By John M. Pachkowski, J.D.
The Federal Reserve Board has updated its Frequently Asked Questions regarding the application of section 13 to the Bank Holding Company Act of 1956 (BHC Act), commonly referred to as the Volcker Rule, and regulations adopted by the Fed, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and Commodity Futures Trading Commission. The Fed noted that while the FAQs apply to banking entities for which the Fed has jurisdiction under section 13 of the BHC Act, they have been developed by staff of all five agencies.
In FAQ No. 17, the agencies’ staff was asked whether a banking entity’s compliance program for market making-related activities may include objective factors on which a trading desk may reasonably rely to determine whether a security is issued by a covered fund. The staff were further asked whether a market maker meets its compliance program requirements by making 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.
Objective factors. At the outset of their analysis the agencies’ staff noted that a bank relying on the market making exemption to the Volcker Rule must have a reasonably designed compliance program for a trading desk involved in the market making activity. As for the design of the compliance program, the staff added that the trading desk may include “objective factors” on which the trading desk may reasonably rely to determine whether a security is issued by a covered fund. For purposes of the Volcker Rule, “objective factors” are considered to be factual criteria that can be used to reliably identify whether an issuer or a particular type of issuer is a covered fund.
As to the issue of relying on objective factors to determine whether a security is issued by a covered fund, the staff concluded that an objective factor would be whether securities of the issuer were offered in transactions registered under the Securities Act. On the other hand, the staff cautioned that it would not be reasonable for a trading desk to rely solely on either or both the name of the issuer or the title of the issuer's securities. They noted that these factors alone would not convey sufficient information about the issuer for a trading desk reasonably to determine whether a security is issued by a covered fund.
Shared utility/service providers. In responding to whether a banking entity can make use of a shared utility or third-party service provider that utilizes objective factors to identify whether an issuer or a particular type of issuer is a covered fund, the agencies’ staff stated that the shared utility, or a third-party service provider must be subject to independent testing and audit requirements applicable to the banking entity's compliance program. The staff also noted that if the shared utility or third-party service provider is not effective in identifying whether a security is issued by a covered fund, then the banking entity must promptly update its compliance program to remedy any defects issues and, as necessary, take action under Volcker Rule implementing regulations, such as terminating an activity or investment.
CEO certification. New FAQ No. 18 discusses the timing of when a banking entity is required to submit the annual CEO certification for prime brokerage transactions. The FAQ also discusses the timing issue as to legacy covered funds.
Although the Volcker Rule regulations generally place certain limitations on a banking entity’s relationships with a covered fund, the regulations allow the banking entity to 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. These prime brokerage transactions are permissible, so long as the conditions enumerated in the final rule are satisfied which includes an annual written CEO certification. For purposes of the Volcker Rule regulations, a “prime brokerage transaction” means any transaction that would be a covered transaction, as defined in section 23A(b)(7) of the Federal Reserve Act that is provided in connection with custody, clearance and settlement, securities borrowing or lending services, trade execution, financing, or data, operational, and administrative support.
To fulfill the certification requirement, a CEO should submit the first certification after the end of the conformance period but no later than March 31, 2016. A banking entity can provide the required annual certification in writing at any time prior to the March 31 deadline to the relevant agency.
The timing of the CEO certification for legacy funds—covered funds sponsored or owned by a banking entity prior to Dec. 31, 2013—must be submitted by March 31 following the end of the relevant conformance period. Since the conformance period currently ends on July 21, 2016, the CEO certification must be submitted by March 31, 2017. However, the Fed has signaled its intentions to further extend the conformance period until July 31, 2017. Therefore, it is conceivable the CEO certification could be submitted by March 31, 2018.
