Extraterritoriality: The Volcker Rule

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Cecily Byrd
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1 News Bulletin June 11, 2012 Extraterritriality: The Vlcker Rule As the U.S. bank regulatry agencies cntinue their effrts t implement the Vlcker Rule under increasing plitical pressure t stiffen the Rule s requirements, it is wrth revisiting hw the Rule, in its current prpsed frm, might affect nn-u.s. banks and their activities even utside the United States. The full impact f the Vlcker Rule n nn-u.s. trading and fund businesses is nly nw cming int fcus, as the U.S. bank regulatrs expect banking firms, including nn-u.s. firms, t begin t develp cmpliance prgrams. This bulletin summarizes in a single place the ways in which the Vlcker Rule may reach utside the U.S. brders and attempt t restrict the trading and investment fund-related activities f freign banking firms. In a nutshell, a nn-u.s. firm with a subsidiary bank rganized under U.S. law r with a branch r agency ffice in the United States may engage in trading r fund-related activity utside the United States nly if (i) the activity has n U.S. cntacts (including staff, facilities fr the activity, and clients r cunterparties) and (ii) the firm abides by several cntinuing requirements. 1 The Vlcker Rule bradly frbids prprietary trading and investing in r spnsring a hedge fund r a private equity fund, tw prhibitins that apply t bth U.S. and nn-u.s. banking firms and t activities bth inside and utside the United States. 2 Fr nn-u.s. firms with a presence in the United States, the Rule des permit certain trading and fund-related activity utside the United States but this permissin is nt a whlesale exemptin. In rder t cnduct therwise frbidden trading r fund activity utside the United States, a nn-u.s. firm must satisfy several cnditins, and it must adhere t several cntinuing requirements. The extent t which U.S. regulatrs have authrity t enfrce the Rule directly with respect t activities utside the United States is uncertain, but cmpliance culd becme an issue when a nn-u.s. banking firm is seeking U.S. regulatry apprval t expand its U.S. banking peratins. A nn-u.s. banking firm with a U.S. presence that plans t cntinue its trading and fund-related businesses utside the United States shuld cnsider fur questins: (i) (ii) whether its nn-u.s. subsidiaries are banking entities that are cvered by the Vlcker Rule; whether its activities are subject t the Rule; 1 Fr a full discussin f the Vlcker cmpliance requirements, please see ur user guide, The Vlcker Rule: Cmpliance Cnsideratins, available n ur website at 2 The Vlcker Rule ( Vlcker r Ddd-Frank ) riginally is sectin 619 f the Ddd-Frank Wall Street Refrm and Cnsumer Prtectin Act ( Ddd-Frank r the Act ) and is nw sectin 13 f the Bank Hlding Cmpany Act, 12 U.S.C The implementing regulatin (the Rule ) remains under develpment. 1 Attrney Advertisement

2 (iii) (iv) what actins are necessary in rder t take advantage f the utside-the-u.s. exemptin; and what its cmpliance bligatins are, even if its nn-u.s. activities are exempt frm the Vlcker Rule. We als address briefly the enfrceability f the extraterritrial prvisins in the Rule. 1. Nn-U.S. Firms Cvered by the Rule The Rule applies t any banking entity. The term includes all nn-u.s. banks that either maintain a branch r agency ffice in the United States r cntrl a cmmercial lending cmpany, as well as any affiliate r subsidiary f a nn-u.s. bank. These banks r cmpanies are referred t in the United States as freign banking rganizatins, r FBOs, and we will use this term thrughut this paper. The nly way fr an FBO t avid Vlcker fully is t limit its U.S. presence t a representative ffice, which may nt engage in banking activities but nly in liaisn, research, and ther nn-substantive representative activities n behalf f the FBO. 2. Activities Subject t the Rule The Rule prhibits bth prprietary trading and the investment r spnsrship f a private equity fund r a hedge fund. The applicatin f these cncepts t freign entities will be cmplex, particularly as t fund-related wrk. A. Trading The ban n prprietary trading prhibits, with sme exceptins, taking a psitin in a security in any f three circumstances: 3 The psitin is held fr the purpse f a shrt-term resale, benefitting frm actual r expected shrt-term price mvements, realizing shrt-term arbitrage prfits, r hedging ne r mre f these psitins. Shrt-term is presumptively 60 days r less. The trading prhibitin rests n the purpse f and intent behind a psitin, and U.S. regulatrs may take actin n psitins that exceed 60 days, if they determine that there is a purpse t trade in the shrt term. Alternatively, an entity may seek t rebut the presumptin, particularly if the entity, fr unfreseen reasns, dispses f a lng-term psitin sner than expected. The psitin is subject t the market risk capital rules, and the banking firm weights the psitin accrdingly. These rules are part f the regulatry capital rules in the United States and allw assets that are reprted as trading assets t be risk-weighted in accrdance with their sensitivity t market prices. This treatment wuld extend t trading assets held n the bks f a U.S. branch r agency ffice f a freign banking rganizatin. Under the language f the Rule and its preamble, it seems unlikely that this prvisin wuld reach any trading assets r liabilities held utside the United States. The entity taking the psitin is ne f fur types f dealers r engages in trading f a type utside the United States that wuld require the entity t register as ne f these types f dealers, if the trading ccurred in the United States. If the instrument being bught r sld is a cvered financial instrument, the prhibitin n prprietary trading is nt based n the specific type f instrument. Many f the same instruments can be held fr investment as well as 3 Of particular interest t nn-u.s. banks may be the Vlcker prvisin that permits entities t trade in U.S. gvernment securities. Nn-U.S. svereign debt des nt receive equal treatment, a pint that was the subject f several cmments n the prpsal frm freign regulatrs and freign banks. 2 Attrney Advertisement

3 in the trading bk. Trading that a banking entity cnducts slely as agent, brker, r custdian fr an unaffiliated third party is nt subject t the Rule. B. Investment in r Spnsrship f a Fund The ban n investments and spnsrships applies generally t funds that, but fr ne f tw exceptins, wuld be required t register with the U.S. Securities and Exchange Cmmissin as an investment cmpany under the Investment Cmpany Act ( ICA ). While the universe f cmpanies subject t the ICA is cmplex, as a starting pint, the definitin f an investment cmpany cvers any cmpany (that issues securities) that is r hlds itself ut as being engaged primarily in the business f investing, reinvesting, r trading in securities. The tw exceptins that trigger the Vlcker Rule are fr funds wned by 100 r fewer investrs (referred t as the 3(c)(1) exceptin) and fr funds wned exclusively by qualified purchasers (referred t as the 3(c)(7) exceptin). 4 There are eleven ther exceptins frm the definitin f investment cmpany in the ICA; nne f these triggers the Vlcker Rule. Fr FBOs, the Rule states that the ban reaches funds rganized r ffered utside the United States but that wuld be encmpassed by either the 3(c)(1) r the 3(c)(7) exemptin if they were ffered r rganized in the United States. The exemptins in the ICA are based n U.S. legal cncepts, and the applicatin t a particular nn-u.s. fund requires careful analysis f at least three questins: First, wuld the nn-u.s. fund hypthetically be subject t the ICA at all? The ICA wuld apply if the fund held itself ut as making investments r if the fund has certain ther characteristics. If the nn-u.s. fund wuld nt be an investment cmpany if U.S. law applied, then it wuld nt be subject t the Vlcker prhibitins and restrictins. Alternatively, if the fund wuld be an investment cmpany but culd qualify fr an exceptin ther than 3(c)(1) r 3(c)(7), then it als wuld avid the Rule. Secnd, is the fund rganized such that it has 100 r fewer investrs r is wned slely by investrs wh are qualified purchasers? If s, then it may be cvered by Vlcker. Third, if the fund has fewer than 100 investrs r is wned by qualified purchasers, are there nevertheless ther exemptins frm the ICA that the fund culd rely n? The eleven ther exemptins in sectin 3(c) f the ICA cver varius activities. It is unclear hw the Vlcker Rule wuld deal with nn-u.s. funds that might serve similar purpses but that wuld nt, f curse, have been rganized with (inapplicable) U.S. restrictins in mind. This part f the Rule culd have a substantial and adverse impact n sme nn-u.s. funds. FBOs and thers that have cmmented n the prpsal have identified Eurpean investment funds, such as Undertakings fr Cllective Investment in Transferable Securities ( UCITS ), as vehicles ptentially subject t Vlcker even thugh ecnmically similar U.S. vehicles may nt. Additinally, funds f funds rganized and ffered in the United States are exempt frm Vlcker, while identical funds rganized and ffered utside the United States are cvered. Further, many f these nn-u.s. funds have an active public market and are listed n varius exchanges, such as the Dublin r Luxemburg Stck Exchange, and therefre have all the substantive characteristics f U.S. public pen-end r clsed-end investment funds that are nt cvered by the Vlcker Rule, but, in rder t be ffered and sld in the U.S., wuld have t rely n an ICA exemptin. Securitizatin transactins are smething f a special case under Vlcker, althugh the Rule des nt distinguish between activity in the United States and that abrad. The statute allws a banking entity t sell r securitize lans free frm Vlcker requirements and cnditins. This full exemptin des nt, hwever, reach the rganizatin r spnsrship f a securitizatin vehicle. The prpsed regulatin des s, but n a qualified basis. 4 In very rugh terms, a qualified purchaser is an individual r family cmpany with mre that $5 millin in investments r an institutin with mre than $25 millin in investments. 3 Attrney Advertisement

4 A banking entity may spnsr r invest in an issuer f asset-backed securities, prvided that the assets cnsist slely f lans, cntractual rights arising frm the lans, and interest rate r freign exchange derivatives materially related t the lans r cntractual rights and that are used fr hedging purpses. Ownership r spnsrship f a fund is subject t the prudential backstps and certain prhibitins n affiliate transactins that are discussed belw. The banking entity als must establish a cmpliance prgram fr its spnsrships r wnership interests. Other investment vehicles may be frbidden r restricted by Vlcker as well, even thugh they d nt present the risks that private equity funds and hedge funds are perceived t present. These include cvered bnd structures and venture capital funds. 3. Cnditins fr Trading r Investing Outside the United States An entity f an FBO that either trades n a prprietary basis r invests in r spnsrs funds utside the United States is nt, n that basis alne, whlly free frm the Vlcker prhibitins. 5 The exemptins fr nn-u.s. activities require such an entity t meet fur cnditins: Entity. The entity must have been rganized utside the United States. The entity will be an FBO, r it will nt. If it is an FBO, then tw requirements apply: The entity must be a qualifying FBO, meaning that Mre than half f its wrldwide business is banking, as measured by assets (excluding banking assets in the United States), ttal revenue, r ttal net incme. (Tw f these three measurements are necessary.) Mre than half f its banking business is utside the United States, als measured n the basis f assets, revenues, and net incme (again, tw ut f three). The entity must cnduct its trading r fund-related activity in cmpliance with certain rules f the Federal Reserve Bard (the Bard ) in Regulatin K. These rules cver a range f matters, including btaining apprpriate regulatry apprvals r filing apprpriate ntices, cperating with Federal Reserve examinatins f branch and agency ffices, and adhering t limits n lans t ne brrwer. If it nt an FBO, then it must meet any tw f three tests: The entity s assets utside the United States exceed its assets inside the United States. The entity s ttal revenues derived frm its business utside the United States exceed its ttal revenues derived frm its business inside the United States. The entity s ttal net incme derived frm its business utside the United States exceeds its ttal net incme derived frm its business inside the Unites States. Nte that all f these tests are at the entity level. 5 The Rule permits certain frms f trading and fund-related activity, including underwriting, market making and hedging (f ther than shrtterm securities), as well as the spnsrship f custmer funds. An FBO may invke ne f these prvisins t supprt its activities, whether inside r utside the United States. This bulletin is limited, hwever, t activities permitted utside the United States. 4 Attrney Advertisement

5 Hlding cmpany. Any affiliate r subsidiary f the FBO that cntrls the entity must be rganized utside the United States. Cunterparty. N cunterparty t the trade r investr in the fund may be a resident f the United States. The Rule defines this term bradly mre bradly than a similar term that is used in Regulatin S f the SEC, t which sme FBOs may have becme accustmed. Fr example, exclusins in the Regulatin S definitin that apply t (amng ther entities) dealers and fiduciaries acting n behalf f nn-u.s. resident custmers and emplyee benefit plans rganized abrad are nt replicated in the Rule and therefre these entities appear t be subject t Vlcker. Lcus f the activity. The activity must ccur slely utside the United States: As t trading, this requirement entails N use f executin facilities. N persnnel directly engaged in the trading may be physically lcated in the United States. A trading decisin culd nt be made in the United States and executed abrad. As t fund-related activity: N interest in the fund may be ffered r sld t a United States resident. 6 The fund must have been rganized utside the United States. An FBO that satisfies these cnditins and can rely n ne f the utside-the-united States exemptins is nt subject t the limitatins n ther exempted activities. Fr example, a banking entity may establish a custmer fund in (r utside f) the United States but nly if, amng ther things, the entity and the fund d nt share a similar name. This cnditin des nt apply t fund activity eligible fr the utside-the-united States exemptin. 4. Cntinuing Obligatins fr Permissible Activities Outside the United States An entity must cntinue t cmply with several bligatins even after it is able t take advantage f the allwance fr trading r fund-related wrk utside the United States, including prudential backstps fr bth trading and fund-related wrk, prhibitins n certain transactins with funds, and a cmpliance prgram. A. Prudential Backstps fr bth Trading and Investment Even after an FBO has established that its trading r fund-related activity ccurs utside the United States, the Vlcker Rule impses fur cntinuing bligatins, knwn as prudential backstps. The activity may nt invlve any material cnflict f interest interests that are materially adverse between an entity and its clients, custmers, r cunterparties. A banking entity may cure the cnflict in ne f tw ways. Disclsure and pprtunity t negate r substantially mitigate. The entity must prvide infrmatin and ther materials 6 Senatrs Carl Levin and Jeff Merkley have said that this cnditin ges t far, where an entity therwise satisfies the utside-the-united States cnditins. 5 Attrney Advertisement

6 In sufficient detail and in a way that a reasnable client, custmer, r cunterparty can meaningfully understand the cnflict; and In a manner that prvides the client, custmer, r cunterparty the pprtunity t negate r substantially mitigate a materially adverse effect created by the cnflict. Infrmatin barriers. The entity creates barriers, memrialized in written plicies and prcedures, that are reasnably designed, given the nature f the entity s business, t prevent a cnflict f interest frm having a materially adverse effect n a client, custmer, r cunterparty. Nte that an infrmatin barrier des nt cure a cnflict f interest if, fr a specific class f transactins r activities, the entity shuld knw r shuld reasnably knw that the barriers will nt prtect against a materially adverse effect resulting frm cnflict. The activity cannt expse the entity t high-risk assets r high-risk strategies. An asset r a strategy is high-risk if it wuld significantly increase the likelihd either that The entity wuld incur a substantial financial lss; r The entity wuld fail. Cmpliance with this cnditin may be especially difficult given the vagueness f the terms, particularly high-risk strategy and substantial lss. Wuld recent large and unsuccessful trades have vilated this cnditin, had it been in effect? The activity cannt threaten the safety and sundness f the entity. The activity cannt threaten U.S. financial stability. The Vlcker Rule des nt explain this standard, but ther Ddd-Frank prvisins use the same standard. B. Additinal Restrictins n Fund-Related Activity An additinal set f restrictins applies when the wrk f an FBO r ne f its subsidiaries with a fund ges beynd that f a nn-cntrlling investr. Specifically, if an entity acts as the investment manager, investment adviser, cmmdity trading advisr, r spnsr t a cvered fund then the restrictins are in effect. The tw restrictins are: Neither the entity nr any ther entity in the FBO structure may lend mney t r purchase assets frm the fund. (This prhibitin is ppularly knws as Super 23A a reference t a U.S. statute limiting but nt prhibiting similar transactins between a bank and its affiliates.) Super 23A des nt apply t prime brkerage transactins, subject t certain limits. Any ther transactins between the fund and any entity in the FBO rganizatin must be n market terms. (Often knwn as Super 23B a reference t a related U.S. statute n transactins between a bank and its affiliates.) C. Cmpliance Prgram The Vlcker Rule requires a prgram that, in the case f an FBO, will ensure bth that trading r fund-related activities cntinue t qualify fr utside-the-u.s. status and that the FBO will adhere t the cntinuing prudential requirements. The cntents f a plan will vary, depending n the size, nature, and scpe f the entity s 6 Attrney Advertisement

7 activities. The mst critical factr is whether an entity has $1 billin r mre in trading assets r liabilities r invests in r spnsrs funds with ttal aggregate assets f $1 billin r mre; if s, cmpliance bligatins becme significantly mre stringent In any case, a cmpliance prgram must include six elements: Internal plicies and prcedures reasnably designed t dcument, describe, and mnitr the activities; A system f internal cntrls reasnably designed t mnitr and identify ptential areas f nncmpliance with the Rule; A management framewrk that clearly delineates respnsibility and accuntability fr cmpliance; Independent testing fr the effectiveness f the cmpliance prgram; Training fr trading persnnel and managers t implement and enfrce the cmpliance prgram; Recrdkeeping sufficient t dcument cmpliance. 5. Implementatin and Enfrcement The effrts f U.S. regulatrs t apply the Vlcker Rule, particularly the prudential backstps, t trading and fundrelated activities f nn-u.s. banks utside f the United States face several challenges, including the fundamental principle that a U.S. gvernment agency des nt have the authrity t exercise any regulatry pwers in a freign cuntry. The Federal Reserve s examinatin pwers ver freign banks are limited t branch and agency ffices in the United States. Nevertheless, FBOs shuld bear in mind that, if they must file an applicatin r ntice with the Bard, the Bard might require infrmatin n their Vlcker cmpliance activities abrad. A starting pint n the part f a U.S. regulatr wuld be a request fr a cmpliance plan. It is wrth nting as well that the Ddd-Frank Act des nt require that U.S. regulatrs reach int freign jurisdictins t apply r enfrce the Vlcker Rule. Indeed, Ddd-Frank bradly embraces the principle f internatinal cmity and cntemplates that U.S. regulatrs will crdinate with their freign cunterparts n majr regulatry issues and, by implicatin, nt act unilaterally n crss-brder issues. This is, f curse, the lngstanding practice f the U.S. regulatrs. The Act authrizes the President t crdinate internatinal plicies relating t limits n, amng ther items, the nature and scale f financial cmpanies. The Act requires the Financial Stability Oversight Cuncil t regularly cnsult with freign gvernments n matters relating t systemic risk a term that, in these circumstances surely encmpasses the Vlcker Rule. Similarly, the Bard and the Secretary f the Treasury must cnsult with their freign cunterparts and multilateral rganizatins n cmprehensive supervisin and regulatin f all highly leveraged and intercnnected financial cmpanies a descriptin that wuld cver the Vlcker Rule plicies. The Act des nt purprt t exempt the Vlcker Rule frm the matters that shuld be handled n a cperative internatinal basis. 7 Overall, the requirements f the prpsed Vlcker Rule regulatins in their current frm culd be seen as a remarkable extensin f U.S. regulatry jurisdictin ver FBO activities arund the wrld, and threaten t have a materially disruptive impact n FBO trading activities in particular. While it may be straightfrward enugh albeit burdensme fr an FBO t limit its internatinal fund custmer base t nn-u.s. residents, it is significantly mre prblematic fr FBOs t engage in trading in U.S. securities r ther financial instruments withut the use f U.S. exchange trading, clearance, r settlement facilities. Mrever, the impsitin and enfrcement f an elabrate cmpliance and cnflicts management regime, as the prpsed regulatins wuld require, culd amunt t an excessive applicatin f U.S. regulatry jurisdictin t ffshre trading and fundrelated activities. 7 Senatrs Levin and Merkley have bserved that the Vlcker Rule is t be implemented in accrdance with internatinal cmity. 7 Attrney Advertisement

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ADVISORY Dodd-Frank Act

ADVISORY Dodd-Frank Act ADVISORY Ddd-Frank Act July 21, 2010 FINAL VOLCKER RULE PROVISIONS On July 21, 2010, President Obama signed int law the Ddd-Frank Wall Street Refrm and Cnsumer Prtectin Act (the Act). The Act subjects