Volcker Rule: Past the Compliance Date, but Not Over the Hump

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1 Volcker Rule: Past the Compliance Date, but Not Over the Hump November 6, 2015 Oliver Ireland Jay Baris 2015 Morrison & Foerster LLP All Rights Reserved mofo.com

2 Volcker Rule Overview 2

3 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 3

4 Volcker Rule Timeline 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 4

5 Conformance Period The Volcker Rule took effect by statute on July 21, 2012 Rule provided for a two-year conformance period, ending July 21, 2014, and that conformance period was 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 5

6 Conformance Schedule: Prop Trading By July 21, 2015, all proprietary trading: Must have been terminated; May be continued pursuant to an applicable exemption (e.g., market-making, hedging, or underwriting); or May be continued, if an individual extension request filed 180 days before July 21, 2015 has been approved. 6

7 Conformance Schedule: Funds On December 18, 2014, the Federal Reserve Board ( Board ) issued an order extending for an additional year i.e. until July 21, 2016 the Volcker rule conformance period for banking entities to conform their investment in and relationships with covered funds and with foreign funds that may be subject to the Volcker Rule, and that were in place prior to December 31, 2013 ( legacy funds ). The order also announces the Board s intention to grant the final oneyear extension of the conformance period until July 21, Extension is consistent with the Board s previous announcement in April 2014 regarding collateralized loan obligations ( CLOs ) that were in place prior to December 31,

8 Conformance Schedule: Funds Board s Order applies to Legacy Funds only -- no extension was granted for post December 31, 2013 activity (although if the relationship or investment was committed before 2014 and funded or carried out thereafter it likely would be permitted to be made or retained during the extended conformance period). The Board will consider whether to take action regarding illiquid funds; however, while the Board is considering the issue, legacy illiquid fund investments and relationship should be able to rely upon the extended conformance period for legacy funds. The Board emphasized that banking entities must act in good faith to conform all of the activities and investments to the Volcker Rule by no later than the expiration of the applicable conformance period. The Board expects banking entities to plan well in advance of the end of the extended conformance period regarding how they will conform or divest legacy funds. 8

9 Conformance Schedule: Funds Foreign non-covered funds may be considered banking entities under the Volcker Rule. Characterization as a banking entity subjects foreign non-covered funds to Volcker Rule prohibitions on investment in covered funds and proprietary trading. In contrast, foreign exempt funds (i.e., SOTUS funds) are considered covered funds and thus are not characterized as banking entities. The extension should permit pre-2014 foreign non-covered funds additional time to resolve their pre-2014 investment (including investments pursuant to pre-2014 capital commitments) in covered funds, while affording regulatory agencies time to address the characterization and treatment of foreign non-covered funds. 9

10 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 10

11 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 11

12 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 licensed or registered, or is required to be licensed or registered, as 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 12

13 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). 13

14 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) 14

15 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 Riskless principal transactions likely are limited to securities and not other financial instruments such as derivatives (see Reg. Y) Possible, as we discuss later, that more business will be structured as agency or riskless principal business 15

16 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 16

17 Permitted Trading for FBOs SOTUS 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) Conditions for SOTUS to be available: Banking entity 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 17

18 SOTUS Conditions (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 18

19 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. 19

20 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; The banking entity holds the interest as trustee or in a similar capacity solely for a customer that is not itself a covered fund; or The banking entity acquires the relevant covered fund in connection with a banking entity-related retirement plan. 20

21 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 21

22 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 22

23 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 23

24 Other Covered Funds 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 Certain foreign funds are covered funds. To be discussed later in connection with Volcker Rule s treatment of foreign funds 24

25 Prudential Backstops Proprietary trading and covered funds activities are not permissible if: The investment/activity/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 25

26 Joint Venture Entities, the Securitization Exemptions, CLOs and other Covered Fund Issues 26

27 Joint Ventures The Volcker Rule excludes from the definition of covered fund any joint venture between a banking entity or one of its affiliates and one or more unaffiliated persons, provided that the joint venture: is comprised of no more than 10 unaffiliated co-venturers; is in the business of engaging in activities that are permissible for the banking entity or affiliate, other than investing in securities for resale or other disposition; and is not, and does not hold itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities. 27

28 Joint Ventures The joint venture exemption was designed to allow banking entities to conduct their business and operations with a limited number of coventurers. In FAQ #15 (published June 12, 2015), the Agencies have carefully circumscribed the joint venture exclusion: The joint venture exclusion will not be met by an issuer that raises money from a small number of investors primarily for the purpose of investing in securities, whether the securities are intended to be traded frequently, held for a longer duration, held to maturity, or held until the dissolution of the entity. Similarly, issuers may not rely on the joint venture exclusion if the issuer raises money from investors primarily for the purpose of investing in securities for resale, even if one of the purposes in forming the entity is to conduct a business or engage in other non-investment activities. 28

29 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 29

30 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 The basic definition of covered fund is a three-pronged test 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 30

31 Volcker Rule Securitization Overview (cont d) Many securitizations rely on other exemptions from the 1940 Act and are therefore not covered funds Even if a securitization issuer relied on 3(c)(1) or 3(c)(7), is another 1940 Act exemption available? Rule 3a-7 for many traditional securitizations Section 3(c)(5)(C) for certain mortgage-backed securities 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 31

32 Exclusions from Covered Fund Definition 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 (LSE) Qualifying asset-backed commercial paper (ABCP) conduit exclusion Qualifying covered bond exclusion Wholly owned subsidiary exclusion 32

33 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; 33

34 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 LSE, 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. 34

35 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. 35

36 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. 36

37 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. 37

38 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 trust-preferred securities ( TruPS )) CLOs that hold debt securities Certain CMOs backed by mortgage securities Auction rate preferred securities Re-securitizations Bond Repackagings Synthetic ABS Synthetic structured products Domestic covered bonds 38

39 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 Final Rule also includes a limited exemption from ownership and sponsorship restrictions to the extent banking entities retain ownership interests in sponsored securitizations to comply with risk retention requirements 39

40 Definition of Ownership Interest 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 specified characteristics deemed by the regulators to be indicia of ownership Of particular concern is the first of the indicia of an ownership interest listed in the Final Rule that the interest has the right to participate in the selection or removal of a general partner, managing member, director, investment manager, investment adviser or commodity trading advisor Many CLOs and CDOs provide rights to a controlling class of senior debt security holders to participate in the designation of investment managers, creating the potential that the holders of even the most senior, highly rated debt securities may be considered to hold ownership interests 40

41 Interim Final Rule re TruPS CDOs The Final Rule caused considerable industry outcry over the definition of ownership interest as applied to CDOs and CLOs particularly from community banks that hold CDOs backed by trust preferred securities ( TruPS ) On January 14, 2014 the Agencies issued an interim final rule providing grandfathering for certain existing TruPS CDOs The interim final rule allows the retention of an interest in or sponsorship of covered funds by banking entities if, among other things, the following conditions are met: The TruPS CDO was established, and the interest was issued, before May 19, 2010; The banking entity reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in qualifying TruPS collateral issued by banking entities; and The banking entity s interest in the TruPS CDO was acquired on or before December 10, 2013, the date the Agencies issued the Final Rule implementing the Volcker Rule. 41

42 Extension of Conformance Periods On April 7, 2014, the Federal Reserve Board announced that it would extend the conformance period during which banking entities must dispose of or restructure non-volcker Rule compliant CLO investments by two years to July 21, 2017, but only for CLOs in place on December 31, Notwithstanding this extension, market-making restrictions went into effect under the proprietary trading portion of the Volcker Rule in July 2015, severely restricting the ability of banking entities to make a market in non-compliant CLOs. This was one factor in the early rush by many legacy CLO issuers to amend their transactions to become Volckercompliant. 42

43 CLOs Special Issues Of the problematic securitization types, CLOs have received the most attention. This is due to the fact that CLOs have been a very successful asset class since the financial crisis, and banks have been the principal investors. CLOs are almost always sold in Rule 144A and Regulation S formats using Section 3(c)(7) as their 1940 Act exemption. Accordingly, CLO issuers meet the definition of covered fund if an exemption is not available. 43

44 CLOs Special Issues (cont d) The primary assets of CLOs are usually senior secured bank loans, along with other types of bank loans. The major CLO Volcker Rule issue is that CLOs have traditionally included a bond bucket under which the asset manager may invest up to specified percentage (5% or 10%) of assets in bonds. This allows the manager to increase yields to subordinate investors. Since bonds are securities, the loan securitization exclusion does not apply. Possible approaches: Change terms so LSE does apply Structuring to use a 1940 Act exemption other than 3(c)(7) Rule 3a-7 Section 3(c)(5)(C) 44

45 CLOs Loan Securitization Exclusion Most CLO issuers have chosen to conform to the LSE, in both new deals and amendments to legacy deals. Bond Buckets remove bond bucket altogether permit bonds if a legal opinion and/or Controlling Class consent is obtained possibly increase buckets for higher yielding loans similar issues and solutions for letters of credit Hedge Agreements must relate to the assets and reduce interest rate or foreign exchange risk legal opinion and/or Controlling Class consent Eligible Investments must be high-quality cash equivalents Participation Interests must be traditional, plain-vanilla participations 45

46 CLOs Loan Securitization Exclusion (cont d) Asset disposition provisions commercially reasonable efforts standard Ownership Interest Protections new amendment provisions to address Volcker Rule issues Controlling Class waiver provisions issuance of non-voting subclass 46

47 CLOs Rule 3a-7 Rule 3a-7 is an exemption from the 1940 Act that applies to many traditional types of securitizations. Importantly, Rule 3a-7 does not require that the securitized assets be loans may include other types of financial assets. The drawback of 3a-7 is that it prohibits the issuer/manager from trading assets for the primary purpose of recognizing gains or decreasing losses resulting from market value changes. This may be problematic for actively managed CLOs. 47

48 CLOs Rule 3a-7 (cont d) Rule 3a-7 has been used more in amendments than in new deals. Some new deals include provisions for both Rule 3a-7 and LSE. Indenture terms: Issuer representation that transaction complies Issuer covenant to maintain compliance Event of default if the foregoing are breached 48

49 CLOs Section 3(c)(5)(C) Section 3(c)(5)(C) of the 1940 Act exempts entities that acquire mortgages and other liens on and interests in real estate. This exemption is routinely used for CMBS issuers. The exemption may also be used by issuers of CLOs backed by commercial real estate loans rather than traditional bank loans. This is a small part of the overall CLO market, but many believe it will grow in the coming years. 49

50 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 50

51 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 51

52 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 52

53 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 53

54 Agencies FAQ on Marketing Restriction On February 27, 2015, the Volcker Inter-Agency Group posted a new FAQ clarifying the scope of the so-called marketing restriction under the SOTUS covered fund exemption. To qualify, the marketing restriction requires that ownership interests in a SOTUS fund must be sold (or must have been sold) pursuant to an offering that does not target residents of the U.S. The FAQ explains that the marketing restriction applies only to the activities of a foreign banking entity (including its affiliates) and does not apply where the foreign banking entity seeks to invest in a covered fund that is sponsored and marketed by a third party. Accordingly, a foreign banking entity may invest in a covered fund pursuant to the SOTUS covered funds exemption that is sponsored by a third party to residents of the U.S., provided that the foreign banking entity complies with all other conditions of the SOTUS covered fund exemption. 54

55 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 55

56 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 56

57 Compliance Programs 57

58 Compliance Programs The Volcker Rule compliance program must be appropriate for the types, size, scope and complexity of activities and business structure of the banking entity Thresholds: Banking entities with no covered activities: A banking entity that does not engage in activities or investments covered by the Volcker Rule may comply by establishing the compliance program prior to becoming engaged in covered activities or investments (other than permitted trading in U.S. government obligations) Banking entities with modest activities: A banking entity with consolidated assets of $10 billion or less engaged in activities or investments covered by the Volcker Rule (other than permitted trading in U.S. government obligations) may comply by including in its existing compliance policies and procedures appropriate references to the Volcker Rule requirements and adjustments as appropriate given its activities, size, scope and complexity Standard compliance program and additional documentation for covered funds: Total consolidated assets of more than $10 billion Enhanced compliance program (Appendix B): Total consolidated assets of $50 billion or more (total U.S. assets for FBOs) 58

59 Key Compliance Program Elements Key elements of compliance program: Written policies and procedures reasonably designed to document, describe, monitor, and limit trading activities subject to the Volcker Rule System of internal controls reasonably designed to monitor compliance with the Volcker Rule and to prevent the occurrence of prohibited activities or investments Management framework that clearly delineates responsibility and accountability for compliance with the Volcker Rule and includes appropriate management review of trading limits, strategies, hedging activities, investments, incentive compensation, and other relevant matters Independent testing and audit of the effectiveness of the compliance program conducted periodically by qualified personnel Training for personnel and managers, and other appropriate personnel, to effectively implement and enforce the compliance program Records sufficient to demonstrate compliance with a Volcker Rule (retained for 5+ years) Additional documentation for covered funds Appendix A and/or Appendix B requirements (if applicable) 59

60 Developing a Compliance Program An effective process for developing a banking entity s compliance program: Inventory all business lines and determine potential impact of Volcker Rule Completion of questionnaires by all business lines Identify all trading desks Perform due diligence of all potentially affected activities Analyze available exemptions and/or exclusions relevant to trading and funds activities covered by the Volcker Rule Remediate non-conforming activities before end of applicable conformance period Create a compliance program tailored to the banking entity s business and structure 60

61 Characteristics of a Successful Compliance Program Ensure that activities covered by the Volcker Rule have been adapted to satisfy the requirements of the relevant exemption(s) and/or exclusion(s): Compliance programs for market-making, underwriting, and riskmitigating hedging activities have been established (if applicable) Policies, procedures, and controls in place to ensure exclusion(s) and/or exemption(s) are satisfied (e.g., liquidity management plan, trading and investments solely outside of the United States, etc.) Appropriate documentation (e.g., written policies and procedures, identification of covered funds, training program, etc.) 61

62 Compliance Program Policies Questions to consider: Do the policies track the rule? Do they cover everything or is some activity left out? Is the institution trying to do an end run on the purpose of the rule? Are there any smoking guns in the file? Are any interpretations of the rule supported by documented rationale? 62

63 Compliance Program Procedures Questions to consider: Do the procedures fully reflect the policies? Do they cover everything or are there gaps? Are the procedures clear and understandable? What are the controls and are they effective? 63

64 Compliance Programs: Practice and Culture Questions to consider: What are your people actually doing? What is the scope and frequency of audits against the policies and procedures? Do you have an adequate training program and is training conducted with sufficient frequency? What do your people do when in doubt? 64

65 Compliance Program Challenges Particular challenges Application of compliance program to banking entities that are not under actual control of parent Monitoring of per-fund and aggregate investment limits (including value) in Section 11 funds Continuing vigilance over compliance with requirements of applicable exemptions Proprietary trading exemptions Covered fund exemptions New product/service process needs to incorporate Volcker Rule clearance Investment monitoring Process for identifying impermissible securitizations Process for vetting public welfare investments Monitoring compliance with Super 23A/23B Monitoring compliance with prudential backstops 65

66 Unique Issues for FBOs: TOTUS Trading Exemption Reliance on exemption for trading totally outside of the United States ( TOTUS ) TOTUS exemption available only to FBOs and other qualifying foreign banking entities All trades must be with an acceptable counterparty. No trading with U.S. counterparty, except: transactions with the foreign operations of a U.S. entity if no personnel of such entity that are located in the United States are involved in the arrangement, negotiation or execution of such purchase or sale; transactions with an unaffiliated market intermediary acting as principal, provided the transaction is promptly cleared and settled through a clearing agency or derivatives clearing organization ( DCO ) acting as a central counterparty; or transactions through an unaffiliated market intermediary acting as agent, provided the transaction is conducted anonymously on an exchange or similar trading facility and is promptly cleared and settled through a clearing agency or DCO acting as a central counterparty. Use of TOTUS Representation Letter for trading with U.S. entities 66

67 Unique Issues for FBOs: Foreign Funds SOTUS ( solely outside the U.S. ) fund exemption for FBOs and other foreign banking entities No ownership interest in foreign fund has been sold pursuant to an offering that targets residents of the United States ( marketing restriction ) FAQ 13: the marketing restriction applies to a foreign banking entity sponsoring the SOTUS fund (and not to a third-party fund in which the foreign banking entity seeks to invest and does not serve as the investment adviser) Foreign private fund exclusion (foreign equivalent fund) Not a covered fund under prong 3 of definition of covered fund Organized/established outside of the United States Ownership interests offered and sold solely outside of the United States Is FAQ 13 applicable? If organized in the United States, would avail itself of 3(c)(1) or 3(c)(7) exclusion from definition of investment company 67

68 Unique Issues for FBOs: Controlled Foreign Funds Controlled Foreign Funds Controlled foreign funds excluded from the definition of covered fund treated as a banking entity affiliate subject to the restrictions of the Volcker Rule Anomaly: consider treatment of controlled SOTUS funds IIB has sought relief for FBOs Many FBOs have made individual extension requests FAQ 14: a foreign public fund advised by a banking entity is not considered to be an affiliate of the banking entity so long as the banking entity does not own, control, or hold with the power to vote 25 percent or more of the voting shares of the fund There may continue to be uncertainty with respect to control over other foreign funds that do not meet the definition of foreign public fund The IIB and other foreign bank trade groups have requested that controlled foreign private funds should not be banking entities Unresolved 68

69 Volcker Rule Multi-entity Compliance How should a multi-entity group deal with Volcker Rule compliance? What is the nature of the compliance program at the subsidiary level? Generally banks have based threshold measurements on consolidated top-tier parent entity, and apply compliance program standards uniformly to all affiliates and subsidiaries How should subsidiary programs roll up into the parent entity? Subsidiaries may have separate sets of policies and procedures specifically tailored to the types of activities and business structure Cross-reference or incorporate relevant provisions of compliance program of parent entity into policies and procedures of subsidiaries What action to take with a banking entity affiliate over which the parent does not exercise actual control? 69

70 Volcker Rule Multi-entity Compliance What type of program should non-financial affiliates have? Affiliates that are not engaged in any activity covered by the Volcker Rule must ensure that activities continue to remain excluded from its coverage Review activities and create supporting documentation on a periodic basis appropriate for the types, size, scope, and complexity of activities Controls can be documented in written policies and procedures for such entities New product/business approval process as a control to ensure compliance Monitoring and independent testing to ensure activities remain excluded Policies and procedures to be amended in the event activities expand to those covered by the Volcker Rule 70

71 Likely Examination Focus OCC Volcker Rule Interim Examination Procedures are a good indicator of what all regulators will focus on. Examination objectives include assessing a banking entity s progress toward: identifying activities subject to the regulations establishing a compliance program reporting metrics as and when required using the metrics to monitor for impermissible proprietary trading identifying its market-making-related activities, market-maker inventory, and reasonably expected near-term demand (RENTD) establishing a compliance program for permitted trading: Market making-related activity Underwriting activity Risk-mitigating hedging 71

72 Likely Examination Focus Assess the bank s plan for: avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies conforming asset management and sponsorship activities conforming securitization activities involving a covered fund conforming underwriting and market-making activities in covered funds conforming hedging activities using covered funds divesting nonconforming investments in covered funds Assess the bank s progress in ensuring compliance with per fund and aggregate investment limits in covered funds Assess the bank s overall progress in taking the necessary actions to meet the requirements of the regulations within the conformance period Also expect assessment of management framework for effective implementation, including appropriate Volcker Rule-specific procedures and controls and training 72

73 Recordkeeping, Documentation and Reporting Recordkeeping, documentation and reporting requirements are based on the types of activities and whether the banking entity is subject to an enhanced compliance program (Appendix B) Generally, banking entities must retain records sufficient to demonstrate compliance with the Volcker Rule for a period no less than 5 years Banking entities engaged in certain forms of permitted proprietary trading (e.g., marketmaking, underwriting, risk-mitigating hedging) are subject to recordkeeping and documentation requirements (including written policies and procedures) specific to such activities Banking entities subject to Appendix B must meet additional documentation requirements Banking entities that engage in proprietary trading and have trading assets and liabilities over certain thresholds (see slide 2) are subject to special recordkeeping and reporting requirements Metrics reporting requirement (Appendix A): total trading assets and liabilities, excluding U.S. government obligations (total trading assets and liabilities of the combined U.S. operations of the foreign banking entity, including all subsidiaries, affiliates, branches and agencies of the foreign banking entity operating, located or organized in the United States) Additional documentation for covered funds Banking entities with more than $10 billion in total consolidated assets must maintain records related to certain excluded funds, among other types of documentation 73

74 Enforcement What sorts of deficiencies or incidents might give rise to disciplinary action? Failure to establish compliance program Actual significant prohibited trading activity Proprietary trading that contributes to manipulation, fraud, or violations of prudential backstops (e.g., unidentified conflicts of interest) Prohibited activity resulting from inadequate review and diligence of covered activities Inadequate documentation to demonstrate good faith efforts to conform to the Volcker Rule 74

75 Potential Sanctions Examiners may potentially issue warnings or provide direction for improvement or correction of violations or non-conformance. Whenever the Agency finds reasonable cause to believe any banking entity has engaged in an activity or made an investment in violation of [the Volcker Rule], or engaged in any activity or made any investment that functions as an evasion of the requirements of [the Rule], [Agency] may take any action permitted by law to enforce compliance with [the Rule], including directing the banking entity to restrict, limit, or terminate any or all activities under [the Rule] and dispose of any investment. Volcker Rule,.21(a). In the preamble to the Volcker Rule, the Agencies stated that they are not limited by such remedies and have a number of enforcement tools at their disposal to carry out their obligations to ensure compliance with the Volcker Rule. 75