Volcker Rule: The Final Rule

Transcription

1 Volcker Rule: The Final Rule February 2014 Henry M. Fields Oliver I. Ireland Kenneth E. Kohler Daniel A. Nathan Gary M. Rosenblum Bank of America 2013 Morrison & Foerster LLP All Rights Reserved mofo.com

2 Volcker Rule The Volcker Rule is the popular name for Section 619 of the Dodd-Frank Act, enacted in July 2010 Codified as Section 13 of the Bank Holding Company Act The statute prohibits (with exceptions) banking entities from: Engaging in proprietary trading; and Sponsoring, or acquiring or retaining an interest in, private equity and hedge funds 2

3 Volcker Rule The statute is broad Congress left regulators to construe it, without much specific direction October 2011: Proposed Rules Proposed rules drew significant comments, including from international banking community December 10, 2013: Final Rule (71 pages) approved by the five relevant U.S. regulatory agencies Effective April 1, page preamble 3

4 Conformance Period The Volcker Rule took effect by statute on July 21, 2012 Provides for a two-year conformance period, ending July 21, 2014 Conformance period recently extended by one year by Federal Reserve to July 21, 2015 Each banking entity is expected to make good faith efforts to conform by end of conformance period Develop plan for disposition or restructuring of existing prohibited investments New capital commitments likely prohibited Honoring capital calls under existing commitments Holding on to CDOs and CLOs awaiting guidance Banking entities expected to terminate/divest stand-alone proprietary trading operations promptly 4

5 Conformance Period Two one-year extensions possible, upon application Further extension of up to five years available, upon application, for continued investment/activity with respect to an illiquid fund To qualify for illiquid fund extension, must demonstrate that retention of interest necessary to fulfill a contractual commitment in effect on May 1, 2010 Condition not met if a regulatory-out allows sale or redemption of interest Banking entity required to make reasonable best efforts to get consent for sale or redemption, and to have that consent denied No expansion of impermissible activities or investments during the conformance period with expectation of extensions 5

6 What the Volcker Rule Covers Banking entities include US banks and thrifts Bank and thrift holding companies Foreign banking organizations (FBOs) that operate a branch/agency or commercial lending company in the US Affiliates of these entities (US and foreign) Banking entities do not include A covered fund (unless it is a banking entity included in one of the first three categories above) A portfolio company held by a financial holding company under the merchant banking or insurance company authority or held by a SBIC (unless it is a banking entity included in one of the first three categories above) Non-banking entities, such as broker-dealers not affiliated with banks, are not subject to the rule 6

7 Proprietary Trading 7

8 Proprietary Trading The general rule is that a banking entity may not engage in proprietary trading engaging as principal for its own trading account in a purchase or sale of one or more financial instruments, including derivatives Definition of trading account incorporates concept of short-term resales, price movements or arbitrage profits Definition of financial instrument includes most derivatives There is a rebuttable presumption that if a banking entity holds in its trading account a financial instrument for less than 60 days, the purchase or sale of such instrument is for the banking entity s trading account Trading as agent on behalf of a customer is not prohibited 8

9 Financial instrument A financial instrument includes: A security (including an option on a security); A derivative (including an option on a derivative); A contract of sale of a commodity future (or an option on same) Certain instruments are not financial instruments: Loans A commodity that is not an excluded commodity, a derivative, or a commodity future Foreign exchange or currency 9

10 Trading account An account that satisfies any one of three criteria: Purpose test: trading for short-term resale (presumed if held for fewer than 60 days) or for benefitting from short-term price movements, short-term arbitrage profits, etc. Market Risk Capital Rule test: if a US bank or thrift or US bank or thrift holding company is subject to the US banking agencies market risk capital rules, a trading account includes an account used to trade in financial instruments that are both market risk capital rule covered positions and trading positions Status test: if the banking entity is a securities dealer, swap dealer or securities-based swap dealer, all trades that would require them to be licensed as such are deemed to be in a trading account 10

11 Proprietary Trading Exclusions Repos or reverse repos Trades arising under certain securities lending or borrowing arrangements Trades for liquidity management pursuant to a plan Trades by a derivatives clearing organization* and clearing agency** in connection with their clearing and settlement activities Trades in connection with excluded clearing activities Trades to satisfy an existing delivery obligation Trades to satisfy a judicial, administrative, arbitration or similar proceeding Trades where the banking entity is acting solely as agent, broker or custodian Trades through a deferred compensation or pension plan Trades made in the ordinary course of collecting a debt previously contracted (DPC exclusion) *Registered under 5b of the Commodity Exchange Act, or exempt from registration pursuant to CFTC regulations, or a foreign derivatives organization permitted to clear for a foreign board of trade registered pursuant to CFTC regulations **Securities Exchange Act of 1934, 3(a)(23). 11

12 Permitted Proprietary Trading The following trading activity as principal is permitted: Trading in US government/agency securities Trading in US municipal securities But trading in derivatives in these two categories of securities does not come within this exemption For such derivatives consider market making or riskmitigating hedging exemptions discussed below Trading by a banking entity that is a regulated insurance company (foreign or domestic) 12

13 Permitted Proprietary Trading (cont d) The prohibition on proprietary trading does not apply to trading as principal on behalf of a customer in a fiduciary capacity or as a riskless principal A banking entity may conduct a transaction for the account of, or on behalf of a customer, but the banking entity cannot have or retain beneficial ownership of the financial instruments A banking entity also can conduct riskless principal activities so long as these are customer-driven and may not expose the banking entity to gains (or losses) on the value of the traded instruments as principal Possible, as we discuss later, that more business will be structured as agency or riskless principal business 13

14 Permitted Proprietary Trading (cont d) Also permitted are Certain risk-mitigating hedging activities Certain market-making activities Certain underwriting activities Overall conditions to these permitted activities The banking entity must maintain an internal compliance program The compensation arrangements of personnel involved in these activities must not be designed to reward proprietary trading The banking entity must be appropriately registered or licensed, or not subject to registration or licensing, to engage in market making or underwriting This is highly complex area See our Client Alert: Offerings.pdf 14

15 Permitted Hedging Activities Permitted risk-mitigating hedging activities must be specifically focused on mitigating identified risks A banking entity may not hedge with respect to generalized risks that a trading desk or combination of desks, or the banking entity as a whole, believe exists, based on non-position-specific modelling or other considerations However, a banking entity may engage in hedging activities that are In connection with and related to individual or aggregated positions, contracts or other holdings and Designed to reduce the specific risks to the banking entity that are related to such positions, contracts or other holdings 15

16 Permitted Hedging Activities (cont d) Additional requirements for risk-mitigating hedging activities: Activity must not give rise, at the inception of the hedge, to any significant new or additional risk that is not itself hedged contemporaneously Continuing review, monitoring and management that requires ongoing recalibration of the hedging activity Compensation arrangements of persons performing risk-mitigating hedging activities are designed not to reward or incentivize prohibited proprietary trading Additional documentation requirements apply with respect to riskmitigating hedging activities established by a trading desk other than the desk responsible for the underlying positions, or to hedge aggregated positions across trading desks 16

17 Permitted Hedging Activities (cont d) Additional requirements for risk-mitigating hedging activities: An internal compliance program containing written policies and procedures regarding positions, techniques and strategies that may be used for hedging, including: Documentation indicating what positions, contracts or other holdings a particular trading desk may use Position and aging limits Analysis designed to ensure that the positions, techniques and strategies that may be used for hedging may be reasonably be expected to demonstrably reduce or otherwise significantly mitigate the specific, identifiable risks being hedged The extent of the required internal compliance program will depend upon the size and activities of the relevant banking entity, but for entities engaging in proprietary trading with consolidated assets of $10 billion or more, it will be quite substantial (discussed below) Rule is quite prescriptive with respect to reporting and recordkeeping requirements, as set out in Appendices A and B 17

18 Permitted Market-Making Activities Requirements for permitted market-making activities: Trading desk that establishes and manages the financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in those types of financial instruments for its own account in commercially reasonable amounts and throughout market cycles The amount, types, and risks of the financial instruments in the trading desk s market-maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties 18

19 Permitted Market-Making Activities (cont d) Routinely standing ready to make a market may differ depending on market conditions and on the type of financial instrument Routinely standing ready means more frequently than occasionally Trading by appointment may meet the requirement Block positioning activity also would meet the requirement For illiquid derivatives or structured instruments a trading desk would need to be able to demonstrate a pattern of taking actions in respond to demand from multiple customers with respect to both long and short risk exposures 19

20 Permitted Market-Making Activities (cont d) Gauging near-term customer demand also may be challenging for certain products Requires assessing historical demand, market conditions, and other factors Preamble contemplates anticipatory trading in connection with creating and distributing structured products 20

21 Permitted Market-Making Activities(cont d) Additional Requirements for permitted market-making activities: Internal compliance program that states The instruments in which each trading desk will make a market Actions the trading desk will take to demonstrably reduce or otherwise significantly mitigate promptly the risks of its financial exposure Hedging market making exposures must comply with the market making exception, not the risk-mitigating hedging exception Limits for each trading desk, based on the nature and amount of the trading desk s market making-related activities Internal controls and ongoing monitoring and analysis of each trading desk s compliance with its limits Authorization procedures, including escalation procedures that require review and approval of any trade that would exceed a trading desk s limit(s) The compensation arrangements of persons performing the market-making activities are designed not to reward or incentivize prohibited proprietary trading. 21

22 Permitted Underwriting Activities Permitted only if the trading desk s underwriting position is related to a distribution of securities for which the bank is an underwriter 33 Act registered, or otherwise characterized as different from ordinary trading by virtue of selling efforts This differs from the definition of a distribution used for Regulation M purposes A Rule 144A offering, a 4(a)(2) offering, bought deal, etc. all may be considered distributions The underwriting position must be designed not to exceed the reasonably expected near term demands of clients Reasonable efforts must be made to sell or otherwise reduce the underwriting position within a reasonable period, taking into account the liquidity, maturity, and depth of the market for the relevant security 22

23 Permitted Underwriting Activities (cont d) Underwriter: defined broadly to include selling group members and other distribution participants Preamble identifies distribution participants that would be included Preamble also identifies activities that may be conducted by an underwriter such as stabilization activities, syndicate shorting, helping an issuer mitigate its risk arising from the issuance of securities in the distribution, etc. However, certain activities, examples of which are provided in the preamble, would not be considered to have been undertaken in connection with underwriting 23

24 Permitted Underwriting Activities (cont d) Amount and type of securities in the underwriting position cannot exceed the reasonably expected near term demands of clients, customers, counterparties, etc. The underwriter must rely on historic experience Can retain an unsold allotment that it was unable to sell, but The trading desk must use reasonable efforts to reduce the position within a reasonable time The underwriter cannot hold the unsold allotment indefinitely The underwriter cannot routinely retain unsold allotments 24

25 Effect on Rule 144A transactions Purchase by FBO or its affiliate of securities for resale in a Rule 144A transaction are prohibited as proprietary trading unless (i) within the SOTUS exemption or (ii) the exemption for permissible underwriting activities (discussed above) The SOTUS exemption will not be available if resale as principal is directly to US QIBs (because SOTUS exemption requires trade with an unaffiliated intermediary for prompt clearance and settlement through a clearing agency or organization acting as a central counterparty) Participation in a global (non-us) tranche should satisfy SOTUS exemption as long as the FBO/affiliate does not participate in the US tranche For US tranche, consider restructuring transaction as private placement to QIBs by issuer, with FBO/affiliate acting as agent 25

26 Effect on Rule 144A transactions (cont d) Underwriting exemption may be available for Rule 144A transactions, but only if the trading desk underwriting position is related to a distribution of securities for which the bank is an underwriter Distribution: registered under the Securities Act of 1933, or otherwise characterized as different from ordinary trading by virtue of selling efforts Amount and type of securities in the underwriting position cannot exceed the reasonably expected near term demands of clients, customers, counterparties, etc. The trading desk must use reasonable efforts to reduce the position within a reasonable time To rely on the underwriting exemption, banking entity is required to have a compliance program and must comply with other requirements, including compensation that does not incentivize proprietary trading May constitute underwriting in the US under Regulation K See our Client Alert: 26

27 Permitted Trading for FBOs The rule establishes an exemption for proprietary trading by a foreign banking organization ( FBO ) to the extent that the trading is conducted solely outside the United States (SOTUS exemption) 27

28 Permitted trading for FBOs (cont d) Conditions: May not be a US banking entity or controlled by a US banking entity If an FBO, must be a qualified foreign banking organization ( QFBO ) If not an FBO, must be organized outside the US and have a majority of its business outside the US The FBO or its affiliate (including relevant personnel who arrange, negotiate or execute the trades, but not those who settle or clear) must be located outside the US and organized under foreign law Trading decisions must be made outside the US Trades (and related hedging) must be booked and accounted for outside the US by a non-us entity No financing of trade by a US branch/agency or US affiliate of the FBO 28

29 Permitted trading for FBOs (cont d) Trades may not be with or through a US entity except: Trades with the foreign operations of US entity as long as no personnel of that entity who are involved in arranging, negotiating or executing the trade are in the US Trades with an unaffiliated intermediary acting as principal (if the trade is promptly cleared and settled through a clearing agency or organization acting as a central counterparty) Trades with an unaffiliated intermediary acting as agent if conducted anonymously on an exchange and promptly cleared and settled through a clearing agency or organization acting as a central counterparty 29

30 Foreign Government Obligations Foreign Government Obligations Trading by a foreign subsidiary of a US banking entity that is a foreign bank or regulated securities dealer in the debt of the foreign government in the country in which the foreign subsidiary is organized A foreign banking entity or affiliate (including a US affiliate) may trade in obligations issued or guaranteed by a foreign sovereign (or any agency or political subdivision) or a multinational central bank of which the foreign sovereign is a part if: The banking entity is not controlled by a top-tier US banking entity and is not a US bank or thrift The obligations are issued or guaranteed by the foreign banking entity s home country sovereign (or agency or political subdivision) or a multinational central bank of which such foreign sovereign is a part Trading in obligations of multilateral development banks not within these exemptions NB: An FBO can trade any foreign debt if it complies with the SOTUS exemption. 30

31 Deal flow under Rule 15a-6 Under SEC Rule 15a-6, foreign broker-dealers and foreign banks acting as principal or agent can solicit securities transactions with US institutional investors if the transactions are effected through a US registered brokerdealer, often a US affiliate. However, such trades as principal by an FBO and/or its foreign affiliates through its US registered broker-dealer affiliate would constitute proprietary trading Trades by an FBO or its offshore affiliates as agent for its customers are not considered proprietary trading and thus can continue to be effected through a US registered broker-dealer affiliate 31

32 Prudential Backstops Proprietary trading activities are not permissible if: The trading involves or results in a material conflict of interest between the banking entity and its clients, customers or counterparties unless (i) the banking entity makes clear and timely disclosure of the conflict or (ii) uses information barriers, such physical separation of personnel or functions, that address the conflict; The trading would result in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or The trading poses a safety and soundness threat to the institution or a threat to US financial stability 32

33 TRADING DESK Building Blocks for Metrics, Compliance Programs Super Banks (over 50 BB in trading assets) Metrics recordkeeping starts June 30, 2014 Metrics/Compliance Programs are built off of Trading Desks Identifying Trading Desks Take inventory of activities to determine if in scope/out of scope Complex exercise Multiple divisions (retail banking; corporate banking; sales and trading; private wealth management; trust/fiduciary; corporate/treasury) Multiple jurisdictions Multiple booking entities Multiple asset classes Numerous technology platforms 33

34 TRADING DESK Building Blocks for Metrics, Compliance Programs Determining what activity or activities comprise a single/discrete Trading Account. Considerations include: PnL attribution historically Reporting Lines Licensing/Registration Asset Classes Consistency internally and awareness of peer approach 34

35 TRADING DESK Building Blocks For Metrics, Compliance Programs (cont d) Classification of Trading Accounts Market Making Primary Hedging Underwriting Risk Mitigating Hedging (multi-desk) Different metric/compliance requirements dependent on which category MM Primary & Underwriting require customer metrics Risk Mitigating Hedging has enhanced risk metrics What is a customer: Other Super Banks (i.e., CIO/Treasury; Asset Manager) Affiliates more significant question 35

36 TRADING DESK Building Blocks For Metrics, Compliance Programs (cont d) Current State Number of Trading Desks - most Super Banks are far along in the process of determining the number of Trading Desks Testing most Super Banks will begin sample testing in March 36

37 Covered Funds 37

38 Covered Funds Prohibition A banking entity, as principal, may not directly or indirectly acquire or retain an ownership interest in, or sponsor, a covered fund The prohibition on acquiring/retaining an ownership interest does not apply if: The banking entity acts solely as agent, broker or custodian for the account of or on behalf of a customer and does not have its own ownership interest The banking entity s ownership interest is held/controlled by it as trustee in connection with a deferred compensation or similar plan; The ownership interest is acquired and held in the ordinary course of collecting a debt; or The banking entity holds the interest as trustee or in a similar capacity solely for a customer that is not itself a covered fund 38

39 Sponsorship A banking entity may not sponsor a covered fund, subject to certain exceptions Sponsorship means To serve as a general partner, managing member, trustee or commodity pool operator (CPO) of a covered fund To select or control selection of a majority of directors, trustees or management of a covered fund To share with the covered fund the same name or a variation of the name 39

40 Ownership Interests A banking entity may not acquire/retain an ownership interest in a covered fund, subject to certain exceptions Ownership interest means any equity, partnership or other similar interest Other similar interest is broadly defined to include Right to participate in the selection/removal of general partner, or managing member, director, investment manager or adviser (but not including typical creditor s rights in the event of a default or acceleration) Right to receive a share of income, gains or profits or, after other interests redeemed or paid, the underlying assets (e.g., the residual in a securitization) Right to receives income on a pass-through basis, or rate of return determined by reference to the performance of the underlying asset Any synthetic right to receive, or be allocated, any of the foregoing Does not include restricted profit interest (carried interest) Ownership interest may include an interest in a covered fund not considered an ownership or equity interest in other contexts Effect on securitizations discussed later 40

41 What is a Covered Fund? Statute prohibits investment in/sponsorship of private equity and hedge funds (not defined) Under the Final Rule, a covered fund includes an issuer that would be an investment company under the Investment Company Act of 1940 (1940 Act) but for Sections 3(c)(1) or 3(c)(7) Section 3(c)(1) exempts from the definition of investment company funds whose securities are sold privately to less than 100 purchasers Section 3(c)(7) exempts from the definition of investment company funds whose securities are sold privately only to qualified purchasers These two exemptions are the principal ones relied upon by private equity and hedge funds, but many other investment companies rely on these exemptions Concept imported from Title IV of the Dodd Frank Act, requiring registration of investments advisers to private funds 41

42 Commodity Pools Certain commodity pools are covered funds A commodity pool is a covered pool when the CPO has claimed an exemption under Rule 4.7 under the Commodity Exchange Act (CEA) The CPO is registered in connection with the operation of a pool that limits investors to qualified eligible persons (QEPs) Exempt commodity pools are covered funds because they have characteristics similar to those of hedge funds or private equity funds They are restricted to investors that meet heightened qualification standards 42

43 Foreign Covered Funds Certain foreign funds are covered funds. To be discussed later in connection with Volcker Rule s treatment of foreign funds 43

44 What is Not a Covered Fund? Companies that do not meet the general definition of an investment company For example, a fund may not be an investment company if it is not engaged or proposes to engage in the business of investing in securities that have a value exceeding 40% of the value of the company s total assets (excluding cash and government securities) Funds that rely on an exception other than those found in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act These could include funds invested primarily, for example, in real estate instead of securities. See our Volcker Rule User s Guide : Guide-to-The-Volcker-Rule.pdf 44

45 Other Exclusions The following entities are also excluded from the definition of covered funds : Wholly owned subsidiaries/joint ventures/acquisition vehicles Registered investment companies (including seeding vehicles) and business development companies Loan securitization issuers (discussed below) Foreign public funds (discussed below) Foreign pension or retirement funds Insurance company separate accounts Bank-owned life insurance company separate accounts SBICs and certain permissible public welfare and similar funds Entities used by the FDIC to dispose of assets as receiver/conservator Others that the federal agencies choose to exclude 45

46 What May or May Not Be a Covered Fund The federal agencies declined to exclude certain entities from the definition of covered fund despite requests to do so In some cases, these are likely covered funds and in others not These entities include Financial market utilities Collateral cash pools Pass-through real estate investment trusts (REITs ) Municipal securities tender option bond transactions Venture capital funds Credit funds Employee securities companies 46

47 Permitted Activities and Investments Customer funds A banking entity may acquire ownership interests in, and/or sponsor, a covered fund as a means of offering investment opportunities to its existing or future customers This customer fund activity must be in connection with the banking entity s trust, fiduciary or investment management services for customers pursuant to a written plan Detailed conditions apply Among other things, the banking entity Cannot guarantee performance of customer funds Cannot share the same name as a customer fund Must make clear and conspicuous specified disclosures in writing to prospective investors 47

48 Permitted Activities and Investments Asset-backed securities A banking entity may acquire ownership interests in an issuing entity of asset-backed securities* that is a covered fund, but only in connection with the banking entity s organization and offering of the covered fund s ownership interests, subject, generally, to the same conditions that apply to customer funds This exemption does not permit a banking entity to invest, as a passive investor, in ownership interests in securitization vehicles that are covered funds Underwriting and market-making activities A banking entity may acquire an ownership interest in a covered fund in connection with the banking entity s underwriting or market making of the covered fund s ownership interests, as long as those activities conform to the Volcker Rule s requirements for permissible underwriting and market making-related activities *See Securities and Exchange Act of 1934, 3(a)(79) 48

49 Investment Limitations Per-fund limits A banking entity s and its affiliates investment in covered funds, as a general rule, cannot exceed 3% of the value of, or the number of ownership interests in, the covered fund During a seeding period of up to one year, the investment may exceed the 3% limit while unaffiliated investors are actively solicited Special rules apply for calculating the per-fund investment limits for ownership interests held in Asset-backed securities issuers in connection with a banking entity s organization and offering of that entity s ownership interests and Covered funds whose ownership interests are underwritten by a banking entity or in which a banking entity makes a market 49

50 Investment Limitations Aggregate investment limits The aggregate value of all ownership interests in such permitted covered fund investments cannot exceed 3% of the banking entity s Tier 1 capital Capital deduction A US banking entity (but not an FBO) is required to deduct from Tier 1 capital its investment in such funds The Volcker Rule treatment does not correspond to Basel III risk weights and deductions for fund investments The Agencies intend to review the interaction between the Volcker Rule and Basel III and propose steps to reconcile them 50

51 Super 23A and 23B Restrictions No banking entity that (i) advises or sponsors a covered fund, (ii) organizes and offers a customer fund or an issuer of ABS, or (iii) holds an ownership interest in an ABS issuer, and no affiliate of any of these, may enter into any of the following transactions with the fund* A loan or extension of credit to the fund (including repos) The purchase of securities issued by the fund (except for permitted ownership interests) The purchase of assets from the fund The issuance of guarantees, acceptances or letters of credit on behalf of the fund Securities borrowing or lending or derivative transactions that result in the banking entity having a credit exposure to the fund *Section 23A also prohibits the acceptance of securities issued by an affiliate as collateral for a loan, but as such a transaction would not be with the covered fund, it is not subject to Super 23A 51

52 Super 23A and 23B Restrictions These restrictions are called Super 23A because, unlike Section 23A itself, which allows affiliated transactions within limits, these prohibitions are absolute However, the following transactions are permitted Acquisitions of ownership interests in a covered fund to the extent permitted elsewhere in the Final Rule Subject to certain conditions, prime brokerage transactions (transactions that would be subject to Super 23A but are provided in connection with custody, clearance and settlement, securities borrowing and lending, trade execution, etc.) with a covered fund in which a covered fund that is managed, sponsored or advised by the banking entity or its affiliates has taken an ownership interest (a second-tier fund ) The market terms requirement of Section 23B of the Federal Reserve Act also applies, as if the banking entity were a bank and the fund it sponsors or advises, its affiliate 52

53 Other Permitted Fund Activities/Investments Risk-mitigating hedging activities Sponsorship of, and investment in, covered funds engaged in permitted risk-mitigating hedging activities, subject to extensive conditions, including a specific internal compliance program Insurance companies Investment and sponsorship by regulated foreign and domestic insurance companies of any covered funds, if conducted in compliance with applicable insurance investment laws 53

54 Prudential Backstops No permitted fund investments and activities are permissible if The investment/activity involves or results in a material conflict of interest between the banking entity and its clients, customers or counterparties, unless The banking entity makes clear and timely disclosure of the conflict, or The banking entity uses information barriers, such as physical separation of personnel or functions, that address the conflict The investment/activity results in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy The investment/activity poses a safety and soundness threat to the institution or a threat to US financial stability 54

55 Foreign Funds Volcker Rule accords special treatment to foreign funds 55

56 Foreign Covered Funds Certain foreign funds are covered funds For a banking entity that is, or is controlled by, a US banking entity (which would include a US branch/agency of a foreign bank), a covered fund includes a foreign fund with the following characteristics The fund is organized outside the US; The fund s interests are offered and sold only to non-us persons; and The fund is sponsored by the US banking entity (or an affiliate) Such a covered foreign fund would not include a foreign fund that, if organized or offered in the US, would not rely on Section 3(c)(1) or 3(c)(7) for an exemption from the definition of an investment company 56

57 Foreign Fund Exclusion The Proposed Rule included as a covered fund any fund organized/offered solely outside the US to non-us persons that would have been a covered fund if organized/offered in the US a foreign equivalent fund The narrowed definition in the Final Rule of a foreign covered fund implies that a foreign equivalent fund is not a covered fund for purposes of sponsorship/ investment by a foreign banking entity (not controlled by a US banking entity) Same fund could be a covered foreign fund for a US banking entity but not for a foreign banking entity Investment in or sponsorship of a foreign equivalent fund by a foreign banking entity not controlled by a US banking entity should not be subject to requirements applicable to covered funds (e.g., prudential backstops, compliance program) Certain US connections with sponsorship or investment activity may make the exclusion unavailable If foreign fund not a covered fund, could be a banking entity if controlled by an FBO 57

58 Foreign Fund Exemption The Volcker Rule contains a specific exemption for a foreign fund. The exemption corresponds to the SOTUS exemption for proprietary trading. To qualify for the foreign fund exemption, the investor/sponsor may not be a US banking entity or controlled by a US banking entity if an FBO, must be a qualifying foreign banking organization ( QFBO ) if not an FBO, must be organized outside the US and have a majority of its business outside the US must make investment/sponsorship decisions outside the US through an entity located and organized outside the US i.e., decision-making personnel must be outside the US back office and administrative functions can be in the US investment advice can be given from the US US-based entity can offer and sell the fund interests but only to non-us persons 58

59 Foreign Fund Exemption (cont d) Additional conditions for foreign fund exemption Fund interests may be offered and sold only in an offering that does not target US Persons (basically, compliant with SEC Regulation S, with appropriate disclosures) Secondary trades Multi-tier funds Parallel funds Fund investment/sponsorship (including any related hedging) cannot be booked or accounted for in a US entity (including in any US branch/agency) No financing of any fund investment/sponsorship may be provided by a US affiliate (including any US branch/agency) Conditions applicable to covered funds apply (e.g., prudential backstops and compliance program) See 59

60 Investments by Foreign Funds No restrictions under Volcker Rule on a foreign excluded fund or foreign exempt fund investing in US portfolio companies or US securities An foreign banking entity would need to determine whether the investment in the foreign fund was otherwise permissible under the Bank Holding Company Act 60

61 Foreign Public Funds A foreign public fund is not a covered fund if The fund is organized outside the US The fund is authorized to offer and sell its interests to retail investors in the fund s home jurisdiction (no investor suitability qualification) The fund sells its interests through one or more public offerings predominantly outside the US (85% or more to non-us Persons) If a US banking entity sponsors the fund, the interests must be sold predominantly to persons other than the sponsoring banking entity, its affiliates and their employees and directors Foreign funds that do not meet the specific conditions of this exclusion may not be covered funds for other reasons They may qualify for the foreign fund exclusion (discussed above) or they may not rely on Section 3(c)(1) or Section 3(c)(7) of the 1940 Act Foreign public funds may also qualify for the foreign fund exemption 61

62 Securitizations 62

63 Securitization Overview Banking entities involved as investors in, sponsors of, or transaction parties (e.g., credit or liquidity providers) with, securitization issuers are subject to severe restrictions or divestiture if the securitization issuer is a covered fund Congress stated in the Dodd-Frank Act its intention that the Volcker Rule not limit or restrict the ability of banking entities to sell or securitize loans In the Final Rule, the Agencies generally followed Congressional intent by making clear that most securitizations of traditional loan products (e.g., mortgage loans, auto loans, student loans and credit card receivables) are not covered funds 63

64 Securitization Overview (cont d) However, the Final Rule creates the possibility that certain securitization vehicles whose assets include securities or derivatives (as opposed to loans) may be covered funds Banking entities should first closely examine the securitizations with which they are involved to determine if they are covered funds If a banking entity has an investment in, sponsors, or engages in certain transactions with a securitization vehicle that is a covered fund, it should closely examine such relationships to determine if they are permissible or require divestiture or restructuring 64

65 Securitization Overview (cont'd) The basic definition of covered fund is a three-pronged test previously described. For most securitization issuers, the relevant test will be that set forth in the first prong of the definition whether the issuer would be an investment company under the 1940 Act but for the exemptions set forth in Section 3(c)(1) or 3(c)(7) of the 1940 Act. Many securitizations rely on other exemptions from the 1940 Act and are therefore not covered funds. A banking entity involved with a securitization should be able to determine the applicable 1940 Act exemption by reviewing the offering documents. If beneficial ownership of securities is limited to 100 or fewer persons, the deal probably relies on Section 3(c)(1) If investors are required to be qualified purchasers for purposes of the 1940 Act, the deal probably relies on Section 3(c)(7) 65

66 Securitization Overview (cont'd) Note that the D-F Act expanded the definition of commodity interest to include swaps Any securitization holding swaps will be a commodity pool and needs to determine if it is required to register with the CFTC A number of no-action letters are available for securitizations; note particularly CFTC Letters and As noted previously, certain commodity pools will be covered funds for purposes of the Volcker Rule Thus in addition to Sections 3(c)(1) and 3(c)(7) of the 1940 Act, certain securitization holding swaps may also bring the issuer within the ownership limitations of the Volcker Rule 66

67 Securitization Overview (cont'd) The Agencies have stated that a deal that relied on Section 3(c)(1) or 3(c)(7) may still not be a covered fund if another 1940 Act exemption is also available If a securitization issuer relied on 3(c)(1) or 3(c)(7), is another 1940 Act exemption available? Section 3(c)(5)(C) for certain mortgage-backed securities Rule 3a-7 for many traditional securitizations Section 3(c)(5)(A) for certain securitizations of consumer receivables Section 3(c)(5)(B) for certain securitizations of trade receivables Rule 3a-5 for finance subsidiaries whose securities are guaranteed by parent 67

68 Exclusions from Covered Fund Definition General If the issuer relied on Section 3(c)(1) or 3(c)(7) of the 1940 Act and another 1940 Act exemption is not available, it may still avail itself of one or more of the 14 enumerated exclusions from the definition of covered fund Of the 14 exclusions, four are most likely to be applicable to a securitization issuer: Loan securitization exclusion Qualifying asset-backed commercial paper (ABCP) conduit exclusion Qualifying covered bond exclusion Wholly-owned subsidiary exclusion 68

69 Loan Securitization Exclusion This exclusion applies to an issuer of ABS if its underlying assets are comprised solely of: loans (defined as any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative) rights or other assets designed to assure the servicing or timely distribution of proceeds to security holders or related or incidental to purchasing or otherwise acquiring, and holding loans, subject to certain limitations certain interest rate or foreign exchange derivatives that (i) directly relate to the loans in the issuing entity, the related ABS or certain related contractual rights or assets and (ii) reduce the interest rate and/or foreign exchange risks related to such loans, the related ABS or permitted contractual rights or assets 69

70 Loan Securitization Exclusion (cont d) certain special units of beneficial interest ( SUBIs ) and collateral certificates (which are issued by certain intermediate special purpose vehicles that themselves satisfy the requirements of the loan securitization exclusion); and certain securities constituting cash equivalents and securities received in lieu of debts previously contracted with respect to the loans underlying the ABS In addition, in order to qualify for the loan securitization exclusion, the issuer may not hold (i) a security, including an ABS, or an interest in an equity or debt security other than as permitted above; (ii) a derivative, other than as permitted above; or (iii) a commodity forward contract The Agencies stated in the preamble that the determination whether a loan or other financial asset is a security is made by reference to the federal securities laws 70

71 Qualifying ABCP Conduit Exclusion This exclusion applies to an issuer of asset-backed commercial paper (ABCP) if the underlying assets are comprised solely of: loans or other assets that would be permissible under the loan securitization exclusion described above, and ABS that are supported solely by assets permissible under the loan securitization exclusion and are acquired by the ABCP conduit as part of the initial issuance of the securities In addition, to qualify for the qualifying ABCP conduit exclusion, a regulated liquidity provider (as defined in the Final Rule) must provide a legally binding commitment to provide full and unconditional liquidity coverage with respect to all the outstanding ABCP issued in the event that funds are required to redeem the maturing ABCP 71

72 Qualifying Covered Bond Exclusion This exclusion applies to an entity that owns or holds a dynamic or fixed pool of assets that covers the payment obligations of covered bonds if such assets or holdings meet the requirements of the loan securitization exclusion In addition, the covered bonds must be debt obligations that are issued either directly by a foreign banking organization ( FBO ) (in which case, the payment obligations of the covered bonds must be fully and unconditionally guaranteed by the entity that owns the permitted cover pool), or by the entity that owns the permitted cover pool (in which case, the payment obligations of the covered bonds must be fully and unconditionally guaranteed by an FBO and the issuer of the covered bonds must be a wholly owned subsidiary that satisfies the requirements of the wholly owned subsidiary exclusion (described below) of the FBO 72

73 Wholly Owned Subsidiary Exclusion This exclusion applies to an entity if all of its outstanding ownership interests are owned directly or indirectly by a banking entity or an affiliate thereof, except that: up to five percent of the entity s ownership interests may be owned by directors, employees, and certain former directors and employees of the banking entity or its affiliates; and within the five percent ownership interest, up to 0.5 percent of the entity s outstanding ownership interests may be held by a third party if the ownership interest is held by the third party for the purpose of establishing corporate separateness or addressing bankruptcy or insolvency This exclusion was added to the Final Rule to clarify that wholly owned depositors and other intermediate transferors of assets in a securitization are not considered covered funds. This exclusion is also likely to be very helpful for banking entities that establish or rely on special purpose funding programs that utilize trust or other tax pass-through vehicles 73

74 Covered Fund Problem Areas Most covered fund problems arise for Section 3(c)(1) or Section 3(c)(7) funds whose assets include securities or derivatives: CDOs backed by securities or derivatives (including CDOs backed by trustpreferred securities ( TruPS )) CLOs that hold debt securities Certain CMOs backed by mortgage securities Re-securitizations Bond Repackagings Synthetic ABS Synthetic structured products Auction rate preferred securities Funding vehicles Domestic covered bonds 74

75 Covered Fund Restrictions If a securitization issuer is determined to be a covered fund, banking entities are prohibited from: acquiring ownership interests in the securitization issuer, sponsoring the securitization issuer, and making loans to, or entering into certain other types of transactions with a securitization issuer for which the banking entity acts as sponsor, investment manager, investment adviser or commodity trading advisor The prohibitions described in the third bullet point above are defined in the Final Rule by reference to the restrictions of Section 23A of the Federal Reserve Act, and are commonly referred to by commenters as the Super 23A provisions. These restrictions, among other things, severely limit the ability of banking entities to provide credit and liquidity support to covered fund securitizations to which they are related as investors, sponsors or advisors Additionally, permitted transactions between the banking entity and the securitization issuer must be on market terms 75

76 Covered Fund Restrictions (cont d) The Final Rule also includes a limited exemption from ownership and sponsorship restrictions to the extent banking entities retain ownership interests in sponsored securitizations not otherwise excluded from the covered fund definition in order to comply with risk retention requirements This exemption, however, does not exempt banking entities from Super 23A restrictions. Additionally, the exemption does not apply if banking entities retain ownership interests in excess of the required retention under risk retention rules, defeating its utility in situations in which rating agencies or prospective investors require a retention in excess of the regulatory risk retention requirement The Final Rule does not itself grandfather, or exempt, structures and investments put in place before the effective date of the Final Rule or before the enactment of the Dodd-Frank Act. Accordingly, banking entities will need to closely examine their existing securitization investments and relationships, and prospective transactions, for compliance with the Volcker Rule 76

77 Definition of Ownership Interest As previously discussed, an ownership interest includes any equity or partnership interest in a covered fund or any other interest in or security issued by a covered fund that exhibits any of certain characteristics on a current, future or contingent basis, including: has the right to participate in the selection or removal of a general partner, managing member, member of the board of directors, investment manager, investment adviser or commodity trading advisor (not including rights of a creditor to exercise remedies in the event of a default); has the right under the terms of the interest to receive a share of the income, gains or profits of the covered fund (regardless of whether the right is pro rata with other owners); has the right to receive the underlying assets of the covered fund, after all other interests have been redeemed and/or paid in full (the residual in securitizations); has the right to receive all or a portion of excess spread; 77

78 Definition of Ownership Interest (cont d) provides that the amounts payable by the covered fund with respect to the interest could, under the terms of the interest, be reduced based on losses arising from the underlying assets of the covered fund, such as allocation of losses, write-downs or charge-offs of the outstanding principal balance, or reductions in the amount of interest due and payable on the interest; receives income on a pass-through basis from the covered fund, or has a rate of return that is determined by reference to the performance of the underlying assets of the covered fund (excluding interests that are entitled to received dividend amounts calculated at a fixed or floating rate); and any synthetic right to have, receive or be allocated any of the rights described above (which would not allow banking entities to obtain derivative exposure to these characteristics) Of particular importance to banking entities engaged in investment banking activities, notwithstanding the general prohibition of a banking entity acquiring an ownership interest in a covered fund, a banking entity may acquire such an ownership interest in connection with certain permitted underwriting and market making-related activities 78