Understanding the Volcker Rule:
g
Covered Funds and Proprietary Trading Prohibitions
Adam Gale
Adam
Gale
Chadbourne & Parke LLP
agale@chadbourne.com
(212) 408‐5196
(212) 408
5196
1
Presenter Adam Gale
Presenter –
Adam Gale
Adam Gale, Counsel in the New York office of Chadbourne & Parke Ad
G l C
l i th N Y k ffi
f Ch db
&P k
LLP, specializes in regulatory and compliance issues for banks, broker‐dealers, hedge funds, private equity funds, commodity traders and registered investment companies He is a frequent traders and registered investment companies.
He is a frequent
writer and speaker on regulatory issues, including issues relating to the Dodd‐Frank Act and the Volcker Rule. Adam is the head of Chadbourne'ss hedge fund practice and represents both established Chadbourne
hedge fund practice and represents both established
hedge fund and private equity fund managers and start‐up entities in fund structure and formation, as well as a number of major j
g
,
investors into funds. Prior to joining Chadbourne, Adam was Senior Counsel at The Bank of New York (now BNY Mellon). He was recently called on to advise the Office of the Comptroller of the Currency on issues relating to the Volcker Rule. Adam has represented both large and small U.S. and foreign banking institutions on U.S. bank regulatory issues. 2
Chadbourne & Parke LLP
Chadbourne & Parke LLP
Chadbourne & Parke LLP is an international law firm with 12 offices Ch
db
& P k LLP i
i t
ti
l l fi
ith 12 ffi
around the world. Since its founding in 1902, Chadbourne has been dedicated to providing practical business solutions to a diverse range of clients in virtually all areas of law emphasizing private
range of clients in virtually all areas of law, emphasizing private equity and hedge fund formation, investment management regulatory and compliance, bank regulation, M&A, corporate/corporate finance, U.S. and international tax, bankruptcy
corporate/corporate finance, U.S. and international tax, bankruptcy and financial restructuring, energy/renewable energy, project finance, insurance/reinsurance, intellectual property, commercial p
y g
,
g
g
y
and product liability litigation, securities litigation and regulatory enforcement, antitrust, real estate and communications. In addition to the U.S. and North America, major geographical areas of concentration include Latin America, Western Europe, Central and Eastern Europe, Russia and the Middle East.
3
Structure of Volcker Rule
• Consists of two general prohibitions:
1. Covered Funds Prohibition
“Banking entities” may not sponsor or
acquire an interest in “covered
covered funds”
funds
2. Proprietary Trading Prohibition
“B ki entities”
“Banking
titi ” may nott engage in
i
“proprietary trading”
4
Agenda
I. Current Status and Who is Covered
II. Covered Funds Prohibition
Covered Funds Prohibition
III. Issues for Non‐U.S. Banks Under the C
Covered Funds Prohibition
d
d
hibi i
IV. Proprietary Trading Prohibition
p
y
g
V. Compliance Programs
5
II. Current Status and
Current Status and
Who is Covered
6
Proposed Rules
Proposed Rules
• Volcker Rule was enacted as § 619 of the Dodd‐Frank Act in July 2010
Act in July 2010.
• The specific provisions, however, must be set forth in p
g
y
g
,
Rules to be promulgated by various regulators, most notably the Board of Governors of the Federal Reserve.
• The Fed issued Proposed Rules in October 2011.
h
d
d
d l
b
• Thousands of comment letters were submitted.
• Awaiting the Final Rules, which were due on July 21, h
l l
h h
d
l
2012. Final Rules are likely to be issued within the next few months
next few months.
• This presentation analyzes the Proposed Rules.
7
Effective Date and Conformance Periods
– Under the Dodd‐Frank Act, the Volcker Rule’s prohibitions were supposed to become “effective”
to become effective on July 21, 2012, even if the Rules were not yet on July 21 2012 even if the Rules were not yet
finalized by that date. – Compliance with the Volcker Rule, however, is not required as of the effective date Instead the Volcker Rule provides for a two‐year
effective date. Instead, the Volcker Rule provides for a two
year transition transition
period (“conformance” period) from the effective date, during which banking entities must bring all of their activities in compliance with all of the Volcker Rule prohibitions.
– Fed has made clear that the conformance period ends on July 21, 2014.
– It was initially unclear whether banking entities, during the two‐year co o a ce pe od, cou d t ate e act t es t at ou d be p o b ted
conformance period, could initiate new activities that would be prohibited under the Volcker Rule.
– In April 2012, the Fed issued guidance that banking entities may continue to engage in prohibited activities, including initiating new activities that g g
p
,
g
g
would be prohibited, until July 21, 2014. – Banking entities need to be careful, however, that any new activities can in fact be wound up prior to July 21, 2014.
8
Who is Covered:
Definition of “Banking Entity”
• Any insured depository institution (as defined in §3 of the Federal Deposit
Insurance Act);
• any company that controls an insured depository institution;
• an
any company
compan that is treated as a bank holding company
compan for purposes
p rposes of § 8
of the International Banking Act of 1978;
• any “affiliate” of the above and
• any subsidiary of the above.
• Includes any non-U.S.
non U S bank with a U.S.
U S branch or agency office
office, or that
operates a New York Article XII investment company subsidiary, and any
affiliate.
• Definition of "banking entity" excludes an institution that functions solely in a
trust or fiduciary capacity and meets a number of other requirements,
including that all or substantially all of the deposits of the institution are in
trust funds and received in a bona fide fiduciary capacity.
9
Definition of “Banking
Banking Entity”
Entity
• Bank Holding Company Act “control” principles apply in determining whether
an affiliate is a “banking entity.”
- Accordingl
Accordingly, an affiliate includes
incl des anyone
an one that owns
o ns 25% or more of the
voting securities of another entity. The affiliate definition therefore picks up
more entities than one might normally think of as affiliates.
• Affiliates or subsidiaries of banks that are asset managers or other
investment advisers are included in the definition of “banking entity”
- But a banking entity is allowed to solely act as an investment adviser to a
fund.
• Under the Proposed Rules
Rules, a “banking
banking entity”
entity does not include a private
equity fund or hedge fund that qualifies for the so-called “asset
management” permitted activity.
- Thus,
Thus a hedge fund sponsored by a banking entity can engage in proprietary
trading.
10
II. Covered Funds Prohibition
11
Summary of Covered Funds Prohibition
Banking entities are prohibited from:
“
“sponsoring”,
i ” or
investing in (acquiring or retaining an “ownership interest” in)
a hedge fund,
fund private equity fund
fund, and numerous other types of privately
offered funds and pooled investment vehicles (referred to as “covered
funds” in the Proposed Rules),
except for funds that are organized and offered by the banking entity,
subject to:
o (a) the banking entity owning no more than 3% of the covered fund;
o (b) an overall limit of 3% of the banking entity's tier 1 capital
invested in covered funds; and
o (c) numerous other limitations,
limitations such as to the name of the fund
fund.
In addition, the banking entity may make seed investments in a fund,
including owning 100% of a fund, for up to one year.
12
Summary of Covered Funds Prohibition
Restrictions on Transactions With Affiliated Covered Funds
(Super 23A Provision):
- Any banking entity that sponsors a covered fund,
- an investment
i
t
t adviser
d i
tto a covered
d ffund
d
(even if it does not otherwise sponsor the fund), and
- any affiliate:
may not enter into a transaction with the fund that would be a
"covered transaction" as defined under Federal Reserve Act
Section 23A, and must also comply with Federal Reserve Act
Section 23B,
exceptt that
th t the
th Federal
F d lR
Reserve may allow
ll
prime
i
brokerage transactions if certain requirements are met.
13
Definition: “Covered Fund”
• The Act prohibits investments in a “hedge fund” or a “private equity
fund”.
• Proposed Rules prohibit investments in a “covered fund”, but the
definitions in both the Act and the Proposed Rule are almost identical:
• An issuer that would be an investment company as defined in the
Investment Company Act of 1940 (the '' '40 Act"), but for section 3(c)(1)
or 3(c)(7) of the ‘40 Act.
• Proposed Rules add two other categories to the definition of “covered
fund”:
o A “commodity
commodity pool”
pool , as defined in section 1a(10) of the Commodity
Exchange Act; and
o An issuer organized outside the U.S. that would be a covered fund if
organized in the U.S. or offered to U.S. residents.
• Regulators also have the ability to later add to the definition of covered
fund any other entity that is a “similar
similar fund”
fund .
14
Covered Fund Definition:
Effect on Other Types of Transactions
• Almost all hedge funds and traditional private equity funds rely on the '40 Act exemptions
from registration under sections 3(c)(1) (100-investor
(100 investor limit) or 3(c)(7) (all investors must
be "qualified purchasers").
• Beyond hedge funds and private equity funds, many other types of privately offered
f d and
funds
d entities
titi also
l rely
l on th
these exemptions,
ti
iincluding
l di th
the ffollowing:
ll i
o most venture capital funds (there is no exemption in the Volcker Rule for VC funds);
o many real estate funds (there is no exemption in the Volcker Rule for RE funds);
o some types of special purpose vehicles used in project finance transactions; and
o some structured finance vehicles (such as CLOs and CDOs).
• Effect of the definition of covered funds is that in any transaction in which a banking
entity
tit is
i iinvolved
l d and
d th
thatt iis using
i a privately
i t l offered
ff d entity
tit th
thatt iis relying
l i on th
the ’40 A
Actt
exemptions, the banking entity will need to determine if the Volcker Rule prohibits the
banking entity’s involvement.
• For example, a banking entity could not invest in a real estate fund that is relying on the
3(c)(1) or 3(c)(7) exemption, without meeting the other requirements of the covered
funds regulations.
15
Covered Fund Definition:
Effect on Tax Equity Transactions
• Another example of the Volcker Rule’s unexpected reach is that some bank
investments as tax equity participants
investments,
participants, in renewable energy projects could run
afoul of the Volcker Rule, depending on how the transactions are structured.
• If a banking entity invested directly into an entity that developed energy
projects (or invested into a holding company that owns project companies)
companies),
there would be no problem because the bank would be investing into an
operating company, which would not be relying on a ‘40 Act exemption.
• If,
If h
however, a b
banking
ki entity
tit formed
f
d an intermediate
i t
di t entity,
tit and
d that
th t
intermediate entity then invests into a project company, the intermediate entity
might be a “covered fund”, depending on the structure, because it is likely that
the intermediate entity would be relying on the 3(c)(1) or 3(c)(7) exemption
under the ’40 Act.
• This type of structure is often used when the banking entity is acting as a
syndicator
di t off ttax equity
it iinvestments,
t
t and
dh
has one or more unaffiliated
ffili t d investors
i
t
in the intermediate entity.
16
Definition: "Sponsoring"
Sponsoring a Fund
"Sponsoring" a fund is defined as:
• serving as a general partner, managing member, or trustee of a covered fund;
(Proposed Rules add serving as a commodity pool operator)
• in any manner selecting or controlling (or having employees, officers, directors
or agents who constitute) a majority of the directors, trustees or management of
a fund; or
• sharing with a fund, for corporate, marketing, promotional, or other purposes,
the same name or a variant of the same name.
• Note that solely acting as an investment adviser to a fund, but not otherwise
investing in the fund or acting in any other capacity (such as acting as a GP), is
allowed ((and the adviser mayy receive “carried interest”),
), as long
g as the adviser
does not share with the fund the same name or a variant of the same name.
• Merely advising a fund, however, subjects the adviser (if it is a "banking entity")
and its affiliates to the Federal Reserve Act Section 23A and 23B restrictions on
transactions with the fund (discussed below).
• Proposed Rules clarify that “trustee” does not include a trustee that has no
investment discretion with respect to a covered fund.
17
Definition: “Ownership
Ownership Interest”
Interest
• Act did not define “ownership interest” but the Proposed Rules define it as:
any equity, partnership or other similar interest (including a GP interest,
warrant, and option) in a covered fund, whether voting or nonvoting,
or any derivative of such interest.
• N
Note
t that
th t the
th addition
dditi off a “derivative
“d i ti off such
h interest”
i t
t” in
i the
th Proposed
P
d Rule
R l
means that banks need to be careful about acquiring swaps or other types of
derivatives that would give the bank an economic interest in a covered fund.
• Proposed Rules specifically exclude “carried interest” - an interest in the
share of the performance allocation - if the banking entity (including its
affiliates and employees) meet a number of requirements:
o serving as the investment manager/adviser or commodity trading adviser;
o sole purpose of the interest is to share in the profits for performance
compensation for services provided (but a clawback obligation (i
(i.e.,
e obligation
to return profits) is allowed);
o the profits are distributed promptly, or if not so distributed, the bank’s
e ested profit
p o t does not
ot sshare
a e in tthe
ep
profits
o ts a
and
d losses
osses o
of tthe
e co
covered
e ed fund;
u d;
reinvested
o the banking entity does not pay for its interest; and
o the interest is not transferable, except to affiliates.
18
3% Limitations
Subject to a long list of further limitations (listed below), a
banking entity may acquire an ownership interest in a fund
fund,
if:
• it organizes and offers the fund
(so it cannot simply be a passive investor);
• its investment is not more than 3% of the total ownership
i t
interests
t in
i any single
i l covered
d ffund
d
(subject to an exception for the first year only); and
• the aggregate value of all of its ownership interests in all
covered funds does not exceed 3% of the banking entity's
tier 1 capital (i.e., its regulatory capital).
19
3% Limitations
Proposed Rules add further requirements as to which investments must
be included in calculating
g the 3% limitation in any
y single
g fund and must
include:
• interests in the fund held by an entity that is controlled, directly or
indirectly, by the banking entity;
• its pro rata share of interests held by a covered fund that is not
controlled by the banking entity, but in which the banking entity owns
or controls more than 5% of the voting shares; and
• co-investments with a covered fund organized by the banking entity.
In addition,
addition under the Proposed Rules,
Rules in calculating 3% limitation in
any single fund, the banking entity must use either the percentage of
(A) capital contributions; or (B) ownership interests, whichever is
greater.
• Note this could cause an issue for a PE fund if an investor is excused
from certain investments, causing the bank’s contributions to exceed
3%, even if its commitment equals 3%.
20
Seed Investments Permitted for One Year
Subject to the further limitations set forth below, a banking entity may
provide a fund with 100% of its initial equity "to
to permit the fund to attract
unaffiliated investors," provided that:
 within one year of the fund's establishment, the banking entity must
reduce its ownership to no more than 3% of the total ownership
interests in the fund, through redemption, sale or dilution (or other
methods);
); and
 the one-year limit may be extended for up to two additional years,
upon a banking entity's application and approval by the Federal
Reserve if it finds that an extension “would
would be consistent with safety
and soundness and in the public interest.”
21
Seed Investments Permitted for One Year
Proposed Rules provide further guidance on extension applications:
• Must
M
b
be submitted
b i d 90 d
days prior
i to the
h end
d off the
h one-year period;
i d
• Explain the plan for reducing the investment in the covered fund;
• Fed will consider a number of factors in reaching its decision
decision,
including:
o whether the investment would result in a “material” exposure by the
banking entity to high-risk assets or trading strategies;
o whether the investment would involve material conflicts of interest
between the banking entity and its clients
clients, customers and
counterparties; and
o the banking entity’s prior efforts to reduce its interests in the fund.
22
Other Requirements
In order to be able to use the 3% limit and the seed investment exceptions, the banking
entity must comply with all of the following requirements:
• provide bona fide trust, fiduciary, or investment /commodity trading advisory services;
• organize and offer the fund only in connection with the provision of such services, and
only to persons who are “customers” of such services of the banking entity;
o Note: Fed has clarified that “customers” includes prospective investors, even if they
have no current relationship with the banking entity.
p y with the Federal Reserve Act Section 23A and 23B restrictions
• with its affiliates, comply
on transactions with such funds (discussed below);
• not, directly or indirectly, guarantee, assume or otherwise insure the obligations or
performance of the fund, or of any fund in which such fund invests;
• not share with the fund, for corporate, marketing, promotional or other purposes, the
same name or a variant of the same name (and the fund cannot use “bank” in its name);
• not allow any director or employee of the banking entity to take or retain any “ownership
interest” in the fund, except for any director or employee who is “directly engaged in
providing investment advisory or other services” to the fund; and
• disclose to prospective and actual investors in the fund, in writing, that any losses in
such
h ffund
d are b
borne solely
l l b
by iinvestors
t
iin th
the ffund
d and
d nott b
by th
the b
banking
ki entity,
tit along
l
with other required disclosures.
23
Further Limitations on Permitted Activities
• In order to engage in any "permitted activity" under the covered funds rules, no
transaction, class of transactions or activity may:
o involve or result in a material conflict of interest between the banking entity
and its clients, customers, or counterparties;
o result, directly or indirectly, in a material exposure to high risk assets or high
risk trading strategies (defined in the Proposed Rules as significantly
increasing the likelihood that the bank would incur a substantial financial loss
or would fail); or
op
pose a threat to the safety
y and soundness of such banking
g entity
y or to the
financial stability of the U.S.
• Proposed Rules provide that a material conflict exists if the banking interests
are materially adverse to the client
client, customer or counterparty with respect to
the transaction, unless either:
o the banking entity timely discloses the conflict in advance, in a manner
allowing the other party to negate or mitigate the adverse effect; or
o the banking entity has established and maintained information barriers in
written policies and procedures designed to prevent the conflict from resulting
in a material adverse effect on the other party
Note that the bank may not rely on the information barriers if it should reasonably
24
know that the conflict may materially adverse effect the other party.
Other Permitted Activities
• In addition to the permitted 3% limitation, the Act includes an exception for
investments in certain covered funds organized outside of the U.S.
(Non-US exemption is discussed in detail below.)
• Proposed Rules include a number of new exceptions as other “permitted
activities”:
o Investments
I
t
t in
i SBICs;
SBIC
o Investments to promote the public welfare under 12 U.S.C. 24;
o Qualified rehabilitation expenditures with respect to building rehabs;
o Risk-mitigating
Risk mitigating hedging activities
- Acting as intermediary for non-bank customer to facilitate customer’s
exposure to profits and losses of the covered fund; or
- Connected to a compensation arrangement with bank employee who
directly provides investment advisory or other services to the fund
- A number of other requirements apply, including: establishing compliance
controls; mitigating exposure to the covered fund through an offsetting
exposure; and documenting at time of the transaction the risk-mitigating
purpose.
25
Further Permitted Activities
Proposed Rules further allow sponsoring, or acquiring an ownership interest in:
• A covered fund that issues asset-backed securities, so long as fund’s assets
are solely
l l comprised
i d of:
f
o Loans;
o Contractual rights or assets arising from loans supporting ABSs; or
o Interest rate or FX derivatives relating to terms of loans or contractual
rights, and used for hedging purposes.
• A jjoint
i t venture
t
b
between
t
the
th banking
b ki entity
tit and
d any other
th person, if the
th JV is
i an
operating company, and does not engage in other prohibited activity.
• An acquisition vehicle for the purpose of a merger or acquisition.
• An issuer of ABS, but only as to the portion of the credit risk that is retained by
a banking entity that is a securitizer or originator.
• A wholly-owned
wholly owned subsidiary of the banking entity that performs liquidity
management activities and carried on the banking entity’s balance sheet.
• Investments in certain bank-owned life insurance separate accounts.
•A
Acquiring
i i an iinterest
t
t iin a covered
d ffund
d iin th
the ordinary
di
course off collecting
ll ti a
debt (so long as bank subsequently divests its interest within one year).
26
Extended Transition Period for "Illiquid
Illiquid Funds"
Funds
The Federal Reserve may, upon application by any
b ki entity,
banking
i extend
d the
h transition
i i period
i d ffor that
h
particular banking entity:
 for
f up to
t a maximum
i
off 5 years (which
( hi h iis iin addition
dditi tto
the 2-year transition period)
- so could extend until July 21,
21 2019; and
 “to the extent necessary to fulfill a contractual obligation
that was in effect on May 1, 2010” to take or retain any
ownership interest in, or otherwise provide additional
capital to, an "illiquid fund. "
27
Extended Transition Period for "Illiquid
Illiquid Funds"
Funds
An "illiquid fund" is defined as a covered fund that:
o as of May 1,
1 2010,
2010 was principally invested in
in, or was invested and
contractually committed to principally invest in, "illiquid assets"; and
o makes all investments pursuant to, and consistent with, an
i
investment
t
t strategy
t t
to
t principally
i i ll invest
i
t in
i illi
illiquid
id assets.
t
• Proposed Rules include a definition of “illiquid assets”, which
includes any asset that is: not cash; not traded on an exchange;
and does not have an initial term of one year or less.
• Most p
private equity
q y funds ((which invest in p
portfolio companies),
p
), as
well as real estate funds and venture capital funds, presumably
would be able to obtain the extension.
• Very few hedge funds would fit within the definition of "illiquid
illiquid fund
fund,"
as the investment strategy of most hedge funds is to principally
invest in liquid, rather than illiquid, assets.
28
Potential Alternative for Bank Investments
Potential Alternative for Bank Investments
● Although a banking entity cannot invest at all in a covered fund
that it does not offer and organize, a banking entity could make a coinvestment, alongside a covered fund, directly into a portfolio
company
p y ((if that p
portfolio company
p y is an operating
p
g company).
p y)
● The co-investment could not be made pursuant to a coi
investment
t
t fund,
f d as that
th t co-investment
i
t
t fund
f d would
ld b
be a ""covered
d
fund", which would violate the Volcker Rule.
● There would be no violation, however, if the banking entity made
a direct investment into the operating company, and the banking
entity could enter into a separate advisory agreement with a fund
manager whereby
h b th
the b
banking
ki entity
tit agrees tto pay ffees tto th
the ffund
d
manager for advising the banking entity on the co-investment.
29
Restrictions on Transactions with Affiliated Covered Funds – Super 23A
• A
A banking entity that advises, manages, sponsors, b ki
tit th t d i
organizes or offers covered funds (and all of the banking entity’s affiliates) may not enter into a g
y
) y
transaction with the covered fund (or with any other covered fund that is controlled by the covered fund) must comply with the restrictions in Section 23A of the
must comply with the restrictions in Section 23A of the Federal Reserve Act (“FRA”) as if the banking entity or affiliate were a member bank and the covered fund were an affiliate of the member bank.
• Any such transaction must also comply with Section 23B of the FRA which requires all transactions
23B of the FRA, which requires all transactions between a member bank and its affiliates to be on an arm’s‐length basis.
30
Section 23A
Section 23A
•
•
Purpose of Section 23A is to protect FDIC‐insured banks P
f S ti 23A i t
t t FDIC i
db k
from engaging in risky transactions.
pp
As applied to covered funds and affiliated member banks, Section 23A prohibits member banks of the FDIC from:
–
–
–
–
–
transacting a loan or extending a line of credit to the covered fund; purchasing or investing in securities issued by the covered fund;
purchasing or investing in securities issued by the covered fund; purchasing assets, including assets subject to an agreement to repurchase, from the covered fund, except such purchase of real and personal property as may be specifically exempted by the Fed by order or regulation; accepting securities issued by the covered fund as collateral security for a loan or extension of credit to any person or company; or issuing a guarantee, acceptance, or letter of credit, including an endorsement or standby letter of credit, on behalf of the covered fund.
31
Why Is This Restriction “Super”
Why Is This Restriction Super 23A?
23A?
• Under
Under usual 23A, a member bank can engage in usual 23A a member bank can engage in
some transactions with the affiliate, for example transactions that involve less than 10% of the stock and surplus of the bank.
d
l
f th b k
o Volcker Rule restrictions relating to Section 23A, however, do not include any de minimis bucket.
however, do not include any de minimis bucket.
• Usual 23A places applies to Federal Reserve member banks and their subsidiaries only. It does not place prohibitions on other affiliates of the member bank
prohibitions on other affiliates of the member bank.
o Volcker Rule 23A provision, however, greatly expands ,
the restrictions on transactions to all affiliates, so it treats all affiliates of a “banking entity” as if they were the member bank.
32
Super 23A: Exception for Prime Brokerage Transactions
• A
A banking entity may enter into a prime brokerage transaction banking entity may enter into a prime brokerage transaction
with a covered fund in which a hedge fund or private equity fund managed, sponsored or advised by the banking entity invests if:
invests, if:
– the covered banking entity is in compliance with the requirements of the Volcker Rule with respect to a covered fund g
y such covered banking entity (or g
y(
organized and offered by
an affiliate or subsidiary thereof);
ff l
b
h
f)
– the chief executive officer (or equivalent officer) of the top‐
tier affiliate of the covered banking entity certifies in writing annually (with a duty to update the certification if annually (with a
duty to update the certification if
the information in the certification materially changes) that the covered banking entity does not, directly or indirectly, gguarantee, assume, or otherwise insure the obligations g
or performance of the covered fund or of
f
f h
df d
f any covered fund in df d
which such covered fund invests; and
– the Fed has not determined that such transaction is inconsistent with the safe and sound operation and condition
with the
safe and sound operation and condition of the covered of the covered
banking entity.
33
Super 23A:
Prime Brokerage Transaction Exception
• U
Under the Proposed Rules, a “prime brokerage d h P
dR l
“ i
b k
transaction” means one or more products or services provided by a covered banking entity to
provided by a covered banking entity to a a
covered fund, such as custody, clearance, securities borrowing or lending services trade execution or
borrowing or lending services, trade execution, or financing, data, operational, and portfolio management support.
g
pp
• Permitted Prime Brokerage Transactions must also comply with Section 23B of the FRA as if the py
counterparty were an affiliate. 34
Issues Concerning Prime Brokerage Transaction Exception
• D
Definition of “prime brokerage transaction” is still vague. fi i i
f“ i
b k
i ” i ill
E.g. – would FX prime brokerage or futures clearing be deemed “prime
deemed prime brokerage transactions?
brokerage transactions?”
• The exception applies only to transactions with funds in g
y
which a fund managed by a bank invests. Does not seem to allow for transacting with funds the same in substance but that are organized as “managed accounts,” or for f d di
funds directly managed by a bank affiliate.
l
d b b k ffili
• Compliance conditions to use the exception, as they require a certification of the CEO of the top tier affiliate
require a certification of the CEO of the top‐tier affiliate of the covered banking entity.
35
III. Covered Funds Prohibition:
I
Issues for Non‐U.S. Banks
f N US B k
36
Conflicts With Foreign Law
Conflicts With Foreign Law
• In
In order to fit within the exceptions to the restrictions on sponsoring a order to fit within the exceptions to the restrictions on sponsoring a
covered fund, the covered fund must not:
– share the same name or a variation of the same name with the banking entity (or with an affiliate or
banking entity (or with an affiliate or subsidiary thereof); or
subsidiary thereof); or
– use the word ‘‘bank’’ in its name.
• Many foreign laws (including for example, UCIT regulations), however, require banks that sponsor a fund to use the bank’ss name in the name of require banks that sponsor a fund to use the bank
name in the name of
fund.
• This prohibition on sharing the same name applies to banking entities and
their affiliates, which would include the asset management arms of banks. ,
g
‐ Many foreign banks have asset management arms that do not use the bank’s name (e.g., SocGen owns Lyxor).
‐ But since the asset management arm is an affiliate, it appears that a fund g
,
pp
could not share the same name as the bank or the affiliate (e.g., Lxyor could not use Lyxor in the name of a fund).
37
Exception for Activities “Solely Outside the United States”
• A
Act and the Proposed Rules allow for the acquisition or t d th P
dR l
ll f th
i iti
retention of any ownership interest in, or the sponsorship of, a covered fund by a banking entity if:
– the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or of one or more States;;
– the activity is conducted pursuant to Section 4(c)(9) or 4(c)(13) of the Bank Holding Company Act;
– no ownership interest in such
no ownership interest in such covered fund is offered for covered fund is offered for
sale or sold to a resident of the United States; and
– the activity occurs solely outside of the United States.
38
Exception for Activities “Solely Outside the United States”
• P
Proposed Rules provide that a banking entity is presumed to be in dR l
id th t b ki
tit i
dt b i
compliance with Section 4(c)(9) or 4(c)(13) of the BHC Act if:
– if it is a qualifying foreign banking organization and in compliance with subpart B of Regulation K of the Federal Reserve Board; or
– if not a foreign banking organization, the entity meets at least two of the following requirements:
g q
• total assets of the covered banking entity held outside of the United States exceed total assets of the covered banking entity held in the United States;
• total revenues derived from the business of the covered banking entity outside of the United States exceed total revenues derived from the business of the covered banking entity in the United States; or
• total net income derived from the business of the covered banking entity outside of the United States exceeds total net income derived from the business of the covered banking entity in the United States.
39
Exception for Activities “Solely Outside the United States”
• P
Proposed Rules would define an activity to have dR l
ld d fi
ti it t h
occurred “solely outside of the United States” only if:
– the
the banking entity
banking entity engaging in the activity is not engaging in the activity is not
organized under the laws of the United States or of one or more States;
– no subsidiary, affiliate, or
b idi
ffili t
employee of the covered l
f th
d
banking entity that is involved in the offer or sale of an ownership interest in the covered fund is incorporated or physically located in
h i ll l t d i the United States or in one or th U it d St t
i
more States; and
– no ownership interest in such
p
covered fund is offered for sale or sold to a resident of the United States.
40
Issues With “Solely Outside the United States” Exception
• “Solely Outside the U.S.” is very narrow “S l l O id h U S ” i
– From a policy perspective, a non‐U.S. bank should be able to acquire a passive ownership interest in a non‐U.S. fund. But the q
p
p
Proposed Rules require that the covered fund not be offered for sale in the U.S. In a passive investment, however, the bank does not control where the fund is offered, so a non‐U.S. bank could be ,
precluded from making investments unless it controls the fund.
– Some non‐U.S. banks may want to U.S.‐based personnel to sell to non‐U S investors But U S personnel of bank affiliates are not
non‐U.S. investors. But U.S. personnel of bank affiliates are not allowed to participate in fund offerings even to non‐U.S. residents.
41
Other Issues for Non U S Banks
Other Issues for Non‐U.S. Banks
• Definition of “covered fund” pulls in every investment p
y
g
g
vehicle – even publicly traded and regulated foreign funds.
• Not clear how to calculate investments in funds for purposes of complying with restrictions limiting to percentage of Tier 1 capital U S restrictions may impinge
percentage of Tier 1 capital. U.S. restrictions may impinge on foreign regulation of non‐U.S. banks.
p
q
• Volcker Rule Super 23A requirements do not have a similar “solely outside the U.S.” provision exception to its prohibitions.
42
IV. Proprietary Trading IV
Proprietary Trading
Prohibition
43
Summary of Proprietary Trading Prohibition
Banking entities may not engage in Banking
entities may not engage in “proprietary
proprietary trading
trading”::
to engage as a principal in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, derivative, future or option on any such security, derivative or future
i d i i
f
principally for the purpose of short‐term resale, benefitting from short‐
term price movements, realizing short‐term arbitrage profits, or hedging p
,
g
g p
,
g g
one of those positions.
• Agency
Agency transactions are outside the scope of the rule.
transactions are outside the scope of the rule
• Under the Proposed Rules, there is a rebuttable presumption that any security, derivative or future that is held for 60 days or less involves proprietary trading unless an exemption applies.
44
Definition: Proprietary Trading (cont )
Definition: Proprietary Trading (cont.)
• Every position taken by a registered broker‐dealer, municipal securities k b
db k d l
l
dealer, government securities dealer, swap dealer or securities‐based swap dealer, in connection with its dealing activities, is proprietary trading, unless an exemption applies (i.e., presumption is that dealing is proprietary trading).
• Swaps, security
Swaps security‐based
based swaps, FX forwards, FX swaps and commodity swaps FX forwards FX swaps and commodity
forwards are classified as “derivatives” and thus subject to the prohibition.
• Even if the following are for the short‐term, loans, spot commodities and spot FX
FX are not covered financial positions, and are thus excluded from d fi
i l
ii
d
h
l d df
the prohibition.
o Note: The Proposed Rules do not include criteria for determining what is a p
g
“loan”, or whether equity‐like control features in an instrument termed a “loan” affect the determination.
45
Proprietary Trading: Exclusions
Proprietary Trading: Exclusions
• R
Repos and Reverse Repos: Accounts used solely for positions dR
R
A
t
d l l f
iti
arising under repos/reverse repos because they are the economic equivalent of a secured loan
• Securities Lending: Accounts used solely for positions held under a S
iti L di
A
t
d l l f
iti
h ld d
securities lending arrangement because such an arrangement operates as a means to facilitate settlement of securities transactions and is not based on expected or anticipated
transactions and is not based on expected or anticipated movements in asset prices.
• Liquidity Management: Accounts used solely for bona fide liquidity management to meet short term liquidity needs in accordance with
management to meet short‐term liquidity needs in accordance with a documented liquidity plan meeting certain criteria.
o Necessary because banks need to manage their liquidity, but the exclusion is narrow and must be pursuant to a documented plan
exclusion is narrow and must be pursuant to a documented plan.
46
Proprietary Trading: Permitted Activities
•
•
•
•
•
•
•
Market Making
Trading in U.S. Government Obligations
Trading in U.S. Government Obligations
Risk‐Mitigating Hedging
Underwriting
Trading on Behalf of Customers
Trading on Behalf of Customers
Trading Solely Outside the U.S.
Certain Trading by Insurance Companies
47
Permitted Activities (cont )
Permitted Activities (cont.)
• Additional requirements that apply to permitted activities:
– Must be conducted in accordance with certain requirements that Must be conducted in accordance with certain requirements that
apply to each permitted activity;
– Banking entity must have implemented the required compliance program (idea being that if no program is in place, banking entity may (id b i th t if
i i l
b ki
tit
engage in a prohibited activity in the guise of a permitted activity);
– For certain exempt trading activities, the trading unit conducting the activity must report quantitative measurements to the U.S. regulators; and
– The banking entity must ensure that the activity would not:
The banking entity must ensure that the activity would not:
• Involve or result in a material conflict of interest between the entity and its clients, customers or counterparties;
• Result, directly or indirectly, in a material exposure by the banking entity to a “high‐risk asset” or “high‐risk trading strategy;” or
Pose a threat to the safety and soundness of the entity or the
• Pose a threat to the safety and soundness of the entity or the financial stability of the United States.
48
Permitted Activity: Market Making
• To qualify for the market‐making permitted activity, the following lf f h
k
k
d
h f ll
requirements must be met:
– Bona Fide Market Making. The particular unit must hold itself out as g
p
willing to buy and sell positions in the particular covered financial position for its own account on a regular or continuous basis.
– Near‐Term Demand. Activities must be designed not to exceed Near Term Demand Activities must be designed not to exceed
reasonably expected near‐term demands of clients, customers or counterparties.
– Revenue. The activities of the trading unit must be designed to generate revenues primarily from sources including fees, commissions and bid/ask spreads, or other income not attributable to changes in /
p
,
g
value, or hedging, of covered financial positions held in the trading account.
49
Permitted Activity: Market Making (cont.)
– Registration. The banking entity must be registered in the U.S., or h b k
b
d
h
excluded or exempt from U.S. registration, as a securities dealer, municipal securities dealer, government securities dealer, swap dealer or security‐based swap dealer, or, if engaged in business as a dealer outside the United States, subject to substantive regulation where its business is located.
– Internal Compliance. The activity must be conducted pursuant to “reasonably designed written policies and procedure” and controls and be subject to independent testing
and be subject to independent testing.
– Compensation. Compensation of persons performing market making activities must be designed not to reward proprietary trading.
50
Permitted Activity:
Trading in U.S. Government Obligations
• “U
“U.S. government obligations” includes U.S. and municipal general, S
t bli ti ” i l d U S d
i i l
l
limited and pass‐through obligations and forward trading. • It does not include obligations of foreign governments or multilateral organizations, derivatives on government obligations or obligations guaranteed by a government issuer. Therefore, any trading in those instruments must qualify as market making or another permitted activity to be permissible.
• Foreign governments have objected that failing to permit trading in foreign government obligations will damage trading.
foreign government obligations will damage trading.
To qualify for the exemption, the following requirements must be met:
• Compliance and Metrics. Trading units that engage in market making‐
related activities or trade in U.S. government obligations must meet l d i ii
d i US
bli i
strict compliance requirements and report a set of metrics to the U.S. regulators.
51
Permitted Activity:
Risk‐Mitigating Hedging
ik ii i
d i
•
To qualify for the exemption, the following requirements must be met:
q
y
p
,
g q
– Specific Risks. The hedging transaction must be made in connection with existing individual or aggregated positions in other holdings and must be designed to reduce specific risks. Portfolio hedging is contemplated.
designed to reduce specific risks. Portfolio hedging is contemplated. Anticipatory hedging (i.e., putting a hedge on ahead of taking a position) is permitted if consistent with risk management practices and is taken “slightly” (
g y
)
before the risk materializes. (Not clear what “slightly” means.)
– Correlation. Hedges must be reasonably correlated to the risk that the purchase or sale is intended to hedge.
– No New Significant Exposures. At inception, the hedge must not give rise to No New Significant Exposures At inception the hedge must not give rise to
new significant unhedged exposures.
– Continuing Review. Ongoing review, monitoring and management of the hedge consistent with written hedging policies must ensure a reasonable level
hedge consistent with written hedging policies must ensure a reasonable level of correlation is maintained and that any significant exposure after inception of the hedge is mitigated. (Need to look at the correlation between the risk and the hedge throughout the life of the transaction )
and the hedge throughout the life of the transaction.)
52
Permitted Activity:
Risk‐Mitigating Hedging
• Disagreement as to whether JP Morgan’s “London Whale” trades would have fit within the hedging exemption had the Volcker Rule been in effect.
In particular, disagreement whether:
• the trades were “reasonably correlated” to the risk
• the hedge gave rise to new significant unhedged the hedge gave rise to new significant unhedged
exposures
• the trades were designed to reduce specific risks
the trades were designed to reduce specific risks
53
Permitted Activity:
Risk‐Mitigating Hedging (cont.)
– Internal Compliance Program. The compliance regime must include l
l
h
l
l d
written hedging policies at the trading unit level and articulated mandates for each trader to ensure that the decision of how to put on a hedge is consistent with such policies and mandates.
– Compensation Incentives. Compensation arrangements must be designed not to reward proprietary risk‐taking
designed not to reward proprietary risk
taking.
– Hedging by Different Entities. If separate legal entities or levels of an organization establish positions and the corresponding hedges, the entity must document the risk‐mitigating purpose of the hedge, the i
d
h ik ii i
f h h d
h
risks that the transaction is designed to reduce, and the level of organization establishing the hedge.
54
Permitted Activity: Underwriting
Permitted Activity: Underwriting
• TTo qualify for the exemption, the following requirements must be lif f th
ti
th f ll i
i
t
tb
met:
– Internal Compliance. The banking entity must have the requisite internal compliance program including written policies and
internal compliance program, including written policies and procedures, internal controls and independent testing required to ensure the underwriting criteria are met.
– Distribution. The transactions must be effected solely in connection Distribution The transactions must be effected solely in connection
with a distribution of securities for which the banking entity is acting as an underwriter. These terms generally track the Reg M definitions of distribution, securities and underwriter, although the definition of underwriter includes a person who has an agreement with another d
i i l d
h h
ih
h
underwriter to engage in a distribution of securities for or on behalf of an issuer or selling security holder.
– Customer Demand. The underwriting activities of the banking entity Customer Demand The underwriting activities of the banking entity
must be designed not to exceed the reasonably expected near‐term demands of clients, customers and counterparties.
55
Permitted Activity:
Underwriting (cont.)
– Revenue. As with the market‐making permitted activity, the h h
k
k
d
h
underwriting activities of the entity must be designed to generate revenues primarily from fees, commissions, underwriting spreads or other income, and not from appreciation in the value of covered financial positions it holds related to such activities or the hedging of such covered financial position.
p
– Compensation Incentives. Compensation arrangements for underwriting personnel must be designed not to reward proprietary risk taking
risk‐taking.
56
Permitted Activity:
Trading on Behalf of Customers
• “Trading on behalf of customers” is narrowly defined:
“T di
b h lf f
t
”i
l d fi d
– Purchase or sale must be conducted by the banking entity g
,
y
g
,
acting as investment adviser, commodity trading adviser, trustee or in a similar fiduciary capacity; conducted for the account of the customer; and involve solely financial positions of which the customer is the beneficial owner; or
positions of which the customer is the beneficial owner; or
– The banking entity is acting as a riskless principal (i.e., the banking entity enters into a purchase or sale of a position for its own account to offset a contemporaneous sale to or
for its own account to offset a contemporaneous sale to or a purchase from a customer); or
– The covered banking entity is an insurance company that purchases or sells a covered financial position for a h
ll
df
l
f
separate account.
57
Permitted Activity:
Trading Solely Outside the U.S.
• TTo qualify for the exemption, the following requirements must be lif f th
ti
th f ll i
i
t
tb
met:
– A U.S. banking entity may not, directly or indirectly, be involved in the trading (thus the exemption is unavailable to U S banking entities
trading (thus, the exemption is unavailable to U.S. banking entities –
even if they are indirectly involved)
– No party to the trade may be a U.S. resident.
• The
The term term “U
U.S. resident
S resident” is unique (and broader than Reg. S definition)
is unique (and broader than Reg S definition)
– it includes natural persons who reside in the U.S., companies organized in the U.S., U.S. branches of foreign entities, non‐U.S. branches of U.S. banks, and discretionary accounts held for the benefit of non‐U.S. residents by a U.S. dealer or fiduciary
dealer or fiduciary
‐ For example, a French banking entity would not be permitted to engage in trading with the London office of a U.S. bank.
– None of the banking entity’s personnel that are directly involved in the g
y p
y
trade may be physically located in the U.S. (although personnel performing purely administrative, clerical or ministerial functions may be in the U.S.)
– Proposed Rules: The trade must be executed wholly outside of the U.S. d l
h
d
b
d h ll
d f h
(risk management and booking outside the U.S. is insufficient)
58
Metrics
• The market making, hedging, underwriting and trading in U.S. government obligations permitted activities require that the banking entity availing g
p
q
g
y
g
itself of the exemption must calculate certain metrics on a daily basis and report them to the U.S. regulators each month, and must also keep records regarding such metrics. • The metrics must be reported at the trading desk level, at one level of the Th
i
b
d
h
di d k l l
l l f h
organization up from the trading desk, and across all trading operations. • The U.S. regulators will analyze the reported information to monitor banking entities’ compliance with the prohibition on proprietary trading.
banking entities
compliance with the prohibition on proprietary trading
• The required metrics fall in to five categories:
– Risk‐management measurements (including VaR, SVaR and VaR exceedance)
– Source‐of‐revenue measurements (including several P&L metrics)
Source of revenue measurements (including several P&L metrics)
– Revenue‐relative‐to‐risk measurement (including P&L volatility and related statistical analyses)
– Customer
Customer‐facing
facing activity measurements (including inventory aging and risk activity measurements (including inventory aging and risk
turnover, and a ratio of customer to noncustomer trades)
– Payment of fees, commissions and spreads measurement (spreads/fees earned vs. paid)
59
V. Compliance Program R
Requirements
i
60
Required Compliance Program:
Proprietary Trading
• Banking entities that engage in proprietary trading must implement a k
h
d
l
comprehensive compliance program. Among other things, it must include:
– Board of directors and CEO responsibility to review and approve of the p
y
pp
program, maintain a culture of compliance and identify responsible business line managers
– Independent testing of the program
Independent testing of the program’ss effectiveness
effectiveness
– A system of internal controls reasonably designed to monitor and identify potential areas of noncompliance and prevent the entity from engaging in prohibited activities
– Authorized risks, instruments and products: risk limits, including yet‐
to‐be‐defined
to
be defined numerical thresholds for each trading unit which will numerical thresholds for each trading unit which will
trigger heightened review of quantitative measurements; internal escalation and regulator notification upon a reasonable likelihood of violation; and firm specific metrics (as necessary)
violation; and firm‐specific metrics (as necessary)
61
Required Compliance Program:
Proprietary Trading
Compliance program requirements (continued):
l
(
d)
– Making and keeping records sufficient to demonstrate compliance with the Proprietary Trading rules
p
y
g
– Internal policies and procedures that specify how trading accounts are identified and describe each trading unit’s objectives and strategies
– Training for trading personnel, managers and other appropriate i i f
di
l
d h
i
personnel
62
Required Compliance Program:
Proprietary Trading (Cont.)
• The compliance rules even apply to banking entities that do not engage in h
l
l
l
b k
h d
proprietary trading:
– Must enact compliance policies that include measures designed to p
p
g
prevent the entities from becoming engaged in such activities and that require the entity to develop and provide for the compliance program required by the Volcker Rule prior to engaging in such activities (or in
required by the Volcker Rule prior to engaging in such activities (or, in the case of covered funds activities, making such investments).
• Proposed Rules state that compliance programs should not follow a generic one size fits all approach, but instead should be carefully tailored i
i fi ll
h b i
d h ld b
f ll il d
to take into account and reflect the unique manner in which the banking entity operates, as well as the particular compliance risks its businesses present.
63
Required Compliance Program:
Covered Funds
• Proposed Rules also require that banking entities develop a compliance program reasonably designed to ensure and monitor compliance with the prohibitions and
reasonably designed to ensure and monitor compliance with the prohibitions and restrictions on covered fund activities.
• All of the same requirements as apply to the Proprietary Trading compliance program, except as applicable to tracking the covered fund rules and activities
except as applicable to tracking the covered fund rules and activities.
• In addition, enhanced reporting and recordkeeping requirements apply if:
o the banking entity has, together with affiliates, aggregate investments in covered funds of $1 billion; or
funds of $1 billion; or
o sponsors or advises, together with its affiliates, covered funds which have total assets of $1 billion
(in each case as measured over the prior four quarters)
(in each case as measured over the prior four quarters)
• Compliance policies and procedures to track the covered funds activities should be somewhat easier to draft and monitor than the proprietary trading activities, but certain monitoring could be difficult (such as tracking whether risk mitigating hedging
certain monitoring could be difficult (such as tracking whether risk‐mitigating hedging activities are within the requirements).
64
Contact Information
Contact Information
Adam D. Gale
Chadbourne & Parke LLP
30 Rockefeller Plaza
New York, NY 10112
(
(212) 408‐5196
)
agale@chadbourne.com
65