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6.20 The Volcker Rule

<< Title VI Overview

6.20 The Volcker Rule

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6.20.     The Volcker Rule.  Subject, to certain exceptions, the Volcker Rule prohibits banking entities from engaging in proprietary trading or acquiring or retaining any equity, partnership or other ownership interest in, or sponsoring, a hedge fund or private equity fund ("Fund"). [§619]  The Volcker Rule prohibitions are not to be construed, however, to limit or restrict the ability of a banking entity or a Significant Nonbank from selling or securitizing loans in a manner otherwise permitted by law. [§619(g)]  

6.20.1.      Banking Entities Covered by Volcker Rule Prohibitions.  "Banking entity" is defined to mean: (i) an insured depository institution, other than certain limited purpose trust companies described below; (ii) a BHC or other company that controls an insured depository institution; (iii) a foreign bank or company that is treated as a BHC; and (iv) any affiliate or subsidiary of the foregoing. [§619(h)(1)]

6.20.1.1.   Exception for Limited Purpose Trust Companies.  Limited purpose nondepository trust companies are not included in the definition of "banking entity," and therefore are not subject to any of the restrictions of the Volcker Rule, unless they are treated as a Significant Nonbank.  To qualify for this exception, a company must function solely in a trust or fiduciary capacity and all or substantially all of its deposits must be in trust funds received in a fiduciary capacity.  In addition, the company must not (i) offer or market insured deposits by or through affiliates; (ii) accept demand deposits or deposits that may be withdrawn by check or similar means for payment to third parties; (iii) obtain payment or payment related services from the Fed; or (ii) exercise borrowing or discount privileges with the Fed. [§619(h)(1)]     

6.20.2   Prohibited Proprietary Trading Activities.  Proprietary trading means engaging as a principal for a party's own trading account in any transaction to purchase or sell, or otherwise acquire, or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on such security, derivative, or contract, or any other security or financial instrument that the appropriate Federal banking agencies, the SEC or the CFTC may, by rule determine.  A trading account is defined as an account used for acquiring or taking positions in these instruments principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements). [§619(h)(1), 619(h)(4)] 

6.20.2.1.  Permitted Proprietary Trading Activities.  Notwithstanding the general prohibition on proprietary trading, a range of trading activities will be permitted, subject to certain limitations, including the absence of conflicts of interest and of certain financial risks: 

§  Purchases, sales, acquisitions, or dispositions of any of the following instruments: (i) U.S. government or agency obligations; (ii) obligations, participations or other instruments of or issued by the Government National Mortgage Association, Fannie Mae, Freddie Mac, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution; or (iii) state or municipal obligations;

 

§  Purchases, sales, acquisitions, or dispositions of any security or other instrument "in connection with underwriting or market-making-related activities" if such activities "are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties";

 

§  Hedging activities that are designed to reduce risks "in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity";

 

§  Purchases, sales, acquisitions, or dispositions of any security or other instrument on behalf of customers;

 

§  Investments in small business investment companies, investments designed to promote the public welfare, or investments that are qualified rehabilitation expenditures with respect to certain historical structures;

 

§  Purchases, sales, acquisitions, or dispositions of any security or other instrument by a regulated insurance company directly engaged in the business of insurance for the general account of the company, or by its affiliates if conducted in accordance with applicable state insurance law, regulations and written guidance, and the appropriate Federal banking agencies have not jointly determined that state law or guidance is insufficient to protect the safety and soundness of the banking entity or the financial stability of the U.S.;

 

§  Proprietary trading solely outside of the U.S. conducted by a banking entity not controlled directly or indirectly by a U.S. banking entity; and

 

§  Such other activity that the appropriate Federal banking agencies, the SEC and the CFTC determine, by rule, would promote and protect the safety and soundness of the banking entity and U.S. financial stability. [§619(d)(1)]

 

6.20.3.  Limitations on Otherwise Permitted Proprietary Trading Activities.  No transaction or activity may be deemed to be a "permitted activity" if it would: (i) involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties; (ii) result, directly or indirectly, in a material exposure to high risk assets or high risk trading strategies; (iii) pose a threat to the safety and soundness of such banking entity; or (iv) pose a threat to U.S. financial stability. [§619(d)(2)]

The Federal banking agencies and the SEC and CFTC are directed to issue regulations to implement the foregoing prohibitions.

6.20.4   Investments in, and Sponsorship of, Hedge Funds and Private Equity Funds Limited.  The Volcker Rule contains an exception to the general prohibition on investing in, or sponsoring, a Fund. [§619(a)(1)(B)]  A Fund is generally defined by reference to those Funds that are exempt from registration under Sections 3(c)(1) and 3(c)(7) of the 1940 Act. [§619(h)(2)]  A banking entity will be considered to sponsor a Fund by (i) serving as a general partner, managing member or trustee of the Fund; (ii) selecting or controlling (or having employees, officers, directors, or agents who constitute) a majority of the directors, trustees or management of a Fund; or (iii) share with a Fund for corporate, marketing or other purposes, the same name or variant of a name. [§619(h)(5)]          

6.20.4.1.   Requirements for Organizing or Offering a Fund.  A banking entity may organize or offer a Fund, including serving as a general partner, managing member or trustee and otherwise managing the Fund, if it meets all of the following requirements, including:

§  The banking entity provides bona fide trust, fiduciary or investment advisory services to the Fund;

 

§  The Fund is organized and offered only in connection with the provision of such services, and only to persons who are customers of such services of the banking entity;

 

§  The banking entity does not acquire or retain any equity or ownership interest in the Fund other than the seed capital and de minimis investments described below;

 

§  The banking entity, and its affiliates, comply with the certain prohibitions and restrictions on transactions with such Funds, as described below;

 

§  The banking entity does not, directly or indirectly, guarantee, assume or otherwise insure the obligations or performance of the Fund, or any Fund in which such Fund invests;

 

§  The banking entity does not share with the Fund, for corporate, marketing, promotional or other purposes, the same name or a variant of the same name;

 

§  No director or employee of the banking entity takes or retains an equity interest, partnership interest or other 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;

 

§  The banking entity discloses to prospective and actual investors in the Fund, in writing, that any losses in such fund are borne solely by investors in the Fund and not by the banking entity, and otherwise complies with any additional rules that the appropriate Federal banking agencies, the SEC and CFTC issue that are designed to ensure that losses in such Funds are borne solely by the investors in the Fund. [§619(d)(1)(G)]

 

6.20.4.2.  Limitations on Investment.  The Volcker Rule appears to permit banking entities to invest in a Fund only if such investment is in a Fund that the banking entity organizes and offers, and it does not appear to permit passive investments in Funds that are unrelated to the banking entity.  The Volcker Rule establishes investment limits on an individual Fund basis and on an aggregate basis. 

6.20.4.2.1.  Seed Capital Investments.  Subject to the overall limitation described below, a banking entity may invest in a Fund it organizes and offers for purposes of establishing the Fund and providing it with sufficient equity to attract unaffiliated investors. [§619(d)(4)(A)]  In such a case, the banking entity must actively seek unaffiliated investors to reduce or dilute the banking entity's interests such that the banking entity will own no more than 3 percent of the Fund within a year of the Fund's launch. [§619(d)(4)(A)]  A banking entity may apply to the Fed for an extension of up to 2 years to comply with this 3 percent requirement. [§619(d)(4)(C)]

6.20.4.2.2. Overall Limitations on Investment.  A banking entity may not invest more than 3 percent of its Tier 1 capital in Funds at any time, or such lower percentage as determined by regulations issued by specified regulatory agencies. [§619(d)(4)(B)] 

                6.20.4.3.   Investments in Funds by Non-U.S. Banking Entities Solely Outside of the US.  A banking entity that is not directly or indirectly controlled by a U.S. banking entity may acquire or retain any equity, partnership or other ownership interest in, or sponsor a Fund solely outside of the U.S. pursuant to Section 4(c)(9) or 4(c)(13), provided that no ownership interest in the Fund is offered for sale or sold to a resident of the U.S. [§619(d)(1)(I)]

                6.20.4.4.     Other Fund Investments May be Permitted by Rule.  It is possible that the appropriate Federal banking agencies, the SEC, and the CFTC may determine, by rule, to permit other investments in Funds if such investments would promote and protect the safety and soundness of the banking entity and U.S. financial stability. [§619(d)(1)(J)]  

6.20.4.5.  Activities with Respect to Funds are Subject to the Same Conflict of Interest/High Risk Limitations as Applicable to Proprietary Trading Activities.  As with proprietary trading activities, no otherwise permissible activity with respect to Funds will be allowed if it would result in one of the prohibited conditions described in Paragraph 6.20.3. above.

6.20.5.    Oversight Council Study of the Implementation of the Volcker Rule. Within six months after the enactment of the Act, the  Oversight Council is to study and provide recommendations regarding the implementation of the provisions of the Volcker Rule ("Volcker Study") with the intention of: (i) promoting and enhancing the safety and soundness of banking entities; (ii) minimizing the risk that insured depository institutions will engage in unsafe and unsound activities; (iii) limiting the inappropriate transfer of federal subsidies relating to deposit insurance and access to liquidity facilities from insured depository institutions to other institutions; (iv) reducing conflicts of interest between the interests of banking entities and Significant Nonbanks and the interests of their customers; (v) limiting activities that have caused undue risk or loss in the past or may be expected to create such risk in the future; (vi) allowing insurance companies to conduct insurance activities in accordance with applicable law, and consistent with the safety and soundness of any affiliated banking entity and of the U.S. banking system; and (vii) appropriately time the divestiture of illiquid assets that will be required as a result of the implementation of the Volcker Rule. [§619(b)(1)]   

6.20.6.   Rulemaking.  Based in part on the recommendations of the Volcker Study, within 9 months after the completion of the Study, the appropriate Federal banking agencies, the Fed, the SEC, and the CFTC are required to adopt regulations to carry out the Volcker Rule.  The regulators are required to coordinate to ensure that consistent regulations are adopted, and that the regulations do not favor or disfavor particular companies to which the regulations apply. [§619(b)(2)]

The agencies are required to adopt regulations within 9 months after the Volcker Study is completed.

6.20.7.   Effective Date, Two Year Transition Period, Possibility for Further Extensions.  Generally, the Volcker Rule will go into effect the earlier of (i) 12 months after the date of the issuance of the final rules described above, or (ii) 2 years after enactment of the Act.  [§619(c)(1)]  Once the Volcker Rule becomes effective, banking entities will have 2 years to conform their activities to the Volcker Rule's requirements. [§619(c)(2)]   The Fed may extend this period for up to three one year periods. [§619(c)(2)]  The Fed is required to issue rules to implement the provisions regarding divestiture no later than 6 months after enactment of the Act.

6.20.7.1.  Additional Divestiture Period for Illiquid Funds.  A banking entity may apply for extensions to the extent necessary to comply with contracts in place as of May 1, 2010 in order to continuing to retain its equity, partnership or other ownership interest in an illiquid Fund.  The Fed is authorized to issue rules regarding illiquid Fund status.  In the case of an investment in an illiquid Fund, the Fed may grant one extension which may be up to 5 years in length. [§619(c)(3)]   As above, the Fed is required to issue rules to implement the provisions regarding divestiture no later than 6 months after enactment of the Act. 

6.20.7.2.     Additional Capital During the Transition Period.  On the same date as the agencies issues their general rules under the Volcker Rule, the agencies are to issue rules to impose additional capital requirements and any other restrictions deemed appropriate in regard to investments in Funds during the transition period. [§619(c)(5)] 

6.20.8.   Potential Increased Capital Requirements for Banking Entities Participating in Proprietary Trading or Fund Activities.  If the appropriate Federal banking agencies, the SEC, and the CFTC determine that additional capital and quantitative limitations, including diversification requirements, are appropriate to protect the safety and soundness of banking entities engaged in permissible proprietary trading or Funds activities, these agencies are directed to issue regulations adopting these additional limitations. [§619(d)(3)] 

6.20.8.1  Calculation of Capital for Purposes of Increased Capital Regulations.  For purposes of determining compliance with any additional capital requirements imposed by the agencies as described in Paragraph 6.20.8.1. above, the aggregate amount of the outstanding investments by a banking entity, including retained earnings, is required to be deducted from the assets and tangible equity of the banking entity, and the amount of the deduction is required to increase commensurate with the leverage of the Fund in which the banking entity invests. [§619(d)(4)(B)(iii)] 

6.20.9.   Increased Capital Requirements for Significant Nonbanks.  While banking entities are prohibited from engaging in certain proprietary trading and Fund-related activities these prohibitions do not apply to Significant Nonbanks.  The Fed is, however, required to adopt rules requiring additional capital and additional quantitative limits, including diversification requirements, for Significant Nonbanks that engage in proprietary trading or acquire or retain any interest in, or sponsor a Fund. [§619(a)(2)]

6.20.10   Prohibitions and Restrictions Applied to Transactions between Banking Entities and Advised or Managed Funds.  Banking entities that directly or indirectly serve as the investment manager, adviser, or sponsor to a Fund or organize or offer such a Fund (and any affiliates of such banking entities) may not engage in "covered transactions" with the Fund, as that term is defined in Section 23A of the Federal Reserve Act. [§619(f)(1)] 

Under the Volcker Rule, Section 23B of the Federal Reserve Act will apply to the banking entity and affiliated funds to the same extent as if the banking entity were a member bank and the fund were an affiliate thereof.  This provision would not prohibit transactions, such as service contracts, that would be subject to Section 23B, but rather would require them to be done on market terms. [§619(f)(2)] 

6.20.10.1.          Exceptions for Prime Brokerage.  The Fed may permit a banking entity to enter into any prime brokerage transaction with a Fund in which a Fund managed, sponsored or advised by the banking entity has taken an equity interest if (i) the banking entity is in compliance with the Volcker Rule's requirements regarding a relationship with a Fund; (ii) the chief executive officer of the banking entity certifies in writing that the banking entity does not, directly or indirectly, guarantee or insure  the obligations or performance of the Fund, or any Fund in which such fund invests; and (iii) the Fed determines that such transaction is consistent with the safe and sound operation and condition of the banking entity. [§619(f)(3)]  Any approved prime brokerage activities will be subject to Section 23B of the Federal Reserve Act as if the counterparty were an affiliate of the banking entity.  [§619(f)(3)(B)]

6.20.11.   Compliance Requirements; Termination of Activities.  The appropriate Federal banking agencies, the SEC, and the CFTC are required to issue regulations as part of the general Volcker Rule rulemaking process regarding internal controls and recordkeeping in order to insure compliance with the Rule. [§619(e)(1)]   If a Federal banking agency, the SEC or CFTC has reasonable cause to believe that a banking entity or a Significant Nonbank has made an investment or engaged in an activity in a manner that functions as an evasion of the Volcker Rule or otherwise violates the Rule, the agency may take action to terminate the activity, after notice and an opportunity for a hearing. [§619(e)(2)]