The Volcker Rules for the Volcker Rule

February 2014Dodd-Frank Alert

A fundamental principle underscoring the Dodd-Frank Wall Street Reform and Consumer Protection Act of 20101 ("Dodd-Frank" or the "Act") is the perceived necessity to curb the proprietary trading and other risk-taking activities of banks, and to divest banks of risky assets, including interests in hedge funds and private equity funds. The markets have dubbed this principle the "Volcker Rule" in acknowledgment of the efforts of Paul Volcker, the former chairman of the Federal Reserve System, to promote it.2 The Act entrusted five regulatory agencies3 with the task of promulgating rules to transform principle into regulation. Under a barrage of industry comment and criticism,4 the final rules have emerged, surprisingly close to the restrictions envisioned in the Dodd-Frank provisions.

Proprietary Trading

The regulators have cast a wide net in defining proprietary trading activities subject to the Act's prohibitions. Under the rules, proprietary trading includes any engagement as a principal for the trading account of a bank to purchase or sell a broad range of financial instruments. "Trading account" is defined broadly as (i) any account for the purchase or sale of financial instruments for short-term trading purposes, (ii) any account maintained by certain banks under market risk capital rules established by banking regulators, and (iii) any account used by a bank in its capacity as dealer, swap dealer or securities-based swap dealer to maintain positions in connection with its dealing activities. Any position held for less than 60 days will be presumed to be held in a trading account. These definitions contain a limited number of exceptions.5 The rules make clear that the prohibitions do not apply to agency, brokerage or custodial transactions for unaffiliated third parties.

Given the breadth of the prohibitions, the exemptions for proprietary trading are crucial to the banks. The Volcker Rule permits underwriting and market-making activities, but the rules are designed to limit such activities on the basis of positions, inventory and risk exposure. Both underwriting and market-making activities must be "client facing" and must not exceed the reasonably expected near-term demands of clients, based upon an analysis of historical and projected customer demand. In addition, in order to qualify for the exemption, the underwriter or market-maker may not have compensation arrangements designed to reward or incentivize prohibited proprietary trading and must develop and maintain a compliance program, as described below.

Underwriting activities are exempted so long as, in addition to the requirements described above, the banking entity acts as an underwriter for an offering of securities (public or private), and the relevant trading desk's underwriting position relates to such distribution. In addition, the bank must make reasonable efforts to sell or otherwise reduce the underwriting position within a reasonable period. Reasonableness is determined by taking into account the liquidity, maturity and depth of the market for the relevant type of security.

To rely on the market-making exemption, a market maker must, in addition to the requirements described above: (i) stand ready to purchase and sell financial instruments for its own account to the market, and (ii) adopt certain policies for individual trading desks, including a description of the financial instruments in which the trading desk makes a market, actions the trading desk will take to hedge its financial risk, limits on inventory, financial exposure and hedging and internal controls monitoring the market-making activity. In addition, large banking entities relying on this exemption must collect and report data regarding trading desk revenue and other metrics.

Banks are also permitted to engage in risk-mitigating hedging activities, but only for "specific, identifiable" risks, as opposed to more generalized risks associated with assets or liabilities generally or risks associated with general market movements or broad economic conditions. Again, hedging activities are required to be subject to strict compliance programs that include internal controls, monitoring and authorization procedures. As with other exemptions, employees engaged in this exemption may not be compensated so as to reward prohibited trading. Other exemptions from proprietary trading, for trading to implement liquidity management programs, trading in certain government obligations, trading on behalf of customers, trading by a regulated insurance company and trading by certain foreign banking entities are similarly delineated. The rules also contain a catch-all that prohibits proprietary trading activities that may otherwise qualify for an exemption, but would (i) pose a threat to the safety and soundness of the bank or to the financial stability of the U.S., (ii) involve a material conflict of interest with customers, or (iii) involve high-risk assets or trading strategies. A "material" conflict of interest would exist if a bank's interests were materially adverse to those of the client in a transaction or activity, unless proper disclosures were made to the client and information barriers were implemented to manage the conflict.

Private Funds

Under the Volcker Rule, banks are prohibited from (i) acquiring or retaining, as principal, any ownership interest in any covered fund or (ii) sponsoring any covered fund. A "sponsor" is an entity that serves as a general partner, managing member, or trustee of a covered fund, or selects or controls a majority of the directors, trustees or management of the covered fund, or shares the same name (or a variation thereof) with the covered fund for marketing, promotional or other purposes.

"Covered funds" are generally investment vehicles, such as hedge funds and private equity funds, and "similar funds", which also include certain commodity pools and certain foreign funds offered outside the U.S. Certain entities are exempt from the definition of covered fund, including entities that can or could rely on an exception or exemption from the definition of "investment company" under the Investment Company Act, other than Section 3(c)(1) or 3(c)(7). This means that many real estate funds will be exempt. Certain entities are explicitly excluded from the definition of covered fund, including foreign public funds6, wholly-owned subsidiaries of a banking entity, certain joint ventures, acquisition vehicles formed solely for engaging in a bona fide merger or acquisition, and issuers of asset-backed securities to the extent the underlying assets are limited exclusively to permitted asset categories.7

The rules state that a bank does not act a "principal" in the following circumstances: (i) when a bank is acting solely as agent, broker or custodian, subject to certain conditions, so long as the activity is for the account of or on behalf of a customer and the bank and its affiliates do not retain beneficial ownership; (ii) when a bank holds the interest through a deferred compensation, stock-bonus, profit-sharing or pension plan and acts as a trustee for the benefit of its current or former employees; (iii) when a bank retains an ownership interest in the ordinary course of collecting a debt previously contracted in good faith, provided that the bank must divest the interest as soon as practicable; and (iv) when a bank acts on behalf of a customer as trustee or a similar fiduciary capacity for a customer that is not a covered fund, so long as the activity is for the account of or on behalf of a customer and the bank and its affiliates do not retain beneficial ownership.

A bank may acquire or retain an ownership interest in or sponsor a covered fund in connection with the organization and offering of such covered fund if, among other things, (i) the covered fund is organized and offered only in connection with the bank's bona fide trust, fiduciary, investment advisory or commodity trading advisory services and the covered fund is only offered to customers of such services (this restriction does not apply if the covered fund is an issuer of asset-backed securities), and (ii) any ownership interest in a covered fund constitutes a "permitted investment", as defined below. The bank must have a written plan outlining how it intends to provide advisory or similar services to its customers and must maintain separateness from the fund, including (i) making mandated disclosures to investors that, among other things, emphasize the separateness of the fund from the bank and discourage expectations that the bank will stand behind the fund's losses, (ii) not having the same name (or a variation thereof) as the covered fund, and (iii) not guaranteeing the fund's performance.

A "permitted investment" in a covered fund includes acquiring or retaining an ownership interest in such covered fund for the purpose of providing initial seed capital to attract investors or retaining a de minimis investment in the fund. In the case of seed capital, within 1 year of the establishment of the fund, the bank must reduce its (and its affiliates') ownership to no more than 3% of the total outstanding ownership interests or the fair market value of the covered fund. A de minimis investment may not exceed 3% of the total outstanding ownership interests or the fair market value of the covered fund. In addition, a bank's aggregate interests in all covered funds that it organizes and offers may not exceed 3% of its tier 1 capital.8 A bank's officers and directors may only hold interests in a covered fund if they are directly engaged in providing the fund with services at the time they take the interests. The ownership of employees may be attributed to the bank itself if the bank or any of its affiliates extends credit or guarantees against loss in connection with such ownership.

The rules also provide for exemptions from the prohibition against acquiring and retaining an ownership interest in a covered fund in connection with certain underwriting and market making-related activities involving such covered fund, certain investments that constitute permitted risk-mitigating hedging activity and certain foreign banking activities.

If a bank or any of its affiliates serves, directly or indirectly, as an investment manager, investment advisor, commodity trading advisor or sponsor of a covered fund that was organized or offered by that bank or in which the bank holds an ownership interest, the bank is prohibited from entering into transactions with that covered fund that would be covered transactions under Section 23A of the Federal Reserve Act. These so-called "Super 23A" restrictions prohibit banks from entering into the following transactions with their related covered funds: (i) extending of credit; (ii) purchasing any investment in securities issued by a related covered fund; (iii) purchasing assets; (iv) issuing a guarantee, acceptance or letter of credit on behalf of the related covered fund; (v) borrowing or lending securities (to the extent such transaction causes the bank to have credit exposure to the related covered fund); and (iv) engaging in certain derivative transactions that cause the bank to have credit exposure to the related covered fund.

Compliance and Reporting Requirements

Banks engaging in proprietary trading or in permissible funds activities must implement a compliance program for the Volcker Rule. The requirements for compliance programs vary based on the size and complexity of the bank. Banks with assets of $10 billion or less may satisfy the compliance program requirement by adding applicable Volcker Rule requirements to their existing compliance policies, while banks with assets of $10 billion or more must establish separate policies for Volcker Rule compliance. For these larger entities, the rules mandate six compliance program elements: (i) trading and exposure limits; (ii) internal controls; (iii) management responsibility for compliance; (iv) independent testing and audit; (v) training; and (iv) recordkeeping. Banks with U.S. assets of $50 billion or more (including banks headquartered outside the U.S.) must satisfy additional requirements related to risk management, independent testing and certification by the chief executive officers of the banks.

The Volcker Rule imposes detailed reporting requirements on all banks with significant trading assets and liabilities. The goal is to help regulators identify prohibited trading and high risk trading strategies. Information is required for each trading desk of a banking entity and for each trading date (although the reports are done on a monthly or quarterly basis). The rules specify seven categories of quantitative information for mandatory reporting, and for each category the rules set out a detailed description, calculation guidelines, and the relevant calculation period: (i) risk and position limits and usage; (ii) risk factor sensitivities; (iii) value-at-risk and stress value-at-risk; (iv) comprehensive profit and loss attribution; (v) inventory turnover; (vi) inventory aging; and (vii) customer-facing trade ratio.

Compliance Deadlines

Banks must be in full compliance with the Volcker Rule by July 21, 2015; however, certain reporting requirements will apply to larger institutions as early as June 30, 2014. The July 21, 2015 deadline is a one-year extension from the deadline contemplated under Dodd-Frank, and accordingly the Federal Reserve has stated that it expects banks to make "good faith" efforts to comply without further extensions.

Developments So Far

Regulators have already revised one requirement under the Volcker Rule in response to criticism from the banking industry.9 Under the Volcker Rule as originally adopted, collateralized debt obligation investments (CDOs) backed by trust-preferred securities ("TruPS") were considered to be securities issued by "covered funds", and therefore banks were required to divest themselves of ownership of TruPS-backed CDOs. Banking industry insiders claimed that this would result in significant losses and write-downs, especially for regional banks.10 A much cited example was Zions Bank's projection that it would have to post an estimated $387 million loss as a result of divestment.11 A petition was filed in federal court by the American Banking Association to stall the implementation of certain related provisions of the Volcker Rule. Lawmakers also publicly criticized the treatment of TruPS under the Volcker Rule. It was reported in the press that the chairman of the House Financial Services Committee was planning to propose a bill stating that nothing in the Volcker Rule should be construed to require the divestiture of any TruPS-backed CDOs issued before a set date.12 In response to this vocal criticism and controversy, regulators adopted an interim final rule which permits banks to retain an ownership interest in, and to sponsor, any issuer of TruPS-backed CDOs if three conditions are met: (i) the issuer was established, and the interest was issued, prior to May 19, 2010, (ii) the bank reasonably believes that the offering proceeds received by the issuer were invested primarily in TruPs or subordinated debt instruments issued by a depository institution holding company that had total assets of less than $15 billion or a mutual holding company, and (iii) the bank acquired the interest on or prior to December 10, 2013, or acquired the interest in the course of a merger with or acquisition of a bank that itself acquired the interest or before that date.

From the time of its conception, the Volcker Rule has been controversial with banks and much discussed in the banking industry. The TruPS issue will very likely not be the only controversy to arise as banks digest the full impact of the Volcker Rule, and regulators and Congress react to the banking industry's ongoing concerns.

1 12 U.S.C ยงยง 5301 et seq.

2 "Banks, Agencies Draw Battle Lines Over 'Volcker Rule'", by Ryan Tracy, James Sterngold and Stephanie Armour, December 11, 2013, The Wall Street Journal (

3 The Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodities Futures Trading Commission.

4 "Regulators Set to Approve Toughened 'Volcker Rule'", by Scott Patterson, December 3, 2013 ( ); "Volcker Rule Sets New Hurdles for Bank", by Scott Patterson, December 10, 2013, The Wall Street Journal (

5 "Financial instruments", for example, do not include loans, spot foreign exchange or spot physical commodities. Proprietary trading excludes certain repurchase and reverse repurchase arrangements, securities lending transactions, and other transactions undertaken for bona fide liquidity management purposes.

6 A "foreign public fund" is one that is organized outside the U.S., is authorized to offer and sell ownership interests to retail investors in the issuer's home jurisdiction, and sells ownership interests predominantly outside the U.S. through public offerings that satisfy enumerated criteria.

7 The Volcker Rule provides an exclusion from the definition of "covered fund" for issuers of asset-backed securities whose underlying assets or holdings are composed exclusively of (i) loans (not including any securities or derivatives), (ii) any rights or other assets designed to assume the servicing or timely distribution of proceeds to security holders or related or incidental to purchasing or otherwise acquiring and holding the loan, (iii) certain interest rate or foreign exchange derivatives, and (iv) certain special units of beneficial interest and collateral securities. An eligible loan securitization may not hold (i) any securities (other than certain cash equivalents and securities received in lieu of debts previously contracted with respect to the loans supporting the asset-backed securities), (ii) most types of derivatives, or (iii) commodity forward contracts.

8 Tier 1 capital is composed of the core capital of the bank, consisting primarily of common stock and retained earnings, but may also include other assets. Tier 1 capital is the primary measure used by regulators to determine a bank's financial strength.

9 "Regulators Ease Volcker Rule Provision on Smaller Banks", by Matthew Goldstein, January 14, 2014, (, last visited January 31, 2014).

10 "Volcker Rule Provision Will Hurt Community Banks" by Andrew R. Johnson, December 25, 2013, The Wall Street Journal (

11 "House Financial Services Chairman to Seek Volcker Rule Change" by Floyd Norris, January 7, 2014, The New York Times (

12 "House Financial Services Chairman to Seek Volcker Rule Change" by Floyd Norris, January 7, 2014, The New York Times (