FEDERAL REGULATOR RELEASES FINAL VOLCKER RULE
On 10 December 2013, US federal financial regulatory agencies released final rules (the "Final Rule" or the "Volcker Rule") implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). Section 619 created Section 13 in the Bank Holding Company Act to generally 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").
On November 7, 2011, the Board of Governors of the Federal Reserve (the "Board"), 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 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. The Final Rule will be effective on 21 July 2015, with the exception of certain reporting requirements discussed below, which have an earlier effective date.
The Volcker Rule applies to any banking entity, defined in both the Proposed Rule and Final Rule as (1) a bank; (2) any company that controls a bank; (3) any company treated as a bank holding company under section 8 of the International Banking Act; or (4) any affiliate or subsidiary of any such entity.
Proprietary Trading Prohibitions. 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.
Among other exemptions to the general prohibition on propriety trading, the Final Rule makes important revisions to 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. Therefore, the Final Rule provides for a foreign trading exemption if:
- the banking entity engaging as principal, making the trading decision, and providing the financing is not located in the US or organized under the laws of the US or any state;
- the purchase or sale 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; and
- the purchase or sale is not conducted with or through any US entity, other than:
- the foreign operations of US entities;
- 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.
Covered Fund Activities Prohibitions. A banking entity may not, as principal, directly or indirectly acquire or retain any ownership interest in or sponsor a covered fund. An ownership interest is any equity, partnership, or other similar interest. To sponsor a covered fund means:
- to serve as a general partner, managing member, trustee, or commodity pool operator of a covered fund;
- to select or control a majority of the directors, trustees, or management of a covered fund; or
- to share the same name or a variation of the same name with a covered fund.
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 organised 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.
In response to critical public comments which asserted that part (3) of the Proposed Rule's definition of covered fund was overly broad, exceeded statutory authority, and potentially violated international treaties, the Final Rule makes meaningful changes to the definition. Under the Final Rule, a foreign fund is an entity that:
- is organised or established outside the US and the ownership interests are offered and sold solely outside the US; and
- is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities.
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 organised under the laws of the US or any state. Therefore, a foreign fund may be a covered fund with respect to a US banking entity that sponsors it, but not a covered fund with respect to a foreign bank that invests in the fund solely outside the US.
In addition, the Final Rule retains exemptions provided in the Proposed Rule, including an exemption for certain 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 organised 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.
By 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.
Compliance Requirements. The Final Rule makes the following changes to compliance program and reporting requirements:
- Compliance Program: Banking entities are expected to establish a compliance program as soon as practicable, but in no event later than the effective date, which has been extended to July 21, 2015. The Final Rule requires a banking entity to comply with enhanced compliance program requirements where:
- the banking entity is required to report on its proprietary trading activities (see below);
- the banking entity has consolidated assets of $50 billion or more; or
- the applicable federal regulator notifies the banking entity that it must comply with the enhanced requirements.
- Reporting Requirements: The Final Rule reduces the number of banking entities subject to reporting requirements by raising the trading activity threshold from $1 billion under the Proposed Rule, to:
- $50 billion beginning on June 30, 2014;
- $25 billion beginning on April 30, 2016; and
- $10 billion beginning on December 31, 2016.
Banking entities with trading activity of $50 billion or more are required to report on a monthly basis, while all other banking entities that are or will be subject to the reporting requirement will only need to report on a quarterly basis. In addition, the Final Rule reduces the number of trading measurements banking entities must report from seventeen in the Proposed Rule to seven. Banking entities should note that the Board's decision to extend the effective date for Volcker Rule compliance to July 21, 2015 does not apply to reporting requirements, which become effective as early as June 30, 2014 for some banking entities.
- Covered Fund Documentation: Banking entities with more than $10 billion in total consolidated assets must maintain records on fund-related activities and investments, particularly on the exclusion or exemption relied upon in determining that a fund is not a covered fund for purposes of the Volcker Rule.
- Simplified Programs for Less Active Banking Entities: Banking entities that do not engage in activities covered by the Volcker Rule are no longer required to develop policies and procedures designed to ensure they do not engage in prohibited activities. Under the Final Rule, these banking entities need only develop a compliance program before engaging in any such activities. Banking entities with total consolidated assets of $10 billion or less that engage in activities covered by the Volcker Rule may satisfy the compliance program requirements by making appropriate references to the Volcker Rule in their existing policies and procedures, but are not required to develop separate compliance programs specific to the Volcker Rule.
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