The Federal Reserve Board (the “FRB” or the “Board”)  issued an advance notice of proposed rulemaking (the “ANPR”) seeking public comment on issues related to activities concerning physical commodities conducted by financial holding companies (“FHCs,” and each a “FHC”) and the restrictions needed to make certain that those activities are conducted in a safe and sound manner that is consistent with applicable law.  The FRB said that the applicable activities are those: (1) found to be “complementary to a financial activity” under section 4(k)(1)(B) of the Bank Holding Company Act (the “BHC Act”); (2) investment activities under section 4(k)(1)(H) of the BHC Act; and (3) physical commodity activities grandfathered under section 4(o) of the BHC Act.  Specifically, the activies related to physical commodities in which the Board has currently authorized FHCs to engage are:

“(1) physical commodity trading involving the purchase and sale of commodities in the spot market, and taking and making delivery of physical commodities to settle commodity derivatives (Physical Commodity Trading); (2) paying power plant owners fixed periodic payments that compensate the owner for its fixed costs in exchange for the right to all or part of the plant’s power output (Energy Tolling); and (3) providing transactions and advisory services to power plant owners (Energy Management Services).”

(collectively, “Complementary Commodities Activities”).

In the ANPR, the FRB notes that in the past several years, banking organizations have increased their activities involving physical commodity trading and during the same period, certain events (including the recent, global financial crisis and various environmental catastrophes) occurred that “suggest that the risks of conducting these activities are changing and the steps that firms may take to limit these risks are more limited.”

The 24 questions regarding the activities related to physical commodities that are posed by the FRB in the ANPR are:

            Question 1.  What criteria should the Board look to when determining whether a physical commodity poses an undue risk to the safety and soundness of a FHC?

            Question 2.  What additional conditions, if any, should the Board impose on Complementary Commodities Activities?  For example, are the risks of these activities adequately addressed by imposing one or more of the following requirements: (i) enhanced capital requirements for Complementary Commodities Activities, (ii) increased insurance requirements for Complementary Commodities Activities, and (iii) reductions in the amount of assets and revenue attributable to Complementary Commodities Activities, including absolute dollar limits and caps based on a percentage of the FHC’s regulatory capital or revenue?

            Question 3.  What additional conditions on Complementary Commodities Activities should the Board impose to provide meaningful protections against the legal, reputational and environmental risks associated with physical commodities and how effective would such conditions be?

            Question 4.  To what extent does the commitment that a FHC will only hold physical commodities for which a futures contract has been approved by the CFTC or for which the Board has specifically authorized the FHC to hold adequately ensure that physical commodities positions of FHCs are sufficiently liquid? What modifications to this commitment, including additional conditions, should the Board consider to ensure that a FHC maintains adequate liquidity in its commodity positions?

            Question 5.  What additional commitments or restrictions are necessary to ensure FHCs engaging in Complementary Commodities Activities do not develop unsafe or unsound concentrations in physical commodities?

            Question 6.  Should the type and scope of limitations on Complementary Commodities Activities differ based on whether the underlying physical commodity may be associated with catastrophic risks?  If so, how should limitations differ, and what specific limitations could reduce liability from potential catastrophic events?

            Question 7.  Does the commitment not to own, operate or invest in facilities for the extraction, transportation, storage, or distribution of commodities adequately insulate a FHC from risks associated with such facilities, including financial risk, storage risk, transportation risk, reputation risk, and legal and environmental risks?  If not, what restrictions should the Board impose to ensure that such extraction, transportation, storage or distribution facilities do not pose safety and soundness risks?

            Question 8.  Do Complementary Commodities Activities pose risks or raise concerns other than those described in this ANPR, and if so, how should those risks or concerns be addressed?

            Question 9.   What negative effects, if any, would a FHC’s subsidiary depository institution experience if the parent FHC was not able to engage in Complementary Commodities Activities?

            Question 10.  How effective is the current value-at-risk capital framework in addressing the risk arising from holdings of physical commodities? Would additional or different capital requirements better address the potential risks associated with Complementary Commodities Activities?

            Question 11.  What are the similarities and differences between the risks posed to FHCs by physical commodities activities, as described in this ANPR, and the risks posed to nonbank financial companies supervised by the Board (“nonbank SIFIs”)?  How do the safety and soundness and financial stability risks posed by physical commodities activities differ, if at all, based on whether the nonbank SIFI controls an IDI?

            Question 12.  What are the similarities and differences between the risks posed to FHCs by physical commodities activities, as described in the ANPR, and the risks posed to savings and loan holding companies that may conduct such activities?  How do the safety and soundness and financial stability risks posed by physical commodities activities differ, if at all, based on whether the savings and loan holding company is or is not affiliated with an insurance company?

            Question 13.  In what ways are non-BHC participants in the physical commodities markets combining financial and nonfinancial products or services in such markets?

            Question 14.  What are the complementarities or synergies between Complementary Commodities Activities and the financial activities of FHCs? How have these complementarities or synergies changed over time?

            Question 15.  What are the competitive effects on commodities markets of FHC engagement in Complementary Commodities Activities?

            Question 16.  Does permitting FHCs to engage in Complementary Commodities Activities create material conflicts of interest that are not addressed by existing law?  If so, describe such material conflicts and how they may be addressed.

            Question 17.  What are the potential adverse effects and public benefits of FHCs engaging in Complementary Commodities Activities?  Do the potential adverse effects of FHCs engaging in Complementary Commodities Activities, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, unsound banking practices, or risk to the stability of the United States banking or financial system, outweigh the public benefits, such as greater convenience, increased competition, or gains in efficiency?

            Question 18.  In what ways would FHCs be disadvantaged if they did not have authority to engage in Complementary Commodities Activities?  How might elimination of the authority affect FHC customers and the relevant markets?

            Question 19.  Should the Board’s merchant banking rules regarding holding periods, routine management, or prudential requirements be more restrictive for investments in portfolio companies that pose significantly greater risks to the safety and soundness of the investing FHC or its subsidiary depository institution(s)?  How could the Board evaluate the types and degrees of risks posed by individual portfolio companies or commercial industries?

            Question 20.  Do the Board’s current routine management restrictions and risk management requirements sufficiently protect against a court piercing the corporate veil of a FHC’s portfolio company?  If not, what additional restrictions or requirements would better ensure against successful veil piercing actions?

            Question 21.  What are the advantages and disadvantages of the Board raising capital requirements on merchant banking investments or placing limits on the total amount of merchant banking investments made by a FHC?  How should the Board formulate any such capital requirements or limits?

            Question 22.  What are the similarities and differences between the risks described above regarding merchant banking investments and the risks regarding investments made under section 4(k)(4)(I) of the BHC Act, which allows insurance companies to make controlling investments in nonfinancial companies (subject to certain restrictions)?

            Question 23.  What are the advantages and disadvantages of the Board instituting additional safety and soundness, capital, liquidity, reporting, or disclosure requirements for BHCs engaging in activities or investments under section 4(o) of the BHC Act?  How should the Board formulate such requirements?

            Question 24.  Does section 4(o) of the BHC Act create competitive equity or other issues or authorize activities that cannot be conducted in a safe and sound manner by an FHC?  If so, describe such issues or activities.

Comments on the ANPR are due no later than March 15, 2014.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.