A draft by market participants outlining the obligations of banks that trade derivatives is heating up a two-year controversy between banks trading sophisticated financial instruments and their regulators.

The report, "Principles and Practices for Wholesale Market Transactions," was released in late March by a group of New York-based organizations, mostly securities and banking trade associations. The group's work has been informally encouraged by the Federal Reserve Bank of New York.

The controversy centers on the duties of dealers of sophisticated financial instruments, such as over-the-counter derivatives, to customers and other counterparties.

In particular, to what lengths must they go to assure that the counterparty has sufficient capability to understand a transaction and its risks? And what is the appropriate response when a dealer bank suspects a counterparty may not have such capability or is taking on too much risk?

Complicating the issue is the closely related question of how dealer banks should treat customers as a matter of good business practice, irrespective of legal duties.

We suggest dealer banks should not be permitted to exploit obvious customer naivete - but that they also should not be required to investigate apparently competent customers.

From a larger perspective, moreover, we recommend that banks place derivatives practices in a relationship context - aiming for profitable transactions that also are in customers' best interests.

Before we flesh out these points, though, here is some background on how the topic of dealer bank behavior became a public issue:

The controversy was largely kindled by the Office of the Comptroller of the Currency's mid-1993 publication of Banking Circular BC-277, "Risk Management of Financial Derivatives."

(Notably, this circular was released before several derivatives end- users suffered losses and launched major lawsuits against derivatives dealers.

BC-277 directs national banks to "identify if a proposed derivatives transaction is consistent with a counterparty's policies and procedures with respect to derivatives activities, as they are known to the bank."

If a bank believes a transaction "may not be appropriate for a particular customer," the bank should "document its own analysis and the information provided to the customer" - including, presumably, its views about the transaction's nonsuitability for the customer.

Banks and their lawyers reacted to BC-277 by suggesting it creates a "suitability rule" for dealer banks similar to - but in some ways even going beyond - the rule applied by securities laws to registered broker- dealers.

The Comptroller's office responded that it was not creating a standard of responsibility for banks to their customers.

Rather, the Comptroller's office said it was asking banks to adopt policies and procedures that would insulate them from losses arising from dealings with counterparties proving either unable or unwilling to uphold their end of derivatives contracts.

The circular apparently is not based on any applicable investor protection statute or regulation, but rather on "safety and soundness" concerns.

But this rationale, if carried to its logical conclusion, could also justify requirements that banks consider the appropriateness of every bank transaction for a particular customer.

Indeed, "Principles and Practices" builds upon this rationale in urging banks "for their own protection" to consider whether counterparties have:

(1) "the capability (internally or through independent professional advice) to understand and make independent decisions regarding a particular transaction or a type of transaction being proposed by the participant," or

(2) "the capability to understand and make independent decisions regarding a transaction, but ... the amount of risk to the counterparty involved in the transaction appears to be clearly disproportionate in relationship to the size, nature and condition of the counterparty's business."

My colleague, Mary Jo Quinn, and I have suggested that dealers and other sophisticated parties to complex financial instruments should not be permitted to ignore meaningful evidence that a counterparty, even though an institution, is unsophisticated and should not be permitted to exploit an apparently unsophisticated customer.

On the other hand, if a dealer bank has no particular reason to believe an institution or other seemingly sophisticated customer is not as capable as it seems to be, the bank should be able to proceed with the proposed transaction without investigating the customer's capabilities, prudence, or overall financial strategy.

To be sure, uncertainties over the legal standards applicable to banks that deal in and trade sophisticated financial instruments will ultimately be eliminated when a standard is agreed upon or imposed by law.

But an equally important question will still remain, one which each banking organization involved in securities activities must answer for itself:

Regardless of the legal standard, how far should a banking organization go to assure that a transaction with a customer does not involve more risk than is appropriate for the customer, or risks the customer does not appreciate?

Each bank must answer the related, but broader, question of whether the types of relationships banks have traditionally had with their customers, including their institutional customers, are the types of relationships the bank wants to have with its derivatives and other investment banking customers.

The assumption seems to persist that as banks increase their participation in the securities markets, their customer relationships should emulate the "transaction-based" approach of large securities firms.

I do not believe this assumption is warranted.

Yes, banks need the protection provided by an arm's-length legal standard in their securities transactions. They should not be liable to customers who apparently have the ability to understand the risks of the transactions into which they enter and who in any event have the ultimate responsibility for the transactions they choose.

But no, this does not mean that sound business strategies permit bank customers to wander into harm's way.

It seems obvious that the best customer relations are not built on transactions selected only on the basis of their profitability to the banking organization.

Rather, good relations are built on profitable transactions that are also in customers' best interests.

When the customer does not understand a transaction or is clearly assuming too much risk, it will rarely benefit the bank to proceed with the transaction.

It follows that banks sticking with the relationship-based approach to customers will have little difficulty in deciding to take reasonable steps to protect their customers from overly risky or otherwise inappropriate transactions - no matter what the law requires.

Mr. Duncan is a partner in the Chicago office of Jones, Day, Reavis & Pogue and co-leader of the law firm's bank capital markets practice.

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