On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act"). This alert focuses specifically on the effects of the so-called "Volcker Rule," contained in Section 619 of the Reform Act, and is one in a series of alerts on the Reform Act.
Lawmakers left many of the key details of financial reform to regulation to be determined by the regulators. Various industry experts have estimated that the new law will require U.S. regulatory agencies to enact over 200 new regulations. Others have asserted that the rulemaking effort required to implement the Reform Act will be unprecedented in its scope and complexity and will exceed the efforts required to implement the post-September 11th measures and the Sarbanes-Oxley Act. As a result, U.S. regulatory agencies will need to enact numerous regulations implementing the Reform Act and, in doing so, will have the opportunity to shape the ultimate effect of financial reform in many critical areas, including the implementation of the Volcker Rule.
Section 619 of the Reform Act enacts a version of the "Volcker Rule" originally proposed by President Obama and White House economic advisor Paul Volcker in January of 2010 (the "Volcker Rule"). The Volcker Rule is intended to help prevent the occurrence of another financial crisis by reducing or eliminating high-risk speculation at financial institutions and encouraging such institutions to focus instead on lower-risk, client-focused activities. The Volcker Rule is controversial because it is unclear whether the activities that it prohibits contributed significantly, if at all, to the financial crisis, and, in a number of cases, these activities may have provided valuable sources of income for banks experiencing historic losses in their traditional loan portfolios. Nevertheless, the Volcker Rule has attracted significant political support from legislators eager to reduce both the perceived risk in the financial system and the perceived excesses of Wall Street during the financial crisis.
The Volcker Rule includes two primary restrictions on the activities of any "banking entity." These restrictions are:
- Prohibitions on "proprietary trading"; and
- A ban on certain hedge fund and private equity activities and investments.
The Volcker Rule defines "banking entity" as any insured bank or thrift, a company that controls an insured bank or thrift, a company that is treated as a bank holding company under Section 8 of the International Banking Act of 1978 and any affiliate of such entity. Nonbank financial companies (other than savings and loan holding companies) are not subject to the restrictions set forth in the Volcker Rule. However, nonbank financial companies supervised by the Board of Governors of the Federal Reserve System (the "Federal Reserve") that engage in activities prohibited by the Volcker Rule will be subject to additional capital requirements for and quantitative limits on proprietary trading or ownership interests in or sponsorship of a hedge fund or private equity fund, as well as rules imposing additional capital charges or other restrictions to address the affiliated transactions concerns of the Federal Reserve.
- Study and Regulations
The Volcker Rule provides that, not later than January 21, 2011, the newly-established Financial Stability Oversight Council (the "Council") must study and make recommendations on implementing the provisions of the Volcker Rule. Not later than nine months after the completion of such study, regulations must be promulgated implementing the Volcker Rule. These regulations must be promulgated by:
- The federal banking regulators jointly with respect to depository institutions;
- The Federal Reserve with respect to bank holding companies and savings and loan holding companies, any company that is treated as a bank holding company for the purposes of Section 8 of the International Banking Act, any nonbank financial company supervised by the Federal Reserve, or any subsidiary of the foregoing;
- The Commodities Futures Trading Commission ("CFTC") with respect to any entity for which it is the primary financial regulatory agency; or
- The Securities and Exchange Commission ("SEC") with respect to any entity for which it is the primary financial regulatory agency.
Each of these regulators is required by statute to "consult and coordinate" with each other to ensure that such regulations are comparable to one another and do not provide advantages or impose disadvantages to companies governed by the Volcker Rule by virtue of which entity regulates them. The Chairperson of the Council shall be responsible for the coordination of these regulations.
- Ban on Proprietary Trading
The Volcker Rule amends Section 13(a) of the Bank Holding Company Act of 1956 (the "BHCA") to prohibit expressly any banking entity from engaging in "proprietary trading."
- The term "proprietary trading" means engaging as a principal for the trading account of the banking entity in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, derivative, contract of sale of a commodity for future delivery, any option on any such security, derivative or contract, or any other security or financial instrument that the appropriate federal banking agencies, the SEC or the CFTC may, by rule, provide.
- The term "trading account" means any account used for acquiring or taking positions in the securities and instruments described above principally for the purpose of selling in the near term (or otherwise profiting from short term price movements) and any other such accounts that the appropriate federal banking agencies, the SEC or the CFTC may, by rule, provide.
While the Volcker Rule prohibits trading in securities for a banking entity's trading account as opposed to trading for the account of a customer, the following activities are expressly permitted by the Volcker Rule:
- Trading in U.S. government or agency securities or obligations;
- Trading in obligations, participations or other instruments issued by government sponsored enterprises, including Ginnie Mae, Fannie Mae, Freddie Mac, any Federal Home Loan Bank, Farmer Mac and any Farm Credit System institution chartered under the Farm Credit Act of 1971;
- Trading in State or municipal obligations;
- Acquiring or disposing of securities in connection with underwriting or market making activities;
- Bona fide risk-mitigating or hedging activities;
- Trading on behalf of the account of a customer;
- Investing in small business investment companies;
- Trading by a regulated insurance company for the general account of such insurance company in compliance with insurance company investment regulations;
- Proprietary trading conducted by a banking entity pursuant to Sections 4(c)(9) (activities conducted by foreign banks, the greater part of which are conducted outside of the United States) or 4(c)(13) (shares of, or activities conducted by, an entity which does not do business in the United States) of the BHCA solely outside the United States, provided that the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or one or more States; or
- Any other activity that the appropriate federal banking agencies, CFTC or SEC, as applicable, determine by rule would promote and protect the safety and soundness of the banking entity or U.S. financial stability.
- Ban on Ownership of Private Equity Funds and Hedge Funds
The Volcker Rule amends Section 13(a) of the BHCA to prohibit expressly any banking entity from organizing and offering a private equity or hedge fund, or sponsoring a hedge fund or private equity fund. Private equity funds and hedge funds are defined as an issuer that would be an investment company, as defined in the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of such Act, or such similar funds as the appropriate federal banking agencies, SEC or CFTC, as applicable, determine by rule. Sponsoring a fund means serving as a general partner, managing member, or trustee of the fund and in any manner selecting or controlling (or having employees, officers, directors, or agents who constitute) a majority of the directors, trustees or management of that fund, or sharing the same name or variation of such name for corporate, marketing, promotional or other purposes.
The prohibitions on private equity and hedge fund activities are subject to exceptions for certain enumerated permitted activities. Such permitted activities are discussed below.
Bona Fide Trust or Investment Advisory Services. A private equity or hedge fund activity will be deemed to be a permitted activity if it meets all of the following conditions:
- The banking entity must provide bona fide trust, fiduciary or investment advisory services. Although the Volcker Rule does not define what are considered "investment advisory services," Section 202(a)(11) of the Investment Advisers Act of 1940 defines an investment adviser as any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities. While banks are excepted from being considered an "investment adviser," the definition provides guidance in determining whether a banking entity is actually providing such services to the funds;
- The fund is organized and offered only in connection with the provision of the bona fide trust or investment advisory services and only to persons who are customers of such services of the banking entity. The purpose of this condition is to limit the fund activities of banking entities to those activities provided solely as a service to existing customers and not intended to be a separate business unrelated to the banking clients. To satisfy this condition, the investors in funds must be willing to establish accounts with the relevant banking entity (or its affiliate);
- The banking entity does not acquire or retain an interest in the funds except for a de minimis investment. A "de minimis investment" is an investment in a hedge fund or private equity fund in which (i) the banking entity actively seeks unaffiliated investors to reduce or dilute its investment, (ii) the banking entity's investment is reduced to not more than 3% of the total ownership of the fund within one year of the fund's establishment (with a possible two year extension) and (iii) the investment is immaterial to the banking entity as defined by regulators pursuant to rulemaking, but in no case in excess of 3% of the banking entity's Tier 1 capital;
- The banking entity complies with Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated thereunder (transactions with affiliates limits);
- The banking entity does not guarantee the obligations or performance of any fund;
- The banking entity does not share the same name with any fund for corporate or marketing purposes;
- No director or employee of the banking entity retains an interest in the fund (unless directly engaged in providing investment advisory services to the fund); and
- The banking entity provides full disclosure to investors, including that the risk of loss borne by investors.
Foreign Activities. The Volcker Rule permits the ownership or sponsorship of a private equity or hedge fund by a banking entity pursuant to Section 4(c)(9) or 4(c)(13) of the BHCA solely outside the United States, provided that:
- No ownership interest in such hedge fund or private equity fund is offered for sale or sold to a resident of the United States; and
- The banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or one or more States.
Seed Money or Other De Minimis Investments. A banking entity also may make and retain an investment in a hedge fund or private equity fund that the banking entity organizes and offers for the purposes of:
- Establishing the fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors; or
- Making a de minimis investment (as defined above).
- Limitations on Permitted Activities
The permitted activities exceptions to both the proprietary trading and private equity prohibitions of the Volcker Rule are subject to certain qualifications. Specifically, no transaction, class of transactions or activity will be deemed to be a permitted activity if it would:
- Involve a material conflict of interest between the banking entity and its customers, clients or counterparties;
- Result, directly or indirectly, in a material exposure to high risk assets or high risk trading strategies;
- Pose a safety and soundness threat to the banking entity; or
- Pose a threat to U.S. financial stability.
- Capital and Quantitative Limits
The appropriate federal bank agencies, the SEC and the CFTC, as applicable, must adopt rules imposing additional capital requirements and quantitative limitations, including diversification requirements, regarding all permitted activities if such regulators determine that such additional capital requirements and limitations are necessary to protect the safety and soundness of banking entities engaged in such activities. For the purposes of determining compliance with applicable capital standards, the aggregate amount of outstanding investments by a banking entity, including retained earnings, will be deducted from assets and tangible equity of the banking entity, and the amount of the deduction will increase commensurate with the leverage of the hedge fund or private equity fund.
In addition, a banking entity that continues to own a private equity fund or hedge fund pursuant to a permitted activity exception is required to seek unaffiliated investors to reduce or dilute its investment to not more than 3% of the total ownership interests in the fund and an amount that is immaterial to the banking entity, provided that in no case may the banking entity's aggregate interests in all private equity and hedge funds exceed 3% of the banking entity's Tier 1 capital.
- Section 23A and 23B Limitations
A banking entity that serves, directly or indirectly, as the investment manager, investment adviser or sponsor to a hedge fund or private equity fund or any affiliate of such banking entity or a banking entity that organizes and offers a hedge fund or private equity fund pursuant to the "seed money" or "de minimis investment" exceptions discussed above:
- May not enter into a transaction with such fund, or any other funds that such fund controls, which would constitute a "covered transaction" under Section 23A of the Federal Reserve Act; and
- Will be subject to Section 23B of the Federal Reserve Act;
as if such banking entity were a Federal Reserve member bank and such hedge fund or private equity fund were an affiliate of such member bank.
Notwithstanding these restrictions, a banking entity may enter into "prime brokerage transactions" with any hedge fund or private equity fund in which a hedge fund or private equity fund managed, sponsored, or advised by such banking entity has taken an ownership interest, provided that certain conditions are met.
- Effective Date and Transition Period
The Volcker Rule does not become effective until the earlier of (i) 12 months after the issuance of final rules implementing the Volcker Rule; and (ii) two years after enactment of the Reform Act (the "Effective Date"). A banking entity will then have two years after the Effective Date to "bring its activities and investments into compliance" with the Volcker Rule. Therefore, as a practical matter, a banking entity may not need to be in compliance with the rule until July of 2014.
In addition, the Federal Reserve may grant up to three one-year extensions of the transition period if "consistent with the purposes of this section" and "not detrimental to the public interest." It is not clear whether the Federal Reserve will grant such extensions as a matter of course (as federal banking regulators routinely do with respect to impermissible investments acquired in acquisition transactions or after charter conversions) or whether the Federal Reserve will be reluctant to grant such extension requests. Additional extensions of up to five years are available in connection with commitments to funds considered to be "illiquid." Assuming a July 21, 2012 Effective Date, a banking entity will have between 4 and 12 years from July 21, 2010 to comply with the Volcker Rule before it will be required to cease its proprietary trading activities or divest its interest in private equity or hedge funds.
At first glance, it appears that, once the Volcker Rule is effective, banking entities will be compelled, subject to the transition periods discussed above, to conform their proprietary trading activities and private equity and hedge fund activities to the requirements of the Volcker Rule or to close, divest or spin off these activities. In this regard, several news agencies reported last week that two large investment banks have decided to close their proprietary trading operations. The decision to close, rather than sell or spin off, proprietary trading operations may be motivated by a combination of factors, including the relatively small size of such operations, the risks entailed and personnel reasons, as well as the new regulatory compliance burden. However, the statutory language is broad enough that banking entities may be able to continue to engage in these activities if they make minor modifications to their business models. For instance, the definition of proprietary trading is broad enough that banking entities may be able to continue to engage in their current trading activities simply by altering the participant in or timing of various trades. As discussed above, the term "proprietary trading" applies only to "engaging as a principal for the trading account of the banking entity in any transaction." Banking entities may be able to continue to engage in the same types of trading activities in which they currently engage by making the trades on an agency rather than a principal basis. Similarly, the term "trading account" means any account used "principally for the purpose of selling in the near term (or otherwise profiting from short term price movements)." The statute does not define what is meant by "selling in the near term (or otherwise profiting from short term price movements)." Accordingly, banking entities may be able to continue to engage in their current trading activities, even on a principal basis, by extending the time frame of the trades so that they are not done in the "near term" or otherwise structured to profit from "short term price movements." In addition, banking entities will still be able to trade, on a principal basis, in government and agency securities and will remain able to maintain long term investments in their investment portfolios as opposed to in private equity or hedge funds. While the regulations that will be adopted by the various regulatory agencies may remove some of the ambiguity in the statutory language, it is likely that banking entities will be able to continue to engage in many of their current trading activities simply by taking advantage of the exceptions set forth in the Volcker Rule.
With respect to private equity or hedge fund activities, despite the extended compliance timeline, many banking entities have already begun the process of taking steps to comply with the Volcker Rule. Several money center banks have announced or completed plans to divest or spin off certain of their private equity or hedge fund investments. Other such banks are expected to take full advantage of the transition period and gradually reduce their ownership in private equity funds and hedge funds over time rather than selling or spinning them off at once. One large financial institution is rumored to be considering moving its proprietary trading operations into a hedge fund and making its traders hedge fund managers. Such institution would then provide seed capital for such hedge fund and have the fund raise additional capital from unaffiliated investors in order to reduce the institution's ownership to a level that complies with the Volcker Rule's restrictions on ownership of private equity funds and hedge funds. However, the timing of the announced transactions and speed at which compliance plans are being formulated indicate that the banking entities have been considering divestitures, spin offs or other strategic changes in their proprietary trading or fund ownership activities for internal business planning reasons rather than in response to the inclusion of the Volcker Rule in the Reform Act. The transactions may also reflect a desire by certain funds and their management to access third party capital and diversify their investor base rather than be owned by one large, heavily regulated banking entity. Based on the numerous different approaches banking entities have chosen or are considering to comply with the Volcker Rule, it is clear that there is ample room for banking entities to creatively structure a plan to comply with the Volcker Rule in a manner that is advantageous to both the banking entities and individuals involved.
In addition, the coming months and years will reveal whether the Reform Act will open up opportunities for non-U.S. financial institutions in the U.S. to compete for business against highly regulated U.S. financial institutions and whether the Reform Act's provisions, including the Volcker Rule, will cause U.S. financial institutions to contract their growth in certain areas of business allowing foreign competitors to fill this void.
- Next Steps
As the process for implementation of financial regulatory reform moves forward, we will keep you updated and provide additional alerts on key developments.