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Brian Reid of the Investment Company Institute said Sifi designation lacks accountability and transparency |
The most effective way for asset managers to defend themselves against designation as a systemically important financial institution (Sifi) could be litigation. Although they are just the latest financial entities to face the prospect of designation, asset mangers’ unique structure means would face additional challenges. These include increased investors' costs, create market divisions between designated and undesignated funds, and cause investors to flee to less regulated areas.
But asset managers are well placed to challenge the decision on the grounds the Financial Stability Oversight Council (FSOC) which assigns the label, lacks jurisdiction to do so.
Section 4k of the Bank Holding Company Act allows for Sifi designation only if 85% or more of assets or revenues are generated by specific banking activities. Lawyers working in the field say the funds have a significant argument against falling within this category, giving them the basis for a legal challenge.
“There are several good legal arguments against Sifi designation,” said one New York-based lawyer who has worked with designated firms. “I think the likelihood of a challenge is high. FSOC is aware of this so they will likely move carefully and deliberately to put off a challenge or any litigation.”
Mounting a challenge won’t be easy
While Dodd-Frank does provide for legal challenges, the high legal standards and lack of transparency can make it a difficult threshold to satisfy.
“Even if you escape designation you may still be a target,” said Don Lamson, a partner at Shearman & Sterling. “The FSOC can designate you again the next year and the process begins anew. Moreover the financial industry as a whole may look at you as an entity that should be regulated.”
“Even if you win, it can be a pyrrhic victory,” he added.
An industry group may be to able bring a challenge on behalf its members, but it is unclear whether a court would grant them standing.
KEY TAKEAWAYS
The Financial Stability Oversight Council is considering regulation that will designate some asset managers as Sifis;
Asset managers are concerned about the cost and regulatory burdens of such a designation given the fund management structure;
Litigation may be the only way the industry could successfully challenge a designation.
Designation and regulation
The process used to determine which entities are Sifis poses another hurdle to bringing litigation or a regulatory challenge. Not until the final stage of the FSOC’s determination process will a company formally know it is being considered.
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FSOC is aware that the likelihood of a legal challenge is high |
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While regulators insist many affect the decision to designate, the market consensus is that size is the most important consideration. Shrinking a fund could help deflect this but, it is unclear how small a fund might need to become.
“There is no interaction with potential firms that are being considered, so they don’t know what aspect of the business model is raising concerns with the regulators,” said Brian Reid, chief economist of the Investment Company Institute. “In this process, there is an absence of transparency and accountability.”
Regulators have also failed to lay out how the designation, which is geared to banks, would be applied to asset managers or funds. The insurance industry, of which several large players were designated Sifis in 2013 (including Prudential and AIG), is still awaiting details of how that regulation will be applied.
“Without knowing how they will be regulated as Sifis, companies are prejudiced in their ability to argue against designation,” said Thomas Vartanian, a partner at Dechert and former regulator with the Office of the Comptroller of the Currency. “FSOC sees the designation of large financial companies as a means of controlling the likelihood and impact of future financial crises.”
Designation goals
Dodd-Frank gives FSOC the ability to label financial entities ‘systemically important’ and impose upon them higher capital and liquidity requirements to help safeguard the market.
But if FSOC raises liquidity standards for a fund, the return on investment would decrease. Since the managers themselves don’t typically hold capital against investments, this would add cost for investors. The agency structure of asset managers means that Sifi regulations would increase their burned without reducing risk.
“The separation between asset managers and the funds they are investing in has kept funds strong for 75 years,” said Reid. “It is core to the Investment Company Act. Breaking down this agency relationship would be very damaging to funds and their investors.”
“What may happen is investors could flee and you would lose efficiencies of scale,” said Lamson. “It’s like squeezing on a balloon, you will find the same risk somewhere else in the market, but perhaps not in as regulated an environment.”
See also
Has Fed overstepped on foreign Sifi rules?
How US prudential standards could fragment global market
Attorneys call for asset managers’ Sifi exemption