Agencies address questions on Volcker Rule compliance programs and CEO certifications

On September 25, 2015, US financial regulators issued additional guidance regarding Volcker Rule compliance programs and certain chief executive officer (“CEO”) certifications. Banking entities with trading desks taking advantage of the market-making exemption from the Volcker Rule’s prohibition on proprietary trading may include objective factors on which the trading desk may reasonably rely to determine whether a security is issued by a covered fund, and may permit the trading desk to use a shared utility or third party service provider that also utilizes objective factors if the utility or service provider is identified in the compliance program and the banking entity reasonably believes that the system of such utility or service provider will identify that a particular security is issued by a covered fund. The agencies also clarified when banking entity CEOs must begin certifying compliance with the prime brokerage exception to the restrictions between a covered fund and its banking entity sponsor or holder of an ownership interest.

The Volcker Rule and its regulations generally prohibit banking entities and affiliates from engaging in proprietary trading or sponsoring or acquiring ownership interests in certain private funds (“covered funds”). In order to assist affected entities in complying with the rule, the agencies that issued the regulations have been issuing guidance periodically in the form of Frequently Asked Questions (FAQ) that appear on each of the agencies’ websites. In order to achieve consistency in interpretations, industry inquiries on Volcker Rule compliance are referred to a committee of representatives of the regulators that issued the rules, with one answer then being adopted by all the regulators. The September 25 issuance brings to 18 the number of questions that they have addressed.

Compliance Programs

Banking entities are required to develop programs reasonably designed to ensure compliance with the prohibitions and restrictions of the Volcker Rule and its exemptions. To take advantage of an exemption, the banking entity’s compliance program must address the banking’s entity use of the exemption.

A question had arisen as to whether a banking entity could include in its compliance program regarding permissible market-making activities objective factors on which its trading desk could rely in determining whether or not a particular security was issued by a covered fund, or utilize a shared utility or service provider that also would utilize objective factors in making those determinations.

The Agencies stated that a banking entity could include such objective favors on which its trading desk may “reasonably rely” to determine if a security was issued by a covered fund. The Agencies defined “objective factors” as “factual criteria that can be used to reliably identify whether an issuer or a particular type of issuer is a covered fund,” which may vary depending upon the issuer. An example of a permissible objective factor is whether the relevant security was issued in connection with an SEC-registered transaction. However, objective factors would not be considered part of a reasonably designed compliance program if they were designed or used to evade the requirements of the Volcker Rule.

The Agencies also noted that for purposes of complying with the market-making exemption, a compliance program could include use of a shared utility or third party service provider that utilizes objective factors to identify whether a security is issued by a covered fund, if the banking entity reasonably believes that the utility’s or service provider’s system will identify securities issued by a covered fund, and use of such shared utility or third party service provider is identified in the trading desk’s compliance program.

The Agencies concluded by noting that ultimately whether a compliance program is reasonably designed to ensure compliance will depend on the facts and circumstances. A compliance program that is reasonably designed for a trading desk engaged in market making-related activities may not be reasonably designed for other activities conducted by the banking entity. In addition, the reliance on objective factors, a shared utility, or a third party service provider is subject to independent testing and audit requirements applicable to the banking entity’s entire Volcker Rule compliance program.

CEO Certifications

Section 23A of the Federal Reserve Act (“Section 23A”) imposes restrictions on certain “covered transactions” between a bank and its affiliates. The Volcker Rule prohibits a banking entity:

(i) that serves, directly or indirectly, as the investment manager, investment adviser, commodity trading advisor, or sponsor to a covered fund,

(ii) that organizes and offers a permissible covered fund, or

(iii) that holds a permissible ownership interest in a permissible covered fund,

and any affiliate of the banking entity, from entering into a covered transaction with the covered fund (or with any other covered fund that is controlled by such covered fund), thus treating the banking entity (and its affiliate) and the covered fund as if they truly were subject to the restrictions of section 23A.

However, notwithstanding this prohibition, the Volcker Rule provides that a banking entity may enter into any “prime brokerage” transaction with any covered fund in which a covered fund managed, sponsored, or advised by such banking entity (or an affiliate) has taken an ownership interest, so long as certain conditions are met, one of which is that the CEO (or equivalent) of the banking entity certifies in writing annually that the banking entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the covered fund or of any covered fund in which such covered fund invests. Prime brokerage transactions covered by this exception are transactions that would be considered “covered transactions” for purposes of Section 23A that are provided in connection with custody, clearance and settlement, securities borrowing or lending services, trade execution, financing, or data, operational, and administrative support.

A question had arisen as to when a banking entity must begin submitting such CEO certifications.

Banking entities that are required to provide the annual CEO certification for prime brokerage transactions as of the end of the conformance period (July 21, 2015) should submit the first CEO certification after the end of the conformance period but no later than March 31, 2016. A banking entity may provide the required annual certification to the relevant Agency in writing at any time prior to the March 31 deadline.

For CEO certifications relating to covered “legacy” funds entitled to an extended conformance period currently ending on July 21, 2016, but which will be extended to July 21, 2017 (i.e., a covered fund sponsored or owned by a banking entity prior to December 31, 2013), banking entities that engage in prime brokerage transactions with such funds should submit their first CEO certification by March 31 following the end of the relevant conformance period.

These CEO certifications must be updated both annually and if the CEO becomes aware that the information in the certification has materially changed at any time in the interim period between filings.

Access the banking, securities and commodities regulators’ Frequently Asked Questions.

Previous Regulation Tomorrow posts on the Volcker Rule’s Frequently Asked Questions:

United States