April 11, 2013
Treasury officials have recently suggested that the Financial Stability Oversight Council (FSOC) may soon designate the first round of systemically significant nonbank financial companies (Nonbank SIFIs). In March, Under Secretary for Domestic Finance Miller and Deputy Assistant Secretary for the FSOC Gerety stated that designations could occur “in the next few months.”
Just last week, moreover, the Board of Governors of the Federal Reserve System (Federal Reserve) finalized its rule on determining when a company is “predominantly engaged in financial activities,” thus making the company potentially subject to FSOC designation. The final rule is notable for stating that an investment firm that does not comply with the Merchant Banking Rule’s investment holding periods and routine management and operation limitations may nonetheless be determined, on a case-by-case basis, to be engaging in “financial activities.” In addition, the final rule rejected the argument that mutual funds — including money market mutual funds — are “not engaged in a financial activity” and therefore not capable of designation.
Designation as a Nonbank SIFI subjects the designated company to a host of regulatory requirements and potential restrictions. Perhaps most significantly, the Nonbank SIFI will become subject to the enhanced prudential standards and early remediation requirements set forth in Sections 165 and 166 of the Dodd-Frank Act (Dodd-Frank). Although in December 2011 the Federal Reserve proposed a regulation (Regulation YY) to implement the Section 165 and 166 requirements for U.S. Nonbank SIFIs, followed by a proposal for foreign firms in December 2012, no final rules have yet been adopted. Many nonbank firms and associations criticized the domestic proposal for seeking to impose bank-like requirements on nonbank firms.
Although the precise requirements for designated firms under Sections 165 and 166 are currently unknown, other provisions of Dodd-Frank will clearly apply to a Nonbank SIFI upon designation. Their overall effect is to subject a Nonbank SIFI to a new regime of Federal Reserve supervision and regulation paralleling that for systemically significant bank holding companies.
In this Client Alert, we summarize the Dodd-Frank provisions that will apply to nonbank financial companies designated as Nonbank SIFIs:
Enhanced Prudential Standards and Early Remediation (Sections 165, 166)
Dodd-Frank requires that “[Nonbank SIFIs] and bank holding companies with total consolidated assets equal to or greater than $50,000,000,000” be subject to prudential standards “that are more stringent than the standards and requirements applicable to nonbank financial companies and bank holding companies that do not present similar risks to the financial stability of the United States.”
The text of Section 165 suggests that, in establishing enhanced standards, the Federal Reserve should consider existing regulation of Nonbank SIFIs and how Nonbank SIFIs pose financial stability risks that differ from those posed by nonbank financial companies that are not designated by the FSOC. The Nonbank SIFI language parallels the requirement that the Federal Reserve consider how $50 billion-or-greater bank holding companies pose different financial stability risks than bank holding companies with less than $50 billion in assets.
The precise application of the statute to Nonbank SIFIs is currently unclear, but proposed Regulation YY indicates that Nonbank SIFI prudential standards would be based on the standards applicable to systemically significant bank holding companies, with certain exceptions. In its release accompanying the domestic Section 165 proposal, the Federal Reserve stated that “[f]ollowing designation of a nonbank financial company by the [FSOC],” it would “thoroughly assess the business model, capital structure, and risk profile of the designated company to determine how the proposed enhanced prudential standards and early remediation requirements should apply.” The Federal Reserve did not, however, discuss in greater detail how it would adapt such standards nor whether a Nonbank SIFI would have any opportunity to consider and respond to the Federal Reserve’s proposed requirements before those requirements became effective.
With respect to capital, the domestic release noted that “some aspects of [the Federal Reserve’s] capital requirements may not take into account the characteristics of activities and assets of [Nonbank SIFIs] that are impermissible for banks and bank holding companies.” The Federal Reserve therefore stated that, once a Nonbank SIFI is designated, it “may consider whether any adjustments to the minimum capital requirements” for the Nonbank SIFI may be appropriate, “within the limits of Section 171 of the Dodd-Frank Act [the Collins Amendment].”[1] Again, however, the Federal Reserve did not elaborate on the nature of any potential adjustments.
Proposed Effective Dates. For U.S. Nonbank SIFIs,[2] proposed Regulation YY sets forth a variety of effective dates.
Designated Nonbank SIFIs Generally. As a general matter, a U.S. Nonbank SIFI that has already been designated when Regulation YY becomes effective would become subject to the enhanced prudential standards and early remediation requirements beginning on the first day of the fifth quarter following the effective date of Regulation YY. For example, if Regulation YY became effective on December 31, 2013, an already-designated U.S. Nonbank SIFI would become subject to its enhanced liquidity requirements, risk management standards and early remediation provisions on January 1, 2015.
Capital. A different effective date applies, however, with respect to the proposed regulation’s risk-based capital requirements and leverage limits: these generally would become effective on the later of the effective date of Regulation YY or 180 days following the company’s designation as a U.S. Nonbank SIFI.
Capital Plan and Stress Test. There would be a third effective date for the proposed regulation’s capital plan and stress test requirements — if designation occurred on or before October 2, 2013, the U.S. Nonbank SIFI would be required to conduct its first company-run stress test, generally using March 31, 2014 data, and report the results of that test to the Federal Reserve by July 5, 2014. It would then be required to conduct its second company-run stress test, generally using September 30, 2014 data, and report the results of that test to the Federal Reserve by January 5, 2015. Such a U.S. Nonbank SIFI’s first capital plan would be due on January 5, 2015.
Single-Counterparty Credit Limits. Proposed Regulation YY states that a U.S. Nonbank SIFI that is designated when the regulation becomes effective would be subject to the single-counterparty credit limits beginning October 1, 2013. The Federal Reserve, however, has the statutory authority to extend the effective date of the limits to July 21, 2015, and it seems extremely likely, given the limits’ controversial nature, that their effective date will be extended to some degree.
Living Wills and Orderly Liquidation Authority (Section 165(d), Title II)
Living Wills. Nonbank SIFIs must file living wills with the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). Assuming a designation on or before October 4, 2013, those agencies’ regulations would require the designated entity to file its resolution plan on July 1, 2014, although the Federal Reserve and the FDIC have the authority, jointly, to choose a different date on at least 180 days’ prior written notice to the Nonbank SIFI.
Orderly Liquidation Authority. Upon designation, a U.S. Nonbank SIFI becomes subject to the Orderly Liquidation Authority (OLA) contained in Title II of the Dodd-Frank Act. Currently, regulators are focusing on “single point of entry” resolution, under which the FDIC would place the top-tier U.S. Nonbank SIFI into resolution and seek to impose losses on equity holders and bondholders of the top-tier entity. Special OLA provisions granting resolution powers to state insurance regulators and the Securities Investor Protection Corporation apply in the case of insurance company and broker-dealer subsidiaries of a liquidated firm.
If an orderly liquidation of an unaffiliated company under Title II is ever carried out, the FDIC may subject Nonbank SIFIs to assessments if such assessments are necessary for the FDIC to repay any amounts borrowed from the Treasury to carry out the liquidation.
Volcker Rule (Section 619)
If a Nonbank SIFI “controls,” within the meaning of the Bank Holding Company Act of 1956 (BHCA), at least one “banking entity,” as defined in the Volcker Rule, which term includes not only FDIC-insured banks but also FDIC-insured savings associations, FDIC-insured industrial banks and non-U.S. banks with branch or agency offices, the Nonbank SIFI will be subject to the Volcker Rule’s outright prohibitions — and permitted activity exceptions — with respect to proprietary trading and private equity and hedge fund activities. Such a Nonbank SIFI may also be subject to the so-called “Super 23A” provisions of the Volcker Rule.
If, by contrast, a Nonbank SIFI does not control any banking entities, then the Nonbank SIFI will be subject to the provision of the Volcker Rule that imposes additional capital requirements and quantitative limits with respect to proprietary trading and private equity and hedge fund activities, “as determined by agency rulemaking,” and to any restrictions that the agencies may impose to address conflicts of interests and risks from fund activities. No such heightened capital requirements, quantitative limits or other restrictions have been established.
New Rules on Acquisitions; Limitations on Influence Over Swaps Entities (Sections 163, 622, 726 and 765)
Bank and Bank Holding Company Acquisitions. Like bank holding companies, a nonbank SIFI must obtain prior Federal Reserve approval to acquire more than 5 percent of the voting shares of a bank holding company or an FDIC-insured bank, to acquire all or substantially all of the assets of a bank holding company or an FDIC-insured bank, and to merge or consolidate with a bank holding company.
Financial Companies with $10 Billion or More in Assets. Prior Federal Reserve approval is also required if a Nonbank SIFI acquires “direct or indirect ownership of control of any voting shares” of a company, other than an insured depository institution, that engages in financial activities within the meaning of Section 4(k) of the BHCA and has $10 billion or more in total consolidated assets. The statute provides exemptions for share acquisitions that would qualify for the exemptions provided by Section 4(c) of the BHCA — such as Section 4(c)(6)’s exemption for noncontrolling acquisitions of 5 percent or fewer voting shares — and for voting shares acquired as part of bona fide underwriting and dealing activities.
In determining whether to approve a Nonbank SIFI’s acquisition of financial company shares, the Federal Reserve must consider, in addition to whether the public benefits of the acquisition outweigh any adverse effects, the extent to which the proposed acquisition would result in greater or more concentrated risks to global or U.S. financial stability or the U.S. economy.[3] In such acquisitions, Federal Reserve approval does not provide an exemption from the requirements of the Hart-Scott-Rodino Act, and so a filing must be made and the waiting period complied with if the transaction meets the statute’s filing thresholds.
The Federal Reserve has not yet proposed regulations interpreting the foregoing provisions, but until it does, it should be expected that the Federal Reserve would interpret them in the same manner that it interprets the BHCA — for example, “control” of shares would be interpreted with reference to the Federal Reserve’s BHCA control rules.
Concentration Limits. A Nonbank SIFIs is also subject to the Dodd-Frank concentration limits that are applicable to bank holding companies and other companies that control an insured depository institution: as a general matter, a Nonbank SIFI may not merge or consolidate with, acquire all or substantially all of the assets of, or otherwise acquire control of, another company, if, on consummation of the transaction, the total consolidated liabilities of the Nonbank SIFI would exceed 10 percent of the aggregate consolidated liabilities of all financial companies at the end of the calendar year preceding the transaction. Although the Federal Reserve is required to issue regulations implementing this concentration limit requirement, it has not yet done so.
Swaps Entities. Dodd-Frank permits the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission, as applicable, to impose limitations on the voting rights of Nonbank SIFIs with respect to their interests in derivatives clearing organizations (DCOs), designated contract markets, clearing agencies, national securities exchanges, swap execution facilities and securities-based swap execution facilities, in order to mitigate conflicts of interest. The CFTC has proposed a rule that would restrict the voting power of Nonbank SIFIs with respect to their interests in DCOs, but that rule has not yet been finalized.
Management Interlock Prohibitions (Section 164)
A Nonbank SIFI is subject to the Depository Institutions Management Interlocks Act as though it were a bank holding company. As a result, a management official of a Nonbank SIFI or any of its affiliates generally may not also serve as a management official of any unaffiliated depository institution, unaffiliated depository institution holding company, unaffiliated Nonbank SIFI or any affiliate of such entities if the unaffiliated depository institution, depository institution holding company, or — as will be the case — the Nonbank SIFI has more than $1.5 billion in total assets.
In addition, a management official of a Nonbank SIFI generally may not serve as management official of any unaffiliated depository institution or unaffiliated depository institution holding company if the organizations in question (or any depository institution affiliate) have offices in the same Metropolitan Statistical Area, in the same city, town or village, or in contiguous or adjacent cities, towns or villages.
Unlike management officials of depository organizations, the statute does not permit a management official of a Nonbank SIFI to seek an exemption from the interlock prohibition in the case of service at a bank holding company with total consolidated assets of $50 billion or more, or at another Nonbank SIFI, other than a temporary exemption for interlocks resulting from a merger, acquisition, or consolidation.
Potential Intermediate Holding Company Requirement (Section 167)
The Federal Reserve may require a Nonbank SIFI that conducts activities other than those that are financial in nature or incidental to a financial activity under Section 4(k) of the BHCA (financial activities) to establish an intermediate holding company (IHC) and conduct “all or a portion of” its financial activities through the IHC. Non-financial activities would remain outside the IHC structure. Although the Federal Reserve is required to promulgate regulations to establish criteria for determining when a Nonbank SIFI must establish an IHC, it has not yet done so.
If an IHC is required for all financial activities, the Nonbank SIFI may nonetheless continue to conduct outside the IHC structure any internal financial activity, “including internal treasury, investment and employee benefit functions,” that was engaged in during the year prior to July 21, 2010, as long as not less than two-thirds of the assets or two-thirds of the revenues generated from any such activity are from or attributable to the Nonbank SIFI or an affiliate, subject to review by the Federal Reserve.
If an IHC is established, the following requirements apply:
Examinations and Enforcement (Sections 121, 161, 162, 172)
The Federal Reserve may examine a Nonbank SIFI, and any of its subsidiaries, for purposes of gaining information regarding:
The Federal Reserve must rely, however, “to the fullest extent possible,” on otherwise available information, and, with respect to depository institution and functionally regulated subsidiaries like broker-dealers, on existing examination reports by the subsidiary’s functional regulator. In addition, the Federal Reserve is required to provide reasonable notice to, and consult with, the primary financial regulatory agency for a subsidiary before beginning an examination, and “to the fullest extent possible, avoid duplication of examination activities.”
Although not the primary regulator for Nonbank SIFIs, the FDIC does have the authority to conduct a special examination of any Nonbank SIFI that is not in a “generally sound condition” for the purpose of implementing Dodd-Frank’s OLA provisions. The FDIC is required to “coordinate to the maximum extent practicable” with the Federal Reserve, “in order to minimize duplicative or conflicting examinations.”
Nonbank SIFIs and their nondepository institution subsidiaries are subject to the enforcement provisions of Section 8 of the Federal Deposit Insurance Act (FDIA), including cease-and-desist proceedings and the imposition of civil money penalties. In addition, if a Nonbank SIFI’s depository institution or functionally regulated nonbank subsidiary is not complying with Federal Reserve orders or regulations under the Dodd-Frank Act or otherwise poses a threat to U.S. financial stability, the Federal Reserve may make a written recommendation to the primary regulator of that subsidiary to initiate a supervisory action or enforcement proceeding. The Federal Reserve has back-up authority to take the recommended action if the primary regulator does not act within 60 days, upon the vote of the Federal Reserve’s board members.
Finally, if the Federal Reserve determines that the Nonbank SIFI poses a “grave threat” to U.S. financial stability, the Federal Reserve may, on an affirmative vote of no fewer than two-thirds of its voting board members, limit mergers, acquisitions, consolidations and other affiliations, restrict the offering of financial products, impose conditions on, or order the termination, of business activities, and, if necessary, require the Nonbank SIFI to sell or transfer assets or off-balance sheet items.
Administration, Reporting and Information Collection (Sections 114, 116, 155, 161 and 318)
A Nonbank SIFI must register with the Federal Reserve within 180 days from the date on which the FSOC makes its final determination. A Nonbank SIFI is subject to assessments that may be imposed to fund the Office of Financial Research (OFR) and to cover the Federal Reserve’s expenses in supervising and regulating Nonbank SIFIs and bank and savings-and-loan holding companies with total consolidated assets of $50 billion or more.
A Nonbank SIFI, and any of its subsidiaries, may be required by the FSOC, acting through the OFR, to submit certified reports to keep the FSOC informed as to:
The Federal Reserve is authorized to require similar reports from a Nonbank SIFI and any of its subsidiaries. Both the OFR and the Federal Reserve are required to use, “to the fullest extent possible,” existing reports and supervisory or otherwise available information in carrying out these requirements. Reporting forms for use by Nonbank SIFIs have not yet been published.
[1] Under the terms of the Collins Amendment, if a Nonbank SIFI is a depository holding company that on May 19, 2010 was not supervised by the Federal Reserve — for example, a savings-and-loan holding company — the Collins Amendment is effective only on July 21, 2015, except for those provisions, which are currently effective, affecting trust preferred securities and other instruments that would not be acceptable capital instruments for an insured depository institution.
[2] The text of the Federal Reserve’s proposed rule for foreign banking organizations and foreign Nonbank SIFIs does not specifically refer to foreign Nonbank SIFIs when discussing the effectiveness of the rule’s substantive provisions. The release accompanying the proposed rule states that “[t]he Board expects to issue an order that provides clarity on how the enhanced prudential standards would apply to a particular foreign nonbank financial company once the company is designated.” For this reason, we have limited our discussion of proposed effective dates to those applicable to U.S. Nonbank SIFIs.
Gibson, Dunn & Crutcher’s Financial Institutions Practice Group lawyers are available to assist in addressing any questions you may have regarding these areas. Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you normally work, or the following:
Arthur Long – New York (212-351-2426, [email protected])
Chuck Muckenfuss – Washington, D.C. (202- 955-8514, [email protected])
Michael D. Bopp – Washington, D.C. (202-955-8256, [email protected])
Kimble Cannon – Washington, D.C. (202–887–3652, [email protected])
Alex Acree – Washington, D.C. (202-887-3725, [email protected])
Colin Richard – Washington, D.C. (202-887-3732, [email protected])
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