FSOC Publishes Volcker Rule Study

Developments of Note

FSOC Publishes Volcker Rule Study FDIC Issues Interim Final Rule Implementing Certain Orderly Liquidation Authority Provisions Financial Stability Oversight Council Issues Study and Recommendations Regarding Concentration Limits on Large Financial Companies SEC and Other Regulators Settle Administrative Proceedings Based on How Ultra-Short Bond Fund Was Marketed and Violations of 1940 Act Concentration Policy Limits ICI Files Comment Letter on President's Working Group Reform Options for Money Market Funds SEC Staff Delivers Study on Enhancing Investment Adviser Examinations to Congress SEC Delivers Study on Uniform Standards for Investment Advisers and Broker-Dealers SEC Proposes Permanent Rules and Forms for Municipal Advisor Registration SEC Staff Issues No-Action Letter Modifying Relief that Permits Broker-Dealers to Rely on Registered Advisers to Perform AML Customer Identification Other Items of Note

New ERISA Litigation Update Available SEC Proposes Rules Regarding Acknowledgement and Verification of Securities-Based Swap Transactions CFTC Proposes Rules and Guidance for Derivatives Clearing Organizations DEVELOPMENTS OF NOTE

FSOC Publishes Volcker Rule Study

The Financial Stability Oversight Council (the "FSOC") published its "Study and Recommendation on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds" (the "Study"). The Study, which was mandated by Section 619 of the Dodd-Frank Act, provides the federal banking agencies, the SEC, and the CFTC (collectively, the "Agencies") with recommendations that the Agencies must consider (but are not obligated to follow) in developing regulations to implement the Volcker Rule. The Agencies are required to adopt such regulations no later than nine months after the FSOC's completion of the study, meaning the regulations must be adopted by October 18, 2011.

The Volcker Rule, which was described in detail in July 28, 2010 Special Edition of the Alert, prohibits a "banking entity" from (1) engaging in trading activity in which it acts as a principal in order to profit from near-term price movements and (2) investing in, or having certain relationships with, any fund that is structured under exclusions commonly used by hedge funds and private equity funds under the Investment Company Act of 1940 (the "Investment Company Act"), unless the activity fits within one of the Volcker Rule's categories of permitted activities, such as market making, hedging, underwriting, or transactions in government securities. A "banking entity" is defined broadly to include (1) any insured depository institution, as defined in Section 3 of the Federal Deposit Insurance Act; (2) any company that controls an insured depository institution; (3) any company treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978, as amended; and (4) any affiliate or subsidiary of such a company.

Recommended Actions to Effectively Implement the Volcker Rule

The Study recommends that the Agencies consider taking the following actions in implementing the Volcker Rule:

Require banking entities to sell or wind down all impermissible proprietary trading desks. Require banking entities to implement a robust compliance regime, including public attestation by the chief executive officer (the "CEO") of the regime's effectiveness. Require banking entities to perform quantitative analysis to detect potentially impermissible proprietary trading without provisions for safe harbors. Perform supervisory review of trading activity to distinguish permitted activities from impermissible proprietary trading. Require banking entities to implement a mechanism that identifies to the Agencies which trades are customer-initiated. Require divestiture of impermissible proprietary trading positions and impose penalties when warranted. Prohibit banking entities from investing in or sponsoring any hedge fund or private equity fund, except in connection with bona fide trust, fiduciary or investment advisory services provided to customers. Prohibit banking entities from engaging in transactions that would allow them to "bail out" a hedge fund or private equity fund. Identify "similar funds" that should be brought within the scope of the Volcker Rule prohibitions in order to prevent evasion of the intent of the rule. Require banking entities to publicly disclose permitted exposure to hedge funds and private equity funds. Recommendations to Restrict Proprietary Trading

The Study includes a discussion of proprietary trading which outlines criteria for defining prohibited activities and describes indicia of permitted activities. The discussion also addresses the statutory limits that on permitted activities, including the prohibition on activities that would involve or result in a material conflict of interest, result in a material exposure to high-risk assets or high-risk trading strategies, pose a threat to the safety and soundness of the banking entity, or pose a threat to the financial stability of the United States.

Principles for Implementation

The Study recommends five fundamental principles that the Agencies should consider in their rulemaking and supervisory efforts with respect to proprietary trading:

The regulations should prohibit improper proprietary trading activity using whatever combination of tools and methods are necessary to monitor and enforce compliance with the Volcker Rule. The regulations and supervision should be dynamic and flexible so the Agencies can identify and eliminate proprietary trading as new products and business practices emerge. The regulations and supervision should be applied consistently across similar banking entities (e.g., large banks, hedge fund advisers, investment banks) and their affiliates to facilitate comparisons. The regulations and supervision should endeavor to provide banking entities with clarity about criteria for designating trading activity as impermissible proprietary trading. The regulations and supervision should facilitate predictable evaluations of outcomes so the Agencies and banking entities can discern what constitutes a prohibited and a permitted trading activity. The regulations and supervision should be sufficiently robust to account for differences among asset classes as necessary (e.g., cash and derivatives markets). Identification of "Bright Line" Proprietary Trading

The Study recommends that the Agencies develop criteria to identify "bright line" proprietary trading. The Study notes that a key requisite element of "bright line" proprietary trading is that the activity involves the use of a banking entity's capital and is organized and conducted for the purpose of benefiting from future price movements. In addition, the Study observes that "bright line" proprietary trading is typically characterized by one or more of the following additional characteristics:

Organized to conduct trading activities for the sole purpose of generating profits from trading strategies; No formal market making responsibilities or customer exposure (or customer exposure that is not commensurate with the level of trading); Physical and/or operational separation from market making and other operations having customer contact; Trades with or is provided the services of, sell side analysts, brokers, and dealers; Receives and utilizes research or soft dollar credits provided by other broker-dealers; and/or Compensation structure similar to those of hedge fund managers and other managers of private pools of capital. Distinguishing Permitted Activities from Impermissible Proprietary Trading Activities

The Study recognizes that, of the permitted activities under the Volcker Rule that relate to proprietary trading, the most difficult to distinguish from impermissible proprietary trading are market making-related activity, risk-mitigating hedging, and underwriting. In each of these areas, the Study identifies indicia of permitted activities that will help the Agencies in determining whether the activity is fully consistent with activities permitted under the Volcker Rule.

Market Making. To ensure that market making does not mask prohibited proprietary trading, the Study recommends that the Agencies should provide guidance that will assist banking entities in determining what constitutes prohibited activity. In particular, the Study recommends that the Agencies consider the SEC's 2008 guidance which established indicia of bona fide market making in equity markets, including: Making continuous, two-sided quotes and holding oneself out as willing to buy and sell on a continuous basis; Making a comparable pattern of purchases and sales of a financial instrument in a manner that provides liquidity; Making continuous quotations that are at or near the market on both sides; and Providing widely accessible and broadly disseminated quotes. The Study also notes that the SEC has stated that, generally, market markers post quotes at a price above the national best bid and provide liquidity on the opposite side of the market. While the SEC has not provided similar guidance for less liquid markets, such as debt, derivatives, or asset-backed security markets, the Study also sets forth indicia that could be applied in less liquid markets to determine if market making activity is in compliance with the Volcker Rule.

Hedging. The Study recommends that, in examining the activities of a trading desk to determine whether a hedge qualifies as risk-mitigating or is instead proprietary trading, the following indicia should be considered: Hedging activity should be designed to reduce the key risk factors in a banking entity's existing exposure, and should offset gains or losses that would arise from those exposures. Hedging activity should adjust over time based on changes in a banking entity's underlying exposures. Hedging activity should also adjust over time if market conditions alter the...