Accept All Cookies
H.R. 4173, the “Wall Street Reform and Consumer Protection Act of 2009” (the “bill”), passed the House of Representatives on December 11, 2009 and garnered substantial publicity as to its requirements for the registration of fund advisers and the further regulation of derivatives.1 Little has been written, however, as to how the bill’s systemic regulation provisions could affect private funds. The bill offers at least two ways in which funds could be affected: the first perhaps unlikely, but very significant; the second less significant, but more likely. Each of these two concerns is summarized below.
Title I of the bill imposes “prudential safeguards” on firms that (i) are deemed to engage, directly or indirectly, in “financial activities” (an undefined term) (ii) if regulators2 determine that either (a) material financial distress at the firm could pose a threat to financial stability or the economy or (b) the nature, scope, size, scale, concentration, and interconnectedness or mix of the firm’s activities pose such a threat (we will call (a) and (b) the “economic threat” determination).3
There would seem little doubt that hedge funds are, and private equity funds very likely are, engaged in “financial activities,” so the primary inquiry for the regulators would be whether such funds pose an “economic threat.” The bill refers to firms as to which an “economic threat” determination has been made as “financial holding companies subject to stricter supervision” (“FHCSSS”).4 A company may be an FHCSSS without regard to whether it owns a bank or qualifies as a “financial holding company” under the Bank Holding Company Act. Thus, essentially all private funds risk designation as an FHCSSS by federal regulators under the bill.5
Of course, the obvious intent of the bill is that the firms designated to be an FHCSSSs would be the largest systemically significant firms, such as Citi, BofA, JP Morgan Chase, Morgan, and Goldman. However, there is no provision in the legislation precluding regulators from designating smaller firms an FHCSSS, indeed much smaller firms. Obviously, regulators have a natural conservative inclination to regulate where they have power to do so (and where they might be cr iticized for failing to do so), and it is not at all inconceivable that, in this case, they would strive to avoid blame for future crises by being generous in awarding FHCSSS status. Unintentionally illustrating this concern, Senator Charles Schumer at a hearing of the Senate Banking Committee two days ago suggested that 50 small but highly correlated hedge funds might combine to create systemic risk.
A determination that a fund is an FHCSSS would trigger severe negative consequences for the fund as generally summarized below.
Obviously, the consequences of a fund being deemed an FHCSSS are very serious and very adverse to the ongoing functioning of its business, and, while the risk of such designation for most funds may not be high, it is there nonetheless.
A more certain, albeit less significant, burden the House-passed bill would impose on large funds and other financial companies is semi-annual stress testing.
Specifically, the bill passed requires that any financial company (even those not designated a FHCSSS) that has more than $10 billion in total assets and is in part or in whole engaged directly or indirectly in financial activities must conduct semiannual stress tests under “baseline,” “adverse,” and “severely adverse” conditions, and must report the results to its primary federal regulator and the Federal Reserve Board.10
The bill further provides that, if the effect of the financial company’s stress test shows that it is significantly or critically undercapitalized (possibly less than 2% tangible equity to total assets, which is the test for an FHCSSS to be deemed critically undercapitalized) under baseline or adverse conditions, it must file a “living will” (rapid resolution plan) with the Federal Reserve Board.11
Thus, even if a large fund were to escape FHCSSS designation, it would have to undergo and pay for semi-annual stress tests and report the results and, if such tests suggest a sufficient decline in capital levels, it would be required to prepare and file with the Federal Reserve Board a “living will” that describes its plans for liquidation and dissolution.
Of course, these new government powers are based on the version of the bill that has passed the House, and no bill as of this writing has been introduced yet in the Senate.
1 See H.R. 4173 (the “bill”).
2 Under the bill, the Financial Services Oversight Council (“FSOC”) is tasked with making “economic threat” determinations. The FSOC would be comprised of the Chairpersons of the federal banking, securities, and commodities agencies, as well as the Secretary of the Treasury. Although the FSOC makes these determination, the Federal Reserve Board acts as “agent” of the FSOC in the implementation of such determinations. See Section 1100 of the bill. Note, as well, the “tie-breaking” function that the FSOC would offer in the event of regulatory disputes between the federal financial agencies. See Section 1002 of the bill.
3 Section 1103(a) of the bill. One of the factors the regulators are to consider is “[t]he extent to which assets are simply managed and not owned by the financial company and the extent to which ownership of assets under management is diffuse”, which would appear to reflect legislative awareness that a fund could be an FHCSSS. Other criteria the regulators are to apply in determining whether a financial firm poses systemic risk include leverage, off-balance sheet exposures, interconnectedness with other financial firms, the firm’s importance as a source of credit and liquidity (including the impact of failure on availability of credit to low-income, minority, and underserved communities), activities, degree of existing regulation of the firm, size, and reliance on short-term funding.
4 All of the new draft legislation has made it virtually impossible for potentially newly regulated entities to obtain a desirable acronym, e.g., one with four letters or less that includes a centrally-placed vowel. It is currently projected that by 2016, all new regulatory acronyms will require a 3-digit “area code” to distinguish them.
5 A firm designated an FHCSSS would have a right to appeal the designation to a federal court of appeals. However, it is not likely that a federal court would substitute its judgment as to systemic risk for the judgment of the regulators. Thus, the right of appeal appears ineffectual.
6 Section 1104(a)(2)(A)(i) of the bill. Again, this reflects conscious consideration by the drafters that a fund can be an FHCSSS.
7 Section 1103(f)(1)(A) of the bill.
8 Section 1103(f)(3) of the bill.
9 Section 1104(c)(2) of the bill.
10 Section 1115(b) of the bill.
11 Section 1104(f)(3)(B) of the bill.