Introduction
'Nonbank financial companies' under the Dodd-Frank Act
Activities considered financial in nature
Specific activities
Introduction
On April 2 2012 the Board of Governors of the Federal Reserve System issued a supplemental notice of proposed rulemaking and a request for comment that would amend the board's Regulation Y to establish the criteria for determining whether a company is 'predominantly engaged in financial activities' for purposes of Title I of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.(1) The board had previously published a notice of proposed rulemaking on February 11 2011, which sought to define when a company is "predominantly engaged in financial activities". Based on comments received primarily raising questions as to whether the conduct of certain financial activities that did not comply with the conditions applicable to bank holding companies should still be considered to be financial activities for purposes of the Dodd-Frank Act, the board issued a supplement to the February release. Comments are due by May 25 2012.
'Non-bank financial companies' under the Dodd-Frank Act
Under the Dodd-Frank Act, the Financial Stability Oversight Council (FSOC) was given the authority to require that certain non-bank financial companies become subject to supervision by the board on a determination by FSOC that the material financial distress of the company, or the nature, scope, size, scale, concentration, interconnectedness or mix of the company's activities, could pose a threat to the financial stability of the United States (for further details please see "FSOC issues final rule on oversight of non-bank financial companies").(2)
The term 'non-bank financial company' includes both:
- a US non-bank financial company – a company (other than a bank holding company and certain other specified types of entity) that is incorporated or organised under the laws of the United States or any state and predominantly engaged in financial activities; and
- a foreign non-bank financial company – a company (other than a bank holding company or foreign bank or company that is, or is treated as, a bank holding company) that is incorporated or organised outside the United States and predominantly engaged in financial activities.
For purposes of the Dodd-Frank Act, a company is considered to be predominantly engaged in financial activities if either:
- the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in Section 4(k) of the 1956 Bank Holding Company Act, as amended) and, if applicable, from the ownership or control of an insured depository institution represent 85% or more of the consolidated annual gross revenues of the company; or
- the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in Section 4(k) of the Bank Holding Company Act) and, if applicable, related to the ownership or control of an insured depository institution represent 85% or more of the consolidated assets of the company.(3)
Activities considered financial in nature
In considering the comments received and proposing the current release, the board looked to the language and legislative intent and history of the Dodd-Frank Act and the Bank Holding Company Act. The board concluded that defining a 'financial activity' to include all of the restrictions imposed on bank holding companies would "severely undermine" the purpose of Title I of the Dodd-Frank Act, since many companies engage in a broad range of financial activities without complying with all of the limitations of the Bank Holding Company Act. To exclude such companies from the scope of Title I simply because they did not abide by all of the conditions placed on a bank holding company would be contrary to congressional intent.
As a result, the board has put forth a proposal that would consider any activity referenced in Section 4(k) of the Bank Holding Company Act to be considered a financial activity without regard to conditions that were imposed on bank holding companies that do not define the activity itself. The supplementary information accompanying the proposed rule states that conditions that do not define the activity itself include those conditions that were imposed to ensure that the activity is conducted in a safe and sound manner, to prevent a financial holding company from controlling a commercial firm or to comply with another provision of the law. In other words, the board is incorporating conditions that are essential to the activity only. Thus, to provide clarity, the board is issuing an appendix to the proposed rule that lists the activities that would be considered to be financial activities as of April 2 2012, including conditions necessary to the definition of the activity as a financial activity, for purposes of determining whether a company is predominantly engaged in financial activities.
Below is a discussion of select financial activities and the treatment that the board has chosen to give to the related conditions.(4)
Merchant banking
Many of the comments that the board received to the proposed rule focused on whether investment activities would cause a company to be deemed to be predominantly engaged in financial activities if the company did not meet the conditions applicable to bank holding companies for carrying out such investment activities.
One of the most significant investment activities permitted under the Bank Holding Company Act is merchant banking. Under the act, a financial holding company is permitted to engage in merchant banking activities so long as the investee company is engaged in activities not authorised under the act and:
- any acquired shares are not acquired or held by a depository institution;
- the shares are acquired and held as part of a bona fide merchant banking activity by a securities affiliate or an affiliate thereof, or in the case of a financial holding company that has an insurance affiliate, an affiliate that provides investment advice to an insurance company and is registered pursuant to the 1940 Investment Advisers Act, or an affiliate thereof;
- any acquired shares are held for a period of time to enable the sale or disposition on a reasonable basis consistent with the financial viability of the company's merchant banking activities, which by regulation the board has generally set at 10 years subject to extension by the board (or 15 years in the case of certain investments in private equity funds); and
- during the period for which the shares are held, the bank holding company does not routinely manage or operate the company, except as may be necessary to obtain a reasonable return on investment on resale or disposition.
Under the proposed rule, a company may be deemed to be engaged predominantly in financial activity if it engages in merchant banking activities and:
- any acquired shares are held for a period of time to enable the sale or disposition thereof on a reasonable basis consistent with the financial viability of the merchant banking activities; and
- during the period the shares are held, the company does not routinely manage or operate such company or entity, except as may be necessary or required to obtain a reasonable return on investment on resale or disposition.
The supplementary information accompanying the proposed rule states that neither the board's regulations governing the period for holding investments (10 or 15 years) nor the board's rules interpreting routine management and operation will apply for purposes of making a determination under Title I of the Dodd-Frank Act. In addition, the requirement as to the type of entity holding the shares (eg, a securities affiliate) does not apply; nor does the requirement that the investee company not engage in Bank Holding Company Act activities.
Asset management
Another financial activity is asset management, which is generally permitted for bank holding companies under the Bank Holding Company Act, but is prohibited if the bank holding company is also engaged in real property management or real estate brokerage, which are activities deemed not to be financial in nature.
However, for purposes of making a determination under Title I of the Dodd-Frank Act, the board has determined that a company engaged in asset management may be predominantly engaged in financial activities even if it conducts real property management and/or real estate broker businesses, so long as the latter activities comprise no more than 15% of the company's activities.
Extensions of credit
Extensions of credit, much like asset management activities, are generally permissible for bank holding companies subject to certain exceptions. For example, the Bank Holding Company Act restricts a bank holding company from having an interest in, participating in, managing, developing, promoting or sponsoring the development of property for which it is arranging commercial real estate equity financing. However, the board has chosen not to impose any of these conditions. Thus, a company may be deemed to be engaging predominantly in financial activities solely by arranging commercial real estate equity financing so long as participation in the impermissible activities, such as property management or development, does not comprise more than 15% of the company's activities.
Additionally, the Bank Holding Company Act imposes certain conditions on a bank holding company's acquisition of debt in default. The bank holding company must:
- divest any impermissible assets securing such debt in default within a certain period of time;
- stand only in the position of a creditor;
- not purchase equity of obligors of debt in default; and
- not acquire debt in default secured by shares of a bank or bank holding company.
The board has taken the position that none of these conditions is essential to the activities and thus these conditions do not apply for purposes of Title I of the Dodd-Frank Act.
Leasing
The Bank Holding Company Act permits bank holding companies to lease personal or real property, and act as an agent, broker or adviser for personal or real property, so long as:
- the lease is on a non-operating basis;
- the initial term of the lease is at least 90 days; and
- in the case of leases involving real property:
- at the inception of the initial lease, the effect of the transaction is to yield a return that will compensate the lessor for not less than the lessor's full investment in the property plus the estimated total cost of financing the property over the term of the lease from rental payments, estimated tax benefits and the estimated residual value of the property at the expiration of the initial lease; and
- the estimated residual value of the property for purposes of the above point does not exceed 25% of the acquisition cost of the property to the lessor.
The board has included in the proposal the same conditions for purposes of making a determination under Title I of the Dodd-Frank Act.
Insurance
The Bank Holding Company Act permits bank holding companies to engage in a broad range of insurance activities, including:
- insuring, guaranteeing, indemnifying against loss, harm, damage, illness, disability or death;
- providing and issuing annuities; and
- acting as principal, agent or broker for purposes of the foregoing, in any state.
Bank holding companies may also engage in various types of activity related to the provision of credit insurance and insurance in small towns.
The board has included insurance as a financial activity without any conditions or limitations for purposes of making a determination under Title I of the Dodd-Frank Act.
Data processing
Bank holding companies are allowed to provide data-processing services, data storage and data transmission services, facilities, databases, advice and access to such services, facilities or databases by any technological means if:
- the data to be processed, stored or furnished is financial, banking or economic; and
- the hardware provided in connection therewith is offered only in conjunction with software designed and marketed for the processing, storage and transmission of financial, banking or economic data, and the general purpose hardware does not constitute more than 30% of the cost of any packaged offering.
The board determined that the latter condition relating to hardware does not define the activity of financial data processing for purposes of making a determination under Title I of the Dodd-Frank Act. Thus, any company that engages in providing such data processing services and related services for financial, banking or economic data may be deemed to be predominantly engaged in financial activity.
For further information on this topic please contact William S Eckland or Stanley J Boris at Sidley Austin LLP by telephone (+1 202 736 8000), fax (+1 202 736 8711) or email ([email protected] or [email protected]).
Endnotes
(1) The proposal is available at www.gpo.gov/fdsys/pkg/FR-2012-04-10/pdf/2012-8515.pdf and www.gpo.gov/fdsys/pkg/FR-2012-04-17/pdf/2012-9210.pdf.
(2) See Section 113 of the Dodd-Frank Act; 12 USC § 5323. On April 3 2012 FSOC released a final rule addressing the criteria that would be used to make such determination. FSOC's rule is available at www.gpo.gov/fdsys/pkg/FR-2012-04-11/pdf/2012-8627.pdf.
(3) See Section 102(a)(6) of the Dodd-Frank Act; 12 USC § 5311(a)(6).
(4) Please review the appendix attached to the proposed rule for a complete list of financial activities.