After a long and suspenseful wait, a proposal to implement the so-called "Volcker Rule" under Section 619 of the Dodd-Frank Act1 is finally seeing the light of day. The Federal banking regulators (the Federal Reserve Board ("Federal Reserve"), the Office of the Comptroller of the Currency ("OCC"), and the Federal Insurance Deposit Corporation ("FDIC")), together with the Securities and Exchange Commission ("SEC") (collectively, the "Agencies"), have issued a joint release ("Proposal" or "Proposing Release") containing a proposed rule ("Proposed Rule") implementing Section 619. The Commodity Futures Trading Commission ("CFTC") has been consulted but is not at this time participating in the Agencies' Proposal.2
Section 619 added new Section 13 to the Bank Holding Company Act ("BHCA").3 Section 13 generally prohibits any "banking entity" from engaging in "proprietary trading" or from acquiring or retaining an "ownership interest" in or "sponsoring" a hedge fund or private equity fund ("covered fund activities"). Banking entities are, however, still allowed to provide services to their customers. As discussed more fully below, a "banking entity" includes insured depository institutions and their holding companies, companies treated as bank holding companies for purposes of Section 8 of the International Banking Act of 1978 ("foreign banking entities"), and affiliates and subsidiaries of any of these companies.
Section 13 also provides that nonbank financial companies supervised by the Federal Reserve ("SIFIs") that engage in proprietary trading or covered fund activities will be subject to additional capital requirements and quantitative limits. Because the Financial Stability Oversight Council has not yet finalized the criteria for SIFI designation, the Federal Reserve is not currently proposing to impose any capital requirements or quantitative limits on SIFIs.4
The Agencies are proposing a common rule, comprised of four subparts and three appendices, to maximize consistency and clarity across banking entities. Although covered entities will only be subject to the rule of one Agency, i.e.,the Agency with primary regulatory authority over the entity under Section 13, each Agency's rule will be uniform.5 The Proposal: (i) describes the key characteristics of both prohibited and permitted activities; (ii) requires each banking entity to establish a comprehensive compliance program; and (iii) requires the calculation and reporting of extensive quantitative data to assist the Agencies and the banking entities to identify activity that might constitute impermissible proprietary trading activity.
Under the Dodd-Frank Act, the final Volcker Rule must become effective on July 21, 2012, although banking entities will have a period after that to come into compliance. In February 2011, the Federal Reserve issued a conformance rule, which is intended to allow markets and market participants time to adjust to the new requirements and prohibitions that will be contained in the final Volcker Rule.6 The conformance rule is included in the Federal Reserve's version of the Proposed Rule as Appendix E. Although banking entities may use the conformance period and any extensions to bring their activities into compliance with the new rules, the compliance program as well as the reporting and recordkeeping requirements—with some exceptions for reporting that cannot be done until activities are conformed—will be effective on July 21, 2012, to meet the statutory mandate. The Proposing Release requests comment on whether this deadline will give banking entities enough time to implement the required changes. The Agencies also intend to use the conformance period to refine and finalize any new reporting requirements they deem necessary.
The Proposed Rule is extremely complex and, given that the Agencies seek comment on more than 400 separate questions, is most likely still quite unsettled.
While the Agencies assert that the Proposed Rule is intended to minimize burdens on smaller banking entities, it is clear that it would entail enormous new compliance costs for all banking entities engaging in covered activities. The Agencies estimate that the reporting and recordkeeping requirements alone would require more than six million hours in the first year.
Comments are due by January 13, 2012.
This alert first provides a brief overview of the Proposed Rule and then discusses the Proposed Rule in greater detail.
Section 13 generally contains two separate prohibitions. First, banking entities are prohibited from engaging in proprietary trading. Second, banking entities are prohibited from acquiring or retaining an ownership interest in or sponsoring a covered fund. The statute contains numerous exceptions to and exemptions from the two general prohibitions.
Subpart A of the Proposed Rule, comprising Sections __.1 and __.2, describes the authority, scope, and purpose of the Proposed Rule and defines some of the commonly used terms in the Proposed Rule, including "banking entity" and "resident" of the US.
Subpart B of the Proposed Rule, comprising Sections __.3 through __.8, addresses prohibited and permitted trading activities. It also defines relevant terms, such as "proprietary trading," and "covered financial position," and lays out the exemptions from the prohibition, which include certain underwriting activities, market making-related activities, risk-mitigating hedging activities, trading in government obligations, trading on behalf of customers, trading by a regulated insurance company, and trading by a foreign banking entity solely outside of the US. Even if otherwise allowed, activities that would involve a material conflict of interest, result in a material exposure of the banking entity to a high-risk asset or trading strategy, or pose a threat to the entity's safety and soundness or to US financial stability are prohibited. Subpart B also contains compliance, reporting, and recordkeeping requirements applicable to covered trading activities and requires banking entities with significant trading activities (i.e., those with average consolidated global trading assets and liabilities of at least $1 billion) to report certain quantitative measurements in connection with their trading activities pursuant to Appendix A.
Subpart C of the Proposed Rule, comprising Sections __.10-__.19, prohibits or restricts acquiring or retaining an ownership interest in, or sponsoring, a "covered fund," and also defines relevant terms, such as "ownership interest" and "sponsor," and establishes exemptions from the restrictions. Banking entities are permitted to organize and offer a covered fund if they satisfy a multi-faceted set of requirements, including, among others, that: i) they provide only bona fide trust, fiduciary, investment advisory, or commodity trading advisory services and the covered fund is organized and offered only in connection with the provision of such services; ii) they do not acquire or retain an ownership interest in the fund except as permitted; iii) they do not guarantee or otherwise insure the fund's obligations; iv) they do not share the fund's name; and v) they make certain disclosures to actual and prospective customers.
Subpart C describes the ownership interests that are permitted, basically limiting a banking entity's per-fund ownership to no more than three percent of the ownership interests in the fund and its aggregate fund investment to no more than three percent of the banking entity's Tier 1 capital. As with covered trading activities, banking entities may engage in certain risk-mitigating hedging activities and activities conducted solely outside of the US. They also may invest in certain types of funds, such as small business investment companies, where the investment has been deemed to be in the public interest, and in asset-backed securitizations consisting solely of loans and other permitted products. In addition, certain other covered fund activities are deemed to be permissible, such as separate accounts used solely for bank-owned life insurance, and certain joint ventures and other structures that are considered not to pose safety and soundness or systemic risk. Subpart C contains compliance, reporting, and recordkeeping requirements for covered fund activities and also prohibits material conflicts of interest and material exposure to high-risk assets and trading strategies.
Subpart D of the Proposed Rule, comprising Sections __.20 and __.21, sets forth the requirements for the compliance program relating to both the trading activities and fund activities prohibitions and addresses termination of activities or investments and penalties for violations. In general, Subpart D calls for enhanced compliance programs, including written policies and procedures, internal controls, a management framework, independent compliance testing, and extensive recordkeeping.
Appendix A sets forth the quantitative measurements that significant banking entities should compute and report with respect to their trading activities.
Appendix B provides "commentary" that is intended to help banking entities and regulators distinguish between permitted market making-related activities and prohibited proprietary trading.
Appendix C sets forth minimum requirements and standards for the Subpart D compliance programs, including for banking entities with significant trading activities. The test for banking entities to be considered significant under Subpart D is different from the Subpart B test, which only requires that average consolidated global trading assets and liabilities be at least $1 billion. For purposes of Appendix C, a banking entity will be considered significant if, as an alternative to the $1 billion trading threshold, its average consolidated trading assets and liabilities are at least 10% of its assets, or it invests in or has relationships with large covered funds, as discussed more fully in Section II.B.6 below. In addition, the entity's primary regulator may treat it as significant if it deems such treatment appropriate.
A. Proprietary Trading Prohibition and Exemptions (Subpart B)
The Proposed Rule prohibits a banking entity from engaging in proprietary trading unless otherwise permitted under the rule. The Proposal generally defines "proprietary trading" as engaging as principal for the "trading account" of a banking entity in any transaction to purchase or sell one or more "covered financial positions." The Proposed Rule clarifies that proprietary trading does not include acting as agent, broker, or custodian for an unaffiliated third party.
Banking Entities. A "banking entity" includes (i) any insured depository institution; (ii) any holding company of an insured depository institution; (iii) any foreign banking entity; and (iv) any affiliate or subsidiary of any of these entities. To avoid an anomalous outcome not intended by the statute, a banking entity does not include any affiliate or subsidiary that is a "covered fund" (defined below) or that is controlled by such a fund. The Proposed Rule will apply to the activities of a banking entity regardless of whether such activities are otherwise authorized under other applicable law.
Covered Financial Positions. A "covered financial position" is any position (including long, short, synthetic or other positions) in securities, derivatives (swaps and security-based swaps, as will be defined by the SEC and the CFTC), commodity futures, and options on any such instruments. Covered financial positions expressly exclude loans, spot foreign exchange, or spot commodities. However, they include positions in these instruments. Loans are broadly defined as any loan, lease, extension of credit, or secured or unsecured receivable. This definition does not, however, include any asset-backed security issued in connection with a loan securitization or otherwise backed by loans. Although Section 13 allows the Agencies to extend the scope of the proprietary trading prohibition to other financial instruments not enumerated in the statute, the Agencies have declined to do so for now.
Trading Accounts. Section 13 defines a "trading account" as "any account used for acquiring or taking positions in securities [or certain other instruments] principally for the purpose of selling in the near-term (or otherwise with the intent to resell in order to profit from short-term price movements)," as well as any other accounts that the Agencies by rule determine. The Proposal recognizes the difficulty of clearly identifying the purpose for which a position is taken and, in order to "provide banking entities with greater clarity," the Proposed Rule identifies three "prongs" that will, if met, cause the relevant account to be a "trading account."
(i) An account is considered a trading account when covered financial positions are taken therein principally for the purpose of short-term resale, benefitting from short-term price movements, realizing short-term arbitrage profits, or hedging another trading account position. This first prong will be construed consistently with the Federal banking agencies' Market Risk Capital Rules' approach to identifying positions taken with short-term trading interest.7
"Short-term" is not defined. The Agencies note that they expect to consider a variety of factors and information, including the new quantitative measurements the Proposed Rule will require. With respect to this prong only, the Proposed Rule includes a presumption that any account used to take a covered financial position held for 60 days or less is a trading account. A banking entity may rebut this presumption if it can demonstrate that the covered financial position, either individually or as a category, was not acquired or taken principally for any of the purposes described above.
(ii) With respect to a banking entity subject to the Market Risk Capital Rules, a trading account includes an account containing any positions in financial instruments subject to the prohibition on proprietary trading that are treated as "covered positions" under those rules (with some limited exceptions). The Proposal notes that the Market Risk Capital Rules use the term "trading account" as that term is defined in the banking entity's Call Report,8 which is substantially identical to the definition in Section 13 of the BHCA, and which incorporates the concept of taking short-term positions.9
(iii) A trading account includes any account in which covered financial positions are taken by banking entities that are registered securities dealers, swap or security-based swap dealers, or certain government securities dealers in connection with their registered activities. This would include any covered financial position taken by a banking entity engaged in the business of a dealer, security-based swap dealer, or swap dealer outside of the US as well, if such position is taken in connection with the activities of such business. These positions will be deemed part of a trading account even if held for more than 60 days.
Expressly excluded from the definition of "trading account" under all three of the above prongs are accounts used: (i) for "bona fide liquidity management purposes"; (ii) to take positions under repurchase or reverse repurchase arrangements or securities lending transactions; or (iii) in connection with certain positions of derivatives clearing organizations or clearing agencies.
To meet the standard of "bona fide liquidity management purposes" under the Proposed Rule, a liquidity management plan must be documented and meet five separate criteria, including that: (i) it specifically authorize particular instruments used for liquidity management purposes; (ii) it be used principally for the purpose of managing the liquidity of the banking entity; (iii) the positions taken be limited to highly liquid financial instruments; (iv) positions be limited to the banking entity's documented near-term funding needs; and (v) the plan be consistent with the relevant Agency's supervisory guidance.
2. Exemptions From the Prohibition, i.e. Permitted Activities
The Proposed Rule permits a banking entity to buy or sell a covered financial position in connection with underwriting activities that are designed not to exceed reasonably expected near-term demands of "clients," "customers," or "counterparties"10 and that meet seven separate criteria enumerated in the rules, including the following:
(i) The banking entity has established an internal compliance program;
(ii) The covered financial position must be a security;
(iii) The transaction must be solely in connection with a "distribution" in which the banking entity acts as "underwriter" (as both terms are defined in the SEC's Regulation M)11;
(iv) The banking entity must be appropriately registered;
(v) As set forth in the statute, the underwriting activities must be designed not to exceed the reasonably expected near-term demands of clients, customers, and counterparties;
(vi) These activities must be designed to generate revenues primarily from fees, commissions, underwriting spreads, or other income, and not from appreciation in the value of related covered financial positions held by the banking entity; and
(vii) Compensation arrangements relating to the underwriting must not encourage proprietary risk-taking.
b) Market Making
The Proposal recognizes the difficulty of clearly distinguishing between permissible market making activities, i.e., those designed to provide intermediation and liquidity services to customers, and prohibited proprietary trading activities, i.e., those involving the generation of profit through speculative risk-taking, because market making-related activities sometimes require the taking of positions as principal in amounts and over periods that differ significantly by asset class and market conditions.
To ensure that banking entities are engaged in "bona fide market making," the Proposed Rule sets out seven criteria, all of which a banking entity must meet in order to rely on this exemption. Some of these criteria are similar to those required for the underwriting exemption and are set forth below.
(i) The banking entity must implement a targeted compliance program consistent with Subpart D of the Proposed Rule.
(ii) The trading desk or organization unit purchasing or selling the covered financial position must hold itself out on a regular and continuous basis as being willing to buy and sell that position (similar to the definition of "market maker" in Section 3(a)(38) of the Securities Exchange Act of 1934 ("Exchange Act")). Appropriate indicia of "holding oneself out" would differ depending on the liquidity of the market for the covered financial position. Block positioning and taking positions in anticipation of customer demand would generally be included in the exemption if undertaken for the purpose of intermediating customer trading.
(iii) The market making-related activities must be designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties. This measure must be specific, i.e., based on particular factors relevant to a unique customer base and not just a "simple expectation of future price appreciation and the generic increase in marketplace demand that such price appreciation reflects."
(iv) The banking entity must be appropriately registered (or exempt) in connection with the covered financial position.
(v) Revenues must come primarily from fees, commissions, spreads, or other income not attributable to price appreciation.
(vi) Compensation incentives must be designed so as not to encourage or reward proprietary risk-taking. Appendix B of the Proposed Rule explains how the Agencies would assess compensation incentives.
(vii) Activities must be consistent with the commentary provided in Appendix B, which discusses the factors the Agencies will use to guide their distinctions between market making-related activities and prohibited proprietary trading activities.
Hedging activities, which we discuss as a separate exemption below, are also considered market making-related activities if they are conducted in order to reduce the specific risks to the banking entity in connection with or related to individual or aggregated positions, contracts, or other holdings acquired pursuant to the market making exemption, and the hedging transaction meets the criteria set out in the exemption for hedging activity.
c) Risk-Mitigating Hedging
The Proposed Rule permits a banking entity to buy or sell a covered financial position if the transaction is made for purposes of risk-mitigating hedging. Recognizing that the purpose of a transaction is often difficult to determine, especially in retrospect, the Agencies once again propose a set of seven criteria that a banking entity must satisfy to rely on the risk-mitigating hedging exemption. These criteria are set forth below.
(i) Implementation of a programmatic compliance regime.
(ii) Written hedging policies and procedures which, for banking entities with significant trading activity, include written policies and procedures at the trading unit level with "clearly articulated trader mandates for each trader."
(iii) Transactions must hedge or mitigate one or more specific risks, such as market risk, counterparty or other credit risk, currency, foreign exchange, or interest rate risk, or basis risk, arising in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity. Banking entities would also be permitted to engage in "dynamic hedging," where material changes in risk resulting from permissible activities or from certain market movements might require a corresponding change to the entity's hedge positions. In addition, anticipatory hedging may be appropriate in some circumstances.
(iv) Transactions must be reasonably (and not merely "tangentially") correlated to the risks they intend to hedge.
(v) The hedging transaction cannot give rise to significant unhedged exposures.
(vi) Any hedging transaction must be subject to continuing review, monitoring, and management.
(vii) Related compensation arrangements must not reward proprietary risk-taking.
In addition to satisfying the above criteria, banking entities must document certain hedging transactions at the time the hedge is established. Documentation must include the purpose of the transaction and identify the risks of the individual or aggregated positions, contracts, or other holdings the transaction is designed to mitigate.
d) Other Exemptions
In addition to the exemptions discussed above, the statute exempts from its proprietary trading prohibition trading in government obligations, trading on behalf of customers, trading by a regulated insurance company, and trading by foreign banking entities. Although the statute grants the Agencies authority to exempt additional activities, the Agencies have decided not to issue any discretionary exemptions at this time.
i) Trading in Government Obligations
The Proposed Rule permits trading in general and limited obligations of the US and US agencies, and of states and political subdivisions thereof. It also allows trading in obligations, participations, or other instruments issued by a government sponsored enterprise.
ii) Trading on Behalf of Customers
To satisfy the statutory exemption for trading on behalf of customers, a transaction will have to fall within one of the following three categories:
(i) the banking entity acts as investment adviser, commodity trading advisor, trustee, or in another fiduciary capacity, and the transaction is for the customer's account and must involve only covered financial positions that the customer beneficially owns;
(ii) the banking entity acts as riskless principal; or
(iii) the banking entity is a regulated insurance company, the transaction is for a "separate account" of the company's insurance policyholders, is conducted in accordance with applicable investment laws, regulations, or guidelines, and all profits and losses from the transaction inure to the benefit of that account.
A "separate account" is an account established or maintained by a regulated insurance company under which income, gains, and losses from assets allocated to the account, whether or not realized, are, in accordance with the applicable contract, credited to or charged against that account without regard to other income, gains, or losses of the insurance company.
iii) Trading by a Regulated Insurance Company
In addition to permitting trading in the separate account of a banking entity that is also a regulated insurance company, the Proposed Rule separately permits the insurance company or an affiliate to buy or sell a covered financial position if it is buying or selling for the insurance company's general account and acting in compliance with applicable investment laws, regulations, or guidelines that have been deemed sufficient by the applicable Federal banking agency to protect the safety and soundness of the banking entity and US financial stability. An insurance company general account is defined as all the assets of the company that are not legally segregated and allocated to separate accounts under applicable state law.
iv) Trading by Foreign Banking Entities
In an effort to limit the extraterritorial reach of the proprietary trading prohibition while also preserving US competitiveness, the Proposed Rule permits certain foreign banking entities to engage in proprietary trading activities that occur solely outside of the US. A banking entity organized under US or state law (and the subsidiaries and branches of any such entity) will not be able to rely on the exemption. A US branch or subsidiary of a foreign banking entity also will not be able to use the exemption.
To qualify for the exemption, a foreign banking entity must conduct the transaction in compliance with Sections 4(c)(9) of the BHCA.12Section 4(c)(9), which has been implemented as Subpart B of the Federal Reserve's Regulation K, sets out a number of conditions and requirements that a foreign banking entity must generally meet in order to rely on that provision's authority, including that more than half of its worldwide business is banking and that more than half of its banking business is outside of the US, as determined by factors set forth in the rule (which largely mirror the test under Section 4(c)(9)).
A transaction will be considered to have been conducted solely outside of the US if: (i) the transaction is conducted by a banking entity not organized under the laws of the US or states; (ii) no party is a US resident, broadly defined; (iii) no personnel of the banking entity directly involved in the transaction is physically located in the US; and (iv) the transaction is executed wholly outside of the US.
e) Other Prohibitions: Material Conflicts of Interest
Even if trading is otherwise permitted, the statute prohibits transactions or activity that would involve or result in a material conflict of interest between a banking entity and its clients, customers, or counterparties, result in a banking entity's material exposure to a high-risk asset or trading strategy, or pose a safety and soundness or systemic threat. The Proposed Rule defines "material conflict of interest," "high-risk asset," and "high-risk trading strategy."
A material conflict of interest will be deemed to exist if a banking entity engages in any transaction, class of transactions, or activity that would involve or result in its interests being materially adverse to the interests of its client, customer, or counterparty with respect to the transaction, class of transactions, or activity, unless the banking entity has appropriately addressed and mitigated the conflict through disclosure or information barriers. The mere fact of being on the opposite side of a transaction from a client, customer, or counterparty will not constitute a material conflict if the transaction is a properly conducted permitted activity.
A high-risk asset under the Proposed Rule is an asset or group of assets that would, if held by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or fail. A high-risk trading strategy similarly is one that would significantly increase the likelihood that a banking entity conducting the strategy would incur a substantial financial loss or fail.
3. Compliance Program, Reporting, and Recordkeeping
All covered banking entities will generally be required to establish a compliance program and comply with onerous reporting and recordkeeping requirements. In addition, banking entities with significant trading activity will also be required to comply with significant quantitative measure reporting requirements. Banking entities that do not engage in prohibited activities will not be required to adopt a new compliance program as long as their existing policies and procedures include measures designed to prevent the entity from engaging in these activities.
The compliance program for all banking entities engaging in covered trading must, at a minimum, include: (i) internal written policies and procedures reasonably designed to document, describe, and monitor the trading activities and covered fund activities; (ii) a system of internal controls reasonably designed to monitor and indentify potential areas of noncompliance; (iii) a management framework with clearly delineated lines of responsibility; (iv) independent testing; (v) training; and (vi) record creation and retention for at least five years.
Appendix A, which must be incorporated into the banking entity's compliance program, requires banking entities with significant trading activities to record and report to their primary financial regulator certain quantitative measures. Measures are required to be calculated daily and reported monthly. These requirements, which vary depending on the size and nature of the trading activities and are required at the trading unit level, are intended to assist the banking entity and the regulators to distinguish between market making and proprietary trading and also to determine whether trading activity has resulted in the banking entity's material exposure to high-risk assets and trading strategies. Requirements are significantly more burdensome for banking entities with gross trading assets and liabilities of at least $5 billion and somewhat less onerous for banking entities with gross trading assets and liabilities between $1 billion and $5 billion. The Proposal notes that the requirements for any of these entities, while necessary, may not be sufficient to identify impermissible activities and thus an adequate compliance program might require more. The Proposed Rule does not contain numerical thresholds for the quantitative measurements, but it appears from the Proposal that the Agencies would generally favor some thresholds. They have requested comment on whether to include thresholds in order to provide banking entities with greater clarity.
B. Covered Fund Activities and Investments (Subpart C)
1. General Prohibition and Definitions
Section 13 of the BHCA generally prohibits a banking entity from acquiring and retaining any ownership interest in, or acting as sponsor to, a covered fund. As with the proprietary trading prohibition, the statute includes a number of exemptions. The Proposed Rule's prohibition would apply to a banking entity engaging in covered activities as principal, directly or indirectly.
A "covered fund" is defined in the statute as "any issuer that would be an investment company, as defined in the [Investment Company Act], but for [S]ection 3(c)(1) or 3(c)(7) of that Act," or any similar fund that the Agencies determine to include. The Proposed Rule tracks the statute by including hedge funds and private equity funds in the definition. It also includes commodity pools and any foreign equivalent of a hedge fund, private equity fund, or commodity pool. However, recognizing that the Section 3(c)(1) and 3(c)(7) exclusions are relied on by a wide variety of entities that would otherwise be considered "investment companies," but that do not typically engage in investment or trading activities, the Proposed Rule excludes any issuer (including an issuer of asset-backed securities) that can rely on any other exclusion or exemption from the definition of "investment company" under the Investment Company Act.
The Proposed Rule defines "ownership interest" broadly to mean any equity, partnership, or other similar interest in a covered fund, whether or not it is a voting interest, as well as any derivative of that interest. Thus, if a debt security of a covered fund has similar characteristics to an equity interest (e.g., it provides the holder with voting rights or the ability to share in the profits or losses), it could be considered an ownership interest. "Carried interest" will generally not be included in the definition of "ownership interest." Thus, the Proposed Rule permits a banking entity to receive an interest as performance compensation for services it or one of its affiliates or employees provides to a covered fund if certain conditions are met.
A banking entity would act as a "sponsor" to a covered fund if it exercises some control over the fund. Thus, a banking entity that serves as a general partner, managing member, trustee, or commodity pool operator of a fund, or that selects or controls a majority of the fund's directors, trustees, or management, or that shares a name or a similar name with the fund, will be deemed to sponsor the fund. However, a trustee that does not exercise investment discretion in a covered fund would not be included.
2. Permitted Activities
The statutory prohibition generally would not apply to the acquisition or retention of an ownership interest by a banking entity that acts in a fiduciary capacity or as a custodian, broker, or agent for an unaffiliated third party. It also would not apply to certain banking entities that are "qualified plans" under Section 401 of the Internal Revenue Code or to directors or employees of a banking entity acting in their personal capacity and who are directly engaged in the provision of advisory services to the covered fund. The prohibition also would not cover prime brokerage transactions, which are defined in the Proposed Rule to mean the provision of services such as custody, clearance, securities borrowing or lending support, trade execution, or financing, data, operational, and portfolio management support.
Thus, the Proposed Rule will allow banking entities to continue to engage in traditional asset management and advisory businesses, such as organizing and offering a covered fund, as long as all of the conditions enumerated in the Proposed Rule are satisfied.
a) Exemption for Bona Fide Fiduciary Services
The banking entity must provide bona fide trust, fiduciary, investment advisory, or commodity trading advisory services and the covered fund must be organized and offered only in connection with those services and only to the banking entity's customers of those services. The banking entity must also comply with ownership and other restrictions and limitations and must make clear disclosure to any prospective or actual investor of the entity's role in the fund, that the fund is not insured by the FDIC, and that losses will be borne by the investor.
The Proposed Rule does not explicitly require a pre-existing customer relationship. Rather, it focuses on the idea that a banking entity may not organize and offer a covered fund as a means of investing in the fund or its assets for itself. Recognizing that substantially similar investment advisory services are subject to variations in functional regulation, the Proposed Rule does not define bona fide services.
b) Permitted Investments
A banking entity may acquire or retain a limited investment interest in a covered fund that it or an affiliate organizes and offers. The Proposed Rule contains both a per covered fund and an aggregate covered funds investment limitation. The banking entity may initially provide the fund with sufficient equity to allow the fund to attract unaffiliated investors. The banking entity will be required to seek such investors actively and to reduce its own seed investment to no more than three percent of the total outstanding ownership interests of the fund within one year of the establishing the fund. After that time, the banking entity's investment may not exceed three percent of the total outstanding ownership interests in the fund. It also may not invest more than three percent of its Tier 1 capital in all covered funds. A banking entity may seek an extension from the Federal Reserve for compliance with the per-fund limitation.
c) Restrictions on Certain Transactions or Relationships
The Proposed Rule generally prohibits transactions or relationships by a banking entity with a covered fund that would be a "covered transaction" under Section 23A of the Federal Reserve Act. However, any transaction permitted under new Section 13(f) of the BHCA (Dodd-Frank Section 619), including prime brokerage transactions and the acquisition or retention of an ownership interest in a covered fund in accordance with Subpart C of the Proposed Rule, that otherwise would have been considered a "covered transaction" under Section 23A and thus prohibited, is nevertheless permissible under the Proposed Rule.
Any transaction that is specifically exempted by the Federal Reserve pursuant to its authority under Section 23A of the Federal Reserve Act to exempt purchases of "real and personal property" would, by definition, not be a "covered transaction" under Section 23A and thus would not be subject to the prohibition in the Proposed Rule.
Any permitted activity will be subject to Section 23B of the Federal Reserve Act as if the banking entity were a member bank and the covered fund were an affiliate of that entity, i.e., permitted transactions must be at least as favorable to the banking entity as they would be if the covered fund were an unaffiliated entity.
d) No Guarantees
To prevent a banking entity from "bailing out" a covered fund in which it has an interest, the Proposed Rule prohibits the banking entity from, directly or indirectly, guaranteeing, assuming, or otherwise insuring the obligations or performance of a covered fund or of any covered fund in which that fund invests.
e) No Sharing of Names
A banking entity that organizes and offers a fund (and its affiliates) may not share a name or a variation of the same name with a covered fund for any purpose. The fund also may not use the word "bank" in its name.
f) Limitations on Director or Employee Activities
The banking entity's directors and employees may not take or retain an ownership interest in a covered fund unless they are directly engaged in providing investment advisory or other services to the fund.
As noted above, the Proposed Rule also requires banking entities engaging in covered fund activities to disclose "clearly and conspicuously" to any prospective or actual investor in the covered fund, among other things, that the fund's losses will be borne solely by investors and that the fund is not insured by the FDIC. The disclosure requirements may be met by including them in the fund's offering documents.
3. Exemptions from the Prohibition
Because such investment is deemed to be in the public interest, the statute and the Proposed Rule permit banking entities to invest in one or more Small Business Investment Companies ("SBICs") and similar funds. As with the exemption from the prohibition on proprietary trading, certain limited risk-mitigating hedging activities in connection with covered fund activities are also permitted. Similarly, foreign banking entities may engage in covered fund activities if those activities occur solely outside of the US. Finally, a covered fund that issues loan-based asset-backed securities is also exempt from the activities prohibition.
a) Permitted Hedging Activities
For the hedging exemption to apply, the transaction with the covered fund must be made in connection with and must be related to individual or aggregate positions, contracts, or other holdings of the banking entity and must be designed to reduce the specific risks to the banking entity from those positions, contracts, or holdings. A banking entity could potentially acquire or retain an ownership interest in a covered fund as a hedge where it (i) acts as "riskless principal" to facilitate customer exposure to the covered fund; and (ii) covers a compensation arrangement with an employee who directly provides investment advisory or other services to the covered fund. Because of the perceived potential for abuse, the Agencies have proposed a multi-faceted test for whether the hedging exemption would be available. In addition to satisfying the requirements discussed above and additional requirements relating to the hedge itself, the banking entity must establish a comprehensive internal compliance program and hedging must be conducted in compliance with written policies and procedures under that program. Many of these requirements are similar to those proposed for the proprietary trading risk-mitigating hedging exemption, discussed above in Section II.A.2.c.
b) Foreign Banking Entities and Activities Outside of the US
As with the exemption from the proprietary trading prohibition, foreign banking entities whose covered fund activities occur solely outside of the US will be exempt from the covered fund activities prohibition as well (see Section II.A.d.4 above for definition of foreign banking entities). For a covered fund activity to have occurred solely outside of the US, it must meet three conditions under the Proposed Rule: (i) it must be conducted by a foreign banking entity; (ii) no subsidiaries, affiliates, or employees of the banking entity may be incorporated or physically located in the US; and (iii) no ownership interest in the fund may be offered or sold to a US resident.
c) Sale and Securitization of Loans
The Proposed Rule exempts from the covered fund activities prohibition a covered fund that issues asset-backed securities where the underlying assets are comprised solely of loans, contractual rights or assets arising directly from those loans, and interest rate or foreign exchange derivatives that materially relate to the terms of those loans or contractual rights or assets and that are used for hedging with respect to the securitization structure. The requirement that derivatives "materially relate" to the terms of the loans is intended to limit the quantity of derivatives that can be used in a securitization of loans. In addition, because any such derivatives must be used to hedge risks that result from any mismatch between the loans and the related asset-backed securities, the Proposing Release notes that the Proposed Rule would not allow a credit default swap by an issuer of asset-backed securities.
4. Discretionary Permitted Activities
The statute permits the Agencies to create additional exemptions that they deem will protect and promote a banking entity's safety and soundness and US financial stability. The Proposed Rule contains three such discretionary exemptions.
a) Bank-owned Life Insurance Separate Accounts ("BOLIs")
Recognizing that investments by banking entities in life insurance policies that cover key employees do not typically involve speculative risks and help banking entities reduce their employee benefit costs, the Proposed Rule permits BOLI investments in separate accounts even though such accounts would be investment companies but for a 3(c)(1) or 3(c)(7) exclusion.
b) Investments in Other Covered Funds
Because a number of entities could be forced to change their corporate structure without any accompanying reduction in risk, the Proposed Rule permits ownership in or sponsorship of: (i) a joint venture between the banking entity and another person as long as the venture is an operating company that does not engage in any prohibited activity under the Proposed Rule; (ii) an acquisition vehicle whose sole purpose is to effectuate the merger or acquisition of an entity with the banking entity or one of its affiliates; and (iii) a wholly-owned subsidiary of the banking entity that engages in bona fide liquidity management services, as described in Section II.A.1, above, and which is carried on the banking entity's balance sheet.
The Proposed Rule also makes clear that a banking entity's compliance with the Dodd-Frank risk retention rules will not constitute prohibited covered fund activities.13 Thus, a banking entity's investment in or sponsorship of an asset-backed securities issuer will be permitted up to the amount of credit risk it is required to retain.
Finally, in order to allow banking entities to manage their risks more effectively, the Proposed Rule permits a banking entity to engage in covered fund activities where such activities are done in the ordinary course of collecting a previous good faith debt.
5. Limitations on Permitted Activities
To the extent that any permitted activity would result in a material conflict of interest or in the banking entity's material exposure to a high-risk asset or trading strategy, or would pose a threat to the banking entity's safety and soundness or to US financial stability, the exemption or exclusion from the general prohibition would be unavailable.
6. Compliance Program, Reporting, and Recordkeeping
The compliance requirements for banking entities engaging in covered fund activities are similar to those required for proprietary trading activities, discussed above in Section II.A.3. With respect to covered fund activities, the threshold to be considered a significant banking entity subject to heightened compliance requirements is either: (i) aggregate investments of the banking entity and its affiliates in covered funds where the average value of those funds over each of the four preceding calendar quarters is at least $1 billion; or (ii) sponsorship by the banking entity and its affiliates of one or more covered funds the average total assets of which are at least $1 billion.
The length and complexity of, and the large number of questions in, the Proposed Rule indicate that the debate will continue on both of the core elements of the Proposal, i.e., proprietary trading and covered fund activities. Because the multi-factored tests and extensive compliance requirements laid out in the Proposed Rule will have a significant impact on all affected market participants, we expect to see active regulatory engagement on this Proposal over the next few months.
1 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2 Section 619 requires the CFTC to adopt rules for covered entities for which it is the primary financial regulator. The statute does not require a joint rulemaking, however, and thus the CFTC will likely issue its rule proposal independently of the Agencies.
3 To be codified at 12 USC § 1851.
4 The FSOC issued a reproposed Notice of Proposed Rulemaking on SIFI designation on the same day that the FDIC approved the Proposed Rule. See Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (Oct. 11, 2011), available atwww.treasury.gov/initiatives/fsoc/Documents/Nonbank%20Designation%20NPR%20-%20Final%20with%20web%20disclaimer.pdf.
5 The Federal Reserve, the OCC, and the FDIC, jointly, have authority over insured depository institutions under Section 13; the Federal Reserve has authority over holding companies of insured depository institution, companies that are treated as bank holding companies for purposes of Section 8 of the International Banking Act, SIFIs, and any subsidiary of any of these entities (except for subsidiaries for which an appropriate Federal banking agency, the SEC, or the CFTC is the primary financial regulatory agency); and the SEC and CFTC have authority over entities for which they are the primary financial regulatory agency, respectively.
6 Final Rule, Conformance Period for Entities Engaged in Prohibited Proprietary Trading or Private Equity Fund or Hedge Fund Activities, 76 Fed. Reg. 8265 (Feb. 14, 2011).
7 See Proposed Rules, Risk-Based Capital Guidelines: Market Risk ("Market Risk Capital Rules"), 76 Fed. Reg. 1890 (Jan. 11, 2011).
8 A Call Report is the Report of Condition and Income that banks are required to file periodically as to their financial condition.
9 The second prong has been included in anticipation of adoption of the proposed Market Risk Capital Rules in this context. The Agencies expect to revisit this prong if such rules are not adopted largely as proposed.
10 The proposal does not define these terms but seeks comment on whether and how they should be defined.
11 17 CFR Part 242.
12 The statute also references Section 4(c)(13) of the BHCA. However, the Federal Reserve has only applied the 4(c)(13) authority to foreign activities of US banking organizations, which are not eligible for the foreign banking entity exemption.
13 Section 941 of Dodd-Frank added new Section 15G to the Securities Exchange Act. Section 15G requires a banking entity that is a securitizer or originator of an asset-backed security to retain an economic interest in some portion of the credit risk of the securitization. The Agencies have proposed, but not yet finalized, credit risk retention rules. See Proposed Rule, Credit Risk Retention, 76 Fed. Reg. 34010 (Jun. 10, 2011).