In today’s article, we look at some impacts the Volcker Rule may have on foreign banks.
Following the huge outpouring of objections from the banking industry over the Volker Rule proposals, which aim to prohibit the ban on proprietary trading for commercial banks and their affiliates and restrict investment in hedge funds and private equity by commercial banks and their affiliates, commercial banks and their affiliates were granted a bonus: two more years to get ready for and adjust to the Volcker Rule. The reform is not expected to commence until the summer of 2014. However, the real question is how the U.S. Presidential election to take place in the fall of 2012 will impact the reform schedule. Should the Republicans, who do not favour the reform, take office, the Volcker Rule could become history even before taking effect.
As we noted in our previous article on the implementation of the Volcker Rule, the regulations will potentially impact not only US banks but also any foreign banks which maintain a U.S. branch or agency office and by any of the foreign bank's affiliates. Just how tight a net may be cast over such foreign bank entities?
What if trading occurs “outside of the US”?
The draft Volcker Rule sets forth that a foreign banking organization (“FBO”) is not subject to the prohibition on proprietary trading to the extent the trading activity occurs “solely outside of the United States.” Four criteria must be satisfied for the transaction to be “solely outside of the United States”:
- The FBO-affiliated entity conducting the purchase or sale is not organized under the laws of the U.S. or any state;
- No party to the purchase or sale (including the FBO affiliate’s counterparty) is a resident of the U.S.;
- No personnel of the FBO-affiliated entity who is directly involved in the purchase or sale is physically located in the U.S.; and
- The purchase or sale is executed outside of the U.S.
To be able to use this exemption, the FBO must also be a “qualified foreign banking organization” (“QFBO”) as defined in the Federal Reserve Board’s Regulation K. In other words, the FBO’s worldwide activities must be predominantly banking, and the FBO’s banking activities must be predominantly outside the United States. Any affiliates of an FBO that does not meet this QFBO requirement would be unable to rely on the “outside of the United States” exemption to the
Volcker Rule’s ban on proprietary trading.
With respect to the QFBO’s non-U.S. subsidiaries, the exemption would be available only if the transaction does not involve any U.S. counterparty, any QFBO employees residing in the U.S., or any U.S. execution facility. Thus, if the transaction involves a U.S. counterparty, U.S. execution facilities, or U.S. employees, the QFBO affiliate must resort to other exemptions, and, if unable to do so, the QFBO affiliate may not conduct the trade.
Other permitted exemptions allowable for foreign banking organizations
A selection of certain permitted exemptions for FBOs includes the following:
a) Trading on behalf of customers, provided that (i) the FBO affiliate is acting as an investment adviser, commodity trading advisor, trustee, or fiduciary, the customer (and not the FBO affiliate) is the beneficial owner; or (ii) the transaction is conducted on a riskless principal basis;
b) Trading in certain government securities, limited to U.S. government or certain U.S. agency securities, State securities, or municipal securities;
c) Purchases or sales of covered financial positions as part of an underwriting and subsequent distribution of securities on behalf of an issuer, provided that the transaction meets certain requirements set forth in the proposal and, provided further, that the FBO is a SEC-registered dealer (or exempt from registration) or, if located outside the U.S., is subject to substantive regulation as a dealer where it is located;
d) Risk-mitigating hedging activities, provided the hedging arrangements satisfy the specific requirements and conditions of the proposal, including the requirement that the risks sought to be reduced are properly documented at the time of the initial purchase or sale; and
e) Transactions by certain regulated insurance companies.
The burden of proof is on the banking entity to establish the basis for the exemption to the satisfaction of the agencies. In other words, the proposal assumes that all transactions conducted in
trading accounts of certain banking entities are unlawful proprietary trading activities unless the banking entity establishes that one of the permitted exemptions applies.
Our next article in this series will examine the recordkeeping and compliance obligations imposed on foreign banking organizations by the draft Volcker Rule.