'Damning' Ruling Against FSOC Could Cripple Council

WASHINGTON — A sharply critical ruling by a federal judge against the Financial Stability Oversight Council's process for designating the insurance firm MetLife as a systemically risky nonbank could have a broader impact that undermines the role of the interagency council.

Judge Rosemary Collyer's decision, which was unsealed Thursday, said the FSOC "ignored or, at least abandoned" key aspects of its own rules and governing statute in designating MetLife.

"Although the specifics of the decision apply solely to MetLife, the court's characterization of FSOC's process is so damning as to undermine the entire framework's credibility," said Karen Shaw Petrou, managing partner with Federal Financial Analytics. "This has considerably broader implications than getting just one grumpy SIFI off a very big hook."

The ruling, which was announced last week but unsealed only after both MetLife and the FSOC moved to have it released, offers a scathing critique of the council's process for designating MetLife as a systemically important financial institution.

"Although an agency can change its statutory interpretation when it explains why, FSOC insists that it changed nothing. But clearly it did so," Collyer said. "FSOC reversed itself on whether MetLife's vulnerability to financial distress would be considered and on what it means to threaten the financial stability of the United States."

Collyer specifically found that the FSOC had departed from its own guidance in a few critical ways and failed to account for or even acknowledge those changes, which she said "renders FSOC's determination process fatally flawed."

First, the guidance requires the council to "seek to assess the vulnerability" of a nonbank to financial stress, suggesting that some pathway to financial distress must be established. But the FSOC simply assumed the company's distress and went from there, Collyer said, which contradicts the guidance. What is more, the council maintains that it did not change positions, which is not true, Collyer said.

"FSOC has steadfastly refused (and still refuses) to acknowledge that it changed positions on whether Dodd-Frank requires FSOC to assess vulnerability to financial distress. Even if FSOC conceded the point, [case law] would require more: 'of course the agency must show that there are good reasons for the new policy,'" Collyer said. "There were no 'good reasons' offered in the final determination because FSOC stated that there was no 'new policy' to begin with."

Collyer said the agency similarly glossed over its obligation to assess the material threat that the firm poses to the U.S. economy, and instead simply summarized its size and interconnectedness. This is not an adequate standard for review, Collyer argued.

"This Court cannot affirm a finding that MetLife's distress would cause severe impairment of financial intermediation or of financial market functioning — even on arbitrary-and-capricious review — when FSOC refused to undertake that analysis itself," Collyer said. "Predictive judgment must be based on reasoned predictions; a summary of exposures and assets is not a prediction."

The court also found that the FSOC did not consider the costs associated with designating MetLife as a SIFI, and cited a recent Supreme Court decision from the 2015 term, Michigan v. Environmental Protection Agency, in determining that costs associated with a regulatory action are "a central part of the administrative process."

The opinion was not all good news for MetLife. The court rejected the firm's argument that it was not eligible for designation because a significant portion of its activities are based overseas, saying that the firm never made these arguments to the FSOC during the designation process and are therefore waived. In any event, Collyer found that its foreign activities were "related to" its domestic financial activities, which is the statutory standard for consideration. But on the remaining conclusions the court made no opinion, finding the designation invalid on other grounds.

Treasury Secretary Jack Lew, who chairs the FSOC, defended the council's designation process Thursday and said that he "strongly disagree[s]" with the ruling, which he said makes the financial system less secure than before. Administration sources said they believe that an appeal of the ruling is likely.

Lew said that Dodd-Frank intentionally gave regulators the ability to apply heightened scrutiny to firms even if they were not demonstrably insecure, precisely because financial distress can arise quickly and with little warning. The ruling has undermined that authority and poses a grave risk to financial reform, Lew said.

"It is FSOC's duty to address the risks associated with very low probability events, just as the failure of AIG or Lehman Brothers would have been considered highly unlikely before the financial crisis," Lew said. "If the Council only responds to risks after they are likely to threaten financial stability, we will pave the way for the next crisis."

Initial reactions to the ruling suggest that the standard on which the FSOC has been basing its determinations may be severely eroded by the opinion.

Cornelius Hurley, a law professor at Boston University, said the FSOC could simply redesignate MetLife with a more robust explanation of the firm's material risk. In that respect, the ruling's impact is fairly limited. However, the court's application of a cost-benefit standard had much more far-reaching effects, not only to the designation of nonbanks as SIFIs but to other Dodd-Frank regulations as well.

"FSOC could take a mulligan and redo its analysis by clarifying its standards thus eliminating the confusion it has created," Hurley said. "However, if it folds on the 'cost analysis' issue, it will jeopardize many existing rules already written under Dodd-Frank and those that are still in the works."

Advocates of Wall Street reform uniformly condemned the ruling. Sen. Sherrod Brown, D-Ohio, a Wall Street hawk who serves as raking member on the Senate Banking Committee, said the decision is a step "in the wrong direction" and that nonbanks played a central role in the 2008 financial crisis.

"We cannot forget that massive nonbank institutions like AIG and Lehman Brothers were central to the last financial crisis, and Wall Street Reform was created to protect everyday working people from once again paying the price when 'too big to fail' institutions go unchecked," Brown said. "Any actions that could undermine or hamstring that important oversight mission are steps in the wrong direction."

Dennis Kelleher, president of the public advocacy group Better Markets, said he was very confident the decision would be appealed, not least because the decision applies a cost-benefit analysis to a designation that does not exist in Dodd-Frank. Kelleher also objected to the opinion's insistence that the FSOC "have a crystal ball" and be able to determine precisely how MetLife would fail and what would happen if it did — a standard he said would be impossible to meet.

"If this were the law, it would seriously cripple financial reform across the government, and the ability for regulators to prevent crashes and bailouts will be seriously reduced," Kelleher said. "If this standard were in place in 2007, Bear Stearns, Lehman Brothers — none of those firms would have been designated."