September 26, 2016

Physical Activities Conducted by Financial Holding

Federal Reserve Proposes Extraordinary Increase in Capital Requirements for Physical Commodity Activities and Certain Merchant Banking Investments, Along With New Prudential Limitations

SUMMARY On September 23, 2016, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued for public comment a proposal (the “Proposal”) that would impose extraordinary capital and other prudential requirements and limitations with respect to physical commodity activities of financial holding companies (“FHCs”). The capital requirements would apply to physical commodity activities that, according to the Federal Reserve, have the potential to expose the FHC to environmental liability (“covered physical commodity activities”). The level of increase is so high that its apparent purpose is to preclude FHCs from exercising at least some of the authorities that were granted by Congress in the Gramm-Leach-Bliley Act of 1999 (“GLBA”). Most notably, the Proposal would:

 Impose a 300 percent weight for regulatory capital purposes on covered physical commodity assets that a FHC is permitted to hold under “complementary” authority;  Impose a 1,250 percent risk weight for regulatory capital purposes on any covered physical commodity held by a FHC in reliance solely on the statutory “grandfather” authority;  Impose a 1,250 percent risk weight for regulatory capital purposes on merchant banking investments in companies that engage in covered physical commodity activities (other than activities permitted under “complementary” authority);  Require a FHC to include in the 5 percent of tier 1 capital limit imposed on physical commodity “complementary” authority all covered physical commodity activities of the FHC and its , including depository institution subsidiaries, conducted under any authority (subject to certain exceptions);

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 Rescind the Federal Reserve’s energy and energy tolling approvals previously authorized under “complementary” authority; and  Impose a new quarterly public reporting requirement that includes detailed disclosures regarding the FHC’s physical holdings and activities.

The Proposal follows an advance notice of proposed rulemaking (the “ANPR”) issued by the Federal Reserve in January 2014, which solicited public comment on whether additional prudential requirements or restrictions on the physical commodity activities of FHCs would be appropriate in light of “the unique and significant that physical commodities activities may impose” on FHCs, particularly relating to potential liability for environmental catastrophes.1 Notably, although the Proposal would impose significant capital requirements on covered physical commodity activities that would effectively prohibit many activities, and, in the case of a 1,250 percent risk weight, a dollar-for-dollar capital charge, the Proposal does not cite any situations in which a FHC has suffered material financial losses with respect to these activities, or where any other has suffered such losses prior to or after the enactment of GLBA.

Although with respect to merchant banking the Proposal relates only to covered physical commodity activity, the Federal Reserve indicates that it is considering the appropriate risk-based capital treatment for all merchant banking investments and specifically asks whether “current capital requirements adequately capture the risks of merchant banking investments not covered under the proposal” and “[i]f not, what additional capital requirements should be applied to merchant banking investments generally.”2

Comments on the Proposal are due by December 22, 2016.

BACKGROUND Bank holding companies (“BHCs”) and their subsidiaries are permitted to engage in certain physical commodity activities pursuant to multiple authorities under the Bank Act of 1956 (the “BHC Act”), most notably expanded authority for BHCs that qualify for FHC status.3

In the January 2014 ANPR, the Federal Reserve solicited public comment regarding potential environmental and other risks that may result from FHC physical commodity activities and whether additional limitations or restrictions would be appropriate.

Like the Proposal, the ANPR focused on the physical commodity activities conducted by most FHCs under “complementary” authority,4 pursuant to which the Federal Reserve authorized several FHCs, on a case-by-case basis and subject to certain prudential limitations, to engage in:

 Physical commodity trading, involving the purchase or sale of commodities in the spot market and taking and making delivery of physical commodities to settle commodity derivatives, limited to commodities for which a has been authorized for trading on a U.S. by the Commodity Futures Trading Commission (the “CFTC”) and subject to a 5 percent of tier 1 capital limit;

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 Energy management services, involving providing transactions and advisory services to power plant owners; and  Energy tolling, involving paying a power plant owner fixed periodic payments that compensate the owner for its fixed costs in exchange for the right to all or part of the plant’s power output.

In the ANPR, the Federal Reserve also requested comment on activities conducted pursuant to the “grandfather” authority under section 4(o) of the BHC Act, which permits a company that was not a BHC and became a FHC following the enactment of GLBA to engage in activities related to the trading, sale or investment in commodities and underlying physical properties in which the company was lawfully engaged as of September 30, 1997.

The ANPR also solicited comment on merchant banking authority, which permits a FHC to make merchant banking investments in any type of nonfinancial company, subject to certain limitations, and particularly focused on physical commodities and related infrastructure assets that have the potential for environmental consequences.

Under the current risk-based capital framework, all exposures to physical commodities are “covered positions” under the market risk rules and are subject to risk-based capital requirements under those rules, whether or not such exposures are trading positions, and, accordingly, capital requirements for commodities positions are determined under those rules but not under the standardized and advanced approaches.5 The Proposal, as released on September 23, 2016, does not propose an amendment to the definition of “covered position” in the market risk rules to exclude from covered position status under those rules covered physical commodity assets that the Proposal would subject to capital requirements under the standardized and advanced approaches. The Federal Reserve comments, in the Supplementary Information included in the Proposal, that “[t]he resulting increase in capital requirements . . . would be in addition to any existing capital requirements relating to market risk or operational risk applicable to assets associated with physical commodity activities of an FHC.”6 It is not clear whether the Federal Reserve in fact intends there to be a doubling up of risk-based capital requirements for covered physical commodity assets. If it does, however, such a doubling up and resulting capital requirements exceeding dollar-for-dollar capital would be extraordinary and unprecedented.

The Proposal, which solicits comment on the Proposal generally and on specific questions provided therein, follows a recent report submitted by the Federal Reserve, the Federal Deposit , and the Office of the Comptroller of the Currency (the “OCC”), to the U.S. Congress and the Financial Stability Oversight Council pursuant to Section 620 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Section 620 Report”), in which the Federal Reserve recommended that Congress repeal the authority of FHCs to engage in merchant banking activities of any kind (including activities relating to physical commodities) and also repeal the commodities “grandfather” authority.7 It also follows a notice of proposed rulemaking issued by the OCC on the same day as the Section 620 -3- Physical Commodity Activities Conducted by Financial Holding Companies September 26, 2016

Report that proposes to repeal the authority of national banks and federal savings associations to deal and invest in copper.8

THE PROPOSAL The risk-based capital requirements and financial reporting and disclosure provisions in the Proposal would apply predominantly to “covered physical commodities”, which are defined as any physical commodity that is, or a component of which is, specifically named in the Comprehensive Environmental Response, Compensation, and Liability Act; the Oil Pollution Act; the Clean Water Act; or the Clean Air Act. The covered physical commodities actually enumerated in the Proposal include oil and oil products, natural gas and natural gas liquids, fertilizer, propylene, coal and coal products, and uranium and uranium products. The aforementioned statutes also apply to certain metals and agricultural products, including lead and nickel. The Proposal also applies to commodities covered by state environmental statutes that may impose similar liability and would require a FHC to identify, on a state-by-state basis, the physical commodities that it owns that are not covered under the enumerated Federal laws but may give rise to liability under state law.

The Federal Reserve asserts that these proposed heightened prudential requirements are necessary in light of the “potential legal, reputational and financial risks associated with the conduct of physical commodity trading activities”, including federal and state environmental laws that may impose liability for damages related to physical commodities. The Federal Reserve also argues that parent companies and affiliated entities may face liability for the acts of subsidiaries pursuant to a “piercing the corporate veil” theory under state law.

A. ENHANCED RISK-BASED CAPITAL REQUIREMENTS

The Proposal would amend the Federal Reserve’s risk-based capital requirements under both the standardized approach and the advanced approaches to increase the risk weight applicable to covered physical commodities held pursuant to complementary authority, grandfather authority and merchant banking authority9 and would be in addition to any existing capital requirements relating to operational risk or counterparty credit risk and, as noted above, possibly market risk as well.

The Federal Reserve estimates that the proposed risk-based capital requirements would increase the aggregate amount of capital required to be held by FHCs engaging in such activities by approximately $4.1 billion. Despite the magnitude of these increases, the Federal Reserve does not suggest any phase- in period.

1. Complementary Authority

The Proposal would assign a 300 percent risk weight to covered physical commodities that are held pursuant to complementary authority, calculated on the simple average of each covered physical commodity’s month-end, end-of-day spot prices over the previous 60 months. -4- Physical Commodity Activities Conducted by Financial Holding Companies September 26, 2016

2. Grandfather Authority

The Proposal would generally assign a 1,250 percent risk weight to covered physical commodities holdings that are held solely under grandfather authority, applied to the market value of covered physical commodities and to the original cost basis of non-commodity on- assets owned by the FHC pursuant to grandfather authority (such as pipelines and refineries, referred to as “section 4(o) infrastructure assets”).

In addition, the Proposal would apply the same 1,250 percent risk weight to all physical commodities held by a FHC under any authority other than merchant banking (and similar authority for insurance company investments) and debt previously contracted to the extent that such investments exceed the cap of five percent of tier 1 capital that is imposed on FHCs that rely on complementary authority. This would severely limit the utility of the 5 percent of total consolidated assets limit that currently applies to a grandfathered FHC under section 4(o) of the BHC Act by imposing an extraordinary increase to the risk weight that would apply to activities that are conducted solely under grandfather authority and would effectively require FHCs to hold dollar-for-dollar capital for these activities.

For activities that could be conducted pursuant to complementary authority or section 4(c)(8) of the BHC Act and that are not in excess of the 5 percent of tier 1 capital cap, the Proposal would apply a 300 percent risk weight.

3. Merchant Banking Authority

The Proposal would assign a 1,250 percent risk weight to covered merchant banking investments in a portfolio company that engages in covered physical commodity activities that are not permissible under complementary authority.10 This significant increase in risk weight may drive out covered merchant banking investments in companies engaged in and oil and gas activities, among others.

The Proposal would assign a lower risk weight to the covered merchant banking investment if all of the physical commodity activities of the portfolio company are permissible under complementary authority (such company referred to as a “commodity trading portfolio company”). These covered commodity activities must be limited to purchasing and selling covered physical commodities in the spot market and taking and making physical delivery of physical commodities to settle derivatives or similar , in each case as permitted under complementary authority and with respect to commodities for which a derivative contract has been authorized for trading on a U.S. futures exchange by the CFTC. The Proposal would assign a 300 percent risk weight to such investments if the portfolio company is publicly traded and a 400 percent risk weight if it is not.

For purposes of the risk-based capital requirements for covered merchant banking investments, the Proposal would not include owning or operating, or buying, owning or storing, a covered physical commodity solely for purposes of powering or supporting a facility or vessel that does not store, produce,

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transport or alter a covered physical commodity except as necessary to power or support the facility or vessel (referred to as the “end-user exception”). For example, the Federal Reserve indicates that an investment in a grocery store that purchases gasoline to transport produce or a that purchases oil for heating may be eligible for the end-user exception, but an investment in a power plant would not be excluded under the Proposal.

The exposure amount of a covered merchant banking investment would be measured as the carrying value of the FHC’s equity investment in the portfolio company engaged in physical commodity activities.

B. LEVEL AND SCOPE OF COMPLEMENTARY PHYSICAL COMMODITY ACTIVITY

1. Cap on Physical Commodity Activities

The Proposal would effectively reduce the cap of 5 percent of tier 1 capital that currently applies to the total value of commodities held by a FHC under complementary authority by requiring a FHC to include all physical commodity holdings of the FHC and any of its subsidiaries, including its depository institution subsidiaries, held pursuant to any authority other than merchant banking authority (or similar authority for insurance company investments) or held in satisfaction of debts previously contracted authority. If a FHC exceeds this cap, the Proposal would require the FHC to reduce its holdings of physical commodities pursuant to section 4(c)(8) of the BHC Act or complementary authority. In practice, however, a FHC could decide to reduce its holdings in depository institution subsidiaries to comply with the limit. Under the Proposal, the limit would apply to spot market purchases or taking and making physical delivery of commodities under complementary authority and under section 4(c)(8) of the BHC Act.11 Although a plausible reading of the Proposal suggests that the limits would not apply to precious metals of which the FHC takes physical delivery pursuant to section 225.28(b)(8)(ii) or 225.28(b)(8)(iii) of the Federal Reserve’s Regulation Y, the rule text is not clear on this point.

2. Rescission of Authorization for Energy Management Services and Energy Tolling

The Proposal would rescind the Federal Reserve’s previous authorization for certain FHCs to engage in energy management services and energy tolling activities pursuant to complementary authority. The Federal Reserve proposes to eliminate the authority to conduct these activities on the basis that they are no longer complementary, citing, among other things, that, of the five FHCs originally authorized to engage in these activities, four have since discontinued these activities in the United States. The Federal Reserve does not, however, make a finding that these activities pose undue risk.

The Proposal would provide a two-year conformance period following the effective date of any final rule.

3. Clarification of Existing Prohibitions

The existing complementary authority for FHCs does not permit a FHC to own, operate or invest in facilities or vessels for the extraction, transportation, storage or distribution of physical commodities

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pursuant to Complementary Authority. In order to provide additional clarity, the Proposal would define the term “operates” to include:

 Participation in the day-to-day management or operations of the facility;  Participation in management and operational decisions that occur in the ordinary course of the business of the facility; and  Managing, directing, conducting or providing advice regarding operations having to do with the leakage or disposal of a physical commodity or hazardous waste or decisions about the facility’s compliance with environmental statutes or regulations.

C. FINANCIAL REPORTING

The Proposal would modify the Federal Reserve’s Form FR Y-9C (the “FR Y-9C”) to include detailed information on physical commodities holdings and activities, which in some cases may present difficulties for FHCs, and would require the FHC to report risk-weighted asset amounts related to certain physical commodity activities.12 Most notably, the Proposal would require the FHC to report publicly:

 The total fair value of certain categories of physical commodities held in inventory, including petroleum and petroleum products, natural gas and natural gas liquids, fertilizer, propylene, coal and coal products, uranium and uranium products and all other covered physical commodities and other physical commodities;  Whether the FHC is engaged in particular physical commodity activities, including whether it owns any physical commodities or investments in covered commodity merchant banking investments, and whether it is engaged in the exploration, extraction, production or refining of physical commodities; and  The total fair value of commodities owned pursuant to complementary authority and grandfather authority.

The Proposal also would modify Schedule HC-R of the FR Y-9C to include new line items related to the proposed capital requirements in the Proposal that would report:

 The market value of covered physical commodity activities conducted under complementary authority or grandfather authority;  The original cost basis of section 4(o) infrastructure assets; and  The carrying value of investments in covered commodity merchant banking investments.

D. COPPER ACTIVITIES

The Proposal would amend the Federal Reserve’s Regulation Y to remove copper from the list of metals that BHCs are permitted to buy, sell and store for their own accounts and the accounts of others without limit pursuant to section 225.28(b)(8)(iii) of the Federal Reserve’s Regulation Y and would remove copper from the list of metals with respect to which a BHC may enter into derivative contracts that require taking delivery of the underlying metal as principal under certain circumstances under section 225.28(b)(8)(ii). BHCs generally are permitted to buy, sell and store precious metals, such as gold, silver, platinum and palladium, and enter into derivatives that require taking delivery as principal, because these precious

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metals are regularly traded for investment in addition to industrial purposes. The Proposal would no longer treat copper as a precious metal and would instead treat it as an industrial metal, subject to the same limitations as other industrial metals, such as lead and tin.

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ENDNOTES 1 Complementary Activities, Merchant Banking Activities, and Other Activities of Financial Holding Companies Related to Physical Commodities, 79 Fed. Reg. 3,329 (Jan. 21, 2014), our memorandum to clients on the topic is available here. 2 Proposal, at p. 31 (Question 4). 3 A FHC is a BHC that is permitted to engage in an expanded scope of activities that are financial in nature if the BHC’s depository institutions are well capitalized and well managed and received “satisfactory” or better in their Community Reinvestment Act examinations. For further information on the authority of FHCs to engage in physical commodities activities, please see our memorandum to clients on the ANPR available here. 4 Under “complementary” authority, a FHC, with prior approval of the Federal Reserve, is authorized to engage in activities that the Federal Reserve determines are “complementary” to a financial activity and do not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. 5 See 12 C.F.R. Part 217, Subpart F. 6 Proposal, at p. 24 (emphasis added). 7 Our memorandum to clients on the Section 620 report is available here. 8 Industrial and Commercial Metals, 81 Fed. Reg. 63,428 (Sept. 15, 2016). 9 Modifications to the risk-based capital treatment rules with respect to merchant banking activities do not require joint regulations issued by the Federal Reserve and the U.S. Department of the Treasury, although a joint regulation is required for modifications to the general merchant banking regulations. 10 Covered physical commodity activities would include: (i) storing, producing, transporting or altering (including by processing or refining) a covered physical commodity; (ii) buying or selling a covered physical commodity in the spot market; (iii) taking or making physical delivery of a covered physical commodity to settle a contract; and (iv) owning or operating a facility or vessel that holds or uses a covered physical commodity. 11 See 12 C.F.R. § 225.28(b)(8)(ii)(B). 12 The FR Y-9C is a consolidated for BHCs that is reported on a quarterly basis.

Copyright © Sullivan & Cromwell LLP 2016

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