Observation 1.2 On The Volcker Rule: Foreign Banking Entities – Location, Location, Location

[co-author: Walter Donaldson]

On December 10, 2013, the Board of Governors of the Federal Reserve System (FRB), Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) adopted final regulations implementing the “Volcker Rule.” The Volcker Rule prohibits banking entities and nonbank financial companies from engaging in proprietary trading and severely restricts their relationships with hedge funds and private equity funds. This action caused a sea change in the way many financial institutions will conduct their operations.

This alert describes the aspects of the new regulations that have a direct impact on foreign banking organizations and foreign operations of U.S. banking entities (collectively, for purposes of this alert, “foreign banking entities”).

How Foreign Banking Entities Are Covered

Banking entities covered by the Volcker Rule include companies that are treated as bank holding companies (BHCs) under the International Banking Act. These include any foreign bank that maintains a U.S. branch or agency, any foreign bank or company that controls a U.S. commercial lending company, and the parent company of any foreign bank or company.1 In addition, by covering all insured U.S. depository institutions and bank holding companies, the regulations reach all foreign operations of those entities.

Authority to Engage in Proprietary Trading

In the face of the core prohibition on proprietary trading, foreign banking entities are accorded special treatment under carefully delineated circumstances. Specifically, the prohibition does not apply to purchases or sales of financial instruments by a qualified foreign banking organization (FBO) under Federal Reserve Regulation K that is not organized or controlled by a U.S. banking entity and conducts the majority of its business outside the United States. The prohibition similarly is inapplicable to a banking entity that is not a FBO, as long as it is not organized under U.S. law and possesses two of the following three characteristics: more assets outside the United States than inside, more foreign revenue than U.S. revenue, and more total net income outside the United States than inside. Whether a FBO or a non-FBO foreign banking entity, the trading transactions are permissible only if that banking entity acting as principal or making the purchase or sale decision and its (or its affiliate’s) involved personnel are not located in the United States; the transactions are not booked or financed by any U.S. branch or affiliate of the banking entity; and no U.S. entity conducts the transactions, (except where no involved personnel are located in the United States; an unaffiliated market intermediary acting as principal clears through a central counterparty clearing agency or derivatives clearing organization; or such intermediary acting as agent conducts the transaction anonymously on an exchange and clears through a central counterparty).

Important caveat: A foreign banking entity may not rely on any proprietary trading exemption if the activity would result in a material conflict of interest with its clients, customers, or counterparties (unless clear advance disclosures are made or information barriers are erected), result in exposure to high-risk assets or trading strategies, or threaten the safety and soundness of the entity or the financial stability of the United States.

Authority to Invest in Foreign Government Obligations

Notwithstanding the general prohibition against proprietary trading, financial instruments that are obligations of, or issued or guaranteed by, a foreign sovereign (including any of its agencies or political subdivisions or any multinational central bank in which it holds membership) may be purchased and sold by U.S. affiliates of foreign banks and foreign affiliates of U.S. banks, if each meets certain narrow, specified conditions.

U.S. affiliate: A U.S. affiliate of a foreign bank must not be controlled by a top-tier U.S. banking entity, the financial instrument must be an obligation of, or issued or guaranteed by, the foreign banking entity’s home country government (including agencies, political subdivisions or multinational central bank of which it is a member), and the U.S. affiliate must not be an FDIC-insured institution.

Foreign affiliate: A foreign affiliate of a U.S. bank must be a bank chartered by a foreign sovereign or a securities dealer regulated by a foreign sovereign, the financial instrument must be an obligation of, or issued or guaranteed by, the foreign banking entity’s home country government (including agencies, political subdivisions or multinational central bank of which it is a member), and the financial instrument must be owned by the foreign banking entity and not financed by any affiliate located in, or organized under the laws of, the United States.

Authority to Invest in or Sponsor Covered Funds

Despite the general prohibition against acquiring ownership of or sponsoring covered funds, a special exemption is available to foreign banking entities under certain conditions. A foreign banking entity that is a FBO may invest in or sponsor covered funds if it is not organized under U.S. law or controlled by a U.S. banking entity, is not located in the United States, and conducts the majority of its business outside the United States. A banking entity that is not a FBO similarly may invest in or sponsor covered funds, as long as it is not organized under U.S. law and possesses two of the following three characteristics: more assets outside the United States than inside, more foreign revenue than U.S. revenue, and more total net income outside the United States than inside. Both FBO and non-FBO foreign banking entities may sell ownership interests only through an offering that does not target U.S. residents, may make all investment or sponsorship decisions only through personnel located outside the United States, and may not book or finance the investments or sponsorships (including hedging transactions) through any U.S. branch or affiliate of the foreign banking entity.

Important note: A foreign bank is not considered to be located in the United States solely because it operates a U.S. branch, agency, or subsidiary.

Permissible U.S. Activities for Foreign Bank Trading and Investment

Although the regulations largely bar U.S. personnel of a foreign banking entity from involvement in proprietary trading and investment in covered funds, U.S. personnel are permitted to engage in “back office” activities, such as clearing and settlement, maintaining and preserving records, furnishing statistical and research data, and providing clerical support, in connection with one or more covered funds. U.S. personnel may also provide investment advice and recommend investment selections to the manager or general partner of a covered fund so long as that investment advisory activity in the United States does not involve control of the covered fund or offering or selling an ownership interest to a U.S. resident. Moreover, the regulations do not prohibit a banking entity, either U.S. or foreign, from acquiring or retaining an ownership interest in a covered fund when acting solely as a customer’s agent, broker, custodian, trustee, or fiduciary, so long as the banking entity and its affiliates do not have or retain beneficial ownership.

Important caveat: A foreign banking entity may not rely on any investment or sponsorship exemption if the activity would result in a material conflict of interest with its clients, customers, or counterparties, result in exposure to high-risk assets or trading strategies, or threaten the safety and soundness of the entity or the financial stability of the United States.

Authority to Invest in Foreign Public Funds

Foreign banking entities can invest in funds having an issuer organized or established outside the United States, which is authorized to offer and sell retail ownership interests to investors in its home jurisdiction and which sells ownership interests in unrestricted and legally compliant public offerings outside the United States. Such funds are not within the definition of covered funds. For a banking entity that is located in the United States or that is controlled by a U.S. banking entity, and any issuer it sponsors, investment in such funds is permitted only if ownership interests are sold predominantly to persons other than the sponsoring banking entity, the issuer, and their affiliates, directors and employees.

Limits on Relationships with Covered Funds [‘Super 23A’]

As noted in Observation 1.1 on the Volcker Rule, any banking entity, U.S. or foreign, and any of its affiliates, if serving as investment manager, investment adviser, commodity trading advisor, or sponsor to a covered fund that organizes and offers a covered fund, or holds an ownership interest in a covered fund, as permitted by the regulations, is prohibited from entering into any transaction with such fund (or any fund controlled by such fund) that meets the definition of a covered transaction under Section 23A of the Federal Reserve Act. Generally, covered transactions include an extension of credit to the fund, a purchase of fund-issued securities, a purchase of assets from the fund, acceptance of fund-issued securities or debt obligations as collateral for loans to third parties, issuance of a guarantee or letter of credit on behalf of the fund, and borrowing or lending securities or engaging in a derivative transaction that results in credit exposure to the fund. Because the Volcker Rule strictly aligns with the Section 23A definition of covered transaction without incorporating any exemptions ordinarily available under Section 23A (or its implementing Regulation W), because it imposes an absolute prohibition on such transactions without reference to any percentage of capital permissibility, and because it applies to all banking entities and their affiliates, it has come to be called “Super 23A.” However, the regulations do exempt from the Section 23A limits the acquisition of certain ownership interests, as wells as certain prime brokerage transactions. In addition, all transactions with covered funds as described above are subject to the market terms requirement under Section 23B.

Compliance Program

A foreign banking entity engaged in trading or fund activities within the scope of the Volcker Rule must institute a program that ensures and monitors compliance with the new regulatory restrictions. The compliance program must include adoption of written policies and procedures with limits on underwriting and market-making; installation of internal controls; provision for management accountability in reviewing trading limits, hedging activities, strategies, and incentive compensation; independent testing and audits; training for trading personnel and maintenance of sufficient records. Enhanced compliance requirements apply to foreign banking entities with total U.S. assets as of the previous calendar year-end of $50 billion or more (including all subsidiaries, affiliates, branches and agencies of the foreign banking entity operating, located or organized in the United States). Entities with assets below $10 billion have much simpler compliance obligations, and entities that do not engage in proprietary trading or covered fund investment or sponsorship are freed from any specific requirements.

Reporting Requirements

Foreign banking entities within the scope of the Volcker Rule that have significant trading activity must prepare and submit to their primary regulatory agency regular reports on an array of quantitative measurements for each trading desk. Reporting thresholds are determined by the average gross sum of the trading assets and liabilities of a foreign banking entity’s combined U.S. operations (including all subsidiaries, affiliates, branches and agencies operating, located or organized in the United States and excluding trading assets and liabilities involving obligations of, or guaranteed by, the United States or any U.S. agency) over the previous consecutive four quarters, as measured as of the last day of each of the four prior calendar quarters. Entities with more than $50 billion in trading assets and liabilities must begin reporting on June 30, 2014; entities with $25 billion or more, on April 30, 2016; and entities with $10 billion or more, on December 31, 2016. Measurements must be calculated for each trading day, with $50 billion entities reporting monthly and entities from $10 billion to $50 billion reporting quarterly.

Important note: For foreign banking entities having total U.S. assets as of the previous calendar year-end of $50 billion or more (including all subsidiaries, affiliates, branches and agencies operating, located or organized in the United States), the CEO must attest that a program is in place that is reasonably designed to achieve compliance. For a U.S. branch or agency, the attestation may be provided for the entire U.S. operations of the foreign banking entity by the senior management officer of the U.S. operations who is located in the United States.

Pepper Point: Currently, most foreign banks are not subject to Volcker-Rule-type restrictions under the laws of their home countries. Where restrictions on proprietary trading and market-making are being considered, the approach leans towards push-out and ring-fencing within a banking entity, as opposed to outright prohibition. Consequently, U.S. regulators will need to monitor the extent to which foreign banks may gain a competitive advantage over U.S. banks and the degree of dislocation that may occur in the global capital markets.

Pepper Point: With respect to foreign public funds, the U.S. regulators presumed that overseas retail investors will be entitled to securities law protections in their home countries. Additionally, the Volcker Rule preamble is clear that such retail investors are expected to be members of the general public, and not have the level of investment sophistication ascribed to institutional investors, high-net-worth individuals, or other professional investors.

Pepper Point: CEO Attestation. There are many aspects and complicated structures associated with a foreign (or domestic) banking organization, but the regulators have specifically imposed CEO attestation requirements for banks holding greater than $50 billion in total U.S. assets to assure compliance with the Volcker Rule.

Pepper Point: Foreign private funds are treated analogously to U.S. private funds. In general, if a foreign private fund is relying on exemption 3(c)(1) or 3(c)(7) of the Investment Company Act to be exempted from the Investment Company Act and it is not otherwise excluded from the covered fund definition in the Volcker Rule, it will be treated as a covered fund.

Endnote

1 The Volcker Rule applies to “banking entities,” which are defined as insured depository institutions (IDIs), companies that control IDIs (BHCs), including foreign banking organizations treated as BHCs, and affiliates and subsidiaries of IDIs and BHCs.