Client Alert The Volcker Rule Proprietary Trading Prohibition:

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1 North America Banking & Finance Client Alert The Volcker Rule Proprietary Trading Prohibition: January 2014 A Primer for Nonfinancial Company CFOs and Treasurers Prepared by: Daniel L. Goelzer daniel.goelzer Additional members of the Baker & McKenzie Volcker Rule team: John J. Conroy, Jr john.conroy Matthew F. Kluchenek matt.kluchenek Ricardo S. Martinez ricardo.martinez Creighton R. Meland creighton.melandjr Hans Montag hans.montag Ira A. Reid ira.reid Michael Sefton michael.sefton Lloyd M. Winans lloyd.winans On December 10, 2013, five federal financial regulatory agencies 1 issued uniform final regulations implementing the Volcker Rule. The Volcker Rule is a provision in the Dodd-Frank Act Wall Street Reform and Consumer Protection Act of 2010 that generally prohibits banks from engaging in proprietary trading of financial instruments and from owning, sponsoring, or having certain relationships with hedge funds and private equity funds ( Covered Funds ). This Client Alert summarizes the terms of the proprietary trading prohibition and the exemptions and exclusions from the proprietary trading ban. It also includes an overview of the related compliance program requirements. The impact of the Rule on foreign banking organizations is discussed in our Client Alert, The Volcker Rule Key Considerations for Foreign Banking Entities (December 2013). Future Baker & McKenzie Client Alerts will address the Covered Funds provision and discuss the Rule s compliance and corporate governance requirements in greater detail. Understanding the proprietary trading restrictions of the Volcker Rule, and the related compliance program requirements, is critical for those responsible for financial institution compliance and governance. For nonfinancial company CEOs, CFOs, and Treasurers, a general understanding of the Rule is also important, since it may have indirect effects on their capital-raising, borrowing, and hedging activities. This Alert ends with a brief comment on some of the possible consequences for nonfinancial companies. What is Proprietary Trading? The Volcker Rule seeks to insulate insured deposit-taking institutions from trading-related risks by prohibiting them from engaging in proprietary trading. Propriety trading is defined as "engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments." For purposes of this prohibition - A banking entity includes any FDIC-insured depository institution and any company that controls, or is an affiliate or subsidiary of, such an institution. Certain foreign companies that are treated as a bank holding company under U.S. law, and their affiliates and subsidiaries, are also included. 2 1 The five agencies are the Federal Reserve, Commodity Futures Trading Commission, Securities and Exchange Commission, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. 2 Final rule.2(c) defines a banking entity as (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any company that is treated as a bank holding company for purposes of section 8 of the International Banking Act of 1978; and (iv) any affiliate or subsidiary of any of the foregoing entities. Affiliate has the same meaning as in Section 2(k) of the Bank Holding Company Act of 1956, 12 U.S.C. 1841(k).

2 A financial instrument is (i) a security, including an option on a security; (ii) a derivative, including an option on a derivative; or (iii) a contract of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery. However, the term financial instrument does not include loans, foreign exchange or currency, or commodities (as distinguished from commodity futures). A trading account includes any account that is used by a banking entity to purchase or sell financial instruments principally for the purpose of shortterm resale or benefitting from actual or expected short-term price movements. The Rule contains a rebuttable presumption that any purchase or sale of a financial instrument by a banking entity is for the entity's trading account, if the financial instrument is held for fewer than 60 days or if the risk of ownership is transferred within 60 days. What is Not Proprietary Trading? Applied literally, the Volcker Rule would prevent banks from engaging in many types of traditional bank activity that pose little systemic risk. Accordingly, the Rule includes a laundry list of exclusions - activities and transactions that could involve some level of proprietary trading, but are outside of the prohibition and therefore remain legal. Under the exclusions, banking entities may purchase or sell financial instruments - Repos. Pursuant to a written repurchase or reverse repurchase agreement with a specific counterparty. Securities Lending. If the purchase or sale arises under a transaction in which the banking entity lends or borrows a security temporarily. The loan must be pursuant to a written securities lending agreement under which the lender retains the economic interests of an owner and has the right to terminate the transaction and to recall the loaned security. Liquidity Management. For the purpose of liquidity management in accordance with a documented liquidity management plan. This exclusion only permits trading in securities, not other types of financial instruments. The banking entity s liquidity management plan must, among other things, limit purchases and sales to highly liquid securities as to which appreciable profits or losses are not reasonably anticipated, and must include policies, procedures, internal controls, and independent testing to ensure that transactions are in accordance with the plan. Clearing. In connection with clearing activities, if the banking entity is a derivatives clearing organization or a clearing agency. In addition, banking entities that are members of a clearing agency, derivatives clearing organization, or designated financial market utility may engage in purchases and sales that are "excluded clearing activities." 3 Delivery and Judicial Obligations. To satisfy a delivery obligation of the banking entity or its customers. The rule also permits trading to satisfy an obligation in connection with a judicial, administrative, self-regulatory organization, or arbitration proceeding. Agent, Broker, or Custodian Transactions. If the banking entity is acting solely as agent, broker, or custodian for its customers. 3 Final rule.3(e)(7) defines a excluded clearing activities. The definition includes transactions that are necessary to correct trading errors or address defaults or that are required by the rules of the clearing agency. 2 Client Alert January 2014

3 Employee Benefit Plan Transactions. Through a deferred compensation, stock-bonus, profit-sharing, or pension plan, provided the banking entity is acting as trustee for the benefit of its own employees. Debt Collection. In the ordinary course of collecting a debt, provided that the banking entity divests the financial instrument as soon as practicable. What Types of Proprietary Trading Are Permitted? In addition to these exclusions, the Rule permits banks to engage in six categories of proprietary trading. In general, these permitted activities are, or are ancillary to, securities-related services that banks are have traditionally offered to customers. The Rule also permits foreign banks and their affiliates to engage in certain forms of proprietary trading beyond those permissible for U.S. institutions. The impact of the Rule on foreign banking organizations is outside the scope of this paper, but is discussed in Baker & McKenzie s Client Alert, The Volcker Rule Key Considerations for Foreign Banking Entities (December 2013). Banking entities that elect to engage in certain of the permitted activities must satisfy stringent compliance program requirements related to that activity, in addition to the compliance requirements applicable to all banking entities. 1. Underwriting The proprietary trading prohibition does not apply to a banking entity's underwriting activities. The banking entity must be acting as an underwriter for a distribution of securities, and the trading desk's underwriting position must be related to the distribution. In addition, a trading desk's underwriting position must be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties; reasonable efforts must be made to sell or otherwise reduce the position within a reasonable period, taking into account the characteristics of the market. The banking entity must establish and enforce a compliance program tailored to the activities of the underwriting trading desk and designed to prevent systematic retention of unsold allotments. 2. Market-Making The proprietary trading prohibition does not apply to a banking entity's marketmaking activities. The trading desk that establishes and manages a position in a financial instrument as market maker must routinely stand ready to purchase and sell the financial instrument and must be willing and available to quote, purchase and sell, or otherwise enter into long and short positions. The amount, types, and risks of the financial instruments in the trading desk's market-maker inventory must be designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties. The banking entity must establish and enforce a compliance program, including inventory limits. 3. Risk-Mitigating Hedging The proprietary trading prohibition does not apply to the risk-mitigating hedging activities of a banking entity. Hedging must be in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity and must be designed to reduce the specific risks in connection with and related to such positions, contracts, or other holdings. The banking entity must establish and enforce a compliance program, including ongoing calibration to make sure the hedging activity does not stray into prohibited proprietary trading. 3 Client Alert January 2014

4 4. Trading in Domestic Government Debt The proprietary trading prohibition does not apply to the purchase or sale of obligations issued or guaranteed by the U.S. government or a U.S. government agency or instrumentality. Trading in obligations of any U.S. state or political subdivision, including municipal securities, is also permitted. 5. Trading on Behalf of Customers The proprietary trading prohibition does not apply to the purchase or sale of financial instruments by a banking entity acting as trustee or in a similar fiduciary capacity, for the account of a customer. Riskless principal transactions with a customer are also permitted. 6. Trading by Insurance Companies The proprietary trading prohibition does not apply to the purchase or sale of financial instruments by a banking entity that is an insurance company or an affiliate of an insurance company. The trading must be for the insurance company's general account or for an established separate account. When Does Permitted Trading Become Prohibited? The six categories of permitted proprietary transactions are subject to an overriding limitation. No transaction or activity is permissible where it would (1) involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties, (2) result, directly or indirectly, in a material exposure to a high-risk asset or trading strategy, or (3) pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States. The material conflict of interest prong of the overriding prohibition does not apply if (1) the banking entity has made timely and effective disclosure to the client, customer, or counter-party in a manner that affords the opportunity to negate or substantially mitigate the adverse effect of the conflict; or (2) the banking entity has established, maintained, and enforced information barriers that are reasonably designed to prevent the conflict of interest from having a material adverse effect on the client, customer, or counter-party. What are the Reporting, Compliance Program, and Corporate Governance Requirements Associated with Proprietary Trading? Beginning on June 30, 2014, banking entities with a gross amount of $50 billion or more in consolidated worldwide trading assets and liabilities (excluding certain U.S. government obligations) are required to report specified "trading metrics" information regarding proprietary trading activity to their oversight agency. The reporting threshold falls to $25 billion on April 30, 2016, and to $10 billion on December 31, The Rule also requires banking entities to implement detailed compliance, internal control, and corporate governance mechanisms designed to ensure compliance with the Rule. Each banking entity must establish the required compliance program as soon as practicable and in no case later than the end of the conformance period July 15, Prior to that date, banking entities are expected to engage in good-faith efforts to fully conform their activities and investments to the requirements of the Rule. As described above, banking entities that engage in underwriting, marketmaking, and risk-mitigating hedging must establish and enforce compliance 4 Client Alert January 2014

5 programs tailored to those activities. In addition to these activity-specific compliance requirements, all banking entities that engage in permitted proprietary trading must implement compliance and corporate governance measures tiered to the size of the entity. Banking entities with total consolidated assets of $10 billion or less may update their existing compliance programs to incorporate the requirements of the Rule. Banking entities with total consolidated assets of more than $10 billion, but less than $50 billion, must establish - Internal Controls. A system of internal controls reasonably designed to prevent violations and monitor compliance with the Volcker Rule. Policies and Procedures. Written policies and procedures reasonably designed to document, describe, monitor and limit trading activities which could be considered proprietary trading. Management Framework. A management framework delineating responsibilities and accountability for compliance with the Rule, including appropriate managerial review of trading activity. Independent Audit and Testing. Independent testing and auditing conducted by the banking entity's qualified personnel or by outside qualified personnel. Training. Ongoing training for trading personnel, managers and other persons to effectively implement and enforce the compliance program. Record-keeping. Records, which must be retained for no less than five years, sufficient to demonstrate compliance with the Rule. U.S. banking entities with $50 billion or more in total consolidated assets, foreign banking entities with $50 billion or more in U.S. assets, and banking entities subject to the trading metrics reporting requirements mentioned above must comply with an enhanced compliance/governance framework. Among other things, the enhanced framework includes - Board-Approved Compliance Program. The banking entity must adopt a written compliance program, approved by its board of directors (or by an appropriate board committee) and by senior management. Culture of Compliance. The board of directors and senior management are responsible for setting and communicating an appropriate culture of compliance and ensuring that appropriate policies regarding the management of trading activities and Covered Fund activities are adopted. This includes ensuring that senior management is "fully capable, qualified, and properly motivated to manage compliance" and that senior management has established appropriate incentives and adequate resources to support compliance with the Volcker Rule. Compliance Reporting to the Board. Senior management and other personnel responsible for compliance with the Rule must periodically review the compliance program and report to the board concerning its effectiveness. This reporting must occur "with a frequency appropriate to the size, scope, and risk profile of the banking entity's trading activities" which must be at least annually. CEO Certification. The banking entity's CEO must conduct an annual review and, based on that review, attest in writing to the relevant oversight agency that the entity has in place processes reasonably designed to achieve compliance with the Rule. 5 Client Alert January 2014

6 Independent Testing Program. At least annually, effectiveness of the compliance program must be tested by a "qualified independent third party," such as the banking entity's internal audit department; compliance personnel or risk managers independent of the unit being tested; outside auditors, consultants; or other qualified independent parties. This testing must include an evaluation of (1) the overall adequacy and effectiveness of the compliance program, (2) the effectiveness of the internal controls, and (3) the effectiveness of the banking entity's management procedures. How Does the Volcker Rule Affect Non-Financial Companies? The Volcker Rule does not impose limitations or compliance requirements on businesses that are not banking entities. Bank corporate customers - and U.S. companies generally - may, however, be indirectly affected. Some commenters on the proposed rule asserted that the proprietary trading prohibition would limit corporate access to financial services and reduce liquidity in markets in which corporations trade, hedge, and issue securities. Last month, five organizations, representing a range of industries, submitted a letter 4 predicting, among other things, that the Rule would - Curtail bank market-making activities, commercial and municipal debt underwriting, holding of inventory to make secondary markets, sweep accounts, commercial paper issuance, and foreign exchange services. As a result, market liquidity will shrink, payments will be slower, and companies will have greater difficulty managing cash flows. Reduce the market for corporate debt and equities. This will cause investors to divert investment to large firms that are perceived as presenting less liquidity risk and will restrict the debt market for small and mid-size companies. Widen transaction spreads. Wider spreads will force companies that issue debt to pay higher interest rates. It is of course premature to determine whether and to what extent these predicted consequences will actually occur. CEOs, CFOs, and corporate treasurers should stay abreast of developments affecting the interpretation and implementation of the Volcker Rule so that they can react accordingly. 4 Letter, dated December 4, 2013, from Business Roundtable, Financial Executives International, National Association of Corporate Treasurers, The Real Estate Roundtable, and U.S. Chamber of Commerce, to The Honorable Ben Bernanke, et al Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a partner means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an office means an office of any such law firm. This may qualify as Attorney Advertising requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome. 6 Client Alert January 2014

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