the volcker rule's impact on foreign banking …the “volcker rule” is the popular name for...

Vol. 30 No. 8 August 2014

HENRY M. FIELDS and BARBARA R. MENDELSON are partners

in the Financial Services practice group of Morrison & Foerster LLP.

Mr. Fields practices in the Los Angeles office of the firm and may be

reached at [email protected]. Ms. Mendelson practices in the New

York office and may be reached at [email protected]. Julian E.

Hammar, of counsel in Morrison & Foerster’s Washington, D.C.

office, contributed significantly to the discussion of the Volcker Rule’s

impact on derivative activities. Assistance in the preparation of the

article was also provided by Diana E. Whitaker, a financial services

associate of the firm.

IN THIS ISSUE

● THE VOLCKER RULE’S IMPACT ON FOREIGN BANKING ORGANIZATIONS

August 2014 Page 97

THE VOLCKER RULE’S IMPACT ON FOREIGN BANKING ORGANIZATIONS

The Volcker Rule imposes U.S. bank regulatory, conflict-of-interest, and compliance rules on the proprietary trading and fund sponsorship, and investment activities of foreign banking organizations (FBOs) both inside and outside the United States. There are exclusions and exemptions in the rule designed, among other things, to mitigate its extraordinary extraterritorial reach. The authors discuss (i) the rule’s complicated provisions as spelled out in the final regulations implementing the statute and (ii) the challenges these present to FBOs forced to grapple with difficult issues of U.S. law and regulation that may depart significantly from those of their home country.

By Henry M. Fields and Barbara R. Mendelson *

The “Volcker Rule” is the popular name for Section 619 of

the Dodd-Frank Wall Street Reform and Consumer

Protection Act (“Dodd-Frank Act”).1 Section 619 was

named after former Federal Reserve Chairman Paul

Volcker, who, in the aftermath of the financial crisis,

championed measures to lower risk-taking by financial

institutions.

In broad brush, the legislation prohibits (with

exceptions) financial institutions and their affiliates from

engaging in proprietary trading, and from sponsoring

and investing in private equity and hedge funds. On

December 10, 2013, following considerable industry and

———————————————————— 1 Pub. L. 111-203 (2010). The Volcker Rule is now embodied as

section 13 of the Bank Holding Company Act of 1956, as

amended (“BHCA”), 12 U.S.C. § 1851.

public comment, the Federal Reserve, the Office of the

Comptroller of the Currency, the Federal Deposit Insurance

Corporation, the Securities and Exchange Commission, and

the Commodity Futures Trading Commission (collectively,

“Agencies”) adopted a final rule implementing the Volcker

Rule (“Final Rule”).2 The Final Rule was accompanied by

———————————————————— 2 Prohibitions and Restrictions on Proprietary Trading and Certain

Interests in, and Relationships With, Hedge Funds and Private

Equity Funds, 79 Fed. Reg. 5536 (Jan. 31, 2014). The CFTC

separately issued an identical version of the Volcker Rule. See

79 Fed. Reg. 5808 (Jan. 31, 2014). All citations in this article to

the Volcker Rule refer to the version as promulgated by Federal

Reserve under 12 C.F.R. Part 248. The OCC’s version of the

Final Rule can be found under 12 C.F.R. Part 44, the FDIC’s

under 12 C.F.R. Part 351, the SEC’s under 17 C.F.R. Part 255,

and the CFTC’s under 17 C.F.R. Part 75.

August 2014 Page 98

extensive commentary, referred to herein as the

“Preamble.”3 References in this article to the Volcker Rule

refer to the legislation as construed by the Agencies in the

Final Rule and in the Preamble.

The Volcker Rule regulates activity by “banking

entities” — broadly defined to include U.S. banks and

savings and loan associations, bank holding companies and

savings and loan holding companies, and foreign banking

organizations that control U.S. banks or that operate

branches or agencies in the United States and their parent

organizations (“FBOs”), and foreign and domestic affiliates

of these entities.4

This article summarizes the Volcker Rule prohibitions

on proprietary trading and sponsorship of and investment in

“covered funds” and focuses, in each case, on the special

impact the Volcker Rule has on FBOs, especially with

respect to activities conducted largely outside the United

States. The Volcker Rule is highly complex. In many

areas, detailed knowledge of U.S. banking, commodities,

and securities laws is critical to understanding its impact.5

We cannot hope to impart that depth of understanding in

this article. Those seeking a detailed understanding of any

specific provisions will need to refer to the legislation and

the Final Rule, as well as the accompanying commentary

contained in the Preamble.

Foreign banks have generally been regulated in the

United States under the principles of national treatment (in

other words, treatment comparable to that accorded

domestic financial institutions) and competitive equality

(creating an equal playing field for foreign and domestic

———————————————————— 3 Citations to the text of the Preamble to the Final Rule

(“Preamble”) refer to approximate location by reference to

footnotes and to page numbers in the Federal Register at 79 Fed.

Reg. 5536-5779.

4 A banking entity does not include a portfolio company held by a

financial holding company under the so-called merchant

banking authority, by an insurance company affiliate, or by a

small business investment company, unless, in any such case,

any such entity is itself a bank, thrift institution, bank holding

company, savings and loan holding company, or an FBO. In

addition, as discussed below, a banking entity does not include a

covered fund.

5 We shall refer throughout this Article to the Commodity

Exchange Act (“CEA”), 7 U.S.C. §§ 1 et seq. and the Securities

Exchange Act of 1934 (“Exchange Act”).

financial institutions within the United States).6 It is well

understood that U.S. branches and agencies of foreign

banks will be subject to the same degree of (or substantially

comparable) regulation as domestic banking entities under

the Volcker Rule, as such branches and agencies compete

in the domestic U.S. banking market. However, as

reflected in the numerous comments received on the

Volcker Rule regulations first proposed in October 2011

(the “Proposed Rule”)7 from FBOs and their

representatives, the extraterritorial application of the

Volcker Rule to the non-U.S. operations of FBOs raises

significant policy issues. Under the banner of protecting

the stability of the U.S. financial system, the Volcker Rule

imposes U.S. bank regulatory rules, conflict-of-interest

rules and compliance requirements on risk-taking, and

investment activities by FBOs in their home countries and

elsewhere outside the United States. Although this

treatment is comparable to the regulation of U.S. banks

with respect to their activities outside the United States, the

extraterritorial application of the Volcker Rule does not

comport with the general principles of home country/host

country regulation, pursuant to which the home country

regulator is responsible for overall prudential supervision of

the home country financial institutions. In addition to such

policy issues, the extraterritorial application of the Volcker

Rule also gives rise to thorny interpretive issues and

difficult questions of implementation.

Congress attempted to address concerns about the

extraterritorial application of the Volcker Rule by

exempting activities of foreign banking entities conducted

solely outside the United States. The Agencies provided

context for this concept in prescribing in the Final Rule

detailed conditions for an exemption for proprietary trading

occurring solely outside the United States. Further, they

created by implication in the Final Rule an exclusion for

foreign fund investment and activity conducted solely

outside the United States, as well as prescribing rules for a

foreign fund exemption. We discuss these exclusions and

exemptions in detail below. As will be seen, it is only with

great difficulty that one can define trading, fund activity,

and investment that occurs “solely outside the United

States.” As a result, these exclusions and exemptions are

———————————————————— 6 These principles were embodied in the International Banking

Act of 1978, 12 U.S.C. §§ 3101 et seq.

7 Prohibitions and Restrictions on Proprietary Trading and Certain

Interests in, and Relationships With, Hedge Funds and Private

Equity Funds, 76 Fed. Reg. 68846 (Nov. 7, 2011).

RSCR Publications LLC Published 12 times a year by RSCR Publications LLC. Executive and Editorial Offices, 2628 Broadway, Suite 29A, New

York, NY 10025-5055. Subscription rates: $650 per year in U.S., Canada, and Mexico; $695 elsewhere (air mail delivered). A 15% discount is

available for qualified academic libraries and full-time teachers. For subscription information and customer service call (866) 425-1171 or visit our Web site

at www.rscrpubs.com. General Editor: Michael O. Finkelstein; tel. 212-876-1715; e-mail [email protected]. Associate Editor: Sarah Strauss

Himmelfarb; tel. 301-294-6233; e-mail [email protected]. To submit a manuscript for publication contact Ms. Himmelfarb. Copyright © 2014 by RSCR Publications LLC. ISSN: 1051-1741. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been

obtained by The Review of Banking & Financial Services from sources believed to be reliable. However, because of the possibility of human or mechanical error

by our sources, The Review of Banking & Financial Services does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible

for any errors or omissions, or for the results obtained from the use of such information.

August 2014 Page 99

narrow in scope and saddled with detailed conditions and

specifications that are likely to prove difficult to construe

and, if successfully construed, equally difficult to satisfy.

Ultimately, clearly distinguishing activities that occur

solely outside the United States in a financial services

industry that is global in its operations and scope may

prove to be an impossible task.

THE PROHIBITION ON PROPRIETARY TRADING

The Proprietary Trading Prohibition: a Primer

Under the Volcker Rule, a banking entity (defined

above) may not trade a “financial instrument” as principal

for its own “trading account.”8 The term “trading account”

is not intended to refer to an actual account in which

financial instruments are traded (although there may be

such accounts). Instead, the term is used as nomenclature

for the transactions subject to the ban on proprietary

trading.9 A financial instrument includes a security, a

derivative, and a contract of sale of a commodity for future

delivery, and options on each of the foregoing. A financial

instrument does not include loans, certain commodities,

foreign exchange, or currency.10

A security is deemed traded if it is bought or sold. A

derivative is deemed sold by a banking entity when it is

executed (e.g., a bank writes an interest rate swap),

terminated (prior to its scheduled maturity), assigned,

exchanged or otherwise transferred, or the rights under the

derivative are extinguished, as the context may require.

Similarly, a commodity future will be deemed “purchased”

when a banking entity enters into the contract for future

delivery.11

A banking entity will be deemed to be trading for its

own trading account in each of three situations:

(i) the trade is for short-term resale or to benefit from

short-term price movements (“Purpose Test”);

(ii) if the banking entity or an affiliate is subject to

U.S. market risk capital rules, the account is used to

trade financial instruments that are both market risk

capital rule covered positions and trading positions, or

hedges of other market risk capital rule covered

positions (“Market Risk Capital Rule Test”);12

or

———————————————————— 8 12 C.F.R. § 248.3(a).

9 Preamble, note 124, 79 Fed. Reg. at 5548 n. 124.

10 Spot foreign exchange transactions are thus not deemed to

constitute proprietary trading of financial instruments.

11 12 C.F.R. §§ 248.2(u) and (x).

12 The language of the Market Risk Capital Rule Test, by using

the term “affiliate,” could, at first glance, be read to mean that

an FBO would be subject to this test if it had a U.S. affiliate

(iii) (A) the trade is by a banking entity that is a

securities dealer,13

swap dealer,14

or security-based

swap dealer,15

or by an entity required to be licensed as

such, to the extent that the trade is of a kind that would

trigger the registration requirement, or (B) the banking

entity is engaged in the business of a dealer, swap

dealer, or security-based swap dealer outside of the

United States, to the extent the financial instrument is

traded in connection with the activities of such

business (“Status Test”).16

Certain observations about the Status Test are in order.

First, domestic banks will have already structured their

securities trading to conform with the exception from the

definition of “dealer” in the Exchange Act for certain bank

securities activities. 17

That exception explicitly permits

banks to buy or sell securities for their own account, or as

trustee or fiduciary for the accounts of their customers, or

trade in certain other common banking instruments.

Therefore, domestic banks should not, in principle, be

concerned about the Status Test on account of their

securities activities.

The situation is not as clear cut for non-banking

affiliates of domestic banks, other than affiliated licensed

securities dealers, which clearly come within the scope of

the Status Test. All other non-banking affiliates would

need to rely on the exception in the definition of “dealer”

for traders who buy and sell securities for their own

account, either individually or in a fiduciary capacity, but

not as part of a regular business.18

The distinction between

“dealers” and “traders” is not always clear. The SEC staff

has taken the position that one who holds oneself out to the

general public as willing to buy or sell securities is likely a

dealer.19

On the other hand, the SEC staff has concluded

footnote continued from previous column…

(such as a U.S. bank holding company or bank subsidiary)

subject to the U.S. market risk capital rules. However, an FBO

would not have market risk capital rule covered positions and

trading positions under the U.S. market risk capital rules. (Nor

would it have information reporting systems to calculate market

risk under the U.S. market risk capital rules.) Accordingly, we

do not believe that the Market Risk Capital Rule Test is

intended to apply to FBOs, although it would apply to an

FBO’s U.S. bank holding company and bank subsidiaries

subject to the U.S. market risk capital rules.

13 Exchange Act, § 3(a)(5), 15 U.S.C. § 78c(a)(68).

14 CEA, § 1a(49), 7 U.S.C. § 1a(49).

15 CEA, § 3a(71), 7 U.S.C. § 78c(a)(71).

16 12 C.F.R. § 248.3(b).

17 Exchange Act, § 3(a)(5)(C), 15 U.S.C. § 78c(a)(5)(C).

18 Exchange Act, § 3(a)(5)(B), 15 U.S.C. § 78c(a)(5)(B).

19 Joseph McCulley Sales, SEC No-Action Letter (Sept. 1, 1972).

August 2014 Page 100

that investment partnerships that actively buy and sell

securities using only their own funds, but which do not hold

themselves out to the public as dealers and do not engage in

market-making, are traders, not dealers.20

This is an area

where non-bank affiliates will need to evaluate their

circumstances and make judgment calls as to whether their

securities trading activities come within the scope of the

Status Test.

Interpretive difficulties also attend those transactions

that would require registration as a “swap dealer”21

or

“security-based swap dealer.”22

In principle, for example,

swaps with a customer by an insured depository institution

in connection with originating a loan with that customer

that meet certain requirements would not require

registration.23

Likewise, swaps or security-based swaps

that hedge a banking entity’s business risk or other end-user

activity generally would not require registration as a swap

dealer or security-based swap dealer.24

Also, trading in

———————————————————— 20

Davenport Management, Inc., SEC No-Action Letter (Apr. 12,

1993).

21 CEA, § 1a(49), 7 U.S.C. § 1a(49). The term “swap dealer”

does not include a person that enters into swaps for such

person’s own account, either individually or in a fiduciary

capacity, but not as a part of a regular business. CEA, §

1a(49)(C), 7 U.S.C. § 1a(49)(C). Nor does it include an entity

that engages in a de minimis quantity of swap dealing in

connection with transactions with or on behalf of its customers.

CEA, § 1a(49)(D), 7 U.S.C. § 1a(49)(D). Currently, a person

engages in a de minimis quantity of swap dealing if it engages

in dealing activity involving no more than $8 billion in notional

amount of swaps over a rolling 12-month period or $25 million

notional with most “special entities” (e.g., states, counties,

cities, etc.). 17 C.F.R. § 1.3(ggg)(4).

22 Exchange Act, § 3(a)(71), 15 U.S.C. § 78c(a)(71). Similar

exceptions apply to the definition of security-based swap dealer

as are contained in the swap dealer definition, including the

“not-as-a-regular-business” and de minimis exceptions. See

note 21 supra.

23 The statutory definition of swap dealer provides that “in no

event shall an insured depository institution be considered to be

a swap dealer to the extent it offers to enter into a swap with a

customer in connection with originating a loan with that

customer.” CEA, § 1a(49), 7 U.S.C. § 1a(49);17 C.F.R.

§ 1.3(ggg)(5). There is no similar exclusion from the definition

of security-based swap dealer.

24 Preamble, note 135, 79 Fed. Reg. at 5549 n.135. See Further

Definition of “Swap Dealer,” “Security-Based Swap Dealer,”

“Major Swap Participant,” “Major Security-Based Swap

Participant,” and “Eligible Contract Participant,” 77 Fed. Reg.

30596, 30611 (May 23, 2012). There may be circumstances

where a person’s activity in entering into swaps to hedge

commercial risk may be considered dealing activity requiring

registration. Id. at 30612.

foreign exchange swaps and forwards25

would not require

registration,26

but foreign currency options and non-

deliverable forwards involving foreign exchange would

need to be taken into account in evaluating whether

registration as a swap dealer is required.27

Certain other

swaps also are not considered in determining whether a

person is a swap dealer or security-based swap dealer as

provided for in CFTC and SEC regulations.28

While

interpretive guidance attempts to clarify when swap or

security-based swap activity will be considered dealing

requiring registration,29

the determination is inherently

subjective, and similar judgment calls may be required as

with the dealer definition. However, even if a transaction

does not meet the Status Test, it will still need to be

evaluated to determine whether it meets the Purpose Test.

The difficulties of applying these highly technical

definitions are compounded when applied to activities of

banking entities outside the United States. Under the Status

Test, if a banking entity is engaged outside the United

States in the business of a dealer, swap dealer, or security-

based swap dealer, the banking entity will be deemed to be

engaged in proprietary trading to the extent the trade is

made in connection with such business.30

The terms

“dealer,” “swap dealer,” and “securities-based swap dealer”

refer to the definitions discussed above. The federal

regulatory agencies rejected a request by representatives of

foreign banks that the Volcker Rule use the relevant foreign

regulators’ counterparts for these terms with respect to

trades outside the United States.31

Accordingly, an FBO or

its non-U.S. affiliate that engages in trading of financial

instruments outside the United States will need to import

the U.S. definitions and related interpretations into its

lexicon to determine whether it is engaged in proprietary

trading under the Volcker Rule. These definitions are

unlikely to conform with those used outside the United

States by home country regulators, which may make it very

difficult to determine whether any particular trade is a

proprietary trade or not under the Status Test. In addition,

———————————————————— 25

A “foreign exchange swap” and a “foreign exchange forward”

are defined in CEA, § 1a(24) and (25), 7 U.S.C. § 1a(24)

and (25).

26 Determination of Foreign Exchange Swaps and Foreign

Exchange Forwards under the Commodity Exchange Act, 77

Fed. Reg. 69694 (Nov. 20, 2012).

27 17 C.F.R. § 1.3(xxx)(2).

28 17 C.F.R. § 1.3(ggg)(6) (CFTC); 17 C.F.R. §§ 240.3a71-1 and

240.3a71-2 (SEC).

29 See Further Definition of Swap Dealer, 77 Fed. Reg. 30596.

30 12 C.F.R. § 248.3(b)(1)(iii)(B).

31 Preamble, note 141 and accompanying text, 79 Fed. Reg. at

5549 n. 141.


exemptions for U.S. banks from certain of the definitions

may not apply to foreign banks.32

Exclusions: Activities Not Considered Proprietary Trading

To mitigate the extensive reach of the proprietary

trading definition, exclusions apply to domestic banking

entities and FBOs alike. For one, trading solely as agent,

broker, or custodian for a customer is not considered

proprietary trading. Second, there are a series of important

transactional exclusions, including the following:33

repurchase agreements and reverse repurchase

agreements;

trading arising under certain securities lending and

borrowing arrangements;

trading securities (but not other financial instruments)

for liquidity management purposes conducted pursuant

to a liquidity management plan of the banking entity

that meets highly prescriptive requirements;34

trades to satisfy an existing delivery obligation;

trades to satisfy a judicial, administrative, arbitration,

or similar proceeding;

trades through a domestic or foreign deferred

compensation plan by the banking entity (as the plan’s

trustee for the benefit of employees); and

trades made in the ordinary course of collecting a debt

previously contracted (“DPC”).

Permitted Proprietary Trading

The Volcker Rule carefully distinguishes between

transactions that are excluded from the definition of

———————————————————— 32

For example, the de minimis exception from the swap dealer or

security-based swap dealer definition applicable to U.S. banks

is not expressly provided for in Section 3(b)(iii)(B) of the Final

Rule.

33 This is not a complete list. See generally 12 C.F.R. § 248.3(d).

34 FBOs that rely on the liquidity management exclusion and are

subject to the proprietary trading reporting obligations

(discussed below) would not be required to include the liquidity

management activities in those reports. Appendix A.II -

Definitions, 79 Fed. Reg. at 5798. However, such FBOs must

describe how they monitor for and prohibit potential or actual

material exposure to high-risk assets or high-risk trading

strategies by each trading desk relying on this exclusion, which

must take into account potential or actual exposure to certain

assets, strategies, and products. Appendix B.II.6. - Other

Compliance Matters, 79 Fed. Reg. at 5801-5802.

proprietary trading (which are not regulated) and

transactions that constitute proprietary trading but are

permitted (which are subject to a compliance regime and

prudential safeguards — referred to in this article as

“prudential backstops”). Specific “permitted” trading

includes trading in U.S. government or government agency

securities, or municipal bonds (but not in derivatives based

on these instruments),35

trading in a riskless principal

capacity,36

and trading in a fiduciary capacity (including as

investment adviser) on behalf of a customer (to the extent

that the banking entity has no beneficial interest in the

financial instrument).37

Trading by a regulated insurance

company affiliate (domestic or foreign) of a banking entity

is also permitted. In addition, the following three broad

categories of trading are permitted: risk-mitigating hedging

activities, market-making activities, and underwriting

activities.38

Each of these three “permitted” proprietary

trading activities is subject to carefully circumscribed and

detailed conditions.39

———————————————————— 35

Preamble, text at notes 1334-1338, 79 Fed. Reg. at 5639-5646.

36 While transactions as agent are excluded from the definition of

proprietary trading, riskless principal transactions are exempted

(and thus subject to a compliance regime and prudential

safeguards). The application of the riskless principal

exemption to derivatives is uncertain. In the Preamble, the

Agencies reported that a commenter had requested guidance

about whether a derivative transaction for a customer with an

offsetting hedged derivative transaction would be considered a

riskless principal transaction. Preamble at note 1429 and

accompanying text, 79 Fed. Reg. at 5648. Presumably the

question was raised because in these offsetting transactions the

banking entity would continue to have obligations to its

customer on one side of the transaction and to its counterparty

on the hedge. The Agencies declined to enter this debate and

referred instead to existing Agency definitions and guidance

regarding riskless principal transactions. Preamble, note 1446

and accompanying text, 79 Fed. Reg. at 5649 n. 1446.

However, all of these references are to riskless principal

transactions involving securities. This leaves open the question

of whether the kind of offsetting transactions discussed above

would be exempted as riskless principal transactions from the

definition of proprietary trading.

37 12 C.F.R. § 248.6. The regulatory agencies declined to

specifically refer to commodity trading advisers as acting in a

fiduciary capacity because of uncertainty as to whether a

commodity trading adviser acts in a fiduciary capacity in each

trade. 79 Fed. Reg. at 5648.

38 12 C.F.R. §§ 248.4, 248.5.

39 For a discussion of the hedging, underwriting, and market-

making exemptions, see User’s Guide to the Volcker Rule

(Feb. 2014), available at http://www.mofo.com/files/

Uploads/Images/131223-A-Users-Guide-to-The-Volcker-

Rule.pdf and the presentation Volcker Rule: Hedging, Market-

http://www.mofo.com/files/%20Uploads/Images/131223-A-Users-Guide-to-The-Volcker-Rule.pdf




To engage in permitted proprietary trading (except

trading of U.S. government, government agency, and

municipal securities), a banking entity must establish and

maintain a comprehensive compliance program reasonably

designed to ensure and monitor compliance with the

Volcker Rule, as well as compliance with the conditions

attached to the conduct of such permitted activities.40

The

compliance regime must be tailored to the size and

complexity of the banking entity’s trading activities. We

discuss the Volcker Rule compliance regime below.

Finally, all such permitted activities are also subject to

prudential backstops, also discussed below, which are

designed to make sure that such permitted activities do not

present undue risk to the banking entities (or to the stability

of the U.S. financial system), or involve material conflicts

of interest that are not adequately addressed.

Special Permitted Activities for FBOs

FBOs face a formidable challenge under the proprietary

trading prohibition. Each FBO (regardless of the extent of

its U.S. activities) must review trading in all financial

instruments in which it engages, not only at branches and

agencies within the United States (as well as in bank and

non-bank subsidiaries in the United States) but also in all of

its offices and affiliates outside the United States to

determine whether it (any of its affiliates) is covered by the

Volcker Rule. If it finds that certain of the activities

outside the United States constitute proprietary trading, but

that the trading is permitted (for example, underwriting,

hedging or market-making activity), then the FBO will

need to superimpose on its home country compliance

regime specific Volcker Rule compliance requirements, and

it will also be obligated to comply with the prudential

backstops.

Certain exemptions are available that somewhat mitigate

the harshness of the Volcker Rule for the non-U.S.

activities of an FBO.

The SOTUS Exemption. The Volcker Rule exempts

foreign banking entities from the prohibition against

proprietary trading to the extent the activity is conducted

“solely outside the United States” (the so-called “SOTUS

Exemption”).41

In determining what constitutes activity

conducted solely outside the United States, the Volcker

Rule (as embodied in the Final Rule) takes a risk-based

approach: it seeks to have the principal risks of proprietary

trading under the SOTUS Exemption remain outside the

footnote continued from previous page…

Making and Regulatory Oversight (Jan. 14, 2014), available at

http://www.mofo.com/files/Uploads/Images/140114-Volcker-

Rule.pdf.

40 12 C.F.R. §§ 248.20(a) and (f)(1).

41 12 C.F.R. § 248.6(e).

United States, while mitigating potentially adverse

competitive effects.

A foreign banking entity is permitted to rely on the

SOTUS Exemption to engage in proprietary trading subject

to the following requirements:

the foreign banking entity may not be a U.S. banking

entity, or directly or indirectly controlled by a U.S.

banking entity;

if an FBO, the foreign banking entity must be a

qualified foreign banking organization, or “QFBO” —

in other words, a majority of its business and banking

activities must be outside the United States;42

if not an FBO (for example, a foreign securities

affiliate of an FBO), the foreign entity must be

organized outside the United States and have a

majority of its business outside the United States;

the FBO or any affiliate engaging in the trading

activity (including any relevant personnel of the FBO

or its affiliates that arrange, negotiate, or execute the

trades (but not those who clear or settle the trades)

must be located outside the United States;

the trading decisions must be made outside of the

United States;

the trades, including any related hedging transactions,

must be booked, and the profit or loss must be

accounted for as principal, outside of the United States

in an entity that is not organized under the laws of the

United States;

no financing of any trades may be provided by a U.S.

branch or agency, or affiliate of the FBO; and

trades may not be conducted with or through a U.S.

entity except:

— trades with the foreign operations of a U.S. entity

as long as no personnel of the U.S. entity who are

involved in the arrangement, negotiation, or

execution of the trades are located in the United

States;

— trades with an unaffiliated intermediary (such as an

unaffiliated U.S. broker-dealer) acting as principal,

provided that the trades are promptly cleared and

settled through a clearing agency or derivatives

clearing organization acting as a central

counterparty; or

———————————————————— 42

Federal Reserve Regulation K, 12 C.F.R. § 211.23(a). Under

the Final Rule, a “quasi-QFBO” also qualifies. 12 C.F.R.

§ 211.23(c).

http://www.mofo.com/files/Uploads/Images/140114-Volcker-Rule.pdf

http://www.mofo.com/files/Uploads/Images/140114-Volcker-Rule.pdf


— trades with an unaffiliated market intermediary

acting as agent if conducted anonymously on an

exchange or similar trading facility, and promptly

cleared and settled through a clearing agency or

derivatives clearing organization acting as a central

counterparty.

Reliance on the SOTUS exemption, as with other

exemptions for permitted activities of FBOs, will also

require adherence to the Volcker Rule compliance regime,

as well as adherence to the prudential backstops. However,

the value of the SOTUS exemption is that it establishes a

“bright line” test for compliance based on the identity of the

counterparty (a non-U.S. entity, with the three exceptions

noted above) with which the FBO or its affiliate is trading.

The prudential backstop requirements discussed below,

however, are troubling, as they import U.S. business

conduct and risk management standards, and U.S. conflict-

of-interest principles (and mitigation measures for such

conflicts of interest) into the non-U.S. trading desks of

foreign banks and their affiliates.

Given the complexity of compliance with the permitted

underwriting, market-making, and hedging exemptions,

many FBOs may choose to restructure their trading

activities to come within the SOTUS Exemption. It

remains to be seen whether this is likely to have a negative

effect on the depth, breadth, and preeminence of U.S.

markets.

Permitted trading in foreign government obligations.

The Proposed Rule did not contain an exemption for

trading in foreign sovereign debt. The lack of such an

exemption was heavily criticized by foreign governments

and foreign banks. They argued for a broad exemption for

trading in foreign sovereign debt, comparable to the

exemption provided for U.S. government and government

agency debt and municipal bonds. The lack of such an

exemption, it was argued, could critically impact the

functioning of money market operations of foreign central

banks and limit the ability of foreign sovereigns to finance

their operations and conduct monetary policy. It was also

argued that the lack of such an exemption for foreign

sovereign debt generally was inconsistent with the principle

of national treatment, and with U.S. multilateral and

bilateral treaties and trade obligations. 43

In the Final Rule, the Agencies adopted a compromise

solution.44

Under the Final Rule, a banking entity

organized under the laws of a foreign sovereign (or directly

or indirectly controlled by a banking entity organized under

the laws of a foreign sovereign) may engage in proprietary

trading in financial instruments issued or guaranteed by

such foreign sovereign, or any agency or political

———————————————————— 43

Preamble, text at notes 1344-1346, 79 Fed. Reg. at 5641.

44 12 C.F.R. § 248.6(b).

subdivision thereof (or a multinational central bank of

which the foreign sovereign is a part).45

However, such

banking entity cannot be a U.S. depository institution, and

such foreign banking entity cannot be controlled by a top-

tier U.S. banking entity.46

A subsidiary of a U.S. banking entity that is a foreign

bank licensed by a foreign sovereign or a securities dealer

regulated by a foreign sovereign is also permitted to trade

in financial instruments issued or guaranteed by such

foreign sovereign, or any agency or political subdivision

thereof (or a multinational central bank of which the

foreign sovereign is a part).47

While acknowledging the potential negative effect on

liquidity for foreign sovereign debt,48

the Agencies

observed that, under the Final Rule, the narrow exemption

granted for trading in foreign sovereign debt was not the

only available means to do so. Foreign banks would be

permitted to trade foreign sovereign debt under the market-

making exemption and underwrite foreign sovereign debt

under the exemption for underwriting activities (including

underwriting and market-making as a primary dealer). In

addition, foreign banks would be able to engage in trading

of foreign sovereign debt (including sovereign debt of

countries other than that of the FBO’s home country) in

compliance with the SOTUS Exemption, as well as for

———————————————————— 45

Obligations of multilateral development banks would not

qualify under this exemption. Preamble, text at notes 1409 and

1410, 79 Fed. Reg. at 5646 and 5647. In the case of a foreign

banking entity that is owned or controlled by a second foreign

banking entity domiciled in a country other than the home

country of the first foreign banking entity, the Volcker Rule

would appear to permit the first foreign banking entity to

engage in proprietary trading only in the sovereign debt of the

first foreign banking entity’s home country, and would permit

the second foreign banking entity to engage in proprietary

trading only in the sovereign debt of the home country of the

second foreign banking entity. Preamble, note 1366, 79 Fed.

Reg. at 5642 n. 1366.

46 The exemption for trading in foreign government obligations is

contained in section 6(b)(1) of the Final Rule. The heading to

section 6(b)(1) is “Affiliates of foreign banking entities in the

United States.” Further, the example provided in the Preamble

involves trading in foreign sovereign debt by the U.S.

operations of a foreign bank. Preamble, text at note 1366, 79

Fed. Reg. at 5643. However, the language of the exemption

that follows is not restricted to U.S. affiliates, and if such

trading is permitted for the U.S. operations of a foreign bank

(other than a U.S. depository institution), it should be

permitted, a fortiori, for the non-U.S. operations of the

foreign bank.

47 12 C.F.R. § 248.6(b)(2).

48 Preamble, text at notes 1374 and 1375, 79 Fed. Reg. at 5643.


liquidity management purposes in accordance with a

liquidity management plan.49

Volcker Rule’s Impact on Rule 15a-6

SEC Rule 15a-6 delineates activities that a foreign bank

or broker-dealer may undertake without triggering U.S.

broker-dealer registration requirements.50

Under Rule 15a-

6, foreign broker-dealers and banks acting in a principal or

agency capacity may solicit transactions with U.S.

institutional investors, provided that such transactions are

effected through a U.S.-registered broker-dealer. Many

FBOs and their foreign broker-dealer affiliates have

customarily used affiliated U.S. registered broker-dealers

for such trades. However, such trades as principal by an

FBO and/or its foreign affiliates through a U.S.-registered

broker-dealer affiliate would constitute proprietary trading

under the Volcker Rule and would not qualify for the

SOTUS Exemption, since the trade would not be affected

through an unaffiliated market intermediary in the United

States.51

If an FBO (or one of its non-U.S. affiliates) wishes to

rely on Rule 15a-6 when trading as a principal, it now must

trade through an unaffiliated U.S.-registered broker-dealer.

However, if it is trading as an agent for a customer, it can

continue to trade through an affiliated U.S.-registered

broker-dealer, as trading in an agent capacity does not

constitute proprietary trading under the Volcker Rule.52

Volcker Rule’s Impact on Rule 144A

FBOs and their non-U.S. securities affiliates often

participate as principals in the distribution of securities in

the United States under SEC Rule 144A by acquiring newly

issued securities from the issuer as principal for resale to

“qualified institutional buyers” as defined under Rule

144A.53

However, such trades would constitute prohibited

proprietary trading under the Volcker Rule and would not

be entitled to the SOTUS Exemption because the trades are

directly with U.S. buyers (and not unaffiliated U.S.

intermediaries). The Volcker Rule’s exemption for

permitted underwriting activities should generally be

available to such FBOs or their affiliates acting as principal,

but the specific requirements for permitted underwriting

would need to be met, a compliance program would need to

———————————————————— 49

Preamble, text at notes 1363-1365, 1374-1375, 79 Fed. Reg. at

5646 and 5647.

50 17 C.F.R. § 240.15a-6.

51 12 C.F.R. § 248.6(e).

52 The Volcker Rule Prohibition on Proprietary Trading:

Considerations for Broker-Dealer Affiliates of Foreign Banking

Organizations (Jan. 9, 2014), available at www.mofo.com/

files/Uploads/Images/140109-Volcker-Rule-Prohibition.pdf.

53 17 C.F.R. § 230.144A.

be adopted and maintained, and the prudential backstops

would need to be observed. In order to avoid these

requirements, FBOs and their affiliates may consider

restructuring their participation in 144A transactions to act

as agents of the issuers in private placements to qualified

institutional buyers, thereby avoiding entirely the

restrictions set forth in the Volcker Rule.54

Prudential Backstops for Proprietary Trading

All permissible proprietary trading (as opposed to

trading that does not constitute proprietary trading),

including pursuant to the SOTUS Exemption, is subject to

so-called prudential backstops.55

These prudential

backstops prohibit otherwise permitted proprietary trading

if the trading would pose a threat to the safety and

soundness of the banking entity, or the financial stability of

the United States, or involve, or would result in, a material

conflict of interest between the banking entity and its

customers or counterparties. A banking entity would have

such a material conflict of interest if its interests are

materially adverse to the interests of its customer or

counterparty, unless the banking entity, (i) before engaging

in the transaction or activity, makes timely disclosure to the

customer or counterparty of clear information regarding the

conflict or (ii) uses information barriers, such as physical

separation of personnel or functions, that address the

conflict. The use of such barriers would not mitigate the

conflict if the banking entity knows or should have known

that such barriers would not be effective in mitigating the

material adverse effect of the conflict of interest.

The prudential backstops also prohibit a transaction or

activity that would result in a material exposure by the

banking entity to high-risk assets or high-risk trading

strategies.

It will likely be particularly difficult for an FBO or its

foreign banking entity affiliate to determine whether it is

complying with the prudential backstops relating to

material conflicts of interest, including taking appropriate

measures to mitigate such conflicts, as these are concepts

rooted in federal and state statutory and common law.

Practices that a banking entity’s home country regulators

may deem to be perfectly appropriate may not pass muster

under U.S. conflict-of-interest standards.

The Final Rule contemplates that the Agencies will rely

on the supervisory process to identify these conflicts,

assets, and strategies. However, it is not clear how the

Agencies will address these prudential backstop issues

———————————————————— 54

It will likely not be practical to structure 144A sales as “riskless

principal transactions” given the financial intermediary’s role

in soliciting prospective purchasers and its expectation of

receiving more than a customary broker’s commission.

55 12 C.F.R. § 248.7.

http://www.mofo.com/%20files/Uploads/Images/140109-Volcker-Rule-Prohibition.pdf

http://www.mofo.com/%20files/Uploads/Images/140109-Volcker-Rule-Prohibition.pdf


when the trading is by the FBO or its foreign affiliate

outside of the United States, especially if the trading is in

reliance on the SOTUS Exemption.

THE PROHIBITION ON SPONSORSHIP OF AND INVESTMENT IN COVERED FUNDS

The Prohibition on Covered Fund Investments and Activities: a Primer

As a general rule (and subject to exceptions described

below), a banking entity may not, as principal, directly or

indirectly acquire or retain an “ownership interest” in, or

“sponsor,” a “covered fund.”56

This general prohibition

does not apply if (i) the banking entity acts solely as agent,

broker, or custodian for the account of a customer and does

not itself retain an ownership interest; (ii) the banking

entity’s ownership interest is held or controlled by it as

trustee in connection with a domestic or foreign deferred

compensation or similar plan for which the banking entity

serves as trustee for the employees covered by the plan;

(iii) the ownership interest is acquired and held in the

ordinary course of collecting a debt; or (iv) the banking

entity holds the ownership interest as trustee or in similar

fiduciary capacity for a customer that is not itself a covered

fund as long as neither the banking entity nor an affiliate

has any beneficial interest in such ownership interest.

Ownership interest. An “ownership interest” means any

equity, partnership, or “other similar interest.” 57

An “other

similar interest” includes any interest in or security issued

by a covered fund that exhibits certain characteristics on a

current, future, or contingent basis, including:

the right to participate in the selection or removal of a

general partner, managing member, member of the

board of directors, investment manager, investment

adviser, or commodity trading advisor (not including

the rights of a creditor to exercise remedies in the event

of a default or an acceleration event);

the right under the terms of the interest to receive a

share of the income, gains, or profits of the covered

fund (regardless of whether the right is pro rata with

other owners);

the right to receive the underlying assets of the covered

fund, after all other interests have been redeemed

and/or paid in full (the “residual” in securitizations);

———————————————————— 56

12 C.F.R. § 248.10(a).

57 12 C.F.R. § 248.10(d)(6).

the right to receive all or a portion of the “excess

spread”;58

the amounts payable by the covered fund with respect

to the interest could, under the terms of the interest, be

reduced based on losses arising from the underlying

assets of the covered fund, such as allocation of losses,

write-downs, or charge-offs of the outstanding

principal balance, or reductions in the amount of

interest due and payable on the interest;

receipt of income on a pass-through basis from the

covered fund, or a rate of return that is determined by

reference to the performance of the underlying assets

of the covered fund (excluding interests that are

entitled to received dividend amounts calculated at a

fixed or floating rate); and

any synthetic right to have, receive, or be allocated any

of the rights described above (which would not allow

banking entities to obtain derivative exposure of these

characteristics).

The definition of ownership interest may include

interests in a covered fund that might not be considered an

ownership interest or an equity interest in other contexts.

For example, synthetic rights in the form of derivative

instruments may not be considered ownership in many

contexts, but for purposes of the Volcker Rule, they may be

ownership interests. Also, debt instruments that exhibit

specific characteristics of equity (such as participation in

profits or losses, or the right to select or remove a person

with investment discretion) could qualify the instruments as

an ownership interest under the Final Rule. Given the

breadth of the definition, there may be particular difficulty

in determining whether investments in various kinds of

structured products would constitute ownership interests.

This has proved to be a particular problem with

collateralized debt obligations (“CDOs”), which typically

provide rights to a controlling class of senior debt holders

to participate in the designation of investment or collateral

managers, or advisers. If the securitization vehicle is a

covered fund (which we discuss below), the banking entity

which is a debt holder may find itself with an investment

that is not permitted under the Volcker Rule.59

———————————————————— 58

The difference (if any) between the interest payments received

from the fund’s assets and the interest paid to holders of other

outstanding interests.

59 The Volcker Rule: Impact of the Final Rule on Securitization

Investors and Sponsors (Dec. 26, 2013), available at

http://www.iflr.com/pdfs/The-Volcker-Rule-impact-of-the-

final-rule-on-securitisation-investors-and-sponsors.pdf. Certain

collateralized pools of trust preferred securities have recently

been granted a narrow exemption from the Volcker Rule by the

http://www.iflr.com/pdfs/The-Volcker-Rule-impact-of-the-final-rule-on-securitisation-investors-and-sponsors.pdf


August 2014 6

A “restricted profit interest” (popularly known as a

“carried interest”) held by an entity in a covered fund for

which the entity (or an employee of the entity) serves as an

investment adviser, investment manager, commodity

trading advisor, or other service provider is not deemed to

be an “ownership interest” if it meets certain conditions.60

Sponsorship. Sponsorship includes serving as a general

partner, managing member, trustee (with investment

discretion), or commodity pool operator (“CPO”) of a

covered fund; having the power to select or control

selection of a majority of directors, trustees, or management

of a covered fund; or sharing with the covered fund the

same name (or a variation thereof).61

Covered Funds

The Volcker Rule legislation prohibits investment in and

sponsorship of private equity and hedge funds. In defining

these terms, Congress imported the key definition of private

fund from Title IV of the Dodd-Frank Act,62

which requires

registration of investment advisers to private funds.

First prong of definition: investment company “but for

Sections 3(c)(1) and 3(c)(7).” A covered fund (under the

first of three definitions) is an issuer of securities that

would be an “investment company” under the Investment

Company Act of 1940 (“1940 Act”) but for Sections 3(c)(1)

or 3(c)(7) of the 1940 Act.63

The definition of investment

company is complex but generally refers to an issuer of

securities that is primarily engaged in (or holds itself out as

primarily engaged in) the business of investing, reinvesting,

or trading in securities.64

Section 3(c)(1) exempts from the

definition of investment company funds whose securities

are sold privately to fewer than 100 purchasers, and Section

3(c)(7) exempts from the definition of investment company

funds whose securities are sold privately only to high net

worth individuals and institutional investors, and others that

meet the qualifications of a “qualified purchaser.”65

These

footnote continued from previous page…

Agencies. 12 C.F.R. § 248.16. The Agencies are reviewing the

possibility of granting broader relief for CDOs.

60 12 C.F.R. § 248.10(d)(6)(ii).

61 12 C.F.R. § 248.10(d)(9).

62 The Dodd-Frank Act, §402, 15 U.S.C. § 80b-2(a)(29) (“The

term ‘private fund’ means an issuer that would be an

investment company, as defined in section 3 of the Investment

Company Act of 1940 (15 U.S.C. 80a-3), but for section 3(c)(1)

or 3(c)(7) of that Act.”). Compare the Dodd-Frank Act, §

619(h)(2), 12 U.S.C. § 1851(h)(2).

63 12 C.F.R. § 248.10(b)(1).

64 15 U.S.C. § 80a-3(a)(1). There are several alternative

definitions, which we do not discuss here.

65 15 U.S.C. § 80b-2(a)(51).

two exemptions are available only if the fund in question is

not making and does not presently propose to make a

public offering of its securities. They are the principal

exemptions relied on by private equity and hedge funds to

avoid registration (and regulation) under the 1940 Act, but

many other issuers of securities also rely on these

exemptions.

To determine whether a fund is a covered fund under the

first prong, at the outset a determination needs to be made

whether the fund would meet the core definition of being an

investment company (without regard to Sections 3(c)(1) or

3(c)(7)) or, alternatively, escapes characterization as an

investment company under a different exemption. For

example, a fund that invests in real estate may be able to

rely on the exemption from the definition of investment

company for issuers of securities that primarily invest in

“purchasing or otherwise acquiring mortgages and other

liens on and interests in real estate.”66

These issues of

characterization are difficult ones and require a thorough

understanding of the 1940 Act and the regulations and

interpretations thereunder.

If the fund is presumptively an investment company and

does not qualify for exemption under another provision of

the 1940 Act, then one needs to determine whether it

qualifies for an exemption under Sections 3(c)(1) or

3(c)(7). If it does not, it is not subject to the Volcker Rule.

For example, pooled investment vehicles sold to the public

do not qualify for an exemption and are required to be

registered under the 1940 Act. Registered investment

companies (e.g., mutual funds or public closed-end funds)

are not covered funds under the Volcker Rule.

Second prong of definition: certain commodity pools. A

second prong of the definition defines as a covered fund

any commodity pool as to which the CPO has claimed an

exemption under Rule 4.7 under the CEA, or the CPO is

registered in connection with the operation of a pool that

limits investors to qualified eligible persons.67

Such

exempt pools are treated as covered funds because they are

restricted to investors that meet heightened qualification

standards and thus have characteristics similar to private

equity or hedge funds. On the other hand, a mutual fund

that makes extensive use of commodity interests and whose

investment adviser must register as a CPO would not be a

covered fund. Following the adoption of the Dodd-Frank

Act and the resulting changes to the definition of a

“commodity pool,” many pooled investment vehicles are

now characterized as commodity pools. As a result of the

changes to the definition of “commodity pool,” it will be

important to consider whether an entity is a commodity

pool and therefore may be a covered fund.

———————————————————— 66

15 U.S.C. § 80a-3(c)(5)(C).

67 CEA, 7 U.S.C. §§ 1, et seq., 17 C.F.R. §§ 1, et seq.


Third prong of definition — foreign funds controlled by

U.S. banking entities and the genesis of the “foreign fund

exclusion.” The third prong of the “covered fund”

definition has special import for FBOs. In the Proposed

Rule, the Agencies included as the third prong of the

covered fund definition “any issuer that is organized or

offered outside the United States that would be a covered

fund as defined in [the first or second prong of the

definition] were it organized or offered under the laws, or

offered to one or more residents, of the United States.”68

This third prong came to be known as a “foreign equivalent

fund” — in other words, the foreign equivalent of a private

fund that would constitute a covered fund if organized in

the United States or offered to U.S. residents. Thus, a

foreign equivalent fund is a fund (i) not organized under the

laws of the United States, (ii) not offered under the laws of

the United States, and (iii) not offered to residents of the

United States, and, which would be a covered fund if it had

the necessary U.S. nexus. A foreign equivalent fund would

not include a public foreign fund because such fund would

continue to be an investment company without regard to

Sections 3(c)(1) or 3(c)(7) of the 1940 Act if offered or sold

to U.S. residents.69

Representatives of the FBO community criticized the

foreign equivalent fund concept on many grounds,

including the inappropriateness of treating foreign funds of

any kind, whether private or public, as subject to the

Volcker Rule. In addition, many critics observed that many

foreign funds were not organized with the goal of

complying with the 1940 Act and its exemptions, and

accordingly it could be difficult to tell which foreign funds

met the definition and which did not.70

———————————————————— 68

Proposed Rule, §__.10.

69 It can be argued there was no need for the third prong in the

Proposed Rule because the definition of an investment

company in the 1940 Act does not have jurisdictional

limitations. That is to say, a foreign fund is still an investment

company under the 1940 Act unless it qualifies for an

exemption. The 1940 Act imposes jurisdictional restrictions by

purporting to regulate those investment companies that have

certain linkages with the United States but not by limiting the

definition of investment company. One could accordingly

argue that a foreign equivalent fund is already captured by the

first prong of the definition, and the third prong is unnecessary.

However, the Agencies nowhere treat the first prong as

covering foreign funds, and as a matter of regulatory

interpretation, the third prong should not be construed in such a

manner as to render it superfluous. In other words, to give the

third prong meaning, the first prong cannot be regarded as

covering foreign funds. This construction is consistent with the

genesis of the regulation from the Proposed Rule to the Final

Rule, which is discussed in the text that follows.

70 79 Fed. Reg. at 5671-5672.

In the Final Rule, the Agencies responded to this

criticism by whittling away at the third prong of the

definition. A covered fund under the third prong of the

definition in the Final Rule refers only to a fund that is, or

is controlled by, a U.S. banking entity and has the

following characteristics:

the fund is, or holds itself out as, an entity that raises

money from investors primarily for the purpose of

investing in securities for resale or other disposition, or

otherwise trading in securities;71

the fund is organized outside the United States;

the fund’s interests are offered and sold only to non-

U.S. persons; and

the fund is sponsored by the U.S. banking entity (or an

affiliate).

However, such a covered fund would not include a

foreign fund that, if organized or offered in the United

States, would not rely on Section 3(c)(1) or 3(c)(7) of the

1940 Act for an exemption from the definition of an

investment company. The avowed purpose of this revised

definition of the third prong was to prevent circumvention

of the Volcker Rule by U.S. banking entities seeking to

sponsor foreign private funds or invest in them.72

The narrowed third prong of the definition of covered

fund implies that a foreign equivalent fund sponsored by a

foreign banking entity or in which a foreign banking entity

invests is not, under the Final Rule, a covered fund (for

purposes of that foreign banking entity) as long as the

foreign banking entity is not controlled by a U.S. banking

entity. For such a foreign banking entity, this results in

such a fund being excluded from the definition of covered

fund under the Volcker Rule. By implication, the first

prong of the definition is not applicable to a foreign

equivalent fund — and was intended only to cover private

funds that had some jurisdictional nexus to the United

States. We shall refer to this as the “foreign fund

exclusion.” The same foreign fund could be a covered

foreign fund for a U.S. banking entity but not for a foreign

banking entity.73

In sum, for a foreign banking entity not controlled by a

U.S. banking entity, the foreign fund exclusion would, in

principle, apply to a fund (i) not organized under the laws

of the United States, (ii) not offered under the laws of the

United States, and (iii) not offered to residents of the

———————————————————— 71

This basically tracks the core definition of what constitutes an

investment company under the 1940 Act, 15 U.S.C. § 80a-

3(a)(1).

72 79 Fed. Reg. at 5671-5673.

73 Preamble, text at note 1698, 79 Fed. Reg. at 5672.


United States. However, although firmly grounded in the

language and logic of the Final Rule, the foreign fund

exclusion is not explicitly recognized in the Final Rule, and

the Agencies have not yet publicly addressed, or given

specific shape to, the foreign fund exclusion. Accordingly,

FBOs looking for certainty in this area may wish to rely on

the explicit foreign fund exemption, discussed below.

Effect of Being or Not Being a Covered Fund

The definition of a “banking entity,” which is discussed

above, includes any affiliate of the banking entity, but

excludes any covered fund that is not itself an insured

depository institution, a bank holding company or an FBO.

Accordingly, if a banking entity controls a covered fund,

the covered fund (which would be an affiliate of the

banking entity by reason of being controlled by the banking

entity) is itself not deemed to be a banking entity and is

thus not subject to the Volcker Rule prohibition on

proprietary trading. However, if a banking entity controls a

fund that is not a covered fund — for example, because it

does not meet any one of the three prongs of the definition

of covered fund discussed above — that fund will be

deemed to be a banking entity and will be subject to the

Volcker Rule proprietary trading prohibitions.74

Foreign Fund Exemption

In addition to the foreign fund exclusion, the Volcker

Rule contains a specific exemption for fund investment and

activity by FBOs and their foreign affiliates to the extent

the activity is conducted solely outside the United States.75

This foreign fund exemption is, in effect, the covered fund

counterpart to the SOTUS Exemption for proprietary

trading. Like the approach to the SOTUS Exemption, the

Agencies’ approach to the foreign fund exemption is

intended to be risk-based, with the objective of limiting the

risk that might be transferred to the U.S. financial system.

Whether the outer boundaries of the foreign fund

exemption and the foreign fund exclusion are congruent is

not entirely clear. If a foreign fund meets all of the

conditions for the foreign fund exemption, it is possible that

the foreign fund will meet the criteria for the foreign fund

exclusion. However, as explained below, the foreign fund

exemption (but not the foreign fund exclusion) may be

available where a U.S. person has acquired an investment

———————————————————— 74

This should not be an issue for banking entities that organize,

advise, sponsor, or manage registered investment companies,

such as mutual funds (or an entity that has made an effective

election to be regulated as a business development company),

as the Federal Reserve has long recognized that such activities

would not make the investment company an affiliate of the

banking entity. See Preamble, text at notes 1737-1740 (and

notes thereto), 79 Fed. Reg. at 5676-5677.

75 12 C.F.R. § 248.13(b).

in a foreign fund in a secondary trade. On the other hand,

the foreign fund exclusion does not necessarily require that

a foreign fund meet all of the specific conditions required to

be satisfied for the foreign fund exemption to apply.76

The foreign fund exemption is subject to the following

requirements (the first two of which are identical to those

contained in the SOTUS exemption for proprietary

trading):

the foreign banking entity may not be directly or

indirectly controlled by a U.S. banking entity;

if an FBO, the foreign banking entity must be a

qualified foreign banking organization, or “QFBO” —

in other words, a majority of its business and banking

activities must be outside the United States,77

or, if the

FBO affiliate is not an FBO, a majority of its business

must be outside the United States;

ownership interests in the covered fund in which the

foreign banking entity invests may not have been sold

in an offering that targets residents of the United

States;

investment/sponsorship decisions by the foreign

banking entity must be made outside of the United

States through an entity located and organized outside

the United States; however, certain functions may be

exercised in the United States, including back office

and administration, and investment advice can be

provided from the United States;78

the fund investment, including any related hedging

transactions, must be booked outside of the United

States in an entity that is not organized under the laws

of the United States; and

no financing of any fund investment may be provided

by a U.S. affiliate of the FBO.

No condition of the foreign fund exemption (or

applicable to the foreign fund exclusion) would require the

fund relying on the exemption (or exclusion) to limit its

investments to foreign securities or other offshore

investments. Accordingly, a foreign exempt fund (or a

foreign excluded fund) should be able to invest in U.S.

portfolio companies. However, authority for a foreign

banking entity to sponsor or invest in a foreign exempt fund

———————————————————— 76

For example, the foreign fund exclusion would not require an

FBO to be a QFBO, or a foreign affiliate of an FBO to have a

majority of its business outside the United States.

77 Regulation K, 12 C.F.R. § 211.23(a).

78 A U.S.-based entity may be involved in offering and selling the

fund interests, as long as all offers and sales are only to non-

U.S. persons.


(or a foreign excluded fund) does not dispense with other

applicable provisions of the BHCA. For example, if an

FBO were to invest in more than five percent of the voting

securities of such a fund, it would need to rely on

appropriate authority for such an investment under the

BHCA. Further, if the FBO were to control such a fund,

the fund’s investments would be attributed to the FBO, and

it would need to rely on appropriate authority for such

attributed investments.

The offering conditions for a foreign exempt fund merit

discussion. Absent circumstances otherwise indicating a

U.S. nexus, the sponsor of a foreign fund will not be

viewed as targeting U.S. residents if it conducts an offering

directed to residents of countries other than the United

States; includes in the offering materials a prominent

disclaimer that the securities are not being offered in the

United States or to residents of the United States; and

includes other reasonable procedures to restrict access to

offering and subscription materials to persons that are not

residents of the United States.79

Sponsors of foreign

exempt funds will need to examine the facts and

circumstances of their particular offerings and confirm that

the offering does not target residents of the United States.

Under the Proposed Rules, the foreign fund exemption

did not apply if any ownership interest was offered or sold

to a U.S. resident. This condition was strongly criticized by

representatives of the foreign bank community. The

condition would have disqualified a foreign fund from

using the exemption if a non-U.S. resident had sold its

interest in a secondary trade to a U.S. resident, or if a

foreign investor, subsequent to its investment in a foreign

fund, had relocated to the United States. This condition

also raised the question as to whether an FBO considering

investment in a foreign fund would need to conduct diligent

inquiry of such a fund to determine whether any such

secondary trades (or relocation of investors) had ever taken

place, and whether it further would need to require, as a

condition to its investment, that in the future no U.S.

investor ever acquire an interest in such a fund.80

The offering restrictions in the Final Rule contain no

such specific disqualification. Instead they prohibit

targeting U.S. residents (presumably in the fund offering

process). This leaves open the possibility that secondary

trades by non-U.S. persons to U.S. persons (not as part of

———————————————————— 79

The Agencies caution FBOs not to send offering materials into

the United States or conduct discussions with persons located

in the United States (other than to or with a person known to be

a dealer or other professional fiduciary acting on behalf of a

discretionary account or similar account for a person who is not

a resident of the United States). Preamble, text at note 2450, 79

Fed. Reg. at 5742.

80 Preamble, text at notes 2433-2437, 79 Fed. Reg. at 5741-5742;

Preamble, text at note 2449, 79 Fed. Reg. at 5742.

the original offering process), or relocation of investors to

the United States, would not disqualify a fund from the

foreign fund exemption.

The offering conditions raise questions about a number

of potential fund structures. For example, sponsors that are

not banking entities may wish to offer concurrently two

parallel funds, one of which is offered and sold only to non-

U.S. persons (including FBOs) and is otherwise designed to

comply with the foreign fund exemption, and the other of

which is offered and sold to U.S. persons that are not

banking entities. The fund manager would cause both

funds to invest (and disinvest) in parallel in each portfolio

investment but maintain the investments in a segregated

manner. Would the Agencies seek to integrate the two

parallel funds for Volcker Rule purposes? Such integration

would disqualify FBOs investing in the foreign fund from

relying on the foreign fund exemption because the parallel

fund had targeted U.S. residents. Commentators asked

about such parallel structures during the comment period on

the Proposed Rule but the Agencies did not provide any

clarifying commentary.81

Nonetheless, there is a strong

basis for not integrating the foreign exempt fund with the

U.S. parallel fund in the situation described above because,

among other factors, the existence of the U.S. parallel fund

does not transfer to the United States the risk of the FBO

investing in the foreign fund.

The Agencies did choose to address multitiered fund

structures in the Preamble.82

The Agencies expect that

activities related to certain “complex fund structures”

should be integrated in order to determine whether a

covered fund interest has been sold to a U.S. Person. An

example given is that of a “feeder fund” organized or

advised by an FBO offered for sale in accordance with the

foreign fund exemption offering restrictions, which is

organized or operated for the purpose of investing in

another covered fund, where the second covered fund is

(i) sold pursuant to an offering that targets U.S. persons and

(ii) either organized and offered, or advised, by the FBO.

Open to question are variations of such fund structures,

including feeder funds organized under the foreign fund

exemption by non-banking entities not subject to the

Volcker Rule for the purpose of investing in one or more

U.S. funds.

Explicit Exclusions from Definition of Covered Funds

The following are explicitly excluded from the

definition of covered funds.83

Foreign public funds. A covered fund does not include

an issuer organized abroad that is authorized to offer and

———————————————————— 81

Preamble, text at note 2445, 79 Fed. Reg. at 5742.

82 Preamble, text after note 2450, 79 Fed. Reg. at 5742-5743.

83 12 C.F.R. § 248.10(c).


sell ownership interests to retail investors (in other words,

investors without heightened qualification standards) in the

issuer’s home jurisdiction and that sells ownership interests

predominantly through one or more public offerings outside

the United States.84

Foreign public funds that do not meet

the specific conditions of this exclusion may not be covered

funds for other reasons. For example, they may qualify for

the foreign fund exclusion, discussed above, or to the extent

interests are sold to U.S. persons, they may not meet the

first or second prong of the definition. Nonetheless, the

existence of this specific exclusion provides a safe harbor

for FBOs and their affiliates for certain foreign public

funds.

Wholly owned subsidiaries. A covered fund does not

include an entity, all of the outstanding ownership interests

of which are owned directly or indirectly by a banking

entity or its affiliate.85

This exemption is likely to be

helpful for financial institutions that establish or rely on

special purpose funding programs that utilize trust or other

tax pass-through vehicles.

Joint ventures. The Final Rule excludes a joint venture

from the definition of a covered fund, if the joint venture is

(i) between the banking entity (or any of its affiliates) and

no more than 10 unaffiliated co-venturers; (ii) in the

business of engaging in activities that are permissible for

the banking entity other than investing in securities for

resale or other disposition, and; (iii) is not, and does not

hold itself out as being, an entity that raises money from

investors primarily for the purpose of investing in securities

for resale or trading.

Acquisition vehicles. The Final Rule excludes

acquisition vehicles from the definition of covered fund,

provided the vehicle is formed solely for the purpose of

engaging in a bona fide merger or acquisition transaction,

and the vehicle exists only for such period as necessary to

effectuate the transaction.

Loan securitizations and covered bonds. The Volcker

Rule was not intended to limit the ability of banking

entities to sell or securitize loans. Issuing entities for asset-

backed securities that satisfy certain conditions and invest

solely in loans are not covered funds. However, the

———————————————————— 84 A foreign fund’s distribution would not be a “public offering”

for purposes of this definition if the distribution imposes a

required minimum level of net worth or net investments.

85 Up to five percent of the entity’s ownership interests may be

owned by directors, employees, and certain former directors

and employees of the banking entity or its affiliates, and within

the five percent ownership interest, up to 0.5 percent of the

entity’s outstanding ownership interests may be held by a third

party if the ownership interest is held by the third party for the

purpose of establishing corporate separateness, or addressing

bankruptcy or insolvency.

Agencies have prescribed strict conditions about what kind

of assets such issuing entities can hold and still not be

covered funds. Qualifying asset-backed commercial paper

conduits and vehicles created to hold assets related to

covered bonds are also exempt from the definition of

covered funds but only if they meet strict conditions. The

strict restrictions on the permissible assets held in a loan

securitization structure have diminished the value of the

loan securitization exemption. In general, the treatment of

securitization vehicles under the Volcker Rule is highly

complex and evolving.86

Funds regulated under the 1940 Act. Covered funds do

not include registered investment companies (e.g., mutual

funds, registered closed-end funds, and ETFs) or business

development companies (“BDCs”). Also excluded are

seeding vehicles for these types of funds that would rely on

Section 3(c)(1) or Section 3(c)(7) of the 1940 Act during

the seeding period.87

Other excluded entities. The Rule also excludes these

from the definition of covered fund:

foreign pension or retirement funds;

insurance company separate accounts;

bank-owned life insurance company separate accounts;

Small Business Investment Companies (“SBICs”) and

certain permissible public welfare and similar funds;

and

entities used by the FDIC to dispose of assets as

receiver or conservator.88

The Agencies indicated that they are working to

establish a process to evaluate requests for other exclusions

———————————————————— 86

The Volcker Rule: Impact of the Final Rule on Securitization

Investors and Sponsors (Dec. 26, 2013), available at.

http://www.iflr.com/pdfs/The-Volcker-Rule-impact-of-the-

final-rule-on-securitisation-investors-and-sponsors.pdf. The

House of Representatives has legislation (H.R. 4167) under

consideration that would broaden the exemption for CLOs.

The legislation is supported by the Institute of International

Bankers, which in a March 12, 2014 letter to the House

Financial Services Committee noted that foreign banks

operating in the United States invest in approximately $60

billion of the $300 billion in outstanding CLO notes. As

mentioned elsewhere in this article, the conformance period for

holding non-conforming CLO notes has recently been extended

for an additional two years.

87 To rely on this “seeding” provision, the banking entity must

operate the vehicle pursuant to a written plan that reflects the

fact that the vehicle will become a registered investment

company or BDC within the time designated by regulation.

88 12 C.F.R. §§ 248.10(c)(5), (6), (7), (11), and 13.




from the definition of covered fund and will provide further

guidance as they gain experience.

Permitted Covered Fund Sponsorship and Investments

Notwithstanding the prohibition on sponsorship and

investment in ownership interests in covered funds, the

Volcker Rule exempts investment and sponsorship of the

following covered funds, subject to detailed prescribed

limitations and conditions, which are summarized below.

Customer funds. A banking entity may acquire

ownership interests in or sponsor a covered fund as a means

of offering investment opportunities to customers. To

qualify for this activity, the covered fund activity must be

in connection with the banking entity’s (or its affiliate’s)

trust, fiduciary, investment advisory, or commodity trading

advisory services for its customers (not necessarily

preexisting customers) pursuant to a written plan or other

documentation outlining how the banking entity or affiliate

intends to provide such services through the organizing and

offering of the fund.89

The sponsorship of or acquisition of ownership interests

in a customer fund is subject to a significant number of

conditions designed to limit the risk taken on by the

banking entity in sponsoring such customer funds and to

deal with potential conflicts of interest. For example, the

banking entity and its affiliates cannot guarantee the fund’s

performance, or guarantee or assume its obligations (or

those of any covered fund in which it invests); the covered

fund cannot share the same name (or a variety thereof) with

the banking entity or an affiliate of the banking entity, and

cannot use the word “bank” in its name; no director or

employee of the banking entity (or an affiliate) can take an

ownership interest in the covered fund (except for a director

or employee who is directly involved in providing advisory

or other services to the fund); and the banking entity must

clearly and conspicuously make a list of disclosures

specified in the Final Rule in writing to any prospective or

actual investor in the covered fund.

An issuing entity of asset-backed securities. A banking

entity may acquire ownership interests in or sponsor a

covered fund that is an issuing entity of asset-backed

securities, subject to the same conditions and limitations

described above for customer funds.90

Underwriting and market-making of ownership interests

of covered funds. A banking entity may acquire ownership

———————————————————— 89

12 C.F.R. § 248.11.

90 12 C.F.R. § 248.12(b)(3). A banking entity may hold

ownership interests in excess of the three percent per-fund limit

to the extent a greater retention percentage is required by the

Exchange Act and the implementing regulations thereunder.

Exchange Act, § 15G, 15 U.S.C. § 78o-1.

interests through the exercise of underwriting or market-

making-related activities in a covered fund in which it may

make a permissible investment, or that it sponsors or

advises (or, in the case of an issuing entity of asset-backed

securities, for which it is a “securitizer”)91

as long as the

underwriting or market-making-related activities conform

to the requirements for such permitted activities under the

proprietary trading prohibition discussed above.92

Per-fund investment limits. Investments by a banking

entity and its affiliates in a customer fund or an issuer of

asset-backed securities, including those acquired in

connection with permissible underwriting and market-

making activities, may not exceed three percent of the value

of (or the number of interests in) the covered fund.93

Affiliation is given special treatment for purposes of the

per-fund limitation and is discussed below.

The three percent per-fund limit is suspended during a

seeding period of one year (which may be extended upon

application). During the seeding period, the banking entity

sponsor must actively seek unaffiliated investors to reduce

the aggregate amount of investment in ownership interests

to conform to the three percent limit.

Aggregate investment limits. The aggregate value of all

ownership interests of a banking entity and its affiliates in a

customer fund or an issuer of asset-backed securities,

including those acquired in connection with permissible

underwriting and market-making activities, may not exceed

three percent of the Tier 1 capital of the banking entity.94

For an FBO, the Tier 1 capital used for this limit is the

consolidated Tier 1 capital of the FBO as calculated under

applicable home country standards. However, for a U.S.

subsidiary of an FBO, Tier 1 capital is calculated as

reported to its primary U.S. bank regulator. For a non-

banking subsidiary of a top-tier U.S. holding company of

an FBO, Tier 1 capital is the Tier 1 capital reported by the

top-tier U.S. holding company. As with the per-fund

limitation, affiliation is given special treatment for purposes

of the aggregate investment limits and is discussed below.

———————————————————— 91

As such term is defined in the Exchange Act, § 15G, 15 U.S.C.

§ 78o-1.

92 12 C.F.R. § 248.11.

93 12 C.F.R. § 248.12(a)(2). A banking entity may hold

ownership interests in excess of the three percent per-fund limit

in an issuer of asset-backed securities to the extent a greater

retention percentage is required by the Exchange Act and the

implementing regulations thereunder. Exchange Act, § 15G,

15 U.S.C. § 78o-11.

94 12 C.F.R. § 248.12(a)(3).


Attribution of ownership interests for purposes of per-

fund and aggregate investment limits.95

Affiliation. If a banking entity sponsors or invests in a

covered fund in accordance with Volcker Rule

conditions, except as described below for multitier

investments, the covered fund will not be treated as an

affiliate for purposes of the per-fund or aggregate

investment limits (with the consequences that the

covered fund’s investments will not be attributed to the

banking entity for such purposes). In addition,

registered investment companies, SEC-regulated

BDCs, and foreign public funds to which the banking

entity provides investment advisory, commodity

trading advisory, or administrative and other services,

will not be considered affiliates of a banking entity for

purposes of the per-fund or aggregate investment limits

so long as the banking entity does not own, control, or

hold 25 percent or more of the voting shares of the

company or fund.96

Multitier investments. Where a banking entity invests

in a feeder fund, its permitted investment shall be

measured only by reference to the master fund in

which the feeder fund invests. The amount invested in

the master fund shall be the banking entity’s pro-rata

share of the master fund held through the feeder fund

(plus any direct investments in the master fund). If a

banking entity organizes and offers a customer fund for

the purpose of investing in other covered funds (in

other words, a fund-of-funds structure), the banking

entity’s ownership interest in a lower-level fund that

the banking entity organizes and offers and in which

the top-tier fund invests shall be the banking entity’s

pro-rata interest in the lower-level fund held through

the top-tier fund (plus any direct investments in such

lower-level fund). The banking entity’s interest in the

top-tier fund must also meet the per-fund limitation.

Co-investment by employees and directors.

Investments in a covered fund sponsored by a banking

entity by an employee or director of a banking entity

will be attributed to the banking entity if the

investment by the employee or director is financed by

the banking entity. In addition, without regard to any

financing provided by a banking entity, any amounts

contributed by an employee or director to receive a

restricted profit interest, or “carried interest,” in a

covered fund is attributed to the banking entity.

Co-investment with a covered fund. According to the

Agencies, the potential for evasion of the investment

limitations may be present where a banking entity

coordinates its direct investment decisions with the

———————————————————— 95

12 C.F.R. §§ 248.12(b) and (c).

96 12 C.F.R. § 248.12(b)(ii).

investments of covered funds that it owns or

sponsors.97

Accordingly, a banking entity sponsoring a

covered fund may offer investors co-investment

opportunities, but cannot itself make any additional

side-by-side co-investments with the covered fund in a

privately negotiated investment unless the value of

such co-investment is less than three percent of the

value of the total amount co-invested by other

investors in such investment. Further, if the co-

investment is made through a co-investment vehicle

that is itself a covered fund (“co-investment fund”), the

sum of the banking entity’s ownership interests in the

co-investment fund and the related covered fund

should not exceed three percent of the sum of the total

ownership interests held by all investors in the co-

investment fund and the covered fund. Finally, if a

banking entity invests side-by-side with a covered fund

that it sponsors in substantially the same positions as

the covered fund, the value of such side-by-side

investments should be included for the purpose of

determining the banking entity’s investment in the

covered fund.

Capital deduction for investments in covered funds. A

banking entity is required to deduct from Tier 1 capital the

greater of (i) the amounts invested in ownership interests of

customer funds or issuers of asset-backed securities, plus

any earnings received and (ii) if the banking entity accounts

for the profits (losses) of the fund’s investments in its

financial statements, the fair market value of such

ownership interests (together with any amounts paid in

obtaining a restricted profit interest).98

An FBO is not required to make any such capital

deduction from its capital. However, any U.S. subsidiary

of an FBO that is required to calculate Tier 1 capital under

U.S capital rules is required to make such deduction with

respect to such investments held, directly or indirectly,

through such subsidiary.

Limitations on Relationships with Certain Covered Funds: “Super 23A”

No banking entity that (i) directly or indirectly serves as

investment manager, investment adviser, commodity

trading advisor, or sponsor to a covered fund, (ii) organizes

and offers a customer fund or a covered fund that is an

———————————————————— 97

Preamble , text after note 2359, 79 Fed. Reg. at 5734.

98 This dollar-for-dollar deduction is intended to protect the safety

and soundness of the banking entity. However, the federal

banking agencies recognize that this deduction does not

correspond to the risk weights and deductions imposed by

applicable bank capital rules. The federal banking agencies

intend to review the inconsistent treatment and to propose

measures to reconcile these two regimes. Preamble, text after

note 2333, 79 Fed. Reg. at 5731.


issuing entity of asset-backed securities, or (iii) continues to

hold an ownership interest in a covered fund that is an

issuing entity of asset-backed securities and no affiliate of

any such banking entity may engage in any transaction with

the applicable covered fund, if the transaction would be a

“covered transaction” as defined in Section 23A of the

Federal Reserve Act, as if the banking entity (or its

affiliate) were a member bank and the applicable covered

fund were an affiliate thereof. 99

A “covered transaction” is defined in Section 23A of the

Federal Reserve Act as follows:

(i) a loan or extension of credit to the affiliate,

including a purchase of assets subject to an agreement

to repurchase;

(ii) a purchase of or an investment in securities issued

by the affiliate;

(iii) a purchase of assets from the affiliate, except such

purchase of real and personal property as may be

specifically exempted by the Board by order or

regulation;

(iv) the acceptance of securities or other debt

obligations issued by the affiliate as collateral security

for a loan or extension of credit to any person or

company;

(v) the issuance of a guarantee, acceptance, or letter of

credit, including an endorsement or standby letter of

credit, on behalf of an affiliate;

(vi) a transaction with an affiliate that involves the

borrowing or lending of securities, to the extent that

the transaction causes a member bank or subsidiary to

have credit exposure to the affiliate; or

(vii) a derivative transaction100

with an affiliate, to the

extent that the transaction causes a member bank or a

subsidiary to have credit exposure to the affiliate.

Under Section 23A of the Federal Reserve Act, such

covered transactions are permitted within limits and subject

to conditions. In addition, under Section 23A and

Regulation W of the Federal Reserve,101

certain

transactions are exempted. However, subject to the explicit

exceptions discussed below, under the Volcker Rule the

transactional prohibition is absolute, and the exemptions

contained in Section 23A and Regulation W do not apply:

hence the reference to this prohibition as “Super 23A.”

As certain acquisitions of ownership interests in covered

funds are permitted to the extent of the applicable

———————————————————— 99

12 C.F.R. § 248.14.

100 As defined in 12 U.S.C. § 84(b).

101 Regulation W, 12 C.F.R. § 223.

exemptions discussed above, an exception has been made

to Super 23A so as not to proscribe under Super 23A what

the exemptions allow. In addition, notwithstanding Super

23A, banking entities, subject to certain conditions, may

enter into prime brokerage transactions with a covered fund

in which an applicable covered fund that is managed,

sponsored, or advised by the banking entity or its affiliate

has acquired an ownership interest (in other words, a

second-tier fund).102

The Final Rule also implements the Volcker Rule’s

application of the “market terms” requirement in Section

23B of the Federal Reserve Act.103

That section requires

that transactions between a bank and its affiliate be on

terms that are substantially the same (or at least as

favorable to the bank) as those prevailing for comparable

transactions with unaffiliated companies. Any banking

entity that (i) directly or indirectly serves as investment

manager, investment adviser, commodity trading advisor,

or sponsor to a covered fund, (ii) organizes and offers a

customer fund or a covered fund that is an issuing entity of

asset-backed securities, or (iii) continues to hold an

ownership interest in a covered fund that is an issuing

entity of asset-backed securities must make sure that the

terms of any transactions with the applicable covered fund

are subject to the standards applicable under Section 23B of

the Federal Reserve Act as if the banking entity were a

bank and the covered fund, its affiliate.

Based on its language, Super 23A would not appear to

apply to the foreign fund exemption unless an FBO serves

as the investment manager, investment adviser, commodity

trading advisor, or sponsor of the foreign exempt fund.

Other Permitted Covered Fund Activities

Permitted risk-mitigating hedging activities. A banking

entity may acquire ownership interests in a covered fund

pursuant to an investment that is designed to demonstrably

reduce or otherwise significantly mitigate the specific,

identifiable risks to the banking entity in connection with a

compensation arrangement with an employee of the

banking entity or an affiliate that directly provides

investment advisory, commodity trading advisory, or other

services to the covered fund.104

The availability of this

exemption is subject to extensive conditions, including an

internal compliance program that is reasonably designed to

———————————————————— 102

Under the Final Rule, a prime brokerage transaction is any

transaction that would be a covered transaction, as defined

above that is provided in connection with custody, clearance

and settlement, securities borrowing or lending services, trade

execution, financing, or data, operational, and administrative

support. 12 C.F.R. § 248.10(d)(7).

103 12 C.F.R. § 248.14(b).

104 12 C.F.R. § 248.13(a).


ensure the banking entity’s compliance with this permitted

fund activity.

Permitted fund activities by regulated insurance

companies. A regulated insurance company (including a

foreign insurance company) that is a banking entity is

permitted to sponsor or acquire ownership interests in a

covered fund, either for the general account of the

insurance company or for one or more separate accounts

established by the insurance company, as long as the

activity is conducted in compliance with applicable

investment laws and regulations (or written regulatory

guidance) applicable to the insurance company.105

Prudential Backstops for Covered Fund Investment and Activity

Sponsorship of and investment in covered funds by

banking entities are permissible under the specified

exceptions discussed above. However, none of these

activities or investments are permissible if the transactions

involve or would result in a material conflict of interest

between the banking entity and its customers or

counterparties that is not mitigated by adequate disclosure

and/or information barriers in appropriate circumstances.106

Also, the exemptions for such covered fund investments

and activities are not available if they result, directly or

indirectly, in a material exposure by the banking entity to a

high-risk asset or a high-risk trading strategy.107

As discussed above with respect to proprietary trading,

the prudential backstops could present difficult compliance

issues for banking entities. The failure to address conflicts

of interest adequately (under U.S. standards that may have

no currency in an FBO’s home country) could deprive a

banking entity of an exemption for covered fund investment

or activity on which the banking entity had relied.

Likewise, the prospect or, in hindsight, the incurrence of a

substantial financial loss could raise the question of

whether the permitted covered fund activity or investment

had presented the kind of material risk to a high-risk asset

or high-risk trading strategy that would have disqualified

the banking entity from relying on a particular exemption.

COMPLIANCE PROGRAMS

The Final Rule requires banking entities, including

FBOs and their non-U.S. affiliates, that are engaged in

proprietary trading or covered fund investment or

sponsorship to establish and maintain a compliance

program that is reasonably designed to ensure and monitor

their compliance with the Volcker Rule, and tailored to the

———————————————————— 105

12 C.F.R. § 248.13(c).

106 12 C.F.R. § 248.15.

107 Id.

size and complexity of the banking entity and its covered

trading and fund activities.108

Certain commenters on the Proposed Rule urged the

Agencies to exempt FBOs altogether from the compliance

regime or, in the alternative, to exempt them from adopting

a compliance regime with respect to their activities outside

the United States or to institute a more narrowly

circumscribed set of compliance requirements outside the

United States. The main thrust of these comments was that

the risk attendant to such activities conducted outside the

United States does not pose a risk for the U.S. financial

system or, ultimately, to U.S. taxpayers. 109

None of these

recommendations were adopted, although the Agencies did

modify the compliance reporting requirements of FBOs

with respect to their covered trading activities conducted

pursuant to the SOTUS Exemption, and their covered fund

activities and investments conducted pursuant to the foreign

fund exemption.110

Banking entities, including FBOs and their non-U.S.

affiliates, that do not engage in proprietary trading or

covered fund investment or sponsoring activities (other

than trading in U.S. government or government agency

obligations) are not required to establish a Volcker Rule-

specific compliance program (until such time as they begin

engaging in such activities). Hence the importance of the

distinctions described above between an excluded activity

or investment (which is not covered by the Volcker Rule),

on the one hand, and permitted or exempt activity or

investment, on the other hand. In the latter case, a

compliance program is required; in the former, it is not.

However, even in the former case, an FBO needs to

monitor carefully all of its trading and fund investment

activity and sponsorship, on a continuing basis, to

determine whether it has engaged (or proposes to engage)

in regulated activity, and the FBO will want to incorporate

such a monitoring system into its internal controls and

compliance programs.111

Banking entities with total consolidated assets of $10

billion or less that engage in covered proprietary trading or

fund activities may satisfy the compliance program

requirement by including appropriate Volcker Rule-specific

references in their existing compliance policies and

procedures. This $10 billion standard should be applied on

a consolidated basis by an FBO, and not on an entity-by-

entity basis.

———————————————————— 108

12 C.F.R. § 248.20.

109 Preamble, text at notes 2533 and 2534, 79 Fed. Reg. at 5750.

110 Preamble, text at note 2550, 79 Fed. Reg. at 5751.

111 Oliver Ireland and Daniel Nathan, The Volcker Rule’s Trojan

Horse for Smaller Banking Entities, BNA’s Banking Report,

102 BBR 647 (April 8, 2014).


Banking entities with more than $10 billion in total

consolidated assets that engage in permitted proprietary

trading, or fund investment or sponsorship are required to

establish and maintain a Volcker Rule compliance program

including the following six elements:

policies and procedures that establish trading,

exposure, and investment limits, and that are otherwise

reasonably designed to ensure compliance with the

Final Rule;112

internal controls reasonably designed to monitor

compliance with the Final Rule;

a management framework that delineates responsibility

and accountability for compliance, and includes

appropriate management review of trading limits,

strategies, hedging activities, investments, incentive

compensation, and other matters requiring attention;

independent testing and audit for the effectiveness of

the compliance program;

training for trading personnel (and those involved in

fund investment or sponsorship) to implement

compliance; and

recordkeeping sufficient to document compliance,

which a banking entity must promptly provide to the

relevant Agency upon request and retain for five years

(or such longer period as is required by the Agency).

FBOs are subject to a more stringent compliance regime

if they have aggregate combined assets in the United States

of $50 billion or more, or if they engage in permitted

proprietary trading (including under the SOTUS

Exemption) and have a minimum level of trading assets and

liabilities that triggers the reporting requirements described

in the next paragraph. The CEO of a banking entity subject

to this more stringent compliance regime will have to attest

on an annual basis in writing that the banking entity has in

place processes reasonably designed to achieve compliance

with the Volcker Rule. In the case of a U.S. branch or

agency of an FBO, the attestation may be provided for the

entire U.S. operations by the senior managing officer of the

FBO’s U.S. operations who is located in the United States.

FBOs that are engaged in proprietary trading activities

under the SOTUS Exemption or as otherwise permitted

(permitted market-making, underwriting, hedging, etc.) are

subject to specific reporting requirements if the average

gross sum of the FBO’s trading assets and liabilities of its

———————————————————— 112

Written policies and procedures must be designed to

document, describe, monitor, and limit activities subject to the

Volcker Rule, including permitted proprietary trading, as well

as activity excluded from the definitions of “proprietary

trading” or “financial instrument.” 12 C.F.R. § 248.20(b)(1).

combined U.S. operations (excluding trading assets and

liabilities involving U.S. government or agency

obligations) equals or exceeds $50 billion (as of June 30,

2014), $25 billion (as of April 30, 2016) or $10 billion (as

of December 31, 2016).

Banking entities with more than $10 billion in total

consolidated assets, including FBOs and their non-U.S.

affiliates, are also required to maintain records

documenting the exclusions from the definition of a

covered fund on which they rely in determining that a fund

they sponsor is not a covered fund.113

The Agencies intend

to monitor the use of fund exclusions to prevent evasion of

the foreign fund and other exemptions.114

In addition, for

each fund sponsored by a banking entity, the banking entity

must retain records documenting its reliance (if this is the

case) on the exclusions for foreign public funds, foreign

pension or retirement funds, loan securitizations, qualifying

asset-backed commercial paper conduits, or qualifying

covered bonds.115

CONFORMANCE PERIOD

The Federal Reserve Board has extended the

conformance period for banking entities to be in

compliance with the Volcker Rule for one year to July 21,

2015. Each banking entity is expected to engage in good-

faith efforts appropriate for its activities and investments

that will result in conformance with the Volcker Rule not

later than the end of the conformance period. Moreover,

banking entities should not expand activities or make

investments during the conformance period with an

expectation that additional time to conform those activities

or investments will be granted, and banking entities with

stand-alone proprietary trading operations are expected to

promptly terminate or divest such operations.

On April 7, 2014, the Federal Reserve provided a special

extension of the conformance period for an additional two

years to July 21, 2017 for the retention by a banking entity

of collateralized loan obligations (“CLOs”) held as of

December 31, 2013, that constitute covered funds because

they do not meet the specific, detailed conditions for

exclusion from the Volcker Rule. The extension was

prompted by concerns expressed by banking entities and

their trade associations that the Final Rule would require

divestiture of ownership interests in CLOs predominantly

backed by commercial loans but which also held a certain

amount of non-conforming assets, such as debt securities.

The extension is intended to provide CLO sponsors

additional time to bring the CLO pools into conformity

with the asset requirements of the Volcker Rule and/or to

———————————————————— 113

12 C.F.R. § 248.20(e)(1).r.

114 Preamble, note 2561, 79 Fed. Reg. at 5752 n. 2561.

115 12 C.F.R. § 248.20(e)(2).


provide additional time for banking entities invested in

CLO structures that do not conform to Volcker Rule

requirements to divest their interests.

CONCLUSION

The Volcker Rule is intended to de-risk financial

institutions so as to limit potential risk to the stability of the

U.S. financial system. However, the rationale for applying

the Volcker Rule to the offshore activities of FBOs is

questionable. Traditionally, and under current principles of

home country/host country banking supervision, home

country legislators and regulators are responsible for

imposing investment and activity limitations on (and to

prescribe conflict-of-interest standards for) the financial

institutions headquartered in their jurisdictions, while host

country regulators have the authority to impose prudential

limitations on (and conflict-of-interest standards for)

activities conducted in the host country. The Volcker Rule

disregards this fundamental principal of international

banking regulation.

The Volcker Rule is highly prescriptive and complex but

breathtaking in its scope. Many questions of interpretation

remain despite the nearly 900 pages of commentary that

accompanied the Final Rule. Over the coming months, the

Agencies can be expected to provide some Volcker Rule

guidance, but a high-degree of clarity is not to be expected

in the short term, especially given the need for the five

Agencies to develop consensus.

FBOs will need to plan how best to achieve compliance

with the Volcker Rule, especially with respect to non-U.S.

operations. Strict adherence with the Volcker Rule by an

FBO in connection with its activities outside the United

States is likely to be a daunting task. Many FBOs may

choose to rely principally (or solely) on the SOTUS

Exemption for proprietary trading by limiting their trading

with U.S. counterparties to unaffiliated intermediaries.

However, reliance on the SOTUS Exemption will require

an appropriate compliance structure. One of many

unanswered questions is how an FBO’s activities outside

the United States will be able to achieve compliance with

the U.S.-centric conflict-of-interest rules embedded in the

prudential backstops.

FBOs may also wish to structure their fund investment

activities and investments to comply with the foreign fund

exclusion or exemption. Divestitures of non-conforming

fund investments may be necessary during the conformance

period. Ongoing fund investment and sponsorship may

also need to be restructured to conform to Volcker Rule

requirements.

Even for those FBOs who tailor most of their activities

to avoid, to the extent possible, engaging in prohibited

investments or activities, extensive monitoring (and

accompanying internal controls) will be required. A more

extensive compliance regime will be required for those who

choose to engage in permitted activities, such as

permissible hedging, underwriting, and market-making

activities, or permissible fund sponsorship and investment.

The Volcker Rule presents a challenge not only for the

banking entities subject to it, but also for the Agencies

responsible for its administration and enforcement. At best,

one can hope for a reasonable, measured, and common-

sense approach. ■

the volcker rule's impact on foreign banking …the “volcker rule” is the popular name for...

Documents