May 2014
Financial
Services
The Volcker Rule
Covered funds, investment activity
and affiliated transactions
A bank’s guide to regulatory change
On 10 December 2013, banks awoke to the release of the final Volcker Rule —
impacting how they operate, the investments that they make and the services
that they provide. Banks no longer have the freedom to organize and provide
services once permitted during the days of the Gramm-Leach-Bliley Act. Instead,
they’ve been prescribed a dose of stringent regulation, significantly changing the
world in which they can operate by impacting their abilities to own and to provide
services to funds and other subsidiaries. Fortunately, a well-designed, thoughtfully
implemented Volcker-compliant program will allow banks to manage their funds
successfully in the new landscape.
Requirements
The Volcker Rule restricts both banks’ ownership in funds and their
ability to enter into transactions with funds. Banks with more than
US$10 billion in consolidated assets must have a detailed fund
compliance plan in place by 22 July 2015. In the interim, banks must
have a conformance period plan that addresses the required actions
that need to occur between now and 22 July 2015 to ensure they’re
compliant with the Volcker Rule. Banks can apply to the Federal
Reserve to extend the conformance period for illiquid funds.
Impact
Ownership interest
The Volcker Rule significantly restricts banks from owning hedge
funds or private equity funds — which necessitates clarity related
to the definition of ownership of hedge funds and private equity
funds. Unfortunately, the Volcker Rule is complex and requires
detailed analysis. The Volcker Rule constructs a complex, layered
approach for banks to define ownership and prohibited funds. There
are eight ownership characteristics which attempt to capture the
“economic sense” of ownership by mainly focusing on participation
in the potential upside and economic downside of the entity. These
characteristics maintain a logic sequence that captures ownership.
The definition of funds would be relatively straightforward except
for the Volcker Rule’s 14 distinct exceptions. While these traps are
at times exasperating, they can also represent important avenues
for reducing the Volcker Rule’s impact. A bank’s Volcker Rule funds’
compliance program must analyze its entities using these traps to
determine the Volcker Rule’s applicability.
Services
The Volcker Rule limits a bank’s ability to provide services to covered
funds through Sections 23A and 23B of the Federal Reserve Act,
which are written to limit a bank’s transactions with affiliates and
to ensure arm’s-length pricing on transactions between the bank
and its affiliates. Under the Volcker Rule, a bank can only provide
certain “prime brokerage” services to “sponsored-covered” funds in
which another bank-covered fund has made an investment. This new
restriction is colloquially referred to as the “Super 23A” restriction
and will present new obstacles to banks that provide prime brokerage,
administration or custodial services to funds that they also manage.
Compliance program
The Volcker Rule has specific compliance program requirements and
it requires the individual business managers to take responsibility
for compliance. The Volcker Rule compliance program requires a
2
thorough inventory of funds and entities with specific explanations
as to why they are or are not covered funds under Volcker. There
must be specific procedures and controls regarding the monitoring of
entity ownership interest, disposition plans, transactions with covered
funds and remediation in the event of a Volcker violation. Finally, the
chief executive officer (CEO) must annually attest that the bank has a
reasonably designed compliance program to comply with the Volcker
Rule for banks with more than US$50 billion in consolidated assets.
The compliance path
Compliance with the Volcker Rule for covered funds can be initiated
through the following four distinct steps:
Step 1: Banks need to survey their entities and the services that they
provide them.
Step 2: Banks need to categorize entities and services as permissible
under the Volcker Rule, or as impermissible, thus necessitating
changes to become permissible.
Step 3: Banks need to conform existing entities to the Volcker Rule by
disposing of, or transforming, the entities and/or services.
Step 4: Banks need to implement a Volcker Rule compliance program
to ensure that entities and services comply with the Volcker Rule
going forward.
Surveying
The goal of surveying is threefold. Banks need a complete inventory of
all funds, entities and activities that the Volcker Rule could cover. The
second goal is to identify which funds or entities the bank owns under
the Volcker Rule and which transactions are entered into with those
funds and entities. The final goal is to collect sufficient information to
determine if the identified entities and activities are covered funds or
transactions under the Volcker Rule, or qualify for an exemption.
Generally, Volcker Rule-covered funds are bank entities that would
require registration under the Investment Company Act of 1940
(40 Act), if they were offered in the US, except for the exemptions
provided by Sections 3(c)(1) and 3(c)(7). In addition to hedge and
private equity funds, banks used these exemptions to establish a joint
venture, acquisition, securitization and countless other entities in order
to avoid 40 Act registrations. Until the Volcker Rule, there was little
consequence of 3(c)(1) or 3(c)(7) categorization. As a result, banks may
have difficulty in ascertaining exactly which entities are 3(c)(1) and 3(c)
(7), and why the entities are qualified for those exemptions. Banks must
ask themselves if that’s the right exemption to use, or if it was the most
expedient. This assessment could be an overwhelming task, but must
be performed or the banks risk divesting permissible assets.
| Volcker Rule fund compliance: a bank’s guide to regulatory change
Volcker Rule defined
As part of the Dodd–Frank Wall Street
Reform and Consumer Protection Act, the
Volcker Rule restricts US banks and their
affiliates from proprietary trading and
restricts their investments in hedge funds
and private equity funds.
The Volcker Rule limits banks’ ability to own
covered funds, which are primarily hedge
fund, private equity and venture capital
investments, to 3% of any one fund and in
total to 3% of a bank’s net worth.
The Volcker Rule is packed with important
definitions that determine the fate of
certain funds and services. This is one of
the most proscriptive rules ever written, so
the devil truly is in the details.
Banks must pay strict attention to the
prescription of regulation dictated by the
Volcker Rule.
May 2014 |
3
Figure 1.
Survey characteristics
Process
Decision
1.0.1
Start
Survey all bank’s
investments
1.2
1.1
Is investment a
permitted investment
or activity outside
the US?
No
1.3
Is investment a
covered fund?
Yes
Yes
1.4
Is investment an
ownership interest?
No
Yes
1.5
Is investment held
YkYj]klja[l]\hjgÕl
interest?
No
No
Is investment held
as a principal?
Yes
Yes
Continue to A
No
1.0.2
Allowed investment
under Volcker Rule
Yes
Yes
1.6
A
Is investment a
permitted riskmitigating hedging
activity?
Yes
1.7
No
Is investment a
permitted fund by a
regulated insurance
company?
Yes
1.8
No
Is investment an
ownership/sponsorship
in a TruPS collateralized debt
obligation?
3.0
Compounding the surveying problem is the Volcker Rule’s broad
definition of ownership interest, which includes investing in certain
debt securities. Under the Volcker Rule, an ownership interest either:
Has an equity or ownership interest
2.
Has the right to remove the entity’s management or
investment adviser
3.
Has the right to receive a share of income from the entity
4
Is investment
allowed under the
asset management
exemption?
No
The flowchart above illustrates the start of the decision process. The
Volcker Rule considers an entity “guilty until proven innocent,” so each
step of the process requires careful consideration and documentation.
1.
Yes
4.0
No
Is investment
allowed under the
asset-backed
securities
exemption?
No
1.0.3
Prohibited investment
under Volcker Rule
Finish
4.
Has the right to receive the underlying assets after other
investors have been redeemed
5.
Has the right to receive the excess spread between the payments
on the entity’s underlying assets and the amounts due to investors
6.
Provides that the interest payable by the entity could be reduced
based upon losses in the underlying assets
7.
Receives interest in a pass-through basis or determined by the
performance of the underlying asset
8.
Represents a synthetic right to receive any of the above
| Volcker Rule fund compliance: a bank’s guide to regulatory change
The Volcker Rule ownership definition includes investing in structured
debt securities. Identifying covered funds poses issues because of
the different exemptions. Conceptually, banks should easily identify
3(c)(1) and 3(c)(7), but the final Volcker Rule contains at least 14
different exemptions, including:
1.
Would be able to use another exemption from the 40 Act
registration such as (3(c)(5) or Securities and Exchange
Commission (SEC) Rule 3a-1
2.
Is a foreign public fund (retail undertakings for collective
investments in transferable securities (UCITS))
3.
Is a joint venture
4.
Is a wholly owned subsidiary
5.
Is an acquisition vehicle
6.
Is a foreign pension or investment company
7.
Is a vehicle established to hold bank-owned life insurance
8.
Is a loan securitization
9.
Is a qualifying asset-backed commercial paper conduit
10. Is a qualifying covered bond
11. Is a small business investment company (SBIC) or public
welfare fund
12. Is a registered investment company
13. Is the entity of a separate account at an insurance company
14. Is an issuer in relation to a Federal Deposit Insurance Corporation
(FDIC) receivership
As one can see, these exceptions to the Volcker Rule contain
considerable conditions.
These exemptions are powerful as they allow many in-the-courseof-ordinary-business entities, such as equipment-leasing vehicles, to
avoid capture under the Volcker Rule. The downside is that a bank
needs a robust survey when it begins to examine its Volcker Rule
entities and activites.
Categorization
Banks can use the survey results to categorize their entities and
activities under the Volcker Rule. The Volcker Rule will clearly affect
some entities and activities, such as true hedge funds and private
equity funds. The Volcker Rule will leave other entities and activities
unscathed, such as registered investment companies. The most
difficult category is when there are multiple possible Volcker Rule
categories for a single fund. This category requires extensive analysis
and thought about how to re-categorize entities and activities to
maximize the strategic value to the bank and its balance sheet.
Conformance
Conformance requires taking existing prohibited entities and activities
and bringing them into conformance with the Volcker Rule. The
options are to dispose or to transform. Many banks probably will
reduce the size of their hedge fund and private equity investments
due to the conflicts between retaining the incentive and management
fees and the limits on the 3% investment amount.
Transformation requires creative thinking. Despite its draconian
consequences, the Volcker Rule’s exemptions, its treatment of foreign
banks, a captive insurance company’s ability to own covered funds,
and the continuance of the merchant banking exemption provide
opportunities to re-categorize entities and activities in order to
conform to the Volcker Rule. Time spent reviewing the survey results
and the Volcker Rule will be time well spent.
Conformance is the toughest step in this plan. Entities and activities will
need to be terminated and/or restructured, which could result in the
uprooting of people and operations. The Volcker Rule will alter flexibility
in future operations. The decisions around Volcker Rule entities and
activities are difficult and carry far-reaching consequences.
Compliance program
The conformance period deals with how banks will become fundcompliant with the Volcker Rule by 22 July 2015. Banks must consider
how they will operate in this new regulatory world going forward,
knowing that future Volcker Rule compliance requires a robust
program. Business managers are the first line of defense, but the
compliance program touches risk, accounting, legal and compliance,
May 2014 |
5
Figure 2.
Volcker Rule compliance program
Board oversight
• Set and communicate culture of Volcker Rule compliance
• Approve the compliance program
• Review effectiveness of the compliance program at least annually
Policies and
procedures
Senior management oversight and CEO attestation
• Implement and enforce the approved Volcker compliance program
• Annual written CEO attestation
Governance
Internal
controls
Volcker steering committee oversight
Provide oversight over the implementation of the Volcker Rule
Management
framework
Second line
of defense:
business
support
functions
Independent
testing
Training
Recordkeeping
Risk
Finance
• Establish policy
• Independent review and testing
• Produce/monitor metrics
Compliance
• Manage and monitor limits
• Investigate/escalate violations
• Monitor remediation of violations
Legal
Human resources
• Calibrate program/change management
• Establish internal controls
• New product/business activity approval
Third line
of defense:
internal audit
Covered fund investments and activities
First line of
defense:
business line
managers
Business line managers
Permitted fund investments and activities (see page 5)
• Foreign public funds
• De minimis thresholds
• Wholly owned subsidiaries
• Asset management
• Loan securitizations
exemption
Own, implement and enforce programmatic compliance
Operations, information technology and data
before finally arriving at the CEO and the board. The Volcker Rule
requires strict compliance going forward.
The Volcker Rule requires meticulous documentation. Banks need to
maintain an inventory of entities and transactions and their Volcker
Rule status. The Volcker Rule presumes transactions and entities are
impermissible unless proven otherwise.
Volcker Rule funds’ compliance involves all areas of a bank. The first
line of defense is the business managers who own the compliance
responsibilities. The Volcker Rule emphasizes this responsibility by
requiring CEO certification in large banks. The second line of defense
is the business support functions, e.g., compliance, finance and
accounting, which oversee the compliance programs and ensure
6
that managers follow required procedures. The third line of defense
is internal audit that periodically, and at least annually, reviews and
tests the effectiveness of the Volcker Rule compliance program. All of
this is overseen by the board of directors who manage Volcker Rule
compliance and ensure that the bank allocates sufficient resources
to Volcker Rule compliance. The Volcker Rule sets out extremely
prescriptive compliance procedures so that a risky venture won’t slip
through the process.
There is life in Volcker Rule fund compliance dystopia. Banks that read
the Volcker Rule carefully and install a precise, thoughtful compliance
program should be able to operate efficiently in the new environment.
Nonetheless, as management explores the Volcker Rule in depth, it
| Volcker Rule fund compliance: a bank’s guide to regulatory change
information that is directly transferable to the Volcker Rule. In
the early stages of the Volcker Rule effort, it is important to
identify and leverage this work.
should remember the following nine considerations:
1.
You are not alone. Private equity and venture technology
partnerships may have to be converted into direct investments.
Joint ventures may have to limit the number of investors
contractually. All banks and investment managers who have
banks as their investors in hedge and private equity funds face
Volcker Rule issues. Addressing these issues will require flexibility
and ingenuity. Investment managers, who are already under
pressure to increase asset size, should be willing to examine
alternative structures in order to retain investments.
2.
Show that you get it. Regulators want to see that the regulated
respect the regulations. Those institutions that install a thorough
Volcker Rule compliance program will influence events as they
move forward. Those that don’t will be negatively impacted.
3.
Lead from the top. Volcker Rule compliance is a tough task which
will require difficult firm-wide and personnel decisions. If the CEO
and the board lead and get involved, the company will follow.
Volcker Rule compliance will be quicker and cheaper for banks
than if Volcker Rule compliance is another regulatory chore
imposed by the regulators.
4.
Interact with the regulators. The Volcker Rule represents the
collective ideas of Governors of the Federal Reserve, Office of the
Comptroller of the Currency, FDIC, the SEC and the Commodity
Futures Trading Commission. The five agencies may have a
difficult time making decisions as they seek to avoid regulatory
arbitrage. Nonetheless, the more interactions that management
has with their regulators, the more the regulators will appreciate
the efforts that bank management is making, and subsequent
decisions will be easier.
5.
Embrace change. You can be certain that just as you near a point
of comfort with your Volcker Rule funds project, someone will
raise another costly, frustrating point. Volcker compliance will be
a long, expensive, challenging process. Don’t get discouraged.
6.
Leverage existing efforts. As a consequence of regulatory efforts
such as Form ADV, Form PF, Form CPO-PQR and the Alternative
Investment Fund Managers Directive, banks have collected much
7.
Talk with your peers. The Volcker Rule is uncharted territory. All
banks are in the same position and facing the same challenges.
Frequent discussions with peer institutions will shed light on
emerging best practices, or address an issue and find a solution.
8.
Consult wisely and often. The Volcker Rule is an interesting mix
of legal and operational issues. Banks that seek advice often
from the proper places will have a better chance of succeeding.
9.
In uncertainty there may be prosperity. Volcker Rule compliance
will necessitate the sale and restructuring of funds and the
transfer of activities to third parties. As these events unfold, banks
that get in front of them will have opportunities to facilitate these
transactions. Banks can use their own Volcker Rule experiences to
help others, particularly private equity and hedge fund managers
looking for new investors, and asset-backed securities issuers
looking to initiate additional transactions.
The state of uncertainty is never a pleasant place to be. The key to
getting out of it is individual proactive efforts that make the situation
better. If banks lead the initiative in framing the actuality of Volcker
Rule fund compliance, they can better control the outcome. 
May 2014 |
7
About the authors
John Sampson is an executive director in the Financial Services
Office of Ernst & Young LLP. He is based in New York and can
be reached at +1 212 773 2729 or [email protected].
Michael Barnes is an executive in the Financial Services Office of
Ernst & Young LLP. He is based in New York and can be reached at
+1 212 773 1411 or [email protected].
EY | Assurance | Tax | Transactions | Advisory
About EY
EY is a global leader in assurance, tax, transaction and advisory services. The
insights and quality services we deliver help build trust and confidence in the
capital markets and in economies the world over. We develop outstanding
leaders who team to deliver on our promises to all of our stakeholders. In so
doing, we play a critical role in building a better working world for our people,
for our clients and for our communities.
EY refers to the global organization, and may refer to one or more, of the
member firms of Ernst & Young Global Limited, each of which is a separate
legal entity. Ernst & Young Global Limited, a UK company limited by guarantee,
does not provide services to clients. For more information about our
organization, please visit ey.com.
Ernst & Young LLP is a client-serving member firm of Ernst & Young Global
Limited operating in the US.
EY is a leader in serving the global financial services marketplace
Nearly 43,000 EY financial services professionals around the world provide
integrated assurance, tax, transaction and advisory services to our asset
management, banking, capital markets and insurance clients. In the Americas,
EY is the only public accounting organization with a separate business unit
dedicated to the financial services marketplace. Created in 2000, the Americas
Financial Services Office today includes more than 6,900 professionals at
member firms in over 50 locations throughout the US, the Caribbean and
Latin America.
EY professionals in our financial services practices worldwide align with key
global industry groups, including EY’s Global Wealth & Asset Management
Center, Global Banking & Capital Markets Center, Global Insurance Center and
Global Private Equity Center, which act as hubs for sharing industry-focused
knowledge on current and emerging trends and regulations in order to help
our clients address key issues. Our practitioners span many disciplines and
provide a well-rounded understanding of business issues and challenges, as
well as integrated services to our clients.
With a global presence and industry-focused advice, EY’s financial services
professionals provide high-quality assurance, tax, transaction and advisory
services, including operations, process improvement, risk and technology, to
financial services companies worldwide.
© 2014 Ernst & Young LLP.
All Rights Reserved.
SCORE No. CK0795
1402-1205721 NY
ED None
This material has been prepared for general informational purposes only and is not intended to be relied
upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.
ey.com/wealthassetmgmt