WASHINGTON — Wall Street banks — and the trade groups and law firms that represent them — are challenging the Federal Reserve Board's basis for restricting ties banks have to physical commodities, arguing it is fundamentally flawed.

The central bank is worried that bank holding companies could potentially face significant legal liabilities if physical commodities they are tied to, such as oil tankers and natural gas pipelines, are part of an environmental disaster.

But the largest banks that have not yet been chased away from the business are pushing back hard against the Fed's analysis, saying existing law is sufficient to protect banks from any potential fallout.

"The vast body of law that has been enacted to deter and address environmental damages provides the basis for developing a framework that market participants may and do utilize to substantially reduce the risk of liability or otherwise mitigate it," John Rogers, executive vice president and chief of staff at Goldman Sachs, wrote in an April 16 letter to the Fed.

At issue is an early plan released by the Fed in January that suggests ways the central bank may limit bank activities in physical commodities. Regulators are weighing whether to expand limits that would reduce a bank's stake as well as how much institutions can trade in certain commodities.

As part of its case, the Fed points to a legal concept known as "piercing the corporate veil," which deals with whether a parent company would be exposed to any liabilities attached to a subsidiary involved in trading physical commodities.

The agency pointed to several high-profile environmental catastrophes, arguing that veil piercing is very likely in such episodes, and therefore additional regulations should be put in place to ensure bank holding companies are not endangered.

"Catastrophes involving environmentally sensitive commodities may cause fatalities and economic damages well in excess of the market value of the commodities involved or the committed capital and insurance policies of market participants," the Fed's proposal said.

The Fed contends that the financial crisis sufficiently made clear the impact of market contagion and the dangers of undervalued tail risks tied to certain activities. It says recent incidents also call into question whether the current set of limits on physical commodities is sufficient to protect safety and soundness.

As a result, several large banks, including JPMorgan Chase, Barclays, Morgan Stanley, and Deutsche Bank, have already taken steps to sell off or limit their involvement with physical commodities.

But Goldman Sachs, one of the last firms to stick by its physical commodities business, is part of another contingent of several high profile banks who dispute the Fed's rationale for implementing tougher restrictions.

"We believe that compliance with the merchant banking rule restriction on routine management, together with appropriate policies and procedures, provides significant safeguards from the threat of corporate veil piercing and from other means of potential liabilities attaching to the financial holding company," Rogers wrote.

He was backed by Timothy Sloan,  the chief financial officer of Wells Fargo, who said the San Francisco-based bank has "never faced any colorable veil-piercing claims tied" to its merchant banking activities.

"The merchant banking and physical commodity trading businesses have never faced any massive tort, commodities-related, environmental or other catastrophic-type liability — the kind of tail risk that is the central concern of the" Fed's plan, Sloan wrote in an April 16 letter. "As required by the board, we also have policies and procedures in place that govern our merchant banking investments and physical commodity trading business. We believe that compliance with the limitations and restrictions set forth in the current regulations adequately insulates us from such liability."

The two firms were also among several that also endorsed a 54-page memo written by four top U.S. law firms, that was included as part of a 233-page comment letter signed by six trade groups led by the Securities Industry and Financial Markets Association. The memo detailed an extensive legal rebuttal citing case law, statutes, and risk-management procedures that they argue would insulate banks trading physical commodities from any catastrophe that might occur.

The memo, which acknowledges the potential risk by firms that handle physical commodities, is designed to help sway the Fed and lawmakers on Capitol Hill that have raised concerns about the issue.

It includes specific measures and safeguards banks can take to help minimize the risk attached to physical commodities trading.

"As we looked at the law, we believed that if you took those measures and safeguards when appropriate, there's a very low risk that the corporate veil would be pierced," said Randall Guynn, a partner at Davis Polk & Wardwell, one of the firms that drafted the memo.

The memo makes a distinction between banks that buy, sell and own commodities — an activity that doesn't normally give rise to environmental liabilities — versus institutions that transport, export or store them, which could give rise to liability claims in the case of an environmental catastrophe.

Any liability would fall to the holder and the operator of the commodity, not the investor, according to the memo.

But federal regulators disagree, arguing that liability could be attached to financial holding companies even if they hire third parties to store and transport commodities.

"FHC's could face liability under the Oil Pollution Act, Clean Water Act, and the Comprehensive Environmental Response, Compensation, and Liability Act if their relationship with the third party contractor were deemed to constitute the ownership or operation of transportation or storage facilities under those laws," according to the Fed's concept proposal. "Moreover, parties not liable as owners or operators under relevant federal law may be held liable under common law, including liability arising from the actions of the third parties hired to store and transport commodities."

In its proposal, regulators cited cases like Deepwater Horizon's offshore oil spill that resulted not only in the deaths of 11 people, but also totaled $42.2 billion in losses for the firm. The Fed also cited the rupture of a natural gas transmission pipeline owned and operated by the Pacific Gas and Electric Co. in San Bruno, Calif. which claimed eight lives and damaged 100 homes. The company is expected to pay up to $565 million in third-party claims.

Lawmakers, too, have warned the ramifications of any catastrophic event — even with its low probability — could be expansive, sparking serious financial stability concerns.

"Depositors might react to such an event by pulling deposits from the affected banks; creditors might decline to renew lines of credit; counterparties might decline to enter into or demand exit from derivative trades or other transactions; financial institutions might decline to offer financing or impose more expensive terms; or stockholders might sell shares and depress the company's share price, all of which could trigger a range of financial difficulties," Sen. Carl Levin, D-Mich., chairman of the Senate Permanent Subcommittee on Investigations, wrote in an April 16 letter.

His committee is investigating potential conflicts of interest and manipulation by banks in commodity markets.

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