Five federal financial regulatory agencies have released final rules implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. That section created the provision in the Bank Holding Company Act (“BHC Act”) which will prohibit any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (“covered fund”).
The BHC Act provision became effective on July 21, 2012, and provided for a two-year conformance period from the effective date. Thus, by July 21, 2014, banking entities would have been required to discontinue prohibited proprietary trading and covered fund activities.
On November 7, 2011, the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission published proposed rules implementing the Volcker Rule (the “Proposed Rule”). The Commodity Futures Trading Commission published their version of the Proposed Rule two months later.
The Proposed Rule prompted thousands of comment letters and required lengthy analysis and discussion by the agencies, ultimately resulting in the release of the Final Rule on December 10, 2013. A July 21, 2014 deadline for compliance would have presented a very aggressive and difficult seven-month compliance timetable for banking entities to wind down prohibited proprietary trading and covered fund activities. In recognition of this, the Board of Governors extended the conformance period for an additional year, until July 21, 2015. The extended conformance period, however, does not apply to certain reporting requirements included in the Final Rule.
The Volcker Rule applies to any banking entity, defined broadly to include banks and certain of their affiliated entities.
Consistent with the Dodd-Frank Act, the Final Rule prohibits a banking entity from engaging in proprietary trading, defined as engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments. Financial instruments include:
- securities, including options on a security
- derivatives, including options on a derivative or
- contracts of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.
The definition of trading account is broad, and includes a number of different accounts a banking entity could use to take advantage of short-term fluctuations in the price of a financial instrument. A banking entity does not engage in proprietary trading by purchasing or selling one or more financial instruments where it acts solely as agent, broker or custodian.
The Final Rule continues certain carveouts from the definition of proprietary trading contained in the Proposed Rule and adds certain additional exemptions including, most notably, certain narrowly construed risk-mitigating hedging activities.
The Final Rule also makes important revisions from the Proposed Rule for the treatment of trading activities by foreign banking entities. During the comment process, numerous commenters expressed concern that the foreign trading exemption contained in the Proposed Rule was too narrow and would unnecessarily prohibit foreign trading activities. Critics of the Proposed Rule expressed specific concern that the Proposed Rule’s requirements would cause foreign banking entities to avoid transactions with overseas subsidiaries and branches of US banking entities and would harm the competitiveness of US trading platforms. In response, the Final Rule’s requirements are designed to ensure that where foreign banking entities engage in proprietary trading, they do so in a manner that places the risk, financing and execution outside the US.
The Volcker Rule also prohibits certain “covered fund” activities. A banking entity may not, as principal, directly or indirectly acquire or retain any ownership interest in or sponsor a covered fund.
In response to critical public comments which asserted that the Proposed Rule’s covered foreign fund definition was overly broad, exceeded statutory authority, and potentially violated international treaties, the Final Rule makes meaningful changes to the definition. The Proposed Rule defined a covered fund to include:
- an issuer that would be an investment company under the Investment Company Act but for exceptions under Sections 3(c)(1) or 3(c)(7) thereof
- any commodity pool under Section 1a(10) of the Commodity Exchange Act and
- any issuer organized or offered outside the US that would be a covered fund, were it organized or offered under the laws, or offered to one or more residents, of the US or one of its states.
The Final Rule creates certain limitations on the inclusion of commodity pools and significantly revises the definition with respect to foreign funds. In focusing on the risks to US banking entities that the Volcker Rule was meant to address, the Final Rule provides that a foreign fund is only a covered fund where it is sponsored by, or has issued an ownership interest to, a banking entity that is, or is controlled by a banking entity that is, located in or organized under the laws of the US or any state.
The Final Rule retains the Proposed Rule’s permitted activities with respect to covered funds. Subject to certain conditions and limitations, banking entities may invest in or sponsor a covered fund in connection with:
- organizing and offering the covered fund
- certain risk-mitigating hedging activities
- de minimis investments in covered funds and
- certain permitted activities and investments outside of the US.
For the purposes of permitted activities and investments outside of the US, the Final Rule revises the requirements in the same way as the foreign trading exemption under the proprietary trading rules. Among other conditions, the Proposed Rule would only have permitted the activities if:
- the banking entity conducting the activity was not organized under the laws of the US or of one or more states
- no subsidiary, affiliate, or employee of the banking entity was incorporated or physically located in the US and
- no ownership interest in the covered fund was offered for sale or sold to a resident of the US.
In contrast, the Final Rule narrows these restrictions to require that:
- the banking entity engaging as principal in, making the decision to, and providing the financing for, the investment in, or the sponsorship of, the covered fund not be located in or organized under the laws of the US or any state and
- the investment or sponsorship is not accounted for as principal by any branch or affiliate located in the US or organized under the laws of the US or any state.
The Final Rule retains the requirement that no ownership interest be offered for sale to a resident of the US, but potentially softens that requirement by clarifying that it is satisfied where an offering does not “target residents” of the US.
The Proposed Rule required banking entities to develop Volcker Rule compliance programs. Banking entities that exceeded certain asset and volume of activity thresholds were subject to enhanced compliance program standards with more specific and complex requirements. Even banking entities that did not engage in any activities covered by the Volcker Rule were expected to develop policies and procedures and a compliance program to prevent prohibited activities. The Final Rule makes certain significant changes to the compliance program and reporting requirements.
As noted above, statutory requirements of the Dodd-Frank Act required banking entities to terminate all prohibited proprietary trading activities and covered fund investments or relationships by July 21, 2014, but permitted the Board to extend the conformance period by up to three one-year periods. On February 14, 2011, the Board published rules for extending the conformance period, and those rules envisioned banking entities applying individually for one-year extensions by submitting written requests to the Board. In conjunction with the release of the Final Rule, however, the Board also extended the conformance period (exclusive of reporting requirements for banking entities with significant trading activities) for all covered banking entities to July 21, 2015.