Every banking organization will have compliance obligations under the Volcker Rule1 published in November (the "Proposed Rule") by four of the federal financial regulatory agencies and, in January, by the Commodity Futures Trading Commission (collectively, the "Agencies").2 The Volcker Rule broadly prohibits a banking entity from engaging in proprietary trading and from acquiring or retaining any kind of ownership interest in or sponsoring a hedge fund or private equity fund. The Rule permits certain kinds of trading or fund activity, however, and the Proposed Rule addresses the parameters of and possible conditions on these activities. Compliance with the requirements in the Proposed Rule and some suggestions for a more streamlined approach are the focus of this paper.3

This paper focuses on the compliance duties that the Proposed Rule creates for all banking organizations, even those not engaged in Volcker Rule activities. While the Proposed Rule is, of course, only a proposal, the time for compliance is running short. Volcker takes effect on July 21, 2012, for all banking entities, whether or not there is a final regulation. The Agencies specifically would require that, by July 21, 2012, the largest organizations begin keeping daily records and making monthly reports of their trading activities and have full compliance programs in place. There is a nominal twoyear conformance period, but the Agencies plan to use that time to fine-tune many of the requirements—underscoring the obligation of banking organizations to have compliance programs up and running in short order. Given this timeframe, the Proposed Rule is the only blueprint for compliance.

The deadline for comments on the Proposed Rule is February 13, 2012. The Agencies have faced a daunting task in developing a regulation that implements the complex Volcker provisions in Dodd-Frank without imposing unnecessary burdens. The Proposed Rule nevertheless would impose some significant burdens not required by Dodd-Frank. As we explain below, various requirements could be streamlined without undermining the statutory purpose.

Highlights

The source of the compliance burdens is that, while the Proposed Rule appropriately attempts to calibrate obligations according to an institution's level of involvement in proprietary trading or fund-related activities, the Proposed Rule as written likely will force even those organizations that present few or no Volcker risks to adhere to many, if not all, of the requirements applicable to riskier institutions. Additionally, for the largest banking organizations with businesses covered by Volcker, the Proposal sets forth a highly detailed compliance regime that may be less effective than a principlesbased regime to be applied on an institution-specific basis. The principal requirements in the Proposed Rule that present these issues include the following:

  • Every banking organization will be compelled to develop a six-point compliance program, even if the organization engages in no trading or fund work covered by Volcker. The Proposed Rule also requires that these organizations have specific compliance programs covering trading for liquidity management and avoidance of high risk in trading not covered by Volcker.
    • For an organization with no trading or fund-related businesses, a set of policies and procedures that bar the organization from trading or fund-related activities, together with the identification of an officer—in all likelihood, the chief compliance officer or chief risk officer—with oversight responsibility, should be sufficient.
  • Smaller institutions that engage in trading or fund-related activities are expected to at least use the elaborate compliance program requirements for the largest institutions as a "model."
    • Because the volume of trading and fund-related work is concentrated in a relatively small number of large banking organizations in the United States, the smaller organizations should not be compelled to model their compliance programs on those of the largest organizations.
  • A banking organization engaged in market making must collect large amounts of data and make several complex quantitative measurements without knowing whether the measurements will meet with regulatory approval. Additionally, every such organization, regardless of size, is required to make several calculations.
    • If the Agencies require detailed measurements, rather than relying on general principles, then the banking organization should identify the specific thresholds at which trading would be either permissible or impermissible.
    • As above, given the concentration of market making and proprietary trading in the largest U.S. banking organizations, smaller banks that undertake market making should be required only to demonstrate that their market-making revenues derive primarily from fees and other sources unrelated to short-term increases in the value of the instruments in which they make markets.

Covered Banking Entities

The Proposed Rule applies to every "covered banking entity" ("CBE"). A "banking entity" is essentially any organization that includes an insured depository institution.4 The Proposed Rule creates three tiers of CBEs, for which compliance obligations are supposed to vary.

  • The first tier (Tier 1) consists of CBEs not engaged in either of the businesses covered by Volcker—proprietary trading in securities or ownership or sponsorship of hedge funds or private equity funds. Notwithstanding what the Agencies say in the Proposed Rule, as a practical matter, even those banking entities within this group will need to create and maintain a compliance program.
  • The second tier (Tier 2) is comprised of CBEs that engage in trading or fund activities and investments on a relatively small scale. Generally, if the value of the trading assets and liabilities of a CBE or of the assets of covered funds5 that a CBE sponsors or in which it invests are less than $1 billion, then the CBE is in the second group.
  • The third tier (Tier 3) is made up of CBEs that either
    • hold trading assets and liabilities (including those of all affiliates and subsidiaries on a worldwide basis), the average gross sum of which is, as measured as of the last day of each of the four prior calendar quarters, equal to or greater than either $1 billion or ten percent of the CBE's total assets;6
    • hold, together with their affiliates and subsidiaries, aggregate investments in one or more covered funds, the average value of which is, as measured as of the last day of each of the four prior calendar quarters, equal to or greater than $1 billion; or
    • sponsor or advise, together with their affiliates and subsidiaries, one or more covered funds, the average total assets of which are, as measured as of the last day of each of the four prior calendar quarters, equal to or greater than $1 billion.

      Within the third group, CBEs that exceed a threshold of $5 billion for any of the activities above (Tier 3.5) are subject to certain data gathering and reporting requirements in addition to those applicable to CBEs over the $1 billion threshold. These additional requirements are best understood within the context of the obligations of all CBEs over the $1 billion threshold.

The understandable foundation of the Proposed Rule is that the more substantial the trading or fund activities of a CBE, the more extensive and rigorous the compliance regime should be. However, the obligations of one group in practice may drift into those of another. Tier 1 CBEs must develop policies and procedures to ensure that they do not enter into the restricted proprietary trading and fund businesses and that, if they do expand into these businesses, they will satisfy new compliance requirements, including the prudential risk management requirements (i.e., the prohibitions on "high-risk" trading and funds activities) which apply to every CBE that engages to any extent in the buying and selling of covered financial instruments or in any private funds investment or management activities. These obligations appear to mean that these Tier 1 CBEs will have to address some of the conditions in Volcker, even though the conditions do not technically apply under the terms of the Proposed Rule. In turn, Tier 2 CBEs will find themselves creating a variation on the detailed compliance program that is required for a Tier 3 CBE because the broader compliance program requirements apply to any CBE that engages to any extent in covered trading and funds activities.

Two additional cautionary notes are in order as to which group a CBE may belong. First, the $1 billion and the 10%-of-assets thresholds for Tier 2 CBEs are stated in the disjunctive and, as a result, smaller banking entities need to pay close attention to the impact of the Proposed Rule's percentage threshold on their investment and activities. The calculation of these dollar and percentage thresholds must include any trading or investment in securities exempt from Volcker restrictions, such as U.S. Treasury and agency securities and related covered financial positions ("CFPs"). For example, a smaller community bank that is actively engaged in Government securities trading activities could inadvertently become a Tier 2 CBE.

Compliance Programs

The compliance framework in the Proposed Rule consists of three sections and three appendices. Section __.20 requires the compliance program, with different requirements for the three different groups of CBEs. Section ___.20(b) sets forth the basic elements of the six-point program. Reporting and record-keeping requirements for trading activities are set forth in section __.7. Section ___.15 directs a CBE that owns or sponsors a permissible fund to comply with section __.20 and Appendix C "as applicable."

The three appendices provide greater detail on the required compliance program. The broadest of the three, Appendix C, describes a full compliance program for Tier 3 CBEs, covering both trading and fund-related activities. Appendix A nominally applies only to Tier 3 CBEs and requires certain quantitative measures to ensure (i) that market-making activities are not a cover for proprietary trading and (ii) that other permissible trading activities are not high risk. Appendix B discusses in a more comprehensive manner than Appendix A the compliance program specifically for market making and applies to Tier 2 CBEs as well as those in Tier 3. The interplay between the two appendices presents complicated compliance issues. Appendix B incorporates by reference several of the quantitative measurements required by Appendix A. The result of that incorporation by reference is that substantial parts of Appendix A apply to the smaller Tier 3 CBEs and to Tier 2 CBEs, even though Appendix A does not impose such requirements. Indeed, in some cases, even Tier 1 CBEs may be compelled to fashion compliance programs based on portions of Appendices A and C.

The six-point program set forth in section __.20(b) for Tier 2 and 3 CBEs includes the following:

  • Internal written policies and procedures reasonably designed to document, describe, and monitor permissible trading activities and activities and investments with respect to covered funds.
  • A system of internal controls reasonably designed to monitor and identify potential areas of noncompliance with the Volcker Rule in trading activities and investments in covered funds—and to prevent the occurrence of activities or investments that are prohibited by Volcker.
  • A management framework that delineates responsibility and accountability for compliance with Volcker.
  • Independent testing for the effectiveness of the compliance program. The testing may be conducted by "qualified" personnel of either the CBE or an outside party.
  • Training for trading personnel and managers, as well as other "appropriate" personnel.
  • The making and keeping of appropriate records and other written compliance documentation. We consider each of the compliance tiers below.

Tier 1

A banking organization's confirmation that it is not covered by Volcker and therefore subject only to comparatively light compliance duties requires a detailed understanding of what constitutes impermissible proprietary trading and a prohibited relationship with or ownership interest in a hedge fund or private equity fund. Moreover, because of the need to develop and implement this understanding, many Tier 1 CBEs will find that the necessary elements of a Volcker Rule "compliance lite" program may not be as "light" as first meets the eye. This determination requires a careful legal analysis and, as a starting point, the following table may be helpful.

Proprietary trading

A CBE is engaged in proprietary trading if its activities reflect any of the following:

  • The CBE reports trading assets and liabilities on
    - Call report: RC, item 5; RI, items 1.e, 5.c
    - FR Y-9C: HC, item 5; HI, items 1.e, 5.c
  • The CBE trades in a capacity other than or in addition to that of agent, broker, or custodian for a third party.
  • The CBE trades securities and other instruments—not only loans, commodities, or foreign exchange or currency.
  • The CBE holds securities for less than 60 days. Note that the 60-day cutoff is not absolute. An Agency would look to several factors relating to positions held for more than 60 days to determine whether to honor the presumption.
  • All positions taken in securities are not limited to the following:
    - Repos and reverse
    - Securities borrowing and lending
    - Bona fide liquidity management

The CBE and its insured depository institution affiliate are organized under U.S. federal or state law or conduct trading inside the United States.

Hedge funds and private equity funds

A CBE is engaged in restricted fund activities if the following three conditions are present:

  • The fund in question is either:
    - An investment company as defined in section 2 of the ICA, but is exempt from registration under 3(c)(1) or (c)(7) of the ICA.
    - A commodity pool, as defined in section 1a(10) of the Commodity Exchange Act.
  • With respect to the fund, the CBE:
    - Holds an ownership interest in the fund;
    - Manages the fund;
    - Controls the fund; or
    - Sponsors the fund.
    Note that a CBE may serve as an independent adviser to such a vehicle without triggering Volcker limits, other than the "Super 23A" restrictions discussed below.
  • Every insured depository institution within the CBE is not trust only and either:
    - Takes deposits other than in a fiduciary capacity;
    - Markets insured deposits through an affiliate;
    - Accepts demand deposits or deposits that may be withdrawn by check or similar means;
    - Makes commercial loans;
    - Obtains Federal Reserve Bank payment services; or
    - Exercises discount or borrowing privileges.

With respect to proprietary trading, two interlocking definitions are critical. Proprietary trading is defined as "engaging as principal for the trading account of the covered banking entity in any purchase or sale of one or more CFPs."7 If there is no trading account or CFP, then there is no proprietary trading.

  • A "trading account" is an account used by a banking entity either to (i) take shortterm "CFPs" (or otherwise benefit from short-term price movements) or (ii) acquire CFPs that are covered by the market-risk capital rule, if the entity is required to use that rule in risk-weighting its assets for capital calculations.8

    Accounts limited to certain CFPs, however, are not trading accounts; namely, accounts for repurchase and reverse repurchase agreements, accounts for temporary securities borrowing or lending transactions, and accounts for the bona fide purpose of liquidity management.9 Certain prerequisites apply to each of these carve-outs, as do the general prudential limitations on high-risk trading activities.

    An account for the bona fide purpose of liquidity management is one that is used to manage liquidity in light of the CBE's risk profile, that limits its trades to highly liquid financial instruments that are not expected to give rise to appreciable profits or losses as a result of short-term price movements, that trades in amounts limited to near-term funding needs, and is consistent with the Agencies' supervisory guidance on liquidity management.10
  • A CFP is any position in a security, a derivative, a commodity future contract, or any option on one of these instruments. Security, derivative, and commodity future have the standard definitions under the pertinent statutes; the term "derivative" encompasses several kinds of instruments. Loans, commodities, and foreign exchange or currency are not CFPs.

As to fund activity, the specific prohibition is that a banking entity may not, as principal, acquire any ownership interest in or sponsor certain types of hedge funds or private equity funds. Funds covered by Volcker are funds that are able to avoid regulation as investment companies under the ICA, by virtue of the exemptions in sections 3(c)(1) or 3(c)(7) of the ICA. These exemptions apply, respectively, to (in general terms) funds with fewer than 100 investors or with investors who all are qualified purchasers. Accordingly, Volcker does not reach three categories of funds: (i) those that are registered investment companies and are regulated as such by the SEC, (ii) those that are exempt from the definition of investment company to begin with under the definition in section 3(b) of the ICA, and (iii) those that are able to rely on a 3(c) exemption other than (3)(c)(1) or 3(c)(7).11 In our experience, however, most funds in which a banking entity likely would have or be interested in sponsoring or taking an ownership interest in rely on the 3(c)(1) and 3(c)(7) exemptions. At the same time, the Proposed Rule extends the coverage of the Volcker Rule to commodity pools subject to the Commodity Exchange Act, as well as "but for" offshore private investment funds that, were they offered in the U.S. or to a United States resident, would have to rely on the 3(c)(1) and 3(c)(7) exemptions.

Turning to the compliance obligations in Tier 1, the Proposed Rule requires that the existing compliance policies and procedures include measures that are designed to prevent the [CBE] from becoming engaged in such activities or making such investments and which require the [CBE] to develop and provide for the compliance program required under paragraph (a) of this section prior to engaging in such activities or making such investments.

That is, a Tier 1 CBE must implement measures with two separate functions: (i) preventing the entity from becoming engaged in activities or investments covered by Volcker and (ii) requiring the necessary compliance plan for CBEs if the entity should enter any of these businesses. These measures unavoidably will include internal policies and procedures, internal controls to ensure that the policies are followed, and designation of responsible and accountable officers. Documentation of these measures also will be required. These Tier 1 measures match at least four of the elements of the required sixpoint compliance program. An Agency also could require a particular CBE to gather data in a way that that will resemble testing, and training may be appropriate. Accordingly, even a CBE that is not engaged and not planning to engage in Volcker-covered activities may have to implement a version of the six-point program.

Specific compliance programs are necessary for two activities of Tier 1 CBEs, which by definition are not otherwise subject to the Volcker Rule or the Proposed Rule. First, a Tier 1 CBE that is engaged in exempt trading activities must ensure that these activities are not high risk. This standard is the same as the requirement for Tier 2 and 3 CBEs in their permissible trading activities, which are covered by Appendices A and C (discussed further below in connection with Tier 3 CBEs). Among other things, Appendix C describes elements of a compliance program to manage trading risk, and Appendix A includes certain quantitative measurements to assess whether trading may be high risk. Accordingly, some Tier 1 CBEs may find it necessary to review Appendices A and C, even though they are otherwise outside the Volcker Rule.

Second, trading for liquidity management purposes is not subject to the Volcker Rule. However, a Tier 1 CBE may continue such trading only if it has a "documented liquidity management plan." This plan must contain five elements. First, it must authorize the specific instruments that may be used for liquidity purposes (in light of the CBE's risk profile) and the circumstances under which it may or must be used. Second, the plan must require that any authorized transaction be principally for the purpose of managing liquidity. The plan must be clear that the transaction is not for the purpose of short-term resale, benefitting from short-term price movements, or hedging a short-term position. Third, the plan must limit the instruments used to those that are highly liquid and with credit and market risks that are not expected to give rise to appreciable shortterm profits or losses. Fourth, the plan must set forth limits on liquidity positions to amounts consistent with near-term funding needs. Fifth, the plan must reflect supervisory guidance on liquidity.

This regime that the Proposed Rule appears to contemplate, and that perhaps inadvertently may apply to Tier 1 CBEs, could be streamlined in many cases. A CBE can identify the bases on which it is not covered by Volcker and then create (if they do not already exist) safeguards to prevent entry into the covered business. For example, it should be sufficient for a Tier 1 CBE that takes financial positions over the long term to establish a policy against short-term trading and to designate an officer to enforce the policy and review possible trades.

At the same time, the requirement that a Tier 1 policy include some degree of anticipation that a CBE will enter Tier 2 is open-ended and is likely to force unnecessary compliance management work by many CBEs. If a Tier 1 CBE plans to engage in permissible trading or fund activity of any kind, it should be aware of the Tier 2 requiremetns and can put in place a compliance program at that point.

Footnotes

1 The Volcker Rule ("Volcker" or the "Volcker Rule") is set forth in section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010) ("Dodd- Frank" or the "Act") and codified in section 13 of the Bank Holding Company Act, 12 U.S.C. § 1851.

2 The Proposed Rule is at 76 Fed. Reg. 68846 (Nov. 7, 2011), http://www.gpo.gov/fdsys/pkg/FR-2011-11-07/pdf/2011-27184.pdf . The agencies that developed the Proposed Rule are the Federal Deposit Insurance Corporation ("FDIC"), the Federal Reserve Board ("FRB"), the Office of the Comptroller of the Currency ("OCC"), and the Securities and Exchange Commission ("SEC"), and the Commodity Futures Trading Commission ("CFTC"). The CFTC version of the Proposed Rule is at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister011112c.pdf .

3 For an overview of the Proposal Rule, please see our alert, The Volcker Rule Proposal: An Initial Review (Oct. 14, 2011), http://www.mofo.com/files/Uploads/Images/111014-Volcker-Rule.pdf .

4 If the only insured depository institution within an organization operates solely in a trust or fiduciary capacity, then the organization is not a banking entity.

5 A "covered fund" under the Proposed Rule includes a hedge fund or a private equity fund as defined in Volcker, a commodity pool, and any issuer as defined in section 2(a)(22) of the Investment Company Act ("ICA") that is organized or offered outside of the United States and that would be a covered fund if it were organized or offered under the laws, or offered to one or more residents, of the United States.

6 The Proposed Rule appears to say that the denominator in calculating the percentage consists of assets only of the CBE and not those of any affiliate or subsidiary, even though their trading assets and liabilities are included in the numerator. This approach does not seem internally consistent and would be one item to clarify in the final rule. Throughout this paper, we refer broadly to the minimum dollar amount as the "$1 billion threshold."

7 12 C.F.R. § __.3(b)(1) (emphasis added).

8 Certain banking entities are deemed to hold trading accounts solely on the basis of taking a CFP of any duration, if the entity is a registered dealer, municipal securities dealer, government securities dealer, swap dealer, or security-based swap dealer or is engaged in dealing, swap dealing, or security-based swap dealing outside of the United States and if the CFP relates to activities in these capacities.

9 An account holding a position taken by a banking entity in its capacity as a derivatives clearing organization also is not a trading account.

10 See, e.g., FRB, SR Letter 10-6 (Mar. 17, 2010) (Intergency Policy Statement on Funding and Liquidity Risk Management).

11 In addition, vehicles established for the securitization of loans are fully exempt from the Volcker Rule. The exemption may not, however, apply to entities that securitize certain non-loan assets.

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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