October 18, 2011 The Impact of Proposed Volcker Rule Regulations on Activities of Non-U.S. Banks Outside of the United States Contents Last week, the Board of Governors of the Federal Reserve System (the Fed ), together with the other federal banking agencies and the Securities and Exchange Commission, approved the issuance of a notice of proposed rulemaking (the Proposal ) that would implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ), commonly known as the Volcker Rule. 1 One of the Dodd-Frank Act s most controversial provisions, the Volcker Rule prohibits banking entities, including any non-u.s. bank with a U.S. presence, from engaging in proprietary trading or investing in or sponsoring hedge funds and private equity funds (together, Private Funds ), subject to certain exceptions. Although the Volcker Rule broadly exempts business conducted by a non-u.s. bank solely outside of the United States, that phrase is not defined in the Dodd-Frank Act itself, and there has been intense speculation about how the Agencies would interpret it. The Proposal is a clear indication that the Agencies intend to interpret the phrase solely outside of the United States very narrowly. Overview of the Volcker Rule and the Proposal... 2 The Impact of the Proprietary Trading Ban on Non-U.S. Banks... 3 The Impact of the Private Fund Prohibition on Non- U.S. Banks... 5 Systemic Risk and Competitive Parity... 6 Reporting, Recordkeeping and Compliance Obligations for Non-U.S. Banks... 7 Next Steps... 8 This note provides a high-level overview of the Volcker Rule as it would be implemented under the Proposal, describing very generally the activities that would be prohibited and those that would be exempted, with a particular focus on its extraterritorial impact on the global operations of non-u.s. banks. 2 1 2 Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds (Oct. 11, 2011), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20111011a1.pdf. While the Dodd- Frank Act directs the Commodity Futures Trading Commission (the CFTC ) to adopt regulations implementing the Volcker Rule with respect to entities for which it is the primary financial regulatory agency, including futures commission merchants and swap dealers, the CFTC is not one of the agencies issuing the Proposal. The CFTC is considering its own Volcker Rule implementing regulations. While this note is focused on the effect of the Proposal on non-u.s. banking entities with a U.S. presence, it is worth noting that many banks based in the United States are of the view that the Volcker Rule and the Proposal treat them less fairly than they treat foreign banks because U.S. banks are not granted an exemption to the prohibitions for their proprietary trading and Private The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 1
Overview of the Volcker Rule and the Proposal Scope The Volcker Rule bans proprietary trading and certain Private Fund activities, as described below, by banking entities, a term that includes U.S. banks and their holding companies, foreign banks with a U.S. branch or agency, and any affiliates of the foregoing. By its terms, the definition picks up all affiliates up, down and across an organization, whether they are organized in the United States or not. Except as specifically provided otherwise, the Volcker Rule s prohibitions are thus effective across a corporate group and around the globe. Proprietary Trading Prohibition Proprietary trading is a complex concept that is only made more so by the Proposal. Very briefly, proprietary trading under the Proposal includes both > purchases or sales of securities, derivatives and futures 3 by any banking entity acting as principal with the purpose of benefiting from short-term price changes, and > all principal trading, regardless of purpose, conducted by dealers in securities, swaps and certain other instruments. There are important exemptions, including exemptions for underwriting, marketmaking, risk-mitigating hedging, trading as a riskless principal on behalf of a customer, and, for non-u.s. banking entities only, trading conducted solely outside of the United States (the Foreign Bank Trading Exemption ). The Foreign Bank Trading Exemption is discussed in more detail below. The Proposal sets forth in detail the principles that the Agencies will use to interpret these exemptions and, in particular, to distinguish market-making from prohibited proprietary trading. Of critical concern to both U.S. and non-u.s. banking entities is that the Proposal would require them to implement burdensome documentation and compliance systems in order to invoke many of these statutory exemptions; in other words, and as just one example, they will not be free merely to self-identify which positions represent bona fide market making and which do not. Private Fund Prohibition The Volcker Rule also prohibits banking entities from investing in, sponsoring or having certain relationships with Private Funds, a term defined as any issuer that 3 Fund activity outside of the United States and foreign banks can avoid the effects of the Volcker Rule by closing their U.S. branches and selling their U.S. bank subsidiaries. The definition of covered financial position excludes loans, physical commodities and foreign exchange. Proposed Section 3(b)(3)(ii). The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 2
would be considered an investment company but for the exemptions provided by Investment Company Act Section 3(c)(1) (which generally exempts private funds the securities of which are owned by fewer than 100 persons) or Section 3(c)(7) (which generally exempts private funds owned only by qualified purchasers), 4 along with any similar funds that the Agencies by rule treat as Private Funds. The Proposal would expand this definition to include offshore funds that, if they had been organized or offered in the United States, would have fallen within the definition of Private Funds. A banking entity that sponsors or offers a Private Fund, or serves as its investment adviser, is also completely barred from entering into a covered transaction, as defined in Section 23A of the Federal Reserve Act, with the 5 Private Fund. Among other things, this would preclude a banking entity from extending credit to an advised Private Fund or to a customer for the purpose of investing in the Private Fund. It would also bar a banking entity from accepting interests in a Private Fund as collateral for a loan to a customer. As with the ban on proprietary trading, there are important exemptions from the Private Fund ban. A banking entity may invest in a Private Fund that it organizes and offers as part of a bona fide investment advisory business, provided that it actively seeks unaffiliated investors for the fund, reduces its ownership stake in the fund to three percent or less within a year of the fund s establishment, and abides by a number of other requirements, including an aggregate limit on total investment in all Private Funds of three percent of the banking entity s tier 1 capital. The Volcker Rule also permits banks to make investments in Private Funds for risk-mitigating hedging purposes and permits non-u.s. banks to invest in or sponsor Private Funds solely outside of the United States (the Foreign Bank Fund Exemption ). The Foreign Bank Fund Exemption is discussed in more detail below. The Impact of the Proprietary Trading Ban on Non-U.S. Banks The Foreign Bank Trading Exemption, as implemented by the Proposal, would allow non-u.s. banking entities to engage in proprietary trading outside of the United States provided that > the non-u.s. banking entity is not directly or indirectly controlled by a U.S. banking entity, 4 5 If a fund is organized outside of the United States, it generally qualifies for one of these exemptions if no more than 100 U.S. persons own the fund or if all the U.S. persons that own the fund are qualified purchasers. 12 U.S.C. 371c. Under Section 23A of the Federal Reserve Act, covered transaction is defined to include (1) loans or extensions of credit to an affiliate, (2) the purchase of an affiliate s securities, (3) asset purchases from an affiliate, (4) the acceptance of an affiliate s securities as collateral, and (5) the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. 12 U.S.C. 371c(b)(7). Effective July 21, 2012, the term covered transaction will also include derivative transactions that create an exposure to an affiliate s creditworthiness. The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 3
> the non-u.s. banking entity conducts the proprietary trading pursuant to Sections 4(c)(9) or 4(c)(13) of the Bank Holding Company Act (the BHC Act ), and > the trading occurs solely outside of the United States. The first of these prongs the requirement that the non-u.s. banking entity not be controlled by a U.S. banking entity is straightforward and broadly designed to prohibit U.S. banks from evading the Volcker Rule by pushing proprietary trading activities into offshore affiliates. 6 The Proposal implements the second prong by providing that a purchase or sale will be considered to have been conducted pursuant to Sections 4(c)(9) and 4(c)(13) of the BHC Act if the banking entity is a qualifying foreign banking organization (a QFBO ) and the transaction is conducted in compliance with Subpart B of the Fed s Regulation K. A foreign bank satisfies the QFBO test if more than half of its worldwide business is comprised of banking and more than half of its business is outside of the United States. The QFBO test is one with which most foreign banks are familiar and, as a practical matter, satisfy already. 7 The reference to compliance with Subpart B of Regulation K is more troubling, however, and is largely unexplained in the Proposal. Regulation K establishes a separate protocol for investment by QFBOs in companies that have a U.S. nexus, and it is not clear whether, to qualify for the Foreign Bank Trading Exemption, a foreign bank s proprietary trading must comply with both the Regulation K protocol and the solely outside of the United States test. If it does, the Foreign Bank Trading Exemption may not extend to all transactions in the securities of U.S. companies, even if such a transaction otherwise is completely outside of the United States. The solely outside of the United States prong will, in any event, likely be the most problematic for foreign banks. Under the Proposal, a transaction would be deemed to have occurred solely outside of the United States only if > the banking entity involved is organized under the laws of a foreign country, > no resident of the United States is a party to the transaction, 6 7 The Agencies have requested comment on whether they should use the authority granted them by Section 13(d)(1)(J) of the BHC Act to allow proprietary trading by U.S.-controlled banking entities outside of the United States pursuant to Section 4(c)(13) of the BHC Act. In addition, in recognition of the fact that the Volcker Rule extends to a foreign industrial company that controls a U.S. thrift or industrial loan company (even though such companies are not otherwise subject to the BHC Act), the Proposal would treat any such company as satisfying this prong it if meets two of the following tests: (1) its total assets held outside of the United States exceed its total assets within the United States, (2) its total revenue derived from its non-u.s. business exceeds its total revenue derived from its business within the United States, or (3) its total net income derived outside of the United States exceeds its total net income derived outside of the United States. The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 4
> the personnel of the banking entity involved with the transaction (other than back office personnel) are not in the United States, and > the transaction is executed wholly outside of the United States. Restricting non-u.s. banking entities from transacting with U.S. residents (a term whose definition is close, but not identical, to the definition of U.S. person in Regulation S under the Securities Act of 1933) could effectively impose a Regulation S-like compliance regime on the secondary market proprietary trading of non-u.s. banking entities. As to the requirement that a transaction be executed wholly outside of the United States, the Agencies note that trades could not be conducted through U.S. execution facilities, but provide no further detail. It is not clear, for example, if the term execution facilities refers to stock exchanges and other trading platforms, payment systems, or securities clearing and settlement systems. Put together, these criteria would make the Foreign Bank Trading Exemption a great deal narrower than the interpretation foreign banks had sought. If adopted as proposed, the Proposal would significantly increase transaction costs and the compliance burden for the trading operations of non-u.s. banking entities, even those that book and conduct trades outside of the United States. The Impact of the Private Fund Prohibition on Non-U.S. Banks The Foreign Bank Funds Exemption allows a non-u.s. banking entity to sponsor or invest in a Private Fund if > the non-u.s. banking entity is not controlled, directly or indirectly, by a banking entity organized in the United States, > the transaction is conducted pursuant to Sections 4(c)(9) or 4(c)(13) of the BHC Act, > the investment or sponsorship is solely outside of the United States, and > no interests in the fund are offered or sold to residents of the United States. With respect to the first two prongs, the Proposal would apply the same test employed under the Foreign Bank Trading Exemption. As to the third prong, the investment in or sponsorship of a Private Fund would be deemed to have been solely outside of the United States if > the banking entity is not organized in the United States, > the banking entity s subsidiaries, affiliates and employees (other than back office employees) involved with the Private Fund are not located in the United States, and The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 5
> ownership interests in the Private Fund are not offered or sold to U.S. residents. These criteria raise many of the same issues discussed above in the discussion of the Foreign Bank Trading Exemption, including the imperfect overlap of the U.S. resident definition with the Regulation S definition of U.S. person and the requirement that any decision-makers be physically located outside of the United States. The Foreign Bank Private Fund Exemption leaves unanswered other practical questions that arise in the particular context of Private Fund structures. For example, are foreign banks as would be a sensible interpretation of the statutory text of the Volcker Rule barred only from investing in foreign Private Funds that continue to sell investments to U.S. investors after the Volcker Rule s effective date? Or will they need to divest or restructure existing interests in Private Funds that were originally offered to U.S. residents, even if the investments are otherwise permissible? Can Private Funds utilize a side-by-side or master-feeder structure to allow foreign banks and U.S. investors to invest in a single adviser s trading strategy without running afoul of the Volcker Rule? The Proposal does not, on its face, appear to restrict non-u.s. banking entities from investing in or continuing to hold foreign Private Funds that themselves invest in U.S. portfolio companies or securities, although it is possible that the reference to compliance with Subpart B of Regulation K, discussed above, will essentially import some degree of restriction on a foreign bank making a controlling investment in a Private Fund that is itself invested in U.S. portfolio companies or assets. Systemic Risk and Competitive Parity In justifying the criteria employed by the Proposal to determine whether proprietary trading or a Private Fund investment would be considered to be solely outside of the United States, the Agencies assert that their goal is to preserve[e] competitive parity within U.S. markets. The Volcker Rule, however, has been justified as an effort to reduce the systemic risks associated with proprietary trading and Private Fund investments, not to protect U.S. banks from competition. Even though ensuring competitive parity among domestic and foreign banking entities does not seem to have been a factor animating Congress s passage of the Volcker Rule, the Agencies have used it to justify a narrow reading of the Foreign Bank Trading and Foreign Bank Funds Exemptions that would sweep in much activity that poses no systemic risk to the U.S. banking system. The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 6
Reporting, Recordkeeping and Compliance Obligations for Non-U.S. Banks In addition to implementing the Volcker Rule s prohibitions, the Proposal would require the adoption of new compliance programs designed to detect and prevent violations. The Proposal s guidelines require banking entities to adopt written policies and procedures, internal controls, employee training, independent testing, recordkeeping and a management framework that assigns responsibility for Volcker Rule compliance. 8 The Proposal requires that a more elaborate and less flexible compliance system, as described in the Proposal s Appendix C, be implemented by banking entities that, together with their affiliates and subsidiaries (1) have trading assets and liabilities of at least $1 billion or which are at least 10 percent of the entity s total assets, or (2) have investments in Private Funds worth $1 billion or more, or sponsor or advise Private Funds with assets equal to or greater than $1 billion. These thresholds would be applied to a banking entity s assets on a worldwide consolidated basis, so that, for example, a non-u.s. banking entity with $1 billion in trading assets and liabilities around the globe would be subject to the heightened compliance obligations, even if only a small percentage of its trading book was booked in or through the United States. Similarly, the Proposal establishes complicated recordkeeping and reporting requirements for banking entities that engage in proprietary trading and that, with their affiliates and subsidiaries, have trading assets and liabilities of $1 billion or more on a worldwide consolidated basis. These obligations are described in Appendix A of the Proposal, and require regular reporting of measurements concerning risk management, sources of revenue, revenue relative to risk, customer facing activity, and payment of fees, commission and spreads. Appendix A also requires banking entities to make and retain records documenting the preparation and content of their reports for five years. Again, large non-u.s. banking entities may find themselves facing onerous reporting obligations whether or not their U.S. operations, standing alone, would trigger the relevant thresholds. Several other sections of the Proposal also impose new recordkeeping and compliance requirements. For instance, in order to rely on the risk-mitigating hedging exemption to the prohibition on proprietary trading, banking entities will be required to implement a compliance program that conforms to the requirements of Appendix D of the Proposal and document the risk-mitigating purpose, the risks of the positions being hedged, and other information for each such transaction. The effective date of the Volcker Rule is July 21, 2012, but Section 619 provides for a two-year period (through July 21, 2014) during which 8 Banking entities that engage in no proprietary trading and have no Private Fund investments or sponsorships would not be required to follow Section 20(b), though their existing compliance policies would need to have measures designed to prevent such trading and investments. The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 7
banking entities may come into compliance, with further extensions possible at the discretion of the Agencies. The Proposal, however, would require that banking entities including non-u.s. banking entities comply with the recordkeeping and reporting requirements, and implement new compliance regimes, by the effective date. Next Steps If adopted as proposed, the Proposal would impose significant new restrictions and administrative burdens on the global banking industry. Non-U.S. banking entities, even those with a relatively small U.S. presence, would likely face burdens that are disproportionate to the systemic risk that they pose to the U.S. financial system. Further, non-u.s. banking entities may find some of their banking activities abroad significantly restricted as many of the limitations on the extraterritorial reach of the Volcker Rule put in place by Congress would arguably be narrowed by the proposed rulemaking. Both U.S. and non-u.s. banks, and their trade groups, have been very active in the Volcker Rule pre-rule-writing phase, and it is likely that the Agencies will receive hundreds of comments on the Proposal during the open comment period, which ends on January 13, 2012. Given the complexity of the issues and the volume of comments they are likely to receive, it is possible that the Agencies will be unable to release a final rule until shortly before the effective date of July 21, 2012. The Volcker Rule s restrictions will be effective on that date, with or without a final rule. The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 8
Contacts Please contact the individuals at the right or any of your usual Linklaters contacts with questions or for more information. For further information please contact: Robin Maxwell (+1) 212 903 9147 robin.maxwell@linklaters.com Jacques Schillaci (+1) 212 903 9341 jacques.schillaci@linklaters.com This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2011 Linklaters in the U.S. provides leading global financial organizations and corporations with legal advice on a wide range of domestic and cross-border deals and cases. Our offices are located at 1345 Avenue of the Americas, New York, New York 10105. Linklaters LLP is a multinational limited liability partnership registered in England and Wales with registered number OC326345. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on www.linklaters.com. Please refer to www.linklaters.com/regulation for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by emailing us at marketing.database@linklaters.com. 1345 Avenue of the Americas New York, NY 10105 Telephone (+1) 212 903 9000 Facsimile (+1) 212 903 9100 Linklaters.com The Impact of Proposed Volcker Rule Regulations on the Non-U.S. Activities of Non-U.S. Banks 9 A14126108/0.11/21 Oct 2011