Federal Reserve Issues Proposed Transition
Rules for “Volcker Rule” Compliance
November 19, 2010
Four months after the enactment of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the “Dodd-Frank Act”) on July 21, 2010,1 the Board of Governors of the Federal
Reserve System (the “Federal Reserve”) has issued proposed transition rules for banking
entities and certain other companies that will be subject to the Dodd-Frank Act’s restrictions on
proprietary trading and sponsoring or investing in hedge funds and private equity funds.2
These restrictions (commonly referred to as the “Volcker Rule”) do not become effective until
the earlier of July 21, 2012 and one year after the issuance of final Volcker Rule implementing
regulations (which will cover matters other than the transition process). Because the various
regulatory agencies are not required to issue final implementing regulations until October 21,
2011, we expect that the effective date of the Volcker Rule will be July 21, 2012. In that case,banking entities will not have to achieve conformance with the Volcker Rule until July 21, 2014(or later, depending on the availability of possible extensions). While banking entities are
expected to use the 2012-2014 conformance period to wind down, divest or take other actions toconform their activities, investments and relationships to the requirements of the Volcker Rule,they are not prohibited from engaging in proprietary trading and private fund activities duringthat period.
Proposed rules relating to this conformance period, and possible extensions, were released by
the Federal Reserve on November 17, 2010. The proposed rules are subject to a 45-day publiccomment period, which will commence once the proposal is published in the Federal Register.
The proposed rules are intended to address only the transition process and do not address othersubstantive Volcker Rule questions (such as defining what is meant by “proprietary trading”)
that will be the subject of an interagency rulemaking process required to be completed by
October 21, 2011. The Federal Reserve is required under the Volcker Rule to issue final rules
regarding the transition process by January 21, 2011, which is the same deadline for the
Financial Stability Oversight Council’s much-awaited study and recommendations on the
Volcker Rule’s implementation.

1

For general background regarding the Dodd-Frank Act, please see our memorandum, titled “U.S. Congress
Nears Completion of Landmark Financial Services Reform Legislation,” dated July 6, 2010, available at
http://www.stblaw.com/siteContent.cfm?contentID=4&itemID=75&focusID=1013.

2

Under the Dodd-Frank Act, a new Section 13 is added to the Bank Holding Company Act (the “BHC Act”) to
provide that a “banking entity” shall not (i) engage in “proprietary trading” or (ii) “acquire or retain any
equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.” For
background regarding the Volcker Rule, please see our memorandum, titled “The Volcker Rule Provisions in
the Dodd-Frank Wall Street Reform and Consumer Protection Act,” dated July 14, 2010, available at
http://www.simpsonthacher.com/siteContent.cfm?contentID=4&itemID=80&focusID=1014.

Memorandum – November 19, 2010

The proposed transition rules3 provide a general two-year conformance period (expected to last
until July 21, 2014) for banking entities engaged in prohibited proprietary trading or private
fund activities. The rules provide a separate conformance period for nonbank financial
companies supervised by the Federal Reserve—none of which have yet been designated—thatwill provide a two-year conformance period (with potential extensions) starting from the dateof such designation. For banking entities, the proposed rules also implement a special
extension period applicable to certain illiquid funds, as discussed below.
The proposed transition rules address only one aspect of the Volcker Rule—the timing issues
related to compliance. The proposed rules were not intended to address other important
aspects of the Volcker Rule that will be crucial to understanding the full implications of the
Volcker Rule are not addressed. The proposed transition rules do not, for example, clarify thestatutory definitions of certain terms, such as “hedge fund” and “private equity fund” (or “suchsimilar funds” that may be subsumed by these terms), “banking entity” or “sponsor.” Also,these proposed transition rules do not address the various additional capital requirements andother restrictions that may be applied under the Volcker Rule, including additional capital that
may be required of banking entities that invest in or sponsor private funds during theconformance period. And they do not implement any of the affiliate transaction restrictions on
relationships with private funds.
A.

The General Conformance Period for Banking Entities: A Two-Year Minimum

As a way of allowing the markets and firms to adjust to the Volcker Rule, a general two-year
conformance period is provided under the Dodd-Frank Act.4 The two-year period commences
upon the earlier of (i) two years from enactment (i.e., July 21, 2012) or (ii) one year from theissuance of final implementing regulations. Assuming the period commences on the second
anniversary of the Dodd-Frank Act, which we believe is the most likely outcome, then the twoyear general conformance period will run until July 21, 2014. During this time, banking entities
may continue to engage in proprietary trading or private fund activities, but will have to divest
or conform such positions or activities by July 21, 2014, absent an extension.
The proposed transition rules (and the supplementary information accompanying the proposed
rules) clarify how new banking entities should be treated under this timing. For a company thatwas not a banking entity (or a subsidiary or affiliate of a banking entity) at the time the DoddFrank Act was enacted but becomes a banking entity (or a subsidiary or affiliate of suchbanking entity) thereafter, then the conformance period would commence on the later of (i) thedate on which the Volcker Rule’s prohibitions would otherwise become effective to banking
entities that were in existence at the time the Dodd-Frank Act was enacted or (ii) two years after
the date on which such company first becomes a banking entity (or a subsidiary or affiliate ofsuch banking entity).

3

The proposed transition rules will be made part of a new Subpart K of the Federal Reserve’s Regulation Y (12C.F.R. §§ 225.180 - 225.182).

4

See Section 13(c)(2) of the BHC Act (as amended by Section 619 of the Dodd-Frank Act); 12 U.S.C.
§ 1851(c)(2).

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Memorandum – November 19, 2010

B.

Potential Extensions to the General Conformance Period
1.

Potential One-Year Extensions to the Conformance Period: A Five-Year Maximum

Once the general conformance period has expired, the Federal Reserve may, upon a request bya banking entity, grant up to three additional one-year extension periods, if, in the Federal
Reserve’s judgment, each such one-year extension is consistent with the Volcker Rule and not
detrimental to the public interest. The process for seeking a one-year extension and the factors
relevant to a determination by the Federal Reserve are discussed in section 3 below.
2.

Potential Five-Year Extension to the Conformance Period for “Illiquid Funds”: The
Five-Year “Add-On”

The Volcker Rule also provides for a single extension, which may be for as long as five years,
with respect to an investment in an “illiquid fund” where the acquisition and retention of aninterest in the fund, or the provision of additional capital to the fund, is “necessary to fulfill acontractual obligation of the banking entity that was in effect on May 1, 2010.” The proposedtransition rules, if adopted, would define what constitutes an illiquid fund under the Volcker
Rule. In also would clarify that the illiquid fund extension is in addition to, and not in lieu of,
the three separate one-year extensions, something that is not entirely clear from the statutory
language. Thus, a banking entity could have up to eight years after the expiration of the twoyear general conformance period (i.e., July 21, 2022) to make and retain qualifying illiquid fundinvestments.
It should be noted that the Volcker Rule prohibits both investments in and sponsorship ofprivate funds. The Volcker Rule, by its terms, only provides the Federal Reserve with theauthority to extend the period that a banking entity may make and retain an investment in an
illiquid fund. Neither the Volcker Rule nor the Federal Reserve’s proposed transition rules
contemplate extensions of the conformance period for sponsorship of illiquid funds.
The process for seeking the five-year extension and the factors relevant to a determination by
the Federal Reserve are discussed in section 3 below.
(i)

The “Illiquid Fund” Definition

The five-year extension may only be requested with respect to investments in illiquid funds.
The Volcker Rule defines an “illiquid fund” as a hedge fund or private equity fund that, as of
May 1, 2010, (i) was principally invested in illiquid assets or was invested in, and contractuallycommitted to principally invest in, illiquid assets; and (ii) makes all investments pursuant to,and consistent with, an investment strategy to principally invest in illiquid assets. However,the proposed rules include a two-prong approach to defining an illiquid fund: the fund must
invest in illiquid assets and the investment in the fund must itself be illiquid.
The proposed transition rules expand on certain key terms used in the statutory definition:“illiquid asset,” “principally invested,” “contractually committed to principally invest” and an“investment strategy to principally invest.” These terms are critical to understanding the twin
set of criteria that will need to be satisfied in order for a banking entity’s investment in a hedge
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Memorandum – November 19, 2010

fund or private equity fund to qualify for the illiquid fund extension. As described below, thefirst set of criteria relate to the fund itself, with the second set of criteria relating to the terms ofbanking entity’s investment in the fund.
(ii)

The Nature, Assets and Investment Strategy of the FundThe first set of criteria focuses on the nature, assets and investment strategy of a hedge fund or
private equity fund. For a fund to qualify as an illiquid fund it must, among other things, beinvested in or be contractually committed to be principally invested in, and have an investment
strategy centered on, “illiquid assets.” The Federal Reserve’s proposed transition rules define
illiquid assets essentially by reference to what they are not. In so doing, the proposed transition
rules contain a definition of “liquid assets,” with a list that includes the following and expressly
solicits comments as to whether additional or alternative metrics or screens should beconsidered:
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Cash and cash equivalents;
Assets that are traded on a recognized, established exchange, trading facility or othermarket on which there exist independent, bona fide offers to buy and sell;
Assets for which there are bona fide, competitive bid and offer quotations inrecognized inter-dealer quotation systems or similar systems;
Assets with prices that are quoted routinely in widely disseminated publications thatare readily available to the general public or through an electronic service thatprovides indicative data from real-time financial networks;
Assets with initial terms of one year or less and that can be monetized or converted
at maturity into liquid assets; andOther assets that the Federal Reserve may determine is a liquid asset.

The proposed rules provide some guidance on what is meant by these various categories ofliquid assets. Most important, the Federal Reserve’s discussion of the proposed rules makes it
clear that the intent is to “include as illiquid assets investments in portfolio companies,
investments in real estate (other than those made through publicly traded REITs), venture
capital investments, and investments in other hedge funds or private equity funds that both are
not publicly traded and invest in illiquid assets.” The fact that some form of secondary trading
exists with respect to such assets is insufficient, standing alone, for them to be treated as liquid
assets. The proposed rules also clarify that an asset (such as restricted stock) is not liquidmerely because it is part of a class that is liquid, if the particular asset held by the fund is
illiquid because of legal restrictions on its sale.
The Volcker Rule also requires that the hedge fund or private equity fund either (i) have been“principally invested” in illiquid assets as of May 1, 2010, or (ii) have been invested to somedegree in illiquid assets and “contractually committed to principally invest” in illiquid assets asof such date.
To be considered “principally invested” in illiquid assets, the proposed rules provide that atleast 75% of the fund’s consolidated total assets (as reflected on the fund’s financial statements
prepared in accordance with applicable accounting standards) must be either illiquid assets (i.e.,
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Memorandum – November 19, 2010

not liquid assets) or risk-mitigating hedges entered into in connection with and related toindividual or aggregated positions in illiquid assets. As examples, the Federal Reserve cites
certain types of funds, such as real estate or start-up companies (e.g., technology, life sciences,alternative energy or “clean tech”) that focused “almost exclusively on one type of illiquid
assets.”To be considered “contractually committed to principally invest” in illiquid assets as of May 1,
2010, a hedge fund’s or private equity fund’s organizational documents (limited partnershipagreements, etc.) or other documents (side letter agreements, etc.) must obligate the fund to be
principally invested in illiquid assets during the period beginning on the date when capital
contributions are first received by the fund for the purpose of making investments and endingon the fund’s expected termination date. The contractual commitment in question is not theinvestor’s commitment to invest in the fund, but the fund’s commitment to make investments
principally in illiquid assets.
Finally, the proposed rules explain what is meant by a hedge fund or private equity fundhaving an “investment strategy to principally invest” in illiquid assets. Such a strategy isevidenced by either the fund (i) marketing or holding itself out to investors as “intending toprincipally invest” in illiquid assets, or (ii) having “a documented investment policy” ofprincipally investing in illiquid assets. In its release, the Federal Reserve advises banking
entities to consider whether a fund’s organizational and contractual documents, marketing
materials or investment policy provide for the fund to principally invest in illiquid assets byexamining “whether the assets to be acquired by the fund (as specified in such materials) are of
the type and nature that would be make the assets ‘illiquid assets’ or ‘liquid assets’ for purposesof the rule.”
The language of the proposed rules make clear that, in order to qualify as an illiquid fund, thefund must both be contractually obligated to principally invest in illiquid assets, as evidenced
by its organizational or other documents, and it must hold itself out to investors as intending toprincipally invest in such assets.
(iii)

The Terms of the Banking Entity’s Investment

The second set of criteria used in determining whether an illiquid fund extension period isavailable focuses on the terms of the banking entity’s investment in a particular hedge fund or
private equity fund. Specifically, the acquisition or retention of an interest in a fund, as well as
the injection of additional capital into the fund, by a banking entity must be necessary to fulfill a“contractual obligation” that the banking entity had on May 1, 2010.
It is important to note that the authority to retain an investment in an illiquid fundautomatically terminates on any date—which may occur in the middle of a five-year
extension—on which the banking entity is no longer contractually obligated to retain theinvestment.
Under the proposed transition rules, a banking entity will be considered to have a contractual
obligation to retain or make an equity, partnership or other ownership interest in an illiquid
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Memorandum – November 19, 2010

fund if it would be prohibited under the terms of its equity, partnership or other ownershipinterest in the fund or under other contractual arrangements with the fund from (i) redeeming
all of its interest in the fund or (ii) selling or otherwise transferring its ownership interests to an
unaffiliated person. Furthermore, a banking entity will be considered to have a contractual
obligation to make additional investments in an illiquid fund if it is required to do so under theterms of its equity, partnership or other ownership interest in the fund or under any othercontractual arrangements it has with the fund.
An important qualification to a finding that a banking entity has a contractual obligation to
make or retain an investment is that (i) the banking entity must not be able to effect a unilateral
termination of the obligation pursuant to the terms of its agreement with the fund; and (ii) if it
may terminate the obligation with the consent of another party or parties, the banking entity
has used its reasonable best efforts to obtain such consent and such consent has been denied.
With regard to (ii), we note that, under the terms of many illiquid fund documents, an investor
does not have a right to redeem or transfer its interest without the general partner’s consent, but
the general partner of the fund will often accommodate such requests.
3.

The Extension Process and Factors Relevant to the Federal Reserve

Whether seeking a one-year extension or a five-year illiquid fund extension, a banking entity
must (i) submit a written request to the Federal Reserve for the extension at least 90 days prior
to the expiration of the applicable time period; (ii) provide the reasons why it believes theextension should be granted; and (iii) offer a detailed explanation of its plan for divesting or
conforming the activity or investment.
The factors to be addressed by a banking entity seeking an extension, and by the Federal
Reserve in acting on such a request, include the following:
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Whether the activity or investment (a) involves or results in material conflicts ofinterest between the banking entity and its clients, customers or counterparties; (b)would result, directly or indirectly, in a material exposure by the banking entity tohigh-risk assets or high-risk trading strategies; (c) would pose a threat to the safety
and soundness of the banking entity; or (d) would pose a threat to the financial
stability of the United States;
Market conditions;
Nature of the activity or investment;
Date that the banking entity’s contractual obligation to make or retain an investmentin the fund was incurred and when it expires;
Contractual terms governing the banking entity’s interest in the fund;Degree of control held by the banking entity over investment decisions of the fund;Types of assets held by the fund;
Expected date for the fund’s winding up of its activities and liquidation, or when its
investments may be redeemed or sold;Total exposure of the banking entity to the activity or investment and the risks that
disposing of, or maintaining, the investment or activity may pose for the banking
entity or for U.S. financial stability;
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Memorandum – November 19, 2010



Cost to the banking entity for disposing the activity or investment within theapplicable period; andOther factors that the Federal Reserve believes to be appropriate.

If a banking entity is primarily supervised by another federal banking agency or by the SEC or
CFTC, the Federal Reserve will consult with such agency prior to any approval of an extension
request.
Under the proposed transition rules, the Federal Reserve will have the authority to impose
conditions on any extension approval if such conditions are necessary or appropriate to (i)protect the safety and soundness of the banking entity or U.S. financial stability, (ii) respond tomaterial conflicts of interest or other unsound banking practices or (iii) further the purposes of
the Volcker Rule and related transition rules.
C.

The Conformance Period for Nonbank Financial Companies Supervised by theFederal Reserve

Under the Dodd-Frank Act, the Federal Reserve is given supervisory authority over certain
nonbank financial companies that are determined by the Financial Stability Oversight Council
to be systemically important. Although such companies are not banking entities for purposes of
the Volcker Rule, they will nevertheless be subject to quantitative limitations, capital charges orother restrictions in order to address risks that their proprietary trading activities or fundrelationships pose. The proposed transition rules provide a two-year conformance period forsuch companies, with the two-year period commencing from the date on which a systemicallyimportant company becomes supervised by the Federal Reserve. These nonbank companies
will also have an opportunity to apply for up to three one-year extensions.
***

For more information about the Volcker Rule, the Federal Reserve’s proposed transition rules or
the process for submitting public comments, please contact a member of the Financial
Institutions Group.
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 – November 19, 2010

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