Final Volcker rule provisions

On July 15, 2010, after a lengthy and sometimes contentious legislative process, the Senate approved the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act). President Obama is expected to sign the Act soon. The Act subjects many financial institutions to an expanded framework of regulatory oversight that is likely to require those institutions to change the way that they operate. In particular, Section 619 of the Act imposes limitations on proprietary trading and fund sponsorship and investment activities by certain banking entities and nonbank financial companies. Section 619, which is based on proposals first advanced by Former Chairman of the Federal Reserve Paul Volcker, is commonly referred to as the “Volcker Rule.”    

As described in more detail below, subject to certain exceptions, the Volcker Rule amends the Bank Holding Company Act of 1956 to prohibit banks and other banking entities from engaging in proprietary trading and from sponsoring or investing in private equity or hedge funds. The Volcker Rule also prohibits banks and other banking entities from extending credit to, or engaging in other covered transactions with, private equity or hedge funds that they advise, manage, sponsor, or organize. Any transactions between a banking entity and any such fund that are not prohibited must be entered into on arms-length market terms. Finally, the Volcker Rule tasks the Federal Reserve Board with imposing additional capital and quantitative limits on systemically important nonbank financial companies that engage in proprietary trading or that sponsor or invest in private equity or hedge funds.

The Volcker Rule does not take immediate effect. Rather, the new Financial Stability Oversight Council established by Section 111 of the Act (the FSOC) is directed first to complete a study of the Volcker Rule that includes recommendations for its implementation. The FSOC must complete the study within six months of the Act’s enactment. Within nine months of completion of the study, the appropriate federal banking agencies, the SEC, the CFTC, and the Federal Reserve Board are required to issue final rules implementing the Volcker Rule. The provisions of the Volcker Rule take effect on the earlier of (i) 12 months following the date final rules are issued, and (ii) two years after the Act’s enactment. Covered entities generally have two years to bring their activities and investments into compliance, subject to the availability of up to three one-year extensions or, in the case of certain investments in illiquid funds, one extension of up to five years.

Prohibition on Proprietary Trading

Subject to the exemptions described below under “Exemptions from Prohibitions on Proprietary Trading and Sponsoring or Investing in Private Equity or Hedge Funds,” the Act amends the Bank Holding Company Act to expressly prohibit proprietary trading by banks and other covered entities.

• What Kind of Entities Are Subject to the Prohibition?
  • Any “banking entity”, which is defined as any insured depository institution, any company that controls an insured depository institution or is treated as a bank holding company for purposes of section 8 of the International Banking Act of 1978, and any affiliate or subsidiary of any such entity. Certain institutions that function solely in a trust or fiduciary capacity and accept deposits on a limited basis are expressly exempted from the definition of “banking entity.”
• What Is Proprietary Trading?
  • With respect to a particular institution, engaging as a principal for the “trading account” of that institution in any transaction to purchase or sell, or otherwise acquire or dispose of, (i) any security, derivative, or contract of sale of a commodity for future delivery, (ii) any option on any of the foregoing, and (iii) any other security or financial instrument as the applicable regulators may determine.
  • The “trading account” of an institution is defined as (i) any account used to acquire or take positions in securities or financial instruments principally for the purpose of selling in the near-term or otherwise with the intent to resell in order to profit from short-term price movements, and (ii) any other account as the applicable regulators may determine.

Prohibition on Sponsoring or Investing in Private Equity or Hedge Funds

Subject to the exemptions described below under “Exemptions from Prohibitions on Proprietary Trading and Sponsoring or Investing in Private Equity or Hedge Funds,” the Act amends the Bank Holding Company Act to expressly prohibit banks and other covered entities from sponsoring, or from acquiring or retaining any equity, partnership, or other ownership interest in, a private equity or hedge fund.

• What Kind of Entities Are Subject to the Prohibition?
  • Any banking entity, as defined above with respect to the prohibition on proprietary trading.
• What Is a “Hedge Fund” or “Private Equity Fund” for Purposes of the Prohibition?
  • A “hedge fund” or “private equity fund” is (i) any issuer that would be an investment company but for the exemptions provided by section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, and (ii) any similar fund as the applicable regulators may determine.
  • Section 3(c)(1) of the Investment Company Act of 1940 is available to funds owned by 100 or fewer investors. Section 3(c)(7) is available to funds owned solely by “qualified purchasers.”
  • This definition is broad enough to pick up venture capital funds as well as more traditional private equity and hedge funds.
• What Does it Mean to “Sponsor” a Private Equity or Hedge Fund?
  • To “sponsor” a fund means:
    • serving as a general partner, managing member, or trustee of the fund;
    • in any manner selecting or controlling (or having employees, officers, directors, or agents who constitute) a majority of the directors, trustees, or management of a fund; or
    • sharing with a fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name.

Exemptions from Prohibitions on Proprietary Trading and Sponsoring or Investing in Private Equity or Hedge Funds

• Permitted Activities. Subject to the blanket limitations described below and to any further limitations imposed by the applicable regulators, the following activities are expressly exempted from the prohibitions on proprietary trading and sponsoring or investing in private equity or hedge funds.
  • Exemption for Sponsorship of and Investment in Funds Offered in Connection with an Investment Advisory Business.
    • A banking entity is permitted to organize and offer a private equity or hedge fund, and may serve as sponsor to such a fund, if (i) the banking entity provides bona fide trust, fiduciary, or investment advisory services as part of its business, (ii) the fund is organized and offered only in connection with such services and only to customers of such services, (iii) the banking entity does not guarantee or otherwise assume or insure the obligations or performance of the fund, (iv) the banking entity does not share the same name, or variation of the same name, with the fund, (v) no director or employee of the banking entity has an ownership interest in the fund unless he or she is directly engaged in providing services to the fund, and (vi) certain other conditions are met.  
    • A banking entity may also make or retain an ownership interest in a private equity or hedge fund that it organizes and offers, provided that any such ownership interest is either (i) a seed capital investment made in order to establish the fund and attract unaffiliated investors, or (ii) a de minimis investment.  
      • Within one year of establishing a fund, the banking entity’s ownership interest in the fund must represent no more than three percent of the fund’s total ownership. The banking entity must actively seek unaffiliated investors to dilute its investment in the fund to such level. The Federal Reserve Board may extend the one-year period for an additional two years under certain circumstances.  
      • The banking entity’s investment in any private equity or hedge fund must be “immaterial” to the banking entity, as defined by the applicable regulators, and in any event the aggregate amount of all such investments may not exceed three percent of its Tier 1 capital.  
  • Underwriting and Market-Making Activities. Purchases, sales, acquisitions, or dispositions of securities and other instruments in connection with underwriting or market-making-related activities, to the extent such activities are designed not to exceed the reasonably-expected near-term demands of clients, customers, or counterparties are permitted.  
  • Risk-Mitigating Hedging Activities. Hedging activities that are designed to reduce specific risks to the banking entity in connection with and related to individual or aggregated positions, contracts, or other holdings of such entity are permitted.  
  • Customer-Driven Investments. Purchases, sales, acquisitions, or dispositions of securities and other instruments on behalf of customers are permitted.  
  • Activities Outside of the United States.  
    • Proprietary trading conducted solely outside of the United States by a banking entity pursuant to paragraph 9 or paragraph 13 of Section 4(c) of the Bank Holding Company Act is permitted, provided that the banking entity is not controlled directly or indirectly by a banking entity that is organized under the law of the United States or one or more States.1
    • The acquisition or retention of any equity, partnership, or other ownership interest in, or sponsorship of, a private equity or hedge fund by a banking entity solely outside of the United States pursuant to paragraph 9 or paragraph 13 of Section 4(c) of the Banking Holding Company Act is permitted, provided that (i) no ownership interest in such fund is offered for sale or sold to a resident of the United States, and (ii) the banking entity is not controlled directly or indirectly by a banking entity that is organized under the law of the United States or one or more States.
  • Investments in Government and Government-Related Obligations. Permitted activities include purchases, sales, acquisitions, or dispositions of obligations issued by (i) the United States or any agency of the United States, (ii) Ginnie Mae, Fannie Mae, Freddie Mac, any Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or any Farm Credit System institution, or (iii) any State or political subdivision of a State.
  • Investments by Insurance Companies and Their Affiliates. Purchases, sales, acquisitions, or dispositions of securities and other instruments by a regulated insurance company, or any affiliate of a regulated insurance company, for the general account of such regulated insurance company are generally permitted, subject to certain conditions.
  • Public Policy Exemptions. Permitted activities include investments in small business investment companies (as defined in section 103 of the Small Business Investment Act of 1958), investments designed to promote the public welfare as provided in 12 U.S.C. § 24(11), and certain investments related to tax-qualified rehabilitated building or certified historic structure projects.
• Blanket Limitations. None of the permitted activities described above are permitted if the activity:
  • would involve or result in a material conflict of interest (as defined by the applicable regulators) between the banking entity and its clients, customers, or counterparties;
  • would result, directly or indirectly, in a material exposure by the banking entity to highrisk assets or high-risk trading strategies (as such terms are defined by the applicable regulators); or
  • would pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.
• Treatment of Certain Securitization Activities. The Act also specifically provides that nothing in the Volcker Rule should be construed as limiting or restricting the ability of a banking entity to sell or securitize loans in a manner otherwise permitted by law.

Limitations on Transactions and Other Relationships with Private Equity and Hedge Funds

The Act also imposes limitations on relationships and transactions between banks and other covered entities, on the one hand, and certain related private equity and hedge funds, on the other hand.

• What Kind of Entities Are Subject to the Limitations?
  • Any banking entity, as defined above with respect to the prohibition on proprietary trading.
• What Is a “Hedge Fund” or “Private Equity Fund” for Purposes of the Limitations?
  • “Hedge fund” and “private equity fund” are defined as described above with respect to the prohibition on sponsoring or investing in such funds.
• What Are the Limitations?
  • No banking entity that serves, directly or indirectly, as the investment manager, investment adviser, or sponsor to a private equity or hedge fund, or that organizes and offers a private equity or hedge fund, and no affiliate of any such banking entity, may enter into a “covered transaction” with any such fund or with any private equity or hedge fund controlled by any such fund.
    • “Covered transaction” is defined by section 23A of the Federal Reserve Act and includes, among other things, (i) any loan or extension of credit to the fund, (ii) any purchase of or investment in securities issued by the fund, (iii) the issuance of a guarantee, acceptance, or letter of credit on behalf of the fund, and (iv) any derivatives transaction or transaction that involves the borrowing or lending of securities, in either case to the extent that the transaction causes the covered entity to have credit exposure to the fund.
    • The Federal Reserve Board may permit a banking entity to enter into prime brokerage transactions with a private equity or hedge fund in which a private equity or hedge fund managed, advised, or sponsored by such banking entity has taken an ownership interest, provided that the Federal Reserve Board concludes that such transactions are consistent with the safe and sound operation and condition of the banking entity and certain other conditions are met.  
  • Any other transactions between a banking entity and any private equity or hedge fund for which it serves as investment manager, investment adviser, or sponsor, or that it has organized and offered, must be on arms’ length market terms, consistent with the requirements of section 23B of the Federal Reserve Act.

Propriety Trading and Sponsorship and Investment Limitations Applicable to Certain Nonbank Financial Companies

The Act amends the Federal Bank Holding Company Act to direct the Federal Reserve Board to impose additional capital and quantitative limits on systemically important nonbank financial companies that engage in proprietary trading or sponsor or invest in private equity or hedge funds.

• What Kind of Entities and Activities are Subject to the Limitations?
  • Nonbank financial companies that have been designated for prudential regulation by the Federal Reserve Board under Section 113 of the Act and that engage in proprietary trading or sponsor, or acquire or retain an equity, partnership, or other ownership interest in, any private equity or hedge fund, in each case as those concepts are applied to banking entities in the prohibitions described above.2
• What Exemptions Apply?
  • Nonbank financial companies are not subject to any additional capital or quantitative limits with respect to activities described above under “Exemptions from Prohibitions on Proprietary Trading and Sponsoring or Investing in Private Equity or Hedge Funds,” provided the activities comply with the blanket limitations described in that section.

Anti-Evasion Provisions

• The Volcker Rule provides the applicable regulators with the authority to order a banking entity or a nonbank financial company to terminate any activity or dispose of any investment that the regulator has reasonable cause to believe functions as an evasion of the requirements of the Volcker Rule.
• The applicable regulators are also directed to issue rules requiring internal controls and recordkeeping to insure compliance with the provisions of the Volcker Rule.

Study, Rule-Making Process, and Effective Date

• FSOC Study. The FSOC is required to complete a study of the Volcker Rule within six months of the Act’s enactment. The study must include recommendations for implementing the Volcker Rule in order to achieve certain enumerated purposes. These purposes include, among other things, to protect taxpayers and consumers and enhance financial stability, limit the inappropriate transfer of federal subsidies to unregulated entities, reduce conflicts of interest, and limit activities that have previously caused undue risk or loss in banking entities and certain nonbank financial companies.
• Rule-Making Process. No later than nine months after the date that the FSOC completes its study, the appropriate federal banking agencies, the SEC, the CFTC, and the Federal Reserve Board must adopt rules carrying out the Volcker Rule. The regulators are required to consult and coordinate with one another to assure that the final rules are comparable and consistent. Rulemaking authority is allocated among the regulators as follows:
  • with respect to insured depository institutions, jointly to the appropriate federal banking agencies;
  • with respect to any entity for which the CFTC is the primary financial regulator under the Act, to the CFTC;  
  • with respect to any entity for which the SEC is the primary financial regulator under the Act, to the SEC; and  
  • with respect to any other entity, to the Federal Reserve Board.  
• Effective Date. The provisions of the Volcker Rule take effect on the earlier of (i) 12 months after the date of the issuance of final rules by the regulators, and (ii) two years after the Act’s enactment.  
• Transition Period. A banking entity or nonbank financial company generally has two years from the date on which the Volcker Rule provisions take effect to bring its activities and investments into compliance. The regulators may impose additional capital and other requirements during the transition period.  
  • Generally-Available Extensions. The Federal Reserve Board may, by rule or order, extend the two-year period for not more than one year at a time and up to an aggregate of three years if it determines that such an extension is consistent with the purposes of the Volcker Rule and would not be detrimental to the public interest.
  • Extensions for Investments in Illiquid Funds. The Federal Reserve Board may also extend the transition period to permit a banking entity to take or retain its equity, partnership, or other ownership interest in, or otherwise provide additional capital to, an “illiquid fund”, provided the extension is necessary in order for the banking entity to fulfill a contractual obligation that was in effect on May 1, 2010. Any such extension must be limited to no more than five years.
    • An “illiquid fund” is a hedge fund or private equity fund that (i) as of May 1, 2010, was principally invested in, or was invested and contractually committed to principally invest in, illiquid assets such as portfolio companies, real estate investments, and venture capital investments, and (ii) makes all investments pursuant to, and consistent with, an investment strategy to principally invest in illiquid assets.
• Rule-Making with Respect to Transition Periods. The Act requires the Federal Reserve Board to issues rules implementing the transition-period provisions of the Volcker Rule no later than six months after the Act’s enactment.