Kathleen A. Scott

In my July 2018 column I discussed proposed changes to the Volcker Rule issued for comment by the federal banking, commodities and securities regulators (collectively, the Agencies).

An extended comment period ended Oct. 17, 2018. This month’s column will discuss some of the comments submitted by non-U.S. banks operating in the United States, their trade associations and other non-U.S. government entities (collectively, the Commenters), focusing on some of the issues of particular importance to them.

Proposed SOTUS Changes

Many banks rely on the “Solely Outside the United States (SOTUS)” exemption from the Volcker Rule’s restrictions on proprietary trading and certain private equity funds (“covered funds”). Revisions to the SOTUS exemption for proprietary trading include elimination of the prohibition that no financing for the banking entity’s purchase or sale be provided by any U.S. branch or affiliate of the banking entity (the “Financing Prohibition”); a narrowing of the restrictions on trading with U.S. counterparties (the “Counterparty Restriction”) and a narrowing of the requirement that no banking entity personnel who arrange, negotiate, or execute such purchase or sale can be located in the United States to a restriction that only “relevant” personnel engaged in the banking entity’s decision in the purchase or sale cannot be located in the United States (the “Personnel Restriction”).

With respect to the covered fund restrictions, in addition to eliminating the Financing Prohibition, the marketing prohibition on a non-U.S. covered fund being offered or sold to U.S. residents would be clarified to apply only if the offering actually is targeted at U.S. residents, thus incorporating into the regulation an interpretation on this issue released by the Agencies in 2015.

Non-U.S. banks generally approved of the proposed changes but in some instances felt the Agencies had not gone far enough. Commenters approved of the lifting of the Counterparty Restriction because it has been a burden for non-U.S. banks having to verify the identity of each counterparty, which had led some non-U.S. banks to narrow their lists of authorized counterparties. In the Supplementary Information accompanying the proposed revised text of the regulation, the Agencies acknowledge that this particular requirement had proved difficult in practice to implement.

The revision of the Personnel Restriction would only require that “relevant personnel” involved in the decision to conduct the trade be outside the United States. Commenters requested clarification of who are to be considered “relevant personnel” and recommended that “relevant personnel” exclude those persons merely operationally executing a trade who have no other involvement in the decision to undertake the limit of the particular trade. Another Commenter requested that personnel at a U.S. banking entity providing investment advisory services to a non-U.S. fund should not be deemed to be “relevant” personnel so long as the trading and investment decisions, and establishment and compliance with investment limits, remain with the non-U.S. asset management company.

Compliance Programs

The Volcker Rule contains detailed compliance obligations. Under the proposal, Volcker Rule compliance program requirements would vary depending upon a banking entity’s average gross sum of trading assets and liabilities on a worldwide consolidated basis over the previous consecutive four quarters (“average gross sum”).

Commenters generally approved of the tiered approach to Volcker Rule compliance programs but also suggested additional revisions:

• Exclude from the calculation of a banking entity’s trading assets and liabilities all U.S. and non-U.S. government obligations in which a banking entity is authorized to trade under the current regulations. Under the proposal, only U.S. government or U.S. government-guaranteed obligations are excluded.

• Clarify that the only “trading assets and liabilities” that should be counted are those that are defined as “financial instruments” in the regulation

• The trading assets and liabilities of non-consolidated affiliates should not be included in the calculation because a banking entity may be able to exercise little or no control over these entities.

Foreign Excluded Funds

One of the most significant issues raised by the Commenters deals with “foreign excluded funds.” The Volcker Rule does not apply to a non-U.S. bank’s investment in or sponsorship of non-U.S. funds organized and offered only outside the United States. However, given the definition of “affiliate” in the Volcker Rule itself (such as owning 25 percent of any class of voting shares), if a non-U.S. banking entity has a large ownership in the non-U.S. fund, or selects the board of directors of the fund, or acts as a general partner or trustee of the fund, it may be deemed to “control” the fund, making it an affiliate of the fund (a “non-U.S. affiliated fund”). Affiliates of banking entities also are considered to be banking entities, and as a result, the non-U.S. affiliated fund would be considered to be a banking entity itself and subject to all the Volcker Rule restrictions. While other types of investment funds are not considered to be banking entities, currently this category of fund is not addressed, while a U.S. fund meeting the definition of a covered fund is not itself deemed to be a banking entity.

On July 21, 2017, the Agencies issued a joint press release indicating that they were coordinating their review of the applicability of the Volcker Rule to certain non-U.S. funds. The U.S. Banking Agencies (the Federal Reserve Board, the Federal Deposit Insurance Corporations and the Office of the Comptroller of the Currency) also issued a joint statement (“Statement”) that while they craft a final position on the matter, they will not take action through July 21, 2018, against non-U.S. banking entities that could be deemed under the current version of the Volcker Rule regulations to “control” those funds. In the proposal, the Banking Agencies extend this no-action position to July 21, 2019, and request comments on possible solutions.

The no-action position applies to a non-U.S. banking entity with a non-U.S. affiliated fund or the non-U.S. affiliated fund itself provided the following conditions were met:

(I) The non-U.S. banking entity’s acquisition or retention of any ownership interest in or sponsorship of a non-U.S. affiliated fund would meet the requirements of the SOTUS exemption if the non-U.S. affiliated fund were subject to the Volcker Rule; and

(II) the fund in question qualifies as a “qualifying foreign excluded fund” (QFEF) which is defined as an entity that:

(1) Is organized or established outside the United States and its ownership interests are offered and sold solely outside the United States;

(2) Would be a “covered fund” for Volcker Rule purposes were the entity organized or established in the United States, or is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;

(3) Would not otherwise be a “banking entity” for Volcker Rule purposes except by virtue of the non-U.S. banking entity’s acquisition or retention of an ownership interest in, or sponsorship of, the entity;

(4) Is established and operated as part of a bona fide asset management business; and

(5) Is not operated in a manner that enables the non-U.S. banking entity to evade the requirements of the Volcker Rule or its implementing regulations.

In establishing the no-action position, the Agencies also noted their concern that a non-U.S. banking entity with such a non-U.S. affiliated fund possibly could use that fund to conduct activity prohibited under the Volcker Rule, thus providing a non-U.S. banking entity with a competitive advantage over U.S. banking entities.

Conversely, non-U.S. banking entities have pointed out that without the no-action position, there is a competitive advantage for non-U.S. funds that are not affiliated with a non-U.S. banking entity vis-à-vis non-U.S. funds that are considered “affiliates” of a non-U.S. banking entity for purposes of the Volcker Rule.

While the proposal extends the applicability of the no-action letter for another year, Commenters are looking for a permanent solution. They noted that the inclusion of these non-U.S. funds is inconsistent with the purpose and intent of the Volcker Rule. Through the addition of the SOTUS exemption, they assert that Congress made it clear that the Volcker Rule was not trying to regulate the non-U.S. fund activities of non-U.S. banks, a position that would be, as noted by one Commenter, in accordance with “longstanding principles of international bank supervision that limit unwarranted extraterritorial application of U.S. banking laws and accord appropriate deference to home country bank supervision.”

Proposed solutions put forth by the Commenters included the following:

(i) Generally exclude from the definition of “banking entity” non-U.S. funds organized outside the United States by non-U.S. banks, the interests of which are offered and sold outside the United States, or at least exclude QFEFs from the definition of “banking entity”;

(ii) Incorporate the QFEF definition into the regulations or otherwise make the no action position permanent;

(iii) Add a presumption that a QFEF is presumed in compliance with the Volcker Rule so long as it meets that definition’s requirements;

(iv) Exclude from the definition of “control” for purposes of the Volcker Rule valid actions required under non-U.S. law that might cause the non-U.S. bank to be deemed to control (within the regulation’s current definition) a non-U.S. fund (in some countries, local law may impose certain fund formation requirements that would be considered to constitute “control” under its current definition in the Volcker Rule);

(v) Exclude QFEF activities from the definition of “proprietary trading” or

(vi) Allow QFEF’s to opt in to being considered a “covered fund” under the definitions provided it could then rely on the SOTUS exemption.

However, if option (vi) is the solution, the Commenters note that Agencies would have to revise the so-called “Super 23A” provision to clarify that its restrictions apply only to U.S. activities and not extraterritorially to covered transactions between a covered fund organized outside the United States and a non-U.S. banking entity’s non-U.S. operations. Section 23A imposes quantitative and qualitative restrictions on a bank’s transactions with its affiliates. Under the Volcker Rule, subject to certain exceptions, a banking entity that serves as an investment manager, investment adviser, or sponsor to a covered fund may not enter into a transaction with that fund if the transaction would be considered a “transaction with an affiliate” for purposes of §23A of the Federal Reserve Act. Commenters also believe that this clarification should be made regardless of the foreign excluded funds issue.

In addition, responding to the Banking Agencies’ concerns that these non-U.S. funds could be used to evade the provisions of the Volcker Rule, Commenters noted that the manner in which non-U.S. funds are organized outside the United States by non-U.S. banks is not new, and should not be viewed by the Agencies as funds suddenly being formed for purposes of evasion; moreover the general anti-evasion provisions of the Volcker Rule should be sufficient to deal with any attempt to utilize non-U.S. funds in violation of the Volcker Rule.

Conclusion

While Commenters generally were positive about many of the proposed changes to the Volcker Rule, as this column’s discussion shows, they still are looking for additional changes to address unnecessary extraterritorial extension of the Volcker Rule when there is no systemic risk to the U.S. financial system, any risk remains outside the United States or there is no connection with the United States at all. It will be interesting to see how the Agencies will balance all the interests in crafting a final rule.

Kathleen A. Scott is a senior counsel in the New York office of Norton Rose Fulbright.