On December 10, 2013, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission (the “Regulators”) adopted the final version of the Volcker Rule1 (the “Rule”). As in earlier versions, the Rule invokes Federal Reserve Chairman Paul Volcker’s core concept of restricting United States banks from making certain kinds of speculative investments that do not benefit their customers. The Rule’s purpose is to put in place, as mandated under the Dodd-Frank Act, regulations to help avoid the financial crisis that occurred during the recent past. The Rule is intended to effectively reduce risks posed to banking entities by proprietary trading activities and investments in or relationships with covered funds while permitting banking entities to continue to provide client-oriented financial services that are critical to capital generation and liquid markets.
In its final form, the Rule prohibits a class of defined “banking entities” from:
The Regulators adopted the Rule to implement Section 13 of the Bank Holding Company Act of 1956 (“BHC Act”). New Section 13 of the BHC Act also provides that a nonbank financial company (“NBFC”) designated by the Financial Stability Oversight Council (“FSOC”) for supervision by the Board of Governors of the Federal Reserve System (while not a banking entity under Section 13 of the BHC Act) would be subject to additional capital requirements, quantitative limits, or other restrictions if the company engages in certain proprietary trading or covered fund activities.
The final Rule is the product of extensive collaboration among the Regulators since the Rule was first proposed in October 2011. The Regulators, while implementing the final Rule, understood the importance in working together to adopt a single rule under the Bank Holding Company Act that can be consistently applied by the Regulators.
The Rule has been designed to ensure that banking entities do not engage in prohibited activities or investments and to ensure that banking entities engage in permitted trading and investment activities in a manner designed to identify, monitor and limit the risks posed by these activities and investments. For instance, any banking entity that is engaged in an activity subject to the Rule must develop and administer a compliance program that is appropriate to the size, scope, and risk of its activities and investments.
While the Rule has been moderated since initially proposed, the limitations within the Rule will likely have a significant impact on the ability of U.S. banking organizations to provide investment management products and services that are competitive with nonbanking firms generally and with non-U.S. banking organizations in overseas markets. It will also effectively prohibit short-term trading strategies by any U.S. banking organization, regardless of the location of its trading business, if those strategies involve instruments other than those specifically permitted for trading, as described below.
A. ENTITIES COVERED
“Banking entities” subject to the Rule prohibitions are defined to mean any insured depository institution (including both banks and thrifts), any company that controls an insured depository institution, or any company treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978, and any affiliate or subsidiary of such an entity.2
However, the term “insured depository institution” is defined not to include any institution that functions solely in a trust or fiduciary capacity if:
Supervised Nonbank Financial Companies
Supervised nonbank financial companies (“NBFCs”) have been determined to be systematically important and therefore subject to Federal Reserve supervision. The Rule requires Supervised NBFCs that do not control a depository institution and that engage in covered activities meet additional capital requirements and additional quantitative limits (to be set by the Federal Reserve by rule) even though they are not strictly “prohibited” from engaging in such activities. Engaging in proprietary trading and taking an ownership interest in or sponsoring a hedge fund or private equity fund are covered activities.
B. ACTIVITIES COVERED
Proprietary Trading Restrictions
The Rule prohibits a banking entity from engaging in proprietary trading. “Proprietary trading” is defined to mean, with respect to covered entities, engaging as a principal for the “trading account” of the banking entity in any purchase or sale of one or more financial instruments. A “financial instrument” means:
A “financial instrument” does not include:
“Trading account” means any account that is used by a banking entity to purchase or sell one or more financial instruments principally for the purpose of:
The definition of proprietary trading also contains clarifying exclusions for the purchases and sales of financial instruments that generally do not involve the requisite short-term trading intent, such as the purchase and sale of financial instruments arising under certain repurchase and reverse repurchase arrangements or securities lending transactions and securities acquired or taken for bona fide liquidity management purposes.
In summary, investments made “for the trading account” would be deemed proprietary trading and therefore prohibited. The “trading account” definition only covers “near-term” transactions, transactions that involve “short-term price movements,” or hedges of the foregoing transactions. Thus, this definition substantially limits the scope of prohibited proprietary trading. However, the Rule also provides the Regulators with the authority to determine that other accounts meet the “trading account” definition. As a result, the Regulators could expand the scope of the prohibition.
Rebuttable Presumption with respect to Proprietary Trading Restrictions
The purchase or sale of a financial instrument by a banking entity shall be presumed to be for the trading account of the banking entity if the banking entity holds the financial instrument for fewer than sixty days or substantially transfers the risk of the financial instrument within sixty days of the purchase (or sale), unless the banking entity can demonstrate, based on all relevant facts and circumstances, that the banking entity did not purchase (or sell) the financial instrument principally for any of the trading account purposes described above.
Permitted Trading Transactions
The Rule specifically permits trading transactions:
The Rule also permits certain risk-mitigating hedging related to a banking entity’s holdings (see section immediately below). Additionally, the Rule would not prohibit trading by foreign banking entities, provided the trading decisions and principal risks of the foreign banking entity occur and are held outside of the United States.
Risk Mitigating Hedging Activities Permitted if Banking Entities Satisfy a Four-Part Test
Risk-mitigating hedging that is designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity is permitted. The banking entity would be required to conduct an analysis (including correlation analysis) supporting its hedging strategy, and the effectiveness of hedges must be monitored and recalibrated as necessary on an ongoing basis. The final rules also would require banking entities to document, contemporaneously with the transaction, the hedging rationale for certain transactions that present heightened compliance risks.
Banking entities can hedge holdings “designed to reduce the specific risks to the banking entity” if they meet a four-part test, which includes:
Banking entities that do not engage in activities covered by the Rule would have no compliance program requirements.
The Rule requires the largest firms (banking entities with more than $10 billion in total consolidated assets, or more than $10 billion in consolidated trading assets and liabilities) engaged in permitted trading transactions to develop and implement enhanced compliance programs and regularly report data on trading activities to the Regulators. Larger banking entities would have to establish a more detailed compliance program, including a required CEO attestation; smaller entities (banking entities with $10 billion or less in total consolidated assets, or $10 billion or less in consolidated trading assets and liabilities) engaged in covered activities would be subject to a simplified compliance regime. Banking entities that do not engage in any activity subject to the Rule, other than trading in exempt government and municipal obligations, would not be required to establish a compliance program.
The Regulators believe that these enhanced compliance programs will help identify, monitor, and limit risks of activities permitted under Section 13, particularly involving banking entities posing the greatest risk to financial stability.
Proprietary Trading Outside the United States
Proprietary trading conducted by a banking entity pursuant to paragraph (9) and (13) of Section 4(c) of the Bank Holding Company Act (“BHC Act”) is permitted, provided the trading occurs solely outside of the United States and the banking entity is not controlled (either directly or indirectly) by a banking entity organized under the laws of the United States. Such transactions may involve U.S. entities only under certain circumstances. Specifically, an exempt transaction may occur (i) with the foreign operations of U.S. entities; (ii) in cleared transactions with an unaffiliated market intermediary acting as principal; or (iii) in cleared transactions through an unaffiliated market intermediary acting as agent, conducted anonymously on an exchange or similar trading facility.
Prohibited Activities Relating to “Hedge Funds” and “Private Equity Funds”
The Rule prohibits a banking entity from acquiring or retaining an equity, partnership, or other ownership interest in, or “sponsoring,” a hedge fund or private equity fund, referred to as “covered funds.” However, the Rule would not prohibit banking entities from providing advice to such funds.
“Sponsor” is defined to include serving as a general partner, managing member, or trustee of a fund; controlling a majority of the directors, trustees or management of a fund; or sharing with the fund for any purpose the same (or a very similar) name.
“Hedge fund” and “private equity fund” have a common definition: all issuers that are exempt from being considered investment companies under the Investment Company Act by virtue of Section 3(c)(1) or Section 3(c)(7) of that act. Investment Company Act Section 3(c)(1) excludes from the definition of an investment company, an issuer whose outstanding securities are beneficially owned by not more than 100 people and that does not make a public offering of its securities. Investment Company Act Section 3(c)(7) excludes from the definition of an investment company, an issuer whose outstanding securities are owned by persons who are “qualified purchasers,” as that term is defined under the Investment Company Act, and does not make a public offering of its securities. A covered fund also includes certain foreign funds and commodity pools, but defined in a more limited manner than under the proposed Rule.
The definition of covered fund contains a number of exclusions for entities that may rely on exclusions from the Investment Company Act of 1940 contained in Section 3(c)(1) or 3(c)(7) of that Act. These include, for example, exclusions for wholly owned subsidiaries, joint ventures, foreign pensions or retirement funds, insurance company separate accounts, and public welfare investment funds. The Rule also implements the statutory rule of construction in Section 13(g)(2) and provides that a securitization of loans, which would include loan securitization, qualifying asset -backed commercial paper conduits, and qualifying covered bonds, is not covered by Section 13 or the final Rule.
Permitted Activities With Respect to the Organization and Offer of a Hedge Fund and Private Equity Fund
In certain circumstances, the Rule permits a banking entity to organize and offer a hedge fund or private equity fund, including serving as a general partner, management member, trustee, or commodity pool operator of the covered fund in any manner selecting or controlling (or having employees, officers, directors, or agents who constitute) a majority of the directors, trustees, or management of the covered fund. The banking entity may organize and offer a hedge fund or private equity fund if it:
Fund Investing Outside of the United States
The acquisition or retention of an ownership interest in a hedge fund or private equity fund by a banking entity pursuant to paragraph (9) or (13) of Section 4(c) of the BHC Act solely outside of the United States is permitted, provided no ownership interest in the fund is offered to residents of the United States and the banking entity is not controlled (directly or indirectly) by a banking entity organized under the laws of the United States.
C. LIMITS ON PERMITTED ACTIVITIES
“Permitted activities” are not allowed under all circumstances. An activity that is “permitted” is still not allowed if the activity:
D. METRICS REPORTING
The Rule requires banking entities with significant trading operations to report certain quantitative measurements designed to monitor certain trading activities. The reporting requirements would be phased in based on the type and size of the firm’s trading activities. A banking entity that meets certain thresholds must furnish the following quantitative measurements:
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this Alert or would like to discuss the topic further, please contact your Foley attorney or the following:
Terry D. Nelson
Bernardo O. Ainza
Los Angeles, California
1 The Volcker Rule is implemented by Section 619 of the Dodd-Frank Act; it is named for former Federal Reserve Chairman Paul Volcker. Section 619 of the Dodd-Frank Act added a new Section 13 to the Bank Holding Company Act of 1956 (“BHC Act”) (codified at 12 U.S.C. 1851).
2 Sec. 8(a) of the International Banking Act of 1978 provides that “(1) any foreign bank that maintains a branch or agency in a State, (2) any foreign bank or foreign company controlling a foreign bank that controls a commercial lending company organized under State law, and (3) any company of which any foreign bank or company referred to in (1) and (2) is a subsidiary shall be subject to the provisions of the Bank Holding Company Act.” Thus, while Section 8 of the International Banking Act does not “treat as a bank holding company” such foreign banks, it does “subject” them to the Act.