A Volcker Rule Primer For Non-Financial Corporate Counsel

Monday, December 19, 2011 - 10:51

One overlooked Dodd-Frank Act regulation that non-financial companies should look at is the Volcker Rule banning proprietary trading.  

Proprietary trading is when a financial firm uses its own funds, rather than its customer’s funds, to purchase debt instruments, securities, commodities, or derivatives, etc., for potential profit.  This form of trading also allows a firm to be a marketmaker, using its proprietary inventory of stocks and bonds to be sold to clients.  Following the 2008 financial crisis, some market observers took the position that proprietary trading encouraged inappropriate risk taking, endangering a firm and the financial system.

On January 21, 2010, President Barack Obama proposed a ban on proprietary trading and named it after former Federal Reserve Chairman Paul Volcker, its chief architect.  The Dodd-Frank Act included a broader version of the Volcker Rule, including some firms’ hedge fund and private equity activities.  Congress mandated that the Volcker Rule go into effect on July 21, 2012, and included some exceptions for market-making activity done on behalf of customers. On October 11, 2011, four of the five regulators tasked with implementation issued a proposed joint rule, which was published in the Federal Register on November 7, 2011.  The comment period will close on January 13, 2012.

The joint rule, spanning 298 pages and over 1,000 questions, was proposed by the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”), the Office of Comptroller of the Currency (“OCC”) and the Securities and Exchange Commission (“SEC”). The Commodity Futures Trading Commission (“CFTC”) did not join in the rulemaking but is expected to issues rules in the future. There is also a two-year conformance period for the Volcker Rule to go into effect.

If the Volcker Rule bans proprietary trading by financial firms, why should counsel of non-financial companies care? The answer is this: how is your company structured and how does it raise capital or mitigate risk?

Many non-financial companies own banks or have financing arms to assist customers in the purchase of goods or services or to mitigate costs, such as credit card fees.  Non-financial companies with banks or financing arms may have to construct Volcker Rule compliance programs to prevent any hint of proprietary trading.  It is unclear if companies with trading desks will have to build similar compliance programs.

Company treasurers use the debt markets to raise the cash for businesses to operate and balance the books at the end of the day.  Despite the market-making and underwriting exceptions, financial institutions will have to correlate their inventory to the expected demand of a trade.  This poses several issues.

For the corporate treasurer it will be harder for the banks to hold inventory of debt or equity instruments if they were not able to sell them.  In fact, banks and their customers will have multiple regulators trying to divine the intent of a trade. Accordingly, the corporate treasury will come under unprecedented regulatory scrutiny, requiring vigilance by company lawyers. This change will force treasurers to rethink capital-raising strategies and work with counsel to protect the legal interests of a company.

The same holds true for a company using derivatives as a risk-mitigation tool.  Trading and hedging activity will come under increased scrutiny, posing legal challenges for what is everyday company activity. The impacts upon non-financial companies are collateral but difficult to ascertain.

The breadth of the Volcker Rule itself makes this a daunting task. The CFTC has not joined the other regulators in the rulemaking, so a company using derivatives cannot understand if it must or how to comply with the Volcker Rule.  The complexity of the questions (one question has 57 sub-questions), the process, and the short comment deadline make us doubt the understanding of the issues by the regulators.

The Chamber has asked the regulators to take action to provide clarity and understanding to the rulemaking deliberations.  Citing the lack of CFTC participation in the proposed rule release, on October 11, 2011, the Chamber wrote to Treasury Secretary Geithner requesting that the Financial Stability Oversight Council coordinate this massive joint rulemaking.  With the CFTC still  being absent from the rulemaking process, the Chamber on November 17, 2011, wrote to the regulators asking that the rule be withdrawn and reproposed when  the CFTC can engage in the rulemaking.  This letter also asked for the comment period to encompass 150 days because of the complexity of the Volcker Rule.  On December 15, 2011, the Chamber again wrote to the regulators citing deficiencies in the cost-benefit and economic analysis of the Volcker Rule and for that process to be rationalized.

While the Volcker Rule is directed at financial firms, those firms provide companies with capital on a daily basis.  The potential need for a Volcker Rule compliance program and increased regulatory scrutiny should give counsel pause, and they should start planning to insure a business’s rights are protected and appropriate measures are taken to insure that corporate treasury functions can withstand increased oversight.