On December 10, 2013, the SEC, FDIC, OCC and Federal Reserve jointly approved the so-called Volcker Rule, prohibiting banking entities and certain nonbank financial institutions (collectively, “banks”) from engaging in proprietary trading or owning interests in or sponsoring certain hedge funds or private equity funds. The rules go into effect on April 1, 2014, but banks will have until July 21, 2015 to come into full conformity with the new rule.
The new rule provides that banks may engage in certain trading activities — specifically, underwriting, market-making and risk-mitigating hedging activities — without violating the rule, provided that (among other things) the bank designs its incentive compensation arrangements for employees engaged in such activities so as not to reward or incentivize prohibited proprietary trading. The agencies state that their goal is not to prohibit employees from being rewarded when these activities generate trading profits for a bank, so long as the the riskiness of the activity is appropriately taken into account in the arrangement and so long as the primary purpose of the arrangement is to reward client service (for underwriting and makret-making activities) or risk reduction (for hedging activities), not speculation in or appreciation in the value of the underlying securities. The agencies have generally adopted a principles-based approach for determining what types of incentive arrangements might violate the rule, rejecting calls to adopt specific vesting requirements for compensation related to such activities or other bright-line standards.
The new rule also exempts certain compensatory profits interests from the general prohibition on banks (or their employees) being able to own interests in hedge funds or private equity funds and allows banks to hold ownership interests in covered funds as a risk-mitigating hedge with respect to compensation arrangements between the bank and employees who provide services to the fund, provided certain requirements are met.
In light of the new rule, banks should begin to review the incentive compensation arrangements covering employees engaged in underwriting, market-making and hedging activities to ensure that these arrangements comply with the new requirements before the July 2015 full implementation deadline.