Introduction
'Banking entity'
Prohibition on proprietary trading
Prohibition on covered funds' activities and investments
Compliance programmes


Introduction

On October 11 2011 the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued a proposed rule implementing the requirements of new Section 13 of the Bank Holding Company Act of 1956, known as the 'Volcker Rule'.(1) Section 13 was added to the act by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Securities and Exchange Commission (SEC) also proposed the same rule on October 12 2011.(2)

The proposed rule generally prohibits a banking entity from:

  • engaging in proprietary trading for its own account;
  • acquiring or retaining an ownership interest in or sponsoring a "covered fund"; and
  • entering into certain relationships with a "covered fund".

There are various exceptions in each case.

The proposed rule also clarifies certain activities in which banking entities may continue to engage, such as underwriting, market-making and trading on behalf of clients. Comments on the proposed rule are due by January 13 2012.

The Volcker Rule will take effect on July 21 2012. However, banking entities will not need to bring their activities, investments and relationships fully into compliance until July 21 2014 and are permitted to retain certain investments for an even longer period of time pursuant to a conformance and extended transition period rule issued by the board in February 2011.(3) Even so, in the commentary to the proposed rule, the agencies state that banking entities are required to begin complying with the proposed rule's reporting and record-keeping and compliance requirements on the effective date (July 21 2012). Furthermore, the agencies state that they expect a banking entity to bring all investments and activities fully into compliance with the requirements of the proposed rule "as soon as practicable" within the conformance period provided by the board's rule.

Title I of the Dodd-Frank Act gives the board supervisory authority over certain non-bank financial companies that the Financial Stability Oversight Council determines to be systemically important. While such companies are not banking entities for the purposes of the Volcker Rule, Section 13 of the Bank Holding Company Act provides for such companies to be subject to additional capital charges, quantitative limitations or other restrictions if they engage in proprietary trading activities or acquire or retain ownership interests in covered funds. In the commentary to the proposed rule, the agencies indicate that the board believes that it would be premature to propose any such requirements, limits or restrictions at this time because no such non-bank financial companies have yet been designated.

'Banking entity'

A 'banking entity' is defined in the proposed rule to include:

  • insured depository institutions (other than certain limited-purpose trust institutions);
  • any company that controls an insured depository institution;
  • any company that is treated as a bank holding company for the purposes of Section 8 of the International Banking Act of 1978 (which includes all foreign banks with a branch or agency (and certain other presences) in the United States); and
  • any affiliate or subsidiary of any of the foregoing, other than:
    • an affiliate or subsidiary that is a covered fund that is organised, offered and held by a banking entity pursuant to, and in accordance with, the proposed rule; or
    • any entity that is controlled by such a covered fund.

The proposed rule does not limit its reach to US organisations or offices. Accordingly, foreign organisations and offices (including foreign offices of US banking entities) are subject to the proposed rule unless an exemption is available.

Prohibition on proprietary trading

Under the proposed rule's prohibition on propriety trading, a banking entity is generally barred from engaging in the purchase or sale of any covered financial position as principal for the trading account of such banking entity.(4)

Covered financial position
A 'covered financial position' for the purposes of the proposed rule is any long, short, synthetic or other position in:

  • a security, including an option on a security;
  • a derivative, including an option on a derivative; or
  • a contract of sale of a commodity for future delivery, or an option on such a contract.

The definition of 'covered financial position' does not include any position that is itself a loan, a commodity or foreign exchange or currency (eg, the spot purchase of a commodity). (There is also a specific exemption from the proposed rule for trading in government obligations.)

Trading account
The definition of a 'trading account' comprises three independent prongs. If any one of these three prongs is met, that account will fall within the definition of a 'trading account':

  • Any account that is used by a banking entity to acquire or take a covered financial position for the purpose of:
    • short term resale;(5)
    • benefiting from actual or expected short-term price movement;
    • realising short-term arbitrage profits; or
    • hedging one or more such positions.

Under this first prong, there is a rebuttable presumption that any account used to take a covered financial position held for 60 days or less is a trading account.(6)

  • Any account that is subject to the Market Risk Capital Rules.(7)
  • Any account used by a banking entity that is:
    • an SEC-registered securities or municipal securities dealer;
    • a government securities dealer that has registered, or that has filed notice, with an appropriate regulatory agency;
    • a CFTC-registered swap dealer; or
    • an SEC-registered security-based swap dealer.

The definition of 'trading account' does not include accounts used for:

  • repurchase or reverse repurchase agreements or securities lending transactions;
  • positions for bona fide liquidity management purposes;(8) or
  • certain positions held by derivatives clearing organisations or clearing agencies.

Permitted trading activities
Notwithstanding the prohibition on proprietary trading, a banking entity may engage in certain underwriting and market-making-related activities, and other activities.

Underwriting
A banking entity is permitted to purchase or sell a covered financial position in connection with the banking entity's underwriting activities to the extent that such activities are designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties provided that seven criteria are met:

  • The banking entity must have established the internal compliance programme required by subpart D of the proposed rule and described below.
  • The covered financial position must be a security.
  • The transaction must be effected solely in connection with a distribution of securities for which the banking entity is acting as an underwriter.(9)(10)
  • The banking entity must have the appropriate dealer registration or otherwise be exempt from registration or excluded from regulation as a dealer.
  • The underwriting activity must be designed not to exceed the reasonably expected near-term demands of clients, customers and counterparties.
  • The underwriting activity must be designed to generate revenues primarily from fees, commissions, underwriting spreads or other income, and not from appreciation in the value of covered positions held in relation to such activities or the hedging of such covered financial position.
  • The compensation arrangement of persons performing the underwriting must be designed not to encourage proprietary risk taking.(11)

Market making
A banking entity is permitted to purchase or sell a covered financial position in connection with the entity's market-making activities. Like the underwriting exception, the banking entity's market-making activities must meet seven criteria:

  • The banking entity must establish a comprehensive compliance programme to monitor and control its market making related activities.
  • Any activity must be bona fide market making.(12) The determination of whether a banking entity is engaged in bona fide market making differs depending upon the nature of the relevant market:
    • In liquid markets, market-making activities should include: making continuous, two sided quotes and holding oneself out as willing to buy and sell on a continuous basis; a pattern of trading that includes both purchases and sales in roughly comparable amounts to provide liquidity; making continuous quotations that are at or near the market on both sides; and providing widely accessible and broadly disseminated quotes.(13)
    • In less liquid markets (ie, over-the-counter markets), market making-related activities should generally include: holding oneself out as willing and available to provide liquidity by providing quotes on a regular (but not necessarily continuous) basis; with respect to securities, regularly purchasing covered financial positions from, or selling the positions to, clients, customers or counterparties in the secondary market; and transaction volumes and risk proportionate to historical customer liquidity and investments needs.

Under either analysis, the market-making exemption would exempt the activities of a trading desk or other organisational unit only to the extent that such activities relate to a covered financial position, and to the extent that such trading desk or other organisational unit is actually engaged in market making relating to such covered financial position. Bona fide market making would include block positioning if undertaken by a trading desk or other organisational unit of a banking entity for the purpose of intermediating customer trading. In addition, bona fide market making-related activity may include taking positions in securities in anticipation of customer demand, so long as any anticipatory buying or selling activity is reasonable and related to clear, demonstrable trading interest of clients, customers or counterparties.

  • The market making-related activities of the banking entity must be designed not to exceed the reasonably expected near-term demands of clients, customers, and counterparties.(14)
  • The banking entity must be appropriately registered as a dealer or exempt from registration or excluded from regulation as a dealer, under applicable securities or commodities laws.
  • The market making-related activities of the banking entity must be designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income not attributable to appreciation in the value of covered financial positions or the hedging of such positions.
  • The compensation arrangements of persons performing market making-related activities must be designed not to encourage or reward proprietary risk taking.
  • The market making-related activities of the banking entity must be consistent with the commentary provided in Appendix B of the proposed rule.

Risk-mitigating hedging activities
A banking entity is permitted to purchase or sell a covered financial position if the transaction is made in connection with, and related to, individual or aggregated positions, contracts, or other holdings of a banking entity and is designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts or other holdings. In order to rely on this hedging exemption, seven criteria must be met:

  • The banking entity must have established an internal compliance programme consistent with the requirements of subpart D of the proposed rule.
  • The hedging activity must have been made in accordance with written policies, procedures and internal controls established by the banking entity pursuant to subpart D.
  • The transaction must hedge or otherwise mitigate one or more specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk or similar risks arising in connection with and related to individual or aggregated positions, contracts or other holdings of a banking entity. This prong reflects the ability of a banking entity to hedge risks on an aggregated portfolio basis (ie, positions across different trading desks). This exemption requires that the banking entity either be already exposed to the specific risks being hedged or engage in anticipatory hedging that:
    • is consistent with appropriate risk management practices;
    • otherwise meets the terms of the hedging exemption; and
    • does not involve the potential for speculative profit.
  • Each hedging transaction must be reasonably correlated to the underlying position. The hedge need not be fully correlated, but cannot be tangentially related. Such reasonable correlation is determined by consideration of the circumstances and the availability of alternative hedging options.(15)
  • At its inception, the hedging transaction cannot give rise to significant exposures that are not themselves hedged in a contemporaneous transaction (ie, over-hedging, correlation trading).
  • Any transaction conducted in reliance on the hedging exemption must be subject to continuing review, monitoring and management after the hedge position is established (ie, ongoing requirements to maintain a reasonable level of correlation and mitigate any significant risk exposure).
  • The compensation arrangements of persons performing the risk-mitigating hedging activities must be designed not to reward proprietary risk taking.

Trading in government obligations
A banking entity is generally permitted to trade in government obligations. Such obligations include:

  • an obligation of the United States or any agency thereof;
  • an obligation, participation or other instrument of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 USC 2001 and following); and
  • an obligation issued by any state or any political subdivision thereof. Government obligations do not include obligations of foreign governments and international and multinational development banks, or options or other derivatives referencing the enumerated government obligations. However, the agencies are asking for comment on whether these instruments should be encompassed in the exemption.

Trading on behalf of customers
Section 13(d)(1)(D) of the Bank Holding Company Act permits a banking entity to purchase or sell a covered financial position on behalf of customers.(16) The proposed rule identifies three categories of transaction that appear to be on behalf of customers within the purpose and meaning of the act:

  • Where the transaction:
    • is conducted by a banking entity acting as investment adviser, commodity trading adviser, trustee or in a similar fiduciary capacity for a customer and for the account of that customer; and
    • involves solely covered financial positions of which the banking entity's customer, and not the banking entity or any subsidiary or affiliate of the banking entity, is beneficial owner.
  • Where the banking entity is acting as riskless principal.(17)
  • Where the banking entity is trading for the separate account of insurance policyholders, in which case the purchase or sale of a covered financial position is on behalf of customers if:
    • the banking entity is an insurance company engaging in the transaction for a separate account;
    • the banking entity is directly engaged in the business of insurance and subject to regulation by a state insurance regulator or foreign insurance regulator;
    • the banking entity purchases or sells the covered financial position solely for a separate account established by the insurance company in connection with one or more insurance policies issued by that insurance company;
    • all profits and losses are allocated to the separate account and inure to the benefit or detriment of the owners of the insurance policies (and not the banking entity); and
    • the trading is conducted in compliance with, and subject to, the insurance company investment and other laws, regulations and written guidance of the state or jurisdiction in which such insurance company is domiciled.

Permitted trading by a regulated insurance company
Subject to four conditions which must all be met, the proposed rule permits a banking entity to purchase or sell a covered financial position if the banking entity is a regulated insurance company acting for its general account or an affiliate of an insurance company acting for the insurance company's general account:(18)(19)

  • The insurance company must directly engage in the business of insurance and be subject to regulation by a state insurance regulator or foreign insurance regulator.
  • The insurance company or its affiliate must purchase or sell the covered financial position solely for the general account of the insurance company.
  • The purchase or sale must be conducted in compliance with, and subject to, the insurance company investment laws, regulations and written guidance of the state or jurisdiction in which such insurance company is domiciled.
  • The appropriate federal banking agencies, after consultation with the council and the relevant insurance commissioners of the states, must not have jointly determined, after notice and comment, that a particular law, regulation or written guidance described above is insufficient to protect the safety and soundness of the banking entity or of the financial stability of the United States.(20)

Trading solely outside the United States
Certain foreign banking entities are permitted to engage in proprietary trading that occurs solely outside the United States.

To qualify as a foreign banking entity, the banking entity must not be directly or indirectly controlled by a banking entity that is organised under the laws of the United States or of one or more states. A US subsidiary or branch of a foreign banking entity would not qualify for the exemption. In addition, a transaction will be considered to have occurred solely outside the United States only if all four of the following conditions are met:

  • The transaction is conducted by a banking entity that is not organised under the laws of the United States or of one or more states.
  • No party to the transaction is a resident of the United States.(21)
  • No personnel of the banking entity that is directly involved in the transaction is physically located in the United States.(22)
  • The transaction is executed wholly outside the United States.

Discretionary exemptions
The agencies may grant, by rule, other exemptions from the prohibition on proprietary trading if the agencies determine that the exemption would promote and protect the safety and soundness of the banking entity and the financial stability of the United States.

Reporting and recordkeeping for covered trading activities
A banking entity that engages in any proprietary trading activity is subject to:

  • the proposed rule's record-keeping requirements as described below; and
  • any additional requirements that the relevant regulatory agency may deem necessary.

Additionally, if any such banking entity, together with its affiliates and subsidiaries, has trading assets and liabilities with a gross sum equal to or greater than $1 billion, as measured on the last day of each of the four prior calendar quarters, the banking entity will be subject to the reporting and record-keeping requirements for various quantitative measures of its covered trading activities set forth in Appendix A to the proposed rule.

Prohibition on covered funds' activities and investments

Under the proposed rule's prohibition on covered funds' activities and investments, a banking entity generally may not, as principal, directly or indirectly acquire or retain any ownership interest in or sponsor a covered fund. The proposed rule does not restrict acquisition or retention of ownership in a covered fund by:

  • a banking entity acting in a fiduciary role;(23)
  • a banking entity acting in good faith as a custodian, broker or agent for customers;
  • a banking entity as trustee for an employee pension plan (ie, acting as a trustee of a qualified plan);(24) or
  • a director or employee of a banking entity who provides advisory services to the covered fund, except as discussed below.

Ownership interest
An 'ownership interest' is defined as any equity, partnership or other similar interest (including, without limitation, a share, equity security, warrant, option, general partnership interest, limited partnership interest, membership interest, trust certificate or other similar instrument) in a covered fund, whether voting or non-voting, or any derivative of such interest.(25) The definition of 'ownership interest' does not include 'carried interest', which is defined as an interest held by a banking entity (or an affiliate, subsidiary or employee thereof) in a covered fund for which such person serves in an advisory capacity, so long as the following four requirements are met:

  • The sole purpose and effect of the interest is for such person to share in profits of the covered fund as compensation for advisory services.
  • All such profit, once allocated, is distributed to such person promptly after being earned or, if not so distributed, the reinvested profit does not share in the subsequent profits and losses of the covered fund.(26)
  • No such person provides funds to the fund to acquire or retain the interest.
  • The interest is not transferable other than to an affiliate or subsidiary of such person.

Sponsor
An entity serves as a sponsor of a covered fund if it:

  • serves as a general partner, managing member, trustee or commodity pool operator of a covered fund;(27)
  • in any manner selects or controls (or has employees, officers or directors, or agents who constitute) a majority of the directors, trustees, or management of a covered fund; or
  • shares with a covered fund, for corporate, marketing, promotional or other purposes, the same name or a variation of the same name.

Covered fund
An entity is considered a covered fund if it is any one of the following:

  • 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) thereof;(28)
  • a commodity pool;(29)
  • any issuer, as defined in Section 2(a)(22) of the Investment Company Act, that is organised or offered outside the United States that would otherwise be a covered fund under the proposed rule, were it organised or offered under the laws of, or offered to one or more residents of, the United States or of one or more states; or
  • any such similar fund as an appropriate agency may determine by rule.

Permitted covered fund activities and investments
Notwithstanding the general prohibition on covered banking entities owning or retaining an ownership interest in or sponsoring a covered fund, banking entities may perform certain activities with respect to, and make certain investments in, covered funds.

Organising and offering a covered fund
Under this carve-out to the general rule, banking entities are permitted to engage in certain traditional asset management and advisory businesses. A banking entity may organise and offer a covered fund if it meets the following eight criteria:

  • The banking entity provides bona fide trust, fiduciary, investment advisory or commodity trading services.
  • The covered fund is organised and offered only in connection with the provision of such services to customers of such services pursuant to a credible plan outlining how the banking entity intends to provide such services through organising or offering such fund.
  • The banking entity meets the investment limits set forth in the proposed rule and discussed below.
  • The banking entity complies with the limitations on affiliate transactions set forth in the proposed rule and discussed below.
  • The banking entity does not guarantee, assume or otherwise insure the obligations or performance of the covered fund or any covered fund in which such fund invests.
  • The covered fund does not share the same name or variation thereof with the banking entity (or any affiliate or subsidiary thereof) and does not use the word 'bank' in its name.
  • No director or employee of the banking entity takes or retains an ownership interest in the covered fund, except for any director or employee who provides investment advisory or other services to the covered fund.
  • The banking entity makes certain disclosures to investors regarding the risks associated with their investment and complies with additional rules of the relevant regulator to ensure that losses are borne solely by investors and not the banking entity.

These eight criteria closely track those set forth in Section 13(d)(1)(G) of the Bank Holding Company Act, with various important clarifications.

First, and likely of greatest importance to banking entities that sponsor covered funds, the agencies have not narrowed the 'customers of such services' requirement to pre-existing customers, thus permitting banks to use this exemption to organise and offer funds to new customers in connection with their trust, fiduciary and investment advisory or commodity trading advisory services. The commentary indicates that a customer can obtain the investment advisory services of a banking entity simply by acquiring an interest in a covered fund organised and offered by the banking entity. The proposed rule does not expressly address the situation in which a banking entity organises or offers a fund, for which it does not technically serve in an advisory role, to make a pooled investment in another fund. Such a 'feeder fund' may not qualify for an exclusion from the general prohibition pursuant to this section of the proposed rule.

Second, the restrictions on a funds name apply to sharing a name with both the banking entity that organises and offers or serves as sponsor to a fund and any affiliates or subsidiaries of the banking entity.

Third, directors or employees of a banking entity that are investment advisers are generally permitted to align their interests with those of the banking entity's customers by investing in the covered funds they advise; however, the agencies have scaled back this exception in the case where the banking entity extends credit to any such director or employee to purchase their ownership interests or otherwise guarantees any such director or employee against loss from participating in the covered fund. In this case, the commentary indicates that the director or employee's ownership interest would generally be imputed to the employing banking entity.

Permitted investment in a covered fund
The prohibition on acquiring and retaining ownership interest in a covered fund does not apply to a banking entity or an affiliate or subsidiary thereof that organises and offers a covered fund for one of the following two purposes:

  • establishing the fund and providing initial seed capital to attract investors; or
  • making and retaining an investment in a fund that does not exceed 3% of the total outstanding ownership interest in the fund.(30)

In regard to seed investments in funds, the banking entity must actively seek unaffiliated investors so as to reduce its ownership to no more than 3% of the total amount or value of outstanding ownership interests in the fund within one year after establishment of the fund (or up to an additional two years on grant of an extension from the board if it finds an extension would be consistent with safety and soundness and not detrimental to the public interest).

Furthermore, in no event shall the aggregate value of all ownership interests of the banking entity in all covered funds that it organises or offers exceed 3% of the Tier 1 capital of the banking entity.(31) For purposes of calculating capital pursuant to the applicable capital rules, a banking entity must deduct the aggregate value of all permitted investments in covered funds from its tier 1 capital.

Note that the de minimis exceptions for a banking entity to own a total amount or value of outstanding ownership interests in a single covered fund of up to 3% and for a banking entity to own an aggregate value of all ownership interests across covered funds apply only to those covered funds that the banking entity organises and offers pursuant to the proposed rule. These authorisations are not general exceptions for investments in third-party funds.

Other permitted covered fund activities and investments
The prohibition on acquiring or retaining an ownership interest in, or acting as sponsor to, a covered fund by a banking entity does not apply to investments that meet any of four criteria:

  • investment in small business investment companies, investments to promote the public welfare or certain qualified rehabilitation expenditures within the Internal Revenue Code or similar State historic tax credit programmes;
  • permitted risk-mitigating hedge activity;(32)
  • investment in an issuer of asset-backed securities (s described in more detail below); or
  • activity undertaken by certain foreign banking entities.

As with the exception to the general ban on proprietary trading, foreign banking entities may rely on an exception to the prohibition on acquiring or retaining ownership interest in or sponsoring a covered fund. Any such activity must meet the following four criteria:

  • The banking entity involved must not be directly or indirectly controlled by a banking entity that is organised under the laws of the United States or of one or more states;
  • The banking entity must be a qualifying foreign banking organisation under the board's Regulation K, or if not, it must meet at least two of the following requirements:
    • total assets held outside the United States exceed total assets held in the United States;
    • total revenues derived from business outside the United States exceed total revenues derived from business in the United States; or
    • total net income derived from business outside the United States exceeds total net income derived from business in the United States;
  • No ownership interest in such fund is offered for sale or sold to a resident of the United States.
  • The activity occurs solely outside the United States.(33)

Permissible covered fund activities
The proposed rule permits banking entities to rely on an exception for certain types of covered funds to enable them to manage risk and structure their businesses as they see necessary to carry out their businesses. The prohibition on acquiring or retaining an ownership interest in, or acting as sponsor to, a covered fund by a banking entity does not apply to covered funds that have one of the following characteristics:

  • Such covered funds are separate accounts used solely for the purpose of purchasing bank-owned life insurance policies.(34)
  • Such covered funds are one of the following types of entity:
    • joint ventures that are operating companies and do not make investments prohibited under the proposed rule;
    • acquisition vehicles with a sole purpose to effectuate a merger or acquisition;
    • wholly-owned subsidiaries engaged in bona fide liquidity management activities;(35) and
    • certain issuers of asset-backed securities as described below.

Furthermore, the general prohibition under the proposed rule as to ownership and retention of an ownership interest in a covered fund does not apply to ownership interests acquired or retained by a banking entity:

  • in the ordinary course of collecting a debt previously contracted in good faith, if done within the applicable time periods provided by the relevant agency; and
  • pursuant to and in compliance with the board's conformance the implementing rules.(36)

Internal controls, reporting and record-keeping for covered fund activities
A banking entity that engages in any covered fund activity or acquiring or retaining an ownership interest as permitted by the proposed rule is subject to:

  • the proposed rule's internal controls, reporting and recordkeeping requirements as described further below; and
  • any additional requirements that the relevant regulatory agency may deem necessary.

Limitations on relationships with a covered fund
The proposed rule implements the Bank Holding Company Act closely with respect to affiliate transactions. Section 13(f)(1) of the act and the proposed rule prohibit a banking entity and its affiliates that serve, directly or indirectly, as the investment manager, investment adviser, commodity trading adviser or sponsor to a covered fund, from entering into certain "covered transactions" as defined in Section 23A of the Federal Reserve Act (a restriction that is being referred to as 'Super 23A') with a covered fund or with any other covered fund that is controlled by such covered fund (an 'affiliated covered fund'):

  • a loan to the affiliated covered fund, including a purchase of assets subject to an agreement to repurchase;
  • a purchase of or investment in securities issued by the affiliated covered fund;
  • a purchase of assets from the affiliated covered fund;
  • acceptance of securities or other debt issued by the affiliated covered fund as collateral for any loan;
  • issuing any guarantee, acceptance or letter of credit on behalf of the affiliated covered fund;
  • the borrowing or lending of securities to the extent that such transaction causes a member bank or subsidiary to have credit exposure to the affiliated covered fund; and
  • certain derivative transactions that cause a member bank or a subsidiary to have credit exposure to the affiliated covered fund.

Significantly, the proposed rule, like Section 13(f) of the act, does not incorporate the exemptions in Section 23A for specified transactions and the board's Regulation W with respect to Section 23A for specified transactions (eg, making loans secured by US government securities; purchasing certain liquid assets, marketable securities and municipal securities; making qualifying intraday extensions of credit; and engaging in certain riskless principal transactions).

The proposed rule provides that a banking entity may, notwithstanding the Super 23A limitations, acquire or retain an ownership interest in a covered fund in accordance with the other provisions of the proposed rule.

Section 13(f)(3)(A) of the act is also implemented in the proposed rule, which allows banking entities to enter into prime brokerage transactions(37) with affiliated covered funds so long as the statutory requirements are met:

  • the banking entity is in compliance with the section of the proposed rule regarding organising and offering a fund;
  • the chief executive officer makes an annual certification that the banking entity is not providing any guarantee of any affiliated covered fund or fund in which such affiliated covered fund invests; and
  • the transaction does not violate safety and soundness principles of the banking entity.

Finally, the proposed rule implements Sections 13(f)(2) and 13(f)(3)(B) of the act by generally requiring that covered transactions with affiliated covered funds be on arm's-length terms as provided in Section 23B of the Federal Reserve Act.(38)

Other limitations on permitted covered funds activities
The proposed rule also states that no transaction, class of transactions or activity is permissible if the transaction, class of transactions or activity would:

  • involve or result in a material conflict of interest between the banking entity and its clients, customers or counterparties;
  • result, directly or indirectly, in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or
  • pose a threat to the safety and soundness of the banking entity or the financial stability of the United States.

Compliance programmes

Under the proposed rule, a banking entity engaged in covered trading activities or covered fund activities and investments must establish compliance programmes appropriate for the size, scope and complexity of activities and business structure of such banking entity. At minimum, such compliance programmes should contain the following specific, core elements:

  • internal written policies and procedures to document, describe and monitor activities and investments for compliance with the proposed rule;
  • internal controls to identify potential non-compliance and prevent prohibited activities;
  • a management framework that clearly delineates responsibility and accountability for compliance;
  • independent testing for the effectiveness of the compliance programme conducted by qualified banking personnel or a qualified outside party;
  • training for trading personnel and managers and other appropriate personnel to implement and enforce the compliance programme; and
  • making and keeping records sufficient to demonstrate compliance for a period of no less than five years on request of a supervisory agency.

If a banking entity's activities are significant enough, the banking entity will have to achieve a more enhanced set of minimum standards for these core elements as set forth in Appendix C to the proposed rule. A banking entity will be considered to have significant activities and thus need to achieve the enhanced standards if the relevant agency deems it appropriate and, as of the last day of each of the four prior calendar quarters, the banking entity, together with its affiliates and subsidiaries:

  • has trading assets and liabilities with a gross sum equal to or greater than $1 billion or equal to 10% or more of its total assets; and
  • has aggregate investments in funds with an average value equal to or greater than $1 billion or sponsors or advises funds with average total assets equal to or greater than $1 billion.

Furthermore, if a banking entity does not engage in covered trading activities or covered fund activities and investments, it must:

  • ensure that its existing compliance policies and procedures adequately prevent the banking entity from participating in such activities and making such investments; and
  • develop and provide for the required compliance programme before engaging in such activities or making such investment.

For further information on this topic please contact Daniel M Rossner, William S Eckland or Benson Cohen at Sidley Austin LLP by telephone (+1 212 839 5300), fax (+1 212 839 5599) or email (drossner@sidley.com, weckland@sidley.com or brcohen@sidley.com).

Endnotes

(1) The proposed rule is available at www.federalreserve.gov/newsevents/press/bcreg/bcreg20111011a1.pdf.

(2) The Commodity Futures Trading Commission (CFTC) has indicated that it is taking a 'wait and see' approach. Commissioner Scott O'Malia said that the CFTC might "put forward… a virtually identical proposal with the other regulators, or we could go it alone".

(3) Such rule is found in 76 Fed Reg 8265 (February 14 2011), available at www.federalreserve.gov/reportforms/formsreview/RegY1_20110214_ffr.pdf.

(4) 'Proprietary trading' does not contemplate a banking entity acting as agent, broker or custodian for an unaffiliated third party.

(5) According to the proposed rule, 'near term' for the purposes of classifying trading activities is "generally measured in hours and days rather than months or years".

(6) According to the proposed rule, these presumptions that arise by reason of a position's holding period are designed to help to determine whether a transaction is within the definition of 'proprietary trading', not whether a transaction is permissible under Section 13 of the Bank Holding Company Act. A transaction may fall within the definition of 'proprietary trading' and yet be permissible if it meets one of the exemptions provided in the proposed rule.

(7) The Market Risk Capital Rules apply to banks and bank holding companies with trading activity that equals 10% or more of the institution's total assets or $1 billion or more. See 12 CFR 3 (Office of the Comptroller of the Currency), Appendix B, 12 CFR 208, Appendix E and 12 CFR 225, Appendix E (board), and 12 CFR 325, Appendix C (Federal Deposit Insurance Corporation).

(8) Acquiring or taking liquidity management positions will not be deemed to constitute proprietary trading to the extent that such activities are used to ensure that the banking entity has sufficient, readily marketable assets available to meet its expected short-term liquidity needs. The proposed rule requires that the transaction be conducted in accordance with a documented liquidity management plan which requires, among other things, any positions taken for liquidity management purposes to be highly liquid and limited to financial instruments whose market, credit and other risks are not expected to give rise to appreciable profits or losses as a result of short-term price movements.

(9) An underwriter may hold securities that it could not sell in the distribution for investment purposes. If the acquisition of such unsold securities were in connection with the underwriting pursuant to the permitted underwriting activities exemption, the underwriter would be able to dispose of such securities at a later time without such activities being prohibited proprietary trading activities.

(10) The definitions of the terms 'distribution of securities' and 'underwriter' are generally identical to the definitions of the same terms provided for by SEC Regulation M.

(11) Incentive structures should primarily reward client revenues and effective client service, not proprietary risk taking.

(12) The language used to describe bona fide market making-related activity is similar to the definition of 'market maker' under Section 3(a)(38) of the Securities Exchange Act of 1934.

(13) These indicia are generally consistent with the indicia of bona fide market making in equity markets articulated by the SEC for the purpose of describing the exception to locate requirement of SEC Regulation SHO for market makers engaged in bona fide market-making activities.

(14) Such expectations must be based on more than an expectation of future price appreciation and the generic increase in marketplace demand that such price appreciation reflects. Rather, a banking entity's expectation should generally be based on the unique customer base of the banking entity's specific market-making business lines and the near-term demands of those customers based on particular factors beyond a general expectation of price appreciation.

(15) Regardless of the degree of correlation, if profits on hedging are appreciably more than expected/potential losses on related positions, such hedge positions are at risk of being prohibited proprietary trades.

(16) The definition of 'customer' remains open for comment, though it appears that the agencies will permit current and prospective customers and counterparties to be treated as customers for the purposes of this exemption.

(17) The proposed language describing riskless principal transactions generally mirrors that used in the board's Regulation Y, Office of the Comptroller of the Currency interpretive letters and the SEC's Rule 3a5-1 under the Securities Exchange Act.

(18) The proposed rule defines 'general account' as all of the assets of the insurance company that are not legally segregated and allocated to separate accounts under applicable state law.

(19) The proposed rule does not contain an analogous exception permitting a regulated insurance company to acquire or retain ownership in or sponsor a covered fund.

(20) No such determination is being formulated.

(21) The agencies note that the proposed definition is similar but not identical to the definition of 'US person' for purposes of SEC Regulation S.

(22) According to the commentary, persons performing purely administrative, clerical or ministerial functions would generally not be viewed as being directly involved in the transaction.

(23) This exclusion does not apply where an ownership interest is held under a trust that constitutes a company as defined in Section 2(b) of the Bank Holding Company Act (eg, a business trust or a statutory trust).

(24) 'Qualified plan' is as defined in Section 401 of the Internal Revenue Code.

(25) According to the agencies, this definition is intended to focus on the substance of the interest over its form (ie, whether an interest provides a banking entity with economic exposure to the profits and losses of the covered fund). As such, a covered fund's debt or other securities could fall within this definition if they exhibit the characteristics of equity.

(26) This is inconsistent with the current industry practice for hedge funds, where it is common for any allocations as covered interest to be maintained in the fund and subject to subsequent profit sharing and loss.

(27) The proposed rule focuses on the banking entity's control over the decision-making and operational functions of the fund. Generally, service as a trustee of a covered fund falls within the definition of acting as a 'sponsor'; however, the proposed rule explicitly excludes a trustee that does not exercise investment discretion with respect to the covered fund, including a directed trustee under the Employee Retirement Income Security Act of 1974.

(28) These two exclusions from the definition of 'investment company' are commonly relied on by hedge funds and private equity funds as well as many other entities, thereby bringing these entities within the coverage of the proposed rule but for the exclusion described further below.

(29) As defined in the Commodity Exchange Act, a 'commodity pool' means any investment trust, syndicate or similar form of enterprise operated for the purpose of trading in commodity interests.

(30) The methodology for a banking entity to determine its outstanding ownership in a covered fund is set forth in the proposed rule and generally requires using the same standards and frequency used by the covered fund for determining its aggregate value of assets and ownership interests. The agencies also note that since many funds do not calculate their valuation on a daily basis, a banking entity's calculation of its ownership in a covered fund need occur only quarterly (unless the covered fund does calculate its valuation on a daily basis, in which case the banking entity must also do so). A banking entity's amount and value of a permitted investment in a single covered fund must include:

  • any ownership interest held under this section of the proposed rule by any entity that is controlled, directly or indirectly, by the covered banking entity; and
  • the pro rata share of any ownership interest held under this section of the proposed rule by any covered fund that is not controlled by the banking entity but in which the banking entity owns, controls or holds with the power to vote more than 5% of the voting shares.

(31) The methodology for calculating Tier 1 capital is set forth in the proposed rule and generally requires determining tier 1 capital on a quarterly and based on the type of banking entity (eg, depository institution or bank holding company). If a banking entity is not required to report Tier 1 capital (and is not a subsidiary of a depository institution or bank holding company that reports Tier 1 capital), such banking entity's tier 1 capital will be the total amount of shareholders' equity of the top-tier affiliate within such organisation as of the last day of the most recent calendar quarter that has ended.

(32) The criteria for permitted risk-mitigating hedging activities involving a covered fund are substantially similar to the risk-mitigating criteria that apply to proprietary trading, as discussed above. A banking entity may acquire an outstanding interest in a covered fund if it is made in connection with and related to individual or aggregated obligations or liabilities of the banking entity in circumstances arising when it acts as intermediary on behalf of a third-party client or directly connected to its compensation of an employee investment adviser. Moreover:

  • the acquisition or retention of an ownership interest in a covered fund must mitigate a substantially similar offsetting exposure to the same covered fund and in the same amount of ownership interest in such covered fund; and
  • at the time of any such transaction, the banking entity must document the risk-mitigating purposes of the transaction and identify the risks to be reduced.

This exemption is likely to prove valuable to banking entities that offer structured products the performance of which references a covered fund.

(33) To qualify under this requirement, the following three criteria must be met:

  • the banking entity engaging in the activity is not organised under the laws of the United States or of one or more states;
  • no subsidiary, affiliate or employee of the banking entity that is involved in the offer or sale of an ownership interest in the covered fund is incorporated or physically located in the United States or in one or more states; and
  • no ownership interest in such covered fund is offered for sale or sold to a resident of the United states.

(34) The agencies recognise that prohibiting investments in bank-owned life insurance policies would eliminate an investment that helps banking entities to reduce risk; however, they have restricted the exception consistent with the purpose of the proposed rule, such that the banking entity does not control the investment decisions regarding the underlying assets or holdings of any separate account and holds its ownership interest in compliance with applicable supervisory guidance regarding bank-owned life insurance.

(35) These are the same bona fide liquidity management requirements pursuant to a liquidity management plan as referenced above.

(36) Such implementing rules generally provide that a banking entity may continue certain existing relationships with a covered fund without complying with the restrictions of Section 13 of the Bank Holding Company Act and the proposed rule until July 21 2014, as such date may be extended by up to three one-year periods by the board. To the contrary, a banking entity would usually not be permitted establish a new relationship with a covered fund after July 21 2012 without being in compliance with the proposed rule.

(37) 'Prime brokerage transaction' is defined to mean one or more products or services provided by a banking entity to a covered fund (eg, custody, clearance, securities borrowing or lending services, trade execution or financing, data, operational and portfolio management support).

(38) Section 23B of the Federal Reserve Act provides that transactions between a member bank and an affiliate must be on terms and in circumstances, including credit standards, that are substantially the same or at least as favourable to such banking entity as those prevailing at the time for comparable transactions with or involving other unaffiliated companies or, in the absence of comparable transactions, on terms and in circumstances, including credit standards, that in good faith would be offered to, or would apply to, non-affiliated companies.