Five federal financial regulatory agencies have released final rules implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 619 created Section 13 in the Bank Holding Company Act (“BHC Act”) to generally prohibit any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (“covered fund”).
Section 13 of the BHC Act became effective on July 21, 2012, and provided for a two-year conformance period from the effective date. Thus, by July 21, 2014, banking entities would be required to discontinue prohibited proprietary trading and covered fund activities.
On November 7, 2011, the Board of Governors of the Federal Reserve , the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission published proposed rules implementing the Volcker Rule (the “Proposed Rule”). The Commodity Futures Trading Commission published their version of the Proposed Rule two months later.
The Proposed Rule prompted thousands of comment letters and required lengthy analysis and discussion by the agencies, ultimately resulting in the release of the Final Rule on December 10, 2013. A July 21, 2014 deadline for compliance would have presented a very aggressive and difficult seven-month compliance timetable for banking entities to wind down prohibited proprietary trading and covered fund activities. In recognition of this, the Board of Governors extended the conformance period for an additional year, until July 21, 2015. The extended conformance period, however, does not apply to the reporting requirements discussed below.
Definition of banking entity
The Volcker Rule applies to any banking entity, defined in both the Proposed Rule and Final Rule as:
- a bank
- any company that controls a bank
- any company treated as a bank holding company under section 8 of the International Banking Act or
- any affiliate or subsidiary of any such entity.
Proprietary trading prohibitions
General. Consistent with the Dodd-Frank Act, the Final Rule prohibits a banking entity from engaging in proprietary trading, defined as engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments. Financial instruments are:
- securities, including options on a security
- derivatives, including options on a derivative or
- contracts of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.
Loans, non-derivative commodities and foreign exchange or currency are not financial instruments. The definition of trading account is broad, and includes a number of different accounts a banking entity could use to take advantage of short-term fluctuations in the price of a financial instrument. A banking entity does not engage in proprietary trading by purchasing or selling one or more financial instruments where it acts solely as agent, broker or custodian.
Exemptions. The Final Rule continues certain carveouts from the definition of proprietary trading contained in the Proposed Rule for trading:
- as part of a repurchase agreement
- liquidity management plan or
- written securities lending agreement.
The Final Rule also adds the following exemptions:
- trading through a deferred compensation, stock-bonus, profit-sharing or pension plan of the banking entity
- trading in the ordinary course of collecting a debt previously contracted in good faith and
- trading to satisfy existing delivery obligations in connection with clearing or settlement activity or judicial, administrative, self-regulatory or arbitration proceedings.
Additional exemptions from the prohibition on proprietary trading are available for banking entities whose activities meet specific criteria for underwriting or market making activities, risk-mitigating hedging activities or trading in government obligations. The Final Rule expands the exemption for government obligations to include, subject to certain limitations, bonds of non-US governments and their subsidiaries.
Foreign trading exemption. The Final Rule makes important revisions from the Proposed Rule for the treatment of trading activities by foreign banking entities. During the comment process, numerous commenters expressed concern that the foreign trading exemption contained in the Proposed Rule was too narrow and would unnecessarily prohibit foreign trading activities. Critics of the Proposed Rule expressed specific concern that the Proposed Rule’s requirements would cause foreign banking entities to avoid transactions with overseas subsidiaries and branches of US banking entities and would harm the competitiveness of US trading platforms.
In response, the Final Rule’s requirements are designed to ensure that where foreign banking entities engage in proprietary trading, they do so in a manner that places the risk, financing and execution outside the US. Therefore, the Final Rule provides for a foreign trading exemption if:
- The banking entity engaging as principal, making the trading decision, and providing the financing is not located in the US or organized under the laws of the US or any state
- The purchase or sale is not accounted for as principal by any branch or affiliate located in the US or organized under the laws of the US or any state and
The purchase or sale is not conducted with or through any US entity, other than:
- The foreign operations of US entities
- In cleared transactions with an unaffiliated market intermediary acting as principal or
- In cleared transactions through an unaffiliated market intermediary acting as agent, conducted anonymously on an exchange or similar trading facility.
Covered fund activities prohibitions
General. A banking entity may not, as principal, directly or indirectly acquire or retain any ownership interest in or sponsor a covered fund. An ownership interest is any equity, partnership or other similar interest. To sponsor a covered fund means:
- to serve as a general partner, managing member, trustee, or commodity pool operator of a covered fund
- to select or control a majority of the directors, trustees, or management of a covered fund or
- to share the same name or a variation of the same name with a covered fund.
Under the Proposed Rule, the prohibition on ownership interests in a covered fund did not apply where the interest was acquired or retained in the ordinary course of collecting a debt previously contracted in good faith. To this, the Final Rule also adds exemptions for ownership interests acquired or retained by a banking entity acting solely as agent, broker or custodian for a customer; through a deferred compensation, stock-bonus, profit-sharing or pension plan of the banking entity; or on behalf of customers as trustee.
Covered fund defined. In response to critical public comments which asserted that the Proposed Rule’s covered foreign fund definition was overly broad, exceeded statutory authority, and potentially violated international treaties, the Final Rule makes meaningful changes to the definition. The Proposed Rule defined a covered fund to include:
- an issuer that would be an investment company under the Investment Company Act but for exceptions under Sections 3(c)(1) or 3(c)(7) thereof
- any commodity pool under Section 1a(10) of the Commodity Exchange Act and
- any issuer organized or offered outside the US that would be a covered fund, were it organized or offered under the laws, or offered to one or more residents, of the US or one of its states.
The Final Rule creates certain limitations on the inclusion of commodity pools and significantly revises the definition with respect to foreign funds. In focusing on the risks to US banking entities that the Volcker Rule was meant to address, the Final Rule provides that a foreign fund is only a covered fund where it is sponsored by, or has issued an ownership interest to, a banking entity that is, or is controlled by a banking entity that is, located in or organized under the laws of the US or any state. A foreign fund is an entity that:
- is organized or established outside the US and the ownership interests are offered and sold solely outside the US, and
- is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities.
Therefore, a foreign fund may be a covered fund with respect to the US banking entity that sponsors it, but not a covered fund with respect to a foreign bank that invests in the fund solely outside the US.The Final Rule clarifies the Proposed Rule’s exemptions from the covered fund definition for wholly owned subsidiaries, joint ventures, acquisition vehicles, bank owned life insurance, loan securitizations and SBICs and public welfare investment funds. Further, new exemptions are provided for:
- Foreign public funds: Issuers organized or established outside of the US that are authorized to offer and sell ownership interests to retail investors in the issuer’s home jurisdiction through one or more public offerings outside of the US.
- Foreign pension or retirement funds: Plans, funds, or programs providing pension or retirement benefits for the citizens or residents of one or more foreign sovereigns or political subdivisions, that are organized and administered outside the US, subject to regulation as pension or retirement plans in the jurisdiction where organized and administered.
- Insurance company separate accounts: Separate accounts, provided that no banking entity other than the insurance company participates in the account’s profits and losses.
- Qualifying asset-backed commercial paper conduits: Issuing entities for asset-backed commercial paper that hold only loans and other assets permissible under the loan securitization exemption and asset-backed securities supported by assets permissible under the loan securitization exemption. The entities must issue only asset-backed securities comprised of a residual interest and securities with a legal maturity of 397 days or less. The entities must also have entered into a legally binding commitment with a regulated liquidity provider.
- Qualifying covered bonds: Entities owning or holding a pool of loans or other assets for the benefit of the holders of covered bonds, subject to certain restrictions also applied to loan securitizations.
Registered investment companies and excluded entities: Any issuers that:
- are registered as investment companies under Section 8 of the Investment Company Act, such as mutual funds;
- may rely on an exclusion or exemption from the definition of investment company under the Investment Company Act; or
- have elected to be regulated as a business development company pursuant to the Investment Company Act.
- Issuers in conjunction with the fdic’s receivership or conservatorship: Issuers formed by or on behalf of the FDIC for the purpose of disposing of assets acquired in the FDIC’s capacity as conservator or receiver.
. The Final Rule retains the Proposed Rule’s permitted activities with respect to covered funds. Subject to certain conditions and limitations, banking entities may invest in or sponsor a covered fund in connection with:
- organizing and offering the covered fund
- certain risk-mitigating hedging activities
- de minimis investments in covered funds and
- certain permitted activities and investments outside of the US.
For the purposes of permitted activities and investments outside of the US, the Final Rule revises the requirements in the same way as the foreign trading exemption under the proprietary trading rules. Among other conditions, the Proposed Rule would only have permitted the activities if:
- the banking entity conducting the activity was not organized under the laws of the US or of one or more states
- no subsidiary, affiliate, or employee of the banking entity was incorporated or physically located in the US and
- no ownership interest in the covered fund was offered for sale or sold to a resident of the US.
In contrast, the Final Rule narrows these restrictions to require that:
- the banking entity engaging as principal in, making the decision to, and providing the financing for, the investment in, or the sponsorship of, the covered fund not be located in or organized under the laws of the US or any state and
- the investment or sponsorship is not accounted for as principal by any branch or affiliate located in the US or organized under the laws of the US or any state.
The Final Rule retains the requirement that no ownership interest be offered for sale to a resident of the US, but potentially softens that requirement by clarifying that it is satisfied where an offering does not “target residents” of the US.
The Final Rule also provides for two additional permitted activities, namely underwriting activities and market making-related activities that involve a covered fund. Subject to certain conditions, these activities are permitted where they meet the requirements applicable to underwriting and market making in the proprietary trading rules. Thus, the Final Rule allows a banking entity more flexibility to underwrite and make a market in the ownership interests of a covered fund in connection with the exemptions for organizing and offering the covered fund.
The Proposed Rule required banking entities to a develop compliance program designed to bring the banking entity into compliance with the Volcker Rule. Banking entities that exceeded certain asset and volume of activity thresholds were subject to enhanced compliance program standards with more specific and complex requirements. Even banking entities that did not engage in any activities covered by the Volcker Rule were expected to develop policies and procedures and a compliance program to prevent prohibited activities. In addition, the Proposed Rule required certain banking entities with significant trading activities to report and keep records of various quantitative measurements of their trading activities. Banking entities were required to comply with these requirements where the average gross sum of their trading assets and liabilities, together with those of affiliates and subsidiaries, as measured as of the last day of each of the four prior calendar quarters, was equal to or greater than US$1 billion (the trading activity threshold).
The Final Rule makes the following changes to compliance program and reporting requirements:
Compliance program: Banking entities are expected to establish a compliance program as soon as practicable, but in no event later than the end of the conformance period, which has been extended to July 21, 2015. The Final Rule requires a banking entity to comply with enhanced compliance program requirements where:
- the banking entity is required to report on its proprietary trading activities (see below)
- the banking entity has consolidated assets of US$50 billion or more or
- the applicable federal regulator notifies the banking entity that it must comply with the enhanced requirements.
Reporting requirements: The Final Rule reduces the number of banking entities subject to reporting requirements by raising the trading activity threshold from US$1 billion under the Proposed Rule, to:
- US$50 billion beginning on June 30, 2014
- US$25 billion beginning on April 30, 2016 and
- US$10 billion beginning on December 31, 2016.
Banking entities with trading activity of US$50 billion or more are required to report on a monthly basis, while all other banking entities that are or will be subject to the reporting requirement will only need to report on a quarterly basis. In addition, the Final Rule reduces the number of trading measurements banking entities must report from seventeen in the Proposed Rule to seven. Banking entities should note that the Board’s decision to extend the conformance period for Volcker Rule compliance to July 21, 2015 does not apply to reporting requirements, which become effective June 30, 2014.
- Covered fund documentation: Banking entities with more than US$10 billion in total consolidated assets must maintain records on fund-related activities and investments, particularly on the exclusion or exemption relied upon in determining that a fund is not a covered fund for purposes of the Volcker Rule.
- Simplified programs for less active banking entities: Banking entities that do not engage in activities covered by the Volcker Rule are no longer required to develop policies and procedures designed to ensure they do not engage in prohibited activities. Under the Final Rule, these banking entities need only develop a compliance program before engaging in any such activities. Banking entities with total consolidated assets of US$10 billion or less that engage in activities covered by the Volcker Rule may satisfy the compliance program requirements by making appropriate references to the Volcker Rule in their existing policies and procedures, but are not required to develop separate compliance programs specific to the Volcker Rule.
As noted above, statutory requirements of the Dodd-Frank Act required banking entities to terminate all prohibited proprietary trading activities and covered fund investments or relationships by July 21, 2014, but permitted the Board to extend the conformance period by up to three one-year periods. On February 14, 2011, the Board published rules for extending the conformance period, and those rules envisioned banking entities applying individually for one-year extensions by submitting written requests to the Board. In conjunction with the release of the Final Rule, however, the Board also extended the conformance period (exclusive of reporting requirements for banking entities with significant trading activities) for all covered banking entities to July 21, 2015.
Unless the Board announces a similar blanket extension in 2014, banking entities that envision an inability to satisfy the certain requirements of the Volcker Rule by that date will need to apply for individual one-year extensions no later than January 20, 2015.