A User’s Guide To The Volcker Rule

SUMMARY

The legislation known as the Volcker Rule was enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and codified in Section 13 of the Bank Holding Company Act ("BHC Act").1 The Volcker Rule generally prohibits, subject to exceptions, a banking entity from engaging in proprietary trading and from acquiring or retaining an ownership interest in or sponsoring a hedge fund or private equity fund. Certain trading and fund activity is expressly permitted - notably, underwriting activities, market making-related activities, and risk-mitigating hedging activities.

The Volcker Rule legislation covered the area with a broad brush, leaving many significant issues open to regulatory interpretation. In December 2013, five federal financial regulatory agencies (collectively, the "Agencies"),2 adopted a final rule (the "Final Rule") construing the Volcker Rule.3 The Final Rule also sets out a compliance and reporting regime for banking entities engaged in proprietary trading or fund sponsorship or investment. The determinations made by the Agencies in the Final Rule reflect two years of comment and debate following the issuance of a Proposed Rule (the "Proposed Rule") in November 2011.

Under the Final Rule, larger banks and bank affiliates (based on total assets) that are engaged in proprietary trading permitted by the Final Rule will be subject to a compliance regime to ensure compliance with the Final Rule. In addition, larger banks and bank affiliates (in terms of the amount of their trading assets and liabilities) that are engaged in proprietary trading permitted by the Final Rule will be required to report a highly technical set of quantitative measures. Banking entities with only a "modest" level of trading and fund investment activities will be subject to a much less comprehensive set of compliance requirements. The compliance requirements are discussed in more detail below.

The Final Rule is complex in scope and has already elicited significant commentary and questions from the banking industry and the public at large. The purpose of this guide is to discuss the requirements of the Final Rule at a practical level. While the relevant components of the Final Rule are addressed here, financial institutions should consider all of the Final Rule's "fine print" - the many detailed definitions and conditions that comprise the Final Rule (as well as the extensive commentary contained in Attachment B to the Final Rule) - before making any decisions regarding compliance.

The Volcker Rule, as construed by the Final Rule, has special application to foreign banking organizations that have U.S. bank subsidiaries or operate branches, agencies or commercial lending company subsidiaries in the United States ("FBOs"). Please refer to our Client Alert dated December 11, 2013 for a more complete explanation of the impact of the Final Rule on FBOs. The Client Alert may be found at http://www.mofo.com/files/Uploads/Images/131211-Volcker-Rule.pdf.

The Conformance Period

The Final Rule is effective April 1, 2014, but the compliance period during which banking entities must conform their activities to the Volcker Rule has been extended for one year until July 21, 2015. Nonetheless, effective June 30, 2014, the largest banking entities (those with $50 billion or more in consolidated trading assets and liabilities, as discussed further below) are required to report quantitative measurements to regulators.

The FRB emphasized in its order approving the extension of the conformance period that 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.

Banking Entities

The Volcker Rule applies to "banking entities." A "banking entity" includes:

any insured depository institution; any company that controls an insured depository institution (in other words, any bank holding company or savings and loan holding company); any FBO; and any affiliate of the foregoing. The term "affiliate" is used as defined in the BHC Act and thus includes any company controlled by a banking entity. Notwithstanding the breadth of the definition of a "banking entity," there are certain specific exceptions. For example, a "banking entity" does not include a covered fund that is not itself a bank holding company or an FBO. This is an important exception. A bank holding company that serves as the general partner of a fund would be deemed to control that fund. But for this exception, the "covered fund" would itself be a "banking entity" subject to the Volcker Rule.

In addition, a "banking entity" does not include a portfolio company held by a bank holding company or an FBO under the so-called BHC Act's merchant banking authority,4 a company controlled by an insurance company affiliate of a bank holding company,5 or any portfolio concern that is controlled by a small business investment company, as defined in Section 103(3) of the Small Business Investment Act of 1958, as long as the portfolio company or...