1. Question: What is the Volcker Rule, and when does it take effect?
Answer: The Volcker Rule was enacted into law as section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). The Volcker Rule prohibits banking entities from engaging in proprietary trading. It also severely restricts the relationships between banking entities and covered funds (e.g., hedge funds/private equity funds).
The Dodd-Frank Act took effect on July 21, 2010. The Volcker Rule was proposed on October 11, 2011, and the final rule was finalized on December 10, 2013. The final rule became effective April 1, 2014. The Federal Reserve Board (FRB) extended the conformance period until July 21, 2015.
Additionally, on December 18, 2014, the Federal Reserve provided banking entities subject to the Volcker Rule with an extension until July 21, 2016 in order to conform their investments in, and relationships with, covered funds and foreign funds that were in place prior to December 31, 2013. This does not apply to new funds formed after December 31, 2013. Importantly, the extension also does not apply to the conformance deadline of July 21, 2015 for the Volcker Rule’s proprietary trading restriction.
2. Question: Who is covered by the Volcker Rule, and what activities are prohibited?
Answer: “Banking entities” are covered by the Volcker Rule.
“Banking entities” are:
- all insured depository institutions (IDIs)
- all companies that control IDIs or are otherwise treated as bank holding companies under the International Banking Act (Foreign Banking Entities)
- all affiliates and subsidiaries of the above entities.
Proprietary Trading: The regulations prohibit a banking entity from engaging in “proprietary trading,” which means engaging as principal for the trading account of a banking entity in any transaction to purchase or sell specified types of financial instruments. A “trading account” refers to three classes of positions taken by a banking entity:
- the purchase or sale of financial instruments for short-term (usually less than 60 days) gain or hedging of other trading accounts
- the purchase or sale of financial instruments treated as “covered positions and trading positions” under federal banking agency market risk capital rules
- the purchase or sale of financial instruments in connection with activities for which the banking entity is licensed as a dealer, swap dealer or security-based swap dealer.
Covered Funds: The regulations also prohibit or restrict a banking entity from acquiring and retaining an ownership interest in, or having certain relationships with, a covered fund. A “covered fund” means a hedge fund or private equity fund characterized by being one of the following:
- an issuer that is exempt from the Investment Company Act of 1940 because it does not propose to make a public offering of its securities and is beneficially owned by no more than 100 persons (section 3(c)(1) exemption) or is owned exclusively by “qualified purchasers” (section 3(c)(7) exemption)
- a commodity pool that is exempt from the Commodity Exchange Act because its participation units are not publicly offered and are owned by “qualified eligible persons”
- a foreign-based entity owned by a U.S. banking entity that raises money to invest in securities for resale or otherwise trades in securities.
3. Question: Who is not covered as part of the Volcker Rule, and what activities are exempt from regulatory restrictions?
Answer: “Banking entities” generally do not include:
- a hedge fund or private equity fund
- a portfolio company held by a financial holding company under its merchant banking powers
- a portfolio company controlled by a small business investment company so long as the portfolio company is not itself an insured depository institution, a bank holding company, a savings and loan holding company or a Foreign Banking Organization (FBO)
- the Federal Deposit Insurance Corporation (FDIC) acting as a conservator or receiver.
Proprietary Trading: Proprietary trading does not include the following:
- certain repurchase and reverse repurchase arrangements, securities lending transactions, or securities acquired for liquidity management purposes
- financial instruments that are not subject to the proprietary trading prohibition, including loans, spot foreign exchange commodities and spot physical commodities
- underwriting and market-making-related activities, provided that the banking entity does the following:
- establishes and enforces a targeted compliance program
- limits its positions, inventory and risk exposure to ensure that they do not exceed the reasonably expected near-term demands of customers and counterparties
- institutes internal controls and independent testing of compliance and makes senior management accountable
- ensures that compensation arrangements for trading desk personnel are designed not to reward or incentivize prohibited proprietary trading.
- risk-mitigated hedging, provided that
- the hedging rationale is documented;
- a robust compliance program is maintained; and
- quantitative measurements are reported.
- trading in U.S. government obligations
- state and municipal government obligations, with no distinctions made among the various types
- trading on behalf of customers
- trading by insurance companies
- trading outside the United States by certain foreign banking entities.
However, a banking entity may not rely on any exemption if the activity would result in a conflict of interest, result in exposure to high-risk assets or trading strategies, or threaten the safety and soundness of the entity or the financial stability of the United States.
Covered Funds: In general, banking entities are not restricted under the Volcker Rule from owning or controlling the following:
- foreign public funds
- wholly owned subsidiaries
- joint ventures
- foreign pension or retirement funds
- acquisition vehicles
- insurance company separate accounts
- bank-owned life insurance
- public welfare investment funds
- loan securitizations
- qualifying asset-backed commercial paper conduits
- qualifying covered bonds that are debt obligations of foreign banking organizations.
In addition, performance compensation for services provided by a banking entity to a covered fund is not a prohibited ownership interest in that fund. An exemption is also made for organizing and offering a covered fund in connection with trust, fiduciary, investment advisory or commodity trading advisory services to customers of the banking entity or its affiliates, including master-feeder funds and fund-of-funds investments, subject to de minimis limits after the first year and exclusion from Tier 1 capital. Furthermore, subject to certain conditions related to customers, investment is permitted in covered funds involved in underwriting, market-making-related activities and risk-mitigating hedging activities.
4. Question: What is the extraterritorial effect of the rule?
Answer: Banking entities covered by the Volcker Rule include companies that are treated as bank holding companies (BHCs) under the International Banking Act of 1978 (IBA). These include any foreign bank that maintains a U.S. branch or agency, any foreign bank or company that controls a U.S. commercial lending company, and the parent company of any foreign bank or company. In addition, by covering all insured U.S. depository institutions and BHCs, the regulations reach all foreign operations of those entities.
5. Question: What type of relief is available for a foreign bank’s home country banks?
Answer: Currently, most foreign banks are not subject to Volcker Rule-type restrictions under the laws of their home countries. Where restrictions on proprietary trading and market-making are being considered, the approach leans towards push-out and ring-fencing within a banking entity, as opposed to outright prohibition. Consequently, U.S. regulators will need to monitor the extent to which foreign banks may gain a competitive advantage over U.S. banks and the degree of dislocation that may occur in the global capital markets.
6. Question: What authority do foreign banking entities have to invest in foreign public funds of their home countries?
Answer: Foreign banking entities may invest in funds having an issuer organized or established outside the United States, which is authorized to offer and sell retail ownership interests to investors in its home jurisdiction and which sells ownership interests in unrestricted and legally compliant public offerings outside the United States. Such funds are not within the definition of “covered funds.” For a banking entity that is located in the United States or that is controlled by a U.S. banking entity, and any issuer it sponsors, investment in such funds is permitted only if ownership interests are sold predominantly to persons other than the sponsoring banking entity, the issuer and their affiliates, directors and employees.
7. Question: What does “SOTUS” mean, and what are the conditions for it?
Answer: FBOs with a U.S. banking presence are permitted to invest in covered funds that are “solely outside the United States” (SOTUS) in the following circumstances:
- the covered funds are not organized under U.S. law or controlled directly or indirectly by a U.S. banking entity
- the covered funds are not located in the United States
- the covered funds conduct a majority of their business outside the United States
- the FBO does not participate in an offer of sale of covered fund interests to a resident of the United States, or the FBO does not sponsor or serve, directly or indirectly, as the investment manager, investment advisor, commodity pool operator or commodity trading advisor to a covered fund that participates in an offer or sale of ownership interests in a covered fund in the United States
- all of the investments or sponsorship decisions involve personnel located outside the United States
- the investments or sponsorships are not booked or financed through U.S. branches or affiliates.
8. Question: What are foreign non-covered funds?
Answer: The Volcker Rule contains a specific exemption from the definition of “covered funds” for a foreign fund. The exemption corresponds to the SOTUS exemption for proprietary trading. The following conditions apply to qualify for the foreign fund exemption:
- the investor/sponsor may not be a U.S. banking entity or controlled by a U.S. banking entity
- if not an FBO, the fund must be organized outside the United States and have a majority of its business outside the United States
- the fund must make investment/sponsorship decisions outside the United States through an entity located and organized outside the United States — i.e., decision-making personnel must be outside the United States
- back office and administrative functions can be in the United States
- investment advice can be given from the United States
- a U.S.-based entity can offer and sell the interests — but only to non-U.S. persons
- fund interests may be offered and sold only in an offering that does not target U.S. persons, including secondary trades, multi-tier funds and Parallel Funds
- fund investment/sponsorship (including any related hedging) cannot be booked or accounted for in a U.S. entity (including in any U.S. branch/agency)
- no financing of any fund investment/sponsorship may be provided by a U.S. affiliate (including any U.S. branch/agency).
9. Question: What are the enhanced compliance requirements for small, medium and large banks, and at what levels do they apply?
Answer: The Volcker Rule provides for certain compliance program requirements that apply to all banks engaging in proprietary trading or permitted covered fund activities. These requirements are tailored to address the bank’s size and complexity. In doing so, larger banks have more detailed and burdensome compliance program requirements, and smaller banks have a much more simple regime.
- Banks with total consolidated assets of less than $10 billion may satisfy the compliance program requirements by including reference to the final rule’s requirements in their existing compliance policies and procedures adjusted to reflect the size, scope and complexity of the bank’s activities.
- Banks with total consolidated assets greater than $10 billion must establish a new compliance program that includes the following:
- policies and procedures
- internal controls
- a governance and management framework
- independent testing and audits of the compliance program
- increased recordkeeping available to the bank’s regulator upon request.
- Banks with total consolidated assets greater than $50 billion are also subject to enhanced compliance requirements that include the following:
- robust risk management and remediation processes
- independent testing and reporting
- other compliance controls to govern the bank’s covered trading and covered fund activities
- submitting annual written attestation by the CEO to the bank’s regulator that the bank has a compliance program in place that is “reasonably designed” to achieve compliance with the final Volcker Rule.
10. Question: What is the Volcker Working Group?
Answer: The Federal Reserve System, the Commodity Futures Trading Commission (CFTC), the FDIC, the Office of the Comptroller of the Currency (OCC), and the Securities and Exchange Commission (SEC) have formed an interagency working group to address and coordinate responses to help ensure consistent application to key supervisory issues that arise under the final regulations of the Volcker Rule. Each agency has designated staff to work specifically on Volcker Rule issues.
The Volcker Working Group is addressing implementation issues on an ongoing basis and will provide the industry with additional guidance or clarity as necessary. This interagency group held its first meeting in January 2014 and will continue to meet on a regular basis going forward to address reporting, guidance and interpretation issues to facilitate compliance with the rule. This includes developing and issuing frequently asked questions as they apply to banking entities under the Volcker Rule.
However, the Volcker Working Group has not been transparent or timely in the way that they provide guidance or answer questions. In fact, SEC Commissioner Kara M. Stein criticized the Volcker Working Group, in a speech on February 9, 2015, for its lack of responsiveness and transparency about the implementation process. She even went so far as to suggest that the Volcker Working Group consider establishing a deadline for indicating whether a question regarding the Volcker Rule will be answered or not and then have a deadline for answering it. As of October 16, 2015, the Volcker Working Group does not provide a way to directly answer individual practicing lawyers’ questions.
11. Question: The Volcker Working Group released guidance regarding the SOTUS covered fund exemption on February 27, 2015. How does FAQ #13 from the Volcker Working Group affect the Marketing Restriction for the SOTUS covered fund exemption?
Answer: The SOTUS covered fund exemption provides that, among other conditions, “no ownership interest in such hedge fund or private equity fund is offered for sale or sold to a resident of the United States.” This is called the “Marketing Restriction.” The most recent Q&A from the Volcker Working Group asks whether the Marketing Restriction applies only to the activities of a foreign banking entity that is seeking to rely on the SOTUS covered fund exemption or whether it applies more generally to the activities of any person offering for sale or selling ownership interests in a covered fund.
Specifically, how does that condition apply to a foreign banking entity that has made, or intends to make, an investment in a covered fund where the foreign banking entity (including its affiliates) does not sponsor or serve, directly or indirectly, as the investment manager, investment advisor, commodity pool operator or commodity trading advisor to the covered fund?
Under FAQ #13, the Marketing Restriction applies to the activities of a foreign banking entity that is seeking to rely on the SOTUS covered fund exemption (including its affiliates). The Marketing Restriction constrains the foreign banking entity in connection with its own activities with respect to the offering of covered funds in the United States, rather than the activities of unaffiliated third parties. So, a foreign banking entity (including its affiliates) that participates in an offer of sale of covered fund interests to a resident of the United States cannot rely on the SOTUS covered fund exemption with respect to that covered fund. In addition, where a banking entity sponsors or serves, directly or indirectly, as the investment manager, investment advisor, commodity pool operator or commodity trading advisor to a covered fund, that banking entity will be viewed by the agencies as participating in any offer or sale by the covered fund of ownership interests in the covered fund including in the United States. In that case, the foreign banking entity would not qualify for the SOTUS covered fund exemption.
12. Question: For the purposes of FAQ #13, what does it mean for a person to be an investment manager, investment advisor, commodity pool operator or commodity trading advisor, such that they cannot use the SOTUS covered fund exemption?
Answer: Although neither FAQ #13 nor the Volcker Rule expressly define the relevant terms described above, we note that the Volcker Rule was promulgated pursuant to the Dodd-Frank Act and that the Dodd-Frank Act itself provides that (1) the term “investment adviser” has the same meaning as in section 202 of the Investment Advisers Act of 1940 (the Advisers Act) and (2) the terms “commodity pool operator” and “commodity trading advisor” have the same meanings as in section 1a of the Commodity Exchange Act. Although these definitions are far from absolute, we believe that the U.S. bank regulatory authorities are likely to consider these definitions as one source of guidance in determining the meaning of these terms for FAQ #13, although they may also consider other factors under the circumstances that pertain to a “functional” definition of these terms.
13. Question: What is the Parallel Fund structure?
Answer: The proposed arrangement for the Parallel Fund is one contemplated by theConsensus Interpretation of the Implementation of Parallel Fund Structures under the Volcker Rule (May 1, 2014) (the Consensus Interpretation), a legal memorandum issued by 15 major U.S. law firms. The Consensus Interpretation took the position that non-U.S. banking entities can invest in certain parallel foreign funds alongside “covered funds” and that such parallel investments do not violate the Volcker Rule. Specifically, the Consensus Interpretation indicated that non-U.S. banking entities should permitted to invest in such Parallel Funds provided that: “1) the Parallel Funds are organized as separate legal entities and have separate sets of investors; and 2) the offering documents or other similar materials provided to investors in the Parallel Fund include a disclosure that the Parallel Fund is being offered exclusively to non-U.S. persons.”
However, since the Consensus Interpretation was issued, the Volcker Rule Working Group released FAQ #13, which clarified that the Marketing Restriction only applies to the FBO seeking to rely on the SOTUS exemption “in connection with its own activities with respect to covered funds rather than the activities of unaffiliated third parties.” FAQ #13 stressed that if a foreign banking entity sponsors or serves, directly or indirectly, as the investment manager, investment advisor, commodity pool operator or commodity trading advisor to a covered fund, that banking entity will be viewed by the agencies as participating in an offer or sale by the covered fund of ownership interests in the covered fund, including in the United States. Such foreign banking entity would not qualify for the SOTUS covered fund exemption.
The change in interpretation of the SOTUS covered fund exemption removed much of the motivation for the Parallel Funds structure.
14. Question: What is the Volcker Rule’s anti-evasion provision?
Answer: The Volcker Rule’s anti-evasion provision is a powerful tool granted by Congress to the regulatory agencies to ensure compliance with the Volcker Rule. Congress included an anti-evasion provision that directed the FRB, the OCC, the FDIC, the SEC and the CFTC (collectively, the Regulatory Agencies) to issue regulations establishing a compliance regime for the Volcker Rule. Congress also gave regulators a sweeping new power to nullify activities or investments if a regulator has reasonable cause to believe that a banking entity did something that functioned as an evasion of the Volcker Rule’s prohibitions.
It does not appear that an entity needs to intend to evade the Volcker Rule, but rather the offending investment or activity only needs to function like an evasion, or otherwise violate the Volcker Rule. The statute provides Regulatory Agencies with the power to ultimately disagree with, and invalidate, a banking entity’s business practice on the grounds that the practice evades or violates the Volcker Rule, even in instances where employees of the banking entity could testify and show evidence of how they believed they were operating in conformance to the rule without intent to evade.
15. Question: What are the Volcker Rule anti-evasion ramifications on the Parallel Fund structure?
Answer: In the case of the Parallel Fund structure, which presents one fund that is marketed to the United States and is subject to the requirements of the Volcker Rule and a second fund that is not marketed to the United States and is not subject to the Volcker Rule requirements, regulators could be looking at how banking entities approach non-U.S. investors when describing the benefits of investing in a fund that does not have the disclosure requirements of the Volcker regime. For example, imagine a foreign investor who is looking for a fund that does not have the disclosure requirements associated with the Volcker Rule because the investor is involved in illicit activities and would like to hide his or her ill-gotten funds. If a banking entity were to persuade the investor to invest in the non-Volcker fund as a way to prevent disclosure, then the regulators could see this as an attempt to evade the Volcker Rule.
16. Question: How does the Volcker Rule’s anti-evasion provision affect FBOs that move some of their operations outside the United States in an attempt to comply with the Volcker Rule?
Answer: A number of financial companies already have taken steps to comply with the Volcker Rule by moving some of their potentially prohibited operations to foreign countries where such activities are not prohibited. In more radical moves, some financial companies have completely divested operations in order to comply.
It is difficult to know how the Regulatory Agencies will respond to these measures as it relates to the Volcker Rule’s anti-evasion provision. It does not appear that an entity needs to intend to evade the Volcker Rule, but rather the offending investment or activity only needs to function like an evasion, or otherwise violate the Volcker Rule.
The Regulatory Agencies have not yet used their power under the anti-evasion provision to disagree with, and invalidate, a banking entity’s business practice on the grounds that the practice evades or violates the Volcker Rule. There is currently no guidance specifically on this issue, and it may be possible that the Regulatory Agencies intend to provide a bright-line rule through enforcement. However, until there are instances of enforcement or guidance on this issue, it will remain an unresolved risk for those FBOs intending to follow the Volcker Rule by removing operations from the United States.
17. Question: Can you explain the 25 percent ownership rule and the effect of FAQ #13?
Answer: FAQ #13 does not address the second major open interpretive question in the foreign fund context — the treatment of controlled foreign funds that are not “covered funds” and whether they could be deemed banking entities subject to the Volcker Rule’s restrictions on proprietary trading and covered fund investments.
Under the Volcker Rule regulations, a banking entity is defined as (1) any insured depository institution, (2) any company that controls an insured depository institution, (3) any company that is treated as a BHC for purposes of section 8 of the IBA, or (4) “any affiliate or subsidiary” of any entity in the foregoing three categories.
The definition of a banking entity also specifically excludes covered funds. The definition of a banking entity does not exclude “foreign non-covered funds.”
Notably, the term “affiliate” used in the banking entity definition is defined under the Volcker Rule regulations as having the same meaning as under the BHC Act. The BHC Act, in turn, defines “affiliate” as “any company that controls, is controlled by, or is under common control with another company.” The BHC Act’s concept of control is broad and states that a company has control over another company if the company owns, controls or has the power to vote at least 25 percent of the other company’s voting securities.
With that background in mind, if a banking entity were to own at least 25 percent of another entity, that second entity would be an affiliate of the banking entity. By being an affiliate of the banking entity, the affiliated entity should itself become a banking entity under the fourth category of the Volcker Rule’s banking entity definition, i.e., “any affiliate or subsidiary of a bank or bank holding company.” Once the fund is considered a banking entity, it is therefore subject to the Volcker Rule’s restrictions on investments in covered funds and the limitations on proprietary trading. In effect, this restriction destroys the purpose of setting up the Parallel Fund structure in order to escape the restrictions of the Volcker Rule on banking entities.
18. Question: How does FAQ #14 work, and does it answer all the questions regarding the 25 percent ownership rule?
Answer: On June 12, 2015, the Volcker Working Group released FAQ #14, which included its interpretation of how the final rule applies to foreign public funds sponsored by a banking entity. The scope of FAQ #14 only applies to foreign public funds and does not address the Regulatory Agencies’ interpretation of how the final rule applies to SOTUS and foreign non-covered funds sponsored by a banking entity. According to FAQ #14, the Volcker Working Group’s interpretation is that foreign public funds controlled by banking entities under the BHC Act as a result of management, contractual or other governance arrangements will not be viewed as banking entities or have their activities attributed, for purposes of the Volcker Rule, to a banking entity sponsor. However, this FAQ does not provide a solution to the problem regarding control arising out of ownership of a foreign public fund’s shares. In order to take advantage of this FAQ, banking entities may not own or control 25 percent of the voting shares of the fund.
FAQ #14 is helpful in providing relief to some foreign public funds, but it does not propose to solve outstanding issues regarding control that could arise from ownership situations under which a banking entity could hold 25 percent or more of the voting shares of a foreign public fund and therefore the fund would still be deemed a banking entity.
Although FAQ #14 closes some doors, it does not address other similar open interpretive questions with respect to SOTUS and foreign non-covered funds, including whether FAQ #14 is to be extended to private funds. One view is that FAQ #14 is to be narrowly construed only to affect foreign public funds. Unless the Regulatory Agencies provide further clarification regarding the scope of FAQ #14, it remains an open question whether the same reasoning would be applied in instances of foreign private funds. There do not appear to be any distinguishing characteristics of private funds that would lead the Regulatory Agencies to develop a different control standard for private funds versus public funds so, by analogy if not by express application, it is possible that FAQ #14 will have an impact.
If FAQ #14 does extend to private funds, any fund that has a controlling bank investor that owns or controls 25 percent or more of the voting shares of the fund would be deemed a banking entity under the Volcker Rule because it would be an affiliate of the controlling bank investor.
19. Question: How does FAQ #16 affect registered investment companies and foreign public funds while they are being seeded?
Answer: The Volcker Rule restricts “banking entities” from sponsoring or investing in covered funds. Registered investment companies (RICs) and foreign public funds are not “covered funds” as defined by the Volcker Rule. However, while they are being organized and “seeded” with capital, investment funds are generally privately held and do not qualify as RICs or foreign public funds, thus creating an issue as to whether the banking entities may seed them.
Under guidance issued in FAQ #16, the Regulatory Agencies will not treat a RIC or a foreign public fund that is controlled during its seeding period by a banking entity as a banking entity during a seeding period of up to three years as long as the seeding vehicles are not established in order to evade the Volcker Rule.
20. Question: Will the Volcker Rule be repealed anytime soon?
Answer: Although it is impossible to predict with 100 percent certainty how Congress will act in the future, we believe that the Volcker Rule is here to stay and there does not seem to be momentum for significant changes in the near future. All parts of the financial system should plan as though these rules will be in place going forward.
21. Question: Where can we look to for guidance on these issues?
Answer: We have not seen a great deal of guidance, aside from the rules themselves, from the Regulatory Agencies working on the Volcker Rule. However, here is a collection of what is currently available.
The Volcker Working Group has developed and issued answers to 18 frequently asked industry questions (as of October 16, 2015), which appear in substantially identical versions on the public websites of each agency involved. These frequently asked questions are updated sporadically by the Volcker Rule Working Group.
On June 12, 2014, the OCC published interim procedures for examiners to assess banks’ progress in developing a framework to comply with the Volcker Rule. These examination procedures are designed to help bank examiners work with banks to determine whether they have business activities or investments that are subject to the regulations.