United States: Volcker Unbound

The regulation that will implement the Volcker Rule was finally issued on December 10, 2013. Major financial institutions around the world will have to review a host of activities and investments in order to comply with the new regime. We discuss below in detail the Rule's prohibition on proprietary trading, its prohibition on sponsoring and investing in private funds, and the impact of these prohibitions on those banking institutions that are headquartered outside the United States. Compliance with the full regulation will be required by July 21, 2015.

Immediately below is a brief summary of the Volcker Rule and the proceedings leading to the final action. Following the summary are separate sections that explain and discuss the significant aspects of the regulation: proprietary trading, private funds, and the impact on banks headquartered outside of the United States. A brief discussion of international ramifications of the Volcker Rule follows.

Shearman & Sterling has prepared the Volcker Assistant©, which may be of use to institutions as they demonstrate required good faith compliance with the rule.1


The Statute

The Volcker Rule was enacted in 2010 by the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank").2 In general, it prohibits banking institutions operating in the United States from engaging in proprietary trading activities and from sponsoring or investing in private funds. A variety of exceptions permit some amount of trading as principal, both for the purpose of satisfying client demands and of hedging the institution's risks, the sponsorship of private funds for purposes of satisfying fiduciary client demands, and some amount of activity outside the United States that would otherwise be impermissible.

While most of the discussion of the impact of the Volcker Rule has focused on risk reduction in commercial banking organizations, the main impetus is cultural, according to former Federal Reserve Chairman Volcker, whose proposal in early 2010 led to its enactment. He explained in a speech: 

The justification for official support and protection of commercial banks is to assure maintenance of a flow of credit to business and individuals and to provide a stable, efficient payment system. Those are both matters entailed in continuing customer relations and necessarily imply an element of fiduciary responsibility. Imposing on those essential banking functions a system of highly rewarded—very highly rewarded—impersonal trading dismissive of client relationships presents cultural conflicts that are hard—I think really impossible—to successfully reconcile within a single institution.3 Despite this justification, almost all of the discussion surrounding the detailed requirements that would enforce the Volcker Rule has focused on the riskiness, or lack thereof, of various activities and investments. Partly this is due to the difficulties that regulatory agencies, especially lawyers, meet when attempting to establish a culture, and in part due to the political process that shaped the Volcker Rule in its final form, where the desire to prohibit future "bail-outs" of global financial institutions came to the forefront. The result is that the resulting requirements focus on the dangers to banking institutions of various activities rather than former Chairman Volcker's concern about highly rewarded impersonal trading polluting client-based business. The two concepts overlap, of course, but client-based activities can nevertheless give rise to significant risks. This leaves a genuine concern that the implementation of the Volcker Rule has gone beyond the concept that underlies it.

The Volcker Rule's prohibition of proprietary trading—for the institution's own account and profit—in financial instruments while allowing customer-serving activities in those same types of financial instruments is at the heart of the difficulty of fashioning a set of detailed requirements intended to implement the prohibition. Similarly, the prohibition on sponsoring or investing in private funds while allowing the sponsorship of such funds in connection with fiduciary activities, again for the purpose of serving customers, entails difficult compromises. The application of the prohibitions and the exceptions is significantly exacerbated when the cross-border activities of institutions are taken into account.

The Regulation

Five Federal regulatory agencies are responsible for interpreting and enforcing the Volcker Rule: the Board of Governors of the Federal Reserve System ("Federal Reserve"), Office of the Comptroller of the Currency ("OCC"), Federal Deposit Insurance Corporation ("FDIC"), Securities and Exchange Commission ("SEC"), and Commodity Futures Trading Commission ("CFTC") (collectively, the "Agencies"). Each one is responsible for certain types of financial institutions with an overlap in certain cases.4

The Agencies issued a notice of proposed rulemaking in October 2011 (the "2011 Proposal").5 After more than two years, the Agencies issued a final regulation, uniform among all of them (the "Final Regulation"), in order to provide detail on how banking institutions are to comply.6 In addition, the Final Regulation imposes a compliance and reporting regime intended to enforce the limits on permissible activities in order to avoid evasions of the main prohibitions.

Effective Date and Period to Conform

The Statute provided that it would become effective two years after enactment, or on July 21, 2012, and that banking entities subject to its requirements would have two more years, until July 21, 2014, to bring existing activities and investment into conformity with final regulations, with authority granted to the Federal Reserve to extend the conformance period, one year at a time, for a total of no more than three additional years.7 The Federal Reserve in 2012 issued a statement that banking entities should "engage in good-faith planning efforts" in order to be prepared to implement final rules when issued.8 Because the Final Regulation has been issued only six months before the July 2014 conformance date, the Federal Reserve issued an order granting a one-year extension to all banking entities until July 21, 2015, noting that it would monitor developments to see if a further extension would be appropriate.9

Litigation was commenced on December 23 by the American Bankers Association and several US banks requesting a stay of one portion of the Final Regulation pertaining to impermissible investments in certain collateralized debt obligations ("CDOs") that may be covered funds.10 The substantive issue is discussed below. The petition requests a stay of enforcement of at least the relevant portion. Further proceedings in the litigation have been delayed until mid-January 2014.

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1 For further information about the Volcker Assistant©, you may wish to visit our micro-site, available at http://www.volckerassistant.com/ .

2 The Volcker Rule is in Section 619 of Dodd Frank, Pub. L. No. 111 203, 124 Stat. 1376 (2010), adding new Section 13 to the Bank Holding Company Act of 1956, as amended ("BHCA"), and codified at 12 USC § 1851. Hereinafter, the statute will be referred to as the "Volcker Rule" or the "Statute".

3 Paul Volcker, William Taylor Memorial Lecture (Sept. 23, 2011) (emphasis in original).

4 For example, the SEC is the primary Federal supervisor of registered broker-dealers, while the Federal Reserve has general "umbrella" supervisory authority over all non-bank subsidiaries of bank holding companies, a category that applies to almost all of the major financial organizations in the United States and a large number of organizations headquartered outside of the United States.

5 76 Fed. Reg. 68,846 (Nov. 7, 2011). If you wish to obtain further information on the 2011 Proposal, you may wish to review our client memorandum issued at that time, "In the Eye of the Beholder: The Volcker Rule Proposal and What It Means" (Oct. 27, 2011), available at http://www.shearman.com/~/media/Files/NewsInsights/Publications/2011/10/In%20the%20Eye%20of%20the%20Beholder%20The%20Volcker%20Rule%20Prop__/Files/View%20full%20memo%20In%20the%20Eye%20of%20the%20Beholder%20%20The%20V__/FileAttachment/IntheEye oftheBeholderTheVolckerRuleProposalandWh__.pdf .

6 The text of the Final Regulation and the supplemental information explaining the decisions made by the agencies (called the "Preamble") can be found at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a1.pdf and http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a2.pdf , respectively. The 2011 Proposal took 127 pages in the Federal Register and posed 383 substantive numbered questions on which comment was requested. The Final Regulation has not yet appeared in the Federal Register, but the version currently available sets out the Final Regulation in 71 pages and the Preamble in 882 pages.

7 12 USC § 1851(c). The provision set the effective date as the earlier of 12 months after the issuance of final rules or two years after the date of enactment. Because the Final Regulation has been issued so much later than contemplated, the July 2014 conformance date is the important one.

8 Federal Reserve System, "Statement of Policy Regarding the Conformance Period for Entities Engaged in Prohibited Proprietary Trading or Private Equity Fund or Hedge Fund Activities," 77 Fed. Reg. 33949 (June 8, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-06-08/pdf/2012-13937.pdf .

9 Federal Reserve System, "Order Approving Extension of Conformance Period" (issued December 10, 2013), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210b1.pdf and Preamble, page 9. Certain reporting requirements imposed on the largest banking entities become effective at dates in 2014, as discussed below.

10 Petition for Review, United States Court of Appeals for the District of Columbia Circuit, American Bankers Association et al. v. Board of Governors et al. (13-1310, filed December 23, 2013).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Barnabas W.B. Reynolds
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