Also contributed by Maurice Horwitz
On March 23, the FDIC published a second Notice of Proposed Rulemaking with respect to the Orderly Liquidation Authority (“OLA”) created by Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rule, which is now in a 60-day public comment period, addresses critical aspects of the OLA, which is intended to address the problem of how to wind down large financial institutions that, if left to receivership, bankruptcy, or other traditional restructuring mechanisms, would pose systemic risks to the financial markets. These companies have been called, colloquially, “Too Big to Fail,” and the Dodd-Frank provisions on orderly liquidation were intended to avoid repetition of the situation faced in the 2008 financial crisis where the government was forced to choose between two unpalatable options – letting troubled financial institutions fail and risking collapse of the entire financial system or committing hundreds of billions of dollars in taxpayer money either directly or to backstop a private acquisition. In this blog entry – the first in a series in which Weil’s Financial Reform Regulatory Center analyzes the impact of the NPR – we address a significant gating question: What companies are potentially subject to the OLA?
Title II Financial Companies
Title II of Dodd-Frank states that the OLA applies to any “financial company,” which is defined as a company organized under the laws of the United States that is:
- a bank holding company as defined by the Bank Holding Company Act of 1956 (12 U.S.C. 1841(a)) (the “BHCA”);
- a nonbank financial company supervised by the Federal Reserve Board of Governors (the “Board”) pursuant to section 113 of Dodd-Frank;
- any company predominantly engaged in activities that the Board has determined are financial in nature or incidental thereto for purposes of the BHCA; or
- a U.S. subsidiary of any of the above engaged in activities that the Board has determined are financial in nature or incidental thereto for purposes of the BHCA (other than insurance companies or federally insured depository institutions).
See § 201(a)(11). Under this definition, a “financial company” includes a broker/dealer registered with the Securities and Exchange Commission (“SEC”) that is also a member of the Securities Investor Protection Corporation (“SIPC”).
A financial company that becomes subject to the OLA is defined as a “covered financial company, ” see § 201(a)(8), (unless the company is a broker/dealer, in which case the company is a “covered broker or dealer,” see § 201(a)(7)). If a covered financial company has U.S. subsidiaries, they may become subject to the OLA as subsidiaries of a covered financial company, which are defined as “covered subsidiaries.” See § 201(a)(9). Certain entities are excluded from these classifications, and therefore, cannot become subject to the OLA. Specifically, an insured depository institution cannot be a covered financial company, and an insurance company, insured depository institution, or covered broker/dealer cannot be a covered subsidiary.
Presumably, by excluding “an insurance company” from the definition of “covered subsidiary,” Congress intended to exclude regulated insurance companies – but this is not clear from the statute. It is clear, however, that while an “insurance company” cannot become subject to the OLA merely because it is the subsidiary of a covered financial company, an insurance company itself can be a covered financial company, and therefore can itself be placed into orderly liquidation under Title II, provided that the requisite “three keys” (set forth below) are turned.
In addition, certain other entities are excluded from the definition of “financial company,” and therefore, also from the OLA; these are a Farm Credit System institution, and a governmental entity, or regulated entity, as defined under section 1303(20) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (i.e., Fannie Mae and Freddie Mac, and any Federal Home Loan Bank).
The Statutory 85% Calculation
For determining whether a company is predominantly engaged in activities that the Board has determined are financial in nature or incidental thereto for purposes of the BHCA, section 201(b) of Dodd-Frank further provides that “[n]o company shall be deemed to be predominantly engaged in activities that the [Board] has determined are financial in nature or incidental thereto for purposes of section 4(k) of the [BHCA], if the consolidated revenues of such company from such activities constitute less than 85 percent of the total consolidated revenues of such company, as the [FDIC], in consultation with the Secretary [of the Treasury], shall establish by regulation.” See § 201(b).
The concept of “activities that are financial in nature” is a term of art under existing law that largely covers banking, lending, underwriting, insurance, investment, and other activities unrelated to general commercial services or manufacturing. By issuing a regulation that defines the terms “predominantly engaged” and “financial activity,” the NPR is intended to clarify how the FDIC will determine whether 85% of a company’s consolidated revenues or assets stem from activities that are “financial in nature.”
Further refining the 85% rule set forth above, the NPR specifies a time period during which a company’s consolidated revenues may be considered by the FDIC for the purposes of the 85% calculation. Specifically, a company may be defined as being “predominantly engaged” in financial activities under one of two circumstances. First, understanding that in any given year, a company could experience a decline in “financially derived” revenues, the NPR provides that a company meets the definition of “predominantly engaged” if in either of its two most recent completed fiscal years, at least 85% of the total consolidated revenues of the company were derived, directly or indirectly, from financial activities. Alternatively, given that a company’s revenue sources could change dramatically and suddenly on account of various types of transactions, such as a merger, consolidation, acquisition, or the establishment of a new business line, the NPR provides that a company is “predominantly engaged” if at any point in time, based upon all the relevant facts and circumstances, and the full range of information available concerning the company, the FDIC determines that the consolidated revenues of the company from financial activities constitute 85% or more of the total consolidated revenues of the company. This would allow the FDIC to consider, for example, the percentage of a company’s consolidated revenues derived from financial activities during such time period of the FDIC’s choosing subsequent to the company’s most recently competed fiscal year.
The NPR defines “total consolidated revenues” as the total gross revenues of a company and all entities subject to consolidation with the company for a fiscal year, as determined in accordance with applicable accounting standards, which are defined as the standards used by the company in preparing its consolidated financial statements, provided that they are (i) US GAAP, (ii) International Financial Reporting Standards, or (iii) such other accounting standards that the FDIC determines to be appropriate. Although the FDIC believes that the NPR’s definition of “applicable accounting standards” will prevent companies from arbitraging the 85% rule by using different accounting standards solely for the purposes of the NPR, it is unclear how the FDIC will prevent companies from changing their accounting standards (or even their organizational structure) to achieve arbitrage. Even if the FDIC cannot prevent companies from making such changes, the FDIC may specify under what circumstances it may consider a change in accounting standards to be for the purpose of evading the 85% rule, and what, in such circumstances, the FDIC may do in order to provide an accurate basis for determining whether a company is a “financial company” for the purposes of the OLA.
The NPR defines “financial activity” to include (i) any activity, wherever conducted, described in section 225.86 of the Board’s Regulation Y or any successor regulation; (ii) ownership or control of one or more depository institutions; and (iii) any other activity, wherever conducted, determined by the Board of Governors – in consultation with the Secretary of the Treasury (the “Secretary”) – under section 4(k)(1)(A) of the BHCA, to be financial in nature or incidental to financial activity. Between section 225.86 of Regulation Y and section 4(k)(4) of the BHCA, “financial activities” include, among other things, banking; lending; underwriting; insurance; safeguarding money or securities; providing financial or investment advisory services; providing administrative or other services to mutual funds; owning shares of a securities exchange; acting as a certification authority for digital signatures; check cashing; providing wire transmission services; providing real estate title services; and organizing, sponsoring and managing a mutual fund.
Under the NPR, “financial activities” includes all financial or incidental activities, regardless of where the activity takes place, whether a bank holding company or foreign banking organization could conduct the same activity under some legal authority other than section 4(k) of the BHCA, or whether any federal or state law other than section 4(k) of the BHCA may prohibit or restrict the conduct of the activity. Thus, for example, all securities underwriting and dealing activities are “financial activities” even if the “Volker Rule” limits the permissible amount of such activity by a bank holding company or affiliate of a depository institution.
Rules of Construction
The NPR sets forth two “rules of construction” that govern the two-year test for revenues derived from a company’s minority, non-controlling equity investments in unconsolidated entities. Under the non-consolidating investment rule, the revenues derived from a company’s equity investment in another company (the “Investee Company”) the financial statements of which are not consolidated with those of the company under the applicable accounting standards, would be considered as revenues derived from a financial activity if the Investee Company itself is predominantly engaged in financial activities under the revenue test of the Proposed Rule. This rule is similar to the approach proposed by the Board for determining whether a non-bank company is predominantly engaged in financial activities under Title I of Dodd-Frank. See 76 Fed. Reg. 7731 (February 11, 2011).
The de minimis rule, on the other hand, permits (but does not require) a company to treat revenues derived from certain de minimis equity investments in Investee Companies as not derived from financial activities without having to separately determine whether the Investee Company is itself predominantly engaged in financial activities. The de minimis rule is subject to certain conditions:
- the company must own less than 5% of any class of outstanding voting shares, and less than 25% of the total equity, of the Investee Company;
- the financial statements of the Investee Company may not be consolidated with those of the company under applicable accounting standards;
- the company’s investment in the Investee Company may not be held in connection with the conduct of any financial activity by the company or any of its subsidiaries (e.g., investment advisory activities; merchant banking investment activities); and
- the aggregate amount of revenues treated as non-financial under the de minimis rule in any year does not exceed 5% of the company’s total consolidated financial revenues.
“Nonbank Financial Companies”
As set forth above, also subject to the OLA is any nonbank financial company supervised by the Board pursuant to section 113 of Dodd-Frank.” See § 201(a)(11)(B)(ii). The term “nonbank financial company” is itself defined in Title I of Dodd-Frank as, inter alia, a company “predominantly engaged in financial activities.” See § 102(a)(4). On February 8, 2011, the Board issued a notice of proposed rulemaking with its own definition of “predominantly engaged in financial activities.” The Board’s definition is substantially similar to the FDIC’s definition, with three differences:
- The FDIC’s definition of “predominantly engaged” looks only at revenues, while the Board considers assets as well as revenues.
- The FDIC considers activities that are “financial in nature and incidental thereto,” while the Board only considers activities that are “financial in nature.”
- The FDIC test refers to the ownership and control of depository institutions, while the Board refers to the ownership, control, and activities of insured depository institutions.
Whether a company is a “nonbank financial company” subject to the Board’s supervision under Title I of Dodd-Frank is determined by the Financial Stability Oversight Council (the “FSOC”), established by Dodd-Frank as the nation’s systemic risk regulator. Assuming a company is predominantly engaged in “activities that are financial in nature,” the FSOC – by supermajority vote – may designate the company as a nonbank financial company (subjecting it to enhanced supervisory measures) based upon, among other things, the following considerations:
- the extent of the leverage of the company;
- the extent and nature of the off-balance-sheet exposures of the company;
- the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
- the importance of the company as a source of credit for households, businesses, and state and local governments and as a source of liquidity for the U.S. financial system;
- the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
- the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
- the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
- the degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
- the amount and nature of the financial assets of the company;
- the amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
- any other risk-related factors that the FSOC deems appropriate.
See § 113(a)(2).
Breadth of “Financial Company” Definition
Dodd-Frank’s “financial company” and “nonbank financial company” categories are potentially quite large and appear to capture any entity predominantly engaged in financial services. For example, these categories could possibly extend to thrifts and their holding companies, broker-dealers, investment advisers (potentially including managers of hedge funds and private equity funds), investment banks, and other asset management firms. In addition, it is possible that certain subsidiaries of a company could fall within the definition of a “financial company,” while others – including the parent company – do not.
When considering the impact of these definitional categories, it is important to distinguish between a company that merely falls within the definition of a “financial company,” and that actually becomes subject to the “three keys” determination (described below) for the commencement of an orderly liquidation under the OLA. In other words, there is a significant difference between merely being eligible for orderly liquidation under the OLA, and actually being placed into orderly liquidation. The former is relatively easy, and does not require a finding that the company is systemically important or poses systemic risk to the financial system – only that the company engages predominantly in financial activities. The latter determination is more difficult to establish, and does require a finding of systemic risk.
As discussed below, this latter determination will not be made until the eve of a company’s OLA liquidation, which leaves creditors and other parties in interest uncertain whether a failed financial company will be resolved under the OLA or the Bankruptcy Code (or, in the case of a broker/dealer, the Securities Investor Protection Act).
The Three Keys
The FDIC alone may determine that a company is a “financial company,” but placing such a company into orderly liquidation requires the so-called “three keys” to be turned. Specifically, even if the FDIC determines that a company qualifies as a “financial company” (or the FSOC designates a company as a nonbank financial company), the OLA requires that the Board and the FDIC consider, either at their own initiative or at the request of the Secretary, whether to make a written recommendation (the “Recommendation”) that the Secretary should appoint the FDIC as the receiver of the financial company. The Recommendation must be made upon a vote of not less than two-thirds of each of both the Board and the board of directors of the FDIC. If the decision involves a financial company that is a broker/dealer, or whose largest U.S. subsidiary is a broker/dealer, the SEC replaces the FDIC as the appropriate federal agency to make the Recommendation along with the Board (the two-thirds voting requirements are the same). If the decision involves a financial company that is an insurance company, or whose largest U.S. subsidiary is an insurance company, then the Director of the Federal Insurance Office must make the Recommendation together with two-thirds of the Board. See § 203(a)(1).
The Recommendation must contain the following:
|(a)||An evaluation of whether the financial company is in default or danger of default;|
|(b)||A description of the effect that a default of the financial company would have on the economic condition or financial stability of the U.S;|
|(c)||A description of the effect that the default would have on the economic condition or financial stability for low-income, minority, or underserved communities;|
|(d)||A recommendation regarding the nature and extent of actions to be taken under the OLA;|
|(e)||An evaluation of the likelihood of private sector alternatives to prevent a default of the financial company;|
|(f)||An evaluation of why a case under the Bankruptcy Code is not appropriate;|
|(g)||An evaluation of the effects on creditors, counterparties, and shareholders of the financial company and other market participants; and|
|(h)||An evaluation of whether the company satisfies the definition of “financial company.”|
See § 203(a)(2).
Based on the Recommendation, the OLA requires that the Secretary take the necessary action to place a financial company into orderly liquidation if the Secretary makes a determination, in consultation with the President of the U.S. (the “Determination”), that:
|(a)||The financial company is in or in danger of default;|
|(b)||Failure and its resolution under applicable federal or state law would have serious adverse effects on the financial stability of the U.S.;|
|(c)||No viable private sector alternative is available to prevent the default of the financial company;|
|(d)||Any effect that an orderly liquidation under the OLA would have on claims or interests of creditors, counterparties, and shareholders of the financial company and other market participants is appropriate, given the impact that an orderly liquidation would have on the financial stability of the U.S;|
|(e)||Action under the OLA would avoid or mitigate such adverse effects on the U.S., taking into consideration the effectiveness of the action in mitigating potential adverse effects on the financial system, the cost to the general fund of the Treasury, and the potential to increase risk taking by creditors, counterparties, and shareholders of the financial company;|
|(f)||A federal regulatory agency has ordered the financial company to convert all of its convertible debt instruments; and|
|(g)||The financial company satisfies the definition of “financial company” under section 201.|
See § 203(b).
Notably, there is no reason why the FDIC could not determine that a company qualifies as a “financial company” on the eve of voting in favor of the Recommendation. Because of this, it should not be assumed that a company is ineligible for the OLA merely because the FDIC has not yet explicitly or publicly determined it to be a “financial company” or the FSOC has not designated it as a “nonbank financial company” for purposes of Title I of Dodd-Frank. The FDIC’s determination could be made at any time, even as part of the “three keys” process. Thus, whether a company is assessing its own, or its counterparties’ susceptibility to the OLA, it should rely on its own analysis, and err on the side of caution, assuming that if a company engages predominantly in activities that are financial in nature, the OLA is among the possible statutory frameworks under which that company ultimately could be liquidated.