Regulations Proposed to Implement the Volcker Rule
October 13, 2011
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) included
the so-called “Volcker Rule,” which prohibits banking entities from engaging in proprietary
trading and from investing in or sponsoring private equity funds and hedge funds. The
Volcker Rule, which was codified as Section 13 of the Bank Holding Company Act of 1956, as
amended (the “BHC Act”), 1 takes effect on July 21, 2012 and banking entities have until July 21,
2014 to bring their activities into compliance with the rule. The Board of Governors of theFederal Reserve System (the “Federal Reserve”) has the authority to grant extensions to banking
entities beyond July 21, 2014 and on February 14, 2011 it issued final rules governing suchextensions. The Federal Reserve, the Office of the Comptroller of the Currency, the Federal
Deposit Insurance Corporation (the “FDIC”) and the Securities and Exchange Commission (the“SEC”) are obligated by Dodd-Frank to issue final regulations governing the Volcker Rule(other than the conformance period extensions) by October 18, 2011. On October 11, 2011, theagencies issued for public comment a joint notice entitled “Prohibitions and Restrictions on
Proprietary Trading and Certain Interests In, and Relationships with, Hedge Funds and Private
Equity Funds” (the “Proposed Rule”).
The public comment period for the Proposed Rule will run until January 13, 2012. Nearly 400
questions have been layered within the proposal to guide public and industry comment and,given the prominence of the Volcker Rule and the financial industry’s oft-expressed concerns
about its potential effects, the comment period is expected to be an active one. Following thecomment period, the agencies are expected to issue a final rule in early 2012.
A.

THE GENERAL PROHIBITION

The Volcker Rule broadly prohibits proprietary trading and sponsoring or investing in private
funds. In adopting the Proposed Rule, the agencies stated that these prohibitions are notintended to prevent banking entities from engaging in client-oriented financial services,
including underwriting, market making and asset management.
In the case of the prohibition on sponsoring or investing in private funds, this interpretation of
the intent of the Volcker Rule results in a Proposed Rule that is favorable to banking entities. In
particular, the Proposed Rule will provide banking entities with considerable leeway to sponsor
private funds as long as they are primarily a way to provide investment management services
to others rather than for the banking entities to make investments for its own account.

1

12 U.S.C. § 1851, et seq.

Memorandum – October 13, 2011

In the case of the prohibition on proprietary trading, the distinction between client-oriented
financial services and other trading activities is sometimes difficult to make. The agencies
acknowledge this challenge and attempt to meet it by adopting a “multi-faceted approach.” In
addition to writing a regulation that sets forth criteria for determining what is permissible andimpermissible, the agencies mandate, in considerable detail, the compliance programs thatbanking entities must establish. The Proposed Rule also contains a separate commentary on
how the agencies will distinguish permissible and impermissible activities. Finally, banking
entities are required to collect and report extensive quantitative data that is intended to assist
both banking entities and agencies in making this distinction.
The Volcker Rule does not apply to nonbank financial institutions that are designated assystemically important by the Financial Stability Oversight Council and, as a result, are subject
to supervision by the Federal Reserve. However, Dodd-Frank requires the Federal Reserve toimpose on such companies that engage in activities prohibited by the Volcker Rule additional
capital requirements, quantitative limits, or other restrictions. The Proposed Rule does notaddress such restrictions, which the agencies believed would be premature in light of the factthat the Council has not designated any nonbank financial institution as systemically significant
or even finalized the criteria for such designations.
B.

THE PROHIBITION OF PROPRIETARY TRADINGThe Proposed Rule defines proprietary trading to mean engaging in the purchase or sale of one
or more covered financial positions as principal for the trading account of the banking entity. A“covered financial position” is defined as any long, short, synthetic or other position in asecurity, a derivative or a contract of sale of a commodity for future delivery. For this purpose,a “derivative” does not include transactions that have been excluded from the definition ofswap by the Commodity Futures Trading Commission and the SEC, or identified banking
products (as defined by statute).
1.

Definition of Trading Account

The term “trading account” is defined in the Proposed Rule as any account used for taking
covered financial positions for the purpose of: (i) short-term resale 2; (ii) benefiting from shortterm price movements; (iii) realizing short-term arbitrage profits 3; or (iv) hedging one or moresuch positions. The term also includes any account used by a banking entity that is subject tothe Market Risk Capital Rules to acquire a position that is subject to those rules, with certain
exceptions. Finally, the term includes any account used by a banking entity that is a securities
2

The explanation of the Proposed Rule states that this would include a derivative, commodity
future or other position that, regardless of the term of that position, is subject to the exchange ofshort-term variation margin through which the banking entity intends to benefit from short-term
price movements.

3

This would include positions taken to benefit from varying prices in different markets, even if noprice movements are required to achieve the benefit.

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Memorandum – October 13, 2011

dealer, swap dealer or securities-based swap dealer to acquire or take a position in connection
with its dealing activities.
The Proposed Rule excludes from the definition of trading account certain positions under
repurchase and reverse repurchase agreements, securities lending transactions, positions taken
for bona fide liquidity management purposes, and certain positions held by clearing agencies.
The definition of trading account repeatedly uses the phrase “short-term,” without further
defining that phrase. The agencies state in the rule that “the precise period of time that may beconsidered near-term or short-term for purposes of evaluating any particular covered financial
position would depend on a variety of factors, including the facts and circumstances of thecovered financial position’s acquisition, the banking entity’s trading and business strategies,
and the nature of relevant markets.” 4 However, the Proposed Rule includes a rebuttablepresumption that an account is a trading account if it is used to take a position that is held forless than 60 days.
2.

Permitted Underwriting Activities

The prohibition on proprietary trading excludes normal underwriting activities. The Proposed
Rule makes it clear that this exemption includes private placements. In general, this exemption
does not present difficult interpretive issues.
3.

Permitted Market Making Activities

The prohibition on proprietary trading does not apply to market making. Perhaps the mostdifficult aspect of implementing the Volcker Rule is distinguishing permissible market making
activities from proprietary trading. The agencies noted that: “Market making-related activities,
like prohibited proprietary trading, sometimes require the taking of positions as principal, andthe amount of principal risk that must be assumed by a market maker varies considerably byasset class and differing market conditions.” 5
The Proposed Rule attacks this issue from three directions. First, it sets forth a number ofcriteria that a banking entity must satisfy to demonstrate that it is engaged in bona fide market
making activities rather than trading. Second, it includes as Appendix B to the Proposed Rule acommentary that discusses how the agencies will distinguish between market making andtrading. Third, it requires banking entities that hold a significant amount of trading assets tocollect and report detailed quantitative information that is intended to permit both the banking
entity and the agencies to identify activities that may constitute proprietary trading.

4

Proposed Rule, at 31.

5

Proposed Rule, at 53.

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Memorandum – October 13, 2011a.

Criteria for Market Making Activities

The Proposed Rule sets forth seven criteria for permitted market making activities. The first
criterion is that the banking entity must establish a compliance program in accordance with
Subpart D to the Proposed Rule. Subpart D requires: (i) internal policies and procedures
reasonably designed to document, describe, and monitor trading activities; (ii) a system ofinternal controls reasonably designed to monitor and identify potential areas of noncompliancewith the Volcker Rule and to prevent the occurrence of activities and investments that areprohibited by the Volcker Rule; (iii) a management framework that clearly delineates
responsibility and accountability for compliance with the Volcker Rule; (iv) independent testingof the effectiveness of the compliance program; (v) training for trading personnel and managers;and (vi) making and keeping records sufficient to demonstrate compliance.
The second criterion is that the trading desk or other organization unit within a banking entitythat relies on the market making exception to take a covered position must actually make amarket in that type of covered position by holding itself out as being willing to buy and sell thecovered position on a regular and continuous basis. In liquid markets, whether a banking entity
is holding itself out as making a market is not difficult to determine. In illiquid markets, theagencies acknowledge that providing quotes may be regular, but not continuous, and thattransaction volumes and risk retention will be a function of customer liquidity and investment
needs. Bona fide market making includes block positioning if it is for the purpose ofintermediating customer trading.
The third criterion is that positions taken must be designed so as not to exceed the reasonably
expected near-term demands of clients. The agencies stated that this expectation “should
generally be based on the unique customer base of the banking entity’s specific market making
business lines and the near-term demands of those customers based on particular factors
beyond a general expectation of price appreciation.” 6 The agencies expect that the data thatbanking entities will be required to collect will be useful in assessing compliance with thiscriterion.
The fourth criterion is that the banking entity must be appropriately registered as a dealer (or aparticular type of dealer) under applicable law.
The fifth criterion is that the revenues attributable to market making activities must be derived
primarily from fees, commissions, bid/ask spreads or other income not attributable toappreciation in the covered positions held in connection with the market making activity.
The sixth criterion is that compensation of employees in the market making function must not
be designed to encourage or reward proprietary risk-taking.

6

Proposed Rule, at 58.

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Memorandum – October 13, 2011

The seventh criterion is that the market making activities must be consistent with thecommentary provided in Appendix B to the Proposed Rule, which describes how agencies’ will
distinguish between permissible market making activities and impermissible proprietary
trading.
b.

Market Making Commentary

Due to differences in markets and in market conditions, the agencies were not able to embody
the distinction between permissible market making activities and impermissible proprietary
trading in a set of hard and fast rules. For this reason, the criteria described above aresupplemented with a commentary that describes, in general terms, the difference between
market making and proprietary trading, in terms of the purpose of the activity (intermediation
rather than to earn profits as a result of price movements), the source of profitability (fees andcommissions rather than price movements on covered positions), the volatility of profits(consistent profitability and low earnings volatility under normal market conditions), and theamount of transactions with non-customers (engaged in only to facilitate transactions withcustomers).
The commentary maps these differences to the following key factors: risk management; sourceof revenues; revenues relative to risk; customer facing activity; payment of fees; andcompensation incentives. For each such factor, the commentary specifically describes what theagencies will look for in assessing whether the trading unit is engaged in proprietary trading
and which of the quantitative measures that banking entities are required to collect the agencies
consider relevant to the assessment of that factor. The agencies will consider not only the
metrics provided by the trading unit, but those provided by other trading units within thebanking entity and those provided by unaffiliated banking entities for the same type of covered
position.
For example, in the case of risk management, the commentary states that where a trading unit
retains risk in excess of the size and type required to provide intermediation services tocustomers, the agencies will consider the trading unit to be engaged in proprietary trading. In
reaching this judgment, the agencies will consider the amount of risk that generally must be
retained to make a market in the position in question, the hedging options that are available tothe trading unit, the amount of risk retained by the trading unit in the past, and the risk
retained and hedging policies of other trading units. In considering how current behavior
compares to past behavior, the agencies will consider market-wide changes in risk and hedging
options, as well as the existence of temporary market disruptions. The metrics that the agencies
will use to assess the risk management factor are VaR and Stress VaR, VaR Exceedence, andRisk Factor Sensitivities.
The commentary proceeds through the other five factors in a similar fashion, citing the relevant
considerations, the circumstances that will suggest impermissible proprietary trading, and theparticular quantitative measures that the agencies consider relevant to assessing that factor.

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Memorandum – October 13, 2011c.

Quantitative Reporting Requirements

Appendix A to the Proposed Rule sets forth reporting and recordkeeping requirements thatmust be complied with by banking entities that hold a significant amount of trading assets. A
banking entity is subject to these requirements if its trading assets and liabilities at the end ofeach of the prior four quarters equal or exceed either $1 billion or 10% of its total assets. A more
extensive set of requirements applies to any banking entity that has trading assets and liabilities
at the end of each of the prior four quarters that equal or exceed $5 billion.
The quantitative measurements must be collected at the level of each “trading unit.” Theparticular entity that is actually executing the transactions is a trading unit. If another entity
oversees that unit and coordinates risk-management for multiple such units, that second entity
would also be considered a trading unit and would be required to collect and report thequantitative measurements with respect to the first trading unit as well as other trading units
for which it is responsible. The top tier entity in the banking organization, is also considered a
trading unit. In this way the activity of the trading unit that is executing the transactions will bereflected in information collected and reported by a series of other trading units within thebanking organization.
Appendix A then lists the specific quantitative measures that must be maintained (e.g., Valueat-Risk, Stress VaR, VaR Exceedence), calculation periods, the frequency of required calculation
and reporting, and recordkeeping requirements.
4.

Permitted Hedging Activities

Another exception from the Volcker Rule prohibition on proprietary trading is risk-mitigating
hedging activities. This exception also presents challenges to the agencies in distinguishing
between hedging transactions that a banking entity enters into so as to manage or eliminate
risks arising from related positions and hedging transactions that a banking entity enters into tobenefit from price movements relating to the hedge position itself. As in the case of market
making, the agencies are adopting a multifaceted approach to making such distinctions: a set ofcriteria that attempt to distinguish permissible from impermissible activities; the requirementthat banking entities put a compliance program in place (including written hedging policies at
the trading unit level and clearly articulated trader mandates); and the requirement to collectquantitative information relating to specific metrics.
The criteria that the Proposed Rule sets forth for engaging in risk-mitigating hedging activities
include a requirement that hedging transactions mitigate one or more specific risks (including
market risk, counterparty risk, currency risk, interest rate risk, basis risk and similar risks)arising in connection with or related to individual or aggregated positions of the banking entity.
The banking entity also must be prepared to identify the specific risks being hedged and how
the hedge reduces those risks. The hedging transaction may not itself give rise to significant
exposures that are not themselves hedged in a contemporaneous transaction. The hedging
transaction also must be subject to continuing review, monitoring and management after the

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Memorandum – October 13, 2011

hedge is established. Finally, the banking entity must document, at the time the hedge isestablished, the risk-mitigating purpose of the transaction.
5.

Other Permitted Proprietary Trading Activitiesa.

Trading on Behalf of Customers

The Volcker Rule excludes from the prohibition on proprietary trading transactions entered into“on behalf of customers” without defining that phrase. The Proposed Rule specifies three typesof transactions that meet this standard: (i) purchase or sale of a financial position in the capacityof an investment advisor or similar fiduciary where the customer is the beneficial owner of theposition; (ii) riskless principal transactions; and (iii) trading for the separate account of
insurance policyholders by a banking entity that is an insurance company.
b.

Permitted Trading by a Regulated Insurance Company

The Volcker Rule includes an exception that permits a banking entity to purchase and sell acovered financial position if the banking entity is a regulated insurance company acting for its
general account or an affiliate of an insurance company acting for the insurance company’s
general account, and the transaction is subject to, and in compliance with, the insurancecompany investment laws of the jurisdiction in which the insurance company operates.
The Proposed Rule includes this exemption. The Proposed Rule defines a “general account” as
all of the assets of the insurance company that are not legally segregated and allocated toseparate accounts under applicable State law. The Proposed Rule’s treatment of this exemption
generally appears to be noncontroversial.
One point that is not addressed by the Proposed Rule is whether the exemption extends toinvestments in private funds. The term “covered financial position” is certainly broad enoughto cover an interest in a private fund. However, investments in private funds are not typicallyacquired with the intent to hold them only for the short term, so arguably such investments are
simply not relevant to the ban on proprietary trading (or to the insurance company generalaccount exemption from that ban). If that is the case, then it would appear that insurancecompanies would need a separate exemption from the Volcker Rule ban on banking entity
investments in private funds. The Volcker Rule itself does not provide one; neither does the
Proposed Rule regarding such investments (discussed below).
The agencies do not discuss this point in the Proposed Rule so it is difficult to say whether the
result is intentional or simply an oversight. It should be noted that the Volcker Rule only
applies to insurance companies that own or control a depository institution or that are foreignbanking organizations with a U.S. branch or agency. In adopting capital rules for banking
entities to implement the Collins Amendment, which (like the Volcker Rule) only applies toinsurance companies that own a U.S. depository institution, the Federal Reserve disregardedcomments from insurance companies that bank capital requirements are inappropriate for
insurance companies in light of their very different business model. The treatment of insurance

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Memorandum – October 13, 2011

company investments in private funds may similarly reflect a view that, absent a statutory
exemption, insurance companies that choose to own depository institutions must live with thesame rules as other companies that own them.
c.

Permitted Trading Outside of the United States

The general policy of the United States with respect to foreign banking organizations thatengage in banking in the United States through a U.S. branch, agency or bank subsidiary is togenerally subject their U.S. financial activities to the same restrictions as apply to U.S. banking
organizations, while not restricting the foreign banking organizations’ non-U.S. activities.
Section 4(c)(9) of the BHC Act provides the Federal Reserve with the authority to implementthat policy by exempting from the BHC Act activities of foreign banking organizations wheresuch an exemption is consistent with the purposes of the BHC Act and in the public interest.
This authority has been used, for example, to exempt from the restrictions of the BHC Act the
non-U.S. activities of foreign banking organizations. In order to be eligible for these
exemptions, the foreign bank must be a “qualified foreign banking organization” (a “QFBO”).
The QFBO test, which is based on assets, revenue and net income, is intended to ensure that theexemptions are only available to a foreign banking organization that it is primarily a bank (itsnon-U.S. banking business exceeds its worldwide nonbanking business) and the banking
business of which is primarily foreign (its non-U.S. banking business exceeds its U.S. banking
business).
Prior to Dodd-Frank, foreign companies that owned depository institutions that are not “banks”
for purposes of the BHC Act (such as thrifts, credit card banks, and industrial loan companies)
were not subject to the BHC Act. Such foreign companies come within the definition of“banking entity” in the Volcker Rule and are generally subject to its restrictions. Suchcompanies may not be engaged in banking (other than holding a U.S. depository institution)
and, if that is the case, will not qualify as QFBOs. The Proposed Rule nevertheless allows suchforeign banking entities to rely upon the same exemption from the Volcker Rule as QFBOs toengage in proprietary trading outside the United States provided that, by certain measures ofassets, revenues and net income, the foreign company’s non-U.S. business is larger than its U.S.
business.
The exemption from the Volcker Rule for proprietary trading that occurs solely outside theUnited States is only available to QFBOs and foreign companies that conduct a majority of theirbusiness outside the United States. In addition, a transaction will be considered to haveoccurred solely outside of the United States and exempt from the ban on proprietary trading
only if four conditions are met. The first condition is that the transaction is conducted by abanking entity that is not organized under the laws of the United States. Because any entity that
controls a company is deemed to be engaged in the activities of that company, this means that
not only must the banking entity that engages in the transaction be foreign, but that each entitythat controls the banking entity must also be foreign. For example, a QFBO could not rely on
this exemption for activity conducted by a subsidiary that is organized under U.S. law.

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Memorandum – October 13, 2011

The second condition is that no party to the transaction may be a resident of the United States.
This is a very strict interpretation of Section 4(c)(9). In general, for purposes of Section 4(c)(9),an activity is considered to be engaged in within the United States only if it is conducted
through a U.S. office or subsidiary. The requirement of the Proposed Rule that no party to thetransaction may be a resident of the United States means that, for example, a foreign bank thathas a trading operation outside the United States, and that has no trading personnel in the
United States, is engaged in prohibited proprietary trading in the United States if in the courseof that activity it purchases a security on an exchange or from an individual located in the
United States. In light of this condition, the remaining two conditions (that no personnel of theforeign bank that is directly involved in the transaction be located in the United States and thatthe transaction is executed wholly outside the United States) may be superfluous.
The term “resident of the United States” is defined to include:(i) any natural person resident in the United States; (ii) any
partnership, corporation or other business entity organized orincorporated under the laws of the United States or any State; (iii)any estate of which any executor or administrator is a resident of
the United States; (iv) any trust of which any trustee, beneficiaryor, if the trust is revocable, settlor is a resident of the UnitedStates; (v) any agency or branch of a foreign entity located in the
United States; (vi) any discretionary or non-discretionary accountor similar account (other than an estate or trust) held by a dealer
or fiduciary for the benefit or account of a resident of the UnitedStates; (vii) any discretionary account or similar account (otherthan an estate or trust) held by a dealer or fiduciary organized orincorporated in the United States, or (if an individual) a residentof the United States; or (viii) any partnership or corporation
organized or incorporated under the laws of any foreign
jurisdiction formed by or for a resident of the United Statesprincipally for the purpose of engaging in one or moretransactions described in . . . the Proposed Rule. 7d.

Limitations on Permitted Proprietary Trading Activities

Proprietary trading that is generally permitted by the Proposed Rule, such as permissible
underwriting and market making activities and risk-mitigating hedging activities, neverthelessis impermissible if it involves a material conflict of interest between the banking entity and its
customers or counterparties, results in a material exposure by the banking entity to a high-risk
asset or poses a threat to the safety and soundness of the banking entity or the financial stabilityof the United States.

7

Proposed Rule, at 80.

Page 9Memorandum – October 13, 2011

The Propose Rule states that the mere fact that a buyer and seller are on opposite sides of atransaction does not, considered alone, amount to a material conflict of interest of the type that
the Volcker Rule was intended to address.
Where a material conflict of interest does exist, it can be addressed by the banking entity
through “clear, timely, and effective disclosure of the conflict” 8. The Proposed Rule provides
additional detail on this way of dealing with conflicts of interest. In many cases, banking
entities use information barriers to prevent a material conflict of interest from having anadverse effect on a client or counterparty. The Proposed Rule generally accepts information
barriers as a way of addressing potential conflicts of interest. However, if, notwithstanding
such information barriers, the banking entity “knows or should reasonably know” that amaterial conflict of interest may have a material adverse effect upon a client or counterparty, it
may not rely on such information barriers alone. In such cases, timely and effective disclosureof the conflict may also be required.
Otherwise permissible trading activities are also impermissible if they results in a material
exposure by the banking entity to a high-risk asset or involve a high-risk trading strategy,
which are defined in the Proposed Rule as assets or strategies that significantly increase thelikelihood that the banking entity would incur a substantial loss or would fail. Other thannoting that assets or strategies with significant embedded leverage might be high risk, it
appears that, at least for now, the agencies will look to the banking entities, which are required
to address high-risk assets and high-risk strategies in their compliance programs, to define what
those terms mean.
C.

THE PROHIBITION ON INVESTING IN AND SPONSORING PRIVATE FUNDSThe Proposed Rule implements this prohibition by generally prohibiting a “banking entity,” “asprincipal,” from directly or indirectly, acquiring or retaining an equity, partnership or other“ownership interest” in, or acting as “sponsor” to, a “covered fund.” These terms are critical tounderstanding the Proposed Rule and are discussed below.
1.

“Banking Entity”

The definition of “banking entity” closely tracks the language of Dodd-Frank. A banking entity
includes: (i) any insured depository institution; (ii) any company that controls an insured
depository institution (i.e., bank and thrift holding companies, but also any company that
directly or indirectly controls a “nonbank bank,” such as a credit card bank or industrial loan
company); and (iii) any company that is treated as a banking holding company under theInternational Banking Act of 1978 (i.e., foreign banks that have a U.S. branch, agency orcommercial lending subsidiary).
Although the term banking entity is defined to include any affiliate or subsidiary of suchbanking entities, the Proposed Rule carves out any affiliate or subsidiary of a banking entity
8

Proposed Rule, at 105.

Page 10Memorandum – October 13, 2011that is a “covered fund” for purposes of the Volcker Rule or an entity controlled by suchcovered fund. This exclusion has a number of ramifications. For example, it was clearly
contemplated that banking entities would be permitted to control certain private funds and thatthose entities would in turn invest in private funds, in a “fund of funds” structure or otherwise.
Had the definition of banking entity included covered funds controlled by a banking entity,
such structures would have been impermissible. Another effect (discussed below) is to exclude
portfolio companies of a covered fund from the prohibition on transactions between a banking
entity and a covered fund.
2.

“Covered Fund”

The Volcker Rule, as adopted by Congress, applies to sponsorships of and investments in a
“private equity fund,” “hedge fund” or “such similar funds” as the appropriate federal banking
and other financial agencies may determine by rule. The Volcker Rule defines a private equity
fund and a hedge fund synonymously as any issuer that would be an investment company but
for the exemptions provided by Section 3(c)(1) (funds with 100 or fewer holders) or 3(c)(7)(funds sold only to “qualified purchasers”) of the Investment Company Act of 1940. The
Proposed Rule defines such funds, and similar funds that the agencies may define by rule, as“covered funds.”
The agencies make clear in the Proposed Rule that an issuer will not be considered a covered
fund if it meets the standards for an exemption from the definition of an “investment company”
under the Investment Company Act other than the Section 3(c)(1) or 3(c)(7) exemptions, even if
it also meets and has relied upon Section 3(c)(1) or 3(c)(7).
Since the enactment of Dodd-Frank and the Financial Stability Oversight Council’s study on the
Volcker Rule that was issued on January 18, 2011, there has been uncertainty as to what theagencies might include within the “such similar funds” bucket. In the Proposed Rule, two types
of funds have been so designated:••

Commodity Pools—a commodity pool, as defined in the Commodity Exchange Act, and“Foreign Equivalents” of Covered Funds—funds that are organized or offered outside
the United States that, if organized or offered within the United States, would becovered funds but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act.

The proposal explains that these entities will be treated as covered funds because they are
generally managed and structured similar to a covered fund, except that they are generally not
subject to federal securities laws due to the types of instruments in which they invest or the factthat they are not organized in the United States.
It is not clear how the foreign equivalent fund provision will be implemented inasmuch as suchfunds may be similar to U.S. private funds without precisely fitting the Section 3(c)(1) or 3(c)(7)
exemption. The agencies may find it necessary to define such foreign equivalents in terms ofstructural characteristics, such as the number and type of investors. It should be clear that
foreign mutual funds are not equivalent to covered funds. Also, to the extent that foreign funds
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Memorandum – October 13, 2011

are sponsored and sold by QFBOs solely outside the United States, they will be exempt from theVolcker Rule even if they are foreign equivalents of covered funds.
The proposal recognizes that certain entities and corporate structures could technically fallwithin the definition of a covered fund, even though they would not usually be thought of as a
private equity fund or hedge fund. Accordingly, the following entities are effectively excluded
from the definition of a covered fund:
•
•

•

•

Joint Ventures—joint ventures that are operating companies and do not engage in any
activity prohibited under the Volcker Rule.
Acquisition vehicles—an acquisition vehicle whose sole purpose and effect is toeffectuate a transaction involving the acquisition or merger of one entity with or into
the banking entity or one of its affiliates.
Certain wholly-owned subsidiaries—wholly-owned subsidiaries of a banking entity thatare principally engaged in performing bona fide liquidity management activities andare carried on the balance sheet of the banking entity.
Loan securitization vehicles—certain issuers of asset-backed securities in the
securitization context.

These exceptions are very narrow. It is not clear that joint ventures that are operatingcompanies and wholly-owned subsidiaries of banking entities would come within theinvestment company definition in the first place. As suggested by one of the questions on
which the agencies seek comment, in excluding entities that the Volcker Rule was not intended
to cover, it would be more helpful for the Proposed Rule to cite the characteristics of a private
fund that might involve the conflict of interest concerns that gave rise to the Volcker Rule.
3.

“As Principal”

The general prohibition on a banking entity investing in covered funds applies only when thebanking entity is investing “as principal,” either directly or indirectly. The Proposed Rule statesthat the prohibition on investing or retaining an ownership interest (including a general partner
or membership interest) in a covered fund does not apply to investments made: (i) by a banking
entity’s director or officer who acquires ownership interests in his or her personal capacity andwho is directly engaged in providing “advisory or other services” to the covered fund,provided that such person does not use funds borrowed from the banking entity to make theinvestment; (ii) by a banking entity acting in good faith in a fiduciary capacity or in its capacity
as a custodian, broker or agent for an unaffiliated third party; and (iii) by a qualified employee
benefits plan under ERISA. 9
This language in the Proposed Rule relates to investments in covered funds as a general matter.
In that regard, item (i) appears to be incorrectly worded: an investment by a director or officer
9

Proposed Rule, at 113.

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Memorandum – October 13, 2011in a fund should not be considered an investment by the banking entity, regardless of whether
or not the person is directly engaged in providing “advisory or other services” to the covered
fund. The language appears to confuse the general analysis of when a banking entity isinvesting as principal, with the rules that apply to a particular exemption for covered funds thatare sponsored by banking entities and in which they have a de minimis investment. One of theconditions to that exemption (discussed below) is that directors and employees, other thandirectors and employees who are directly engaged in providing “advisory or other services” tothe covered fund, may not invest in the fund.
4.

“Ownership Interest”

An “ownership interest” in a covered fund is defined broadly to include any equity, partnershipor “other similar interest” in a covered fund, whether voting or nonvoting, as well as any
derivative of such interest. This would include, without limitation, shares, equity securities,
warrants, options, general partnership interests, limited partnership interests and membershipinterests.
The proposal makes clear that substance, not form, will be what matters. In this regard, thefocus will be on the attributes of an ownership interest and, specifically, whether it provides abanking entity with economic exposure to the profits and losses of the covered fund. For
example, if a debt instrument exhibits substantially the same characteristics as an equity
instrument (e.g., voting rights; the right or ability to share in the fund’s profits or losses; theability to earn a return, either directly by contract or through a synthetic interest, based on theperformance of the fund’s underlying holdings or investments), then the agencies may treat it
as an ownership interest for purposes of the Volcker Rule.
“Carried interest” received by a banking entity as compensation for serving as an investment
manager or investment advisor to a covered fund will not be considered an ownership interestin such fund provided that: (i) the sole purpose of the interest is to provide performancecompensation for services provided to the fund; (ii) the carried interest is distributed to thebanking entity (or if temporarily reinvested in the fund, the banking entity does not share in the
profits or losses related to such reinvestment); (iii) the banking entity provides no funds inconnection with acquiring or retaining this interest and (iv) the interest is not generallytransferrable by the banking entity.
5.

“Sponsor”

The definition of sponsorship under the Proposed Rule is the same as the definition provided
by the statute. An entity will be the “sponsor” of a covered fund if it: (i) serves as its generalpartner, managing member, trustee (unless such trustee does not exercise investment
discretion) or commodity pool operator; (ii) in any manner, selects or controls (or has
employees, officers, directors or agents who constitute) a majority of the directors, trustees ormanagement of a covered fund; or (iii) shares with a covered fund the same name or a variationof the same name for corporate, marketing, promotional or other purposes.

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Memorandum – October 13, 2011

D.

THE MAIN EXEMPTIONSThere are a number of exemptions from the Volcker Rule’s general prohibition on banking
entities sponsoring or investing in covered funds. The main exemptions are discussed below,
but there are also a number of exemptions, including those for investing in funds qualifying as“small business investment companies” and community reinvestment-related funds, bankowned life insurance (BOLI), and funds for which an ownership interest has been acquired in
the ordinary course of collecting a debt previously contracted.
1.

The Sponsored Funds Exemption

Perhaps the most important aspect of the Proposed Rule as it relates to private funds is thetreatment of funds sponsored by a banking entity in which the banking entity has a small
investment. The statutory language requires that such a fund be organized and offered “only inconnection with the provision of bona fide trust, fiduciary, or investment advisory services andonly to persons that are customers of such services of the banking entity.” This language could
have been interpreted to mean that such a fund could only be sold to persons who had asignificant pre-existing relationship to the banking entity as a trust, fiduciary or investment
advisory client, in which case this exemption would have been of little use to most banking
entities, preventing them from sponsoring funds going forward. Instead, the agencies drafted
the Proposed Rule so that banking entities will be permitted to sponsor funds in the future,provided that this activity is primarily a way to offer investment management services rather
than as a way of making proprietary investments in funds.
a.

Bona Fide Trust, Fiduciary, or Investment Advisory Service to Customers

The Proposed Rule interprets generously the statutory requirement that the fund be organizedand offered “only in connection with the provision of bona fide trust, fiduciary, or investment
advisory services and only to persons that are customers of such services of the banking entity.”First, it does not interpret the language to mean that the fund may only be offered to preexisting customers of the banking entity’s bona fide trust, fiduciary, or investment advisory
services. No pre-existing relationship is required. Second, the Proposed Rule does not requirethat any services be offered directly to the customer. The services needs only be provided to thefund, and indirectly to the customer as an investor on the fund. Third, the agencies note thatbanking entities provide trust, fiduciary, investment advisory or commodity trading advisory
services in a variety of different ways and state that the exemption does not require that suchservices be offered in any particular way to such a fund.
Although the agencies’ interpretation of this statutory language is somewhat generous, it isconsistent with the agencies’ overall view of the purpose of the Volcker Rule: it was intended torestrict proprietary investments, but was not intended to interfere with client-oriented activities
of banking entities.

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Memorandum – October 13, 2011b.

Investment Limitations

A banking entity that makes or retains an investment under this exemption must comply withspecified investment limitations.
(A)

Per Fund Limitation

An investment in a single fund held pursuant to this exemption may not exceed 3% of the total
amount or value of outstanding ownership interests of such fund at any time after one year
from the date of the fund’s establishment.
For this purpose, a banking entity is required to include investments in the covered fund thatare made by any entity that the banking entity controls, and the pro rata share of investments inthe covered fund by any entity in which the banking entity has an investment that is noncontrolling but that constitutes more than 5% of the voting shares of the entity. 10 The banking
entity is not required to include investments made by directors and employees (who arepermitted to invest provided that they are directly engaged in providing investment advisoryor other services to the covered fund), as long as the banking entity has not funded suchinvestments or guaranteed them against loss.
Co-investments alongside of a fund will be treated as an investment by the banking entity in thefund itself (and, accordingly, counted toward the 3% per-fund limitation) if such co-investments
arise from a contractual obligation or if the banking entity is found to be acting in concert
toward a common goal of investing in a fund that it organized or offered. This restriction
would prevent a banking entity from sponsoring a fund and effectively holding a greater than
3% interest in the fund by co-investing alongside the fund each time it makes an investment.
Similarly, it would prevent a banking entity from evading the prohibition on investing in thirdparty funds by entering into a formal or informal agreement with such a fund to invest lock stepalongside the fund. We expect that the agencies will recharacterize co-investments asinvestments in a fund only where there is an actual agreement or a pattern of co-investing thatsuggests an agreement. It seems unlikely that a merchant banking investment by a banking
entity in a portfolio company would be recharacterized as an investment in a fund merely
because both the banking entity and an unrelated fund invested in the same company.
The calculation of the 3% limit is based on investments made and ownership interests held,
without regard to committed funds not yet called for investment. The banking entity must
calculate its investment in the same manner and according to the same standards utilized by thefund itself. The banking entity may not hold more than 3% of the value of all the investments
made in the fund (i.e., the value of its investments in the fund, divided by the value of theinvestments made by all other investors in that fund), 3% of the ownership interests issued by
the fund (i.e., the number of ownership interests held in the fund divided by the total number ofownership interests held by all persons in that fund), or be subject to more than 3% of the lossesof the fund.
10

Proposed Rule, at 238.

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Memorandum – October 13, 2011

The agencies will expect a banking entity to calculate its per-fund limitation whenever the fundperforms such calculation or issues or redeems interests, but in any event no less frequently
than quarterly.
(B)

Aggregate Tier 1 Capital Limitation; Deduction from CapitalWith respect to all covered funds that a banking entity invests in pursuant to this advised fund
exemption, the aggregate ownership interest must not exceed 3% of the banking entity’s Tier 1
capital, as calculated on a quarterly basis. For the purposes of this test, the valuation of abanking entity’s investments is based on applicable accounting standards.
For certain banking entities, such as thrift holding companies or holding companies forindustrial loan companies, which do not calculate and report Tier 1 capital in accordance withregulatory capital standards, the Proposed Rule requires that such entities rely on the total
amount of shareholders’ equity of the top-tier entity within such organization.
The Proposed Rule also requires that investments in advised covered funds be deducted fromTier 1 capital. The statute provided that such deduction increase commensurate with theleverage of the fund. The Proposed Rule does not include such a requirement, but the questions
posed in the rule request comment on whether and how the rule should be modified to include
such a requirement. The questions suggest an approach in which only investments in highly
leveraged funds would be fully deducted from Tier 1 capital. 11c.

No Guarantees or Name Sharing; Required Disclosures

The Proposed Rule implements the prohibition on a banking entity guaranteeing, assuming orotherwise insuring the obligations or performance of the covered fund or any covered fund inwhich the first covered fund invests. Also prohibited is any sharing of the same name, or avariation of the same name, by the covered fund with the banking entity for corporate,
marketing, promotional or other purposes. The covered fund is not permitted to use the word“bank” in its name. For the exemption to apply, the banking entity must also make certain
disclosures to prospective and actual investors regarding, among other things, the role of thebanking entity (including its affiliates, subsidiaries and employees) in sponsoring or providing
services to the covered fund and that any losses in the fund are to borne solely by investors.
d.

Limitations on Ownership by Directors and Employees

A banking entity’s directors and employees are prohibited from acquiring or retaining anownership interest in a covered fund that relies upon this exemption, except for any director or
employee who is directly engaged in providing investment advisory or other services to thecovered fund. The agencies appear to recognize that allowing certain directors and employees
to acquire or retain an ownership in a covered fund is consistent with industry practice in that
11

Proposed Rule, at 137 (Question 269).

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Memorandum – October 13, 2011

fund customers and clients often request that such individuals have “skin in the game” withrespect to the fund they manage or advise. To address concerns that director or employee
investments in a covered fund may provide an opportunity for a banking entity to evade theper-fund and aggregate investment limits, the Proposed Rule generally attributes an ownershipinterest in a covered fund to the employing banking entity if the banking entity either extends
credit for the director or employee to acquire an ownership interest or guarantees the director
or employee against loss on the investment.
e.

Affiliate Transaction Restrictions

As discussed more fully below, the Proposed Rule requires that the banking entity comply withthe limitations on certain relationships with covered funds.
2.

Offshore Exemption Applicable to Foreign Banks

As discussed above in the context of proprietary trading, the Volcker Rule applies to a foreignbanking organization that is subject to the BHC Act by virtue of having a branch, agency orbank subsidiary in the United States. Such foreign banks, provided that they meet the QFBO
test, may engage in activities deemed to occur outside the United States without regard to theVolcker Rule or the other restrictions of the BHC Act. Regulation K generally provides that an
activity is deemed to be engaged in within the United States if it is conducted through a U.S.
office or subsidiary of a foreign banking organization. The Volcker Rule provides much more
restrictive requirements that must be met in order for proprietary trading (discussed above) andsponsoring and investing in private funds to be considered outside the United States.
The Volcker Rule also applies to a foreign company that directly or indirectly controls an
insured depository institution that is not a “bank” for purposes of the BHC Act, such as a thrift,
credit card bank or a industrial loan company. Such a foreign company may not be a foreignbanking organization or satisfy the QFBO test. The Proposed Rule makes available to suchcompanies, provided that they are organized under foreign law and the majority of theirbusiness is foreign, the same exemptions from the Volcker Rule that are available to QFBOs.
Under the Proposed Rule, a covered fund investment or sponsorship will be considered to haveoccurred solely outside of the United States only if the following conditions are satisfied:•••the banking entity making the investment or engaging in sponsorship activities is notorganized under U.S. law (as explained above);no subsidiary, affiliate or employee of the banking entity that is “involved” in the offer orsale of an ownership interest in the covered fund is incorporated or physically located in the
United States; andno ownership interest in the covered fund is offered for sale or sold to a U.S. resident.

Importantly, the exemption is not dependent on the location of the assets in which the fundinvests, the location of the investment manager for those assets, or (except as noted below) the
jurisdiction in which the fund is organized. All of those things may occur in the United States.
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Memorandum – October 13, 2011

Therefore, a U.S. private fund that is not itself a banking entity, may sponsor a fund that is soldto foreign banking entities as long as the fund is offered and sold solely to non-U.S. residents
and the individuals and entities of the foreign banking entity that are involved in theinvestment are incorporated and physically located outside the United States.
In anticipation of the Proposed Rule, private equity groups have considered whether thisexemption could be satisfied by a parallel fund structure in which one fund would be offered to
U.S. investors, a second fund would be offered and sold solely to non-U.S. investors, and thetwo funds would invest in lock step and be managed by a single private equity group. Such astructure would be consistent with the language of the Proposed Rule, although the moreclosely such funds are managed in parallel the more risk there will be that the agencies regard
them as a single fund.
In a case in which a foreign banking entity itself wishes to sponsor a fund to be offered and soldto non-U.S. residents, it would appear that the fund would need to be organized under non-U.S.
law because it would be viewed as an affiliate of the foreign banking entity and the exemption
requires that no affiliate of the banking entity that is “involved” in the offer or sale of anownership interest in the covered fund is incorporated in the United States.
3.

Hedging-Related Exemption

The Proposed Rule provides an exemption for a banking entity having an ownership interest ina covered fund in order to reduce specific risks arising in connection with two situations: (i)where the banking entity acts as intermediary on behalf of a non-banking entity customer tofacilitate the exposure by the customer to the profits and losses of the covered fund; and (ii)where the banking entity provides an employee with incentive-based compensation directlytied to the performance of a particular covered fund, provided that the employee “directly
provides investment advisory or other services” to such fund. A banking entity could only relyon this exemption to hedge obligations or liabilities that flow from these two situations.
However, even with respect to these two situations, the scope of this exemption is intended tobe narrow. Among other things, the Proposed Rule requires a close match between thereference asset and the hedge. That is, the acquisition or retention of an interest in a covered
fund must hedge a “substantially similar offsetting exposure” to the same covered fund and in
the same amount of ownership interests in that covered fund. The agencies will also require
documentation at the time the hedging transaction is effected, not afterwards, that identifies the
specific risks the transaction is designed to reduce. Also, the acquisition or retention of aninterest in a covered fund, as a hedge, may not give rise to significant exposures that were notalready present at the time of the transaction.
E.

RESTRICTIONS ON TRANSACTIONS WITH ADVISED COVERED FUNDS

Consistent with the Volcker Rule, the Proposed Rule flatly prohibits a banking entity that serves
as an investment manager, advisor or sponsor to a covered fund (or that organizes and offers acovered fund pursuant to an exemption), including any of the banking entity’s affiliates, fromPage 18

Memorandum – October 13, 2011

entering into any “covered transaction” with the covered fund or any covered fund that iscontrolled by the first-tier covered fund.
The term “covered transaction” comes from Section 23A of the Federal Reserve Act andincludes loans, extensions of credit, purchases of assets and affiliate securities, issuances ofguarantees by an insured depository institution and credit exposures from derivatives
transactions. Unlike Section 23A, which permits covered transactions between a bank and its
affiliate so long as such transactions meet specified quantitative and other requirements, theVolcker Rule prohibits such covered transactions outright. Accordingly, none of the
exemptions contained in Section 23A and the Federal Reserve’s Regulation W are incorporated
into the Proposed Rule.
Importantly, the prohibition on covered transactions does not extend to a covered fund’stransactions with other covered funds in which it invests, nor does it extend to transactions
between a banking entity and portfolio companies of a covered fund. The prohibition also does
not apply to prime brokerage transactions (e.g., custody, clearance, securities borrowing or
lending services, trade execution or financing, data, operational and portfolio management
support) with a covered fund, subject to certain conditions. Investments and ownershipinterests in covered funds expressly permitted by the Volcker Rule (for example, the acquisitionof up to 3% of a sponsored fund’s total ownership) are also not prohibited, even though theymight otherwise fall within the boundaries of Section 23A.
The Proposed Rule also implements the requirement that all transactions between a covered
fund and a banking entity that serves as its investment manager, advisor or sponsor (or thatorganizes and offers such covered fund pursuant to an exemption) satisfy the qualitative
standard set forth in Section 23B of the Federal Reserve Act. Section 23B generally provides thattransactions between a bank and an affiliate be on “market” terms and under circumstances thatare substantially the same or at least as favorable to the bank as those prevailing at the time forcomparable transactions with unaffiliated companies. Section 23B applies broadly to mostcommercial transactions with an affiliate, including prime brokerage transactions with acovered fund and any transaction in which an affiliate is receiving a fee for providing services.
F.

COMPLIANCE MATTERS

Under the Proposed Rule, banking entities engaged in proprietary trading or covered fundactivities and investments will need to establish a compliance program “reasonably designed”
to ensure and monitor compliance with the Volcker Rule and related regulations. The
compliance program must be appropriate for the size, scope and complexity of the banking
entity’s activities and business structure. At a minimum, the compliance program must
comprise the following elements: (i) written policies and procedures designed to document,
describe and monitor proprietary trading and covered fund activities and investments; (ii)internal controls to monitor and identify potential areas of noncompliance; (iii) a management
framework that delineates responsibility and accountability for compliance; (iv) independent
testing of effectiveness; (v) training; and (vi) recordkeeping. For a banking entity withsignificant proprietary trading or covered fund investments and activities (i.e., if it has, together

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Memorandum – October 13, 2011

with its affiliates and subsidiaries, trading assets and liabilities of at least $1 billion or 10% of
total assets, or aggregate investments in or sponsorships of covered funds of at least $1 billion),
the Proposed Rule specifies a variety of minimum standards for each element of the complianceprogram.
As proposed, banking entities must develop and implement a compliance program by July 21,
2012, even though any prohibited activities and investments are not required to be conformed
to comply with the Volcker Rule by that date.
G.

THE CONFORMANCE PERIOD AND THE BAN ON “NEW” INVESTMENTS

The Proposed Rule specifies that the effective date for the Volcker Rule is July 21, 2012. After
this date, banking entities are expected to fully conform their investments and activities withina two-year conformance period that lasts until July 21, 2014. The Federal Reserve has the ability
to extend this period, upon a request by a banking entity, in accordance with the final rule itissued on February 14, 2011 (the “Conformance Rule”). 12 The Proposed Rule incorporates the
Conformance Rule, but makes minor technical and conforming edits to account for changes
related to the definition of “banking entity” and the new “covered fund” definition, among
other things.
Significantly, the preamble to the Proposed Rule states that the Conformance Rule “does not
authorize a banking entity to engage in new or additional prohibited activities or investments”
during the two-year conformance period. As applied to particular activities and investments,
this interpretation does not appear to be consistent with the plain language of the Volcker Rule.
On the other hand, it does seem to be a reasonable interpretation to regard this two year period
as one in which banking entities should be winding down their impermissible activities rather
than ramping them up. We would not expect that the agencies would prevent a banking entity
from completing an acquisition during this conformance period that included some activities
and investments that will be prohibited by the Proposed Rule, provided that the banking entity
has a plan for achieving compliance within a reasonable period. Any such transaction should
be discussed with the agencies in advance.
***

The issuance of the Proposed Rule marks an important milestone for implementation of the
Volcker Rule. While the final rule adopted by the agencies in 2012 will no doubt differ from the
Proposed Rule in some respects, it is clear that implementation of the Volcker Rule will havesignificant implications for banking entities and private funds.

12

See “Conformance Period for Entities Engaged in Prohibited Proprietary Trading or Private
Equity Fund or Hedge Fund Activities,” 76 Fed. Reg. 8265 (Feb. 14, 2011). For backgroundregarding the Conformance Rule, please see our memorandum, titled “Reflections on DoddFrank: A Look Back and a Look Forward,” dated July 21, 2011, at 37-43, available at
http://www.simpsonthacher.com/content/Publications/pub1248.pdf.

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Memorandum – October 13, 2011

For more information about the Proposed Rule and its potential implications, as well as howcomments may be submitted to the agencies, please contact any of the members of our Financial
Institutions or Private Funds groups, as listed below.
FINANCIAL INSTITUTIONS
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Gary Rice(212) 455-7345
grice@stblaw.com

Ellen Patterson(212) 455-2499
epatterson@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Stacie McGinn(212) 455-2250
smcginn@stblaw.com

Caroline Gottschalk(212) 455-3523
cgottschalk@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

PRIVATE FUNDSTom Bell(212) 455-2533
tbell@stblaw.com

Michael Wolitzer(212) 455-7440
mwolitzer@stblaw.com

Glenn Sarno(212) 455-2706
gsarno@stblaw.com

Barrie Covit(212) 455-3141
bcovit@stblaw.com

Olga Gutman(212) 455-3522
ogutman@stblaw.com

Jonathan Karen(212) 455-3274
jkaren@stblaw.com

This memorandum is for general informational purposes and should not be regarded as legal advice.
Furthermore, the information contained in this memorandum does not represent, and should not be
regarded as, the view of any particular client of Simpson Thacher & Bartlett LLP. Please contact yourrelationship partner if we can be of assistance regarding these important developments. The names andoffice locations of all of our partners, as well as additional memoranda, can be obtained from our website,www.simpsonthacher.com.
The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

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Memorandum – October 13, 2011

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