A draft staff memorandum outlining proposed regulations to implement the so-called "Volcker Rule" was leaked this past Wednesday, giving early insight into the thinking of the Federal financial regulatory agencies. Two days later, the staff's unofficial proposed regulation text followed. For foreign banks, the draft is especially troublesome because in many respects it draws no distinction between US and non-US operations of foreign banks and requires compliance with a complicated set of rules in order to avoid being considered to be engaging in a prohibited activity in the United States. This client publication provides an overview of several key issues that should concern non-US banks.
Background
The Dodd-Frank Act's Section 619 was proposed by former Federal Reserve Chairman Paul Volcker as a way to separate commercial banks from proprietary trading and private investment fund activities.1 A US government study mandated by the Dodd-Frank Act was released in February 2011 discussing a variety of issues that need to be considered in designing regulations to implement the Rule, and banks and practitioners have been waiting since then for proposed regulations to be issued jointly by the Federal agencies required to enforce the Rule. The Federal Deposit Insurance Corporation ("FDIC") has scheduled a meeting on Tuesday, October 11 to consider issuing proposed regulations, but the American Banker obtained a copy of the draft and posted it (dated as of September 30, 2011) on its website. A draft of the proposed regulation itself began to circulate last Friday; it too was dated as of September 30. The draft memorandum totals 205 pages, and the regulatory language 83 pages, both in single-space typescript. While there is no guarantee that the two drafts considered and ultimately approved by the FDIC will be the same, since changes could have been made in the interim, it seems likely that the vast bulk of the drafts will be unchanged. The Securities and Exchange Commission ("SEC") has scheduled a meeting to consider the proposal on Wednesday, October 12. The Federal Reserve and Comptroller of the Currency ("OCC"), also need to adopt the proposal, and their staffs worked together on the drafts, but meetings to do so have not been announced. It appears that the Commodity Futures Trading Commission ("CFTC") will issue its own corresponding proposed rule covering those financial institutions subject to CFTC jurisdiction, notwithstanding the statutory requirement that all of the agencies' implementing rulemaking proposals be coordinated, to prevent potential regulatory arbitrage.
Cross-Border Aspects Generally
The Federal Reserve's longstanding approach to its regulations under the Bank Holding Company Act of 1956, as amended ("BHCA"), Federal Reserve Act and other statutes has been to authorize US institutions to engage in a wider range of activities overseas than is permitted inside the United States. This approach has been based on the perception that US institutions need more flexibility when operating offshore in order to compete with non-US institutions, which are generally subject to fewer activity restrictions. Similarly, non-US institutions are authorized under US banking law to engage in almost any activity outside the United States to avoid imposing US requirements globally. The Federal Reserve has usually been given broad authority to create exceptions applicable both to US and non-US institutions when operating through non-US offices and affiliates.
The Volcker Rule does not grant this authority to the Federal Reserve or other agencies, but rather provides a far narrower type of exemption. In addition, there is no provision in Dodd-Frank excluding the non-US operations of US institutions from its coverage. Accordingly, it seems clear that US institutions will have to comply with Volcker Rule requirements on a worldwide basis. Non-US institutions have a partial exemption from the Volcker Rule for proprietary trading and certain private fund activities that take place "solely outside of the United States."2 A major question has been the manner in which the agencies would interpret that provision. The answer provided by the draft proposal is disappointing. The staff's apparent intention in interpreting that provision very narrowly was to create a level playing field for US and non-US institutions in the United States, but the end result will have a significant extraterritorial impact. Indeed, the mood on Capital Hill recently has shifted from the general pro-regulatory stance when Dodd-Frank was enacted in July 2010 to one that increasingly urges regulators to recognize the need for interpreting the Act not to apply extraterritorially. To that end, Senator Tim Johnson, Chair of the Senate Banking Committee, and Rep. Barney Frank, a co-author of the Act, both wrote to regulators recently with precisely that message.
As is shown below, the draft shows almost no sign that its drafters understood that the proposed regulation would apply to non-US operations of non-US banks. Because the Volcker Rule applies globally to US institutions, this is understandable. It is also typical of the regulation-drafting process. The agency staffs have a difficult enough time figuring out what the rules should be for institutions operating in the United States and usually ignore or have a difficult time wrestling with non-US applicability. In this case, the Federal Reserve among the agencies would be primarily concerned about the effect on non-US headquartered institutions, and the issues to be resolved are so numerous and complex that staffs likely focused only on US operations in their negotiations. It will be up to the non-US institutions to prepare comment letters to the agencies explaining any problems that the proposal presents and alternatives that would alleviate the problems yet serve the same regulatory purpose.
Proprietary trading
The draft, consistent with the text of the Volcker Rule, generally prohibits proprietary trading through a "trading account" of a "banking entity". A "trading account" is defined to include any one of three types of accounts on an entity's books: very generally, an account holding short-term positions, an account treated as a trading account for purposes of US risk-based capital calculations, and an account at a registered broker-dealer or similar entity (including a non-US one) that causes the entity to be registered as a securities dealer. A "banking entity" includes an entity subject to the BHCA by virtue of the International Banking Act of 1978, which includes all non-US banks with a branch or agency (and certain other entities) in the United States and any subsidiary or affiliate thereof. Nothing limits the definition of "banking entity" to US offices or organizations, and accordingly non-US offices and subsidiaries of an institution subject to the BHCA are covered. Thus, any account that would fall within the definition of a "trading account" that is on the books of a non-US office or subsidiary of a non-US bank is potentially covered.
The failure to limit coverage to US operations of non-US institutions presents the following issues:
1. The statute provides an exclusion for proprietary trading conducted "solely outside of the United States". The draft defines this exclusion to apply only if (a) a company organized under non-US law that is controlled by a non-US company is doing so, (b) no party to the transaction is a US resident, (c) no personnel directly involved in the transaction is physically located in the United States (generally, not including "persons performing purely administrative, clerical, or ministerial functions" according to the draft memorandum), and (d) the transaction is "executed wholly outside the United States." The definition of a US resident is broad and could include the account of a non-US resident held by a US dealer or fiduciary, other than an estate or trust. While the four criteria appear stringent but reasonable, the language used by regulators to interpret the criteria prompts concern:
These four criteria are intended to ensure that a transaction executed in reliance on the exemption does not involve US counterparties, US trading personnel, US execution facilities, or risks retained in the United States. The presence of any of these factors would appear to constitute a sufficient locus of activity in the US marketplace so as to preclude availability of the exemption. (Emphasis added). Some important issues to be considered and resolved in this regard include:
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a. If a non-US institution has a discretionary or non-discretionary securities account for a US resident outside the United States, may the institution not engage in any trades with that account that would constitute proprietary trading? Will other non-US banks, when executing a proprietary trade with a managed account at another non-US bank, have to determine whether its trade is with an account of a US resident, and thereby prohibited?
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b. What does it mean to "execute" a transaction outside the United States? Can the institution buy a US equity through a US exchange? Can the trade be paid for and custodied in the United States? Would that be "administrative" or fall within another exception?3
c. If a non-US institution chooses to engage in such transactions in a manner compliant with the Volcker Rule, does it have to maintain records and compliance systems and make reports as required by the proposal? The requirements are discussed below.
d. May personnel at a US office or subsidiary of a non-US institution give advice or information to a non-US trader concerning a proposed transaction?
e. Many non-US institutions have a "shell" branch in the Cayman Islands or Bahamas that is operated by personnel at a US branch, and for virtually all regulatory purposes it is treated as a non-US branch. Would such a shell branch not be allowed to engage in proprietary trading solely because personnel at the US branch are directing it?
2. The draft imposes a host of recordkeeping and reporting requirements on banking entities with trading accounts. Indeed, fully half of the draft regulation (36 single-spaced pages) is devoted to recordkeeping guidelines. The purpose of these requirements is to determine whether any "permissible activities", such as market-making in securities and responding to customer demand, are in fact disguised impermissible forms of proprietary trading. Depending on the aggregate size of the banking entity's trading activities, it may be subject to a requirement to obtain information on a daily basis concerning 17 different metrics related to the business and to report on a monthly basis the results to the US agency with jurisdiction over the entity.4 US banking entities will have to do so on a global basis. Significantly, the draft proposal does not specify that only US-based trading activities should be taken into account for purposes of determining whether the compliance responsibilities are triggered. Will non-US institutions subject to the requirement have to maintain such records and file such reports as to their non-US operations? Would the requirement apply to trading that qualifies for the foreign-transaction exclusion discussed above? Would the requirements apply if all of the entity's propriety trading takes place outside of the United States?
3. The recordkeeping and reporting must be done for each "trading unit" in the institution. Such units can be very small, but also include larger subsets of the institution and apparently the entire institution itself. Will "trading units" wholly outside the United States be subject to this requirement?
4. Acquiring instruments for hedging purposes is a permissible exemption from the prohibition. However, if a hedge is acquired for the purpose of hedging instruments held by another entity in the organization, several requirements must be met, including the preparation of a record contemporaneous with executing the transaction identifying the hedge. If a hedge is acquired in the United States and hedges a position held at a non-US entity, or vice versa, must this requirement be complied with? While the draft acknowledges that portfolio hedging is not prohibited, there are numerous instances where the agencies express a preference for a more granular approach, so that entities must be able to demonstrate that a trade was booked with a clear hedging purpose in mind. Squaring the two concepts will be difficult.
5. As noted above, the definition of "trading account" includes an account at a US registered broker-dealer that causes the company to be so registered. An account on the books of a non-US affiliate that is registered as a securities dealer with the local securities regulatory agency is also automatically covered as a "trading account", but only if registration is required "in connection with the activities of such business". What does this limitation mean (since countries may differ in how they define dealing activities, the answer may depend on the physical location where the activities are conducted)?
6. The draft does not propose to require that institution executives certify the compliance of the institution's Dodd- Frank Act controls, but asks in a question (one of hundreds of questions strewn throughout the draft memorandum) whether such certification should be required. If the agencies did so, would the certification apply to non-US operations as well as US ones?
Private funds
Similar to the general prohibition on proprietary trading, the Volcker Rule prohibits a banking institution from engaging in various activities related to investment funds not required to be registered as investment companies under the Investment Company Act of 1940. Covered funds may include certain non-US organized funds even if not offered to US residents. Thus, a US institution is generally prohibited from organizing and sponsoring a private fund, with exceptions related to advisory and fiduciary businesses, and from investing in such a fund. An exception allows non-US institutions to organize, sponsor and invest in funds that are organized under non-US law and that are not marketed to US residents to be investors. The draft regulation says that a transaction otherwise subject to the prohibition will be treated as having occurred solely outside of the United States only if (a) the transaction or activity is conducted by a legal entity not organized under US law or controlled by a US company, (b) no office, affiliate or employee involved in the offer or sale of an interest in a non-US fund is incorporated or physically present in the United States, and (c) no ownership interest is offered for sale or sold to a US resident.
1. May a non-US fund otherwise compliant with the draft acquire US securities or other assets? The draft is silent on this point. However, another requirement, which is applicable to all non-US institutions subject to the BHCA, is that any non-US operations be consistent with Section 4(c)(9) of the BHCA and the Federal Reserve's Regulation K implementing it. Regulation K has elaborate restrictions governing investments in US companies and in non-US companies that have US subsidiary operations. Do all of those restrictions apply to the funds?
2. The draft says that US subsidiaries and personnel may not conduct the permissible activity, but suggests this should not be an absolute prohibition on any connection with the activity and that certain administrative services should be permissible. Does this mean that a US investment advisory subsidiary, or personnel at a US branch, may provide advice concerning investments by the non-US fund? The draft disallows selling efforts, but does not address advisory activities explicitly. If a non-US advisor conducts the vast bulk of the advisory business, may a US affiliate provide advice to that advisor, perhaps acting as a subadvisor?
3. The draft allows acquisition of a private fund interest if the purpose is to hedge a permissible transaction. The same issue arises as in the case of proprietary trading: if an acquisition is made by a US arm of a non-US institution to hedge a position at a non-US affiliate, do all of the requirements applicable to a US institution apply?
4. The draft does not generally allow acquisition of an interest in or sponsorship of a private fund where an ownership interest is offered for sale or sold to a US resident. If this restriction applies to secondary market sales, what types of assurances or monitoring will be required to ensure that no fund interests have been marketed or sold to a US resident?
5. The Volcker Rule allows an institution to organize and sponsor a private fund for its advisory and fiduciary customers subject to various restrictions. One of the restrictions prohibits the institution from "seeding" such funds in an amount that, in the aggregate for all such funds, exceeds three percent of the institution's tier 1 capital. The relevant tier 1 capital figure is the institution's tier 1 capital as of the most recent calendar quarter ended as reported to US regulators. May non-US institutions that report their tier 1 capital to the Federal Reserve on an annual basis use their tier 1 capital as calculated at year-end?
6. As for proprietary trading, the draft requires that an institution engaged in permissible private fund activity have a compliance program governing several aspects of the business. Do non-US institutions engaged only in non-US private fund activities have to implement such a program?
7. The draft contains some nuggets of relief, such as permitting a banking entity to acquire and retain an ownership interest in, or act as sponsor to an issuer of, asset-backed securities, to the extent required by the credit risk retention or "skin-in-the-game" provisions of Title IX of Dodd-Frank, and not be treated as the holder of an impermissible interest in a private fund. The presence of such provisions, however, in combination with the overall tone of the draft prompts a reader to wonder whether there are other instances where overlapping requirements in other titles of Dodd-Frank, or other laws, may not be interpreted in a consistent and reasonable way.
8. The draft imposes a complex set of transaction restrictions on dealings with advised, managed or sponsored private funds (known as the "Super 23A" rule). Will these restrictions apply in the context of a transaction that is entirely outside of the United States (e.g., a transaction between a non-US affiliate and a non-US fund)?
Additional questions will undoubtedly arise as the draft continues to be reviewed and especially after final action by the FDIC, SEC and any other agency. It will be important for non-US institutions to provide specific comments and proposed solutions to address the ambiguities in the manner in which the new regulations would affect their businesses both in the US and overseas.
Footnotes
1 If you wish to know more about the background of the Dodd-Frank Act and the Volcker Rule, please see our previous client memoranda: "FSOC Study on Implementing the Volcker Rule -- A Series of Missed Opportunities and Some Surprises" (January 2011), "The Volcker Rule Continues to Garner Outsized Attention in the Wake of Passage of Financial Reform Legislation" (October 19, 2010). The Dodd-Frank Act is technically the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law No. 111-203, 124 Stat. 1376 (2010).
2 Dodd-Frank Act, § 619(d)(1), provides that several activities are permitted subject to agency restrictions: (H) "Proprietary trading conducted by a banking entity pursuant to paragraph (9) or (13) of section 4(c) [of the BHCA], provided that the trading occurs solely outside of the United States and that the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or one or more States." Subsection (I) has similar language for private funds.
3 According to the draft proposal, proprietary trading does not include "acting solely as agent, broker, or custodian for an affiliated party."
4 For example, according to the draft regulation (at Section 4(c)(4) of Appendix A), one of the data points is:
4. Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio Profit and Loss Description: Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio Profit and Loss should be calculated using standard statistical methods with respect to Portfolio Profit and Loss, exclusive of Spread Profit and Loss. Calculation Period: 30 days, 60 days and 90 days.
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.