swaps. These basic products can be combined
           with each other in a multitude of ways or with other financial products to
           create more complex OTC derivatives.


Forwards   Forwards are OTC contracts that obligate the holder to buy or sell a
           specific underlying at an agreed-upon price, quantity, and date in the
           future. The price of each forward contract may be agreed upon in advance

           5
            Futures contracts obligate the holder to buy or sell a specific amount or value of an underlying asset,
           reference rate, or index at a specified price on a specified future date.
           6
            Options (American-style) give the purchaser the right, but not the obligation, to buy (call option) or
           sell (put option) a specified quantity of a commodity or financial asset, or to settle for its cash value, at
           a particular price (the exercise or strike price) on or before a specified future date. For this right, the
           purchaser pays the seller (writer) an amount called the option premium. A European-style option can
           only be exercised on its expiration date. Options may be traded on an exchange or OTC.
           7
            ISDA is a trade association that represents 318 members worldwide. Its primary membership includes
           183 dealers.
           8
            Market risk is the exposure to the possibility of financial loss caused by adverse changes in the values
           of assets or liabilities.
           9
            For exchange-traded derivatives, credit risk is borne by clearinghouses that serve as intermediaries
           between the parties to all transactions by becoming the buyer to every seller and the seller to every
           buyer. Clearinghouses guarantee the performance of exchange-traded contracts so that parties to
           these transactions do not have to evaluate the creditworthiness of each other.
           10
             Leverage is possible when the capital needed to own, control, or receive financial gains from an
           investment is less than the investment’s full value. Derivatives provide leverage because they require
           less capital than that needed to directly participate in the underlying markets. Greater leverage results
           in the possibility of greater gains or losses relative to capital.
           Page 27                                              GAO/GGD-98-5 OTC Derivatives Sales Practices
                    Chapter 1
                    Introduction




                    or determined at the time of delivery. Forward contracts exist for many
                    underlyings, including traditional agricultural or physical commodities, as
                    well as for currencies (referred to as foreign exchange forwards) and
                    interest rates (referred to as forward rate agreements). Market
                    participants can use forwards to protect their assets and liabilities against
                    the risks associated with rate and price movements, called hedging, or to
                    profit from correctly anticipating rate and price movements. Generally,
                    counterparties to forwards intend either to make or take delivery of the
                    underlying.


OTC Options         OTC options are privately negotiated contracts that can be used for hedging
                    or to profit from correctly anticipating rate and price movements. OTC
                    option contracts also exist for many underlyings, including commodities,
                    currencies, interest rates, and equities. Like other OTC derivatives, OTC
                    options are designed to satisfy specific end-user requirements because
                    specific terms, such as the exercise price, maturity date, and type of
                    underlying, are negotiated.


Swaps               Swaps are OTC agreements that typically require counterparties to make
                    periodic payments to each other for a specified period. The calculation of
                    these payments is based on an agreed-upon amount, called the notional
                    amount, that generally is exchanged only in currency swaps.11 The
                    periodic payments may be a fixed or floating (variable) amount. Floating
                    payments may change with fluctuations in interest or currency rates or
                    equity or commodity prices, depending on the contract terms. Swaps are
                    used to hedge a risk or obtain more desirable financing terms, and they
                    can be used to profit from correctly anticipating rate and price
                    movements.


Plain Vanilla OTC   The simplest derivatives, such as the basic forwards, options, and swaps
Derivatives         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




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



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




                   spread12—tends to be narrow. Furthermore, large transactions can be
                   executed through one dealer at a single price. Therefore, through the
                   availability of dealers, liquidity is provided for plain vanilla OTC derivatives.
                   Although no official data are available, according to some dealers, plain
                   vanilla OTC derivatives account for 80 to 90 percent of all OTC derivatives
                   activity.


More Complex OTC   In contrast to plain vanilla OTC derivatives, the more complex OTC
Derivatives        derivatives have features that may make them more difficult to value.
                   Their values may be based on, or derived from, more than one underlying
                   asset, reference rate, or index. An example of a more complex OTC
                   derivative is a “rainbow call option,” whose value is based on the highest
                   1-year yield available from among four underlyings—cash, the 10-year U.S.
                   Treasury note, the 30-year U.S. Treasury bond, and the Standard & Poor’s
                   500 Index.13 Unlike plain vanilla interest rate swaps in which the notional
                   amount remains constant to maturity, this amount may change during the
                   life of more complex swaps. Some OTC derivatives may be complex
                   because they contain, or have embedded in them, other derivatives—for
                   example, a swap with an embedded option that grants the holder the right,
                   but not the obligation, to terminate the swap contract at some future time.
                   Complex OTC derivatives may have other features, such as a multiplier that
                   magnifies the effect of a price movement in the underlying.

                   In contrast to plain vanilla OTC derivatives, more complex OTC derivatives
                   are offered by fewer dealers, or they may even be the creation, or
                   proprietary product, of one dealer. Fewer dealers means less liquidity and
                   wider bid-ask spreads, making it more difficult to offset14 or unwind15 an
                   earlier transaction at a favorable price. Also, an end-user may find it
                   difficult to independently determine the price or value of a complex OTC
                   derivative that has very complicated terms or that is the proprietary
                   product of one dealer. End-users may attempt to determine the market
                   price of OTC derivatives on the basis of a model. However, the resulting

                   12
                    The bid-ask spread is the difference between the highest price a buyer will pay and the lowest price a
                   seller will accept for a particular product.
                   13
                     The Standard & Poor’s 500 Index measures the performance of 500 common stocks.
                   14
                     Offset of an OTC derivatives contract occurs when a market participant enters into an equal but
                   opposite contract. Entering into an equal but opposite contract with the same counterparty eliminates
                   the market and credit risks associated with the original contract. Doing so with a different
                   counterparty eliminates the market risk but not the credit and other risks associated with carrying two
                   contracts.
                   15
                     Unwind of an OTC derivatives contract occurs when the counterparties agree to settle or terminate
                   the original contract or assign one party’s contractual obligations to a new party.



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




                  price may not correspond closely to what would actually occur in the
                  marketplace, assuming a buyer or seller could be found. The large fees
                  that some more complex OTC derivatives transactions generate are an
                  economic incentive for dealers to develop new products and refine
                  existing products developed by other dealers.


                  MBS are debt securities that are created from residential mortgages. They
Mortgage-Backed   are backed (collateralized) by pools (groups) of mortgages, most of which
Securities        are 30-year obligations.16 The process of pooling mortgages and using
                  them to back a new issue of securities is called securitization.17 Investors
                  in MBS are entitled to receive a portion of the interest and principal
                  payments generated by the mortgage pool. MBS provide funds to the
                  mortgage market by enabling mortgage lenders to sell the mortgages that
                  they originate, thereby replenishing their funds for additional mortgage
                  lending. MBS effectively expand funds available for housing by attracting
                  investors in mortgage loans.

                  MBS consist of mortgage pass-through securities (also called
                  mortgage-backed certificates) and collateralized mortgage obligations
                  (CMO).18 Mortgage pass-through securities entitle investors to share on a
                  pro rata basis in all principal and interest payments received from the
                  mortgage pool. CMOs, which are a form of multiple-class securities, entitle
                  investors to share in principal and interest payments in accordance with a
                  payment schedule. The payment schedule may divide the mortgage pool
                  into classes, called tranches, and specify the order in which the tranches
                  are to receive principal and interest payments. CMO tranches receiving the
                  earliest payments, by design, contain less risk than is found in simple
                  mortgage pass-through securities. However, the creation of these relatively


                  16
                   Mortgages may be pooled according to a common characteristic such as their maturity date, as in a
                  pool of 30-year mortgages.
                  17
                    Technically, MBS are a subset of asset-backed securities, which is a term that is used to describe
                  securities created from securitized assets. In addition to mortgages, other types of assets that are
                  securitized in creating asset-backed securities include auto loans, credit card receivables, equipment
                  leases, and corporate bonds. Because market participants distinguish MBS from all other asset-backed
                  products, this report follows that convention.
                  18
                    The term “CMO” is commonly used to refer to both CMOs and real estate mortgage investment
                  conduits (REMIC). Unlike other CMOs, REMICs allow investors to select securities containing the
                  desired levels of risk. This greater selection is possible because REMIC mortgage pools are separated
                  by maturity and credit risk classes, while other CMO mortgage pools are separated only by maturity
                  class. REMIC mortgage pools may contain mortgages of lesser credit quality, while other CMO
                  mortgage pools generally consist of top quality mortgages. As a result, REMICs receive a range of
                  credit ratings, whereas other CMOs normally receive the highest ratings. The overwhelming majority
                  of multiple-class MBS are REMICs.



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




                   safe and stable tranches requires the creation of more risky tranches that
                   can be highly volatile in price.


                   Structured notes are debt securities19 that combine elements of traditional
Structured Notes   debt instruments and OTC derivatives.20 Interest payments for traditional
                   debt instruments are generally either a stated fixed amount or a variable
                   amount that is based on fluctuations in a specified interest rate. In
                   contrast, the interest and/or principal payments for structured notes may
                   be linked to two or more specified interest or currency rates, or to equity
                   or commodity prices. Structured notes may contain precise formulas
                   describing how these payments are tied to such rates and prices and how
                   they are to be computed. For example, a more complex type of structured
                   note, the inverse floater (also called an inverse floating rate note) pays
                   investors a rate of interest that moves in the opposite direction of a
                   specific market interest rate. Because its value tends to move in the
                   opposite direction of other debt instruments, the inverse floating rate is
                   often used for hedging. Inverse floating rate notes typically contain
                   options that effectively set maximum and minimum rates that will be paid
                   to holders.

                   Structured notes may also have OTC derivatives embedded in them, such as
                   forwards, options, and swaps. By combining debt and OTC derivatives into
                   a single product, structured notes can provide a more efficient and
                   economic means of managing certain risks than debt and OTC derivatives
                   as separate products. For example, a company can, by purchasing a
                   structured note, limit its credit risk to one party (the issuer) and limit its
                   risk management costs to one product.

                   Structured notes can be attractive both to investors and issuers. They can
                   be customized to meet investors’ preferences for risk and return. Such
                   customization, which is hard to replicate with traditional debt securities,

                   19
                     To the extent that structured notes are hybrid financial instruments, they can be futures or
                   commodity option contracts if they do not meet the terms and conditions of the Commodity Futures
                   Trading Commission’s hybrid instrument exemption (17 C.F.R. Part 34). A hybrid financial instrument
                   possesses, in varying combinations, characteristics of forwards, futures, options, securities, and/or
                   bank deposits. Unlike many other derivatives, hybrid financial instruments generally serve a
                   capital-raising function. For the purpose of this report, we assume that structured notes meet the
                   conditions of the Commodity Futures Trading Commission’s hybrid instrument exemption and,
                   therefore, are securities and not futures.
                   20
                     A universally accepted definition of structured notes does not exist. For example, the Federal
                   National Mortgage Association and the Federal Home Loan Bank (the central credit system for savings
                   and loan institutions) differ on the types of callable debt they consider to be structured notes. Also,
                   certain other market participants consider all callable debt to be structured notes because the callable
                   feature is an embedded call option.



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




                       can be attractive to investors seeking to hedge their unique risks or
                       possibly earn greater returns than those offered by traditional debt
                       securities.21 The customization is not needed by issuers but is offered to
                       attract investors. Structured notes can be attractive to issuers seeking to
                       lower their cost of capital through access to cheaper financing sources.
                       However, the customized features, though attractive to investors, can
                       contain rate and price risks that are unwanted by the issuer. To offset such
                       unwanted risks, issuers can enter into swaps or options with dealers at the
                       time of issuance. Structured notes are generally of high credit quality
                       because most are issued by highly rated (AAA/Aaa or AA/Aa)22
                       corporations or government-sponsored enterprises (GSE)23 and, therefore,
                       are considered by market participants to have minimal credit risk.


                       Growth in the OTC derivatives market has continued since 1993 because of
OTC Derivatives,       the popularity of plain vanilla products, which continue to dominate the
MBS, and Structured    market relative to more complex products. In contrast, the MBS market and
Note Markets’ Growth   the largest segment of the structured note market experienced significant
                       declines between 1993 and 1995, but they are now showing signs of
and Participants’      recovery. OTC derivatives market participants include dealers and
Activities             end-users. In addition to these participants, the MBS and structured note
                       markets include issuers and underwriters. Various types of financial
                       institutions market OTC derivatives, MBS, and structured notes.


Market Growth          According to the most recent global survey by the Bank for International
                       Settlements,24 the notional/contract amount outstanding of OTC derivatives
                       was estimated at $47.5 trillion worldwide and $11 trillion in the United




                       21
                        Structured notes also may be preferred by some market participants over traditional debt and
                       derivatives because of certain accounting, regulatory, or tax considerations that are beyond the scope
                       of this report.
                       22
                        According to major credit rating agencies—Standard & Poor’s and Moody’s—AAA/Aaa are the
                       highest credit ratings, indicating that the capacity to repay debt is extremely strong. AA/Aa indicate a
                       very strong capacity to repay, differing from AAA/Aaa by only a small degree.
                       23
                         GSEs are privately owned financial intermediaries established pursuant to federal law to facilitate
                       lending for purposes that the federal government has deemed socially important, such as education,
                       agriculture, and housing.
                       24
                        The Bank for International Settlements, among other functions, provides a forum for cooperative
                       efforts by the central banks of major industrial countries.
                       Page 32                                            GAO/GGD-98-5 OTC Derivatives Sales Practices
                           Chapter 1
                           Introduction




                           States, as of March 31, 1995.25 MBS issuances26 grew from $371 billion in
                           1990 to a peak of $991 billion in 1993. MBS issuances then declined 45
                           percent between 1993 and 1994 to $541 billion and declined another 40
                           percent between 1994 and 1995 to $326 billion. However, total issuances
                           for 1996 grew to $474 billion.

                           Structured note issuances grew each year between 1990 and 1994, which is
                           the last year for which we were able to obtain estimates for corporations.27
                           Structured note issuances for both GSEs and corporations were estimated
                           to be $18 billion in 1990 and $92 billion in 1994. Structured note issuances
                           by GSEs alone were estimated to be $44 billion in 1993. In 1994, they were
                           estimated to be $40 billion and accounted for 43 percent of the estimated
                           structured note issuances for that year. However, in 1995, GSE-issued
                           structured notes declined by 75 percent to $10 billion. This decline was
                           consistent with the significant drop in overall structured note activity that
                           market participants told us they experienced or witnessed that year. In
                           1996, GSE-issued structured notes, though still below the peak reached in
                           1993, increased to $12 billion.


The Nature and Extent of   MBS and structured notes are similar to other securities, such as stocks and
Issuer, Underwriter, and   bonds, in that they are issued—created and sold to investors—to raise
Dealer Activities          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

                           25
                             Central Bank Survey of Foreign Exchange and Derivatives Market Activity 1995, Monetary and
                           Economic Department, Bank for International Settlements (Basle, Switzerland: May 1996). The Bank
                           for International Settlements conducts this comprehensive survey every 3 years and these amounts
                           represent the most current data available. As previously discussed, the notional amount does not
                           measure the amount at risk in derivatives transactions. According to the Federal Reserve, the amount
                           at risk, as measured by the gross market value of OTC derivatives outstanding, was $328 billion for
                           U.S. entities, as of March 1995, or about 3 percent of the notional/contract amount. (The gross market
                           value is the cost that would be incurred if the outstanding contracts were replaced at prevailing
                           market prices.)
                           26
                             Issuances are not the same as trading volume. Issued securities are counted only once in issuance
                           statistics, but may be counted more than once in trading volume to reflect each change in ownership.
                           27
                             The data do not include structured notes issued by foreign corporations and foreign banks,
                           structured certificates of deposit, structured commercial paper, or structured notes issued in the
                           European medium-term note market. Our data sources were Bloomberg Financial Markets and the
                           Journal of Applied Corporate Finance.


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




                            the securities are not sold to other dealers or investors, the firms
                            underwriting the issue will own the unsold portion of the issuance.
                            Underwriters can also agree to offer securities on a “best efforts” basis,
                            whereby any portion of the issuance that is not purchased by other dealers
                            or investors is returned to the issuing entity.


Various Types of            Dealers from various industries market OTC derivatives, MBS, and
Institutions Actively       structured notes. Data on the total number of banks, securities firms, and
Market OTC Derivatives,     other dealers of OTC derivative products were not available. In the United
                            States, banks account for the majority of OTC derivatives volume. In 1996,
MBS, and Structured Notes   the top 10 bank holding companies28 in terms of assets, all of which
                            market these products, accounted for about 94 percent of the total volume
                            of OTC derivatives held by all banks. Regulated broker-dealers market OTC
                            derivatives.29 In addition, the affiliates of some securities firms actively
                            market nonsecurities OTC derivatives, with the affiliates of six of the
                            largest firms being the most active. Insurance company affiliates are also
                            somewhat active, with three affiliates actively marketing nonsecurities OTC
                            derivatives in volumes comparable to that of some of the securities firm
                            affiliates. Together, these dealers conduct thousands of OTC derivatives
                            transactions annually. Complete statistics are not available on the total
                            number of dealers marketing MBS and structured notes, but regulators
                            estimated that hundreds of financial institutions market these products.
                            Securities firms account for the largest volumes, but banks and bank
                            affiliates also market MBS and structured notes.


                            The sales practices that dealers use to market OTC derivatives, MBS, and
Sales Practices for         structured notes can involve various activities. For example, in discussing
OTC Derivatives,            potential transactions, dealers may attempt to determine whether a
MBS, and Structured         particular product is appropriate or suitable for the end-user by
                            considering several factors, such as the product’s complexity relative to
Notes                       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

                            28
                              Bank holding companies are corporations that own one or more banks.
                            29
                              Broker-dealers are agents that handle public orders to buy and sell securities. They act as principals
                            that buy and sell securities for their own accounts.



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




                        included as a part of the confirmation materials that document the
                        transaction.

                        Another aspect of marketing these products is the establishment of the
                        transaction price. The transaction price is usually negotiated between the
                        dealer and the end-user and can be influenced by market conditions and
                        other factors, including whether the end-user has other business
                        transactions with the dealer, such as loans or securities underwriting.
                        After a transaction is entered into, the dealer may be asked to periodically
                        assist the end-user in determining the current value of the product.
                        End-users are less likely to need such assistance for plain vanilla OTC
                        derivatives that have readily available dealer price quotes or for certain
                        MBS products that have an active secondary market. Dealers may also be
                        asked to unwind an OTC derivatives contract, and this may require one
                        party to pay the other an amount representing any change in the contract’s
                        market value.

                        The nature of the relationship and expectations between dealers and
                        end-users can vary, depending on the product involved. OTC derivatives
                        transactions create obligations between counterparties that continue over
                        the life of the contracts, and thus involve counterparty credit risk. Because
                        of counterparty credit risk, dealers and end-users of OTC derivatives
                        usually seek to enter into transactions with credit-worthy counterparties.
                        Such creditworthiness concerns are important because the counterparties
                        to a swap, for example, are obligated to exchange periodic payments over
                        the life of the contract. Therefore, until the contract matures, each party is
                        at risk that the other may not fully meet its obligations. In contrast, some
                        securities transactions, including those in MBS and structured notes,
                        involve a change in ownership, and thus no additional obligations would
                        exist between the dealer and end-user.


                        The dealers of OTC derivatives, MBS, and structured notes may be subject to
Various Regulators      oversight by various federal or other regulatory bodies.30 Bank dealers are
Oversee the Dealers     generally overseen by either the Federal Reserve System, which oversees
Marketing OTC           the bank holding companies and state-chartered banks that are its
                        members, or the Office of the Comptroller of the Currency (OCC), which
Derivatives, MBS, and   oversees nationally chartered banks. Of the 10 largest bank OTC derivatives
Structured Notes        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

                        30
                         State agencies also oversee banking, securities, and insurance activities, although this report does
                        not address such oversight in detail.



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




entities to conduct securities activities, including marketing MBS and
structured notes, and these entities are also subject to oversight by the
Securities and Exchange Commission (SEC). Banks can also conduct
limited securities activities—primarily in securities issued by the U.S.
government, GSEs, or certain state or local governments—from the banking
entity itself.

As previously noted, the activities of dealers marketing OTC derivatives
that are securities as well as those marketing MBS and structured notes are
overseen by SEC. The activities of dealers marketing OTC derivatives that
are determined to be futures are subject to the Commodity Futures
Trading Commission’s (CFTC) oversight. Firms that market securities must
do so from an entity registered with SEC and subject to various regulations,
such as regulations requiring minimum levels of capital. In addition, firms
offering futures and commodity options to the public must register with
CFTC and comply with the Commodity Exchange Act (CEA) and regulations
promulgated under the act, unless otherwise exempted.

Registered securities and futures firms are also required to join and
subject themselves to the rules and requirements of a self-regulatory
organization (SRO).31 Such SROs also impose sales practice-related
requirements on their members. Most OTC derivatives are not considered
to be securities or futures by the dealers offering them. Nonsecurities and
nonfutures activities may be conducted in a subsidiary separate from the
regulated entity. Consequently, securities and futures firms typically
conduct their nonsecurities and nonfutures OTC derivatives activities
outside of their registered entities in affiliates that are not subject to SEC or
CFTC regulation. CFTC has also exempted swaps and certain other OTC
derivatives from the requirement that such activities be conducted in an
affiliate subject to its regulation, but CFTC has retained the authority to
take action against fraudulent conduct involving exempted products that
are futures. (Ch. 2 discusses the regulatory framework for OTC derivatives,
MBS, and structured notes in greater detail.)


In addition to working individually, the federal financial market regulators
also work collectively to address issues relating to the financial markets.
The heads of the Department of the Treasury, CFTC, the Federal Reserve,
and SEC comprise the President’s Working Group on Financial Markets.
Staffs from OCC and other regulatory agencies also participate in this
group’s activities. The Working Group was established after the 1987

31
  SROs play an extensive role in the regulation of the U.S. securities and futures industries. SROs
include all of the U.S. securities and commodities exchanges, the National Association of Securities
Dealers, the National Futures Association, and the Municipal Securities Rulemaking Board.



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




                     market crash to address issues concerning the competitiveness, integrity,
                     and efficiency of the financial markets, and it is chaired by the Secretary of
                     the Treasury. The Working Group meets periodically to share information
                     and to coordinate regulatory policies and activities, and it also meets on
                     those matters relating to OTC derivatives.


                     To address congressional concerns associated with sales practices for OTC
Objectives, Scope,   derivatives, MBS, and structured notes, our objectives were to analyze
and Methodology      (1) the federal sales practice requirements applicable to these products
                     and the dealers marketing them; (2) the extent of end-user satisfaction
                     with sales practices, product use, and related disputes and the costs of
                     these disputes; (3) the views of end-users and dealers on the nature of
                     their relationship and responsibilities; (4) the actions dealers and
                     end-users have taken to reduce the potential for sales practice disputes;
                     and (5) the actions regulators have taken to address sales practice issues.

                     To analyze federal sales practice requirements applicable to these
                     products and the dealers marketing them, we reviewed federal laws and
                     regulations related to sales practices and discussed them with federal
                     financial market regulators. We also reviewed the proposed and final rule
                     issued jointly by the three federal bank regulators32 regarding bank sales
                     of government securities, which include MBS and structured notes issued
                     by GSEs. In addition, we reviewed the sales practice guidance provided by
                     federal bank regulators for their examiners and the dealers they oversee.

                     To analyze the extent of end-user satisfaction with sales practices
                     involving OTC derivatives, MBS, and structured notes, we sent
                     questionnaires to the financial officers of nearly 2,400 randomly selected
                     U.S. organizations in 1995.33 Using the best information we could identify,
                     we constructed a universe of over 49,000 public-sector and private-sector
                     U.S. organizations that might be using these products,34 including not only
                     the largest organizations, which were determined on the basis of financial


                     32
                      The three federal commercial bank regulators are the Federal Deposit Insurance Corporation (which
                     oversees state-chartered banks that are not members of the Federal Reserve System), the Federal
                     Reserve System, and OCC.
                     33
                       Our survey also included a request for data on asset-backed securities, but because of the relative
                     absence of reported sales practice problems associated with these products, we do not report our
                     survey results for these products, except when they cannot be separated from those for MBS. See
                     appendix I for more details on the survey design, methodology, and results, and see appendix II for a
                     reprint of the survey questionnaire.
                     34
                      See appendix I for a discussion of how we determined which organizations might be using OTC
                     derivatives, MBS, and structured notes.



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




or other measures of size, but also the smaller organizations in each
industry. Our sample was drawn from 19 populations of such
organizations. Some of these 19 populations were divided into 2 or more
strata on the basis of an appropriate measure of organization size—such
as assets, revenues, student enrollment, or census counts. Our
questionnaire requested data on the use of these products within the 12
months preceding the survey.

Our questionnaire asked organizations to rate the sales practices of
dealers with whom they entered into contracts across the following six
dimensions: (1) disclosure of downside risks, (2) quality of transaction
documentation provided, (3) suitability of products proposed,
(4) competitiveness of pricing and fees, (5) provision of accurate
mark-to-market35 pricing information, and (6) assistance in unwinding
transactions. Our questionnaire also asked the organizations to separately
rate the sales practices of dealers that proposed contracts but who they
did not use for the three applicable dimensions listed above—(1), (3), and
(4). We developed these sales practice dimensions on the basis of reviews
of regulatory and dealer documents and discussions with regulators,
dealers, and end-users. We also asked the organizations to provide overall
ratings of sales practices both for dealers with whom the organizations
entered into contracts as well as dealers that proposed contracts but who
they did not use.

To analyze the extent of product use, we evaluated the approximately
1,800 responses received to our questionnaire. We developed statistically
valid estimates of the extent of each product’s use across all 19
populations, subject to a 95-percent confidence level, unless otherwise
indicated. We compared our results to regulatory data and 27 other recent
studies that reported rates of OTC derivatives usage. We also compared our
survey results regarding the reasons derivatives were used to studies by
other organizations.

To analyze the extent of sales practice disputes between end-users and
dealers and the costs of these disputes, we collected data on investigations
by securities regulators and on complaints these organizations received in
the 4-year period from January 1993 through December 1996. We also
reviewed reports and findings of federal regulators and state audit
departments for cases where an end-user incurred a loss and subsequently
alleged deficient dealer sales practices. Additionally, we used public and

35
  Marking to market is the practice of periodically adjusting the valuation of an asset or liability to
reflect current market values.



Page 38                                             GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1
Introduction




nonpublic information to compile a list of entities that were known to
have incurred losses on OTC derivatives, MBS, or structured notes, and we
attempted to identify those cases where sales practice allegations had
been raised.

To analyze the views of end-users and dealers on the nature of their
relationship and responsibilities, we evaluated the responses of survey
respondents who reported being satisfied as well as those who expressed
being dissatisfied with dealer sales practices. We also interviewed by
telephone 50 survey respondents, including about one-half of whom
expressed satisfaction and about one-half of whom expressed general
dissatisfaction with dealer sales practices. The respondents were
judgmentally selected from the industries we surveyed to include large
and small organizations and users of OTC derivatives, MBS, and structured
notes as well as nonusers that had heard sales presentations. The
interviews were performed, among other reasons, to learn more about
(1) why end-users were satisfied or dissatisfied with dealer sales practices
and (2) what opinions end-users had on fiduciary relationships.

In addition, we analyzed two sets of voluntary guidance prepared by two
dealer groups that address sales practice issues. We also reviewed
comments on this voluntary guidance made by end-user associations, legal
experts, the U.S. Department of Labor, and others. Finally, we attended
industry conferences; reviewed conference documents, court cases, and
congressional testimony; and interviewed dealer, end-user, and federal and
state regulatory officials regarding the relationship and responsibilities of
dealers and end-users in OTC derivatives transactions.

To analyze the actions that dealers and end-users have taken to reduce the
potential for sales practice disputes, we interviewed 14 dealers active in
marketing OTC derivatives, MBS, and structured notes, including securities
firms, banks, and insurance companies; 15 small, medium, and large
end-users; 11 dealer and end-user associations; and 5 U.S. federal
regulators. We interviewed the end-users and dealers regarding their
internal controls and the practices they used to reduce the likelihood of
sales practice disputes. In addition, we reviewed studies by other
organizations that surveyed end-user management practices and internal
controls for OTC derivatives, MBS, and structured notes. We also
interviewed regulators and reviewed regulatory examination results
regarding weaknesses they identified in policies, procedures, and
practices that could lead to sales practice disputes. Furthermore, we
reviewed end-user association guidance to members regarding the policies



Page 39                              GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 1
Introduction




and practices that should be in place before using these products. Finally,
we reviewed state legislation whose goal was to minimize the risks that
OTC derivatives, MBS, and structured notes pose to governments at the state
level or lower and that was enacted by 14 states between January 1994 and
September 1996.

To analyze the actions that regulators have taken to address sales practice
issues, we interviewed federal financial market regulators. We also
reviewed the examination reports and supporting workpapers for the
special examinations of the seven largest banks marketing OTC derivatives,
MBS, and structured notes. These special examinations were conducted by
OCC and the Federal Reserve from mid-1994 through mid-1995. We
reviewed the guidance provided by federal bank regulators for their
examiners and the dealers they oversee that addresses sales practices and
overall risk management responsibilities. We also reviewed congressional
testimony, examination policies, guidance, procedures, workpapers, and
reports pertaining to the marketing of these products.

We did our work in Chicago, Cincinnati, Dallas, Los Angeles, Minneapolis,
and Washington, D.C., between June 1994 and August 1997 in accordance
with generally accepted government auditing standards. We requested
comments on a draft of this report from the heads, or their designees, of
CFTC, the Department of the Treasury, the Federal Reserve Board, OCC, SEC,
the National Association of Securities Dealers (NASD), and the New York
Stock Exchange (NYSE). We also requested comments from the End-Users
of Derivatives Association (EUDA),36 the Government Finance Officers
Association (GFOA),37 ISDA, and the National Association of State Auditors,
Controllers and Treasurers (NASACT).38 The nontechnical comments from
these organizations are presented and evaluated at the end of chapter 7
and are reprinted along with additional responses in appendixes III
through IX.




36
 EUDA monitors and provides educational material to members on legal, tax, regulatory, and
accounting issues affecting OTC derivatives, GSEs, and financial institutions.
37
 GFOA represents approximately 13,000 finance officers from federal, state, provincial, and local
governmental entities in the United States and Canada.
38
  The National Association of State Auditors, Comptrollers and Treasurers represents the fiscal and
auditing professionsals of state governments and provides for information sharing, training, and policy
formulation.



Page 40                                           GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 2

Federal Sales Practice Requirements Vary by
Product and Dealer

               The federal sales practice requirements designed to protect end-users of
               OTC derivatives vary, depending, in part, on whether the specific product in
               question is a security, a futures contract, or neither product. If an OTC
               derivative falls within the definition of a security or futures contract, the
               transaction is subject to the applicable sections of the federal laws
               governing the sale of those products. Although it is not always clear which
               OTC derivatives fall within these definitions, SEC and CFTC agreed that one
               dealer’s sales practices related to certain OTC derivatives warranted action,
               and they cooperated in taking enforcement action against the dealer. If an
               OTC derivative is not covered by the federal securities or commodities
               laws, an end-user with a sales practice complaint would need to seek
               redress against a dealer by asserting primarily state statutory or common
               law claims.1 In contrast to OTC derivatives, MBS and structured notes are
               typically securities; therefore, their sale is subject to the federal securities
               laws, except when exempted from specific provisions.

               The sales practice requirements that a dealer must follow when marketing
               OTC derivatives in the United States also vary, depending on which
               regulator, if any, oversees its activities. If the dealer is a bank, all of its
               activities are subject to oversight by one of the federal regulatory agencies
               responsible for ensuring that banks are appropriately managing their risks.
               Unlike the requirements applicable to securities, which are intended to
               protect investors, the requirements placed on banks marketing OTC
               derivatives are intended primarily to limit the risk that such activities pose
               to a bank. Securities and futures firms, as well as insurance companies,
               that offer nonsecurities and nonfutures OTC derivatives typically do so
               from affiliates that are not subject to direct regulatory oversight.2
               However, should SEC or CFTC determine that a specific OTC derivatives
               transaction is a security or a futures contract, the transaction would be
               subject to the respective regulator’s jurisdiction, absent an agency
               exemption or a successful court challenge. Members of the President’s
               Working Group on Financial Markets have stated that the scope of SEC and
               CFTC authority and existing sales practice requirements are adequate to
               protect the markets and OTC derivatives end-users.




               1
                Common law is derived from judicial decisions, rather than from statute.
               2
                Firms would also typically market OTC derivatives that CFTC has exempted from most provisions of
               the CEA from these unregulated affiliates.



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                           The sales practice requirements designed to protect end-users of OTC
Sales Practice             derivatives vary. Some OTC derivatives are subject to the requirements
Requirements Vary,         found in the securities laws, including their antifraud provisions and SRO
Depending on the           rules. Some OTC derivatives may be subject to similar requirements found
                           in the laws applicable to futures trading in the United States. When federal
Product                    laws do not apply, disputes involving OTC derivatives would need to be
                           addressed by asserting primarily state statutory or common law claims,
                           such as fraud or breach of fiduciary duty. In comparison, dealers
                           marketing MBS and structured notes that are securities must comply with
                           the federal securities laws.


Some OTC Derivatives Are   OTC  derivatives that are securities are subject to the sales practice
Subject to the Federal     requirements in the federal securities laws that SEC administers. OTC
Securities Laws            derivatives that are considered to be securities include OTC options on
                           securities, including options on stock indexes. However, such OTC
                           derivatives represent a small portion of the overall volume of these
                           products. According to the most recent global survey by the Bank for
                           International Settlements, the notional amount of equity OTC
                           derivatives—which would include products either previously determined
                           or likely considered to be securities—was $579 billion, or 1.4 percent of
                           the total OTC derivatives contracts outstanding (net of local and
                           cross-border double-counting), at the end of March 1995. The gross market
                           value for equity derivatives was $50 billion, or 2.8 percent of the total OTC
                           derivatives contracts outstanding, at the end of March 1995. Although SEC
                           could not provide comparable data on the extent to which U.S.
                           broker-dealers market OTC derivatives that are securities, an SEC official
                           confirmed that the percentage of such U.S. firms’ activities were likely to
                           be similar to those identified in the Bank for International Settlements
                           survey.

                           The sale of any OTC derivative contract that is considered to be a security
                           is subject to the antifraud provisions of the securities laws that are
                           intended to protect customers and to foster market integrity by prohibiting
                           fraudulent conduct in securities transactions.3 A dealer can violate these
                           antifraud provisions by making material misstatements about the security
                           being recommended or misleading a customer by omitting information
                           material to the transaction. Under the authority granted by these laws, SEC
                           can act against dealers or their personnel for violating these provisions,
                           including imposing fines on them, restricting their activities, or revoking

                           3
                            As indicated in chapter 1, all of a firm’s activities in securities must be conducted in an affiliate
                           registered with SEC as a broker-dealer and subject to that agency’s oversight as well as to the rules
                           and oversight of one or more securities industry SROs.



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their registration. An end-user may also bring a civil action for a violation
of these laws and seek rescission (or undoing of the transaction) or
damages.

In addition to complying with the securities laws, dealers marketing OTC
derivative securities must comply with the requirements of the securities
industry SROs of which they are members.4 For example, NASD’s members
offering securities to the public must comply with its Conduct Rules.5
These rules, among other things, require that a dealer, before
recommending a product to an end-user, obtain and evaluate information
about the end-user’s financial condition and investment objectives to
ensure that the product is suitable. (A recently issued NASD rule
interpretation that discusses dealers’ responsibilities relating to
institutional end-users is discussed below.)

The extent to which some OTC derivatives are securities and, therefore,
subject to the securities laws is not always clear. SEC officials told us that,
as a matter of policy, the agency does not limit its authority by delineating
categories of OTC derivatives that are not securities. Relative certainty
exists for options on securities, which are considered to be securities
under the securities laws. For other OTC derivative products, case-by-case
determinations are made. SEC officials said that the agency responds, when
requested, to dealer inquiries about whether SEC would consider a specific
proprietary OTC derivative contract to be a security. In other cases, dealers
independently evaluate the characteristics of individual OTC derivative
products to determine whether the products meet the definition of a
security as defined in the securities laws. However, when dealers conduct
activities in products on the basis of their own determination that the
product involved is not a security, SEC or a court may later disagree with
their determination. Even if a product meets the definition of a security,
SEC officials told us that they can exempt products from various provisions
of the securities laws, although, according to agency officials, the agency
has never exempted any product from the antifraud provisions of these
laws.6




4
 These suitability requirements and SRO activities to enforce them are discussed in chapter 6.
5
 Until July 1996, these Conduct Rules were known as Rules of Fair Practice.
6
 Similarly, except for certain energy products, CFTC officials indicated that their agency has not
exempted any products from the antifraud provisions of the CEA.



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                           In cooperation with CFTC, SEC took action under the securities laws against
                           Bankers Trust,7 in 1994, for its conduct in transactions with Gibson
                           Greetings, Inc., involving two OTC derivatives contracts. In acting against
                           Bankers Trust, SEC found that the two transactions involved were
                           securities because they were options on U.S. Treasury securities.8
                           Accordingly, SEC found that Bankers Trust violated various sections of the
                           securities laws, including making false statements or omissions in the sale
                           of securities, supplying materially inaccurate valuations of derivatives
                           transactions, and failing to supervise marketing personnel.9


Some OTC Derivatives Are   Some OTC derivatives are subject to the CEA, which governs futures trading
Subject to the Federal     in the United States and which is administered by CFTC. U.S. firms offering
Commodities Laws           futures and certain options10 contracts to the public must register with
                           CFTC and comply with the CEA and regulations promulgated under the act
                           as well as with applicable SRO rules. The CEA provides various sales
                           practice-related requirements that must be adhered to by these and other
                           firms offering such products, unless otherwise exempted from such
                           requirements. When establishing accounts, firms are required by SRO rules
                           to obtain certain information pertaining to their customers’ financial
                           condition and trading experience. CFTC generally requires that firms make
                           certain disclosures about the risks of products and provide customers
                           with a standardized risk disclosure document before engaging in
                           transactions. The CEA also prohibits fraudulent conduct, including material
                           misstatements and omissions. CFTC can bring actions against firms for
                           violating the CEA. In addition, the CEA allows futures and options customers
                           to pursue private claims against a firm for fraud, but questions have been



                           7
                            SEC’s action was taken against Bankers Trust’s securities affiliate—BT Securities—as summarized in
                           Securities and Exchange Act Release No. 35136, dated December 22, 1994. Unless otherwise indicated,
                           in this report “Bankers Trust” refers to the parent firm—Bankers Trust New York Corporation, which
                           is a bank holding company—and two of its wholly owned subsidiaries—Bankers Trust Company,
                           which is a bank, and BT Securities Corporation, which is a securities broker-dealer.
                           8
                            The basis for CFTC’s action against Bankers Trust is discussed on pages 71 and 72.
                           9
                            Although SEC acted against Bankers Trust’s registered broker-dealer affiliate, it could not have taken
                           these sales practice actions unless the transactions in question were securities.
                           10
                             Such options include options on commodities, futures, and stock index futures traded on a board of
                           trade but do not include options on securities, securities indexes, or foreign currencies traded on a
                           national securities exchange. CEA section 2(a)(1)(B), which codified the Shad-Johnson Jurisdictional
                           Accord, excludes options on one or more securities from CFTC’s jurisdiction but provides CFTC with
                           jurisdiction over futures (and options thereon) on broadly based stock indexes. Options on securities
                           are regulated by SEC under federal securities laws. In addition, U.S. firms offering trade options are
                           not required to register with CFTC. Trade options are options that are offered to commercial
                           counterparties who enter into these transactions solely for purposes related to their business.



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raised about the application of the CEA’s fraud provisions to OTC derivatives
transactions.11

The extent to which some OTC derivatives are subject to the CEA is
uncertain.12 CFTC’s regulatory framework is focused primarily on the
oversight of exchange-traded futures and certain options and of
intermediaries engaging in such transactions on behalf of customers. CFTC
has issued regulations that allow trade options13 on commodities, except
on certain enumerated domestic agricultural commodities,14 to be traded
off-exchange. Forwards and certain OTC foreign-currency transactions are
excluded from regulation under the CEA,15 including its antifraud
provisions. In 1992, Congress granted CFTC the authority to exempt certain
OTC derivatives, including swaps, from almost all of the CEA’s provisions.16
Without determining that swaps were futures, CFTC issued a rule that
exempted eligible swaps from all but the CEA’s antifraud and
antimanipulation provisions.17 Although CFTC’s swaps exemption preserves
the CEA’s antifraud provisions, the provisions only apply to the extent that
swaps are found to be subject to the act.

As previously discussed, CFTC took a sales practice-related action, in
cooperation with SEC, against Bankers Trust for activities involving swaps

11
 For example, the judge in Procter & Gamble Co. v. Bankers Trust Co. and BT Sec. Corp., 925 F. Supp.
1270 (S.D. Ohio, May 9, 1996), concluded that Procter & Gamble could not bring a claim under section
4b of the CEA, the general antifraud provision. Section 4b prohibits fraud in connection with a futures
contract made “for or on behalf of any other person.” The judge concluded that Bankers Trust could
not act “for or on behalf of” the company because both were principals; therefore, the typical
customer-broker relationship did not exist.
12
 See The Commodity Exchange Act: Legal and Regulatory Issues Remain (GAO/GGD-97-50, Apr. 7,
1997).
13
  See 17 C.F.R. § 32.4 (1996).
14
 On June 9, 1997, CFTC issued an advanced notice of proposed rulemaking in the Federal Register
seeking comment on whether it should lift its ban on trade options on domestic agricultural
commodities.
15
 The forward exclusion is set forth in CEA section 1(a)(11). The Treasury Amendment excludes
certain OTC foreign-currency transactions from the CEA; this exclusion is set forth in CEA section
2(a)(1)(A)(ii). As discussed in our April 1997 report on the CEA, the scope of the Treasury Amendment
has been unclear.
16
  CFTC was granted the authority to exempt swaps meeting certain criteria and other OTC derivatives
traded among appropriate persons from the CEA by the Futures Trading Practices Act of 1992. See our
April 1997 report for a more detailed discussion of CFTC’s use of its exemptive authority and related
issues.
17
  These provisions do not cover the standardized risk disclosures that would otherwise be required
when marketing futures and options contracts subject to the CEA. See C.F.R. Part 35 (1996). In a
similar action, CFTC exempted certain energy contracts from the CEA’s antifraud provisions but not
from its antimanipulation provisions.



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                           and other products that are subject to the CEA exemption. In taking this
                           action, CFTC enumerated the transactions that were involved in the
                           violations but did not indicate whether it considered the transactions to be
                           futures or options contracts subject to the CEA. Instead, it asserted that
                           Bankers Trust, by its conduct, had assumed the role of a commodity
                           trading advisor18 and had violated the antifraud provisions of the CEA
                           governing such parties’ activities.


State Statutory and        To the extent that OTC derivatives are not covered by either the federal
Common Law Claims          securities or commodities laws, an end-user alleging sales practice
Would Be Asserted in       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
Disputes Involving OTC     duty.19 These claims, which are typically advanced in suits against dealers,
Derivatives That Are Not   are either tort20 or contract based. Although similar in certain respects,
Subject to Federal Laws    tort claims are based upon the existence of a special relationship that
                           creates a duty owed by the dealer to the end-user, while contract claims
                           are based upon the contractual relationship between the dealer and
                           end-user. Tort-based claims that are typically asserted by end-users
                           include claims of fraud and fraudulent concealment against dealers.
                           End-users may also assert a claim of breach of fiduciary duty. For such
                           claims, a derivatives dealer may have a duty to disclose material
                           information to an end-user if the court finds that an explicit or de facto
                           fiduciary relationship exists. End-users may also assert a claim that the
                           dealer’s alleged misstatements or omissions constitute a negligent
                           misrepresentation. In addition, other state law claims may be asserted. For
                           example, under New York law, the judge in the Procter & Gamble case
                           found that an implied contractual duty to disclose in business negotiations
                           exists when one party has superior knowledge not known to the other and
                           the party with superior knowledge knows that the other party is acting on
                           the basis of mistaken knowledge.21 In resolving these cases, the nature of
                           the relationship between the parties to the transaction is critical to
                           determining the duties that the dealer owes the end-user.

                           18
                            A commodity trading advisor is an individual or firm that, for pay, issues analyses or reports
                           concerning commodities, including the advisability of trading in futures or commodity options.
                           19
                             End-users could also seek redress under the federal Racketeer Influenced and Corrupt Organizations
                           Act. In addition, dealers may be subject to federal criminal enforcement actions under applicable mail
                           fraud or wire fraud statutes.
                           20
                            A tort is a wrongful act (except for those involving a breach of contract) for which damages are
                           imposed.
                           21
                             925 F. Supp. at 1290. The judge concluded that Bankers Trust “had a duty to disclose material
                           information to plaintiff before both the parties entered into the swap transactions . . . and also had a
                           duty to deal fairly and in good faith during the performance of the swap transactions.” Id. at 1291.



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                           Contract-based claims do not require the existence of a special duty
                           between the dealer and end-user. For example, an end-user may advance a
                           contract-based claim for rescission due to misrepresentation. This claim
                           would restore the parties to the positions they held before they entered
                           into the contract. If the end-user is a governmental entity, it may assert an
                           ultra vires claim.22 To support this claim, the end-user may argue that the
                           transaction at issue is unenforceable because it violates a provision in its
                           charter. An end-user may also claim that the contract is voidable because
                           the end-user was a victim of economic duress and, therefore, did not enter
                           into the contract of its own free will. Finally, an end-user may assert that
                           the contract is unenforceable under the applicable statute of frauds.
                           Although the specifics may vary from jurisdiction to jurisdiction, the
                           statute of frauds generally states that contracts in excess of a certain
                           dollar amount that cannot be performed within 1 year are unenforceable
                           unless in writing and signed by the party against whom the contract is
                           being enforced. To reduce the likelihood of the success of this claim, New
                           York amended this statute in 1994 to improve the enforceability of oral OTC
                           derivatives transactions.


MBS and Structured Notes   MBS  and structured notes are typically considered to be securities and
Are Typically Subject to   subject to the federal securities laws,23 except when exempted from
the Securities Laws        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

                           22
                            This claim would likely be advanced only by governmental entities because corporations typically
                           may not rely on this doctrine to invalidate a contract.
                           23
                            As noted in chapter 1, we are assuming for the purpose of this report that structured notes meet the
                           conditions of CFTC’s hybrid instrument exemption and are securities, not futures.



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issuance disclosure provisions of the laws that apply to corporate-issued
securities. As a result, GSEs are not generally required to obtain SEC
approval before offering securities publicly, and such issuances need not
be accompanied by prospectuses that identify the issuer and describe its
business operations and financial condition.24 Nevertheless, GSEs have
chosen to voluntarily follow the same practices that corporate securities
issuers are required to follow. For example, GSE securities issuances are
accompanied by prospectuses that contain the same type of disclosures as
would be required for other company securities that are registered with
SEC. GSE security issuances also typically include a discussion of the
structure and risks of the securities being offered.

As previously discussed, dealers marketing securities, including MBS and
structured notes, must comply with the requirements of the securities
industry SROs of which they are members. NYSE and NASD supervise the
majority of dealers offering MBS and structured notes, and both place
similar requirements on their members, including requiring firms to
determine the suitability of products before recommending them to their
customers. Although NASD’s suitability rule had long applied to stocks and
other securities, the provisions of this rule were not extended to its
members’ marketing of government securities, including GSE-issued MBS
and structured notes, until August 1996.25

In recognition of the significant institutional participation in the markets
for these securities, NASD also implemented an interpretation of its
suitability rule to clarify the responsibilities that dealers have to
institutional end-users.26 Such users are defined by the rule to include any
entity other than a natural person.27 This interpretation provides that a
dealer must, on the basis of information either supplied by the end-user or

24
  The Federal Agricultural Mortgage Corporation, commonly known as Farmer Mac, is an exception;
its security issuances are registered with SEC.
25
  NASD had been prohibited from applying its full complement of sales practice rules to the marketing
of government securities by a longstanding statutory restriction that was removed by subsequent
legislation. On August 22, 1996, SEC approved NASD’s proposed extension of its rules to these
securities with an associated interpretation for applying them to institutional end-users. (This
restriction and its impact on NASD’s operations are discussed in ch. 6.) Because this restriction
applied only to government securities, NASD was able to apply its full complement of sales practice
rules to the marketing of corporate-issued CMOs.
26
 Self-Regulatory Organizations; National Association of Securities Dealers, Inc; Order Granting
Approval to Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval to
Amendment Nos. 4 and 5 to Proposed Rule Change Relating to Application of the Rules of Fair
Practice to Transactions in Exempted Securities (Except Municipals) and an Interpretation of its
Suitability Rule, 61 Fed. Reg. 44100 (Aug. 27, 1996).
27
 The interpretation indicates that its tenets are most appropriately applied to institutional customers
with more than $10 million in securities holdings.



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                             otherwise known to the dealer, determine whether the end-user is capable
                             of evaluating the risk of the specific transaction and whether the end-user
                             is making an independent investment decision. The interpretation includes
                             a number of factors that are relevant to making this determination,
                             including the end-user’s employment of outside consultants or advisors,
                             the end-user’s general level of sophistication and level of sophistication
                             with respect to the particular product, the complexity of the product, and
                             the end-user’s ability to understand and independently assess the product.
                             Other relevant information might include whether the end-user had
                             established a pattern of accepting the dealer’s recommendations, had
                             access to investment suggestions from other sources, and had supplied
                             information about its investment portfolio to the dealer. If a dealer
                             determines that the end-user is capable of independently evaluating
                             investment risk and making its own decision about the transaction, the
                             dealer’s obligation regarding the end-user’s suitability is to be considered
                             fulfilled. The interpretation stresses that the determination can only be
                             made on the basis of the particular facts and circumstances of the
                             transaction, including the particular relationship between the dealer and
                             end-user.


                             Sales practice requirements also vary, depending on which regulator, if
Sales Practice               any, oversees the dealers’ activities. Bank OTC derivatives activities are
Requirements Vary,           subject to requirements of the federal banking regulators as a part of their
Depending on the             oversight of all bank activities. Banks marketing MBS and structured notes
                             are now expected to comply with suitability rules similar to those that
Regulator of the             apply to securities firms offering such products. Banks marketing OTC
Dealers’ Activities          derivatives, MBS, and structured notes may also be subject to oversight by
                             different regulators, depending on which legal entity within their
                             corporate structure conducts these activities. Securities, futures, and
                             insurance firms typically conduct their nonsecurities and nonfutures OTC
                             derivatives marketing in affiliates not subject to direct federal oversight,
                             although some individual transactions may be subject to oversight.
                             Members of the President’s Working Group on Financial Markets have
                             stated that the scope of SEC and CFTC authority and existing sales practice
                             requirements are currently adequate to protect the end-users of derivatives
                             and the markets.


Bank Activities Are          All of the activities of banks are subject to oversight by at least one federal
Regulated to Protect Their   regulatory agency—either the Federal Deposit Insurance Corporation, the
Financial Condition          Federal Reserve, or OCC. These regulators are responsible for ensuring the



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safety and soundness of banks to protect depositors and the federally
administered Bank Insurance Fund. The regulators address this
responsibility by placing various requirements on banks, including
periodic reports of financial condition, maintenance of minimum capital
levels, and periodic bank examinations. Almost all of the banks actively
marketing OTC derivatives, MBS, and structured notes are overseen by
either the Federal Reserve or OCC.

In response to the large increase in the volume of bank activity in OTC
derivatives and other financial products over the last decade, bank
regulators revised and expanded the guidance provided to examiners and
banks to more specifically address the risks that these activities pose,
including those risks related to sales practices. Previously, according to
bank regulatory officials, the only bank sales practice-related guidance
was “know your customer” rules under which regulators expected banks
to obtain sufficient information about customers’ financial condition and
business activities to prudently extend credit or engage in other financial
transactions with them.

In 1993 and 1994, OCC and the Federal Reserve each issued new guidance
that more specifically addresses sales practice issues as a part of a bank’s
overall responsibilities for managing the risks of its financial activities,
including OTC derivatives. Both sets of guidance place generally the same
requirements on examiners and banks. OCC’s October 1993 guidance28
directs the banks it oversees to assess and document the appropriateness
of transactions, as a part of managing the credit risk arising from these
transactions. In a follow-up 1994 OCC interpretation,29 OCC states that
consistent with safe and sound practices, banks should not recommend
transactions that they know, or have reason to know, would be
inappropriate for counterparties on the basis of available information.
According to the interpretation, banks should also determine whether
proposed transactions are consistent with counterparties’ policies and
procedures, as these are known to them. Specifically, banks should
understand the risks that counterparties are trying to manage or assume
through the use of derivative products. The interpretation also requires
that banks ensure counterparties understand the general market risk of
transactions and explain, particularly for those counterparties that they



28
  Banking Circular 277: Risk Management of Financial Derivatives, OCC (Washington, D.C.: Oct. 1993).
29
 Risk Management of Financial Derivatives: Questions and Answers Re: BC-277 (OCC Bulletin 94-31),
OCC (Washington, D.C.: May 1994).



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determine lack sophistication, how transactions will achieve the
counterparties’ objectives.30

The Federal Reserve’s December 1993 guidance31 to the banks it oversees
states that sound business practices require member banks to take steps
to ascertain the sophistication of derivatives counterparties, including
whether counterparties understand the nature and risks of transactions. If
a bank determines that its counterparty is unsophisticated, either generally
or with respect to a specific transaction, the guidance directs it to educate
the counterparty about the risks associated with the proposed transaction.
Furthermore, the guidance provides that when a bank recommends a
derivatives transaction to an unsophisticated counterparty, it should
ensure that it has adequate information about the counterparty on which
to base its recommendation. In the guidance issued to examiners,32 the
Federal Reserve indicates that banks should have established standards
for complex products to ensure that counterparties are not entering into
transactions where they fail to understand the risks. The guidance also
notes that bank management should be cognizant of the potential for
activities in these products to result in financial losses and harm the
bank’s reputation.

The goal of the guidance applicable to OTC derivatives issued by the
Federal Reserve and OCC is primarily to protect the safety and soundness
of banks rather than their counterparties or the end-users of the products
banks offer.33 The requirements banks are to follow when marketing such
products are designed to reduce their exposure to risk of loss from
end-user default or transaction disputes.34 Although the Federal Reserve’s
guidance places additional sales practice requirements on banks, its
guidance also states that end-users are ultimately responsible for their
own transactions. Regarding OCC’s guidance, a senior OCC official

30
 As discussed in chapter 6, OCC subsequently issued more detailed guidance in 1996 and 1997 with
additional sales practice-related expectations for the banks it oversees; however, this additional
guidance does not change the requirements described in this chapter.
31
  Examining Risk Management and Internal Controls for Trading Activities of Banking Organizations,
[SR 93-69 (FIS)], Division of Banking Supervision and Regulation, Board of Governors of the Federal
Reserve System (Washington, D.C.: Dec. 1993).
32
   Trading Activities Manual, Division of Banking Supervision and Regulation, Board of Governors of
the Federal Reserve System (Washington, D.C.: Mar. 1994).
33
 Bank regulatory officials indicated that bank dealers’ compliance with these requirements should
have the indirect effect of protecting counterparties and end-users from abusive practices.
34
  Under federal banking laws, aggrieved end-users have no right of private action or redress similar to
that provided by federal securities or commodities laws. As a result, aggrieved end-users must seek
redress under state statutory and common law.



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                          explained that it does not task banks with determining the suitability of
                          OTC derivatives transactions for their customers, but the guidance is meant
                          to ensure that the activities are being conducted in a safe and sound
                          manner. According to the official, a suitability rule would represent a
                          fundamental change in the relationship between a bank and its customers
                          because certain transactions, such as loans, deposits, and letters of credit,
                          are entered into on a principal-to-principal basis. Although intended
                          primarily to protect banks, bank regulator officials told us that the
                          interests of end-users would indirectly be protected by banks complying
                          with the prudent practices recommended in bank guidance.


Bank Regulators Adopted   Bank regulators have placed additional requirements on banks that market
Additional Requirements   securities. Banks marketing securities must now comply with substantially
for Dealers Marketing     the same suitability rule as securities firms that market such products. In
                          1994, the Federal Deposit Insurance Corporation, the Federal Reserve,
Securities                OCC, and the Office of Thrift Supervision issued a joint statement
                          applicable to banks and thrifts marketing nondeposit investment products,
                          including mutual funds and annuities, to retail customers.35 This joint
                          statement also applied to banks marketing government securities,
                          including GSE-issued MBS and structured notes to retail customers.
                          Although securities products have always been subject to the antifraud
                          provisions of the securities laws, the interagency statement tasks banks
                          offering nondeposit investment products—some of which are not
                          securities—with determining the suitability of such products before
                          recommending them to retail customers.

                          Bank regulators have also recently approved additional sales practice
                          rules for banks that deal in government securities. As authorized by the
                          Government Securities Act Amendments of 1993, the three federal bank
                          regulatory agencies—the Federal Reserve, the Federal Deposit Insurance
                          Corporation, and OCC—issued a March 1997 joint rule on bank sales of
                          government securities, including GSE-issued MBS and structured notes.36 In
                          addressing dealers’ obligations to determine suitability before making a
                          recommendation to institutional end-users, the rule uses language similar
                          to the recently approved NASD rule, as previously discussed. As of July 1,
                          1997, which was the effective date of the banking regulators’ rule, banks

                          35
                           Interagency Statement on Retail Sales of Nondeposit Investment Products, Board of Governors of the
                          Federal Reserve System, Federal Deposit Insurance Corporation, OCC, and Office of Thrift
                          Supervision (Washington, D.C.: Feb. 15, 1994).
                          36
                             Government Securities Sales Practices, Board of Governors of the Federal Reserve System, Federal
                          Deposit Insurance Corporation, OCC, and Office of Thrift Supervision (Washington, D.C.: Mar. 12,
                          1997).



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                          Federal Sales Practice Requirements Vary
                          by Product and Dealer




                          and securities firms marketing these securities became subject to
                          essentially the same rules regarding determining suitability before
                          recommending purchase of GSE-issued MBS and structured notes.


Banks Market Products     Banks market OTC derivatives, MBS, and structured notes from various legal
From Various Legal        entities within their organizational structures, and this affects which
Entities That May Be      regulators, if any, oversee these activities. Regulators indicated that most
                          banks use bank employees to market OTC derivatives. However, some also
Subject to Oversight by   use their securities affiliates’ staffs to market them, depending on
Different Regulators      corporate preferences or the extent to which securities are also being
                          offered to their customers. Nevertheless, any OTC derivative marketing
                          activities by such securities affiliate staff would not be subject to the
                          securities laws unless the product being marketed is a security. A bank
                          examiner explained that banks’ use of the same staff to market both
                          securities and nonsecurities OTC derivatives may reflect an effort to have
                          marketing staff be able to select the most appropriate product for the
                          specific risk management needs or investment objectives of an end-user,
                          regardless of the regulatory status of the individual products.

                          The corporate entities used by banks to market MBS and structured notes
                          also vary. The Banking Act of 1933, commonly known as the Glass-Steagall
                          Act, allows banks and their affiliates to underwrite and deal in certain
                          types of securities known as bank-eligible securities. These include
                          GSE-issued MBS and structured notes. The act generally prohibits banks
                          from underwriting and dealing in bank-ineligible securities, such as those
                          issued by corporations, including MBS37 and structured notes. Federal
                          regulators have provided banks with limited authority to underwrite and
                          deal in ineligible securities through affiliates of their holding company.
                          These affiliates—called Section 20 affiliates after the relevant section of
                          the act—are permitted to engage in securities underwriting and dealing as
                          long as the affiliate generates no more than 25 percent of its gross
                          revenues from ineligible securities.38 Regulators told us that most banks
                          with such affiliates market MBS and structured notes exclusively from
                          these entities to provide as large a revenue base as possible for conducting
                          activities in ineligible securities. Because these Section 20 affiliates are
                          also registered as broker-dealers with SEC, they are also subject to

                          37
                            To distinguish them from GSE-issued securities, MBS issued by corporations are called “private label.”
                          38
                           The previous limit on revenues derived from ineligible securities activities for Section 20 affiliates
                          was 10 percent, but the Federal Reserve raised the percentage to 25 percent, effective March 6, 1997.
                          However, national banks may sell their own assets in a securitized form and, therefore, may be
                          deemed underwriters for purposes of the securities laws, but not for purposes of the Glass-Steagall
                          Act.



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                             examinations by SEC and securities industry SROs to ensure that they
                             comply with the sales practice requirements of the federal securities laws
                             when selling securities.


Unregulated Affiliates Are   Affiliates of securities, futures, and insurance firms that market
Not Subject to Direct        nonsecurities or nonfutures OTC derivatives are not directly regulated by
                             SEC or CFTC.39 Securities and futures firms are allowed to conduct activities
Federal Oversight, but
                             in nonsecurities and nonfutures products outside of the entities that are
Regulators May Assert        subject to direct SEC or CFTC oversight, respectively. Some securities firms
Jurisdiction Over Specific   have established one or more separate affiliates that conduct OTC
Products                     derivatives activities. For example, because counterparties are sensitive to
                             the credit risk inherent in most OTC derivatives contracts, several
                             securities firms have created separately capitalized subsidiaries to conduct
                             activities in these products. These affiliates were specifically structured to
                             receive the highest credit ratings by rating agencies to increase their
                             attractiveness as counterparties to end-users of these products. SEC
                             officials told us that firms generally cite the stringent treatment that OTC
                             derivatives receive under SEC and CFTC capital requirements as the reason
                             firms do not conduct such activities in regulated entities, rather than a
                             desire to avoid sales practice requirements.

                             Some insurance firms also market OTC derivatives to end-users. However,
                             unless the products involved are subject to SEC or CFTC jurisdiction, the OTC
                             derivatives marketing activities of these firms are not subject to federal
                             regulatory oversight. The regulation of the insurance industry is primarily
                             a state responsibility.40 However, officials from the state insurance
                             regulatory commissions of the states with major insurance company
                             dealers of OTC derivatives, including New York, New Jersey, and Delaware,
                             told us that they did not directly oversee insurance firms’ marketing of
                             these products because such activities were conducted in noninsurance
                             affiliates.

                             As previously discussed, to the extent that nonsecurities OTC derivatives
                             activities are legally conducted outside of a regulated firm, they are not
                             subject to direct SEC or CFTC oversight. By offering these products from

                             39
                               As discussed in chapter 6, the affiliates of securities and futures firms that market OTC derivatives
                             are subject to indirect SEC and CFTC oversight under the risk assessment authority Congress granted
                             to these agencies in 1990 and 1992, respectively. Also, as discussed in chapter 6, SEC and CFTC
                             worked with the firms most active in the OTC derivatives markets to establish a set of voluntary
                             guidance for participating firms to follow. The guidance presents a framework of management
                             controls and risk measurement practices.
                             40
                               Congress has strictly limited the extent to which federal law preempts state insurance law.



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                           affiliates, dealers have, in effect, determined that these products are not
                           subject to the securities laws or most provisions of the CEA. However, SEC,
                           CFTC, or a court could determine that a product offered by an unregulated
                           affiliate is subject to the provisions of the federal securities or
                           commodities laws, respectively, and take action against the dealer when
                           they find violations of these laws.


The Working Group          According to SEC and CFTC officials, the President’s Working Group on
Concluded That the Scope   Financial Markets has discussed the need to expand SEC and CFTC authority
of Regulators’ 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
and Sales Practice         members, the officials comprising the Working Group concluded that no
Requirements Are           changes requiring legislation are currently needed to protect the financial
Adequate                   markets or end-users of derivatives. SEC and CFTC officials also told us that
                           their agencies have been able to take appropriate actions under their
                           existing authorities when problems have arisen. For example, as
                           previously discussed in this chapter, SEC and CFTC took a cooperative
                           action against Bankers Trust for its conduct in OTC derivatives transactions
                           with Gibson Greetings. The legal entity cited was BT Securities, which is a
                           subsidiary of Bankers Trust.41 SEC and CFTC officials told us that if they
                           believed their authority was insufficient, they would ask Congress to
                           address the issue.42

                           One member of the Working Group, the Chairman of the Federal Reserve,
                           indicated in a February 1997 speech that institutional end-users of OTC
                           derivatives have demonstrated their ability to protect themselves from
                           fraud. He noted that when dealers have engaged in deceptive practices,
                           end-users have been able to obtain restitution either by taking legal action
                           or threatening to do so. He indicated that, while the threat of legal action
                           by end-users may deter misconduct, dealers are motivated by the need to
                           stay competitive, which requires that they maintain a good reputation.

                           Officials familiar with the operations of the Working Group indicated that
                           the various members have shared information relating to OTC derivatives
                           sales practice issues. The members obtained this information through
                           special study efforts or otherwise collected it during their routine


                           41
                            BT Securities is an affiliate of Bankers Trust Company and is authorized to conduct securities
                           activities under section 20 of the Federal Reserve Act. Both are subsidiaries of Bankers Trust New
                           York Corp., which is a bank holding company.
                           42
                            CFTC has offered Congress legislative amendments to address technical issues to clarify its authority
                           under the CEA in several respects. As of , Congress had not enacted these amendments.



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oversight activities. However, Federal Reserve and SEC officials indicated
that data on market characteristics relevant to sales practice issues, such
as increased market participation by new dealers, more widespread use of
complex products, or increased marketing to or product use by less
sophisticated end-users, was not routinely collected by their agencies.
Furthermore, they said that no formal mechanism or expectation existed
for the members to continue collecting and sharing such information on a
periodic basis.




Page 56                                    GAO/GGD-98-5 OTC Derivatives Sales Practices
Chapter 3

Satisfaction With Sales Practices Was High
and Disputes Were Limited, but When
Disputes Occurred Losses Were Often Large
                         According to our 1995 survey, end-users were generally satisfied with the
                         sales practices of dealers offering OTC derivatives, MBS, and structured
                         notes. Product use varied with end-users reporting less use of OTC
                         derivatives than of MBS and structured notes, and larger organizations
                         generally reporting more use of all of the products than smaller
                         organizations. Review of regulatory and other data indicated that cases
                         involving sales practice disputes were not widespread. However, when
                         disputes did arise, the losses were often large, with dealers and end-users
                         generally experiencing other financial impacts. These included direct costs
                         from litigation or regulatory fines and indirect costs, such as reduced
                         revenues and income.


                         According to our 1995 survey of a wide range of U.S. organizations, most
Most End-Users Were      end-users were generally satisfied with the sales practices of the dealers
Generally Satisfied      that marketed OTC derivatives, MBS, and structured notes to them. The rates
With Dealer Sales        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
Practices                products. End-users reported lower rates of dissatisfaction with the sales
                         practices of dealers they had used than for dealers that made
                         presentations to them but were not used. Finally, the respondents to our
                         survey provided generally consistent reasons for any dissatisfaction with
                         specific elements of dealer practices.


Few End-Users Reported   When asked to rate the sales practices of the dealers with whom they had
Dissatisfaction With     entered into transactions, few end-users of OTC derivatives, MBS, or
Dealers Used             structured notes reported dissatisfaction. To obtain information on how
                         satisfied organizations who had heard proposals were with these dealers’
                         sales practices, we asked the organizations we surveyed to indicate
                         whether they were “very satisfied,” “somewhat satisfied,” “neither satisfied
                         nor dissatisfied,” “somewhat dissatisfied,” or “very dissatisfied” for each of
                         the products included in this review.1 They were asked to provide these
                         ratings for the following six individual elements of sales practices:
                         (1) disclosure of downside risks, (2) quality of transaction documentation
                         provided, (3) suitability of products proposed, (4) competitiveness of
                         pricing and fees, (5) provision of accurate mark-to-market pricing
                         information, and (6) assistance in unwinding transactions. Respondents
                         were also asked to provide a rating of their overall level of satisfaction or
                         dissatisfaction with dealer sales practices. In addition, survey respondents
                         were asked to provide ratings in these categories for (1) dealers they used

                         1
                          Respondents were also able to indicate that they either “did not know” or had “no opinion.”



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and Disputes Were Limited, but When
Disputes Occurred Losses Were Often Large




for transactions involving OTC derivatives, MBS, or structured notes and
(2) dealers that made product proposals to them but whom they did not
use for a particular product.

As shown in figure 3.1, 2 percent of the organizations across the industries
we surveyed reported being “somewhat” or “very dissatisfied” with the
overall sales practices of the dealers they used for plain vanilla OTC
derivatives contracts. For MBS dealers used, 7 percent2 of users reported
being similarly dissatisfied; for structured note dealers used, 13 percent
reported being similarly dissatisfied.




2
 All the population estimates from our survey have sampling errors of plus or minus 10 percentage
points, or less, at the 95-percent confidence level, unless otherwise noted. This means that a 95-percent
probability exists that if we were to survey all of the organizations in this population, the actual result
obtained would fall within a range above and below the estimate cited of no more than the amount of
the sampling error for that particular estimate. See appendix I for the exact sampling errors for each
estimate in the report and more information about the various errors that may affect survey estimates.
For example, survey respondents may intentionally or accidentally misreport their organizations’
product usage.



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                                                          Satisfaction With Sales Practices Was High
                                                          and Disputes Were Limited, but When
                                                          Disputes Occurred Losses Were Often Large




Figure 3.1: Overall Sales Practice Ratings Reported for Dealers Used and Dealers Not Used, by Product

Percentage of satisfaction with sales practices

100


         85

 80
                                                                      71
                                                                                                                                   64
 60

                                                                                                                                                                   48
                                                                                                       46

 40
                                       33
               29                                                                                                                                      29
                                                                                            27
                                                     21                        20                20                                                          20
 20                         17
                                                                                                                                         15
                                  13                                                                                                              13
                                                                                        7                            8                                                          8
                                                                                                                                                                          4
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                                                                           a
      Plain vanilla OTC Derivatives                              MBS                                                            Structured notes b


               Dealers used

               Dealers not used c


                                                          Note 1: The categories of satisfied and dissatisfied in this figure represent the total of those
                                                          respondents that reported being somewhat or very satisfied or somewhat or very dissatisfied,
                                                          respectively, with dealers’ overall sales practices. The neutral category represents those that
                                                          reported being neither satisfied nor dissatisfied.

                                                          Note 2: Ratings may not add to 100 percent due to rounding.

                                                          a
                                                           The satisfaction ratings for dealers used relate to MBS only, but ratings for dealers not used
                                                          include other asset-backed securities because we were unable to separate out such products
                                                          from these responses.
                                                          b
                                                           The sampling error for the percentage of structured notes users who reported being satisfied
                                                          (64 percent) was plus or minus 11 percent.




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Disputes Occurred Losses Were Often Large




c
 Dealers not used were those that made product proposals to end-users but were not used for a
particular product.


Source: GAO survey.


Our survey indicated that 79 percent3 of the end-users of more complex
OTC derivatives were somewhat or very satisfied with the dealers with
whom they did business, which was comparable to the levels of
satisfaction reported for dealers of the three product types shown in figure
3.1. Because of the small number of end-users of more complex OTC
derivatives and the even smaller number who reported being dissatisfied
with the dealers they used, we could not make a reliable estimate of the
extent of dissatisfaction with overall dealer sales practices for more
complex products. Similarly, the small number of end-users reporting
dissatisfaction with other products among our survey respondents
precluded a statistically valid analysis of dissatisfaction by the size of
organization or by industry subgroups.

As shown in figure 3.1, an analysis of our survey results indicated that
organizations reported less satisfaction with the overall sales practices of
dealers they heard presentations from but with whom they did not do
business. The percentages of organizations that were either somewhat or
very dissatisfied with the overall sales practices of dealers that they did
not use could be at least twice as high as the comparable percentages for
dealers that were used.4 The overall level of dissatisfaction with dealers
not used was 17 percent for plain vanilla OTC derivatives, 26 percent for
more complex derivatives,5 27 percent for MBS and/or asset-backed
securities, and 29 percent for structured notes.

Between 4 and 8 percent of the organizations not using a particular
product were contacted by at least one dealer offering that product during
the survey period. Furthermore, some evidence exists that the extent to
which dealers contacted nonusers is somewhat higher than these
percentages suggest because some nonusers contacted chose not to rate
the dealers’ presentations. These respondents reported that they generally
did not listen to the dealers’ complete presentations or thoroughly

3
 Subject to a plus or minus 19-percent sampling error.
4
 The differences in dissatisfaction levels between dealers used and not used were statistically
significant for plain vanilla OTC derivatives and MBS, while the differences for more complex OTC
derivatives and structured notes were not statistically significant due to the small numbers of
dissatisfied end-users of these products in our sample.
5
 Subject to a plus or minus 12-percent sampling error.



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                             and Disputes Were Limited, but When
                             Disputes Occurred Losses Were Often Large




                             evaluate them because they did not find the products appropriate for their
                             organization or for their investment objectives.

                             For those end-users and nonusers who rated dealers they did not do
                             business with, the higher level of dissatisfaction reported with the dealers
                             not used suggests that potential end-users may have chosen not to do
                             business with dealers whose sales practices were objectionable or
                             appeared questionable for particular transactions.6 Comments by some
                             end-users were consistent with this interpretation, as some respondents
                             indicated that they refused to do business with some dealers. Also, some
                             respondents noted that their satisfaction with dealer sales practices varied
                             by product at some dealers or depended on which member of a dealer’s
                             sales staff presented a transaction.


Respondents Provided         Respondents who were dissatisfied with dealer sales practices provided
Consistent Reasons for       similar reasons for their dissatisfaction with two individual elements of
Their Dissatisfaction With   sales practices—disclosure of downside risk and suitability of products
                             proposed.7 In addition to providing ratings on their overall satisfaction
Specific Elements of         with dealers’ sales practices (as shown in fig. 3.1), survey respondents also
Dealer Sales Practices       provided ratings of individual sales practice elements. For disclosure of
                             downside risk, none of the estimates for the rate of dissatisfaction with
                             dealers used exceeded 20 percent for any of the products. End-users of
                             structured notes reported the highest rate of
                             dissatisfaction—17 percent—with thks element. However, for dealers not
                             used, these rates of dissatisfaction were higher. Twenty percent of the
                             organizations in our population reported dissatisfaciton with the risk
                             disclosure practices of dealers not used that offered plain vanilla OTC
                             derivatives, while 38 percent8 reported dissatisfaction with the risk
                             disclosure practices of dealers not used that offered more complex OTC
                             derivatives. In addition, 27 percent of the organizations reported
                             dissatisfaction with the risk disclosure practices of dealers they had not
                             used for MBS, and 31 percent reported dissatisfaction with the risk
                             disclosure practices of dealers they had not used for structured notes.


                             6
                              In some cases, respondents might have rated the same firm as a dealer used and as a dealer not used
                             because an end-user may have entered into a transaction for a product with a dealer on one occasion
                             but may have chosen not to do so on another occasion.
                             7
                              Because of the relatively few end-users of OTC derivatives that existed and the even fewer number
                             that were dissatisfied, we could not make (1) precise estimates of the extent of dissatisfaction with
                             these two elements of sales practices and (2) any estimates of the extent of dissatisfaction with the
                             other four elements of sales practices that we asked survey respondents to rate.
                             8
                              Subject to a plus or minus 13-percent sampling error.



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Disputes Occurred Losses Were Often Large




In follow-up conversations or in their written comments, some
respondents explained why they were dissatisfied with dealer risk
disclosures. Officials at 19 of the 50 judgmentally selected organizations
with which we followed up told us that they were dissatisfied in some way
with the amount of information dealers had provided.9 For example, an
official of a money management firm said that risk disclosure was the
primary problem with dealer sales practices. For MBS and structured notes,
he said that dealers had not provided sufficient information about the
reduced market liquidity of some products and that end-users could not
rely on commercially available pricing information to determine the
market liquidity or prices that could be received for products.

Some officials at these 19 organizations commented that even dealer
personnel did not appear to understand the potential downside risks of the
products. For example, an official at a mutual fund told us that dealer staff
often provided written materials on how product use could be beneficial,
but the dealer staff could not always answer questions about how the
value of the products would change as interest rates changed. An
insurance company official wrote on the survey form that his firm’s
dissatisfaction rating reflected experiences with some of the smaller
dealers that contacted the firm. The official believed that the larger dealers
generally did a good job of explaining the merits and risks of products.

According to our survey results for another individual sales practice
element that we asked questionnaire recipients to rate, organizations were
not always satisfied with the suitability of the products dealers proposed,
and this dissatisfaction was again more significant for dealers they did not
use.10 For this particular element, all of our estimates of dissatisfaction
with dealers used fell below 10 percent. However, for dealers not used, the
estimates of dissatisfaction were higher—18 percent of end-users reported
being somewhat or very dissatisfied with the suitability of plain vanilla OTC
derivatives proposed by dealers that were not used, while 42 percent11
reported dissatisfaction with the suitability of more complex OTC
derivatives transactions proposed by dealers that were not used. Thirty-six
percent reported dissatisfaction with the suitability of MBS that were


9
 We conducted follow-up telephone interviews with 50 judgmentally selected organizations that had
responded to the survey—about one-half of which had expressed dissatisfaction and one-half of which
were generally satisfied with dealer sales practices. See appendix I for more information on our
methodology.
10
 When rating this aspect of dealer sales practices, survey respondents were not asked to rate whether
dealers had complied with any legal requirement to determine the suitability of a recommendation.
11
    Subject to a plus or minus 13-percent sampling error.



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                        Satisfaction With Sales Practices Was High
                        and Disputes Were Limited, but When
                        Disputes Occurred Losses Were Often Large




                        offered but not purchased, and 39 percent reported dissatisfaction with
                        the suitability of structured notes that were offered but not purchased.

                        Officials at 16 of the 50 organizations with which we followed up indicated
                        that dealers were not sufficiently considering end-user circumstances
                        when proposing transactions. For example, an official at a money market
                        mutual fund said that, although such funds should maintain fixed net asset
                        values, many of the transactions dealers proposed to his organization were
                        for products that could cause large declines in the value of the fund. A
                        credit union official described mixed experiences. He said some dealers
                        seemed interested in selling a product regardless of the credit union’s
                        needs and requirements, but others were more willing to describe
                        products and attempt to understand the organization’s needs. Officials of
                        at least three organizations were concerned that dealers were marketing
                        GSE-issued structured notes by portraying them as safe,
                        government-backed investments, even though the values of such products
                        could be quite volatile.

                        Although some organizations were concerned about the suitability of
                        products that dealers offered, other organizations generally welcomed
                        receiving proposals even if the product was not currently appropriate or
                        suitable for them. For example, officials at a hardware products
                        manufacturer that exported worldwide explained that their firm used OTC
                        derivatives for managing its foreign currency exposures and for altering
                        the mix of fixed and floating interest rate obligations used to finance its
                        operations. Although the firm had specific guidelines related to its use of
                        these products, it was still interested in hearing ideas that could lead to
                        alternative ways of meeting its needs. Similarly, officials at three large
                        multinational firms told us that, even though their firms receive numerous
                        proposals from dealers, they explore only those they considered
                        appropriate for them. However, they appreciated receiving the other
                        proposals so that they could better evaluate their own risk management
                        activities.


                        Our survey revealed that the extent of OTC derivatives, MBS, and structured
Reported Product        notes usage varied, with fewer organizations reporting use of OTC
Usage Varied Across     derivatives than of MBS and structured notes. In general, larger
Products and by         organizations were more likely than smaller ones to report using any of
                        these products, although smaller organizations were active users in some
Organization Size and   industries, such as banking. The extent of reported product usage also
Type                    varied across industries and organizations, with more financial



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                         Satisfaction With Sales Practices Was High
                         and Disputes Were Limited, but When
                         Disputes Occurred Losses Were Often Large




                         organizations reporting use of the products than nonfinancial
                         organizations, such as state and local governments. Surveys conducted by
                         other organizations covering periods after that of our survey indicated that
                         rates of usage showed little change, with some showing slight declines.


Few Organizations        Our end-user survey measured the usage of OTC derivatives, MBS, and
Reported Using OTC       structured notes over a broad population of U.S. organizations. The survey
Derivatives, More        results indicated that relatively few public and private organizations used
                         an OTC derivative product, with an estimated 11 percent12 of such
Reported Using MBS and   organizations reporting using such a product in the 12 months before our
Structured Notes         survey was received, beginning for most organizations in the spring of
                         1995. Some of these organizations had reported using either plain vanilla
                         or more complex OTC derivatives, and others had reported using both. We
                         estimated that in the period defined by our survey, approximately 5,200
                         end-users of OTC derivatives (plain vanilla, more complex, or both) existed
                         in the population of approximately 49,000 potential end-users from which
                         we drew our sample.13

                         As shown in figure 3.2, 10 percent of these organizations reported using
                         plain vanilla OTC derivatives, and 2 percent reported using more complex
                         OTC derivatives. Reported usage of other products was somewhat more
                         widespread—approximately 24 percent of such organizations reported
                         holding at least one MBS, and 16 percent reported holding at least one
                         structured note during the study period. We estimated the number of
                         end-users for these products to be approximately 11,500 for MBS and 7,700
                         for structured notes. Although we did not survey individual investors,
                         regulators and exchange officials told us that few individuals used OTC
                         derivatives and their usage of MBS and structured notes was small. For
                         example, NYSE officials estimated that individual investors accounted for
                         about 5 percent of the volume in the MBS market.




                         12
                           Subject to a plus or minus 2-percent sampling error.
                         13
                          See appendix I for a detailed description of how we defined this population and drew our survey
                         sample.



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                                         Disputes Occurred Losses Were Often Large




Figure 3.2: Extent of Reported Product
Usage Across the Potential User
Population                               Percentage of use, by organization
                                         30



                                         25                                                             24


                                         20


                                                                                                                          16
                                         15



                                                     10
                                         10



                                             5

                                                                      2

                                             0
                                                 Plain vanilla    More                                  MBS           Structured
                                                                  complex                                             notes

                                                 OTC Derivatives a                                  Securities

                                         a
                                          Includes securities OTC derivatives.


                                         Source: GAO survey.




Larger Organizations Were                As shown in figure 3.3, the larger organizations were more likely to
More Likely to Be                        indicate that they were users of OTC derivatives, MBS, and structured
End-Users                                notes.14




                                         14
                                           We grouped the organizations in each industry into one or more substrata by asset size, investment
                                         portfolio size, revenue, sales, population, or other relevant indicators of financial size, depending on
                                         the type of industry and the information available. However, for banks and credit unions, we obtained
                                         additional information on past usage of certain OTC derivative products and MBS that was used to
                                         improve the accuracy of our groupings for these firms, not just in terms of financial size, but also in
                                         terms of the likelihood of current product usage. Therefore, the criteria for division between larger and
                                         smaller organizations vary across industries, and although the larger subgroups are typically
                                         comprised of the top 10 percent of the population, from 1 percent to about 33 percent of some
                                         industries may be apportioned to the largest subgroups. See appendix I for a more thorough
                                         description of how we defined large and small industry subgroups.



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Figure 3.3: Extent of Reported Product
Usage, by Organization Size
                                         Percentage of use, by organization
                                         50




                                         40
                                                                                                      37



                                         30


                                                                                                                     22
                                         20                                                                 19

                                                    14
                                                                                                                           13

                                         10                 9

                                                                      4
                                                                             1
                                             0
                                                   Plain vanilla   More complex                         MBS        Structured
                                                                                                                   notes

                                                  OTC Derivatives a                                  Securities

                                                           Large organizations
                                                           Small organizations


                                         Note: See appendix I for a description of how we defined large and small organizations across
                                         industry strata.

                                         a
                                          Includes securities OTC derivatives.


                                         Source: GAO survey.


                                         Even though large organizations were more likely to be end-users of these
                                         products, some types of small organizations, which were aggregated in the
                                         survey analysis because of the small sample sizes involved, reported using
                                         MBS at higher rates. For example, small banks, credit unions, and insurance
                                         companies—aggregated in the survey analysis because of the small sample
                                         sizes involved—reported using MBS at a combined rate of 40 percent,15
                                         which was about twice the estimated 21-percent usage rate across all


                                         15
                                             Subject to a plus or minus 11-percent sampling error.



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                          other organizations. In addition, 35 percent16 of the small bank, credit
                          union, and insurance company subgroup reported using structured notes,
                          while overall 12 percent of all other organizations reported use of such
                          products. Similarly, OCC reported that, as of March 31, 1996, 41 percent of
                          the approximately 8,600 banks with less than $250 million in assets had
                          invested in structured notes that had a total market value of about $6.2
                          billion. According to OCC, the percentage of small banks using structured
                          notes was equal to that of the other 1,274 banks with assets exceeding
                          $250 million.


Product Usage Varied by   Our survey results indicated that usage of OTC derivatives, MBS, and
Industry                  structured notes was generally higher among the more specialized and
                          perhaps more sophisticated financial services and investment
                          management industries.17 As shown in figure 3.4, among the various
                          industries we surveyed, reported use by GSEs indicated that they were the
                          most active users of all three of these product types. On the basis of
                          information provided by the 31 GSEs that responded to our survey,
                          71 percent of these large and generally financially sophisticated
                          institutions reported using OTC derivatives. About the same percentage
                          also reported using MBS, while 57 percent of GSEs reported using structured
                          notes. A group we classified as “other financial corporations”—which
                          included large credit-financing organizations, mortgage brokers and
                          lenders, and leasing agencies—also reported being active users of OTC
                          derivatives. In contrast, banks, credit unions, and insurance companies
                          reported active use of MBS and structured notes but comparatively less use
                          of OTC derivatives.




                          16
                            Subject to a plus or minus 13-percent sampling error.
                          17
                            Statistics on the rates of usage by all industry substrata are shown in appendix I, tables I.5 through
                          I.8.



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Figure 3.4: Extent of Reported Product Usage, by Industry

Percentage of use, by organization
80
          73
     71



60             57
                     54                                                                              55




                                                                                                          40
40
                                                       33

                                   27
                                        25                                24
                          23
                                                            20
20
                                                                                                                                                     16
                                             12                                                                                                           11
                                                  10                 10                                                               10                               9
                               6                                                                                                                 7                 7
                                                                               5                 5                                                             4
                                                                                                                                           2 3
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     Financially oriented organizations                                                                        Other organizations



                    OTC Derivatives

                    MBS
                    Structured notes


                                                                 Note 1: Because of the small number of respondents in some industries, small differences in
                                                                 usage percentages may not be statistically significant.

                                                                 Note 2: Appendix I describes the organizations that are included in the groupings in this figure.

                                                                 a
                                                                 Pension funds include both private and public (governmental) pension funds.


                                                                 Source: GAO survey.




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In addition, the survey results from the pension fund industry indicated
differing levels of usage within certain subgroups. Although the average
usage rates reported across the overall universe of large and small public
and private pension funds were not above average, the large public
pension fund subgroup reported relatively higher usage rates. Forty-one
percent of the large public pension funds reported using plain vanilla OTC
derivatives, 33 percent reported using structured notes, and 74 percent
reported using MBS.

Our survey also showed that nonfinancial corporations (service and
manufacturing firms), endowments and colleges, and state and local
governmental entities18 did not make extensive use of any of the products.
Among nonfinancial corporations, overall reported usage rates were
average or below average for all of the products. However, the “larger
organization” subgroup of nonfinancial corporations19 did report using
plain vanilla OTC derivatives to a great extent. We estimated that
66 percent20 of the population of large U.S. nonfinancial firms used plain
vanilla OTC derivatives during the survey period. This estimate is
comparable to those of other surveys of similar organizations, many of
which reported usage rates of over 50 percent.

Although higher proportions of firms in the specialized, sophisticated
financial industries may be using OTC derivatives, MBS, and structured
notes, they often represented a smaller total number compared to the
actual number of reported end-users among some of the more populous
nonfinancial industries. For example, even though 71 percent of GSEs
reported using OTC derivatives, they made up less than 1 percent of the
entire number of estimated end-users. However, nonfinancial corporations
made up an estimated 22 percent of the total population of end-users of
OTC derivatives, even though only 10 percent of the firms in this industry
grouping reported using these products. Similarly, while 27 percent of the
aggregated industry group of mutual funds, money market funds, and
commodity pools reported using OTC derivatives, the number of such
organizations represented 39 percent of the total number of end-users for
this product type.


18
 Local governmental entities included state treasuries, local school districts, special districts, cities,
and counties (see app. I, table I.2).
19
  For publicly held corporations, we drew our sample of large organizations from the top 10 percent
(annual sales over $1.4 million) of our population of approximately 5,600 firms. For privately held
nonfinancial corporations, we designated the top 200 firms on the basis of their assets (2.5 percent of
our universe of 8,000) as large corporations.
20
  Subject to a plus or minus 12-percent sampling error.



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More Recent Studies       A number of publicly reported studies conducted after our survey
Generally Showed Little   generally showed either no change or slight declines in the proportion of
Change in Product Usage   organizations in various industries that use OTC and other derivatives. To
                          assess the magnitude and direction of any change in usage that may have
                          taken place after our survey closed in October of 1995, we reviewed
                          studies conducted by three external organizations that measured usage
                          among specific industries over a period extending to October 1995 or
                          beyond.21 Two of the three studies concluded that a slight decrease in
                          derivative product usage had occurred among certain organizations after
                          1995. A series of surveys conducted by Greenwich Associates estimated
                          that 68 percent of a selected sample of public and private nonfinancial
                          corporations used derivatives in 1995, while 59 percent of such
                          corporations used derivatives in 1996.22 The Greenwich Associates’
                          surveys suggest that for nonfinancial corporations, usage reached a high
                          point in 1995, after having increased somewhat in the preceding years.
                          Surveys of public and private pension plans conducted for the September
                          1995 and March 1997 issues of Institutional Investor Magazine concluded
                          that derivatives usage had declined from 52 percent to 48 percent.23
                          However, another set of surveys of publicly held U.S. nonfinancial
                          corporations in 1994 and 1995 found an increase in the proportion of
                          derivative product users. The Wharton School of Business estimated that
                          41 percent of these organizations used derivatives in October 1995, an
                          increase from November 1994.24




                          21
                            Although we attempted to confirm that the industry populations surveyed and products specified in
                          these other studies were generally similar to those discussed in this report, the estimates of usage from
                          these other studies are usually not directly comparable to those from our survey because of the
                          variability of the samples selected and questions asked. Most of the recent studies we reviewed rely on
                          small, nonprobability convenience samples that usually represent a self-selected subset of only the
                          larger organizations within any particular industry. We did not assess the quality or verify the results of
                          any of these external studies.
                          22
                             North American Treasury Services, 1996 Report, Greenwich Associates (Greenwich, CT: July 1996).
                          This survey obtained 588 personal interviews with senior treasury managers at a judgmental sample of
                          multinational corporations, large domestic companies, foreign subsidiaries, regional banks, and
                          government agencies in May through July of 1995 and 457 interviews in May through July of 1996.
                          23
                             “Pensionforum Survey,” Institutional Investor Magazine (New York, NY: Sept. 1995 and Mar. 1997).
                          This survey received an unknown number of responses from a judgmental sample survey of 800
                          corporate and 250 public pension plan sponsors, conducted quarterly.
                          24
                             1995 Survey of Derivatives Usage By U.S. Non-Financial Firms, Wharton School of
                          Business/Canadian Imperial Bank of Commerce/Wood Gundy (Philadelphia, PA: Apr. 1996). This
                          survey received 530 responses in 1994 and 350 in 1995 from a sample of over 2,000 U.S. nonfinancial
                          firms listed on Standard & Poor’s Compustat database. The 1995 sample also included an
                          undetermined number of additional Fortune 500 firms that had not been included in the 1994 sample.



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                            Concerns about dealer sales practices have been raised in many of the
Sales Practice              publicized losses incurred by end-users of OTC derivatives, MBS, and
Concerns Did Not            structured notes. Although many of the losses were large, sales practice
Appear to Be                concerns related to OTC derivatives involved primarily one dealer. More
                            sales practice concerns were raised for transactions involving MBS and
Widespread but              structured notes. However, such losses involved a relatively limited
Involved Many Large         number of dealers.
Losses
Concerns About Dealer       Combining publicly available information and regulatory data, we
Sales Practices Were        compiled a list of U.S. and foreign end-users that experienced losses from
                            OTC derivatives, MBS, or structured note transactions with U.S. dealers.25
Raised in Many Publicized
                            From this list and with the information used to compile it, we identified
Losses                      losses in which sales practice concerns were raised by end-users or
                            regulators. Through this effort, we identified 360 end-user losses involving
                            OTC derivatives, MBS, and structured notes, with the earliest loss occurring
                            in April 1987 and the latest loss occurring in March 1997.26 These end-user
                            losses totaled an estimated $11.4 billion. Sales practice concerns were
                            raised in 209, or 58 percent,27 of these losses and were associated with an
                            estimated $3.2 billion in losses. However, since many disputes were
                            associated with a relatively limited number of dealers, and given the many
                            thousands of transactions in OTC derivatives, MBS, and structured notes and
                            the hundreds of billions of dollars at risk in these transactions over the




                            25
                              Our list of end-user losses was compiled from publicly available information and regulatory data. To
                            identify losses, we conducted searches of periodicals, industry publications, special studies, and
                            litigation reporting service data. We also reviewed regulatory case data and discussed such cases and
                            related matters with banking, securities, and futures regulators. We limited our list to end-user losses
                            directly involving OTC derivatives (forwards, options, and swaps), MBS, or structured notes. We
                            excluded losses that dealers incurred and that foreign end-users transacting with foreign dealers
                            incurred. We also excluded derivatives-related losses involving the sale of mutual funds or OTC
                            contracts that CFTC or a court found to be illegal, off-exchange futures contracts. Although many of
                            the losses are supported by multiple sources, we generally did not confirm the accuracy of the
                            information provided by such sources.
                            26
                              The number of losses and the total amount of losses may be overstated by including losses involving
                            products not covered in this report and unrealized losses. The number of losses and the total amount
                            of losses may also be understated to the extent that all losses were not publicly reported. In this
                            regard, we have included in the number of losses instances where the entity was reported as having a
                            loss, even when the loss amount was not reported and, therefore, could not be included in the total
                            loss amount.
                            27
                              This percentage, as with similar percentages reported in this section, is not a statistically valid
                            estimate of the actual extent to which sales practice concerns have been raised in connection with
                            OTC derivatives, MBS, and structured note transactions. It is based on a compilation of losses that is
                            not necessarily representative of the population of transactions involving OTC derivatives, MBS, and
                            structured notes.



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                         period we reviewed,28 we found that sales practice concerns were not
                         widespread.

                         As indicated above, not all OTC derivatives, MBS, and structured note losses
                         involved sales practice disputes. For example, 42 percent of the publicly
                         reported losses were not accompanied by sales practice disputes, and for
                         OTC derivatives, 59 percent of the reported losses were not associated with
                         such disputes. End-users that incurred losses may not have raised sales
                         practice concerns if the products were used to hedge other positions that
                         had offsetting gains. EUDA confirmed that some end-users suffering large
                         derivatives losses had been using the products as hedges. In such
                         instances, the losses were not unexpected because the derivatives
                         operated as anticipated and were offset by gains in the underlying hedged
                         items. Alternatively, when derivatives performed differently than the way
                         the dealer had represented they would perform, EUDA said disputes have
                         arisen.


OTC Derivatives Losses   Our review identified 44 end-user losses that involved OTC derivatives
With Sales Practice      transactions with U.S. dealers. These losses totaled an estimated
Concerns Involved        $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
Primarily One Dealer     covering an estimated $1.7 billion in losses. The losses with sales practice
                         concerns involved 9 dealers; however 1 dealer, Bankers Trust, was
                         involved in 9 of the 18 end-user losses.

                         Sales practice allegations against Bankers Trust have been among the
                         most widely publicized and have resulted in lawsuits and regulatory
                         action. As noted in our 1994 report on OTC derivatives, Bankers Trust is a
                         major U.S. OTC derivatives dealer,29 and it had a reputation for offering
                         some of the most sophisticated derivatives products. In April 1994, two of
                         its customers, Procter & Gamble and Gibson Greetings, Inc., announced
                         that they faced losses on certain complex OTC derivatives transactions with
                         Bankers Trust. Procter & Gamble announced after-tax losses of about
                         $102 million on two complex swaps transactions, and Gibson Greetings
                         reported after-tax losses of almost $20 million in a series of complex
                         swaps and options transactions. Both corporations, as well as several
                         other Bankers Trust customers that suffered losses, filed suit against


                         28
                          According to the Federal Reserve, the amount at risk, as measured by the gross market value of OTC
                         derivatives outstanding, was $328 billion for U.S. entities, as of March 1995, or about 3 percent of the
                         notional/contract amount.
                         29
                           See GAO/GGD-94-133.



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Bankers Trust alleging, among other things, fraudulent sales practices. As
discussed on page 78, Bankers Trust has settled with Procter & Gamble
and Gibson Greetings as well as with other customers.

SEC, CFTC, and the Federal Reserve investigated Bankers Trust’s conduct,
and each regulator reached a settlement or similar agreement with
Bankers Trust (the SEC and CFTC actions were discussed in ch. 2, and the
Federal Reserve’s action is discussed in ch. 6). In December 1994, SEC and
CFTC concluded their investigations with a joint settlement addressing
Bankers Trust’s dealings with Gibson Greetings. Without admitting or
denying SEC’s and CFTC’s findings, Bankers Trust agreed to the issuance of
SEC and CFTC orders finding that the bank violated antifraud provisions of
the federal securities and commodities laws and agreed to pay a
$10 million fine. During the same period, the Federal Reserve entered into
an agreement with Bankers Trust that required it to establish, among other
things, new marketing and sales practice policies that were consistent
with safe and sound banking practices.

The eight dealers involved in the remaining nine end-user losses with sales
practice concerns were largely major U.S. securities firms;30 however,
unlike the losses associated with Bankers Trust, these losses generally
involved instances where only one end-user had raised concerns about a
dealer’s conduct. The end-users incurring the losses were foreign firms,
individuals, and a state, and their losses ranged from an estimated
$8 million to $371 million. In these losses, many of which involved
lawsuits, the end-users alleged, among other things, that the dealers had
misrepresented the risks of the products or induced the end-user to enter
into unsuitable or unauthorized derivatives transactions.

Regulatory staff at SEC, NASD, and NYSE told us that they have received few,
if any, other complaints against securities firms involving OTC derivatives.
Notwithstanding the limited number of complaints and publicized OTC
derivatives losses involving sales practice concerns, the extent to which
such concerns exist may not be fully apparent. Speaking at an industry
conference, an OCC official said that the agency’s examiners identified
instances in which banks agreed to settle certain OTC derivatives
transactions for less than the amounts due after their customers expressed
concerns about the practices that the banks used to market the products.
The OCC official was not able to estimate the total number of such
occurrences or the dollar amounts involved. Furthermore, an official from

30
  According to press accounts and other sources, five of these cases have been settled and the other
four cases are ongoing.



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                          a financial markets consulting firm also indicated that some of its clients
                          have settled transactions for amounts less than due under circumstances
                          similar to those described by the OCC official. In addition, EUDA expressed
                          the view that more sales practice disputes between end-users and dealers
                          have arisen than were aired publicly, many of which it said probably
                          involved modest losses.


More Sales Practice       MBS and structured notes were used more often than OTC derivatives, and a
Concerns Were Raised in   greater number of sales practice concerns were raised with these products
MBS and Structured Note   than with OTC derivatives. Our review identified 285 end-user losses
                          connected with MBS and/or structured note transactions. These losses
Transactions, but Such    totaled an estimated $5.6 billion. Sales practice concerns were raised in
Concerns Generally        190 of these losses, accounting for 67 percent of the total losses and
Involved Few Dealers      covering an estimated $1.6 billion. The losses associated with sales
                          practice concerns involved 56 dealers, ranging from major national
                          securities firms to smaller regional firms. However, 8 dealers were
                          involved in 148 of these losses. According to press accounts and similar
                          articles, common sales practice allegations included the dealers
                          misrepresenting the risks of the products and/or omitting material
                          information about them.

                          Our review of regulatory efforts to enforce securities laws applicable to
                          MBS and structured notes also indicated that cases in which sales practice
                          concerns were raised involved a limited number of firms, with an even
                          smaller number of firms accounting for large numbers of disputes with
                          individual end-users. To assess the extent to which sales practice concerns
                          were associated with MBS or structured note transactions, we collected
                          data on investigations by securities regulators and on complaints these
                          organizations received in the 4-year period from January 1993 through
                          December 1996. The regulatory organizations included were SEC, NASD, and
                          NYSE.31 In total, we found that these organizations had conducted 55 dealer
                          investigations during this 4-year period. However, some of these
                          investigations involved several personnel at individual firms, and some
                          dealers had been investigated by more than one regulator. Table 3.1
                          summarizes the status of these investigations.




                          31
                           As discussed in chapter 2, NASD and NYSE together oversee most of the securities firms marketing
                          MBS or structured notes in the United States.



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Table 3.1: Status of Investigations of
Dealers by SEC, NASD, and NYSE                                                                                Number of dealers
From 1993 Through 1996 for Cases         Investigation status                                              SEC           NASD           NYSE
Involving MBS and Structured Notes
                                         Dealers still under investigation                                    10               6               4
                                         Dealer investigations resulting in formal
                                          sanctions against a firm or selected personnel                       0               6               8
                                         Cases closed with no action taken                                     9               3               2
                                         Cases not pursued:
                                           Dealer out of business (e.g., bankrupt)                             1               0               0
                                           Case referred to another regulator                                  0               1               1
                                           Dealers investigated for nonsales practice
                                            violations instead                                                 4               0               0
                                           Total of cases not pursued                                          5               1               1
                                         Total                                                                24             16               15
                                         Note: Forty-four dealers were subject to investigation by these regulators during this period. The
                                         table totals to 55 as some dealers were being investigated by more than 1 regulator.

                                         Sources: GAO analysis of data from SEC, NASD, and NYSE.



                                         Overall, SEC, NASD, and NYSE investigated a total of 44 different dealers.
                                         However, just a few firms accounted for a large number of the losses in
                                         which individual end-users had raised sales practice concerns. For
                                         example, 6 Houston firms were being investigated or considered for
                                         investigation across more than 78 end-users. SEC and NASD staff were
                                         investigating 1 of these dealers for its dealings with as many as 30
                                         customers in several states. This firm consented to a regulatory
                                         settlement, stating that it had committed various sales practice-related
                                         violations, including making material misrepresentations of MBS risks,
                                         failing to adequately supervise its sales representatives, and lacking
                                         procedures to ensure that product risks were disclosed to end-users. SEC
                                         was also investigating at least 3 other dealers for activities involving
                                         numerous end-users, ranging from 10 to 23 end-users at each firm.

                                         Typically, these cases involved dealers marketing GSE-issued MBS, including
                                         some of the more volatile variations, to municipal and county governments
                                         and colleges. For example, an end-user in one of these cases—City
                                         Colleges of Chicago—had estimated losses of around $38 million, as of
                                         March 1996, after purchasing about $110 million in volatile MBS from one
                                         dealer. In at least two of the cases that SEC or the SRO staff were
                                         investigating, the end-users had accused dealer personnel of marketing
                                         high-risk securities by characterizing them as safe, federally insured
                                         investments.



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                                    Although the bulk of these cases involved a few smaller securities firms,
                                    some of the largest securities firms were involved in the MBS case that had
                                    the largest loss. In this case, Askin Capital Management, a New York-based
                                    investment management firm, reportedly lost over $660 million after the
                                    declines it experienced from adverse market movements led to the
                                    April 1994 liquidation of several funds it managed. These funds had been
                                    invested in some of the most volatile CMO tranches. Some of the fund
                                    investors sued Askin Capital Management and at least three large
                                    securities firms that sold Askin the volatile products.32 The investors
                                    alleged that Askin promised them high returns without large risks, but
                                    instead purchased high risk securities. The suit claims that the three large
                                    securities dealers abetted Askin in these fraudulent sales because they
                                    needed Askin and others to buy the higher risk CMO tranches before the
                                    lower risk tranches could also be sold, thereby ensuring the profitability of
                                    the entire issuance of securities.

                                    Other than these cases, regulators reported that a limited number of
                                    allegations of deficient dealer sales practices involving MBS and structured
                                    notes were identified. Table 3.2 shows the number of complaints received
                                    by securities industry regulatory bodies from 1993 through 1996 for MBS.
                                    These data indicate that the total complaints involving MBS was about
                                    1 percent of the total number of complaints received. These regulatory
                                    bodies did not separately track complaints, if any, they had received
                                    involving structured notes.

Table 3.2: Complaints Received by
Regulators From 1993 Through 1996                                                                                    Total complaints
                                                           Complaints involving MBS sales practices                   for all products
Involving MBS Sales Practices and
Total Complaints for All Products   Regulator               1993        1994        1995        1996        Total        (1993-1996)a
                                    SEC                        42         112          50          30        234                  49,869
                                    NASD                       51          69          57          29        206                  18,345
                                    NYSE                       71         300         405        122         898                   3,984
                                    a
                                     Includes all products for which these regulators received complaints (including stocks, corporate
                                    bonds, etc.). The volume of stocks, bonds, and other products being traded likely exceeds the
                                    volumes attributable to MBS, but we did not attempt to standardize complaint information, such
                                    as by calculating the ratio of complaints to volume traded, across products due to the lack of data
                                    on trading volumes for all products.

                                    Source: GAO analysis of data from NASD, NYSE, and SEC.



                                    The bulk of the sales practice cases being reviewed by regulators involved
                                    MBS; however, one case involving structured notes has been widely

                                    32
                                     The three large securities dealers were Kidder Peabody; Bear Stearns; and Donaldson, Lufkin &
                                    Jenrette.



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                         Chapter 3
                         Satisfaction With Sales Practices Was High
                         and Disputes Were Limited, but When
                         Disputes Occurred Losses Were Often Large




                         reported by the press. In 1994, Orange County, CA, filed for bankruptcy
                         after incurring over $1.7 billion in losses in its investment portfolio that
                         included GSE-issued structured notes. While about $970 million of the
                         losses were attributed to structured notes, the county had also used other
                         nonderivative products and had borrowed heavily to make additional
                         investments. Alleging deficient sales practices, the county filed suit against
                         two dealers—Merrill Lynch and Morgan Stanley—that sold it structured
                         notes. Other cases involving losses on structured notes have been made
                         public, but they did not involve allegations of deficient sales practices.


                         Transactions in OTC derivatives, MBS, and structured notes can present
When They Occurred,      significant risks to dealers and end-users. In addition to the familiar risks
Sales Practice-Related   arising from adverse market movements or counterparty default, dealers
Disputes Were Often      with inadequate sales practices expose themselves to significant
                         compliance and reputation risks. We found that, in the recent losses
Costly to Dealers and    involving sales practice disputes, the associated dealers and end-users
End-Users                frequently experienced significant costs related to these risks.

Compliance and           Although the potential for OTC derivatives and related financial products to
Reputation Risk Losses   produce losses from adverse market movements or counterparty default
Can Arise From Sales     has been widely discussed, parties to transactions in these products are
                         also subject to losses arising from compliance and reputation risks. These
Activities               risks are defined by OCC in December 1995 guidance and appear to aptly
                         describe the various potential losses and costs that can arise from sales
                         practice disputes.33 OCC describes compliance risk as the potential for
                         losses that result when an entity violates or does not comply with existing
                         laws, rules, regulations, prescribed practices, or ethical standards. The OCC
                         guidance also indicates that this risk is present when the laws or rules
                         governing certain products or customer activities are ambiguous or
                         untested—the situation that seems to have applied to the rapidly growing
                         markets for OTC derivatives. The actual types of losses that result from the
                         failure to adequately manage activities posing compliance risk include
                         regulatory fines, civil lawsuit penalties and damages, legal fees, and voided
                         contracts.

                         Entities entering transactions in OTC derivatives, MBS, and structured notes
                         without sound sales practices or adequate controls also subject
                         themselves to a second major risk—reputation risk. OCC defines this risk
                         as the potential for reduced earnings and firm value when negative public

                         33
                          Comptroller’s Handbook: Large Bank Supervision—Bank Supervision and Examination Process,
                         OCC (Washington, D.C.: Dec. 1995).



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                           Disputes Occurred Losses Were Often Large




                           opinion affects an institution’s ability to establish new customer
                           relationships or maintain existing ones. Such losses can also arise if the
                           shareholders of a public corporation or the investors in an investment
                           company or mutual fund file suit or reduce their investments in the
                           affected institution.


Some Dealers Experienced   The Bankers Trust case exemplifies the serious compliance and reputation
Significant Costs          risks that deficient marketing of OTC derivatives, MBS, and structured notes
Associated With Sales      can pose. Bankers Trust’s OTC derivatives sales practice disputes have
                           already resulted in significant costs, and additional compliance and
Practice Disputes          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



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Disputes Occurred Losses Were Often Large




wrongdoing, Merrill Lynch agreed to pay Orange County $27 million and to
reimburse the county and California $3 million to end a criminal probe
into the firm’s role in the county’s bankruptcy. Under the agreement,
Merrill Lynch will also implement changes in its procedures and training.
The agreement will not affect the county’s $2 billion civil damage lawsuit
against Merrill Lynch. The county also filed suit against a second major
securities dealer—Morgan Stanley—from whom it purchased structured
notes. Since initiating an investigation of this case, SEC has taken action
against the county’s treasurer and assistant treasurer.

As of June 6, 1997, SEC had not taken action against any of the dealers
involved for their conduct in marketing structured notes to Orange
County, and SEC officials advised us they do not discuss ongoing
investigations.34 However, a press account indicated that some Merrill
Lynch staff had earlier raised concerns with its management about the
potential risks involved with both marketing securities to and
underwriting the debt of Orange County, but that management had not
adequately addressed these concerns. If so, Merrill Lynch may have failed
to adequately consider the potentially serious compliance and reputation
risks of its sales practices and other dealings with Orange County.

A number of other dealers also face potential regulatory action or are
involved in litigation as a result of their sales of MBS and structured notes.
For example, Askin Capital’s loss of as much as $660 million on MBS in
1994 resulted in an SEC investigation of its fund’s activities and of the
dealers that sold it these investments. As previously discussed, investors in
its funds have also filed suit against these dealers in a New York state
court. These investors are seeking almost $700 million in restitution and an
additional $1 billion for damages from each of the three dealers named in
the suit.

Some smaller securities firms have also incurred and continue to face
additional costs from their dealings in MBS and structured notes. As
previously indicated, as many as 44 dealers are being investigated by
regulators for their sales of MBS and some have already been assessed
monetary sanctions by federal and state securities regulators or their
designated SRO. For example, Westcap Securities of Houston, TX, entered
into a consent settlement with SEC in February 1996 in which SEC found
that sales representatives had made false or misleading statements to

34
  However, SEC has filed complaints against one securities firm—CS First Boston—and two
individuals employed by that firm for their role in underwriting the debt securities Orange County used
to fund its investment portfolio. These complaints allege that the financial condition of the county at
the time of these issuances was not adequately disclosed to investors in these securities.



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                            Disputes Occurred Losses Were Often Large




                            customers in marketing CMOs and had excessively traded customer
                            accounts to maximize sales commissions. SEC found that supervision of
                            sales personnel had been deficient. SEC revoked the firm’s registration as a
                            broker-dealer and ordered it to pay over $800,000 in regulatory penalties
                            and customer restitution. The firm declared bankruptcy in April 1996.

                            Other smaller securities firms under regulatory investigation also incurred
                            additional losses and costs as a result of their sales practice-related
                            problems. For example, another Houston securities firm—Government
                            Securities Corporation—was fined $400,000 by NASD and has paid more
                            than $11 million in restitution and other costs as part of its activities with
                            over 30 local government and other public fund customers. The firm was
                            also suspended from selling certain securities to such customers for 2
                            years. Other end-user suits against dealers included one involving
                            Escambia County, FL, which sued in U.S. district court four of the dealers
                            that sold it volatile MBS that had declined in value by $21 million. In
                            another action, Odessa College of Texas settled legal proceedings under
                            terms that were not publicly disclosed against four dealers that had sold it
                            similar securities.


Some End-Users Also         In addition to the losses that end-users suffered when adverse market
Experienced Significant     movements reduced the value of their OTC derivatives, MBS, and structured
Costs From Sales Practice   note holdings, some end-users have experienced additional costs and
                            losses similar to the compliance and reputation risk losses incurred by
Disputes                    dealers. The widely publicized case of Orange County is a primary
                            illustration of the additional adverse financial impacts that an end-user can
                            experience beyond the original investment loss.

                            In December 1994, the county filed for bankruptcy—the largest reported
                            occurrence of a governmental insolvency in the United States, according
                            to a 1995 statement to Congress by the SEC Chairman—as a result of losses
                            on the portfolio of investments it managed for itself and 187 other local
                            government participants. As indicated in the Chairman’s statement, the
                            subsequent liquidation of this portfolio produced at least a $1.7 billion
                            loss.35 His statement also elaborates that, as a result of the bankruptcy
                            filing, two major rating services downgraded Orange County’s debt to
                            speculative grade status.




                            35
                              Although $1.7 billion was initially reported as the amount of the loss, some estimates indicated that
                            total losses exceeded $2 billion.



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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.




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Responsibilities Increases the Potential for
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                   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.


                   Some of the widely publicized losses on OTC derivatives, MBS, and
Disputes Have      structured notes have resulted in disputes between the end-users and
Centered on        dealers involved over the specific roles and responsibilities that each
Counterparty       envisioned for the other, including whether a fiduciary relationship
                   existed.1 An institution acting as a fiduciary to an end-user, whether
Responsibilities   established by law or fact, must act in good faith and with loyalty and
                   honesty towards the end-user and disclose to the end-user all material
                   facts relevant to actions it takes within the context of the fiduciary
                   relationship. In one lawsuit, Procter & Gamble accused Bankers Trust of
                   misusing the trust and confidence it had placed in the bank by inducing
                   the firm to enter into swaps that were represented as being safe
                   investments, when instead the transactions entailed considerable
                   undisclosed risk. Bankers Trust countered that it acted solely as a
                   principal by dealing with and not on behalf of Procter & Gamble—that is,
                   by dealing with the firm on an arm’s-length basis. The bank also indicated
                   that Procter & Gamble, as with other counterparties, was responsible for
                   making its own assessment of the likely rewards and risks of the
                   transactions, although the bank contended that it had responded to any
                   questions posed and had provided reasonable and accurate information.
                   The resolution of this case is discussed on pages 102 and 103.

                   1
                    In general, a fiduciary relationship is a relationship in which one party owes a duty of trust, loyalty,
                   and confidence to another. These relationships include, but are not limited to, those specifically
                   imposed by law. The party that owes the duty of trust, loyalty, and confidence is a fiduciary and thus
                   may not deal at arm’s length (or on equal terms) with the other party but has a duty to provide full
                   disclosure of all relevant facts about transactions, including any financial benefits it receives. A
                   fiduciary’s loyalty must be undivided in that it has a duty not to act on behalf of a competitor and not
                   to advance self-interests at the expense of the other party. A fiduciary is entitled to compensation for
                   duties performed unless it is waived by prior agreement.



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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’



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                              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.


                              Differences between end-users and dealers in the way they view their
The Potential for             responsibilities in transactions involving OTC derivatives, MBS, and
Additional Disputes           structured notes indicate that costly disputes may continue to accompany
Arises From the               end-user losses. Our survey indicated that a large percentage of end-users
                              believed that a fiduciary relationship exists when they engage in
Differing Views of            transactions involving these products. However, additional follow-up
End-Users and                 contacts with respondents revealed that, when end-users indicated a
                              fiduciary relationship existed, they were expecting dealers to accurately
Dealers                       describe product features, performance, and material risks. Our survey
                              also indicated that a significant percentage of end-users relied on dealers
                              for investment advice.

                              However, end-users’ views on counterparty relationships differed from
                              those reflected in voluntary guidance issued by two groups of dealer
                              representatives. In the guidance, transactions in OTC derivatives are
                              presumed to be on an arm’s-length basis—with no special responsibilities
                              or reliance expected of either party—unless otherwise agreed to or
                              provided by law. While the dealer-issued guidance is voluntary and
                              intended only to supplement any existing responsibilities that parties to
                              these transactions may have, the approaches to the nature of the
                              relationship, degree of reliance, and expectations for risk disclosure
                              between parties differed in some, but not all, respects from the way that
                              such issues are addressed in existing U.S. and U.K. regulatory
                              requirements applicable to securities, futures, and other financial
                              products.


End-Users Attributed          In our survey, we asked end-users to indicate the extent to which they
Some Fiduciary                believed a fiduciary relationship existed between them and dealers
Responsibilities to 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




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                                        involving plain vanilla OTC derivatives, and that 48 percent2 attributed such
                                        responsibilities to dealers in some or all transactions involving more
                                        complex OTC derivatives, as shown in figure 4.1.


Figure 4.1: Extent to Which End-Users
Believed Dealers Had a Fiduciary
Relationship                                Percentage of end-users indicating fiduciary relationship existed

                                        100




                                            80



                                                                                                   60
                                            60                                                                           58
                                                   53
                                                                            48

                                            40                                     36
                                                            31
                                                                                                              25                 26

                                            20




                                             0
                                                  Plain vanilla            More complex a               MBS            Structured
                                                                                                                       notes
                                                   OTC Derivatives b                             Securities


                                                            In some cases                        Never
                                                            In all cases

                                        Note: Percentages of end-users indicating no opinion are not shown.

                                        a
                                            Subject to a plus or minus 16-percent (or less) sampling error.
                                        b
                                            Includes securities OTC derivatives.


                                        Source: GAO survey.




                                        2
                                         Subject to a plus or minus 16-percent sampling error. See footnote 2 in chapter 3 for an explanation of
                                        sampling errors related to estimates from our survey analysis.



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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



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                                        money managers—were least likely to believe that a fiduciary relationship
                                        existed. Entities whose use of these products was generally more limited,
                                        such as state and local governments and nonfinancial corporations, were
                                        correspondingly more likely to believe a fiduciary relationship existed.


End-Users Also Indicated                In addition to views regarding fiduciary responsibilities, end-users
Reliance on Dealers for                 indicated that they relied to some extent on dealers to provide investment
Investment Advice                       advice as part of these transactions. As shown in figure 4.2, the percentage
                                        of end-users that indicated they relied on dealers to provide investment
                                        advice from some to a very great extent ranged from 59 percent for plain
                                        vanilla OTC derivatives to 84 percent for structured notes.


Figure 4.2: Extent to Which End-Users
Relied on Dealers for Investment
Advice                                  Percentage of end-users indicating reliance
                                        100


                                                                                                                            84
                                         80
                                                                                              73

                                                                        64
                                         60     59




                                         40             36
                                                                                32


                                                                                                        20
                                         20

                                                                                                                                    10


                                          0
                                              Plain vanilla            More complex a              MBS                      Structured
                                                                                                                            notes
                                              OTC Derivatives b                              Securities



                                                        To some or moderate extent                 To little or no extent
                                                        To great or very great extent


                                        Note: The percentages of end-users indicating no opinion are not shown.




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                          a
                              Subject to a plus or minus 15-percent sampling error.
                          b
                              Includes securities OTC derivatives.


                          Source: GAO survey.




Dealer-Issued Guidance    In 1995, two dealer groups each issued guidance that addresses sales
Asserts an Arm’s-Length   practices, including the nature of the relationship and the specific
Relationship              responsibilities of parties to transactions involving OTC derivatives. The
                          first set of guidance, the Framework for Voluntary Oversight (the
                          Framework), was issued by the Derivatives Policy Group in March 1995.
                          This group consists of six securities firms whose affiliates did
                          approximately 90 percent of all U.S. securities firm-related business in
                          nonsecurities OTC derivatives.3 The Framework was issued in response to
                          concerns by Congress and others that the nonsecurities OTC derivatives
                          activities of these firms were conducted in affiliates not subject to any
                          direct U.S. regulation.4 The Framework contains procedures the
                          participating firms have agreed to voluntarily follow in four major areas
                          related to OTC derivatives, including counterparty relationships, which
                          address dealer sales practices.5 Specifically, the counterparty relationships
                          section consists of guidelines for professional intermediaries to follow in
                          dealing with nonprofessional counterparties. Currently, the Framework
                          applies only to the six firms and only to their nonsecurities OTC derivatives
                          activities.6

                          In August 1995, six financial industry groups,7 in coordination with the
                          Federal Reserve Bank of New York, released the Principles and Practices
                          for Wholesale Financial Market Transactions (the Principles). The purpose
                          of the Principles is to define the relationship between institutional

                          3
                           The six firms include CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan
                          Stanley, and Salomon Brothers.
                          4
                           See chapter 2 for more detail on the regulatory structure under which these firms operate and chapter
                          6 for a discussion of SEC and CFTC monitoring of these firms.
                          5
                           The other three areas are management controls, reporting, and evaluation of risk in relationship to
                          capital.
                          6
                          The Framework enumerates the products it covers. SEC officials told us that, in general, it addresses
                          OTC derivatives not otherwise subject to regulation under the securities laws.
                          7
                           The six groups included the Emerging Markets Traders Association, the Foreign Exchange Committee
                          of the Federal Reserve of New York, ISDA, the New York Clearing House Association, the Public
                          Securities Association, and the Securities Industry Association. Since being issued in August 1995, the
                          Principles has been endorsed by two additional associations, the Institute of International Bankers and
                          the Bankers Roundtable.



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participants and to set out sound practices to be followed as part of
transactions in OTC financial products, including OTC derivatives, MBS, and
structured notes. This guidance does not purport to apply to transactions
involving retail customers. The Principles resulted from an invitation by a
senior official at the New York Federal Reserve Bank to representatives of
the six groups to develop a code of conduct for U.S. financial markets.8 In
contrast to the Framework, the Principles was promoted for use by all
institutional market participants and does not make distinctions in its
recommended practices on the basis of any differences in the professional
or nonprofessional nature of the parties to a transaction.

Although differences between the two sets of dealer-issued guidance exist,
we did not find these differences to be material. One of the members of
the Principles drafting committee, whose firm also served on the
committee that developed the Framework, reached the same general
conclusion. At an April 5, 1995, public meeting at which the Principles
drafting committee discussed the provisions of Principles, he stated that
the spirit of the two documents is the same and that it would be unfair to
contrast them simply because they use different language in some
sections.

Overall, we found that the two sets of dealer-issued guidance advocate a
similar approach to counterparty relationships. Both assert that the
relationship between counterparties—unless otherwise agreed to by the
parties or provided by law—is arm’s length with neither party relying on
the other, even if information is exchanged. Also, neither set of guidance
requires risk disclosure on specific transactions by either party, although
each states that the parties should consider exchanging such information
when the transaction is more complex or involves leverage. The summary
introducing the Framework also indicates that the six participating firms
have agreed to provide a generic risk disclosure document to new
counterparties.9 In addition, both sets of guidance recommend similar
procedures for exchanging pricing information and controlling and
supervising personnel. Furthermore, both state that they are not intended
to create legally enforceable obligations; however, courts could find the
guidance useful in evaluating counterparty relationships and defining
counterparties’ respective common law responsibilities. Table 4.1
compares the major sales practice provisions of the two sets of guidance.


8
 Several such codes existed for foreign market participants, but no code existed for U.S. market
participants.
9
 The counterparty relationships section of the Framework states that firms “should consider
providing” these generic risk disclosure documents.



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Table 4.1: Key Sales Practice Elements of the Dealer-Issued Guidance
Element                 The Framework                                                 The Principles
Nature of the            Transactions are predominantly arm’s length in which         Transactions are arm’s length and both parties should
 relationship            each party has the responsibility to review and              have the capability to understand and make
                         evaluate the terms, risks, and benefits of the               independent decisions about transactions.
                         transaction.
Reliance on the          A dealer should not create the impression that it is         Absent any written agreement or applicable law or
 dealer                  acting in an advisory capacity and should take steps         regulation, information passed between the parties
                         to clarify the relationship if the counterparty indicates    should not be construed as investment advice or
                         that it believes the dealer is acting in such a role.        recommendations upon which the other party may
                                                                                      rely.
Disclosure of risk       No disclosure is required on specific transactions, but      No disclosure is required, and, if none is requested,
                         the summary indicates participating firms have               the counterparties are to assume that each has
                         agreed to provide a generic risk disclosure statement        sufficient information about transaction risks and
                         that describes principal OTC derivatives risks and that      terms for its decisionmaking process. A written outline
                         clarifies the nature of the counterparties’ relationship.    of the material terms of the transaction is considered
                         Also, when specifically requested, particularly for          helpful. If a transaction is particularly complex or has
                         more complex or leveraged transactions, dealers              significant leverage, counterparties are advised that
                         should provide additional information that accurately        they may wish to share more information, such as
                         presents the potential transaction’s risks and benefits,     scenario analyses.
                         such as scenario analyses (which shows how a
                         product’s value may change under different market
                         circumstances).
Disclosure of            When provided, such information should be prepared           Counterparties are not obligated to provide valuations
  valuation or pricing   in good faith and should not be misleading. Dealers          but should have policies to address the specific
  information            should take steps to ensure that their counterparties        methodology used for calculating such information. If
                         understand the type of price quote or valuation they         unable to internally value transactions, counterparties
                         are receiving (i.e., indicative price, firm price, or        should seek external valuations and clearly indicate
                         mid-market valuation).                                       the desired type of valuation information being sought.
Internal controls        Dealers should adopt internal policies and                   Counterparties should have board or senior
                         procedures to foster strong relationships with               management-approved policies covering their use of
                         counterparties. Mechanisms should be in place for            financial products and should maintain and enforce
                         supervising activities of personnel engaged in OTC           controls and compliance procedures, including those
                         derivatives transactions.                                    relating to supervising personnel, to ensure that such
                                                                                      transactions are conducted in accordance with
                                                                                      applicable legal and regulatory requirements, internal
                                                                                      policies, and other requirements.
                                               Sources: GAO analyses of the Framework for Voluntary Oversight and the Principles and
                                               Practices for Wholesale Financial Market Transactions.



                                               As a part of stating that neither counterparty should rely on the other, both
                                               the Framework and the Principles advocate that each party should be
                                               capable of independently analyzing prospective transactions. This
                                               expectation is generally consistent with existing risk management
                                               guidance, such as that issued by the Group of Thirty10 and others, for


                                               10
                                                 The Group of Thirty is an international financial policy organization whose members include
                                               representatives of central banks, international banks and securities firms, and academia.



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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.




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                             The Framework and the Principles also note that participants must be
                             mindful of the potential for transactions to result in disputes as well as to
                             expose them to compliance risk—the risk of loss from counterparty or
                             shareholder lawsuits, regulatory fines, and voided contracts—and
                             reputation risk—the risk of loss from reduced revenues and firm value.
                             Both sets of dealer guidance acknowledge that certain transactions pose
                             greater levels of these risks, such as when the transaction is more complex
                             or involves leverage, or when the counterparty lacks sophistication or the
                             capability to independently analyze the transaction. In such cases, both
                             indicate that participants may wish to increase the amount of information
                             they exchange, involve additional internal personnel or external advisors
                             in negotiating the transactions, or take other steps, including avoiding the
                             transaction. Both sets of guidance also advocate that counterparties
                             establish policies and procedures to assess and mitigate the extent to
                             which these transactions create compliance and reputation risks for each
                             party, such as when counterparties appear to believe that the dealer has
                             assumed an advisory role.


The Dealer-Issued            To identify any significant differences between the dealer-issued voluntary
Guidance Differs in Some,    guidance11 and other existing sales practice standards, we compared the
but Not All, Respects From   major tenets of the dealer guidance to the approaches embodied in bank
                             supervisory guidance, a foreign code of conduct, and U.S. commodities
Regulatory Standards         and securities laws.12 Differences between the dealer-issued guidance and
Applicable to Other          these other standards could generally be attributed to differences in their
Activities                   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

                             11
                               The drafters of the Principles intended that their guidance be applicable to all institutional financial
                             market transactions, not just to those involving OTC derivatives. Nonetheless, they have
                             acknowledged that entities adhering to the guidance are not relieved of any obligations under existing
                             law.
                             12
                               We were aware when doing these comparisons that the dealer-issued guidance is most relevant to
                             transactions involving nonsecurities OTC derivatives, which currently lack a specific body of law
                             relevant to sales practices.



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take steps to ensure that the counterparty is made aware of transaction
risks. The goal of bank supervisory guidance as it relates to OTC derivatives
is to promote the safety and soundness of regulated institutions; it is not
specifically intended to protect those who engage in financial transactions
with these institutions.

The expectations for dealers set out in the dealer-issued guidance are also
similar in some, but not all, respects to the requirements applicable to
futures trading in the United States. Similar to the dealer guidance, U.S.
commodities laws do not require entities marketing futures and
exchange-traded options to determine whether such products are suitable
for their customers. However, in contrast to the Principles, U.S.
commodities laws require that the customer be apprised of the significant
risks of buying and selling these products, including disclosing that the
prices of futures and options can be volatile and that the customer may
incur losses that are larger than the amount originally invested.

The dealer-issued guidance is most similar to regulatory requirements
issued in one of the major foreign markets for OTC derivatives and foreign
exchange. In July 1995, the Bank of England issued an update to The
London Code of Conduct,13 which was developed in conjunction with U.K.
market participants. Similar to the U.S. dealer-issued guidance, the U.K.
code establishes that the nature of the relationship for products in
institutional markets involves transactions between principals, with
end-users assumed to be capable of independently evaluating the
transaction. In addition, the U.K. code states that if the end-user wishes to
retain the other party as an adviser, it should do so in writing.14 Just as
with the U.S. dealer-issued guidance, the U.K. code also states that
participants share an interest in maintaining high standards of business
conduct and fair dealing. However, whereas compliance with the U.S.
dealer-issued guidance is voluntary, compliance with the U.K. code is
mandatory. The code indicates that the U.K. central bank—the Bank of
England—will view breaches of its provisions seriously, will investigate
complaints, and may employ a range of sanctions against violators.

The responsibilities envisioned by the dealer-issued guidance contrast
most with the SEC requirements imposed on dealers marketing securities in

13
 The London Code of Conduct: For Principals and Broking Firms in the Wholesale Markets, Bank of
England (London: July 1995).
14
 The U.K. code classifies securities firms, banks, and other financial institutions as “core” principals
and considers other institutions, companies, and governments as “noncore” principals active in these
markets. Core principals are expected to adhere to this code in their dealings and noncore principals
are expected to understand these institutions’ roles and responsibilities.



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                        the United States. Although the Framework and the Principles do not
                        supersede existing regulatory requirements, they vary in several major
                        respects from U.S. securities law requirements. Whereas the dealer-issued
                        guidance asserts that an arm’s-length relationship exists between
                        counterparties, dealers marketing securities are expected to ensure that
                        transactions they recommend are suitable, given the investment
                        objectives, financial condition, and sophistication of the end-user.
                        Disclosure of transaction risk, which the dealer-issued guidance makes
                        optional for specific transactions, is generally expected as part of
                        securities transactions.

                        The differences between the dealer-issued guidance and U.S. securities
                        laws may stem, in part, from differences in the types of entities to which
                        each applies. The dealer-issued guidance addresses transactions between
                        participants who tend to be large financial and commercial entities and
                        tend to be financially sophisticated. In addition, the dealer-issued guidance
                        does not apply to individual investors. In contrast, the antifraud provisions
                        of the U.S. securities laws apply equally to all investors and do not
                        distinguish between institutional and individual end-users.15 Furthermore,
                        the required disclosures that must be made as part of corporate securities
                        issuances are designed to ensure that any superior knowledge about the
                        financial condition and risks associated with the entity issuing the
                        securities are made known to prospective investors.


                        End-user and dealer reactions to the specific tenets of the Framework and
Reconciling the Views   the Principles have been mixed. Such reactions may reflect the parties’
of End-Users and        differing interests when it comes to defining the nature of their
Dealers Could Be        relationship in transactions involving OTC derivatives. Part of the difficulty
                        arises because altering the nature of the relationship between end-users
Difficult               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.




                        15
                          In some cases, U.S. securities laws make distinctions between types of investors, such as the reduced
                        disclosure requirements pertaining to private placements of securities. NASD’s recent suitability
                        interpretation also addresses dealers’ responsibilities to institutional versus other end-users.



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Reactions to the Tenets of   End-user representatives, including EUDA, GFOA, the National Association of
the Dealer-Issued            State Treasurers (NAST),16 the North American Securities Administrators
Guidance Have Been           Association (NASAA),17 and the Department of Labor have criticized the
                             tenets of the dealer guidance.18 Others, including legal experts, have also
Mixed                        voiced concerns about specific provisions of the guidance. In contrast,
                             representatives of dealers and certain other organizations have supported
                             the guidance.

                             Although public comments were not sought on the Framework, the
                             drafting committee of the Principles solicited comments before finalizing
                             the guidance. We analyzed the comment letters to identify the views of
                             end-users and others on the specific tenets of the dealer-issued guidance,
                             many of which were common to both the Principals and the Framework.
                             Of the 21 organizations that commented, we spoke with 9 that provided
                             substantive criticisms of the Principles. These nine organizations told us
                             that their primary criticisms had not been addressed in the final version of
                             this guidance.

                             One of the primary objections raised by commenting organizations was
                             that the dealer-issued guidance inappropriately assumes that an
                             arm’s-length relationship should prevail for all transactions. Those citing
                             this issue argued that the dealer guidance thus imposes a “one-size-fits-all”
                             model on end-users despite their varying levels of financial sophistication.
                             For example, in their joint comments on the final draft of the Principles,
                             three associations representing governmental entities19 stated that
                             because the guidance uses the term “participant” to refer to both dealers
                             and end-users, no distinction is made between their respective roles and
                             responsibilities. As a result, they believe that the value of most of the
                             document is negated. Additionally, the associations stated that end-users
                             are a diverse group and that assuming they all have equivalent levels of
                             expertise, responsibility, and access to information is erroneous.




                             16
                               NAST is a 75-member association of state and territorial treasurers, deputies, and staff.
                             17
                               NASAA members are the securities regulators of the 50 states, the District of Columbia, Puerto Rico,
                             the Canadian provinces and territories, and Mexico. It develops model codes and guidelines, facilitates
                             cooperative enforcement efforts, fosters information-sharing, and provides training.
                             18
                               As well as reviewing journal articles and conference proceedings, we also obtained copies of critical
                             letters that various organizations sent to the drafting committee of the Principles. These organizations
                             included the Treasury Management Association, the Financial Executives Institute, NASACT, and the
                             New York State Bar Association.
                             19
                               The three associations were GFOA, NAST, and NASAA.



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Another criticism has been that the Principles may reduce end-users’ legal
protections. In a May 3, 1996, letter to the Federal Reserve Bank of New
York, EUDA noted that Bankers Trust offered the Principles as
documentation of common practices for OTC derivatives transactions in
support of its litigation with Procter & Gamble. EUDA indicated that
Bankers Trust’s action affirmed the association’s original concerns that
the Principles would be used by dealers to reduce the legal protections
afforded end-users. EUDA characterized the Principles as “essentially a
unilateral effort on the part of the dealer community to shift
responsibilities from the dealers to end-users and to buttress the position
of the dealers in pending and possible future litigation.” Some have argued
that adherence to the dealer guidance may negatively affect the ability of
end-users to claim reliance on dealer representations. GFOA, NASACT, and
NAST stated in a joint issuance to their members that they might
inadvertently waive existing legal rights if they agreed to be bound by the
Principles without careful prior review.20 In their letter commenting on the
draft of the Principles, these organizations also indicated that the attempt
by the guidance to preclude reliance on a dealer was not realistic because
potential investors should be able to, and often do, rely on representations
made by dealers about products. However, the organizations stated that
the guidance would require written acknowledgement by the dealer before
any such reliance could occur.

Some of the commenting organizations also objected to the guidance
because it does not place any responsibilities on dealers to disclose
transaction risks or valuations. For example, in its November 1995
newsletter, EUDA stated that the Principles drafting committee had
“philosophically rejected the idea that dealers should have any affirmative
obligation to disclose material risks of OTC derivative transactions to
end-users, irrespective of the complexity or novelty of the transactions.”
Later in that newsletter, EUDA stated that “the final Principles make it clear
that a dealer is not obligated to provide periodic valuations to its end-user
counterparty, regardless of whether the instrument sold is a proprietary
product of the dealer for which market valuations are neither publicly
available nor readily ascertainable.” The associations representing
governments stated that the guidance should recognize a dealer’s
affirmative obligation to provide information material to a transaction
instead of requiring an end-user to request it. They believe that failing to
do so inappropriately assumes that both sides have equal information.
They also objected to the Principles’ assumption that any additional

20
   State and Local Government Investor Protection ALERT, GFOA, NAST, and NASACT (Washington,
D.C.: Oct. 16, 1995).



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transaction information, if not specifically requested, is considered
unnecessary.

In commenting on the Principles, various associations representing
governmental entities stated that the Federal Reserve’s agreement with
Bankers Trust21 would be a better model for disclosing risk and ensuring
that end-users understand transactions.22 Such a model would require
dealers to (1) provide every counterparty with information about the
material terms and risks of any applicable proposed transactions,
(2) ensure that every counterparty could understand such terms and risks,
and (3) ensure that the means by which product prices and values are
determined are reasonably clear to counterparties. Dealers would also be
required to meet specific disclosure obligations for proposed transactions.

Another criticism of the guidance was that end-users were insufficiently
involved in their development. For example, the Department of Labor
stated in its comment letter on the draft Principles that “entities which had
no involvement in the creation of the Principles, had not agreed to adhere
to the Principles, or may not even have known of its existence could be
viewed as subject to the Principles.” The agency also stated that the
Principles should only apply to entities that subscribe to them in writing.
According to EUDA, “the process followed in developing the Principles and
Practices was fundamentally flawed” because representatives of the
end-user community were excluded from the Principles Drafting
Committee. The treasurer of a major utility, who is an EUDA board member,
was quoted in an industry publication as stating that “this is probably the
only area in the finance world where a group of dealers have shaped both
the products and all of the surrounding rules and regulations, with no
input from those who are not dealers.”23

Finally, in a May 1995, letter to the Principles drafting committee, GFOA
contrasted the Framework with the Principles by stating that the
Framework “takes limited steps in advising professional intermediaries to
OTC transactions to disclose information regarding risks, clarify valuation
questions, and provide training regarding counterparty relationships.” A
GFOA official told us that, although these documents call for largely the



21
  The Bankers Trust-Federal Reserve agreement applied these heightened requirements only to those
transactions involving significant leverage. The agreement is discussed more fully in chapter 6.
22
 Comments on Principles and Practices for Wholesale Market Transactions, GFOA, NAST, and
NASAA (Washington, D.C.: May 19, 1995).
23
  “Resolving the Dealer-User Conflict,” Derivatives Strategy, May 1996, Vol. 1, No. 6, page 17.



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                             same practices, GFOA believed that the Framework was more balanced in
                             tone.

                             Representatives of dealers and other organizations have viewed the
                             Principles more positively. A member of the ISDA board told us that the
                             greater use of OTC derivatives has increased the need for dealers to
                             formally explain their products and activities, including the risks
                             associated with product use and the nature of their responsibilities in
                             these transactions. A managing director at a large U.S. securities firm said
                             that he disapproved of end-users who, when faced with losses, decide that
                             they were not fully informed about the transactions. Therefore, he saw the
                             guidance as valuable for describing the customary way the institutional
                             markets work and for clarifying that dealers, unless otherwise agreed to,
                             do not have fiduciary obligations as part of these transactions. An official
                             from the New York Federal Reserve Bank indicated that the Principles
                             provides a sound basis for relationships between parties conducting
                             activities in financial products. He said that it assumes an arm’s-length
                             relationship unless otherwise agreed to and acknowledged that parties can
                             agree to alter this assumption in writing if it does not fit their
                             circumstances. He also stated that the United Kingdom makes the same
                             assumption about the nature of counterparty relationships, and it would
                             be problematic for U.S. practices to be inconsistent with those of other
                             major markets.


The Interests of End-Users   Difficult issues remain to be resolved before the differing interests of
and Dealers Conflict When    end-users and dealers over the nature of their relationship can be
It Comes to Defining Their   reconciled. To date, attempts to address these differences have not been
                             successful. The primary areas of disagreement and uncertainty between
Relationship                 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



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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,



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                          an SEC commissioner said that dealers sometimes are tempted to describe
                          products in sophisticated terms to increase their proprietary value.

                          Although comments on a draft of the Principles were solicited in a public
                          session, few meetings between end-user and dealer groups have been held.
                          A representative of GFOA said that members of the Principles drafting
                          committee met with their organization and other governmental end-user
                          associations just before issuing the final draft of that document. A
                          representative from another end-user organization told us that his
                          organization had been approached in early 1996 about working on a
                          committee to revise the Principles, but they had declined to participate at
                          that time because, according to this official, participation was made
                          contingent on endorsing the Principles. As of August 1997, no additional
                          meetings for the purpose of reconciling dealer and end-user views on the
                          nature of their relationship as part of OTC derivatives transactions had
                          been held.


The Financial Impact of   Resolving disagreements about the nature of the relationship between
Altering the Nature of    end-users and dealers may be more difficult because the resolution can
Relationships May Make    affect who bears what costs in transactions involving OTC derivatives, MBS,
                          and structured notes. As our survey and other information indicated,
Resolving Disagreements   end-users believe they should be able to rely on the information that
More Difficult            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



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                              the markets.24 The Chairman testified that dealers in financial transactions
                              sometimes assume a role beyond that of a mere counterparty, such as
                              when they provide advisory services. However, if dealers are required to
                              ensure that an end-user’s use of a product is appropriate, such
                              requirements may serve as a means for end-users to shift a transaction’s
                              risk back to the dealer through legal actions. If such legal risks are
                              exacerbated, dealers may begin charging a premium to cover uncertain
                              future legal claims, and some dealers could move their activities overseas
                              or withdraw from the market altogether. He said that such an outcome
                              would present considerable costs to the economy because of the resulting
                              interference in liquid and efficient markets.


A Dealer Group Proposed       ISDA proposed standardized language that describes the nature of the
Contract Language to          relationship between counterparties to OTC derivatives transactions and
Address the Nature of         that could be incorporated into OTC derivative contracts. ISDA suggests that
                              this language be added to the ISDA master agreement—the standardized
Counterparty                  contract used to document the obligations of parties to OTC derivatives
Relationships                 transactions.25 If included as part of such contracts, each party would be
                              representing that

                          •   it was not relying on the other party and was making its own decisions
                              about the transaction,
                          •   it was capable on its own (or with independent professional advice) of
                              understanding the terms of the transaction and its risks, and
                          •   it was not acting as a fiduciary or an advisor in the transaction.

                              An official from a large U.S. corporation indicated that his firm refused to
                              sign contracts with this provision. He said that, although his firm did not
                              expect dealers to act as fiduciaries, it wanted to be able to rely on
                              statements of fact made by the dealers about product performance under
                              different market conditions. He noted that, although his firm was large
                              enough to refuse to sign contracts that included language such as that
                              suggested by ISDA, smaller end-users might not have the same clout and
                              thus might sign as a condition of completing a transaction.

                              An attorney speaking on behalf of EUDA at a July 1996 industry forum said
                              that the organization was cautioning end-users about signing contracts


                              24
                               Testimony by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System:
                              Committee on Banking, Housing, and Urban Affairs; United States Senate (Washington, D.C.: Jan. 5,
                              1995).
                              25
                                Representation Regarding Relationship Between Parties, ISDA (New York, N.Y.: Mar. 6, 1996).



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                             with this language in the event that doing so waived rights they might
                             otherwise have, such as the ability to claim fraud on the basis of
                             misrepresentations or omissions of fact. Although ISDA had amended the
                             representation in an attempt to address this concern, the attorney told us
                             that she was aware of the amendment when she spoke at the conference
                             and that EUDA’s reservations about the representation’s language persist.


Recent Court Decisions       In two cases resolved since 1995, courts have indicated that, although OTC
Have Found That OTC          derivatives dealers were not acting as fiduciaries, they were held
Derivatives Dealers Have     responsible for being accurate when disclosing transaction risks. The first
                             case, decided in the English Commercial Court in December 1995, was
Some Responsibilities, but   decided in the dealer’s favor. Although a U.K. case, the decision is relevant
They Have Not Resolved       to U.S. OTC derivatives counterparties because many of their swaps
Key Issues                   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



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                           these three counts to proceed to trial. Bankers Trust had argued that the
                           transactions in question had been conducted at an arm’s length. In the
                           ruling, the judge concluded that Bankers Trust had not been acting for or
                           on behalf of Procter & Gamble as in a typical customer-broker context, but
                           instead the two were principals to a contract and, therefore, no fiduciary
                           duties were imposed. However, he did find that, under New York law,
                           Bankers Trust had a duty to disclose material information about the
                           transaction, both before and during the transactions, and also had a duty
                           to deal fairly and in good faith during the performance of the transactions.

                           The judge’s ruling in the Procter & Gamble case did not definitively settle
                           the extent to which dealers, in general, have responsibilities to disclose
                           material information about transaction risks or the other requirements
                           that may apply to dealers’ marketing activities. Since the ruling was made,
                           several journal articles have provided conflicting views on the implications
                           of the judge’s ruling on dealers’ obligations. At a July 1996 conference in
                           Washington, D.C., representatives of dealers and end-users as well as legal
                           experts also offered conflicting views on the conclusions that could be
                           drawn from the ruling. Furthermore, in its announced settlement with an
                           individual Bankers Trust employee who had marketed these products to
                           Gibson Greetings, SEC stated that it disagreed with the Ohio judge’s ruling
                           in the Procter & Gamble case regarding the inapplicability of federal
                           securities laws to certain OTC derivative products.


The Need to Address        Representatives of regulators, end-users, and dealers have recognized the
Conflicting Views on the   need to reach agreement on the specific responsibilities of dealers as a
Nature of Counterparty     part of transactions in OTC derivatives, MBS, and structured notes. While
                           speaking at a forum for end-users about the relationship that should
Relationships Has Been     prevail between end-users and dealers in institutional market transactions,
Recognized                 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



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market efficiency and reduce dealers’ legal liability. Furthermore, he said
that having dealers agree on the rules regarding their responsibilities was
better than having thousands of end-users attempting to individually
negotiate the nature of their relationship with dealers. However, he also
acknowledged that when the nuances of relationships do not fit within the
generally agreed-upon framework, then changes could still be individually
negotiated.

Others have also recognized a need for end-users and dealers to agree on
the nature of their relationship. A former securities regulator said that
end-users and dealers need to agree on a set of common terms so that
each side understands what type of information the other is providing and
which statements can be relied on and which cannot. End-users and
dealers should also discuss when and how scenario analyses should be
provided. Coming to such agreement could reduce the number of
instances where legal disputes occur. In response to an end-user’s
concerns over the need to rely on the information dealers provide about
product features and performance, ISDA’s legal counsel agreed that the
parties need to discuss these issues with the goal of reaching a consensus.
In a May 1996 article, an EUDA board member remarked that the
organization hoped to continue to work with dealers to develop mutually
acceptable practices for these products.

Some market participants have observed that the involvement of one or
more federal financial market regulators may be needed to assist
end-users and dealers in resolving disagreements about dealer
responsibilities. Speaking at a June 1996 risk management forum,
representatives of a large dealer bank and a securities firm indicated that
financial regulators had a role to play in assisting the end-user and dealer
communities in reaching agreement on their responsibilities. At an
industry forum in July 1996, an attorney with futures regulatory expertise
commented that the existence of different regulatory requirements and
dealer-issued guidance creates confusion over what standards apply or
should apply to transactions in these products. He expressed the desire
that end-users and dealers jointly come to agreement and suggested that
the standards proposed by bank regulators would be a good starting point
for considering what form such agreements could take. He and other
forum participants indicated that financial market regulators, especially
SEC and CFTC, could assist in clarifying the legal standards that are
applicable to these transactions. EUDA has also acknowledged that federal
financial market regulators could play a role in this process. In a May 3,




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1996, letter to the New York Federal Reserve Bank, the end-user
association called for guidelines that

“. . . could be endorsed and implemented by both dealers and end-users. This would
require, however, that all sides and views be invited to the drafting table without
preconditions. If the Federal Reserve Bank of New York does not want to facilitate such a
dialogue under its auspices, we feel certain that other interested persons or government
agencies would do so.”


Although not calling for federal involvement, the Chairman of the Federal
Reserve Board provided some criteria for appropriate regulatory
intervention in the markets. In the previously cited January 1995
congressional testimony, the Chairman stated that markets function most
efficiently when both parties are free to enter transactions at their own
discretion and are unhampered by the need to serve the interests of their
counterparties. He emphasized that any consideration of regulation in this
area should adhere to the principle that parties to financial transactions
are responsible for their own decisions. However, he noted that
misrepresentation and fraud could not be tolerated. He also said that, in
some cases, end-users may not reasonably be expected to understand the
risks involved in certain complex products, and that dealers in financial
transactions sometimes act as more than just a counterparty by providing
advisory services. According to the Chairman, addressing the situation
may require limiting the use of some products to only certain
organizations, providing guidance to end-users for investment and risk
management, encouraging them to obtain independent advice, or
encouraging them to diversify their portfolios. However, he cautioned
against approaches that would allow end-users to shift a transaction’s risk
back to the dealer through legal actions, because such approaches would
likely increase transaction costs, discourage dealers from offering these
products, and interfere with currently liquid and efficient markets.




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                     Regardless of whether end-users and dealers collectively reach agreement
                     on the nature of their relationship, they can individually protect
                     themselves against sales practice disputes by having in place strong
                     corporate governance systems,1 including internal controls and related
                     practices. In discussions with us, dealers described implementing internal
                     controls and sales practices that were consistent with those advocated by
                     the two sets of dealer-issued voluntary guidance analyzed in chapter 4.
                     Nonetheless, regulators identified weaknesses in sales practices that
                     exposed dealers to the risk of loss. Similarly, end-users described a range
                     of procedures for controlling investment risk; however, some lacked basic
                     controls. Also, reviewing organizations identified specific weaknesses in
                     end-user controls that contributed to losses. To help end-users better
                     manage their activities, professional associations have issued guidance for
                     their members to use in strengthening their corporate governance systems,
                     including their internal controls and related practices. Actions have also
                     been taken by various state governments to reduce the risk of loss
                     associated with the use of OTC derivatives, MBS, and structured notes.


                     In our previous reports on derivatives, we stressed the importance of
Corporate            organizations having strong corporate governance systems to ensure that
Governance Systems   risk management and internal control systems are in place and functioning
Can Address Sales    as anticipated. Under an effective corporate governance system, the board
                     of directors approves policies and oversees the organization’s activities in
Practice Issues      financial products, including OTC derivatives, MBS, and structured notes. In
                     addition to losses arising from adverse market movements or counterparty
                     defaults, the marketing and use of these products can expose dealers and
                     end-users to risks that can be similarly costly. Various entities, such as the
                     Federal Reserve, OCC,2 and the Group of Thirty,3 have issued guidance that
                     emphasizes the need for sound corporate governance systems to address
                     the risks posed by dealing in and using these products. These sets of
                     guidance are applicable to dealer marketing and end-user investment
                     activities. As discussed at the end of this chapter, various end-user groups

                     1
                      Governance systems are concerned with transactions and relationships within an organization,
                     including who controls which activities, who makes decisions, and who has what responsibilities for
                     which claims against the revenues and assets of a company. Although we refer to these systems as
                     corporate governance, they also apply generally to governmental entities.
                     2
                      In addition to guidance for banks acting as dealers, the Federal Reserve and OCC have issued
                     guidance for banks that use OTC derivatives and other financial products primarily as end-users. See
                     Evaluating the Risk Management and Internal Controls of Securities and Derivative Contracts Used in
                     Nontrading Activities, Federal Reserve Board (SR 95-17) (Washington, D.C.: Mar. 28, 1995) and
                     Comptrollers Handbook: Risk Management for Derivatives, OCC (Washington, D.C.: Oct. 1994).
                     3
                       Derivatives: Practices and Principles, Global Derivatives Study Group, Group of Thirty (Washington
                     D.C.: July 1993).



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                          have also issued guidance that is specifically targeted to their members’
                          investment activities and that addresses the importance of a strong
                          corporate governance system.


                          The dealers we contacted described sales practice policies and procedures
Dealers Described         for marketing OTC derivatives, MBS, and structured notes that we found to
Sales Practice Policies   be consistent with the Framework and the Principles that were discussed
and Procedures That       in chapter 4.4 Dealers indicated that the extent to which they disclosed
                          transaction risks depended on the product and the needs of the end-user.
Were Consistent With      In general, they explained that the amount and type of information they
the Dealer-Issued         disclosed about the risks of transactions in OTC derivatives, MBS, and
                          structured notes varied depending on the complexity of the product. For
Guidance                  more complex products, dealers generally indicated that they would
                          provide more detailed descriptions, explanations, and materials about the
                          product’s performance and risks. The firms also indicated that scenario
                          analyses were sometimes provided, particularly for more complex
                          transactions. The dealers explained that the amount of information they
                          provided also varied depending on the sophistication of the end-user. For
                          example, officials at one of the large securities firms told us that end-user
                          sophistication was key to determining how much information was
                          included in proposals—that is, the less sophisticated the end-user, the
                          more information they would include.

                          Although dealers of OTC derivatives, MBS, and structured notes told us that
                          they considered the circumstances of end-users when marketing these
                          products, they did not view this as necessary for all transactions. At least
                          four of the dealers we contacted explicitly stated that they were not
                          responsible for assessing the suitability of OTC derivatives transactions for
                          end-users. However, all of the dealers said that their firms’ policy is to
                          tailor transactions to end-user objectives and sophistication. For example,
                          officials at a major bank and a major securities firm indicated that,
                          although suitability determinations are not legally required for OTC
                          derivatives, their staff are generally protective of their relationships with
                          end-users and would not knowingly enter into transactions that were
                          inappropriate for end-users. However, officials at another major securities
                          firm told us that they would enter into a transaction they believed was
                          inappropriate for an end-user if the end-user insisted on proceeding even
                          after hearing the dealer’s advice against such action. Dealers also generally

                          4
                           We interviewed or obtained written responses from 14 dealers, including 5 large U.S. securities firms,
                          3 large U.S. banks, and 1 foreign bank—all of which marketed OTC derivatives, MBS, or structured
                          notes. In addition, we obtained information from two smaller banks and three smaller securities firms
                          that almost exclusively marketed MBS and structured notes.



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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



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                  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.


                  Although dealers described following sales practices that were consistent
Regulatory        with the dealer-issued voluntary guidance, regulatory examinations
Examinations      indicated that most dealers had some areas where improvements were
Surfaced Dealer   warranted. As noted in chapter 3, we did not find that a large number of
                  dealers had deficient sales practices. In addition, in examinations
Weaknesses        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



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                       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.


                       Our review found that the policies and controls varied widely at the
End-Users Described    organizations we contacted that used OTC derivatives, MBS, and structured
a Range of Controls,   notes. From a judgmentally selected sample of respondents to our survey,
but Some Lacked        we obtained information through telephone interviews about the practices
                       and controls in place at 50 organizations that had used OTC derivatives,
Basic Controls         MBS, or structured notes or that had only heard dealer presentations on
                       these products. The organizations we contacted described a range of
                       policies and practices governing the use of these products.5 Some
                       described very sophisticated and involved processes, whereas others
                       acknowledged that very few formal policies or practices existed. For

                       5
                        We did not obtain complete information from every organization we contacted, therefore, totals for
                       individual policies or controls do not add to the total number of organizations contacted.



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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




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conduct such evaluations, indicated that they would only use dealers with
high credit ratings.

Consistent with the descriptions of the practices followed by respondents
we contacted, surveys by other organizations also found that end-user
practices and controls varied across firms.6 For example, a 1995 survey by
the Wharton School of Business found that while 76 percent of
respondents had policies addressing their use of these products, only
3 percent reported results monthly to their boards, 25 percent reported
results quarterly, 20 percent reported results annually, and 51 percent
reported results on an as-needed basis.7 This survey and one other8 also
found that just under one-half of the respondents conducted stress-testing
or scenario analyses on their portfolios to determine how they could be
affected by severe market changes. A 1995 survey of 75 large,
multinational corporations found that their ability to internally determine
the value of their holdings varied widely across these organizations,
depending on the products involved. Seventy-six percent reported being
capable of pricing forwards and futures contracts, but only 38 percent of
the corporations reported that they could independently price swaps and
swaptions,9 and 14 percent reported such capabilities for complex
options.10

Other surveys also found that the controls employed by end-users varied.
Separate surveys by two financial journals of between 150 and 200 large
U.S. firms reported that the authority for entering into transactions in OTC
derivatives and similar products resided mainly with senior managers who
were responsible for the organizations’ finances, but that some firms had




6
 We attempted to confirm that the organizations and products examined in these other surveys were
generally comparable to those discussed in this report; however, we did not otherwise assess the
quality or verify the results of these surveys.
7
  1995 Survey of Derivatives Usage by U.S. Non-Financial Firms, Wharton School of Business/Canadian
Imperial Bank of Commerce/Wood Gundy. (Philadelphia, PA: Oct. 1995). This survey received 142
responses from end-users in a random sample of U.S. publicly held nonfinancial firms.
8
  “Survey of CFOs,” Institutional Investor Magazine (June 1995). This survey received 150 responses
from chief financial officers from a judgmentally selected sample of large U.S. public and private
corporations.
9
 A swaption is an option that grants the holder the right to enter into a swap with predetermined
terms.
10
   Emcor Fax Survey, Emcor Risk Management Consulting, Inc. (Nov. 1995). This survey received 75
responses from finance officers from a judgmentally selected sample of large, multinational
corporations.



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                        recently begun requiring additional levels of approval.11 Similarly, an
                        accounting firm’s survey of U.S. and international investment fund
                        companies reported that one-third of those surveyed who had used
                        derivatives had a supervisory board or risk management committee that
                        established limits on the use of derivatives and similar products.12

                        A more recent survey that addressed the practices of end-users also
                        showed that practices varied across organizations. In November 1996, one
                        of the large public accounting firms issued a survey of almost 700 financial
                        and nonfinancial organizations that used exchange-traded and OTC
                        derivatives.13 According to this survey, although these organizations
                        followed generally consistent practices in accounting for these
                        transactions, a range of practices existed for how they defined and
                        evaluated the risks of these activities.


                        Although concerns over dealer sales practices have arisen in a number of
Reviewing               recent losses, in some of these cases, weaknesses in the end-user’s
Organizations Found     internal controls and practices contributed to the end-user’s losses.
That Weaknesses at      Various groups have called for end-users to improve their management of
                        and controls over the use of products like OTC derivatives, MBS, and
End-Users               structured notes to reduce the potential for losses and resulting sales
Contributed to Losses   practice disputes. The types of controls advocated by these groups are
                        intended to reduce end-user dependence on the information provided by
                        dealers and the resulting vulnerability to deficient dealer sales practices.
                        Federal and state regulators, state audit departments, and other reviewing
                        organizations that examined end-user losses where sales practice disputes
                        existed found that the end-users involved had multiple weaknesses in their
                        internal controls and practices that contributed to their losses. We
                        reviewed the reports and findings of these organizations for nine cases
                        where an end-user incurred a loss and subsequently alleged deficient
                        dealer sales practices. Among the weaknesses identified at these end-users
                        were inadequacies related to investment policies, oversight of investment
                        activities, separation of duties, staff training and qualifications, and
                        internal audits.

                        11
                         “Reader Survey” and “1995 Derivatives Survey,” Treasury and Risk Management Magazine (Spr. 1993
                        and July-Aug. 1995). This survey received 95 responses in 1993 and 201 responses in 1995 from finance
                        officers from a judgmentally selected sample of U.S. public and private nonfinancial corporations.
                        “Survey of CFOs,” Institutional Investor Magazine (June 1995).
                        12
                           Derivatives Usage by Investment Funds, Ernst & Young, LLP (Oct. 1995). Ernst & Young surveyed a
                        judgmentally selected sample of 143 U.S. and foreign investment fund companies in 1995.
                        13
                           Survey on Current Accounting for Risk Management Activities, KPMG Peat Marwick (Nov. 1996).
                        This survey received 139 responses from officials at a judgmentally selected sample of 700 financial
                        and nonfinancial organizations that used forwards, futures, swaps, and options.


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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



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                        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.


                        In response to recent reported losses, various organizations issued
Various Organizations   guidance on recommended practices for reducing the risks of engaging in
Issued Guidance for     OTC derivatives, MBS, and structured note transactions. Although most of

End-Users               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




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derivatives.14 About 1 year later, NAST issued revised guidance15 that
focuses on preferred practices for government-administered investment
pools in which smaller state and local government funds are pooled and
invested centrally. That same year, the Treasury Management Association
(TMA)16 issued guidelines on internal controls and appropriate disclosures
for end-users of derivatives.17 Finally, in November 1996, the Risk
Standards Working Group (RSWG)18 issued 20 standards for managing and
measuring risks.19 The GFOA and TMA guidance is written specifically for
derivatives use, while NAST and RSWG guidance is intended for all
investment products. All four sets of guidance favor explicitly written
policies and objectives that have been approved by executive management
or the board of directors.

As shown in table 5.1, the four sets of guidance also call for similar
practices, which, if not followed, can leave an end-user more vulnerable to
sales practice disputes. However, each set of guidance has a different
emphasis. The GFOA guidance emphasizes the importance of internal
controls in reducing risks, such as establishing written investment
guidelines, reporting requirements, and oversight systems. The NAST
guidance focuses on the importance of communicating with pool
participants, establishing the authorization to invest in certain types of
products, and ensuring that investment policies exist—including
borrowing and diversification policies. The RSWG guidance stresses the
importance of risk management—including setting overall risk
management objectives, valuing investments, and measuring risk-adjusted
rates of return.




14
 GFOA’s primary risk management guidance for end-users of derivatives was presented in GFOA
Recommended Practice: Use of Derivatives by State and Local Governments (Washington, D.C.:
June 7, 1994). GFOA also released other guidance related to these issues, including GFOA
Recommended Practice: Diversification of Investments in a Portfolio (Washington, D.C.: 1997), and
GFOA Recommended Practice: Sale of Derivative Instruments by State and Local Governments
(Washington, D.C.: 1995).
15
  Guidelines for Local Government Investment Pools, NAST (Washington, D.C.: July 27, 1995).
16
  TMA was founded in 1979 and represents 7,000 members, consisting of cash management
professionals, such as treasurers from the private sector. TMA seeks to educate, communicate, and
recognize the treasury management profession.
17
 Voluntary Principles and Practices Guidelines for End-Users of Derivatives, TMA (Bethesda, MD: Oct.
1995).
18
 RSWG was established by 11 individuals from the institutional investment community to create a set
of risk standards for institutional investment managers and institutional investors.
19
 Risk Standards for Institutional Investment Managers and Institutional Investors, RSWG (New York,
NY: Nov. 1996).


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                                               The TMA guidance pays particular attention to end-user management
                                               controls, calls for end-users to obtain any necessary independent
                                               expertise, and provides an extensive list of disclosure standards and
                                               practices. Overall, RSWG and TMA provide the most detail on implementing
                                               their guidance.




Table 5.1: Key Elements of Various Organizations’ Investment Guidance for End-Users
                                                             Issuing organizations
Element              GFOA                            NAST                           RSWG                           TMA
Authority to use     An analysis should be           The end-user should            Fiduciary responsibilities     Policies should conform
 products            conducted to ensure that        prepare a written              of internal and external       with regulations. The
                     constitutional and statutory    statement that provides        investment managers            Procedures should
                     authority to execute            legal authority for the        should be specified in         address risks arising from
                     derivatives contracts           investment pool and that       writing and describe their     derivatives use. Personnel
                     exists. End-users should        establishes the                authority to make              authorized to enter
                     also ensure that provisions     relationship between pool      investment decisions and       transactions should be
                     against indebtedness and        managers and participants.     capacity to enter              designated in writing.
                     procurement statutes are                                       agreements.
                     not violated.
Written investment   Purpose and objectives of       Written policies should        Written and approved           End-users should have
 policies            derivatives use should be       address investment             policies should address        written, board-established
                     in writing. Policies should     objectives and risks—with      investment philosophy,         policies and objectives
                     mandate sound asset and         safety, liquidity, and yield   risk tolerance, and            related to investment
                     liability management and        as priorities. Policies        investment guidelines.         strategies, risk tolerances,
                     adequately consider             should describe eligible       Technical terms should be      and risk philosophy.
                     safety, liquidity, and yield.   products and strategies        defined in writing and risk    Acceptable derivative
                     The risk characteristics of     and any restrictions on        limits should be stated in     products and strategies
                     products that might make        such. They should also         concrete terms and             along with their objectives
                     them inappropriate for use      specify desired product        updated as necessary.          and goals should be
                     should be considered,           and overall portfolio          Back-up plans in the event     specified.
                     including their price           maturities, limits on          of physical emergencies
                     volatility, liquidity,          amounts invested in each       or financial crisis should
                     leverage, and valuation         type of security, and          be in writing. Risk policies
                     difficulty.                     extent to which borrowing      should be consistently
                                                     can be used.                   applied.
                                                                                                                                    (continued)




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                                                                 Issuing organizations
Element          GFOA                           NAST                            RSWG                           TMA
Suitability of   Written acknowledgement        Dealers should follow the       In determining the             Discussions should be
  investments    should be obtained from        same standards of               appropriateness of             held to ensure that
                 dealers that they have         conduct as required for         investment strategies and      employees involved with
                 received, read, and            treasurers, and treasurers      instruments (1) investment     derivatives activities
                 understood the end-user’s      should obtain signed            strategies should be           clearly understand
                 debt and investment            agreements of                   compared to the intent of      applicable policies and
                 policies, including whether    understanding from              compensation incentives        procedures. In conducting
                 derivatives are authorized     dealers that the investment     and to written investment      daily operations, a
                 and the recommended            alternatives being offered      strategies; (2)                transaction’s potential to
                 product is suitable for the    are suitable for the            contemplated activities        harm counterparty
                 end-user. Entities should      end-users’ objectives.          should be compared to          relations should be
                 also be aware of when                                          risk and return goals; (3)     evaluated.
                 dealers are acting as                                          the impact of relevant risks
                 agents or are taking a                                         on each instrument and
                 proprietary position and                                       the overall portfolio should
                 should evaluate potential                                      be identified, measured,
                 conflicts of interest before                                   and understood; and (4)
                 entering transactions.                                         returns should be adjusted
                                                                                for risk to determine an
                                                                                instrument’s relative
                                                                                performance.
Reports on       End-users should regularly     End-users should disclose       Requirements for routine       Relevant risks as well as
 activities      report derivatives use to      to all pool participants and    reporting and deviation        risk management and
                 governing bodies and           prospective participants        reporting should be            other reporting policies
                 make appropriate               their investment                defined. Also, procedures      and procedures should be
                 disclosures in official        objectives, pool liquidity,     for reporting to higher        established and should
                 statements and other           and potential access limits     management levels when         provide useful and
                 documents. End-users           to invested funds.              deviations continue should     relevant information.
                 should also follow             Participants should also        be defined. Risk policies      Financial statement
                 generally accepted             receive statements that         should be consistently         disclosures and
                 accounting principles to       assess and account for          applied and supported by       accounting should comply
                 report on derivatives use,     pool activities, including      management.                    with industry regulations
                 hold early discussions with    detailed reports of portfolio                                  and standards.
                 public accounting              holdings, market values,                                       Disclosures should, at a
                 organizations on               and maturity as well as the                                    minimum, discuss the
                 derivatives use, and use       independent auditor’s                                          types of derivative
                 special reporting              report and opinion.                                            products used, the goals
                 procedures, if necessary.                                                                     and objectives of their use,
                                                                                                               and the way their use is
                                                                                                               controlled.
                                                                                                                               (continued)




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                                                                 Issuing organizations
Element          GFOA                           NAST                           RSWG                          TMA
Oversight and    Procedures should be           An independent advisory        Oversight of line             Systems and procedures
 monitoring of   established for periodic       board should monitor           investment activities         for oversight should be
 transactions    monitoring of derivatives      investment activities of the   should be independent         established to (1) review
                 use. Recordkeeping             investment manager for         from oversight of             legal relationships
                 systems should be              compliance with written        compliance with risk          between counterparties to
                 sufficiently detailed to       objectives. An external        policies using updated        derivatives transactions
                 allow governing bodies,        audit of the investment        guidelines and control        and the derivatives
                 auditors, and examiners to     function and treasury          procedures. Roles, lines of   transaction process, (2)
                 determine if use is in         should be completed at         responsibility, and           periodically review
                 accordance with                least annually.                reporting should be clearly   compliance with policies
                 established objectives.                                       written. Separation of        and procedures, (3)
                                                                               responsibilities and          identify and review policy
                                                                               adequate checks and           changes, (4) identify
                                                                               balances should be in         deviations from written
                                                                               place. Evaluations of the     policies and procedures,
                                                                               validity and                  (5) ensure compliance
                                                                               appropriateness of            with accounting disclosure
                                                                               strategies, valuation         standards, and (6) review
                                                                               methodologies, models,        internal controls.
                                                                               and systems should be
                                                                               conducted by an
                                                                               independent third party.
Pricing and      Competitive price              The portfolio should be        Products should be priced     Procedures and methods
  valuation of   comparisons should be          marked-to-market at least      daily, weekly, or whenever    of valuing derivatives
  transactions   obtained before entering a     monthly. Values should         feasible as well as           exposure and measuring
                 transaction. End-users         also be determined by an       whenever material events      current, potential, and
                 should be aware that little    independent pricing            occur, using consistent       underlying exposures;
                 or no standardized pricing     service or by using            and documented                marking-to-market;
                 information is available for   multiple assessments to        mechanisms and                dictating the frequency of
                 some products.                 formulate an average. The      methodologies. More than      valuing derivatives; and
                                                method of valuation should     one external source for       ensuring compliance with
                                                be disclosed.                  pricing information should    valuation procedures
                                                                               exist and internal pricing    should be approved and
                                                                               should be independently       established. End-users
                                                                               verified. Sources of          should not rely solely on
                                                                               valuation should be           one counterparty for
                                                                               evaluated for incentives to   valuation information but
                                                                               inflate or deflate prices.    should have access to
                                                                               Material differences in       adequate internal or
                                                                               pricing between internal or   external expertise.
                                                                               external sources should
                                                                               be reconciled and the
                                                                               reasons reported and
                                                                               monitored.

                                          Sources: GFOA, NAST, RSWG, and TMA.




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                       Between 1994 and 1996, at least 14 states made changes that address the
Some State             use of OTC derivatives, MBS, and structured notes by governmental entities
Governments Acted to   within their states.20 These actions—which included 11 states21 enacting
Reduce the Risk of     legislation and 3 states22 making executive branch policy changes—were
                       taken after governmental entities in some of these states incurred
Loss                   unanticipated losses from derivatives use. These actions were taken to
                       minimize the risk of loss that product use poses to governments in at least
                       one of three ways—by improving end-users’ policies, procedures, and
                       controls; limiting the use of certain types of products; or placing additional
                       requirements on dealers.

                       One way that state governments have sought to decrease the likelihood of
                       losses arising from the use of OTC derivatives, MBS, and structured notes
                       was by requiring governmental entities to revise their own investment
                       policies, procedures, and controls. Thirteen states took actions that place
                       additional requirements on the investing entities within their states. For
                       example, legislative bodies in Florida and Texas placed a similar new
                       requirement on governmental units within their respective states to adopt
                       investment plans that make the safety of investment funds a primary
                       objective of government investment strategies. California and Florida now
                       require their treasurer or unit carrying out the state’s investment activities
                       to follow the prudent investor/person standard.23 Eleven states imposed
                       requirements for strengthening internal controls on local governments.
                       For example, Ohio now requires treasurers in local governments to
                       establish and file written investment policies with the state, prepare
                       quarterly investment reports, and provide monthly portfolio updates.

                       Several states also placed restrictions on the types of products that
                       governmental entities could use. Ten of the 14 states now prohibit or
                       restrict the use of OTC derivatives, MBS, and/or structured notes. For
                       example, New Mexico now prohibits governmental entities in that state
                       from using complex financial products, including structured notes.
                       Wisconsin’s legislation allows its state investment board to use derivatives


                       20
                         In this section, we did not attempt to obtain comparable information from all states on any actions
                       that may have been taken to improve investment policies, procedures, and practices. Instead, we
                       summarized those that received broader public attention.
                       21
                        These states were California, Colorado, Florida, Illinois, Kansas, Louisiana, Minnesota, Maryland,
                       Ohio, Texas, and Wisconsin.
                       22
                         These states were New Mexico and Oklahoma.
                       23
                         The prudent person standard requires those investing on behalf of the governmental entity to act as a
                       prudent person would be expected to act—with discretion and intelligence to seek reasonable income,
                       to preserve capital, and in general, to avoid speculative investments.



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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.




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Regulators Have Improved Sales Practice
Oversight of Regulated Firms, but Some
Weaknesses Remain
              Federal financial market regulators have improved their oversight of
              dealer sales practices, but have not taken certain steps that would better
              ensure dealers follow sound practices when marketing OTC derivatives,
              MBS, and structured notes. To limit the risks that these activities pose to
              regulated institutions, bank regulators have promulgated specific
              requirements for the marketing of financial products and conducted
              examinations to monitor the extent to which banks comply with them. As
              a result, bank supervisory guidance addresses sales practices more
              extensively than in the past. We also found that these regulators’
              examinations were generally thorough in addressing issues related to
              banks’ sales practices for OTC derivatives, MBS, and structured notes.
              However, the Federal Reserve’s guidance does not yet adequately address
              areas where weaknesses in a bank’s practices could lead to sales
              practice-related losses, although agency officials told us the Federal
              Reserve plans to address these areas in updated guidance that the agency
              expects to issue by the end of 1997.

              In contrast to banking regulators, the regulatory authority of SEC and CFTC
              does not extend to the unregulated affiliates of the firms they otherwise
              regulate. To address concerns about the risks these activities pose to the
              regulated entity, SEC and CFTC worked with the six U.S. securities firms
              whose affiliates did approximately 90 percent of all U.S. securities
              firm-related business in these products on the Framework for Voluntary
              Oversight. Under the Framework, the participating firms are to provide SEC
              and CFTC with more information about their unregulated activities;
              however, the two regulators are not to receive information that could be
              used to determine the extent to which the firms are following the sales
              practice provisions of the Framework. Finally, SEC relies primarily on the
              securities SROs to oversee the sales practices of MBS and structured note
              dealers. Although certain jurisdictional and other factors affected SROs’
              ability to fully assess dealers’ sales practices, recent changes in the law
              and corresponding rules removed the most serious limitation affecting one
              SRO.




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                           Both the Federal Reserve and OCC have taken various actions to address
Bank Regulators’           sales practice issues. Both regulators issued guidance to their examiners
Efforts to Oversee         and the banks they oversee that address the risks of marketing OTC
Sales Practices Have       derivatives, MBS, and structured notes. They subsequently conducted
                           targeted examinations of bank sales practices for these products,
Increased, but             including reviewing areas not adequately addressed in each agency’s
Updated Federal            guidance. To ensure that subsequent examinations would also adequately
                           review these areas, OCC issued additional guidance to address these
Reserve Guidance Has       weaknesses, but the Federal Reserve has not yet issued updated guidance.
Not Yet Been Issued        Federal Reserve officials told us they expect to issue revised guidance that
                           will address the sales practice areas not specifically covered in their
                           existing guidance by the end of 1997. In addition, the Federal Reserve
                           placed specific sales practice-related requirements on one bank’s
                           transactions in certain types of complex OTC derivatives transactions as
                           part of a 1994 enforcement action.


Bank Regulators Expanded   In 1993 and 1994, OCC and the Federal Reserve issued guidance to the
Sales Practice             banks they regulate. This guidance was also used by their examiners to
Requirements for Banks     review banks’ activities. The two sets of supervisory guidance were
                           designed to address the risks associated with the increasing volume of
                           banks’ activities in OTC derivatives and other financial products. According
                           to OCC and Federal Reserve officials, before these issuances, sales
                           practice-related guidance generally consisted of requirements that banks
                           obtain sufficient information about a customer’s financial condition and
                           business activities before extending credit to or engaging in other financial
                           transactions with the customer—referred to as the “know your customer”
                           rule.

                           In expanding the treatment of sales practice issues, OCC and Federal
                           Reserve guidance generally contained the same requirements to be
                           followed by banks and used by bank examiners. Specifically, OCC guidance
                           required that banks not recommend transactions that they know, or have
                           reason to know, would be inappropriate for their customers on the basis
                           of available information about the end-user. The Federal Reserve required
                           banks to determine the sophistication of derivatives counterparties,
                           including whether counterparties understood the nature and risks of
                           transactions. In separate guidance to its examiners,1 the Federal Reserve
                           indicated that banks should establish standards to ensure that
                           counterparties are not entering into transactions in complex products

                           1
                             Trading Activities Manual, Division of Banking Supervision and Regulation, Board of Governors of the
                           Federal Reserve System (Washington, D.C.: Mar. 1994).



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                            where they do not understand the risks. The guidance also noted that bank
                            management should be cognizant of the risks to the bank’s reputation
                            arising from its activities in these products. In December 1995, OCC issued
                            additional guidance that more extensively discussed the risks—including
                            compliance and reputation risks—that are associated with marketing
                            financial products. This guidance also provided extensive criteria to help
                            examiners evaluate the degree to which a bank was exposed to these risks
                            and how well they were being managed.


Bank Regulators Generally   In response to publicized sales practice disputes, OCC and the Federal
Conducted Thorough          Reserve conducted focused examinations of the largest bank dealers that
Examinations After Sales    addressed sales practices associated with OTC derivatives, MBS, and
                            structured notes. In 1995, OCC conducted targeted examinations of several
Practice Problems           large bank dealers to assess their practices. OCC also published a summary
Surfaced                    of the results of these reviews, including identifying a list of best practices
                            followed by the banks they reviewed. Similarly, the Federal Reserve
                            targeted sales practices in examinations of major bank dealers conducted
                            from mid-1994, when Bankers Trust’s sales practice-related problems
                            became public, to mid-1995. The scope of both regulators’ examinations
                            was broader than required by their existing supervisory guidance.

                            We reviewed the examination reports and supporting workpapers for
                            seven of the targeted examinations that the two bank regulators
                            conducted and found that these examinations were generally thorough in
                            addressing key areas related to sales practices. As part of our review, we
                            searched various sources for information applicable to sales
                            practices—including securities regulators’ examination materials, private
                            risk management guidance, and case studies of end-user losses—and
                            identified six elements that could comprise a thorough examination of an
                            institution’s sales practices. These elements include the existence of sales
                            practice policies and procedures, management oversight and controls over
                            marketing personnel, management oversight and controls over price
                            quotes and valuation information, management supervision of
                            restructured transactions,2 policies and procedures for assessing
                            counterparty sophistication and appropriateness, and adequacy of
                            disclosures to counterparties. We found that OCC and Federal Reserve
                            examiners had reviewed at least five of these six elements at each of the
                            banks they examined. The element examiners most commonly omitted
                            from review involved management supervision of restructured

                            2
                             Restructured transactions are those in which the terms or conditions of an existing contract have
                            been changed.



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                           transactions. Also, the Federal Reserve’s efforts focused primarily on more
                           complex OTC derivatives transactions because agency officials believed
                           that such transactions were harder for end-users to understand and value
                           and thus were more prone to sales practice disputes.


OCC Addressed              Although the guidance OCC and the Federal Reserve issued through 1996
Weaknesses in Its          expanded sales practice-related requirements, our analysis revealed that
Guidance, but Updated      they did not address several sales practice areas related to compliance and
                           reputation risks. These areas had been noted by regulators and dealers as
Federal Reserve Guidance   among those in which sales practice disputes were likely to arise. For
Has Not Yet Been Issued    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.



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                           As of June 20, 1997, the Federal Reserve had not yet issued updated
                           guidance, but agency officials told us that the agency expected to do so by
                           the end of 1997. Federal Reserve staff provided us with a draft of the
                           updated guidance to review. The planned revisions to the guidance would
                           address the elements we identified as missing in the existing guidance.


The Federal Reserve        Separately from the guidance issued to all of the banks that it oversees, the
Placed Higher Sales        Federal Reserve tasked at least one bank with more stringent
Practice Requirements on   requirements as a part of a 1994 supervisory agreement. As discussed in
                           chapter 3, some Banker’s Trust counterparties raised concerns about the
One Bank                   bank’s marketing of OTC derivatives, which prompted regulatory
                           investigations. As a result of its investigation, the Federal Reserve entered
                           into a supervisory agreement with Bankers Trust that imposed extensive
                           new requirements on some of the bank’s activities in more complex OTC
                           derivatives to increase the amount of information the bank provided on
                           product risks as well as price and valuation calculations.

                           Specifically, the agreement included required practices for the bank’s
                           marketing of leveraged derivative transactions (LDT), whose payment flows
                           and values are highly sensitive to changes in relevant market rates, prices,
                           or indexes to which they are linked.3 The agreement required Bankers
                           Trust to (1) provide every counterparty with sufficient information about
                           the terms and risks of any LDT it entered, (2) reasonably ensure that every
                           counterparty has the ability to understand this information, and
                           (3) conduct its LDT business in a manner that ensured reasonable price and
                           valuation transparency to its counterparties.

                           The supervisory agreement also imposed specific disclosure obligations
                           on the bank for proposed LDT transactions, including providing a written
                           term sheet setting out material terms, explaining the risks, and preparing
                           sensitivity analyses that show a broad range of potential outcomes. Both
                           the term sheet and sensitivity analyses were to describe the various
                           assumptions Bankers Trust used to evaluate transaction risks. To achieve
                           reasonable price transparency, Bankers Trust was also to provide LDT
                           counterparties with indicative (approximate) price quotes, which were to
                           be updated daily for highly market sensitive LDTs and monthly for other

                           3
                            See Written Agreement By and Among Bankers Trust New York Corporation, and Bankers Trust
                           Company, and BT Securities Corporation, and Federal Reserve Bank of New York (FRB Docket No.
                           94-082), (Dec. 4, 1994). The agreement defines LDTs to include transactions where a market move of
                           two standard deviations in the first month would reduce the value of a counterparty’s position by the
                           lower of 15 percent of the notional amount or $10 million, transactions where the counterparty’s final
                           principal payment is at risk, coupon swaps where the coupon can drop to zero or exceed twice the
                           market rate, and transactions applying leverage (i.e., a multiplier) to rates or a spread between rates.



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                     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.


                     SEC, CFTC, and the various industry SROs have increased their sales practice
Jurisdictional and   oversight of firms that deal in OTC derivatives, MBS, and structured notes.
Other Limitations    However, the approaches used to conduct this oversight were sometimes
Have Affected        affected by these organizations’ lack of authority over the full range of
                     firms’ marketing activities. Under legislation passed in the early 1990s, the
Oversight of         firms under SEC and CFTC jurisdiction must provide SEC and CFTC,
Securities Firms’    respectively, with information to be used in assessing the risks that such
                     firms’ unregulated activities, including those in nonsecurities and
Sales Practices      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



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                             provide additional information about their OTC derivatives activities.
                             However, SEC and CFTC are not to receive information about the extent to
                             which these firms are following the sales practice provisions of the
                             guidance.

                             In contrast to nonsecurities OTC derivatives, SEC has jurisdiction over the
                             marketing of MBS and structured notes4 and has conducted examinations
                             of dealers and taken enforcement actions against them for violations of
                             the securities laws. SROs, such as NASD and NYSE, provide most of the
                             routine oversight of dealers marketing these products and also have
                             conducted examinations of and taken enforcement actions against dealers
                             of these products. However, SRO efforts have sometimes been made more
                             difficult by limits to their authority over particular firms or products. NASD
                             faced the most serious restrictions, but recent changes to the law and
                             applicable rules have removed these restrictions.


SEC and CFTC Jurisdiction    As discussed in chapter 2, SEC and CFTC direct regulatory authority is
Is Limited, but the          limited to products defined as securities or futures (including certain
Regulators Receive           options), respectively, and to the firms registered with these regulators to
                             conduct such activities. Because nonsecurities and nonfutures OTC
Information on Affiliates’   derivatives activities are usually conducted in affiliates outside of the
Activities                   direct oversight of these two regulators, neither regulator conducts
                             examinations of these firms’ sales of OTC derivatives.

                             To better assess the risk posed by the activities of these affiliates on the
                             financial condition of a regulated broker-dealer, SEC was granted authority
                             under the Market Reform Act of 1990 to collect certain types of
                             information from the entities it regulates about their unregulated activities.
                             CFTC was provided similar authority by the Futures Trading Practices Act
                             of 1992. Both regulators subsequently issued risk assessment rules that
                             require the firms subject to their regulation to submit additional
                             information about their unregulated activities. For example, firms
                             overseen by both SEC and CFTC provide these regulators with information
                             on the total notional/contract amounts, aggregated credit risk exposure,
                             and credit exposures concentrated by industry or counterparty arising
                             from their OTC derivatives activities. The two regulators were to receive
                             information from the regulated entities subject to these rules on a
                             quarterly basis beginning in 1995. Firms regulated by both SEC and CFTC
                             were to provide these regulators with descriptions of the systems they use

                             4
                              As previously discussed, we assume for the purposes of this report that structured notes meet the
                             terms and conditions of CFTC’s hybrid exemption.



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                            to manage the risks associated with transactions in nonsecurities OTC
                            derivatives. SEC and CFTC officials confirmed that, in general, they have
                            been receiving the information required under their rules.


SEC and CFTC Lack           The rapid growth of the OTC derivatives market and some highly publicized
Information to Assess the   losses by end-users raised concerns by Congress and others about the
Sales Practices of          potential risks that OTC derivatives use by unregulated affiliates might pose
                            to the regulated entity and the financial system. SEC and CFTC responded by
Unregulated Affiliates      working with the six securities firms whose affiliates are most active in the
                            OTC derivatives markets to develop the Framework, which includes a sales
                            practice-related section (the provisions of which are discussed ch. 3).
                            According to an SEC official, the affiliates of these six firms accounted for
                            about 90 percent of the OTC derivatives activity done by securities firm
                            affiliates.

                            To supplement the responsibilities that securities firms have under the risk
                            assessment rules, the Framework expands the participating firms’
                            commitment to taking additional voluntary steps related to their
                            unregulated activities. These steps include reporting additional
                            information to SEC and CFTC on their market and credit risk management
                            systems and controls, risk in relation to the capital reserved against these
                            activities, and credit concentrations and revenues from these activities.
                            The Framework also outlines management controls that the firms are to
                            follow. In addition, the firms have agreed to annual external audits whose
                            purpose is to verify their adherence to the management control provisions
                            of the Framework.5

                            Unlike the other aspects of the Framework, the provisions relating to sales
                            practices are less prescriptive and do not call for SEC and CFTC to receive
                            additional information on the firms’ activities. These provisions suggest
                            that participating firms (1) provide generic risk disclosure forms to new
                            counterparties, (2) prepare accurate marketing materials that fairly
                            present a transaction’s benefits and risks, and (3) adopt internal controls
                            sufficient to ensure that strong counterparty relationships are maintained.
                            SEC officials told us that the agency had worked with the participating
                            firms to ensure that the counterparty relationships section was included in
                            the Framework because they believed that fair treatment of end-users is a
                            prerequisite to the growth and evolution of the OTC derivatives market. In a

                            5
                             Because its OTC derivatives affiliate is subject to oversight in the United Kingdom, CS First Boston is
                            not subject to the additional reporting requirements but has committed to adhering to the other
                            elements of the Framework. SEC officials told us that under SEC risk assessment rules, the agency
                            receives copies of quarterly financial reports that the affiliate files with its U.K. regulator.



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                           speech to end-users, an SEC commissioner said that the financial integrity
                           of the OTC derivatives markets would be harmed if participants perceived
                           them as unfair or rampant with abuse, thus, regulators have an interest in
                           the sales practices used to market these products.

                           Although the firms agreed to external audits addressing their adherence to
                           certain provisions of the Framework, as planned, these audits will not
                           address the sales practices provisions. The Framework also does not
                           stipulate that the participating firms report on the extent to which they are
                           implementing the sales practice provisions of the Framework. For
                           example, the participating firms have not provided copies of their sales
                           practice policies—as they did as part of SEC’s risk assessment process for
                           their risk management systems—and descriptions of the internal controls
                           they have established to ensure that such policies are being followed. In
                           addition, the firms are not expected to periodically provide the regulators
                           with internal audit reports that document adherence to these policies and
                           controls. Without a mechanism to collect such information, SEC and CFTC
                           will lack sufficient data to indicate whether these firms are conducting
                           their OTC derivatives marketing activities in ways that foster the fairness
                           and integrity of these markets as was envisioned by the agencies when the
                           sales practice provisions were included in the Framework.


SEC Relies Primarily on    Although SEC relies primarily on SROs to oversee the activities of MBS and
SROs to Oversee MBS and    structured note dealers, including their sales practices, it has an active
Structured Note Dealers,   regulatory program under which it receives reports on dealers’ financial
                           condition, examines broker-dealers and evaluates their compliance with
but Also Conducts          laws and regulations, and conducts investigations of possible violations of
Examinations and Takes     the securities laws. The goals of its oversight are to (1) ensure the quality
Enforcement Actions        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.




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                            SEC is also expanding its examination procedures to address sales practice
                            issues. According to officials in SEC’s Office of Compliance Inspections and
                            Examinations, new examination modules have been created to facilitate
                            their examiners’ review of products such as MBS and structured notes.
                            Routine sales practice modules include updated steps to address current
                            rules and case law regarding markups and confirmation disclosures, and
                            specialized modules are being created for government securities. SEC is to
                            use these specialized modules to review NASD’s implementation of its new
                            government securities rule (as discussed on p. 133).

                            Although SROs also conduct enforcement activities, SEC considers
                            enforcing the securities laws to be one of its most important missions.6 As
                            discussed in chapter 3, SEC officials had initiated investigations against 24
                            dealers from 1993 through 1996 for deficiencies related to the sale of MBS
                            and structured notes. In some of these cases, SEC has taken action against
                            the dealer involved, including assessing monetary penalties, imposing
                            operating restrictions, or revoking a dealer’s license to conduct business.
                            In several cases, both SEC and an SRO were investigating the conduct of the
                            same dealer. A senior SEC Enforcement Division official explained that,
                            when an SRO either has an investigation under way or has sanctioned a
                            firm, SEC usually avoids initiating a parallel effort but sometimes will seek
                            additional penalties for egregious cases. Decisions to pursue such actions
                            also depend on the size and frequency of the violations and the dollar
                            value involved. (See ch. 3 for a discussion of the results of SEC
                            enforcement actions.)


Various Factors Also        Securities industry SROs, particularly NASD and NYSE, are an integral part of
Affected SROs’ Ability to   the oversight of firms marketing MBS and structured notes. However, these
Fully Assess Dealer Sales   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
Practices                   not the sales activities of those firms’ unregulated affiliates that are not
                            also members. The way that certain customers use dealers of MBS and
                            structured notes also reduced the SRO staffs’ ability to fully assess sales
                            practices for some transactions.

                            As part of their activities, NASD and NYSE have conducted examinations of
                            securities firms. In 1996, NASD conducted 2,359 examinations and NYSE
                            conducted 326 examinations that addressed sales practices, according to

                            6
                             Similarly, CFTC considers enforcing the CEA to be one of its most important missions. Except for the
                            Bankers Trust case previously discussed, we do not address CFTC enforcement actions in the OTC
                            markets because they typically involved the illegal marketing of off-exchange futures, which is
                            generally outside the scope of this report.



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each SRO’s statistics. SRO officials told us that the examinations generally
reviewed firms’ sales practice policies, procedures, and controls over
marketing personnel. These organizations also had conducted
enforcement investigations of possible sales practice violations, with NASD
having performed investigations of 16 dealers and NYSE having performed
investigations of 15 dealers from January 1993 through December 1996.
(See ch. 3 for additional discussion of SRO enforcement action results.)

The way in which securities industry SROs conducted their sales practice
oversight differed from the way they met their other responsibilities.
According to a NYSE official, these SROs obtain reports and conduct
examinations to ensure that their members are financially sound and in
compliance with SRO rules and relevant federal securities law
requirements. To facilitate these examinations and reduce the overlap of
SRO jurisdiction over securities firms that conduct activities on multiple
exchanges, usually just one SRO is designated to review the financial
condition of such firms.7 However, the NYSE official said that the individual
SROs remain responsible for conducting their own examinations for sales
practice purposes, unless they contract with another SRO to have such
examinations conducted on their behalf.

Dealers’ sales practice activities relating to OTC derivatives, MBS, and
structured notes were not always subject to review by securities industry
SROs. As previously discussed, the largest securities firms generally
conduct their nonsecurities OTC derivatives activities in affiliates that are
not registered with SEC. Although a dealer conducting activities in
securities is required to join and submit to oversight by at least one
securities industry SRO, its other nonsecurities affiliates, such as those
conducting nonsecurities OTC derivatives activities, are not subject to SRO
oversight.

The way that certain end-users conduct their activities in MBS and
structured notes also affected SROs’ ability to fully assess sales practices.
NYSE officials told us that assessing the adequacy of their members’ sales
practices for MBS and structured notes could generally only be done when
the customers involved are retail end-users. However, they estimated that
such end-users account for only about 5 percent of the purchases of MBS.
The remainder of such securities are purchased by institutional end-users
that do not always maintain their holdings in accounts at NYSE-member
securities firms. Instead, some transfer their purchases to custodial

7
 The SRO with responsibility for conducting the financial condition examination of a securities firm is
known as its designated examining authority.



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                             accounts at banks or other money managers. According to NYSE officials,
                             reviewing an end-user’s portfolio is an important way for them to
                             determine the appropriateness and suitability of transactions for the
                             particular end-user. However, the transfer of purchases by some
                             institutional end-users to other accounts generally precluded NYSE staff
                             from determining the appropriateness and suitability of transactions for
                             such end-users.


Removal of Restrictions on   The most serious limitation on an SRO’s ability to assess sales practices
NASD Oversight Should        was faced by NASD. Before August 1996, NASD could not fully assess and
Improve Sales Practice       take appropriate actions against certain deficiencies in the sales practices
                             of dealers marketing GSE-issued MBS and structured notes, which
Oversight                    accounted for the bulk of those securities issued.8 As noted in chapter 2,
                             NASD had been prohibited from applying its full complement of sales
                             practice rules to the marketing of government securities by a long-standing
                             provision in the Securities Exchange Act of 1934.9 This restriction was
                             removed by the Government Securities Act Amendments of 1993, and,
                             after several rounds of public comment and revision, NASD obtained SEC
                             approval to implement the rules and an associated interpretation on
                             August 22, 1996.

                             While in effect, this restriction on NASD’s authority affected its enforcement
                             activities. In cases where NASD determined that dealers’ sales practices
                             warranted disciplinary action, the SRO was unable to pursue such cases as
                             violations of its Rules of Fair Practice because GSE-issued securities were
                             exempt from these rules.10 Instead, it had to pursue the enforcement cases
                             under the antifraud provisions of the securities laws. However, the burden
                             of proof for fraud violations was harder to meet than that for
                             noncompliance with SRO rules. The removal of restrictions on NASD
                             authority will allow the SRO to pursue cases as violations of its own rules
                             and should improve its ability to oversee sales practices for MBS and
                             structured notes.




                             8
                              NASD officials could not determine how many of their 5,000 members marketed GSE-issued securities;
                             however, the officials indicated that in 1994 over 300 of the firms they oversaw held such securities
                             and that most were probably offering them to end-users.
                             9
                              This restriction did not extend to NYSE.
                             10
                                 As indicated in chapter 2, these rules are now known as Conduct Rules.



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Conclusions and Recommendations


              Although OTC derivatives are subject to sales practice requirements that
Conclusions   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



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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



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Conclusions and Recommendations




them in some or all cases. As reflected in the two sets of dealer-issued
voluntary guidance—the Framework and the Principles—dealers have
generally considered such transactions to be conducted at arm’s length,
with minimal responsibilities existing for either party beyond those of
honest and fair dealing. To the extent that the differing views of end-users
and dealers increase the likelihood of sales practice disputes that expose
regulated institutions to material losses or that otherwise could prove
disruptive to the markets, federal regulators have an interest in the
reconciliation of these differences. The reconciliation of such differences
does not entail federal regulators imposing a resolution on the markets.
Rather, the type of relationship and accompanying responsibilities that
should prevail in OTC derivatives transactions should be agreed upon by
market participants.

A clearer understanding of the nature of end-user and dealer
responsibilities may also be necessary for the voluntary standards to
receive more widespread acceptance among end-users. In addition, these
standards may be the only ones applicable to some unregulated market
participants, such as insurance company affiliates. Therefore, by assisting
market participants in reaching a clearer understanding of their
responsibilities, federal financial market regulators may enhance the
overall integrity of the markets. Reaching a clearer understanding may
also encourage product use, where appropriate, by organizations that have
limited their use because of concerns about transaction risks and
uncertainty about the roles and responsibilities of dealers and end-users.
Finally, reaching such an understanding could result in greater diligence
by both end-users and dealers in ensuring that they comprehend product
risks before entering into transactions.

Notwithstanding the potential benefits of an improved understanding
between dealers and end-users, the issues surrounding their relationships
are complex and federal involvement may not necessarily result in an
agreement that is widely accepted. Even if an increased level of
understanding between these groups could be reached, the likelihood of
legal disputes when large losses occur might not decrease. However,
federal financial market regulators would be justified in considering
whether they can help end-users and dealers reach a mutually acceptable
agreement because of the importance of these products to the financial
markets and the U.S. economy. Consultation with market participants on
this subject might assist regulators in assessing whether they should
assume such a role.




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                         Conclusions and Recommendations




                         Regardless of whether they decide to assist end-users and dealers in
                         resolving their differences, federal financial regulators can take other
                         specific actions to address the risks to dealers that market OTC derivatives,
                         MBS, and structured notes. Although the Federal Reserve has conducted
                         examinations of banks’ activities and issued guidance on the
                         responsibilities of banks that market these products, its guidance remains
                         incomplete. Specifically, it does not direct bank examiners to assess the
                         adequacy of bank policies and controls related to disclosing risk, acting in
                         a fiduciary or advisory capacity, or supervising marketing personnel.
                         Weaknesses in these areas existed in some cases where sales practice
                         disputes have arisen. Although we found both bank regulators’
                         examinations to be generally thorough, specifically addressing these areas
                         in the Federal Reserve’s guidance would better ensure that such areas
                         receive similar attention in future examinations. Federal Reserve officials
                         have efforts under way to update this guidance, and our review of a draft
                         of this updated guidance indicates that it would address the elements we
                         identified as missing in the existing guidance.

                         SEC and CFTC participation in the development of the Framework reflects
                         their concern with the risks posed by the sales practices and other
                         activities of the largely unregulated dealers in these markets. In lieu of
                         additional regulation of this market, the Framework is to result in SEC and
                         CFTC periodically receiving additional information, including the results of
                         external audits, on some aspects of participating dealers’ OTC derivatives
                         activities. This information should improve the ability of SEC and CFTC to
                         conduct the legislatively mandated risk assessments of the entities they
                         regulate. However, information on these dealers’ adherence to the sales
                         practice provisions of the Framework is not included in the information
                         these regulators are to receive. Adherence to these provisions is important
                         for ensuring market fairness and integrity. In the absence of a mechanism
                         for ensuring such adherence, SEC and CFTC cannot be sure that these firms’
                         commitment to voluntarily follow the sales practice provisions of the
                         Framework is being fulfilled, casting doubt on whether a voluntary
                         arrangement is an adequate substitute for direct federal oversight.


                         We recommend that the Secretary of the Treasury, as Chairman of the
Recommendations to       President’s Working Group on Financial Markets, take the following
the President’s          actions:
Working Group on
                     •   Ensure that the members of the Working Group establish a mechanism for
Financial Markets        systematically monitoring developments in the OTC derivatives markets to



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                          Chapter 7
                          Conclusions and Recommendations




                          assess whether developments warrant introducing specific federal sales
                          practice requirements.
                      •   Lead the members of the Working Group in considering the extent to
                          which it should assist end-users and dealers in reaching agreement on the
                          nature of their relationship in transactions involving OTC derivatives.


                          We recommend that the Chairman of the Federal Reserve Board
Recommendation to         implement planned revisions to the Federal Reserve examination
the Federal Reserve       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.


                          We recommend that the Chairpersons of SEC and CFTC establish a
Recommendation to         mechanism for determining that participating firms are following the sales
SEC and CFTC              practice provisions of the Framework for Voluntary Oversight.


                          We requested comments on a draft of this report from the heads, or their
Agency and Industry       designees, of CFTC, the Federal Reserve Board, OCC, SEC, and Treasury. We
Comments and Our          also requested comments from two securities industry SROs (NASD and
Evaluation                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



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Conclusions and Recommendations




ISDA generally objected to our recommendations, with both opposing
additional federal involvement in the OTC derivatives markets to address
sales practice issues. SEC’s views were mixed.

SEC, Treasury, and ISDA objected to our recommendation that the Working
Group establish a mechanism for systematically monitoring developments
in the OTC derivatives markets. Specifically, SEC and Treasury officials
commented that the Working Group’s current efforts, which generally
include the principals meeting every 6 weeks and the staff meeting every 2
weeks, are adequate to address market developments. Similarly, ISDA
commented that it is not readily apparent that a formal monitoring
mechanism would be any more effective than the existing structure. In
contrast, EUDA, GFOA, and NASACT supported this recommendation. EUDA
indicated that taking the recommended steps—as they relate to this and
our other recommendation to the Working Group—will lead to greater
market safety and soundness, particularly concerning new dealers or
end-users entering the markets. We continue to believe that the Working
Group needs a formal mechanism for monitoring the OTC derivatives
markets. As discussed in this report, the market characteristics that
contributed to the relatively high level of end-user satisfaction and the
relatively limited number of sales practice disputes could change as the
markets evolve. This report recognizes that the federal financial market
regulators monitor the OTC derivatives activities of the firms subject to
their respective oversight, and they discuss market developments of which
they become aware through their joint participation in the Working Group.
However, this report also observes that the agencies that participate in the
Working Group do not routinely collect the information necessary to
ensure that they are able to systematically detect changes in market
characteristics. Thus, the Working Group lacks a formal mechanism for
obtaining the necessary information for monitoring developments related
to sales practices. Such a mechanism is important because it could alert
the Working Group to the need for reassessing the adequacy of existing
sales practice requirements applicable to OTC derivatives. The information
to be assessed could include the number and types of new dealers and
end-users entering the markets, the types of complex new products being
introduced, and changes in the types or sophistication of end-users to
whom products are being marketed.

Treasury and ISDA also objected to our recommendation that the Working
Group consider the extent to which it should assist end-users and dealers
in reaching agreement on the nature of their relationship in transactions
involving OTC derivatives. Treasury was concerned that, because such



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Conclusions and Recommendations




relationships are contractual, no single model may be appropriate. ISDA
commented that no need exists for the Working Group to involve itself in
mediating between dealers and end-users, that the involvement of market
participants and regulators to date has been sufficient, and that the issues
involved are complex and federal involvement may not result in an
agreement that is widely accepted. In addition, ISDA stated that the draft
report offered no evidence suggesting that disputes among privately
negotiated derivatives contracts (that is, OTC derivatives contracts) are
more frequent than in other commercial dealings, that these markets have
been largely free of sales practice abuses, and that courts and regulators
have not had difficulty in finding remedies when necessary. For these
reasons, ISDA indicated that it did not support expanded regulatory activity.
ISDA also commented that the report does not substantiate that the OTC
derivatives market is “in any way broken and needs fixing,” that our
recommendations do not follow logically from the facts or conclusions in
the report, and that our recommendations contradict the views of market
participants and regulators.

SEC commented that in its efforts to address financial market issues, the
Working Group has had discussions with end-users and professional
counterparties (dealers) and that it believes the Working Group would be
willing to continue this dialogue. However, SEC stated that it is not
necessary for the government to intervene and define contractual
obligations for professional and sophisticated counterparties. The Federal
Reserve noted that it has recognized the importance of and encouraged
voluntary industry efforts in this area, and the three end-user associations
supported our recommendation.

We continue to support our recommendation that the Working Group
consider assisting market participants in reaching agreement on the nature
of their relationship in OTC derivatives transactions. This report
acknowledges that the issues involved in reaching agreement between
dealers and end-users are complex and may not lend themselves to a
single, widely accepted solution. For this reason, we do not intend that the
Working Group impose a model that defines counterparty relationships in
OTC derivatives transactions. In addition, we do not base our
recommendation to the Working Group on a finding that a high frequency
of sales practice abuses exists or that courts and regulators have had
difficulty in finding remedies when abuses occur. Instead, we present
evidence that end-users and dealers do not always agree on the nature of
their relationship, including their responsibilities, in OTC derivatives
transactions. Although the dealer-issued voluntary guidance asserts that



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Conclusions and Recommendations




the nature of the relationship is arm’s length, our survey found that a
majority of end-users believed that dealers had fiduciary responsibilities in
some or all OTC derivatives transactions, and that a majority indicated they
relied on dealers from some to a very great extent as part of these
transactions. To the extent that the differing views of end-users and
dealers increase the likelihood of sales practice disputes that expose
regulated institutions to material losses or that otherwise effect the sound
financial condition of regulated institutions and the fairness and integrity
of the markets, we concluded that the federal financial market regulators
have an interest in the reconciliation of these differences.

Regarding ISDA’s objection to additional regulatory activity, our report
concludes that no legislation or regulation is currently needed.
Nonetheless, our views on the benefits of federal regulatory involvement
in the OTC derivatives markets differ from those of ISDA. In this regard, our
recommendations address the need for the federal financial markets to
fulfill their responsibilities related to ensuring the sound financial
condition of regulated institutions and the fairness and integrity of the
markets, without creating unnecessary or costly burdens for them. We do
not recommend that the federal financial market regulators resolve the
differences between dealers and end-users by defining the nature of their
relationship for them. Rather, we recommend that they consider, as
participants in the Working Group, whether the benefits of assisting
market participants are sufficient to warrant their involvement and
whether their involvement is likely to achieve the desired result. The
Working Group’s assistance could involve facilitating discussions between
dealers and end-users that lead to agreement in key areas where they now
disagree. Regarding ISDA’s comment that our recommendations contradict
the views of market participants and regulators, this report recognizes the
varying support of these parties for our recommendations.

Treasury officials commented that the draft report appeared to be critical
of establishing an arm’s-length relationship as the default model for OTC
derivatives transactions. ISDA officials supported the arm’s-length
relationship as the default model, noting that it is the appropriate starting
place for institutional market participants. This report does not reach a
conclusion on the appropriate default model for counterparty
relationships. It presents the views of both those who support and oppose
an arm’s-length relationship as the default model. As clarified in chapter 7,
we conclude that the type of relationship and accompanying
responsibilities that should prevail in OTC derivatives transactions should
be agreed upon by market participants, and we recommend that the



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Conclusions and Recommendations




Working Group consider assisting market participants in reaching
agreement on these issues.

The Federal Reserve commented favorably on our recommendation to its
chairman. That is, the agency indicated that it has efforts under way that
would fully respond to our recommendation that the agency revise its
examination guidance to more specifically address the need to assess the
adequacy of banks’ policies and controls related to disclosing risk,
creating advisory relationships, and supervising marketing personnel.

In addressing our recommendation that SEC and CFTC establish a
mechanism for determining that participating firms are following the sales
practice provisions of the Framework, SEC indicated that it is willing to
discuss with the affected parties the feasibility of extending the external
auditor’s role to incorporate a review of sales practice procedures. This
appears to be an appropriate first step towards implementing our
recommendation. As indicated in chapter 6, SEC and CFTC could also
request that the participating firms provide copies of their sales practice
policies—as was done for these firms’ risk management systems as part of
SEC’s risk assessment process—and descriptions of the internal controls
these firms have established to ensure that such policies are being
followed. CFTC did not comment on this recommendation.

However, NASACT opposed this recommendation to SEC and CFTC,
contending that these agencies’ participation in a compliance program
would be recognized as an endorsement of the Framework and would
present new legal obligations without first being subject to the due
process associated with a new regulation. In place of our
recommendation, NASACT proposed that the drafters of the Framework and
end-users work with SEC and CFTC to further clarify counterparty
relationships. GFOA also expressed concern that the dealer-issued
voluntary guidance could establish legal obligations, noting that Bankers
Trust cited the Principles as support in legal actions involving Procter &
Gamble.

Our recommendation is not intended to create new legal obligations for
dealers or end-users. Regarding NASACT’s concern that SEC and CFTC
participation in a compliance program related to the Framework would
present new legal obligations (presumably for end-users), this report notes
that the Framework is not intended to apply to end-users. Instead, the
Framework specifically states that it applies only to the participating firms
and only to their nonsecurities OTC derivatives activities. Although the



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Conclusions and Recommendations




Framework indicates that it is not intended to create legally enforceable
obligations, this report acknowledges that the courts could find the
guidance useful in evaluating counterparty relationships and defining
common law responsibilities. To the extent that market participants find
this potential outcome objectionable, they can individually take steps to
clarify their relationship with counterparties in each transaction they
enter.

We believe that a more effective approach would be for end-users and
dealers to participate in a joint effort to reach agreement on the nature of
their relationship in OTC derivatives transactions, and we have
recommended that the Working Group consider assisting the parties in
this process. We make our recommendation to the Working Group in the
belief that a coordinated effort by the federal market regulators would be
a more effective means of reaching agreement on the nature of
counterparty relationships, including the responsibilities of counterparties
to OTC derivatives transactions. An additional advantage to this approach is
that the resulting agreement would not make distinctions between types of
dealers and end-users. That is, it would not distinguish between dealers
that are banks and dealers that are securities firm affiliates or their
end-user counterparties. As a result, should the Working Group assist
dealers and end-users in reaching an agreement on the nature of their
relationship, the resulting agreement would be applicable to all dealers
and end-users of OTC derivatives.

This report also notes that, in lieu of additional regulation, SEC and CFTC
are already participating with the drafters of the Framework in a voluntary
program that includes monitoring the nonsales practice provisions of the
Framework by external auditors. We are merely recommending that such
monitoring be extended to the sales practice provisions of the Framework.
As we conclude in this chapter, adherence to these provisions is important
for ensuring market fairness and integrity. In the absence of a mechanism
for ensuring such adherence, SEC and CFTC cannot be sure that a
participating firm’s commitment to voluntarily follow the sales practice
provisions of the Framework is being fulfilled, thereby casting doubt on
whether a voluntary arrangement is an adequate substitute for direct
federal oversight.




Page 143                             GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix I

Methodology for GAO Survey of End-Users


              Beginning in March 1995, we sent questionnaires to 2,381 randomly
              selected organizations drawn from a wide range of U.S. public and private
              industries, representing a universe of approximately 49,000 organizations
              that were potential end-users of plain vanilla over-the-counter (OTC)
              derivatives, complex OTC derivatives, structured notes, and asset-backed
              securities.1 Our objectives in conducting the survey were to estimate for
              these four product types (1) the extent of end-user satisfaction with dealer
              sales practices and (2) the extent of product use.

              The questionnaire requested data on the usage of specific products within
              the 12 months preceding receipt of the survey. It also asked respondents
              to rate the sales practices of any dealers with whom they engaged in
              transactions across six dimensions: (1) disclosure of downside risks,
              (2) quality of transaction documentation provided, (3) suitability of
              products proposed, (4) competitiveness of pricing and fees, (5) provision
              of accurate mark-to-market pricing information, and (6) assistance in
              unwinding transactions. In addition, it asked the organizations to
              separately rate the sales practices of dealers that proposed contracts, but
              who they did not use, over the three applicable dimensions listed
              above—(1), (3), and (4). We developed these sales practice dimensions on
              the basis of reviews of regulatory and dealer documents and discussions
              with regulators, dealers, and end-users. Lastly, the questionnaire asked
              organizations to provide overall ratings of sales practices both for dealers
              with whom the organizations entered into contracts as well as dealers that
              proposed contracts but who they did not use.

              From the returned surveys, we selected a judgmental sample of 70 of the
              respondents, drawn from a wide spectrum of large and small organizations
              across all of the industries surveyed. Some were end-users and others
              were nonusers of the four types of products; some were satisfied with
              dealer sales practices, while others were dissatisfied. We completed
              telephone follow-up interviews with 50 of these respondents to learn more
              about the reasons for their satisfaction or dissatisfaction with dealer sales
              practices, their opinions on fiduciary relationships, and the range of
              end-user sales practice-related policies, procedures, and practices.
              Although the results of these follow-up interviews are not generalizable to
              any larger population of potential end-users, the 50 organizations
              contacted generally reflect the range of organization types and sizes,
              product usage, and satisfaction levels.



              1
               We included mortgage-backed securities as a subset of asset-backed securities in the questionnaire.



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                       Appendix I
                       Methodology for GAO Survey of End-Users




                       To respond to a request made by the former Chairman of the
Design of the Survey   Subcommittee on Telecommunications and Finance, House Committee
Sample                 Energy and Commerce, we set out to determine the extent of end-user
                       satisfaction with the sales practices of dealers offering OTC derivatives,
                       mortgage-backed securities (MBS), and structured notes across a wide
                       universe of U.S. public and private organizations that might be using these
                       products, including not only the organizations with the largest finances,
                       but also the smaller organizations in each industry. The former Chairman
                       also asked us to determine the extent of product use.

                       To obtain a statistically precise estimate (one with a low sampling error)
                       of the level of satisfaction with dealer sales practices, we needed to collect
                       as many survey responses as possible from current end-users, which are
                       more likely to have experienced sales practice presentations. Our prior
                       work and that of other organizations indicated that larger organizations
                       tend to be end-users of these products more often than smaller
                       organizations.

                       However, we were concerned that smaller organizations, which might use
                       these products less often and have fewer resources for managing their
                       financial activities, might have different sales practice experiences than
                       larger organizations. Any such differences would not be reflected by our
                       estimate of the level of satisfaction, if small organizations were excluded
                       from the survey. Also, we did not want to exclude from our estimate of
                       usage a significant number of smaller organizations that had at least some,
                       if limited, potential for being end-users. Therefore, to obtain unbiased
                       estimates of satisfaction and usage, we included proportionately more
                       large organizations in our sample, while still selecting some organizations
                       that would represent the smaller entities in the population under study.

                       We began by defining the populations we would survey. We identified 19
                       public and private industries that we concluded would thoroughly cover
                       potential end-users. For each of the 19 survey strata representing these
                       industries, we had to compile a frame, or a listing of all known
                       organizations in a population, ideally without duplicates or omissions. The
                       frames had to include mailing addresses, relevant contact names, and
                       enough information about the organizations to allow classification by
                       industry and financial size and to allow the assignment of a unique
                       identification number. In several of the industries we surveyed, our frames
                       did not cover all of the known organizations, but were restricted to
                       organizations above a minimum financial size, determined by the
                       availability of data in the lists we used. Nevertheless, the scope of each



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                                              Appendix I
                                              Methodology for GAO Survey of End-Users




                                              frame covered a significant proportion of the smaller organizations in that
                                              industry and adequately comprised the population of organizations that
                                              would have a reasonable probability of derivative product usage and
                                              experience with dealer sales practices. See table I.1 for a description of the
                                              19 industry strata, the scope of organizations included in those strata, and
                                              the sources for the sample frames we developed to represent those
                                              populations.


Table I.1: Design of Potential End-User Sample Frame
                                                                                Indicators of size       Size/Usage substratification
Strata (19)         Population definition                Frame used             and/or usage             criteria
Cities and          All 38,995 local governments,        Directory of           Population counts        Large substratum defined as
  counties          such as counties,                    Governments, 1988:     from 1990 decennial      organizations in top 5 percent,
                    municipalities, and townships,       Name and Address       census.                  representing 70 percent of total
                    that were identified in a 1987       File (U.S. Bureau of                            population count. Small
                    census and updated by                the Census).                                    substratum consists of all other
                    subsequent annual surveys                                                            organizations.
                    (excludes states).
Special             All 32,838 local government          Directory of           Population counts of     Large substratum defined as
 districts          special districts or authorities,    Governments, 1988:     cities in which the      the special districts (except
                    such as airports, hospitals,         Name and Address       districts are located,   sewerage and water supply
                    utilities, ports, and terminals.     File (U.S. Bureau of   from 1990 decennial      districts nationwide and other
                                                         the Census).           census.                  multifunction districts in Texas)
                                                                                                         with addresses in the 30 most
                                                                                                         populous cities. Small
                                                                                                         substratum consists of all other
                                                                                                         organizations.
Local school        All 14,222 school districts and      Directory of           School enrollments       Large substratum defined as
  districts         systems.                             Governments, 1988:     from the 1992-93         organizations in the top 10
                                                         Name and Address       school year.             percent, representing 60
                                                         File (U.S. Bureau of                            percent of total school
                                                         the Census).                                    enrollment. Small substratum
                                                                                                         consists of all other
                                                                                                         organizations.
State               Offices of all 50 state treasurers Various government       Not applicable.          No substratification.
  treasuries        and the District of Columbia.      directories.
Private pension     All 46,795 corporate and union       1995 Money Market      Total pension assets.    Large substratum defined as
  funds and union   (headquarters and local)             Directory                                       organizations with $20 million in
  funds             pension funds with investment        Pensionscope                                    pension assets and over,
                    assets of $1 million and over        Database (Money                                 representing approximately the
                    that were identified in a            Market Directories,                             top 10 percent of organizations.
                    periodic review of Department        Inc.).                                          Small substratum consists of all
                    of Labor Form 5500 filings                                                           other organizations.
                    (Annual Return/Report of
                    Employee Benefit Plan) and a
                    proprietary survey conducted
                    by Money Market Directories,
                    Inc.
                                                                                                                                 (continued)



                                              Page 146                                    GAO/GGD-98-5 OTC Derivatives Sales Practices
                                              Appendix I
                                              Methodology for GAO Survey of End-Users




                                                                                   Indicators of size      Size/Usage substratification
Strata (19)           Population definition               Frame used               and/or usage            criteria
Public pension       All 1,167 pension funds and          1995 Money Market        Total pension assets.   Large substratum defined as
  funds and          retirement systems sponsored         Directory                                        organizations with $1 billion in
  retirement systems by state, county, and municipal      Pensionscope                                     pension assets and over,
                     governments with investment          Database (Money                                  representing approximately the
                     assets of $1 million or more,        Market Directories,                              top 10 percent of organizations.
                     identified and updated               Inc.).                                           Small substratum consists of all
                     periodically by Money Market                                                          other organizations.
                     Directories, Inc.
Endowments and        All 4,855 private educational       1995 Money Market        Total assets.           Large substratum defined as
  foundations         and museum funds; private and       Directory                                        organizations with $100 million
                      public charitable endowments;       Pensionscope                                     in total assets and over,
                      and foundations with assets of      Database (Money                                  representing approximately the
                      $1 million or more, identified      Market Directories,                              top 10 percent of organizations.
                      and updated periodically by         Inc.).                                           Small substratum consists of all
                      Money Market Directories, Inc.                                                       other organizations.
College and           All 3,667 2-year and 4-year U.S.    Digest of Education      Current-fund            Large substratum defined as
 university           colleges, universities, technical   Statistics, 1994         revenues, as reported organizations with $80 million
 operating funds      institutes, and vocational          (National Center for     for the 1991-92 period. and over in current-fund
                      programs, identified by             Education Statistics).                           revenue for the 1991-92
                      Department of Education                                                              reporting period, representing
                      surveys, conducted annually.                                                         approximately the top 10
                                                                                                           percent of organizations. Small
                                                                                                           substratum consists of all other
                                                                                                           organizations.
Institutional money   All 1,759 registered U.S.           1995 Money Market        Total managed assets. Large substratum defined as
  managers            investment advisor firms, bank      Directory                                      organizations with $1 billion in
                      and trust departments, and          Pensionscope                                   managed assets and over,
                      insurance companies                 Database (Money                                representing approximately the
                      managing various assets of at       Market Directories,                            top 36 percent of organizations.
                      least $1 million, identified and    Inc.).                                         Small substratum consists of all
                      updated periodically by Money                                                      other organizations.
                      Market Directories, Inc.
                                                                                                                                (continued)




                                              Page 147                                       GAO/GGD-98-5 OTC Derivatives Sales Practices
                                             Appendix I
                                             Methodology for GAO Survey of End-Users




                                                                              Indicators of size     Size/Usage substratification
Strata (19)          Population definition              Frame used            and/or usage           criteria
Government-          All 33 GSEs and GSE-like           Ward’s Business       Not applicable.        No substratification.
 sponsored           organizations that we identified   Directory, (1994
 enterprises (GSE)   as being in existence in March     edition); previously
                     of 1995, including major credit    published GAO
                     organizations, such as the         products, and
                     Federal National Mortgage          consultation with GAO
                     Association and the Federal        experts.
                     Home Loan Mortgage
                     Association, regional Federal
                     Home Loan Banks, Farm Credit
                     Banks, and other organizations
                     with the Standard Industrial
                     Code (SIC) classification of
                     6111 (“Federal and Federally
                     Sponsored Credit”). Excludes
                     approximately 238 Farm Credit
                     Associations whose day-to-day
                     asset or liability management is
                     generally carried out at the
                     bank level or higher.
Commodity pools      Includes 844 commodity pools       National Futures      Net asset value of     Large substratum defined as
                     with U.S. operators, with total    Association.          pool, as of January    organizations with $31.5 million
                     net asset value of $1 million or                         1995.                  net asset value and over,
                     more, as of January 1995,                                                       representing approximately the
                     according to National Futures                                                   top 33 percent of organizations.
                     Association records.                                                            Small substratum consists of all
                                                                                                     other organizations.
Mutual funds         All 6,358 individual equity and    Lipper Analytical     Total net assets under Large substratum defined as
                     bond mutual funds (except for      Services, Inc.        management.            organizations with $450 million
                     municipal bond funds),                                                          in total net asset value and
                     identified by Lipper Analytical                                                 over, representing
                     Services, Inc., as of January                                                   approximately the top 10
                     1995.                                                                           percent of organizations. Small
                                                                                                     substratum consists of all other
                                                                                                     organizations.
Money market         All 1,237 taxable and              Lipper Analytical     Total net assets under Large substratum defined as
 funds               tax-exempt money market            Services, Inc.        management.            organizations with $1.15 billion
                     mutual funds, including                                                         net asset value and over,
                     municipal bond funds,                                                           representing approximately the
                     identified by Lipper Analytical                                                 top 10 percent of organizations.
                     Services, Inc., as of January                                                   Small substratum consists of all
                     1995.                                                                           other organizations.
                                                                                                                             (continued)




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                                                                                Indicators of size     Size/Usage substratification
Strata (19)      Population definition                Frame used                and/or usage           criteria
Publicly held    The 5,581 U.S. parent                Compact Disclosure        Total annual sales     Large substratum defined as
  nonfinancial   companies with at least 500          (Disclosure, Inc.) and    figure most recently   organizations with $1.4 billion
  corporations   stockholders of one class of         the March 14, 1995,       reported in Compact    annual sales and over,
                 stock, at least $5 million in        Pink Sheets (National     Disclosure records.    representing approximately the
                 assets, and filing reports with      Quotation Bureau,                                top 10 percent of organizations.
                 the Securities and Exchange          Inc.).                                           Small substratum consists of all
                 Commission in the 18 months                                                           other organizations.
                 before the 1994 review by
                 Compact Disclosure. Excludes
                 companies listed in Compact
                 Disclosure on the basis of a
                 debt issue and not traded on a
                 national or regional exchange,
                 or on the National Association
                 of Securities Dealers
                 Automated Quotation system,
                 and which had sales of less
                 than $25 million. Also excludes
                 companies with a primary SIC
                 in the financial industry and
                 foreign-based companies with
                 American Depository Receipts
                 listed on U.S. stock exchanges.
Privately held   The 8,204 U.S.-based                 1994 Directory of         Total sales as         Large substratum defined as
  nonfinancial   nonfinancial privately held          Corporate Affiliations,   reported in Ward’s     the top 200 corporations in total
  corporations   ultimate parent companies with       Volume 5—U.S.             1995 Business          1994 sales, representing
                 annual revenues of at least $10      Private Companies         Directory of U.S.      approximately the top 2 percent
                 million or a workforce of at least   (National Register        Private and Public     of organizations in the
                 300 people as listed in the 1994     Publishing) and           Companies.             population. Small substratum
                 Directory of Corporate               Ward’s 1995 Business                             consists of all other
                 Affiliations, Volume 5—U.S.          Directory of U.S.                                organizations.
                 Private Companies. Excludes          Private and Public
                 public organizations and             Companies (Gale
                 companies with a primary SIC         Research, Inc.).
                 in the financial industry.
                                                                                                                            (continued)




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                                                                                Indicators of size         Size/Usage substratification
Strata (19)         Population definition               Frame used              and/or usage               criteria
Largest nonbank     The largest 120 firms with          Ward’s 1995 Business    Total assets as            No substratification.
  financial         assets over $100 million, as        Directory of U.S.       reported in Ward’s
  corporations      identified by Ward’s 1995           Private and Public      1995 Business
                    Business Directory. Includes        Companies (Gale         Directory of U.S.
                    financial companies other than      Research, Inc.).        Private and Public
                    banks, insurance companies,                                 Companies.
                    and securities firms. Includes
                    firms classified under the
                    following SICs: 6141, personal
                    credit institutions; 6153,
                    short-term business credit
                    firms; 6159, miscellaneous
                    business credit firms;
                    6162, mortgage bankers and
                    correspondents; and 6163, loan
                    brokers. Does not include
                    subsidiaries of banks or thrifts
                    but may include subsidiaries of
                    insurance or nonfinancial
                    companies.
Banks and thrifts   All 9,816 U.S. thrifts and          Holding company,        Total assets as            Largest substratum defined as
                    single-bank and multibank           bank, and thrift data   reported in June 1994      those institutions with total
                    holding companies or lead           files in June 1994      Call Reports and total     assets of $225 million or more
                    banks with national or state        (#188) Call Report      dollar amount of           and reporting $300 million or
                    charters. Does not include New      (Federal Financial      assets and liabilities     more in holdings of MBS and
                    York Investment Companies or        Institutions            reported in all            notional amounts of forwards,
                    trust companies. Branches,          Examination Council).   categories of MBS,         options, and swaps (3 percent
                    subsidiaries, or individual                                 either held to maturity,   of the population). Middle
                    banks that are members of                                   available for sale, or     substratum defined as
                    larger families of banks are also                           held in trading            institutions with total assets of
                    excluded.                                                   accounts plus total        less than $225 million and
                                                                                off-balance sheet          reporting $300 million or more
                                                                                notional value dollar      in holdings of MBS and notional
                                                                                amounts of various         amounts of forwards, options,
                                                                                interest rate and          and swaps and institutions of
                                                                                foreign exchange           any asset size and reporting up
                                                                                forwards, options,         to $300 million in holdings of
                                                                                and swaps.                 MBS and notional amounts of
                                                                                                           forwards, options, and swaps
                                                                                                           (33 percent of the population).
                                                                                                           Smallest substratum defined as
                                                                                                           institutions of any asset size
                                                                                                           reporting no holdings of these
                                                                                                           products (64 percent of the
                                                                                                           population).
                                                                                                                                   (continued)




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                                                                             Indicators of size        Size/Usage substratification
Strata (19)     Population definition              Frame used                and/or usage              criteria
Insurance       The 2,523 ultimate parent           Best’s Insurance         Total assets as           Large substratum defined as
  companies     property/casualty and               Reports, 1994 edition    reported in 1994          organizations with $700 million
                life/health insurance companies (A.M. Best, Inc.).           edition of Best’s         in assets and over,
                identified in the 1994 edition of                            Insurance Reports.        representing approximately the
                Best’s Insurance Reports.                                                              top 12 percent of organizations.
                Includes foreign-owned U.S.                                                            Small substratum consists of all
                subsidiaries or divisions that list                                                    other organizations.
                their U.S. executive
                management in Best’s
                Insurance Reports. Also
                includes insurance companies
                owned by holding companies
                outside of the insurance
                industry. Does not include
                subsidiaries or divisions of
                other U.S. insurance
                companies.
Credit unions   All 13,380 federally insured       Data tapes from the       Total assets in 1994.     Largest substratum defined as
                corporate and natural person       National Credit Union     Also, total holdings of   all 45 of the corporate credit
                credit unions in the United        Administration.           collateralized            associations, 25 of which
                States. Includes the U.S.                                    mortgage obligations      reported holding CMOs or
                Central Credit Union. Natural                                (CMO) and real estate     REMICs as of December 1994
                person credit unions primarily                               management                (less than 1 percent of the
                serve individuals who are their                              investment conduits       population). Second
                member-owners. Corporate                                     (REMIC) in June 1994.     substratum defined as the
                credit unions are cooperatively                                                        1,147 natural person credit
                owned by the natural person                                                            unions with any CMO or REMIC
                credit unions and serve them                                                           holdings as of June 1994
                by investing a portion of their                                                        (approximately 9 percent of the
                assets or loaning them funds                                                           population). Third substratum
                for liquidity purposes.                                                                defined as the 1,204 natural
                                                                                                       person credit unions with no
                                                                                                       CMO or REMIC holdings as of
                                                                                                       June 1994, but with $50 million
                                                                                                       or more in assets
                                                                                                       (approximately 9 percent of the
                                                                                                       population). Fourth substratum
                                                                                                       defined as the 10,984 natural
                                                                                                       person credit unions with no
                                                                                                       CMO or REMIC holdings as of
                                                                                                       June 1994 and less than $50
                                                                                                       million in assets (approximately
                                                                                                       82 percent of the population).a

                                        a
                                         Totals do not sum to 100 percent due to rounding.

                                        Source: GAO.



                                        After identifying the 19 strata representing broad industries, we then
                                        subdivided 16 strata into 2 or more substrata on the basis of financial size



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and, if available, the extent of past product usage. We did not subdivide
three strata—state treasuries, GSEs, and the largest nonbank financial
corporations—because they were already narrow industries with too few
organizations to subdivide by size. We substratified to group organizations
on the basis of how likely they were to be current end-users of OTC
derivatives, MBS, and structured notes so that we could sample them at
different rates. In each of the industry strata, we chose indicators of
financial size, such as annual revenues, assets under management, or
population in the governmental jurisdiction served. For the bank and
credit union strata, additional information identifying past users of certain
kinds of products was available from financial reports.

Typically, we defined the larger substrata in each industry as the top 10
percent of the number of organizations in the population when ranked by
size, although the cutpoints defining the large substrata varied from
approximately the top 1 percent to 33 percent of some populations,
depending on our knowledge of that particular industry or the
characteristics of the sampling frames (see table I.1). For example, we
defined the large credit union substratum as only the corporate credit
unions, which covered less than 1 percent of all credit unions. Corporate
credit unions, which tend to be large, differ in structure and function from
smaller “natural person” credit unions. In addition, we defined a cutpoint
of $1 billion in assets under management for money managers, resulting in
the large substratum covering 36 percent of the organizations in the
population, because that asset level was the highest available in the
computerized list that we used. Organizations known to have recently
used certain MBS and derivatives were included in the larger substrata of
banks, thrifts, and credit unions.

The sample was drawn from each substratum at different
rates—proportionately more organizations were drawn from the substrata
of large entities and recent users, which we expected to yield a relatively
high proportion of current users, and fewer from the substrata of smaller
entities, which we expected to yield fewer end-users. This differential rate
of sampling was necessary to obtain a sample that would meet both the
objectives of developing an acceptable estimate of overall usage and an
acceptable estimate of users’ opinions. See table I.2 for the exact
allocation of the original survey sample of 2,422 organizations2 across the


2
 Of the 2,422 organizations in the original sample, 41 were determined to be ineligible (out of business,
wrong industry, duplicate listing, and similar dispositions) before mailout. From the 2,381
questionnaires mailed out, we determined that an additional 177 organizations were ineligible during
the course of the survey. The final working sample size was 2,204 organizations.



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                        substrata and the aggregation of the 19 strata into the 9 industry groups
                        that we used to present our findings throughout this report.


                        To develop our questionnaire, we consulted representatives of the dealer
Questionnaire Design    community, groups representing end-users, financial regulators, and other
                        finance experts. We also conducted many in-depth interviews with finance
                        officers from state and local governmental entities and private
                        corporations on subjects to be included in the questionnaire. After drafting
                        a questionnaire and receiving comments from the aforementioned groups,
                        we conducted five pretests of the questionnaire with a variety of likely
                        respondents drawn from several of the survey populations. The
                        information gathered during such tests was used to improve the structure
                        of the questionnaire as well as the phrasing of specific questions.


                        The mailout of questionnaires began during the last week of March 1995.
Survey Administration   Follow-up mailings with replacement questionnaires and a renewed appeal
                        encouraging response were sent to nonrespondents beginning in the last
                        week of May 1995. In the second week of July 1995, we began to make
                        telephone follow-up calls to a sample of organizations that had not yet
                        responded to either the first or second questionnaire mailing. A random
                        sample of approximately 50 percent of the nonrespondents was drawn
                        from across all of the strata, and we administered a short telephone
                        interview questionnaire to that sample of 365. The follow-up interviews
                        determined the reason for nonresponse, prompted the return of the full
                        questionnaire, or collected basic data from the organization if a mail
                        questionnaire would not be returned by the respondent. The survey was
                        closed out at the end of October 1995, after which no additional responses
                        were included in our results. Because the questionnaire asked for product
                        usage and sales practice experience for the 12 months preceding the
                        survey, and given that respondents were filling out and returning
                        questionnaires from April 1995 through October 1995, the maximum
                        possible period of financial activity covered by the survey was from
                        April 1994 through October 1995.


                        We attempted to collect data from every one of the organizations chosen
Survey Response         in our random sample. However, for a variety of reasons, such as refusals,
                        we did not receive usable responses from a number of entities. After
                        sending a replacement questionnaire to nonrespondents and following up
                        by telephone with a random sample of the remaining nonrespondents, we



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determined the final status of our entire sample (see table I.2). We
received 1,755 usable responses, for an overall response rate of 80 percent.
Although some of the survey strata exhibited higher or lower rates of
response than others, the response rates did not vary systematically by
size of stratum. Because we hypothesized that large and small
organizations would differ on key variables, a large difference in response
rates between large and small substrata could have introduced bias into
the overall survey results.




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Table I.2: Disposition of Survey Sample Across All Strata
                                                                                                Original       Original
Industry groups (9) Strata (19)                     Substrata (38)                            population       sample       Ineligible
State and            Cities and counties            Large: population ≥ 37,000
  local government                                                                                 1,932            100             1
                                                    Small: population < 37,000                    37,104             50             5
                     State and local special        Large: top 30 urban areas
                     districts                                                                       489             50             5
                                                    Small: all other districts                    32,349             50             4
                     Local school districts         Large: enrollment ≥ 5,250                      1,426             50             0
                                                    Small: enrollment < 5,250                     12,796             50             0
                     State treasuries               All states and District of Columbia               51             51             0
Pension funds        Private pension/Union funds Large: assets ≥ $20 million                       4,407            100             3
                                                    Small: assets < $20 million                   41,349            100             5
                     Public pension                 Large: assets ≥ $1 billion
                     funds/Retirement systems                                                        123             75             1
                                                    Small: assets < $1 billion                     1,044             25             0
Endowment and        Endowments and                 Large: assets ≥ $100 million
  college funds      foundations                                                                     507             50             3
                                                    Small: assets < $100 million                   4,348             50             1
                     College and university         Large: revenue ≥ $80 million
                     operating funds                                                                 366             50             3
                                                    Small: revenue < $80 million                   3,301             50             1
Money managers       Institutional money            Large: assets ≥ $1 billion
                     managers                                                                        637            122             0
                                                    Small: assets < $1 billion                     1,122             72             3
GSE                  GSE                            All                                               33             33             1
Investment funds     Commodity pools                Large: net asset value ≥ $31.5
                                                    million                                          286             29             7
                                                    Small: net asset value < $31.5
                                                    million                                          558             26             0
                     Mutual funds                   Large: assets ≥ $450 million                     636            125             3
                                                    Small: assets < $450 million                   5,722             75             1
                     Money market mutual funds Large: assets ≥ $1.2 billion                          124             75             0
                                                    Small: assets < $1.2 billion                   1,113             75             5
Nonfinancial         Publicly held nonfinancial     Large: sales ≥ $1.4 billion
 corporations        corporations                                                                    506             75             0
                                                    Small: sales < $1.4 billion                    5,075             74             1
                     Privately held nonfinancial    Large: top 200, by sales
                     corporations                                                                    200             50             3
                                                    Small: all others                              8,004            121            16




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                             Follow-up       Follow-up        Follow-up      Follow-up           Total   Response rate
Respondents Nonrespondents     sample         ineligible   respondents nonrespondents       responses        (percent)

         67             32         10                 6              4                 0            71               76
         45              0           0                0              0                 0            45              100

         23             22           7                5              2                 0            25               63
         29             17         14                 5              8                 1            37               90
         34             16           7                0              6                 1            40               80
         34             16           6                1              4                 1            38               78
         32             19           5                1              4                 0            36               72
         54             43         17                 3            11                  3            65               69
         63             32         18                 4            11                  3            74               81

         60             14           8                2              5                 1            65               90
         16              9           4                2              2                 0            18               78

         32             15         10                 3              4                 3            36               82
         38             11           7                1              5                 1            43               90

         37             10           6                1              5                 0            42               91
         35             14         10                 4              2                 4            37               82

         70             52         32                12            11                  9            81               74
         64              5           0                0              0                 0            64               93
         31              1           0                0              0                 0            31               97

         18              4           0                0              0                 0            18               82

         13             13           7                4              2                 1            15               68
         58             64         22                 5            12                  5            70               60
         36             38         27                 3            21                  3            57               80
         36             39         17                 0            14                  3            50               67
         28             42         32                15            10                  7            38               69

         46             29         12                 3              7                 2            53               74
         42             31         12                 2              9                 1            51               72

         33             14           7                5              2                 0            35               83
         70             35         11                 4              7                 0            77               76
                                                                                                             (continued)




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                                                                                            Original       Original
Industry groups (9) Strata (19)                  Substrata (38)                           population       sample       Ineligible
Other financial      Largest nonbank financial   Top 120, by assets
 corporations        corporations                                                                120            120             7
Banks/ Credit        Banks and thrifts           Large/Past users: MBS and
 unions/ Insurance                               derivative usage ≥ $300 million
 companies                                       and assets ≥ $225 million                       309             75             2
                                                 Medium/Past users: (1) usage <
                                                 $300 million or (2) usage ≥ $300
                                                 million and assets < $225 million             3,194             75             1
                                                 Small/No past usage: $0 usage,
                                                 any asset size                                6,313             50            10
                     Insurance companies         Large: assets ≥ $700 million                    299             50             3
                                                 Small: assets < $700 million                  2,224             50            13
                     Credit unions               45 corporate credit unions                       45             45             0
                                                 Natural person credit unions, past
                                                 users of MBS                                  1,147             54             2
                                                 Natural person credit unions, no
                                                 past usage, assets ≥ $50 million              1,204             25             0
                                                 Natural person credit unions, no
                                                 past usage, assets < $50 million             10,984             25             0
Total                N/A                         N/A                                         191,447          2,422           110




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                              Follow-up       Follow-up        Follow-up      Follow-up           Total   Response rate
 Respondents Nonrespondents     sample         ineligible   respondents nonrespondents       responses        (percent)

          71             42         19                 7            12                  0            83               78


          59             14           7                4              2                 1            61               88


          55             19           7                1              5                 1            60               82

          30             10           6                2              3                 1            33               87
          33             14         10                 2              6                 2            39               87
          27             10           5                0              3                 2            30               81
          38              7           3                1              2                 0            40               91

          50              2           0                0              0                 0            50               96

          25              0           0                0              0                 0            25              100

          22              3           0                0              0                 0            22               88
       1,554            758        365               108           201                 56         1,755               80
                                   Source: GAO.




                                   The overall survey statistics appearing in this report represent estimates of
Calculation of Survey              the entire population of U.S. private industry and state and local
Estimates                          governmental entities from which the sample was drawn. To be able to
                                   make an estimate of the entire population, each questionnaire we received
                                   was statistically adjusted, or “weighted,” so that its influence in
                                   determining the overall survey result was proportional to the number of
                                   other, nonsampled entities it had to represent in its industry. Specific
                                   weights were calculated for returned questionnaires within each of the
                                   substrata formed by the cross-classification of industry with organizational
                                   size and/or past usage. The weights were also adjusted to represent
                                   different sample selection rates within substrata for the initial sample and
                                   the follow-up sample of nonrespondents.

                                   Not all of the sample substrata are included in the overall survey results.
                                   Five of the “smallest” substrata were removed from the overall survey
                                   estimates made in this report and analyzed separately. They were: small
                                   cities and counties, small special districts, small school districts, small
                                   private pension and union funds, and small nonuser credit unions. These



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five substrata represent populations that are very numerous, yet very low
in financial assets and activity. We discovered a very low rate of product
usage among these entities and, therefore, decided to separate them from
the rest of the sample. See tables I.3 and tables I.5 through I.8 for the
estimates of usage of the various products by these very small
organizations. Although the size of the entire original population, including
the 5 smallest strata, is approximately 191,000, the population to which we
project our overall survey estimates in this report, after removing the very
small organization strata and adjusting the population for ineligibles, is
approximately 49,000 organizations.

In addition to the overall estimates that are projectable to the entire
population of U.S. public and private industry from which the sample was
drawn, this report contains some estimates for more specific industry
groupings. Because the number of sampled organizations falling within
any 1 of the 19 industries was usually too small to yield precise estimates
for that individual industry, we aggregated responses from several
comparable industries to form 9 industry groups (see table I.2). For
example, we combined questionnaires received from mutual funds, money
market funds, and commodity pools into one analytical group. Although
the individual industries combined in a group generally exhibit the same
characteristics on most survey items, a great deal of variation may exist in
rates of usage and satisfaction among some of the combined industries.

This report also breaks down survey results by the size of organization
and/or past usage of certain MBS and derivative products across the entire
sample and within each industry group. As previously described, we
separated the industries into as many as four substrata. The cutpoints
separating these substrata of “larger” from “smaller” organizations in each
of the 19 industries are somewhat arbitrary and are based on different
measures across each industry. As a result, “larger” organizations in one
industry are not necessarily similar to those in another industry.

Beyond the limited breakdowns of the survey results by broad categories
of industry and size, it is not possible to make any estimates of acceptable
precision. Because the survey sample was designed to make overall
estimates across a large number of industries, an insufficient number of
sampled institutions exists within the fine categories of industry, size,
geographical location, or other subgroups. Some subgroup estimates that
are made in this report are accompanied by a note to the reader that the
small number of observations involved make calculation of sampling error
unfeasible and heighten the likelihood of significant nonsampling error.



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                     The concept of sampling errors and other survey errors is discussed in the
                     following sections.


                     Because we reviewed a statistical sample of organizations, each estimate
Sampling Error       developed from the sample has a measurable precision, or sampling error.
                     The sampling error is the maximum amount by which the estimate
                     obtained from a statistical sample can be expected to differ from the true
                     population value we are estimating. Sampling errors are stated at a certain
                     confidence level—in this case 95 percent. This means that the chances are
                     19 out of 20 that if we surveyed all of the organizations in the population,
                     the true value obtained for a question on this survey would differ from the
                     estimate obtained from our sample by less than the sampling error for that
                     question. The sampling errors for all of the survey estimates made in this
                     report are listed in tables I.3 through I.14. For the state treasury, GSE, and
                     other financial institution strata, we selected all known organizations in
                     the population as defined, so there is technically no sampling error
                     associated with those estimates. However, missing observations due to the
                     nonresponse of some of the sampled organizations in those strata creates
                     statistical uncertainty similar to sampling error.


                     In addition to the reported sampling errors, the practical difficulties of
Nonsampling Errors   conducting any survey may introduce other types of errors, commonly
                     referred to as nonsampling errors. For example, intentional or accidental
                     misreporting, differences in how a particular question is interpreted, the
                     level of effort a respondent makes to answer the questions accurately, or
                     the types of people who do not respond can introduce unwanted
                     variability into the survey results.

                     We included steps in the questionnaire design, data collection, and data
                     analysis stages for the purpose of reducing such nonsampling errors.
                     While designing the questionnaire, we solicited expert opinions on the
                     wording and structure of our questions and their answer categories, we
                     received feedback on our questions and answers during a focus group with
                     end-users, and we pretested the survey instrument with five organizations
                     from our sample.

                     During data collection, we checked whether some answers respondents
                     gave on their questionnaires were logically consistent with other answers.
                     While conducting an in-depth telephone follow-up with a sample of
                     respondents who were particularly satisfied or dissatisfied with sales



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                       Methodology for GAO Survey of End-Users




                       practices, we attempted to verify some of their previous answers and thus
                       gauge the reliability of a subset of the questions.

                       To reduce nonresponse bias, we attempted to convert a sample of
                       50 percent of the nonrespondents to respondents through telephone
                       follow-ups. To assess the potential impact of nonresponse on our
                       estimates, we examined a group of respondents who may be similar to
                       nonrespondents in terms of characteristics that determine questionnaire
                       responses—those organizations that were initially nonrespondents but
                       were converted through telephone follow-up. When we compared the
                       answers of those converted nonrespondents to organizations that
                       responded without follow-up, we found the only material difference to be
                       that a smaller proportion of the converted nonrespondents used MBS and
                       fewer were dissatisfied with the sales practices of dealers offering MBS.
                       Finally, in processing and tabulating the survey data, we employed a
                       number of procedures to reduce errors that arise from these activities.



Sampling Errors
Associated With the
Key Survey Estimates
Cited in This Report




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                                          Methodology for GAO Survey of End-Users




Table I.3: Proportion of Organizations
Using OTC Derivatives (Plain Vanilla or                                                                                    Sampling
More Complex) in the 12 Months            Organizations, by size category and industry                    Estimate          error (±)
Preceding Receipt of Survey, by Size      group                                                           (percent)        (percent)
Category and Industry Group               Size category:
                                              All organizations in the population, excluding the
                                                five smallest strata                                             11%               2%
                                              Large organizations                                                14                2
                                              Small organizations, excluding the five smallest
                                               strata                                                             9                3
                                              Smallest five strata (smallest local governmental
                                               entities, smallest credit unions, and smallest
                                               private pension funds)                                           <1                  a

                                          Industry group:
                                              Banks and thrifts, credit unions, and insurance
                                               companies                                                          5                3
                                              Endowments, foundations, and college and
                                                university operating funds                                        7                5
                                              Other financial corporations (credit financing
                                               firms, mortgage brokers and lenders, and
                                               leasing agencies)                                                 54                6
                                              GSEs                                                               71                3
                                              Money managers                                                     10                5
                                              Mutual funds, money market funds, and
                                               commodity pools                                                   27                9
                                              Public and private pension funds and retirement
                                                systems                                                          10                5
                                              Publicly and privately held nonfinancial
                                                corporations                                                     10                5
                                                                                                                                    a
                                              State and local governmental entities                               4
                                          a
                                          Number of cases insufficient to make an estimate.

                                          Source: GAO.




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                                     Methodology for GAO Survey of End-Users




Table I.4: Proportion of Estimated
Total Users Represented by Each                                                                                       Sampling
Industry Group                                                                                       Estimate          error (±)
                                     Industry group                                                  (percent)        (percent)
                                     Banks and thrifts, credit unions, and insurance
                                      companies                                                             12%               7%
                                     Endowments, foundations, and college and
                                       university
                                       operating funds                                                      11                7
                                     Other financial corporations                                            1               <1
                                     GSEs                                                                  <1                <1
                                     Money managers                                                          3                2
                                     Mutual funds, money market funds, and commodity
                                      pools                                                                 39               10
                                     Public and private pension funds and retirement
                                       systems                                                               9                5
                                     Publicly and privately held nonfinancial corporations                  22               10
                                                                                                                               a
                                     State and local governmental entities                                   2
                                     Total                                                                 100%             N/A
                                     a
                                     Number of cases insufficient to make an estimate.

                                     Source: GAO.




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                                         Methodology for GAO Survey of End-Users




Table I.5: Proportion of Organizations
Using Plain Vanilla OTC Derivatives,                                                                                      Sampling
by Size Category and Industry Group      Organizations, by size category and industry                    Estimate          error (±)
                                         group                                                           (percent)        (percent)
                                         Size category:
                                             All organizations in the population, excluding the
                                               five smallest strata                                             10%               2%
                                             Large organizations                                                14                2
                                             Small organizations, excluding the five smallest
                                              strata                                                             9                3
                                             Smallest five strata (smallest local governmental
                                              entities, smallest credit unions, and smallest
                                              private pension funds)                                           <1                  a

                                         Industry group:
                                             Banks and thrifts, credit unions, and insurance
                                              companies                                                          5                3
                                             Endowments, foundations, and college and
                                               university operating funds                                        6                5
                                             Other financial corporations (credit financing
                                              firms, mortgage brokers and lenders, and
                                              leasing agencies)                                                 54                6
                                             GSEs                                                               68                3
                                             Money managers                                                     10                5
                                             Mutual funds, money market funds, and
                                              commodity pools                                                   27                9
                                             Public and private pension funds and retirement
                                               systems                                                          10                5
                                             Publicly and privately held nonfinancial
                                               corporations                                                     10                5
                                                                                                                                   a
                                             State and local governmental entities                               3
                                         Other subgroups:
                                             Large publicly and privately held nonfinancial
                                               corporations                                                     66               12
                                             Large public pension funds and retirement
                                               systems                                                          41                9
                                             Proportion of organizations that have not used
                                               plain vanilla OTC derivatives, but have received
                                               a proposal to enter into such a contract in the
                                               last 12 months                                                    8                2
                                         a
                                         Number of cases insufficient to make an estimate.

                                         Source: GAO.




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                                         Methodology for GAO Survey of End-Users




Table I.6: Proportion of Organizations
Using More Complex OTC Derivatives,                                                                                       Sampling
by Size Category and Industry Group      Organizations, by size category and industry                    Estimate          error (±)
                                         group                                                           (percent)        (percent)
                                         Size category:
                                             All organizations in the population, excluding the
                                             five smallest strata                                                2%               1%
                                             Large organizations                                                 4                1
                                             Small organizations, excluding the five smallest
                                                                                                                                   a
                                             strata                                                              1
                                             Smallest five strata (smallest local governmental
                                             entities, smallest credit unions, and smallest
                                             private pension funds)                                              0                0
                                         Other subgroups:
                                             Proportion of organizations that have not used, but
                                             have received a proposal for more complex OTC
                                             derivatives                                                         6                2
                                         a
                                         Number of cases insufficient to make an estimate.

                                         Source: GAO.




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                                         Methodology for GAO Survey of End-Users




Table I.7: Proportion of Organizations
Using MBS, by Size Category and                                                                                           Sampling
Industry Group                           Organizations, by size category and industry                    Estimate          error (±)
                                         group                                                           (percent)        (percent)
                                         Size category:
                                             All organizations in the population, excluding the
                                               five smallest strata                                             24%               3%
                                             Large organizations                                                37                4
                                             Small organizations, excluding the five smallest
                                              strata                                                            19                4
                                             Smallest five strata (smallest local governmental
                                              entities, smallest credit unions, and smallest
                                                                                                                                   a
                                              private pension funds)                                             3
                                         Industry group:
                                             Banks and thrifts, credit unions, and insurance
                                              companies                                                         55                8
                                             Endowments, foundations, and college and
                                               university operating funds                                       16                7
                                             Other financial corporations (credit financing
                                              firms, mortgage brokers and lenders, and
                                              leasing agencies)                                                 23                4
                                             GSEs                                                               73                3
                                             Money managers                                                     33                8
                                             Mutual funds, money market funds, and
                                              commodity pools                                                   25                9
                                             Public and private pension funds and retirement
                                               systems                                                          24                7
                                             Publicly and privately held nonfinancial
                                                                                                                                   a
                                               corporations                                                      2
                                             State and local governmental entities                               7                5
                                         Other subgroups:
                                             Small banks and thrifts, credit unions, and
                                              insurance companies                                               40               11
                                             All other organizations except for small banks
                                               and thrifts, credit unions, and insurance
                                               companies                                                        21                2
                                             Large public pension funds and retirement
                                               systems                                                          74                9
                                             Proportion of organizations that have not used
                                               MBS, but have received a proposal to enter into
                                               such a contract in the last 12 months                             4                2
                                         a
                                         Number of cases insufficient to make an estimate.

                                         Source: GAO.




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                                         Methodology for GAO Survey of End-Users




Table I.8: Proportion of Organizations
Using Structured Notes, by Size                                                                                           Sampling
Category and Industry Group              Organizations, by size category and industry                    Estimate          error (±)
                                         group                                                           (percent)        (percent)
                                         Size category:
                                             All organizations in the population, excluding the
                                               five smallest strata                                             16%               3%
                                             Large organizations                                                22                3
                                             Small organizations, excluding the five smallest
                                              strata                                                            13                4
                                             Smallest five strata (smallest local governmental
                                              entities, smallest credit unions, and smallest
                                                                                                                                   a
                                              private pension funds)                                             2
                                         Industry group:
                                             Banks and thrifts, credit unions, and insurance
                                              companies                                                         40                8
                                             Endowments, foundations, and college and
                                               university operating funds                                       11                6
                                             Other financial corporations (credit financing
                                              firms, mortgage brokers and lenders, and
                                              leasing agencies)                                                  6               <1
                                             GSEs                                                               57                3
                                             Money managers                                                     20                7
                                             Mutual funds, money market funds, and
                                              commodity pools                                                   12                6
                                             Public and private pension funds and retirement
                                               systems                                                           5                4
                                             Publicly and privately held nonfinancial
                                                                                                                                   a
                                               corporations                                                      3
                                             State and local governmental entities                               9                6
                                         Other subgroups:
                                             Small banks and thrifts, credit unions, and
                                              insurance companies                                               35               13
                                             All organizations except for small banks and
                                               thrifts, credit unions, and insurance companies                  12                2
                                             Large public pension funds and retirement
                                               systems                                                          33                9
                                             Proportion of organizations which have not used
                                               structured notes, but have received a proposal
                                               to enter into such a contract in the last 12 months               5                1
                                         a
                                         Number of cases insufficient to make an estimate.

                                         Source: GAO.




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                                           Methodology for GAO Survey of End-Users




Table I.9: Proportion of Organizations Rating Overall Sales Practices for Dealers Used, by Product Offered
                               Somewhat or very        Neither satisfied nor      Somewhat or very
                                    satisfied               dissatisfied             dissatisfied                     No opinion
                                          Sampling                     Sampling                      Sampling                 Sampling
                              Estimate     error (±)      Estimate      error (±)      Estimate       error (±)   Estimate     error (±)
Product                       (percent)   (percent)       (percent)    (percent)       (percent)     (percent)    (percent)   (percent)
Plain vanilla OTC
  derivatives                       85%            8%            13%             8%             2%            a
                                                                                                                        <1%            a

More complex OTC
                                                                   a              a              a            a           a            a
 derivatives                        79            19
                                                                                                                                       a
MBS                                 71             8             20              8               7           4           2
                                                                                                                                       a
Structured notes                    64            11             20              9              13           9           4
                                           a
                                            Number of cases insufficient to make an estimate.

                                           Source: GAO.




Table I.10: Proportion of Organizations Rating Overall Sales Practices for Dealers Not Used, by Product Offered
                               Somewhat or very        Neither satisfied nor      Somewhat or very
                                    satisfied               dissatisfied             dissatisfied             No opinion
                                          Sampling                     Sampling                      Sampling                 Sampling
                              Estimate     error (±)      Estimate      error (±)      Estimate       error (±)   Estimate     error (±)
Product                       (percent)   (percent)       (percent)    (percent)       (percent)     (percent)    (percent)   (percent)
Plain vanilla OTC
  derivatives                       29%            9%            33%             9%         17%              7%         21%          10%
More complex OTC
                                                                                                                                       a
 derivatives                        16             9             51             14              26          12           7
MBS                                 20             8             46             10              27           8           8            7
                                                                                                                                       a
Structured notes                    15             7             48             12              29          10           8
                                           a
                                            Number of cases insufficient to make an estimate.

                                           Source: GAO.




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                                           Methodology for GAO Survey of End-Users




Table I.11: Proportion of Organizations Somewhat or Very Dissatisfied With Disclosure of Downside Risks or Suitability of
Products Proposed, by Dealers Used and Not Used
                                            Dealers used                                    Dealers not used
                           Disclosure of downside         Suitability of products       Disclosure of downside     Suitability of products
                                    risks                       proposed                         risks                   proposed
                                          Sampling                      Sampling                      Sampling                   Sampling
                              Estimate     error (±)       Estimate      error (±)        Estimate     error (±)    Estimate      error (±)
Product                       (percent)   (percent)        (percent)    (percent)         (percent)   (percent)     (percent)    (percent)
Plain vanilla OTC
  derivatives                        6%               a
                                                                 <1%                a
                                                                                              20%             8%           18%           7%
More complex OTC
                                                      a                             a
 derivatives                        12                             3                            38           13            42           13
MBS                                  5            3                4            3               27            8            36            9
                                                                                    a
Structured notes                    17            9                7                            31           10            39           10
                                           a
                                           Number of cases insufficient to make an estimate.

                                           Source: GAO.




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                                         Methodology for GAO Survey of End-Users




Table I.12: Proportion of End-Users of
a Product Who Believed a Fiduciary                                                          Total of some and all cases
Relationship Exists                                                                                          Sampling error (±)
                                         Product                                        Estimate percent             (percent)
                                         Plain vanilla OTC derivatives                                 53%                10%
                                         More complex OTC derivatives                                  48                   16
                                         MBS                                                           60                    7
                                         Structured notes                                              58                    9




                                         Page 172                                  GAO/GGD-98-5 OTC Derivatives Sales Practices
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                                              Methodology for GAO Survey of End-Users




           In all cases                      In some cases                             Never                              No opinion
       Estimate Sampling error           Estimate Sampling error              Estimate Sampling error              Estimate Sampling error
       (percent)  (±) (percent)          (percent)  (±) (percent)             (percent)  (±) (percent)             (percent)  (±) (percent)
              35%               10%               18%                7%               31%                   9%             16%                8%
              28                15                19                10                36                    16             16                15
              37                 7                23                 6                25                    6              15                 6
              36                 9                22                 7                26                    9              16                 6
                                              Source: GAO.




Table I.13: Proportion of End-Users of a Product Who Believed a Fiduciary Relationship Exists in Some or All Cases, by
Industry Group
                                                              Plain vanilla OTC
                                                                  derivatives              MBS             Structured notes
                                                                                 Sampling                    Sampling                 Sampling
                                                                    Estimate      error (±)     Estimate      error (±)   Estimate     error (±)
Industry group                                                      (percent)    (percent)      (percent)    (percent)    (percent)   (percent)
Aggregated subgroup of large and small banks and thrifts,
 credit unions, and insurance companies                                     58%        24%             63%          10%          63%         13%
Endowments, foundations, and college and university
                                                                                            a                                                  a
  operating funds                                                           31                         58           24           34
Other financial corporations (credit financing firms, mortgage
                                                                                                                                               a
 brokers and lenders, leasing agencies)                                     54             6           75            4           73
GSEs                                                                        27             4           38            4           41           5
Money managers                                                              39             24          52           15           49          20
Mutual funds, money market funds, and commodity pools                       42             18          52           24           47          23
                                                                                            a                                                  a
Public and private pension funds and retirement systems                     78                         51           20           69
                                                                                                                      a                        a
Publicly and privately held nonfinancial corporations                       73             19          63                        86
                                                                                            a                         a                        a
State and local governmental entities                                       81                         87                        84
                                              a
                                               Number of cases insufficient to make an estimate.

                                              Source: GAO.




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                                          Methodology for GAO Survey of End-Users




Table I.14: Proportion of All End-Users
of a Product That Relied on the Dealer                                                     To some, moderate, great, or very
for Investment Advice                                                                                great extent
                                                                                                              Sampling error (±)
                                          Product                                        Estimate (percent)           (percent)
                                          Plain vanilla OTC derivatives                                  59%               10%
                                          More complex OTC derivatives                                   64                  15
                                          MBS                                                            73                    6
                                          Structured notes                                               84                    6




                                          Page 174                                  GAO/GGD-98-5 OTC Derivatives Sales Practices
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To a great or very great extent   To some or a moderate extent            To little or no extent                 No opinion
     Estimate Sampling error          Estimate Sampling error             Estimate Sampling error          Estimate Sampling error
     (percent)  (±) (percent)         (percent)  (±) (percent)            (percent)  (±) (percent)         (percent)  (±) (percent)
            28%              10%              31%                9%               36%               10%            5%               3%
                                                                                                                                     a
            28               18               36                16                32                15             4
            36                7               37                 7                20                 6             7                3
            42                9               42                 9                10                 5             6                4
                                          a
                                           Number of cases insufficient to make an estimate.

                                          Source: GAO.




                                          Page 175                                        GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix II

GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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Derivatives, Structured Notes, and
Asset-Backed Securities




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Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




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Derivatives, Structured Notes, and
Asset-Backed Securities




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GAO Survey of Sales Practices for OTC
Derivatives, Structured Notes, and
Asset-Backed Securities




Page 189                                GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix III

Comments From the Board of Governors of
the Federal Reserve System

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




                             Page 190   GAO/GGD-98-5 OTC Derivatives Sales Practices
               Appendix III
               Comments From the Board of Governors of
               the Federal Reserve System




See comment.




               Page 191                                  GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix III
Comments From the Board of Governors of
the Federal Reserve System




Page 192                                  GAO/GGD-98-5 OTC Derivatives Sales Practices
              Appendix III
              Comments From the Board of Governors of
              the Federal Reserve System




              The following is GAO’s comment on the July 30, 1997, letter from the Board
              of Governors of the Federal Reserve System.


              The Federal Reserve commented that its guidance on the investment and
GAO Comment   end-user activities of banking institutions may be helpful to end-users
              generally. We agree and have added a specific citation to this guidance as
              well as Office of the Comptroller of the Currency guidance for institutions
              acting as end-users of OTC derivatives and other financial products.




              Page 193                                  GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IV

Comments From the Office of the
Comptroller of the Currency




              Page 194      GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix V

Comments From the Securities and
Exchange Commission

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




See p. 139.




                             Page 195   GAO/GGD-98-5 OTC Derivatives Sales Practices
                 Appendix V
                 Comments From the Securities and
                 Exchange Commission




See p. 140.




See p. 142.




See comment 1.




                 Page 196                           GAO/GGD-98-5 OTC Derivatives Sales Practices
                 Appendix V
                 Comments From the Securities and
                 Exchange Commission




Now on p. 90.




See comment 2.


Now on p. 88.


See comment 3.




See comment 4.




                 Page 197                           GAO/GGD-98-5 OTC Derivatives Sales Practices
               Appendix V
               Comments From the Securities and
               Exchange Commission




               The following are GAO’s comments on the Securities and Exchange
               Commission’s (SEC) August 15, 1997, letter.


               1. SEC commented that our draft report did not adequately discuss the
GAO Comments   differences between the two sets of dealer-issued guidance—the
               Framework for Voluntary Oversight and the Principles and Practices for
               Wholesale Financial Market Transactions. First, SEC stated that, while our
               draft report noted that both sets of guidance assert the relationship
               between parties to nonsecurities over-the-counter (OTC) derivatives
               transactions is one of arm’s length, the report provides no additional
               discussion of the affirmative responsibility, under the Framework, for a
               dealer to clarify the nature of the relationship when it becomes aware that
               the nonprofessional counterparty (end-user) mistakenly believes that the
               dealer has assumed advisory obligations. Second, SEC stated that our draft
               report alluded in table 4.1, but did not discuss, that, while the Principles
               recommends that policies regarding the use of financial products be
               maintained, the Framework goes further by expressly recommending that
               controls be established to reduce the risk of misunderstandings and
               contractual disputes between parties.

               Although differences between the two sets of dealer-issued guidance exist,
               we did not find these differences to be material, and we did not find them
               to exist in the two respects that SEC cited. Our overall analysis of the key
               provisions of each set of guidance indicates that they are consistent in the
               following: type of relationship they assert; the degree to which the parties
               should rely on each other; and the specific responsibilities of parties
               regarding the disclosure of risk, the exchange of pricing and valuation
               information, and the controls that should be in place. Also, given that
               adherence to each set of guidance is voluntary, the difference in
               terminology used is not material. This report now notes that a member of
               the Principles drafting committee, whose firm also served on the
               committee that developed the Framework, reached the same general
               conclusion. He stated that the spirit of the two documents is the same and
               that it would be unfair to contrast them simply because they use different
               language in some sections.

               Regarding the first difference between the Framework and Principles that
               SEC cited, table 4.1 of this report provides our summary of the key sales
               practice provisions of these two sets of guidance. In this table, we state
               that the Framework indicates that professional intermediaries (dealers)
               should take steps to clarify the relationship if its counterparty appears to



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Appendix V
Comments From the Securities and
Exchange Commission




believe that the dealer has assumed an advisory role. However, this
responsibility is not unique to the Framework, as the Principles, in section
5.2, similarly states that participants may wish to maintain policies and
procedures for identifying and addressing exceptional situations that pose
relationship, reputational, or litigation (compliance) risks, including those
in which the counterparty appears to assume incorrectly that it may rely
on the participant for recommendations or investment advice. This section
of the Principles also represents the provision related to controls that SEC
cited as a second difference between the two sets of dealer-issued
guidance. The draft report summarized this aspect of both sets of
guidance.

In addition, we added text in chapter 4 that cites a situation posing
compliance and reputation risks for which both documents call for
policies and procedures—that is, when counterparties incorrectly assume
an advisory relationship exists. In summary, our report indicates that both
sets of guidance contain similar expectations for participants regarding
the need to establish controls to address the risk arising from
misunderstandings and contractual disputes between parties.

2. In identifying another difference between the two sets of dealer-issued
guidance, SEC stated that the Principles may be implemented in whole or in
part, whereas the Framework should be implemented in its entirety. We
found that this difference between the two sets of guidance results
because the firms that have agreed to voluntarily adhere to the Framework
have done so to avoid direct federal regulation. Notwithstanding this
difference, our discussion of the key provisions of the two sets of guidance
focuses primarily on the nature of the relationship and types of the
responsibilities they advocate. Differences in the extent to which each set
of voluntary guidance may be implemented is not material to this
discussion; therefore, we did not modify the report.

3. SEC stated that while our draft report correctly indicated that the
Framework applies only to six firms and only to their nonsecurities OTC
derivatives activities, this implies that a large number of firms as well as a
large amount of activity may be operating outside of the Framework. SEC
stated that the six firms that have agreed to implement the Framework are
responsible for more than 90 percent of the nonsecurities OTC derivatives
business conducted by unregistered affiliates of broker-dealers, and that
these affiliates do not conduct securities OTC derivatives activities, as these
must be conducted through an SEC registered and regulated broker-dealer.




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Appendix V
Comments From the Securities and
Exchange Commission




By describing the specific firms and activities covered by the Framework,
we did not intend to imply that large amounts of securities firms’ OTC
derivatives activities are not addressed by the Framework or by some
other regulatory regime. We acknowledged in the draft report that the
participating firms account for 90 percent of the OTC derivatives activities
of security firm affiliates. We revised this text to indicate that such
activities involve nonsecurities OTC derivatives. Although we indicate in
chapter 1 of this report that firms conducting securities activities must do
so in affiliates registered with and subject to regulation by SEC, we have
also added text to that effect in chapter 2.

4. SEC commented that our draft report did not always clearly distinguish
between OTC derivatives that are securities and those that are not. We
revised the text of this report and the figures appearing in chapters 3 and
4, as appropriate, to make this distinction. We also added text in chapter 2,
explaining that OTC derivatives that are considered to be securities
represent a small percentage of the overall volume of OTC derivatives.




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Appendix VI

Comments From the End-Users of
Derivatives Association

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




                             Page 201   GAO/GGD-98-5 OTC Derivatives Sales Practices
               Appendix VI
               Comments From the End-Users of
               Derivatives Association




See comment.




See p. 74.




               Page 202                         GAO/GGD-98-5 OTC Derivatives Sales Practices
              Appendix VI
              Comments From the End-Users of
              Derivatives Association




              The following is GAO’s comment on the End-Users of Derivatives
              Association’s August 1, 1997, letter.


              The association commented that the draft report might give the impression
GAO Comment   that sales practice disputes are largely the result of end-users suffering
              large financial losses. It elaborated that end-users have suffered large
              losses without objecting to dealer conduct when derivatives that were
              used as hedges operated as dealers represented. In such cases, derivatives
              losses were offset by gains in the underlying hedged items.

              We did not intend to imply that end-users routinely blame dealers when
              they incur losses. In chapter 3, we presented estimates of the percentage
              of reported losses in which sales practice concerns were raised. While we
              could not determine if the products were used for hedging, the data
              (which are not statistically valid) show that about 59 percent of publicized
              over-the-counter derivatives losses did not result in sales practice
              disputes. Nonetheless, we revised the report to further clarify that
              end-users do not routinely raise sales practice concerns when they incur
              losses and to describe the circumstances under which they might raise
              such concerns.




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Appendix VII

Comments From the Government Finance
Officers Association

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




See comment 1.




                             Page 204   GAO/GGD-98-5 OTC Derivatives Sales Practices
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              Comments From the Government Finance
              Officers Association




See p. 100.




See p. 102.




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                 Comments From the Government Finance
                 Officers Association




See p. 52.




See comment 2.




See p. 142.




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                 Officers Association




See comment 3.




See comment 4.




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                 Officers Association




See comment 5.




See comment 6.




See p. 116.




See comment 7.




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                 Officers Association




See comment 8.




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Comments From the Government Finance
Officers Association




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Officers Association




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Officers Association




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               Comments From the Government Finance
               Officers Association




               The following are GAO’s comments on the Government Finance Officers
               Association’s July 30, 1997, letter.


               1. The association commented that we should recognize the role and
GAO Comments   importance of state securities regulators in enforcing the securities laws.
               We added a footnote to the executive summary and to chapter 1 to clarify
               that state agencies also oversee banking and securities activities but that
               this report does not assess their oversight in detail.

               2. The association commented that the presentation in the draft report of
               survey statistics by financially oriented organizations and other
               nonfinancial organizations could be misleading. The association was
               particularly concerned about the treatment of public pension funds and
               state and local governments because pension funds (both public and
               private) were included in the financially oriented category, while state and
               local governments were included among other organizations. We clarified
               this report by adding footnotes to the related text that explain the types of
               organizations within each grouping. We also added a note to figure 3.4,
               indicating that appendix I describes the organizations included in the
               groupings.

               3. The association commented that our draft report erred in relying on the
               Principles and Practices for Wholesale Financial Market Transactions
               when describing the participants in transactions covered by the
               dealer-issued guidance. The association elaborated that participants,
               including end-users, are not only large financial and commercial entities
               that are more likely to be financially sophisticated, but they also include
               state and local governments, churches, schools, charities, and others who,
               although holding large portfolios, would not be construed as commercial
               entities or would not necessarily be financially sophisticated.

               The association correctly points out that participants may include
               end-users that are not large or financially sophisticated. However, our
               point was that the dealer-issued guidance was designed to apply to larger
               entities that tend to be financially sophisticated. In addition, our
               discussions with regulators and dealers as well as the results of our survey
               confirmed that the predominant users of over-the-counter (OTC)
               derivatives, mortgage-backed securities, and structured notes are larger
               organizations, most of which are in financially oriented industries and
               most of which tend to be more financially sophisticated.




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Comments From the Government Finance
Officers Association




4. The association commented that the draft report is technically correct in
stating that the U.S. securities laws “generally” apply equally to all
investors, but noted that these laws sometimes distinguish between
institutional and individual customers. We added a footnote to chapter 4
that recognizes the securities laws and regulatory guidance that make
distinctions between institutional and individual customers and modified
the text to clarify that the antifraud provisions of U.S. securities laws do
not make such distinctions.

5. The association commented that our report should clarify that the
association’s concern regarding the ability of an end-user to rely on dealer
statements only when acknowledged in writing by the dealer was not
based on the association’s analysis of the Principles but was drawn
directly from the document itself. Our draft report quoted from the letter
the association sent to the Principles drafting committee, and that letter
correctly interprets the Principles as requiring written agreement between
the parties before one can rely on the other.

6. The association commented that the individual cited in the draft report
as asserting that dealers, unless otherwise agreed to, do not have fiduciary
obligations in OTC derivatives transactions was expressing his opinion or
that of his employer. (We referred to this individual as the managing
director of a large securities firm and the association referred to him as an
International Swaps and Derivatives Association board member.) The
association stated that this assertion has not been settled by law. We
attributed the statement in question to the official who made it, and by
doing so, indicated that it represents his opinion.

7. The association noted that an executive branch action in Connecticut
was taken between 1994 and 1996 to institute changes to investment
policies and controls in that state. We revised chapter 5 of this report to
incorporate Connecticut’s action. We also added a footnote in chapter 5 to
clarify that we did not attempt to obtain comparable information on all
state actions to improve investment policies, procedures, and practices.

8. Although generally endorsing the recommendations in our report, the
association asked that we recommend that the Federal Reserve, the
Securities and Exchange Commission, and the Commodity Futures
Trading Commission ensure that the process for coordinating the issuance
of dealer-issued guidance in any form outside of the federal regulatory
process be more inclusive of affected market participants. As the draft
report indicated in chapter 7, we envisioned that the President’s Working



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Appendix VII
Comments From the Government Finance
Officers Association




Group on Financial Markets might facilitate a process under which market
participants could reach agreement on the nature of their relationship,
including their responsibilities in transactions involving OTC derivatives.
Implicit in our related recommendation is that a common set of mutually
agreed-upon guidance would be issued for dealers and end-users. We
make our recommendation to the Working Group, whose membership
includes the Federal Reserve, the Securities and Exchange Commission,
and the Commodity Futures Trading Commission, in the belief that a
coordinated effort by the federal market regulators would be more
effective than individual efforts in addressing the need for end-users and
dealers to reach agreement on the nature of counterparty relationships.




Page 215                               GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII

Comments From the International Swaps
and Derivatives Association

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




                             Page 216   GAO/GGD-98-5 OTC Derivatives Sales Practices
              Appendix VIII
              Comments From the International Swaps
              and Derivatives Association




See p. 139.




See p. 140.




See p. 141.




See p. 140.




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 1.




See comment 1.




See comment 2.




See comment 3.




                 Page 218                                GAO/GGD-98-5 OTC Derivatives Sales Practices
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                 Comments From the International Swaps
                 and Derivatives Association




See comment 3.




See comment 3.




See p. 139.




See comment 4.




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                 Comments From the International Swaps
                 and Derivatives Association




See comment 4.




See comment 5.




See comment 6.




See comment 6.




                 Page 220                                GAO/GGD-98-5 OTC Derivatives Sales Practices
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Comments From the International Swaps
and Derivatives Association




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               Appendix VIII
               Comments From the International Swaps
               and Derivatives Association




               The following are GAO’s comments on the International Swaps and
               Derivatives Association’s August 15, 1997, letter.


               1. The association commented that the report’s consideration of sales
GAO Comments   practice issues for mortgage-backed securities (MBS) and structured notes
               in the same context as those for over-the-counter (OTC) derivatives is
               intellectually and practically inappropriate, and that the report is
               confusing and incomplete in differentiating between these transaction
               types. The association also noted that the report found that greater losses
               and more dissatisfaction existed for MBS and structured notes than for OTC
               derivatives, even though the former are subject to the securities
               laws—suggesting that regulation is not necessarily effective in reducing
               problems.

               We attempted to ensure that this report distinguishes, as appropriate,
               among OTC derivatives, MBS, and structured notes. As our report states, it
               addresses sales practices for the three product categories because losses
               associated with each of them were receiving public and regulatory
               attention at the time we began our review. Furthermore, although we
               agree with the association that significant differences in the products and
               their regulatory schemes exist, the products share many risk
               characteristics and are frequently marketed by the same dealers and used
               by many of the same market participants. As a result, by including all three
               product categories, our report provides useful information to those trying
               to understand the similarities and differences among the sales practice
               requirements for the OTC markets.

               The association’s conclusion that the higher level of disputes and
               dissatisfaction associated with MBS and structured notes indicates that the
               regulatory regime is not fully effective is open to question. First, the bulk
               of MBS and structured notes are government securities that are issued by
               government-sponsored enterprises (GSE) and marketed by broker-dealers.
               However, as our report notes, the National Association of Securities
               Dealers (NASD), a self-regulatory organization with oversight
               responsibilities for a significant number of MBS and structured note
               dealers, was limited in its ability to assess the marketing of GSE-issued
               securities against its full complement of sales practice rules by a
               long-standing statutory restriction. This restriction was removed by the
               Government Securities Act Amendments of 1993. Nonetheless, NASD rules
               governing GSE-issued securities were not approved until August 1996. As
               this report states, the removal of this restriction and implementation of



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Appendix VIII
Comments From the International Swaps
and Derivatives Association




these rules should improve the oversight of this products, which may, over
time, lead to a reduction in sales practice-related complaints.

Second, the higher level of sales practice-related disputes and
dissatisfaction associated with MBS relative to OTC derivatives may be
partly attributable to the lower level of sophistication of MBS end-users
compared to that of OTC derivatives end-users. Also, because MBS involve
the transfer of ownership, the dealer and end-user do not have an ongoing
relationship vis-a-vis a specific transaction. As a result, an unethical dealer
may find MBS end-users more vulnerable targets when contemplating
committing fraud.

2. The association commented that the definition of losses as discussed in
the draft report may be flawed. The association noted that loss totals
included in the report were compiled from public information and
depended on end-user self-reporting. It also noted that steps to confirm
their accuracy had not always been taken. Furthermore, it noted that
actual losses may be significantly lower than those reported because of
the inclusion of unrealized losses, which may have been mitigated by
offsetting hedging transactions.

Our report now acknowledges not only the limitations and weaknesses
that exist in the loss totals but also the potential that losses may be
overstated by including unrealized losses and understated by omitting
losses that were not publicly reported. Because of these limitations, we
used this information only as one indicator of the extent of sales practice
concerns and supplemented it with data from regulators, our survey of
end-users, and discussions with market participants and regulators.

3. The association commented that while the draft report attempts to put
the level of losses in context, it obscures how small the losses are relative
to total market activity. The association provided calculations comparing
the losses we reported to the gross market value of OTC derivatives
outstanding in the United States, as of March 1995. The association
concluded that we should have emphasized the resulting relatively small
loss percentage when explaining that sales practice-related losses did not
appear to be widespread.

We added text to the loss discussion in chapter 3 that recognizes sales
practice concerns are not widespread relative to the limited number of
dealers involved in the losses that have been reported, the thousands of
transactions that have occurred over the period discussed, and the



Page 223                                GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix VIII
Comments From the International Swaps
and Derivatives Association




hundreds of billions of dollars at risk in these transactions. We did not use
the loss data that we developed to perform calculations such as those the
association presented due to its limitations. Doing so would have
suggested greater precision in and validity to the statistical results than is
otherwise warranted. Notwithstanding this objection, comparing the
cumulative loss total for multiple years to the amounts outstanding as of a
single later year, as the association did, is not appropriate. Because losses
on transactions initiated in one year may not be incurred until several
years later, a more relevant analysis would be to compare losses on
transactions initiated in a single year to the amount at risk in transactions
initiated during that same year. However, data to make such calculations
were not generally available.

4. The association commented that the two sets of dealer-issued guidance
served as the basis for productive discussions between dealers and
end-users for clarifying counterparty relationships and noted that the only
appropriate starting place for institutional participants in derivatives is an
arm’s-length relationship. The association stated that the parties are free
to alter such a relationship if they agree to do so, but such variations
should occur on a privately negotiated basis. Furthermore, the association
stated that the federal government does not have a role to play in bilateral
negotiations between “parties that can take care of themselves,” and that
additional regulation and the increased potential for litigation would only
result in higher transaction costs with little offsetting benefits.

We agree that the dealer-issued guidance has provided opportunities for
discussion between dealers and end-users. However, our survey results
show that end-users attribute fiduciary responsibilities to and rely on
dealers as part of OTC derivatives transactions. Also, end-users and others
have objected to the presumption of an arm’s-length relationship as
evidenced in the formal comments these groups submitted on one set of
guidance—the Principles and Practices for Wholesale Financial Market
Transactions. This evidence indicates a lack of acceptance and/or
understanding of the specific responsibilities the dealer-issued guidance
asserts for OTC derivatives transactions. Our recommendation calls for the
federal regulators that participate in the Working Group to consider
whether they can assist in bridging this lack of agreement or
understanding. We do not anticipate that the Working Group would dictate
the nature of the relationship that should prevail because this would fail to
account for the inevitable and appropriate differences in the actual
relationships between parties. Instead, the Working Group could facilitate




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Appendix VIII
Comments From the International Swaps
and Derivatives Association




discussions between dealers and end-users that might lead to agreement in
key areas where they now disagree.

5. The association asserted that in many instances our support for
proposing regulatory intervention is anecdotal. We do not rely on
anecdotal information to support our recommendations. Rather, such
information is used primarily to illustrate the results provided by our
survey and to provide insights into other data we obtained—such as
end-users’ formal comments on the Principles.

6. The association commented that the draft report should have
emphasized in its recommendations the need for universal implementation
of and adherence to the internal control and risk management
recommendations in the Group of Thirty report published in July 1993. We
recognized the importance of internal controls in two previous reports on
derivatives.3 The May 1994 report makes three recommendations to one or
more of the federal financial market regulators on this subject. The
inclusion of chapter 5 in this report—discussing guidance to dealers and
end-users related to sales practice issues and describing dealer and
end-user efforts to implement related internal controls—reflects our
continued concern about the adequacy of market participants’ internal
controls and our support for efforts to improve them. Implementing
controls such as those advocated by the Group of Thirty and others could
significantly reduce dealer and end-user exposure to the type of
compliance and reputation risk losses that can arise from engaging in
transactions involving OTC derivatives and other financial products.




3
 See Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,
1994) and Financial Derivatives: Actions Taken or Proposed Since May 1994 (GAO/GGD/AIMD-97-8,
Nov. 1, 1996.



Page 225                                        GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix IX

Comments From the National Association of
State Auditors, Comptrollers and Treasurers

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




See comment.




                             Page 226   GAO/GGD-98-5 OTC Derivatives Sales Practices
              Appendix IX
              Comments From the National Association of
              State Auditors, Comptrollers and Treasurers




See p. 142.




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Comments From the National Association of
State Auditors, Comptrollers and Treasurers




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              Appendix IX
              Comments From the National Association of
              State Auditors, Comptrollers and Treasurers




              The following is GAO’s comment on the National Association of State
              Auditors, Comptrollers and Treasurers’ July 28, 1997, letter.


              The association commented that end-users who were generally satisfied
GAO Comment   with dealer sales practices at the time of our 1995 survey may not be
              satisfied with them today due to the promulgation of the Framework for
              Voluntary Oversight and the Principles and Practices for Wholesale
              Financial Market Transactions. The association elaborated that no
              end-users were included in the Derivatives Policy Group that issued the
              Framework, and no substantive revisions were made to the Principles as a
              result of the association’s input.

              End-user comments on the provisions of these documents, including those
              that the association discusses in its letter, are discussed in this report. Our
              report also recognizes that the market characteristics that contributed to
              the relatively high level of end-user satisfaction and the relatively limited
              number of sales practice disputes could change as the markets evolve. For
              this reason, we recommend that the President’s Working Group on
              Financial Markets establish a mechanism for systematically monitoring
              developments in the over-the-counter derivatives markets to assess
              whether developments warrant introducing specific federal sales practice
              requirements.




              Page 229                                      GAO/GGD-98-5 OTC Derivatives Sales Practices
Appendix X

Major Contributors to This Report


                        Cecile O. Trop, Assistant Director
General Government      Cody J. Goebel, Co-project Manager
Division, Washington,   James R. Black, Senior Evaluator
D.C.                    Frederick T. Evans, Senior Evaluator
                        Rosemary Healy, Attorney
                        Christine J. Kuduk, Evaluator
                        Carl M. Ramirez, Senior Social Science Analyst
                        Desiree W. Whipple, Communications Analyst


                        David J. Diersen, Co-project Manager
Chicago Field Office    Melvin Thomas, Sub-project Manager
                        Daniel K. Lee, Evaluator
                        Cristine M. Marik, Evaluator
                        Angela Pun, Evaluator
                        Richard S. Tsuhara, Senior Evaluator
                        Francis M. Zbylski, Senior Operations Research Analyst (Retired)


                        Donald F. Fulwider, Deputy Director
Office of Special
Investigations




(233441)                Page 230                           GAO/GGD-98-5 OTC Derivatives Sales Practices
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