Volcker Rule Regulations Proposed

Transcription

1 October 2011 / Issue 13 A legal upate from Dechert s Financial Institutions Group Volcker Rule Regulations Propose Section 619 of the Do-Frank Act the Volcker Rule attempts to limit perceive risks in the financial system create by (i) proprietary traing operations of banks an their affiliate companies through a set of Traing Restrictions an (ii) investments by banks an affiliate companies in private equity an hege funs an relationships with such funs through a set of Fun Restrictions. On October 11 an 12, the Boar of Directors of the Feeral Deposit Insurance Corporation ( FDIC ), the Boar of Governors of the Feeral Reserve System ( FRB ), the Office of Comptroller of the Currency ( OCC ) an the Securities an Exchange Commission ( SEC ) took steps to implement the Volcker Rule by approving a propose interagency rule ( Propose Rule ). It is not clear when the fifth agency require to issue rules implementing the Volcker Rule ( Agency Rules ), the Commoity Futures Traing Commission ( CFTC ), will act. 1 The Volcker Rule becomes effective on July 21, 2012 ( Effective Date ), regarless of whether implementing Agency Rules are effective on that ate. The Propose Rule has a comment ealine of January 13, Thus, with a final rule not likely to be issue until just a few months before the Effective Date, impacte institutions may be uner pressure to act rapily to respon to some of the terms of the final rule which become applicable immeiately. This consieration will be mitigate to some extent by the general two-year conformance perio provie for in the Volcker Rule. 1 Together the FRB, SEC, OCC, FDIC an CFTC are referre to as Agencies. To the extent that a particular reference relates to the Propose Rule, the term Agencies oes not inclue the CFTC. The Propose Rule recognizes the enormous complexity associate with sharply reucing, but not fully prohibiting, proprietary traing an fun investment an relate activities. In that regar, the Agencies have solicite input on nearly 400 questions regaring the implementation of the Volcker Rule. As we have seen with the propose rule on the Do-Frank Act s creit risk retention requirements, informe comments from market participants are critical to ensuring that agency rulemaking action takes a comprehensive view of the issues an operational consierations relate to the implementation of the rule. What Types of Entities Are Subject to the Propose Rule? Two Prongs of the Volcker Rule The application of the Volcker Rule has two istinct prongs. Entities that meet the efinition of banking entity are subject to the Traing Restrictions an the Fun Restrictions. Entities that are esignate as systemically important financial institutions (each one, a SIFI ) by the Financial Stability Oversight

2 Council ( FSOC ) are not subject to the Traing Restrictions or Fun Restrictions, but are subject to aitional capital requirements an quantitative limitations base on their proprietary traing an relationships with private equity or hege funs. The Propose Rule oes not aress any such requirements for SIFIs at this time, since the FSOC has not yet finalize the criteria for esignation of, or esignate, any SIFIs. Banking Entity Because all banking entities will be subject to Traing Restrictions an Fun Restrictions it is critical to recognize the broa reach of the term banking entity, which covers: Any insure epository institution: Uner the Volcker Rule an insure epository institution is any FDIC insure bank or savings institution. The efinition in the Propose Rule also reflects the exclusion in the Volcker Rule for trust or fiuciary institutions that meet certain requirements. Any company that controls an insure epository institution: This inclues bank holing companies ( BHCs ) an savings an loan holing companies. It woul also apply to any other company that controls any insure epository institution, such as an inustrial bank or creit car bank that is not treate as a bank for purposes of the Bank Holing Company Act ( BHCA ). Any foreign bank that maintains a branch or agency in a State, an any company that controls such a foreign bank, as well as any commercial lening company organize uner State law that is a subsiiary of a foreign bank or its controlling company uner section 8 of the International Banking Act of 1978 (Foreign Banking Organization or FBO ): As iscusse below, certain activities of non- U.S. elements of an FBO may be exempt from these restrictions if they meet the off-shore exemption requirements set forth in the Propose Rule. Any affiliate or subsiiary of any of the foregoing: Thus, wherever there is an ultimate controlling parent company of an insure epository institution ( Parent Company ), then all entities that are irectly or inirectly controlle by the parent company will be banking entities. A banking entity woul not inclue either a Covere Fun (as efine below) that is organize, offere an hel by a banking entity as a Customer Fun (as efine below) as permitte uner the Propose Rule or an entity that is controlle by such a Customer Fun. Finally, a mutual fun generally woul not be a subsiiary or affiliate of a banking entity if the banking entity only provies avisory or aministrative services, has certain limite investments in, or organizes, sponsors an manages the mutual fun in accorance with BHCA rules. Uner the Propose Rule the iniviual Agencies will supervise particular banking entities that are uner their jurisiction an such banking entities are referre to as covere banking entities an are efine in the iniviual Agency rules. 2 2 Within this upate, a reference to a banking entity shoul be consiere a reference to a covere banking entity. For purposes of the FRB, a covere banking entity is any banking entity that is: (1) a state member bank; (2) a BHC; (3) a savings an loan holing company; (4) a foreign banking organization; (5) any company that controls an insure epository institution; an (6) any subsiiary of the preceing entities other than a subsiiary for which the OCC, FDIC, CFTC or SEC is the primary financial regulatory agency. As a result of this efinition, in a situation where an iniviual controls a covere banking entity an also separately controls another company, the FRB will not consier the other company to be an affiliate of a covere banking entity an thus the other company an its subsiiaries an affiliates will not be treate as covere banking entities. For purposes of the OCC, a covere banking entity is (1) a national bank; (2) a Feeral branch or agency of a foreign bank; (3) a Feeral savings association or a Feeral savings bank; an (4) any subsiiary of a company escribe in this paragraph s sections (1) through (3), other than a subsiiary for which the CFTC or SEC is the primary financial regulatory agency. For purposes of FDIC, a covere banking entity is an insure epository institution for which the FDIC is the appropriate Feeral banking agency uner the Feeral Deposit Insurance Act. For purposes of the SEC, a covere banking entity is an entity for which the SEC is the primary financial regulatory agency, incluing brokerealers, investment companies an investment avisers. Affiliate an subsiiary woul be efine in accorance with the FRB s Regulation Y governing BHCs. October 2011 / Issue 13 2

3 Restrictions on Proprietary Traing The Propose Rule takes an important step in proviing guiance on the critical question of what proprietary traing is, but leaves significant uncertainties. It oes, however, establish what may be a major compliance buren on banking entities that engage in a significant level of traing activities. What is Proprietary Traing? Proprietary traing is efine as: [E]ngaging as a principal for the traing account of the covere banking entity in any purchase or sale of one or more covere financial positions. Proprietary traing oes not inclue acting solely as agent, broker, or custoian for an unaffiliate thir party. The Volcker Rule generally efines a traing account as an account use for acquiring or taking positions in relevant instruments principally for the purpose of selling in the near term (or otherwise with the intent to resell in orer to profit from short-term price movements). Three Categories of Traing Accounts Uner the Propose Rule The Propose Rule provies a far more etaile efinition of what will be consiere to be a traing account. It creates three categories of activity or status that will cause an account to be treate as a traing account. Short-Term Intent An account will be eeme a traing account if it is use by a banking entity to acquire or take covere financial positions for the purpose of: Short-term resale; Benefitting from actual or expecte short-term price movements; 3 3 The Propose Rule notes that this clause of the efinition oes not require the resale of the position, instea it requires only an intent to engage in any form of transaction on a short-term basis, incluing a transaction separate from, but relate to, the initial acquisition of the position, for the purpose of benefitting from a short-term movement in the price of the unerlying position. Realizing short-term arbitrage profits; or Heging one or more of the foregoing positions. The Propose Rule establishes a rebuttable presumption that any account use to acquire or take a covere financial position (subject to certain exceptions) that the banking entity hols for sixty ays or less will be a traing account unless the banking entity can emonstrate base on all the facts an circumstances that the covere financial position, either iniviually or as a category was not acquire or taken principally for any of the above escribe purposes. 4 Notably the Propose Rule oes not establish a rebuttable presumption that an account which hols covere financial positions for sixty-one ays or will be presume not to be a traing account. Market Risk Capital Rule Covere Positions An account use to take covere financial positions (other than positions that are foreign exchange erivatives, commoity erivatives, or contracts of sale of a commoity for future elivery) which are market risk capital covere positions will be treate as a traing account if the banking entity or any affiliate that is a BHC calculates risk-base capital ratios uner the Market Risk Capital Rules ( MRC Rules ). The Propose Rule notes that the MRC Rules efine an MRC covere position to inclue all positions in a bank s traing account. 5 Significantly, neither the MCR Rules, the Call Report, nor relevant accounting stanars provie a precise efinition of what constitutes a near-term or short-term position for purposes of etermining whether a position is of a type hel in a traing account or is a traing security. Relevant accounting stanars note that nearterm for purposes of classifying traing activities is 4 The Propose Rule emphasizes that the sixty-ay perio is only a presumption. Thus, if a banking entity acquire a covere financial position with a emonstrate intent of holing it for investment or other non-traing purposes but because of unanticipate evelopments, such as increase customer eman or unexpecte liquiity emans, hel it less than sixty ays, those facts an circumstances woul generally suggest that the position was not acquire with short-term traing intent, notwithstaning the presumption. 5 The Call Report instructions note that traing account positions inclue any position that is classifie as traing securities. Uner GAAP, traing securities are escribe as being bought an hel principally for the purpose of selling them in the near term an use with the objective of generating profits on short-term ifferences in price. October 2011 / Issue 13 3

4 generally measure in hours an ays rather than months or years. The Propose Rule provies the following important insight with regar to how the Agencies expect to evaluate what constitutes a traing account uner the Propose Rule: The Agencies expect that the precise perio of time that may be consiere near-term or short-term for purposes of evaluating any particular covere financial position woul epen on a variety of factors, incluing the facts an circumstances of the... acquisition, the banking entity s traing an business strategies, an the nature of the relevant markets. In consiering the purpose for which a... position is taken an evaluating whether such position is acquire or taken for short-term purposes, the Agencies inten to rely on a variety of information, incluing quantitative measurements of banking entities covere traing activities..., supervisory review of banking entities compliance practices an internal controls, an supervisory review of iniviual transactions. While the Agencies offer more guiance in the Propose Rule than was containe in the Volcker Rule, they are not currently planning to provie bright line tests. In some respects, this is similar to how the feeral banking agencies have aresse compliance with the anti-money launering program requirements of the Bank Secrecy Act. The banking agencies provie general guiance as to how a program shoul operate, but ultimately conuct a relatively subjective evaluation of the strength of a particular program, particularly if significant issues regaring questionable transactions have arisen. Dealer Activity Traing Accounts Positions taken by banking entities in connection with certain ealer activities will be treate as traing accounts. The specifie ealer statuses an activities are the following: A ealer or municipal securities ealer registere with the SEC; A government securities ealer that is registere or has file notice with an appropriate regulatory agency; A security-base swap ealer that is registere with SEC; 6 an A banking entity engage in the business of a ealer, swap ealer, or security-base swap ealer outsie of the U.S. 7 Certain Accounts Not Deeme to be Traing Accounts Four types of activity involving covere financial positions woul not cause an account to be eeme a traing account. Those four activity types are: Repurchase or reverse repurchase agreement positions pursuant to which the banking entity has agree in writing to both purchase an sell a state asset at state prices an on state ates, or on eman with the same counterparty. Positions that arise uner a transaction in which the banking entity lens or borrows a security temporarily to or from another party pursuant to a written securities lening agreement uner which the lener retains the economic interests of an owner, an has the right to terminate the transaction an to recall the loane security on terms agree by the parties. Positions taken for bona fie liquiity purposes. This provision will require a banking entity to operate uner a ocumente liquiity management plan that must meet a set of five requirements. 8 Positions taken by a banking entity that is a erivative clearing organization registere uner the Commoity Exchange Act or a clearing agency 6 The foregoing provisions only apply to positions taken by a banking entity in connection with one of the specifie provisions, not to all of the activities of the banking entity. 7 The final clause is a notable extraterritorial assertion of jurisiction uner the Propose Rule that, among other things, may raise efinitional issues uner foreign law. 8 The Agencies are concerne with the potential for abuse of the liquiity management exclusion. They note that the Agencies will review liquiity plans an transactions effecte uner them to ensure that the applicable criteria are met an that any position taken is fully consistent with such a plan. The Propose Rule further states that any transactions in which positions characterize as being for liquiity purposes o give rise to appreciable profits or losses as a result of short-term price movements will be subject to significant regulatory scrutiny an, absent compelling explanatory facts an circumstances, woul be viewe as prohibite proprietary traing. A swap ealer that is registere with the CFTC; October 2011 / Issue 13 4

5 registere with the SEC uner the Securities Exchange Act of 1934 ( Exchange Act ). What is a Covere Financial Position? An important limiting factor on the reach of the Traing Restriction is the efinition of covere financial position since the efinition of traing account is limite to covere financial positions. Uner the Propose Rule, a covere financial position means any position, incluing any long, short, synthetic or other position, in the following: A security, incluing an option on a security; A erivative, incluing an option on a erivative; or A contract of sale for a commoity for future elivery, or option on a contract of sale of a commoity for future elivery. A covere financial position oes not inclue any position that itself is (i) a loan, 9 (ii) a commoity, or (iii) foreign exchange or currency. Activities to Which the Traing Restrictions Do Not Apply It is essential to recognize that simply because an activity meets the efinition of proprietary traing, a banking entity is not necessarily prohibite from engaging in the activity. The Propose Rule sets forth a range of activities that are exempte from the Traing Restrictions. However, the requirements impose on these activities in orer to qualify for an exemption may result in changes in how such activities have typically been conucte. Permitte Unerwriting Activities In orer to qualify as a permitte unerwriting activity a purchase or sale of a covere financial position must meet the following requirements: The banking entity must have establishe an internal compliance program that meets the requirements of the Propose Rule. The covere financial position must be a security. 9 For purposes of the Propose Rule a loan is any loan, lease, extension of creit, or secure or unsecure receivable. The purchase or sale must be effecte solely in connection with a istribution of securities for which the banking entity is acting as unerwriter. 10 The banking entity must meet certain ealer registration requirements. The unerwriting activities of the banking entity with respect to the position must be esigne to not excee the reasonably expecte near-term emans of clients, customers an counterparties. The unerwriting activities of the banking entity must be esigne to generate revenues primarily from fees, commissions, unerwriting spreas or other income not attributable to (i) appreciation in the value of positions relate to such activities, or (ii) the heging of positions relate to such activities. 11 The compensation arrangements of persons performing unerwriting activities must not be esigne to rewar proprietary risk-taking. 12 Permitte Market Making-Relate Activities 10 The Propose Rule iscusses the types of activities that the Agencies will take into consieration in etermining whether a banking entity is acting as an unerwriter as part of a istribution of securities. The Propose Rule states that there may be circumstances where an unerwriter hols for investment purposes securities it coul not sell in the istribution. Assuming that the securities were acquire in a permitte unerwriting the banking entity woul be permitte to ispose of the securities at a later time. 11 This requirement is intene to ensure that permitte unerwriting activities emonstrate patterns of revenue generation an profitability consistent with, an relate to, services an unerwriter provies to its customers in bringing securities to market, rather than changes in market value of the securities unerwritten. 12 This provision is likely to raw significant comment. The Propose Rule provies further explanation of its intent by stating that it targets an incentive compensation structure that rewars speculation in, an appreciation of, the market value of unerwritten securities, rather than success in bringing securities to market for a client. While a banking entity may appropriately take into account revenues resulting from movements in the price of securities that the banking entity unerwrites to the extent that such revenues reflect the effectiveness with which its personnel have manage risk, the banking entity shoul provie compensation incentives that primarily rewar client-base revenues an effective client service, not proprietary risktaking. October 2011 / Issue 13 5

6 The Propose Rule states that it may be ifficult to istinguish principal positions that appropriately support market making-relate activities from positions taken for short-term speculative purposes. In orer to aress this concern the Propose Rule sets forth a series of requirements in orer for the purchase or sale of a covere financial position to qualify as a permitte market making-relate activity: The banking entity must have establishe an internal compliance program that meets the requirements of the Propose Rule; The traing esk or other unit that conucts the purchase or sale hols itself out as being willing to buy an sell the covere financial position for its own account on a regular an continuous basis; 13 The market making-relate activities of the banking entity are esigne to not excee the reasonably expecte near-term emans of clients, customers an counterparties; 14 The covere entity must meet certain ealer registration requirements; The market making-relate activities of the banking entity are esigne to generate revenues primarily from fees, commissions, bi/ask spreas or other income not attributable to (i) appreciation in the value of covere financial positions it hols in traing accounts, or (ii) the heging of positions its hols in traing accounts; The market making-relate activities of the traing esk or other unit that conucts the purchase or sale must be consistent with guiance provie in the Propose Rule; an The compensation arrangements of persons performing market-making relate activities are not esigne to rewar proprietary risk-taking. 15 The Propose Rule further provies that the prohibition on proprietary traing oes not apply to certain heging activities relating to permissible market making-relate activities that comply with the Propose Rule requirements for permitte risk-mitigating heging activities. Permitte Risk Mitigating Heging Activities The Propose Rule provies an exemption from the Traing Restrictions for a purchase or sale of a covere financial position mae in connection with an relate to iniviual or aggregate positions of the banking entity an is esigne to reuce the specific risks to the banking entity relate to such positions. The Propose Rule notes that it can often be ifficult in retrospect to etermine whether a banking entity engage in a transaction to mitigate risks arising from relate positions or to profit from price movements relate to the hege position itself. In orer to aress this concern the Propose Rule establishes a series of requirements in orer for a purchase or sale to qualify for this exception: The banking entity must have establishe an internal compliance program that meets the requirements of the Propose Rule; The position must hege or mitigate one or more specific risks arising from or in connection with an relate to iniviual or aggregate positions; 16 The position must be reasonably correlate to the risks it is intene to hege or mitigate; The Propose Rule provies a further iscussion of the level, an type of, activity that will be expecte in orer for a banking entity to meet this requirement. 14 The Agencies will closely monitor this requirement. The Propose Rule notes that a banking entity s expectation regaring near-term customer eman shoul generally be base on the unique customer base of the banking entity base on particular factors beyon a general expectation of price appreciation. It further notes that to the extent a traing esk or other unit of a banking entity is engage wholly or principally in traing that is not in response to, or riven by, customer emans, the Agencies woul not expect those activities to qualify as permitte market making-relate activities. 15 The Propose Rule provies aitional guiance regaring the Agencies view of permitte market making relate activities in a commentary set forth in an Appenix B. 16 These risks may inclue market, creit, an interest rate risks. The Propose Rule notes that it permits the heging of risks on a portfolio basis. It cautions, however, that a banking entity shoul be prepare to ientify the specific position or portfolio of positions that is being hege an emonstrate that the heging transaction is risk-reucing in the aggregate. 17 A banking entity will not be expecte to show a full correlation, instea only a reasonable correlation will be require. October 2011 / Issue 13 6

7 It must not give rise at the inception of the hege to significant exposures that were not alreay present an that are not hege contemporaneously; The position must be subject to ongoing monitoring an management; 18 an The compensation arrangements of persons performing risk-mitigating heging are not esigne to rewar proprietary risk-taking. Permitte Traing in Government an Government- Relate Obligations The Traing Restrictions o not apply to a purchase or sale of (i) an obligation of the U.S. or an agency, (ii) an obligation, participation or other instrument of or issue by Ginne Mae, Fannie Mae, Freie Mac, a Feeral Home Loan Bank, the Feeral Agricultural Mortgage Corporation or certain Farm Creit System institutions, or (iii) an obligation of a state or a subivision thereof. Permitte Traing on Behalf of Customers The Traing Restrictions o not apply to certain purchases an sales on behalf of a banking entity s customers. This exemption is available in the following situations: The banking entity is acting as investment aviser, or in another fiuciary capacity, for the account of the customer, an as to which the customer is the beneficial owner. 19 The banking entity is acting as a riskless principal in a transaction in which the banking entity after receiving an orer to purchase or sell a covere financial position from or to a customer, purchases or sells the covere financial position for its own account to offset a contemporaneous sale to or purchase from the customer. 18 A banking entity s internal policies shoul be esigne to ensure that heges remain effective as correlations or other factors change. A risk-mitigating hege typically woul be unwoun as exposure to the unerlying risk is reuce or increase as unerlying risk is increase. The Propose Rule notes that selective heging woul be inicative of prohibite proprietary traing. The banking entity is an insurance company that purchases or sells a covere financial position solely for a separate account establishe by the insurance company for one or more insurance policies issue by the insurance company. All profits an losses arising from the transaction must be allocate to the separate account an inure to the benefit or etriment of the owners of the policies an not the insurance company. 20 The transaction must be conucte in compliance with, an subject to, applicable state insurance law an regulation. Permitte Traing in the General Account of an Insurance Company The Traing Restrictions o not apply to the purchase or sale of a covere financial position if a banking entity is an insurance company acting for its general account 21 or an affiliate of an insurance company acting for the insurance company s general account. The insurance company must satisfy the following require- ments; 20 The insurance company must irectly engage in the business of insurance an be subject to regulation by a State insurance regulator or foreign insurance regulator; The insurance company or affiliate must purchase or sell solely for the general account of the insurance company; The purchase or sale must be conucte in compliance with, an subject to, insurance company investment laws, regulations an written guiance of the applicable State or other jurisiction of omicile; an The appropriate Feeral banking agencies, after consultation with the FSOC an the relevant insurance commissioners of the States, must not have jointly etermine after notice an comment, that a particular law, regulation, or written guiance is insufficient to protect the safety an The Propose Rule notes that the Agencies woul not consier profits from a separate account to inure to the benefit of a banking entity if the banking entity were solely to receive payment, out of separate account profits, of fees unrelate to the investment performance of the separate account. 19 The Propose Rule notes that where a banking entity acts as an investment aviser to a mutual fun, any traing by the aviser on behalf of the mutual fun woul be permitte uner this exception as long as all the relevant criteria were met. 21 A general account is efine as all of the assets of an insurance company that are not legally segregate an allocate to separate accounts uner State law. October 2011 / Issue 13 7

8 sounness of the banking entity or the financial stability of the U.S. 22 Permitte Off-Shore Traing The Propose Rule provies an exemption for traing by a banking entity that occurs outsie of the U.S. an meets the following requirements: The banking entity must not be irectly or inirectly controlle by a banking entity that is organize uner the laws of the U.S. or one or more of the States; 23 The purchase must be authorize by section (4)(c)(9) or (4)(c)(13) of the BHCA; 24 an The purchase or sale must occur wholly outsie of the U.S. In orer to meet this requirement a transaction must satisfy the following conitions: No personnel of the banking entity who is irectly involve in the purchase or sale is physically locate in the U.S. 26 The purchase or sale is execute wholly outsie of the U.S. Other Discretionary Exemptions The Volcker Rule permits the Agencies to grant other exemptions from the Traing Restrictions if they etermine that the exemption woul promote an protect the safety an sounness of the banking entity an the financial stability of the U.S. The Propose Rule requests comment on whether the Agencies shoul consier any such exemptions. Overriing Limitations on Exempte Proprietary Traing Activities The banking entity conucting the purchase an sale is not organize uner U.S. or State law. No party to the purchase or sale is a resient of the U.S. 25 No transaction, class of transactions or activity will be consiere permissible uner one of the exemptions if the transaction, class of transactions, or activity woul: Involve or result in a material conflict of interest between the banking entity an its clients, customers, or counterparties; The Propose Rule notes that the Feeral banking agencies have not at this point propose to etermine that the laws, regulations an guiance of any particular jurisiction are insufficient. The Feeral banking agencies inten to monitor together with the Feeral Insurance Office such laws, regulations an guiance. 23 As a result of this clause, any banking entity that has an ultimate U.S. controlling company may not utilize this exception even if its activities are wholly conucte outsie the U.S. The Propose Rule also provies that a U.S. subsiiary or branch of a foreign banking entity woul not qualify for this exception. 24 In orer to satisfy this conition, a banking entity that is an FBO must be a qualifying FBO ( QFBO ) as efine in 12 C.F.R (a), an must conuct the purchase or sale in compliance with Subpart B of the FRB s Regulation K. For a banking entity that is an FBO but not a QFBO, it must meet at least two of the following three requirements: (i) total assets of the banking entity hel outsie the U.S. excee total assets hel in the U.S., (ii) total revenues erive from the business of the banking entity outsie the U.S. excee total revenues erive in the U.S., an (iii) total net income erive from the business of the banking entity outsie the U.S. excees total net income from the business of the banking entity in the U.S. resient, (iv) a trust of which any trustee, beneficiary, or if the trust is revocable, any settlor is a U.S. resient, (v) any agency or branch locate in the U.S., (vi) any iscretionary or non-iscretionary account or similar account (other than an estate or trust) hel by a ealer or fiuciary for the benefit or account of a resient of the U.S., an (vii) any iscretionary account or similar account (other than an estate or trust) hel by a ealer or fiuciary organize uner U.S. law, or (if an iniviual) a resient of the U.S. 26 The Propose Rule woul not treat persons performing purely aministrative, clerical or ministerial functions as persons irectly involve in the transaction. 27 The Propose Rule requests comments on the potential relationship between, an interplay of, the Propose Rule an Section 621 of the Do-Frank Act regaring conflicts of interest relating to certain securitizations which contains a prohibition on certain material conflicts of interest. 25 A resient is (i) a natural person resient in the U.S., (ii) a business entity organize uner U.S. or State law, (iii) any estate of which any executor or aministrator is a U.S. October 2011 / Issue 13 8

9 Result, irectly or inirectly in a material exposure by the banking entity to a high-risk asset 28 or high-risk traing strategy; 29 or Pose a threat to the safety an sounness of the banking entity or to the financial stability of the U.S. The Propose Rule states that conflicts of interest may arise in a variety of circumstances in connection with permitte traing activities. It notes that a banking entity may acquire information about a particular company through its lening or other activities, which, if improperly transmitte to an use in its traing operations, woul permit the banking entity to use such information to its customers, clients or counterparties isavantage. It further notes that a banking entity may conuct a transaction in which it places its own interests ahea of its obligations to its customers, clients or counterparties, or it may seek to gain by treating one customer involve in a transaction more favorably than another customer in the transaction. Finally, it observes that concerns regaring conflicts of interest are likely to be elevate when a transaction is complex, highly structure or opaque. The Propose Rule provies that a material conflict of interest exists if the banking entity engages in any transaction, class of transactions or activity that woul involve or result in the banking entity s interests being materially averse to the interests of its client, customer or counterparty with respect to such transaction, class of transactions, or activities unless the banking entity either (i) makes a timely an effective isclosure that provies the customer, client or counterparty the opportunity to negate, or substantially mitigate, any materially averse effect on the client, customer or counterparty, or (ii) the banking entity has establishe, maintaine an enforce information barriers A high-risk asset is an asset or group of relate assets that woul, if hel by a banking entity, significantly increase the likelihoo that the banking entity woul incur a substantial financial loss or woul fail. 29 A high-risk traing strategy is a traing strategy that woul, if engage in by a banking entity, significantly increase the likelihoo that the banking entity woul incur a substantial financial loss or woul fail. 30 A banking entity may not rely on such information barriers if in any specific situation it knows or reasonably shoul know that, notwithstaning such barriers, the conflict of interest may involve or result in a materially averse effect on the client, customer or counterparty. containe in written policies that are reasonably esigne to prevent the conflict of interest from involving or resulting in a materially averse effect on a client, customer or counterparty. In comments that a some complication to this point, the Propose Rule observes that while the foregoing conflicts may be material for purposes of the Propose Rule, the mere fact that the buyer an seller are on opposite sies of a transaction an have iffering economic interests woul not be eeme a material conflict of interest with respect to transactions relate to bona fie unerwriting, market making, riskmitigating heging or other permitte activities, assuming these activities are conucte in a manner that its consistent with the Propose Rule an securities an banking laws an regulations. Dealings with Private Equity Funs or Hege Funs The Volcker Rule prohibits any banking entity from acquiring or retaining an ownership interest in, or sponsoring, 31 a hege fun or private equity fun ( Covere Fun ), as a principal, irectly or inirectly, subject to certain exceptions. 32 The Volcker Rule also prohibits a banking entity that serves as an investment manager, investment aviser, or sponsor to a Covere Fun, an any affiliates of the banking entity, from entering into certain covere transactions with 31 A sponsor is an entity that (i) serves as a general partner, member, trustee, or commoity pool operator of a Covere Fun, (ii) in any manner selects or controls a majority of the irectors, trustees or management of a Covere Fun; or (iii) shares a name or similar name with a Covere Fun for corporate, marketing, promotional or other purposes. 32 Because the Volcker Rule aresses principal activities, the prohibition on acquiring or retaining ownership interests in Covere Funs woul not apply to interests hel (i) by a banking entity in goo faith in a fiuciary capacity (subject to a limite exception), (ii) by a banking entity in goo faith in its fiuciary capacity as a custoian, broker, or agent for an unaffiliate thir party, (iii) by a qualifie plan as that term in efine in section 401 of the Internal Revenue Coe of 1956 uner certain circumstances, or (iv) by a irector or employee of a banking entity who acquires the interest in his or her personal capacity an who is irectly engage in proviing avisory or other services to the Covere Fun, unless the banking entity, irectly or inirectly, extene creit for the purpose of enabling the irector or employee to acquire the ownership interest in the Covere Fun an the creit was use to acquire such ownership interest in the Covere Fun. October 2011 / Issue 13 9

10 Covere Funs, as that term is efine in section 23A of the Feeral Reserve Act an imposes restrictions containe in section 23B of the Feeral Reserve Act on certain other types of transactions an relationships between a banking entity an a Covere Fun. Definition of Covere Fun A hege fun or a private equity fun means an issuer that that woul be an investment company but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 ( ICA ) or similar funs as the Agencies may etermine by rule. The efinitions of hege fun an private equity fun have been combine into a single term a Covere Fun. The Propose Rule acknowleges that the statutory efinition of private equity fun an hege fun coul potentially inclue within its scope many entities an corporate structures that woul not usually be thought of as private equity funs or hege funs. It gives as examples: joint ventures, acquisition vehicles, an certain wholly-owne subsiiaries. The Propose Rule aresses this overreach to some extent through certain exemptions it offers to particular types of entities that might rely on section 3(c)(1) or 3(c)(7) exclusions. Significantly, the Propose Rule makes clear that if an issuer, incluing an issuer of asset-backe securities, may rely on another exclusion or exemption from the efinition of investment company, apart from the exclusions in section 3(c)(1) or 3 (c)(7), such as section 3(c)(5), it woul not be consiere to be a Covere Fun as long as it can satisfy all the requirements for the alternative exclusion. In aition, the Volcker Rule Agencies have propose to use their authority to esignate similar funs to exten the efinition of Covere Fun to inclue: A commoity pool, as efine in section 1a(10) of the Commoity Exchange Act; an Any issuer, as efine in section 2(a)(22) of the ICA, that is organize an offere outsie of the U.S. that woul be a Covere Fun were it organize or offere uner the laws, or offere to one or more resients, of the U.S. or of one or more States. The Agencies explaine that these aitional types of entities were ae to the efinition of Covere Fun because they are generally manage an structure similar to a covere fun, except that they are not generally subject to the Feeral securities laws ue to the instruments in which they invest or the fact that they are not organize in the Unite States or one or more States. Definition of Ownership Interest An ownership interest is efine broaly as any equity, partnership, or other similar interest in a Covere Fun, whether voting or nonvoting, or erivative of such interest. The efinition is intene to focus on whether the interest provies a banking entity with exposure to the profits an losses of the Covere Fun rather than the particular form of the interest. 33 A carrie interest that meets certain requirements will not be consiere to be an ownership interest. An exclue carrie interest means an interest hel by a banking entity (or an affiliate, subsiiary, or employee thereof) in a Covere Fun for which the banking entity (or affiliate party) serves as investment manager, investment aviser, or commoity traing avisor, provie that among other things, the sole purpose an effect of the interest is to allow the banking entity (or affiliate party) to share in the profits of the Covere Fun as performance compensation for services provie to the Covere Fun, an further provie that the banking entity (or affiliate party) may be obligate uner the terms of such interest to return profits previously receive. Permitte Organizing an Offering of a Covere Fun in Connection with Certain Banking Entity Services Requirements for Involvement with a Customer Fun The Volcker Rule s prohibition on organizing an offering a Covere Fun, incluing serving as a general partner, managing member, or trustee or in any way selecting or controlling a majority of the irectors, trustees or management of the Covere Fun oes not apply if: The banking entity provies bona fie trust, fiuciary, investment avisory, or commoity traing avisory services to the Covere Fun. 33 Accoringly, the Propose Rule notes that to the extent a ebt security exhibits substantially the same characteristics as an equity or other ownership interest, such as the right or ability to share in the Covere Fun s profits or losses, the Agencies woul consier such instrument as an other similar instrument. October 2011 / Issue 13 10

11 The Covere Fun is organize an offere only in connection with the provision of bona fie trust, fiuciary, investment avisory, or commoity traing avisory services an only to persons that are customers of such services of the banking entity, pursuant to a creible plan outlining how the banking entity intens to provie avisory or similar services to it customers through organizing an offering the Covere Fun. 34 The banking entity oes not acquire or retain an ownership interest in the Covere Fun except as permitte uner the Propose Rule. The banking entity complies with the prohibitions an restrictions on transactions an relationships with the Covere Fun impose uner the Propose Rule. The banking entity oes not irectly or inirectly guarantee, assume or otherwise insure the obligations or performance of the Covere Fun or any Covere Fun in which the Covere Fun invests. The Covere Fun for corporate, marketing, promotional, or other purposes, oes not share the same or similar name with the banking entity or any of its affiliates, an oes not use the wor bank in its name. No irector or employee of the banking entity takes or retains an ownership interest in the Covere Fun, except for any irector or employee of the banking entity who is irectly engage in proviing investment avisory or other services to the Covere Fun. The banking entity makes specifie isclosures to its prospective an actual investors in the Covere Fun. A Covere Fun that meets the foregoing requirements is referre to as a Customer Fun. Permitte Investments in Customer Funs The general prohibition on holing an ownership interest in a Covere Fun oes not apply to a Customer Fun. A banking entity is permitte to make a sufficient initial 34 The customer relationship oes not have to be a preexisting one. It may be establishe in connection with the banking entity s organization an offering of a Covere Fun. The Propose Rule cautions that a banking entity may not organize an offer a Covere Fun as a means of itself investing in the Covere Fun or in the assets hel in the Covere Fun. equity investment to permit the Customer Fun to attract unaffiliate investors as require for a Customer Fun. The banking entity must actively seek unaffiliate investors to reuce its ownership interests to no more than three percent 35 of the total amount or value of outstaning ownership interests of the Customer Fun generally not later than one year after the establishment of the Customer Fun. 36 The Propose Rule limits the aggregate value of all ownership interests of the banking entity in all Customer Funs to no more than three percent of the tier 1 capital of the banking entity. A banking entity is require to euct the aggregate amount of all investments in Customer Funs from the banking entity s tier 1 capital. Other Permitte Covere Fun Activities Permitte by the Volcker Rule The Propose Rule also permits investment in, an sponsorship of, certain Covere Funs that are not Customer Funs as provie in the Volcker Rule. The Propose Rule permits holing an ownership interest in, an sponsoring, small business investment companies that meet certain requirements. The Propose Rule also permits investments in a Covere Fun in connection with risk-mitigating heging activities that meet certain requirements. Permitte Off-Shore Covere Fun Investments an Activities The Propose Rule provies an exemption from the prohibitions on the acquisition or retention of an ownership in, or sponsorship of, a Covere Fun by a banking entity if the following requirements are met: The banking entity must not be irectly or inirectly controlle by a banking entity that is organize uner the laws of the U.S. or one or more of the States; 35 The Propose Rule establishes special rules for attributing ownership interests in a Customer Fun to a banking entity an for etermining the value of the banking entity s interests in a Customer Fun. 36 Upon application by a banking entity to the FRB, the FRB may exten the perio for reaching the reuce level of investment for up to two years taking into account a set of specifie factors, an may impose conitions on such extension. October 2011 / Issue 13 11

12 The purchase must be authorize by section (4)(c)(9) or (4)(c)(13) of the BHCA; 37 No ownership interest in the Covere Fun is offere for sale or sol to a resient of the U.S.; an The activity must occur solely outsie of the U.S. In orer to meet this requirement a transaction must satisfy the following conitions: The banking entity conucting the purchase an sale is not organize uner U.S. or State law; an No subsiiary, affiliate, or employee of the banking entity that is involve in the offer or sale of an ownership interest in the Covere Fun is incorporate in or physically locate in the U.S. or one or more States. 38 Permitte Involvement in Loan Securitizations A banking entity may acquire or retain an ownership interest, or act as a sponsor to, a Covere Fun that is an issuer of asset-backe securities ( Loan Securitization Exemption ), the assets of which are solely comprise of: Loans; Contractual rights or assets irectly arising from loans supporting the asset-backe securities; an Interest rate or foreign exchange erivatives that materially relate to the terms of the loans or contractual rights or assets an that are use for heging purposes with respect to the securitization structure. The preamble to the Propose Rule states that the propose efinition of a banking entity woul not inclue any entity that is a subsiiary or affiliate of a banking entity that is a Covere Fun an any entity controlle by such Covere Fun. However, the pro- 37 The same requirements apply to this provision as apply in regar to Permitte Off-shore Traing as escribe above. 38 The Propose Rule inicates that an employee or entity with no customer relationship an involve solely in proviing aministrative services to the Covere Fun, such as clearing an settlement or maintaining an preserving recors of the Covere Fun with respect to a transaction where no ownership interest is offere for sale or sol to a resient of the U.S., woul not be subject to this requirement. pose regulatory text appears to be more restrictive. It provies an exclusion from the term banking entity to: A covere fun that is organize, offere an hel by a banking entity pursuant to.11 an in accorance with the provisions of Subpart C, incluing the provisions governing relationships between a covere fun an a banking entity. The reference to section.11 on its face is limite to a Customer Fun an thus woul not appear to exten to any other type of permitte ownership in, or sponsorship of a Covere Fun. Thus, a Covere Fun that is hel an/or sponsore uner the Loan Securitization Exemption coul be subject to being treate as a banking entity. In this regar, the Propose Rule requests comments on whether the exclusion for Customer Funs shoul be moifie to exclue any Covere Fun. In a relate matter, the Propose Rule notes that an issuer of asset-backe securities that is both (i) an affiliate or subsiiary of a banking institution an (ii) oes not rely on an exclusion containe in section 3(c)(1) or 3(c)(7) of the ICA (an thus woul not be treate as a Covere Fun) woul be a banking entity. As a result, such an entity woul be subject to the relate restrictions an requirements uner the Propose Rule, incluing (i) the prohibition on proprietary traing, (ii) limitations on investments in, an relationship with Covere Funs, an (iii) compliance program an recorkeeping an reporting requirements. The Propose Rule notes that given the breath of the efinition of affiliate, these requirements may apply to a significant portion of the outstaning securitization market, incluing issuers of asset-backe securities that rely on rule 3a-7 or section 3(c)(5) of the ICA. Other Permitte Covere Fun Activities Authorize by the Agencies The Volcker Rule authorizes the Agencies to permit banking entities to engage in Covere Fun activities that the Agencies etermine promote an protect the safety an sounness of a banking entity an the financial stability of the U.S. In reliance on that authority, the Propose Rule woul not apply to prohibitions on acquiring or retaining an ownership interest or to acting as a sponsor in the following circumstances: October 2011 / Issue 13 12