Six months after issuing regulations to implement the Volcker Rule1 (the “Rule”), the Federal Reserve Board, the other federal bank regulators and the Securities and Exchange Commission (the “Agencies”) on June 10 issued guidance on the Rule in the form of six Frequently Asked Questions (and answers). Four of the FAQs are focused on how the Rule affects banking entities that acquire or retain ownership interests or sponsor “covered funds” and two specifically address proprietary trading questions. We summarize the clarifications that affect relationships with covered funds (generally, private investment funds relying on section 3(c)(1) or 3(c)(7) of the Investment Company Act). The FAQs can be found here.
Conformance Period – FAQ 3.
While the implementing regulations2 were literally effective April 1, 2014, the statute that is the Volcker Rule itself contemplates a “conformance period” during which affected banking entities are to conform their activities and investments. The Federal Reserve Board has extended that conformance period to July 21, 2015 and has the authority to extend it a year at a time twice more.
The third FAQ asks how the Rule’s requirements apply during the conformance period. The answer provides little more guidance than what the Federal Reserve Board has previously given. During the conformance period a banking entity is expected to engage in good-faith efforts that will result in conformance no later than the end of the conformance period. Such efforts include evaluating the extent to which the entity is engaged in covered activities and investments and developing and implementing a specific plan to conform by the deadline. Banking entities should not expand activities and make investments during the conformance period with the expectation that additional time will be granted.
The FAQ provides an example relating to the treatment of investments in covered funds as capital during the conformance period. The Rule requires that the limited permitted investments a banking entity may have in a covered fund be deducted from the entity’s Tier 1 capital for purposes of calculating compliance with various capital requirements. The example explains that this deduction need not be taken until the end of the conformance period.
Loan Securitization Servicing Assets – FAQ 4.
The regulation implementing the Volcker Rule exempts loan securitizations from the definition of the term “covered fund.” This exemption, however, is premised upon the fund’s assets being limited to (i) loans and certain other assets designed that are held for the purpose of assuring the servicing or timely distribution of proceeds to holders of the asset-backed securities and (ii) other, incidental, assets provided that such assets are “cash equivalents” or securities received in lieu of the loans. The fourth FAQ addresses whether such assets must be cash equivalents or securities received in lieu of loans or whether other servicing assets may be held.
The Agencies explain that a servicing asset may be any type of asset, but, if it is a security, it must either be a cash equivalent or received in lieu of a loan. “Cash equivalents,” the agencies explain, means high quality, highly liquid short term investments whose maturity corresponds to the securitization’s expected need for funds and whose currency corresponds to either the underlying loans or the asset-backed securities.
Foreign Public Fund Seeding Vehicles – FAQ 5.
The implementing regulation also excludes from the definition of “covered” fund certain non-U.S. public funds, i.e. issuers (i) organized outside of the U.S., (ii) authorized to sell ownership interests to retail investors in their home jurisdictions, (iii) selling those interests predominantly through public offerings outside the U. S. The regulation also excludes seeding vehicles that will become U. S. registered investment companies (RICs), but does not address seeding vehicles for non-U.S. public funds.
In the fifth FAQ, the Agencies clarify that seeding vehicles for non-U.S. public funds will not be treated differently than seeding vehicles for RICs if the non-U.S. seeding vehicle is formed and operated pursuant to a written plan to become a qualifying foreign public fund. In order to qualify for this treatment, the plan must document the banking entity’s determination that the seeding vehicle will become a foreign public fund, the time period during which the vehicle willbe a seeding vehicle, the banking entity’s plan to market the seeding vehicle to investors within one year of its establishment, and the banking entity’s plan to operate the seeding vehicle consistent with the investment strategy (including leverage) of the issuer upon becoming a foreign public fund.
Name-sharing Prohibition – FAQ 6.
While the Volcker Rule generally prohibits a banking entity from acquiring or retaining an ownership interest in a covered fund or sponsoring such a fund, it does expressly permit a banking entity, subject to certain conditions, to organize and offer a fund to its investment advisory or trust customers. Those conditions include the fund not sharing the same name or variation of the same name with the banking entity or any affiliate of the banking entity.
The last FAQ explains that the name of the permitted covered fund must be sufficiently distinct from the name of the banking entity that the fund’s use of the name would not likely lead to customer confusion regarding the relationship between the two. It further explains that what is to be avoided is featuring the same root word, initials, or logo, trademark, or other corporate symbol used by, or that references, a connection with the banking entity or affiliate thereof.
OCC Interim Examination Procedures
The day after the regulators issued FAQs on the Volcker Rule, the Office of the Comptroller of the Currency (the “OCC”), the principal federal regulator of national banks and federal savings associations, issued 24 pages of interim examination procedures on the Volcker Rule.
The purpose of the new OCC interim examination procedures is to help examiners determine whether banks have activities subject to the Rule and to guide examiners in assessing plans banks have to comply with the Rule.
Banks that do not have ownership interests in covered funds and do not sponsor them or have certain relationships with them and limit their proprietary trading to domestic government obligations do not need compliance programs and apparently will not be covered by these procedures.
The examiners are to assess the bank’s progress in identifying:
- banking entities that engage in activities covered by the Rule,
- its proprietary trading,
- its ownership interests in covered funds,
- the covered funds that it sponsors or advises, and
- its ownership interests in and sponsorship of firms that rely on exclusions from the definition of “covered fund.”
Unless the Federal Reserve Board extends the date, all banking entities are to conform with the Rule by July 21, 2015 (except as to ownership interests in, and sponsorship of, certain collateralized loan obligations as to which the conformance period ends July 21, 2017). The OCC interim examination procedures direct the examiners to assess progress toward establishing a compliance program, including compensation arrangements that incentivize impermissible proprietary trading and whether the bank is devoting sufficient resources to having the compliance program in place by the end of the conformance period. This assessment will also consider whether the bank’s audit and risk management functions have accounted for the Rule in their plans. Examiners are also to assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies. To do so, the examiners will assess the bank’s plan for identifying and addressing material conflicts and for avoiding material high-risk exposures and also whether the bank is devoting sufficient resources to the effort.
While these examination procedures technically are only those of the OCC and other regulators have not issued such procedures, until those regulators issue such procedures, these procedures should serve as a helpful guide to compliance officers and other internal control functions at all banking entities.