Background

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the Volcker Rule1 ("the Rule"), was signed into law on July 21, 2010. The Rule adds a new Section 13 to the Bank Holding Company Act of 1956 and it is codified at 12 USC § 1851. Regulators presented proposed regulations regarding the Rule on October 11, 2011 and gave the public until February 13, 2012 to submit comments. Finally, on December 10, 2013, all five regulators approved the final regulations and these were published in the Federal Register in January, 2014 as an interim final regulation. Institutions within the scope of the Rule must now begin finalizing strategies related to further involvement with activities regulated under the Rule.

The premise of the Rule is that banking entities2 should be prohibited from trading or owning "risky assets."  The Rule has two primary components: a prohibition on proprietary trading and a prohibition on sponsoring a "covered fund" or acquiring any ownership interest in the same. Each of these prohibitions contains complex definitions as well as exemptions. The Rule is intended to permit banking entities to continue critical client-oriented financial services, subject to appropriate risk management.

Proprietary Trading

Prohibition on Proprietary Trading

The Rule prohibits any banking entity from engaging in proprietary trading. The main purpose of this prohibition is to limit the risk-taking by banking entities as they try to profit by trading in "risky assets". The broad prohibition against proprietary trading and the various exemptions to it are each the subject of complex definitional provisions.  Institutions which determine to avail themselves of exemptions must undertake extensive internal compliance programs and the adoption of detailed policies and procedures at the individual trading desk level.  Finally, larger banking entities will be obligated under the regulations to capture and calculate transaction and position data on a variety of quantitative metrics on a daily basis and to report such data to regulators. 

Definitions

"Proprietary trading" is defined as "engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments."

"Financial instruments" generally include any security, derivative, commodity future or option on any of the foregoing.  However, the definition excludes loans, most commodities (as opposed to commodity futures) and foreign exchange or currency.

There are three different tests used to determine what constitutes a "trading account." If the account passes any of the tests, it is considered a trading account under the Rule. Trading accounts consist of any one of the following:

  • any account used by a banking entity to purchase or sell financial instruments principally for the purpose of short-term resale, benefiting from short-term price movements, realizing short-term arbitrage profits or hedging one or more of the foregoing positions3,
  • any account used by an insured depository institution or bank holding company or savings and loan holding company to purchase or sell financial instruments that are both covered positions and trading positions (or hedges of the foregoing) under the market risk capital requirements imposed on such institutions, and
  • any account used by a securities dealer, swap dealer, or security-based swap dealer to purchase or sell financial instruments for any purpose.4


Exclusions from the Definition of  "Proprietary Trading"
 Notwithstanding the scope of the definition of proprietary trading outlined above, there are significant exclusions from the definition.  These exclusions refer to purchases and sales of financial instruments:  (i) in repurchase or reverse repurchase transactions, (ii) in securities lending transactions, (iii) for liquidity management purposes5, (iv) by a banking entity which is a derivatives clearing organization or clearing agency in connection with clearing activities, (v) by a banking entity which is a member of a clearing agency, derivatives clearing organization or designated financial market utility in connection with excluded clearing activities, (vi) in satisfaction of existing delivery obligations or of an obligation in connection with a judicial, administrative, self-regulatory organization or arbitration proceeding, (vii) by a banking entity that is acting solely as agent, broker, or custodian, (viii) in connection with certain employee benefit plans and (ix) in connection with debt collection activities.

Exemptions from the Prohibition on Proprietary Trading

In addition to activities which are excluded from the definition of proprietary trading, the Rule sets forth several exemptions from the general prohibition.  These exemptions generally contain significant conditions, including documentation and compliance requirements, and related definitions.  Following is a summary of the exemptions:

1. Underwriting activities.  A banking entity is permitted to engage in underwriting activities only if (i) the banking entity is acting as an underwriter for a distribution of securities6 and the trading desk's underwriting position is related to such distribution, (ii) the amount and type of securities in the trading desk's underwriting position are 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 time period, taking into account the liquidity, maturity, and depth of the market for the relevant type of security, (iii) the banking entity maintains compliance policies and procedures directed to compliance at the trading desk level,7 (iv) the compensation arrangements of underwriting personnel are designed not to reward or incentivize prohibited proprietary trading, and (v) the banking entity is licensed or registered to conduct the underwriting activities.

2. Market-making related activities.  A banking entity is permitted to engage in market-making related activities only if (i) the trading desk8 that manages financial exposure routinely stands ready to purchase and sell financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in 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, (ii) the amount and type of securities in the trading desk's market-maker inventory are designed not to exceed the reasonably expected near term demands of clients, customers or counterparties, (iii) the banking entity maintains compliance policies and procedures directed to compliance at the trading desk level, (iv) the compensation arrangements of market-making personnel are designed not to reward or incentivize prohibited proprietary trading, and (v) the banking entity is licensed or registered to conduct the market-making activities.

3. Risk-mitigating hedging activities.  A banking entity is permitted to engage in hedging activity designed to reduce or otherwise significantly mitigate, and demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, commodity price risk, basis risk or similar risks, arising in connection with and related to identified positions, contracts, or other holdings of the banking entity, provided that (i) the hedge does not give rise to any significant new or additional risk which is not concurrently hedged and (ii) the hedge is subject to continuing review, monitoring and management by the banking entity.  This exemption is also conditioned upon the maintenance of an effective compliance program, and extensive documentation requirements at the trading desk level.  Similar limits on compensation arrangements for hedging personnel are required.

4. Other exemptions from the prohibition on proprietary trading.  The Rule provides certain other exemptions, each with their own conditions and requirements, which pertain to (i) trading in domestic government obligations, (ii) trading in foreign government obligations, (iii) trading on behalf of customers, (iv) trading by a regulated insurance company and (v) trading by foreign banking entities.

The exemptions to the proprietary trading prohibition are subject to several broad limitations:

  • No transaction or activity is permissible if it would involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties.
  • No transaction or activity is permissible if it would result, directly or indirectly, in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy.
  • No transaction or activity is permissible if it would pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.

Covered Funds Activities and Investments

Prohibition on Acquiring or Retaining an Ownership Interest in and Having Certain Relationships with a Covered Fund

The Rule provides that "a banking entity may not, as principal, directly or indirectly, acquire or retain any ownership interest in or sponsor a covered fund."  As in the case of the proprietary trading rules, there are a host of definitions, exclusions and exceptions to this general rule.

Exclusions

The Rule does not apply to banking entities acting:

  • solely as an agent, broker, or custodian for the account of a customer,
  • as trustee for an employment benefit plan of the banking entity,
  • in good faith debt collection activities, or
  • on behalf of customers as trustee or similar fiduciary relationship for the account of a customer which is not a covered fund.

Definitions

A "covered fund" is a private investment company,9 a private commodity pool,10 or an offshore entity controlled by a U.S. banking entity.11 Notwithstanding the broad scope of this definition, the Rule provides exclusions therefrom for (i) foreign public funds,12 (ii) wholly-owned subsidiaries,13 (iii) joint ventures,14 (iv) acquisition vehicles, (v) foreign pension or retirement funds, (vi) insurance company separate accounts, (vii) bank owned life insurance, (viii) loan securitizations,15  (ix) qualifying asset-backed commercial paper conduits,16 (x) qualifying covered bonds,17 (xi) SBICs and public welfare investment funds, (xii) registered investment companies and excluded entities and (xiii) issuers in conjunction with the FDIC's receivership or conservatorship operations.

"Ownership Interest" means any equity, partnership or similar interest.18 "Ownership Interest" does not include a "restricted profit interest".  This exclusion enables investment advisers to collect some forms of carried interests from funds without application of the Rule.

"Sponsoring" a covered fund means to:

  • serve as a general partner, managing member, trustee, or commodity pool operator of the fund,
  • in any manner select or control (or having employees, officers, directors or agents who constitute) a majority of the directors, trustees, or management of a fund, or
  • share with a fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name.

Exemptions for Organizing and Offering, Underwriting, and Market Making with Respect to Covered Funds

The Rule permits banking entities to organize and offer covered funds only if:  (i) the banking entity or its affiliate provides bona fide trust, fiduciary, investment advisory or commodity trading advisory services, (ii) the covered fund is organized and offered only in connection with such services and only to persons who are customers of such services, (iii) the banking entity and its affiliates do not acquire ownership interests in the covered fund, except as otherwise permitted by the Rule, (iv) the banking entity and its affiliates comply with the Rule's limitations on relationships with covered funds (as discussed below), (v) the banking entity and its affiliates do not guarantee, assume or insure the obligations or performance of the covered fund, (vi) the covered fund does not share the same name, or a variation of the same name, of the banking entity or its affiliates and does not include the word "bank" in its name, (vii) no director or employee of the banking entity or its affiliates takes an ownership interest in the covered fund, except for those persons directly engaged in providing services to the covered fund, and (viii) the banking entity includes customary investment risk legends in the offering materials it submits to investors in the covered fund.

A banking entity which securitizes asset-backed securities and is subject to Dodd-Frank's rules on risk retention for securitizers is granted some relief from the foregoing conditions.  It is not necessary for the banking entity to be engaged in bona fide trust, fiduciary investment advisory or commodity trading advisory services and it is not necessary to limit the offering to the banking entity's customers.

A banking entity is also permitted to engage in underwriting and market-making activities involving a covered fund so long as:  (i) the activities comply with the underwriting and market-making rules for proprietary trading, (ii) the banking entity is permitted to organize and offer a covered fund under the Rule and includes ownership interests acquired or retained in connection with underwriting or market-making for any particular fund in its calculations of per-fund limits and capital treatment for permitted investments discussed below, and (iii) the aggregate value of all permitted ownership interests are included in a banking entity's calculations of aggregate limits for ownership interests and capital treatment for permitted investments discussed below.

Exemptions for Permitted Investments in Covered Funds

Notwithstanding the Rule's prohibitions on acquiring and retaining ownership interests in covered funds, a banking entity may acquire and retain such ownership interests in a covered fund for the purpose of either (i) establishing the fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors or (ii) making de minimis investments.  Each of these activities is subject to limitations.  A de minimis investment in a covered fund may not exceed 3% of the value of the outstanding ownership interests of the fund (the "per fund" limit).19  By contrast, investments made to establish a fund are not subject to per fund limits in the fund's first year, provided that the banking entity actively seeks unaffiliated investors to reduce its position to per fund limits.  In addition, the aggregate value of all ownership interests of the banking entity and its affiliates in all covered funds may not exceed 3% of the Tier 1 capital of the banking entity (the "aggregate" limit).  As noted above, ownership interests in connection with underwriting and market-making activities are included in these calculations.  Although the per fund and aggregate limits apply to the aggregate holdings of the banking entities and their affiliates, the Rule excludes from the determination of holdings the holdings of certain registered investment companies, business development companies and foreign public funds which might be considered affiliates of the banking entity.20 Finally, the banking entity's Tier 1 capital is charged in an amount equal to the greater of (i) all amounts paid to acquire the ownership interests and (ii) the fair market value of such ownership interests.

Exemptions for Permitted Risk-Mitigating Hedging Activities

The Rule provides a very narrow exemption for investments in a covered fund which reduce risk to the banking entity arising from an employee compensation arrangement that is tied to the performance of the covered fund.  The hedging activity must demonstrably reduce or significantly mitigate one or more specific risks arising in connection with the compensation arrangement with an employee who directly provides investment advisory, commodity trading advisory or other services to the covered fund.  The investment may not give rise to any significant new or additional risk which is not itself contemporaneously hedged. The Rule also requires the banking entity to implement and enforce an internal compliance program that includes reasonably designed policies and procedures, internal controls and ongoing monitoring, management and authorization procedures. In addition, the compensation arrangement to which the hedge relates must provide that any losses incurred by the banking entity on the hedge be offset by a reduction in the amounts payable to the employee.

Exemptions for Certain Permitted Covered Fund Activities and Investments Outside of the United States

A banking entity may acquire or retain an ownership interest in, or sponsor, a covered fund if: (i) the banking entity is not organized in the United States or controlled by a banking entity organized in the United States, (ii) the activity or investment is permitted under paragraph 9 or 13 of section 4(c) of the Bank Holding Company Act,21 (iii) no ownership interest in the covered fund is offered or sold to a United States resident, and (iv) the activity or investment occurs solely outside of the United States.

Exemptions for Permitted Covered Fund Interests and Activities by a Regulated Insurance Company

An insurance company may acquire or retain an ownership interest in, or sponsor, a covered fund if:  (i) the ownership interest is held solely for the general account of the insurance company or for one or more separate accounts established by the insurance company, (ii) the acquisition and retention of the ownership interest is conducted in accordance with applicable insurance company regulations, and (iii) federal banking agencies have not determined that a particular insurance company regulation is insufficient to protect the safety and soundness of the insurance company or the financial stability of the United States.

Limitations on Relationships with a Covered Fund

Generally, no banking entity that serves as the investment manager, investment adviser, commodity trading advisor or sponsor to a covered fund, that organizes and offers a covered fund as permitted by the Rule or that continues to hold an ownership interest as permitted by the Rule, may enter into a transaction with the covered fund that would be a covered transaction22 under Section 23A of the Federal Reserve Act, assuming that the banking entity were a member bank and the covered fund were an affiliate.  However, the Rule provides exceptions for the acquisition and retention of ownership interests as permitted by the Rule and also for certain prime brokerage transactions.

A banking entity which serves as the investment manager, investment adviser, commodity trading advisor or sponsor to a covered fund must comply with the restrictions on transactions between member banks and affiliates imposed under 23B of the Federal Reserve Act, assuming that the banking entity were a member bank and the covered fund were an affiliate.23

Other Limitations on Permitted Covered Fund Activities

No exempt transaction may be conducted by a banking entity with a covered fund if the transaction would:  (i) involve or result in a material conflict of interest between the banking entity and its clients, customers or counterparties, (ii) result in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy or (iii) pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.  In this context, a banking entity can mitigate a conflict of interest, and proceed with the transaction, through timely and effective disclosure of the conflict, or through established, adequate information barriers.

Compliance

Each banking entity is required to develop a program reasonably designed to ensure and monitor compliance with the prohibitions on proprietary trading and covered fund activities and investments. The terms, scope, and detail of the compliance program must be appropriate for the type, size, scope, and complexity of activities and business structure of the entity. The minimum requirements for all banking entities include:

  • written policies and procedures reasonably designed to document, describe, monitor, and limit trading activities and covered fund activities and investments subject to the Rule;
  • a system of internal controls reasonably designed to monitor compliance with the Rules and to prevent the occurrence of activities or investments prohibited by the Rule;
  • a management framework that clearly delineates responsibility and accountability for compliance, and includes appropriate management review of trading limits, strategies, hedging activities, investments, incentive compensation, and other matters;
  • independent testing and audit of the effectiveness of the compliance program conducted by qualified personnel of the banking entity or by a qualified outside party;
  • training for trading personnel and managers, as well as other appropriate personnel, to effectively implement and enforce the compliance program; and
  • making and keeping records sufficient to demonstrate compliance, which the banking entity must promptly provide to the appropriate federal agency upon request and retain for at least five years.

Certain large banking entities24 engaged in proprietary trading are subject to "enhanced compliance" requirements. These entities are required to establish, maintain, and enforce a governance and management framework that is reasonably designed to ensure that appropriate personnel are responsible and accountable for the effective implementation and enforcement of the compliance program, a clear reporting line with a chain of responsibility, and the periodic review of the compliance program by senior management. 

A significantly broader group25 of banking entities engaged in proprietary trading will be required to report quantitative metrics on their trading activities.

Effective Date and Compliance Dates

The Rule became effective April 1, 2014, but affected banking organizations generally will have until July 21, 2015 to bring their proprietary trading and private fund activities into conformance with the Rule. This new conformance date is an administrative extension of the original statutory conformance date of July 21, 2014. Also, the deadline for conformance by banking entities in connection with loan securitizations will be extended to July 21, 2017 with regard to their ownership interests in, and sponsorship of, any loan securitizations that had been in place as of December 31, 2013.

An important exception to the extension is that banking organizations with significant trading activities will be required to report quantitative metrics on their trading activities beginning in July 2014. In addition, banking organizations are expected to engage in "good faith efforts" to bring all of their covered activities into compliance by the July 2015 conformance date. To this end, the Federal Reserve Board has warned that "banking entities should not expand activities and make investments during the conformance period with an expectation that additional time to conform those activities or investments will be granted."

Impact of the Volcker Rule on Capital Markets

In promulgating the Rule, the regulators cited sharply differing views of commenters on the likely impact of the Rule on the capital markets, particularly as a result of the proprietary trading restrictions.  Critics of the Rule foresaw a reduction in the efficiency of markets, economic growth and employment as a result of loss of liquidity.  Further negative forecasts included high transition costs as non-banking entities assumed trading activities currently performed by banking entities, a reduction in commercial output and resource exploration due to a lack of hedging counterparties, and reduced access to debt markets.

Supporters of the Rule emphasized that restrictions in proprietary trading may reduce systemic risk and lower the probability of another financial crisis.

The regulators contend that the Rule as promulgated achieves a balance between promoting healthy economic activity and reducing regulatory burdens where appropriate.  Time will tell whether the right balance has been achieved. ?


This article was authored by Patrick D. Sweeney, a partner at Herrick, Feinstein LLP, and by Joshua Lustiger, a summer associate. This article summarizes in broad outline the principal provisions of the Volcker Rule.  The Rule itself is heavily detailed and qualified, and has been nuanced by substantial commentary submitted by the regulatory agencies responsible for the Rule.  Application of the Rule to specific circumstances will require a review of pertinent provisions of the Rule in greater detail than that present in this article.  We at Herrick, Feinstein LLP are available to assist you with any analysis of the Rule which you may require.

1  These provisions are based on proposals made by Paul A. Volcker, former Federal Reserve Bank (FRB) Chairman and former White House economic advisor.

2  "Banking entities" include (a) any insured depository institution, (b) any company that controls an insured depository institution, (c) any company that is treated as a bank holding company under the International Banking Act of 1978, or (d) any "affiliate" or "subsidiary" of the foregoing. There are exclusions for "covered funds" (as hereinafter defined) and certain portfolio companies and portfolio concerns which might be considered affiliates or subsidiaries of banking entities in any of the first three categories above. There is also an exclusion for the FDIC acting in its corporate capacity or as a conservator or receiver for a banking entity.

3 There is a rebuttable presumption that any purchase or sale of a financial instrument shall be presumed to be for the trading account of the banking entity if the banking entity holds the financial instrument for fewer than 60 days (or substantially transfers the risk of the financial instrument unless the banking entity can demonstrate that it did not purchase or sell the financial instrument for any of the foregoing purposes.

4 The category includes the purchase and sale of financial instruments by any such dealer outside of the United States if the banking entity conducts such business on an unregistered basis.

5 This exclusion applies to purchases and sales of securities only and requires a documented liquidity management plan with mandatory provisions.

6 Distributions include private placements as well as registered offerings.

7 The requirements of the underwriting exemption are thus applied to the aggregate trading activities of a relatively limited group of employees on a single desk.

8 The Rule defines a trading desk as the smallest discrete unit of organization of a banking entity that buys or sells financial instruments for the trading account of the banking entity or an affiliate thereof.

9 A private investment company depends upon Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 for an exemption from registration
thereunder.

10 A private commodity pool is one in which the investors are all or substantially all "qualified eligible persons" as defined under the Commodity Exchange Act.

11 In order to fall within the definition, the banking entity must either sponsor or have an ownership interest in the entity.

12 A "foreign public fund" is (i) organized or established outside of the United States, (ii) is authorized to offer and sell ownership interests to retail investors in the issuer's home jurisdiction and (iii) sells ownership interests predominantly through one or more public offerings outside of the United States.  Ownership interests may not be "predominantly owned" by the banking entity or the issuer or their respective affiliates, directors and employees.  

13 "Wholly-owned subsidiaries" include subsidiaries with up to 5% ownership by employees or directors and up to 0.5% ownership by third parties for corporate separateness or insolvency concerns.

14 Joint ventures are limited to 10 unaffiliated joint venturers and must be in a business permissible for banking entities, other than investing in securities for resale or other disposition.

15 A "loan securitization" is an issuing entity for asset-backed securities whose assets consist solely of loans, servicing and distribution rights, interest rate or foreign exchange derivatives and special units of beneficial interest and collateral certificates.  A loan securitization generally may not include securities.

16 An asset-backed commercial paper conduit which holds only assets permissible for a loan securitization, issues only short-term asset-backed securities and is supported by a regulated liquidity provider.

17 "Qualifying covered bonds" are bonds issued or guaranteed by a foreign banking organization and secured by a dynamic or fixed pool of assets conforming to the requirements for a loan securitization.

18 "Similar interests" include voting rights, rights to share in income, assets and excess spreads, distribution rights subject to reduction by entity losses, rights to income on a pass-through basis or by reference to asset performance, and synthetic rights to any of the foregoing.

19 However, securitizers of asset-backed securities may hold up to the amount of the required risk retention, if such amount exceeds 3%.

20 By contrast, the Rule includes within the calculation of banking entity holdings the holdings of any director or employee of the banking entity which have been financed by the banking entity.

21 These sections permit ownership interests in and activities with certain non-U.S. entities, as defined in the statute.

22 Section 23A defines "covered transaction" to include loans to affiliates, investments in affiliates, asset purchases from affiliates, acceptance of affiliate obligations as collateral for any loan,  issuing a guaranty on behalf of an affiliate, borrowing or lending securities with affiliate if credit exposure to affiliate is created and derivative transactions which create credit exposure to the affiliate.

23 Section 23B essentially requires member banks to deal at arm's length with their affiliates.

24 Large banking entities are generally considered those with reported total assets of $50 billion or more.

25

Ultimately, those banks with $10 billion total consolidated assets.