This matters for energy companies because many utilize specialized affiliates or other cooperative arrangements to centralize their commercial hedging and risk management functions and/or to conduct their activities as producers, processors, commercial users, or merchants of energy commodities when transacting with unaffiliated third parties.1 Dodd-Frank defines “financial entities” in part by cross-reference to the BHCA’s definition of activities that are “financial in nature.” While one might assume that the activities of these specialized affiliates or other cooperative arrangements, plainly conducted in furtherance of commercial purposes, would be far from the BHCA’s concept of activities “financial in nature,” the CFTC has suggested the opposite. Its recent actions have prompted concern that these “commercial outward-facing affiliates” (a term that we will use to refer to all such affiliates and arrangements) might be deemed to be “financial entities” because their activities are “financial in nature” and therefore bar them from utilizing certain exclusions (such as the end-user clearing exception) and delayed compliance (such as extended time periods to meet reporting requirements).
The CFTC at first declined to provide any clarification on the view that Dodd-Frank’s cross-reference to other statutes, including the BHCA, “constrains the Commission’s discretion in this area.”2 It recently issued no-action relief relating to “treasury affiliates,” but its narrow definition of that term coupled with the conditions it attached render the no-action relief inapplicable to many, if not most, of the commercial outward-facing affiliates operating in the energy industry.3 The statutory definition of “financial entity,” however, should not leave the matter in doubt, because properly read, the statute’s reference to the BHCA does not embrace most (if not all) activities conducted by commercial outward-facing affiliates for hedging or other commercial purposes. The CFTC should act, and act quickly, to clarify the situation, or many energy companies will be forced to dramatically restructure their commercial derivatives activities. Providing greater clarity would allow markets to continue to operate efficiently, while leaving the CFTC ample room to police any attempts to mischaracterize as “commercial in nature” activities that are actually “financial in nature.”
Dodd-Frank’s Reference to BHCA Section 4(k) in Context
Title VII of Dodd-Frank amended the Commodities Exchange Act (CEA) to subject the vast majority of swaps to mandatory clearing, trading, reporting, potential margin, and other requirements, but the statute and accompanying regulations also provide exceptions or delayed compliance from some of those requirements to commercial enterprises.4 To limit the scope to bona fide commercial enterprises, relief from these requirements is available only to an entity that is not a “financial entity.” Title VII includes several specific types of entities, such as swap dealers (SDs) and major swap participants (MSPs) as “financial entities,” but also defines the term to include: “person[s] predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956.”5
Energy companies have been concerned that the CFTC would use this last provision to sweep commercial outward-facing affiliates into the definition. Much of the discussion in the regulatory record turns on what it means to be “predominantly engaged” in activities that are in “the business of banking” or “financial in nature.” That issue is critically important because it serves to prevent companies that may only be tangentially engaged in such activities from being swept into the statutory definition. Notably, although the BHCA defines “predominantly engaged” for purposes of that act,6 Dodd-Frank does not incorporate that definition, which is not within section 4(k). The CFTC, therefore, has significant discretion to formulate its own interpretation of what it means to be “predominantly engaged.”7 An equally fundamental question, however, is what these activities actually cover. No one contends that commercial outward-facing affiliates are engaged in “the business of banking,” which the CFTC has recognized is a “term of art found in the National Bank Act.”8 The issue, therefore, is whether a commercial outward-facing affiliate’s activities are “financial in nature, as defined in section 4(k)” of the BHCA.9
BHCA section 4(k) allows financial holding companies to engage in activities that are “financial in nature or incidental to such activities,” as well as activities that are complementary to such activities if they do not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.10 Section 4(k)(4) lists eight specific types of “activities that are financial in nature” such as lending, insuring against loss, providing investment advisory services, underwriting securities, engaging in merchant banking, and the like.11 Commercial outward-facing affiliates generally do none of that. Section (4)(k)(4)(F), however, also encompasses “activity that the board [of Governors of the Federal Reserve (board)] has determined . . . to be so closely related to banking or managing or controlling banks as to be a proper incident thereto . . . .”12
At first blush, the idea that this language includes commercial outward-facing affiliates may seem clear. The reasoning goes like this: Dodd-Frank includes within the definition of financial entities those entities “predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k).” While commercial outward-facing affiliates are not engaged in core banking activities, the board has, under BHCA section 4(k)(4)(F), promulgated in Regulation Y a broad list of activities in which many commercial outward-facing affiliates do engage, such as investing as a principal in certain swaps, options, futures, and forward contracts under certain circumstances.13 Because commercial outward-facing affiliates might predominantly engage in some of those activities, and because the board has defined those activities as “financial in nature” under section 4(k), therefore these commercial outward-facing affiliates, the argument goes, must be “financial entities” under Dodd-Frank.
That argument is wrong, however, because Congress did not incorporate any list of activities that are isolated from banking, either in Regulation Y or elsewhere. By referencing activities that are “financial in nature, as defined in section 4(k),” Congress included only the activities listed in section 4(k) (such as lending, insurance, merchant banking, and the like, described above) and other activities that the board has determined are “closely related to banking.” Regulation Y includes a laundry list of activities in which a bank holding company may engage as “proper incident[s]” to its banking. In the context in which the board promulgated Regulation Y, the listed activities are inherently related in some way to banking; the statute requires that they be “so close” as to be “a proper incident” to banking activities. It would be absurd to suggest, however, that courier or data processing services—which are also listed in Regulation Y14—are, standing alone, necessarily financial in nature simply because a bank holding company may engage in them as incidents to its banking services. No one could contend, for example, that if a delivery company such as United Parcel Service set up a subsidiary catering to banks and financial companies, that such a subsidiary would be a “financial entity” for purposes of Title VII simply by being “predominantly engaged” in an activity that, when conducted by a bank holding company itself, falls within Regulation Y. Yet considering a commercial outward-facing affiliate a financial entity simply because its commercial hedging and risk management activities would, if engaged in by a bank holding company, fall within Regulation Y rests on the same illogical ground.
One appellate court has already declined to adopt such flawed reasoning. In American Bar Association v. Federal Trade Commission,15 the D.C. Circuit Court of Appeals rejected the Federal Trade Commission’s (FTC) attempt to impose certain bank privacy rules on lawyers who, by offering real estate settlement services that are included in Regulation Y, thereby became, in the FTC’s view, “financial institutions” through the operative statute’s incorporation of BHCA section 4(k). Although the court devoted significant attention to the special problems inherent in interfering with traditional state regulation of lawyers, it rejected the FTC’s position (that lawyers were “covered financial institutions”) in part because merely providing services that the board had designated as “closely related to banking” in the context of Regulation Y did not mean that an attorney was “engaging in the business of financial activities as described in [section 4(k)].”16
As American Bar Association implies, what is at issue is not the meaning of section 4(k), which the CFTC has recognized is “within the jurisdiction of, and therefore subject to interpretation by, the Board of Governors.”17 Instead, the issue is the context in which Dodd-Frank Title VII incorporates section 4(k). As the Supreme Court has noted when interpreting statutory cross-references, “context counts.”18 The Court has observed that “‘most words have different shades of meaning and consequently may be variously construed, not only when they occur in different statutes, but when used more than once in the same statute or even in the same section.’”19 Therefore, “[a] given term in the same statute may take on distinct characters from association with distinct statutory objects calling for different implementation strategies.”20 The CFTC has not only the discretion, but the affirmative responsibility, to take that context and the Dodd-Frank’s purposes into account.
Title VII’s cross-reference to BHCA section 4(k) illustrates the point. In section 4(k) itself, the list of activities that are financial in nature is intended to be permissive—it sets out the activities in which financial holding companies may engage. However, as incorporated under Dodd-Frank Title VII for purposes of providing certain relief to commercial enterprises, the same list is intended to be just the opposite—restrictive—in that it restricts “financial entities” from claiming the relief that Congress intended for nonfinancial commercial enterprises. Therefore, “activities that are financial in nature” for purposes of permitting financial holding companies to engage in them—such as incidentals like data processing, printing, and courier services21—are distinct from “activities that are financial in nature” where used to define the financial companies that Congress intended to exclude from relief, such as the end-user exception to mandatory clearing.
The CFTC has acknowledged that “whether an activity is ‘financial’ is determined by the nature of the activity, rather than by what type of firm conducts the activity.”22 Yet one cannot assess the “nature” of an activity in a vacuum. There is a distinction between activities that are inherently financial in nature, such as those expressly listed in section 4(k)(4)(A)-(E), (G)-(I), and those that are financial only by virtue of being “closely related to banking” and thereby “proper incident[s] thereto” under section 4(k)(4)(F). When the board addresses that issue under the BHCA, the activities are necessarily related to banking because the question is whether and under what circumstances a bank holding company may engage in them. Removed from that context, however, the statutorily required nexus—“so closely related to banking . . . as to be a proper incident thereto”23—cannot be assumed.
Simply because an activity is listed in Regulation Y as a proper incident to a bank holding company’s banking activities does not mean that such activities are in other contexts “closely related to banking” within the meaning of section 4(k).24 Moreover, even if BHCA section 4(k)(4)(F) did not expressly require that the activities be “closely related to banking,” the CEA’s reference to section 4(k) as a whole could not be read so broadly as to reach activities of a far different kind than those enumerated in the BHCA, such as lending, investment, investment advice, insurance, underwriting, and merchant banking. Courts frequently apply the settled principle that “a word is known by the company it keeps (the doctrine of noscitur a sociis). . . . to avoid ascribing to one word a meaning so broad that it is inconsistent with its accompanying words, thus giving ‘unintended breadth to the Acts of Congress.’”25 When faced with a similar situation in the Securities Exchange Act’s definition of “security,” the Supreme Court determined that “the phrase ‘any note’ should not be interpreted to mean literally ‘any note,’ but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.”26 Instead, the Court limited “any note” to notes that bear a “strong resemblance,” based on factors including the parties’ motivations and public expectations, to one of the other types of instruments listed in the definition.27 Doing otherwise would have given the Exchange Act a reach far broader than Congress intended. By the same token, section 4(k) must be understood to refer to activities that are similar in scope to the activities specifically referenced therein. Doing otherwise would stretch “activities that are financial in nature, as defined in” the BHCA beyond the accompanying words and would give Dodd-Frank an unintended and unnecessary breadth.28 A reasoned review of the intersection between Dodd-Frank and the BHCA, as well as Supreme Court precedent, provides the CFTC with the basis to analyze the definition of “financial entity” in the context of Title VII of Dodd-Frank and to clarify that commercial enterprises using commercial outward-facing affiliates to centralize their commercial hedging and risk management functions and other commercial activities are not engaged in “financial activities” for purposes of Title VII (subject to the appropriate facts and circumstances).
Facts and Circumstances Analysis of Commercial Outward-Facing Affiliate Activities
In other contexts, the CFTC has frequently applied a ‘‘facts and circumstances’’ analysis to distinguish various kinds of activities under Dodd-Frank. It should do the same here. The CFTC previously declined to give a categorical exclusion for treasury affiliates, based on its view that the statute constrained its discretion to do so.29 In doing so, however, the CFTC assumed that a treasury affiliate could be deemed a financial entity if its “sole or primary function is to undertake activities that are financial in nature as defined under section 4(k) of the Bank Holding Company Act.”30 And it subsequently premised no-action relief for certain treasury affiliates on that basis, again without making any independent findings that the activities of such treasury affiliates are in reality “financial in nature.”31
The CFTC could provide greater certainty in the industry, however, while preserving its ability to police evasion, by making a reasoned determination whether commercial outward-facing affiliates’ activities are in fact commercial in nature as opposed to “financial in nature” under Title VII. The CFTC has applied that approach to other issues under Dodd-Frank. For example, in distinguishing investment activities from a “commercial merchandising transaction” for purposes of the forward contract exclusion, the CFTC noted that a hedge fund that took “delivery of gold as part of its investment strategy would not be engaging in a commercial activity” under the CFTC’s interpretative guidance while the same hedge fund would be engaged in commercial activity if it owned an affiliate that mined and supplied gold to jewelry stores as a raw material for manufacturing.32 Many elements of those transactions are the same, but the commercial purpose of the latter changes its nature and its regulatory treatment. By the same token, the commercial purposes of commercial outward-facing affiliates’ activities place them in a fundamentally different context than similar swap transactions that bank holding companies might undertake.
To the extent supported by the facts and circumstances, the hedging, risk management, and other commercial activities of a commercial outward-facing affiliate would, under a contextual reading of Dodd-Frank, place such entity outside the definition of “financial entity” because those activities do not fall within section 4(k)(4) of the BHCA. They are neither the specific types of activity listed in subsections 4(k)(4)(A)-(E), (G)-(I) nor a category of activity that is “closely related to banking” or “a proper incident thereto” under subsection 4(k)(4)(F). In other words, engaging in certain swaps, options, futures, and forward contracts is not “financial in nature” where used for hedging, risk management, or other commercial purposes by a nonbank entity in connection with nonbank activities. Therefore, absent other considerations, such commercial outward-facing affiliate would not be a “financial entity” for purposes of electing the end-user exception and other requirements, such as reporting, clearing, and margin, under Title VII of Dodd-Frank. It is urgent that the CFTC clarify that it will take a ‘‘facts and circumstances’’ approach in evaluating whether a commercial outward-facing affiliate is in fact engaged in financial activities as defined in section 4(k). At the same time, the CFTC should provide additional clarification and certainty that a commercial outward-facing affiliate will not be subject to enforcement action if it makes a reasonable determination that it is not a “financial entity” based on the “facts and circumstances.” Doing so would allow markets to continue to operate efficiently, while preserving the CFTC’s authority to ensure that commercial outward-facing affiliates are engaged in bona fide commercial activities and deserving of relief from certain requirements under Title VII of Dodd-Frank as Congress intended.
1. Such structures enable commercial enterprises to manage their risks comprehensively and more efficiently, allowing them to net their commercial activities and hedging across the entire corporate family to lower costs and reduce risks.
2. End-User Exception to the Clearing Requirement for Swaps; Final Rule, 77 Fed. Reg. 42560, 42563 (July 19, 2012).
3. See CFTC Letter No. 13-22, No-Action Relief from the Clearing Requirement for Swaps Entered into by Eligible Treasury Affiliates (June 4, 2013).
4. See CEA § 2(h)(7)(A); CFTC Letter No. 13-08, Staff No-Action Relief from the Reporting Requirements of § 32.3(b)(1), etc. (Apr. 5, 2013).
5. CEA § 2(h)(7)(C)(i)(I)-(VIII).
6. See 12 U.S.C. § 5311(a)(6).
7. The CFTC has clarified that in the case of inter-affiliate swaps, a holding company may consider its affiliates’ activities “on a cumulative basis . . . when assessing whether the holding company is ‘predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k)’” of the BHCA. Clearing Exemption for Swaps Between Certain Affiliated Entities, 78 Fed. Reg. 21750, 21764, n.76 (Apr. 11, 2013). The CFTC should adopt the same approach to assess whether commercial outward-facing affiliates are, in conjunction with their affiliated companies, “predominantly engaged” in financial activities. Failing to do so would draw a false distinction between companies engaged in the same conduct but through different ownership structures. For example, a company that conducts certain activities within a single entity would not be deemed a “financial entity” under the “predominantly engaged” test whereas a company that conducts identical activities through subsidiaries that utilize a commercial outward facing affiliate could be erroneously deemed a “financial entity” under the same test. Without clarification from the CFTC, this lack of certainty could result in unnecessary and costly corporate restructurings in the energy industry.
8. 77 Fed. Reg. at 42562 (citing 12 U.S.C. § 24 (Seventh)). The cited provision allows national banks to “carry on the business of banking” by “discounting and negotiating . . . evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes.” 12 U.S.C. § 24 (Seventh). Similarly, BHCA § 2(c) defines a “bank” as an insured bank under section 3(h) of the Federal Deposit Insurance Act or, with certain exceptions, an institution that both accepts demand deposits and makes commercial loans. See 12 U.S.C. § 1841(c)(1). Commercial outward-facing affiliates engaged in commercial hedging and other similar commercial transactions obviously are not engaged in these sorts of core banking activities.
9. CEA § 2(h)(7)(C)(i)(VIII).
10. See BHCA § 4(k)(1).
11. See BHCA § 4(k)(4)(A)-(E), (G)-(I).
12. BHCA § 4(k)(4)(F) (emphasis added).
13. See 12 C.F.R. § 225.28(b)(8).
14. See 12 C.F.R. § 225.28(b)(10), (14).
15. 430 F.3d 457 (D.C. Cir. 2005).
16. See id. at 461, 467.
17. 77 Fed. Reg. at 42563. Such interpretation by the board is also subject to the statutory requirement that the board consult with the Secretary of the Treasury. See BHCA § 4(k)(2).
18. Environmental Defense v. Duke Energy Corp., 549 U.S. 561, 575–76 (2007). The Board recognized this point in promulgating regulations regarding the scope of financial activities under Title I of Dodd-Frank. See Definitions of “Predominantly Engaged in Financial Activities,” etc.; Final Rule, 78 Fed. Reg. 20756, 20758, n.21 (Apr. 5, 2013).
19. Duke Energy, 549 U.S. at 574 (quoting Atlantic Cleaners & Dyers, Inc. v. United States, 286 U. S. 427, 433 (1932)).
21. See 12 C.F.R. § 225.28(b)(10), (14).
22. 78 Fed. Reg. at 20767.
23. BHCA § 4(k)(4)(F).
24. It is also far from clear that Regulation Y’s language would reach those activities. Neither Regulation Y itself nor the Board’s explanatory discussion mention hedging, risk management, or commercial activities. See Bank Holding Companies and Change in Bank Control (Regulation Y), 62 Fed. Reg. 9290, 9336 (Feb. 28, 1997).
25. Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 574 (1995) (citation omitted).
26. Reves v. Ernst & Young, 494 U.S. 56, 63 (1990).
27. See id. at 65–67.
28. Some industry observers have looked with concern at the Board’s recent action under Title I of Dodd-Frank, which defines “U.S. nonbank financial company” by a similar cross-reference to “activities that are financial in nature” under BHCA section 4(k). See Dodd-Frank § 113(a). The Board promulgated Regulation PP, which adopts a broad list of activities patterned on Regulation Y. See Definitions of “Predominantly Engaged in Financial Activities,” etc.; Final Rule, 78 Fed. Reg. 20756 (Apr. 5, 2013) (promulgating 12 C.F.R. Part 242). Regulation PP does not, however, change the analysis because again, the context in which it operates is much different than Title VII of Dodd-Frank. Title I and Regulation PP define the scope of “financial activities” that may cause an entity to be potentially designated as a systemically important financial institution (SIFI) and therefore subject to regulation as if it were a bank holding company.
29. See 77 Fed. Reg. at 42563.
31. See CFTC Letter No. 13-22, No-Action Relief from the Clearing Requirement for Swaps Entered into by Eligible Treasury Affiliates (June 4, 2013).
32. Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement,” 77 Fed. Reg. 48208, 48229 (Aug. 13, 2012) (emphasis added).