A law recently passed by Congress has exempted some banks from the so-called “Volcker Rule” and eliminated some of its restrictions. In addition, the Federal banking agencies have proposed additional changes to the Volcker Rule. The Volcker Rule is an amendment to the Bank Holding Company Act adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.1 The rule prohibits “Banking Entities” from engaging in proprietary trading and from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with “Covered Funds.”
A Banking Entity includes an FDIC insured depository institution, any company that controls such an institution, or any company that is treated as a bank holding company for purposes of the International Banking Act of 1978.2
A Covered Fund refers to a hedge fund or private equity fund.
The Economic Growth, Regulatory Relief and Consumer Protection Act (“the Reform Act”) was signed into law on May 24, 2018.3 As further described below, it provides relief from the Volcker Rule for small banking institutions and general relief to all Banking Entities from certain restrictions on the naming of Covered Funds.
On May 30, 2018, the Federal Reserve Board, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission (collectively, the “Federal Banking Agencies”) issued a joint notice of proposed rulemaking (“NPRM”) seeking comment on proposed changes to the Volcker Rule, including modifications to transaction restriction placed on Banking Entities.4 The issues related to Covered Funds on which the Federal Banking Agencies are seeking comment are set forth below.
I. Reform Act Effects on the Volcker Rule
Under Section 203 of the Reform Act, Banking Entities (and any company that controls them) are exempted from the Volcker Rule if they have (1) less than $10 billion in total consolidated assets and (2) trading assets and liabilities that are not more than 5% of their total consolidated assets. The exemption, however, is not available to any insured depository institution that is controlled by a company that itself exceeds the $10 billion and 5% thresholds.
Additionally, Section 204 of the Reform Act modifies the Volcker Rule’s prohibition on Banking Entities sharing the same name, or a variation of the same name, with a Covered Fund. Under the Reform Act, Covered Funds are permitted to share a name or a variation of the same name as a Banking Entity that is an investment adviser to the fund so long as (i) the name does not include the word “bank” and (ii) the investment adviser is not, and does not itself share the same name or variation of the same name as, an insured depository institution, a company that controls an insured depository institution, or a company that is otherwise treated as a bank holding company.
II. NPRM Proposed Amendments Concerning Covered Funds Under the Volcker Rule
In 2013, the Federal Banking Agencies issued a final rule implementing regulations under the statute. The NPRM attempts to clarify, and reduce the burdens related to complying with, the Volcker Rule. Comments on the NPRM are due 60 days after its publication in the Federal Register. Provisions relevant to Covered Funds are outlined below:
- The Definition of Covered Fund: The Federal Banking Agencies did not propose specific amendments to the definition of Covered Funds or exclusions therefrom, but the preamble discusses the definition and exclusions at length. The Federal Banking Agencies seek comment on whether the 2013 final rule definition effectively implements the statute and is appropriately tailored to identify funds engaging in activities contemplated by Section 13. The Federal Banking Agencies also request comment on whether the definition is inappropriately imprecise and whether such imprecision has led to any unintended results.
- Ownership of Covered Funds in an Underwriting Capacity: The NPRM relaxes the limits on a Banking Entity’s ownership interests in Covered Funds. Specifically, the NPRM removes the requirement that the Banking Entity include for purposes of the aggregate fund limit5 and capital deduction the value of any ownership interests of the Covered Fund acquired or retained in accordance with the underwriting or market-making exemption.
- Super 23A Prohibitions: The 2013 final rule placed restrictions on a Banking Entity’s ability to enter into certain “Covered Transactions”6 with a Covered Fund which the Banking Entity serves, directly or indirectly, as the investment manager, investment adviser, commodity trading advisor, or sponsor, or a Covered Fund which the Banking Entity organizes and offers. Covered Transactions include: (i) a loan or extension of credit to the Covered Fund; (ii) purchases of or an investment in securities issued by the Covered Fund, other than those in accordance with the rules implementing the Volcker Rule; (iii) a purchase of assets, from the Covered Fund, except such purchase of real and personal property as may be specifically exempted; (iv) the acceptance of securities or other debt obligations issued by the Covered Fund as collateral security for a loan or extension of credit to any person or company; (v) the issuance of a guarantee, acceptance, or letter of credit, including an endorsement or standby letter of credit, on behalf of a Covered Fund; or (vi) any credit exposure to the Covered Fund arising from a derivative transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction with a Covered Fund.The provisions are referred to as the Super 23A Restrictions because they apply the restrictions of Section 23A of the Federal Reserve Act that apply to transactions made by a bank and its affiliates. While Section 23A provides exemptions from its restrictions, Super 23A does not. The NPRM requests comment on whether to provide the Section 23A exemptions in the Super 23A context, allowing Banking Entities to engage to a limited extent in Covered Transactions with Covered Funds they sponsor, advise, or organize and offer.
- Risk-Mitigating Hedging: The NPRM expands the current exemption to allow a Banking Entity to acquire a Covered Fund interest as a hedge when acting as an intermediary on behalf of a customer that is not itself a Banking Entity to facilitate the exposure by the customer to the profits and losses of the Covered Fund. The NPRM notes that the expanded permissibility of hedging transactions would be subject to specified risk limits and appropriate monitoring and risk management.
- Covered Fund Activity Outside the United States: The Volcker Rule currently provides an exemption for non-U.S. Banking Entities to invest in Covered Funds outside of the United States. This exemption, however, is unavailable if the ownership interests are acquired through an offering that targets United States residents. In 2015, the Federal Banking Agencies published an FAQ clarifying that the restriction on marketing to U.S. residents applies only when the Banking Entity relying on the exemption participates in the offering. The NPRM codifies the FAQ.
- Foreign Excluded Funds: On July 21, 2017, the Federal Banking Agencies issued a statement about the possible unintended consequences and extraterritorial impact of section 13 and the 2013 final rule on foreign private funds, which are excluded from the definition of “Covered Fund” in the 2013 final rule.7 The statement provided no-action relief for one year for a foreign Banking Entity based on attribution of the activities of a qualifying foreign excluded fund to the foreign Banking Entity, or against a qualifying foreign excluded fund as a Banking Entity. The NPRM extends the no-action relief an additional year and seeks comment on how to address this issue permanently.
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The changes made to the Volcker Rule by the Reform Act and the proposed changes in the NPRM may provide for additional opportunities for Banking Entities to participate with Covered Funds. Seward & Kissel LLP will continue to provide insight on any developments regarding the NPRM and the Reform Act. If you have any questions, please contact Paul Clark, Casey Jennings or Lauren Michnick in the Washington, DC Office at 202-737-8833 or contact any member of our Investment Management Group.
1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2 Bank Holding Company Act of 1956, 12 U.S.C.S. § 1851.
3 Economic Growth, Regulatory Relief, and Consumer Protection Act, 115 S. 2155, 2017 S. 2155, 115 S. 2155.
4 Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, __ Fed. Reg. __ (2018) [Hereinafter, “NPRM”].
5 This refers to the aggregate value of all ownership interests of the Covered Fund acquired or retained by the Banking Entity and its affiliates for purposes of the limitation on aggregate investments in Covered Funds. NPRM at 193.
6 The term “Covered Transaction” refers to transactions defined in Section 23A of the Federal Reserve Act as if the Banking Entity were a member bank and the related Covered Fund were its affiliate. 12 U.S.C.S. § 371c.