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.
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:
A. Entities Covered:
"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. 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:
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."
B. Activities Covered
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, 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:
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:
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:
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.
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.
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.
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
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" 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:
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:
I. Rules of Construction
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:
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.
 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.
 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.
 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.
 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.
 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).
 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.
 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.
 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.
 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.
 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.
 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 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, email@example.com) or C. F. Muckenfuss (202-955-8514, firstname.lastname@example.org) in the firm’s Washington, D.C. office, Kimble Charles Cannon (310-229-7084, email@example.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, firstname.lastname@example.org)
John F. Olson – Washington, D.C. (202-955-8522, email@example.com)
Amy L. Goodman – Washington, D.C. (202-955-8653, firstname.lastname@example.org)
Alan Platt – Washington, D.C. (202-887-3660, email@example.com)
Michael Bopp – Washington, D.C. (202-955-8256, firstname.lastname@example.org)
Securities Law and Corporate Governance Expertise
Ronald O. Mueller – Washington, D.C. (202-955-8671, email@example.com)
Brian Lane – Washington, D.C. (202-887-3646, firstname.lastname@example.org)
Lewis Ferguson – Washington, D.C. (202-955-8249, email@example.com)
John H. Sturc – Washington, D.C. (202-955-8243, firstname.lastname@example.org)
Dorothee Fischer-Appelt – London (+44 20 7071 4224, email@example.com)
Alan Bannister – New York (212-351-2310, firstname.lastname@example.org)
Adam H. Offenhartz – New York (212-351-3808, email@example.com)
George B. Curtis – Denver (303-298-5743, firstname.lastname@example.org)
Paul J. Collins – Palo Alto (650-849-5309, email@example.com)
Robert C. Blume – Denver (303-298-5758, firstname.lastname@example.org)
David P. Burns – Washington, D.C. (202-887-3786, email@example.com)
Charles R. Jaeger – San Francisco (415-393-8331, firstname.lastname@example.org)
Broker-Dealer and Investment Adviser Compliance Expertise
K. Susan Grafton – Washington, D.C. (202-887-3554, email@example.com)
Barry Goldsmith – Washington, D.C. (202-955-8580, firstname.lastname@example.org)
George Schieren - New York (212-351-4050, email@example.com)
Mark K. Schonfeld – New York (212-351-2433, firstname.lastname@example.org)
Financial Institutions Law Expertise
C.F Muckenfuss – Washington, D.C. (202-955-8514, email@example.com)
Christopher Bellini – Washington, D.C. (202-887-3693, firstname.lastname@example.org)
Amy Rudnick – Washington, D.C. (202-955-8210, email@example.com)
Dhiya El-Saden – Los Angeles (213-229-7196, firstname.lastname@example.org)
Kimble Charles Cannon – Los Angeles (310-229-7084, email@example.com)
Howard Adler – Washington, D.C. (202-955-8589, firstname.lastname@example.org)
Richard Russo – Denver (303-298-5715, email@example.com)
Dennis Friedman – New York (212-351-3900, firstname.lastname@example.org)
Robert Cunningham – New York (212-351-2308, email@example.com)
Joerg Esdorn – New York (212-351-3851, firstname.lastname@example.org)
Wayne P.J. McArdle – London (+44 20 7071 4237, email@example.com)
Stewart McDowell – San Francisco (415-393-8322, firstname.lastname@example.org)
C. William Thomas, Jr. – Washington, D.C. (202-887-3735, email@example.com)
Real Estate Expertise
Jesse Sharf – Century City (310-552-8512, firstname.lastname@example.org)
Alan Samson – London (+44 20 7071 4222, email@example.com)
Fred Pillon – San Francisco (415-393-8241, firstname.lastname@example.org)
Dennis Arnold – Los Angeles (213-229-7864, email@example.com)
Michael F. Sfregola – Los Angeles (213-229-7558, firstname.lastname@example.org)
Andrew Lance – New York (212-351-3871, email@example.com)
Eric M. Feuerstein – New York (212-351-2323, firstname.lastname@example.org)
David J. Furman – New York (212-351-3992, email@example.com)
L. Mark Osher – Los Angeles (213-229-7694, firstname.lastname@example.org)
Drew C. Flowers – Los Angeles (213-229-7885, email@example.com)
Teresa J. Farrell – Orange County (949-451-3895, firstname.lastname@example.org)
Deborah A. Cussen – San Francisco (415-393-8226, email@example.com)
Bankruptcy Law Expertise
Michael Rosenthal – New York (212-351-3969, firstname.lastname@example.org)
David M. Feldman – New York (212-351-2366, email@example.com)
Oscar Garza – Orange County (949-451-3849, firstname.lastname@example.org)
Craig H. Millet – Orange County (949-451-3986, email@example.com)
Thomas M. Budd – London (+44 20 7071 4234, firstname.lastname@example.org)
Gregory A. Campbell – London (+44 20 7071 4236, email@example.com)
Janet M. Weiss – New York (212-351-3988, firstname.lastname@example.org)
Matthew J. Williams – New York (212-351-2322, email@example.com)
J. Eric Wise – New York (212-351-2620, firstname.lastname@example.org)
Tax Law Expertise
Arthur D. Pasternak – Washington, D.C. (202-955-8582, email@example.com)
Paul Issler – Los Angeles (213-229-7763, firstname.lastname@example.org)
J. Nicholson Thomas – Los Angeles (213-229-7628, email@example.com)
Jeffrey M. Trinklein – New York (212-351-2344, firstname.lastname@example.org)
Romina Weiss – New York (212-351-3929, email@example.com)
Benjamin H. Rippeon – Washington, D.C. (202-955-8265, firstname.lastname@example.org)
Executive and Incentive Compensation Expertise
Stephen W. Fackler – Palo Alto (650-849-5385, email@example.com)
Charles F. Feldman – New York (212-351-3908, firstname.lastname@example.org)
Michael J. Collins – Washington, D.C. (202-887-3551, email@example.com)
Sean C. Feller – Los Angeles (213-229-7579, firstname.lastname@example.org)
Amber Busuttil Mullen – Los Angeles (213-229-7023, email@example.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.