The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission jointly adopted and the Commodity Futures Trading Commission separately adopted a final rule (the “Final Rule”) today implementing the restrictions contained in Section 619 of the Dodd-Frank Act, known as the “Volcker rule,” that generally prohibit banking entities from engaging in proprietary trading and from sponsoring and/or investing in certain types of private funds.
Goodwin Procter is preparing more extensive materials addressing the Final Rule that we plan to distribute to recipients of the Financial Services Alert in the near future. However, some of the more significant aspects of the Final Rule include the following:
- The explanatory preamble to the Final Rule indicates that the Federal Reserve Board has exercised its authority under Section 13(c)(2) of the Bank Holding Company Act to extend by one year, until July 21, 2015, the period during which banking entities must conform their activities and investments to the requirements of the Volcker Rule.
- The Final Rule permits trading in certain government obligations, including:
- obligations of or issued or guaranteed by the United States;
- an obligation, participation, or other instrument of, or issued or guaranteed by, an agency of the United States, the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation or a Farm Credit System institution chartered under and subject to the Farm Credit Act; and
- obligations of states and their political subdivisions, including any municipal security;
- The Final Rule exempts market-making activities from the prohibition on proprietary trading, subject to certain requirements intended to ensure that exempt market making activity is customer facing and designed not to exceed the reasonably expected demands of clients. The Final Rule does not require that market making activities be designed to generate revenues primarily from fees or other customer revenues. However, it does require banking entities with significant trading activities to report data regarding patterns of revenue generation by market making trading desks.
- The Final Rule incorporates an exemption for risk mitigating hedging activities, subject to limitations intended to ensure that the exemption only permits hedging designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks in connection with and related to the contracts or other holdings of the banking entity.
- With respect to covered funds, the Final Rule narrows the definition of covered fund from the one contained in the proposed implementing regulation in a manner that addresses many of the concerns raised during the comment process. In particular, the Final Rule does not include all commodity pools within the definition of covered fund but instead covers pools for which (i) there is a registered commodity pool operator that has claimed an exemption under 17 C.F.R. § 4.7 for a pool offered solely to qualified eligible persons, or (ii) there is a registered commodity pool operator and the pool has certain characteristics, including that substantially all participation units of the pool are owned by qualified eligible persons under 17 C.F.R. §§ 4.7(a)(2) and 4.7(a)(3). The Final Rule also narrows the definition of covered fund as it applies to funds organized outside of the United States so that it focuses on funds sponsored by a U.S. banking entity or in which a U.S. banking entity is an investor.
- The Final Rule specifically excludes a number of entities from the definition of covered fund, including foreign public funds, wholly-owned subsidiaries, certain joint ventures, registered investment companies, business development companies, funds that may rely on an Investment Company Act exclusion or exemption other than Section 3(c)(1) or Section 3(c)(7), small business investment companies, certain issuers of asset backed securities, and qualifying asset-backed commercial paper conduits. However, the Final Rule does not provide a separate exclusion for CLOs.
- A banking entity engaged extensively in certain permitted proprietary trading and covered fund activities must create and maintain a compliance program that, among other things, requires its CEO to attest annually that the banking entity has in place processes to establish, maintain, enforce, review, test and modify the required compliance program in a manner reasonably designed to achieve compliance with the Volcker rule.
The Final Rule applies to community and regional institutions, including those with less than $10 billion of total consolidated assets. However, the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency released a document entitled “The Volcker Rule: Community Bank Applicability” in which they asserted that the vast majority of community banks have little or no involvement in prohibited proprietary trading or investment activities in covered funds and, accordingly, would not have any compliance obligations under the Final Rule if they do not engage in covered activities other than trading in certain government, agency, state or municipal obligations. However, community banks that engage in additional activities covered by the Final Rule may need to adjust their policies and procedures accordingly. For example, the guidance document notes that community banks engaged in other trading activities, such as risk mitigating hedging, may need to adopt an appropriate liquidity plan. The Final Rule provides that the compliance program must be “appropriate for the types, size, scope and complexity of activities and business structure of the banking entity.”