On January 30, 2019, the five federal agencies with rulemaking authority over the Volcker Rule (the “Volcker Rule Agencies”)1 agreed to solicit public comment on a proposal (the “Proposal”) to revise certain provisions of the Volcker Rule related to covered funds.2 If adopted in its current form, the Proposal would ease the restrictions and prohibitions contained in the Volcker Rule’s covered fund provisions. The Volcker Rule Agencies are requesting comment on all aspects of the Proposal, including 87 specific questions related to various aspects of the Proposal.
The Volcker Rule Agencies acknowledge that the definition of covered fund is overly-broad.3 The Proposal includes new exclusions intended to narrow the definition. A number of the exclusions contained in the Proposal have been requested by various banking entities and trade organizations in prior rulemakings. If the Proposal is adopted in its current form, or in substantially similar form, in our view, it will provide additional opportunities for banking entities to invest in, sponsor, or extend credit to entities that are currently covered funds, in certain circumstances.
The Proposal has not yet been published in the Federal Register, but comments are due on April 1, 2020.
The Volcker Rule
The Volcker 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 (1) an FDIC insured depository institution, (2) any company that controls such an institution, (3) any company that is treated as a bank holding company for purposes of the International Banking Act of 1978, and (4) any affiliate of any of the foregoing.4 While the Volcker Rule was intended to limit banking entities’ risk with respect to investments in and certain relationships with private equity funds and hedge funds, the definition of “covered fund” in the Volcker Rule has, in practice, swept in many other types of entities and investment vehicles.5
Recent Changes to Tailor the Volcker Rule
As outlined previous Client Alerts, the Volcker Rule Agencies in October 2019, adopted a number of changes to the Volcker Rule, largely focused on the compliance regime and the proprietary trading provisions, which generally had the effect of easing the Volcker Rule’s restrictions.6
During that rulemaking, the Volcker Rule Agencies asked for public comment on the covered fund provisions. The Proposal is a response to those comments.
The most significant proposed amendments in the Proposal are the following.
- Adding four (or potentially five) new exclusions from the covered fund definition.
Venture capital funds. The Proposal borrows the definition of “venture capital fund” from the SEC’s regulations under the Investment Advisers Act of 1940.7 To qualify for the proposed exclusion, such a fund would not be permitted to engage in proprietary trading. Banking entities would be subject to several limitations and requirements with respect to the investment or sponsorship in such a fund, including a prohibition on guaranteeing the performance of the fund, certain disclosure requirements, an obligation to ensure that the activities of the fund were consistent with the banking entity’s safety and soundness obligations, and compliance with the Volcker Rule’s Super 23A provisions8 and general backstop provisions9 with respect to the fund.
Certain long-term investment funds. The Proposal requests comment on whether the Volcker Rule should exclude long-term investment funds that do not meet the definition of a venture capital fund, if such an entity (1) makes long-term investments a banking entity could make directly, (2) holds itself out as intending to hold an investment for a minimum time period (the Proposal suggests two years), (3) whose relevant offering and governing documents reflect a long-term investment strategy, and (4) that meet all requirements of the proposed qualifying venture capital fund exclusion other than meeting the definition of a venture capital fund.
Credit funds. The Proposal would exclude funds that make loans, invest in debt, or otherwise provide credit that banking entities are permitted to provide directly under existing banking law. The Proposal’s exclusion for these credit funds would be modeled after the loan securitization exclusion (“LSE”) that already exists in the Volcker Rule. The exclusion would only be available to entities that do not issue asset-backed securities (the LSE has the opposite requirement). Issuers relying on the credit fund exclusion would be permitted to hold (1) loans, (2) debt instruments, (3) related rights or other assets that are related to acquiring, holding, servicing, or selling loans or debt instruments, and (4) certain interest rate or foreign exchange rate derivatives. Debt instruments are not currently permissible assets for funds relying on the LSE,10 though the other three categories of assets listed above are. Similar restrictions and limitations as discussed under the venture capital fund exclusion above would apply to banking entities’ relationships with credit funds that qualify for the exclusion.
Customer facilitation vehicles. The Proposal would create an exclusion for vehicles formed by or at the request of a customer of a banking entity, for purposes of providing that customer with exposure to a transaction, investment strategy, or other service provided by the banking entity. All but a minimal percentage of the ownership interests in the vehicle would be required to be owned by the customer. Most of the conditions described above under venture capital funds would apply to banking entities with respect to customer facilitation vehicles, apart from complying with Super 23A.
Family wealth management vehicles. The Proposal would exclude from the covered fund definition any entity that, (1) if organized as a trust, the grantors are all family customers, and, (2) if not organized as a trust, a majority of voting interest are owned, directly or indirectly, by family customers and the entity is owned only by family customers and up to 3 closely related persons.11 Banking entities relying on the exclusion would have to, among other things, provide bona fide trust, fiduciary, investment advisory, or commodity trading advisory services to the entity, be prohibited from guaranteeing its obligations or performance, make certain disclosures, limit its ownership interests in the vehicle to a de minimis amount, enter only into arms’ length transactions with the vehicle, and comply with prohibitions on purchases of low quality assets.
- Broadening currently existing exclusions from the covered fund definition.
Foreign public fund exclusion. The Proposal would replace certain requirements of the Volcker Rule’s current foreign public fund exclusion12 and exclude from the covered fund definition funds organized and offered outside the United States that: (1) are authorized to offer and sell ownership interests and (2) that such ownership interests are offered and sold through one or more public offerings.
Loan securitization exclusion. Under the current LSE,13 a securitization vehicle is limited to holding only loans and related or servicing assets. The Proposal would permit securitization vehicles to hold “non-loan assets” in a “bucket” making up no more than 5% of the vehicle’s assets, and would not necessarily limit “non-loan assets” to include only debt instruments, though the Proposal includes a request for public comment on such limitations.
SBICs and public welfare investment funds. The Proposal would permit the current exclusion for small business investment companies (“SBICs”)14 to continue to apply, in certain circumstances, to entities that surrender their SBIC licenses while in wind-down.
- Codifying guidance that corrects certain unintended consequences of the banking entity definition for so-called foreign excluded funds.
On July 21, 2017, the Volcker Rule Agencies issued a statement (the “QFEF Guidance”) about the possible unintended consequences and extraterritorial impact of the Volcker Rule on certain foreign private funds, which do not meet the “base” definition of a covered fund.”15
The Proposal would codify the substance of the QFEF Guidance in the Volcker Rule. Among other requirements, the foreign banking entity’s investment in ,or activities with respect to, a foreign excluded fund would have to be made solely outside the United States; that is, such investment or activity would have to comply with the Volcker Rule’s “solely outside the United States” or “SOTUS”16 exemption, if the foreign excluded fund were a covered fund.
- Carving out certain extensions of credit (so-called “exempt covered transactions”) from the Volcker Rule’s “Super 23A” prohibitions.
The Volcker Rule’s Super 23A provisions prohibit a banking entity from entering into certain “covered transactions”17 with a covered fund for 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.
There are several types of covered transactions that are exempt from the limits of Section 23A and Regulation W.18 When the Volcker Rule Agencies adopted the Volcker Rule, they did not “import” any of these exemptions into the Super 23A restrictions. Under the Proposal, all covered transactions that are exempt pursuant to the statute or Regulation W would also be exempt pursuant to Super 23A. Not all exempt covered transactions are applicable to banking entities and covered funds, but some important ones are, including purchasing certain liquid assets and marketable securities, purchasing extensions of credit subject to repurchase agreements, intraday extensions of credit, riskless principal transactions, and securities financing transactions.
- Amending the definition of “ownership interest.”
The Proposal would provide a safe harbor from the ownership interest definition19 for senior loan or debt interests that have only specified rights to principal, interest, and fees not determined by reference to the fund’s performance. This would permit banking entities to make debt investments in covered funds that might otherwise be captured by the “other similar interest” prong of the ownership interest definition.
The Proposal would also clarify that the right to participate in the removal or replacement of an investment manager as a creditor’s remedy upon default or acceleration would not cause a debt interest to fall within the ownership interest definition.
- Changing the treatment of parallel investments by banking entities in covered funds.
One commonly used exemption that permits banking entities to hold ownership interests in and sponsor covered funds, within certain limits, is the so-called asset management exemption.20 Among other things, banking entities relying on the asset management exemption are permitted to hold no more than 3% of ownership interests in a covered fund. In the Preamble to the 2013 Volcker Rule, the Volcker Rule Agencies provided guidance on calculating the 3% limit that required banking entities to apply against the limit any investment made by the banking entity in parallel with investments made by a covered fund in which the banking entity held an ownership interest. The Proposal would eliminate this attribution of parallel investments to the covered fund, if the banking entity made the parallel investment in compliance with applicable laws and regulations, and consistently with its safety and soundness requirements.
Conclusion and action items
Some of the parameters of the proposed exclusions are still being considered by the Volcker Rule Agencies; banking entities and investment management firms should consider submitting comment letters regarding these parameters, as well as suggesting any additional exclusions or other revisions to the covered fund provisions before the April 1 deadline.
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The full text of the Proposal as posted on the Federal Reserve’s website can be found by clicking here.
Seward & Kissel LLP will continue to provide insight on developments regarding the Volcker Rule. If you have any questions, please contact Paul Clark, Casey Jennings, Nathan Brownback, or Lauren Michnick in the Washington, DC office at 202-737-8833, or contact any member of our Investment Management Group.
1 The Volcker Rule Agencies are the Office of the Comptroller of the Currency (“OCC”), the Board of Governors of the Federal Reserve System (“Board”), the Federal Deposit Insurance Corporation (“FDIC”), the Commodity Futures Trading Commission (“CFTC”), and the Securities and Exchange Commission (“SEC”). The statutory Volcker Rule is Section 13 of the Bank Holding Company Act of 1956, as amended, 12 U.S.C. § 1851.
3 Proposal at 16 (“The [Volcker Rule] agencies recognized in the preamble to the 2013 rule that the definition of ‘covered fund’ was expansive and, based on their experiences implementing the rule, the agencies are now proposing several new exclusions from the covered fund provisions to address the potential over-breadth of the covered fund definition and related requirements.”).
4 12 C.F.R. § 248.2(c).
5 A covered fund, as defined in the Volcker Rule, includes (1) an issuer that is excluded from the definition of “investment company” pursuant to Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940; (2) certain commodity pools, registered or exempt, that are offered to investors that meet certain investor sophistication requirements under the Commodity Exchange Act; and (3) only with respect to U.S. banking entities, or non-U.S. banking entities that “parent up” to a U.S. banking entity, non-U.S. funds in which the banking entity invests or that it sponsors that are offered and sold solely outside the United States and that raise money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities. See 12 C.F.R. § 248.10(b).
6 Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 83 Fed. Reg. 33432 (July 17, 2018) (the “2018 NPRM”).
7 Rule 203(l)-1 under the Advisers Act, 17 C.F.R. § 275.203(l)-1.
8 12 C.F.R. § 248.14.
9 12 C.F.R. § 248.15.
10 However, as discussed below, in the Proposal the Volcker Rule Agencies are considering allowing a small percentage of the issuer’s assets to consist of debt instruments.
11 The definition of “family customer” is borrowed from the Advisers Act definition of “family client.” See Rule 202(a)(11)(G)-1(d)(4) under the Advisers Act, 17 C.F.R. § 275.202(a)(11)(G)-1(d)(4).
12 12 C.F.R. § 248.10(c)(1).
13 12 C.F.R. § 248.10(c)(8).
14 12 C.F.R. § 248.10(c)(11).
15 Such funds are referred to as “foreign excluded funds,” and those that meet the Volcker Rule Agencies’ criteria for relief are defined as qualifying foreign excluded funds, or QFEFs. Statement regarding Treatment of Certain Foreign Funds under the Rules Implementing Section 13 of the Bank Holding Company Act (July 21, 2017), available at https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20170721a1.pdf.
16 12 C.F.R. § 248.13(b).
17 The list of covered transactions was imported to the Volcker Rule from the Board’s Regulation W, which implements Section 23A of the Federal Reserve Act. 12 U.S.C. § 371c; 12 C.F.R. Part 223. While Regulation W limits transactions between a Federal Reserve System member bank and its affiliates, the Super 23A provisions of the Volcker Rule outright prohibit covered transactions between a banking entity (as if it were a member bank under Regulation W) and a related covered fund (as if the covered fund were the member bank’s affiliate. 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.
18 See 12 U.S.C. § 371c(d); 12 C.F.R. § 223.42.
19 12 C.F.R. § 248.10(d)(6).
20 12 C.F.R. § 248.12(a); see § 248.11(a), § 248.12(b) for additional requirements imposed on banking entities relying on the asset management exemption.