Michael T. Escue
Michael T. Escue ()

In January 2014, the Federal Reserve issued an advance notice of proposed rulemaking (ANPR) in which it raised questions regarding increased limits and restrictions on the physical commodities activities of financial holding companies (FHCs) under the Bank Holding Company Act of 1956 (BHC Act).1 The Federal Reserve cites recent environmental events as a reason for its review of physical commodities activities by FHCs. The ANPR cites the Deepwater Horizon oil spill, the incident at the Fukushima Daiichi nuclear power plant, and other environmental events to support its concerns that “the costs and liability related to physical commodity activities can be difficult to limit and higher than expected.”

The ANPR follows a period of heightened focus on the participation of FHCs in physical commodities activities, culminating in the release by the Federal Reserve of a brief statement in July 2013 that it is “reviewing the 2003 determination that certain commodity activities are complementary to financial activities” and thus permissible for FHCs, referring to the Federal Reserve’s initial approval of certain physical commodities activities under “complementary” authority. Subsequently, the Senate Subcommittee on Financial Institutions held a hearing at which several witnesses criticized the role of financial institutions in commodity markets and a second hearing examining the physical commodities activities FHCs are authorized to conduct under the BHC Act and the economic impact of such activities on the physical commodity and energy markets and their impact on the safety and soundness of the banking system.

The ANPR was issued by the Federal Reserve in connection with its review of the scope of the physical commodities activities it has previously authorized under the provision of the BHC Act that allows it to approve physical commodities activities of FHCs that are complementary to permissible financial activities. In addition to its concerns regarding the risks presented by physical commodities activities, the Federal Reserve also raised questions regarding how closely connected physical commodities activities are to permissible financial activities and whether continuing to permit the conduct of physical commodities activities by FHCs is necessary to preserve competitive equality between FHCs and competitors in permissible financial activities.

The Federal Reserve is also soliciting public comments on whether additional restrictions should be placed on “merchant banking” activities. Importantly, the Federal Reserve is apparently considering additional restrictions on all investments made under the merchant banking authority, not just those involving physical commodities activities. Finally, the Federal Reserve seeks comments regarding activities conducted under the BHC Act’s grandfather provision for physical commodities activities, which provides certain FHCs authority to engage in physical commodities activities.

The ANPR includes 24 specific questions seeking comment on the risks and benefits of allowing FHCs to conduct physical commodities activities under the various provisions of the BHC Act and the conditions under which these activities should be conducted.

BHC Act Authority

The BHC Act contains three principal authorities under which FHCs may engage in physical commodities activities:

• “Complementary Authority.” Section 4(k)(1)(B) of the BHC Act authorizes FHCs to engage in physical commodities activities, with Federal Reserve approval, that are complementary to authorized financial activities and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.

• “Merchant Banking Authority.” Section 4(k)(4)(H) of the BHC Act authorizes FHCs to make investments in nonfinancial companies, including companies engaged in physical commodities activities, provided that, among other restrictions, the FHC does not take part in routine management or operation of such company and, generally, the FHC does not hold the investment for more than 10 years.

• “Grandfather Authority.” Section 4(o) of the BHC Act authorizes certain companies that were not bank holding companies and became FHCs after the Gramm-Leach-Bliley Act to continue to engage in physical commodities activities subject to certain restrictions.

Complementary Authority

Under Complementary Authority, the Federal Reserve has previously authorized FHCs, on a case-by-case basis, to engage in three types of commodities activities:

• “Physical Commodities Trading”—purchasing and selling commodities in the spot market, and taking and making delivery of physical commodities to settle commodity derivatives.

• “Energy Tolling”—paying power plant owners 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.

• “Energy Management Services”—providing transactions and advisory services to power plant owners.

Each Federal Reserve approval for an FHC to engage in such activities is accompanied by restrictions and prudential limits. For example, the Federal Reserve requires an FHC to limit the aggregate market value of commodities held under the Complementary Authority as a result of Physical Commodities Trading to no more than 5 percent of the FHC’s consolidated tier 1 capital, and similar size limits apply to Energy Tolling and Energy Management Services activities. Also, the Federal Reserve has not permitted FHCs to “own, operate, or invest in facilities for the extraction, transportation, storage, or distribution of commodities.”

The ANPR requests public comment on whether the restrictions that have accompanied Federal Reserve approvals under the Complementary Authority are adequate to protect safety and soundness and financial stability. The ANPR cited recent examples of environmental events that have resulted in large monetary and financial costs to the constituent parties and states that “[a]lthough the likelihood of a catastrophic event is small in the short term, catastrophes involving physical commodities continue to occur, and the resultant damages are very difficult to measure, even after the event has occurred, and may be extremely large.”

The ANPR also suggests that the Federal Reserve is placing an increased focus on macro-prudential risks (i.e., to the financial system generally) of commodities activities in addition to the micro-prudential risks (i.e., to the safety and soundness of the financial institution). The Federal Reserve stated that its review of commodities activities is consistent with its obligation under the Dodd-Frank Act to address systemic risks posed by large financial institutions. The Federal Reserve cites concerns relating to “market contagion,” and it notes that 11 of the 12 FHCs that are authorized to engage in activities under the Complementary Authority are also designated as global systemically important banks (G-SIBs) and two G-SIBs conduct physical commodities activities under the Grandfather Authority

To correct any potential inadequacies of existing prudential requirements imposed under the Complementary Authority, the Federal Reserve is considering the following limitations and restrictions: (i) enhanced capital requirements, (ii) increased insurance requirements, and (iii) forcing a reduction in these activities through “absolute dollar limits and caps based on a percentage of the FHC’s regulatory capital or revenue.” In assessing the possible costs of narrowing or eliminating the Complementary Authority, the Federal Reserve is also soliciting public comment regarding the relationship between physical commodities activities and the financial activities they complement.

Merchant Banking Authority

Under the Merchant Banking Authority, FHCs may make investments in nonfinancial companies, including companies engaged in commodities activities, subject to certain limitations, such as Regulation Y’s prohibition of FHCs engaging in routine management or operation of a merchant banking portfolio company, except in limited circumstances, and the 10-year holding period applicable to most merchant banking investments.2

In addition to the management and holding period restrictions noted above, the Federal Reserve imposes certain prudential requirements, such as the requirement that an FHC establish policies and procedures designed to ensure the maintenance of corporate separateness between the FHC and its merchant banking portfolio companies to protect the FHC and its subsidiary insured depository institutions from legal liability incurred by its portfolio companies.3

Similar to the concerns raised with respect to Complementary Authority, the Federal Reserve cites recent environmental disasters involving physical commodities that could subject portfolio companies to substantial legal, environmental, and reputational risk. Expanding the scope of the discussion beyond physical commodities activities, the Federal Reserve also notes that “other commercial activities” may pose the same or similar types of risks that could result in significant losses. As an example, the ANPR mentions that owners or operators of factories that use substances that are hazardous to public health or the environment may face significant risk. Specifically, the Federal Reserve is considering a number of actions to address the potential risks associated with all merchant banking investments, including: (i) more limited merchant banking investment holding periods; (ii) additional restrictions on routine management of merchant banking portfolio companies; (iii) additional capital requirements on some or all merchant banking investments; and (iv) enhanced reporting requirements to the Federal Reserve or public disclosures regarding merchant banking investments.

Grandfather Authority

Under the Grandfather Authority, companies that became bank holding companies and FHCs after Nov. 12, 1999, may continue to engage in activities related to the trading, sale, or investment in commodities if the company was engaged in the United States in commodities activities as of Sept. 30, 1997. The Grandfather Authority limits such activities to no more than 5 percent of an FHC’s total consolidated assets and prohibits FHCs from cross-marketing the services of its subsidiary depository institutions and its subsidiaries engaged in commodities activities under the Grandfather Authority. The ANPR does not list concerns regarding this authority specifically, but it requests public comment on whether, given the risks commodities activities may pose to safety and soundness, additional prudential requirements are necessary.

Michael T. Escue is a partner in the financial institutions group of Sullivan & Cromwell. Taylor C. Auten, an associate at the firm, assisted with the preparation of this article.

Endnotes:

1. Complementary Activities, Merchant Banking Activities, and Other Activities of Financial Holding Companies related to Physical Commodities, 79 FR 3329 (January 21, 2014). The Federal Reserve has extended the deadline for comments to April 16, 2014.

2. 12 C.F.R. §225.171–72.

3. 12 C.F.R. §175(a).