In October 2011, federal regulators in the US issued a proposed rule to implement the ‘Volcker Rule’ provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank or the Act). The purpose of the proposed rule is, broadly, to prohibit proprietary trading by banking entities and to restrict those entities from sponsoring, investing in, or having certain financial relationships with hedge funds, private equity funds and similar funds. The proposed rule is highly complex with the regulators' explanation in excess of 300 pages and asking almost 1,400 questions.
The Volcker Rule proposal has two main components: a prohibition on proprietary trading by covered banking entities, and a prohibition on covered banking entities investing or sponsoring a hedge fund, or private equity fund, or other ‘similar fund’.
Proprietary trading ban:
The proposed rule provides that a banking entity may not engage in proprietary trading, subject to certain exceptions. What complicates the prohibition is that trading as principal – the proposal's essential description of proprietary activity – occurs as part of other financial activities critical to the functioning of markets (market-making) and as part of the management of risk (hedging), among other activities. Exceptions are created for market-making, hedging, customer and other principal activities, subject however to a number of limiting conditions.
Restriction on owning or sponsoring a hedge fund, private equity fund, or other similar fund:
The ‘covered funds’ provisions of the Volcker Rule are intended to prohibit a banking entity from doing indirectly, or even inadvertently what the proprietary trading provision prohibits it from doing directly: trading as principal in financial instruments. Specifically, the proposed rule prohibits a banking entity from directly or indirectly, acquiring or retaining equity, partnership, or other ownership interests in, or sponsoring, a ‘covered fund’ – except as may be permitted under the proposed rule. The proposed rule also prohibits a banking entity from conducting certain financial transactions with a hedge or private equity fund that it owns, sponsors, advises, or manages.
Which institutions are subject to these prohibitions?
These prohibitions would apply generally to a ‘banking entity’, which includes any insured depository institution, any company that controls it and any foreign bank that has US banking operations including any parent and any affiliate or subsidiary of these entities.
What is a covered hedge fund or private equity fund?
As proposed, a ‘covered fund’ is any issuer that ‘would be’ an investment company under the Investment Company Act of 1940, but for the exclusion provided by Sections 3(c)(1) or 3(c)(7) – generally applicable to ‘private funds’– i.e. hedge funds and private equity funds that are not making and do not presently propose to make a public offering of its securities and either (i) has outstanding securities that are beneficially owned by not more than 100 persons, or (ii) has outstanding securities that are owned exclusively by qualified purchasers.
The proposed rule also includes as ‘covered funds’:
- A ‘commodity pool’ – any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in ‘commodity interests’ (swaps and certain other instruments in addition to futures);
- A ‘foreign equivalent fund’ – a fund organised and offered outside the US that would be a ‘covered fund’ if organised or offered under US law or to one or more US residents.
What covered fund activities or investments would be permitted?
The proposed rule includes a number of specific exemptions, described as ‘permissible covered fund activities or investments’. Two of the permissible covered fund activities are briefly summarised below.
Exemption for covered fund activities outside the US
The proposed rule permits foreign banking entities subject to the Volcker Rule to sponsor and invest in covered funds outside the US, subject to certain requirements. While acknowledging the need to limit the extraterritorial impact of the Volcker Rule ‘covered fund’ prohibition, the conditions to the exemption in the proposed rule appear to be very narrow in scope and driven more by a desire to ensure competitive equity between US and foreign banks in the US, rather than by any focus on where the foreign covered fund is located.
Asset management exemption for organising and offering a covered fund
Among the more significant exemptions is the asset management exemption that allows banking entities to organise and offer a covered fund in connection with bona fide trust, fiduciary, or investment advisory services to customers. Investments in such funds are subject to de minimis
limits; a banking entity may own less than 3% of the total amount or value of each covered fund's outstanding ownership interests and, in an aggregate amount, in all such covered funds at a level that is less than 3% of the banking entity's Tier 1 capital. Further, a de minimis
covered fund is prohibited from using the same name as the banking entity or any affiliate or subsidiary, or any variation of those names.
Prohibited relationships with covered funds
The proposed rule bans a banking entity that serves directly or indirectly as the investment manager, investment adviser, commodity trading advisor, or sponsor to a covered fund, or that organises and offers a de minimis
covered fund, and any affiliate thereof, from engaging in certain transactions – such as lending transactions – with such covered fund, or with any covered fund controlled by such fund.
Compliance and record-keeping requirements
The proposed rule would impose significant new compliance requirements on banking entities that engage in ‘covered fund’ activities. At a minimum, the proposed rule would require that a banking entity's compliance programme includes: (i) internal written policies and procedures reasonably designed to document, describe and monitor the banking entity's covered fund activities and investments; (ii) internal controls reasonably designed to monitor and identify potential areas of non-compliance; (iii) a management framework that clearly delineates responsibility and accountability for compliance; (iv) independent testing for the effectiveness of the compliance programme; (v) training for trading personnel and managers to effectively implement and enforce the compliance program; and (vi) creation and maintenance of records to demonstrate compliance.
Major concerns with the proposal
The public comment period on the proposed rule expired on 13 February2012 and several hundred extensive comments were filed by the public, industry trade associations and individual firms, both domestic and foreign. These comments emphasised the need for substantial changes in the proposed rule. Large institutions and their trade associations were uniform in urging the agencies to repropose a less controversial and much more narrowly focused and simpler rule.
Significant policy and technical concerns were expressed by many in the asset management industry on various aspects of the proposed rule. On the broader policy front, asset management firms expressed significant concern that the exception from the proprietary trading prohibition for market-making activities by banking entities is too narrow, and will reduce liquidity that banking entities provide to clients of asset management firms. Commentators indicated that reduced liquidity could cause a decrease in portfolio values, an increase in transaction costs and a decrease in the demand for, and price of, corporate issuances.
In addition, asset management industry comments emphasised a basic flaw in the ‘covered funds’ provision, namely, the regulators proposed definition of the term ‘covered fund’ sweeps in a wide range of entities – domestic and foreign – that have never been considered hedge or private equity funds. In particular, many commentators stated that the proposed rule should exclude all registered funds (and their non-US counterparts) from the definition of a covered fund.
Federal regulators are now considering industry and public comments on the proposed rule. The breadth and depth of comments is likely to lead to a renewed proposal, or to a substantially modified final rule. The next round of the Volcker Proposal will thus bear watching.