Recently, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board (FRB) each issued rules related to different aspects of the Dodd-Frank Act. The FDIC published in the Federal Register an interim final rule clarifying how it will treat certain creditor claims under the new orderly liquidation authority (OLA) granted under Title II of the Dodd-Frank Act. The FRB issued in the Federal Register a proposed rule that implements two provisions of the Dodd-Frank Act related to the designation by the Financial Stability Oversight Council (FSOC) of systemically important nonbank financial companies for supervision by the FRB. The FRB also issued a final rule regarding the conformance period for compliance with Section 619 of the Dodd-Frank Act, which is better known as the “Volcker Rule.”
Systemically Important Nonbank Financial Company Designation
The FRB issued a proposed rule on February 11, 2011 that would amend Regulation Y so that it would (1) establish the criteria for determining whether a company is “predominantly engaged in financial activities” and (2) define the terms “significant nonbank financial company” and “significant bank holding company” for purposes of Title I of the Dodd-Frank Act. Title I of the Dodd-Frank Act allows the FSOC to designate a nonbank financial company for supervision by the FRB if it determines that the company could pose a threat to the financial stability of the United States. The proposed rule can be found athttp://www.federalreserve.gov/newsevents/press/bcreg/bcreg20110208a1.pdf.
The proposed rule provides two scenarios under which a company is predominantly engaged in financial activities:
- if the consolidated annual gross financial revenues of the company in either of its two most recently completed fiscal years represent 85 percent or more of the company’s consolidated annual gross revenues in that fiscal year
- if the consolidated total financial assets of the company as of the end of either of its two most recently completed fiscal years represent 85 percent or more of the company’s consolidated total assets as of the end of that fiscal year.
The proposed rule expands upon the criteria for determining whether a company is predominantly engaged in financial activities outlined in Title I of the Dodd-Frank Act by specifying over what time period the annual gross revenues or consolidated assets of a company should be considered in making the determination. The proposed rule also states that the amount of a company’s financial revenues and financial assets would be determined as a percentage of consolidated annual gross revenues and consolidated assets. The company’s consolidated annual gross revenues and consolidated total assets are to be determined under and in accordance with U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards. The proposed rule also specifically states that the accounting standards used for the predominantly financial test must be the same standards that the company uses in the ordinary course of its business. The proposed rule allows companies to use year-end consolidated financial statements that they already prepare for financial reporting in order to provide a transparent, accurate and comparable basis for determining revenue and asset amounts across companies, and to help reduce the potential regulatory burden.
The proposed rule defines a “significant nonbank financial company” as (1) any nonbank financial company supervised by the FRB; and (2) any other nonbank financial company that had $50 billion or more in total consolidated assets as of the end of its most recently completed fiscal year. The proposed rule also defines a “significant bank holding company” as any bank holding company, or any foreign bank that is treated as a bank holding company, that had $50 billion or more in total consolidated assets as of the end of the most recently completed calendar year.
Pepper Point: The FRB specifically requested comments on certain portions of the proposed rule. The FRB requested comments regarding the two-year period for determining whether a company is primarily engaged in financial activities as well as whether the use of consolidated year-end financial statements prepared in accordance with GAAP is appropriate, among other issues. The request for comments suggests that the FRB may be open to altering the proposed rule. As such, any interested parties should respond with comments within the appropriate time frame. Comments should be received on or before March 30, 2011.
FDIC Authority under Title II of the Dodd-Frank Act
The FDIC issued proposed rules to implement OLA in the Federal Register on October 19, 2010. For a discussion of the proposed rules, please refer to Pepper Hamilton’s January 11, 2011 Financial Services Alert, “Federal Regulators Propose New Reporting Requirements for OTS-Regulated Savings Associations and Savings and Loan Holding Companies.” The FDIC issued an interim final rule to implement OLA on January 25, 2011. The interim final rule can be found at http://www.fdic.gov/regulations/laws/federal/2011/11finalJan25.pdf.
The interim final rule came about after the FDIC received 27 comment letters and held two meetings with various industry representatives and trade associations regarding the proposed rule. A majority of the comments related to matters beyond the scope of the proposed rule, indicating the need for additional rulemaking in the future.
The interim final rule differs from the proposed rule by clarifying the standard for valuation of collateral on secured claims. The interim final rule indicates that the FDIC will use the fair market value of collateral as of the date that the FDIC was appointed as receiver. The interim final rule eliminates the provision in the proposed rule that stated that the fair market value of government-issued or government-guaranteed securities would be the par value of the securities.
The interim final rule also differs from the proposed rule by clarifying the treatment of contingent claims. The interim final rule makes it clear that the treatment of contingent claims under Title II OLA parallels their treatment under the Bankruptcy Code. The language of the interim final rule indicates that holders of contingent claims should expect to receive no less than the amount they would have received if the covered financial company had been a debtor in a case under Chapter 7 of the Bankruptcy Code.
Additionally, the interim final rule clarifies the provision in the proposed rule stating that the FDIC will avoid taking a lien on some or all of the assets of a covered financial company that is an insurance company or a covered subsidiary or affiliate of an insurance company unless it makes a determination that taking such a lien is necessary for the orderly liquidation of the company and will not unduly impede or delay the liquidation or rehabilitation of the insurance company. The interim final rule states that the power to take a lien on a company’s assets is limited to the assets of the company that received an advance of funds.
The proposed rule elicited a number of comments regarding the availability of additional payments to creditors. Many commenters expressed concern about the prohibition of any additional payments to holders of long-term debt based on an assumption that shorter-term creditors are likely to receive such payments. The interim final rule does not change the standards outlined in the proposed rule, based upon the FDIC’s conclusion that short-term debt holders are unlikely to meet the criteria set forth in the Dodd-Frank Act permitting additional payments.
One issue that the interim final rule does not cover is whether the FDIC will use its avoidance powers under Title II of the Dodd-Frank Act to avoid securitization transactions. To address this issue, the Acting General Counsel to the FDIC issued two opinion letters in the last several months. The Acting General Counsel indicated that until the FDIC adopts a regulation addressing the applicability of its avoidance powers, it will not, when acting as receiver for a covered financial company, reclaim, recover, or recharacterize as property of the covered financial company or the receivership assets transferred by such company prior to the end of the applicable transition period of a regulation, provided that such transfer satisfies the conditions for the exclusion of such assets from the property of the estate of such company under the Bankruptcy Code. The latest opinion letter, dated January 14, 2011, also indicates that FDIC staff recommends that the FDIC Board of Directors consider further regulations governing Title II of the Dodd-Frank Act. The Acting General Counsel recommends that such regulations incorporate a transition period of 90 days.
Pepper Point: The interim final rule has a request for comments, which must be received by the FDIC not later than March 28, 2011. Organizations that have an interest in OLA under Title II of the Dodd-Frank Act should analyze the benefit of submitting comments. In any event, such organizations should monitor further rulemaking by the FDIC to fully understand how the FDIC will implement OLA.
Pepper Point: Despite the number of comments it received regarding the availability of additional payments to creditors under Title II of the Dodd-Frank Act, the FDIC chose not to change the availability of additional payments as discussed in the proposed rule. Although the FDIC indicates that it is unlikely that short-term debt holders can receive additional payments under the Dodd-Frank Act, counterparties to organizations that could fall under the OLA of the Dodd-Frank Act should consider the possibility of differing treatment of similarly situated creditors when evaluating a transaction.
Conformance Period for Compliance with the Volcker Rule
The FRB issued a final rule in the Federal Register on February 14, 2011 that implements the conformance period during which banking entities and nonbank financial companies supervised by the FRB must bring their activities and investments into compliance with the Volcker Rule (the Rule). The final rule, which can be found at http://www.gpo.gov/fdsys/pkg/FR-2011-02-14/pdf/2011-3199.pdf, will become effective on April 1, 2011.
The Rule does not take effect until the earlier of July 21, 2012 or one year after the issuance of final regulations by federal regulatory agencies. In order to give entities an adequate time frame to come into compliance, however, the Rule provides an additional conformance period. The additional conformance period generally extends through the date that is two years after the date on which the Rule becomes effective. The final rule issued by the FRB implements these provisions and also addresses how the conformance period applies to an entity that first becomes a banking entity after the enactment of the Dodd-Frank Act.
The Rule also allows the FRB to extend the general conformance period by up to three additional one-year periods. In order to grant any extension, the FRB must determine that the extension is consistent with the purposes of the Rule and would not be detrimental to the public interest. An entity that seeks the FRB’s approval for an extension of the conformance period must:
- submit a request in writing to the FRB at least 180 days prior to the expiration of the applicable time period
- provide the reasons why the entity believes the extension should be granted, and
- provide a detailed explanation of the banking entity’s plan for divesting or conforming the activity or investment in accordance with the Rule.
When evaluating a request for an extension of the conformance period, the FRB may consider a number of facts and circumstances related to the activity, investment or fund, all of which are listed in the final rule.
The Rule also contains a provision for extending the transition period for “illiquid funds.” The provision permits an entity to request approval from the FRB for an additional extension of up to five years in order to permit the entity to meet contractual commitments in place as of May 1, 2010, to a hedge fund or private equity fund that qualifies as an “illiquid fund.” The final rule requires that an entity’s investment in, or relationship with, a hedge fund or private equity fund meet two sets of criteria to qualify for this extended transition period. The first set of criteria focuses on the nature, assets and investment strategy of the fund itself. The second set of criteria focuses on the terms of the entity’s investment in the fund.
A company that first becomes a banking entity after the enactment date of the Dodd-Frank Act (July 21, 2010) must come into compliance with the Rule by the later of one of two dates. The first is the date the Rule’s prohibitions would otherwise have become effective with respect to the company. The second is two years after the date on which the company first becomes a banking entity.
Pepper Point: The FRB will consider a number of factors when an entity requests an extended conformance period. Entities that may consider such a request should carefully review and analyze all of the factors that the FRB will consider. It is critical for an entity to understand the factors and anticipate possible FRB reactions to requests so that it can adequately plan investment activities going forward, which should include potential strategies to exit an investment without material risk to the institution.
Pepper Point: The FRB notes that the final rule does not address definitional or other aspects of the Rule that are subject to, or more appropriately addressed as part of, the separate interagency rulemaking to be conducted under the Dodd-Frank Act. For example, the final rule incorporates without modification the definitions of “hedge fund” and “private equity fund” contained in the Dodd-Frank Act. As such, entities that may fall under the purview of the Rule should monitor interagency rulemaking to fully understand what investments and activities will be restricted once the Rule is effective.