Senators Merkley and Levin introduce proprietary trading legislation
On March 10, 2010, Senators Jeff Merkley (D-OR) and Carl Levin (D-MI), along with co-sponsors Sherrod Brown (D-OH), Edward Kaufman (D-DE), and Jeanne Shaheen (D-NH), introduced S. 3098, the “Protect Our Recovery Through Oversight of Proprietary Trading Act of 2010” or the “PROP Trading Act.”1
The PROP Trading Act amends the Bank Holding Company Act to prohibit “banking entities”2 from engaging in proprietary trading and entering into certain relationships with hedge funds and private equity funds. In general, the PROP Trading Act does not affect hedge funds’ or private equity funds’ own proprietary trading activities.
The following are key elements of the PROP Trading Act as introduced:
- Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds.
- Banking entities would be prohibited from engaging in “proprietary trading.” For this purpose, “proprietary trading” is defined to mean “engaging as a principal in any transaction to purchase or sell, or which would put capital at risk as a principal in or related to any stock, bond, option, contract of sale of a commodity for future delivery, swap, security-based swap,” as well as any other security or financial instrument that the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) jointly so define by rule.
- Banking entities also would be prohibited from taking or retaining any equity, partnership, or other ownership interest in a hedge fund or private equity fund and also from sponsoring3 a hedge fund or private equity fund. The terms “hedge fund” and “private equity fund” encompass any company or other entity that is exempt from registration as an investment company pursuant to section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, and also any similar funds as determined by the Federal Reserve.
- “Specified nonbank financial companies”4 that engage in proprietary trading or take or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund would be subject to additional capital requirements and additional quantitative limits on such trading and such interests or sponsorships, which are to be established by the Federal Reserve and the FDIC by joint rulemaking (see below).
- The Federal Reserve and the FDIC would have authority to exclude from the Act’s prohibitions individual transactions, classes of transactions, and activities, including but not limited to (1) the purchase or sale of obligations of the United States or any agency thereof, obligations, participations, or other instruments of, or issued by, Ginnie Mae, Fannie Mae, or Freddie Mac, and obligations of any state or political subdivision thereof, (2) underwriting and market-making to serve clients, customers, or counterparties, (3) risk-mitigating hedging activities, (4) investment in one or more small business investment companies or investments designed primarily to promote the public welfare, and (5) proprietary trading conducted by certain companies organized under the laws of a foreign country the greater part of whose business is conducted outside of the United States or by companies that do no business in the United States except as an incident to their international or foreign business (provided that the Federal Reserve exempts such companies, the trading occurs solely outside the United States and that such person is not controlled directly or indirectly by a U.S. person).
- The Federal Reserve and FDIC, however, could not exclude from the prohibitions any transaction, class of transactions, or activity that (1) would result in a material conflict of interest between the banking entity or nonbanking financial company and its clients, customers, or counterparties, (2) would result, directly or indirectly, in exposure to high risk assets or high risk trading strategies (as such terms are jointly defined by the Federal Reserve and the FDIC), (3) would pose a threat to the safety and soundness of the banking entity or the nonbanking financial company, or (4) would pose a threat to the financial stability of the United States.
- The Federal Reserve and FDIC, in consultation with the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission, would be required to adopt rules within 180 days after enactment of the PROP Trading Act to effectuate the Act’s prohibitions. Such rules would be required to take effect within 18 months after their adoption and not later than 24 months after the date of enactment of the PROP Trading Act..
- Limitations on Relationships with Hedge Funds and Private Equity Funds
- A banking entity that serves, directly or indirectly, as the investment manager or investment adviser to a hedge fund or private equity fund would be prohibited from entering into a “covered transaction,” as such term is defined in section 23A of the Federal Reserve Act,5 with such fund, and also from providing “custody, securities lending, or other prime brokerage services” to such fund. Moreover, transactions between such banking entities and their managed or advised funds would have to be on arms’ length market terms, consistent with the requirements of section 23B of the Federal Reserve Act.
- Prohibitions on Conflicts of Interest in Securitizations
- An underwriter, placement agent, initial purchaser, or sponsor of an asset-backed security would be prohibited. as long as the asset-backed security is outstanding and held by unaffiliated investors, from engaging in any transaction that would (1) give rise to “any material conflict of interest” with respect to any investor in a transaction arising out of such activity, or (2) undermine “the value, risk, or performance” of the asset-backed security.
- The SEC would also be required to issue, within 180 days of the PROP Trading Act’s enactment, a rule imposing restrictions on “the timing and extent of proprietary trading” by an underwriter, placement agent, initial purchaser, or sponsor, and any affiliate or subsidiary of such an entity, in any securities, security-based swaps, or similar financial instruments that are derived from, or related to, an asset-backed security for which the entity, or its affiliate or subsidiary, has acted as underwriter, placement agent, initial purchaser, or sponsor.
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