Volcker Rule Update: Final Rule Includes New Exclusions from the Definition of “Covered Fund”

July 8, 2020

Executive Summary

A new final rule has made significant changes to several key provisions of the Volcker Rule that restrict investments by banking entities in covered funds. Investment managers should be aware of these changes, as they will impact what types of funds can be organized and offered by bank-affiliated managers, as well as whether and to what extent banking entities can invest in certain investment funds. As further discussed below, these changes include:

  • Four new exclusions from the “covered funds” definition, including exclusions for venture capital funds and credit funds, such that banking entities will be eligible to invest in and/or sponsor such funds;
  • A clarification that a banking entity’s investments made in parallel with investments made by a covered fund will not be counted against the banking entity’s 3% investment limit in that covered fund, if applicable;
  • Broadened versions of existing exclusions from the covered fund definition;
  • Clarification of, and a safe harbor from, the definition of an “ownership interest” in a covered fund relating to certain debt interests;
  • Codification of staff guidance regarding treatment of certain foreign funds as banking entities; and
  • New carveouts from the list of transactions prohibited by the Volcker Rule’s “Super 23A” provisions.


On June 25, 2020, the Board of Governors of the Federal Reserve (“Board”) announced that the five federal agencies with rulemaking authority over the Volcker Rule (the “Agencies”)1 have adopted a final rule (the “Final Rule”)2 increasing the ability of banks and their affiliates to invest in and sponsor “covered funds,” as defined in the Volcker Rule (“Covered Funds”).3 The Final Rule will take effect on October 1, 2020.

The Volcker Rule prohibits “banking entities” (“Banking Entities”)4 from engaging in “proprietary trading” (“Proprietary Trading”)5 and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with Covered Funds. While the Volcker Rule was designed to restrict investments in and sponsorship of hedge funds and private equity funds by Banking Entities, many other types of investment vehicles are captured by the Covered Fund definition.

The Final Rule creates four new exclusions from the Covered Fund definition, including exclusions for venture capital funds and credit funds, plus two additional new exclusions. Among other things, the Final Rule also broadens four already-existing exclusions. Any such addition to or expansion of the list of exclusions increases the investment options for Banking Entities in funds that, before the Final Rule, were Covered Funds. Likewise, investment managers that are affiliated with banks will likely have greater flexibility to sponsor certain funds that were Covered Funds.

Key Modifications in the Final Rule

New exclusions. While the Final Rule makes a number of important changes to the Volcker Rule’s Covered Fund provisions, the most significant modifications for the investment management industry are likely to be two of the four new exclusions from the Covered Fund definition, for venture capital funds and credit funds.

  • Venture capital funds. The Final Rule creates a new exclusion from the Covered Fund definition for venture capital funds. It adopts the definition of “venture capital fund” from regulations under the Investment Advisers Act,6 but provides that, in order to qualify for the exclusion, such a venture capital fund must also refrain from engaging in Proprietary Trading. Banking Entities will be subject to certain limitations and requirements with respect to their investment in or sponsorship of a venture capital fund.7 Nonetheless, they will be permitted to sponsor a venture capital fund, and they will not be subject to a 3% limit (or any other limit) on the percentage of such a fund’s ownership interests they can hold.
  • Credit funds. The Final Rule creates a new exclusion for funds that make loans, invest in debt, or otherwise provide credit that Banking Entities are permitted to provide directly under existing federal banking laws. The exclusion is available only to funds that do not issue asset-backed securities or engage in Proprietary Trading. Issuers relying on the credit fund exclusion will be permitted to hold only (1) loans, (2) debt instruments the Banking Entity would be permitted to hold directly, (3) related rights or other assets that are related to acquiring, holding, servicing, or selling loans or debt instruments,8 and (4) certain interest rate or foreign exchange rate derivatives. Banking Entities will be subject to certain limitations and requirements with respect to their investment in or sponsorship of a credit fund,9 but as with venture capital funds, they will be permitted to sponsor credit funds, or hold ownership interests in them without a percentage limit.
  • The Final Rule also creates two other new exclusions from the Covered Fund definition, for family wealth management vehicles, and customer facilitation funds.

Parallel investments and the 3% limit. Banking Entities that hold ownership interests in and sponsor Covered Funds often rely on the so-called asset management exemption to comply with the Volcker Rule.10 Among other limitations and requirements, Banking Entities relying on the asset management exemption are permitted to hold no more than 3% of the ownership interests of any Covered Fund. In the Preamble to the 2013 Volcker Rule, the Agencies required Banking Entities to calculate as part of this 3% limit any direct investment made by the Banking Entity in parallel with investments made by a Covered Fund in which the Banking Entity held any ownership interests. The Final Rule eliminates this attribution of parallel investments to the Covered Fund for purposes of the 3% limit, as long as the Banking Entity makes the parallel investment in compliance with applicable laws and regulations, and consistent with its own safety and soundness obligations.

Other Elements of the Final Rule

Expanded exclusions. The Final Rule expands on four existing exclusions from the Covered Fund definition, including:

  • The foreign public fund exclusion, for non-U.S. funds that resemble U.S. registered investment companies, by, among other things, eliminating a requirement that fund interests be offered and sold to retail investors in the fund’s home jurisdiction and by easing requirements related to the portion of the funds interests that must be sold in public offerings;
  • The loan securitization exclusion, which most notably has been modified to permit securitization vehicles relying on it to hold certain debt securities as a small portion of their assets; and
  • Exclusions for small business investment companies and public welfare investment funds.

Ownership interest definition. The Final Rule provides clarification and changes to the definition of “ownership interest.”11 One component of the ownership interest definition is that an interest that allows the holder to participate in the selection or removal of a fund’s investment manager, other than in events of default or acceleration, constitutes an ownership interest. In the Final Rule the Agencies permit certain common rights of creditors with respect to debt interests in a Covered Fund that allow for participation in the removal of an investment manager without triggering the ownership interest definition.12 The Final Rule also creates a safe harbor for certain senior loan and senior debt interests that lack specified equity-like features such that they are not captured by the ownership interest definition.

QFEF Guidance codified. The Final Rule codifies 2017 Agency guidance (the “QFEF Guidance”) regarding the extraterritorial impact of the Volcker Rule on certain qualifying foreign excluded funds (“QFEFs”). A QFEF does not meet the definition of a Covered Fund but does meet the definition of a Banking Entity, because it is a fund that is “controlled” for purposes of the BHCA by a foreign Banking Entity, and is therefore an affiliate of that Banking Entity, subject to the full range of the Volcker Rule’s Proprietary Trading, Covered Fund, and compliance requirements.13 The QFEF Guidance provided, and the Final Rule provides, that a QFEF will not be treated as a Banking Entity as long as it meets certain requirements. Among these requirements, the foreign Banking Entity’s investment in, or activities with respect to, the QFEF will have to comply with the Volcker Rule’s “solely outside the United States” or “SOTUS” exemption,14 as if the QFEF were a Covered Fund. A fund that qualifies as a QFEF pursuant to the Final Rule is exempt from treatment as a Banking Entity for most purposes.

Carveouts from Super 23A provisions. The Final Rule carves out certain transactions from the Volcker Rule’s “Super 23A” provisions, which generally prohibit so called “covered transactions” – largely, extensions of credit — from a Banking Entity to a Covered Fund. Such transactions will be permissible under the Final Rule, and include, among others, riskless principal transactions and short-term extension of credit made in the ordinary course of business in connection with payment, clearing, and settlement services.

* * * * *

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 Agencies are the Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and the Securities and Exchange Commission.  The statutory Volcker Rule is Section 13 of the Bank Holding Company Act of 1956, as amended, (the “BHCA”), codified at 12 U.S.C. § 1851.  Each Agency has its own version of the Volcker Rule Regulations.  See, e.g., 12 C.F.R. Part 248 (Board version).

2   Agencies, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds (June 25, 2020), available at https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200625a1.pdf.

3   12 C.F.R. § 248.10(b) (any issuer that is excluded from the definition of an “investment company” pursuant to Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, certain commodity pools, and, in some circumstances, certain foreign equivalents of such issuers).

4   12 C.F.R. § 248.2(c) (generally, insured depository institutions, their holding companies and affiliates).

5   12 C.F.R. § 248.3(a), (b)(1)(i) (generally, the purchase or sale for a Banking Entity’s own trading account of certain financial instruments principally for purposes of short term resale, benefitting from short-term price movements or realizing arbitrage profits, or hedging positions resulting from the foregoing).

6   Rule 203(l)-1 under the Advisers Act, 17 C.F.R. § 275.203(l)-1.

7   These limitations include a prohibition on guaranteeing the performance of the fund, certain disclosure requirements, an obligation to ensure that the activities of the fund are consistent with the Banking Entity’s safety and soundness obligations, compliance with the Volcker Rule’s backstop provisions, 12 C.F.R. § 248.15, and, for a Banking Entity that sponsors or acts as investment adviser or commodity trading adviser to the fund and holds ownership interests in the fund, compliance with the Volcker Rule’s Super 23A provisions, 12 C.F.R. § 248.14.

8   Permissible rights or assets related or incidental to loans and debt instruments can include equity securities pursuant to the Final Rule, if such securities are received on customary terms in connection with such loans or debt instruments.  The Agencies indicate that they expect, but do not explicitly require in the Final Rule, that such equity securities will not make up more than 5% of the assets of the fund.

9   Supra note 7.

10   12 C.F.R. § 248.11(a); 12(a).

11   12 C.F.R. § 248.10(d)(6).

12   Examples include the right to participate in the removal of an investment manager if the investment manager becomes insolvent or bankrupt, or if there is a change of control of the investment manager.  Final Rule at 151-152.

13   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.

14   12 C.F.R. § 248.13(b).


Related Attorneys