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Wall Street banks have mounted a massive legal defense of their physical commodities activities, in a last-ditch effort to convince regulators that chartering oil tankers and owning power plants pose no risk to the financial system.
In a 54-page memo drafted by four leading law U.S. law firms and commissioned by six major financial industry groups, they argue that existing statutes, case law and risk-management procedures protect regulated banks - and therefore the taxpayer - from any catastrophe that might unfold in the course of trading physical commodities.
"The legal framework governing such activities permits a (bank) to conduct them without presenting an undue risk" to its safety and soundness, the memo states, citing sources ranging from environmental statutes to Supreme Court decisions to guidance from the Federal Reserve's own bank examination manual.
It was attached to an even lengthier letter submitted at the end of a three-month period for the Fed to take public comments on potential new regulations that would limit banks' ability to trade and invest in physical commodities. It is not clear how quickly the Fed may move to craft formal rules, which would also face a period of public scrutiny.
In announcing in January its plans to reexamine existing rules and requirements for such trading, the Fed cited disasters including BP's (BP.L) oil spill in the Gulf of Mexico in 2010 and the derailment and explosion of an oil train in Canada last year as cause for concern over the impact of a commodity catastrophe.
The memo focused on two issues in detail: whether banks face liability for damages under three federal environmental statutes, or for incidents involving their portfolio companies, or merchant banking investments, which are typically held at arm's length.
The memo argues that environmental statutes generally assign liability to owners and operators of the facilities from which an environmentally sensitive substance is leaked or spilled, and that mere ownership of the commodity does not create liability. Courts have historically agreed, unless the commodity owner controls the circumstances of its transport or storage.
Most banks are already barred from directly owning commodity infrastructure. Morgan Stanley (MS.N), which along with Goldman Sachs (GS.N), is theoretically allowed to do so, has already agreed to sell its physical oil trading operations.
Similarly, financial holding companies are unlikely to be found liable for the actions of their portfolio companies, which are held as arm's length investments and must be disposed of within 10 years, under a doctrine known as "corporate separateness."
For a court to "pierce the corporate veil" and find a parent company liable, it must show that the parent company exercised an extraordinary degree of control over the subsidiary and that domination led to injury, something that is already prohibited within existing banking guidelines.
"The conclusion is that the law is generally settled in this area, and that banks are complying with all of the requirements necessary to ensure that the corporate veil is not pierced," said Carter McDowell, the associate general counsel of Securities Industry and Financial Markets Association (SIFMA), which submitted the letter alongside other groups.
The Fed extended an initial March 15 deadline to April 16 to give the four law firms time to compose the memo, said McDowell.
"This is as close as we could get to a legal opinion," he said, noting that it reflects the unanimous interpretation of all four law firms and their senior management.
The letter is the latest effort by banks including Goldman Sachs and Bank of America (BAC.N) to defend their physical trading operations. After several years of slim margins, strong first-quarter earnings by several banks suggest revenues may be improving as some banks quit the business.
The Fed's own authorization letters and examination manual describes steps a financial holding company must take to legally distance itself from its operating subsidiaries, the memo points out, thus further limiting any possibility of its facing liability for damages.
The memo was accompanied by a six-page document detailing best practices for limiting environmental liability and ensuring "corporate separateness."
It advises banks to "avoid operating vessels, railcars, pipelines or other transportation or storage facilities used to transport physical commodities," and to make sure that portfolio companies maintain a separate "office space, address ... and similar aspects of an independent existence."
Since the first bank was granted a license to trade physical commodities in 2003, a dozen have become substantial participants in the markets for some of the most commonly traded commodities, including oil and electricity.
They joined Morgan Stanley and Goldman Sachs, which had been active in commodities since the 1980s.
In the past year, major banks including JPMorgan Chase and Co (JPM.N) and Deutsche Bank (DBKGn.DE) have scaled back their commodities exposure, citing both intensifying regulation and lower profits. Total commodity trading revenue at banks has fallen to a third of its $14 billion peak in 2008.
Wall Street banks make legal case for physical commodities trade | Reuters
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