On October 12, 2011, the Securities and Exchange Commission joined the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation in proposing for comment the so-called “Volcker Rule” to implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. That section of the Dodd-Frank Act in effect requires regulated banking institutions to cease proprietary trading and certain investment activities. The proposed rule and its corresponding explanations and questions for comment are too extensive, complex, and detailed to be adequately described in a blog post or entry. But because the rule will likely be a topic of considerable comment and debate, it seems worthwhile to provide a very brief description of it.
The rule would restrict “covered banking entities” – which essentially are banks and other insured depository institutions, bank holding companies, and entities that are affiliated with them – from two types of activities:
- Engaging in “proprietary trading” – which essentially is trading for the covered banking entity’s own account in securities, derivatives, and commodities contracts; and
- Sponsoring or investing in, for the covered banking entity’s own account, private equity or hedge funds, or extending credit to affiliated private equity or hedge funds, including commodity pools.
Each of these restrictions is phrased as a prohibition, but with various exceptions or exemptions. Among the significant activities that would be exempted from the prohibition on proprietary trading are:
- Certain securities underwriting activities as an SEC-registered broker-dealer or a part of a non-U.S. dealer business.
- Certain securities market-making activities as an SEC-registered broker-dealer or a part of a non-U.S. dealer business.
- Certain hedging activities intended to mitigate specific risks of the covered banking entity’s own investment or financial positions, contracts, or other holdings.
Also, this prohibition would not apply to trading activities by a covered banking activity on behalf of its customers, including where it is acting as a trustee or other fiduciary, an investment adviser, or a commodity trading advisor.
The rule would require a covered banking entity to maintain formal policies and programs to ensure and monitor compliance with the restrictions on proprietary trading and, depending on the level of exempted activities, to satisfy certain recordkeeping and reporting obligations.
Among the significant activities that would be excluded or exempted from the prohibition against sponsoring or investing in a private equity or hedge fund are:
- Sponsoring or owning an interest in loan (including receivables) securitization entities.
- Owning a carried interest, as performance compensation, in a fund for which the covered banking entity serves as investment adviser or manager or commodity trading advisor.
- Sponsoring (i.e., serving a general partner, trustee, managing member, or commodity pool operator of) a fund offered only to customers of the covered banking entity’s trust, fiduciary, or investment advisory services.
- Owning an interest in a fund organized and offered by the covered banking entity as the result of a seed capital investment to establish the fund for unaffiliated investors or an investment that is 3% or less of the total outstanding ownership interest in the fund (which is subject to specified calculation procedures).
- Owning an interest in a fund that is designed to mitigate specific risks of the covered banking entity corresponding or relating to obligations or liabilities of the covered banking entity acting as an intermediary on behalf of a customer or connected to a compensation arrangement with an employee who provides investment advisory or other services to the fund.
- A non-U.S. covered banking entity sponsoring or owning an interest in certain funds offered and sold only outside of the U.S.
These exceptions and exemptions would also apply to the prohibition against lending or having any other credit exposure (including by guarantee or derivatives transaction) to a private equity or hedge fund. But a covered banking entity would be permitted to engage in any such excepted or exempted activity only if the activity would not (1) involve a material conflict of interest with any of the covered banking entity’s customers or clients, (2) result in material exposure to “high-risk assets” or “high-risk trading strategies” (as defined in the rule), or (3) threaten the safety and soundness of the covered banking entity or the financial stability of the U.S.
The rule would require a covered banking entity to maintain formal policies and programs to ensure and monitor compliance with the restrictions on sponsoring and investing in private equity or hedge funds, and those compliance-program requirements would be enhanced depending on the level of the covered banking entity’s excepted or exempted activity.
OUR TAKE: The public reactions to the rule by consumer groups and by banking- and securities-industry organizations have varied widely. Not surprisingly, the former are concerned that the prohibitions are subject to exceptions or exemptions that are too broad, and the latter are concerned that the restrictions are too severe to permit banks to operate properly and profitably. The release also acknowledges the difficulty of formulating an appropriate rule and poses many questions about the scope and operation of the rule for comment. We expect that the comments, which are due January 13, 2012, will be varied and interesting and that formulating the final rule will be challenging.