United States: Dodd-Frank At 4: Where Do We Go From Here?

Where do we go from here? As we mark another milestone in regulatory reform with the fourth anniversary of the enactment of the Dodd-Frank Act, it strikes us that although most studies required to be undertaken by the Act have been released and final rules have been promulgated addressing many of the most important regulatory measures, we are still living with a great deal of regulatory uncertainty and extraordinary regulatory complexity.

In this summary, we provide a brief recap of the most significant Dodd-Frank Act related regulatory developments of the last year. We also offer our thoughts on what's left....


Substantial rulemaking progress was made in the last year (since July 2013) with many of the most important and most controversial Dodd-Frank Act related rules having been finalized. Below we offer a quick recap of the most significant regulatory developments of the last year in the United States. We also provide a review of the most significant developments in Europe.


Regulatory Capital Requirement

Just before the last anniversary of the enactment of the Dodd-Frank Act, in early July 2013, the Federal Reserve Board, the OCC, and the FDIC (collectively, the "Agencies") approved the publication of the final regulatory capital rules (the "Regulatory Capital Rules," or "Rules"). The Regulatory Capital Rules make major changes to the U.S. regulatory capital framework in an effort to strengthen the regulatory capital of U.S. banking organizations and bring the United States into compliance with the Basel Committee's current international regulatory capital accord ("Basel III"). The Rules replace the Agencies' general risk-based capital rules, advanced approaches rule, market risk rule, and leverage rules, as provided by the Rules' transition provisions. In brief, the Rules:

  • Revise the basic definitions and elements of regulatory capital. Consistent with Basel III, Tier 1 capital will consist of common equity Tier 1 capital and additional Tier 1 capital. Total Tier 1 capital, plus Tier 2 capital, will constitute total risk-based capital. The Rules require a number of capital adjustments, exclusions, and deductions (e.g., goodwill, other intangibles, and most deferred tax assets).
  • Make substantial changes to the credit risk weightings for banking and trading book assets through the adoption of material elements of the Basel II standardized approach for credit risk weightings.
  • Finalize changes made to the Basel capital framework in the aftermath of the financial crisis to large U.S. banking organizations subject to the advanced Basel II capital framework (the "advanced approach framework").
  • Adopt a new phased-in capital conservation buffer for all covered banking organizations equal to 2.5% of total risk-weighted assets, and for banking organizations subject to the advanced approach framework, the Rules adopt a macro-economic countercyclical capital buffer of up to 2.5% of total risk-weighted assets.
  • Adopt a separate Tier 1 leverage capital requirement, measured as a ratio of Tier 1 capital, minus deductions, to average on-balance sheet assets. Banking organizations subject to the advanced approach framework will be subject to a new and separate supplementary leverage ratio.

The Rules became effective on January 1, 2014, with a mandatory compliance date of January 1, 2015, for banking organizations that are not subject to the advanced approaches framework. On that date, most banking organizations would be required to begin the transition to the full implementation of the new capital framework by 2018. For banking organizations subject to the advanced approaches framework, the effective date and compliance period, and the start of the transition period, was January 1, 2014. The Rules provide phase-in/phase-out periods for certain aspects, including minimum capital ratios, adjustments and deductions, non-qualifying capital instruments, capital conservation and countercyclical capital buffers, supplemental leverage ratio for advanced approaches banks, and changes to the PCA rules, which generally take effect by January 1, 2019.

For more information on the Regulatory Capital Rules, please see

Volcker Rule

The Final Rule

The final Volcker Rule was adopted more than two years after the proposed rule, and three and a half years after the Dodd-Frank Act was enacted. On December 13, 2013, the Federal Reserve, the FDIC, the OCC, the SEC, and the CFTC (together, the "Agencies") adopted the final rule (the "Final Rule") implementing Section 13 of the Bank Holding Company Act.

The Volcker Rule generally prohibits, subject to exceptions, banking entities – a broad term that includes banks, bank holding companies, foreign banks treated as bank holding companies, and their respective affiliates – from (i) engaging in proprietary trading and (ii) acquiring or retaining ownership interests in, or acting as sponsors to, certain hedge funds and private equity funds ("covered funds"). Certain trading and fund activity is expressly permitted – notably, underwriting activities, market-making related activities, and risk-mitigating hedging activities. In addition, the Volcker Rule has special application for foreign banking organizations ("FBOs").

The Volcker Rule legislation covered the area with a broad brush, leaving many significant issues open to regulatory interpretation. The Final Rule is complex in scope and has elicited significant commentary and questions from the banking industry and the public at large. We address only certain selected topics from the Final Rule.

Proprietary Trading

Proprietary trading is defined as engaging as principal for the trading account of the banking entity in the purchase or sale of a financial instrument. The Final Rule does not prohibit a banking entity from engaging in agency or riskless principal transactions. A "financial instrument" includes: a security; a derivative; and a contract of sale of a commodity for future delivery (or an option on the same). Specifically excluded from the definition of "financial instrument" are loans; a commodity that is not an "excluded commodity," a derivative or a commodity future; and foreign exchange or currency. A "trading account" is also broadly defined and, given that, certain types of trading are specifically excluded from the rule's coverage, such as repo and securities lending transactions and trades where the banking entity is acting solely as agent, broker or custodian. However, trades are presumed to be for the trading account of a banking entity if the banking entity holds the position for fewer than 60 days, unless the banking entity can demonstrate otherwise.

The Volcker Rule permits certain trading activities – notably, in connection with permitted underwriting activities, market making-related activities, and risk-mitigating hedging activities – and the Final Rule addresses the parameters of and possible conditions on these activities. In order to engage in a permitted activity, a banking entity must comply with three overall conditions: the banking entity must maintain an internal compliance program required by Subpart D to ensure that the banking entity complies with the conditions permitting the activity; the compensation arrangements of personnel involved in these activities must not be designed to reward or to create incentives to engage in prohibited proprietary trading; and the banking entity must be licensed or registered to engage in the permitted activity.

Trading in connection with underwriting activities is permitted only if the trading desk's underwriting position is related to a "distribution" of securities for which the banking entity is acting as underwriter. The underwriting position must be designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties, and reasonable efforts are made to sell or otherwise reduce the underwriting position within a reasonable period, taking into account the liquidity, maturity, and depth of the market for the relevant type of security. In order to determine "near-term demands," an underwriter must make reasonable judgments based on its experience with similar offerings, its knowledge of the market and market conditions, and its book-building experience.

The prohibition on proprietary trading does not apply to purchases or sales of financial instruments by a banking entity made in connection with the banking entity's market making-related activities. Market making-related activities are permitted only if the relevant trading desk "routinely stands ready" to purchase and sell one or more types of financial instruments related to its financial exposure and is "willing and available" to quote, purchase, or sell those types of financial instruments for its own account in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instruments. The amount, types, and risks of the financial instruments in the marketmaker inventory must be designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties.

The prohibition on proprietary trading does not apply to certain risk-mitigating hedging activities. Subject to numerous conditions, hedging activities that are "in connection with and related to individual or aggregated positions, contracts or other holdings" and "designed to reduce the specific risks to the banking entity" that are "related to such positions, contracts or other holdings" are permitted. In order to distinguish between these permitted hedging activities and impermissible proprietary trading, the Final Rule requires that a banking entity establish a compliance program, which we discuss in our Volcker Rule User's Guide. The banking entity should determine at the inception of its trading that the risk-mitigating hedging activity should be demonstrably risk reducing or mitigating. The Agencies note that "at the inception of the hedging activity, the risk-reducing hedging activity [must not] give rise to significant new or additional risk that is not itself contemporaneously hedged." The Release also makes clear that this exemption is not intended to address a banking entity's hedging activities with respect to "generalized risks that a trading desk or combination of desks, or the banking entity as a whole, believe exists based on non-position-specific modelling or other considerations."

The prohibition on proprietary trading does not apply to the following: trading in U.S. government or government agency securities; trading in municipal bonds; trading by a foreign banking entity or a foreign bank subsidiary of a U.S. banking entity of debt of a foreign government (or of any agency or political subdivision of that foreign government) issued by the foreign country in which the foreign banking entity or the foreign bank subsidiary is organized; and trading by a banking entity that is a regulated insurance company (including a foreign insurance company), whether for the insurance company's general account or for a separate account. In addition, the prohibition does not extend to trades by the banking entity as trustee or in a similar fiduciary capacity for a customer, so long as the transaction is conducted for the account of, or on behalf of, the customer, and the banking entity (or an affiliate) does not have or retain a beneficial ownership of the financial instruments. A banking entity also can conduct riskless principal activities so long as these are "customer-driven and may not expose the banking entity to gains (or losses) on the value of the traded instruments as principal." The Final Rule establishes an exemption for proprietary trading by an FBO to the extent the trading is conducted solely outside the United States.

The permitted proprietary trading activities referenced above are not permissible under the Final Rule if they would involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties; they would result in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or they pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States (the so-called "prudential backstops").

Fund Investment and Sponsorship

General prohibition. The Volcker Rule generally prohibits a banking entity, as principal, directly or indirectly (in other words, through a subsidiary), from acquiring or retaining an ownership interest in, or sponsoring, a "covered fund."

Exception. This prohibition does not apply to a banking entity that acts solely as agent, broker or custodian, so long as the activity is conducted for the account of, or on behalf of, a customer, and the banking entity (and any affiliate) does not retain beneficial ownership interest. The prohibition also does not apply to a banking entity that acts as a trustee for a customer that is not itself a covered fund.

What is a covered fund? Broadly speaking, a covered fund falls into three categories or prongs.

First, a covered fund includes any issuer that would be an "investment company" as defined in the Investment Company Act of 1940 (the "ICA"), but for exemptions for private funds provided by section 3(c)(1) and section 3(c)(7) of the ICA. Section 3(c) (1) excludes issuers whose outstanding securities are beneficially owned by not more than 100 persons and is not making or proposing to make a public offering. Section 3(c)(7) excludes issuers, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition, are "qualified purchasers" and are not making or proposing to make a public offering.

Second, a covered fund includes a commodity fund for which the commodity pool operator ("CPO") has claimed an exemption under Rule 4.7 under the Commodity Exchange Act (available when pool offerings are limited to certain qualified investors).

Thus, exempt commodity pools fall within the definition of a covered fund, because they have characteristics similar to those of private funds, as discussed above.

Third, covered funds include foreign funds (that is, those organized abroad and whose interests are sold abroad to non-U.S. residents) that are sponsored by a U.S. banking entity or its affiliate. Covered funds do not include foreign funds that, if organized in the United States, would be investment companies but for section 3(c)(1) or section 3(c)(7) of the ICA.

Exemptions.The Final Rule excludes several entities from the definition of covered fund, including:

  • Foreign public funds;
  • Wholly owned subsidiaries;
  • Joint ventures;
  • Certain acquisition vehicles;
  • Securitization-related vehicles;
  • Registered investment companies; and
  • Certain other entities related to insurance company separate accounts and retirement funds.

Entities not specifically excluded from the definition of covered fund.The Final Rule does not specifically exclude certain entities, such as financial market utilities, collateral cash pools, pass-through real estate investment trusts, municipal securities tender option bond transactions and venture capital funds, because while they appear to fall within the definition of covered funds, they may be able to rely on exemptions from the definition of an investment company other than the exemptions found in section 3(c)(1) and section 3(c)(7).

Scope of the prohibition. Generally, banking entities may not "sponsor" or acquire an "ownership interest" in a covered fund, subject to certain exceptions for permissible activities. The Final Rule defines sponsorship and ownership interest in detail. Note that interests that may not be ownership interests in some contexts may fall within the definition of ownership interests for purposes of the rule.

Permitted covered fund sponsorship and investments.The rule allows banking entities to invest in or sponsor covered funds under limited circumstances. For example, banking entities may own or sponsor covered funds for certain "customer funds" in a fiduciary capacity, subject to many conditions. Banking entities must limit their investment to three percent of the value of the covered fund, or the number of ownership interests in the covered fund. During the "seeding period," banking entities may exceed this limit. In addition, the Final Rule exempts foreign banking entities from the prohibition against investment in and sponsorship of covered funds to the extent the activity is conducted solely outside the United States, as further described below.

Super 23A.The rule also restricts banking entities from entering into "covered transactions" with respect to permissible covered funds. Covered transactions means the kinds of transactions between banking entities and their affiliates that section 23A of the Federal Reserve Act restricts. Unlike section 23A, however, the rule imposes absolute transactions prohibitions, and thus this part of the rule is referred to as "Super 23A."

Volcker Rule Impacts on Securitization

Banking entities involved as investors in, sponsors of, or transaction parties (e.g., credit or liquidity providers) with securitization issuers may be subject to severe restrictions or required divestiture if the securitization issuer is a covered fund.

In the Dodd-Frank Act, Congress stated its intent that the Volcker Rule not limit or restrict the ability of banking entities to sell or securitize loans. In the Final Rule, the Agencies generally followed this intent by making clear that most securitizations of traditional loan products (e.g., mortgage loans, auto loans, student loans and credit card receivables) are not covered funds.

However, the Final Rule creates the possibility that certain securitization vehicles – particularly those whose assets include securities or derivatives (as opposed to loans) – may be covered funds. The consequences of a securitization vehicle being determined to be a covered fund are binary. If the vehicle is a covered fund, investors, sponsors and transactional counterparties will be subject to severe restrictions that in many cases will preclude their involvement altogether; if the vehicle is not a covered fund, banking entities may be involved with the securitization without restriction under the Volcker Rule.

As described above, the basic definition of "covered fund" is a three-pronged test. For most securitization issuers, the relevant test will be that set forth in the first prong of the definition – whether the issuer would be an investment company under the ICA but for the exemptions set forth in section 3(c)(1) or section 3(c)(7) of the ICA.

Many securitizations rely on other exemptions from the ICA and are therefore not covered funds. Even if the transaction was intended to rely on section 3(c)(1) or section 3(c)(7), it may still not be a covered fund if another ICA exemption is also available or if the transaction can be restructured to comply with another exemption.

If the securitization issuer relied on section 3(c)(1) or section 3(c)(7) and another ICA exemption is not available, it may still avail itself of one or more of the 14 enumerated exclusions from the definition of covered fund. These include exclusions for qualifying loan securitizations, asset-backed commercial paper ("ABCP") conduits, qualifying covered bonds, and securities issued by certain wholly owned subsidiaries of a securitization issuer.

For most securitizations that rely on section 3(c)(1) or section 3(c)(7), including many collateralized debt obligations ("CDOs"), collateralized loan obligations ("CLOs") and certain collateralized mortgage obligations ("CMOs"), the key question will be whether the so-called "loan securitization exclusion" is available. This exclusion is available only if the assets underlying the securitization consist only of loans as opposed to securities or derivatives, with very limited exceptions for certain types of ancillary assets that support the securitization. If the primary assets of a section 3(c)(1) or section 3(c)(7) securitization include non-permitted securities or derivatives – which is often the case with CDOs, CLOs and CMOs – the securitization vehicle will likely be a covered fund.

As noted above, banking entities are prohibited from, among other things, acquiring or holding "ownership interests" in covered funds. While most market participants fully expected that the definition of "ownership interest" would include truly equity-like interests such as residuals and deeply subordinated debt securities, the definition of "ownership interest" in the Final Rule is sufficiently broad that it includes not only these equity-like interests, but also potentially senior, highly rated debt securities issued by securitization vehicles such as CDOs and CLOs as the result of certain voting or other management control rights given to such senior classes in many transactions. As a result, many banking entities are analyzing whether securities they previously considered to clearly be debt securities may nonetheless be considered prohibited "ownership interests" for purposes of the Final Rule, most likely requiring divestiture prior to the end of the conformance period.

Limited Regulatory Relief

On January 14, 2014, the Agencies issued an interim final rule granting banking entities relief from Volcker Rule restrictions for certain previously issued CDOs backed by trust preferred securities. This relief is of limited applicability and does not address many of the interpretational concerns raised by securitization market participants regarding the Final Rule. It is unclear whether additional guidance addressing these concerns will be forthcoming from the Agencies.


One of the greatest impacts of the Volcker Rule upon banking entities is found in its requirements that the covered institutions adopt compliance systems and procedures designed to ensure that they are complying with the Rule. The scope of the requirements depends on the banking entity's size and the extent of its proprietary trading and covered fund activities. Banking entities not engaged in such activities have no obligation to establish a relevant compliance program, and those with "modest activities," that is, total assets of $10 billion or less, have very minimal requirements that may be included in their existing compliance policies and procedures. All others must implement a compliance program that addresses these six points:

  • Written policies and procedures reasonably designed to supervise proprietary trading and covered fund activities;
  • Internal controls reasonably designed to monitor compliance with the Volcker Rule;
  • A management framework that delineates responsibility and accountability for compliance with the Volcker Rule;
  • Independent testing and auditing of the effectiveness of the compliance program;
  • Training to appropriately implement and enforce the compliance program; and
  • Recordkeeping sufficient to demonstrate compliance with the Volcker Rule.

In addition, the Final Rule requires larger entities, those with total consolidated assets of $50 billion or more or, in the case of a foreign bank, with total U.S. assets of $50 billion or more, to have the "enhanced minimum standards for compliance programs" provided in Appendix B to the Final Rule. In general, the enhanced standards address similar requirements to those in the six-point program required of all firms, but also provide highly prescriptive and detailed obligations for all components of an entity's proprietary trading activities, including its trading desks; descriptions of risks and risk management processes; authorized risks, instruments and products; hedging policies and procedures; analysis and quantitative measurements; and remediation. A similar level of detail is given to the enhanced compliance program for covered funds activities or investments.

The Final Rule also requires a banking entity with significant trading assets and liabilities – over $50 billion between June 30, 2014 and April 29, 2016; $25 billion between April 30, 2016 and December 30, 2016; and $10 billion beginning on December 31, 2016 – that are engaged in proprietary trading permitted by the Rule to furnish periodic reports – within 30 days of the end of the month, and for the largest entities within 10 days of the end of the month beginning in January 2015 – reporting various quantitative measures to their regulators, and to maintain relevant records, in order to assist the regulators in determining whether the banking entities are complying with the Final Rule. The seven quantitative measurements fall into three categories: Risk-Management Measurements, Source-of-Revenue Measurements and Customer-Facing Activity Measurements.

Foreign Banking Organizations

The Final Rule also impacts FBOs – in other words, foreign banks that own U.S. banks or Edge Corporations or operate branches or agencies in the United States, and companies that control such foreign banks – and banking entities that are affiliates of FBOs (together, "foreign banking entities").

In particular, the Volcker Rule exempts foreign banking entities from the prohibition against proprietary trading to the extent the activity is conducted solely outside the United States ("SOTUS Exemption"). Under the Final Rule, foreign banking entities are now permitted to rely on the SOTUS Exemption to engage in proprietary trading subject to the following requirements:

  • The foreign banking entity may not be directly or indirectly controlled by a U.S. banking entity;
  • The foreign banking entity must be a qualifying foreign banking organization ("QFBO") or an affiliate of a QFBO that has the preponderance of its business outside of the United States;
  • The foreign banking entity engaging in the trading activity (including any relevant personnel of the foreign banking entity that arrange, negotiate or execute the trades, but not those who clear or settle the trades) must be located outside the United States and must not be organized under U.S. law;
  • The trading decisions must be made outside of the United States;
  • The trades, including any related hedging transactions, must be booked, and the profit or loss must be accounted for as principal, outside of the United States in an entity that is not organized under the laws of the United States; and
  • No financing of any trades may be provided by a U.S. branch or affiliate of the foreign banking entity.

Trades may not be conducted with or through a U.S. entity, except:

  • Trades with the foreign operations of a U.S. entity, as long as no personnel of the U.S. entity located in the United States are involved in the arrangement, negotiation, or execution of the trades;
  • Trades through an unaffiliated intermediary acting as principal, provided that the trades are promptly cleared and settled through a clearing agency or derivatives clearing organization acting as a central counterparty; or
  • Trades through an unaffiliated market intermediary acting as agent, if conducted anonymously on an exchange or similar trading facility and promptly cleared and settled through a clearing agency or derivatives clearing organization acting as a central counterparty.

Further, the Final Rule also permits foreign banking entities to engage in proprietary trading in their home-country government obligations.

The Volcker Rule also exempts foreign banking entities from the prohibition against investment in and sponsorship of covered funds to the extent the activity is conducted solely outside the United States. The exemption for foreign banking entities under the Final Rule is subject to the following requirements:

  • The foreign banking entity may not be directly or indirectly controlled by a U.S. banking entity;
  • The foreign banking entity must be a QFBO or an affiliate of a QFBO that has the preponderance of its business outside of the United States;
  • Ownership interests in the covered fund in which the foreign banking entity invests have been sold only in an offering that does not target residents of the United States;
  • Investment/sponsorship decisions must be made outside of the United States;
  • The fund investment, including any related hedging transactions, must be booked outside of the United States in an entity that is not organized under the laws of the United States; and
  • No financing of any fund investment may be provided by a U.S. affiliate of the foreign banking entity.

The Final Rule also excludes foreign funds from the definition of covered funds, subject to certain requirements, if they are not sponsored by U.S. banking entities or no U.S. banking entities have an ownership interest in the fund, and the funds' ownership interests must be offered or sold solely outside the United States.

To read this article in full, please click here.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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