The Deal: Prudential Doesn't Sue U.S.; Other 'SIFIs' Aren't Likely To Either

NEW YORK ( The Deal) -- Prudential Financial's ( PRU) decision not to sue the government for designating it a "systemically important" firm is a sign that other large financial institutions that come under new sweeping oversight of federal regulators won't file lawsuits either.

Last month, Prudential received the designation by the Financial Stability Oversight Council, the group of regulators charged in the wake of the 2008 crisis with identifying emerging threats to the economy. The council said that the big interconnected insurance firm would have a hard time selling assets in a period of financial stress and as a result could "inflict significant damage on the broader economy" should its financial condition become desperate.

One lawyer familiar with the process noted that Prudential may be less concerned about the designation because it might give creditors and counterparties some comfort in believing that the government considers the firm too big to fail and will bail it out in a financial crisis.

He added that a 31-page study released earlier this month by the recently created Office of Financial Research, a unit of the Treasury Department, indicates that many large asset management firms could be next. The study, which was prepared for the council, identifies ways that asset management activities could create vulnerabilities to the economy.

Large hedge funds, private equity firms and mutual funds all fall under this category. For example, the study raised concerns about these firms' use of leverage and whether regulators can adequately supervise firms that have operating subsidiaries in multiple countries. "Redemption risk," the concern that investors will all seek to cash out their investments at the same time, is discussed, as well as problems associated with how these firms are overly interconnected and complex.

The report noted that 10 firms each have more than $1 trillion in global assets under management, including nine U.S.-based firms. Also it added that at the end of 2012, the top five mutual fund complexes managed 49% of U.S. mutual fund assets.

That's why regulatory observers note that the largest firms in the asset management category, including BlackRock, Pimco ( PIMIX), a unit of Allianz, and billionaire investor Warren Buffett's Berkshire Hathaway ( BRK.A) ( BRK.B), could be next.

Other possible designees include Fidelity Investments, Vanguard Group and State Street's ( STT) State Street Global Advisors.

The mega-insurer MetLife reported in July that the council is in the third stage of a three-stage designation review process with it.

The designation will eventually subject Prudential, which has more than $1 trillion of assets under management, to new capital and liquidity restrictions as well as obligations to write a so-called living will explaining how it will dismantle itself in a way that doesn't wreak havoc on the markets. However, specifications for most of those requirements have not yet been set so it remains unclear when the compliance burdens any firms designated as SIFIs will fully kick in.

Prudential on Friday said after careful review it won't seek to rescind the designation. Firms have 30 days from when they are designated to decide if they want to file a lawsuit challenging the decision.

Regulatory observers said they expect the council to designate other large financial institutions, including, possibly, big hedge funds, private equity firms and even large mutual fund managers, in the months and years to come.

Analysts and people familiar with the council's Prudential decision contend that the next firms to be designated are unlikely to follow up with judicial challenges in federal district court even though they are permitted to do so.

This is because the legal hurdles are almost insurmountable and even if they win their lawsuits the market will continue to believe that they could pose a risk to the financial system, they said.

Donald N. Lamson, partner at Shearman & Sterling LLC in Washington, said he expects that the general trend will be for designated financial institutions not to challenge their designation in judicial proceedings.

"The process is really stacked against the industry participant," Lamson said.

Lamson said that even if a company succeeds at overturning a designation in court, the market will continue to believe that it could pose a risk to the financial system. He added that even if a company wins in court there is no assurance that the FSOC will not come back and designate the firm the following year.

Lamson added that the council hasn't really provided any clear indication about whether it believes one sector might be more risky than another. He said that the only thing regulators have made clear is that if the financial institution is big, it could be designated.

"If I were a large insurance company, private equity firm or other asset management firm I would wonder: 'Am I next?' " he said. "There's little limit to the type of entity that could be designated."

Prudential is the third nonbank subjected to the new oversight and the third firm to decide not to challenge the designation in court. American International Group and GE Capital, a unit of General Electric, both have been designated and neither filed lawsuits. The major U.S. banks have been given the designation as well. A Treasury official declined to comment on Prudential's decision.

However, an attorney close to Prudential's designation process noted that the fact that three nonbank designated firms decided not to file lawsuits challenging the decision is an indication that others won't do so either.

-- Written by Ronald Orol In Washington