On April 19, 2012, the Board of Governors of the Federal Reserve System (Federal Reserve) issued a statement (Statement) clarifying the obligations of banking entities during the conformance period prior to the time of required full compliance with Section 619 of the Dodd- Frank Act (the Volcker Rule).1 The Statement is intended to clarify the final rule issued by the Federal Reserve in February 2011 (Final Conformance Rule).2 Section 619 grants authority to the Federal Reserve to define the conformance periods provided by the Volcker Rule.3 While the Final Conformance Rule was issued solely by the Federal Reserve, the Statement was released jointly by the Federal Reserve and the other four agencies with responsibility for implementation of the Volcker Rule (the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Commodity Futures Trading Commission (CFTC), together with the Federal Reserve, the Agencies). On November 7, 2011 four of the Agencies published a draft rule implementing the Volcker Rule (Draft Volcker Rule).4
The Volcker Rule becomes effective July 21, 2012. However, Congress in Section 619 adopted a conformance period that is intended to “give markets and firms an opportunity to adjust to the Volcker Rule.”5 This period is defined as a two-year period, which may be extended by the Federal Reserve for up to three additional one-year periods based on certain specified criteria. The conformance period applies to any banking entity, or nonbanking entity supervised by the Federal Reserve, conducting any activities that would be prohibited or restricted by the Volcker Rule. Commentary to the Final Conformance Rule states that it is intended to provide a covered entity a period in which it “can wind down, sell or otherwise conform its activities, investments and relationships.”6 The Draft Volcker Rule stated that this requirement imposed an obligation on a covered entity to conform its activities and investments to the Volcker Rule “as soon as is practicable” during the conformance period.7
The Final Conformance Rule, in conjunction with the complexity of the proposed Volcker Rule, raised many questions for banking entities concerning what they would be required to do during the conformance period. In particular, it became apparent that the Agencies would not issue a final rule implementing the Volcker Rule prior to the beginning of the conformance period, which meant that covered entities might be required to begin conforming their activities without knowing which activities would need to be conformed to what standards.
The Federal Reserve then issued the Statement in order to provide clarity regarding obligations of covered entities during the conformance period, which it does by stating that the Federal Reserve “confirms that banking entities by statute have two years from July 21, 2012, to conform all of their activities and investments to section 619, unless that period is extended by the [Federal Reserve].” However, the Statement raises almost as many questions as it answers, and in fact does not answer several important outstanding issues.
- WHEN DOES A BANKING ENTITY NEED TO START CONFORMING ITS ACTIVITIES TO THE REQUIREMENTS OF THE VOLCKER RULE?
Many commentators and news reports concluded that the Statement gives banking entities until July 2014 to conform their activities. This view is overly simplistic and overlooks the obligations placed on banking entities during the conformance period.
The Statement provides that banking entities must conform all of their activities by the end of the conformance period, which is July 2014 unless extended by the Federal Reserve.8 In order to be in full compliance by the end of this period, banking entities will have to take significant steps to cease, divest or otherwise comply with the Volcker Rule prior to that date. If an entity is counting on requesting and receiving an extension of the conformance period, it will have to make such a request no later than 180 days prior to July 2014. It will not know whether such a request will be granted until much closer to the conformance date (note that the Federal Reserve estimates that it will receive over 700 requests for extensions, which if true will cause the process to be very slow). Therefore, we estimate that banking entities will need to begin conforming their activities no later than year end 2013, and if their activities are highly complex, perhaps as much as six months prior to then. We note that it will be very difficult for banking entities to begin conformance efforts until a final rule implementing the Volcker Rule is issued.
- WHAT ARE "GOOD FAITH EFFORTS'?
The Statement provides that the Federal Reserve expects a banking entity to “engage in good faith efforts, appropriate for its activities and investments, that will result in the conformance of all of its activities and investments … by no later than the end of the conformance period.” The Statement does not define or explain what will constitute “good faith efforts,” but when coupled with the timing described above it clearly will require banking entities to do some amount of conformance during the conformance period.
This requirement is troublesome in two respects. First, the more trading activities and investments that a banking entity has that are subject to the Volcker Rule, the more efforts the Statement requires them to take during the conformance period. As no banking entity could be expected to do much of anything before the final rule implementing the Volcker Rule becomes effective, it is possible that banking entities with complex activities will need to begin conformance actions immediately after issuance of the final rule implementing the Volcker Rule. Second, we expect that most banking entities will seek up to three one-year extensions of the conformance period from the Federal Reserve. It is likely that the Federal Reserve will review whether a banking entity has acted in “good faith” in its conformance activities in determining whether to grant each extension. Thus, in order to obtain an extension, a banking entity may have to begin significant conformance of its activities during the conformance period.
- WHAT IS A CONFORMANCE PLAN?
The Statement requires a banking entity to develop a conformance plan that describes and evaluates such entity’s activities and investments and specifically explains how the entity will conform such activities and investments to the Volcker Rule. The thoroughness of a conformance plan, and whether it is being followed, will be factors used by the Federal Reserve to determine whether a banking entity is acting in good faith.
- MAY BANKING ENTITIES ENGAGE IN NEW TRADING AND INVESTMENT ACTIVITIES DURING THE CONFORMANCE PERIOD?
The Statement makes clear that banking entities may continue to engage in existing activities and investments during the conformance period, at least until they are required to make good faith efforts to conform such activities and investments. However, the Statement does not provide any guidance to banking entities that do not (as of July 21, 2012) engage in activities or have investments covered by the Volcker Rule but wish to do so de novo or through acquisition during the conformance period. Similarly, the Statement does not provide guidance to banking entities that wish to expand their trading or fund investment activities during the conformance period through acquisition or by entering into new lines of trading activities or new covered fund structures. In fact, we expect that the Federal Reserve will require banking entities to list all forms of trading activities and fund investments in their conformance plans, and be held to conforming the listed matters as part of showing “good faith”. While many banking entities have broad based programs that can easily include variations on existing platforms (and which would be characterized as a continuation of existing activities), other banking entities may find themselves blocked from taking up the “latest product” during the conformance period.
- NOTWITHSTANDING THE STATEMENT, WHAT OTHER OBLIGATIONS COULD APPLY TO BANKING ENTITIES DURING THE CONFORMANCE PERIOD?
The Statement notes that the final rule implementing the Volcker Rule may, when issued, require banking entities to comply with reporting or recordkeeping requirements. This provision is somewhat "tongue in cheek," as the Statement itself requires banking entities to file conformance plans, which themselves will require banking entities to survey their records and report the results to regulators. The Agencies may require these or such other actions in the final rule implementing the Volcker Rule, all of which could change the ability of a banking entity to conduct trading or investment activities during the conformance period.
- WHAT DOES THIS MEAN FOR NON-U.S. BANKS?
The Statement does not address the scope of the exemptions for covered activities taking place outside the United States or the ability of a covered entity headquartered outside the U.S. to take advantage of those exemptions. Given that covered entities will not be able to begin conformance activities until after the issuance of the final rule implementing the Volcker Rule, the application of the rule to certain non-U.S. activities of non-U.S. covered entities will continue to be uncertain. At the same time, large and complex non- U.S. entities may ultimately face an especially difficult task in developing their conformance plans within the time that will, effectively, be allowed within 2013.