SEC Climate Rule Analysis by BGR

By Keaghan Ames, Vice President, BGR Financial Services Practice

When the Security and Exchange Commission’s (SEC) proposed climate disclosure rule was first announced in March of 2022, it consequently caught the attention of every publicly-traded company. In what many consider to be the most onerous enhancement to the securities disclosure regime since the Securities Act of 1933, the rule, if finalized, would change the way publicly traded companies view the climate’s impact and the risks associated not only in their public disclosures but potentially throughout their entire business.

Will Scope 3 be Included and When’s it Getting Finalized?

The two questions everyone is asking: will Scope III be included and when will it be finalized? The final rule has been expected for many months, with initial speculation as to its release beginning in Q3 of 2023. Yet, the rule continues to be delayed. Why?

The short answer is that the decision around whether to include Scope III is dragging the process out, due to the concerns over its ability to withstand legal scrutiny.

The longer answer is that SEC Chair Gary Gensler finds himself in a difficult position. For starters, if Scope III requirements are included in the overall rule, numerous outside groups have publicly warned the SEC it will face litigation, which is the last thing the head of the agency wants. Beyond the very real litigation risk and external political pressures detailed below, there are internal political factors for Chair Gensler to consider as well. The SEC’s decision-making boils down to three viewpoints:

(1) Chair Gensler’s, who would like to see Scope III included, but not at the expense of the rest of his regulatory agenda;

(2) Democratic Commissioner Caroline Crenshaw’s, who believes Scope III should be mandatory and may not vote for any final rule without the inclusion of Scope III (thereby shelving the proposal as any rule would require all three Democratic votes); and,

(3) the Office of the General Counsel’s (OGC), who understands that Scope III is potentially a stretch of SEC authority and contains near-certain litigation risk.

While the rumors will continue to percolate as to when the rule will come out, the real answer is either (a) when these three parties come to an agreement or (b) negotiations end and there is no compromise to be struck between those three viewpoints. If the likelier latter scenario (option B) plays out and Gensler determines that he would like to include Scope III, it is foreseeable that Gensler pushes finalization as close to the Congressional Review Act (CRA) window as possible. The CRA window, Congress’ 60 legislative days-long period of time to overturn any given rule by a majority vote, is usually sometime in mid-May heading into an election year. According to the congressional schedule set by leadership in both Houses, the deadline, for now, is estimated to be May 14, 2024.

At the time of this post, the rule is rumored yet again to come out next month (that being said, the same rumor has circulated every month for the last six months). That timeline is certainly possible, and the public will be given a five-day Sunshine Act notice prior to an open meeting to consider the rule. However, if Gensler was truly worried about balancing the rest of his regulatory agenda (all items require OGC’s attention and focus) and getting the climate disclosure rule with Scope III finalized prior to the CRA window, it would seem fitting that the rule is finalized in late April or early May.

As always, we continue to track developments on the rule and will continue to update the group and your clients accordingly.

Process Background

The SEC’s proposal seeks to standardize climate disclosures through mandatory tiers of climate exposure:

  • Scope 1: registrants’ direct greenhouse gas (GHG) emissions;
  • Scope 2: indirect GHG emissions from purchased electricity and other forms of energy separately disclosed, expressed both by disaggregated constituent greenhouse gases and in the aggregate, and in absolute terms, not including offsets, and in terms of intensity (per unity of economic value or production; and,
  • Scope 3: everything else associated with a company’s activities including emissions from third-party contractors, employee commuting, business travel, purchased goods and services, leased assets, etc.

Comprehensibly, the entire proposed rule could prove onerous for several publicly traded companies. The inclusion of Scope III has been heavily criticized, given the SEC prioritized its “materiality” threshold for disclosures (see SEC Chair Gensler’s argument on materiality). On the above requirements, several energy companies have long had to disclose Scope I and certain Scope II emissions under EPA guidelines. Scope I and Scope II would prove difficult (yet not unforeseen) for all non-energy companies to begin calculating and for all companies to begin disclosing to shareholders. Furthermore, Scope III disclosures would be extremely difficult for numerous reasons, not the least of which is, there is no standard methodology proposed by the SEC for calculating the universe of Scope III disclosures. Thus, companies could spend millions on regulatory burn just for the SEC to tell them their methodology for calculating Scope III is incorrect.

Argument Background

Needless to say, various industries ranging across traditional financial services, energy, healthcare, transportation, and even traditional agriculture have expressed significant concerns about the proposal over the last two years. Last week’s House Financial Services Subcommittee on Oversight and Investigations hearing focused on the legal grounds for challenging the SEC’s authority to even propose Scope III requirements. (See the Chamber of Commerce’s letter stating “[h]owever, the SEC’s Proposed Rules, as currently crafted, exceed the SEC’s lawful authority and are vast and unprecedented in their scope, complexity, rigidity and prescriptive particularity.”)

Even certain Democrats in Gensler’s own party find the rule overly burdensome, such as Senator Jon Tester (D-MT).

The SEC has stated that its goal for this rule is to provide “consistent, comparable, and reliable – and therefore decision-useful – information to investors.” Ensuring that climate risk-related information is available to investors is core to the SEC’s statutory authority and a response to increasing investor demand for this information. Opponents argue that the SEC is overstepping its authority as Scope III disclosure would require publicly traded companies to obtain information from privately held companies, who are outside the SEC’s regulatory authority. Opponents also point to privacy and confidentiality concerns given the amount of data that may need to be disclosed. The SEC has faced notices of potential legal action should Scope III make it into the final rule but has also received pressure from left-wing and climate groups and some Democratic lawmakers to keep Scope III included.

Analyzing the Basel III Proposal

BGR Financial Services Practice Head Andy Lewin, Keaghan Ames, and Advisory Board Member Brigit Polichene break down the latest banking standards proposal known as Basel III.

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BGR Deep Dives: Breaking Down the Basel III Endgame Implementation

By Keaghan Ames, BGR Vice President, Financial Services Practice

Late last week, the banking regulators (Federal Reserve, FDIC, and OCC) issued the long-anticipated proposal that aims to implement changes from 2017 to international capital standards (the “Endgame Standard”) adopted by the Basel Committee on Banking Supervision (“Basel Committee”). However, the beltway is abuzz over the fact that the proposal goes far beyond the proposed changes from the Basel Committee and instead aims at fundamentally increasing the amount of capital large ($250 billion +) and medium-sized ($100-250 billion) banks are required to carry.

The most noticeable deviation from the proposed international Basel III changes entails the rollback of legislative and regulatory tailoring reform resulting from Congressional adoption of S.2155. By way of background, only six years ago Congress passed, with bipartisan support, S.2155, a law that would tailor banking regulation for firms based on various risk factors, not size alone. Last week’s proposal deviates from the resulting tiered framework using the recent bank failures of SVB and Signature, which were considered risk management and supervisory failures, as a justification for the regulators to treat any bank with over $100 billion in assets the same as the largest U.S. bank.

Many banks are individually assessing how the thousand plus page proposal will impact their operations. At a high level, the proposal will fundamentally modify the current capital regime by increasing the amount of capital all banks over $100 billion in assets must carry. The regulations are expected to increase common equity tier 1 (CET1), which is primarily common stock of banks, by 16%. To say this will be onerous for the top 40+ impacted banks would be an understatement. It also changes how affected bank holding companies will have to calculate their capital requirements, adding a new expanded risk-based calculation in addition to the existing standardized approach. Under this dual-stack requirement, banks will be required to hold the higher of the two-risk weighted asset amounts to satisfy their capital requirements. The proposal also adds a number of other significant regulatory burdens and changes including eliminating the use of internal models to assess credit and operational risks, requiring medium-sized banks to unnecessarily switch their calculation of counterparty risk of derivatives exposure, including derivatives when calculating the cross-jurisdictional activity risk factor, adding counter-cyclical capital buffers for banks that pose little macro-economic threats (e.g., not too-big-to-fail), and requiring all banking organizations with more than $100 billion in assets to reflect unrealized gains and losses on available-for-sale securities in regulatory capital.

The expansion of the capital proposal is not entirely unexpected, but is still unfortunate as it will ultimately increases costs for the American public and retail and commercial borrowers. Whenever banks are required to hold more capital, it affects their ability to lend that capital back out to small businesses and the investing public. As it is, the credit markets are already in a slightly tumultuous time given the commercial real estate challenges and high mortgage interest rates.

Given the bleak picture painted by the proposal, the industry needs to vigorously advocate for changes to the final rule. There are both regulatory and congressional advocacy paths available to deal with the proposal. On the regulatory front, there were significant dissenters in the Fed and the FDIC who highlighted some procedural and substantive concerns with the proposal including the overly broad scope. Fed Chairman Powell said in his statement on the proposal, “While there could be benefits of still higher capital, as always we must also consider the potential costs.” Suffice it to say the costs of the proposal are significant and banks would be wise to highlight these substantive issues and the absence of a cost-benefit analysis in the proposal with the regulators over the 120-day comment period.

On the Hill, there are members on both sides of the aisle who fought and voted for S.2155. These members will be motivated to protect established law over the proposed regulation. With election season just around the corner, the economy is sure to be a dominant political topic. The potential for an unnecessary squeeze on credit lending will be an important discussion in the months ahead.

Bank Failures: Insights and Implications

By Keaghan Ames, Vice President, Financial Services

Behind the drama of the debt ceiling, many policymakers and in Washington and the states have been keeping tabs on recent bank failures and what if any actions need to be taken. In recent weeks, both the House Financial Services Committee (HFSC) and Senate Banking Committee (SBC) each hosted two hearings focused largely on the failing of Silicon Valley Bank (SVB)and Signature Bank: (1) calling former executives from SVB and Signature to testify as to what happened at their respective failed institutions; and, (2) semi-annual testimony of the federal prudential supervisors (including the FRB, FDIC, and OCC) with the SBC also including NYDFS Superintendent Adrianne Harris California DFPI Commissioner Hewlett to discuss the failures as well.

Back in March, BGR cited that most of the Hill had retreated to their ideological corners and by and large many have remained there. In addition to calling for a rollback of the previous Administration’s tailoring reform under S.2155, progressive democrats are also citing concerns around too-big-too-fail, particularly with more acquisitions on the way akin to the JP Morgan acquisition of First Republic. Moderate Democrats and Republicans continue to be focused on supervisory deficiencies including the lack of supervisory action taken following ratings downgrades of the failed institutions over the last two years.  It should be noted that the GAO recently testified in front of the HFSC subcommittee on Oversight and Investigations regarding its report citing FRB and FDIC supervisory deficiencies.

Despite the continued attention on these failures from the Hill, it’s still unlikely any legislation comes about as a result of these banking failures. However, we expect increased attention by Republicans and moderate Democrats on oversight of the financial regulators. To that end, Senators Tom Tillis (R-NC) and Jon Tester (D-MT) called on President Biden to appoint an independent investigator to “hold both reckless bank executives and ineffective federal regulators accountable for their roles in the recent bank failures.” In their letter, they cite that the Federal Reserve’s review of SVB’s failure was insufficient (see more from BGR here).

From the regulators, however, there will likely be some action in the coming months. The Federal Reserve Bank (FRB) and FDIC have made it clear they plan on taking policy actions to remediate the fallout. The FRB has made clear they plan on raising capital requirements through the implementation of Basel III, which was set to happen prior to the bank failures. Additionally, FRB Vice Chair for Supervision Michael Barr continued to reiterate that the Fed will reassess the tailoring reform from S.2155, including potentially rolling back regulatory and supervisory relief for medium, small, and foreign banks. The FDIC has noticed a proposed special assessment on any bank over $50 billion in assets with uninsured deposits to offset the costs associated with these failures, the comment period for which is open. Finally, the FDIC has also outlined a number of insurance deposit reforms, which was acknowledged by HFSC Chairman Patrick McHenry (R-NC). Congressional action would be needed for any changes to deposit insurance.

BGR Deep Dives: Federal Reserve SVB Review

Recapping the Federal Reserve SVB Review: What Happened and What’s Next

By Keaghan Ames, Vice President, Financial Services Practice

The collapse of Silicon Valley Bank (“SVB”) in March was at a minimum correlated with a series of chain reactions, including the failing of several other banks. For many, uncertainty about the particular details around how SVB failed resulted in certain doubts about the resiliency of several regional banks, including First Republic’s, and their ability to hold deposits and navigate fixed income markets.

Seven weeks later, the Federal Reserve (“the Fed”) recently announced the results of their review on the failure of SVB (“the review”). Each of these findings brings with them vastly different implications for the market and the continued national attention on medium-sized/regional banks ($100 billion- $250 billion in assets). The Federal Reserve made four findings. While the first three findings are readily understood and anticipated, the fourth finding will be the topic of discussion in Washington in the weeks to come.

  1. Silicon Valley Bank’s board of directors and management failed to manage their risks.
  2. Supervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity.
  3. When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough.

SVB’s inability to manage interest rate risk and scale its risk management framework with the growth of the bank was widely known prior to the Fed’s review. However, some of the risk-metrics around SVB were startling, specifically three facts: (a) 94% of the deposits at SVB were uninsured comparative to 41% among its other large banking organization (LBO) peers; and, (b) SVB actively removed interest-rate hedges beginning in early 2022, as rates were being raised by the Federal Reserve and, (c) beginning in Q4 of 2021, the unrealized losses on SVB’s investment portfolio securities continued to grow in the billions of dollars.

On the regulatory and supervisory side, the Senate Banking Committee and House Financial Services Committee hearings in late March revealed that the Fed and FDIC were aware of a number of these risk management deficiencies, including a lack of interest rate risk management upon the part of SVB. The review also confirms that the regulators did not fully extend the growth of these risks (i.e., the same scaling issue that SVB’s management had). There were also several delays by the Fed, including seven-months to develop an enforcement action related to some of SVB’s deficiencies and failing to take any material supervisory actions following significant rating downgrades in the 2022 Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk (CAMELS) and Large Financial Institution (LFI) ratings.

  1. The Board’s tailoring approach in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA)[1] and a shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.

FRB Vice Chair for Supervision Barr made clear in the recent congressional hearings, well in advance of the conclusion of the Federal Reserve’s review, that he anticipated significant regulatory and supervisory changes as a result of SVB’s failure. Though the first three findings confirm that the SVB management and Federal Reserve supervisory teams failed to act in a prudent and/or expedited fashion, the report still suggests that the tailoring reform, implemented under S.2155 (i.e., EGGRCPA), contributed to the collapse of SVB. Specifically, SVB “may have more proactively managed its liquidity and capital positions or maintained a different balance sheet composition” but for the reform from tailoring. (emphasis added)

Many within the beltway believe that the Federal Reserve will use this “may have” as a justification to take actionable regulatory reform for regional and foreign banks. As far as anticipated reactions, industry and congressional policymakers will have a difficult time reconciling the notion that the deficiencies with SVB’s risk management and with the Federal Reserve’s supervisory teams should lead to further regulatory and supervisory reform for the entire banking sector. Particularly when that reform could lead to another one-size-fits-all regulatory approach that will ultimately squeeze medium sized banks and hinder competition in the banking sector.

Next Steps

Prior to the collapse of SVB, the regulators were already rumored to be increasing capital requirements on banks through the U.S. implementation of Basel III, a global overhaul of bank capital standards. The review seems to indicate that the Federal Reserve will finalize the Basel III reform and conduct a series of other reforms including rolling back the tailoring reform under S.2155 (EGRRCPA).

Congressionally, there will likely be more hearings. We anticipate Chair McHenry (R-NC) of the House Financial Services Committee, his top lieutenants, and several members of Congress on a bi-partisan basis will be hard pressed to support rolling back the tailoring reform, particularly in the current economic environment. Traditionally, the Fed’s Vice Chair for Supervision has testified before the Senate Banking Committee and House Financial Services Committee in May so it’s quite possible that the Hill will have an opportunity to speak with Vice Chair Barr in the near future.

[1] The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) is also known by its bill number: S.2155.