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Volcker Rule Securitization Issues

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Volcker Rule Securitization Issues Volcker Rule Securitization Issues mofo.com All Rights Reserved | All | Reserved Rights LLP | | LLP February 2014 Presented By Foerster Jerry R. Marlatt & Kenneth E. Kohler ©2014 Morrison Morrison ©2014 Volcker Rule • On December 10, 2013, the federal banking agencies, the SEC and the CFTC approved the final version of the Volcker Rule • Very detailed release of almost 900 pages • The rule, based on section 619 of Dodd-Frank, will substantially limit the circumstances in which many banking entities may enter into derivatives • Because of prohibitions of trading activities, could substantially reduce market liquidity • The rule will prohibit sponsorship or ownership of same securitizations 2 Volcker Rule (cont’d) • The rule applies to a very broad range of banking entities, including insured depository institutions, companies controlling an insured depository institution, and companies treated as bank holding companies, and any affiliate or subsidiary of any of the foregoing • The general rule — • a banking entity may not engage in “proprietary trading” except as permitted by the rule. • a banking entity may not acquire or retain any “ownership interest” in or sponsor a “covered fund” except as permitted by the rule • There is no grandfathering for ownership interests 3 Volcker Rule/Proprietary Trading • Proprietary trading – “engaging as principal for” its own “trading account” in a “purchase or sale of one or more financial instruments,” including derivatives • Definition of “trading account” incorporates concept of “short-term” resales, price movements or arbitrage profits • Definition of “financial instrument” includes most derivatives • There is a rebuttable presumption that if a banking entity holds in its trading account a financial instrument for less than 60 days, the purchase or sale of such instrument is for the banking entity’s trading account 4 Volcker Rule/Proprietary Trading (cont’d) • Certain types of trading are excluded from the definition of proprietary trading: • Repo/reverse repo; • Securities lending; • Liquidity management pursuant to a plan; • Derivative clearing organization (DCO) and clearing agency trades; • Trades to satisfy an existing delivery obligation; • Trades to satisfy a court, judicial or similar proceeding; • Trades where the banking entity is acting solely as agent, broker or custodian; • Trades through a deferred compensation plan; and • Trades made in the ordinary course of collecting a debt previously contracted. • No exclusion for interaffiliate trades 5 Volcker Rule/Proprietary Trading (cont’d) • The prohibition on proprietary trading also does not apply to: • Trading in US government/agency securities; • Trading in munis; • Trading by a foreign bank sub of a US banking entity in debt of the foreign government where the sub is located; • Trading on behalf of a customer in a fiduciary or riskless principal capacity; or • Trading by a banking entity that is a regulated insurance company 6 Volcker Rule • The prohibition on proprietary trading does not apply to certain risk- mitigating hedging activities or certain market-making activities as well as certain underwriting activities • Permitted risk-mitigating hedging activities do not explicitly include a “portfolio hedge” • However, they do permit hedging activities that are: • “in connection with and related to individual or aggregated positions, contracts or other holdings” and • “designed to reduce the specific risks to the banking entity” that are “related to such positions, contracts or other holdings” 7 Volcker Rule/Hedging Activities (cont’d) • Additional requirements for risk-mitigating hedging activities: • An internal compliance program containing written policies and procedures regarding positions, techniques and strategies that may be used for hedging, including: • Documentation indicating what positions, contracts or other holdings a particular trading desk may use • Position and aging limits • Analysis designed to ensure that the positions, techniques and strategies that may be used for hedging may be reasonably be expected to demonstrably reduce or otherwise significantly mitigate the specific, identifiable risks being hedged • The extent of the required internal compliance program will depend upon the size and activities of the relevant banking entity, but for entities engaging in proprietary trading that have consolidated assets of $10 billion or more it will be quite substantial. • Rule is quite prescriptive with respect to reporting and recordkeeping requirements. 8 Volcker Rule/Hedging Activities (cont’d) • Additional requirements for risk-mitigating hedging activities: • Activity must be conducted in accordance with written policies, procedures and internal controls • Activity must be designed to reduce or otherwise significantly mitigate and demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks arising in connection with identified positions, contracts, or other holdings • Activity must not give rise, at the inception of the hedge, to any significant new or additional risk that is not itself hedged contemporaneously • Continuing review, monitoring and management that requires ongoing recalibration of the hedging activity • Compensation arrangements of persons performing risk-mitigating hedging activities are designed not to reward or incentivize prohibited proprietary trading • Additional documentation requirements apply with respect to risk-mitigating hedging activities established by a trading desk other than the desk responsible for the underlying positions, or to hedge aggregated positions across trading desks 9 Volcker Rule/Market-Making Activities (cont’d) • The prohibition on proprietary trading does not apply to certain market-making activities; • Requirements for permitted market-making activities: • Trading desk that establishes and manages the financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in those types of financial instruments for its own account in commercially reasonable amounts and throughout market cycles • The amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties 10 Volcker Rule/Market-Making Activities (cont’d) • Additional requirements for permitted market-making activities: • Internal compliance program that states • The instruments in which each trading desk will make a market • Actions the trading desk will take to demonstrably reduce or otherwise significantly mitigate promptly the risks of its financial exposure • Limits for each trading desk, based on the nature and amount of the trading desk’s market making-related activities • Internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits • Authorization procedures, including escalation procedures that require review and approval of any trade that would exceed a trading desk’s limit(s) • The compensation arrangements of persons performing the market-making activities are designed not to reward or incentivize prohibited proprietary trading. 11 Volcker Rule/Underwriting • The market-making exception is permitted only if the trading desk underwriting position is related to a “distribution” of securities for which the bank is an underwriter • Distribution: 33 Act registered, or otherwise characterized as different from ordinary trading by virtue of selling efforts – Securities law terms • Underwriter: defined broadly to include selling group members and other distribution participants – Securities law terms • Amount and type of securities in the underwriting position: cannot exceed the reasonably expected near term demands of clients, customers, counterparties, etc. • The trading desk must use reasonable efforts to reduce the position within a reasonable time 12 FBOs • The rule establishes an exemption for proprietary trading by an FBO to the extent that the trading is conducted solely outside the United States (SOTUS exemption) • SOTUS means • FBO not organized under U.S. or State law • majority of total assets held outside the U.S. • majority of total revenues derived from business outside U.S. • majority of total net income derived from business outside U.S. • the personnel or affiliate that arrange, negotiate or execute the trade are not located in the U.S. or organized under U.S. law • the personnel who make the decision to trade are not located in U.S. • the trade and any related hedging is not accounted for by any branch or affiliate located in the U.S. or organized under U.S. law 13 FBOs (cont’d) • no financing for the trade is provided by a branch or affiliate located in U.S. or organized under U.S. law • with certain exceptions, the trade is not conducted with or through a U.S. entity 14 “Prudential” backstop • Proprietary trading activities are not permissible if: • They involve or result in a material conflict of interest between the banking entity and its clients, customers or counterparties, or • They would result in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy, or • They pose a safety and soundness threat to the institution or a threat to US financial stability 15 Covered funds • The rule prohibits a banking entity,
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