After a long and suspenseful wait, a proposal to implement the
so-called "Volcker Rule" under Section 619 of the
Dodd-Frank Act1 is finally seeing the light of day. The
Federal banking regulators (the Federal Reserve Board
("Federal Reserve"), the Office of the Comptroller of the
Currency ("OCC"), and the Federal Insurance Deposit
Corporation ("FDIC")), together with the Securities and
Exchange Commission ("SEC") (collectively, the
"Agencies"), have issued a joint release
("Proposal" or "Proposing Release") containing
a proposed rule ("Proposed Rule") implementing Section
619. The Commodity Futures Trading Commission ("CFTC")
has been consulted but is not at this time participating in the
Agencies' Proposal.2
Section 619 added new Section 13 to the Bank Holding Company Act
("BHCA").3 Section 13 generally prohibits any
"banking entity" from engaging in "proprietary
trading" or from acquiring or retaining an "ownership
interest" in or "sponsoring" a hedge fund or private
equity fund ("covered fund activities"). Banking entities
are, however, still allowed to provide services to their customers.
As discussed more fully below, a "banking entity"
includes insured depository institutions and their holding
companies, companies treated as bank holding companies for purposes
of Section 8 of the International Banking Act of 1978
("foreign banking entities"), and affiliates and
subsidiaries of any of these companies.
Section 13 also provides that nonbank financial companies
supervised by the Federal Reserve ("SIFIs") that engage
in proprietary trading or covered fund activities will be subject
to additional capital requirements and quantitative limits. Because
the Financial Stability Oversight Council has not yet finalized the
criteria for SIFI designation, the Federal Reserve is not currently
proposing to impose any capital requirements or quantitative limits
on SIFIs.4
The Agencies are proposing a common rule, comprised of four
subparts and three appendices, to maximize consistency and clarity
across banking entities. Although covered entities will only be
subject to the rule of one Agency, i.e., the Agency with
primary regulatory authority over the entity under Section 13, each
Agency's rule will be uniform.5 The Proposal: (i)
describes the key characteristics of both prohibited and permitted
activities; (ii) requires each banking entity to establish a
comprehensive compliance program; and (iii) requires the
calculation and reporting of extensive quantitative data to assist
the Agencies and the banking entities to identify activity that
might constitute impermissible proprietary trading activity.
Under the Dodd-Frank Act, the final Volcker Rule must become
effective on July 21, 2012, although banking entities will have a
period after that to come into compliance. In February 2011, the
Federal Reserve issued a conformance rule, which is intended to
allow markets and market participants time to adjust to the new
requirements and prohibitions that will be contained in the final
Volcker Rule.6 The conformance rule is included in the
Federal Reserve's version of the Proposed Rule as Appendix E.
Although banking entities may use the conformance period and any
extensions to bring their activities into compliance with the new
rules, the compliance program as well as the reporting and
recordkeeping requirements—with some exceptions for
reporting that cannot be done until activities are
conformed—will be effective on July 21, 2012, to meet the
statutory mandate. The Proposing Release requests comment on
whether this deadline will give banking entities enough time to
implement the required changes. The Agencies also intend to use the
conformance period to refine and finalize any new reporting
requirements they deem necessary.
The Proposed Rule is extremely complex and, given that the Agencies
seek comment on more than 400 separate questions, is most likely
still quite unsettled.
While the Agencies assert that the Proposed Rule is intended to
minimize burdens on smaller banking entities, it is clear that it
would entail enormous new compliance costs for all banking entities
engaging in covered activities. The Agencies estimate that the
reporting and recordkeeping requirements alone would require more
than six million hours in the first year.
Comments are due by January 13, 2012.
This alert first provides a brief overview of the Proposed Rule and
then discusses the Proposed Rule in greater detail.
I. Overview
Section 13 generally contains two separate prohibitions. First,
banking entities are prohibited from engaging in proprietary
trading. Second, banking entities are prohibited from acquiring or
retaining an ownership interest in or sponsoring a covered fund.
The statute contains numerous exceptions to and exemptions from the
two general prohibitions.
Subpart A of the Proposed Rule, comprising
Sections __.1 and __.2, describes the authority, scope, and purpose
of the Proposed Rule and defines some of the commonly used terms in
the Proposed Rule, including "banking entity" and
"resident" of the US.
Subpart B of the Proposed Rule, comprising
Sections __.3 through __.8, addresses prohibited and permitted
trading activities. It also defines relevant terms, such as
"proprietary trading," and "covered financial
position," and lays out the exemptions from the prohibition,
which include certain underwriting activities, market
making-related activities, risk-mitigating hedging activities,
trading in government obligations, trading on behalf of customers,
trading by a regulated insurance company, and trading by a foreign
banking entity solely outside of the US. Even if otherwise allowed,
activities that would involve a material conflict of interest,
result in a material exposure of the banking entity to a high-risk
asset or trading strategy, or pose a threat to the entity's
safety and soundness or to US financial stability are prohibited.
Subpart B also contains compliance, reporting, and recordkeeping
requirements applicable to covered trading activities and requires
banking entities with significant trading activities
(i.e., those with average consolidated global trading
assets and liabilities of at least $1 billion) to report certain
quantitative measurements in connection with their trading
activities pursuant to Appendix A.
Subpart C of the Proposed Rule, comprising
Sections __.10-__.19, prohibits or restricts acquiring or retaining
an ownership interest in, or sponsoring, a "covered
fund," and also defines relevant terms, such as
"ownership interest" and "sponsor," and
establishes exemptions from the restrictions. Banking entities are
permitted to organize and offer a covered fund if they satisfy a
multi-faceted set of requirements, including, among others, that:
i) they provide only bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services and the
covered fund is organized and offered only in connection with the
provision of such services; ii) they do not acquire or retain an
ownership interest in the fund except as permitted; iii) they do
not guarantee or otherwise insure the fund's obligations; iv)
they do not share the fund's name; and v) they make certain
disclosures to actual and prospective customers.
Subpart C describes the ownership interests that are permitted,
basically limiting a banking entity's per-fund ownership to no
more than three percent of the ownership interests in the fund and
its aggregate fund investment to no more than three percent of the
banking entity's Tier 1 capital. As with covered trading
activities, banking entities may engage in certain risk-mitigating
hedging activities and activities conducted solely outside of the
US. They also may invest in certain types of funds, such as small
business investment companies, where the investment has been deemed
to be in the public interest, and in asset-backed securitizations
consisting solely of loans and other permitted products. In
addition, certain other covered fund activities are deemed to be
permissible, such as separate accounts used solely for bank-owned
life insurance, and certain joint ventures and other structures
that are considered not to pose safety and soundness or systemic
risk. Subpart C contains compliance, reporting, and recordkeeping
requirements for covered fund activities and also prohibits
material conflicts of interest and material exposure to high-risk
assets and trading strategies.
Subpart D of the Proposed Rule, comprising
Sections __.20 and __.21, sets forth the requirements for the
compliance program relating to both the trading activities and fund
activities prohibitions and addresses termination of activities or
investments and penalties for violations. In general, Subpart D
calls for enhanced compliance programs, including written policies
and procedures, internal controls, a management framework,
independent compliance testing, and extensive recordkeeping.
Appendix A sets forth the quantitative
measurements that significant banking entities should compute and
report with respect to their trading activities.
Appendix B provides "commentary" that is
intended to help banking entities and regulators distinguish
between permitted market making-related activities and prohibited
proprietary trading.
Appendix C sets forth minimum requirements and
standards for the Subpart D compliance programs, including for
banking entities with significant trading activities. The test for
banking entities to be considered significant under Subpart D is
different from the Subpart B test, which only requires that average
consolidated global trading assets and liabilities be at least $1
billion. For purposes of Appendix C, a banking entity will be
considered significant if, as an alternative to the $1 billion
trading threshold, its average consolidated trading assets and
liabilities are at least 10% of its assets, or it invests in or has
relationships with large covered funds, as discussed more fully in
Section II.B.6 below. In addition, the entity's primary
regulator may treat it as significant if it deems such treatment
appropriate.
II. Discussion
A. Proprietary Trading Prohibition and Exemptions (Subpart B)
1. Prohibition
The Proposed Rule prohibits a banking entity from engaging in
proprietary trading unless otherwise permitted under the rule. The
Proposal generally defines "proprietary trading" as
engaging as principal for the "trading account" of a
banking entity in any transaction to purchase or sell one or more
"covered financial positions." The Proposed Rule
clarifies that proprietary trading does not include acting as
agent, broker, or custodian for an unaffiliated third party.
Banking Entities. A "banking entity" includes (i) any
insured depository institution; (ii) any holding company of an
insured depository institution; (iii) any foreign banking entity;
and (iv) any affiliate or subsidiary of any of these entities. To
avoid an anomalous outcome not intended by the statute, a banking
entity does not include any affiliate or subsidiary that is a
"covered fund" (defined below) or that is controlled by
such a fund. The Proposed Rule will apply to the activities of a
banking entity regardless of whether such activities are otherwise
authorized under other applicable law.
Covered Financial Positions. A "covered financial
position" is any position (including long, short, synthetic or
other positions) in securities, derivatives (swaps and
security-based swaps, as will be defined by the SEC and the CFTC),
commodity futures, and options on any such instruments. Covered
financial positions expressly exclude loans, spot foreign exchange,
or spot commodities. However, they include positions in these
instruments. Loans are broadly defined as any loan, lease,
extension of credit, or secured or unsecured receivable. This
definition does not, however, include any asset-backed security
issued in connection with a loan securitization or otherwise backed
by loans. Although Section 13 allows the Agencies to extend the
scope of the proprietary trading prohibition to other financial
instruments not enumerated in the statute, the Agencies have
declined to do so for now.
Trading Accounts. Section 13 defines a "trading account"
as "any account used for acquiring or taking positions in
securities [or certain other 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. The Proposal recognizes the difficulty of
clearly identifying the purpose for which a position is taken and,
in order to "provide banking entities with greater
clarity," the Proposed Rule identifies three
"prongs" that will, if met, cause the relevant account to
be a "trading account."
(i) An account is considered a trading account when covered
financial positions are taken therein principally for the purpose
of short-term resale, benefitting from short-term price movements,
realizing short-term arbitrage profits, or hedging another trading
account position. This first prong will be construed consistently
with the Federal banking agencies' Market Risk Capital
Rules' approach to identifying positions taken with short-term
trading interest.7
"Short-term" is not defined. The Agencies note that they
expect to consider a variety of factors and information, including
the new quantitative measurements the Proposed Rule will require.
With respect to this prong only, the Proposed Rule includes a
presumption that any account used to take a covered financial
position held for 60 days or less is a trading account. A banking
entity may rebut this presumption if it can demonstrate that the
covered financial position, either individually or as a category,
was not acquired or taken principally for any of the purposes
described above.
(ii) With respect to a banking entity subject to the Market Risk
Capital Rules, a trading account includes an account containing any
positions in financial instruments subject to the prohibition on
proprietary trading that are treated as "covered
positions" under those rules (with some limited exceptions).
The Proposal notes that the Market Risk Capital Rules use the term
"trading account" as that term is defined in the banking
entity's Call Report,8 which is substantially
identical to the definition in Section 13 of the BHCA, and which
incorporates the concept of taking short-term
positions.9
(iii) A trading account includes any account in which covered
financial positions are taken by banking entities that are
registered securities dealers, swap or security-based swap dealers,
or certain government securities dealers in connection with their
registered activities. This would include any covered financial
position taken by a banking entity engaged in the business of a
dealer, security-based swap dealer, or swap dealer outside of the
US as well, if such position is taken in connection with the
activities of such business. These positions will be deemed part of
a trading account even if held for more than 60 days.
Expressly excluded from the definition of "trading
account" under all three of the above prongs are accounts
used: (i) for "bona fide liquidity management
purposes"; (ii) to take positions under repurchase or reverse
repurchase arrangements or securities lending transactions; or
(iii) in connection with certain positions of derivatives clearing
organizations or clearing agencies.
To meet the standard of "bona fide liquidity
management purposes" under the Proposed Rule, a liquidity
management plan must be documented and meet five separate criteria,
including that: (i) it specifically authorize particular
instruments used for liquidity management purposes; (ii) it be used
principally for the purpose of managing the liquidity of the
banking entity; (iii) the positions taken be limited to highly
liquid financial instruments; (iv) positions be limited to the
banking entity's documented near-term funding needs; and (v)
the plan be consistent with the relevant Agency's supervisory
guidance.
2. Exemptions From the Prohibition, i.e. Permitted
Activities
a) Underwriting
The Proposed Rule permits a banking entity to buy or sell a covered
financial position in connection with underwriting activities that
are designed not to exceed reasonably expected near-term demands of
"clients," "customers," or
"counterparties"10 and that meet seven
separate criteria enumerated in the rules, including the
following:
(i) The banking entity has established an internal compliance
program;
(ii) The covered financial position must be a security;
(iii) The transaction must be solely in connection with a
"distribution" in which the banking entity acts as
"underwriter" (as both terms are defined in the SEC's
Regulation M)11;
(iv) The banking entity must be appropriately registered;
(v) As set forth in the statute, the underwriting activities must
be designed not to exceed the reasonably expected near-term demands
of clients, customers, and counterparties;
(vi) These activities must be designed to generate revenues
primarily from fees, commissions, underwriting spreads, or other
income, and not from appreciation in the value of related covered
financial positions held by the banking entity; and
(vii) Compensation arrangements relating to the underwriting must
not encourage proprietary risk-taking.
b) Market Making
The Proposal recognizes the difficulty of clearly distinguishing
between permissible market making activities, i.e., those
designed to provide intermediation and liquidity services to
customers, and prohibited proprietary trading activities,
i.e., those involving the generation of profit through
speculative risk-taking, because market making-related activities
sometimes require the taking of positions as principal in amounts
and over periods that differ significantly by asset class and
market conditions.
To ensure that banking entities are engaged in "bona
fide market making," the Proposed Rule sets out seven
criteria, all of which a banking entity must meet in order to rely
on this exemption. Some of these criteria are similar to those
required for the underwriting exemption and are set forth
below.
(i) The banking entity must implement a targeted compliance program
consistent with Subpart D of the Proposed Rule.
(ii) The trading desk or organization unit purchasing or selling
the covered financial position must hold itself out on a regular
and continuous basis as being willing to buy and sell that position
(similar to the definition of "market maker" in Section
3(a)(38) of the Securities Exchange Act of 1934 ("Exchange
Act")). Appropriate indicia of "holding oneself out"
would differ depending on the liquidity of the market for the
covered financial position. Block positioning and taking positions
in anticipation of customer demand would generally be included in
the exemption if undertaken for the purpose of intermediating
customer trading.
(iii) The market making-related activities must be designed not to
exceed the reasonably expected near-term demands of clients,
customers, or counterparties. This measure must be specific,
i.e., based on particular factors relevant to a unique
customer base and not just a "simple expectation of future
price appreciation and the generic increase in marketplace demand
that such price appreciation reflects."
(iv) The banking entity must be appropriately registered (or
exempt) in connection with the covered financial position.
(v) Revenues must come primarily from fees, commissions, spreads,
or other income not attributable to price appreciation.
(vi) Compensation incentives must be designed so as not to
encourage or reward proprietary risk-taking. Appendix B of the
Proposed Rule explains how the Agencies would assess compensation
incentives.
(vii) Activities must be consistent with the commentary provided in
Appendix B, which discusses the factors the Agencies will use to
guide their distinctions between market making-related activities
and prohibited proprietary trading activities.
Hedging activities, which we discuss as a separate exemption below,
are also considered market making-related activities if they are
conducted in order to reduce the specific risks to the banking
entity in connection with or related to individual or aggregated
positions, contracts, or other holdings acquired pursuant to the
market making exemption, and the hedging transaction meets
the criteria set out in the exemption for hedging activity.
c) Risk-Mitigating Hedging
The Proposed Rule permits a banking entity to buy or sell a covered
financial position if the transaction is made for purposes of
risk-mitigating hedging. Recognizing that the purpose of a
transaction is often difficult to determine, especially in
retrospect, the Agencies once again propose a set of seven criteria
that a banking entity must satisfy to rely on the risk-mitigating
hedging exemption. These criteria are set forth below.
(i) Implementation of a programmatic compliance regime.
(ii) Written hedging policies and procedures which, for banking
entities with significant trading activity, include written
policies and procedures at the trading unit level with
"clearly articulated trader mandates for each
trader."
(iii) Transactions must hedge or mitigate one or more specific
risks, such as market risk, counterparty or other credit risk,
currency, foreign exchange, or interest rate risk, or basis risk,
arising in connection with and related to individual or aggregated
positions, contracts, or other holdings of the banking entity.
Banking entities would also be permitted to engage in "dynamic
hedging," where material changes in risk resulting from
permissible activities or from certain market movements might
require a corresponding change to the entity's hedge positions.
In addition, anticipatory hedging may be appropriate in some
circumstances.
(iv) Transactions must be reasonably (and not merely
"tangentially") correlated to the risks they intend to
hedge.
(v) The hedging transaction cannot give rise to significant
unhedged exposures.
(vi) Any hedging transaction must be subject to continuing review,
monitoring, and management.
(vii) Related compensation arrangements must not reward proprietary
risk-taking.
In addition to satisfying the above criteria, banking entities must
document certain hedging transactions at the time the hedge is
established. Documentation must include the purpose of the
transaction and identify the risks of the individual or aggregated
positions, contracts, or other holdings the transaction is designed
to mitigate.
d) Other Exemptions
In addition to the exemptions discussed above, the statute exempts
from its proprietary trading prohibition trading in government
obligations, trading on behalf of customers, trading by a regulated
insurance company, and trading by foreign banking entities.
Although the statute grants the Agencies authority to exempt
additional activities, the Agencies have decided not to issue any
discretionary exemptions at this time.
i) Trading in Government Obligations
The Proposed Rule permits trading in general and limited
obligations of the US and US agencies, and of states and political
subdivisions thereof. It also allows trading in obligations,
participations, or other instruments issued by a government
sponsored enterprise.
ii) Trading on Behalf of Customers
To satisfy the statutory exemption for trading on behalf of
customers, a transaction will have to fall within one of the
following three categories:
(i) the banking entity acts as investment adviser, commodity
trading advisor, trustee, or in another fiduciary capacity, and the
transaction is for the customer's account and must involve only
covered financial positions that the customer beneficially
owns;
(ii) the banking entity acts as riskless principal; or
(iii) the banking entity is a regulated insurance company, the
transaction is for a "separate account" of the
company's insurance policyholders, is conducted in accordance
with applicable investment laws, regulations, or guidelines, and
all profits and losses from the transaction inure to the benefit of
that account.
A "separate account" is an account established or
maintained by a regulated insurance company under which income,
gains, and losses from assets allocated to the account, whether or
not realized, are, in accordance with the applicable contract,
credited to or charged against that account without regard to other
income, gains, or losses of the insurance company.
iii) Trading by a Regulated Insurance Company
In addition to permitting trading in the separate account of a
banking entity that is also a regulated insurance company, the
Proposed Rule separately permits the insurance company or an
affiliate to buy or sell a covered financial position if it is
buying or selling for the insurance company's general account
and acting in compliance with applicable investment laws,
regulations, or guidelines that have been deemed sufficient by the
applicable Federal banking agency to protect the safety and
soundness of the banking entity and US financial stability. An
insurance company general account is defined as all the assets of
the company that are not legally segregated and allocated to
separate accounts under applicable state law.
iv) Trading by Foreign Banking Entities
In an effort to limit the extraterritorial reach of the proprietary
trading prohibition while also preserving US competitiveness, the
Proposed Rule permits certain foreign banking entities to engage in
proprietary trading activities that occur solely outside of the US.
A banking entity organized under US or state law (and the
subsidiaries and branches of any such entity) will not be able to
rely on the exemption. A US branch or subsidiary of a foreign
banking entity also will not be able to use the exemption.
To qualify for the exemption, a foreign banking entity must conduct
the transaction in compliance with Sections 4(c)(9) of the
BHCA.12 Section 4(c)(9), which has been implemented as
Subpart B of the Federal Reserve's Regulation K, sets out a
number of conditions and requirements that a foreign banking entity
must generally meet in order to rely on that provision's
authority, including that more than half of its worldwide business
is banking and that more than half of its banking business is
outside of the US, as determined by factors set forth in the rule
(which largely mirror the test under Section 4(c)(9)).
A transaction will be considered to have been conducted solely
outside of the US if: (i) the transaction is conducted by a banking
entity not organized under the laws of the US or states; (ii) no
party is a US resident, broadly defined; (iii) no personnel of the
banking entity directly involved in the transaction is physically
located in the US; and (iv) the transaction is executed wholly
outside of the US.
e) Other Prohibitions: Material Conflicts of Interest
Even if trading is otherwise permitted, the statute prohibits
transactions or activity that would involve or result in a material
conflict of interest between a banking entity and its clients,
customers, or counterparties, result in a banking entity's
material exposure to a high-risk asset or trading strategy, or pose
a safety and soundness or systemic threat. The Proposed Rule
defines "material conflict of interest," "high-risk
asset," and "high-risk trading strategy."
A material conflict of interest will be deemed to exist if a
banking entity engages in any transaction, class of transactions,
or activity that would involve or result in its interests being
materially adverse to the interests of its client, customer, or
counterparty with respect to the transaction, class of
transactions, or activity, unless the banking entity has
appropriately addressed and mitigated the conflict through
disclosure or information barriers. The mere fact of being on the
opposite side of a transaction from a client, customer, or
counterparty will not constitute a material conflict if the
transaction is a properly conducted permitted activity.
A high-risk asset under the Proposed Rule is an asset or group of
assets that would, if held by the banking entity, significantly
increase the likelihood that the banking entity would incur a
substantial financial loss or fail. A high-risk trading strategy
similarly is one that would significantly increase the likelihood
that a banking entity conducting the strategy would incur a
substantial financial loss or fail.
3. Compliance Program, Reporting, and Recordkeeping
All covered banking entities will generally be required to
establish a compliance program and comply with onerous reporting
and recordkeeping requirements. In addition, banking entities with
significant trading activity will also be required to comply with
significant quantitative measure reporting requirements. Banking
entities that do not engage in prohibited activities will not be
required to adopt a new compliance program as long as their
existing policies and procedures include measures designed to
prevent the entity from engaging in these activities.
The compliance program for all banking entities engaging in covered
trading must, at a minimum, include: (i) internal written policies
and procedures reasonably designed to document, describe, and
monitor the trading activities and covered fund activities; (ii) a
system of internal controls reasonably designed to monitor and
indentify potential areas of noncompliance; (iii) a management
framework with clearly delineated lines of responsibility; (iv)
independent testing; (v) training; and (vi) record creation and
retention for at least five years.
Appendix A, which must be incorporated into the banking
entity's compliance program, requires banking entities with
significant trading activities to record and report to their
primary financial regulator certain quantitative measures. Measures
are required to be calculated daily and reported monthly. These
requirements, which vary depending on the size and nature of the
trading activities and are required at the trading unit level, are
intended to assist the banking entity and the regulators to
distinguish between market making and proprietary trading and also
to determine whether trading activity has resulted in the banking
entity's material exposure to high-risk assets and trading
strategies. Requirements are significantly more burdensome for
banking entities with gross trading assets and liabilities of at
least $5 billion and somewhat less onerous for banking entities
with gross trading assets and liabilities between $1 billion and $5
billion. The Proposal notes that the requirements for any of these
entities, while necessary, may not be sufficient to identify
impermissible activities and thus an adequate compliance program
might require more. The Proposed Rule does not contain numerical
thresholds for the quantitative measurements, but it appears from
the Proposal that the Agencies would generally favor some
thresholds. They have requested comment on whether to include
thresholds in order to provide banking entities with greater
clarity.
B. Covered Fund Activities and Investments (Subpart C)
1. General Prohibition and Definitions
Section 13 of the BHCA generally prohibits a banking entity
from acquiring and retaining any ownership interest in, or acting
as sponsor to, a covered fund. As with the proprietary trading
prohibition, the statute includes a number of exemptions. The
Proposed Rule's prohibition would apply to a banking entity
engaging in covered activities as principal, directly or
indirectly.
A "covered fund" is defined in the statute as "any
issuer that would be an investment company, as defined in the
[Investment Company Act], but for [S]ection 3(c)(1) or 3(c)(7) of
that Act," or any similar fund that the Agencies determine to
include. The Proposed Rule tracks the statute by including hedge
funds and private equity funds in the definition. It also includes
commodity pools and any foreign equivalent of a hedge fund, private
equity fund, or commodity pool. However, recognizing that the
Section 3(c)(1) and 3(c)(7) exclusions are relied on by a wide
variety of entities that would otherwise be considered
"investment companies," but that do not typically engage
in investment or trading activities, the Proposed Rule excludes any
issuer (including an issuer of asset-backed securities) that can
rely on any other exclusion or exemption from the
definition of "investment company" under the Investment
Company Act.
The Proposed Rule defines "ownership interest" broadly to
mean any equity, partnership, or other similar interest in a
covered fund, whether or not it is a voting interest, as well as
any derivative of that interest. Thus, if a debt security of a
covered fund has similar characteristics to an equity interest
(e.g., it provides the holder with voting rights or the ability to
share in the profits or losses), it could be considered an
ownership interest. "Carried interest" will generally not
be included in the definition of "ownership interest."
Thus, the Proposed Rule permits a banking entity to receive an
interest as performance compensation for services it or one of its
affiliates or employees provides to a covered fund if certain
conditions are met.
A banking entity would act as a "sponsor" to a covered
fund if it exercises some control over the fund. Thus, a banking
entity that serves as a general partner, managing member, trustee,
or commodity pool operator of a fund, or that selects or controls a
majority of the fund's directors, trustees, or management, or
that shares a name or a similar name with the fund, will be deemed
to sponsor the fund. However, a trustee that does not exercise
investment discretion in a covered fund would not be
included.
2. Permitted Activities
The statutory prohibition generally would not apply to the
acquisition or retention of an ownership interest by a banking
entity that acts in a fiduciary capacity or as a custodian, broker,
or agent for an unaffiliated third party. It also would not apply
to certain banking entities that are "qualified plans"
under Section 401 of the Internal Revenue Code or to directors or
employees of a banking entity acting in their personal capacity and
who are directly engaged in the provision of advisory services to
the covered fund. The prohibition also would not cover prime
brokerage transactions, which are defined in the Proposed Rule to
mean the provision of services such as custody, clearance,
securities borrowing or lending support, trade execution, or
financing, data, operational, and portfolio management
support.
Thus, the Proposed Rule will allow banking entities to continue to
engage in traditional asset management and advisory businesses,
such as organizing and offering a covered fund, as long as
all of the conditions enumerated in the Proposed Rule are
satisfied.
a) Exemption for Bona Fide Fiduciary Services
The banking entity must provide bona fide trust,
fiduciary, investment advisory, or commodity trading advisory
services and the covered fund must be organized and offered only in
connection with those services and only to the banking entity's
customers of those services. The banking entity must also comply
with ownership and other restrictions and limitations and must make
clear disclosure to any prospective or actual investor of the
entity's role in the fund, that the fund is not insured by the
FDIC, and that losses will be borne by the investor.
The Proposed Rule does not explicitly require a pre-existing
customer relationship. Rather, it focuses on the idea that a
banking entity may not organize and offer a covered fund as a means
of investing in the fund or its assets for itself. Recognizing that
substantially similar investment advisory services are subject to
variations in functional regulation, the Proposed Rule does not
define bona fide services.
b) Permitted Investments
A banking entity may acquire or retain a limited investment
interest in a covered fund that it or an affiliate organizes and
offers. The Proposed Rule contains both a per covered fund and an
aggregate covered funds investment limitation. The banking entity
may initially provide the fund with sufficient equity to allow the
fund to attract unaffiliated investors. The banking entity will be
required to seek such investors actively and to reduce its own seed
investment to no more than three percent of the total outstanding
ownership interests of the fund within one year of the establishing
the fund. After that time, the banking entity's investment may
not exceed three percent of the total outstanding ownership
interests in the fund. It also may not invest more than three
percent of its Tier 1 capital in all covered funds. A banking
entity may seek an extension from the Federal Reserve for
compliance with the per-fund limitation.
c) Restrictions on Certain Transactions or Relationships
The Proposed Rule generally prohibits transactions or relationships
by a banking entity with a covered fund that would be a
"covered transaction" under Section 23A of the Federal
Reserve Act. However, any transaction permitted under new Section
13(f) of the BHCA (Dodd-Frank Section 619), including prime
brokerage transactions and the acquisition or retention of an
ownership interest in a covered fund in accordance with Subpart C
of the Proposed Rule, that otherwise would have been considered a
"covered transaction" under Section 23A and thus
prohibited, is nevertheless permissible under the Proposed
Rule.
Any transaction that is specifically exempted by the Federal
Reserve pursuant to its authority under Section 23A of the Federal
Reserve Act to exempt purchases of "real and personal
property" would, by definition, not be a "covered
transaction" under Section 23A and thus would not be subject
to the prohibition in the Proposed Rule.
Any permitted activity will be subject to Section 23B of the
Federal Reserve Act as if the banking entity were a member bank and
the covered fund were an affiliate of that entity, i.e.,
permitted transactions must be at least as favorable to the banking
entity as they would be if the covered fund were an unaffiliated
entity.
d) No Guarantees
To prevent a banking entity from "bailing out" a covered
fund in which it has an interest, the Proposed Rule prohibits the
banking entity from, directly or indirectly, guaranteeing,
assuming, or otherwise insuring the obligations or performance of a
covered fund or of any covered fund in which that fund
invests.
e) No Sharing of Names
A banking entity that organizes and offers a fund (and its
affiliates) may not share a name or a variation of the same name
with a covered fund for any purpose. The fund also may not use the
word "bank" in its name.
f) Limitations on Director or Employee Activities
The banking entity's directors and employees may not take or
retain an ownership interest in a covered fund unless they are
directly engaged in providing investment advisory or other services
to the fund.
g) Disclosures
As noted above, the Proposed Rule also requires banking entities
engaging in covered fund activities to disclose "clearly and
conspicuously" to any prospective or actual investor in the
covered fund, among other things, that the fund's losses will
be borne solely by investors and that the fund is not insured by
the FDIC. The disclosure requirements may be met by including them
in the fund's offering documents.
3. Exemptions from the Prohibition
Because such investment is deemed to be in the public interest, the
statute and the Proposed Rule permit banking entities to invest in
one or more Small Business Investment Companies ("SBICs")
and similar funds. As with the exemption from the prohibition on
proprietary trading, certain limited risk-mitigating hedging
activities in connection with covered fund activities are also
permitted. Similarly, foreign banking entities may engage in
covered fund activities if those activities occur solely outside of
the US. Finally, a covered fund that issues loan-based asset-backed
securities is also exempt from the activities prohibition.
a) Permitted Hedging Activities
For the hedging exemption to apply, the transaction with the
covered fund must be made in connection with and must be related to
individual or aggregate positions, contracts, or other holdings of
the banking entity and must be designed to reduce the specific
risks to the banking entity from those positions, contracts, or
holdings. A banking entity could potentially acquire or retain an
ownership interest in a covered fund as a hedge where it (i) acts
as "riskless principal" to facilitate customer exposure
to the covered fund; and (ii) covers a compensation arrangement
with an employee who directly provides investment advisory or other
services to the covered fund. Because of the perceived potential
for abuse, the Agencies have proposed a multi-faceted test for
whether the hedging exemption would be available. In addition to
satisfying the requirements discussed above and additional
requirements relating to the hedge itself, the banking entity must
establish a comprehensive internal compliance program and hedging
must be conducted in compliance with written policies and
procedures under that program. Many of these requirements are
similar to those proposed for the proprietary trading
risk-mitigating hedging exemption, discussed above in Section
II.A.2.c.
b) Foreign Banking Entities and Activities Outside of the US
As with the exemption from the proprietary trading prohibition,
foreign banking entities whose covered fund activities occur solely
outside of the US will be exempt from the covered fund activities
prohibition as well (see Section II.A.d.4 above for definition of
foreign banking entities). For a covered fund activity to have
occurred solely outside of the US, it must meet three conditions
under the Proposed Rule: (i) it must be conducted by a foreign
banking entity; (ii) no subsidiaries, affiliates, or employees of
the banking entity may be incorporated or physically located in the
US; and (iii) no ownership interest in the fund may be offered or
sold to a US resident.
c) Sale and Securitization of Loans
The Proposed Rule exempts from the covered fund activities
prohibition a covered fund that issues asset-backed securities
where the underlying assets are comprised solely of loans,
contractual rights or assets arising directly from those loans, and
interest rate or foreign exchange derivatives that materially
relate to the terms of those loans or contractual rights or assets
and that are used for hedging with respect to the securitization
structure. The requirement that derivatives "materially
relate" to the terms of the loans is intended to limit the
quantity of derivatives that can be used in a securitization of
loans. In addition, because any such derivatives must be used to
hedge risks that result from any mismatch between the loans and the
related asset-backed securities, the Proposing Release notes that
the Proposed Rule would not allow a credit default swap by an
issuer of asset-backed securities.
4. Discretionary Permitted Activities
The statute permits the Agencies to create additional
exemptions that they deem will protect and promote a banking
entity's safety and soundness and US financial stability. The
Proposed Rule contains three such discretionary exemptions.
a) Bank-owned Life Insurance Separate Accounts
("BOLIs")
Recognizing that investments by banking entities in life insurance
policies that cover key employees do not typically involve
speculative risks and help banking entities reduce their employee
benefit costs, the Proposed Rule permits BOLI investments in
separate accounts even though such accounts would be investment
companies but for a 3(c)(1) or 3(c)(7) exclusion.
b) Investments in Other Covered Funds
Because a number of entities could be forced to change their
corporate structure without any accompanying reduction in risk, the
Proposed Rule permits ownership in or sponsorship of: (i) a joint
venture between the banking entity and another person as long as
the venture is an operating company that does not engage in any
prohibited activity under the Proposed Rule; (ii) an acquisition
vehicle whose sole purpose is to effectuate the merger or
acquisition of an entity with the banking entity or one of its
affiliates; and (iii) a wholly-owned subsidiary of the banking
entity that engages in bona fide liquidity management
services, as described in Section II.A.1, above, and which is
carried on the banking entity's balance sheet.
The Proposed Rule also makes clear that a banking entity's
compliance with the Dodd-Frank risk retention rules will not
constitute prohibited covered fund activities.13 Thus, a
banking entity's investment in or sponsorship of an
asset-backed securities issuer will be permitted up to the amount
of credit risk it is required to retain.
Finally, in order to allow banking entities to manage their risks
more effectively, the Proposed Rule permits a banking entity to
engage in covered fund activities where such activities are done in
the ordinary course of collecting a previous good faith debt.
5. Limitations on Permitted Activities
To the extent that any permitted activity would result in a
material conflict of interest or in the banking entity's
material exposure to a high-risk asset or trading strategy, or
would pose a threat to the banking entity's safety and
soundness or to US financial stability, the exemption or exclusion
from the general prohibition would be unavailable.
6. Compliance Program, Reporting, and Recordkeeping
The compliance requirements for banking entities engaging in
covered fund activities are similar to those required for
proprietary trading activities, discussed above in Section II.A.3.
With respect to covered fund activities, the threshold to be
considered a significant banking entity subject to heightened
compliance requirements is either: (i) aggregate investments of the
banking entity and its affiliates in covered funds where the
average value of those funds over each of the four preceding
calendar quarters is at least $1 billion; or (ii) sponsorship by
the banking entity and its affiliates of one or more covered funds
the average total assets of which are at least $1 billion.
III. Conclusion
The length and complexity of, and the large number of questions in, the Proposed Rule indicate that the debate will continue on both of the core elements of the Proposal, i.e., proprietary trading and covered fund activities. Because the multi-factored tests and extensive compliance requirements laid out in the Proposed Rule will have a significant impact on all affected market participants, we expect to see active regulatory engagement on this Proposal over the next few months.
Footnotes
1. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2. Section 619 requires the CFTC to adopt rules for covered entities for which it is the primary financial regulator. The statute does not require a joint rulemaking, however, and thus the CFTC will likely issue its rule proposal independently of the Agencies.
3. To be codified at 12 USC § 1851.
4. The FSOC issued a reproposed Notice of Proposed Rulemaking on SIFI designation on the same day that the FDIC approved the Proposed Rule. See Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (Oct. 11, 2011), available at www.treasury.gov/initiatives/fsoc/Documents/Nonbank%20Designation%20NPR%20-%20Final%20with%20web%20disclaimer.pdf.
5. The Federal Reserve, the OCC, and the FDIC, jointly, have authority over insured depository institutions under Section 13; the Federal Reserve has authority over holding companies of insured depository institution, companies that are treated as bank holding companies for purposes of Section 8 of the International Banking Act, SIFIs, and any subsidiary of any of these entities (except for subsidiaries for which an appropriate Federal banking agency, the SEC, or the CFTC is the primary financial regulatory agency); and the SEC and CFTC have authority over entities for which they are the primary financial regulatory agency, respectively.
6. Final Rule, Conformance Period for Entities Engaged in Prohibited Proprietary Trading or Private Equity Fund or Hedge Fund Activities, 76 Fed. Reg. 8265 (Feb. 14, 2011).
7. See Proposed Rules, Risk-Based Capital Guidelines: Market Risk ("Market Risk Capital Rules"), 76 Fed. Reg. 1890 (Jan. 11, 2011).
8. A Call Report is the Report of Condition and Income that banks are required to file periodically as to their financial condition.
9. The second prong has been included in anticipation of adoption of the proposed Market Risk Capital Rules in this context. The Agencies expect to revisit this prong if such rules are not adopted largely as proposed.
10. The proposal does not define these terms but seeks comment on whether and how they should be defined.
11.17 CFR Part 242.
12. The statute also references Section 4(c)(13) of the BHCA. However, the Federal Reserve has only applied the 4(c)(13) authority to foreign activities of US banking organizations, which are not eligible for the foreign banking entity exemption.
13. Section 941 of Dodd-Frank added new Section 15G to the Securities Exchange Act. Section 15G requires a banking entity that is a securitizer or originator of an asset-backed security to retain an economic interest in some portion of the credit risk of the securitization. The Agencies have proposed, but not yet finalized, credit risk retention rules. See Proposed Rule, Credit Risk Retention, 76 Fed. Reg. 34010 (Jun. 10, 2011).
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