On October 12, 2011, the Federal Deposit Insurance Corporation (FDIC), along with the Board of Governors of the Federal Reserve System (FRB) and the Office of the Comptroller of the Currency (OCC), (together, the "Federal Banking Agencies") issued a joint notice of proposed rulemaking (NPR)1 implementing section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank" or DFA), the so-called Volcker Rule.2 The Securities Exchange Commission (SEC and together with the Federal Banking Agencies, the "Agencies") voted to issue the Volcker Rule NPR on October 13, 2011. Although section 619, which established a new section 13 of the Bank Holding Company Act, calls for the Federal Banking Agencies, the SEC and the Commodity Futures Trading Commission (CFTC) to all issue rules implementing section 619 for institutions within their respective primary jurisdictions, the CFTC is not listed as an issuing agency in the NPR approved by the Federal Banking Agencies and SEC. Press reports have suggested the CFTC is taking a "wait-and-see" approach and may issue its own variation of a proposed rule.3
What you need to know now
The Volcker Rule NPR is almost 300 pages, and includes over 380 questions on matters which the Agencies want input through the comment process. As a result, this Update is necessarily quite long, and detailed. What is missing, however, is a lot of what is missing in the NPR: namely answers to the questions asked by the Agencies, and important details on where the lines will be drawn between permissible and impermissible activities.
Dodd-Frank requires compliance with the Volcker Rule beginning on July 21, 2012. As a result, there will not be much time for entities and persons affected to make comments, and for the Agencies to shape the final rule. It will also be critical for affected persons and entities, as well as the Agencies, to consider the competitive impact of the Volcker Rule on U.S. banks and how the Volcker Rule will impact both banks and regulatory structure (arbitrage) on a global basis. A complete understanding of this complex set of rules, and interaction with other regulatory matters is critical.
Section 619 of Dodd-Frank generally prohibits "banking entities"4 from (1) engaging in "proprietary trading"5 in securities, derivatives, or certain other financial instruments, and (2) from investing in, sponsoring, or having certain relationships with a "hedge fund" or "private equity fund."6 The statute also provides for a number of exceptions to those two general rules.
The Agencies stated that the NPR clarifies the scope of the act's prohibitions and, consistent with statutory authority, provides certain exemptions from these prohibitions. As discussed in more detail below, the NPR:
- Exempts transactions in certain instruments, including obligations of the U.S. government or a U.S. government agency, the government-sponsored enterprises, and state and local governments, from the statute's prohibitions;
- Clarifies, to some extent, the market-making activities that are exempt from the prohibition on proprietary trading, and the compliance and recordkeeping requirements related to such activities, including commentary intended to assist banking entities in distinguishing permitted market making-related activities from prohibited proprietary trading activities;
- Provides detail on permissible trading for risk mitigating hedging purposes and permits hedging on a portfolio basis;
- Clarifies, to some extent, a banking entity's ability to organize, offer, invest in and engage in transactions with a "covered fund" (e.g., a hedge fund or private equity fund) and the conditions such banking entities and funds must meet;
- Provides additional details and requirements for foreign banks to meet the exemption on the prohibitions for activities that occur wholly outside the United States.
The comment period on the NPR will be open until at least January 13, 2012, and the Agencies have requested comment on nearly 400 questions regarding the NPR. If there is a general theme to most of the questions the Agencies have asked, it is whether the Agencies have struck an appropriate balance, and whether provisions are workable. The statute mandates that the rules become effective on July 21, 2012, but also permits a delay in compliance pursuant to the transition rules issued by the Federal Reserve in November 2010.7
Prohibition on proprietary trading
The NPR's definition of proprietary trading follows the statutory definition and includes engaging as principal for the trading account of a banking entity in any transaction to purchase or sell certain types of financial positions, or "covered financial positions." The NPR clarifies and defines the statutorily granted exemptions to the general prohibition on proprietary trading with the caveat that no banking entity may engage in a permitted activity if that activity would involve or result in a material conflict of interest or material exposure of the banking entity to high-risk assets or high-risk trading strategies, or pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States. The Agencies have declined at this time to exercise their authority to grant any discretionary exemptions from the general prohibition on proprietary trading outside of the statutory carve-outs.
The NPR clarifies that several categories of activities fall outside the scope of the definition of proprietary trading because they do not involve engaging as a principal in prohibited activities (e.g., transactions in which a banking entity acts as an agent, broker, or custodian for an unaffiliated third party). The rule describes three independent types of transactions in which a banking entity's purchase or sale of a covered financial position will be considered to be on behalf of a customer, and not subject to the general prohibition:
- Where the purchase or sale of a covered financial position 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 thereof, is beneficial owner. To qualify, transactions should not be structured in a manner that could benefit or harm the banking entity.
- A transaction is on behalf of customers if the banking entity is acting as riskless principal. The NPR's description of riskless principal transactions mirrors existing agency regulations and interpretations of that term.
- A banking entity that is an insurance company may trade in covered financial positions for the separate account of insurance policyholders.
In addition to the foregoing, a banking entity may purchase or sell a covered financial position if the banking entity is a regulated insurance company (or affiliate) acting for the insurance company's general account, subject to restrictions.
Exemption for foreign banks outside the United States
The NPR implements Section 619's exemption for certain foreign banking entities to engage in proprietary trading that occurs solely outside the United States. First, foreign trading may be exempt when the banking entity conducting the trading is not directly or indirectly controlled by a banking entity organized under federal or state laws. Therefore, this exemption applies only to foreign-organized banking entities controlled by foreign-organized entities, and would not apply, for example, to a U.S. subsidiary of a foreign banking entity.
Second, to qualify for the exemption, the banking entity must either be a qualifying foreign banking organization and conduct the trade in compliance with subpart B of the FRB's Regulation K8, or meet at least two of the following requirements:
- Total assets held outside of the U.S. exceed total assets held in the U.S.;
- Total revenues derived from outside of the U.S. exceed total revenues derived from in the U.S.; or
- Total net income derived from outside of the U.S. exceeds total net income derived from in the U.S.
Third, a trade will be considered to have occurred solely outside the U.S. only if it meets four conditions:
- Transaction is conducted by a banking entity not organized under federal or state laws;
- No party to the transaction is a U.S. resident;
- No personnel of the banking entity that is directly involved in the transaction is physically located in the U.S.; and
- Transaction is executed wholly outside the U.S.
If these requirements remain in the final rule, many banks that utilize employees in the U.S. to advise on or execute trades in other parts of the world will have to restructure their operations or relocate some of their employees outside the United States in order to comply.
Covered financial position
The NPR defines a financial position subject to the prohibition on proprietary trading, or a "covered financial position," to include any position (long, short, synthetic, or otherwise) in a security, derivative, or commodity future, along with any option on such an instrument. The terms "security" and "commodity" are defined by reference to existing securities and commodities laws. The term "derivative," is broadly defined within the NPR and includes within its scope swaps and security-based swaps, along with other transactions that operate in "economic substance" as derivatives. Although the Treasury Secretary has recently proposed to exclude foreign exchange swaps and foreign exchange forwards from the definition of "swap" for the purposes of the Commodity Exchange Act, the NPR includes both types of transactions in the definition of derivative.9 The Agencies explained, in part, that while the Treasury Secretary's determination on foreign exchange swaps and forwards is pending, they included such contracts in the definition of this NPR, but asked for comment on whether the definition should exclude such foreign exchange swaps and forwards if the Treasury determination is finalized.
The NPR permits the purchase or sale of a covered financial position that is: an obligation of the U.S. government or any agency thereof; certain other obligations, including Federal Home Loan Bank obligations; and obligations issued by any state or any political subdivision thereof. Permitted types of obligations under this exception include general, limited, and pass-through obligations. The NPR does not extend the exemption to transactions in the obligations of an agency of a state or political subdivision thereof, or to foreign government obligations. The NPR discussed the statutory exemption for small business investment companies and public welfare investments, but the Agencies noted that such exemptions seemed to only properly apply to the covered fund activities portion of the rule, rather than the prohibition on proprietary trading, and therefore did not exempt such transactions from the proprietary trading prohibition.
The term "trading account" is defined by statute as "any account used for acquiring or taking positions in securities [or other enumerated instruments] principally for the purpose of selling in the near-term or otherwise with the intent to resell in order to profit from short-term price movements," as well as any other accounts that the Agencies by rule determine.10 The proposed definition of trading account contains three independent prongs. Qualification under any prong qualifies an account as a "trading account" for purposes of the ban on proprietary trading.
A trading account includes any account used by a banking entity to acquire or take covered financial positions principally for the purpose of short-term resale, benefiting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging one or more such positions. Because the test is intent-based, the resale of a position is not required in order for a position to fall within this category
- Rebuttable presumption
"Short-term" is not defined. However, under the NPR any account used to acquire or take a covered financial position that is held for sixty days or less is considered a trading account within the scope of the first prong, unless the banking entity can demonstrate that the position was not acquired principally for short-term trading purposes. This presumption may be rebutted by reference to the particular facts and circumstances surrounding the acquisition of a particular position.
- A trading account includes any account used by a banking entity to acquire or take a covered financial position, other than certain foreign exchange and commodities positions, that is also a market risk capital rule covered position, if the banking entity, or any affiliate of the banking entity that is a bank holding company, calculates risk-based capital ratios under the Market Risk Capital Rules.
This prong of the trading account definition is being proposed in contemplation of the proposed revisions to the Market Risk Capital Rules and may change accordingly. The Agencies recognize that neither the Market Risk Capital Rules, the Call Report, nor the relevant accounting standards provide a precise definition of what constitutes "near-term" or "short-term." Accordingly, the Agencies contemplate reviewing a variety of information - including quantitative measurements of a banking entity's covered trading activities and supervisory review of compliance practices, internal controls, and individual transactions - in order to determine whether a position meets the "near-term" or "short-term" standards.
- Any account used to acquire or take a covered financial position by SEC-registered securities or municipal securities dealers, CFTC-registered swap dealers, SEC-registered security-based swap dealers, and government securities dealers in connection with their registered or notice requiring activities.
The proposed definition of trading account excludes from its scope certain types of positions and accounts because they do not involve the requisite short-term trading intent. The types of covered financial positions excluded from the definition of a trading account include: positions held under certain repurchase or reverse repurchase agreements, positions arising from securities lending transactions, positions taken for bona fide liquidity management purposes, and certain covered financial positions held by derivatives clearing organizations or clearing agencies. Transactions within an account excluded for bona fide liquidity management purposes must be conducted pursuant to a documented liquidity management plan that meets five criteria specified within the NPR.
Permitted underwriting activities
The NPR permits a banking entity to purchase or sell a covered financial position in connection with underwriting activities. Seven criteria must be met in order for an entity to be engaged in bona fide underwriting:
- The banking entity must have an established internal compliance program.
- The covered financial position that is being purchased or sold must be a security.
- The transaction must be in connection with a distribution of securities for which the banking entity is acting as an underwriter. This prong generally tracks the SEC's Regulation M for definitions, except that the NPR's definition of "underwriter" is broader and would include a person who has an agreement with another underwriter to engage in a distribution of securities for or on behalf of an issuer or selling security holder.
- If the transaction involves a security that requires a person to be a U.S.-registered dealer in order to engage in underwriting, then the banking entity must have the appropriate dealer registration, have filed the appropriate notices, or be exempt from registration, as applicable. If the activities are occurring overseas and do not require U.S. registration, then the banking entity must be subject to substantive regulation of its business dealings in the jurisdiction in which the business is located.
- The underwriting activities of the banking entity with respect to the covered financial positions must be designed not to exceed the reasonably expected near-term demands of clients, customers, and counterparties.
- The underwriting activities of the banking entity must be designed to generate revenues primarily from fees, commissions, underwriting spreads or other income, and not from appreciation in the value of the covered financial positions the banking entity holds related to such activities, or the hedging of such covered financial positions.
- The compensation scheme for persons performing underwriting activities at the banking entity must be designed not to encourage proprietary risk-taking.
Permitted market-making activities
A banking entity may purchase or sell a covered financial position in connection with its market making-related activities. In order to distinguish between bona fide market making activities and positions that are taken as part of a speculative trading strategy, the NPR requires banking entities engaged in market making to have in place an appropriate compliance regime, discussed below. Seven criteria must be met by an entity seeking to rely upon the market making exception:
- The banking entity must establish a comprehensive compliance program that includes policies, procedures, and internal controls designed to ensure that prohibited proprietary trading positions are not taken under the guise of permitted market making-related activity.
- The trading desk or other unit of the banking entity that purchases or sells a particular covered financial position must hold itself out as being willing to buy and sell, or otherwise enter into long and short positions in, the covered financial position for its own account on a regular or continuous basis, to ensure that bona fide market making-related activities are covered. The Agencies expect to take an approach similar to that used by the SEC in determining whether a person is engaging in bona fide market making.11
- The market-making related activities must be designed so as to not exceed the reasonably expected near-term demands of clients, customers, and counterparties.
- The banking entity relying upon the exemption must be appropriately registered as a dealer, or exempt from registration or regulation, under the 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 held in trading accounts or the hedging of such positions.
- The compensation of persons performing market making-related activities must be designed not to encourage or reward proprietary risk-taking.
- The market making-related activities must be consistent with Appendix B commentary.12
Hedging transactions related to market making positions and holdings will also quality under this exemption provided that two requirements are met:
- The purchase or sale must be conducted in order to reduce market making-related risks.
- The transaction must also meet the criteria specified in the general exemption for hedging for risk-mitigating purposes.
Permitted risk-mitigating hedging activities
The NPR clarifies the circumstances under which hedging activities involving covered financial positions qualify as risk-mitigating activities exempt from the general ban on proprietary trading. Seven criteria must be met in order to rely upon the hedging exemption:
- The banking entity must have in place an internal compliance program.
- Transactions for which the banking entity relies upon the hedging exemption must have been made in accordance with the written policies, procedures, and internal controls established by the internal compliance program.
- 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. The NPR allows banking entities to hedge risks on a portfolio basis and also permits anticipatory hedging, subject to certain restrictions.
- The transaction must be reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions and the risks and liquidity of those positions, to the risks or risks the transaction is intended to hedge or otherwise mitigate.
- The hedging transaction must not create, at its inception, significant exposures that are not themselves hedged in a contemporaneous transaction.
- Any transaction conducted in reliance on the hedging transaction must be subject to continuing review, monitoring and management after the hedge position is established. Such review, monitoring, and management must be consistent with written policies and procedures, maintain a reasonable level or correlation between the underlying and the hedging positions and the risks and liquidity of those positions, and mitigate any significant exposure arising out of the hedge post-inception.
- Compensation arrangements of persons performing the risk-mitigating hedging activities must be designed not to reward proprietary risk-taking.
In addition to those criteria, the NPR imposes documentation requirements on certain types of hedging transactions. In particular, the requirements relate to when the hedging activities occur at a different organizational level than the underlying position being hedging.
Covered fund activities
Section 619 of DFA broadly prohibits banking entities from acquiring and retaining any equity, partnership or other ownership interest in hedge funds or private equity funds unless specifically exempted by the statute itself or by the Agencies upon a determination that the exemption will promote and protect the safety and soundness of banking entities and U.S. financial stability.
As an initial matter, the NPR defines two new terms related to fund activities, "ownership interest" and "covered fund."
Section 619 of the DFA defines hedge and private equity funds to mean any issuer that would be an investment company but for two exemptions under the Investment Company Act such similar funds as the Agencies may determine by rule.13 The Agencies propose to combine the terms hedge fund and private equity fund into a single term—"covered funds"—and to include a commodity pool within that definition as a similar fund. The definition further includes the foreign equivalent of any identified covered fund. This is a very broad definition and encompasses many fund types in addition to what is typically thought of as a private equity fund or hedge fund.
The NPR defines "ownership interest" in a covered fund to mean any equity, partnership, or similar interest (including, without limitation, a share, equity security, warrant, option, generally partnership interest, limited partnership interest, membership interest, trust certificate or other similar interest) whether voting or nonvoting, or any derivative of such interest. Rather than focusing on the form of interest, this definition focuses on the attributes of the interest and whether it exposes the banking entity to profits and losses. It also is meant to cover a banking entity's direct or indirect interest as principal.
However, and taking into account how fund managers are traditionally compensated, the NPR specifically excludes carried interests from the definition of "ownership interest" where the interest meets the following requirements:
- The sole purpose of the interest is to allow the banking entity (or an affiliate, subsidiary, or employee) to share in the profits of the covered fund as performance compensation for services provided, but the banking entity may be obligated under the terms of the interest to return profits previously received;
- All profits, once allocated, are distributed to the banking entity promptly after being earned or, if not so distributed, the reinvested profits of the banking entity do not share in the subsequent profits and losses of the covered fund;
- The banking entity does not provide funds to the covered fund in connection with acquiring or retaining the carried interest; and
- The interest is not transferrable except to an affiliate or subsidiary.
Statutory exemptions from fund prohibitions
Section 619 provides five statutory exemptions from the prohibition on acquiring and retaining interests in covered funds: (i) organizing and offering a covered fund and the related acquisition and retention of fund interests; (ii) interests in small business investment companies (SBICs),14 public welfare investments,15 and qualified rehabilitation expenditures;16 (iii) risk-mitigating hedging activities; (iv) foreign banking entity investments; and (v) loan securitizations. The NPR sets forth the requirements for use of each of these exemptions. The NPR also sets forth significant restrictions on banking entity relationships with covered funds as discussed below.
Investment in Funds Organized and Offered
Section 619 permits a banking entity to organize and offer to bank fiduciary and investment management clients a covered fund as part of its bona fide trust and investment management activities. The following eight conditions must be met to qualify for the exemption:
- The banking entity must provide bona fide trust, fiduciary, investment advisory, or commodity trading advisory services;
- The covered fund must be organized and offered only in connection with the provision of bona fide trust, fiduciary, investment advisory, or commodity trading advisory services and only to persons that are customers of such services of the banking entity;
- The banking entity may not acquire or retain an ownership interest in the covered fund except the de minimis amounts listed below;
- The banking entity must comply with the restrictions governing relationships with covered funds (i.e., prohibiting most 23A covered transactions between the banking entity and the fund and requiring any permissible transaction to be on arms-length basis);
- The banking entity may not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the covered fund or of any covered fund in which such covered fund invests;
- The covered fund may not share the same name with the banking entity and may not use the word "bank" in its name;
- No director or employee of the banking entity may take or retain an ownership interest in the covered fund, except for any director or employee of the banking entity who is directly engaged in providing investment advisory or other services to the covered fund; and
- The banking entity must clearly and conspicuously disclose, in writing, to any prospective and actual investor in the covered fund certain enumerated disclosures contained in the NPR informing investor of, among other things, that there is no guarantee of the investment, that losses to the fund will be borne by the investors, and the investment is not insured by the FDIC.
In connection with organizing or offering a fund, a banking entity may acquire and retain an ownership interest in a covered fund that the banking entity organizes and offers pursuant to section 619, for the purposes of (i) establishing the covered fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors, or (ii) making a de minimis investment in the covered fund. For purposes of the NPR, a de minimis investment must be:
- Less than 3% of the total outstanding ownership interests of such fund (after the expiration of any seeding period (generally one year) provided under the rule);
- One that will not result in more than 3% of the losses of the covered fund being allocable to the banking entity's investment; and
- One that when added together with all other investments in covered funds in the aggregate is no more than 3% of the banking entity's tier 1 capital.
A banking entity's investment in covered funds must be deducted from its tangible and tier 1 capital.
Interests in SBICs, public welfare investments and qualified rehabilitation expenditures
Section 619 also permits the Agencies to exempt activities and investments related to SBICs, public welfare investments and qualified rehabilitation expenditures. The NPR would permit these investments without limitation as to amount of ownership interest the banking entity may own, hold or control.
Risk-mitigating hedging activities
The Volcker Rule additionally permits the Agencies to exempt risk-mitigating hedging activities in connection with and related to individual or aggregate positions, contracts or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings. This is different from the risk-mitigating hedging mentioned above related to proprietary trading. Under the exceptions to the proprietary trading ban, banking entities have more flexibility to hedge on a portfolio basis. The NPR would permit investments in covered funds for risk-mitigating hedging purposes that meet the following requirements:
- The banking entity is acting as intermediary on behalf of customer that is not itself a banking entity to facilitate a customer's exposure to the profits and losses of the covered fund (similar to acting as riskless principal) or a compensation arrangement with an employee of the banking entity that directly provides investment advisory or other services to that fund;
- The hedge must represent a substantially similar offsetting exposure to the same covered fund and in the same amount of ownership interest in the covered fund arising out of the transaction that the acquisition or retention of an ownership interest in the covered fund is intended to hedge or otherwise mitigate; and
- The banking entity must document, at the time transaction is executed, the hedging rationale for all hedging transactions involving an ownership interest in a covered fund.
Foreign banking entity investments
Foreign banking entities are permitted to acquire or retain ownership in, or to sponsor, a covered fund under the following circumstances. The first two general requirements are substantially similar to the foreign bank exemption discussed above as an exemption to the proprietary trading prohibition.
First, the banking entity must not be directly or indirectly controlled by a banking entity that is organized under federal or state laws.
Second, to qualify for the exemption, the banking entity must either be a qualifying foreign banking organization conducting the activity in compliance with subpart B of the FRB's Regulation K17 or meet at least two of the following:
- Total assets held outside of the U.S. exceed total assets held in the U.S.;
- Total revenues derived from outside of the U.S. exceed total revenues derived from in the U.S.; or
- Total net income derived from outside of the U.S. exceeds total net income derived from in the U.S..
Third, the activity must have occurred solely outside of the U.S., which requires that it meet the following three requirements:
- The entity engaging in the activity is not organized under federal or state laws;
- No subsidiary, affiliate, or employee of the entity involved in the offer or sale of an ownership interest in the covered fund is incorporated or physically located in the U.S. or any state; and
- No ownership interest in such covered fund is offered for sale or sold to a U.S. resident.
Section 619 explicitly permits loan securitizations. The NPR would permit banking entities to acquire and retain an interest in a covered fund that is an issuer of asset-backed securities so long as the fund's assets are solely comprised of the following:
- Contractual rights or assets directly arising from the loans supporting the asset-backed security; and
- Interest rate or foreign exchange derivatives that materially relate to the terms of the loans or contractual rights or assets and are used for hedging purpose with respect to the securitization structure.
This is meant to permit a banking entity to invest and retain an interest in qualifying loan and asset securitizations that it organizes and offers beyond the limits permitted for other funds it may organize and offer.18 The Agencies also provided a regulatory exemption to facilitate implementation of section 15G of the Securities Exchange Act, the risk retention requirement added by section 941 of the DFA, discussed below.
Section 619 also authorizes the Agencies to permit any covered fund investment or activity determined to promote the safety and soundness of banking entities and U.S. financial stability. The NPR identifies and would permit a banking entity to invest in, retain and/or sponsor four types of covered funds that would otherwise be prohibited.
The four exceptions are: (i) investments in Bank-Owned Life Insurance (BOLI) separate accounts (e.g., key-man life insurance often used to reduce the cost of employee benefit plans); (ii) investments in covered funds that are common corporate vehicles (e.g., certain operating companies that are structured as LLCs and joint ventures); (iii) investments in covered funds to the extent such amounts are the value or economic interest required to be retained by an organizer or securitizer of an asset-backed security pursuant to section 15G of the Securities Exchange Act;19 and (iv) investments in covered funds acquired in the ordinary course of collecting debts previously contracted (e.g., ownership interest of covered funds used to secure an extension of credit). The NPR also permits banking entities to acquire or retain interests pursuant to and in compliance with the Conformance or Extended Transition Period authorities provided for under the rule.
The Agencies have determined that allowing banking entities to rely on these authorities enables the entities to manage their risks and structure their business in a manner consistent with their chosen form and in a manner that otherwise complies with the law.
Notable Items Not Exempt from the Fund Activity Prohibitions
It is important to note that there is no provision in the NPR that would permit bank holding companies to continue to invest in and retain interests in covered funds that would otherwise be permitted under section 4(c)(6) of the Bank Holding Company Act. Moreover, although the Federal Reserve's rules regarding merchant banking investments by financial holding companies encourage those investments to made through funds, such funds are typically structured as private investment companies that meet the definition of covered funds and thus would become prohibited after the effective date. Finally, although some of the legislative history suggests the Congress did not intend to prohibit investments in venture capital funds, the definition of covered fund does exclude venture capital funds within the definition of covered funds, but the NPR does request comment on whether venture capital funds should be exempt, and what would be the legal basis to do so.
Relationships with covered funds
Section 619 broadly prohibits a banking entity that serves, directly or indirectly, as an investment manager, investment advisor, commodity trading advisor or sponsor to a covered fund and banking entities that organize and offer a covered fund (and affiliates of that banking entity) from entering into a transaction with the covered fund (or any other covered fund controlled by the fund) that would be a covered transaction under section 23A of the Federal Reserve Act (FRA) as if the banking entity or its affiliate were a member bank and the covered fund were an affiliate of the banking entity. This is more restrictive than the general application of section 23A, which permits covered transactions within statutory quantitative and qualitative limits.
The NPR provides several exceptions:
- A banking entity may acquire and retain an ownership interest in a covered fund in compliance with the NPR;
A banking entity may enter into any prime brokerage transaction with a covered fund where
- the banking entity is in compliance with the limits for covered funds organized and offered by the entity
- the CEO of the top-tier affiliate of the banking entity certifies annually that the banking entity does not guarantee, assume or otherwise insure the obligations or performance of the covered fund or of any covered fund in which it invests and
- the FRB has not determined that the transaction is inconsistent with the safe and sound operation and condition of the banking entity.
Both section 619 and the NPR subject the same banking entity to section 23B of the FRA with respect to its permissible transactions with covered funds, including permissible prime brokerage transactions.
General limits on permitted covered fund activities
Even if an investment or activity is permitted by the NPR, a banking entity may not engage in the investment or activity if (i) there would be a material conflict of interest between banking entity and clients, customers or counterparties, (ii) there would be material exposure to high risk assets or high risk trading strategy, or (ii) the investment or activity poses a safety and soundness risk to the banking entity or a risk to U.S. financial stability. The definitions of "material conflict of interest," "high risk assets" and "high risk trading strategy" are the same as those provided for proprietary trading.
Compliance recordkeeping, and reporting requirements
The NPR requires a banking entity engaged in covered trading activities or covered fund activities to develop and implement a program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions of the Volcker Rule. The NPR specifies six elements that each compliance program must include:
- Internal written policies and procedures reasonably designed to document, describe, and monitor the covered trading activities and covered fund activities and investments of the banking entity to ensure that such activities comply with section 13 of the BHC Act and the NPR;
- A system of internal controls reasonably designed to monitor and identify potential areas of noncompliance with section 13 of the BHC Act and the NPR in the banking entity's covered trading and covered fund activities and to prevent the occurrence of activities that are prohibited by section 13 of the BHC Act and the NPR;
- A management framework that clearly delineates responsibility and accountability for compliance with section 13 of the BHC Act and the NPR;
- Independent testing for the effectiveness of the compliance program, conducted by qualified banking entity personnel or a qualified outside party;
- Training for trading personnel and managers, as well as other appropriate personnel, to effectively implement and enforce the compliance program; and
- Making and keeping records sufficient to demonstrate compliance with section 13 of the BHC Act and the NPR, which a banking entity must promptly provide to the relevant Agency upon request and retain for a period of no less than 5 years.
The compliance and record keeping requirements are somewhat scalable, as banking entities that engage in more significant covered trading and covered fund activities (generally defined as more than $1 billion in covered trading assets or having such assets consist of more than 10% of assets, for trading and sponsoring or holding more than $1 billion in covered fund assets) will have additional compliance requirements.
In addition, covered banking entities with more than $1 billion in trading assets will be required to calculate and report significant data regarding the trading activity.20 The banking entity must generally calculate the applicable quantitative measures each trading day and report it to the appropriate Agency on a monthly basis. The data that must be calculated and reported include:
- Value-at-Risk (VaR) and Stress VaR;
- VaR Excedance;21
- Risk Factor Sensitivities;
- Risk and Position Limits;
- Portfolio Profit and Loss;
- Spread Profit and Loss; and
- Fee Income and Expense.
The NPR states that the quantitative measurements "are not intended to serve as a dispositive tool for the identification of permissible or impermissible activities." However, clearly such data will be used as type of red flag or early warning system. The collection of such data is in line with requests from Senators Merkley and Levin, who authored the Senate amendment leading to the inclusion of the Volcker Rule in Dodd-Frank.22
The Volcker Rule NPR asks well over 380 questions of commenters, and cites to legislative history more than most rulemakings. These facts seem to indicate the difficulty the regulators faced in drafting a rule that sets sufficiently clear definitions, without prohibiting activities that Congress intended to be permitted, and the likelihood that we will see significant changes in the final rule. Because section 619 requires compliance with the Volcker Rule beginning on July 21, 2012, it is almost certain that the agencies will finalize a rule by then. Not having at least an interim final rule in place by the statutory deadline would likely pose significant interruptions in market making and fund formation. However, this NPR will likely generate a great number of comments the agencies will have to consider before they will be able to get to that point, given the number of questions that have been posed in the rule, as well as a number of trading and fund variations the NPR may not have captured.
In the final analysis, the regulators will also have to consider the interaction of the final version of this rule with other provisions required by Dodd-Frank, such as the risk retention requirements, as well as influences from abroad, such as the Vickers Report's call for ring-fencing of retail deposit taking activities from investment banking activities, for example as proprietary trading, in banks in the United Kingdom. Such balancing will be a challenge for the regulators, as well as those seeking to comment and influence the final rulemaking.