Volcker Rule Background - K&L Gates
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
Lexis Practice Advisor®
Volcker Rule
A Lexis Practice Advisor® Practice Note by Eric S. Yoon, K&L Gates LLP
For more information on the Volcker Rule as it relates to
collateralized loan obligations, or CLOs, see Collateralized
Loan Obligations under the Volcker Rule.
Eric S. Yoon
Volcker Rule Background
K&L Gates LLP The Volcker Rule contains two prohibitions aimed at “banking
entities”: A banking entity may not (1) engage in “proprietary
Introduction trading” or (2) as principal, directly or indirectly, acquire or
retain any ownership interest in, or sponsor, “covered funds,”
This practice note provides an overview of the Volcker which essentially are private equity funds and hedge funds.
Rule, which was enacted in 2010 as Section 619 of the The Rule is named after former Federal Reserve chairman
comprehensive Dodd-Frank Wall Street Reform and Paul A. Volcker Jr., who proposed these restrictions under
Consumer Protection Act (Dodd-Frank Act) and codified as the stated belief that certain types of speculative activities—
Section 13 of the Bank Holding Company Act of 1956 (BHC namely, the types intended to be covered under the Rule—
Act), 12 U.S.C. §1851. The final regulations implementing had contributed to the onset of the financial crisis of 2007–
the Volcker Rule, which were proposed by the responsible 2010.
U.S. federal agencies (Responsible Federal Agencies)—the
Board of Governors of the Federal Reserve System (Federal The following banking entities are subject to the Volcker Rule:
Reserve), the Commodity Futures Trading Commission
• Any insured depository institution (i.e., any bank or savings
(CFTC), the Securities and Exchange Commission (SEC),
association the deposits of which are insured by the FDIC)
the Federal Deposit Insurance Corporation (FDIC), and the
Office of the Comptroller of the Currency (OCC)—were • Any company that controls an insured depository
promulgated on December 10, 2013, and became effective institution
on April 1, 2014. 12 C.F.R. Parts 44, 248 and 351; 17 C.F.R. • Any company that is treated as a bank holding company
Parts 75 and 255. for purposes of Section 8 of the International Banking
Act of 1978 (i.e., any foreign banking organization that is
This practice note addresses:
a registered bank holding company or has a U.S. branch,
• Volcker Rule Background agency, or commercial lending company subsidiary, but not
merely a representative office)
• Legislative and Regulatory Updates
• Any affiliate or subsidiary of any of the foregoing entities
• Proprietary Trading
As the last bullet indicates, the definition of a banking
• Covered Funds Activities
entity encompasses a surprisingly broad range of entities.
• Compliance and Penalties It may not seem intuitive to include some of these entitieswithin such definition. For instance, suppose your client is
a foreign insurance company with no U.S. presence, and
Legislative and Regulatory
the ultimate parent of this insurance company is a foreign Updates
holding company that has a local bank subsidiary with a small
branch in New York City. That holding company and each of In a 2017 development, the U.S. Treasury Department
its subsidiaries worldwide, including your client insurance issued in June 2017 a document titled “A Financial System
company, is a banking entity within the meaning of the That Creates Economic Opportunities Banks and Credit
Volcker Rule and therefore is subject to the Volcker Rule Unions”. This document was a report in response to President
prohibitions and restrictions described in this practice note. Trump’s Executive Order 13772 of February 3, 2017, which
established the policy of his administration to regulate the
“Proprietary trading,” the first of the two restricted activities U.S. financial system in a manner consistent with a set of
under the Volcker Rule, is defined very broadly to cover “Core Principles” set forth therein. The Treasury report
purchase or sale, as principal, of “financial instruments” identified laws, treaties, regulations, guidance, reporting and
(again, defined rather broadly) by a banking entity for one record keeping requirements, and other government policies
of its “trading accounts.” Similarly, the second Volcker Rule- that it said “inhibit Federal regulation of the U.S. financial
mandated restriction—direct or indirect acquisition or system.”
retention of any “ownership interest” in, or sponsorship
of, a “covered fund” by banking entities—on its face The Treasury report contains a detailed list of
curbs a bewildering array of fund formation / investment recommendations to Congress and the Responsible
management activities. Moreover, each banking entity must Federal Agencies to further this aim. Some of the salient
have in place a compliance program reasonably designed recommendations in the report for “improving the Volcker
to ensure and monitor compliance with the prohibitions Rule” include revisions to the following provisions (all of
and restrictions under the Volcker Rule. The compliance which are discussed below in this practice note):
program must include, among other things, written policies
• Exempt from the Volcker Rule banking entities with $10
and procedures reasonably designed to document, describe,
billion or less in assets.
monitor, and limit the activities in question; a system of
internal controls reasonably designed to monitor compliance; • Exempt from the proprietary trading prohibitions of the
independent testing and audit; and a minimum five-year Volcker Rule banking entities with over $10 billion in assets
record maintenance requirement. In counseling your banking that are not subject to the market risk capital rules.
entity clients regarding the risk of noncompliance, you • Eliminate the 60-day rebuttable presumption from the
should also remind them that because the Volcker Rule has definition of proprietary trading.
been codified as part of the BHC Act, this statute’s civil and
criminal sanctions regime could apply to contraventions and • Regulators should give banks additional flexibility to adjust
violations of the Rule. their determinations of the reasonable amount of market-
making inventory:
Recognizing the risk of overregulation, as well as the oo For illiquid securities, banks should have greater
heightened compliance burden, associated with this leeway to anticipate changes in markets.
vastly complicated rule, Congress and the Responsible
Federal Agencies have attempted to lessen the unintended oo For over-the-counter derivatives, regulators should
consequences of the Volcker Rule in two principal ways. focus more on ensuring that banks appropriately
First, there are definitional exclusions, both statutory and hedge the positions they maintain.
regulatory, from broadly defined terms such as “financial oo Banks that have not yet established a market-making
instrument,” “trading account,” “covered fund,” and presence in a particular asset class should have more
“ownership interest.” Second, there is a fairly broad array of discretion to meet the reasonably expected near-term
exemptions for certain types of activities and investments— demands (RENTD) condition.
presumably those that fall safely outside the speculation-
oo Banking entities should be able to enter into block
curbing intent behind this regime—that remain within
trades even if they involve a trading volume outside of
the defined proscriptions and therefore would otherwise
historical averages.
be impermissible for banking entities. This practice note
provides a general summary of the definitional exclusions and • Eliminate the requirement to maintain documentation of
policy-driven exemptions regarding (1) proprietary trading the specific assets and risks being hedged.
and (2) investment in and sponsorship of covered funds, in • The existing “enhanced” compliance program under the
that order.regulations should apply only to those banking entities However, complexities in the statute and the implementing
with at least $10 billion in trading assets and liabilities on regulations may result in certain foreign excluded funds
a consolidated basis; the original application was to all becoming subject to the Volcker Rule and, as such, a number
banking entities with over $50 billion in total consolidated of foreign banking entities, foreign government officials, and
assets. other market participants have expressed concern about
possible unintended consequences and extraterritorial
• Banks should be given greater ability to tailor their
impact. In particular, they have contended that certain foreign
compliance programs to the particular activities engaged in
excluded funds may fall within the definition of “banking
by the bank and the particular risk profile of that activity.
entity” under the Volcker Rule if they are an affiliate of a
• Regulators should adopt a simple definition of covered foreign banking entity under the BHC Act by virtue of typical
funds that focuses on the characteristics of hedge funds corporate governance structures for funds sponsored by a
and private equity funds with appropriate additional foreign banking entity in a foreign jurisdiction or by virtue
exemptions as needed. of investment by the foreign banking entity in the fund. For
• The exemptions in Section 23A of the Federal Reserve Act instance, where a foreign banking entity owns a large amount
should be restored in the Volcker Rule so that they apply to of the fund, selects the board of directors of the fund, or
banking entities’ transactions with their covered funds. acts as general partner or trustee of the fund, the foreign
bank may be deemed by law to “control” the foreign fund.
• The initial “seeding period” exemption from the covered
A foreign fund thus deemed to be controlled by a foreign
funds investment restriction should be extended to three
banking entity would be an affiliate of the foreign bank under
years, rather than one year, to provide banking entities
the BHC Act, and the statute by its terms subjects an affiliate
with additional time to stand up new funds and allow
of a banking entity to the restrictions on covered fund and
them to establish the track records they need to attract
proprietary trading activities in the United States.
investors.
• Banking entities other than depository institutions and The July 21, 2017 announcement stated that staffs of the
their holding companies should be permitted to share a Responsible Federal Agencies are considering ways in which
name with funds they sponsor, provided that the separate the implementing regulation may be amended, or other
identity of the funds is clearly disclosed to investors. appropriate action may be taken, to address any unintended
consequences of the Volcker Rule for foreign excluded funds
• An exemption of the Volcker Rule’s definition of banking
in foreign jurisdictions. The announcement left open the
entity should be provided for foreign funds owned or
possibility that Congressional action may be necessary to
controlled by a foreign affiliate of a U.S. bank or a foreign
fully address the issue.
bank with U.S. operations.
• Consideration should be given to permitting a banking The announcement further noted that, in order to provide
entity that is sufficiently well-capitalized—such that the additional time, the Federal Reserve, the OCC and the FDIC
risks posed by its proprietary trading are adequately will not propose to take action during the one-year period
mitigated by its capital—to opt out of the Volcker Rule ending July 21, 2018, against a foreign banking entity based
altogether, if the institution remains subject to trader on attribution of the activities and investments of qualifying
mandates and ongoing supervision and examination to foreign excluded funds to the foreign banking entity, or
reduce risks to the safety net. against a qualifying foreign excluded fund as a banking entity,
in each case where the foreign banking entity’s acquisition
Coordinated Reviews for Qualifying Foreign or retention of any ownership interest in, or sponsorship
Excluded Funds of, the qualifying foreign excluded fund would meet the
On July 21, 2017, the Responsible Federal Agencies requirements for permitted covered fund activities and
announced that they are coordinating their respective investments solely outside the United States, as more fully
reviews of the treatment of certain foreign funds under the described below in this practice note.
Volcker Rule. These “foreign excluded funds” are investment
funds organized and offered outside of the United States The Economic Growth Act
that are excluded from the definition of “covered fund” and, On May 24, 2018, the Economic Growth, Regulatory Relief,
as such, the restrictions of the Volcker Rule generally would and Consumer Protection Act (Economic Growth Act) was
not apply to investments in, or sponsorship of, such funds by signed into law. The Economic Growth Act, among other
a foreign banking entity. things, benefits community banks— institutions with $10billion or less in assets—and makes key changes to enhanced “Financial instrument” includes a security, a derivative, and
prudential standards and supervision requirements and a contract of sale of a commodity for future delivery, or an
provides that banking organizations with less than $10 billion option on any of the foregoing. The term “security” includes
in aggregate assets will no longer be subject to the Volcker any note, stock, security future, bond, debenture, certificate
Rule. Section 204 of the Economic Growth Act further of interest, or participation in any profit-sharing agreement,
amends the Volcker Rule by removing the restriction that any collateral-trust certificate, certificate of deposit for a
generally prohibits hedge funds and private equity funds from security, any put, call, straddle, option, or privilege on any
having the same name, or a variation of the same name, as a security, certificate of deposit, or group or index of securities,
“banking entity” that is an investment adviser to the fund. or any put, call, straddle, option, or privilege entered into on
This amendment, however, keeps in place the prohibition on a national securities exchange relating to foreign currency, or
sharing a name with a bank. in general, any instrument commonly known as a “security.”
The term “derivative” includes any swap (as defined in the
In June 2018, the Federal Reserve, the OCC, and the FDIC Commodity Exchange Act), security-based swap (as defined
each issued a Notice of Proposed Rulemaking (2018 NPR) in the Securities Exchange Act of 1934), purchase or sale
proposing several changes to the Volcker Rule. The 2018 of a commodity for deferred delivery that is intended to be
NPR proposed significant changes to the Volcker Rule’s physically settled, or any foreign exchange forward or foreign
proprietary trading restrictions, a new tiered system of exchange swap. Swaps include ISDA master agreements.
compliance, and a streamlined set of compliance metrics.
In other words, financial instruments cover an extensive
2019 Amendments array of financial products and contracts. The term financial
In August through October 2019, the Responsible Federal instrument, however, does not include:
Agencies adopted, in a series of separate actions, several
• A loan
amendments to the Volcker Rule (2019 Amendments), which
adopted certain aspects of the 2018 NPR that narrow and • A commodity, unless it is (1) an excluded commodity (other
simplify some of the restrictions thereunder while leaving than foreign exchange or currency), (2) a derivative, (3) a
other aspects to be dealt with in future regulatory action. contract of sale of a commodity for future delivery, or (4)
The effective date for the 2019 Amendments is January an option on a contract of sale of a commodity for future
1, 2020, and banking entities must comply with them by delivery
January 1, 2021. The existing rule will remain in effect until • Foreign exchange or currency
the compliance date, but a banking entity may voluntarily
The term trading account is also defined broadly. If an
comply, in whole or in part, with the 2019 Amendments prior
account meets one of the following three tests, then such
to the compliance date, except that, in the case of metric
account is a trading account under the Volcker Rule:
reporting, early application is subject to the Responsible
Federal Agencies’ adoption of certain requisite technological • Purpose test. Is the account used to purchase or sell
updates. Since the 2019 Amendments represent a narrowing financial instruments principally for the purpose of (1)
of Volcker Rule restrictions, there would be no practical short-term resale, (2) benefitting from actual or expected
reason for the typical banking entity to delay instituting an short-term price movements, (3) realizing short-term
otherwise permitted accelerated compliance. As such, in this arbitrage profits, or (4) hedging one or more positions
practice note those provisions of the Volcker Rule that were resulting from the purchases or sales described in
amended by the 2019 Amendments are described as though (1) through (3)? The 2019 Amendments reversed the
they are currently in effect. Also, where appropriate, some of presumption in this short-term purpose prong, which
the salient aspects of the 2019 Amendments are noted below previously held that the purchase/sale of a financial
as annotations to the existing rules. instrument is presumed to be for the trading account if the
banking entity holds the instrument for fewer than 60 days
Proprietary Trading or substantially transfers the risk of the instrument within
60 days of the purchase/sale, unless the banking entity can
demonstrate that it did not purchase/sell the instrument
Nature of the Proprietary Trading Prohibition
principally for any of the aforementioned purposes. The
The first part of the Volcker Rule prohibits a banking entity
new presumption, adopted in the 2019 Amendments,
from engaging in proprietary trading. “Proprietary trading”
is that the purchase/sale of a financial instrument is
is defined to mean engaging as principal for the “trading
presumed not to be for the trading account if the banking
account” of the banking entity in any purchase or sale of one
entity holds the instrument for 60 days or longer and does
or more financial instruments.not transfer substantially all of the risk of the instrument the Volcker Rule prohibition on the same:
within 60 days of the purchase/sale.
• Repo and reverse repo transactions
• Dealer registration test. If the account is used by a
banking entity to purchase/sell financial instruments for • Securities lending transactions
any purpose, is the banking entity (1) a U.S. licensed or • Purchase/sale pursuant to a liquidity management plan.
registered securities dealer, swap dealer, or security-based The liquidity management plan must be documented;
swap dealer, to the extent the instrument is purchased/sold specifically contemplate and authorize the particular
in connection with the activities that require the banking securities to be so used; and specify the permissible
entity to be so licensed or registered; or (2) engaged in amount, types, and risks of the attendant securities (e.g.,
the business of a dealer, swap dealer, or security-based must be highly liquid securities). The 2019 Amendments
swap dealer outside of the United States, to the extent expanded the liquidity management exclusion beyond
the instrument is purchased/sold in connection with the securities to also permit FX forwards, swaps, and cross-
activities of such business? If the answer to either of the currency swaps.
foregoing questions is yes, then the account in question is a
• Purchase/sale by a derivatives clearing organization or
Volcker Rule trading account.
a clearing agency in connection with clearing financial
• Market risk capital rule test. If the account is used to instruments
purchase/sell financial instruments that are both market
• Excluded clearing activities by a member of a clearing
risk capital rule covered positions and trading positions (or
agency, a member of a derivatives clearing agency, or a
hedges of other market risk capital rule covered positions),
member of a designated financial market utility
is the banking entity or any affiliate thereof an FDIC-
insured depository institution, bank holding company, or • Purchase/sale in satisfaction of (1) an existing delivery
savings and loan holding company that calculates risk- obligation of the banking entity or its customers (e.g.,
based capital under the market risk capital rule? Again, if prevention or closeout of a failure to deliver) in connection
the answer to this question is yes, then the account is a with delivery, clearing, or settlement activity or (2) an
trading account. Under the 2019 Amendments, institutions obligation of the banking entity in connection with a
subject to the U.S. market risk capital rule are now judicial, administrative, self-regulatory organization (SRO),
required to look only to the market risk capital prong and or arbitration proceeding
the dealer prong (i.e., the test described in the preceding • Purchase/sale by a banking entity acting solely as agent,
paragraph), in what amounts to a two (rather than three)- broker, or custodian
pronged condition. If an account does not fall under the
• Purchase/sale through a deferred-compensation, stock-
“trading account” definition under either of those two
bonus, profit-sharing, or pension plan of the banking entity
tests, then the banking entity may, without further applying
in its capacity as trustee for the benefit of current or
the third, intent-based purpose test to see if that prong is
former employees
triggered, determine that the account is not a Volcker Rule
trading account. • Purchase/sale in the ordinary course of collecting a debt
previously contracted in good faith, provided that the
The 2018 NPR proposed to replace the intent-based purpose
banking entity divests the financial instrument as soon as
test of the proprietary trading definition and the related 60-
practicable
day rebuttable presumption, all described above, with a new
accounting prong that captures positions recorded at fair The 2019 Amendments adopted the following new or
value on a recurring basis, which the Responsible Federal expanded exclusions from the “proprietary trading” definition:
Agencies believed would cover derivatives, trading securities,
• Purchase/sale of one or more financial instruments that
and available-for-sale (AFS) securities. However, this proposal
was made in error by a banking entity in the course
was widely criticized by commentators raising concerns
of conducting a permitted or excluded activity or is a
that the new accounting prong may create, perhaps in an
subsequent transaction to correct such an error
unintended way, a new set of questions regarding its scope
and application. The 2019 Amendments left intact the three- • Contemporaneously entering into a customer-driven swap
pronged test as is, and did not adopt the proposed accounting or customer-driven security-based swap and a matched
prong that had been proposed in the 2018 NPR. swap or security based-swap if (i) the banking entity retains
no more than minimal price risk; and (ii) the banking entity
Exclusions from the “proprietary trading” definition. The is not a registered dealer, swap dealer, or security-based
following types of transactions are not deemed to constitute swap dealer
proprietary trading and therefore are outside the purview of• Purchase/sale of one or more financial instruments that • The banking entity has established the requisite internal
the banking entity uses to hedge mortgage servicing compliance program.
rights or mortgage servicing assets in accordance with a • The compensation arrangements are designed not to
documented hedging strategy reward or incentivize prohibited proprietary trading.
• Purchase/sale of a financial instrument that does not meet
the definition of trading asset or trading liability under the Market Making–Related Activities
applicable reporting form for a banking entity as of January Market making-related activities are permitted only if:
1, 2020
• The trading desk routinely stands ready to purchase
As you can see, the exceptions from the definition of and sell the types of financial instruments related to the
“proprietary trading” are quite numerous. In counseling your financial exposure and is willing and available to quote,
banking entity client, it is therefore critical to examine the purchase, and sell in commercially reasonable amounts
entire list of exceptions at the outset to determine whether a
• The amount, types and risks in the trading desk’s inventory
particular activity may fall under an exception, because once
are designed not to exceed the reasonably expected
an activity is outside the definition of proprietary trading, you
near-term demands (RENTD), based on (1) the liquidity,
are in the clear as far as that activity is concerned.
maturity, and depth of the market and (2) demonstrable
analysis of historical customer demand, current inventory,
Permitted Proprietary Trading Activities and market and other factors
To recap, the Volcker Rule prohibits a banking entity from
engaging in proprietary trading, which is defined to mean • If any established limit for a trading desk is exceeded, the
engaging as principal for the trading account of the banking trading desk takes actions to come back into compliance
entity in any purchase or sale of one or more financial promptly
instruments. As noted above under Nature of the Proprietary • The banking entity has established the requisite internal
Trading Prohibition, certain trading activities that would compliance program
otherwise fall within the definition of proprietary trading are
• The compensation arrangements are designed not to
expressly excluded from it. There is an array of proprietary
reward or incentivize prohibited proprietary trading
trading activities that would normally fall within the definition
but, for a variety of policy reasons, are permitted for banking In the context of this market-making exemption to the
entities, typically because they do not constitute the type of proprietary trading prohibition, as well as in the context
speculative trading that the Volcker Rule is intended to curb. of recordkeeping and reporting requirements discussed
under “Compliance Program Requirements,” “Proprietary
These permitted proprietary trading activities include (1) Trading Reporting Requirements,” and “New Three-Pronged
underwriting activities, (2) market making–related activities, Compliance and Reporting Requirements” in Compliance
(3) risk-mitigating hedging activities, (4) trading in U.S. and and Penalties, the concept of a “trading desk” is important
non-U.S. government securities, (5) trading on behalf of because the relevant provisions center around the question
customers, (6) trading by a regulated insurance company, and of what is, in fact, a trading desk. The term was originally
(7) trading activities of foreign banking entities. Each of these defined as the smallest discrete organized unit of a banking
activities is discussed in further detail below. entity that purchases or sells financial instruments for
the trading account of the banking entity or an affiliate
Underwriting Activities thereof. The Responsible Federal Agencies expected a
Underwriting activities are permitted subject to the following trading desk to be managed and operated as an individual
criteria, which are designed to limit and detect evasive unit and to reflect the level at which the profit and loss of
transactions: the traders is attributed. The Agencies apparently believe
that this approach helps to manage risks of trading activity
• The banking entity is acting as an underwriter for more effectively by requiring the establishment of limits,
a distribution of securities and the trading desk’s management oversight, and accountability at the level where
underwriting position is related to such distribution. the trading activity occurs. Significantly, this meant, and still
• The amount and types of securities in the underwriting to an extent means that a trading desk may span more than
position are designed not to exceed the reasonably one legal entity, employees of a single trading desk may be
expected near-term demands, and reasonable efforts working on behalf of multiple affiliated legal entities, and
are made to reduce the underwriting position within a trades and positions managed by the desk may be booked
reasonable period. in different affiliated entities. If a single trading desk books
positions in different affiliated legal entities, it must haverecords that identify all positions included in the trading positions and does not give rise to any significant new or
desk’s financial exposure and the legal entities where such additional risk that is not hedged at the same time
positions are held. • The compensation arrangements are not designed to
reward or incentivize prohibited proprietary trading
The 2019 Amendments now define the term “trading desk”
to mean “the smallest discrete unit of organization of a banking As had been proposed in the 2018 NPR, the 2019
entity that purchases or sells financial instruments for the Amendments removed the requirements for correlation
trading account of the banking entity or an affiliate thereof.” analysis, as well as a showing that the hedge “demonstrably
The subtle shift from the former wording “organized unit of a reduces or otherwise significantly mitigates” an identifiable
banking entity” to the new wording apparently was intended risk.
to achieve an alignment with criteria used to establish trading
desks for other operational, management, and compliance Trading in U.S. and Non-U.S. Government
purposes. The criteria include a well-defined unit that
Securities
engages in coordinated trading activity, operates subject to a
Proprietary trading in the following financial instruments is
common set of risk levels and limits, submits information to
permitted:
management as a unit, and books its trades together. In this
regard, the new definition of “trading desk” alleviates some • U.S. federal, state, and local government obligations: A
of the confusion that arose under the former definition as to financial instrument that is an obligation of: (1) the U.S.
exactly what a particular trading desk for a specific financial government, 2) an agency of the United States or a U.S.
instrument was. government–sponsored enterprise (including Ginnie Mae,
Fannie Mae, and Freddie Mac), (3) a U.S. state or a political
As had been proposed in the 2018 NPR, the 2019
subdivision thereof, including any municipal security or
Amendments provide that compliance with RENTD under
(4) the FDIC (including in its capacity as conservator or
the market-making and underwriting exemptions would
receiver)
be presumed if the banking entity maintains and enforces
internal risk limits for each trading desk. Therefore, banking • A financial instrument that is an obligation of a non-U.S.
entities are now permitted to base risk and other desk sovereign (or any agency or political subdivision thereof),
limits on internal models and analyses, rather than having so long as: (1) the banking entity making the purchase/
to conduct any externally-formulated mandatory analysis. sale is organized under (or is controlled by a banking entity
Internal limits for underwriting desks must be set for (i) the organized under) the laws of a foreign sovereign and is not
amount, types, and risks of the desk’s underwriting positions; controlled by a top-tier banking entity that is organized
(ii) the level of exposure to relevant risk factors arising from under the laws of the United States, (2) the financial
the desk’s underwriting positions; and (iii) the period of time instrument is an obligation of the foreign sovereign under
a security may be held. Internal limits for market-making the laws of which the foreign bank entity referred to below
desks must be set for (i) the amount, types, and risks of the is organized (e.g., in the case of a Spanish banking entity,
desk’s market-maker positions; (ii) the amount, types, and the financial instrument must be a Spanish government
risks of the products, instruments, and exposures the trading obligation) and (3) the purchase/sale is not made by an
desk may use for risk management purposes; (iii) the level FDIC-insured depository institution (Note this exemption is
of exposure to relevant risk factors arising from the desk’s only available to affiliates of foreign banking entities in the
financial exposure; and (iv) the period of time a financial United States.)
instrument may be held.
Trading on Behalf of Customers
The prohibition against proprietary trading does not apply to
Risk-Mitigating Hedging Activities the purchase or sale of financial instruments as follows:
The prohibition against proprietary trading does not apply to
risk-mitigating hedging activities in connection with individual • Fiduciary transactions. Purchase or sale by a banking
or aggregated positions, contracts, or other holdings designed entity acting as trustee or in a similar fiduciary capacity, as
to reduce the specific risks in connection therewith, if: long as (1) the transaction is conducted for the account of,
or on behalf of, a customer; and (2) the banking entity does
• The banking entity has established the requisite internal not have or retain beneficial ownership of the financial
compliance program instrument.
• The hedging activity, at its inception, is designed to reduce • Riskless principal transactions. Purchase or sale by a
or mitigate specific, identifiable risks (e.g., market risk, banking entity acting as riskless principal in a transaction in
counterparty risk) arising in connection with identifiedwhich the banking entity, after receiving from a customer 1 The banking entity is not organized (or controlled by a
an order to purchase a financial instrument, purchases banking entity that is organized) under the laws of the
the financial instrument for its own account to offset a United States or any U.S. state.
contemporaneous sale to the customer.
2 The purchase or sale is made pursuant to Section 4(c)(9)
Trading by a Regulated Insurance Company or 4(c)(13) of the BHC Act. A foreign banking organization,
The prohibition against proprietary trading does not apply more than half of whose worldwide business is banking and
to the purchase or sale of financial instruments by a banking more than half of whose banking business is outside the
entity that is an insurance company (or an affiliate thereof) if United States (a qualifying foreign banking organization, or
all of the following conditions are met: QFBO), by meeting at least two of the three quantitative
tests measuring its consolidated assets, revenues, and net
• The insurance company or its affiliate purchases or sells income, is allowed some relief from the extraterritorial
the financial instruments solely for the general account of reach of the BHC Act.
the insurance company or a separate account established
by the insurance company. 3 The transaction takes place solely outside the United
States (TOTUS). TOTUS means:
• The purchase or sale is conducted in compliance with
the insurance company investment laws, regulations, and a) The banking entity engaging as principal in the
written guidance of the U.S. state or the jurisdiction of purchase or sale (including relevant personnel) is not
domicile of such insurance company. located in the United States or organized under the
• The appropriate Responsible Federal Agencies have not laws of the United States or any U.S. state
determined that the particular law, regulation, or written b) The banking entity (including relevant personnel) that
guidance referred to above is insufficient to protect the makes the decision to purchase or sell as principal is
safety and soundness of the covered banking entity or the not located in the United States or organized under
financial stability of the United States. the laws of the United States or any U.S. state
For purposes of this exemption, the following defined terms c) The purchase or sale (including any transaction
apply: arising from risk-mitigating hedging related to the
instruments purchased or sold) is not accounted for
“Insurance company” means a company that is organized
as principal on a consolidated basis by any branch
as an insurance company, primarily and predominantly
or affiliate that is located in the United States or
engaged in writing insurance or reinsurance risks
organized under the laws of the United States or any
underwritten by insurance companies, subject to
U.S. state
supervision as such by a U.S. state insurance regulator or
a foreign insurance regulator. As had been proposed in the 2018 NPR, the 2019
Amendments removed several conditions from the TOTUS
“General account” means all of the assets of an insurance trading exemption, including (1) the prohibition against the
company except those allocated to one or more separate purchase or sale being conducted with or through a U.S.
accounts. entity, (2) the prohibition against provision of financing for
the transaction by any U.S. branch or entity and (3) the
“Separate account” means an account established and
requirement that no U.S. personnel be involved in arranging,
maintained by an insurance company in connection with
negotiating, or executing the transaction.
one or more insurance contracts to hold assets that are
legally segregated from the insurance company’s other To say that foreign banks and their affiliates play a major role
assets, under which income, gains, and losses (whether in the U.S. banking, trading, and investment management
or not realized) from assets allocated to such account spheres is an understatement. As such, if your client is a
are credited to or charged against such account without foreign banking entity, it would be prudent to query at the
regard to other income, gains, or losses of the insurance outset whether a TOTUS exemption may apply with respect
company. to a trading activity (or, as noted below, a fund investment/
sponsorship activity) that may otherwise be covered by and
Trading Activities of Foreign Banking Entities restricted under the Volcker Rule.
The prohibition against proprietary trading does not apply
to the purchase or sale of financial instruments by a foreign Backstop Prohibition
banking entity under the following conditions. None of the activities discussed above under “Permitted
Proprietary Trading Activities” in Proprietary Trading(including underwriting, market making, risk-mitigating (7) (individual investments of at least $5 million) of the
hedging, trading in government securities, and SOTUS Investment Company Act of 1940 (1940 Act) –or–
trading) is permissible if the transaction or activity would: • A commodity pool (1) for which the commodity pool
operator has claimed an exemption under 17 CFR 4.7
• Involve or result in a material conflict of interest
or (2) for which a CFTC-registered commodity pool
between the banking entity and its clients, customers, or
operator is the commodity pool operator, substantially all
counterparties
participation units of which are owned by qualified eligible
• Result, directly or indirectly, in a material exposure by the persons (QEPs), and participation units of which have not
banking entity to a “high-risk asset” or a “high-risk trading been publicly offered to non-QEPs.
strategy”
The apparent legislative intent behind this somewhat
• Pose a threat to the safety and soundness of the banking convoluted definition of covered fund is to bring within
entity or to the financial stability of the United States the purview of the Volcker Rule only those funds that are
A high-risk asset is an asset that would, if held by a banking commonly referred to as private equity funds or hedge
entity, significantly increase the likelihood that the banking funds. However, as you can see, the definition can cover
entity would incur a substantial financial loss or would pose many other types of pooled investment vehicles, most of
a threat to the financial stability of the United States. A which presumably had, or will have, little to do with banking
high-risk trading strategy is a trading strategy that would, entities’ imprudent involvement with speculative instruments.
if engaged in by a banking entity, significantly increase the Be that as it may, the question of whether a particular fund
likelihood that the banking entity would incur a substantial or vehicle is or is not a Volcker Rule “covered fund” has been
financial loss or would pose a threat to the financial stability and likely will continue to be a source of some confusion
of the United States. among practitioners. For instance, the SEC has stated that,
“certain federally sponsored structured financings, such
In order to mitigate potential conflicts of interest, prior to as those sponsored by the Federal National Mortgage
effecting the transactions in question, the banking entity Association, are exempted from the [1940 Act] under Section
must take one of the following actions: 2(b), which exempts, among other things, activities of United
States Government instrumentalities and wholly owned
• The banking entity must make clear, timely, and effective
corporations of such instrumentalities.” See, e.g., Federal
disclosure of the nature of the conflict of interest and
National Mortgage Association, SEC No-Action Letter (May
other required information; and make such disclosure
25, 1988). If an issuer may rely on Section 2(b) of the 1940
explicitly and effectively, in a manner that provides the
Act, it would be relying on a 1940 Act exemption other than
recipient of the disclosed information the opportunity
the exclusions contained in Section 3(c)(1) or 3(c)(7), and thus
to negate any material adverse effect of the purported
would be excluded from the definition of “covered fund.”
conflict.
• The banking entity must establish, maintain, and enforce Covered funds also include, for any banking entity that is
certain prescribed information barriers (such as physical (or is controlled by a banking entity that is) located in or
separation of personnel or functions, or limitations on organized under the laws of the United States or any U.S.
types of activity) that are memorialized in written policies state, an entity (1) that is organized or established outside
and procedures. the United States and the ownership interests of which are
offered and sold solely outside the United States; (2) that
Covered Funds Activities is, or holds itself out as being, an entity or arrangement
that raises money from investors primarily for the purpose
Nature of the Covered Funds Prohibition of investing in securities for resale or otherwise trading in
We now turn to the second prohibition under the Volcker securities; and (3) (A) whose sponsor is that banking entity
Rule, which provides that a banking entity shall not, as or an affiliate thereof; or (B) that has issued an ownership
principal, directly or indirectly, acquire or retain any interest that is owned directly or indirectly by that banking
“ownership interest” in, or “sponsor,” a “covered fund.” entity (or an affiliate thereof).
A covered fund means either: For this purpose, a U.S. branch, agency, or subsidiary of a
foreign banking entity is considered to be located in the
• An issuer of securities that is excluded from the definition United States. However, the foreign bank that operates or
of “investment company” based solely on Section 3(c) controls that branch, agency or subsidiary is not considered
(1) (100 or fewer beneficial owners) or Section 3(c) to be located in the United States solely by virtue ofoperating or controlling the U.S. branch, agency, or subsidiary. • Investment limits described below in subsection 4
In other words, generally speaking, a banking entity whose (Investing in a Fund Organized by a Banking Entity) under
ultimate parent is a foreign bank or holding company can, in “Permitted Covered Funds Activities” in Covered Funds
a way that one whose ultimate parent is a U.S. entity cannot, Activities
engage in certain types of covered funds–related activities • Transfer restrictions to nonaffiliates.
offshore as long as there is no U.S. entity in the chain of
ownership leading from the ultimate foreign parent to the A banking entity is a “sponsor” of a covered fund if such
would-be covered fund in question. banking entity:
The 2018 NPR does not propose any changes to the “covered • Serves as a general partner, managing member, trustee or
fund” definition, but requests comment on a number of commodity pool operator of the fund
revisions, including: whether to adopt a characteristics- • In any manner selects or controls a majority of the
based definition of covered fund; and whether to revisit directors, trustees or management of the fund –or–
the conditions of various exclusions from the covered
• Shares with the fund, for corporate, marketing,
fund definition, including those for foreign public funds,
promotional, or other purposes, the same name or a
securitizations, family wealth management vehicles, and joint
variation of the same name
ventures.
The following types of funds, vehicles, and products are
Ownership interests subject to the Volcker Rule include any excluded from the definition of covered funds:
equity, partnership, or other similar interest in a covered
fund, whether voting or nonvoting, or any derivative of such • Foreign public funds
interest. Determinative factors for “other similar interests” • Wholly owned subsidiaries
include (1) the right to participate in the selection or removal
• Joint ventures
of general partner and the like; (2) the right to receive a
share of the income, gains, or profits of the fund; (3) the right • Acquisition vehicles
to receive the underlying assets of the fund after all other • Foreign pension or retirement funds
interests have been redeemed or paid in full; (4) the right to
• Insurance company separate accounts
receive all or a portion of excess spread; (5) a provision that
the amounts payable by the covered fund with respect to the • Bank-owned life insurance
interest could be reduced based on losses arising from the • Loan securitizations
underlying assets of the covered fund; (6) receipt of income
• Qualifying asset-backed commercial paper conduits
on a pass-through basis from the covered fund, or a rate of
return that is determined by reference to the performance • Qualifying covered bonds
of the underlying assets of the covered fund; and (7) any • SBICs and public welfare investment funds
synthetic right to have, receive, or be allocated any of the
• Registered investment companies and excluded entities
foregoing.
(Note, again, that an issuer of securities that may rely on
The term ownership interest, however, does not include an exclusion or exemption from the definition of investment
“restricted profit interest” (or carried interest), which is an company under the 1940 Act other than the exclusions
interest held by an entity (or a current or former employee contained in Section 3(c)(1) (100 or fewer beneficial
thereof) in a covered fund for which the entity (or the owners) or Section 3(c)(7) (individual investments of at
employee) serves as investment manager, investment advisor, least $5 million) would not be a “covered fund.”)
commodity trading advisor, or other service provider. Some of • Issuers in conjunction with the FDIC’s receivership or
the factors that determine the designation of restricted profit conservatorship
interest are:
• Any issuer that the Responsible Federal Agencies jointly
• The sole purpose and effect of the interest is to allow the determine should be excluded from the covered fund
entity (or the employee) to share in the profits of the fund definition
as compensation for the services provided, along with
certain obligations to return previously received profits Permitted Covered Funds Activities
To recap, the Volcker Rule prohibits a banking entity, as
• All such profits, once allocated, are distributed promptly
principal, directly or indirectly, from acquiring or retaining
after being earned or are retained for the sole purpose of
any ownership interest in, or sponsoring, a covered fund.
establishing a reserve amount for subsequent losses
As noted above under “Nature of the Covered FundsProhibition” in Covered Funds Activities, certain funds and extent described below in subsection 4 (Investing in a
other investment vehicles that would ordinarily fall within Fund Organized by a Banking Entity)
the definition of covered funds are expressly excluded from (d) The banking entity and its affiliates comply with the so-
it. There is also an array of covered funds investment and called Super 23A and 23B requirements to the extent
sponsorship activities that would fall within the relevant described below in Permitted Covered Funds Activities
definitions which, for a variety of policy reasons, are – Limitations on Covered Fund Relationships
permitted for banking entities. They include the following
seven circumstances: (1) acting as an agent, broker, or (e) The banking entity does not guarantee, assume, or
custodian, (2) permitted organizing and offering, (3) otherwise insure the obligations or performance of the
permitted underwriting and market making, (4) investing in a covered fund (or any other covered fund in which the
fund organized by a banking entity, (5) risk-mitigating hedging covered fund invests)
activities, (6) activities and investments outside of the United (f) The covered fund, for corporate, marketing,
States, and (7) regulated investment companies. Each of promotional, or other purposes, does not (1) share the
these is discussed in greater detail below. same name or a variation of the same name with the
banking entity and (2) does not use the word “bank” in
1 Agent, Broker, or Custodian its name
The general prohibition against a banking entity acquiring (g) No director or employee of the banking entity takes
or retaining any ownership interest in or sponsoring a or retains an ownership interest in the covered fund,
covered fund does not apply to the following situations: except for those who are directly engaged in providing
relevant services to the fund at the time of taking such
• Banking entity acting solely as agent, broker, or ownership interest
custodian, so long as the activity is conducted for the
(h) The banking entity clearly and conspicuously discloses
account of, or on behalf of, a customer and the banking
to any prospective and actual investor in the covered
entity does not have or retain beneficial ownership of
fund:
such interest
• That any losses in the fund will be borne solely by the
• If the ownership interest is held by the banking entity
investors and not by the banking entity; therefore,
as trustee for the benefit of its current or former
the banking entity’s losses will be limited to losses
employees through a deferred compensation, pension, or
attributable to the ownership interests in the fund
other similar plan
held by the banking entity in its capacity as investor
• In the ordinary course of collecting a debt previously
• That the ownership interests in the fund are not
contracted in good faith, provided that the banking
insured by the FDIC, and are not deposits at,
entity divests the ownership interest as soon as
obligations of, or endorsed or guaranteed in any way
practicable and within the period prescribed by the
by any banking entity (unless that is the case)
applicable U.S. regulatory agency
• The role of the banking entity in sponsoring or
2 Permitted Organizing and Offering
providing any services to the fund
In general, a banking entity may acquire or retain an 3 Permitted Underwriting and Market Making
ownership interest in or sponsor a covered fund in
connection with organizing and offering such fund, if all of A banking entity may engage in underwriting or market
the following conditions are met: making–related activities involving a covered fund, subject
to the following conditions:
(a) The banking entity provides bona fide trust, fiduciary,
investment advisory, or commodity trading advisory (a) Such activities are conducted in accordance with
services the requirements described above with respect to
underwriting and market making-related activities
(b) The fund is organized and offered only in connection
in “Permitted Proprietary Trading Activities” under
with the provision of bona fide trust, fiduciary,
Proprietary Trading.
investment advisory, or commodity trading advisory
services, and only to persons that are customers of (b) Any ownership interests acquired in connection
such services offered by the banking entity with underwriting and market making–related
activities are included in the calculation of
(c) The banking entity and its affiliates do not acquire or
ownership interests permitted to be held under
retain an ownership interest in the fund except to thethe limitations described immediately below in under the authority of either (1) providing initial
subsection 4 (Investing in a Fund Organized by a equity in connection with establishment of a fund
Banking Entity). or (2) de minimis investment may not exceed 3% of
the tier 1 capital of the banking entity, as calculated
(c) The aggregate value of all ownership interests of
as of the last day of each calendar quarter. For
the banking entity and its affiliates in all covered
this purpose, the aggregate value of all ownership
funds acquired under the permitted organizing,
interests held by a banking entity is the sum of
offering, underwriting, and market making
all amounts paid or contributed by the banking
authorities are included in the same calculation of
entity in connection with acquiring or retaining an
ownership interests referred to in clause (b) above.
ownership interest in covered funds, on a historical
The 2019 Amendments eliminated (i) the application cost basis.
of the 3% aggregate and per-fund limits and the capital
5 Risk-Mitigating Hedging Activities (as revised under the
deduction to ownership interests in third-party covered
2019 Amendments)
funds that are acquired by a banking entity in reliance on
the underwriting and market-making exemptions, as well An ownership interest in a covered fund that is designed
as (ii) the application of 3% per-fund limit to positions to reduce or otherwise significantly mitigate the specific,
in third-party covered funds acquired in underwriting identifiable risks to the banking entity in connection with
or market-making capacity where a banking entity a compensation arrangement with an employee of the
guarantees, assumes, or otherwise insures the obligations banking entity or an affiliate thereof that directly provides
or performance of such third-party funds. investment advisory, commodity trading advisory, or other
services to the covered fund; or (ii) a position taken by the
4 Investing in a Fund Organized by a Banking Entity
banking entity when acting as intermediary on behalf of a
A banking entity may acquire and retain an ownership customer that is not itself a banking entity to facilitate the
interest in a covered fund organized and offered by it, for exposure by the customer to the profits and losses of the
two distinct purposes: covered fund, is permitted only if:
a) Provision of initial equity in connection with the (a) The banking entity has established a compliance
establishment of a fund, in order to attract unaffiliated program that includes (i) reasonably designed policies
investors, subject to a seeding period limit as well as and procedures and (ii) internal controls and ongoing
an aggregate limit. monitoring, management and authorization procedures
• Seeding period. The banking entity (1) must (b) The acquisition of the ownership interest (i) is made in
actively seek unaffiliated investors to reduce accordance with the requisite policies, procedures and
(through redemption, etc.) the aggregate amount internal controls; (ii) is designed to reduce or otherwise
of all ownership interests of the banking entity in significantly mitigate one or more specific, identifiable
the fund to the de minimis limits discussed below risks arising (A) out of a transaction conducted solely
and (2) must, no later than one year after the date to accommodate a specific customer request with
of establishment of the fund (i.e., the date on which respect to the covered fund or (B) in connection with
the investment adviser begins making investments the compensation arrangement with the employee
pursuant to the investment strategy for the fund), who directly provides investment advisory, commodity
conform its ownership interest in the fund to the trading, or other services to the covered fund; (iii)
per-fund limits discussed below. This one-year does not give rise to any significant new or additional
period can be extended for up to two additional risk that is not hedged contemporaneously; and
years by the Federal Reserve. (iv) is subject to continuing review, monitoring, and
management
b) De minimis investment, subject to per-fund limits and
an aggregate limit. (c) Where applicable, the compensation arrangement
relates solely to the covered fund in which the
• Per-fund limits. A de minimis investment in any
banking entity or any affiliate has acquired an
covered fund may not exceed 3% of the total
ownership interest pursuant to this exception, and
number or value of the outstanding ownership
such arrangement provides that any losses incurred
interests of the fund.
by the banking entity on such interest will be offset by
• Aggregate limit. The aggregate value of all corresponding decreases in amounts payable under
ownership interests of the banking entity and its such arrangement
affiliates in all covered funds acquired or retainedYou can also read
