Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions

Federal RegisterSep 12, 2017

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FEDERAL RESERVE SYSTEM

12 CFR Parts 217, 249, and 252

[Regulations Q, WW, and YY; Docket No. R-1538]

RIN 7100-AE52

Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions

AGENCY:

Board of Governors of the Federal Reserve System (Board), Federal Reserve System.

ACTION:

Final rule.

SUMMARY:

The Board is adopting a final rule to promote U.S. financial stability by improving the resolvability and resilience of systemically important U.S. banking organizations and systemically important foreign banking organizations pursuant to section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Under the final rule, any U.S. top-tier bank holding company identified by the Board as a global systemically important banking organization (GSIB), the subsidiaries of any U.S. GSIB (other than national banks, federal savings associations, state nonmember banks, and state savings associations), and the U.S. operations of any foreign GSIB (other than national banks, federal savings associations, state nonmember banks, and state savings associations) would be subjected to restrictions regarding the terms of their non-cleared qualified financial contracts (QFCs). First, a covered entity generally is required to ensure that QFCs to which it is party provide that any default rights and restrictions on the transfer of the QFCs are limited to the same extent as they would be under the Dodd-Frank Act and the Federal Deposit Insurance Act. Second, a covered entity generally is prohibited from being party to QFCs that would allow a QFC counterparty to exercise default rights against the covered entity, directly or indirectly, based on the entry into a resolution proceeding under the Dodd-Frank Act or Federal Deposit Insurance Act, or any other resolution proceeding, of an affiliate of the covered entity. The final rule also amends certain definitions in the Board's capital and liquidity rules; these amendments are intended to ensure that the regulatory capital and liquidity treatment of QFCs to which a covered entity is party is not affected by the final rule's restrictions on such QFCs. The Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) are expected to issue final rules that would subject GSIB subsidiaries for which the OCC and FDIC are the appropriate Federal banking agency to requirements substantively identical to those in this final rule.

DATES:

The final rule is effective on November 13, 2017.

FOR FURTHER INFORMATION CONTACT:

Anna Harrington, Senior Supervisory Financial Analyst (202) 452-6406, or Sean Campbell, Associate Director, (202) 452-3760, Division of Supervision and Regulation; or Will Giles, Senior Counsel, (202) 452-3351, or Lucy Chang, Senior Attorney, (202) 475-6331, Legal Division, Board of Governors of the Federal Reserve System, 20th and C Streets NW., Washington, DC 20551. For the hearing impaired only, Telecommunications Device for the Deaf (TDD) users may contact (202) 263-4869.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Background

B. Notice of Proposed Rulemaking and General Summary of Comments

C. Overview of Final Rule

D. Consultation With U.S. Financial Regulators, the Council, and Foreign Authorities

II. Restrictions on QFCs of GSIBs

A. Covered Entities (Section 252.82(b) of the Final Rule)

B. Covered QFCs (Section 252.82(c) of the Final Rule)

C. Definition of “Default Right” (Section 252.81 of the Final Rule)

D. Required Contractual Provisions Related to the U.S. Special Resolution Regimes (Section 252.83 of the Final Rule)

E. Prohibited Cross-Default Rights (Section 252.84 of the Final Rule)

F. Process for Approval of Enhanced Creditor Protections (Section 252.85 of the Final Rule)

III. Transition Periods

IV. Costs and Benefits

V. Revisions to Certain Definitions in the Board's Capital and Liquidity Rules

VI. Regulatory Analysis

A. Paperwork Reduction Act

B. Regulatory Flexibility Act: Final Regulatory Flexibility Analysis

C. Riegle Community Development and Regulatory Improvement Act of 1994

D. Use of Plain Language

I. Introduction

A. Background

In May 2016, the Board invited comment on a notice of proposed rulemaking (“proposal” or “proposed rule”) to impose restrictions on the qualified financial contracts (QFCs)—such as derivatives contracts and repurchase agreements—of U.S. global systemically important banking organizations (GSIBs) and the U.S. operations of global systemically important foreign banking organizations or “foreign GSIBs” (collectively, “covered entities”).

The proposal would have required the QFCs of covered entities to contain contractual provisions that opt into the temporary stay-and-transfer treatment of the Federal Deposit Insurance Act (FDI Act) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), thereby reducing the risk that the stay-and-transfer treatment would be challenged by a QFC counterparty or a court in a foreign jurisdiction. The FDI Act and Title II of the Dodd-Frank Act create special resolution frameworks for failed financial firms that provide that the rights of a failed firm's counterparties to terminate their QFCs are temporarily stayed when the firm enters a resolution proceeding to allow for the transfer of the relevant obligations under the QFC to a solvent party. The proposal also would have prohibited the exercise of default rights in QFCs related, directly or indirectly, to the entry into resolution of an affiliate of a covered entity (cross-default rights), subject to certain creditor protection exceptions that would not be expected to interfere with an orderly resolution.

81 FR 29169 (May 11, 2016).

This final rule, which is part of a set of actions by the Board to address the “too-big-to-fail” problem, addresses one of the ways in which the severe distress or failure of a major financial firm can destabilize the U.S. financial system. Protecting the financial stability of the United States by helping to address this too-big-to-fail problem is a core objective of the Dodd-Frank Act,

which Congress passed in response to the 2007-2009 financial crisis and the ensuing recession. As illustrated by the failure of Lehman Brothers in September of 2008, the failure of a large, interconnected financial company could cause severe damage to the U.S. financial system and, ultimately, to the economy as a whole. The Dodd-Frank Act and the actions that U.S. financial regulators have taken to implement it and to otherwise protect U.S. financial stability help to address the too-big-to-

fail problem in two ways: By reducing the probability that a systemically important financial company will fail, and by reducing the damage that such a company's failure would do if it were to occur. The second of these strategies, which is supported by this final rule, centers on measures designed to help ensure that a failed company's passage through a resolution proceeding—such as bankruptcy or the special resolution process created by the Dodd-Frank Act—would be more orderly, thereby helping to mitigate destabilizing effects on the rest of the financial system.

The Dodd-Frank Act was enacted on July 21, 2010 (Pub. L. 111-203). According to its preamble, the Dodd-Frank Act is intended “[t]o promote the financial stability of the United States by improving accountability and transparency in the financial system, to end `too big to fail', [and] to protect the American taxpayer by ending bailouts.”

The Dodd-Frank Act itself pursues this goal through numerous provisions, including by requiring systemically important financial companies to develop resolution plans (also known as “living wills”) that lay out how they could be resolved in an orderly manner if they were to fail and by creating a new resolution regime, the Orderly Liquidation Authority, applicable to systemically important financial companies. 12 U.S.C. 5365(d), 5381-5394. Moreover, section 165 of the Dodd-Frank Act directs the Board to promote financial stability through regulation by subjecting large bank holding companies and nonbank financial companies designated for Board supervision to enhanced prudential standards “[i]n order to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.” 12 U.S.C. 5365(a)(1).

This final rule represents a further step to increase the resolvability and resilience of U.S. GSIBs and foreign GSIBs that operate in the United States. The final rule complements the Board's final rulemaking on total loss-absorbing capacity, long-term debt, and clean holding company requirements for GSIBs (TLAC final rule)

and the ongoing work of the Board and the Federal Deposit Insurance Corporation (FDIC) on resolution planning requirements for GSIBs. The final rule focuses on improving the orderly resolution of a GSIB by limiting disruptions to a failed GSIB through its financial contracts with other companies. In particular, the requirements of the final rule seek to facilitate the orderly resolution of a failed GSIB by limiting the ability of the firm's QFC counterparties to terminate such contracts immediately upon entry of the GSIB or one of its affiliates into resolution. Given the large volume of QFCs to which covered entities are a party, the exercise of default rights en masse as a result of the failure or significant distress of a covered entity could lead to failure and a disorderly resolution if the failed firm were forced to sell off assets, which could spread contagion by increasing volatility and lowering the value of similar assets held by other firms, or to withdraw liquidity that it had provided to other firms.

82 FR 8266 (Jan. 24, 2017).

The largest financial firms are interconnected with other financial firms through large volumes of financial contracts of various types, including derivatives transactions. The severe distress or failure of one entity within a large financial firm can trigger disruptive terminations of these contracts, as the counterparties of both the failed entity and other entities within the same firm exercise their contractual rights to terminate the contracts and liquidate collateral. These terminations, especially if counterparties lose confidence in the GSIB quickly and in large numbers, can destabilize the financial system and potentially spark a financial crisis through several channels. They can destabilize the failed entity's otherwise solvent affiliates, causing them to fail and thereby destabilizing the entire organization, as well as potentially causing their counterparties to fail in a chain reaction that can ripple through the system. They also may result in fire sales of large volumes of financial assets, such as the collateral that secures the contracts, which can in turn weaken and cause stress for other firms by lowering the value of similar assets that they hold.

For example, the triggering of default rights by counterparties of Lehman Brothers (Lehman) in 2008 was a key driver of the destabilization that resulted from its failure.

At the time of its failure, Lehman was party to very large volumes of financial contracts, including over-the-counter derivatives contracts.

When its holding company declared bankruptcy, Lehman's counterparties exercised their default rights.

Lehman's default “caused disruptions in the swaps and derivatives markets and a rapid, market-wide unwinding of trading positions.”

Meanwhile, “out-of-the-money counterparties, which owed Lehman money, typically chose not to terminate their contracts” and instead suspended payment, reducing the liquidity available to the bankruptcy estate.

The complexity and disruption associated with Lehman's portfolios of financial contracts led to a disorderly resolution of Lehman.

This final rule is meant to help avoid a repeat of the systemic disruptions caused by the Lehman failure by preventing the exercise of default rights in financial contracts from leading to such disorderly and destabilizing severe distress or failures in the future.

See

“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” 3, FDIC Quarterly (2011) (“The Lehman bankruptcy had an immediate and negative effect on U.S. financial stability and has proven to be a disorderly, time-consuming, and expensive process.”),

https://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf

See

Michael J. Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” FRBNY Economic Policy Review 185 (Dec. 2014),

https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf

See id.

“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” 3, FDIC Quarterly (2011),

https://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf

Michael J. Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” FRBNY Economic Policy Review 185 (Dec. 2014),

https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf

See

Mark J. Roe and Stephen D. Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman's Derivatives Portfolio,” Yale Journal on Regulation (2015) (“Lehman's failure exacerbated the financial crisis, especially after AIG's collapse in the days afterwards prompted counterparties to close out positions, sell collateral, and thereby depress and freeze markets. Many financial players stopped trading for fear that their counterparty would be the next Lehman or that their counterparty had large unseen exposures to Lehman that would make the counterparty itself fail. Such was the case with the Reserve Primary Fund, a money market fund that held too many defaulting obligations of Lehman. That reaction led to a further panic, a threat of a run on money market funds, and a government guarantee of all money market funds to stem the ongoing financial degradation throughout the economy.”).

This final rule responds to the threat to financial stability posed by such default rights in two ways. First, the final rule reduces the risk that courts in foreign jurisdictions would disregard statutory provisions that would stay the rights of a failed firm's counterparties to terminate their contracts when the firm enters a resolution proceeding under one of the special resolution frameworks for failed financial firms created by Congress under the FDI Act and the Dodd-Frank Act. Second, the final rule facilitates the resolution of a large financial entity under the U.S. Bankruptcy Code and other resolution frameworks by ensuring that the counterparties of solvent affiliates of the failed entity cannot unravel their contracts with the solvent affiliate based solely on the failed entity's resolution.

The Board is issuing this final rule under section 165 of the Dodd-Frank Act, as well as its safety and soundness and other relevant authorities.

Section 165 instructs the Board to impose enhanced prudential standards on bank holding companies with total consolidated assets of $50 billion or more “[i]n order to prevent or mitigate risks to the financial stability of the

United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.”

These enhanced prudential standards must increase in stringency based on the systemic footprint and risk characteristics of covered firms.

Section 165 requires the Board to impose enhanced prudential standards of several specified types and also authorizes the Board to establish “such other prudential standards as the Board of Governors, on its own or pursuant to a recommendation made by the Council, determines are appropriate.”

12 U.S.C. 321-338a, 481-486, 1467a, 1818, 1828, 1831n, 1831o, 1831p-l, 1831w, 1835, 1844(b), 1844(c), 3101

et seq.,

3101 note, 3904, 3906-3909, 4808, 5361, 5362, 5365, 5366, 5367, 5368, 5371.

12 U.S.C. 5365(a)(1).

12 U.S.C. 5365(a)(1)(B), (b)(3)(A)-(D).

12 U.S.C. 5365(b)(1)(B)(iv).

The enhanced prudential standards in this final rule are intended to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure of a GSIB. In particular, the final rule's requirements are intended to improve the resolvability and resilience of U.S. GSIBs under the U.S. Bankruptcy Code, Title II of the Dodd-Frank Act, or, with reference to insured depository institutions that are GSIB subsidiaries, the FDI Act, and reduce the potential that resolution of the firm will be disorderly and lead to disruptive asset sales and liquidations.

The final rule should also improve the resilience of the U.S. operations of foreign GSIBs, and thereby increase the likelihood that a failed foreign GSIB with U.S. operations would be successfully resolved by its home jurisdiction authorities without the severe distress or failure of the foreign GSIB's U.S. operating entities and with limited effect on the financial stability of the United States.

As discussed in detail in this

SUPPLEMENTARY INFORMATION

section, this rule is intended to help prevent systemic disruptions that may arise as a result of the exercise of certain contractual rights contained in QFCs entered into by GSIBs or their subsidiaries. This rule includes certain limitations on the exercise of these rights with a view to preventing such systemic disruptions. Separate from these limitations, both Title II of the Dodd-Frank Act and the FDI Act include various restrictions on the exercise of rights by parties to QFCs and provide the FDIC, as receiver of a company subject to resolution under Title II or the FDI Act, with special authorities. None of the provisions of this rule should be construed as being intended to modify or limit, in any manner, the rights and powers of the FDIC as receiver under Title II or the FDI Act, including, without limitation, the rights of the FDIC as receiver to enforce provisions of Title II or the FDI Act that limit the enforceability of certain contractual provisions.

The Board has tailored this final rule to apply only to those banking organizations whose disorderly failure or severe distress would be likely to pose the greatest risk to U.S. financial stability: The U.S. GSIBs and the U.S. operations of foreign GSIBs. The Board believes that limiting the application of this final rule in this way sensibly balances the costs and benefits of the rule by effectively managing systemic risk while at the same time limiting the burden of compliance by not requiring non-GSIB firms with total assets in excess of $50 billion to comply with any part of this final rule.

Qualified financial contracts, default rights, and financial stability.

The final rule pertains to several important classes of financial transactions that are collectively known as “qualified financial contracts.”

QFCs include derivatives, repurchase agreements (also known as “repos”), reverse repos, and securities lending and borrowing agreements.

GSIBs enter into QFCs for a variety of purposes, including to borrow money to finance their investments, to lend money, to manage risk, and to enable their clients and counterparties to hedge risks, make markets in securities and derivatives, and take positions in financial investments.

The final rule adopts the definition of “qualified financial contract” set out in section 210(c)(8)(D) of the Dodd-Frank Act, 12 U.S.C. 5390(c)(8)(D).

See

final rule § 252.81.

The definition of “qualified financial contract” is broader than this list of examples, and the default rights discussed are not common to all types of QFC.

See

final rule § 252.81.

QFCs play a role in economically valuable financial intermediation when markets are functioning normally. But they are also a major source of financial interconnectedness, which can pose a threat to financial stability in times of market stress. The final rule focuses on a context in which that threat is especially great: The severe distress or failure of a GSIB that is party to large volumes of QFCs, which are likely to include QFCs with counterparties that are themselves systemically important.

By contract, a party to a QFC generally has the right to take certain actions if its counterparty defaults on the QFC (that is, if it fails to meet certain contractual obligations). Common default rights include the right to suspend performance of the non-defaulting party's obligations, the right to terminate or accelerate the contract, the right to set off amounts owed between the parties, and the right to seize and liquidate the defaulting party's collateral. In general, default rights allow a party to a QFC to reduce the credit risk associated with the QFC by granting it the right to exit the QFC and thereby reduce its exposure to its counterparty upon the occurrence of a specified condition, such as its counterparty's entry into a resolution proceeding.

Where the defaulting party is a GSIB entity, the private benefit of allowing counterparties of GSIBs to take certain actions must be weighed against the harm that these actions may cause by contributing to the severe distress or disorderly failure of a GSIB and increasing the threat to the stability of the U.S. financial system as a whole. For example, if a significant number of QFC counterparties exercise their default rights precipitously and in a manner that would impede an orderly resolution of a GSIB, all QFC counterparties and the financial system may potentially be worse off and less stable.

This may occur through several channels. First, the exits may drain liquidity from a troubled GSIB, forcing the GSIB to rapidly sell off assets at depressed prices, both because the sales must be done within a short timeframe and because the elevated supply may push prices down. These asset fire sales may cause or deepen balance-sheet insolvency at the GSIB, causing a GSIB to fail more suddenly and reducing the amount that its other creditors can recover, thereby imposing losses on those creditors and threatening their solvency. The GSIB may also respond to a QFC run by withdrawing liquidity that it had offered to other firms, forcing them to engage in fire sales. Alternatively, if the GSIB's QFC counterparty itself liquidates the QFC collateral at fire sale prices, the effect will again be to weaken the GSIB's balance sheet as the GSIB marks those assets down to the new fire sale induced price level.

The counterparty's rights to set-off amounts owed, terminate the contract, or suspend payments may allow it to further drain the GSIB's capital and liquidity by withholding payments that it would otherwise owe to the GSIB. The GSIB may also have rehypothecated collateral that it received from QFC counterparties, for instance in repo or securities lending transactions that fund other client arrangements, in which case demands from those counterparties for the early

return of their rehypothecated collateral could be especially disruptive.

See

“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” 8, FDIC Quarterly (2011),

https://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf

(“A disorderly unwinding of [qualified financial contracts] triggered by an event of insolvency, as each counterparty races to unwind and cover unhedged positions, can cause a tremendous loss of value, especially if lightly traded collateral covering a trade is sold into an artificially depressed, unstable market. Such disorderly unwinding can have severe negative consequences for the financial company, its creditors, its counterparties, and the financial stability of the United States.”).

See generally

Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed, “Matching Collateral Supply and Financing Demands in Dealer Banks,” FRBNY Economic Policy Review 127 (Dec. 2014),

http://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412kirk.pdf

The asset fire sales discussed above can also spread contagion throughout the financial system by increasing volatility and by lowering the value of similar assets held by other firms, potentially causing these firms to suffer mark-to-market losses, diminished market confidence in their own solvency, margin calls, and creditor runs (which could lead to further fire sales, worsening the contagion). Finally, the early terminations of derivatives upon which the surviving entities of the failed GSIB relied to hedge their risks could leave those entities with major risks unhedged, increasing the entities' potential losses going forward.

Where there are significant simultaneous terminations and these effects occur contemporaneously, such as upon the failure or severe distress of a GSIB that is party to a large volume of QFCs, they may pose a substantial risk to financial stability. In short, QFC continuity is important for the orderly resolution of a GSIB because it helps to ensure that the GSIB entities remain viable and to avoid instability caused by asset fire sales.

Consequently, the Board and the FDIC have identified the exercise of certain default rights in financial contracts as a potential obstacle to orderly resolution in the context of resolution plans filed pursuant to section 165(d) of the Dodd-Frank Act

and have instructed the most systemically important firms to demonstrate that they are “amending, on an industry-wide and firm-specific basis, financial contracts to provide for a stay of certain early termination rights of external counterparties triggered by insolvency proceedings.”

12 U.S.C. 5365(d).

Board and FDIC, “Agencies Provide Feedback on Second Round Resolution Plans of `First-Wave' Filers” (Aug. 5, 2014),

http://www.federalreserve.gov/newsevents/press/bcreg/20140805a.htm

See also

Board and FDIC, “Guidance for 2018 § 165(d) Annual Resolution Plan Submissions By Foreign-based Covered Companies that Submitted Resolution Plans in July 2015,” (Mar. 24, 2017),

https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20170324a21.pdf

; Board and FDIC, “Guidance for 2017 § 165(d) Annual Resolution Plan Submissions By Domestic Covered Companies that Submitted Resolution Plans in July 2015,” (Apr. 13, 2016),

https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20160413a1.pdf

; Board and FDIC, “Agencies Provide Feedback on Resolution Plans of Three Foreign Banking Organizations,” (Mar. 23, 2015),

http://www.federalreserve.gov/newsevents/press/bcreg/20150323a.htm

; Board and FDIC, “Guidance for 2013 165(d) Annual Resolution Plan Submissions by Domestic Covered Companies that Submitted Initial Resolution Plans in 2012” (Apr. 15, 2013),

http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20130415c2.pdf

Direct defaults and cross-defaults.

This final rule focuses on two distinct scenarios in which a non-defaulting party to a QFC is commonly able to exercise the rights described above. These two scenarios involve a default that occurs when either the GSIB legal entity that is a direct party

to the QFC or an affiliate of that legal entity enters a resolution proceeding.

The first scenario occurs when a GSIB entity that is itself a direct party to the QFC enters a resolution proceeding; this preamble refers to such a scenario as a “direct default” and refers to the default rights that arise from a direct default as “direct default rights.” The second scenario occurs when an affiliate of the GSIB entity that is a direct party to the QFC (such as the direct party's parent holding company) enters a resolution proceeding; this preamble refers to such a scenario as a “cross-default” and refers to default rights that arise from a cross-default as “cross-default rights.” For example, a GSIB parent entity might guarantee the derivatives transactions of its subsidiaries, and those derivatives contracts could contain cross-default rights against a subsidiary of the GSIB that would be triggered by the bankruptcy filing of the GSIB parent entity even though the subsidiary continues to meet all of its financial obligations.

In general, a “direct party” refers to a party to a financial contract other than a credit enhancement (such as a guarantee). The definition of “direct party” and related definitions are discussed in more detail below.

This preamble uses phrases such as “entering a resolution proceeding” and “going into resolution” to encompass the concept of “becoming subject to a receivership, insolvency, liquidation, resolution, or similar proceeding.” These phrases refer to proceedings established by law to deal with a failed legal entity. In the context of the failure of a systemically important banking organization, the most relevant types of resolution proceeding include the following: For most U.S.-based legal entities, the bankruptcy process established by the U.S. Bankruptcy Code (Title 11, United States Code); for U.S. insured depository institutions, a receivership administered by the FDIC under the FDI Act (12 U.S.C. 1821); for companies whose “resolution under otherwise applicable Federal or State law would have serious adverse effects on the financial stability of the United States,” the Dodd-Frank Act's Orderly Liquidation Authority (12 U.S.C. 5383(b)(2)); and, for entities based outside the United States, resolution proceedings created by foreign law.

See

Michael J. Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” FRBNY Economic Policy Review 185 (Dec. 2014),

https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf

Importantly, this final rule does not affect all types of default rights. Moreover, the final rule is concerned only with default rights that run

against

a GSIB—that is, direct default rights and cross-default rights that arise from the entry into resolution of a GSIB entity. The final rule does not affect default rights that a GSIB entity (or any other entity) may have against a counterparty that is not a GSIB entity. This limited scope is appropriate because, as described above, the risk posed to financial stability by the exercise of QFC default rights is greatest when the defaulting counterparty is a GSIB entity.

Single-point-of-entry resolution.

Cross-default rights are especially significant in the context of a GSIB failure because GSIBs typically enter into large volumes of QFCs through different entities controlled by the GSIB. For example, a U.S. GSIB is made up of a U.S. bank holding company and numerous operating subsidiaries that are owned, directly or indirectly, by the bank holding company. From the standpoint of financial stability, the most important of these operating subsidiaries are generally a U.S. insured depository institution, a U.S. broker-dealer, and similar entities organized in other countries.

Many complex GSIBs have developed resolution strategies that rely on a single-point-of-entry (SPOE) resolution strategy. In an SPOE resolution of a GSIB, only a single legal entity—the GSIB's top-tier bank holding company—would enter a resolution proceeding. The losses that led to the GSIB's failure would be passed up from the operating subsidiaries that incurred the losses to the holding company and would then be imposed on the equity holders and unsecured creditors of the holding company through the resolution process.

This strategy is designed to help ensure that the GSIB subsidiaries remain adequately capitalized and that operating subsidiaries of the GSIB are able to continue to meet their financial obligations without defaulting or entering resolution themselves. The expectation that the holding company's equity holders and unsecured creditors would absorb the GSIB's losses in the event of failure would help to maintain the confidence of the operating subsidiaries' creditors and counterparties (including their QFC

counterparties), reducing their incentive to engage in potentially destabilizing funding runs or margin calls and thus lowering the risk of asset fire sales. A successful SPOE resolution would also avoid the need for separate resolution proceedings for separate legal entities run by separate authorities across multiple jurisdictions, which would be more complex and could therefore destabilize the resolution of a GSIB.

The Board's final rule regarding total loss-absorbing capacity, long term debt and clean holding company requirements (TLAC rule) addresses the need for adequate external loss-absorbing capacity at the holding company level by requiring the top-tier holding companies of the U.S. GSIBs and the U.S. intermediate holding companies of foreign GSIBs to maintain outstanding required levels of unsecured long-term debt and TLAC, which is defined to include both tier 1 capital and eligible long-term debt.

See

82 FR 8266, 8287 (Jan. 24, 2017).

The Board's TLAC rule is intended to help, though not exclusively, to lay the foundation necessary for the SPOE resolution of a GSIB by requiring the top-tier holding companies of U.S. GSIBs and the U.S. intermediate holding companies of foreign GSIBs to maintain sufficient amounts of loss-absorbing capacity that could be used for resolution and to adopt a “clean holding company” structure, under which certain financial activities that could pose obstacles to orderly resolution would be impermissible for the holding company and could only be conducted by its operating subsidiaries.

See

82 FR 8266 (Jan. 24, 2017).

Other orderly resolution strategies.

This final rule is also intended to yield benefits for other approaches to resolution. For example, preventing early terminations of QFCs would increase the prospects for an orderly resolution under a multiple-point-of-entry (MPOE) strategy involving a foreign GSIB's U.S. intermediate holding company going into resolution or a resolution plan that calls for a GSIB's U.S. insured depository institution to enter resolution under the FDI Act. As discussed above, the final rule should help support the continued operation of one or more affiliates of an entity that has entered resolution to the extent the affiliate continues to perform on its QFCs.

U.S. Bankruptcy Code.

When an entity goes into resolution under the U.S. Bankruptcy Code, attempts by the debtor entity's creditors to enforce their debts through any means other than participation in the bankruptcy proceeding (for instance, by suing in another court, seeking enforcement of a preexisting judgment, or seizing and liquidating collateral) are generally blocked by the imposition of an automatic stay.

A key purpose of the automatic stay, and of bankruptcy law in general, is to maximize the value of the bankruptcy estate and the creditors' ultimate recoveries by facilitating an orderly liquidation or restructuring of the debtor. The automatic stay thus solves a collective action problem in which the creditors' individual incentives to become the first to recover as much from the debtor as possible, before other creditors can do so, collectively cause a value-destroying disorderly liquidation of the debtor.

See

11 U.S.C. 362.

See, e.g.,

Aiello

Providian Financial Corp.,

239 F.3d 876, 879 (7th Cir. 2001).

However, the U.S. Bankruptcy Code largely exempts QFC

counterparties of the debtor from the automatic stay through special “safe harbor” provisions.

Under these provisions, any rights that a QFC counterparty has to terminate the contract, set-off obligations, or liquidate collateral in response to a direct default are not subject to the stay and may be exercised against the debtor immediately upon default. (The U.S. Bankruptcy Code does not itself confer default rights upon QFC counterparties; it merely permits QFC counterparties to exercise certain rights created by other sources, such as contractual rights created by the terms of the QFC.)

The U.S. Bankruptcy Code does not use the term “qualified financial contract,” but the set of transactions covered by its safe harbor provisions closely tracks the set of transactions that fall within the definition of “qualified financial contract” used in Title II of the Dodd-Frank Act and in this final rule.

11 U.S.C. 362(b)(6), (7), (17), (27), 362(o), 555, 556, 559, 560, 561. The U.S. Bankruptcy Code specifies the types of parties to which the safe harbor provisions apply, such as financial institutions and financial participants.

Id.

The U.S. Bankruptcy Code's automatic stay also does not prevent the exercise of cross-default rights against an affiliate of the party entering resolution. The stay generally applies only to actions taken against the party entering resolution or the bankruptcy estate,

whereas a QFC counterparty exercising a cross-default right is instead acting against a distinct legal entity that is not itself in resolution—the debtor's affiliate.

See

11 U.S.C. 362(a).

Title II of the Dodd-Frank Act and the Orderly Liquidation Authority.

Title II of the Dodd-Frank Act imposes stay requirements on QFCs of financial companies that enter resolution under that Title. In general, no financial firm (regardless of size) is too-big-to-fail and a U.S. bank holding company (such as the top-tier holding company of a U.S. GSIB) that fails would be resolved under the U.S. Bankruptcy Code. Congress recognized, however, that a financial company might fail under extraordinary circumstances in which an attempt to resolve it through the bankruptcy process would have serious adverse effects on financial stability in the United States. Title II of the Dodd-Frank Act establishes the Orderly Liquidation Authority (OLA), an alternative resolution framework intended to be used in rare circumstances to manage the failure of a firm that poses a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.

Title II authorizes the Secretary of the Treasury, upon the recommendation of other government agencies and a determination that several preconditions are met, to place a financial company into a receivership conducted by the FDIC as an alternative to bankruptcy.

Section 204(a) of the Dodd-Frank Act, codified at 12 U.S.C. 5384(a).

See

section 203 of the Dodd-Frank Act, codified at 12 U.S.C. 5383.

Title II empowers the FDIC to transfer the QFCs to a bridge financial company or some other financial company that is not in a resolution proceeding and should therefore be capable of performing under the QFCs.

To give the FDIC time to effect this transfer, Title II temporarily stays QFC counterparties of the failed entity from exercising termination, netting, and collateral liquidation rights “solely by reason of or incidental to” the failed entity's entry into OLA resolution, its insolvency, or its financial condition.

Once the QFCs are transferred in accordance with the statute, Title II permanently stays the exercise of default rights for those reasons.

See

12 U.S.C. 5390(c)(9).

12 U.S.C. 5390(c)(10)(B)(i)(I). This temporary stay generally lasts until 5:00 p.m. eastern time on the business day following the appointment of the FDIC as receiver.

12 U.S.C. 5390(c)(10)(B)(i)(II).

Title II addresses cross-default rights through a similar procedure. It empowers the FDIC to enforce contracts of subsidiaries or affiliates of the failed covered financial company that are “guaranteed or otherwise supported by or linked to the covered financial company, notwithstanding any contractual right to cause the termination, liquidation, or acceleration of such contracts based solely on the insolvency, financial condition, or receivership of” the failed company, so long as, if such contracts are guaranteed or otherwise supported by the covered financial company, the FDIC takes certain steps to protect the QFC counterparties' interests by the end of the business day following the company's entry into OLA resolution.

12 U.S.C. 5390(c)(16).

These stay-and-transfer provisions of the Dodd-Frank Act are intended to mitigate the threat posed by QFC default rights. At the same time, the provisions allow appropriate protections for QFC counterparties of the failed financial

company. The provisions stay only the exercise of default rights based on the failed company's entry into resolution, the fact of its insolvency, or its financial condition. Further, the stay period is brief, unless the FDIC transfers the QFCs to another financial company that is not in resolution (and should therefore be capable of performing under the QFCs) or, if applicable, provides adequate protection that the QFCs will be performed.

The Federal Deposit Insurance Act.

Under the FDI Act, a failing insured depository institution would generally enter a receivership administered by the FDIC.

The FDI Act addresses direct default rights in the failed bank's QFCs with stay-and-transfer provisions that are substantially similar to the provisions of Title II of the Dodd-Frank Act discussed above.

However, the FDI Act does not address cross-default rights, leaving the QFC counterparties of the failed depository institution's affiliates free to exercise any contractual rights they may have to terminate, net, or liquidate collateral based on the depository institution's entry into resolution. Moreover, as with Title II of the Dodd-Frank Act, there is a possibility that a court of a foreign jurisdiction might decline to enforce the FDI Act's stay-and-transfer provisions under certain circumstances.

12 U.S.C. 1821(c).

See

12 U.S.C. 1821(e)(8)-(10).

B. Notice of Proposed Rulemaking and General Summary of Comments

The proposal was intended to increase GSIB resolvability and resiliency by addressing two QFC-related issues. First, the proposal sought to address the risk that a court in a foreign jurisdiction may decline to enforce the QFC stay-and-transfer provisions of Title II and the FDI Act discussed above. Second, the proposal sought to address the potential disruption that may occur if a counterparty to a QFC with an affiliate of a GSIB entity that goes into resolution under the U.S. Bankruptcy Code or the FDI Act exercises cross-default rights.

Scope of application.

The proposal's requirements would have applied to all “covered entities.” Under the proposal, “covered entity” included: Any U.S. top-tier bank holding company identified as a GSIB under the Board's rule establishing risk-based capital surcharges for GSIBs (GSIB surcharge rule);

any subsidiary of such a bank holding company; and any U.S. subsidiary, U.S. branch, or U.S. agency of a foreign GSIB.

“Covered entity” did not include national banks and Federal savings associations that are supervised by the Office of the Comptroller of the Currency (OCC), because the OCC was expected to issue, and ultimately did issue, a proposed rule that would subject those institutions to requirements substantively identical to those proposed by the Board's rule for covered entities.

12 CFR 217.402; 80 FR 49106 (Aug. 14, 2015).

See

proposed rule § 252.81.

In the proposal, “qualified financial contract” or “QFC” was defined to have the same meaning as in section 210(c)(8)(D) of the Dodd-Frank Act,

and included, among other things, derivatives, repos, and securities borrowing and lending agreements. Subject to the exceptions discussed below, the proposal's requirements would have applied to any QFC to which a covered entity is party (covered QFC). Under the proposal, a covered entity would have been required to conform pre-existing QFCs if a covered entity enters into a new QFC with a counterparty or its affiliate.

12 U.S.C. 5390(c)(8)(D).

See

proposed rule § 252.81.

Required contractual provisions related to the U.S. Special Resolution Regimes.

Under the proposal, covered entities would have been required to ensure that covered QFCs include contractual terms explicitly providing that any default rights or restrictions on the transfer of the QFC are limited to at least the same extent as they would be pursuant to the OLA and the FDI Act (U.S. Special Resolution Regimes).

The proposed requirements were not intended to imply that the statutory stay-and-transfer provisions would not in fact apply to a given QFC, but rather to help ensure that all covered QFCs would be treated the same way in the context of an FDIC receivership under the Dodd-Frank Act or the FDI Act. This provision was intended to address the first issue listed above and to decrease the QFC-related threat to financial stability posed by the failure and resolution of an internationally active GSIB. This section of the proposal was also consistent with analogous legal requirements that have been imposed in other national jurisdictions

and with the Financial Stability Board's “Principles for Cross-border Effectiveness of Resolution Actions.”

See

proposed rule § 252.83.

See, e.g.,

Bank of England Prudential Regulation Authority, Policy Statement, “Contractual stays in financial contracts governed by third-country law” (Nov. 2015),

http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps2515.pdf

Financial Stability Board, “Principles for Cross-border Effectiveness of Resolution Actions” (Nov. 3, 2015),

http://www.fsb.org/wp-content/uploads/Principles-for-Cross-border-Effectiveness-of-Resolution-Actions.pdf.

The Financial Stability Board (FSB) was established in 2009 to coordinate the work of national financial authorities and international standard-setting bodies and to develop and promote the implementation of effective regulatory, supervisory, and other financial sector policies to advance financial stability. The FSB brings together national authorities responsible for financial stability in 24 countries and jurisdictions, as well as international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.

See generally

Financial Stability Board,

http://www.fsb.org

Prohibited cross-default rights.

Under the proposal, a covered entity would have been prohibited from entering into covered QFCs that would allow the exercise of cross-default rights—that is, default rights related, directly or indirectly, to the entry into resolution of an affiliate of the direct party—against it.

Covered entities would have been similarly prohibited from entering into covered QFCs that included a restriction on the transfer of a credit enhancement supporting the QFC from the covered entity's affiliate to a transferee upon the entry into resolution of the affiliate.

See

proposed rule § 252.83(b).

The Board did not propose to prohibit a covered entity from entering into QFCs that allow its counterparties to exercise direct default rights against the covered entity. Under the proposal, a covered entity also could, to the extent not inconsistent with Title II or the FDI Act, enter into a QFC that grants its counterparty the right to terminate the QFC if the covered entity fails to perform its obligations under the QFC.

Industry-developed protocol.

As an alternative to bringing their covered QFCs into compliance with the requirements set out in the proposed rule, covered entities would have been permitted to comply with the requirements of the proposed rule by adhering to the International Swaps and Derivatives Association (ISDA) 2015 Universal Resolution Stay Protocol, including the Securities Financing Transaction Annex and the Other Agreements Annex (together, the “Universal Protocol”).

The preamble to the proposal explained that the Board viewed the Universal Protocol as achieving an outcome consistent with the outcome intended by the requirements of the proposed rule by

similarly limiting direct default rights and cross-default rights.

ISDA, “Attachment to the ISDA 2015 Universal Resolution Stay Protocol,” (Nov. 4, 2015),

http://assets.isda.org/media/ac6b533f-3/5a7c32f8-pdf/

See

proposed rule § 252.85(a).

Process for approval of enhanced creditor protection conditions.

The proposal also would have allowed the Board, at the request of a covered entity, to approve as compliant with the proposal covered QFCs with creditor protections other than those that would otherwise be permitted under section 252.84 of the proposal.

The Board would have been permitted to approve such a request if, in light of several enumerated considerations,

the alternative creditor protections would mitigate risks to the financial stability of the United States presented by a GSIB's failure to at least the same extent as the proposed requirements.

See

proposed rule § 252.85.

See

proposed rule § 252.85(c).

Amendments to certain definitions in the Board's capital and liquidity rules.

The proposal also would have amended certain definitions in the Board's capital and liquidity rules to help ensure that the regulatory capital and liquidity treatment of QFCs to which a covered entity is party would not be affected by the proposed restrictions on such QFCs. Specifically, the proposal would have amended the definition of “qualifying master netting agreement” in the Board's regulatory capital and liquidity rules and would similarly amend the definitions of the terms “collateral agreement,” “eligible margin loan,” and “repo-style transaction” in the Board's regulatory capital rules.

Comments on the Proposal.

The Board received approximately 30 comments on the proposed rule from banking organizations, trade associations, public interest advocacy groups, and private individuals. Board staff also met with some commenters at their request to discuss their comments on the proposal, and summaries of these meetings may be found on the Board's public Web site.

A number of commenters, including GSIBs that would be subject to the requirements of the proposal, expressed strong support for the proposed rule as a well-considered effort to reduce systemic risk with minimal burden and as one of the last important steps to ensure a more efficient and orderly resolution process for all covered entities and thereby to protect the stability of the U.S. financial system. Other commenters, however, expressed concern with the proposed rule. These commenters generally argued that the proposal should not restrict contractual rights of GSIB counterparties and contended that the proposal shifts the costs of resolving the covered entities to non-defaulting counterparties. Some commenters argued that the proposal would not assuredly mitigate systemic risk, as the requirements could result in increased market and credit risk for QFC counterparties of a GSIB. Commenters also argued that it would be more appropriate for Congress to impose the proposal's restrictions on contractual rights through the legislative process rather than for the Board to do so through a regulation.

As described above, the proposal applied to “covered entities,” which was defined to mean all U.S. GSIBs and their subsidiaries, as well as the U.S. operations (subsidiaries, branches, and agencies) of GSIBs that are foreign banking organizations. The proposal generally defined “subsidiary” as an entity controlled by a GSIB under the Bank Holding Company Act (BHC Act). Commenters urged the Board to move to a financial consolidation standard to define the subsidiaries of covered entities, arguing that the concept of control under the BHC Act includes entities (1) that are not under the operational control of the GSIB and over whom the GSIB does not have the practical ability to require remediation and (2) which are unlikely to raise the types of concerns for the orderly resolution of GSIBs targeted by the proposal. For similar reasons, these commenters argued that, for purposes of the requirement that a covered entity conform existing QFCs if a covered entity enters into a new QFC with a counterparty or its affiliate, a counterparty's “affiliate” should also be defined by reference to financial consolidation rather than BHC Act control.

Commenters also expressed concern that the definition of “covered QFCs” under the proposal was overly broad. The proposal required a covered QFC to explicitly provide that it is subject to the stay-and-transfer provisions of Title II and the FDI Act and prohibited a covered entity from being a party to a QFC that would allow the exercise of cross-default rights. Commenters argued that the final rule should exclude QFCs that do not contain any contractual transfer restrictions, direct default rights, or cross-default rights, as these QFCs do not give rise to the risk that counterparties will exercise their contractual rights in a manner that is inconsistent with the provisions of the U.S. Special Resolution Regimes. Commenters also urged the Board to exclude QFCs governed by U.S. law from the requirement that QFCs explicitly “opt in” to the U.S. Special Resolution Regimes since it is already sufficiently clear that such QFCs are subject to the stay-and-transfer provisions of Title II and the FDI Act. With respect to the proposal's prohibition against provisions that would allow the exercise of cross-default rights in covered QFCs of a GSIB, commenters argued that the final rule should clarify that QFCs that do not contain such cross-default rights or transfer restrictions regarding related credit enhancements are not within the scope of the prohibition.

Commenters also requested that certain types of contracts that may include transfer or default rights subject to the proposal's requirements (

e.g.,

warrants; certain commodity contracts, including commodity swaps; certain utility and gas supply contracts; certain retail customer and investment advisory agreements; securities underwriting agreements; securities lending authorization agreements) be excluded from all requirements of the final rule because these types of contracts do not raise the risks to the resolution of a covered entity or financial stability that are the target of this final rule and because certain existing contracts of these types would be difficult, if not impossible, to amend. Commenters also requested that securities contracts that typically settle in the short term or that typically include only transfer restrictions and not default rights similarly be excluded from all requirements of the final rule because they do not impose ongoing or continuing obligations on either party after settlement. In all of the above cases, commenters argued that remediation of such outstanding contracts would be burdensome with no meaningful resolution benefits. Certain commenters also urged the Board to apply the final rule only to contracts entered into after the final rule's effective date and not to contracts existing as of the final rule's effective date.

As noted above, the proposal would have deemed compliant covered QFCs amended by the existing Universal Protocol (which allows for creditor protections in addition to those otherwise permitted by the proposed rule). Commenters generally supported this aspect of the proposal, although they requested express clarification that adherence to the existing Universal Protocol would satisfy all of the requirements of the final rule. Commenters urged that the final rule should also provide a safe harbor for a future ISDA protocol that would be substantially similar to the existing Universal Protocol except that it would seek to address the specific needs of buy-side market participants, such as

asset managers, insurance companies, and pension funds who are counterparties to QFCs with GSIBs, to allow, for example, entity-by-entity adherence and the exclusion of certain foreign special resolution regimes.

Commenters expressed support for the exemption in the proposal for cleared QFCs but requested that this exemption be broadened to extend to the client leg of a cleared back-to-back transaction and also to exclude any contract cleared, processed, or settled on a financial market utility (FMU) as well as any QFC conducted according to the rules of an FMU. Commenters also requested an exemption for QFCs with sovereign entities and central banks. Commenters further requested a longer period of time for covered entities to conform covered QFCs with certain types of counterparties to comply with the requirements of the final rule. Commenters also requested that the Board coordinate with other regulatory agencies, consider comments submitted to the OCC regarding its proposal and from entities not regulated by the Board, and finalize a rule with conformance periods consistent with the OCC's final rule. In addition, commenters requested confirmation that modifications to contracts to comply with this rule would not trigger other regulatory requirements (

e.g.,

margin requirements for non-cleared swaps) or impact the enforceability of QFCs. The Board has considered the comments received on this proposal, including those of entities not regulated by the Board, as well as the comments submitted to the OCC and FDIC regarding their respective proposals, and these comments and changes in the final rule are described in more detail throughout the remainder of this

SUPPLEMENTARY INFORMATION

C. Overview of Final Rule

The Board is adopting this final rule to improve the resolvability and resilience of GSIBs and thereby reduce threats to financial stability. The Board has made a number of changes to the proposal in response to concerns raised by commenters, as further described below.

The final rule is intended to facilitate the orderly resolution of the most systemically important banking firms—the GSIBs—by limiting the ability of the firms' counterparties to terminate QFCs upon the entry of the GSIB or one or more of its affiliates into resolution. The rule requires the inclusion of contractual restrictions on the exercise of certain default rights in those QFCs. In particular, the final rule requires the QFCs of covered entities to contain contractual provisions that opt into the stay-and-transfer treatment of the FDI Act and the Dodd-Frank Act to reduce the risk that the stay-and-transfer treatment would be challenged by a QFC counterparty or a court in a foreign jurisdiction. The final rule also prohibits covered entities from entering into QFCs that contain cross-default rights, subject to certain creditor protection exceptions that would not be expected to interfere with an orderly resolution.

The final rule also facilitates the implementation of the Universal Protocol, which can extend, through contractual agreement, the application of the resolution frameworks of the FDI Act and the Dodd-Frank Act to all QFCs entered into by a GSIB and its subsidiaries, including QFCs entered into by covered entities outside of the United States, and establishes restrictions on cross-default rights that are similar to those in the final rule. The final rule is necessary to implement the Universal Protocol provisions regarding the resolution of a GSIB under the U.S. Bankruptcy Code, as these provisions do not become effective until implemented by U.S. regulations. To support further adherence to the Universal Protocol, the final rule creates a safe harbor allowing covered entities to sign up to the Universal Protocol and thereby amend their QFCs pursuant to the Universal Protocol as an alternative to implementing the restrictions of the final rule on a counterparty-by-counterparty basis. In addition, the final rule provides that covered QFCs amended pursuant to adherence of a covered entity to a new protocol (the “U.S. Protocol”) would be deemed to conform to the requirements of the final rule. The U.S. Protocol may differ from the Universal Protocol in the certain respects discussed below, but otherwise must be substantively identical to the Universal Protocol.

The final rule requires covered entities to conform certain covered QFCs to the requirements of the final rule on the first day of the first calendar quarter that begins a year after issuance of the final rule (first compliance date) and phases in conformance requirements with respect to all covered QFCs over a two-year period depending on the type of counterparty. As explained below, a covered entity generally is required to conform pre-existing QFCs only if the covered entity or an affiliate of the covered entity enters into a new QFC with the same counterparty or a consolidated affiliate of the counterparty on or after the first compliance date.

1. Covered Entities

The final rule continues to apply to “covered entities,” which generally are U.S. GSIBs and their subsidiaries and the U.S. operations of foreign GSIBs. “Subsidiary” continues to be defined in the final rule by reference to BHC Act control. Because the FDIC and OCC are expected to finalize substantively identical final rules to that of the Board, the definition of “covered entity” in the final rule excludes state savings associations and state nonmember banks (FSIs), which are supervised by the FDIC, and GSIB subsidiaries (

e.g.,

national banks), U.S. branches, and U.S. agencies that are supervised by the OCC. The final rule refers to FSIs and entities supervised by the OCC (

e.g.,

national banks) that would be covered entities but for this exclusion as “excluded banks.”

As discussed below, certain other types of GSIB subsidiaries, such as merchant banking portfolio companies, are also excluded from the final rule.

See

final rule § 252.81 for definitions of “excluded bank” and “FSI.”

See also

12 U.S.C. 1813.

2. Covered Qualified Financial Contracts

The final rule, like the proposal, defines “qualified financial contract” or “QFC” to have the same meaning as in section 210(c)(8)(D) of the Dodd-Frank Act

and would include, among other things, derivatives, repos, and securities lending agreements.

Subject to the exceptions discussed below, the final rule's requirements apply to any QFC to which a covered entity is party (covered QFC). The final rule makes clear that covered entities do not need to conform QFCs that have no transfer restrictions, direct default rights, or cross-default rights, as these QFCs have no provisions that the rule is intended to address.

The final rule also excludes retail investment advisory agreements and certain existing warrants.

It also provides the Board with authority to exempt one or more covered entities from conforming certain contracts or types of contracts to the requirements of the final rule after considering, in addition to any other factor the Board deems relevant, the burden the exemption would relieve and the potential impact of the exemption on the resolvability of the covered entity or its affiliates.

12 U.S.C. 5390(c)(8)(D).

See

final rule § 252.81; proposed rule § 252.81.

See

final rule § 252.84(a).

See

final rule § 252.88(c).

See

final rule § 252.88(d).

The final rule also makes clear that a covered entity must conform existing

QFCs with a counterparty if the GSIB group (

i.e.,

the covered entity or its affiliates that are covered entities or excluded banks) enters into a new QFC with that counterparty or its affiliate, defined by reference to financial consolidation principles. In particular, the final rule provides that a covered QFC includes a QFC that the covered entity entered, executed, or otherwise became a party to before the first compliance date of this final rule if the covered entity or any affiliate that is a covered entity or excluded bank also enters, executes, or otherwise becomes a party to a QFC with the same person or a consolidated affiliate of that person on or after the first compliance date.

“Consolidated affiliate” is a defined term in the final rule that is defined by reference to financial consolidation principles.

See

final rule § 252.82(c).

See

final rule § 252.81.

3. Required Contractual Provisions Related to the U.S. Special Resolution Regimes

Under the final rule, covered entities are required to ensure that covered QFCs include contractual terms explicitly providing that any default rights or restrictions on the transfer of the QFC are limited to the same extent as they would be pursuant to the U.S. Special Resolution Regimes.

However, any covered QFC that is governed under U.S. law and involves only parties (other than the covered entity) that are domiciled in, incorporated in, organized under, or whose principal place of business is located in the United States, including any state, or that is a U.S. branch or agency (U.S. counterparties) is also excluded from the requirements of the final rule relating to Title II of the Dodd-Frank Act and the FDI Act because it is sufficiently clear that the stay-and-transfer provisions of those acts would be enforceable.

See

final rule § 252.83.

See

final rule § 252.83(a).

4. Prohibited Cross-Default Rights

Under the final rule, a covered entity is prohibited from entering into covered QFCs that would allow the exercise of cross-default rights—that is, default rights related, directly or indirectly, to the entry into resolution of an affiliate of the direct party—against it.

Covered entities are similarly prohibited from entering into covered QFCs that would restrict the transfer of a credit enhancement supporting the QFC from the covered entity's affiliate to a transferee upon the entry into resolution of the affiliate.

See

final rule § 252.84(b).

See id.

The final rule does not prohibit covered entities from entering into QFCs that provide their counterparties with direct default rights against the covered entity. Under the final rule, a covered entity may be party to a QFC that, to the extent not inconsistent with Title II or the FDI Act, provides the counterparty with the right to terminate the QFC if the covered entity fails to perform its obligations under the QFC.

5. Industry-Developed Protocol

As an alternative to bringing their covered QFCs into compliance with the requirements of the final rule, the final rule allows covered entities to comply with the rule by adhering to the Universal Protocol.

The final rule also permits compliance with the final rule through adherence to a new protocol (the U.S. Protocol) that is the same as the existing Universal Protocol but for minor changes intended to encourage a broader range of QFC counterparties to adhere only with respect to covered entities and excluded banks. The Universal Protocol and the U.S. Protocol differ from the requirements of this final rule in certain respects. Nevertheless, as described in greater detail below, the final rule allows compliance through adherence to these protocols in light of the fact that the protocols contain certain desirable features that the final rule lacks and produce outcomes substantially similar to this final rule.

See

final rule § 252.85(a).

6. Process for Approval of Enhanced Creditor Protection Conditions

The final rule also allows the Board, at the request of a covered entity, to approve as compliant with the final rule covered QFCs with creditor protections other than those that would otherwise be permitted under section 252.84 of the final rule.

The Board could approve such a request if, in light of several enumerated considerations, the alternative approach would prevent or mitigate risks to the financial stability of the United States presented by a GSIB's failure and would protect the safety and soundness of bank holding companies and state member banks to at least the same extent as the final rule's requirements.

See

final rule § 252.85(c).

See

final rule § 252.85(c)-(d).

7. Amendments to Certain Definitions in the Board's Capital and Liquidity Rules

The final rule also amends certain definitions in the Board's capital and liquidity rules to help ensure that the regulatory capital and liquidity treatment of QFCs to which a covered entity is party is not affected by the proposed restrictions on such QFCs. Specifically, the final rule amends the definition of “qualifying master netting agreement” in the Board's regulatory capital and liquidity rules and similarly amends the definitions of the terms “collateral agreement,” “eligible margin loan,” and “repo-style transaction” in the Board's regulatory capital rules.

D. Consultation With U.S. Financial Regulators, the Council, and Foreign Authorities

In developing this final rule, the Board consulted with the FDIC, the OCC, and the Financial Stability Oversight Council (Council).

The final rule reflects input received by the Board during this consultation process. Furthermore, the Board has consulted with, and expects to continue to consult with, foreign financial regulatory authorities regarding this final rule and the establishment of other standards that would maximize the prospects for the cooperative and orderly cross-border resolution of a failed GSIB on an international basis.

One commenter also requested that the Board consult with other agencies with entities under their jurisdiction affected by the final rule. Several commenters requested that the Board consult with the OCC in developing its final rule and coordinate its final rule with that of the OCC. Board staff has consulted with the Council as well as the FDIC and OCC in developing this final rule.

Certain commenters also requested that the Board consult with foreign regulatory authorities in developing its final rule.

The OCC is expected to finalize a rulemaking that would subject national banks, Federal savings associations, Federal branches, and Federal agencies of GSIBs to requirements substantively identical to those proposed here for covered entities. Similarly, the FDIC is expected to finalize a rulemaking that would subject state nonmember bank and state savings association subsidiaries of GSIBs to requirements substantively identical to those proposed here for covered entities. The Board has consulted with the OCC and FDIC in the development of their respective final rules. The banking agencies have endeavored to harmonize their respective rules to the extent possible and to provide specificity and clarity in the final rule to minimize the possibility of conflicting interpretations or uncertainty in their application. Moreover, the banking agencies intend to consult with each other and coordinate as needed regarding implementation of the final rule.

II. Restrictions on QFCs of GSIBs

A. Covered Entities (Section 252.82(b) of the Final Rule)

The proposed rule applied to “covered entities,” which included (a) any U.S. GSIB top-tier bank holding company, (b) any subsidiary of such a bank holding company that is not a “covered bank,” and (c) the U.S. operations of any foreign GSIB, with the exception of any “covered bank.” In the proposal, the term “covered bank” was defined to include certain entities, such as certain national banks, that are supervised by the OCC. Covered banks would have been exempt from the requirements of the proposal because the OCC was expected to issue a proposed rule that would impose substantively identical requirements on covered banks.

Commenters supported this exemption for QFCs of covered banks on the basis that these banks should not have to comply with two sets of rules.

Section 252.88 of the Board's proposal also clarified that covered entities would not be required to conform covered QFCs with respect to a part of a covered QFC that a covered bank also would be required to conform under the proposed rule that the OCC subsequently issued.

Commenters requested further clarification on the interaction between the final rules of the Board and the OCC to avoid legal uncertainty. As noted above, the OCC and FDIC are expected to finalize rules that are substantively identical to this final rule, and the banking agencies are expected to coordinate in the interpretation of the rules. Section 252.88(b) of the final rule, which addresses potential overlap between the agencies' final rules, has been clarified in response to commenters' requests. Section 252.88(b) is discussed in more detail below.

Under the proposal, covered entities included the entities identified as U.S. GSIB top-tier holding companies under the Board's GSIB surcharge rule

as well as all subsidiaries of U.S. GSIBs (other than covered banks, as defined in the proposal).

The definition of “subsidiary” under the proposal included any company that is owned or controlled directly or indirectly by another company, where the term “control” was defined by reference to the BHC Act.

The BHC Act definition of control includes ownership, control or the power to vote 25 percent of any class of voting securities; control in any manner of the election of a majority of the directors or trustees; or exercise of a controlling influence over the management or policies.

12 CFR 217.402.

See also

80 FR 49082 (Aug. 14, 2015).

See

proposed rule § 252.82(a)(1).

See

12 CFR 252.2.

See

12 U.S.C. 1841(a).

A few commenters urged the Board not to expand the scope of covered entity to include non-GSIBs, arguing that such an expansion would exceed the Board's statutory authority under the Dodd-Frank Act. The Board is not including non-GSIBs as covered entities in its final rule.

A number of commenters urged the Board to move to a financial consolidation standard to define a “subsidiary” of a covered entity instead of BHC Act control.

These commenters argued that, under Generally Accepted Accounting Principles, a company generally would consolidate an entity in which it holds a majority voting interest or over which it has the power to direct the most significant economic activities, to the extent it also holds a variable interest in the entity. In addition, commenters pointed out that financially consolidated subsidiaries are often subject to operational control and generally fully integrated into the parent's enterprise-wide governance, policies, procedures, control frameworks, business strategies, information technology systems, and management systems. These commenters pointed out that the concept of BHC Act control was designed to serve other policy purposes (

e.g.,

separation between banking and commercial activities). A number of commenters argued that BHC Act control may include an entity that is not under the day-to-day operational control of the GSIB and over whom the GSIB does not have the practical ability to require remediation of that entity's QFCs to comply with the proposed rule. Moreover, commenters contended that entities that are not consolidated with a GSIB for financial reporting purposes are unlikely to raise the types of concerns for the orderly resolution of GSIBs targeted by the proposal. Commenters also noted that the ISDA master agreements and the Universal Protocol define “affiliate” by reference to ownership of a majority of the voting power of an entity or person. For these reasons, commenters urged the Board to define the term “subsidiary” of a covered entity based on financial consolidation under the final rule.

Commenters generally expressed a similar view with respect to the definition of “affiliate” of a covered entity as the term is used in sections 252.83 and 84 of the proposed rule. That term which was similarly defined by reference to BHC Act control under the proposal.

Commenters urged that, regardless of whether a financial consolidation standard is adopted for the purpose of defining “subsidiary,” the final rule should exclude from the definition of “covered entity” entities over which the covered entity does not exercise operational control, such as merchant banking portfolio companies, section 2(h)(2) companies, joint ventures, sponsored funds as distinct from their sponsors or investment advisors, securitization vehicles, entities in which the covered entity holds only a minority interest and does not exert a controlling influence, and subsidiaries held pursuant to provisions for debt previously contracted in good faith (DPC subsidiaries).

With respect to merchant banking authority, which allows a financial holding company to make a majority or minority investment in a portfolio company that is engaged in activity that is not financial in nature, certain commenters noted that section 4(k) of the BHC Act prohibits the financial holding company from routinely managing or operating the portfolio company except as may be necessary or required to obtain a reasonable return on investment upon resale or other disposition of the portfolio company.

Regarding sponsored funds, commenters argued that each sponsored or advised fund is a separate legal entity that is distinct from its sponsor or investment advisor regardless of whether the fund is consolidated and that the sponsor or advisor has no claim on the fund's assets and may not use the fund's assets for its benefit.

See, e.g.,

12 U.S.C. 1842(a)(A)(ii), 1843(c)(2); 12 CFR 225.12(b), 225.22(d)(1).

12 U.S.C. 1843(k)(4)(H)(iv); 12 CFR 225.171(a).

In terms of foreign GSIBs, certain commenters argued that foreign banking organization (FBO) subsidiaries for which the FBO has been given special relief by Board order not to hold the subsidiary under an intermediate holding company should not be included in the definition of covered entity, even if such entities would be consolidated under financial consolidation principles.

These commenters argued that, since neither the covered entity nor the foreign GSIB parent would provide credit support to these entities or name such entities in a cross-default provision in a QFC or related agreement, the failure of any of these types of entities would be unlikely to affect QFCs entered into by the covered entity or any other affiliate. These commenters further noted that the few such requests that have been granted by the Board often involved situations in which the FBO did not have sufficient operational control over the entity to ensure its compliance. Commenters also requested that U.S.

branches and agencies of FBOs be excluded from the definition of “covered entity” and “U.S. operations” of foreign GSIBs where the foreign GSIB's home country legal framework meets the objectives of the final rule. These commenters argued that the requirements of the final rule would be duplicative of requirements on a foreign GSIB's U.S. branches and agencies if those entities' QFCs are already subject to existing and substantially equivalent resolution powers in the home country, without a proportionate incremental benefit to their resolvability or reduction in risk to U.S. financial stability.

Board orders granting requests from FBOs for such treatment can be found at Regulation YY Foreign Banking Organization Requests,

https://www.federalreserve.gov/supervisionreg/regulation-yy-foreign-banking-organization-requests.htm

In the alternative, these commenters requested that the requirements only apply to U.S. branches of foreign GSIBs insofar as the home resolution regime and group resolution strategy would not adequately ensure that early termination rights, including cross-default rights against the U.S. IHC or subsidiaries, will not be triggered in resolution.

Under the final rule, a “covered entity” is generally (a) any U.S. GSIB top-tier bank holding company; (b) any subsidiary of such a company that is not a national bank, Federal savings association, Federal branch, Federal agency, or FSI; and (c) the U.S. operations of any foreign GSIB that is not a national bank, Federal savings association, Federal branch, Federal agency, or FSI, with certain specified exceptions.

“FSI” is defined to include state nonmember banks and state savings associations, which are supervised by the FDIC.

National banks, Federal savings associations, Federal branches, Federal agencies, and FSIs that are exempt from the final rule are “excluded banks” under the final rule.

Excluded banks are exempt from the requirements of this final rule because the OCC and FDIC are expected to issue final rules that would impose substantively identical requirements on excluded banks in the near future.

See

final rule § 252.82(b).

The terms “state non-member bank” and “state savings association” are defined in the final rule by reference to section 3 of the Federal Deposit Insurance Act, 12 U.S.C. 1813.

See

final rule § 252.81.

See

final rule § 252.81. However, excluded banks do not include subsidiaries of a GSIB that are DPC subsidiaries or portfolio companies owned under the Small Business Investment Act of 1956, or public welfare investments.

Section 252.88(b) of the final rule, like the proposal, clarifies that covered entities are not required to conform covered QFCs with respect to a part of a covered QFC that an excluded bank also would be required to conform under the final rules that the OCC and FDIC are expected to issue. Such overlap could occur, for example, where a bank holding company that is a covered entity provides, as part of a master agreement governing swaps, a guaranty for a swap between a subsidiary that is an excluded bank and the excluded bank's counterparty.

See also

12 U.S.C 5390(c)(8)(D)(vi)(V), (viii). As requested by commenters, this provision in the final rule has been revised to further clarify its application.

U.S. GSIB bank holding companies.

As in the proposal, covered entities include the entities identified as U.S. GSIB top-tier holding companies under the Board's GSIB surcharge rule.

Under the GSIB surcharge rule, a U.S. top-tier bank holding company subject to the advanced approaches rule

must determine whether it is a GSIB by applying a multifactor methodology established by the Board.

The methodology evaluates a banking organization's systemic importance on the basis of its attributes in five broad categories: Size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity.

See

final rule § 252.82(b)(1); 12 CFR 217.402.

12 CFR part 217, subpart E.

12 CFR 217.402, 217.404.

12 CFR 217.404.

Accordingly, the methodology provides a tool for identifying those banking organizations whose failure or material distress would pose especially large risks to the financial stability of the United States. Improving the orderly resolution and resolvability of such firms, including by reducing risks associated with their QFCs, would be an important step toward achieving the goals of the Dodd-Frank Act. The final rule's focus on GSIBs is also in keeping with the Dodd-Frank Act's mandate that more stringent prudential standards be applied to the most systemically important bank holding companies.

Moreover, several of the attributes that feed into the determination of whether a given firm is a GSIB incorporate aspects of the firm's QFC activity. These attributes include the firm's total exposures, its intra-financial system assets and liabilities, its notional amount of over-the-counter derivatives, and its cross-jurisdictional claims and liabilities.

12 U.S.C. 5365(a)(1)(B).

Under the GSIB surcharge rule's methodology, there are currently eight U.S. GSIBs: Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley Inc., State Street Corporation, and Wells Fargo & Company. This list may change in the future in light of changes to the relevant attributes of the current U.S. GSIBs and of other large U.S. bank holding companies.

U.S. GSIB subsidiaries.

Covered entities also include all subsidiaries of the U.S. GSIBs (other than excluded banks and the exceptions described below).

U.S. GSIBs generally enter into QFCs through subsidiary legal entities rather than through the top-tier holding company.

Therefore, in order to increase GSIB resilience and resolvability by addressing the potential obstacles to orderly resolution posed by QFCs, it is necessary to apply the restrictions to the U.S. GSIBs' subsidiaries. In particular, to facilitate the resolution of a GSIB under an SPOE strategy, in which only the top-tier holding company would enter a resolution proceeding while its subsidiaries would continue to meet their financial obligations, or an MPOE strategy where an affiliate of an entity that is otherwise performing under a QFC enters resolution, it is necessary to ensure that those subsidiaries or affiliates do not enter into QFCs that contain cross-default rights that the counterparty could exercise based on the holding company's or an affiliate's entry into resolution (or that any such cross-default rights are stayed when the holding company enters resolution). Moreover, including U.S. and non-U.S. entities of a U.S. GSIB as covered entities should help ensure that such cross-default rights do not affect the ability of performing and solvent entities of a GSIB—regardless of jurisdiction—to remain outside of resolution proceedings.

See

final rule § 252.82(b)(2).

Under the clean holding company component of the Board's recent TLAC final rule, the top-tier holding companies of U.S. GSIBs would be prohibited from entering into direct QFCs with third parties.

See

82 FR 8266, 8298 (Jan. 24, 2017).

“Subsidiary” in the final rule continues to be defined by reference to BHC Act control, as does the definition of “affiliate.”

The final rule does not define covered entities to include only those subsidiaries of GSIBs that are financially consolidated, as requested by certain commenters. Defining “subsidiary” and “affiliate” by reference to BHC Act control is consistent with the definitions of those terms in the FDI Act and Title II of the Dodd-Frank Act. Specifically, Title II permits the FDIC, as receiver of a covered financial company or as receiver for its subsidiary, to enforce QFCs and other contracts of subsidiaries and affiliates, defined by reference to the BHC Act, notwithstanding cross-default rights based solely on the insolvency, financial condition, or receivership of the covered financial company.

Therefore, maintaining consistent definitions of subsidiary and affiliate with Title II should better ensure that QFC stays may be effected in resolution under a U.S. Special Resolution Regime. As covered entities are subject to the activity

restrictions and other requirements of the BHC Act, they should already know all of their BHC Act-controlled subsidiaries and be familiar with BHC Act control principles.

Moreover, GSIBs should be able to rely on governance rights and other negotiated mechanisms to ensure that such subsidiaries conform their QFCs to the final rule's requirements.

See

12 CFR 252.2.

12 U.S.C. 5390(c)(16).

For example, a covered entity may own more than 5 percent (and less than 25 percent) of the voting shares of a registered investment company for which the covered entity provides investment advisory, administrative, and other services, and has a number of director and officer interlocks, without controlling the fund for purposes of the BHC Act.

See

letter to H. Rodgin Cohen, Esq., Sullivan & Cromwell (First Union Corp.), from Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System (June 24, 1999) (finding that a bank holding company does not control a mutual fund for which it provides investment advisory and other services and that complies with the limitations of section 4(c)(7) of the BHC Act (12 U.S.C. 1843(c)(7)), so long as (i) the bank holding company reduces its interest in the fund to less than 25 percent of the fund's voting shares after a six-month period, and (ii) a majority of the fund's directors are independent of the bank holding company and the bank holding company cannot select a majority of the board);

See also

12 U.S.C. 5390(c)(8)(D).

The application of the rule's requirements to a “covered QFC” was one of the most commented upon aspects of the proposal. Certain commenters argued that the definition of QFC in Title II of the Dodd-Frank Act was overly broad and imprecise and could include agreements that market participants may not expect to be subject to the stay-and-transfer provisions of the U.S. Special Resolution Regimes. More generally, commenters argued that the proposed definition of QFC was too broad and would capture contracts that do not present any obstacles to an orderly resolution. Commenters urged the Board to exclude a variety of types of QFCs from the requirements of the final rule. In particular, a number of commenters urged the Board to exclude QFCs that do not contain any transfer restrictions or default rights, because these types of QFCs do not give rise to the risk that counterparties will exercise their contractual rights in a manner that is inconsistent with the provisions of the U.S. Special Resolution Regimes. Commenters named several examples of contracts that fall into this category, including cash market securities transactions, certain spot FX transactions (including securities conversion transactions), retail brokerage agreements, retirement/IRA account agreements, margin agreements, options agreements, FX forward master agreements, and delivery versus payment client agreements. Commenters contended that these types of QFCs number in the millions at some firms and that remediating these contracts to include the express provisions required by the final rule would require an enormous client outreach effort that would be extremely burdensome and costly while providing no meaningful resolution benefits. For example, commenters pointed out that for certain types of transaction, such as cash securities transactions, FX spot transactions, and retail QFCs, such a requirement could require an overhaul of existing market practice and documentation that affects hundreds of thousands, if not millions, of transactions occurring on a daily basis and significant education of the general market.

Commenters also urged the Board to exclude QFCs that do not contain any default or cross-default rights but that may contain transfer restrictions. Commenters contended that examples of these types of agreements included investment advisory account agreements with retail customers, which contain transfer restrictions as required by section 205(a)(2) of the Investment Advisers Act of 1940, but no direct default or cross-default rights; underwriting agreements;

106

and client onboarding agreements. A few commenters provided prime brokerage or margin loan agreements as examples of transactions that generally do not have default or cross-default rights but may have transfer restrictions. Another commenter also requested the exclusion of securities market transactions that generally settle in the short term, do not impose ongoing or continuing obligations on either party after settlement, and do not typically include default rights.

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In these cases, commenters contended that remediation of these agreements would be burdensome with no meaningful resolution benefits.

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However, certain commenters noted that underwriting, purchase, subscription, or placement agency agreements may contain rights that could be construed as cross-default rights or default rights.

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In the alternative, the commenter requested that such securities market transactions be excluded to the extent they are cleared, processed, and settled through (or subject to the rules of) FMUs through expansion of the proposed exemption for transactions with central counterparties. This aspect of the comment is addressed in the subsequent section discussing requests for expansion of the proposed exemption for transactions with central counterparties.

Commenters also argued for the exclusion of a number of other types of contracts from the definition of covered QFC in the final rule. In particular, a number of commenters urged the Board to exclude contracts issued in the capital markets or related to a capital market issuance, like warrants or a certificate representing a call option, typically on a security or a basket of securities. Although warrants issued in capital markets may contain direct default and cross-default rights as well as transfer restrictions, commenters argued that remediation of outstanding warrant agreements would be difficult, if not impossible, since remediation would require the affirmative vote of a substantial number of separate voting groups of holders to amend the terms of the instruments and that obtaining such consent could be expensive due to “hold-out” premiums. Commenters also

argued that since these instruments are traded in the markets, it is not possible for an issuer to ascertain whether a particular investor in such instruments has also entered into other QFCs with the dealer or any of its affiliates (or vice versa) for purposes of complying with the proposed mechanism for remediation of existing QFCs. Commenters argued that issuers would be able to comply if the final rule's requirements applied only on a prospective basis with respect to new issuances, since new investors could be informed of the terms of the warrant at the time of purchase and no after-the-fact consent would be required, as is the case with existing outstanding warrants. Commenters expressed the view that prospective application of the final rule's requirements to warrants would allow time for firms to develop new warrant agreements and warrant certificates, to engage in client outreach efforts, and to make any appropriate public disclosures. Commenters suggested that the requirements of the final rule should only apply to such instruments issued after the effective date of the final rule and that the compliance period for such new issuances be extended to allow time to establish new issuance programs that comply with the final rule's requirements. Other examples of contracts in this category given by commenters include contracts with special purpose vehicles that are multi-issuance note platforms, which commenters urged would be difficult to remediate for similar reasons to warrants other than on a prospective basis.

Commenters also urged the exclusion of contracts for the purchase of commodities in the ordinary course of business (

e.g.,

utility and gas energy supply contracts) or physical delivery commodity contracts more broadly.

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In general, commenters argued that exempting these contracts would not increase systemic risk but would help ensure the smooth operation of utilities and the physical commodities markets.

109

Commenters indicated that failure to make commodity deliveries on time can result in the accrual of damages and penalties beyond the accrual of interest (

e.g.,

demurrage and other fines in shipping) and that counterparties may not be able to obtain appropriate compensation for amendment of default rights due to the difficulty of pricing the risk associated with an operational failure due to the failure to deliver a commodity on time. Commenters also contended that agreements with power operators governed by regulatory tariffs would be difficult, if not impossible, to remediate.

110

108

For example, some commenters urged the exclusion of all contracts requiring physical delivery between commercial entities in the course of regulatory business such as (i) contracts subject to a Federal Energy Regulatory Commission-filed tariff; (ii) contracts that are traded in markets overseen by independent system operators or regional transmission operators; (iii) retail electric contracts; (iv) contracts for storage or transportation of commodities; (v) contracts for financial services with regulated financial entities (

e.g.,

brokerage agreements and futures account agreements); and (vi) public utility contracts.

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One commenter also argued that utility and gas supply contracts are covered sufficiently in section 366 of the U.S. Bankruptcy Code. This section of the U.S. Bankruptcy Code places restrictions on the ability of a utility to “alter, refuse, or discontinue service to, or discriminate against, the trustee or the debtor solely on the basis of the commencement of a case under [the U.S. Bankruptcy Code] or that a debt owed by the debtor to such utility for service rendered before the order for relief was not paid when due.” 11 U.S.C. 366. The purpose and effect of section 252.84 of the final rule and section 366 of the U.S. Bankruptcy Code are different and therefore do not serve as substitutes. Section 366 of the U.S. Bankruptcy Code does not address cross-defaults or provide additional clarity regarding the application of the U.S. Special Resolution Regimes. Similarly, section 252.84 of the final rule does not prevent a covered entity from entering into a covered QFC that allows the counterparty to exercise default rights once a covered entity that is a direct party either enters bankruptcy or fails to pay or perform under the QFC.

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One commenter also requested exclusion of overnight transactions, particularly overnight repurchase agreements, arguing that such transactions present little risk of creating negative liquidity effects and that an express exclusion for such transactions may increase the likelihood that such contracts would remain viable funding sources in times of liquidity stress. Although the final rule does not exempt overnight repo transactions, the final rule may have limited if any effect on such transactions. As described below, the final rule provides a number of exemptions that may apply to overnight repo and similar transactions. Moreover, the restrictions on default rights in section 252.84 of the final rule do not apply to any right under a contract that allows a party to terminate the contract on demand or at its option at a specified time, or from time to time, without the need to show cause.

See

final rule § 252.81 (defining “default right”). Therefore, section 252.84 does not restrict the ability of QFCs, including overnight repos, to terminate at the end of the term of the contract.

The final rule applies to any “covered QFC,” which generally is defined as any “in-scope QFC” that a covered entity enters into, executes, or to which the covered entity otherwise becomes a party.

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As under the proposal, “qualified financial contract” or “QFC” is defined in the final rule as in section 210(c)(8)(D) of Title II of the Dodd-Frank Act and includes swaps, repo and reverse repo transactions, securities lending and borrowing transactions, commodity contracts, and forward agreements.

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Parties that enter into contracts with covered entities have been potentially subject to the stay-and-transfer provisions of Title II of the Dodd-Frank Act since its enactment. Consistent with Title II, the final rule does not exempt QFCs involving physical commodities. However, as explained below, the final rule responds to concerns regarding the smooth operation of physical commodities end users and markets by allowing counterparties to terminate QFCs based on the failure to pay or perform.

111

See

final rule § 252.82(c).

112

See

final rule § 252.81.

See also

12 U.S.C. 5390(c)(8)(D).

In response to concerns raised by commenters, the final rule exempts QFCs that have no transfer restrictions or default rights, as these QFCs have no provisions that the rule is intended to address. The final rule effects this exemption by limiting the scope of QFCs potentially subject to the rule to those QFCs that explicitly restrict the transfer of a QFC from a covered entity or explicitly provide default rights that may be exercised against a covered entity (in-scope QFCs).

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This change addresses a major concern raised by commenters regarding the overbreadth of the definition of “covered QFC” in the proposal. The change also mitigates the burden of complying with the proposed rule without undermining its purpose by not requiring covered entities to conform contracts that do not contain the types of default rights and transfer restrictions that the final rule is intended to address. The Board has declined, however, to exclude QFCs that have transfer restrictions (but no default rights or cross-default rights), as requested by certain commenters, as such QFCs would have provisions (

i.e.,

transfer restrictions) that are subject to the requirements of the final rule and could otherwise impede the orderly resolution of a covered entity or its affiliate.

113

See

final rule § 252.82(d).

The final rule provides that a covered entity is not required to conform certain investment advisory contracts described by commenters (

i.e.,

investment advisory contracts with retail advisory customers

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of the covered entity that only contain the transfer restrictions required by section 205(a) of the Investment Advisers Act). The final rule also exempts existing warrants evidencing a right to subscribe or to

otherwise acquire a security of a covered entity or its affiliate.

115

The Board has determined to exclude these types of agreements since there is persuasive evidence that these types of contracts would be burdensome to conform and that it is unlikely that excluding such contracts from the requirements of the final rule would impair the orderly resolution of a GSIB.

116

114

See

final rule § 252.88(c)(1). The final rule defines retail customer or counterparty by reference to the Board's Regulation WW.

See

12 CFR 249.3;

See also

12 CFR 217.2.

The final rule also makes clear that, if one or more FMUs are the only counterparties to a covered QFC, the covered entity is not required to conform the covered QFC to the final rule.

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Therefore, an FMU's default rights and transfer restrictions under the covered QFC are not affected by the final rule. However, this exclusion would not include a covered QFC with a non-FMU counterparty, even if the QFC is settled by an FMU or if the FMU is a party to such QFC, because the final rule is intended to address default rights of non-FMU parties. For example, if two covered entities engage in a bilateral QFC that is facilitated by an FMU and, in the course of this facilitation each covered entity maintains a QFC solely with the FMU, then the final rule would not apply to each QFC between the FMU and each covered entity but the requirements of the final rule

would

apply to the bilateral QFC between the two covered entities. This approach ensures that QFCs that are directly with FMUs are treated in a manner similar to transactions between covered entities and CCPs, but also ensures that QFCs conducted by covered entities that are related to the direct QFC with the FMU

remain subject to the final rule's requirements.

134

See

final rule § 252.88(a)(2). In response to commenters, the final rule uses the definition of FMU in Title VIII of the Dodd-Frank Act and may apply, for purposes of the final rule, to entities regardless of jurisdiction. The definition of FMU in the final rule includes a broader set of entities, in addition to CCPs. However, the definition in the final rule does not include depository institutions that are engaged in carrying out banking-related activities, including providing custodial services for tri-party repurchase agreements. The definition also explicitly excludes certain types of entities (

e.g.,

registered futures associations, swap data repositories) and other types of entities that perform certain functions for or related to FMUs (

e.g.,

futures commission merchants).

The final rule does not explicitly exclude futures and cleared swaps agreements with a futures commission merchant, as requested by a commenter. The nature and scope of the requested exclusion is unclear, and, therefore, it is unclear whether the exclusion would be necessary, on the one hand, or overbroad, on the other hand. However, the final rule makes a number of other clarifications and exemptions that may help address the commenter's concern regarding FCM agreements.

Exclusion of certain QFCs under multi-branch master agreements of foreign banking organizations.

To avoid imposing unnecessary restrictions on QFCs that are not closely connected to the United States, the proposal excluded from the definition of “covered QFC” certain QFCs of foreign GSIBs that lack a close connection to the foreign GSIB's U.S. operations.

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The proposed definition of “QFC” included master agreements that apply to QFCs.

136

Master agreements are contracts that contain general terms that the parties wish to apply to multiple transactions between them; having executed the master agreement, the parties can then include those terms in future contracts through reference to the master agreement. Moreover, the Dodd-Frank Act's definition of “qualified financial contract,” which the proposal would adopt, treats master agreements for QFCs together with all supplements to the master agreement (including underlying transactions) as a single QFC.

137

135

See

proposed rule § 252.86.

136

See

proposed rule § 252.81.

137

12 U.S.C. 5390(c)(8)(D)(viii);