During the week of October 10, 2011 the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System (the “Board”), the Federal Deposit Insurance Corporation and the Securities and Exchange Commission jointly approved a Notice of Proposed Rulemaking that proposes rules (collectively, the “Proposed Rules”) to implement the provisions of Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that added a new Section 13 to the Bank Holding Company Act of 1956 (“BHC Act”), popularly known as the “Volcker Rule.” Under the terms of the Volcker Rule, the Commodity Futures Trading Commission (“CFTC”) also is required to approve the Rulemaking. Although such action is anticipated, the timing is uncertain.
The Volcker Rule generally prohibits a “Banking Entity” from engaging in proprietary trading or acquiring or retaining any equity, partnership, or other ownership interest in, or sponsoring an issuer that would be, an investment company under the Investment Company Act of 1940, but for Section 3(c)(1) or 3(c)(7) thereof, or such similar funds as determined by the appropriate regulatory agency (each, a “Covered Fund”). A “Banking Entity” is defined broadly to mean: (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any company that is treated as a bank holding company for purposes of Sec. 8 of the International Banking Act of 1978; and (iv) any affiliate or subsidiary of the foregoing. (An overview of the Volcker Rule can be accessed through this link.)
The 298 page Rulemaking raises numerous interpretative issues and solicits comments, to be submitted no later than January 13, 2012, on approximately 400 multi-faceted questions. (A copy of the Rulemaking can be accessed through this link). This Alert provides a summary of some of the most significant provisions of the Rulemaking that directly impact the sponsorship of, and ownership of interests in, “Covered Funds” by “Banking Entities,” including securitization transactions. A more detailed textual analysis of the Rulemaking is set forth in the Summary Overview that can be accessed through this link.
- The Sponsorship of, and Ownership of Interests in, Covered Funds.
A. Definition of “Banking Entity.”
Absent regulatory relief, the broad definition of the term “Banking Entity” would cause a bank affiliated Covered Fund to be deemed to be a Banking Entity and any other Covered Fund controlled by such a fund also to be deemed to be a Banking Entity. The unintended result would be, de facto, to make it impermissible for a Banking Entity to organize and manage a “fund of funds” investment program.
Proposed Rule 10(b)(1) provides relief by excluding from the definition of a Covered Fund a fund that is sponsored by a Banking Entity in accordance with the requirements of the Volcker Rule and a Covered Fund that is controlled by such a Covered Fund.
(See Sec. II.A.1 of Summary.)
B. Customer Relationship and Name Conditions to Permitted Sponsorship of a Covered Fund.
The Volcker Rule provides that, notwithstanding the general prohibition on the sponsorship of, and holding of interests in, a Covered Fund, a Banking Entity may engage in various permitted activities. A Banking Entity may “sponsor” a Covered Fund if, among other things, the Covered Fund is organized and offered only in connection with bona fide trust, fiduciary, investment advisory, or commodity trading advisory services to persons that are “customers of such services” of the Banking Entity.
The Supplemental Information section of the Rulemaking clarifies that the requirement that a customer relationship exist with a person who invests in a sponsored fund does not require that the customer relationship have been established prior to the offering of such services. At the same time, Proposed Rule 11(b) specifies that the customer relationship must be established “pursuant to a credible plan or similar documentation outlining how the [Banking Entity] intends to provide advisory or similar services to its customers through organizing and offering such fund.”
The Supplemental Information section of the Rulemaking also specifies that a Banking Entity “may not organize and offer a Covered Fund as a means of itself investing in the fund or assets held in the fund.” Although no further explanation is provided, this statement appears intended to emphasize the general prohibition on a Banking Entity directly investing in non-sponsored Covered Funds.
Lastly, Proposed Rule 11(f) clarifies that a Covered Fund, for corporate, marketing, promotional, or other purposes cannot “(1) share the same name or a variation of the same name with [a Banking Entity] (or an affiliate or subsidiary thereof); and (2) [can] not use the word “bank” in its name.” Accordingly, a Covered Fund advised by an investment adviser affiliate of a Banking Entity could not, as is now common practice, incorporate into its name the name of its adviser even if such name does not share the name, or a variation of the name, of the parent bank.
(See Sec. II.B of the Summary.)
C. Exclusion of Carried Interest from Prohibition on Ownership of Interest in a Covered Fund; Inclusion of Derivatives of an Equity Interest in Definition of Ownership Interest.
Proposed Rule 10(a)(3) provides an exception to the general prohibition on a Banking Entity from holding an Ownership Interest in a Covered Fund to permit it to hold an Ownership Interest in order that it may receive performance compensation for the services it provides directly, or through one of its affiliates, subsidiaries, or employees to a Covered Fund, subject to certain conditions.
The definition of “Ownership Interest” is defined broadly to mean, with respect to a Covered Fund, any equity, partnership, or other similar interest in a Covered Fund, whether voting or nonvoting, as well as any derivative of such interest. As stated in the Supplemental Information section of the Rulemaking: “the definition focuses upon the attributes of the interest and whether it provides a banking entity with economic exposure to the profits and losses of the covered fund, rather than its form.”
(See Sec. II.C.1 of the Summary.)
D. Calculation of Permitted De Minimis Ownership Interest in a Sponsored Covered Fund.
One of the conditions for a Banking Entity to be permitted to sponsor a Covered Fund is that it may not hold more than a de minimis Ownership Interest in any one Covered Fund or in the aggregate in all such sponsored funds.
Proposed Rule 12 specifies that for purposes of determining whether a Banking Entity is in compliance with the limitations and restrictions on permitted investments in Covered Funds, a Banking Entity must take into account the value of: (i) “controlled investments;” (ii) the pro rata share of “non-controlled investments;” and (iii) certain “parallel investments” to the extent that a Banking Entity is “contractually obligated to directly invest in, or is found to be acting in concert through knowing participation in a joint activity or parallel action . . . .”
(See Sec. III.C.1 of the Summary.)
E. Acting as Agent, Broker, or Custodian for an Unaffiliated Third Party Separately Managed Account.
Notwithstanding the Volcker Rule general prohibition on proprietary trading by a Banking Entity, the definition of “proprietary trading” in Proposed Rule 3 excludes “acting solely as agent, broker, or custodian for an unaffiliated third party.”
Under Proposed Rule 6, the general prohibition on proprietary trading also does not apply to “the purchase or sale of a covered financial position by a [Banking Entity] on behalf of customers.”
Accordingly, a Banking Entity could provide advisory or other services to an unaffiliated separately managed account.
(See Secs. II.C.2 and III.D of the Summary.)
F. Permitted Activities of Non-U.S. Banking Entities.
The prohibitions of the Volcker Rule do not apply to the acquisition or retention of any ownership interest in, the sponsorship of, a Covered Fund by a Banking Entity, if:
(i) The [Banking Entity] is not directly or indirectly controlled by a [Banking Entity] that is organized under the laws of the United States or of one or more States; (ii) The activity is conducted pursuant to paragraph (9) or (13) of section 4(c) of the BHC Act; (iii) No ownership interest in such covered fund is offered for sale or sold to a resident of the United States; and (iv) The activity occurs “solely outside the United States.”
Proposed Rule 13(c) clarifies when an activity is considered to be conducted pursuant to paragraph (9) or (13) of Sec. 4(c) of the BHC Act and the conditions that must be satisfied for a non-U.S. Banking Entity to conduct certain activities “solely outside the United States.”
Global non-U.S. domiciled Banking Entities that conduct extensive asset management activities in the United States face challenges in conforming such activities to the requirements of the Volcker Rule. Careful consideration should be given to the scope of the permissible Covered Fund sponsorship and investment activities that can be conducted in the United States in conjunction with the scope of the permissible Covered Fund and investment activities that can be conducted outside the United States.
(See Secs. II.B and III.E of the Summary.)
G. Other Limitations on Permitted Covered Fund Activities.
Proposed Rule 17 sets forth specific conditions for satisfying the requirement of the Volcker Rule that no permitted activity may:
(i) Involve or result in a material conflict of interest between the [Banking Entity] and its clients, customers, or counterparties; (ii) Result, directly or indirectly, in a material exposure by the [Banking Entity] to a high-risk asset or a high-risk trading strategy; or (iii) Pose a threat to the safety and soundness of the [Banking Entity] or the financial stability of the United States.
These conditions include either making clear, timely and effective disclosure or establishing, maintaining and enforcing effective “information barriers that are reasonably designed to prevent the conflict of interest from involving or resulting in a materially adverse effect on a client, customer or counterparty.”
(See Sec. IV.C of the Summary.)
H. Compliance Programs.
Proposed Rule 20 and the Supplemental Information section of the Rulemaking generally require a Banking Entity to establish an enhanced compliance program with respect to the Volcker Rule, including written policies and procedures, internal controls, a management framework, independent testing of the compliance program, training, and recordkeeping.
(See Sec. V of the Summary.)
I. Conformance Period.
The Proposed Rules do not set forth substantive changes to the Transition Rule adopted on February 8, 2011 by the Board to implement the conformance period provisions of the Volcker Rule.
For purposes of the requirement that a Banking Entity must bring its activities and investments into conformance with the Volcker Rule no later than July 21, 2014 (the “Conformance Period”), subject to possible extensions, the Supplemental Information section of the Rulemaking emphasizes that the Volcker Rule and the Transition Rule “do not permit a [Banking Entity] to engage in any new activity or make any new investment in a [Covered Fund] without complying with the restrictions and prohibitions of [the Volcker Rule] and implementing rules thereunder.”
At the same time, the Supplemental Information section of the Rulemaking clarifies that:
the conformance period (or, in the case of an illiquid fund for which a banking entity has received Board approval, the extended transition period) generally permits a banking entity to retain an existing investment in a covered fund, make additional capital contributions to a covered fund if contractually obligated to do so, or continue certain existing relationships with a covered fund. However, pursuant to the conformance period or extended transition period, a banking entity may not make a new investment or capital contribution that it is not contractually obligated to make in, or establish a new relationship with, a covered fund after the effective date of the proposed rule.
The example is given that: “a banking entity may retain an existing ownership interest in a covered fund under authority of the conformance period or extended transition period without regard to the per-fund or aggregate fund limitations contained in [the Proposed Rules].”
As is evident from the foregoing excerpts from the Rulemaking, the application of the Transition Rule and the Proposed Rules to any particular Banking Entity and its Covered Fund activities is particularly fact sensitive.
(See Secs. II., C and VI of the Summary.)
A. Definition of “Loan” Does Not Include “Asset Backed Securities.”
Proposed Rule 13(d) would allow a Banking Entity to acquire an Ownership Interest in, or act as sponsor to, an issuer of asset-backed securities that would be a Covered Fund as long as that issuer holds only certain assets, i.e., “Loans,” rights and assets directly arising from those Loans and a limited amount of derivatives that are used in the securitization relating to those Loans. The definition of “Loan” includes “any loan, lease, extension of credit or secured or unsecured receivable,” and, while described in the Supplemental Information section of the Rulemaking as “expansive,” it does not include asset-backed securities. The exclusion of assetbacked securities is surprising and significant because many securitization vehicles that would be Covered Funds hold asset-backed securities.
(See Secs. III.F and III.H.2(iv) of the Summary.)
B. Limitations on Relationships Between a Banking Entity and Covered Funds.
Proposed Rule16 would broaden the application of Sections 23A and 23B of the Federal Reserve Act by: (i) prohibiting “covered transactions” between a Banking Entity and Covered Funds and by treating a Banking Entity as a “member bank” and Covered Funds as affiliates thereof under such legislation, subject to specified exceptions for holding a permitted Ownership Interest and engaging in certain permitted prime brokerage transactions; and (ii) providing that all permitted transactions between a Banking Entity and Covered Funds be on market terms.
Under the Federal Reserve Act, “covered transactions” broadly include, among other things, the following activities between a member bank and its affiliates: (i) a loan or extension of credit, including a purchase of assets subject to an agreement to repurchase; (ii) the acceptance of securities or other debt obligations issued by the affiliate as collateral security for a loan; (iii) the issuance of a guarantee, acceptance, or letter of credit; and (iv) a derivative transaction, to the extent the transaction causes a member bank to have a credit exposure to the affiliate.
Therefore, although Proposed Rule 16 would allow a Banking Entity to have an Ownership Interest in, or to act as sponsor to, an asset-backed securities issuer that is a Covered Fund, it would not allow such Banking Entity to engage in many significant, customary securitization-related business activities with that asset-backed securities issuer.
Historically, such restrictions have not been applied to securitizations for two reasons. First, Section 23A of the Federal Reserve Act (“Section 23A”) has governed, but not prohibited, covered transactions. That is, such transactions have been permitted, but required to meet specified quantitative and qualitative requirements. Therefore, a Banking Entity could structure covered transactions to satisfy those limitations. Second, Section 23A has governed only the relationships between a member bank and its affiliates and not all asset-backed securities issuers have been deemed to be “affiliates” of a Banking Entity that sponsor them or have an ownership interest in them. The proposed expansion of Section 23A, without limitations on its applicability if certain standards are met, could have a serious negative impact on the way in which bank sponsors of asset-backed securities issuers have historically conducted their business. For example, it is the norm for a bank sponsor (a Banking Entity) of asset-backed commercial paper conduits (a Covered Fund), to provide both the liquidity and credit enhancement for their conduits (a covered transaction). Proposed Rule 16 would prohibit such arrangements.
(See Secs. IV.A and IV.B of the Summary.)
- Concluding Observations.
The Rulemaking is a significant step forward in the formulation and adoption of final rules implementing the Volcker Rule although the timing, and the outcome, of further action remain uncertain. The CFTC has not yet acted, the comment period on the Proposed Rules does not end until January 13, 2012, and there is no established deadline for the adoption of final rules.
Against this background, bear in mind that the Volcker Rule automatically becomes effective on July 21, 2012 and Banking Entities must conform their activities to its requirements no later than July 21, 2014 (subject to extensions being granted on a discretionary basis) regardless of whether final implementing rules have been adopted by that date. The Volcker Rule required that the regulatory agencies “adopt rules to carry out” its provisions by October 18, 2011, not merely to have jointly approved a Rulemaking proposal. This delay has further complicated the regulatory and business challenges faced by Banking Entities.
On a positive note, the Proposed Rules provide: (i) regulatory relief to fund-offunds structures; (ii) clarification that a Banking Entity can hold an Ownership Interest necessary to permit it to be compensated through certain “carried interest” arrangements; (iii) clarification that the “customer relationship” condition for permitted Covered Fund sponsorship is not required to be “pre-existing;” (iv) clarification that a Banking Entity can continue to provide advisory and other services to customers through customary separately managed account arrangements; and (v) clarification that certain existing activities can be conducted during the Conformance Period. These themes, however, are counterbalanced by: (i) renewed emphasis that the regulatory agencies will carefully scrutinize how Banking Entities comply with the strict limitations on permitted activities and Ownership Interests (including the use of derivatives), restrictions on new activities and investments that are commenced during the Conformance Period; and (ii) the severe limitations that would be imposed on customary securitization transactions.
The provisions of the Rulemaking are complex and leave many questions unanswered. Moreover, in this uncertain regulatory environment the application of the Proposed Rules to the business activities of each Banking Entity is highly fact sensitive.