When an agency finds it necessary to repropose a rulemaking, one can safely surmise that something needs to be added and hopefully something may be saved. The Financial Stability Oversight Council ("FSOC") has recently reproposed a rule ("Re-Proposal") governing its process for designating a nonbank financial company (also a "company") as systemically important and subject to increased supervision. The Re-Proposal is noteworthy both for what has been added and for what remains the same. For both proposals, an observer will ask "Is my company likely to be designated as systemically important and what can I do to prevent that from happening?" The answer to that question is far from certain.

January Proposal, Public Comments, and FSOC Response

The Dodd-Frank Act authorizes the FSOC to determine that a company will be supervised by the Board of Governors of the Federal Reserve System ("Federal Reserve") and be subject to heightened prudential standards if the FSOC determines that either "material financial distress" at the company or the nature, scope, size, scale, concentration, interconnectedness, or the mix of the company's activities could pose a threat to the financial stability of the United States.1 A "nonbank financial company" is a domestic or foreign company, but not a bank holding company, that is "predominantly engaged in financial activities" in the United States, i.e., its (i) annual gross revenues from financial activities (including bank ownership) exceed 85 percent of its annual gross revenues; or (ii) its assets related to financial activities (and bank ownership) exceed 85 percent of its total assets.

The FSOC issued an advance notice of proposed rulemaking on October 6, 2010, seeking comment on the factors that the Dodd-Frank Act requires to be considered in designating a company as a SIFI. On January 26, 2011, the FSOC issued a notice of proposed rulemaking ("Proposal") seeking comment regarding the specific criteria and analytic framework that it should apply in making designations. The FSOC on October 11, 2011 issued a Re-Proposal, including interpretive guidance ("Guidance") regarding the designation framework.2

The FSOC received comments on the Proposal that were critical: it was vague as to the factors that the FSOC must consider in making designations of SIFI's. Commenters asked that the FSOC identify the metrics it would use in assessing those factors, so that companies could anticipate and take action to reduce the potential for designation as a SIFI. More basic, some commenters challenged the authority of the FSOC to issue rules setting forth the process and standards it will follow in making SIFI determinations. While the Dodd-Frank Act authorizes the FSOC to issue rules as may be necessary for the conduct of its business, the Act does not specifically authorize the FSOC to issue rules regarding matters related to SIFI determinations. Other comments indicated the Proposal was too vague to satisfy the "notice and comment" requirements under the Administrative Procedure Act or the due process requirements of the US Constitution.

In response to these comments, the FSOC revised the Proposal to provide additional details about the determination process, including the metrics that it would use to designate SIFIs, and how a company might contest such a determination. Much of the additional detail is contained in Guidance attached as an appendix to the revised proposed rule. The Guidance describes how the FSOC would conduct a determination and the "channels" that most commonly transmit the negative effects of a company's financial distress to other firms, thereby posing a threat to US financial stability. The FSOC articulated its authorities generally, but did not specifically respond to arguments that it lacked authority to issue a rule concerning the designation process.3

Designation Standards

The FSOC may designate a company as a SIFI upon a determination that "material financial distress" at the company (imminent danger of insolvency or default on its financial obligations) could pose a threat to the financial stability of the United States. The FSOC would assess the impact of the company's financial distress in a period of overall stress in the financial services industry and in a weak macroeconomic environment. Alternatively, a company may be designated as a SIFI upon a determination that the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities could pose a threat to US financial stability, regardless of whether the company is experiencing financial distress. The FSOC indicates that because of the "significant overlap" between the two standards, it is likely that the outcome of an assessment of a company would be the same under either standard.

A "threat to the financial stability of the United States" would exist if there were an impairment of financial intermediation or market functioning sufficiently severe to inflict damage on the broader economy. The FSOC found that such an impairment can occur most commonly through one of three "channels":

  • Exposure. A company's creditors, counterparties, investors, or other market participants suffer material impairment through their exposure to the company and thereby pose a threat to US financial stability. Metrics to measure this exposure include total consolidated assets, credit default swaps outstanding, derivative liabilities, loans and bonds outstanding, and leverage ratio.
  • Asset liquidation. A company holds assets that, if liquidated quickly, would significantly disrupt trading or funding or cause significant losses or funding problems for other firms with similar holdings due to falling asset prices. Metrics to measure this exposure include total consolidated assets and short-term debt ratio.
  • Critical function or service. A company is no longer able or willing to provide a service that is relied upon by market participants and for which there are no substitutes. The FSOC would apply company-specific analyses with respect to this channel, rather than a quantitative metric.

The threat a putative SIFI may pose to US financial stability through these channels is likely to be worse if the company is sufficiently difficult to resolve in bankruptcy so as to disrupt markets or adversely impact other firms.

Analytic Framework for Statutory Considerations

There are 10 considerations enumerated in Dodd-Frank that must be considered when evaluating whether to designate a company as a SIFI, which the FSOC collapsed into six "factors": (1) size, (2) interconnectedness, (3) substitutability, (4) leverage, (5) liquidity risk and maturity mismatch, and (6) existing regulatory scrutiny.4 Three of the six factors (size, substitutability and interconnectedness) assess the potential impact of a company's financial distress on the broader economy. The remaining three (leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny) assess the vulnerability of a company to financial distress. The Guidance details the FSOC's rationale for selecting the six factors and identifies metrics for evaluating a company in terms of each factor.

Size

Size involves the amount of financial services or intermediation that a company provides. Metrics used to assess size include total consolidated assets or liabilities and total risk-weighted assets.

Interconnectedness

Interconnectedness refers to linkages between companies that may transmit the effects resulting from a company's financial distress. An example is a company's exposure to counterparties. Metrics used to assess interconnectedness include the identity of a company's principal contractual counterparties, which reflects the concentration of the company's assets financed by particular firms and the importance of the company's counterparties to the market.

Substitutability

Substitutability captures the extent to which other firms could provide similar financial services at a similar price and quantity if a company withdraws from a particular market. Metrics used to assess substitutability include the market share of a company and its competitors, and the stability of market share over time.

Leverage

Leverage involves a company's exposure or risk in relation to its capital. Leverage increases a company's risk of financial distress, by raising the likelihood that it will suffer losses exceeding its capital, and thus its dependence on its creditors. Metrics used to assess leverage include total assets and total debt relative to total equity; gross notional exposure of derivatives and off-balance sheet obligations relative to total equity or net assets under management; and changes in leverage ratios, which may indicate that a company is rapidly increasing its risk profile.

Liquidity Risk and Maturity Mismatch

Liquidity risk refers to the risk that a company may not have sufficient funding to satisfy its short-term needs. A maturity mismatch, the difference between the maturities of assets and liabilities, affects a company's ability to survive a period of stress. Metrics used to assess liquidity and maturity mismatch include liquid asset ratios, indicating a company's ability to repay its short-term debt; and the ratio of highly liquid assets to the net cash outflows that a company could encounter in a short-term stress scenario.

Existing Regulatory Scrutiny

The FSOC will consider the extent to which a company already is subject to regulation, which reduces risk, and the authority of those regulators. Metrics used to assess existing regulatory scrutiny include reporting obligations, capital or liquidity requirements, enforcement actions, and resolutions.

Designation Process

The FSOC proposed a three-stage process in making SIFI determinations, each stage involving an analysis based on an increasing amount of information. The first stage narrows the universe of companies for further evaluation using quantitative thresholds that are applicable across the financial sector. This approach will allow a company to predict whether it may be subject to additional FSOC review. The second stage involves an analysis of the potential for the identified companies to pose a threat to US financial stability, based on information available through existing public and regulatory sources, including industry- and firm-specific metrics, and information obtained from the company. In the third stage, the FSOC would contact those companies that merit further review, to obtain additional information. The Office of Financial Research (the "OFR") or the appropriate regulatory agency also could collect this information. Only candidates in this narrow group ordinarily would be subject to designation.5

Stage 1

In the first stage ("Stage 1"), metrics are applied to identify for further evaluation a group of companies that is most likely to satisfy one of the determination standards. The Stage 1 thresholds relate to the factors of size, interconnectedness, leverage, and liquidity risk and maturity mismatch and measure the susceptibility of a company to financial distress and the potential for that company's distress to spread. These thresholds commonly apply to companies that operate in different types of financial markets and industries. The FSOC believes that these three factors are particularly good in assessing the potential for a company to pose a threat to financial stability across financial markets. Moreover, there tends to be good data currently available relating to these factors.

The thresholds are:

  • Total Consolidated Assets — $50 billion in global total consolidated assets for US nonbank financial companies, consistent with the asset threshold for subjecting bank holding companies to enhanced prudential standards, or $50 billion in US total consolidated assets for foreign companies.
  • Credit Default Swaps Outstanding — $30 billion in gross notional credit default swaps outstanding for which a company is the reference entity.
  • Derivative Liabilities — $3.5 billion of derivative liabilities after taking into account the effects of master netting agreements and cash collateral held with the same counterparty.

The FSOC also identified three thresholds that would have captured many of the nonbank financial companies that encountered financial distress during the recent financial crisis, including Bear Stearns, Countrywide, and Lehman Brothers:

  • Loans and Bonds Outstanding — $20 billion of outstanding loans and bonds. A proxy for interconnectedness, companies with a large amount of loans and bonds outstanding tend to be more interconnected with the financial system.
  • Leverage Ratio — A leverage ratio of total consolidated assets to total equity of 15 to 1, excluding separate accounts which are not available to claims by general creditors.
  • Short-Term Debt Ratio — A ratio of debt with a maturity of less than 12 months to total consolidated assets (excluding separate accounts) of 10 percent.

The Stage 1 quantitative thresholds are designed to apply to companies that operate in different types of financial markets and industries. The FSOC anticipated criticism that there may not be available data with which to make determinations for all types of companies and recognized that the Stage 1 thresholds may not identify relevant companies in all cases. For example, the FSOC would apply Stage 1 thresholds to hedge funds and private equity firms, even though less data is generally available about these companies than for other companies. The FSOC anticipates that this lack of data may be temporary as the adoption of rules implementing Dodd-Frank reporting requirements for advisers to hedge funds and private equity firms, commodity pool operators, and commodity trading advisors will result in greater availability of data. Similarly, the threshold to measure derivative liabilities captures only current, but not potential future exposure. The FSOC hopes to obtain information to remedy this deficiency once there are final rules regarding reporting of data on swaps and security-based swaps.

A company will be evaluated further in Stage 2 if it meets both the total consolidated assets threshold and any one of the other thresholds.

Stage 2

The FSOC would next analyze and prioritize the potential threat that each of those companies identified in Stage 1 could pose to US financial stability based on information available through existing public and regulatory sources. At this stage, the FSOC will begin the consultation process with primary financial regulatory agencies or home country supervisors. The FSOC will rely on information available through the OFR or financial regulatory agencies before requiring the submission of reports from any company.

Stage 3

Based on the analysis in Stage 2, the FSOC would contact those companies that merit further evaluation in Stage 3. In this stage, the FSOC would analyze a company's potential to pose a threat to financial stability based on information obtained directly from the company.

A company selected for additional review will receive notice ("Notice of Consideration") that it is being considered for a proposed determination. The Notice of Consideration would include a request that the company provide information for evaluation, and an opportunity to submit additional written materials to the FSOC. The company may be asked to produce confidential business information such as internal assessments, internal risk management procedures, funding details, counterparty exposure or position data, strategic plans, resolvability, potential acquisitions or dispositions, and other anticipated changes to the company's business or structure that could affect the threat to US financial stability posed by the company.

The FSOC would evaluate qualitative factors, including a company's "resolvability," the transparency of its operations, its complexity, and the extent to which the company already is subject to regulatory oversight. Resolvability refers to the complexity of a company's structure, and obstacles to its resolution should its failure adversely affect financial stability. Resolvability also involves legal entity operations issues, e.g., spinning off business lines, maintaining continuity of services, and affiliate issues.

The FSOC may, by a vote of two-thirds of its members (including an affirmative vote of the Chairperson), propose to designate a company as a SIFI.6 The FSOC would then issue a written notice of the proposed designation to the company, including an explanation of the basis for the decision.7 A company may request a hearing to contest the determination, after which the FSOC will determine by a vote of two-thirds of the voting members of the FSOC (including the affirmative vote of the Chairperson) whether to designate the company as a SIFI. The FSOC will provide the company with written notice of the final determination, including an explanation of the basis for its decision. A company that has been designated as a SIFI may bring an action in US district court to rescind the determination.

Observations

The FSOC deserves praise for responding to the comments that center, at bottom, on the question, "Is my company likely to be designated a SIFI and what can I do to prevent that from happening?" The short answer is that a company can make a better prediction than before, but the Re-Proposal could have provided greater clarity.

The most positive improvement is that the FSOC is outlining its process for designations. Immediately, however, two contrary ideas collide. On the one hand, it is difficult to devise six metrics to serve as a proxy for excluding companies from designation in every instance. The FSOC reasonably wants to preserve its discretion to designate as a SIFI an "outlier" that poses risk to the system but that would not be captured by the six factors. On the other hand, companies seek certainty as to their potential status as SIFIs. Because these positions essentially are irreconcilable, observers are bound to react that the Re-Proposal is more specific than before, but still too vague.

Ironically, by providing increased specificity, the FSOC is potentially opening its Re-Proposal to further criticism. For example, by stating that the statute's two standards for making a determination — i.e., a firm's possible demise causing instability or a firm causing instability even if it were not in financial distress — are overlapping, one can infer that the FSOC may perceive no real difference between the two standards. That statement could sow confusion and prompt observers to wonder whether there are other interpretive issues in construing SIFI designations that are not immediately apparent.

The Guidance is helpful in revealing the FSOC's thinking that there are "channels" through which a company most likely will transmit its financial distress to other firms and markets, but there could be more detail on the subject. Does the FSOC believe other channels could stoke contagion, but to a lesser extent? What kind and how many? What are the attributes of the three identified channels that warrant inclusion in the Re-Proposal? How many other channels were considered for inclusion but rejected?

While the Re-Proposal helpfully articulates how a determination will be conducted, the process can be refined. A tiered approach for conducting a review is intriguing. Still, one might ask, what other models were considered but rejected? Were better models discarded? The Guidance addresses the FSOC's rationale for collapsing the 10 statutory considerations into six factors, but it largely repeats the original proposal's framework for incorporating the statutory considerations. The detail, while a positive development, still is more conclusory than probing.

The Guidance provides examples of metrics for evaluating a nonbank financial company in each of the six factors, but it is not clear why some metrics were chosen and others rejected. Because the list is not exclusive, applying the metrics to a particular company, especially in the later stages of the determination process, could lead to diverging conclusions as to whether a company warrants designation as a SIFI.

Stage 1 presents a clear logic, but demonstrates weaknesses. The metrics identified are not new, and some, like size, are intuitive. But are these metrics too prescriptive? What makes them appropriate, to the exclusion of other metrics? Will some putative SIFI's slip through the system because other metrics are not included in the model? Conversely, because the FSOC has reserved discretion to use other metrics, the list in the Guidance is nonexclusive and companies thus have less certainty as to their status. Identifying a safe harbor with greater precision might represent a loss of some discretion for the FSOC, but it would help deflect potential challenges that the proposal is too vague. The FSOC also acknowledged possible problems in applying the identified metrics given limited availability of data, especially for hedge funds and private equity funds. The decision to apply poor quality data, especially to hedge funds, can lead to potential challenges of specific determinations and, by extension, may undermine determinations where data may be more reliable.

The Guidance's description of Stage 2 provides even less insight into the FSOC's thinking than the discussion of Stage 1. We have learned that companies identified in Stage 1 for further evaluation may be asked to provide more information, but it is unclear precisely how the evaluation might be conducted. The relative absence of detail concerning Stage 2, when contrasted with the greater detail provided concerning Stages 1 and 3, could lead to further criticism.

Stage 3 appears to be far more intrusive than the other stages. It is not clear just how extensive or burdensome an information request from OFR or the FSOC might be. The role of the OFR in the process is opaque. It can take up to 180 days for the FSOC to rule on a proposed designation, once a company's file is complete. In some cases it could take longer.

The Re-Proposal helpfully added that a company may submit written materials to contest a determination, including materials concerning whether the company meets the standards for a determination. Still, for a company "on the bubble," it will be necessary to consider how to respond to the FSOC as this stage. A useful point of reference may be a company receiving an invitation from the SEC to provide a "Wells submission" when the staff is considering whether to take an enforcement action. In both questions one would ask, "How cooperative should a company be in providing materials?" A larger question is whether and under what circumstances a company should resist a designation? There is some additional discussion of how the FSOC will vote on a determination and conduct a hearing should a company contest its proposed designation, but, as with other features of the proposal, the additional detail is summary.

In many respects the Re-Proposal is not that different from the original proposal. The FSOC did not abandon its original view of the designation process and reiterated its support for the six factor framework. The Re-Proposal repeats with virtually no change the table in the original proposal that illustrated the relationship between the 10 statutory considerations and the six factors. A review of the text of the regulation itself shows few structural changes to the rule, which reflect a reorganization of text rather than a wholesale rethinking of the proposal. While there are some changes, they are minor and reveal refinements rather than a rejection of the prior approach.

Conclusion

It is intriguing that the FSOC sought to repropose its rulemaking on SIFI designation. The FSOC deserves praise for revealing in greater detail the process it will follow in making designations, but the process still is indefinite and largely opaque. Nonbank companies engaged in financial activities still will have significant questions as to whether they may be subject to designation. Commenters have one more chance to weigh in before a final rule is issued. With luck, hopefully the FSOC will provide even more insight into its thinking in a final rule, responding to criticism that it lacks authority even to promulgate this rule.

Footnotes

1 The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). Section 165(b) of the Dodd-Frank Act mandates the Federal Reserve to establish prudential standards for companies that have been designated as possibly posing a threat to US financial stability to include concentration limits and requirements relating to risk-based capital, leverage, risk management, resolution plans, and credit exposure reporting. The Federal Reserve also may adopt standards relating to contingent capital, enhanced public disclosures, and short-term debt limits. In this note we refer to a nonbank financial company that is subject to such a determination as a "SIFI." We also refer to the process by which a company is designated as a SIFI either as a "determination" or a "designation."

2 "Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies," 75 FR 61,653 (Oct. 6, 2010), 76 FR 4,555 (Jan. 26, 2011) and 76 FR 64,264 (Oct. 18, 2011). If you would like to read about the Proposal, you may wish to see our client memorandum, "Greetings! We're from the Fed and We're Here to Supervise You," (March 30, 2011) http://www.shearman.com/files/Publication/90aae1b4-4e2c-4cf7-b430-3f7112b244a6/Presentation/PublicationAttachment/6fec6c18-be2d-4451-9972-01f357922c6a/FIA-03302011-Nonbank_Financial_Companies_March_2011.pdf.

3 Sections 113, 115, and 165 of the Dodd-Frank Act permit the FSOC to exercise its determination authority; make recommendations to financial regulatory agencies to apply heightened standards and safeguards for a financial activity conducted by bank holding companies or SIFIs to reduce the risk of significant liquidity, credit, or similar problems; designate financial market utilities and payment, clearing and settlement activities that are systemically important, and make recommendations to the Federal Reserve concerning the establishment of prudential standards applicable to SIFIs.

4 These considerations include the: (A) extent of the leverage of the company; (B) extent and nature of the off-balance sheet exposures of the company; (C) extent and nature of the transactions and relationships of the company with other significant companies and bank holding companies; (D) importance of the company as a source of credit and liquidity for the US financial system; (E) importance of the company as a source of credit for low-income, minority, or underserved communities; (F) extent to which assets are managed rather than owned by the company, and ownership of assets under management is diffuse; (G) nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company; (H) degree to which the company already is regulated by one or more regulatory agencies; (I) amount and nature of the financial assets of the company; and (J) amount and types of the company's liabilities, including the degree of reliance on short-term funding. See Dodd-Frank Section 113(a)(2).

5 The FSOC may consider any company for a determination at any point in the three-stage evaluation process should the company pose a threat to US financial stability.

6 If the FSOC is unable to determine whether the financial activities of a U.S. nonbank financial company pose a threat to the financial stability of the United States, based on reports and publicly available information, it may request the Federal Reserve to conduct an examination of the company.

7 The FSOC also would notify any company subject to a Stage 3 review that the company has not been designated as a SIFI. Such a company still could be subjected to FSOC review at a later date for a possible SIFI designation. The FSOC indicates it will make proposed determinations of SIFIs within 180 days after receiving necessary information from a company.

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