D.C. District Court Rescinds FSOC s Designation of MetLife as Systemically Important

D.C. District Court Rescinds FSOC s Designation of MetLife as Systemically Important Decision Cites Fundamental Violations of Established Administrative Law, Including a Failure to Consider the Costs of Regulation and Unexplained Deviations From Prior Regulatory Guidance INTRODUCTION On March 30, 2016, in MetLife, Inc. v. Financial Stability Oversight Council, Judge Rosemary M. Collyer of the U.S. District Court for the District of Columbia (the Court ) rescinded the designation of MetLife, Inc. ( MetLife ) by the Financial Stability Oversight Council ( FSOC ) as a systemically important nonbank financial company under Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ). 1 The Court concluded that, although MetLife is a nonbank financial company eligible for designation under Section 113 of the Dodd-Frank Act, 2 FSOC s basis for designating MetLife was fatally flawed in at least three respects. First, FSOC deviated from its own guidance without explanation by failing to assess MetLife s actual vulnerability to financial distress. Second, FSOC failed to establish a basis for a finding that MetLife s material financial distress would cause an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy, within the meaning of FSOC s guidance. Third, FSOC failed to weigh the perceived benefits of designating MetLife against the possible costs of taking such action, including the possibility that imposing billions of dollars in cost could actually make MetLife more vulnerable to distress. 3 New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com

MetLife raised other grounds for rescinding the designation, but the Court concluded that these three flaws were sufficient to justify granting the relief requested by MetLife and did not reach those other grounds. LEGAL FRAMEWORK Section 113 of the Dodd-Frank Act empowers FSOC, an interagency body chaired by the Secretary of the Treasury, to designate certain nonbank financial companies for supervision by the Board of Governors of the Federal Reserve System (the Federal Reserve ) and application of enhanced prudential standards. 4 Members of FSOC include the Chairs of the Federal Reserve, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, and the Commodity Futures Trading Commission, as well as the heads of several other Federal agencies, an independent insurance expert appointed by the President and several non-voting representatives, including state regulators. -2- As of the date of this memorandum, four nonbank financial companies have been designated by FSOC: American International Group, Inc., General Electric Capital Corporation, Inc., Prudential Financial, Inc. and MetLife. March 31, 2016, General Electric Capital Corporation, Inc. submitted a petition to FSOC seeking to rescind its designation in light of material changes in its operations. A. ELIGIBILITY FOR DESIGNATION To be eligible for designation under Section 113(a) of the Dodd-Frank Act, a company must be a U.S. nonbank financial company. 5 A company incorporated or organized in the United States qualifies as a U.S. nonbank financial company if it is predominantly engaged in financial activities, meaning that 85% of its consolidated assets are related to, or 85% of its consolidated annual gross revenues are derived from, activities that are financial in nature, as that phrase is defined in Section 4(k) of the Bank Holding Company Act (the BHC Act ). 6 Under Section 4(k) of the BHC Act, activities that are financial in nature include, in relevant part, (i) engaging in certain specified insurance activities in any State, and (ii) acquiring or controlling, by an insurance company, certain investments that, among other things, are made in the ordinary course and in accordance with relevant State law governing such investments, subject to restrictions on the parent company routinely manag[ing] or operat[ing] the investee company. 7 B. CRITERIA FOR DESIGNATION A nonbank financial company may be designated by FSOC for enhanced supervision under either of two determination standards: (i) when material financial distress at the company could pose a threat to the financial stability of the United States (the First Determination Standard ), or (ii) when the nature, scope, size, scale, concentration, interconnectedness or mix of the [company s] activities could pose the same threat (the Second Determination Standard ). 8 On In respect of the First Determination Standard (which was the basis on which FSOC designated MetLife), Congress identified ten factors that FSOC

must consider in determining whether material financial distress at a company could pose a threat to U.S. financial stability, and it also provided that FSOC shall consider any other risk-related factors that [it] deems appropriate. 9 In its guidance for nonbank financial company determinations (the Guidance ), 10 FSOC stated that it had incorporated the statutory factors into an analytic framework consisting of six categories: size, interconnectedness, substitutability, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny. The Guidance further stated that with respect to these six categories: three categories (interconnectedness, substitutability, and size) seek to assess the potential impact of the nonbank financial company s financial distress on the broader economy ; and the remaining three categories (leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny) seek to assess the vulnerability of a nonbank financial company to financial distress. 11 FSOC further elaborated in the Guidance that it would consider a threat to the financial stability of the United States to exist if there would be an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy. 12 Significant damage on the broader economy, according to the Guidance, might be inflicted through any one of several transmission channels. FSOC identified the following three channels as the most likely to facilitate the transmission of the effects of a company s material financial distress in this regard: the exposure transmission channel ( Exposure Channel ), which considers whether exposures of a company s creditors, counterparties, investors or other market participants to the company are significant enough to materially impair those entities; the asset liquidation transmission channel ( Asset Liquidation Channel ), which considers whether the company holds assets that, if liquidated rapidly, could cause a fall in asset prices and result in a significant disruption to trading or funding in key markets or cause significant losses or funding problems for other firms with similar holdings; and the critical function or service transmission channel ( Critical Function or Service Channel ), which considers whether the company would no longer be willing or able to provide a critical function or service relied on by market participants that is not readily substituted. 13 FSOC added that the degree to which an institution is complex, opaque, or difficult to resolve in bankruptcy such that its resolution in bankruptcy would disrupt key markets or have a material adverse impact on other financial firms or markets is also relevant to determining whether that institution is likely to constitute a threat to U.S. financial stability. 14 C. CONSEQUENCES OF DESIGNATION Upon designation, a company becomes subject to supervision by the Federal Reserve, the application of enhanced prudential standards, and restrictions on certain merger or acquisition transactions. 15 Federal Reserve has the authority to examine and require reports of designated nonbank financial companies. 16 In addition, such companies are subject to the Federal Reserve s Large Institution -3- The

Supervision Coordinating Committee supervision framework; as set forth in the Federal Reserve s Supervision and Regulation Letter 12-17, the Federal Reserve s risk management guidance and supervisory expectations in this regard cover areas such as capital and liquidity planning, corporate governance, recovery and resolution planning, and the management of core business lines, among others. 17 Although thus far the Federal Reserve has promulgated comprehensive enhanced prudential standards for only one designated nonbank financial company, 18 these standards are generally required by statute to include, at a minimum, risk-based capital requirements and leverage limits, liquidity requirements, overall risk management requirements, resolution plan and credit exposure report requirements and concentration limits. 19 The Federal Reserve may also establish additional standards, such as a contingent capital requirement, enhanced public disclosures and short-term debt limits, as well as such other prudential standards as it deems appropriate. 20 Section 163(b) of the Dodd-Frank Act generally requires a designated nonbank financial company to provide prior notice to the Federal Reserve before acquiring voting shares of any company (other than an insured depository institution) that is engaged in financial activities and that has total consolidated assets of $10 billion or more. 21 In connection with its review of such a notice, the Federal Reserve is required to consider a number of factors, including the extent to which the proposed acquisition would result in greater or more concentrated risks to global or U.S. financial stability or the U.S. economy. 22 In addition, Section 622 of the Dodd-Frank Act prohibits a designated nonbank financial company from merging or consolidating with, or acquiring, another company if the resulting company s liabilities upon consummation would exceed 10 percent of the aggregate liabilities of all financial companies. 23 D. REVIEW OF DESIGNATION FSOC is required to reevaluate its designations annually, and a designated entity may apply to have its designation rescinded. FSOC s reevaluation process considers whether any material changes at the company justify a rescission of the designation. 24 PROCEDURAL HISTORY On July 16, 2013, FSOC notified MetLife that the company had reached Stage 3 of FSOC s designation process. On September 4, 2014, FSOC voted to make a proposed determination regarding MetLife, and provided MetLife with a Notice of Proposed Determination (the NPD ) setting forth its grounds for proposing designation. On October 3, 2014, MetLife filed a notice invoking its right to a hearing contesting the proposed determination, and submitted evidence and arguments challenging the grounds for designation set forth in the NPD. A non-public hearing before FSOC was held on November 3, 2014. 25-4-

On December 18, 2014, in a 9-1 decision, FSOC voted to designate MetLife under Section 113 of the Dodd-Frank Act and provided MetLife with an Explanation of the Basis of [FSOC] s Final Determination (the Final Determination ). The Final Determination explained that FSOC had based MetLife s designation on the First Determination Standard that material financial distress at MetLife could pose a threat to the financial stability of the United States. 26 As explained by the Court in its March 30, 2016 opinion, the Final Determination reached four primary conclusions: (i) counterparties could suffer significant losses if MetLife experienced material financial distress (i.e., through the Exposure Channel), (ii) financial distress might prompt MetLife to liquidate assets quickly and thereby disrupt capital markets (i.e., through the Asset Liquidation Channel), (iii) existing regulatory scrutiny would not be able to stop either threat from being realized, but rather would risk exacerbating those threats, and (iv) MetLife s complexity would hamper its resolution and thus prolong uncertainty, requiring coordination among numerous regulators, receivers or courts. 27 The independent member of FSOC having insurance expertise dissented from the Final Determination, stating that the Final Determination conclude[d] that the origin of the company s systemic risk would stem from a sudden and unforeseen insolvency of unprecedented scale, of unexplained causation, and without effective regulatory responses or safeguards. 28 FSOC s non-voting state insurance commissioner representative also wrote separately in opposition to the Final Determination, stating that the Council failed to appropriately consider the efficacy of the state insurance regulatory system, used a flawed asset liquidation argument, and failed to address criticism that it did not conduct a robust analysis of characteristics of MetLife beyond its size. 29 On January 13, 2015, MetLife filed a complaint (the Complaint ) in the U.S. District Court for the District of Columbia challenging FSOC s designation, as permitted under Section 113(h) of the Dodd-Frank Act, and subsequently filed a motion for summary judgment. The Department of Justice, on behalf of FSOC, filed a cross-motion for summary judgment. Oral argument was held before Judge Rosemary M. Collyer on February 10, 2016. THE OPINION On March 30, 2016, Judge Collyer issued an opinion under seal and an accompanying order granting in part MetLife s motion for summary judgment, denying the Department of Justice s cross-motion for summary judgment, and rescinding the Final Determination. The opinion was unsealed and released publicly on. The Court granted MetLife s cross-motion for summary judgment as to Counts IV, VI (in part) and VII, which argued as follows: Count IV FSOC s designation of MetLife was arbitrary and capricious and violated the Dodd- Frank Act, FSOC s own regulations, and the Administrative Procedure Act ( APA ) 30 because FSOC failed to assess MetLife s vulnerability to material financial distress; -5-

Count VI FSOC s designation of MetLife was arbitrary and capricious and violated the Dodd- Frank Act and the APA because it depended upon unsubstantiated, indefinite assumptions and speculation both with respect to the severity of hypothetical material financial distress at MetLife, and with respect to the effect that MetLife s material financial distress could have on the broader economy which failed to satisfy the statutory standards for designation and FSOC s own interpretive guidance; 31 and Count VII FSOC s designation of MetLife was arbitrary and capricious and violated the Dodd- Frank Act and the APA because FSOC failed to consider the economic effects (the costs) of designation on MetLife. In the opinion, the Court concluded that FSOC s Final Determination was founded on fundamental violations of established administrative law. 32 In particular, FSOC, without explanation, reversed itself on whether MetLife s vulnerability to financial distress would be considered and on what it means to threaten the financial stability of the United States, deviating from its own Guidance, and focused exclusively on the presumed benefits of its designation and ignored the attendant costs. 33 The Court dismissed Count I, in which MetLife argued that it cannot be designated because it is not a nonbank financial company under Section 113 of the Dodd-Frank Act (because of its extensive foreign operations), but, having concluded that the relief sought by MetLife could be granted on the basis of Counts IV, VI and VII, the Court determined it was unnecessary to consider the remaining counts MetLife asserted in its Complaint. A. METLIFE IS ELIGIBLE FOR DESIGNATION As a threshold matter, the Court concluded that MetLife was a nonbank financial company eligible for designation because it was predominantly engaged in financial activities. More than 30% of MetLife s consolidated assets and more than 25% of its consolidated revenues are extraterritorial, and MetLife argued that those foreign activities are not financial in nature under the applicable statutory definitions. 34 The Court concluded that the investments made by MetLife s subsidiary American Life Insurance Company ( ALICO ) in foreign insurance companies are financial in nature under Section 4(k)(4)(I) of the BHC Act as insurance company investments. 35 The Court also concluded that, even if MetLife s foreign insurance activities are not themselves financial, those activities are related to MetLife s domestic insurance activities (which are themselves financial in nature under Section 4(k)(4)(B) of the BHC Act) under the broad meaning of the term related to. 36 Accordingly, the Court concluded that MetLife is a nonbank financial company eligible for designation under Section 113 of the Dodd-Frank Act. B. FSOC DEVIATED WITHOUT ACKNOWLEDGEMENT OR EXPLANATION FROM ITS PRIOR GUIDANCE PROVIDING FOR AN ASSESSMENT OF AN ENTITY S VULNERABILITY TO FINANCIAL DISTRESS The Court noted that the Guidance promulgated by FSOC contemplated two separate inquiries: (i) an assessment of the vulnerability of a nonbank financial company to financial distress, 37 separate assessment of the impact of such distress on national financial stability. 38-6- and (ii) a FSOC argued that

the two separate inquiries cited in the Guidance should be interpreted as a single inquiry, as the very risks that can make a company vulnerable to distress are the ones that can cause its distress to pose a threat to the broader economy, and that, as a result, the Final Determination reflected no change in position on the part of FSOC. 39 Guidance] in consequential fashion. 40 The Court rejected this argument, concluding that it misstates [the In the Court s view, the Guidance clearly contemplated a separate inquiry into the vulnerability of a nonbank financial company to financial distress; because FSOC failed to explain its deviating from the Guidance, the Court concluded that this change in position was arbitrary and capricious. 41 C. FSOC DID NOT UNDERTAKE REASONED ANALYSIS OF THE THREAT DISTRESS AT METLIFE COULD POSE TO U.S. FINANCIAL STABILITY The Court also concluded that FSOC did not under either the Exposure or Asset Liquidation [C]hannels apply the standard announced in the Guidance 42 that it will consider a threat to U.S. financial stability to exist if there would be an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy. 43-7- In fact, the Court concluded, the Final Determination hardly adhered to any standard when it came to assessing MetLife s threat to U.S. financial stability. The Exposure [C]hannel analysis merely summed gross potential market exposures, without regard to collateral or other mitigating factors, and every possible effect of MetLife s imminent insolvency was summarily deemed grave enough to damage the economy. 44 In response to the Department of Justice s arguments that FSOC should be granted leeway to make predictive judgments about a company s possible threat to U.S. financial stability, the Court flatly stated that [p]redictive judgment must be based on reasoned predictions; a summary of exposures and assets is not a prediction. 45 D. FSOC IMPROPERLY IGNORED THE COSTS OF DESIGNATION The Court identified a third fundamental flaw in FSOC s reasoning: it intentionally refused to consider the cost of regulation, a consideration that is essential to reasoned rulemaking. 46 In the Complaint, MetLife highlighted the significant economic costs that could result from designation, including the imposition of higher capital requirements to which most of its principal competitors would not be subject. These capital requirements could force MetLife to increase costs to consumers and potentially withdraw from certain markets, or, if MetLife chose not to take such action, result in the loss of billions of dollars in value due to the resulting reduction in its return on investment. 47 FSOC argued that it was not required to consider these costs, as Section 113(a)(2)(K) of the Dodd-Frank Act did not explicitly require any consideration of such costs, 48 instead mandating that FSOC must consider any other risk-related factors that [it] deems appropriate. 49 The Court noted, however, that, as held by the U.S. Supreme Court in Michigan v. Environmental Protection Agency, 50 [a]ppropriate and necessary plainly subsumes consideration of cost, 51 adding that the qualifier risk-related used in Section 113(a)(2)(K) of the Dodd-Frank Act further implies that

FSOC was required to consider both the risk of destabilizing the market and the risk of distress in the first place. 52 The Court noted that FSOC never responded to MetLife s allegation that imposing billions of dollars in cost could actually make MetLife more vulnerable to distress. 53 FSOC s refusal to consider cost as part of its calculus made it impossible to know whether its designation does significantly more harm than good and in itself rendered the Final Determination, in the Court s view, arbitrary and capricious. 54 The Court also rejected FSOC s argument that, even if cost is a risk-related factor, it should only be considered later, when it can be determined under the yet unwritten enhanced prudential standards, on the basis that a court may uphold agency action only on the grounds that the agency invoked when it took the action, and that FSOC s Final Determination, instead of arguing that the possible costs of regulation should be considered at some later point, summarily concluded that these costs should not be considered at all. 55 FUTURE DEVELOPMENTS AND IMPLICATIONS OF THE OPINION The Department of Justice has not, as of the date of this memorandum, announced whether it will appeal the Court s order, but it has 60 days to do so. 56 also decide whether to seek a stay. If the Department of Justice decides to appeal, it must The Court s opinion reinforces the importance of a cost-benefit analysis to the proper framing of regulation and to the operation of the administrative decision-making process, including where a regulator is engaging in predictive judgments and where such costs remain uncertain. As the Court noted in its opinion (quoting Michigan), reasonable regulation ordinarily requires paying attention to the advantages and the disadvantages of agency decisions. 57 The Court s opinion is likely to influence the analysis undertaken by FSOC in annually reevaluating its existing designations and in adjudicating requests to rescind existing designations. As noted, on March 31, 2016, General Electric Capital Corporation, Inc. submitted a request to FSOC to rescind its designation. If there is an appeal, other arguments raised by MetLife, regarding both defects in the designation process and the substance of the Final Determination, which the Court did not reach, could be raised as possible alternative grounds for affirming the Court s ruling. These alleged defects arose from, among other things, (i) FSOC s failure to consider less costly alternatives to designation and to provide a reasoned explanation for rejecting such alternatives, and (ii) the fact that the same officials at FSOC were involved in multiple phases of the designation process, which MetLife alleged violated the Due Process Clause of the Fifth Amendment and the constitutional separation of powers. 58 Copyright Sullivan & Cromwell LLP 2016 * * * -8-

ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 C.A. No. 15-0045 (D.D.C. Mar. 30, 2016). Sullivan & Cromwell LLP, along with other law firms, represented MetLife in connection with the FSOC designation process. 12 U.S.C. 5323(a). MetLife, slip op. at 32. 12 U.S.C. 5323(a). Id. Similar provisions apply to the designation of foreign nonbank financial companies. See id. 5323(b). Id. 5311(a)(4)(B), (a)(6). Id. 1843(k)(4)(A)-(I). Id. 5323(a)(1). Id. 5323(a)(2). 12 C.F.R. 1310 App. A. Id. 1310 App. A.II.d.1. Id. 1310 App. A.II.a. Id. Id. See 12 U.S.C. 5365(b)(1)(A) (requiring the Federal Reserve to establish enhanced prudential standards); 5363(b) (establishing prior notice requirements for certain acquisitions); 1852 (establishing concentration limits). 12 U.S.C. 5361. Federal Reserve, Supervision and Regulation Letter 12-17: Consolidated Supervision Framework for Large Financial Institutions (Dec. 17, 2012). See Federal Reserve, Final Order Applying Enhanced Prudential Standards and Reporting Requirements to General Electric Capital Corporation, 80 Fed. Reg. 44,111 (July 24, 2015). 12 U.S.C. 5365(b)(1)(A). The requirement to submit a resolution plan has already been established by rule for all designated nonbank financial companies. See 12 C.F.R. part 243. 12 U.S.C. 5323(b)(1)(B). Id. 5363(b). Id. 5363(b)(4). 12 U.S.C. 1852; 12 C.F.R. part 251. 12 C.F.R. 1310.23. See also FSOC, Nonbank Designations FAQs, q. 18 (Feb. 4, 2015), available at http://www.treasury.gov/initiatives/fsoc/designations/pages/nonbank-faq.aspx. MetLife, slip op. at 11. Id. at 11 (quoting the Final Determination). Id. at 12. Explanation of the Basis of the Financial Stability Oversight Council s Final Determination that Material Financial Distress at MetLife Could Pose a Threat to U.S. Financial Stability and that MetLife Should be Supervised by the Board of Governors of the Federal Reserve System and Be Subject to Prudential Standards (Dec. 18, 2014), Dissenting and Minority Views at 3, available at -9-

29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 ENDNOTES (CONTINUED) http://1.usa.gov/1oq5dyj. See also id. at 2 (stating that FSOC s Asset Liquidation Channel analysis relie[d] on implausible, contrived scenarios as well as failures to appreciate fundamental aspects of insurance and annuity products, and, importantly, State insurance regulation and the framework of the McCarran-Ferguson Act ). Id. at 7. See also id. at 10 (stating that the Final Determination ma[de] claims that retail policyholder or corporate customers would suffer losses as a result of the material financial distress at MetLife, but [did] not detail how those losses translate into an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy ). 5 U.S.C. 500 et seq. The Court stated that it does not accept all of the theories alleged in Count VI, but rests its decision on the basis that FSOC erred as a matter of administrative law by contradicting its own Guidance. MetLife, slip op. at 25, fn.19. The Court did not discuss MetLife s allegations regarding the assumptions FSOC used in respect of the severity of MetLife s hypothetical material financial distress, including with respect to the macroeconomic environment and the assumed responses of policyholders and state regulators, among others. MetLife, slip op. at 33. Id. at 1. See 12 U.S.C. 1843(k)(4)(B) (applying to insurance activities in any State ); id. 1843(k)(4)(I) (applying to insurance company investments made in the ordinary course of business in accordance with State law, and subject to limitations on routinely manag[ing] or operat[ing] the investee company). MetLife, slip op. at 14-16. MetLife had argued that these foreign insurance investments did not qualify as financial in nature under Section 4(k)(4)(I) because, among other reasons, MetLife routinely manages and operates its foreign insurance subsidiaries. Cf. 12 U.S.C. 1843(k)(4)(I)(iv). MetLife, slip op. at 17-18. Under the statutory definition, a company is predominantly engaged in financial activities if 85% of its consolidated assets are related to financial activities. 12 U.S.C. 5311(a)(6). Id. at 19 (quoting 12 C.F.R. 1310 App. A.II.d.1). Id. at 20. Id. at 19 (quoting Def. Mot. for Summ. J. [Dkt. 84-1] at 34). Id. at 19. Id. at 19-20, 24. Id. at 27. Id. at 24 (quoting 12 C.F.R. 1310 App. A.II.a). Id. at 25. Id. at 26. Id. at 33. Compl. 132. MetLife, slip op. at 28-29. 12 U.S.C. 5323(a)(2)(K). 135 S. Ct. 2699 (2015). -10-

ENDNOTES (CONTINUED) 51 52 53 54 55 56 57 58 MetLife, slip op. at 31 (quoting Michigan, 135 S. Ct. at 2709). Id. at 32. Id. Id. Id. at 32-33. On, Treasury Secretary Jacob J. Lew released a statement indicating that FSOC intend[s] to continue defending vigorously the process and the integrity of FSOC s work. Press Release, U.S. Department of the Treasury, Statement from Treasury Secretary Jacob J. Lew on MetLife v. Financial Stability Oversight Council (), available at https://www.treasury.gov/press-center/press-releases/pages/jl0410.aspx. Id. at 33 (quoting Michigan, 135 S. Ct. at 2707). See Compl. 80-94, 135-141. -11-

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