On December 10, 2013, five federal agencies issued the long-awaited final rules implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (codified as Section 13 of the Bank Holding Company Act of 1956, as amended) (the “Volcker Rule”). Scott Alvarez, General Counsel of the Board of Governors of the Federal Reserve System (the “Fed”), said it best with a nod to the Beatles, it’s been “A long and Winding Road” to finalize the Volcker Rule—three and a half years after its enactment and more than two years after its implementing rules were first proposed. While regulators strived to simplify the highly complex content of the rules, the preamble alone racks up to more than 880 pages.
The final rules, which include numerous changes from the proposal, become effective April 1, 2014. However, in addition to approving the implementing rules, the Fed also approved a one-year extension on the Conformance Period so that all banking entities must now be fully compliant with the final rules by July 21, 2015. Greenberg Traurig is working on more focused summaries of the rules for specific activities and client types, but below is a summary the material points of interest in the final rules and significant differences from the proposal.
As discussed in our October 25, 2011 Alert, the Volcker Rule generally prohibits banking entities from:
- engaging in proprietary trading of securities or
- acquiring or retaining any ownership interest in, sponsoring, or having certain relationships with hedge funds and private equity funds,
in each case subject to certain exemptions and exclusions. In addition, the Volcker Rule subjects certain nonbank financial companies that engage in such activities or have such interests or relationships to additional capital requirements, quantitative limits, or other restrictions.
The Proprietary Trading Prohibition
The final rules’ definition of “proprietary trading” generally parallels the statutory definition and includes engaging, as principal, for the “trading account” of the covered banking entity in any purchase or sale of one or more enumerated financial instruments. The final rules retain the proposed rules’ approach for defining “trading account” to include short-term, market risk rule and dealer trading accounts, but modify the definition to address commenters’ desires for greater certainty. Additionally, the final rules expand the proposed rules’ rebuttable presumption that trades are for a trading account where the banking entity holds the financial instrument for fewer than 60 days. The final rules also include trades where the banking entity substantially transfers the risk of the financial instrument within 60 days of purchase. The final rules also clarify the four proposed exclusions from proprietary trading, while adding new exclusions, such as trading (i) to satisfy existing delivery obligations of the baking entity or its customers to prevent or close out a failure to deliver; (ii) through a deferred compensation, stock-bonus, profit-sharing or pension plan of the banking entity as trustee for employees; and (iii) in the ordinary course of collecting a debt previously contracted in good faith. The final rules also implement the statutory exemptions for underwriting and market making as well as permitted risk-mitigating hedging activities designed to reduce, and demonstrably reduce or significantly mitigate, specific, identifiable risks of individual or aggregated positions of the banking entity.
Banking entities relying on these exemptions, however, are subject to the rules’ compliance requirements, which are designed to ensure that the banking entity identifies, monitors and limits the risks associated with these activities. Specifically, the internal compliance program must include, among other requirements, authorization procedures including (i) escalation procedures that require review and approval of any trade that would exceed a trading desk’s limits, (ii) demonstrable analysis of the basis for any temporary or permanent increase to such limits and (iii) independent review of such demonstrable analysis and approval.
Similar to the proposed rules, the final rules permit trading in various United States government obligations and obligations of States and their political subdivisions. The final rules also permit proprietary trading in obligations issued by agencies and instrumentalities acting on behalf of States and municipalities (e.g., port authority bonds and bonds issued by municipal agencies or corporations). In addition, the final rules also permit under certain circumstances, trading in foreign sovereign obligations, including obligations of an agency or political subdivision of that foreign sovereign (e.g., securities issued by foreign central banks).
The final rules also exempt certain foreign banking entities that engage in proprietary trading that occurs solely outside the U.S and are designed to ensure that the risk, decision-making, arrangement, negotiation, execution and financing of the activity resides solely outside the United States. The foreign trading exemption is available only to foreign banking entities, provided that: (i) the banking entity either engaging as principal, making the decision to purchase or sell, or financing the purchase or sale is not located in the United States and is not organized under the laws of the United States or any State; (ii) the purchase or sale is not accounted for as principal directly or on a consolidated basis by any branch or affiliate located in the United States or organized under the laws of the United States or any State; and (iii) the purchase or sale is not conducted with or through any United States entity, other than the foreign operations of a United States entity, 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.
The final rules raise the metrics reporting threshold in the proposed rules for trading desks engaged in covered trading activity so that only banking entities with more than average trading assets and liabilities on a consolidated, worldwide basis for the preceding year equal to or greater than $10 billion, are required to report. The final rules also provide a phased-in approach based on the size of the trading activity through December 31, 2016. Importantly, reporting of metrics for all banking entities has been delayed until June 30, 2014, with only large institutions needing to report on 7 of the metrics during the Conformance Period.
The Covered Fund Prohibitions
The final rules include a definition of the entities to be covered by the statutory terms “hedge fund” and “private equity fund,” as well as other similar funds. The definition of “covered funds” under the final rules is more tailored than the proposed rules so that only vehicles used for the investment purposes that were the focus of the statutory prohibition would be within the scope of the rules. In particular, the final rules exclude certain issuers who would be investment companies under the Investment Company Act of 1940, as amended, but for Section 3(c)(1) or 3(c)(7). Those excluded issuers include certain foreign public funds, wholly-owned subsidiaries, joint ventures, and acquisition vehicles, foreign pension or retirement funds, insurance company separate accounts, bank owned life insurance, loan securitizations, qualifying asset-based commercial paper conduits, qualifying covered bonds, SBICs and public welfare investment funds, as well as SEC-registered investment companies and business development companies.
The final rules’ definition of covered funds also includes certain commodity pools as “similar funds” provided for under the statutory definition as they are similar to those that would be investment companies under the Investment Company Act, but for Section 3(c)(1) or 3(c)(7). However, the final definition of covered funds was tailored from the proposed rules so that only commodity pools for which the operator either (i) has claimed an exemption under CFTC Rule 4.7 for pools owned solely by qualified eligible persons or (ii) is registered under the Commodity Exchange Act of 1936, as amended, and operates a pool substantially owned by qualified eligible persons that is not publicly offered to anyone who is not a qualified eligible person. Importantly, the definition now carves out commodity pools with operators relying thede minimis exclusion and exemption in CFTC Rules 4.5 and 4.13, including certain real estate funds and certain securitization vehicles, to the extent they are not otherwise included in the definition by virtue of relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act.
To prevent evasion of the Volcker Rule, the final rules’ definition of covered funds also includes as “similar funds” certain foreign funds that are organized, offered and sold solely outside the United States. However, unlike the proposed rules, the final rules limit application of the covered fund definition only to any banking entity that is, or is controlled by a banking entity that is, located in or organized or established under the laws of the United States or any State. To apply equal treatment with domestic funds, application to those foreign funds is further limited to any foreign fund that, were it subject to United States securities laws, would be able to rely on an exclusion or exemption from the definition of investment company other than Section 3(c)(1) or 3(c)(7) of the Investment Company Act. This theoretical application of United States securities laws to funds, especially unaffiliated funds, can be challenging for the foreign banking entity making an investment in the fund in its home jurisdiction.
The final rules also require banking entities, under certain conditions, to organize and offer covered funds, and to engage in (i) underwriting or market making-related activities, (ii) risk-mitigating hedging activities, (iii) activities that occur solely outside of the United States and (iv) insurance company activities.
Compliance Program and CEO Attestation Requirements
The final rules require banking entities engaged in covered activities (other than exempt government and municipal obligations) to establish an internal compliance program reasonably designed to ensure and monitor compliance with the Volcker Rule and the final rules. The complexity of the compliance requirements vary according to the size of the banking entity and activity conducted with more detailed requirements for larger entities. In particular, banking entities with US$50 billion or more total consolidated assets (or a foreign banking entity that has total United States assets of US$50 billion or more) must provide a CEO attestation to their regulator that the entity has in place a program reasonably designed to achieve compliance with the requirements of the Volcker Rule and the final rules. However, the CEO does not need to attest to the banking entity’s actual compliance. Unlike the proposed rules, the final rules allow banking entities with total assets below US$10 billion to update their existing compliance program in a manner that addresses the types and amounts of activities the entity conducts rather than incorporate the six compliance program elements set forth in the final rules for larger banking entities, which include certain written policies and procedures, internal controls, management framework, independent testing and audit, training and record keeping.