Banking on Volcker: Big Crisis, Big Rule

October 19, 2011

By Thomson Reuters Accelus staff

NEW YORK, Oct. 19 (Business Law Currents) – Banking lawyers should be forgiven if they’re not returning calls right away: they’re busy trying to digest the Volcker Rule (or “the rule”). The proposed rule’s 298-page doorstop represents the collective efforts of the Treasury Department, Fed, FDIC and SEC to implement §619 of the Dodd-Frank Act, which itself added a new §13 to the Bank Holding Company Act of 1956 (the BHC Act). The intent of the Volcker Rule is to “generally prohibit any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (“covered fund”), subject to certain exemptions.”

So does the Volcker Rule satisfy its mandate? To paraphrase ‘The Simpsons’: yes with an “if,” no with an “unless.” The rule carves out significant exemptions from the proscription against proprietary trading, but each of these exceptions has a number of criteria required to take advantage of the exemption. Moreover, a number of the rule’s measures provide for rebuttable presumptions of non-compliance for certain types of trading activity.

The Volcker Rule carves out significant exemptions in the following areas: underwriting and market-making related activities; risk-mitigating hedging; and “exemptions for trading in certain government obligations, trading on behalf of customers, trading by a regulated insurance company, and trading by certain foreign banking entities outside the United States.” In addition, the rule imposes reporting and record-keeping requirements, and addresses some narrower applications in the context of specific transactions with covered funds.


Cobbling together definitions of key terms, the rule borrows liberally from the BHC Act. Beginning with the baseline for the Volcker Rule’s application, the rule provides:

Proprietary trading means engaging as principal for the trading account of the covered banking entity in any purchase or sale of one or more covered financial positions. Proprietary trading does not include acting solely as agent, broker, or custodian for an unaffiliated third party.

Another key term, “trading account,” gets a three-pronged definition as being:

[A]ny account used for acquiring or taking positions in securities [or other enumerated instruments] principally for the purpose of selling in the near-term (or otherwise with the intent to resell in order to profit from short-term price movements), as well as any such other accounts that the Agencies by rule determine.

The definition of trading account includes one of the rebuttable presumptions mentioned above. “To provide additional clarity and guidance regarding the trading account definition,” the Volcker Rule’s supplemental commentary explains, “the proposed rule also includes a rebuttable presumption that any account used to acquire or take a covered financial position that is held for sixty days or less is a trading account under the first prong, unless the banking entity can demonstrate that the position was not acquired principally for short-term trading purposes.”2 (Emphasis added)

Significantly, the rule explains that intent, rather than actual liquidation of a position, can bring a banking entity within the definition of trading account. “This part of the trading account definition does not require the resale of the position; rather, it requires only an intent to engage in any form of transaction on a short-term basis (including a transaction separate from, but related to, the initial acquisition of the position) for the purpose of benefitting from a short-term movement in the price of the underlying position.”

The Volcker Rule excludes from the definition of trading account (rather than exempting from the rule’s application): positions under certain repurchase and reverse repurchase arrangements; positions under securities lending transactions; positions taken for liquidity management purposes; and positions of derivatives clearing organizations and clearing agencies. These exclusions have not been granted in a vacuum. The rule notes that “the Agencies are concerned with the potential for abuse of this clarifying exclusion – specifically, that a banking entity might attempt to improperly mischaracterize positions acquired or taken for prohibited proprietary trading purposes as positions acquired or taken for liquidity management purpose.”


The depth, breadth and interstices of the Volcker Rule’s exemptions should fuel considerable discussion. While underwriting seems organically distinct from proprietary trading in one sense, it nonetheless shares many of the same characteristics. The rule permits banking entities to continue with underwriting activity, provided they meet seven criteria:

  1. The banking entity must have an internal compliance program (as detailed in the rule);
  2. The covered financial position purchased or sold must be a security;
  3. The transaction must be effected solely in connection with a distribution of securities for which the banking entity is acting as an underwriter;
  4. The banking entity must have appropriate dealer registration (as ordinarily required when dealing with various types of securities);
  5. The underwriting activities must be designed not to exceed the reasonably expected near-term demands of clients, customers and counterparties;
  6. The underwriting activities of the banking entity must be designed to generate revenues primarily from fees, commissions, underwriting spreads or other income, and not from appreciation in the value of covered financial positions; and
  7. The compensation arrangements of persons performing underwriting activities at the banking entity must be designed not to encourage proprietary risk-taking.

The Volcker Rule also carves out an exemption for “permitted market making-related activities.” Because, as the rule’s commentary explains, “It may be difficult to distinguish principal positions that appropriately support market making-related activities from positions taken for short-term, speculative purposes,” the rule proposes a “multi-faceted approach” to implement the exemption. Like the underwriting exemption above, the market making-related activities exemption requires seven criteria “designed to ensure that any banking entity relying on the exemption is engaged in bona fide market making-related activities and conducts those activities in a way that is not susceptible to abuse through the taking of speculative, proprietary positions as a part of, or mischaracterized as, market making-related activity.”

Like underwriting and market making, the rule’s carve out for “permitted risk-mitigating hedging activities” imposes a framework with seven required criteria. The agencies have requested comment on more than 50 questions (including sub-questions) related to this proposed provision. Less controversial should be the Volcker Rule’s provision for “permitted trading on behalf of customers.” While the rule avoids the seven-step approach for this exemption, it nonetheless “identifies three categories of transactions that, while they may involve a banking entity acting as principal for certain purposes, appear to be on behalf of customers within the purpose and meaning of the statute.”

One provision likely to generate attention is the exemption for “permitted trading outside of the United States.” Here, in theory, the rule “limits the extraterritorial application of the prohibition on proprietary trading to the foreign activities of foreign firms, while preserving national treatment and competitive equality among U.S. and foreign firms within the United States.” In order to take advantage of this exemption, “the banking entity must not be directly or indirectly controlled by a banking entity that is organized under the laws of the United States or of one or more States.” As for what constitutes “trading solely outside of the United States,” not surprisingly the Volcker Rule lays down a multi-step test:

  • The transaction is conducted by a banking entity that is not organized under the laws of the United States or of one or more States;
  • no party to the transaction is a resident of the United States;
  • no personnel of the banking entity that is directly involved in the transaction is [sic] physically located in the United States; and
  • the transaction is executed wholly outside the United States.

As the Volcker Rule explains, “These four criteria are intended to ensure that a transaction executed in reliance on the exemption does not involve U.S. counterparties, U.S. trading personnel, U.S. execution facilities, or risks retained in the United States. The presence of any of these factors would appear to constitute a sufficient locus of activity in the U.S. marketplace so as to preclude availability of the exemption.”

Clouding the picture somewhat is the rule’s treatment of “covered fund activities and investments outside of the United States. Here the express permission in §13(d)(1)(I) of the BHC Act (implemented in the Volcker Rule) “permits certain foreign banking entities to acquire or retain an ownership interest in, or to act as sponsor to, a covered fund so long as such activity occurs solely outside of the United States and the entity meets the requirements of sections 4(c)(9) or 4(c)(13) of the BHC Act.” According to the rule.

Section 13(d)(1)(I) of the BHC Act permits a banking entity to acquire or retain an ownership interest in, or have certain relationships with, a covered fund notwithstanding the prohibition on proprietary trading and restrictions on investments in, and relationships with, a covered fund, if: (i) such activity or investment is conducted by a banking entity pursuant to paragraph (9) or (13) of section 4(c) of the BHC Act; (ii) the activity occurs solely outside of the United States; (iii) no ownership interest in such fund is offered for sale or sold to a resident of the United States; and (iv) the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or of one or more States.

At first glance, there appears to be some potential wiggle room. What if, for example, a U.S. bank had a non-controlling interest (e.g. a joint venture) in a foreign entity that sought to take advantage of either the exemption for covered funds or trading by a foreign banking entity. It’s not outside the realm of possibility that some such JV could be crafted to evade a restriction against “direct or indirect control,” while still engaging in otherwise proscribed activity. The Volcker Rule, however, explains that, “Consistent with the statutory language, a banking entity organized under the laws of the United States or any State and the subsidiaries and branches of such banking entity (wherever organized or licensed) may not rely on the exemption.” On the other hand, the rule does allow a banking entity to maintain an interest in a domestic covered fund under limited circumstances.

For example, the Volcker Rule permits a banking entity to maintain an “interest in” a covered fund that is “an issuer of asset-backed securities, the assets or holdings of which are solely comprised of: (i) loans; (ii) contractual rights or assets directly arising from those loans supporting the asset-backed securities; and (iii) interest rate or foreign exchange derivatives that (A) materially relate to the terms of such loans or contractual rights or assets and (B) are used for hedging purposes with respect to the securitization structure.” According to the rule, “the phrase ‘materially relate to terms of such loans’ is intended to quantitatively limit the derivatives permitted in a ‘securitization of loans’ … to include only those derivatives where the notional amount of the derivative is tied to the outstanding principal balance of the loans supporting the asset-backed securities of such issuer, either individually or in the aggregate.” Significantly, “the proposed rule would not allow the use of a credit default swap by an issuer of asset-backed securities.” (emphasis added)

The Volcker Rule also takes on two of the most controversial elements of the post-crisis investigation: shorting positions of a bank’s customers, and high-risk trading. The rule provides that “an otherwise-permitted activity would not qualify for a statutory exemption if it would involve or result in a material conflict of interest.” The rule prohibits a banking entity from transactions presenting a conflict of interest unless prior to the transaction, the banking entity makes timely and effective disclosure of the conflict; or has in place effective “information barriers”—physical separation of personnel or functions to eliminate the conflict of interest.

The Volcker Rule defines high-risk asset and high-risk trading strategy as those that would “significantly increase the likelihood that the covered banking entity would incur a substantial financial loss or would fail.”

The provisions mentioned above represent only the tip of the statutory iceberg; 300 pages of The Supplemental Materials pose nearly 400 questions, nearly all with additional sub-questions, seeking comment on the intricacies of the rule. While banks may throw up objections to some of the strictures of perceived ambiguities in the Volcker Rule, it might take a while for the picture to clear up.

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at )

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