Charles Whitehead

FIASCO is a great read. Like Matt, I put it in the genre of a Liar’s Poker (something with which I am familiar as Salomon’s former general counsel in Japan – but many years after Liar’s Poker came out and a few years after Frank left Tokyo). I first came across FIASCO in downtown Tokyo shortly after I arrived there and used it as a guide to audit local sales practices (the rumor, somewhat apocryphally, was that so did Japan’s regulators a few years later when they audited Morgan Stanley in Tokyo).

My perspective, however, differs from the overall picture that FIASCO paints. In today’s alphabet world of SPDRs, CDOs, ABSs, and so on, it may be difficult to remember that the derivatives and structured finance business of the 1990s – the period about which Frank was writing – was still relatively new. For example, the first non-CBOT equity derivatives were not publicly listed until January 1990, and that required a series of SEC-approved rule changes. PERLs (principal exchange rate linked notes), which are highlighted in FIASCO, were relatively new and the “cutting edge” in structured derivatives. Today, there is an active and deep retail market in exchange-traded puts and calls; and PERLs have become fairly standardized. In the FIASCO environment, however, it’s not a surprise that there would be informational asymmetries, regulatory arbitrage and simple, garden variety fraud. Practitioners at the time will recall some of the abuses described in FIASCO (and numerous others that aren’t).

However, I think there is another side of the story that is worth noting. Let me use one example from FIASCO to illustrate my point. FIASCO notes that U.S. governmental agencies were large issuers of structured notes, and attributes that to traders in insurance companies, pension funds, and others who were looking to hide what were, in effect, derivatives transactions within investment grade securities – a kind of regulatory arbitrage. No doubt, there were instances of this occurring – I came across this myself, and I recall a few cases where public pension funds repudiated trades on the basis that they were not authorized to enter into them in the first place. But, in light of those concerns, many firms also instituted pre-screening requirements, including (in some cases) a legal opinion on the purchaser’s authority to buy the relevant securities. So why, then, use U.S. govern­mental agencies as issuers?

Many purchasers had clear caps on the amount of illiquid securities they could purchase. Rule 144A had only recently been introduced (in 1990) and, in many instances, did not satisfy the purchaser’s liquidity requirement. Although Regulation D was already 10 years old, there were concerns about integrating/aggregating derivative instruments – if an issuer sells notes that are linked to the Nikkei index on Monday, where the index price is struck at 10,000, and then issues a second series of Notes on Tuesday, where the index price is struck at 10,100 (due to an overnight change in the Japanese stock markets), are they considered part of the same offering? And at what point might the combined series of issuances (and the efforts to sell them) be considered a general solicitation? A registered offering, on the other hand, raised its own set of concerns – the normal concerns over delays associated with SEC review, but also competitive concerns since publicly available SEC filings would tip your new products to your competitors. Universal shelf registration was only introduced in 1993, and I’m aware of at least one instance in the mid-1990s where the SEC staff had comments on the disclosure in a prospectus supplement after a takedown had occurred (what a nightmare!). So where to turn? U.S. governmental agencies solved a lot of problems – their securities are exempt from the 1933 Act registration requirements (avoiding the Regulation D and after-the-fact SEC comment concerns), they meet most purchasers’ liquidity requirements, and as an added bonus (during the pre-Gustafson years), they were part of a small class of issuers that were understood not to take on § 12(a)(2) disclosure liability. Plus they had investment grade ratings and were relatively sophisticated about new financial instruments.

To be clear, I appreciate the main thrust of FIASCO – that abuses are likely (perhaps inevitable) in new markets, with new instruments, and within Wall Street’s “eat what you kill” environment. But the same can be said of other instruments – take, for example, the distressed debt markets where the buy-sell spreads can make derivatives trading look benign. And there is another side of the story, where deliberation, thoughtful structuring, and practical concerns drove some of the developments described in FIASCO. The book, however, serves as a healthy and worthwhile warning about the risks of an evolving financial marketplace, perhaps underscored by the recent sub-prime problems and, according to some recent reports, the related liquidity puts (see the Fortune article on Citigroup’s exposure at http://money.cnn.com/2007/11/09/news/newsmakers/ merrill_rubin.fortune/index.htm?postversion=2007111119).

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