‘You Know It When You See It’1 – Or Do You?
This is first in Pepper’s series of client alerts dealing with specific effects of the ‘Volcker Rule’ on various market segments.
On December 10, 2013, after more than three years of intensive development, the Board of Governors of the Federal Reserve System (FRB), Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) adopted final regulations implementing the “Volcker Rule,” added to the Bank Holding Company Act of 1956 by Section 619 of the Dodd-Frank Act, which prohibits banking entities and nonbank financial companies from engaging in proprietary trading and severely restricts their relationships with hedge funds and private equity funds. In taking this action, the agencies have caused a sea change in the way many financial institutions will conduct their operations.
This alert provides an overview of the significant features of the Volcker Rule. Future Alerts will include a discussion of the following issues:
- affiliated transaction restrictions under Section 23A of the Federal Reserve Act and conflicts of interest under Dodd-Frank Section 621, Section 27B of the Securities Act of 1933, Rule 127B and affiliated covered funds
- money market mutual funds
- private pools of capital
- government-sponsored enterprises
- foreign banking organizations: exemption planning for trading in foreign sovereign debt and extra-territorial issues potentially beyond congressional intent
- syndicated loans and asset-backed securities
- compliance/CEO certifications, and
- acquisition and disposition of non-conforming trading businesses and bank-affiliated funds.
With a regulation of 71 pages and an explanatory preamble running well over 800 pages, the only certainty is that waves of agency guidance and interpretations will fill the coming months and years. As new as the regulations may be, several industry groups are threatening legal challenges. Calls for delay or re-proposal are coming from Capitol Hill and dissenting regulatory officials. Because of the complexities of the regulations, even proponents fear that enforcement will be inconsistent across the agencies and harmful dislocations will occur in the financial markets. How much compliance infrastructure will be required to understand and green-light a business line and a transaction? Since more than three years have passed since the Volcker Rule became law, banking entities already have begun to adjust their business models. Expect that the regulations will create new opportunities for nonbanking entities to take over spin-offs of nonconforming trading businesses and bank-affiliated funds.
Who Is Covered by the Regulations?
The regulations apply to “banking entities.” That term is defined to include generally all insured depository institutions (IDIs), all companies that control IDIs or are otherwise treated as bank holding companies, and all affiliates and subsidiaries of those entities.
Who Is Not Covered by the Regulations?
“Banking entities” generally will not include a hedge fund or private equity fund that is not a banking entity, a portfolio company held by a financial holding company under its merchant banking powers that is not a banking entity, a portfolio concern controlled by a small business investment company (SBIC) that is not a banking entity, and the FDIC acting as a conservator or receiver.
What Do the Regulations Prohibit or Restrict?
Proprietary Trading. The regulations prohibit a banking entity from engaging in “proprietary trading,” which generally means engaging as principal for the trading account of a banking entity in any transaction to purchase or sell specified types of financial instruments. A “trading account” generally refers to three classes of positions taken by a banking entity – the purchase or sale of financial instruments for short-term (usually less than 60 days) gain or hedging of other trading accounts, the purchase or sale of financial instruments treated as “covered positions and trading positions” under federal banking agency market risk capital rules, and the purchase or sale of financial instruments in connection with activities for which the banking entity is licensed as a dealer, swap dealer or security-based swap dealer.
Covered Funds. The regulations also prohibit or restrict a banking entity from acquiring and retaining an ownership interest in, or having certain relationships with, a covered fund. A “covered fund” generally means a hedge fund or private equity fund characterized by its being (a) an issuer that is exempt from the Investment Company Act of 1940 because it does not propose to make a public offering of its securities and is beneficially owned by no more than 100 persons or is owned exclusively by “qualified purchasers,” (b) a commodity pool that is exempt from the Commodity Exchange Act because its participation units are not publicly offered and are owned by “qualified eligible persons,” or (c) a foreign-based entity owned by a U.S. banking entity that raises money to invest in securities for resale or otherwise trade in securities.
What Activities Are Exempt from the Regulatory Restrictions?
Proprietary Trading. Proprietary trading does not include certain repurchase and reverse repurchase arrangements, securities lending transactions and securities acquired for liquidity management purposes. Financial instruments that are not subject to the proprietary trading prohibition include loans, spot foreign exchange and spot physical commodities. Underwriting and market making-related activities are not restricted, provided that the banking entity establishes and enforces a targeted compliance program; limits its positions, inventory and risk exposure to ensure that they do not exceed the reasonably expected near-term demands of customers and counterparties; institutes internal controls and independent testing of compliance; makes senior management accountable; and ensures that compensation arrangements for trading desk personnel are designed not to reward or incentivize prohibited proprietary trading. Risk-mitigated hedging is permitted, provided the hedging rationale is documented, a robust compliance program is maintained, and quantitative measurements are reported. Also unrestricted are trading in U.S. government obligations; state and municipal government obligations, with no distinctions made among the various types; trading on behalf of customers; trading by insurance companies; and trading outside the United States by certain foreign banking entities.
An important caveat: A banking entity may not rely on any exemption if the activity would result in a conflict of interest, result in exposure to high-risk assets or trading strategies, or threaten the safety and soundness of the entity or the financial stability of the United States.
Covered Funds. In general, excluded from the restrictions on ownership of, and relationships with, covered funds (subject to certain conditions) are foreign public funds, wholly-owned subsidiaries, joint ventures, foreign pension or retirement funds, acquisition vehicles, insurance company separate accounts, bank-owned life insurance, public welfare investment funds, loan securitizations, qualifying asset-backed commercial paper conduits, and qualifying covered bonds that are debt obligations of foreign banking organizations. Performance compensation for services provided by a banking entity to a covered fund is not a prohibited ownership interest in that fund. An exemption also is made for organizing and offering a covered fund in connection with trust, fiduciary, investment advisory, or commodity trading advisory services to customers of the banking entity or its affiliates, including master-feeder fund and fund-of-funds investments, subject to de minimis limits after the first year and exclusion from Tier 1 capital. Additionally, subject to certain conditions, investment is permitted in covered funds involved in underwriting, market making-related activities, and risk-mitigating hedging activities.
An important caveat: Certain transactions between a banking entity and a covered fund that are covered transactions under Section 23A of the Federal Reserve Act (transactions with affiliates) are prohibited; all other transactions with covered funds are subject to the market terms requirement under Section 23B; and reliance on any exemption is prevented when it would lead to the same adverse results as noted for proprietary trading.
What Reporting Requirements Are Imposed by the Regulations?
Banking entities having significant trading activity must prepare and submit to its primary regulatory agency regular reports on an array of quantitative measurements for each trading desk. Entities with more than $50 billion in trading assets and liabilities must begin reporting on June 30, 2014; entities with $25 billion or more, on April 30, 2016; and entities with $10 billion or more, on December 31, 2016. Measurements must be calculated for each trading day, with $50 billion entities reporting monthly and entities from $10 billion to $50 billion reporting quarterly.
What Compliance Requirements Are Imposed by the Regulations?
A banking entity engaged in covered trading or fund activities must institute a program that ensures and monitors compliance with the new regulatory restrictions. Entities of $10 billion to $50 billion in total assets must adopt written policies and procedures with limits on underwriting and market-making; install internal controls; provide for management accountability in reviewing trading limits, hedging activities, strategies, and incentive compensation; conduct independent testing and audits; train trading personnel and maintain sufficient records. Entities with total assets of $50 billion or more and smaller entities that are subject to metrics reporting must adopt an enhanced compliance program. Especially noteworthy: the CEO of such an entity must attest that a program is in place that is reasonably designed to achieve compliance, but, unlike Sarbanes-Oxley, it appears this attestation is not a certification of the accuracy of any information or documentation.
When Do the Regulations Take Effect?
The regulations take effect on April 1, 2014. The Federal Reserve has exercised its discretionary authority under the Dodd-Frank Act to extend the deadline by which banking entities must conform their activities to the regulations until July 21, 2015.
Pepper Point: Affected enterprises need to continue to drill down into their business practices, market and administrative structures, and competition policies, and confirm compliance. Boards have substantial oversight responsibility. We will be issuing industry-specific alerts including recommendations concerning assessment, processes, and procedures to support necessary CEO compliance certifications in the near future. Compliance burdens at the enterprise level differ depending upon the size of the enterprise, the covered activity, and exemption planning, including, for example, whether collateralized loan obligations and similar loan securitization vehicles, including bridge loan facilities, are exempt from the definition of “covered funds.”
Pepper Point: The rulemaking process veered from Federal Reserve Chairman Paul Volcker’s recommendation. Specialized rules and exemptions have been crafted by the regulators. Will Congress seek to simplify and bring back a version of the Glass-Steagall Act in light of the interconnectedness of international markets?
1 See former Federal Reserve Chairman Paul Volcker’s testimony “It’s like pornography: you know it when you see it ...” Senate Banking, Housing and Urban Affairs Committee testimony, February 2, 2010. Also see, threshold test used by Justice Potter Stewart in his concurring opinion in Jacobellis v. State of Ohio, 378 U.S. 184 (1964).
Frank A. Mayer, III and Jonathan L. Levin