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A N 8 8 D 8 B 1 AR SINCE WWW. NYLJ.COM THRUSDAY, MARCH 13, 2014 Limits on Physical Activities

n January 2014, the Federal Reserve for physical commodities activities, which issued an advance notice of proposed provides certain FHCs authority to engage Irulemaking (ANPR) in which it raised in physical commodities activities. questions regarding increased limits and The ANPR includes 24 specific questions restrictions on the physical commodities seeking comment on the and benefits of activities of financial holding allowing FHCs to conduct physical commodi- (FHCs) under the Bank Holding ties activities under the various provisions Act of 1956 (BHC Act).1 The Federal Reserve of the BHC Act and the conditions under cites recent environmental events as a rea- which these activities should be conducted. son for its review of physical commodities BHC Act Authority activities by FHCs. The ANPR cites the Deep- water Horizon oil spill, the incident at the The BHC Act contains three principal Fukushima Daiichi nuclear power plant, and authorities under which FHCs may engage other environmental events to support its Michael T. Escue in physical commodities activities: concerns that "the costs and liability related • "Complementary Authority." Section to physical activities can be dif- 4(k)(1)(B) of the BHC Act authorizes FHCs The ANPR was issued by the Federal ficult to limit and higher than expected." to engage in physical commodities activi- Reserve in connection with its review of the The ANPR follows a period of heightened ties, with Federal Reserve approval, that scope of the physical commodities activi- focus on the participation of FHCs in physi- are complementary to authorized finan- ties it has previously authorized under the cal commodities activities, culminating in cial activities and do not pose a substan- provision of the BHC Act that allows it to the release by the Federal Reserve of a brief tial to the safety and soundness of approve physical commodities activities of statement in July 2013 that it is "reviewing depository institutions or the financial FHCs that are complementary to permis- the 2003 determination that certain com- system generally. sible financial activities. In addition to its modity activities are complementary to • "Merchant Banking Authority." Section concerns regarding the risks presented by financial activities" and thus permissible 4(k)(4)(H) of the BHC Act authorizes FHCs physical commodities activities, the Federal for FHCs, referring to the Federal Reserve's to make investments in nonfinancial compa- Reserve also raised questions regarding how initial approval of certain physical com- nies, including companies engaged in physi- closely connected physical commodities modities activities under "complementary" cal commodities activities, provided that, activities are to permissible financial activi- authority. Subsequently, the Senate Subcom- among other restrictions, the FHC does not ties and whether continuing to permit the mittee on Financial Institutions held a hear- take part in routine or opera- conduct of physical commodities activities ing at which several witnesses criticized the tion of such company and, generally, the by FHCs is necessary to preserve competi- role of financial institutions in commodity FHC does not hold the investment for more tive equality between FHCs and competitors markets and a second hearing examining than 10 years. in permissible financial activities. the physical commodities activities FHCs • "Grandfather Authority." Section The Federal Reserve is also soliciting are authorized to conduct under the BHC 4(o) of the BHC Act authorizes certain public comments on whether additional Act and the economic impact of such activi- companies that were not bank holding restrictions should be placed on "merchant ties on the physical commodity and energy companies and became FHCs after the banking" activities. Importantly, the Federal markets and their impact on the safety and Gramm-Leach-Bliley Act to continue to Reserve is apparently considering additional soundness of the banking system. engage in physical commodities activities restrictions on all investments made under subject to certain restrictions. the merchant banking authority, not just those involving physical commodities MICHAEL T. ESCUE is a partner in the financial institu- Complementary Authority tions group of Sullivan & Cromwell. TAYLOR C. AUTEN, activities. Finally, the Federal Reserve seeks an associate at the firm, assisted with the preparation comments regarding activities conducted Under Complementary Authority, the of this article. under the BHC Act's grandfather provision Federal Reserve has previously authorized THRUSDAY, MARCH 13, 2014

FHCs, on a case-by-case basis, to engage Reserve cites concerns relating to "market that "other commercial activities" may pose in three types of commodities activities: contagion," and it notes that 11 of the 12 the same or similar types of risks that could • "Physical Commodities Trading"—pur- FHCs that are authorized to engage in activi- result in significant losses. As an example, chasing and selling commodities in the spot ties under the Complementary Authority the ANPR mentions that owners or opera- market, and taking and making delivery of are also designated as global systemically tors of factories that use substances that are physical commodities to settle commodity important banks (G-SIBs) and two G-SIBs hazardous to public health or the environ- derivatives. conduct physical commodities activities ment may face significant risk. Specifically, • "Energy Tolling"—paying power plant under the Grandfather Authority the Federal Reserve is considering a num- owners fixed periodic payments that com- To correct any potential inadequacies of ber of actions to address the potential risks pensate the owner for its fixed costs in existing prudential requirements imposed associated with all merchant banking invest- exchange for the right to all or part of the under the Complementary Authority, the ments, including: (i) more limited merchant plant's power output. Federal Reserve is considering the following banking investment holding periods; (ii) • "Energy Management Services"—provid- limitations and restrictions: (i) enhanced additional restrictions on routine manage- ing transactions and advisory services to capital requirements, (ii) increased insur- ment of merchant banking portfolio compa- power plant owners. ance requirements, and (iii) forcing a reduc- nies; (iii) additional capital requirements on Each Federal Reserve approval for an FHC tion in these activities through "absolute some or all merchant banking investments; to engage in such activities is accompanied dollar limits and caps based on a percentage and (iv) enhanced reporting requirements by restrictions and prudential limits. For of the FHC's regulatory capital or revenue." to the Federal Reserve or public disclosures example, the Federal Reserve requires an In assessing the possible costs of narrowing regarding merchant banking investments. FHC to limit the aggregate market value of or eliminating the Complementary Author- commodities held under the Complemen- ity, the Federal Reserve is also soliciting Grandfather Authority tary Authority as a result of Physical Com- public comment regarding the relationship Under the Grandfather Authority, compa- modities Trading to no more than 5 percent between physical commodities activities nies that became bank holding companies of the FHC's consolidated tier 1 capital, and and the financial activities they complement. and FHCs after Nov. 12, 1999, may continue similar size limits apply to Energy Tolling Merchant Banking Authority to engage in activities related to the trad- and Energy Management Services activities. ing, sale, or investment in commodities if Under the Merchant Banking Authority, Also, the Federal Reserve has not permitted the company was engaged in the United FHCs may make investments in nonfinancial FHCs to "own, operate, or invest in facilities States in commodities activities as of Sept. companies, including companies engaged for the extraction, transportation, storage, 30, 1997. The Grandfather Authority limits in commodities activities, subject to cer- or distribution of commodities." such activities to no more than 5 percent tain limitations, such as Regulation Y's The ANPR requests public comment of an FHC's total consolidated assets and prohibition of FHCs engaging in routine on whether the restrictions that have prohibits FHCs from cross-marketing the management or operation of a merchant accompanied Federal Reserve approvals services of its depository insti- banking portfolio company, except in lim- under the Complementary Authority are tutions and its engaged in com- ited circumstances, and the 10-year holding adequate to protect safety and sound- modities activities under the Grandfather period applicable to most merchant banking ness and financial stability. The ANPR Authority. The ANPR does not list concerns investments.2 cited recent examples of environmental regarding this authority specifically, but it In addition to the management and hold- events that have resulted in large mon- requests public comment on whether, given ing period restrictions noted above, the etary and financial costs to the constitu- the risks commodities activities may pose to Federal Reserve imposes certain prudential ent parties and states that "[a]lthough the safety and soundness, additional prudential requirements, such as the requirement that likelihood of a catastrophic event is small requirements are necessary. in the short term, catastrophes involving an FHC establish policies and procedures physical commodities continue to occur, designed to ensure the maintenance of cor- and the resultant damages are very diffi- porate separateness between the FHC and ••••••••••••••••••••••••••••• its merchant banking portfolio companies to 1. Complementary Activities, Merchant Banking Activities, cult to measure, even after the event has and Other Activities of Financial Holding Companies related occurred, and may be extremely large." protect the FHC and its subsidiary insured to Physical Commodities, 79 FR 3329 (January 21, 2014). The Federal Reserve has extended the deadline for comments to The ANPR also suggests that the Federal depository institutions from legal liability April 16, 2014. incurred by its portfolio companies.3 2. 12 C.F.R. §225.171–72. Reserve is placing an increased focus on 3. 12 C.F.R. §175(a). macro-prudential risks (i.e., to the financial Similar to the concerns raised with Read more: http://www.newyorklawjournal.com/ id=1202646609081/Limits-on-Physical-Commodities- system generally) of commodities activities respect to Complementary Authority, the Activities#ixzz34R9lfaM7 in addition to the micro-prudential risks (i.e., Federal Reserve cites recent environmental Reprinted with permission from the March 13, 2014 edition of the NEW YORK to the safety and soundness of the financial disasters involving physical commodities LAW JOURNAL © 2014 ALM Media Properties, LLC. All rights reserved. Further that could subject portfolio companies to duplication without permission is prohibited. For information, contact 877-257-3382 institution). The Federal Reserve stated that or [email protected]. # 070-06-14-22 its review of commodities activities is con- substantial legal, environmental, and repu- sistent with its obligation under the Dodd- tational risk. Expanding the scope of the Frank Act to address systemic risks posed discussion beyond physical commodities by large financial institutions. The Federal activities, the Federal Reserve also notes