More than three years following the passage of the Dodd-Frank Act, and intense inter-agency negotiations, the federal financial regulatory agencies collectively adopted the final version of the “Volcker Rule,” or “Rule”—which imposes new and potentially severe limitations on domestic and foreign banking entities’ activities in regard to proprietary trading and investments in “covered funds.” The 72-page final Rule is accompanied by over 800 pages of interpretative guidance, to address more than 1,200 questions that the federal agencies asked commenters to address.

This Alert provides an overview of the principal elements of the Rule and identifies several significant concerns that have already been raised by industry participants. Importantly, we provide our thoughts regarding the process by which banking entities might analyze their current business models and transactional structures, with the goal of avoiding an interruption in deal flow and/or business models by identifying possible coverage by the Rule, as well as adopting modifications to comply with the Rule and prevent or minimize adverse business consequences.

Additional client communications will explore in detail categories of activities and transactions impacted by the Rule, as well as interpretative guidance issued by the federal financial regulatory agencies.

Overview of the Final Rule
The final version of the Rule addresses numerous criticisms of the proposed Rule raised by the industry, and adopts modifications that range from liberalizations in regard to the Rule’s coverage to exemptions for specific transactions that expand coverage. What follows is a short synopsis of pertinent components of the Rule, including: (a) coverage; (b) proprietary trading; (c) investment in and sponsorship of covered funds; (d) compliance and governance obligations and (e) the effective date of the Rule and the compliance period.

Following the summary, this Alert provides a short discussion of financial activities and categories of financial transactions that are significantly affected by the Rule, as well as our recommendations to analyze the impact the Rule will have on deal flow and business plans in order to avoid disruption of the same.

An appropriate starting point for understanding the Rule is the definition of a “banking entity,” which includes:

• An FDIC-insured depository institution;
• Any company that controls an FDIC-insured depository institution;
• Any company that is treated as a bank holding company under the International Banking Act; and
• Any affiliate or subsidiary of any of the foregoing entities.¹

Proprietary Trading
For banking entities, the Rule establishes a general prohibition on all forms of “proprietary trading.” The term “propriety trading” is defined as “engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments.”

The Rule focuses on a banking entity’s “trading account,” from which trades are conducted, and includes any account used to purchase or sell financial instruments principally for the purpose of:

• Short-term resale;
• Benefiting from price movements;
• Realizing short-term arbitrage; or
• Hedging any of the above.²

Stated another way, the prohibitions on proprietary trading apply to all trading accounts of a banking entity, which means that an institution must undertake to properly identify the location or locations within its corporate structure where trading as principal takes place.³

The following types of “financial instruments” are subject to the prohibition:

• Securities;
• Options on securities;
• Derivatives;
• Options on derivatives;
• Foreign exchange swaps and forwards; and
• Contracts of sale for commodities for future delivery (and options thereon)

Importantly, excluded from the prohibition on proprietary trading are purchases and sales of financial instruments when a banking entity is acting solely as agent, broker or custodian. In addition (but in certain cases subject to conditions) the following trading activities in financial instruments are excluded from the prohibition on proprietary trading:

• Loans;
• Certain commodities;
• Repurchase agreements;
• Reverse repurchase agreements;
• Securities lending agreements;
• Foreign exchange and currency;
• Trades relating to a banking entity’s role as a derivatives clearing organization or clearing agency;
• Trades satisfying the banking entity’s delivery obligations, or relating to the failure of a customer to delivery, clear or settle;
• Satisfying the obligation of the banking entity in regard to a judicial or administrative proceeding;
• Trades through a deferred compensation, profit-sharing , pension or similar plan by a banking entity as trustee for the employees of the banking entities; and
• Trades relating to the collection of a debt.

In addition to the above-described exceptions, the Rule creates several important activity exceptions that permit trading in financial instruments otherwise subject to the Rule’s prohibition: (a) underwriting; (b) market-making; (c) risk-mitigating hedging; (d) liquidity management; (e) trading in U.S. Government and foreign sovereign debt; and (e) trading by foreign banking entities.

Significant considerations as to each of these activity exceptions are as follows:

Underwriting. The Rule permits a banking entity’s trading desk to participate in the underwriting of securities, subject to the adoption of policies and procedures relating to reasonable limits and demands of clients and customers, as well as factors such as liquidity, maturity and the depth of the market of the underwritten security.

Market-Making. In a similar manner to the exception for underwriting, the Rule permits a banking entity and its trading desk to make a market in a security, subject to the adoption of policies and procedures addressing, among other things, the near-term needs of clients, customers and counterparties.

Risk-Mitigation Hedging. While the Rule permits risk-mitigation hedging activities, the Rule limits hedging to “specifically identifiable risks including market risk, counterparty or other credit risk,…arising in connection with and related to identifiable positions, contracts or other obligations of the banking entity.” As stated in the supplementary information accompanying the Rule, hedging of an entire portfolio is not contemplated by this exception (as compared to hedging specific risks identified within a portfolio). Further, for personnel charged with hedging, compensation arrangements cannot be designed to reward proprietary trading.

Liquidity Management. The Rule provides an important exception for liquidity management from the prohibition on proprietary trading. Written policies and procedures must be adopted, including the identification of the specific securities to be used for liquidity purposes.

Trading in U.S. Government Obligations and Foreign Sovereign Debt. The Rule provides a broad exception permitting a banking entity to trade in U.S. government securities, GSE-related securities, as well as obligations issued by States and any State political subdivision.

In regard to foreign sovereign obligations, the trading exception is narrower. For a non-U.S. banking entity owned by a U.S. banking entity, trading is permitted in the government obligations of the chartering country of the non-U.S. banking entity. For the U.S. offices of a non-U.S. banking entity (a “foreign banking organization” pursuant to the International Banking Act), trading is permitted in the home-country obligations.

Trading by Foreign Banking Entities. Although the proprietary trading prohibitions of the Rule generally apply to the trading operations of U.S. operations of foreign banks, the Rule exempts foreign trading operations of foreign banks provided the trades take place “solely outside of the U.S.” The Rule clarifies that certain trades may occur on an anonymous basis in the U.S. on an exchange or through an unaffiliated intermediary. However, elements of the trade, including the risk, strategy and oversight must take place outside of the U.S.

1. Excluded from the definition are the following: (a) a covered fund that is not itself a banking entity; (b) companies controlled by a small business investment company (provided that the company not a banking entity); and (c) the FDIC when acting as a receiver or conservator.
2. In addition, a trading account includes trading relating to market-risk capital rules for banking entities subject to the market risk capital rules, and all trades if the banking entity is engaged in the business of a dealer, swap dealer or security-based swap dealer.
3. Although the prohibition on proprietary trading applies to banking entities of all asset size, the related compliance and reporting requirements, discussed below, are imposed based upon the size of the banking entity and are extremely rigorous for those exceeding $50 billion in U.S. assets.