November 28, 2011

INSTITUTE OF INTERNATIONAL BANKERS

IMPLEMENTATION OF THE DODD-FRANK ACT—KEY ISSUES FOR INTERNATIONAL BANKS

The Volcker Rule—Cross-border Issues Affecting Proprietary Trading

I. Executive Summary

A. The “Volcker Rule”, Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), is codified as Section 13 of the Bank Holding Company Act of 1956 (the “BHCA”).

1. The Volcker Rule’s basic operative provision relevant to this Outline is that “[u]nless otherwise provided in [the Rule], a banking entity shall not . . . engage in proprietary trading; . . . [i.e.,] engag[e] as principal for the trading account of the banking entity . . . 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 financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission [(the ‘SEC’)] and the Commodity Futures Trading Commission [(the ‘CFTC’)] may, by rule . . . determine”. (Emphasis added.)1

2. The Federal Reserve Board (the “Federal Reserve”), the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (the “FDIC”) and the SEC have issued a proposed rule to

1 Although not discussed in this Outline, the Volcker Rule also restricts banking entities’

private equity fund and hedge fund activities.

© Cleary Gottlieb Steen & Hamilton LLP, 2011. All rights reserved. This Outline was prepared as a service to clients and other friends of Cleary Gottlieb to discuss recent developments that may be of interest to them. The information in this Outline is, therefore, general, and should not be considered or relied on as legal advice.

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implement the Volcker Rule, which is open for comment through January 13, 2012 (the “Proposed Rule”).2

B. The Volcker Rule will apply to the global activities of banking organizations that have banking operations in the United States, and all of their affiliates and subsidiaries worldwide (collectively “banking entities”). Accordingly, the Volcker Rule will apply to each foreign banking organization with a branch, agency or bank subsidiary in the United States, and all of its affiliates and subsidiaries (collectively, an “FBO”).

C. The Proposed Rule takes a very restrictive approach to the statutory exception for the foreign trading activities of FBOs (the “Foreign Trading Exception”), despite Congressional intent to limit the Volcker Rule’s extraterritorial effect. Under the Proposed Rule:

1. FBO proprietary trading outside of the United States would be permitted only if there is no trading with U.S. counterparties and no involvement by the FBO’s U.S. personnel (except for ministerial functions), and only if transactions are executed wholly outside of the United States.

2. All trading with U.S. counterparties or on U.S. exchanges/execution facilities would be subject to the operation of the Volcker Rule.

3. Exceptions to the Volcker Rule’s prohibitions on proprietary trading which would be applicable to both U.S. and non-U.S. banking entities (i.e., which would not fall within the Foreign Trading Exception) would be subject to onerous compliance, reporting and recordkeeping requirements. These requirements could be applied on a global basis, including to an FBO’s non-U.S. operations.

D. Banking entities are required to begin complying with the Volcker Rule in July 2012, although they will have a two-year conformance period to come into full compliance (with possible extensions).

2 See 76 Fed. Reg. 68844 (Nov. 7, 2011).

Reference is made to the Cleary Gottlieb Alert Memo -- The Volcker Rule Proposal: Challenges, Open Issues and Unintended Consequences (Nov. 21, 2011) for a more detailed discussion of the key implications of the Proposed Rule for market participants, as well as of specific analytical issues and interpretive questions throughout the Proposed Rule that should be addressed in comments and considered as businesses prepare for the July 2012 effective date of the Volcker Rule. The Alert Memo addresses proprietary trading, funds activities (including implications for employee compensation arrangements), the impact on securitization activities, and timing and practical challenges related to required compliance programs.

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E. The Proposed Rule is only a preliminary proposal, and many open issues are yet to be resolved or may be subject to change. Comments from banks, trade associations, home country regulators and other governmental authorities will be critical.

1. With comments on the Proposed Rule due by January 13, 2012, a final rule could come in late spring 2012.

2. Given the timing of the Proposed Rule, extensions of the effective date/conformance period are legitimate subjects for comment.

II. Scope of Covered “Banking Entities” Subject to the Proprietary Trading Prohibition

A. “Banking Entities”. The Volcker Rule will apply to (1) U.S. insured depository institutions, (2) companies that control U.S. insured depository institutions (including bank holding companies (“BHCs”) and financial holding companies (“FHCs”)), (3) FBOs, and (4) the affiliates and subsidiaries (including broker-dealer subsidiaries) of each of the foregoing.

B. No U.S. Territorial Limitation. The Volcker Rule will apply to a banking entity’s global operations. The Proposed Rule interprets the Foreign Trading Exception (see Part V below) very narrowly, and subjects such Exception to significant limitations.

C. Other Affiliated Commercial and Financial Companies. The Volcker Rule adopts the BHCA’s definition of “control” and “affiliate”, potentially drawing in a wide range of companies that would not ordinarily be viewed as the affiliates of a financial company and for which the policy justification for applying the Volcker Rule prohibitions is limited at best.3

3 For purposes of the BHCA, one company has “control” over another company if the first

company (i) directly or indirectly or acting through one or more other persons owns, controls, or has power to vote (a) 25% or more of any class of voting securities of the other company, or (b) one-third or more of the total equity of the other company; (ii) controls in any manner the election of a majority of the directors of the other company; or (iii) directly or indirectly exercises a “controlling influence” over the management or policies of the other company. “Affiliate” is defined to include any company that controls, is controlled by, or is under common control with, another company. 12 U.S.C. §§ 1841(a)(2), (k); 12 C.F.R. §§ 225.2(a), (e); 12 C.F.R. § 225.144.

The concept of “controlling influence” is wide-ranging. See Tortoriello, Guide to Bank Underwriting, Dealing and Brokerage Activities (Thomson West, 16th ed. 2011) (the “Guide to Bank Underwriting”) at Part VII.A.

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1. For example, FBOs sometimes have controlling positions in foreign commercial operating companies. As drafted, the Proposed Rule would appear to apply to the commercial operating company subsidiaries and affiliates of FBOs.

2. Many FBOs have minority investments in other financial services companies that operate outside of the United States. Such investments could subject such companies to the Volcker Rule prohibitions if the investing FBO has technical “control” over the financial services company under the BHCA, even if it has no operational ability to control the conduct of business of such company or force such company to comply with restrictions intended to be applicable to U.S. banks.

3. The Volcker Rule could also be read to apply to an FBO/FHC’s controlled merchant banking investments,4 forcing the relevant FBO/FHC to push down its Volcker Rule compliance procedures to underlying portfolio companies.

III. Prohibition on “Proprietary Trading”

A. “Proprietary Trading”: engaging in the “purchase or sale” of one or more “covered financial positions” as principal for the “trading account” of the banking entity.

1. The Proposed Rule would define each of these key terms broadly, and any activity that falls within the proprietary trading definition would be prohibited unless it falls within one of the Volcker Rule’s specific exceptions.

2. Volcker Rule definitions generally would be applied in the same way to both U.S. and foreign banking entities, making the scope of the Foreign Trading Exception critically important for an FBO’s non-U.S. trading activities.

B. “Purchase and sale” is defined to encompass a wide range of transactions that could create, eliminate, increase or reduce exposure to a covered financial position. In the case of derivatives, for example, the Proposed Rule would cover the execution, early termination, assignment, exchange or conveyance of, or extinguishment of rights or obligations under, a derivative.

C. “Covered financial position” is defined very broadly to include any position (whether long, short, synthetic or other) in a security, derivative, contract of sale

4 See 12 C.F.R. §§ 225.170 et seq.

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of a commodity for future delivery, or option on any such security, derivative or contract.

D. “Trading Account”.

1. The Proposed Rule would use three overlapping definitions to capture the intent of a banking entity to earn short-term profits: (a) a “Purpose Test”, (b) a “Market Risk Capital Rule Test”, and (c) a “Dealer Registration Test”. The Proposed Rule would also establish a rebuttable presumption that any account used to take a covered financial position that is held for 60 days or less is a “trading account” (the “60-day rebuttable presumption”).

(a) Purpose Test: The Purpose Test is the core of the definition of “trading account”, reaching any account used by a banking entity to acquire or take one or more covered financial positions principally for the purpose of (i) reselling in the short term, (ii) benefitting from actual or expected short-term price movements, (iii) realizing short-term arbitrage profits, or (iv) hedging one or more positions described above.

(b) Market Risk Capital Rule Test: A trading account would include any account used by a banking entity to acquire or take one or more covered financial positions that are “covered positions” under the Market Risk Capital Rules as implemented in the United States.5

(i) Most FBOs will not be required to apply the Market Risk Capital Rule Test because the Proposed Rule would define the Market Risk Capital Rules to include only the U.S. rules implementing the Basel Committee market risk framework.

(ii) The Proposed Rule is somewhat ambiguous regarding the extent to which the Market Risk Capital Rule Test would

5 The current “Market Risk Capital Rules” are set forth in: 12 C.F.R. Part 3, Appendix B

(OCC); 12 C.F.R. Part 208, Appendix E (Federal Reserve: state member banks); 12 C.F.R. Part 225, Appendix E (Federal Reserve: BHCs/FHCs); 12 C.F.R. Part 325, Appendix C (FDIC).

The Federal banking agencies have proposed revisions to the Market Risk Capital Rules that would conform the U.S. Rules more closely to the Basel Committee’s definition of “trading book”. See 76 Fed. Reg. 1890 (Jan. 11, 2011) (solicitation of public comments). See generally Interpretive Issues with Respect to the Revisions to the Market Risk Framework (Basel Committee, Nov. 2011).

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apply to an FBO’s U.S. BHC subsidiary that is (or becomes) subject to the U.S. Market Risk Capital Rules, or to such a BHC subsidiary’s affiliates.

(c) Dealer Registration Test: A trading account would also include any account used by a banking entity to acquire or take one or more covered financial positions for any purpose, if the banking entity is a registered securities dealer, municipal securities dealer, government securities dealer, swap dealer or security-based swap dealer (each a “dealer”).

(i) In each case, the definition would apply to the extent a position is acquired or taken in connection with the activities of the dealer that require it to be registered.

(ii) The definition would apply to a banking entity engaged in the business of a dealer outside of the United States to the extent a position is acquired or taken in connection with the activities of such business.

(iii) One impact of the Dealer Registration Test is that each dealer would be required to implement the full range of compliance, reporting and recordkeeping programs contemplated by the Proposed Rule.

(iv) In the context of any particular FBO, determining whether the entity is “engaged in the business” of a dealer, or whether a position was taken “in connection with” the entity’s dealing activities, may not always be clear. In practice, this may mean that the Volcker Rule could apply to all positions held by an FBO itself (if the FBO is itself engaged in dealer activities as a universal bank) or in any of the FBO’s foreign dealer subsidiaries.

E. Interaffiliate Transactions

1. The Proposed Rule does not address the treatment of interaffiliate transactions. From a common sense perspective, such transactions -- which are typically entered into as a way to manage enterprise-wide risk, liquidity and capital (although other purposes are also possible) -- would seem to be outside the scope of the definition of proprietary trading.

2. However, the Proposed Rule’s approach to defining trading account (on an entity-by-entity basis), as well as the application of the 60-day rebuttable presumption, raises a question whether some interaffiliate trades, swaps and other positions could fall into the definition of proprietary trading.

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3. Were this to occur, it is not clear that the permitted trading activities described below would be sufficient to exempt all such transactions, and the burden of documenting such transactions in order to rely on these exemptions could create substantial inefficiencies.

4. Application of the Volcker Rule on an entity-by-entity basis could have especially severe consequences for FBOs operating in the United States that manage their market positions, liquidity and capital on a global basis.

IV. General Volcker Rule Exceptions

A. Instruments Exempt from the Proprietary Trading Prohibition

1. Exempt government securities.

(a) The Volcker Rule exempts proprietary trading in U.S. government securities, securities of U.S. sponsored enterprises (including Ginnie Mae, Fannie Mae and Freddie Mac), and obligations of U.S. states and political subdivisions.

(b) Options and other derivatives on exempt government securities are not exempted.

(c) While the Proposed Rule would not exclude the sovereign debt of other nations -- which may be in violation of certain U.S. treaty obligations, including under NAFTA -- Question 122 in the Preamble to the Proposed Rule (the “Preamble”) does at least invite public comment on whether the Proposed Rule should include “an additional exemption for proprietary trading in the obligations of foreign governments and/or international and multinational development banks . . . If so, what types of obligations should be exempt? How would such an exemption promote and protect the safety and soundness of banking entities and the financial stability of the United States?”

2. “Identified Banking Products” such as deposit accounts, savings accounts, certificates of deposit and banker’s acceptances.

3. Loans and loan participations (including in connection with sales and securitizations), but not securities backed by loans.

4. “Spot” transactions in physical commodities, precious metals, energy products, foreign exchange and currency.

(a) The Proposed Rule does not provide guidance on what settlement timeframe is necessary for a spot transaction to qualify for the exemption.

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(b) Options and other derivatives on foreign exchange and related transactions are not exempted.

5. Investments in small business investment companies and community development investment funds.

B. Trading Activities Permitted Under the Volcker Rule6

1. Repurchase or reverse repurchase arrangements and securities lending transactions.

2. Positions taken for bona fide liquidity management purposes subject to a documented liquidity management plan.

3. Underwriting/“market-making-related” activities subject to specific criteria designed to ensure that prohibited proprietary trading is not disguised as a permitted activity, including that:

(a) The banking entity has established a comprehensive internal compliance program.

(b) The banking entity is registered as a dealer with the appropriate regulator, or otherwise is exempt from registration or excluded from regulation as a dealer.

A banking entity located outside the United States would be required to be engaged in the business of a dealer outside the United States and be subject to substantive regulation of such business in that jurisdiction.

(c) The activity is designed not to exceed the reasonably expected near-term demands of clients, customers and counterparties.

(d) The activity is designed to generate revenues primarily from fees, commissions, underwriting or bid-ask spreads or other income not attributable to appreciation in the value of covered financial positions the banking entity holds related to such activities or the hedging of such covered financial positions.

6 The Volcker Rule: Considerations for Implementation of Proprietary Trading

Regulations (Securities Industry and Financial Markets Association/Oliver Wyman & Co., 2011) includes a detailed description of how permitted underwriting, market-making, hedging and related activities provide essential liquidity in various asset classes (securities, derivatives and commodities), and raises concerns if Volcker Rule implementation does not accurately reflect market realities.

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(e) The banking entity’s compensation arrangements are designed to primarily reward client revenues and effective client services, not to encourage proprietary risk-taking.

(f) Under the Proposed Rule, with respect to underwriting activities:

(i) “Underwriting” would be limited to transactions which involve (A) purchases and sales of securities that are (B) effected solely in connection with a distribution of securities for which the banking entity is acting as an underwriter.7

(ii) A “distribution” is identified by the presence of a greater than normal magnitude of sales and special selling efforts. Based on Regulation M precedents, transactions that could potentially be deemed distributions under the underwriting exception include registered public offerings, private placements, transactions pursuant to Rule 144A under the Securities Act of 1933, major sales campaigns by a broker-dealer, and sales made pursuant to a shelf registration statement.

(g) Under the Proposed Rule, with respect to market-making-related activities:

(i) Such activities would be limited to “trading desk[s] or other organizational unit[s]” that:

(A) Are engaged in “bona fide” market making in the covered financial position (where the “organizational unit that conducts the purchase or sale holds itself out as being willing to buy and sell, including through entering into long and short positions in, the covered financial position for its own account on a regular or continuous basis”); and

(B) Conduct their activities in a manner consistent with commentary set forth in an appendix to the Proposed Rule (“Appendix B”) with respect to the factors that distinguish market-making from proprietary trading.

7 The Proposed Rule’s definitions of distribution and underwriter mirror the definitions in

the SEC’s Regulation M (17 C.F.R. Part 242 (“Regulation M”)), and the Proposed Rule indicates that the terms should be interpreted in a manner consistent with interpretations under Regulation M.

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(ii) Appendix B includes a substantial discussion of the different characteristics of market-making and proprietary trading, and identifies six factors that could lead the regulators to find a banking entity’s market-making activities to be prohibited proprietary trading:

(A) Trading activity in which a trading unit retains risk in excess of the size and type required to provide intermediation services to customers.

(B) Trading activity in which a trading unit primarily generates revenues from price movements of retained principal positions and risks, rather than customer revenues.

(C) Trading activity in which a trading unit (1) generates only very small or very large amounts of revenue per unit of risk taken, (2) does not demonstrate consistent profitability, or (3) demonstrates high earnings volatility;

(D) Trading activity in which a trading unit either (1) does not transact through a trading system that interacts with orders of others or primarily with customers of the banking entity’s market-making desk to provide liquidity services, or (2) holds principal positions in excess of reasonably expected near-term customer demands;

(E) Trading activity in which a trading unit routinely pays rather than earns fees, commissions or spreads; and

(F) The use of compensation incentives for employees of a particular trading activity that primarily reward proprietary risk-taking.

(h) If an FBO’s underwriting or market-making-related activities do not fall within the Foreign Trading Exception -- because, for example, the activities involve a U.S. resident counterparty or U.S. personnel -- such activities would need to satisfy numerous applicable conditions on market-making (including restrictions on sources of revenue and employee compensation for these activities and external reporting and recordkeeping requirements).

(i) Application to FBOs of the underwriting/market-making-related conditions creates significant concerns about extraterritorial application of U.S. laws, and compliance may prove to be

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significantly more burdensome for FBOs than for U.S. domestic banking organizations.

4. Trading “on behalf of” customers as principal when (a) acting as investment adviser or trustee, or in a similar fiduciary capacity; (b) in “riskless principal” trades; or (c) trading by insurance companies for the separate accounts of insurance policyholders.

The statutory text of the Volcker Rule would support expanding this exception to include many other types of transactions that a banking entity could undertake to accommodate a customer; e.g., by permitting a banking entity to enter into any transaction as principal to effect a customer’s valid and independent business purpose.8

5. “Risk-mitigating” hedging activities related to “individual or aggregated positions, contracts or other holdings” (i.e., “portfolio” hedging).

(a) “Hedging” activities would be subject to conditions designed to ensure that prohibited proprietary trading is not disguised as permitted hedging, including that:

(i) A banking entity that seeks to rely on the hedging exception must establish a comprehensive internal compliance program.

(ii) Compensation arrangements related to hedging activities must be designed not to reward proprietary risk-taking.

(iii) Hedging activities must be conducted in accordance with written policies, procedures and controls.

(iv) Hedging activities must hedge or otherwise mitigate one or more specific risks related to individual or aggregated positions.

(v) Hedging activities must be reasonably correlated to the risks that the transaction is intended to hedge or otherwise mitigate.

8 The concept of engaging in a transaction as principal “to effect a customer’s valid and

independent business purpose” is well-recognized and is reflected in numerous orders, interpretations and guidance provided by the Federal banking agencies with respect especially to equity, commodity and similar derivative transactions. See, e.g., Guide to Bank Underwriting at Part II.E.3.

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(vi) Hedging activities must not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a contemporaneous transaction.

(vii) Hedging activities must be subject to continuing review, monitoring and management after the hedge position is established.

(b) A banking entity would need to contemporaneously document hedges that are established at a level of the organization that is different from the level of the organization establishing the positions meant to be hedged. At a minimum, the banking entity would need to identify the risk-mitigating purpose of the transaction, the risks to be reduced, and the level of the organization that is establishing the hedge.

(c) The requirements that would be imposed on hedging activities could seriously impair hedging strategies that focus on enterprise-wide risk. More generally, it will be important to make sure that the expressed expectation of significant foresight in banking entities’ hedging decisions -- to be able to identify risks, effectively hedge the risks without significant other exposures, and continually review such hedges -- not create compliance traps for banking entities.

(d) The additional burdens placed on hedging activities in the United States may cause FBOs to seek to hedge risks -- even those arising from U.S. activities -- outside of the United States using the Foreign Trading Exception, despite the potential for additional costs and inefficiencies.

C. A foreign or domestic regulated insurance company and its affiliates would be exempted from the proprietary trading ban when trading for the insurance company’s “general account”.

V. The Foreign Trading Exception: Permitted Trading by Foreign Banking Entities Outside of the United States

A. The Proposed Rule would permit banking entities that are organized under foreign law and controlled only by entities organized under foreign law to engage in proprietary trading outside of the United States. The U.S. subsidiaries, branches and agencies of foreign banking entities are not eligible for the Foreign Trading Exception, nor are foreign subsidiaries of FBOs if they are controlled by a U.S. intermediate company.

1. Text of the Foreign Trading Exception. Under the statutory text, the Volcker Rule’s prohibitions do not apply to “[p]roprietary trading

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conducted by a banking entity pursuant to paragraph (9) or (13) of section 4(c) [of the BHCA], provided that the trading occurs solely outside of the United States and that the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or of one or more States”.

2. “QFBO” Requirement. An FBO which seeks to rely on the Foreign Trading Exception would be required to be a qualifying foreign banking organization (“QFBO”).9

(a) The QFBO requirement in the Proposed Rule appears to be intended to satisfy the statutory mandate that proprietary trading under the Foreign Trading Exception be conducted pursuant to Section 4(c)(9) or 4(c)(13) of the BHCA. The discussion in the Preamble strongly suggests that QFBO status alone should be sufficient to satisfy this mandate.

(b) Under the Proposed Rule, a banking entity that is not an FBO, and therefore not generally subject to the BHCA, would be required to satisfy a test that largely mirrors the QFBO test.

3. Solely Outside of the United States. Transactions under this exception must take place “solely outside of the United States”. The Proposed Rule takes a narrow interpretation of the statutory text, and would deem a transaction to have taken place solely outside of the U.S. only where:

(a) No party to the transaction is a resident of the United States;

(b) No employee of the banking entity who is directly involved in the transaction is physically located in the United States (although personnel performing purely administrative, clerical or ministerial functions would not be subject to this restriction); and

(c) The transaction is “executed” wholly outside the United States, a requirement apparently intended to exclude U.S. execution facilities.

4. U.S. Resident Definition

(a) The Proposed Rule’s definition of “U.S. resident” is based on, but broader than, the definition of U.S. person under the SEC’s Regulation S.10 For example, the Proposed Rule appears to define

9 12 C.F.R. Part 211, subpart B.

10 17 C.F.R. Part 230 (“Regulation S”). See specifically 17 C.F.R. § 230.902(k).

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U.S. resident to include the foreign branches of U.S. residents (e.g., foreign branches of U.S. banks and insurance companies), which are specifically excluded from the comparable definition under Regulation S.11

(b) This difference could be problematic from the perspective of U.S. banking entities which conduct permissible trading activities through their overseas branches; such branches would not be eligible counterparties of an FBO under the Foreign Trading Exception, and the FBO would need to rely on a different exception from the proprietary trading prohibition for transactions with such branches.

(c) The U.S. resident limitation in the Foreign Trading Exception should generally permit foreign banking entities to trade with all natural persons (including U.S. citizens) who reside outside the United States, and with the foreign subsidiaries of U.S. companies (so long as such subsidiaries were not formed principally for the purpose of trading with FBOs relying on the Foreign Trading Exception), subject to compliance with other terms of the Foreign Trading Exception and the Proposed Rule’s anti-evasion provisions.

(d) The U.S. resident limitation in the Foreign Trading Exception should also permit a foreign banking entity to trade on a foreign exchange, so long as (i) the foreign exchange does not permit direct participation by U.S. residents, and (ii) trading by foreign members of the exchange on behalf of U.S. residents does not take place on a disclosed basis.

B. Practical Issues Raised by the Narrowness of the Foreign Trading Exception

1. An FBO would not be able to engage in proprietary trading outside the United States in reliance on the Foreign Trading Exception if U.S. counterparties, U.S. execution facilities or personnel in the U.S. are involved in the trading.

11 Question 295 in the Preamble invites public comment on whether the Proposed Rule

“effectively define[s] a resident of the United States for . . . purposes [of the Foreign Trading Exception]? If not, how should the definition be altered? What definitions of resident of the United States are currently used by banking entities? Would using any one of these definitions reduce the burden of complying with [the Volcker Rule]? Why or why not?”

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2. Accordingly, all trading with U.S. counterparties or on U.S. exchanges/execution facilities would be subject to the operation of the Volcker Rule.

3. Questions remain as to whether “execution” -- which, under the Proposed Rule’s articulation of the Foreign Trading Exception, must take place outside of the United States -- could include payment, clearing, settlement and custody, or instead would be limited to its commonly understood meaning; i.e., the venues where counterparties reach legally binding agreements (e.g., exchanges, swap execution facilities and other trading platforms).

C. Policy Issues Raised by the Narrowness of the Foreign Trading Exception

1. The narrow interpretation of the Foreign Trading Exception that the Proposed Rule reflects is not required by the plain language of the Volcker Rule’s statutory text, which focuses on the location of the activity that a banking entity conducts as principal and where a banking entity exposes itself to risk: the Volcker Rule itself requires only that “trading occur[ ] solely outside of the United States”.12

(a) The manner in which the Proposed Rule appears to apply the concept of what it means for an activity to be conducted “solely” outside of the United States is inconsistent with longstanding banking and securities law precedents that have determined the location of trading and similar activity based on the location of the risk and the ultimate mind and management of the activity (and not

12 Question 293 and 294 in the Preamble at least invite public comment on the appropriate

scope of the Foreign Trading Exception:

“Question 293. Are the Proposed Rule’s provisions regarding when a transaction or activity will be considered to have occurred solely outside the United States effective and sufficiently clear? If not, what alternative would be more effective and/or clearer? Should additional requirements be added? If so, what requirements and why? Should additional requirements be modified or removed? If so, what requirements and why or how?”

“Question 294. Is the proposed [Foreign Trading Exception] consistent with the purpose of the [Dodd-Frank Act]? Is the proposed [Foreign Trading Exception] consistent with respect to national treatment for foreign banking organizations? Is the proposed [Foreign Trading Exception] consistent with the concept of competitive equity?”

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by consideration of such factors as the location of the counterparty).13

(b) The Proposed Rule justified this divergence on grounds of concern over “competitive parity”, but “competitive party” is not a concept which the Volcker Rule prescribes.

2. Cross-border transactions have been analyzed under both banking and securities laws based on the location of risk and management.

(a) For example, prior to the passage of the Gramm-Leach-Bliley Act, the Federal Reserve and the OCC repeatedly affirmed that a non-U.S. entity could conduct U.S. dealing activity through an affiliated U.S. bank or broker acting as agent consistent with the Glass-Steagall Act’s prohibition on banks and BHCs dealing and underwriting securities in the United States, because the dealing activity would be attributed to the foreign affiliate which holds the risk as principal and exercises ultimate control of the dealing/underwriting operation, and not to the U.S. agent.14

13 Indeed, in 1991 the Federal Reserve explicitly reversed the position it had originally

taken in 1970 (American International Bank Letter re Investment in Henry Ansbacher & Co. Ltd., Nov. 13, 1970), and concluded that it was not inconsistent with a requirement that a foreign bank subsidiary of a U.S. banking organization only “engage in international or foreign banking and financial activity” for the foreign bank, acting from outside the United States, to make loans to U.S. borrowers for U.S. domestic purposes. 56 Fed. Reg. 19549, 19563-64 (Apr. 29, 1991).

14 Reference is made in the Guide to Bank Underwriting at Part XI.E for an extensive discussion of applicable precedent. See, e.g., OCC Interpretive Letter No. 371 (June 13, 1986) (granting Citibank, N.A. permission to acquire Vickers de Costa Securities, Inc., a U.S. registered broker-dealer, and concluding that Vickers could continue to conduct brokerage on behalf of foreign subsidiaries of Citicorp despite the Glass-Steagall Act’s prohibition on dealing in securities in the United States because the principal risk of the trades would be borne outside of the United States and not by Vickers itself); Security Pacific Corp. (“SecPac”) (Federal Reserve Approval Letter, Apr. 18, 1988) (granting SecPac permission to acquire control of a U.S. registered broker-dealer and concluding that the broker-dealer could act as a broker for foreign affiliates of SecPac without violating the Glass-Steagall Act’s prohibition on dealing in securities in the United States, focusing on the location of the risk and ultimate mind and management).

Although in the context of cross-border underwriting by foreign banks that were not otherwise authorized to engage in underwriting in the United States, the Federal Reserve (in 12 C.F.R. § 211.605) concluded that public underwriting involving an affiliated U.S. agent of U.S. registered securities for distribution in the United States is an activity “in the United States” even if the underwriting risk is assumed outside the United States, the

(continued)

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(b) The SEC has likewise long adhered to the position that when a foreign broker or dealer conducts securities transactions with U.S. persons through a U.S. registered broker-dealer (which acts as agent or intermediary), that foreign broker-dealer’s operations (including its dealing positions) remain, for regulatory, operational, capital and other purposes, outside of the United States and outside of the U.S. regulatory framework.15

(c) Moreover, unlike with respect to the FBO-related exception from the Volcker Rule prohibition on certain private equity and hedge fund operations conducted “solely outside of the United States” (the “Foreign Fund Exception”, and together with the Foreign Trading Exception, the “Foreign Activity Exceptions”) -- which prohibits the offer or sale of a “foreign” fund “to a resident of the United States”, the statutory text of the Foreign Trading Exception does not include any comparable language with respect to proprietary trading transactions with “U.S. residents”.

3. Congress appears to have crafted the Foreign Activity Exceptions to avoid unwarranted U.S. limitations on proprietary trading and fund-related activities conducted by non-U.S. entities outside of the United States.16 The implementation of these Exceptions in the narrow manner

___________________________ (continued)

Federal Reserve reached this conclusion in the context of concern that a U.S. affiliate without underwriting power could be evading the statutory framework under the Gramm-Leach-Bliley Act. However, recognizing the difference between U.S.-directed underwriting, on the one hand, and non-U.S. dealer transactions, on the other, the Federal Reserve did not extend this analysis to dealing in securities which foreign banks conduct in accordance with longstanding Federal Reserve precedent.

15 For example, Rule 15a-6 under the Securities Exchange Act of 1934 exempts a foreign broker or dealer from the Exchange Act’s registration requirements where such foreign broker or dealer effects transactions outside the United States in securities with U.S. investors through a U.S. registered broker-dealer, subject to certain conditions. See also SecPac (avail. July 7, 1988) (one of several pre-Rule 15a-6 SEC no-action letters permitting a BHC’s U.S.-registered broker-dealer subsidiary to act as agent in executing orders placed by non-U.S.-registered foreign affiliates; see also Guide to Bank Underwriting at Part IX.E.2).

16 See, e.g., 156 Cong. Rec. S5897 (daily ed. July 15, 2010) (colloquy between Sen. Merkley and Sen. Levin) (“[the Foreign Activity Exceptions] recognize rules of international regulatory comity by permitting foreign banks, regulated and backed by foreign taxpayers, in the course of operating outside of the United States to engage in activities permitted under relevant foreign law”).

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contemplated by Proposed Rule, however, would have significant extraterritorial effects.

4. The narrow definition of a permissible “foreign” transaction proposed in the Foreign Trading Exception -- a clear departure from the ways that U.S. banking and securities regulators have analyzed cross-border transactions in loans and securities for more than 20 years -- is likely to raise significant concerns at the level of EU, European national and Asian national banking regulators regarding what appears to be a broadly extraterritorial approach to the application of the Volcker Rule and a violation of principles of international comity. The legislative history of the Dodd-Frank Act specifically directed U.S. regulators to take an approach to cross-border application of the Volcker Rule in a manner consistent with prior Federal Reserve precedent.17

5. FBOs may, in general, seek to avoid or limit transactions as principal with U.S. counterparties (including foreign branches of U.S. banks, and U.S. dealers and fiduciaries trading on behalf of foreign customers) outside of the United States, adversely affecting global liquidity in a wide range of securities, derivatives and other markets.

6. Narrow application of the Foreign Trading Exception could also adversely affect the willingness of foreign banking entities to invest (and conduct operations) in the United States, and may result in the movement of jobs and transactions overseas.

(a) Foreign banking entities may consider redirecting their trading in U.S. assets to other foreign financial institutions which are not themselves Volcker Rule “banking entities” and which may themselves engage in transactions with U.S. counterparties.

(b) In addition, FBOs may seek to establish or facilitate the operation of alternate trading platforms outside the United States for the purpose of engaging in home country-permitted proprietary trading activities involving U.S. securities.

17 See, e.g.,156 Cong. Rec. S5889-S5890 (daily ed. July 15, 2010) (statement of Sen.

Hagan) (“For consistency’s sake, I would expect that, apart from the U.S. marketing restrictions, [the Foreign Fund Exception] will be applied by the regulators in conformity with and incorporating the Federal Reserve’s current precedents, rulings, positions, and practices under sections 4(c)(9) and 4(c)(13) of the [BHCA] so as to provide greater certainty and utilize the established legal framework for funds operated by bank holding companies outside of the United States”).

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VI. Other Considerations

A. “Anti-evasion” Provisions. Regulators would be permitted to compel termination/divestiture of activities and investments that function as an “evasion” of the Volcker Rule.

B. “Backstop Provisions”. No trading activities that would otherwise be permitted would be permitted if they would result in (1) “material” conflicts of interest between the banking entity and its clients, customers or counterparties; (2) “material” exposure to “high-risk” assets and trading strategies; or (3) threats to the safety and soundness of the banking entity or the financial stability of the United States.

Because the Backstop Provisions would apply to activities permissible under the Foreign Activity Exceptions, they could be read to provide an independent basis to prohibit or condition activities of FBOs, even those which are conducted wholly outside the United States.

C. Reporting and Recordkeeping Requirements.

1. The Proposed Rule would impose significant reporting and recordkeeping requirements on banking entities that engage in trading activities. The requirements include:

(a) Specific reporting of quantitative metrics by banking entities with over $1 billion in consolidated worldwide trading assets and liabilities. Banking entities with over $5 billion in consolidated worldwide trading assets and liabilities would report on a broader cross-section of data.

(b) Reporting on 6 different metrics by hedging, underwriting and government securities units, and up to 22 different metrics for market-making units.

(c) A prescriptive 6-part compliance program for significant traders with over $1 billion in consolidated worldwide trading assets and liabilities.

2. There is no express limit on the extraterritorial application of these requirements. It is not clear from the Proposed Rule the extent to which FBOs could limit their compliance with these reporting requirements to only a subset of the organization, or to only their U.S.-facing activities, nor how U.S. regulators would examine such compliance programs.

3. An FBO that seeks to engage in any market-making, underwriting or other permitted trading in the United States may be required to implement the Proposed Rule’s reporting measures outside the United States on a global basis, including as to all of its non-U.S. operations.

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D. Conformance Period.

1. In February 2011, the Federal Reserve issued its final rule regarding the conformance period for banking entities engaged in activities which, ultimately, may be prohibited by the Volcker Rule (the “Conformance Rule”).18

2. The Volcker Rule’s statutory effective date is July 21, 2012. Under the Conformance Rule, a banking entity will have an additional two-year period (until July 2014) during which it can wind down any proprietary trading activity. This two-year period can be extended by up to three one-year periods, which could delay conformance in certain circumstances until July 21, 2017.

(a) A banking entity must request an extension 180 days in advance of the statutory conformance date, explaining the reasons for the request, and providing a detailed plan for divestiture or conformance. The Federal Reserve has indicated that it expects to act on such requests within 90 days of receipt of a complete record. Although commenters have suggested that the Federal Reserve has the authority to grant one three-year extension of the conformance date, the Conformance Rule provides that the conformance period cannot be extended for more than one year at a time.

(b) To approve an extension, the Federal Reserve must determine that the extension would be consistent with the purposes of the Volcker Rule and not detrimental to the public interest. The Conformance Rule provides that the Federal Reserve must take into account the following factors in order to grant an extension for otherwise prohibited proprietary trading activities:

(i) Whether the activities:

(A) Would involve or result in material conflicts of interest between the banking entity and its clients, customers or counterparties;

(B) Would result, directly or indirectly, in a material exposure by the banking entity to high-risk assets or high-risk trading strategies;

(C) Would pose a threat to the safety and soundness of the banking entity; or

18 See 12 C.F.R. §§ 225.180 et seq.

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(D) Would pose a threat to the financial stability of the United States.

(ii) Market conditions.

(iii) The nature of the proprietary trading in question.

(iv) The total exposure of the banking entity in respect of proprietary trading, and any risks that disposing or maintaining the relevant trading positions may pose to the banking entity or to U.S. financial stability.

(v) The cost of divestiture or conformance.

(vi) The banking entity’s prior efforts to divest or conform, evaluated under a “reasonable best efforts” standard.

3. The conformance period for financial institutions that become banking entities after July 21, 2012, will extend for two years from the date they first became banking entities subject to the Volcker Rule.

4. The preamble to the Conformance Rule19 indicated that the conformance period applies only to “activities commenced prior to the Volcker Rule’s effective date”, which left open the question of what activities will be permitted during the conformance period itself. The Preamble to the Proposed Rule clarified that proprietary trading operations existing as of the effective date of the Volcker Rule will be able to continue to operate during the conformance period, but that activities must be conformed “as soon as practicable” during the conformance period.

(a) The Proposed Rule suggests that a banking entity will be required to identify the “trading units” in its organization that are engaged in proprietary trading, and describe the types of proprietary trading in which they engage. Trading units would not be permitted to expand their proprietary trading activities after the effective date of the Volcker Rule, or to begin new proprietary trading activities they were not involved in prior to the effective date.

(b) It is unclear whether “as soon as practicable” means “as soon as possible” or “when it makes sense to do so.” While there should be some flexibility to continue proprietary trading activities past July 2012, regulators may want to see some concrete steps towards winding down of activities during the conformance period.

19 See 76 Fed. Reg. 8265 (Feb. 14, 2011) (final rule).

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(c) The expectations of regulators with respect to the pace of conformance are not entirely clear. They appear to understand that achieving full conformance will be a difficult, iterative process, but expect that banking entities will have made good faith efforts to develop proper compensation structures (including identification of any problematic pay practices) and compliance, reporting and recordkeeping systems by the effective date of the Volcker Rule.

E. Comments on the Proposed Rule are due by January 13, 2012 (unless, as some commentators have requested, the comment period is extended), with a final rule likely to be issued in late spring 2012. The Federal Reserve stated in the Preamble to the Conformance Rule that it expects to review the Rule again once the final regulations implementing the Volcker Rule are issued, to determine whether adjustments or modifications might be appropriate. Because the Proposed Rule is only a preliminary proposal, and many open issues are yet to be resolved or may be subject to change, it is possible that there will be extensions to the Volcker Rule effective date and/or conformance period.

Robert L. Tortoriello Tel. No.: 212-225-2390 E-mail: rtortoriello@cgsh.com

Patrick Fuller

Tel. No.: 202-974-1534 E-mail: pfuller@cgsh.com

Melissa M. Ruth

Tel. No.: 212-225-2843 E-mail: mruth@cgsh.com