[On November 5, 2014,] the Board of Governors of the Federal Reserve System (the “Federal Reserve”) approved a final rule (the “Final Rule”) implementing Section 622 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”),[1] which establishes a financial sector concentration limit (the “Section 622 Concentration Limit”). The Section 622 Concentration Limit generally prohibits insured depository institutions, bank holding companies, foreign banking organizations (“FBOs”) that are treated as bank holding companies, savings and loan holding companies, other companies that control an insured depository institution, as well as nonbank financial companies designated by the Financial Stability Oversight Council for supervision by the Federal Reserve (each, a “financial company”)[2] from merging or consolidating with, or acquiring control of, another company if the resulting company’s total consolidated liabilities upon consummation would exceed 10 percent of the aggregate consolidated liabilities of all financial companies as calculated under Section 622 (“Total Financial Sector Liabilities”).

The Final Rule contains a number of notable revisions and clarifications from the Federal Reserve’s rule as originally proposed (the “Proposed Rule”),[3] including:

• Eliminating the Prior-Notice Requirement for Transactions that Do Not Cause a Financial Company to Exceed the Section 622 Concentration Limit: Under the Final Rule, financial companies are not required to provide written notice to the Federal Reserve in order to consummate a transaction that would cause the resulting financial company’s total consolidated liabilities to exceed eight percent of Total Financial Sector Liabilities immediately after consummation of the transaction, as would have been required under the Proposed Rule.
• Subjecting Controlled Merchant Banking Investments to the Section 622 Concentration Limit: The Final Rule, in a departure from the Proposed Rule, eliminates the exclusion of merchant banking acquisitions from the Section 622 Concentration Limit. As a result, a financial company would need to include relevant merchant banking investments that are “controlled” for bank regulatory purposes by the financial company in its calculation of its share of Total Financial Sector Liabilities and would be prohibited from making a controlling merchant banking investment if the investment would increase the financial company’s total consolidated liabilities above the 10 percent limit.
• Excluding Securitization Transactions from the Section 622 Concentration Limit: The Final Rule provides a new exception for certain securitization transactions by excluding from the definition of “covered acquisition” an acquisition of ownership or control of a company that is, or will be, an issuer of asset-backed securities (as defined in Section 3(a) of the Securities Exchange Act of 1934 (the “Exchange Act”)) so long as the financial company that retains an ownership interest in the company complies with the credit risk retention requirements of Section 941 of the Dodd-Frank Act.[4]
• Introducing a General Consent Process for Approval of Certain De Minimis Transactions: In implementing Section 622’s exception for de minimis transactions, the Final Rule provides a general consent for transactions that result in an increase in a financial company’s total consolidated liabilities of less than $100 million, when aggregated with all other acquisitions by the financial company under this general consent authority during the preceding 12 months. Transactions that exceed the $100 million threshold must receive advance approval from the Federal Reserve, and all de minimis transactions are subject to an aggregate cap of $2 billion over the preceding 12-month period.
• Adjusting the Calculation of Total Financial Sector Liabilities: The Final Rule provides adjustments to and clarifications of the Federal Reserve’s calculation of Total Financial Sector Liabilities, including that the Federal Reserve will calculate Total Financial Sector Liabilities for the initial compliance period beginning July 1, 2015 and ending June 30, 2016 (the “Initial Period”) using financial companies’ consolidated financial sector liabilities as of December 31, 2014, rather than as an average of the aggregate financial sector liabilities as of December 31, 2013 and December 31, 2014, as under the Proposed Rule. This change was in response to industry comment that it would be burdensome or impossible for certain financial companies that were not otherwise required to report this information as of December 31, 2013 to provide this data for purposes of Section 622. In all periods subsequent to the Initial Period, Total Financial Sector Liabilities will be calculated as the average of financial companies’ aggregate financial sector liabilities as of December 31 of each of the preceding two years.

The preamble to the Final Rule (the “Preamble”) states that the Final Rule is effective as of January 1, 2015. The Federal Reserve will not release its first measure of Financial Liabilities until “no later than July 1,” 2015, and the Preamble refers to the period beginning July 1, 2015 and ending June 30, 2016 as the “initial period.” Accordingly, it is likely that financial companies will not be expected to come into compliance with the Section 622 Concentration Limit until July 1, 2015 as a practical matter.

BACKGROUND

The Section 622 Concentration Limit prohibits a financial company from making an acquisition if, as a result of the acquisition, the financial company’s consolidated liabilities would exceed 10 percent of the aggregate liabilities of all financial companies. Acquisitions that are subject to the Section 622 Concentration Limit include transactions where a financial company merges and consolidates with, acquires all or substantially all of the assets of, or otherwise acquires control of, another company (each, a “covered acquisition”), using the Bank Holding Company Act definition of “control.”[5]

For purposes of the Section 622 Concentration Limit, “consolidated liabilities” of a financial company equals the company’s total risk-weighted assets determined under the risk-based capital rules applicable to bank holding companies minus regulatory capital as calculated under those rules.[6] The liabilities of financial companies not subject to consolidated risk-based capital rules are measured using “applicable accounting standards,” which would include “such other accounting standard or method of estimation that the [Federal Reserve] determines is appropriate. . . .”[7]

Section 622 complements two existing statutory restrictions on growth by large banking organizations: the Riegle-Neal Interstate Banking Act of 1994,[8] which prohibits bank holding companies from holding more than 10 percent of nationwide deposits, and Section 604(d) of the Dodd-Frank Act,[9] which establishes a “financial stability factor” which the Federal Reserve may employ to assess the “risk to the stability of the United States banking or financial system” against anticipated public benefit in evaluating proposed acquisitions, mergers, or consolidations.

DISCUSSION – HIGHLIGHTS

Notable elements of the Final Rule include:

A. ELIMINATION OF NOTICE PROVISIONS FOR TRANSACTIONS THAT DO NOT CAUSE THE RESULTING FINANCIAL COMPANY TO BREACH THE SECTION 622 CONCENTRATION LIMIT

In response to industry comment,[10] the Final Rule eliminates a provision in the Proposed Rule that would have required a financial company to provide written notice to the Federal Reserve by the earlier of (i) 60 days before consummation of the covered acquisition and (ii) 10 days after execution of the transaction agreement in order to consummate a transaction that would cause the resulting financial company’s liabilities to exceed eight percent of Total Financial Sector Liabilities immediately after consummation of the transaction. The requirement would have imposed an approval requirement on transactions that otherwise would not be subject to Federal Reserve review and approval.

Instead, the Preamble urges financial companies to implement policies and procedures to monitor compliance with Section 622, noting that a financial company that violates the Section 622 Concentration Limit by consummating an acquisition that would result in a breach of the limit may be required to divest any company or assets acquired in violation of the limit.

B. APPLICABILITY OF SECTION 622 TO CERTAIN CATEGORIES OF TRANSACTIONS

The Final Rule provides several important clarifications and adjustments regarding the categories of transactions that are deemed covered acquisitions pursuant to Section 622.

1. Controlling Merchant Banking Investments Are Covered Acquisitions

Under the Final Rule, unlike the Proposed Rule, controlling merchant banking investments are covered acquisitions. The Proposed Rule would have provided an exception for such transactions because a financial company generally acquires the shares for passive investment, holds the shares for a limited period of time and does not exert managerial control over the investment. In response to a comment letter from a consumer advocacy group, however, the Final Rule abandons the “passive investment” rationale for excluding merchant banking investments from the reach of Section 622 and instead draws a distinction between a non-targeted investment—such as the collection of a debt previously contracted, which will continue to be exempt from the Section 622 Concentration Limit under the Final Rule—and an “intentional investment decision,” such as the decision by a financial company to engage in a merchant banking transaction in order to invest in a nonfinancial company. In the Preamble, the Federal Reserve now suggests that Section 622 was intended as a comprehensive limitation on growth and that, absent evidence of Congressional intent to exclude a particular category of transaction, the Section 622 Concentration Limit should apply. Based on this rationale, the Final Rule brings merchant banking activities within the scope of Section 622.

Merchant banking investments where the covered financial company does not, as a result, “control” the target company for bank regulatory purposes[11] would still not be covered acquisitions for purposes of the Section 622 Concentration Limit.

2. Certain Securitization Transactions Excluded from the Section 622 Concentration Limit

In response to industry comment,[12] the Final Rule provides a new exclusion for certain securitization transactions that would allow a financial company to engage in a securitization transaction even if the transaction would cause the financial company’s liabilities to exceed the Section 622 Concentration Limit. Specifically, the Final Rule excludes the acquisition of ownership or control of a company that is, or will be, an issuer of asset-backed securities (as defined in Section 3(a) of the Exchange Act)[13] so long as the financial company that retains an ownership interest in the company complies with the credit risk retention requirements of Section 941 of the Dodd-Frank Act. The Final Rule does not provide any guidelines for when the asset-backed security must be issued after the acquisition by the financial company.

This new exclusion from the definition of covered acquisition under the Final Rule would not, however, appear to cover transactions that involve the acquisition of a legal entity instead of the underlying assets—for example, where 100 percent of the equity of a limited liability company that owns a pool of loans is purchased instead of the underlying pool of loans itself—to the extent the entity being acquired does not purport to issue asset-backed securities (as defined in the Exchange Act) in the future.

3. No Relief for Ordinary Course Business Transactions Structured as Controlling Investments

The Final Rule was not modified from the Proposed Rule to address commenters’ concerns that the Section 622 Concentration Limit may hinder financial companies’ ability to continue to engage in a wide range of ordinary-course business transactions, such as small business and community development investments or leases, that are commonly structured as controlling investments in an entity. As a result, as a financial company approaches the Section 622 Concentration Limit, it will need to take special care in evaluating whether even such ordinary-course business transactions that are structured as investments in an entity will be controlling investments and, therefore, subject to the limit.

C. PRIOR CONSENT FOR DE MINIMIS TRANSACTIONS

Under the Final Rule, as under the Proposed Rule, a financial company may rely on Section 622’s de minimis exception to engage in transactions that exceed the Section 622 Concentration Limit by up to $2 billion in the aggregate during any 12-month period. A financial company seeking to rely on the de minimis exception generally must follow the prior-approval procedures described in the next paragraph. In response to industry comment,[14] however, the Final Rule establishes a general consent process (the “De Minimis General Consent”) for a transaction that would result in an increase in a financial company’s total consolidated liabilities of less than $100 million, when aggregated with all other acquisitions by the financial company under the De Minimis General Consent during the 12 months preceding the date of the transaction. A financial company relying on the De Minimis General Consent must provide notice to the Federal Reserve within 10 days of the acquisition.[15]

Under the Final Rule, if a covered acquisition would cause a financial company to exceed the $100 million limit of the De Minimis General Consent, a financial company seeking to rely on the de minimis exception must file a request with the Federal Reserve prior to consummation of the proposed transaction. The Final Rule provides that the Federal Reserve will act on such requests within 90 days after receipt of the “complete request unless that time period is extended by the [Federal Reserve].” Based on past practice, it is likely that the Federal Reserve would not consider the 90-day period to have begun until it considers the application request to be complete, rather than when the request is first sent. In response to industry comment,[16] the Final Rule also establishes that the standard under which the Federal Reserve will review a transaction under the de minimis exception is “whether the consummation of the covered acquisition could pose a threat to financial stability.” This is a rigorous standard, which appears to set a high bar for the Federal Reserve to object to a proposed transaction, particularly in the case of an ordinary course “covered acquisition” within the $2 billion threshold.

D. CALCULATING TOTAL FINANCIAL SECTOR LIABILITIES

The Final Rule preserves the basic approach of the Proposed Rule to calculating liabilities but makes several important modifications and clarifications to the calculation of Total Financial Sector Liabilities:

• First, under the Final Rule, for the Initial Period, the Federal Reserve will calculate Total Financial Sector Liabilities by aggregating individual financial companies’ financial sector liabilities as of December 31, 2014. The Proposed Rule would have calculated Total Financial Sector Liabilities for the Initial Period as the average of aggregate financial sector liabilities as of December 31, 2013 and December 31, 2014. This change was in response to industry comment that it would be burdensome or impossible for certain financial companies that were not otherwise required to report this information as of December 31, 2013 to provide this data for purposes of Section 622. Consistent with the Proposed Rule, in all subsequent periods, Total Financial Sector Liabilities will be calculated as the average of the aggregate financial sector liabilities as of December 31 for each of the preceding two calendar years.
• Second, the Preamble notes that the Federal Reserve will “consider adjusting” the methodology for calculating Total Financial Sector Liabilities “if necessary because of future regulatory changes” that may have destabilizing or distortive effects on the application of the Section 622 Concentration Limit.
• Third, the Preamble clarifies that certain mutual and fraternal insurance companies that prepare financial statements in accordance with statutory accounting principles (“SAP”) rather than U.S. generally accepted accounting principles (“U.S. GAAP”) may file an estimate of consolidated liabilities as calculated under SAP. According to the Preamble, an estimation under SAP is subject to the Federal Reserve’s “review and adjustment.”
• Fourth, covered financial companies that have not previously reported consolidated financial information to any federal banking regulator will report their consolidated financial sector liabilities on a Financial Company Report of Consolidated Liabilities (“FR XX-1”). The Federal Reserve will collect the first Form XX-1s on March 31, 2015.

E. THE FINAL RULE’S IMPACTS ON U.S. FINANCIAL COMPANIES VERSUS FOREIGN BANKING ORGANIZATIONS

In calculating the liabilities of an FBO, the Final Rule, like the Proposed Rule, looks only to the FBO’s “U.S. operations,” which is defined as the liabilities of all U.S. branches, agencies and subsidiaries of the FBO that are domiciled in the United States. The Final Rule thus has the effect of favoring business combinations between U.S. financial companies and foreign companies that are structured, as a legal matter, such that the foreign financial entity is the technical survivor of the merger, for example, even where the U.S. financial company is the larger counterparty or where the merger is a merger of equals.

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[1] Codified at 12 U.S.C. § 1852.

[2] 12 U.S.C. § 1852(a)(2).

[3] The Proposed Rule was published by the Federal Reserve in the Federal Register in May 2014. The Federal Reserve, Concentration Limits on Large Financial Companies, 79 Fed. Reg. 27801 (May 15, 2014). For additional information regarding the Proposed Rule, see our memorandum to clients titled Dodd-Frank Act: Additional Concentration Limits on Large Financial Companies; Federal Reserve Proposes Rules Implementing Dodd-Frank Section 622’s Prohibition on Business Combinations Where the Resulting Financial Company’s Total Consolidated Liabilities Would Exceed 10 Percent of Aggregate U.S. Financial Sector Liabilities (May 28, 2014), available at http://www.sullcrom.com/dodd-frank-act-additional-concentration-limits-on-large-financial-companies.

[4] 15 U.S.C. § 78o-11.

[5] Section 2(a)(2) of the Bank Holding Company Act identifies “control” where an entity (i) directly or indirectly, or acting through one or more other persons, owns, controls, or has the power to vote 25 percent or more of any class of voting securities of the company; (ii) controls in any manner the election of a majority of the directors or trustees of the company; or (iii) directly or indirectly exercises a controlling influence over the management or policies of the company. 12 U.S.C. § 1841(a)(2).

[6] Under the Final Rule, as under the Proposed Rule, U.S. financial companies that are not subject to consolidated risk-based capital rules, such as savings and loan holding companies, nonbank financial companies supervised by the Federal Reserve, bank holding companies with total consolidated assets of less than $500 million and U.S. depository institution holding companies that are not bank holding companies or savings and loan holding companies, must calculate liabilities in accordance with “applicable accounting standards,” which includes GAAP “or such other accounting standard or method of estimation that the [Federal Reserve] determines is appropriate.” As any of these types of entities becomes subject to risk-based capital rules under new regulations, they will then calculate their liabilities for purposes of Section 622 using the rules applicable to bank holding companies. Under the Final Rule, the calculation methodology applicable to U.S. financial companies subject to consolidated risk-based capital rules and foreign financial companies is unchanged from the Proposed Rule. Additional detail regarding the Federal Reserve’s calculation methodology is provided in Section D.

[7] Final Rule § 251.2(a).

[8] 12 U.S.C. § 1842(d)(2).

[9] 12 U.S.C. § 1842(c)(7). The growth of large banking organizations is further restrained by federal antitrust provisions.

[10] See The Clearing House Association L.L.C., Comment Letter Regarding Proposed Rule for the Dodd-Frank Financial Sector Concentration Limits (July 8, 2014), at 14-15, available at https://www.theclearinghouse.org/issues/banking-regulations/dodd-frank/20140708-tch-comments-on-concentration-limit (“The Clearing House Comment Letter”).

[11] See footnote 5.

[12] See The Clearing House Comment Letter at 8.

[13] The Exchange Act defines “Asset-backed security” as “a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including (i) a collateralized mortgage obligation; (ii) a collateralized debt obligations; (iii) a collateralized bond obligations; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the [Securities and Exchange Commission], by rule, determines to be an asset-backed security for purposes of this section; and does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.”

[14] See The Clearing House Comment Letter at 13.

[15] The Final Rule does not specify whether a financial company must report the aggregate increase in its liabilities resulting from all acquisitions during the 12 months preceding the projected date of the acquisition or only the increases resulting from transactions in which the financial company relied on the de minimis exception or the De Minimis General Consent.

[16] See The Clearing House Comment Letter at 13.

The full and original memorandum was published by Sullivan & Cromwell LLP on November 12, 2014, and is available here.