The Volcker Rule: Overview and Recent Developments Affecting Banking Entities, Funds and Securitization Vehicles

by Dechert LLP
Contact

Following years of incubation, in December 2013, five U.S. regulatory agencies – the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (collectively, Agencies) – approved a final rule (Final Rule or Regulations) implementing the so-called “Volcker Rule” enacted in the Dodd-Frank Act. While the Volcker Rule itself comprised a mere 11 pages in the Dodd-Frank Act, the Final Rule and preamble adopted by the Agencies take up 270 pages of the Federal Register. At a basic level, the Volcker Rule is intended to limit risks to the financial system that Congress believes may be created by: (i) proprietary trading operations of insured depository institutions, foreign banking entities with certain U.S. operations, and the affiliates of the foregoing entities (collectively, banking entities) through a set of “proprietary trading restrictions;” and (ii) investments and certain relationships between banking entities and private equity and hedge funds (referred to as “covered funds”) through a set of “covered fund restrictions.”

This article provides a general overview of the Regulations as well as a discussion of related recent developments. Additional analysis of the Regulations is provided in the following DechertOnPoints:

Who Is Covered by the Regulations?

The Regulations apply to entities that fall within the definition of “banking entity,” which includes: (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any foreign bank that maintains a branch or agency in a State, and any company that controls such a foreign bank, as well as any commercial lending company organized under State law that is a subsidiary of a foreign bank or its controlling company under section 8 of the International Banking Act of 1978 (FBO); and (iv) any affiliate or subsidiary of any of the foregoing.1 Further, entities that are designated as systemically important financial institutions (SIFIs) by the Financial Stability Oversight Council but are not banking entities are to be subject to additional capital charges or other restrictions related to the risks and conflicts of interest that the Regulations are intended to address. SIFIs, however, are not subject to the proprietary trading or covered fund restrictions that apply to banking entities.

Restrictions on Proprietary Trading

The Regulations generally prohibit a banking entity from engaging as principal for its own trading account in any purchase or sale of one or more financial instruments. An account will be considered a trading account if the banking entity’s trading in that account: (i) involves short-term trading intent (generally less than 60 days); (ii) is subject to the market risk capital requirements; or (iii) involves purchases, or sales undertaken in connection with activity that requires a banking entity to register as a dealer, a swap dealer, or a security-based swap dealer. A financial instrument may be either: (i) a security, including an option on a security; (ii) a derivative, including an option on a derivative; or (iii) a contract of sale for a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.2

Certain transactions are expressly excluded from the definition of proprietary trading. These include: (i) repos and reverse repurchase agreements; (ii) securities lending; (iii) liquidity transactions; (iv) derivatives clearing; (v) excluded clearing activity; (vi) clearing settlement or proceeding-related activities; (vii) agent, broker, or custodian transactions; (viii) employee plan transactions; and (ix) debt previously contracted transactions. Beyond the trading activities that are specifically excluded from the definition of proprietary trading, the Regulations provide for certain additional permitted trading activities, including certain underwriting, market-making and risk-mitigating hedging activities, as well as trading carried out on behalf of the banking entity’s customers.3 Such permitted activities, however, are subject to further requirements regarding material conflicts of interest and high-risk activities.

Covered Fund Restrictions

The Regulations generally prohibit a banking entity from acquiring or retaining an ownership interest in, or sponsoring, a covered fund, as a principal, directly or indirectly. Covered funds are investment funds that fall within one of three categories: (i) entities that rely on the section 3(c)(1) or 3(c)(7) exclusions from registration as an investment company under the Investment Company Act of 1940; (ii) certain commodity pools; and (iii) certain foreign funds. A range of entities are excluded from covered fund status, including:

  • foreign public funds;
  • wholly-owned subsidiaries;
  • joint ventures;
  • acquisition vehicles;
  • foreign pension or retirement funds;
  • insurance company separate accounts;
  • bank-owned life insurance separate accounts;
  • loan securitizations;
  • qualifying asset-backed commercial paper conduits;
  • qualifying covered bonds;
  • small business investment companies and public welfare investment funds; and
  • registered investment companies and business development companies.

As with the restriction on proprietary trading, the Regulations provide for a variety of permitted covered fund-related activities, as long as certain requirements are met. Most notably, a banking entity may sponsor or invest in covered funds where it is providing bona fide trust, fiduciary, investment advisory or commodity trading services to customers. In addition, a banking entity is permitted to acquire or retain an ownership interest in, or act as sponsor to, a covered fund that is an issuer of asset-backed securities in connection with, directly or indirectly, organizing such issuer and offering its securities, and such a banking entity may engage in underwriting or market making-related activities in connection with covered fund ownership (provided, in each case, that such activities are conducted in accordance with certain specified restrictions).

Even where the Regulations permit a banking entity to retain sponsorship of or investment in a covered fund, pursuant to the exemptions discussed above, the banking entity (and its affiliates) is nevertheless prohibited from entering into certain “covered transactions” with those funds.4 The Regulations draw on the concepts found in sections 23A and 23B of the Federal Reserve Act. However, where section 23A merely places limits on covered transactions between affiliated entities, the Regulations’ so-called “Super 23A provision” prohibits such transactions altogether. The Regulations’ Section 23B provisions require that certain other transactions between a banking entity and a covered fund be substantially the same or at least as favorable to the banking entity as those prevailing at the time for comparable transactions with or involving unaffiliated companies, or in the absence of comparable of transactions, on terms and under circumstances that in good faith would be offered to an unaffiliated party.

Conformance Period

The Dodd-Frank Act provided that the Volcker Rule would take effect upon the earlier of: (i) 12 months after issuance of the Regulations; or (ii) July 21, 2012, and that banking entities would generally have two years from the Rule’s effectiveness to bring their activities into compliance. The Dodd-Frank Act also granted the FRB the authority and discretion to adopt rules to extend the conformance period by up to three additional one-year periods. On the same day the Agencies adopted the Final Rule, the FRB issued an order extending the conformance period for one year, until July 21, 2015.

Subsequent Volcker Rule Developments

Exemption for Investment in TruPS CDOs

Following the release of the Final Rule, the Agencies faced opposition concerning the Regulations’ treatment of certain trust preferred securities (TruPS CDOs). This opposition included a lawsuit filed by the American Bankers Association, which asserted that the Agencies had violated the Administrative Procedure Act in adopting a definition of ownership interest that included bank interests in TruPS CDOs. In January 2014, the Agencies approved an interim final rule permitting banking entities to retain interests in certain TruPS CDOs, provided that certain qualifications are met.

Extension of Conformance Period for Collateralized Loan Obligations

Responding to industry concerns regarding the Regulations’ treatment of certain debt interests in collateralized loan obligations (CLOs) as generally impermissible ownership interests, the FRB in April 2014 announced that it plans to provide two additional one-year extensions for banking entities to retain such CLO ownership interests.

SEC Issues FAQs to Address Volcker Rule-Related Questions

On June 10, 2014, the Staff of the Divisions of Trading and Markets, Investment Management and Corporation Finance of the SEC published guidance on the Regulations, in the form of FAQs. In the document, the Staff addressed six questions, ranging from the scope of the definition of “trading desk” to a discussion concerning the provision barring a covered fund from sharing the same name or a variation of the same name as a banking entity that organizes and offers such fund. For example, the FAQs clarified, among other things, that an entity that is formed and operated pursuant to a written plan to become a foreign public fund would be excluded from the definition of a covered fund (thus receiving the same treatment as similarly-situated registered investment companies and business development companies).

1

 
Certain entities are excluded from the definition of “banking entity.” These entities include: (i) a covered fund that is not itself a banking entity (by virtue of being an insured depository institution, a company that controls an insured depository institution or an FBO); and (ii) portfolio companies held under the merchant banking and insurance company authorities for financial holding companies under sections 4(k)(4)(H) and (I) of the Bank Holding Company Act. In addition, the Regulations clarify that registered investment companies that are sponsored by or that receive investment advice from banking entities will generally not be deemed to be controlled by the banking entities (and thus will not be deemed to themselves to be banking entities), provided that the sponsoring or advising banking entity does not hold 25% or more of any class of voting stock of the registered investment company.

2

 
Specific exclusions from the definition include: (i) a loan that is not treated as a security or a derivative; (ii) a commodity that is not (A) an excluded commodity (other than foreign exchange or currency), (B) a derivative, (C) a contract of sale of a commodity for future delivery; or (D) an option on a contract of sale of a commodity for future delivery; or (iii) foreign exchange or currency.

3

 
Additional permitted proprietary trading activities include: trading in U.S. government and government-related obligations; certain trading in foreign government obligations; trading by a regulated insurance company; and trading by foreign banking entities with a foreign entity ultimate parent.

4

 
Covered transactions include, among other things: loans or extensions of credit; purchases of securities; and the issuance of guarantees.
 

 

Written by:

Dechert LLP
Contact
more
less

Dechert LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.
Feedback? Tell us what you think of the new jdsupra.com!