As expected, the U.S. federal regulators voted last week to approve the final Volcker Rule, which imposes restrictions on banking entities’ ability to engage in proprietary trading and to own and sponsor private investment vehicles.  The Volcker Rule applies broadly to banking entities, including certain non-U.S. banks, and while the U.S. regulators have considered the extraterritorial concerns raised in respect of the proposed Volcker Rule and have re-focused and narrowed their aim in this regard to some degree, key issues remain for European securitization transactions.  This eAlert seeks to provide preliminary answers to certain of those issues, and we will continue to closely analyze the Volcker Rule in the coming months.
 

What is the Volcker Rule?

Section 619 of the U.S. Dodd-Frank Act—the so-called "Volcker Rule"—restricts a banking entity from undertaking (as principal) proprietary trading activities and/or certain activities or roles in respect of "covered funds." The final Volcker Rule represents the outcome of the rulemaking process under section 619.

When do the requirements take effect? Are existing arrangements grandfathered?

The Volcker Rule does not provide for grandfathering with respect to existing arrangements, and takes effect from April 1, 2014. The date for full compliance with the Volcker Rule is July 21, 2015, although U.S. regulators have made clear, in extending the conformance period until July 2015, that banking entities must engage in good faith efforts to conform their activities to the Volcker Rule's requirements during the conformance period and should not expand their activities and make investments with an expectation that the conformance period will be extended. As a practical matter, this means that banking entities should begin immediately to take steps to come into compliance with the Volcker Rule. Additionally, banking entities with consolidated trading assets and liabilities of USD50 billion or more will be required to report quantitative measurements beginning June 30, 2014; those of USD25bn or more will be required to report beginning April 30, 2016; and those of USD10bn or more will be required to report beginning December 31, 2016.

Which entities are relevant banking entities for these purposes?

Banking entities include insured depository institutions (and their controlling companies), companies treated as bank holding companies for the purposes of the U.S. International Banking Act of 1978 and, with respect to each of the foregoing, any affiliates and subsidiaries. Companies treated as bank holding companies for these purposes will include non-U.S. banking organizations with branches or agencies in the U.S. As a result, EU banking organizations will generally be within this scope if they have a U.S. presence (which will be the usual position for most large banking groups).

Which entities are covered funds for these purposes?

The provisions of the Volcker Rule most relevant to European securitizations are set out in Sections .10 through .15 of the Volcker Rule, the so-called "covered funds" provisions. These provisions prohibit a banking entity from (i) acting as "sponsor" of, or acquiring or retaining an "ownership interest" in, a covered fund and/or (ii) entering into "covered transactions" (the so-called "Super 23A" transactions) with covered funds for which the banking entity (x) serves as sponsor, investment manager, investment advisor, or commodity trading advisor or (y) organizes and offers the covered fund and continues to hold an ownership interest therein. If a vehicle is not a covered fund (either because it does not satisfy the definition or because an exclusion applies), then the covered fund related restrictions under the Volcker Rule (including the Super 23A prohibitions) will not apply in respect of that vehicle.

Covered funds are defined to include three categories of issuers: (i) entities relying on section 3(c)(1) or 3(c)(7) of the U.S. Investment Company Act of 1940, (ii) exempt commodity pools under CFTC Rule 4.7 and certain other commodity pools offered to substantively similar types of investors as such exempt commodity pools, and (iii) in respect of a banking entity that is, or that is controlled by a banking entity that is, organized or located in the United States, certain non-U.S.-established and -offered securities funds, unless the fund, were it subject to U.S. securities laws, is able to rely on an Investment Company Act exemption other than section 3(c)(1) or 3(c)(7).

How can a non-U.S. banking entity own or sponsor a non-U.S. vehicle?

A non-U.S. banking entity can own or sponsor a non-U.S. vehicle generally in one of three ways: (1) if the vehicle is not a covered fund by definition, (2) if the vehicle is a covered fund but is eligible for one of the exclusions from the definition of covered fund, and (3) if the banking entity relies on one of the permitted exemptions that allow offering and sponsoring covered funds, subject to applicable ownership limits and Super 23A restrictions.

Any non-U.S. securities fund that does not offer its interests in the United States will not be a covered fund with respect to a non-U.S. banking entity, so long as the non-U.S. banking entity is not controlled by a U.S. banking entity and is not otherwise acting via a U.S. located branch, agency or subsidiary.¹  It is worth noting that under the previously proposed Volcker Rule, the definition of covered fund would have extended to non-U.S. vehicles regardless of whether or not they had a connection to a U.S. banking entity or offered their interests in the United States or to U.S. investors (the previous so-called "foreign equivalent" provisions). Helpfully, the final Volcker Rule treats such vehicles as covered funds only with respect to U.S. banking entities (or entities controlled by U.S. banking entities). As a result, non-U.S. banking entities should not be restricted under the covered fund provisions of the Volcker Rule in their interactions with a non-U.S.-established or -offered vehicle that doesn't offer securities in the United States. This is clearly very good news for European issuers who can originate transactions solely on the basis of a non-U.S. offering.

Any non-U.S. vehicle, however, that is required to rely on section 3(c)(1) or section 3(c)(7) of the Investment Company Act will be a covered fund. Whether a vehicle is required to rely on section 3(c)(1) or section 3(c)(7) requires a careful analysis of the vehicle's status under the definition of "investment company" in the Investment Company Act and of various exemptions in the Investment Company Act and interpretations of the Securities and Exchange Commission issued over time. Issuers that hold residential or commercial loan assets, for example, may be able to rely on section 3(c)(5)(C) of the Investment Company Act, while certain static-pool securitization vehicles may be able to rely on rule 3a-7 under the Investment Company Act. To the extent the vehicle is an investment company and cannot rely on an available exemption in the Investment Company Act, it would be required to rely on section 3(c)(1) or 3(c)(7). Therefore, in the case of some transactions which include a U.S. offering, it may be feasible to structure the offering to rely on one of the other exemptions, which would have the effect of removing the transaction from the scope of the covered fund restrictions in the Volcker Rule. This has already been practice in some markets, such as some repackaging trades and (albeit much more challenging) CLO transactions.

To be clear, the covered fund definition may capture securitization issuers, intermediary vehicles and/or warehouse vehicles, and the principles above are required to be considered and applied on a case-by-case basis.

Are loan securitizations and ABCP conduits permitted?

Yes, loan securitizations and ABCP conduits are permitted pursuant to the conditional exclusions. While the original proposals contemplated the provision of limited flexibility for certain sponsorship and/or ownership related activities in certain contexts (e.g., in the context of certain loan securitizations), helpfully the final Volcker Rule provides flexibility for a wider range of arrangements through the inclusion of a number of general exclusions to the covered fund definition. From the perspective of European securitizations, the key exclusions include those for loan securitizations and qualifying ABCP conduits, both of which result in the activities in respect of the vehicle being fully carved out from both the sponsorship and ownership restriction and also from the Super 23A prohibitions.

The loan securitization exclusion requires that the assets and holdings of the relevant issuer are comprised solely of "loans" (which are widely defined to be any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative) and certain contractual rights and assets designed to assure the servicing or timely distribution of proceeds to security holders or related to purchasing or otherwise acquiring or holding the loans. Helpfully, the U.S. agencies have confirmed that covered funds may enter into common interest rate and cross-currency hedging arrangements that directly relate to the loans or other assets that the vehicle may hold under the loan securitization exclusion and reduce the interest rate or cross-currency risk related to those assets. Significantly, securities may not be held unless they are (i) cash equivalents, (ii) received in lieu of debts previously contracted with respect to the loans supporting the securities, or (iii) certain collateral certificates or special units of beneficial interest.

Based on the foregoing, a transaction backed in part by corporate bonds (as may be the case in the context of, for example, a managed CLO with a securities bucket) will not benefit from the loan securitization exclusion. While there is a technical argument that the removal of the bonds from the underlying asset pool may be sufficient on its own to bring an existing transaction into compliance with the loan securitization exclusion, it remains to be seen whether, in the absence of corresponding amendment of the transaction terms, banking entities undertaking any relevant activities in respect of the vehicle will be sufficiently comfortable with their ongoing compliance position in this context.

The exclusion for qualifying asset-backed commercial paper (ABCP) issuers is also subject to the satisfaction of certain conditions. Such conditions significantly overlap with the loan securitization exclusion, as relevant conduit issuers may only invest in the assets permissible for loan securitizations and certain asset-backed securities (backed by the same types of permissible underlying assets) acquired in an initial issuance from an issuer or underwriter. The conditions also require all securities issued by the issuer to have a maturity of 397 days or less and full and unconditional liquidity coverage from a regulated liquidity provider with respect to all outstanding securities issued by the issuer. Concerns have been raised that a number of existing conduits arrangements are unlikely to be able to satisfy all of the exclusion conditions in the absence of some restructuring.

What does acting as "sponsor" in respect of a covered fund include?

For these purposes, "sponsor" is defined to mean: "(i) to serve as general partner, managing member, or trustee of a covered fund or to serve as a commodity pool operator with respect to a covered fund, (ii) in any manner to select or to control (or to have employees, officers, or directors, or agents who constitute) a majority of the directors, trustees, or management of a covered fund, or (iii) to share with a covered fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name."

While it is not clear, the commentary published with the final Volcker Rule suggests that, in the context of the first limb of the definition, the U.S. agencies have in mind entities that have an ongoing ability to exercise control over a fund, and that control for these purposes should be linked to the exercise of investment discretion. This suggests that certain common securitization service providers (such as traditional asset servicers/administrators, security/note trustees and arrangers/underwriters without an ongoing role) may not be regarded to be a sponsor for these purposes (assuming the other limbs of the sponsor definition would not be triggered), although consideration will be required on a case-by-case basis.

In general, banking entities should bear in mind the various elements of the sponsor definition and consider taking steps in the context of new transactions to document and clarify (in mandate letters or elsewhere as appropriate) which entity actually undertakes and has control with respect to certain relevant actions (such as appointing the directors or the trustee).

What is an "ownership interest"?

As noted above, the Volcker Rule restricts a banking entity from acquiring or retaining an "ownership interest" of a covered fund in general. Such interests are widely defined to mean "any equity, partnership or other similar interest … other than a restricted profit interest." In turn, "other similar interests" is defined by reference to specified characteristics that are similar to those of equity or other ownership interests, including having "the right to participate in the selection or removal of a general partner, managing member, member of the board of directors or trustees, investment manager, investment adviser, or commodity trading advisor of the covered fund (excluding the rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event)."

Certain subordinated or residual interests in securitizations that function like equity are most likely to be regarded as ownership interest for these purposes. Alarmingly, however, questions have arisen as to whether senior notes in certain transactions may also be ownership interests. These questions have so far focused on whether limited recourse debt could be regarded to be a relevant interest and also on whether certain noteholder rights could be construed to trigger the "other similar interests" definition limb set out above. While the position is not clear, there are arguments against each of these possible interpretations from both a technical and a policy perspective.

We note that, in particular, concerns have been raised in the context of a managed CLO where senior noteholders may have the right to remove the manager in certain circumstances (typically "for cause") outside of a note default event or acceleration scenario. While consideration will be required on a case-by-case basis, there is a logical interpretation of the ownership interest definition that would lead to a reasonable conclusion that the Volcker Rule should not be read in a strict manner to carve-out note-related default events only, and should instead be read to exclude wider default or creditor protection related events. From a policy perspective, "for cause" and certain other removal rights are not inconsistent in principle with the default event scenarios clearly excluded by the U.S. agencies. Given the significant implications of senior notes being subject to the Volcker Rule restrictions, this is currently a key area of focus and discussion.

Are there any exemptions/permitted activities provisions to note with respect to the restriction on sponsorship and ownership?

Yes. The Volcker Rule provides for certain limited exemptions from the general restriction on banking entities sponsoring, acquiring or retaining an ownership interest in a covered fund. These exemptions permit sponsorship and ownership activities in certain contexts, including in connection with organizing and offering a covered fund or underwriting and market making with respect to a covered fund, but do not exempt the banking entity from the Super 23A covered transaction prohibitions if the banking entity is a sponsor of a covered fund or has organized or offered the covered fund.

The permitted activities provisions in respect of organizing and offering a covered fund include a general provision (potentially available in the context of all covered funds) and a more targeted provision for activities undertaken in respect of covered funds that are issuing entities of asset-backed securities (ABS), in each case, subject to certain conditions. Securitizations will likely find the ABS exemption most applicable. The ABS-targeted provision cross-refers to many of the general provision conditions (including those related to the separate limitations on ownership interest levels and disclosures) and provides relief with respect to banking entities that are "securitizers" of the issuing entity under section 15G(a)(3) of the Exchange Act or that acquire or retain an ownership interest in the issuer as required by section 15G of the Exchange Act and the corresponding implementing regulations (i.e., under the U.S. risk-retention requirements). It is worth noting, however, that certain banking entity roles are unlikely to satisfy the securitizer definition (including arrangers/underwriters and entities that fall within the EU Capital Requirements Directive regime's definition of sponsor). The role would not, for instance, extend to a bank arranger in a managed CLO, and the flexibility provided for retained interests does not accommodate retention in accordance with the EU regime (which regime does not line up in all respects with the U.S. regime). Banking entities making use of the organizing and offering exemptions and the related underwriting and market-making exemption are subject to certain ownership limitations. 

Additional exemptions exist in connection with permitted hedging in connection with employee compensation arrangements and for regulated insurance companies, as well as for certain offshore activities. In the case of the latter, as noted above, even if a non-U.S.-established and -offered vehicle is within the covered fund definition (e.g., under the commodity pool limb), certain sponsorship and investment activities undertaken by a non-U.S. banking entity solely outside the United States may be permitted under the "foreign funds exemption" provisions (being the revised "solely outside of the U.S." (SOTUS) provisions).

The availability of the exemptions outlined above will require consideration on a case-by-case basis.

What is Super 23A?

As noted above, in general, the Volcker Rule restricts a banking entity from entering into certain transactions with certain related covered funds, a restriction commonly referred to as "Super 23A" as it applies certain restrictions included in section 23A of the U.S. Federal Reserve Act (which sets parameters with respect to the transactions that banks may undertake with their affiliates) to banking entities and related covered funds.

Under the relevant provisions, other than in limited circumstances, a banking entity that undertakes certain roles with respect to a covered fund (e.g., serving as sponsor (see above), investment manager, investment advisor or commodity trading advisor) or that holds an ownership interest in a covered fund it organized and offered is, itself and via its affiliates, restricted from entering into a covered transaction with the covered fund. Relevant transactions for these purposes include extending credit/making loans, investing in securities issued by the covered fund, purchasing assets, and entering into certain derivative transactions.
While there are few exemptions to the Super 23A restrictions, a banking entity that acquires and retains an ownership interest in a covered fund in accordance with the exemptions/permitted activities provisions would not trigger Super 23A as a result of those activities, and a banking entity may engage in certain prime brokerage transactions without triggering Super 23A as a result of those activities.

Please feel free to contact any of the Allen & Overy attorneys listed below with any questions or if you require further consultation with these or any other issues raised by the Volcker Rule.

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_{1 A banking entity would need to further consider the commodity pool status of a non-U.S. fund, as non-U.S. funds trading commodities are not specifically carved out of the definition of covered fund and, as a result, a non-US commodity fund with significant levels of commodity interest transactions (including swaps) may be a covered fund. Non-U.S. securitization vehicles, however, may be able to rely on interpretive positions issued by the Commodity Futures Trading Commission with respect to securitization vehicles.}