mmi legal & compliance webinar: the volcker rule …77128436)_(1)_mmi volcker... mmi legal &...

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MMI Legal & Compliance Webinar: The Volcker Rule and the Final Regulations

January 15, 2014 Charles M. Horn Julie A. Marcacci Please note that any advice contained in this communication is not

intended or written to be used, and should not be used, as legal advice.

© Morgan, Lewis & Bockius LLP

Topics to be Discussed

•  Overview of prohibited Volcker Rule proprietary trading and private fund sponsorship/investment activities under the final interagency regulations (“Regulations”)

•  Proprietary trading activities under the Volcker Rule; primary exclusions and exemptions

•  Funds covered by the Volcker Rule funds prohibition; major exclusions

•  Nature, scope and conditions of the Volcker Rule exception for “organized and offered” funds

•  Prohibited transactions between banking entities and covered funds •  Conflicts of interest and other high risk mitigation requirements •  Compliance program requirements •  Effective date; conformance date •  Particular implications for retail and institutional account managers

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Introduction

•  The Regulations were adopted by the Agencies on December 10, 2013 under section 619 of the Dodd-Frank Wall Street Accountability and Consumer Protection Act (“Dodd-Frank Act”), two years after these rules were initially proposed (the “Proposed Rules”)

•  Generally, the Volcker Rule prohibits, subject to important exclusions and exceptions: –  “Proprietary trading” in securities and other “financial

instruments” by “banking entities,” and

–  Banking entities from “sponsoring” or acquiring an “ownership interest” in private equity and hedge funds (collectively, “covered activities”).

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The Final Regulations: An Overview

•  The Regulations prohibit “banking entities,” which are generally defined as insured depository institutions, companies affiliated with insured depository institutions, and foreign banks with U.S. banking operations, from engaging in short-term proprietary trading of securities, derivatives, commodity futures and options, and similar instruments for their own account

•  The Regulations also impose limits on banking entities’ investments in, and other relationships with, hedge funds or private equity funds, certain commodity pools, and certain foreign private funds (defined as “covered funds”)

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Proprietary Trading – Key Terms

•  The Regulations incorporate and define the key statutory coverage terms of the Volcker Rule. –  “Banking entity” -- see prior slide

–  “Proprietary trading” -- engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments

–  “Trading account” – an account that is used to purchase or sell financial instruments principally for the purpose of short-term resale and similar enumerated purposes

–  “Financial instrument” -- any security, commodity forward, or derivative. Not included are loans, spot commodities or spot foreign exchange or currency

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“Proprietary Trading” Definitional Exclusions

•  Excluded transactions and activities include: –  Qualifying repo and reverse repo transactions

–  Purchases or sales of securities in connection with qualifying securities lending and borrowing transactions

–  Purchases and sales of securities for liquidity management purposes

–  Purchases or sales of financial instruments by a derivatives clearing organization (“DCO”) or a clearing agency in connection with clearing financial instruments

–  Excluded clearing activities by members of a clearing agency, DCO, or a designated financial market utility

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“Proprietary Trading” Definitional Exclusions (cont’d)

•  Excluded transactions and activities include: –  Purchases and sales of financial instruments to satisfy existing

delivery obligations of the banking entity or its customers, or to satisfy an obligation in connection with a legal proceeding

–  Purchases and sales of financial instruments by a banking entity that is acting solely as agent, broker, or custodian

–  Purchases and sales of financial instruments through a qualifying domestic or foreign deferred compensation, stock-bonus, profit-sharing, or pension plan of the banking entity for the benefit of plan participants

–  Qualifying debt-previously-contracted (DPC) purchases or sales of financial instruments

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Underwriting Exemption

•  The Regulations exempt from the prohibition of proprietary trading qualifying underwriting activities

•  The underwriting exemption requires a banking entity to comply with five core elements or standards –  Must act as an “underwriter” for a “distribution” of “securities” and the

underwriting position must be “related to” such a distribution

–  Amount and types of securities not to exceed near-term demands and efforts must be made to reduce the position within a reasonable period

–  Must establish, implement, maintain, and enforce an internal compliance program

–  Compensation arrangements may not be designed to “reward or incentivize” prohibited proprietary trading

–  Must be licensed or registered to engage in such activities 8


Market Making Exemption

•  The Regulations’ implementation of the statutory exemption for market making activities contains several key conditions: –  Must stand ready to purchase/sell, and quote

–  Inventory must correlate to “reasonably expected” near-term client demands

–  Internal compliance program is required

–  Prompt remedial action is required if limits exceeded

–  Trader compensation scheme cannot reward or incentivize prohibited proprietary trading

–  Must be licensed as necessary to engage in such activity

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Risk-Mitigating Hedging Exemption

•  The Regulations exempt a banking entity’s risk-mitigating hedging activities in connection with and related to positions, contracts or other holdings that are designed to reduce the specific risks associated with such positions, contracts or holdings –  A banking entity may only hedge risks that are specific and

identifiable in order to avail itself of this exemption

–  A banking entity must be able to identify the specific financial instrument or components of the financial instrument positions that are being hedged

–  No scenario or non-specific hedging activities allowed

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Liquidity Management Exclusion

•  The Regulations implement the statutory exemption for proprietary trading for liquidity management purposes through an exclusion from the definition of “proprietary trading” subject to several conditions: –  May only trade securities

–  Securities must be highly liquid and not reasonably expected to give rise to appreciable profits and losses due to short-term price movement

–  Trading activities cannot expose banking entity to substantial risk

–  Must create a plan that specifically authorizes the securities to be used

–  Required to develop and maintain a compliance program 11


Foreign Bank Trading Exemption

•  Foreign banking entities located outside of the U.S. that are not directly or indirectly controlled by a U.S. bank are permitted to engage in proprietary trading, provided that: –  Entity is not located in the U.S. or organized under U.S./state law

–  Purchase or sale is not accounted for as principal directly or on a consolidated basis by any U.S. branch or affiliate

–  No financing for the purchase or sale is directly or indirectly provided by any U.S. branch or affiliate

–  The purchase or sale is not conducted with or through any U.S. entity other than specified purchases or sales: (i) with the foreign operations of a U.S. entity; (ii) with an unaffiliated market intermediary acting as principal; or (iii) through an unaffiliated market intermediary

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Other Proprietary Trading Exemptions

•  Insurance company exemption: trading for general or separate accounts of a “regulated insurance company”

•  Trading on behalf of customers •  Trading in government obligations

–  U.S. Government and agency obligations

–  Foreign sovereign and multilateral organization obligations (limited availability to U.S. banking entities)

–  State, municipal and political subdivision obligations

–  Derivatives on such instruments cannot be traded under this exemption

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Covered Funds Prohibition and Restrictions

•  The Regulations prohibit any banking entity from acquiring or retaining an “ownership interest” in, or “sponsoring”, a hedge fund or private equity fund (covered fund), subject to certain exemptions, including: –  investment and sponsorship activities in connection with

“organizing and offering” a covered fund

–  small business and public welfare fund activities

–  covered fund activities of foreign banking entities occurring “solely outside of the U.S.”

•  The prohibition on covered fund activities and investments applies to the consolidated, worldwide operations of U.S. banking entities

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Definition of “Covered Fund”

•  The statutory Volcker Rule covers any entity that would be an investment company under the Investment Company Act of 1940 but for the exclusions under sections 3(c)(1) and 3(c)(7) of that act, or such similar funds as the Agencies may, by rule, determine.

•  The Regulations generally extend the definition to commodity pools offered to qualified eligible purchasers, as well as to foreign private funds that, were they offered in the U.S., would rely on the Investment Company Act section 3(c)(1) or 3(c)(7) exemption

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Definition of “Covered Fund” (cont.)

•  Funds excluded from the definition of a “covered fund”: –  foreign public funds

–  wholly owned subsidiaries of banking entities: up to 5% of these entities may be owned by directors and employees of the banking entity

–  joint ventures that do not engage in investing money for others, and are limited to not more than 10 investors other than the banking entity

–  acquisition vehicles

–  foreign pension or retirement funds

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Definition of “Covered Fund” (cont’d)

•  Funds excluded from the definition of a “covered fund”: –  insurance company separate accounts

–  separate accounts used to purchase qualifying BOLI

–  certain loan securitization vehicles

–  qualifying asset-backed commercial paper conduits

–  qualifying covered bonds (non-U.S. jurisdiction)

–  SBICs and qualifying public welfare investment funds

–  registered investment companies

–  any other issuer excluded by joint action of the Agencies

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Other “Covered Fund” Definitions

•  “Sponsor”: –  Serve as general partner, managing member or similar capacity

–  Select or control, or have officers/directors/ employees who constitute, a majority of fund directors, trustees or similar persons

–  Share a name/variation of name with a covered fund

•  “Ownership interest”: –  Equity, partnership or “similar interest”

–  Does not include carried interests (“restricted profit interest”)

•  “U.S. resident”: –  Relies on SEC Regulation S “U.S. person” definition

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“Organized and Offered” Exemption

•  A banking entity may sponsor/hold an ownership interest in a covered fund in connection with “organizing and offering” the fund to fiduciary and asset management clients, subject to certain conditions: –  Must provide “bona fide trust, fiduciary, or advisory services” and may

only offer to customers of these trust, fiduciary or advisory services

–  May establish the customer relationship for these services through or in connection with the organization and offering of the covered fund

–  Must develop a written plan or similar documentation

–  May not directly or indirectly guarantee, assume, or otherwise insure the obligations or performance

–  Must make specified written disclosures to investors

–  May not share or use certain names 19


Permitted Investments in a Covered Fund

•  “De minimis” investment exemption for “organized and offered” funds only –  3% per-fund investment limitation

–  3%-of-capital aggregate investment limitation

•  Seeding activities: one year •  Attribution of ownership interests

–  Only to banking organization controlled entities

–  Co-investments

•  Extensions of permitted investment periods •  Permitted hedging activities (limited)

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Insurance Company Activities

•  Exempts the acquisition or retention by a domestic or foreign insurance company, or an affiliate thereof, of any ownership interest in, or the sponsorship of, a covered fund, subject to three conditions: –  Ownership interest is held solely for the general account of the

insurance company or for one or more separate accounts

–  Holding complies with, and subject to, the insurance company investment laws, regulations, and written guidance where such insurance company is domiciled

–  The federal banking agencies, after consultation with FSOC or the relevant insurance commissioners, have not jointly determined that a particular insurance law, regulation, or written guidance is “insufficient to protect the safety and soundness of the banking entity, or the financial stability of the U.S.”

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Treatment of Foreign Funds

•  Foreign Public Funds –  The Regulations create a conditional exclusion for “foreign public funds”

that are broadly sold outside of the United States

•  Covered Funds Offered “Solely Outside of the U.S.” –  The banking entity (including relevant personnel) that makes the

decision to invest or act as sponsor is not located in the United States

–  The investment or sponsorship, including any related hedging transactions, is not accounted for as principal in the United States

–  Ownership interests in the covered fund are not targeted to U.S. residents

–  No financing for the banking entity’s ownership or sponsorship is provided by a U.S. affiliate of the foreign banking entity

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Limitations on Transactions and Relationships with a Covered Fund

•  The Volcker Rule generally prohibits a banking entity that, directly or indirectly, serves as investment manager, investment adviser, or sponsor to a covered fund, or that “organizes and offers” a covered fund, from entering into a transaction with a covered fund that would be a “covered transaction” as defined in section 23A of the Federal Reserve Act (bank transactions with affiliates) –  Regulations allow permitted “de minimis” investments

made under the “organized and offered” exemption

•  Transactions between banking entities and covered funds also must satisfy section 23B “arm’s length” requirements

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High-Risk Trading and Covered Fund Activities

•  The Volcker Rule prohibits a banking entity from engaging in a covered activity or making an investment if the activity or investment would –  pose a threat to the safety and soundness of the banking

entity or to the financial stability of the United States, or

–  involve a “material conflict of interest between a banking entity and its clients, customers, or counterparties” or “high-risk assets or trading strategies.”

•  The Regulations allow certain conflicts to be managed through “timely and effective” disclosure, or information barriers

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Compliance and Reporting Requirements

•  Banking entities engaged in proprietary trading or covered fund activities and investments must develop and administer a compliance program reasonably designed to ensure and monitor compliance with the Volcker Rule and the Regulations, based on a tiered approach calibrated to the size, complexity and activities of a banking organization.

•  The Regulations specify a variety of data collection and reporting requirements that are applicable primarily to banking entities that are engaged in proprietary trading activities.

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Authority to Address Violations, or Terminate Activities or Investments

•  The Regulations include a separate provision broadly allowing the Agencies to require the termination of impermissible trading and covered fund activities, and impose penalties for violations of the Volcker Rule and the Regulations.

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Effective Date and Conformance Period

•  The Regulations become effective on April 1, 2014; affected banking organizations generally will have until July 21, 2015 to bring proprietary trading and private fund activities into conformance

•  Banking organizations are expected to engage in “good faith efforts” to bring all of their covered activities into compliance by the July 2015 conformance date

•  But, banking entities that expand activities and make investments during the conformance period will not be given additional time to conform those activities or investments

•  Regulators have some limited authority to extend the conformance period 27


Implications for Retail and Institutional Account Managers

•  Impact on Bank-Affiliated Managers –  What is the relevance of trading prohibitions and

exclusions/exemptions for the managed account business (e.g., principal trading with customers)?

–  Private funds requirements will lead to changes in alternative investments product offerings: conditions; disclosures; representations; certifications; support arrangements

–  Managers are subject to fewer restrictions than sponsors

–  Compliance and reporting requirements – banking organizations must document compliance with the Volcker Rule

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•  Impact on Bank-Affiliated Sponsors –  Private funds limitations will curtail non-customer-oriented

alternative investment activities of sponsors; but some exclusions may be significant going forward

–  Customer-oriented funds will have to comply with a variety of new requirements, including name issues, new disclosures, management certifications and limitations on seeding, funding and liquidity support activities

–  Compliance management and reporting requirements again loom large, because compliance with the Volcker Rule will be very process- and documentation-driven

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•  Impact on Independent Managers –  There may be changes in private fund product offerings

–  There may be changes in how bank trading desks and fund sponsors/managers do business with third-party managers

–  Bank proprietary trading and private funds limitations, and their exclusions and exceptions, are very policy/plan driven, and banking organizations will be expected to document compliance with the Volcker Rule

–  Bank fund sponsors and managers may start asking for rights, agreements and representations to facilitate their compliance

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