The Final “Volcker Rule” under the Dodd-Frank U.S. Financial Regulatory Reform Bill

July 12, 2010

The "Dodd-Frank Wall Street Reform and Consumer Protection Act" ("Dodd-Frank") was approved by the U.S. House of Representatives on June 30, 2010 and is expected to be passed by the U.S. Senate in coming weeks.  The bill contains a version of the "Volcker Rule" (the "Rule") — so named for former Federal Reserve Chairman Paul Volcker — that differs in material respects from the version originally introduced from the Senate bill into the House-Senate Conference.  As in earlier versions, the Rule invokes Chairman Volcker’s core concept of separating certain risk activities from the federal bank subsidy.

In its final form, the Rule follows the approach of the Merkley-Levin amendment that was introduced into (but not acted on by) the Senate.  It would prohibit a class of defined "banking entities" from engaging in private capital fund investing and proprietary trading and require that regulators apply quantitative limits and capital requirements to any nonbank financial company supervised by the Federal Reserve ("Supervised NBFCs") that engages in these same activities.  "Banking entities" for this purpose would include any entity that controls a depository institution and any of its affiliates.  A company that is both a banking entity and a Supervised NBFC would be subject to the outright prohibition on banking entities engaging in the activities.

The Rule establishes a series of exemptions from these prohibitions, restrictions and limitations — exemptions that both allow banking entities to participate in the activities and free Supervised NBFCs from otherwise applicable capital requirements and quantitative limits.  The rule also grants considerable discretion to regulators — discretion to clarify very broad core definitions, grant further exemptions, and subject even activities that are "permitted’ under the statute to regulations and restrictions.  Thus, the true impact of the Rule will not be clear until regulations are written, terms more clearly defined, and exceptions considered and granted.

Overview:

While there is no doubt the Volcker Rule will have a meaningful impact on the extent to which companies benefiting from the federal bank subsidy can engage in risk activities, it is not yet clear where the final lines will be drawn.  For example, while "hedge fund" and "private equity fund" are defined to mean any issuer exempt from registration as an investment company under the Investment Company Act, House Financial Services Chairman Barney Frank stated during floor debate that the intent was not to prohibit investment in subsidiaries or joint ventures that hold investment but rather to "prohibit firms from investing in traditional private equity funds and hedge funds."  The Chairman’s statement underscores the task of the regulators to adopt implementing rules that reflect  the intent expressed in legislative history when addressing the at times broad statutory language.

The final Volcker Rule offers a number of complexities and unresolved issues, as more fully discussed below.  However, consider the following core structural elements of the Rule:

  • Entities Covered.  Prohibitions on proprietary trading and engaging in covered transactions with sponsored hedge funds and private equity funds would extend not only to insured depository institutions but also to any company that "controls" an insured depository institution, foreign firms treated as bank holding companies under the International Banking Act, and any of their affiliates or subsidiaries;
  • Council Study.  The Financial Stability Oversight Council would conduct a study and make recommendations on implementing the Rule, but unlike some earlier versions of the Rule considered by the Senate would not have clear authority to overrule any of the statutory provisions of the Rule;
  • Supervised Nonbank Financial Companies.  Only a very narrow set of entities will be Supervised NBFCs subject to the capital requirements and quantitative limits but not within the definition of "banking entities."  In fact, in the beginning, there will be no such companies.  Companies covered by the limitations will come into existence only over time. This can happen either as nonbank financial companies are designated for Federal Reserve supervision because they are systemically significant (under sec. 113 of Dodd-Frank) or as former bank holding companies with consolidated assets of $50 billion or more that received federal assistance under the Emergency Economic Stabilization Act of 2008 dispose of their insured depository institution subsidiaries and become Supervised NBFCs (under sec. 117 of Dodd-Frank) — and even then such entities may appeal the designation;
  • Exemptions.  Exemptions would apply to "permitted activities" that include investments in obligations of the United States and various government sponsored entities, such as Fannie Mae and Freddie Mac, investments in a small business investment company, and the sponsorship of a hedge or private equity fund for sale to customers that entails a de minimis investment by the organizing banking entity;
  • Broad Regulator Discretion.  Federal banking agencies, the SEC, and the CFTC (collectively the "Regulators") would have broad authority to adopt rules imposing additional capital requirements and quantitative limits (as well as diversification requirements) on fund ownership and proprietary trading activities even if these activities are "permitted" and regardless of whether it is a banking entity or a Supervised NBFC that does not control a depository institution engaging in the activity, as well as authority to authorize additional exemptions;
  • Affiliate Transactions.  Affiliate transaction rules would apply to relationships between banking entities and sponsored funds, with Federal agencies required to place limits on the relationships that banks, their affiliates, and bank holding companies can have with sponsored hedge funds and private equity funds; and
  • Foreign Companies.  Prohibitions would not apply to investments or activities conducted by foreign-organized companies whose businesses are conducted outside the United States or companies that do no business inside the United States except that are incidental to their international business, provided the companies are not directly or indirectly controlled by companies organized under United States laws.

A.  Entities Covered:

"Banking Entities"

"Banking entities" subject to the Rule prohibitions are defined to mean any insured depository institution (including both banks and thrifts), any company that controls an insured depository institution, or any company treated as a bank holding company for purposes of sec. 8 of the International Banking Act of 1978, and any affiliate or subsidiary of such an entity.[1]  Thus, for example, the term includes savings and loan holding companies. 

However, the term "insured depository institution" is defined not to include any institution that functions solely in a trust or fiduciary capacity if:

  • Substantially all the deposits of the institution are in trust funds and are received in a bona fide fiduciary capacity;
  • No deposits are insured by the FDIC or marketed through an affiliate of an FDIC insured institution;
  • The institution does not accept demand deposits (or similar deposits);
  • The institution does not obtain payment related services from any Federal Reserve bank or exercise discount or borrowing privileges under the Federal Reserve Act.

Supervised Nonbank Financial Companies

Supervised NBFCs are nonbank financial companies that are determined to be systemically important and therefore subject to Federal Reserve supervision.  Dodd-Frank would require that Supervised NBFCs that do not control a depository institution and that engage in covered activities meet additional capital requirements and additional quantitative limits (to be set by the Federal Reserve by rule) even though they are not strictly "prohibited" from engaging in such activities.  Engaging in proprietary trading and taking an ownership interest in or sponsoring a hedge fund or private equity fund are covered activities.  Supervised NBFC that do not own a depository institution may engage in activities permitted to banking entities under the Rule without these restrictions, except that they must comply with the capital requirements and quantitative limits that the Regulators place on permitted activities "to protect the safety and soundness of banking entities engaged in these activities."[2] 

B.  Activities Covered

Proprietary Trading

The Volcker Rule prohibits a banking entity from engaging in proprietary trading, and requires the Federal Reserve to set capital requirements and quantitative limits on a Supervised NBFC that does not control a depository institution that does so.  The rules regarding these restrictions and limitations are subject to certain exceptions.

"Proprietary trading" is defined to mean, with respect to covered entities, "engaging as a principal for the trading account of the banking entity or nonbank financial company supervised by the Federal Reserve in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument" that regulators by rule determine. 

"Trading account" is defined to mean "any account used for acquiring or taking positions in" the listed securities and instruments "principally for the purpose of selling in the near term (or otherwise with the intent to sell in order to profit from short-term price movements)" and otherwise as regulators determine by rule.

Activities Relating to "Hedge Funds" and "Private Equity Funds"

The Volcker Rule prohibits a banking entity from acquiring or retaining an equity, partnership, or other ownership interest in, or "sponsoring," a hedge fund or private equity fund.  It also requires the Federal Reserve to set capital requirements and quantitative limits on the activities of a Supervised NBFC that does not control a depository institution related to such funds.  Both are subject to certain exceptions. 

"Sponsor" is defined broadly (as it was in previous iterations of the bill) to include serving as a general partner, managing member, or trustee of a fund; controlling a majority of the directors, trustees or management of a fund; or sharing with the fund for any purpose the same (or a very similar) name.

"Hedge fund" and "private equity fund" have a common definition: all issuers that are exempt from being considered investment companies under the Investment Company Act by virtue of sec. 3(c)(1) or sec. 3(c)(7) of that act,[3] as well as to "such similar funds" as the Regulators by rule determine.  This definition is very broad and could be interpreted to apply to many structures that would not be commonly considered hedge funds and private equity funds even under the broadest commonly understood meanings and even though Congress may not have intended such an expansive result.

C.  Permitted Activities

Banking entities are permitted to engage in ten categories of activity described in Dodd-Frank.  In addition, a Supervised NBFC that does not control a depository institution may engage in these "permitted activities" without being subject to additional capital requirements or quantitative limits.  If otherwise allowed by Federal and State law, and if the Regulators do not set restrictions or limits on these activities, then the following ten categories of activities are permitted:

  • Trading in Government Securities.  Transactions in obligations of the United States or any agency of the United States, or any instruments issued by 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 federally chartered Farm Credit System institution, or obligations of any State or a political division of any State;
  • Underwriting and Market Making.  The purchase or sale of securities described in the definition of "proprietary trading" that is "in connection with an underwriting or market-making activities" to the extent that such activities "are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties";
  • Trading for Risk Mitigation.  Risk mitigating hedging activities in connection with holdings of the banking entity that are designed to reduce risks to the banking entity;
  • Trading for Customers.  The purchase, sale or disposition of securities described in the definition of "proprietary trading" (that is, any security, derivative, commodities futures contract, option, derivative, or other security or financial instrument that Regulators determine) that are "on behalf of customers";
  • Small Business Investment Company Investing.  Investments in "small business investment companies," investments designed primarily to promote the public welfare of the type permitted in paragraph (11) of sec. 5136 of the United States Code, or (and this final point was added by the House conferees during the final House-Senate Conference session) investments that are qualified rehabilitation expenditures on qualified historic structures;
  • Insurance Company Trading.  The purchase, sale or disposition of securities in the definition of "proprietary trading" by a regulated insurance company (or an affiliate) for the general account of the company if the transaction is conducted in compliance with insurance company investment laws and the appropriate Federal banking agencies, after consulting with the Council and other regulators, have not determined that the insurance company investment law being relied upon is insufficient to protect safety and soundness of the banking entity or of U.S. financial stability;
  • Fund Offering as Investment Advisor/Fiduciary.  Organizing and offering a private equity fund or hedge fund (including serving as a general partner or controlling a majority of directors or management) if:
    • The banking entity provides bona fide trust, fiduciary or investment advisory services;
    • The fund is organized and offered only in connection with the provision of bona fide trust, fiduciary or investment advisory services only to customers of such services of the banking entity; and
    • The banking entity acquires only a de minimis investment;
      • A "de minimis investment" is defined to be no more than 3% of a single fund’s total ownership interest within a transition period of one to three years.
      • A second element of the de minimis requirement is that all investments in hedge funds and private equity funds in the aggregate be "immaterial to the banking entity," which will be defined by rule but may by statute be no more than 3% of the banking entity’s tier 1 capital.
      • Also, note that the scope of this provision will not be clear until the terms "trust, fiduciary or investment advisory services" and "customers" are defined by regulation.
    • The banking entity complies with the restrictions on affiliate transactions with any fund it sponsors consistent with sec. 23A and sec. 23B of the Federal Reserve Act;
    • The banking entity does not guarantee, assume or insure the obligations or performance of the fund, or any fund in which such fund invests;
    • The banking entity does not share the same name (or a variation of the name) with the fund for corporate, marketing, promotional or any other purpose;
    • No director or employee of the banking entity takes or retains an ownership interest in the fund (except one that is "directly engaged in providing investment advisory or other services" to the fund); and
    • The banking entity discloses to investors in writing that losses in the fund are borne solely by investors in the fund and not by the banking entity, and complies with rules designed to ensure that losses in the fund are not in fact borne by the banking entity.
  • Outside the United States
    • Proprietary Trading.  Proprietary trading conducted by a banking entity pursuant to paragraph (9) and (13) of sec. 4(c) of the Bank Holding Company Act ("BHC Act"), provided the trading occurs solely outside of the United States and the banking entity is not controlled (either directly or indirectly) by a banking entity organized under the laws of the United States;
    • Fund Investing.  The acquisition or retention of an ownership interest in a hedge fund or private equity fund by a banking entity pursuant to paragraph (9) or (13) of sec. 4(c) of the BHC Act solely outside of the United States provided no ownership interest in the fund is offered to residents of the United States and the banking entity is not controlled (directly or indirectly) by a banking entity organized under the laws of the United States; and
  • Other Activities.  Other activities the Regulators determine by rule would promote safety and soundness of the banking entity and United States financial stability.

D.  Limits on Permitted Activities

"Permitted activities" are not allowed under all circumstances.  An activity that is "permitted" is still not allowed if the activity:

  • Would result in a "material" conflict of interest (as will be defined by rule) between the banking entity and its clients or counterparties;
  • Would result (directly or indirectly) in a "material" exposure (as will be defined by rule) by the banking entity to high-risk assets or trading strategies;
  • Would pose a threat to safety and soundness of the banking entity; or
  • Would pose a threat to the financial stability of the United States.

Capital and Quantitative Limits on Permitted Activities:

The Regulators are required to adopt rules that impose additional capital requirements and quantitative limits (including diversification requirements) on permitted activities if they determine these limitations are appropriate to protect safety and soundness of banking entities engaged in permitted activities.  Thus, even if an activity is permitted and not otherwise subject to limitations, if the Regulators elect to set limits they may do so.

E.  Permitted De Minimis Investments in Funds

Notwithstanding the general restriction on banking entities owning private equity and hedge funds, a banking entity can make and retain an investment in a hedge fund or private equity fund that it "organizes and offers" a fund for the purpose of establishing the fund and providing it with sufficient initial equity to permit the fund to attract unaffiliated investors.  Several conditions must be met to utilize this provision:

  • The banking entity must seek unaffiliated investors to reduce or dilute its own interest;
  • The investments in the fund must be reduced through redemption, sale or dilution to no more than 3% of the total ownership interest in the fund within a year of the date the banking entity establishes the fund (which deadline the Federal Reserve has the authority to extend upon the application of the banking entity for up to 2 additional years); and
  • The investment in the fund must be "immaterial to the banking entity," as will be defined by rule.  However, note that under the statute an investment in a fund will not be considered "immaterial" if it causes the aggregate of all interests a banking entity holds in all hedge funds and private equity funds to exceed 3% of the banking entity’s own tier 1 capital.[4] 

A plain reading of this provision suggests that meeting these de minimis requirements alone is sufficient to let a banking entity organize and offer a fund and continue to hold a small investment in that fund.  There is no requirement that the investment or sponsorship also meet the requirements of one of the "permitted activities" exceptions set forth in sec. 619(d)(1)(G) as described above.  Note, for example, that while the exception for offering a fund as an investment advisor or fiduciary references the de minimis standard in sec. 619(d)(4), there is no reference in the "de minimis" provision back to any of the earlier "permitted activities" exceptions.[5]

As commented above, a banking entity can apply to the Federal Reserve to extend for 2 additional years the time it has to reduce its ownership in a fund to 3% of the total ownership interest in the fund.[6] 

The "de minimis" provision also contains a final subparagraph providing that the aggregate amount of the outstanding investment by a banking entity, including retained earnings, must be deducted from the assets and tangible equity of the banking entity, and that the amount of the deduction must increase with the leverage of the hedge or private equity fund.[7]

F.  Anti-Evasion

The Regulators are required to issue regulations requiring internal controls and recordkeeping to insure compliance with the Rule.  If the Regulators have reasonable cause to believe a banking entity or Supervised NBFC has made an investment or engaged in an activity that "functions as an evasion of the requirements of" the Rule "or otherwise violates the restrictions of" the Rule, then they must order, after notice and opportunity for hearing, the banking entity or Supervised NBFC to terminate the activity and (as relevant) dispose of the investment.

G.  Affiliate Transaction Rules Applied to Advised, Managed or Sponsored Funds

  • Section 23A Applied:  No banking entity that serves, directly or indirectly, as the investment manager, advisor, or sponsor of a hedge fund or private equity fund or that organizes and offers a fund (or any affiliate of such a company) may enter into a transaction with the fund (or any fund controlled by the fund) which transaction is a "covered transaction" under sec. 23A of the Federal Reserve Act. 
    • Exempted Activities Covered.  Note that sec. 23A applies to relationships between banking entities and the funds they organize and offer even if this is done in connection with bona fide trust, fiduciary or investment advisory services even though organizing such funds is otherwise exempt from the Rule prohibitions.
  • Section 23B Applied:  A banking entity will also be subject to sec. 23B of the Federal Reserve Act as if the banking entity were a member bank and the fund were an affiliate.  Among other things, this means that transactions must be on terms substantially the same (or at least as favorable) as those prevailing for comparable transactions with nonaffiliated companies.
    • Affiliates Not Covered.  Note the sec. 23B restrictions do not expressly apply to transactions between a fund and affiliates of the banking entity.

Exception for Prime Brokerage Transactions with Funds:

Notwithstanding the restrictions on affiliate transactions, the Federal Reserve may permit a banking entity or a Supervised NBFC to enter into a "prime brokerage transaction"[8] with any hedge fund or private equity fund in which another hedge fund or private equity fund managed, sponsored, or advised by it has taken an equity, partnership, or other ownership interest (but the Rule does not appear to allow a banking entity or Supervised NBFC to engage in prime brokerage transactions with a hedge fund or private equity fund that it directly manages, sponsors, or advises) if:

  • The banking entity or Supervised NBFC is in compliance with the requirements for organizing and offering a private equity or hedge fund;
  • The CEO (or equivalent) of the banking entity certifies in writing annually that it does not guarantee the obligations of any fund it organizes, offers or controls;
  • The Federal Reserve has determined that the transaction is consistent with the safe and sound operation and condition of the banking entity or Supervised NBFC.  Note, however, that it is unclear how the Federal Reserve is to make this determination, whether by rule or otherwise; and
  • The transaction complies with the requirements of 23B as if the counterparty were an affiliate of the banking entity.

H.  Additional Capital Charges and Restrictions on Supervised NBFCs not controlling a depository institution

Supervised NBFCs that do not control a depository institution are not subject to the prohibition on proprietary trading or sponsoring or investing in hedge funds or private equity funds.  Nevertheless, the Regulators must adopt rules imposing additional capital requirements and other restrictions on Supervised NBFCs that do not control a depository institution as follows:

  • General Restrictions.  Supervised NBFCs that do not control a depository institution engaging in proprietary trading or sponsoring or investing in hedge funds or private equity funds must generally meet additional capital requirements and quantitative limits even though they are not "prohibited" from engaging in these activities; and
  • Affiliate Transaction and Prime Brokerage Restrictions.  Additional capital charges or other restrictions must be placed on Supervised NBFCs that engage in the kinds of affiliate transactions and prime brokerage transactions described above (in the context of banking entities) "to address the risks to and conflicts of interest of banking entities."[9]

I.  Rules of Construction

  • The prohibitions and restrictions of the Rule apply even if the activities of a banking entity or a Supervised NBFC are approved by the Federal Reserve.
  • Nothing in the Rule limits the ability of a banking entity or Supervised NBFC to sell or securitize loans.
  • Nothing in the Rule limits the authority of any regulator under applicable law.

J.  Timeline

  • Council Study:  Within 6 months of enactment the Council must study and make recommendations on implementing the Rule.
  • Rulemaking:  Within 9 months of the completion of the study the Regulators and the Federal Reserve[10] must consider the study and adopt regulations to carry out the Rule.  Note that the Federal Reserve is to issue regulations with respect to any company that controls an insured depository or that is "treated as a bank holding company" for purposes of the International Banking Act, for any Supervised NBFC, and any of their subsidiaries.  The agencies writing the Rules are required to consult and coordinate to provide consistent application, with the Chairperson of the Council coordinating regulations.[11]
    • Rules must include:
      • regulations implementing the permitted transactions provisions and any limitations on permitted transactions.
      • regulations imposing additional capital requirements and quantitative limits (including diversification requirements) on permitted activities if the Regulators determine these limitations are appropriate to protect safety and soundness of banking entities engaged in permitted activities.
      • regulations setting the ownership level in a fund that is "immaterial to the banking entity" which in any event cannot be more than 3% of the banking entity’s own tier 1 capital.
      • regulations regarding internal controls and recordkeeping to insure compliance with the Rule.
      • rules determining what "similar funds" are to be included in the definition of "hedge fund" and "private equity fund."
      • rules defining the full extent of the definition of "trading account" for purposes of purposes of determining the scope of prohibitions on proprietary trading.
      • rules defining additional securities that, if traded by a covered entity as a principal for its own trading account, constitute proprietary trading.
      • rules defining additional accounts that count as "trading accounts" for purposes of determining the scope of the prohibition on proprietary trading.
  • Effective Date:  The rule takes effect on the earlier of (i) 12 months after the issuance of final rules or (ii) 2 years after enactment of the Rule.  Thus, if the study and rulemaking take their full 15 months, then the section goes effective just 9 months after the issuance of final rules.
  • Divestiture:  Banking entities and Supervised NBFCs must divest to bring their activities in compliance with the Rule within 2 years of the effective date or 2 years (in the case of a new Supervised NBFC) after the date the entity becomes a Supervised NBFC.  The Federal Reserve can extend this period 1 year at a time (if determined not to be detrimental to the public interest) for a total of 3 additional years.  This means that divestiture could be extended out a total of 7 years after the date of enactment — 2 years for the effective date plus an initial 2 year transition period plus three additional single year extensions
    • Note, also, that within 6 months of enactment the Federal Reserve must issue the rules that will implement this divestiture provision.
  • Extension for Illiquid Funds:  If a banking entity had a contract in place as of 5/1/10 obligating it to retain an interest in or provide capital to an illiquid fund[12], then it can petition the Federal Reserve for an extension of the transition period.  The Federal Reserve can grant a single extension of not more than 5 years.  The most likely interpretation for this provision is that the maximum time for divestiture could be as long as 9 years after the date of enactment — based on the single 5 year extension being a substitute for the otherwise available three single year extensions.  However, note that if it were interpreted that this extension is available in addition to the three one-year extensions allowed for regular divestitures, then the transition period could be extended to as long as 12 years after enactment (note that, in favor of arguing for the consecutive interpretation, the three 1 year extensions can be granted by the Federal Reserve "by rule" and are considered part of the "conformance period" in contrast to the "extended transition for illiquid funds" period that can only be granted by the Federal Reserve upon application).  Regardless of this interpretive issue, however, if the contractual obligation to invest in the illiquid fund terminates before the end of the extension period then the banking entity must immediately exit the investment. 
    • Note that within 6 months of enactment the Federal Reserve must issues rules that will implement the extension provision for illiquid funds.
  • Limits on Additional Capital:  Notwithstanding that divestiture is not required until 2 years after the effective date (at earliest), on the date rules are issued (9 months after the study is completed, or at most 15 months after enactment), the Regulators are required to issue rules imposing additional capital requirements and "any other restrictions, as appropriate, on any equity, partnership, or ownership interest in or sponsorship of a hedge fund or private equity fund by a banking entity."  Thus, even before divestiture is required there likely will be additional requirements and restrictions placed on ownership by a banking entity.

K.  Studies

Council Study and Rulemaking:

The Financial Stability Oversight Council must conduct a study and make recommendations on rules implementing the section within 6 months of enactment.  This is a critical study because it will set the tone for the rulemaking by Regulators.  Many of the timeline dates also key off of when the study and recommendations are completed.  The Council is to recommend measure that would:

  • Promote the safety and soundness of banking entities;
  • Protect taxpayers, consumers, enhance financial stability, and reduce risk that depository institutions and their affiliates will engage in unsafe activities;
  • Limit inappropriate transfer of Federal subsidies (i.e., deposit insurance);
  • Reduce conflicts of interest between banking entities and Supervised NBFCs and their customers;
  • Limit activities that have cause undue risk of loss or "that might reasonably be expected to create undue risk of loss";
  • Accommodate the business of insurance wile protecting safety and soundness of any banking entity with which an insurance company is affiliated; and
  • "appropriately time the divestiture of illiquid assets."

Study on Bank Investment Activities

Sec. 620 (renumbered in the House-Senate Conference but still related to the Volcker Rule) requires a second study for completion within 18 months of enactment under which the appropriate Federal banking agencies are required to jointly review and report on the activities a banking entity may engage in under Federal and State law.  The report is to include recommendations on the potential negative effect of banking activities on safety and soundness of the United States financial system, the appropriateness of such activities and any additional restrictions that may be needed to address safety and soundness.

L.  Prohibition on Conflicts of Interest in Certain Securitizations

While not technically a part of the Volcker Rule, a late House-Senate Conference addition to Dodd-Frank was sec. 621 addressing conflicts of interest relating to securitizations of asset backed securities ("ABS").  The provision prohibits an underwriter, placement agent, sponsor, or initial purchaser (or any affiliate or subsidiary) from engaging in a transaction that would involve or result in a material conflict of interest with an investor for 1 year after the initial closing of the sale of an ABS (including a synthetic).  Exceptions include transactions that are risk mitigating hedging activities designed to reduce specific risks relating to the initial sale and transactions in ABS that are consistent with the commitments of the underwriter, placement agent, sponsor, or initial purchaser (as applicable) or that are bona fide market making activities.



 [1]  Sec. 8(a) of the International Banking Act of 1978 provides that "(1) any foreign bank that maintains a branch or agency in a State, (2) any foreign bank or foreign company controlling a foreign bank that controls a commercial lending company organized under State law, and (3) any company of which any foreign bank or company referred to in (1) and (2) is a subsidiary shall be subject to the provisions of the Bank Holding Company Act."  Thus, while sec. 8 of the International Banking Act does not "treat as a bank holding company" such foreign banks, it does "subject" them to the act.  Note also that where Dodd-Frank mentions this provision in other sections it refers specifically to sec. "8(a)" rather than to sec. 8.

 [2]  The Volcker Rule is set out in sec. 619 of Dodd-Frank.  Note that paragraph (a)(2) of sec. 619 establishing the obligations of Supervised NBFC refers to paragraph "(d)(3)."  This subparagraph refers only to protecting the safety and soundness of "banking entities" but arguably should include protecting the safety and soundness of Supervised NBFCs as well.  This may be a candidate for technical amendment.

 [3]  Investment Company Act sec. 3(c)(1) exempts from being an investment company an issuer whose outstanding securities are beneficially owned by not more than 100 people and that does not make a public offering of its securities.  Sec. 3(c)(7) exempts an issuer whose outstanding securities are owned by persons who are qualified purchasers and does not make a public offering of its securities.

 [4]  The Senate substituted "tier 1 capital" for the previous "tangible common equity" during the final hours of the House-Senate Conference.  Tier 1 capital generally includes common shares, preferred shares, and deferred tax assets whereas tangible common equity, a less commonly used measure, includes only common shares.  Thus, the late Senate switch should, all else being equal, allow for expanded investment by smaller banking entities and those employing preferred shares in their capital structures.

 [5]  There is, however, some ambiguity about the relationship between the permitted activities exceptions and the de minimis provision.  This will need to be resolved through rulemaking.  In the interim, a conservative approach would be to presume that the requirements of both provisions must be met (i.e., that a fund must be offered as a trust or investment advisory service to customers, not share a common name with the offeror, and that the offeror may not guaranty the fund, PLUS that the investment must be reduced to no more than 3% of fund equity within 1-3 years and that the aggregate of all fund investments must not exceed 3% of the offeror’s tier 1 capital).

 [6]  There appears to be a minor error in this provision in that it refers to subparagraph "(B)(i)(I)" when subparagraph "(B)(ii)(I)" was clearly intended.

 [7]  The purpose of this subparagraph is unclear.  The subparagraph states that it applies to paragraph "(3)," but paragraph "(3)" concerns the capital and quantitative limits to be applied to permitted activities whereas paragraph "(4)" concerns the "de minimis" tests.  Also, the provision mentions "tangible equity," which is the measure for which the Senate substituted "tier 1 capital" at the last opportunity during the House-Senate Conference.  For these reasons the subparagraph is a candidate for clarification or technical revision.

 [8]  The term "prime brokerage transaction" is not defined in Dodd-Frank.  The related term "prime brokerage services" is considered a generic term for a bundle of services provided to hedge funds and professional investors that require the ability to borrow securities and capital and be able to invest on a net basis, and in which the "prime broker" generally provides a centralized securities clearing facility in which a fund’s or investor’s collateral requirements are netted across all transactions handled by that prime broker.

 [9]  It is unclear why this provision refers to "banking entities" when it concerns the activities of Supervised NBFCs.  It may reflects that the 23A and 23B limits apply only to banking entities and not to Supervised NBFCs.  However, because additional capital charges and other restrictions are to be applied to Supervised NBFCs to address 23A and 23B concerns, the wording may need to be changed in a technical amendment.

 [10]  The primary financial regulatory agencies are to jointly issue rules with respect to insured depository institutions.  The Federal Reserve is to do so with respect to any company that controls an insured depository institution or that is treated as a bank holding company for purposes of sec. 8 of the International Banking Act, any Supervised NBFC, and any of their subsidiaries other than subsidiaries of which another agency is the primary financial regulatory agency issuing rules.  The CFTC and SEC are to issue rules with respect to entities for which they are the primary financial regulatory agency.

 [11]  The effective date for the Rule keys off of the date final rules are issued.  However, as noted above, multiple agencies will be issuing rules.  While the statute requires that these agencies coordinate for "consistency and comparability" there is no requirement that the agencies issue rules on the same date.  If the agencies don’t issue their rules simultaneously there may be confusion regarding what is the effective date, or multiple effective dates may result for different classes of regulated entities.

 [12]  Note that "illiquid fund" is a defined term in the section, and means a hedge or private equity fund that, as of May 1, 2010 was principally invested in, or was invested and contractually committed to principally invest in, illiquid assets and that makes all investments consistent with an investment strategy to principally invest in illiquid assets.

Gibson, Dunn & Crutcher LLP

Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above.  Please contact Michael Bopp (202-955-8256, mbopp@gibsondunn.com) or C. F. Muckenfuss (202-955-8514, cmuckenfuss@gibsondunn.com) in the firm’s Washington, D.C. office, Kimble Charles Cannon (310-229-7084, kcannon@gibsondunn.com) in the firm’s Los Angeles office, or any of the following members of the firm’s Financial Regulatory Reform Group:

Public Policy Expertise
Mel Levine – Century City (310-557-8098, mlevine@gibsondunn.com)
John F. Olson – Washington, D.C. (202-955-8522, jolson@gibsondunn.com)
Amy L. Goodman – Washington, D.C. (202-955-8653, agoodman@gibsondunn.com)
Alan Platt – Washington, D.C. (202-887-3660,
aplatt@gibsondunn.com)
Michael Bopp – Washington, D.C. (202-955-8256, mbopp@gibsondunn.com)

Securities Law and Corporate Governance Expertise
Ronald O. Mueller – Washington, D.C. (202-955-8671, rmueller@gibsondunn.com)
Brian Lane – Washington, D.C. (202-887-3646, blane@gibsondunn.com)
Lewis Ferguson – Washington, D.C. (202-955-8249,
lferguson@gibsondunn.com)
John H. Sturc – Washington, D.C. (202-955-8243,
jsturc@gibsondunn.com)
Dorothee Fischer-Appelt – London (+44 20 7071 4224, dfischerappelt@gibsondunn.com)
Alan Bannister – New York (212-351-2310, abannister@gibsondunn.com)
Adam H. Offenhartz – New York (212-351-3808, aoffenhartz@gibsondunn.com)
George B. Curtis – Denver (303-298-5743, gcurtis@gibsondunn.com)
Paul J. Collins – Palo Alto (650-849-5309, pcollins@gibsondunn.com)
Robert C. Blume – Denver (303-298-5758, rblume@gibsondunn.com)
David P. Burns – Washington, D.C. (202-887-3786, dburns@gibsondunn.com)
Charles R. Jaeger – San Francisco (415-393-8331, cjaeger@gibsondunn.com) 

Broker-Dealer and Investment Adviser Compliance Expertise
K. Susan Grafton – Washington, D.C. (202-887-3554,
sgrafton@gibsondunn.com)
Barry Goldsmith – Washington, D.C. (202-955-8580,
bgoldsmith@gibsondunn.com)
George Schieren - New York (212-351-4050, gschieren@gibsondunn.com)
Mark K. Schonfeld – New York (212-351-2433, mschonfeld@gibsondunn.com)

Financial Institutions Law Expertise
C.F Muckenfuss – Washington, D.C. (202-955-8514, cmuckenfuss@gibsondunn.com)
Christopher Bellini – Washington, D.C. (202-887-3693,
cbellini@gibsondunn.com)
Amy Rudnick – Washington, D.C. (202-955-8210,
arudnick@gibsondunn.com)
Dhiya El-Saden – Los Angeles (213-229-7196, delsaden@gibsondunn.com)
Kimble Charles Cannon – Los Angeles (310-229-7084, kcannon@gibsondunn.com)

Corporate Expertise
Howard Adler – Washington, D.C. (202-955-8589,
hadler@gibsondunn.com)
Richard Russo – Denver (303-298-5715,
rrusso@gibsondunn.com)
Dennis Friedman – New York (212-351-3900,
dfriedman@gibsondunn.com)
Robert Cunningham – New York (212-351-2308,
rcunningham@gibsondunn.com)
Joerg Esdorn – New York (212-351-3851, jesdorn@gibsondunn.com)
Wayne P.J. McArdle – London (+44 20 7071 4237, wmcardle@gibsondunn.com)
Stewart McDowell – San Francisco (415-393-8322, smcdowell@gibsondunn.com)
C. William Thomas, Jr. – Washington, D.C. (202-887-3735, wthomas@gibsondunn.com)

Private Equity Expertise
E. Michael Greaney – New York (212-351-4065, mgreaney@gibsondunn.com)

Private Investment Funds Expertise
Edward Sopher – New York (212-351-3918, esopher@gibsondunn.com)
Jennifer Bellah Maguire – Los Angeles (213-229-7986, jbellah@gibsondunn.com)

Real Estate Expertise
Jesse Sharf – Century City (310-552-8512,
jsharf@gibsondunn.com)
Alan Samson – London (+44 20 7071 4222,
asamson@gibsondunn.com)
Fred Pillon – San Francisco (415-393-8241, fpillon@gibsondunn.com)
Dennis Arnold – Los Angeles (213-229-7864, darnold@gibsondunn.com)
Michael F. Sfregola – Los Angeles (213-229-7558, msfregola@gibsondunn.com)
Andrew Lance – New York (212-351-3871, alance@gibsondunn.com)
Eric M. Feuerstein – New York (212-351-2323, efeuerstein@gibsondunn.com)
David J. Furman – New York (212-351-3992, dfurman@gibsondunn.com)
L. Mark Osher – Los Angeles (213-229-7694, mosher@gibsondunn.com)
Drew C. Flowers – Los Angeles (213-229-7885, dflowers@gibsondunn.com)
Teresa J. Farrell – Orange County (949-451-3895, tfarrell@gibsondunn.com)
Deborah A. Cussen – San Francisco (415-393-8226, dacussen@gibsondunn.com)

Crisis Management Expertise
Theodore J. Boutrous, Jr. – Los Angeles (213-229-7804, tboutrous@gibsondunn.com)

Bankruptcy Law Expertise
Michael Rosenthal – New York (212-351-3969,
mrosenthal@gibsondunn.com)
David M. Feldman – New York (212-351-2366, dfeldman@gibsondunn.com)
Oscar Garza – Orange County (949-451-3849, ogarza@gibsondunn.com)
Craig H. Millet – Orange County (949-451-3986, cmillet@gibsondunn.com)
Thomas M. Budd – London (+44 20 7071 4234, tbudd@gibsondunn.com)
Gregory A. Campbell – London (+44 20 7071 4236, gcampbell@gibsondunn.com)
Janet M. Weiss – New York (212-351-3988, jweiss@gibsondunn.com)
Matthew J. Williams – New York (212-351-2322, mjwilliams@gibsondunn.com)
J. Eric Wise – New York (212-351-2620, ewise@gibsondunn.com)

Tax Law Expertise
Arthur D. Pasternak – Washington, D.C. (202-955-8582, apasternak@gibsondunn.com)
Paul Issler – Los Angeles (213-229-7763, pissler@gibsondunn.com)
J. Nicholson Thomas – Los Angeles (213-229-7628, nthomas@gibsondunn.com)
Jeffrey M. Trinklein – New York (212-351-2344, jtrinklein@gibsondunn.com)
Romina Weiss – New York (212-351-3929, rweiss@gibsondunn.com)
Benjamin H. Rippeon – Washington, D.C. (202-955-8265, brippeon@gibsondunn.com)

Executive and Incentive Compensation Expertise
Stephen W. Fackler – Palo Alto (650-849-5385, sfackler@gibsondunn.com)
Charles F. Feldman – New York (212-351-3908, cfeldman@gibsondunn.com)
Michael J. Collins – Washington, D.C. (202-887-3551, mcollins@gibsondunn.com)
Sean C. Feller – Los Angeles (213-229-7579, sfeller@gibsondunn.com)
Amber Busuttil Mullen – Los Angeles (213-229-7023, amullen@gibsondunn.com

© 2010 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.