On October 11, 2011, the Financial Stability Oversight Council (“FSOC”) released a second notice of proposed rulemaking (the “October NPR”) to develop regulations implementing Section 113 of the Dodd-Frank Act.1 Section 113 grants FSOC the authority to subject certain United States and foreign nonbank financial companies2 to supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and its prudential standards. The October NPR modifies and enhances the Federal Reserve’s previous proposal and guidance to implement Section 113 by (1) proposing a three-stage evaluation process to identify with increasing scrutiny the companies which pose the greatest threat to U.S. financial stability, culminating in FSOC’s designation of those companies, (2) certain uniform quantitative metrics to be used in the three-stage process, and (3) significant explanatory guidance included as an Appendix (the “Appendix”).
The October NPR is FSOC’s latest in a series of releases addressing the implementation of Section 113 of the Dodd-Frank Act. On January 26, 2011, FSOC issued its first notice of proposed rulemaking (the “January NPR”), suggesting a qualitative six-category framework based on the ten statutory considerations required by Section 113(a)(2) of the Dodd-Frank Act. Many commenters to the January NPR expressed concern that the proposed framework’s near-exclusive reliance on qualitative and subjective analysis lacked the detail and quantifiable metrics necessary for implementing an effective framework. In response to those comments, in the October NPR FSOC proposes a three-stage evaluation process in which each nonbank financial company will be subjected to progressively more detailed and in-depth evaluations, applying both quantitative metrics and qualitative evaluation, intended to give market participants significantly more certainty regarding where each company will stand with respect to potential FSOC designation.
Designation by FSOC may prove particularly challenging for nonbank financial companies. It will subject them not only to the significant burdens of additional supervision and prudential regulation by the Federal Reserve, but also to Section 165(d) of the Dodd-Frank Act, requiring each such FSOC-designated company to prepare and submit an annual resolution plan, or “living will.”3 Living wills are intended to give the Agencies a detailed “blueprint” for the rapid and orderly resolution of the company under the Bankruptcy Code (or other applicable insolvency regime) if that company experiences material financial distress. For nonbank financial companies previously subject to little or no regulation, FSOC designation will likely require the devotion of significant financial and managerial resources to initially comply and maintain compliance with these new regulations.
A. Stage 1 - Quantitative Threshold Test
Quantitative Metrics. Stage 1 introduces a two-part test using six quantitative criteria to identify nonbank financial companies that may satisfy one of the two FSOC determination standards4 and thus require further evaluation in the process’ subsequent stages. The six criteria are similar to the January NPR’s framework in establishing quantitative thresholds for size, interconnectedness, leverage, and liquidity risk and maturity mismatch. The data used by FSOC to conduct each company’s Stage 1 test will be derived solely from publicly available information and regulatory sources.
The first part of the Stage 1 test looks at a company’s total consolidated asset size against established thresholds: (i) for U.S. nonbank financial companies, the threshold is $50 billion in global total consolidated assets and (ii) for foreign nonbank financial companies, the threshold is $50 billion in U.S. total consolidated assets. If the company exceeds the size threshold in part one, then the second part applies, in which the company must exceed one of the following five thresholds:
Hedge Funds and Private Equity Funds. The quantitative metrics included in Stage 1 are intended to apply to all industries in which nonbank financial companies operate, but FSOC identifies specific industries for which the proposed metrics may not adequately identify the appropriate companies for continued review.5 Beginning in 2012, hedge funds, private equity funds and others will be required to file Form PF with the Securities and Exchange Commission (“SEC”) or the Commodity Futures Trading Commission (“CFTC”), as applicable. Using financial disclosures required in these filings and other sources, FSOC will consider developing an additional set of metrics or thresholds to evaluate those types of companies in Stage 1. For asset management companies, FSOC and its various member agencies will analyze the potential risks those companies pose to the U.S. financial system, and consider mitigating those risks through FSOC designation, promulgating additional regulations, or developing additional quantitative metrics relevant to asset managers.
FSOC will periodically review and assess the quantitative thresholds as new data becomes available over time, and it may adjust thresholds.6 Critically, if FSOC determines that the quantitative thresholds in the first stage inadequately assess the ways in which a particular company might pose a threat to U.S. financial stability, FSOC may evaluate other company-specific qualitative or quantitative factors.
B. Stage 2 - Application of Six-Category Framework
The second stage of the October NPR’s three-stage process focuses on the potential threat each individual nonbank financial company could pose to U.S. financial stability. FSOC will apply a broader version of the January NPR framework to evaluate each company’s risk profile and characteristics in light of the framework’s six categories. The Appendix includes comprehensive detail, discussion and guidance on the six-category framework’s function so each of the six categories can be used to either qualitatively evaluate a company using both industry-specific and company-specific factors, or assess sample representative quantitative metrics. FSOC also proposes to add at least two additional qualitative factors, such as the impact of the company’s resolution on the broader economy and the extent to which the company is already subject to existing regulation. The Stage 2 analysis will be based solely on information available to FSOC from public or regulatory sources, including information obtained from the company’s primary financial regulatory agency or home country supervisor and information provided voluntarily by the company.
C. Stage 3 - In-Depth Analysis And FSOC Determination
In-Depth Analysis. In the final stage of the three-stage evaluation process, FSOC will conduct a detailed, in-depth review of each company, focusing on whether that company could pose a threat to U.S. financial stability due to its material financial distress or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities. FSOC has developed several additional analyses to assess the potential threat a company could pose to U.S. financial stability:
In Stage 3, FSOC will have access to all information compiled about each company during the first two stages, as well as information requested directly from the company through FSOC’s information requests. At the conclusion of Stage 2, each company marked for evaluation in Stage 3 will receive notice that it is under consideration for a proposed determination. In that notice, FSOC will likely include a request to the company to provide certain quantitative and qualitative information that FSOC deems relevant to its evaluation.
Confidentiality Concerns. FSOC’s information request to each nonbank financial company may vary significantly based on the company’s business and activities and the information already available to FSOC through other sources, but it will likely include requests for confidential business information such as internal assessments and procedures, strategic plans, funding details, and potential acquisitions and dispositions, as well as other anticipated changes to the company’s business. Although FSOC may request confidential and other business information directly from the company under its broad authority, it must work with the Office of Financial Regulation and other primary financial regulatory agencies to use information already available through publicly available or regulatory sources. FSOC and its member agencies are required to maintain the confidentiality of such information to the fullest extent of applicable law, which will provide enhanced, but not ironclad, protection from such information being released publicly. These requirements may require nonbank financial companies to carefully consider if or how these requirements will impact their reporting requirements under the Securities Exchange Act of 1934. Nonbank financial companies may also assess the risk that sensitive information about the company, as well as its trade secrets, could end up in the hands of their competitors despite such information receiving confidential treatment under one or more exemptions under the Freedom of Information Act.
1 76 FR 64264.
2 The definitions for “foreign nonbank financial companies” and “U.S. nonbank financial companies” in the October NPR are in part contingent on the defined term “predominantly engaged in financial activities,” which is defined in Section 102(a)(6) of the Dodd-Frank Act and for which the Federal Reserve published a notice of proposed rulemaking proposing requirements for determining if a company is predominantly engaged in financial activities. 76 FR 7731.
3 As implemented by the joint final rule (the “Final Rule”) approved by the Federal Reserve and the Federal Deposit Insurance Corporation (the “FDIC” and together with the Federal Reserve, the “Agencies”). 76 FR 67323.
4 12 C.F.R. § 1310.10(a) in the October NPR. The “First Determination Standard” applies if FSOC determines that “material financial distress” at the nonbank financial company could pose a threat to U.S. financial stability. The “Second Determination Standard” applies if FSOC determines that the nature, scope, size, scale, concentration, interconnectedness, or mix of the company’s activities could pose a threat to U.S. financial stability. In the Appendix, FSOC states that it expects significant overlap between the two standards.
5 These industries include financial guarantors, asset management companies, private equity firms, and hedge funds.
6 For example, as more data becomes available in connection with additional regulations promulgated by the SEC and CFTC regarding swap transactions, FSOC will promulgate new quantitative metrics to more appropriately measure each company’s derivative liabilities.
7 In the Appendix, FSOC defines the term “threat to the financial stability of the United States” as an “impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy.” In addition, FSOC identifies the primary channels, or methods of transmission, that may lead to impairment of financial intermediation and financial market functioning.
David S. Katz is a Partner in the Corporate and Financial Services Department in Willkie Farr and Gallagher’s Washington, DC office. Scott R. Tkacz is an Associate in the Washington, DC office’s Corporate and Financial Services Department.