Assistance with complex securities litigation.Securities Litigation
The Final Rule “prohibits 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.”1 The Final Rule takes effect on April 1, 2014 and all banking entities must conform by July 21, 2015.
The Final Rule applies to “banking entities” defined as insured depository institutions or companies that control an insured depository institution, a company considered a bank holding company for purposes of Section 8 of the International Banking Act of 1978, or any affiliates or subsidiaries of the aforementioned entities. Foreign owned banks with trading activities taking place entirely outside the United States are exempt from the proprietary trading and covered fund activities prohibitions. For example, a banking entity that is located or organized under the laws of the United States or controlled directly or indirectly by a U.S. banking entity is not exempt from the prohibition. However, a non-U.S. bank is exempt from the prohibition provided that they do not engage as principal to the transaction while in the U.S., do not serve as an intermediary in the transaction, do not finance the transaction, or do not have a U.S. branch or affiliate engaged in the transaction.
The Final Rule comes as the Basel Committee of Banking Supervision (BCBS) looks to strengthen global capital and liquidity rules with the Basel III capital adequacy standards. Originally approved in 2010 by the G20 nations, the Basel III standards remain in development with a lengthy planned phase-in period. Together with the Basel III standards, the Final Rule looks to make banks more financially robust and reduces incentives for excessive risk-taking.
Together with the 71 page Final Rule, the Agencies released an almost 900 page preamble containing important supplementary information. Our initial review has focused on the compliance aspects, hedging activities, and risk measurements required by the Final Rule, as well as potential consequences and takeaways for banking entities.
Final Rule Subpart D-Establish a Compliance Program
The Final Rule’s Subpart D requires banking entities involved in proprietary trading and covered fund activities to “develop and provide for the continued administration of a compliance program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions”2 on various trading and covered fund activities. The Final Rule’s compliance program for banking entities with at least $10 billion in consolidated assets and liabilities rests largely on six elements, which include:
These six elements are simply a high level starting point. More detailed, and potentially more onerous requirements are explained within each element. For example, with respect to covered fund investing, banking entities are required to maintain specified records regarding documentation of certain exclusions and exemptions relied upon under the “Covered Fund Provisions” and documentation of the value of certain investments in foreign public funds.
For larger banking entities with consolidated assets and liabilities of $50 billion or more that engage in proprietary trading (permitted under Final Rule Subpart B), there are additional compliance standards which can be found in Appendix B of the Final Rule. As Appendix B makes clear, compliance programs require an effective management framework and corporate governance structure. This includes a written compliance program approved by the board of directors and management procedures enforcing and maintaining compliance. Furthermore, specific individuals must be held accountable. Responsibilities for managerial roles include:
First Steps to Prepare
The lead time and amount of preparation for each of the six elements above varies greatly, so firms need to closely evaluate their current compliance capabilities and begin to prepare. Examples of good practices include:
As with most new regulatory requirements, the Final Rule still has many unknowns. These recommended planning procedures may help smooth the transition and lessen the risk of unpreparedness.
Final Rule Appendix A – Quantitative Measurements Used to Monitor Trading Activities
For banking entities engaging in covered trading activities, Appendix A of the Final Rule establishes requirements for the reporting of quantitative measurements for each trading desk. The measurements include:
These metrics are characterized as risk-management measurements, source-of-revenue measurements, and customer-facing activity measurements. Both the reporting frequency and the level of reporting vary depending on the banking entity’s size and the scope of its trading activities. The required start dates for these reporting requirements are June 30, 2014 for banking entities with consolidated assets and liabilities exceeding $50 billion and various dates in 2016 for smaller banking entities.
First Steps to Prepare Examples of good questions to consider include:
Again, an implementation team could help to examine these questions.
Risk-Mitigating Hedging Activities and Accounting
The Final Rule permits certain risk-mitigating hedging activities, provided the banking entity meets certain internal compliance requirements and can establish that the hedging activity is “designed to reduce or otherwise significantly mitigate and demonstrably reduces or otherwise significantly mitigates” one or more risks.3 The risks for which risk-mitigating hedging activities are permitted include market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, commodity price risk, basis risk, or similar risks related to individual or aggregated position-- not risks related to general economic or market developments that may impact the banking entity’s revenues or profits. For instance, a banking entity could enter into an interest rate swap to hedge against a specific portfolio of loans, but can no longer engage in the general macro hedging activities that do not relate to individual or aggregated positions that have specific, identifiable risk(s).
These risk-mitigating hedging activities are only permitted if the banking entity’s internal compliance program, as required under Subpart D, includes:
Any hedging activities must be subject to continuing review, monitoring and management by the banking entity, must be consistent with the required written policies and procedures, and must be recalibrated accordingly if necessary. Additionally, the compensation arrangements for personnel performing the risk-mitigating hedging activities must be designed so that they do not reward or incentivize prohibited proprietary trading.
Notably, the preamble makes specific reference to hedge accounting standards, stating that the Final Rule does not refer to or expressly rely on these standards for classifying circumstances in which a transaction may be considered a hedge of another transaction. This distinction is important because such accounting standards are designed for financial statement purposes, not to identify proprietary trading, and they change often and are thus likely to change in the future without consideration of the potential impact on the Volcker Rule.
First Steps to Prepare Initial preparation for compliance and related accounting issues can be closely tied to the compliance program steps described above. Examples of good practices include:
The Final Rule leans more heavily on larger banking entities engaged in significant trading activities than smaller, less active banking entities, and the degree of difference is notable. The Final Rule's risk measurements are relatively few in number and will be familiar to risk management and accounting professionals. However, the Final Rule applies to a broad set of securities, investments, and proprietary trading activities. The fact that the Final Rule allows for certain permitted risk-mitigating hedging activities, provided the compliance rules are followed as described above, means there is gray area for different interpretations. Further, the requirements for identifying permitted risk mitigating activities do not necessarily comply with related financial accounting standards for securities transactions. Add it all up and there is plenty that we see to keep banking entities, their advisors, and U.S. securities regulators busy as the Final Rule goes into effect.
First Steps to Prepare
Banking entities and their internal and outside counsel should consider the steps necessary to implement a comprehensive compliance implementation plan. This process begins with identifying responsible senior managers across banking entities’ operations to lead teams in planning a robust compliance infrastructure. Drafting a plan that sets goals and timeframes, identifies skill sets and staffing needs, and allows for system process testing is an important first step toward preparing for Final Rule conformance.
Duff & Phelps has extensive experience assisting financial firms in complying with new financial regulations, responding to regulatory inquiries, managing compliance and risk management system implementations, and advising clients with securities related disputes.
1.See page 1 of the Final Rule Reamble.
Assistance with complex securities litigation.Securities Litigation
Regionally targeted assistance for asset managers in compliance program development, implementation and maintenanceBy Jurisdiction
Comprehensive support for asset managers registering in the U.S.U.S. Regulation