On April 3, 2012, the Financial Stability Oversight Council (“FSOC”) released a final rule (the “Release”) and interpretive guidance (the “Guidance,” and together with the Release, the “Final Rule”) implementing section 113 of the Dodd-Frank Act, which may be of particular interest to certain insurance companies, asset managers, investment advisers, private equity funds, hedge funds, nonbank lenders and other financial services companies. Section 113 grants FSOC the authority to subject certain United States and foreign companies “predominantly engaged in financial activities”[1] (collectively, a “nonbank financial company” or “nonbank financial companies”) that are designated as systemically important nonbank financial companies (so-called nonbank "SIFIs") to enhanced supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and to prudential standards. As currently proposed, these prudential standards include risk-based capital and leverage requirements, liquidity standards, risk management requirements, single-counterparty credit limits, stress testing requirements and debt-to-equity limits, among others.[2]
The Dodd-Frank Act requires the Federal Reserve to issue regulations defining when a company is “predominantly engaged in financial activities.”[3] In a notice of proposed rulemaking issued on April 2, 2012, the Federal Reserve proposed to define “financial activities” to mean all activities that are listed as permissible activities for bank holding companies under section 4(k) of the Bank Holding Company Act and Regulation Y.[4] The proposed definition includes 34 enumerated activities identical to those described in section 4(k) and implementing regulations, but adapted without regard to the limiting conditions imposed on bank holding companies that do not define the activity itself. If adopted as proposed, the rule’s very broad application would likely meet the Federal Reserve’s stated goal of capturing as many companies as possible within the definition of “nonbank financial company,” making them potentially subject to section 113 of the Dodd-Frank Act and implementing regulations, including the Final Rule.
The Final Rule substantially adopts the form and the substance of FSOC’s second notice of proposed rulemaking and interpretive guidance (collectively, the “NPR”) issued on October 18, 2011.[5] All of the NPR’s key provisions were retained: (1) the three-stage process for evaluating each nonbank financial company, culminating with FSOC’s identification and designation of certain nonbank financial companies that pose a threat to the financial stability of the United States, (2) applying quantitative metrics in Stage 1 and at other times during the process, (3) applying the six-category framework using a combination of quantitative metrics and qualitative analysis in Stage 2, (4) using in-depth analysis in Stage 3 to evaluate a nonbank financial company’s potential to pose a threat to U.S. financial stability, (5) adopting policies and procedures to govern the determination process, including timing, notice and information requirements, and (6) including significant detail, analytical criteria and interpretive explanation in the Guidance.
FSOC declined to make substantive changes in the Final Rule that would fundamentally impact the analytical framework or the overall determination process developed in the NPR. Instead, the Final Rule adopts incremental changes and clarifications, including how certain evaluation criteria will be applied to particular industries, such as insurance companies, asset managers and investment advisers. This memorandum highlights certain of the changes incorporated in the Final Rule. For a more detailed description of the analytical framework and overall designation process first proposed in the NPR and incorporated in the Final Rule, please see Willkie’s client memorandum dated October 21, 2011, available on the firm’s website.
Stage 1: Quantitative Metrics
- For U.S. nonbank financial companies, the Stage 1 thresholds are based on the global assets, liabilities and operations of the nonbank financial company and its subsidiaries.
- For foreign nonbank financial companies with U.S. operations, the Stage 1 thresholds are calculated based solely on the U.S. assets, liabilities and operations of the company and its subsidiaries.
- The $20 billion “loans and bonds outstanding” threshold has been renamed “total debt outstanding,” clarifying that this term broadly include loans (whether secured or unsecured) bonds, repurchase agreements, commercial paper, surplus notes (for insurance companies) and other forms of indebtedness, regardless of maturity.
- The $3.5 billion “derivative liabilities” threshold clarifies that FSOC will account for the effects of master netting agreements and cash collateral held with the same counterparty when a nonbank financial company discloses the effects on a net basis.
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In noting the differences between statutory accounting principles (“SAP”) and generally accepted accounting principles (“GAAP”), particularly with respect to insurance companies, FSOC includes the following guidance:
- For Stage 1 only, embedded derivatives included for the “derivative liabilities” threshold must be calculated using GAAP.
- GAAP will be used to calculate the Stage 1 thresholds for all companies when such information is available, otherwise FSOC will rely on SAP, international financial reporting standards or other data, as available.
- For Stages 2 and 3, FSOC will review each company’s financial statements prepared in accordance with SAP, if applicable.
- FSOC clarifies that although it expects its determinations will apply to individual legal entities, it has authority to assess nonbank financial companies in a manner that addresses the Dodd-Frank Act’s statutory considerations and such other factors as it deems appropriate.
- When applying Stage 1 thresholds to investment advisers, FSOC may consider the aggregate risks posed by separate funds managed by the same adviser, particularly if the funds’ investments are identical or highly similar.
- When applying Stage 1 thresholds to asset managers, FSOC will appropriately reflect the distinct nature of assets under management compared to the asset manager’s own assets, and FSOC may consider additional guidance regarding additional metrics and thresholds (including relating to assets under management).
Stages 2 and 3: Analysis, Procedures and Proposed Determination
- For the “liquidity risk and maturity mismatch” category in the six-category framework, FSOC clarifies that the risk of interest rate fluctuations and reinvestment risk may be considered in evaluating maturity mismatch of life insurance companies.
- For the “existing regulatory scrutiny” category in the six-category framework, FSOC clarifies that it will consider both the existence and the effectiveness of consolidated supervision of a nonbank holding company.
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FSOC clarifies the confidential treatment of information under the Freedom of Information Act (“FOIA”) to give market participants additional comfort:[6]
- FSOC expects information submitted by nonbank financial companies will likely contain or consist of (1) trade secrets, commercial and financial information or (2) agency supervisory or regulatory information relating to examinations, both of which are subject to withholding under FOIA;[7] however, such information will not be given a blanket exemption under FOIA.
- Data, information and reports collected from federal and state financial regulatory agencies other than the Office of Financial Research (“OFR”), member agencies, and the Federal Insurance Office may be withheld from public disclosure in reliance on the FOIA exemptions discussed above.
- FSOC confirmed that it does not intend to publicly announce or otherwise disclose the name of any nonbank financial company that is under evaluation for determination prior to a final determination.
Notice Requirements
Throughout the Final Rule FSOC clarifies its requirements and expectations to provide notice to nonbank financial companies regarding significant developments during the evaluation process. The following chart summarizes these notice requirements, noting instances in which FSOC expressly declined to provide notice.
Until its publication in the Federal Register, the Final Rule is available on FSOC’s webpage on the Department of Treasury’s website, and on the Federal Deposit Insurance Corporation’s and the Federal Reserve’s websites.
[1] Section 102(a)(6) of the Dodd-Frank Act generally defines a nonbank company as “predominantly engaged in financial activities” if 85 percent of its annual gross revenues or 85 percent of its total consolidated assets are derived from activities that are financial in nature.
[2] On January 5, 2012, the Federal Reserve released a notice of proposed rulemaking seeking public input regarding the development of enhanced prudential standards applicable to “covered companies” to implement Section 165 of the Dodd-Frank Act. As proposed, “covered companies” includes all U.S. and foreign nonbank financial companies designated by FSOC under Section 113 of the Dodd-Frank Act and its implementing regulations contained in the Final Rule. The public comment period has been extended until April 30, 2012. 77 FR 594.
[3] Section 102(b) of the Dodd-Frank Act.
[4] The Federal Reserve’s April 2 release amends the original notice of proposed rulemaking issued by the Federal Reserve on February 11, 2011 which stopped short of including a specific definition of “financial activities.”
[5] 76 FR 64264.
[6] On April 3, 2012, FSOC adopted a final rule to implement provisions of FOIA setting forth procedures for requesting access to, and making disclosures of, information contained in FSOC’s records, to be codified at 12 CFR §§ 1301.1-1301.12.
[7] 5 U.S.C. 552(b)(4) and (8).
Published April 20, 2012.
