U.S. District Court Judge Rosemary Collyer recently released her opinion invalidating the decision of the Financial Stability Oversight Council (FSOC or the Council) to designate MetLife a systemically important financial institution (SIFI). Beyond its impact on MetLife, the court’s opinion raises significant issues for any future SIFI designations by FSOC, and for financial regulatory agency actions more generally. Further, this decision may change the regulatory climate interested parties have encountered before FSOC and other financial regulatory agencies since the Dodd-Frank Act was enacted. The decision may also significantly change the litigation calculus for parties that are considering a possible court challenge to the regulatory actions of such agencies.
The court ruled against FSOC, essentially concluding that FSOC could not arbitrarily hypothecate a scenario of material financial distress and tether a SIFI designation to such a speculative scenario without a strong supporting analysis. Specifically, the court found that FSOC appeared to take contradictory positions as to whether the Council was required to evaluate the likelihood that MetLife would encounter material financial distress and, therefore, had not followed its own rules. The court also concluded that FSOC had relied on assumptions that were not supported by the record to establish a basis for finding that MetLife’s material financial distress would materially impair MetLife’s counterparties. The court found that:
FSOC never projected what the losses would be, which financial institutions would have to actively manage their balance sheets, or how the market would destabilize as a result. This Court cannot affirm a finding that MetLife’s distress would cause severe impairment of financial intermediation or of financial market function – even on arbitrary and capricious review – when FSOC refused to undertake that analysis itself. Predictive judgment must be based on reasoned predictions; a summary of exposures and assets is not a prediction.
(Emphasis in original.) The court found that, in order to make a designation, FSOC’s own rules required it to identify a causal connection between a company’s material financial distress and the potential resulting impairment of financial markets, which would be sufficiently severe to inflict significant damage on the U.S. economy. Instead, FSOC had assumed such damage, which the court concluded was in contravention of FSOC’s own policy, as well as being arbitrary and capricious.
In addition – and perhaps most significantly – the Council’s refusal to consider the costs of a SIFI designation led it to a decision that the court considered arbitrary and capricious under the Administrative Procedure Act. In that regard, the court looked to the Supreme Court’s decision at the end of its last term inMichigan v. EPA, 135 S. Ct. 2699 (2015), where the EPA refused to consider costs in connection with the issuance of a regulation because it was authorized to issue regulations that were “appropriate and necessary.” The Supreme Court found that under an “appropriate” standard, an agency was required to consider important aspects of a problem – and that cost was such an aspect. The Court stated that cost must be balanced against benefit because “[n]o regulation is ‘appropriate’ if it does significantly more harm than good,” and on that basis, the Court invalidated the EPA’s rule.
FSOC argued in the MetLife case that the potential cost to a designated company is not a risk-related factor because such cost is unrelated to whether the company’s distress could pose a threat to financial stability. The court disagreed, pointing out the obvious: if FSOC doesn’t know and consider costs as part of its determination, it cannot know whether the designation does significantly more harm than good, and therefore, it cannot determine whether the action is a “reasonable” course to pursue. The court concluded that, as a result, MetLife’s designation was arbitrary and capricious.
Almost immediately, on April 7, the Treasury Department announced that the government would appeal Judge Collyer’s decision. Any such appeal is likely to be decided when the current FSOC members and staff are long gone and a new Administration has taken the reins.
If the court’s decision is ultimately upheld, FSOC will have to rehabilitate its approach to the SIFI designation process and include rigorous, empirical analysis demonstrating how and why financial distress at a company will have a required impact on financial stability. The Council will also have to conduct a serious analysis of costs and benefits and demonstrate why benefits outweigh costs. The most significant question for potential targets of FSOC – such as other insurers, asset managers and funds – is how much time and oxygen this FSOC has left in its tank, and what, if anything, it can get done before its members begin to depart and are replaced by “acting” officials.
The court’s application of the Supreme Court’s ruling in Michigan v. EPA also raises issues for other financial regulatory agency actions. The Securities and Exchange Commission (SEC), in proposing its liquidity management and derivatives rules, provided cost-benefit analyses which acknowledge real and substantial costs, but which we believe rely on speculative benefits not supported by an empirical evaluation or quantification. These points are addressed in Dechert’s comment letters to the SEC on these proposed rules.1 These rules, if finalized without adequately addressing the principles of Michigan v. EPA, could be subject to challenges.
Dechert was counsel to an amicus party, the U.S. Chamber of Commerce, in the MetLife challenge.