Understanding the Volcker Rule: Covered Funds and Proprietary Trading Prohibitions. Chadbourne & Parke LLP agale@chadbourne.com

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1 Understanding the Volcker Rule: Covered Funds and Proprietary Trading Prohibitions Adam Gale Chadbourne & Parke LLP (212)

2 Presenter Adam Gale Adam Gale, Counsel lin the New York office of Chadbourne & Parke LLP, specializes in regulatory and compliance issues for banks, broker dealers, hedge funds, private equity funds, commodity tradersandregisteredinvestment and registered investment companies. He is a frequent writer and speaker on regulatory issues, including issues relating to the Dodd Frank Act and the Volcker Rule. Adam is the head of Chadbourne's hedge fund practice and represents both established hedge fund and private equity fund managers and start up entities in fund structure and formation, as well as a number of major investors into funds. Prior to joining Chadbourne, Adam was Senior Counsel at The Bank of New York (now BNY Mellon). He was recently called on to advise the Office of the Comptroller of the Currency on issues relating to the Volcker Rule. Adam has represented both large and small U.S. and foreign banking institutions on U.S. bank regulatory issues. 2

3 Chadbourne & Parke LLP Chadbourne & Parke LLP is an international ti law firm with 12 offices around the world. Since its founding in 1902, Chadbourne has been dedicated to providing practical business solutions to a diverse range of clients in virtually all areas of law, emphasizing private equity and hedge fund formation, investment management regulatory and compliance, bank regulation, M&A, corporate/corporate finance,u.s. and international tax, bankruptcy and financial restructuring, energy/renewable energy, project finance, insurance/reinsurance, intellectual property, commercial and product liability litigation, securities litigation and regulatory enforcement, antitrust, real estate and communications. In addition to the U.S. and North America, major geographical areas of concentration include Latin America, Western Europe, Central and Eastern Europe, Russia and the Middle East. 3

4 Structure of Volcker Rule Consists of two general prohibitions: 1. Covered Funds Prohibition Banking entities may not sponsor or acquire an interest in covered funds 2. Proprietary Trading Prohibition Banking entities may not engage in proprietary trading 4

5 Agenda I. Current Status and Who is Covered II. Covered Funds Prohibition III. Issues for Non U.S. Banks Under the Covered Funds Prohibition i IV. Proprietary Trading Prohibition V. Compliance Programs 5

6 I. Current Status and Who is Covered 6

7 Proposed Rules Volcker Rule was enacted as 619 of the Dodd Frank Act in July The specific provisions, however, must be set forth in Rules to be promulgated by various regulators, most notably the Board of Governors of the Federal Reserve. The Fed issued Proposed Rules in October Thousands of comment letters were submitted. Awaiting the Final Rules, which hwere due on July 21, Final Rules are likely to be issued within the next few months. This presentation analyzes the Proposed Rules. 7

8 Effective Date and Conformance Periods Under the Dodd Frank Act, the Volcker Rule s prohibitions were supposed to become effective on July 21, 2012, even if the Rules were not yet finalized by that date. Compliance with the Volcker Rule, however, is not required as of the effective date. Instead, the Volcker Rule provides for a two year transition period ( conformance period) from the effective date, during which banking entities must bring all of their activities in compliance with all of the Volcker Rule prohibitions. Fed has made clear that the conformance period ends on July 21, It was initially unclear whether banking entities, during the two year conformance o ce period, could initiate new activities t that would dbe prohibited under the Volcker Rule. In April 2012, the Fed issued guidance that banking entities may continue to engage gg in prohibited activities, including initiating new activities that would be prohibited, until July 21, Banking entities need to be careful, however, that any new activities can in fact be wound up prior to July 21,

9 Who is Covered: Definition of Banking Entity Any insured depository institution (as defined in 3 of the Federal Deposit Insurance Act); any company that controls an insured depository institution; any company that is treated as a bank holding company for purposes of 8 of the International Banking Act of 1978; any affiliate of the above and any subsidiary of the above. Includes any non-u.s. bank with a U.S. branch or agency office, or that operates a New York Article XII investment company subsidiary, and any affiliate. Definition of "banking entity" excludes an institution that functions solely in a trust or fiduciary capacity and meets a number of other requirements, including that all or substantially all of the deposits of the institution are in trust funds and received in a bona fide fiduciary capacity. 9

10 Definition of Banking Entity Bank Holding Company Act control principles apply in determining whether an affiliate is a banking entity. - Accordingly, an affiliate includes anyone that owns 25% or more of the voting securities of another entity. The affiliate definition therefore picks up more entities than one might normally think of as affiliates. Affiliates or subsidiaries of banks that are asset managers or other investment advisers are included in the definition of banking entity - But a banking entity is allowed to solely act as an investment adviser to a fund. Under the Proposed Rules, a banking entity does not include a private equity fund or hedge fund that qualifies for the so-called asset management permitted activity. - Thus, a hedge fund sponsored by a banking entity can engage in proprietary trading. 10

11 II. Covered Funds Prohibition 11

12 Summary of Covered Funds Prohibition Banking entities are prohibited from: sponsoring, or investing in (acquiring or retaining an ownership interest in) a hedge fund, private equity fund, and numerous other types of privately offered funds and pooled investment vehicles (referred to as covered funds in the Proposed Rules), except for funds that are organized and offered by the banking entity, subject to: o (a) the banking entity owning no more than 3% of the covered fund; o (b) an overall limit of 3% of the banking entity's tier 1 capital invested in covered funds; and o (c) numerous other limitations, such as to the name of the fund. In addition, the banking entity may make seed investments in a fund, including owning 100% of a fund, for up to one year. 12

13 Summary of Covered Funds Prohibition Restrictions on Transactions With Affiliated Covered Funds (Super 23A Provision): - Any banking entity that sponsors a covered fund, - an investment t adviser to a covered fund (even if it does not otherwise sponsor the fund), and - any affiliate: may not enter into a transaction with the fund that would be a "covered transaction" as defined under Federal Reserve Act Section 23A, and must also comply with Federal Reserve Act Section 23B, except that t the Federal Reserve may allow prime brokerage transactions if certain requirements are met. 13

14 Definition: Covered Fund The Act prohibits investments in a hedge fund or a private equity fund. Proposed Rules prohibit investments in a covered fund, but the definitions in both the Act and the Proposed Rule are almost identical: An issuer that would be an investment company as defined in the Investment Company Act of 1940 (the '' '40 Act"), but for section 3(c)(1) or 3(c)(7) of the 40 Act. Proposed Rules add two other categories to the definition of covered fund : o A commodity pool, as defined in section 1a(10) of the Commodity Exchange Act; and o An issuer organized outside the U.S. that would be a covered fund if organized in the U.S. or offered to U.S. residents. Regulators also have the ability to later add to the definition of covered fund any other entity that is a similar fund. 14

15 Covered Fund Definition: Effect on Other Types of Transactions Almost all hedge funds and traditional private equity funds rely on the '40 Act exemptions from registration under sections 3(c)(1) (100-investor limit) or 3(c)(7) (all investors must be "qualified purchasers"). Beyond hedge funds and private equity funds, many other types of privately offered funds and entities also rely on these exemptions, including the following: o most venture capital funds (there is no exemption in the Volcker Rule for VC funds); o many real estate funds (there is no exemption in the Volcker Rule for RE funds); o some types of special purpose vehicles used in project finance transactions; and o some structured finance vehicles (such as CLOs and CDOs). Effect of the definition of covered funds is that in any transaction in which a banking entity is involved and that t is using a privately offered entity that t is relying on the 40 Act exemptions, the banking entity will need to determine if the Volcker Rule prohibits the banking entity s involvement. For example, a banking entity could not invest in a real estate fund that is relying on the 3(c)(1) or 3(c)(7) exemption, without meeting the other requirements of the covered funds regulations. 15

16 Covered Fund Definition: Effect on Tax Equity Transactions Another example of the Volcker Rule s unexpected reach is that some bank investments, as tax equity participants, in renewable energy projects could run afoul of the Volcker Rule, depending on how the transactions are structured. If a banking entity invested directly into an entity that developed energy projects (or invested into a holding company that owns project companies), there would be no problem because the bank would be investing into an operating company, which would not be relying on a 40 Act exemption. If, however, a banking entity formed an intermediate t entity, and that t intermediate entity then invests into a project company, the intermediate entity might be a covered fund, depending on the structure, because it is likely that the intermediate entity would be relying on the 3(c)(1) or 3(c)(7) exemption under the 40 Act. This type of structure is often used when the banking entity is acting as a syndicator of tax equity investments, t and has one or more unaffiliated investors in the intermediate entity. 16

17 Definition: "Sponsoring" a Fund "Sponsoring" a fund is defined as: serving as a general partner, managing member, or trustee of a covered fund; (Proposed Rules add serving as a commodity pool operator) in any manner selecting or controlling (or having employees, officers, directors or agents who constitute) a majority of the directors, trustees or management of a fund; or sharing with a fund, for corporate, marketing, promotional, or other purposes, the same name or a variant of the same name. Note that solely acting as an investment adviser to a fund, but not otherwise investing in the fund or acting in any other capacity (such as acting as a GP), is allowed (and the adviser may receive carried interest ), as long as the adviser does not share with the fund the same name or a variant of the same name. Merely advising a fund, however, subjects the adviser (if it is a "banking entity") and its affiliates to the Federal Reserve Act Section 23A and 23B restrictions on transactions with the fund (discussed below). Proposed Rules clarify that trustee does not include a trustee that has no investment discretion with respect to a covered fund. 17

18 Definition: Ownership Interest Act did not define ownership interest but the Proposed Rules define it as: any equity, partnership or other similar interest (including a GP interest, warrant, and option) in a covered fund, whether voting or nonvoting, or any derivative of such interest. Note that t the addition of a derivative of such interest t in the Proposed Rule means that banks need to be careful about acquiring swaps or other types of derivatives that would give the bank an economic interest in a covered fund. Proposed Rules specifically exclude carried interest - an interest in the share of the performance allocation - if the banking entity (including its affiliates and employees) meet a number of requirements: o serving as the investment manager/adviser or commodity trading adviser; o sole purpose of the interest is to share in the profits for performance compensation for services provided (but a clawback obligation (i.e., obligation to return profits) is allowed); o the profits are distributed promptly, or if not so distributed, the bank s reinvested ested profit does not share in the profits and losses of the covered ed fund; o the banking entity does not pay for its interest; and o the interest is not transferable, except to affiliates. 18

19 3% Limitations Subject to a long list of further limitations (listed below), a banking entity may acquire an ownership interest in a fund, if: it organizes and offers the fund (so it cannot simply be a passive investor); its investment is not more than 3% of the total ownership interests t in any single covered fund (subject to an exception for the first year only); and the aggregate value of all of its ownership interests in all covered funds does not exceed 3% of the banking entity's tier 1 capital (i.e., its regulatory capital). 19

20 3% Limitations Proposed Rules add further requirements as to which investments must be included in calculating the 3% limitation in any single fund and must include: interests in the fund held by an entity that is controlled, directly or indirectly, by the banking entity; its pro rata share of interests held by a covered fund that is not controlled by the banking entity, but in which the banking entity owns or controls more than 5% of the voting shares; and co-investments with a covered fund organized by the banking entity. In addition, under the Proposed Rules, in calculating 3% limitation in any single fund, the banking entity must use either the percentage of (A) capital contributions; or (B) ownership interests, whichever is greater. Note this could cause an issue for a PE fund if an investor is excused from certain investments, causing the bank s contributions to exceed 3%, even if its commitment equals 3%. 20

21 Seed Investments Permitted for One Year Subject to the further limitations set forth below, a banking entity may provide a fund with 100% of its initial equity "to permit the fund to attract unaffiliated investors," provided that: within one year of the fund's establishment, the banking entity must reduce its ownership to no more than 3% of the total ownership interests in the fund, through redemption, sale or dilution (or other methods); and the one-year limit may be extended for up to two additional years, upon a banking entity's application and approval by the Federal Reserve if it finds that an extension would be consistent with safety and soundness and in the public interest. 21

22 Seed Investments Permitted for One Year Proposed Rules provide further guidance on extension applications: Must be submitted 90 days prior to the end of the one-year period; Explain the plan for reducing the investment in the covered fund; Fed will consider a number of factors in reaching its decision, including: o whether the investment would result in a material exposure by the banking entity to high-risk assets or trading strategies; o whether the investment would involve material conflicts of interest between the banking entity and its clients, customers and counterparties; and o the banking entity s prior efforts to reduce its interests in the fund. 22

23 Other Requirements In order to be able to use the 3% limit and the seed investment exceptions, the banking entity must comply with all of the following requirements: provide bona fide trust, fiduciary, or investment /commodity trading advisory services; organize and offer the fund only in connection with the provision of such services, and only to persons who are customers of such services of the banking entity; o Note: Fed has clarified that customers includes prospective investors, even if they have no current relationship with the banking entity. with its affiliates, comply pywith the Federal Reserve Act Section 23A and 23B restrictions on transactions with such funds (discussed below); not, directly or indirectly, guarantee, assume or otherwise insure the obligations or performance of the fund, or of any fund in which such fund invests; not share with the fund, for corporate, marketing, promotional or other purposes, the same name or a variant of the same name (and the fund cannot use bank in its name); not allow any director or employee of the banking entity to take or retain any ownership interest in the fund, except for any director or employee who is directly engaged in providing investment advisory or other services to the fund; and disclose to prospective and actual investors in the fund, in writing, that any losses in such fund are borne solely l by investors in the fund and not by the banking entity, along with other required disclosures. 23

24 Further Limitations on Permitted Activities In order to engage in any "permitted activity" under the covered funds rules, no transaction, class of transactions or activity may: o involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties; o result, directly or indirectly, in a material exposure to high risk assets or high risk trading strategies (defined in the Proposed Rules as significantly increasing the likelihood that the bank would incur a substantial financial loss or would fail); or o pose a threat to the safety and soundness of such banking entity or to the financial stability of the U.S. Proposed Rules provide that a material conflict exists if the banking interests are materially adverse to the client, customer or counterparty with respect to the transaction, unless either: o the banking entity timely discloses the conflict in advance, in a manner allowing the other party to negate or mitigate the adverse effect; or o the banking entity has established and maintained information barriers in written policies and procedures designed to prevent the conflict from resulting in a material adverse effect on the other party Note that the bank may not rely on the information barriers if it should reasonably know that the conflict may materially adverse effect the other party. 24

25 Other Permitted Activities In addition to the permitted 3% limitation, the Act includes an exception for investments in certain covered funds organized outside of the U.S. (Non-US exemption is discussed in detail below.) Proposed Rules include a number of new exceptions as other permitted activities : o Investments t in SBICs; o Investments to promote the public welfare under 12 U.S.C. 24; o Qualified rehabilitation expenditures with respect to building rehabs; o Risk-mitigating hedging activities - Acting as intermediary for non-bank customer to facilitate customer s exposure to profits and losses of the covered fund; or - Connected to a compensation arrangement with bank employee who directly provides investment advisory or other services to the fund - A number of other requirements apply, including: establishing compliance controls; mitigating exposure to the covered fund through an offsetting exposure; and documenting at time of the transaction the risk-mitigating purpose. 25

26 Further Permitted Activities Proposed Rules further allow sponsoring, or acquiring an ownership interest in: A covered fund that issues asset-backed securities, so long as fund s assets are solely l comprised of: o Loans; o Contractual rights or assets arising from loans supporting ABSs; or o Interest rate or FX derivatives relating to terms of loans or contractual rights, and used for hedging purposes. A joint venture between the banking entity and any other person, if the JV is an operating company, and does not engage in other prohibited activity. An acquisition vehicle for the purpose of a merger or acquisition. An issuer of ABS, but only as to the portion of the credit risk that is retained by a banking entity that is a securitizer or originator. A wholly-owned owned subsidiary of the banking entity that performs liquidity management activities and carried on the banking entity s balance sheet. Investments in certain bank-owned life insurance separate accounts. Acquiring i an interest t in a covered fund in the ordinary course of collecting a debt (so long as bank subsequently divests its interest within one year). 26

27 Extended Transition Period for "Illiquid Funds" The Federal Reserve may, upon application by any banking entity, extend the transition i period for that particular banking entity: for up to a maximum of 5 years (which h is in addition to the 2-year transition period) - so could extend until July 21, 2019; and to the extent necessary to fulfill a contractual obligation that was in effect on May 1, 2010 to take or retain any ownership interest in, or otherwise provide additional capital to, an "illiquid fund. " 27

28 Extended Transition Period for "Illiquid Funds" An "illiquid fund" is defined as a covered fund that: o as of May 1, 2010, was principally invested in, or was invested and contractually committed to principally invest in, "illiquid assets"; and o makes all investments pursuant to, and consistent with, an investment t strategy t to principally i invest in illiquid id assets. Proposed Rules include a definition of illiquid assets, which includes any asset that is: not cash; not traded on an exchange; and does not have an initial term of one year or less. Most private equity funds (which invest in portfolio companies), as well as real estate funds and venture capital funds, presumably would be able to obtain the extension. Very few hedge funds would fit within the definition of "illiquid fund, " as the investment strategy of most hedge funds is to principally invest in liquid, rather than illiquid, assets. 28

29 Potential Alternative for Bank Investments Although a banking entity cannot invest at all in a covered fund that it does not offer and organize, a banking entity could make a coinvestment, alongside a covered fund, directly into a portfolio company (if that portfolio company is an operating company). The co-investment could not be made pursuant to a co- investment t fund, as that t co-investment t fund would be a "covered fund", which would violate the Volcker Rule. There would be no violation, however, if the banking entity made a direct investment into the operating company, and the banking entity could enter into a separate advisory agreement with a fund manager whereby the banking entity agrees to pay fees to the fund manager for advising the banking entity on the co-investment. 29

30 Restrictions on Transactions with Affiliated Covered Funds Super 23A A banking entity that t advises, di manages, sponsors, organizes or offers covered funds (and all of the banking entity s affiliates) may not enter into a transaction with the covered fund (or with any other covered fund that is controlled by the covered fund) must comply with the restrictions in Section 23A of the Federal Reserve Act ( FRA ) as if the banking entity or affiliate were a member bank and the covered fund were an affiliate of the member bank. Any such transaction must also comply with Section 23B of the FRA, which requires all transactions between a member bank and its affiliates to be on an arm s length basis. 30

31 Section 23A Purpose of Section 23A is to protect tfdic insured dbanks from engaging in risky transactions. As applied to covered funds and affiliated member banks, Section 23A prohibits member banks of the FDIC from: transacting a loan or extending a line of credit to the covered fund; purchasing or investing in securities issued by the covered fund; purchasing assets, including assets subject to an agreement to repurchase, from the covered fund, except such purchase of real and personal property as may be specifically exempted by the Fed by order or regulation; accepting securities issued by the covered fund as collateral security for a loan or extension of credit to any person or company; or issuing a guarantee, acceptance, or letter of credit, including an endorsement or standby letter of credit, on behalf of the covered fund. 31

32 Why Is This Restriction Super 23A? Under usual 23A, a member bank can engage in some transactions with the affiliate, for example transactions that involve less than 10% of the stock and surplus of the bank. o Volcker Rule restrictions relating to Section 23A, however, do not include any de minimis bucket. Usual 23A places applies to Federal Reserve member banks and their subsidiaries only. It does not place prohibitionson on otheraffiliates ofthemember bank. o Volcker Rule 23A provision, however, greatly expands the restrictions on transactions to all affiliates, so it treats all affiliates of a banking entity as if they were the member bank. 32

33 Super 23A: Exception for Prime Brokerage Transactions A banking entity may enter into a prime brokerage transaction with a covered fund in which a hedge fund or private equity fund managed, sponsored or advised by the banking entity invests, if: the covered banking entity is in compliance with the requirements of the Volcker Rule with respect to a covered fund organized and offered by such covered banking entity (or an affiliate or subsidiary thereof); the chief executive officer (or equivalent officer) of the toptier affiliate of the covered banking entity certifies in writing annually (with a duty to updatethe the certification if the information in the certification materially changes) that the covered banking entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the covered fund or of any covered fund in which such covered fund invests; and the Fed has not determined that such transaction is inconsistent with the safe andsoundoperationandconditionof operation of the covered banking entity. 33

34 Super 23A: Prime Brokerage Transaction Exception Under the Proposed drules, a prime brokerage transaction means one or more products or services provided by a covered banking entity to a covered fund, such as custody, clearance, securities borrowingorlendingservices services, tradeexecution execution, or financing, data, operational, and portfolio management support. Permitted Prime Brokerage Transactions must also comply pywith Section 23B of the FRA as if the counterparty were an affiliate. 34

35 Issues Concerning Prime Brokerage Transaction Exception Dfiii Definition of prime brokerage transaction is still vague. E.g. would FX prime brokerage or futures clearing be deemed prime brokerage transactions? The exception applies only to transactions with funds in which a fund managed by a bank invests. Does not seem to allow for transacting with funds the same in substance but that are organized as managed accounts, or for funds directly managed by a bank affiliate. Compliance conditions to use the exception, as they require a certification of the CEO of the top tier tier affiliate of the covered banking entity. 35

36 III. Covered Funds Prohibition: Issues for Non U.S. US Banks 36

37 Conflicts With Foreign Law In orderto fit within the exceptions to the restrictions on sponsoringa covered fund, the covered fund must not: share the same name or a variation of the same name with thebankingentity entity (orwith an affiliate orsubsidiary thereof); or use the word bank in its name. Many foreign laws (including for example, UCIT regulations), however, require banks that sponsor a fund to use the bank s name in the name of fund. This prohibition on sharing the same name applies to banking entities and their affiliates, which would include the asset management arms of banks. Many foreign banks have asset management arms that do not use the bank s name (e.g., SocGen owns Lyxor). But since the asset management arm is an affiliate, it appears that a fund could not share the same name as the bank or the affiliate (e.g., Lxyor could not use Lyxor in the name of a fund). 37

38 Exception for Activities Solely Outside the United States Act and the Proposed drules allow for the acquisition iti or retention of any ownership interest in, or the sponsorship of, a covered fund by abanking entity if: the banking entity is not directly or indirectly controlled by abanking entity that is organized under the laws of the United States or of one or more States; the activity is conducted pursuant to Section 4(c)(9) or 4(c)(13) of the Bank Holding Company Act; no ownership interest in such covered fund is offered for sale or sold to a resident of the United States; and the activity occurs solely outside of the United States. 38

39 Exception for Activities Solely Outside the United States Proposed drules provide that t a banking entity is presumed to be in compliance with Section 4(c)(9) or 4(c)(13) of the BHC Act if: if it is a qualifying foreign banking organization and in compliance with subpart B of Regulation K of the Federal Reserve Board; or if not a foreign banking organization, the entity meets at least two of the following requirements: total assets of the covered banking entity held outside of the United States exceed total assets of the covered banking entity held in the United States; total revenues derived from the business of the covered banking entity outside of the United States exceed total revenues derived from the business of the covered banking entity in the United States; or total net income derived from the business of the covered banking entity outside of the United States exceeds total net income derived from the business of the covered banking entity in the United States. 39

40 Exception for Activities Solely Outside the United States Proposed drules would dfi define an activity it to have occurred solely outside of the United States only if: the banking entity engaging in the activity is not organized under the laws of the United States or of one or more States; no subsidiary, bidi affiliate, or employee of the covered banking entity that is involved in the offer or sale of an ownership interest in the covered fund is incorporated or physically located din the United dstates t or in one or more States; and no ownership interest in such covered fund is offered for sale or sold to a resident of the United States. 40

41 Issues With Solely Outside the United States Exception Solely l Outside the U.S. US is very narrow From a policy perspective, a non U.S. bank should be able to acquire a passive ownership interest in a non U.S. fund. But the Proposed Rules require that the covered fund not be offered for sale in the U.S. In a passive investment, however, the bank does not control where the fund is offered, so a non U.S. bank could be precluded from making investments unless it controls the fund. Some non U.S. banks may want to U.S. based personnel to sell to non U.S. investors. But U.S. personnel of bank affiliates are not allowed to participate in fund offerings even to non U.S. residents. 41

42 Other Issues for Non U.S. US Banks Definition of covered fund pulls in every investment vehicle even publicly traded and regulated foreign funds. Not clear how to calculate investments in funds for purposes of complying with restrictions limiting to percentage of Tier 1 capital. U.S. US restrictions may impinge on foreign regulation of non U.S. banks. Volcker Rule Super 23A requirements do not have a similar solely outside the U.S. provision exception to its prohibitions. 42

43 IV. Proprietary Trading Prohibition 43

44 Summary of Proprietary Trading Prohibition Bankingentities may not engagein proprietary trading : to engage as a principal in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, derivative, future or option on any such security, derivative i or future principally for the purpose of short term resale, benefitting from shortterm price movements, realizing short term arbitrage profits, or hedging g one of those positions. Agency transactions are outside the scope of the rule. Under the Proposed Rules, there is a rebuttable presumption that any security, derivative or future that is held for 60 days or less involves proprietary trading unless an exemption applies. 44

45 Definition: Proprietary Trading (cont.) Every position taken by a registered broker dealer, municipal securities dealer, government securities dealer, swap dealer or securities based swap dealer, in connection with its dealing activities, is proprietary trading, unless an exemption applies (i.e., presumption is that dealing is proprietary trading). Swaps, security based swaps, FX forwards, FX swaps and commodity forwards are classified as derivatives and thus subject to the prohibition. Even if the following are for the short term, loans, spot commodities and spot FX are not covered financial i positions, ii and are thus excluded dfrom the prohibition. o Note: The Proposed Rules do not include criteria for determining what is a loan, or whether equity like control features in an instrument termed a loan affect the determination. 45

46 Proprietary Trading: Exclusions Repos and Reverse Repos: Accounts used solely ll for positions arising under repos/reverse repos because they are the economic equivalent of a secured loan Securities Lending: Accounts used solely ll for positions held hldunder a securities lending arrangement because such an arrangement operates as a means to facilitate settlement of securities transactions and is not based on expected or anticipated movements in asset prices. Liquidity Management: Accounts used solely for bona fide liquidity management to meet short term term liquidity needs in accordance with a documented liquidity plan meeting certain criteria. o Necessary because banks need to manage their liquidity, but the exclusion is narrow and must be pursuant to a documented plan. 46

47 Market Making Proprietary Trading: Permitted Activities Trading in U.S. Government Obligations Risk Mitigating Hedging Underwriting Trading on Behalf of Customers Trading Solely Outside the U.S. Certain Trading by Insurance Companies 47

48 Permitted Activities (cont.) Additional requirements that apply to permitted activities: Mustbeconductedin accordance with certain requirements that apply to each permitted activity; Banking entity must have implemented the required compliance program (idea bi being that t if no program is in place, banking entity may engage in a prohibited activity in the guise of a permitted activity); For certain exempt trading activities, the trading unit conducting the activity must report quantitative measurements to the U.S. regulators; and The banking entity must ensure that the activity would not: Involve or result in a material conflict of interest between the entity and its clients, customers or counterparties; Result, directly or indirectly, in a material exposure by the banking entity to a high risk asset or high risk trading strategy; or Pose a threat to the safety and soundness of the entity or the financial stability of the United States. 48

49 Permitted Activity: Market Making To qualify lf for the market making k permitted activity, the following requirements must be met: Bona Fide Market Making. The particular unit must hold itself out as willing to buy and sell positions in the particular covered financial position for its own account on a regular or continuous basis. Near Term Demand. Activities must be designed not to exceed reasonably expected near term demands of clients, customers or counterparties. Revenue. The activities of the trading unit must be designed to generate revenues primarily from sources including fees, commissions and bid/ask spreads, or other income not attributable to changes in value, or hedging, of covered financial positions held in the trading account. 49

50 Permitted Activity: Market Making (cont.) Registration. The banking entity must be registered in the U.S., or excluded or exempt from U.S. registration, as a securities dealer, municipal securities dealer, government securities dealer, swap dealer or security based swap dealer, or, if engaged in business as a dealer outside the United States, subject to substantive regulation where its business is located. Internal Compliance. The activity must be conducted pursuant to reasonably designed written policies and procedure and controls andbesubject to independenttesting testing. Compensation. Compensation of persons performing market making activities must be designed not to reward proprietary trading. 50

51 Permitted Activity: Trading in U.S. Government Obligations U.S. government obligations includes US U.S. and municipal ii general, limited and pass through obligations and forward trading. It does not include obligations of foreign governments or multilateral organizations, derivatives on government obligations or obligations guaranteed by a government issuer. Therefore, any trading in those instruments must qualify as market making or another permitted activity to be permissible. Foreign governments have objected that failing to permit trading in foreign government obligations will damage trading. To qualify for the exemption, the following requirements must be met: Compliance and Metrics. Trading units that engage in market making related activities iii or trade in US U.S. government obligations i must meet strict compliance requirements and report a set of metrics to the U.S. regulators. 51

52 Permitted Activity: Risk Mitigating ik ii i Hedging di To qualify for the exemption, the following requirements must be met: Specific Risks. The hedging transaction must be made in connection with existing individual or aggregated positions in other holdings and must be designed to reduce specific risks. Portfolio hedging is contemplated. Anticipatory hedging (i.e., putting a hedge on ahead of taking a position) is permitted if consistent with risk management practices and is taken slightly before the risk materializes. (Not clear what slightly means.) Correlation. Hedges must be reasonably correlated to the risk that the purchase or sale is intended to hedge. No New Significant Exposures. At inception, the hedge must not give rise to new significant unhedged exposures. Continuing Review. Ongoing review, monitoring and management of the hedge consistent withwrittenhedgingwritten hedging policies mustensure a reasonable level of correlation is maintained and that any significant exposure after inception of the hedge is mitigated. (Need to look at the correlation between the risk and the hedge throughout the life of the transaction.) 52

53 Permitted Activity: Risk Mitigating Hedging Disagreement as to whether JP Morgan s London Whale trades would have fit within the hedging exemption had the Volcker Rule been in effect. In particular, disagreement whether: the trades were reasonably correlated to the risk the hedge gave rise to new significant unhedged exposures the trades were designed to reduce specific risks 53

54 Permitted Activity: Risk Mitigating Hedging (cont.) Internal Compliance Program. The compliance regime must include written hedging policies at the trading unit level and articulated mandates for each trader to ensure that the decision of how to put on a hedge is consistent with such policies and mandates. Compensation Incentives. Compensation arrangements must be designednotto not to reward proprietary risk taking. Hedging by Different Entities. If separate legal entities or levels of an organization establish positions and the corresponding hedges, the entity must document the risk mitigating ik ii i purpose of the hd hedge, the risks that the transaction is designed to reduce, and the level of organization establishing the hedge. 54

55 Permitted Activity: Underwriting To qualify for the exemption, the following requirements must be met: Internal Compliance. The banking entity must have the requisite internal compliance program, including written policies and procedures, internal controls and independent testing required to ensure the underwriting criteria are met. Distribution. The transactions must be effected solely in connection with a distribution of securities for which the banking entity is acting as an underwriter. These terms generally track the Reg M definitions of distribution, securities and underwriter, although the definition of underwriter includes a person who has an agreement with ihanother underwriter to engage in a distribution of securities for or on behalf of an issuer or selling security holder. Customer Demand. The underwriting activities of the banking entity must be designed not to exceed the reasonably expected near term demands of clients, customers and counterparties. 55

56 Permitted Activity: Underwriting (cont.) Revenue. As with the market making k permitted activity, the underwriting activities of the entity must be designed to generate revenues primarily from fees, commissions, underwriting spreads or other income, and not from appreciation in the value of covered financial positions it holds related to such activities or the hedging of such covered financial position. Compensation Incentives. Compensation arrangements for underwriting personnel must be designed not to reward proprietary risk taking. 56

57 Permitted Activity: Trading on Behalf of Customers Trading on bhlf behalf of customers is narrowly defined: dfi d Purchase or sale must be conducted by the banking entity acting as investment adviser, commodity trading adviser, trustee or in a similar fiduciary capacity; conducted for the account of the customer; and involve solely financial positions of which the customer is the beneficial owner; or The banking entity is acting as a riskless principal (i.e., the banking entity enters into a purchase or sale of a position for its own account to offset a contemporaneous sale to or a purchase from a customer); or The covered banking entity is an insurance company that purchases or sells a covered financial position for a separate account. 57

58 Permitted Activity: Trading Solely Outside the U.S. To qualify for the exemption, the following requirements must be met: A U.S. banking entity may not, directly or indirectly, be involved in the trading (thus, the exemption is unavailable to U.S. US banking entities even if they are indirectly involved) No party to the trade may be a U.S. resident. The term U.S. resident is unique (and broader than Reg. S definition) it includes natural persons who reside in the U.S., companies organized in the U.S., U.S. branches of foreign entities, non U.S. branches of U.S. banks, and discretionary accounts held for the benefit of non U.S. residents by a U.S. dealer or fiduciary For example, a French banking entity would not be permitted to engage in trading with the London office of a U.S. bank. None of the banking entity s personnel that are directly involved in the trade may be physically located in the U.S. (although personnel performing purely administrative, clerical or ministerial functions may be in the U.S.) Proposed Rules: The trade must be executed wholly outside of the U.S. (risk management and booking outside the U.S. is insufficient) 58

59 Metrics The market making, hedging, underwriting and trading in U.S. government obligations permitted activities require that the banking entity availing itself of the exemption must calculate certain metrics on a daily basis and report them to the U.S. regulators each month, and must also keep records regarding such metrics. The metrics must be reported at the trading desk klevel, l at one level lof the organization up from the trading desk, and across all trading operations. The U.S. regulators will analyze the reported information to monitor bankingentities compliance with the prohibitiononproprietary on proprietary trading. The required metrics fall in to five categories: Risk management measurements (including VaR, SVaR and VaR exceedance) Source of revenue of revenue measurements (including several P&L metrics) Revenue relative to risk measurement (including P&L volatility and related statistical analyses) Customer facing activitymeasurements (including inventory aging and risk turnover, and a ratio of customer to noncustomer trades) Payment of fees, commissions and spreads measurement (spreads/fees earned vs. paid) 59

60 V. Compliance Program Requirements 60

61 Required Compliance Program: Proprietary Trading Banking entities that engage in proprietary trading must implement a comprehensive compliance program. Among other things, it must include: Board of directors and CEO responsibility to review and approve of the program, maintain a culture of compliance and identify responsible business line managers Independent testing of the program s effectiveness A system of internal controls reasonably designed to monitor and identify potential areas of noncompliance and prevent the entity from engaging in prohibited activities Authorized risks, instruments and products: risk limits, including yetto be defined numerical thresholds for each trading unit which will trigger heightened review of quantitative measurements; internal escalation and regulator notification upon a reasonable likelihood of violation; and firm specific metrics (as necessary) 61

62 Required Compliance Program: Proprietary Trading Compliance program requirements (continued): Making and keeping records sufficient to demonstrate compliance with the Proprietary Trading rules Internal policies and procedures that specify how trading accounts are identified and describe each trading unit s objectives and strategies Training i for trading personnel, managers and other appropriate personnel 62

63 Required Compliance Program: Proprietary Trading (Cont.) The compliance rules even apply to banking entities that do not engage in proprietary trading: Must enact compliance policies that include measures designed to prevent the entities from becoming engaged in such activities and that require the entity to develop and provide for the compliance program required by the Volcker Rule prior to engaging in such activities (or, in the case of covered funds activities, making such investments). Proposed Rules state that compliance programs should not follow a generic one size fits all approach, but instead should ldbe carefully tailored to take into account and reflect the unique manner in which the banking entity operates, as well as the particular compliance risks its businesses present. 63

64 Required Compliance Program: Covered Funds Proposed Rules also require that banking entities develop a compliance program reasonably designed to ensure and monitorcompliance with the prohibitions and restrictions on covered fund activities. All of the same requirements as apply to the Proprietary Trading compliance program, except as applicable to trackingthe the covered fund rules and activities. In addition, enhanced reporting and recordkeeping requirements apply if: o the banking entity has, together with affiliates, aggregate investments in covered funds of $1 billion; or o sponsors or advises, together with its affiliates, covered funds which have total assets of $1 billion (in each case as measured over the prior four quarters) Compliance policies and procedures to track the covered funds activities should be somewhat easier to draft and monitor than the proprietary trading activities, but certain monitoring could be difficult (such as tracking whether risk mitigating hedging activities are within the requirements). 64

65 Contact Information Adam D. Gale Chadbourne & Parke LLP 30 Rockefeller Plaza New York, NY (212)