Henry M. Fields, Oliver I. Ireland, Jiang Liu, Barbara R. Mendelson, and Mark R. Sobin
Banking + Financial Services, Financial Institutions + Financial Services, and Financial Services
On August 20, 2019, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) approved a final rule (the “2019 Final Rule”) to amend the rules implementing Section 13 of the Bank Holding Company Act of 1956 (the “Volcker Rule”). It is expected that the other three federal agencies responsible for implementing the Volcker Rule (together with the OCC and FDIC, the “Agencies”) will approve the 2019 Final Rule in the coming days. On August 26, 2019, we summarized in a client alert the key changes under the 2019 Final Rule affecting all banking entities. In this client alert, we focus on the changes that affect foreign banking entities.
The Volcker Rule generally prohibits banking entities from engaging in proprietary trading or from investing in, sponsoring, or having certain relationships with hedge funds and private equity funds (“covered funds”). In 2013, the Agencies adopted regulations to implement the Volcker Rule (the “2013 Rule”). With the benefit of more than five years of experience under the Volcker Rule, foreign banking entities have found that certain of the regulations have unduly burdened their operations outside the United States and, in their view, have been unnecessary in accomplishing the Volcker Rule’s policy objectives.
The 2019 Final Rule provides relief for foreign banking entities from the burden of Volcker Rule compliance principally in two ways: first, it tailors compliance obligations based on the level of U.S. trading assets and liabilities, thereby relieving many foreign banking entities from complex internal controls dedicated to Volcker Rule compliance and, second, it removes certain restrictive conditions for exemptions from Volcker Rule prohibitions on covered fund and proprietary trading activities engaged in by foreign banking entities outside the United States.
The 2019 Final Rule will be effective on January 1, 2020. However, banking entities will not be required to comply with the 2019 Final Rule until January 1, 2021 (the “Compliance Date”). Prior to the Compliance Date, banking entities may voluntarily comply, in whole or in part, with the 2019 Final Rule.
TAILORING THE APPLICATION OF THE VOLCKER RULE
The 2019 Final Rule segments banking entities based on their level of trading assets and liabilities into the following three categories.
1. Significant Trading Assets and Liabilities. A banking entity would be in this category if either: (i) the banking entity (together with its affiliates and subsidiaries) has an average gross sum of trading assets and liabilities over the previous consecutive four quarters equal to or greater than $20 billion; or (ii) the applicable Agency has determined that the banking entity should be treated as having significant trading assets and liabilities.
2. Moderate Trading Assets and Liabilities. A banking entity would have moderate trading assets and liabilities if it neither falls within the category of “Limited Trading Assets and Liabilities,” described below, nor falls within the category of “Significant Trading Assets and Liabilities,” described above.
3. Limited Trading Assets and Liabilities. A banking entity would be in this category if the banking entity (together with its affiliates and subsidiaries) has an average gross sum of trading assets and liabilities over the previous consecutive four quarters of less than $1 billion.
The 2019 Final Rule subjects banking entities with higher levels of trading assets and liabilities to more stringent requirements. By contrast, banking entities with “Limited Trading Assets and Liabilities” are presumed to be compliant with the Volcker Rule and will not have an obligation to demonstrate compliance on an ongoing basis.
For a foreign banking organization (FBO), trading assets and liabilities are the trading assets and liabilities (excluding U.S. government and government agency securities) of the combined U.S. operations of the top-tier FBO (including all subsidiaries, affiliates, branches, and agencies of the FBO operating, located, or organized in the United States). Thus, this tailoring proposal will have the effect of placing many FBOs, except those with a large U.S. presence, into the Limited Trading Assets and Liabilities category.
TRADING AND COVERED FUNDS ACTIVITIES OUTSIDE THE UNITED STATES
The Volcker Rule contains exemptions for activities conducted by foreign banking entities solely outside the United States. The 2019 Final Rule removes some of the more burdensome conditions for these exemptions in a manner designed to increase the ability of foreign banking entities to qualify for the exemptions. The changes focus principally on whether the risk inherent in the activity is located or held outside of the United States.
Exemption for Trading Outside the United States
The 2013 Rule provides an exemption from the proprietary trading restrictions for trading by a foreign banking entity outside the United States (the so-called “TOTUS exemption”). To rely on the TOTUS exemption, the 2013 Rule requires, among other conditions, that trades not be conducted with or through a U.S. entity (subject to certain exceptions). This has required foreign banking entities to verify whether counterparties are U.S. entities or qualify for exceptions. It has become an industry practice for foreign banking entities to request so-called “TOTUS representation letters” from counterparties that are designed to support the determination, among other things, that the counterparty is not a U.S. entity or, if a foreign operation of a U.S. entity, that no personnel of such U.S. entity located in the United States are involved in the arrangement, negotiation, or execution of the relevant purchase or sale. A significant feature of the 2019 Final Rule is that it eliminates this requirement. In other words, a foreign banking entity can now conduct trades with U.S. counterparties and still rely on the TOTUS exemption, as long as it complies with other TOTUS exemption requirements. As a result, TOTUS representation letters should soon be a relic of the past.
The TOTUS exemption requirements have been relaxed in other respects. The 2013 Rule requires, among other things, that any employees of the foreign banking entity or its affiliate that arrange, negotiate, or execute the trade outside the United States, not be located in the United States. The 2019 Final Rule relaxes this condition by prohibiting only those involved in the decision to make the trade from being located in the United States. The 2019 Final Rule also eliminates the 2013 Rule’s requirement that no financing for the purchase, sale, or investment be provided by any branch or affiliate of the foreign banking entity located in the United States.
In summary, under the 2019 Final Rule, there are only three conditions for a foreign banking entity (that is a qualifying foreign banking organization under Federal Reserve’s Regulation K) to rely on the TOTUS exemption:
i. The banking entity engaging as principal in the purchase or sale (including relevant personnel) is not located in the United States or organized under the laws of the United States or of any State;
ii. The banking entity (including relevant personnel) that makes the decision to purchase or sell as principal is not located in the United States or organized under the laws of the United States or of any State; and
iii. The purchase or sale, including any transaction arising from risk-mitigating hedging related to the instruments purchased or sold, is not accounted for as principal directly or on a consolidated basis by any branch or affiliate that is located in the United States or organized under the laws of the United States or of any State.
Exemption for Covered Funds Solely Outside the United States
Under the 2013 Rule, certain covered fund activity involving a foreign banking entity is permissible if it meets the requirements of the exemption for covered fund activity that occurs solely outside the United States (the so-called “SOTUS covered fund exemption”). The 2019 Final Rule eliminates one such requirement, i.e., that no financing for the ownership or sponsorship of the covered fund be provided by a branch or affiliate of the foreign banking entity located or organized under the laws of the United States.
The SOTUS covered fund exemption now requires that “no ownership interest in the covered fund may be offered for sale or sold to a resident of the United States.” Consistent with clarification provided in FAQ No. 13, the 2019 Final Rule enables foreign banking entities to rely on the SOTUS covered fund exemption for foreign funds that are marketed to residents of the United States, if the foreign banking entity does not participate in the marketing. Again, consistent with FAQ No. 13, a foreign banking entity will be deemed to participate in the offering or marketing of ownership interests in covered funds to U.S. residents if the foreign banking entity or its affiliate serves as the covered fund’s sponsor, investment manager, investment adviser, commodity pool operator, or commodity trading adviser.
In summary, under the 2019 Final Rule, there are only four conditions for a foreign banking entity (that is a qualifying foreign banking organization under Federal Reserve’s Regulation K) to rely on the SOTUS covered fund exemption:
i. The banking entity acting as sponsor, or engaging as principal in the acquisition or retention of an ownership interest in the covered fund, is not itself, and is not controlled directly or indirectly by, a banking entity that is located in the United States or organized under the laws of the United States or of any State;
ii. The banking entity (including relevant personnel) that makes the decision to acquire or retain the ownership interest or act as sponsor to the covered fund is not located in the United States or organized under the laws of the United States or of any State;
iii. The investment or sponsorship, including any transaction arising from risk-mitigating hedging related to an ownership interest, is not accounted for as principal directly or indirectly on a consolidated basis by any branch or affiliate that is located in the United States or organized under the laws of the United States or of any State; and
iv. An ownership interest of the covered fund is not sold and has not been sold pursuant to an offering that targets residents of the United States in which the banking entity or any affiliate thereof participates, directly or indirectly, as a sponsor, investment manager, investment adviser, commodity pool operator or commodity trading advisor.
Extension of No-Action Relief for Certain Foreign Excluded Funds
A “foreign excluded fund” is generally understood to be a fund:
i. in which a foreign banking entity invests or that it sponsors;
ii. that is organized under the laws of a foreign jurisdiction;
iii. the ownership interests of which are offered and sold solely outside the United States; and
iv. that 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.
Foreign excluded funds are not “covered funds” under the 2013 Rule.
Under the 2013 Rule, the definition of a “banking entity” includes any affiliate of a banking entity but excludes “covered funds.” Covered funds controlled by a banking entity, even though they are affiliates of the banking entity, are not themselves banking entities by virtue of the exclusion. However, since foreign excluded funds are not covered funds, they cannot avail themselves of the exclusion from the definition of banking entity. Therefore, if a foreign excluded fund is affiliated with a banking entity (through sponsorship or other means), then it will be deemed to be a banking entity and subject to the prohibitions of the Volcker Rule.
On July 21, 2017, the Federal Reserve, OCC, and FDIC (the “Banking Agencies”) announced that they would not enforce the prohibitions and restrictions of the Volcker Rule with respect to the activities of certain “qualifying foreign excluded funds” controlled by “foreign banking entities” (the “No-action Relief”). This No-action Relief was initially set to expire on July 21, 2018 but, in connection with consideration and adoption of the 2019 Final Rule, has been extended, first, until July 21, 2019 and, then again, until July 21, 2021, to provide the Agencies with time to issue a separate proposed rule to address this issue, among other things.
The No-action Relief applies to a “qualifying foreign excluded fund,” which generally means a foreign excluded fund that is:
(i) affiliated with a foreign banking entity;
(ii) established and operated as part of the bona fide asset management business of the foreign banking entity; and
(iii) not operated in a manner that enables the foreign banking entity to evade the requirements of the Volcker Rule.
Pursuant to the No-action Relief, the Banking Agencies will not take action (i) against a foreign banking entity based on attribution to the foreign banking entity of the activities and investments of a qualifying foreign excluded fund, or (ii) against the qualifying foreign excluded fund based on its status as a banking entity.
 The 2019 Final Rule has not yet been published in the Federal Register. Citations to the preamble to the 2019 Final Rule (the “Preamble”) are to the 2019 Final Rule as released by the FDIC, available at: https://www.fdic.gov/news/board/2019/2019-08-20-notice-dis-a-fr.pdf.
 The Agencies responsible for issuing rules to implement the Volcker Rule are the OCC, the FDIC, the Board of Governors of the Federal Reserve System (“Federal Reserve”), the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission.
 Please see our client alert.
 Foreign banking entity means a banking entity that is not, and is not controlled directly or indirectly by, a banking entity that is located in or organized under the laws of the United States or any state. A banking entity includes (subject to exceptions) the following: (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any company that is treated as a bank holding company for purposes of section 8 of the International Banking Act of 1978; and (iv) any affiliate or subsidiary of a banking entity. §__.2(c).
 The Agencies will need to complete certain technological programming to accept metrics compliant with the 2019 Final Rule, which they anticipate will take place during the period ending on the Compliance Date. Banking entities seeking to switch over to revised metrics before the Compliance Date will need to coordinate with their regulators.
 The 2019 Final Rule excludes from the calculation of trading assets and liabilities all financial instruments that are obligations of, or guaranteed by, the United States, or that are obligations, participations, or other instruments of or guaranteed by, an agency of the United States or a government-sponsored enterprise, as described in the regulations.
 §__.20(g). Under the Final Rule, the Agencies must go through certain required notice and response procedures in order to make such a determination. §__.20(g)(2). It should be emphasized, however, that the lack of an obligation to demonstrate compliance does not relieve a banking entity from compliance with the Volcker Rule’s restrictions.
 See supra note 6.
 Not all foreign banking entities are FBOs. For example, a foreign banking entity that is subject to the Volcker Rule solely due to its control of an insured Utah industrial bank (which is not a “bank” as defined in Section 2 of the Bank Holding Company Act of 1956, as amended) is not an FBO and has to include its trading assets and liabilities on a worldwide consolidated basis.
 12 C.F.R. 248.13(b)(1)(iii).
 See §__.13(b).
 For more information regarding this no-action relief, please see our client alert.
 See Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; Office of the Comptroller of the Currency, Statement regarding Treatment of Certain Foreign Funds under the Rules Implementing Section 13 of the Bank Holding Company Act (July 17, 2019), available at: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20190717a1.pdf.
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