Alert February 22, 2011

FRB Issued Final Rule to Implement Volcker Rule Conformance Periods

The FRB issued a final rule (the “Final Rule”) to implement the conformance periods during which banking entities and nonbank financial companies supervised by the FRB must bring their activities and investments into compliance with the provisions of the Dodd‑Frank Act that restrict proprietary trading and certain relationships with and investments in hedge funds and private equity funds, commonly known as the “Volcker Rule.”  A summary of the proposed version of the Final Rule appeared in the November 23, 2010 Alert.  The Final Rule becomes effective April 1, 2011.

The FRB adopted the Final Rule in substantially the same form as proposed.  However, there are some important differences between the proposal and the Final Rule:

  • The Volcker rule contemplates an extended transition period with respect to existing contractual commitments as of May 1, 2010 to remain invested in a hedge fund or private equity fund invested principally in illiquid assets.  The FRB expanded the conditions under which an asset may be considered an “illiquid asset” to include situations where an asset is subject to contractual restriction on sale or redemption for a period of three years or more.
  • The FRB has clarified that, in determining whether a fund is contractually committed to principally invest or has an investment strategy to principally invest in illiquid assets, a banking entity may take into account written representations made in the fund’s offering documents (in addition to those contained in the fund’s organization documents).
  • The proposed rule would have required a banking entity to submit a request for an extension of time to conform to the Volcker Rule 90 days prior to the expiration of the applicable time period, but the Final Rule requires that such submissions be made 180 days in advance.  The FRB clarified that it expects to act on requests for an extension of time within 90 days of submission.
  • The FRB made modifications to the Final Rule to clarify that, in determining whether the FRB may grant an extension of time to conform to the Volcker Rule, the FRB may consider whether divestiture or conformance of the activity or investment would involve or result in a material conflict of interest between the banking entity and unaffiliated clients, customers or counterparties.  The FRB has also clarified that it may also consider a firm’s prior efforts to divest or conform its activities or investments, including, with respect to an illiquid fund, whether the banking entity has made reasonable best efforts to terminate or obtain a waiver of its contractual commitments to take or retain an equity, partnership or other ownership interest in, or provide capital to, an illiquid fund.
  • The FRB has clarified that, if a banking entity is granted an extended transition period to take or retain an investment in an illiquid fund, the banking entity may continue to serve as general partner, managing member or sponsor of the fund to the extent such service is related to the banking entity’s retention of its permitted ownership interest.  However, it may not act as general partner, managing member or sponsor with respect to a fund if it did not serve in that role as of May 1, 2010.

Notably, the FRB declined to make several changes requested by commenters:

  • The FRB did not adopt the suggestion of some commenters that the Final Rule allow the FRB to grant up to three one-year extensions of the conformance period at one time but, instead, made a modification in the Final Rule to clarify that the FRB will only grant up to three separate one-year extensions of time.  With respect to the single five-year extension for illiquid funds, the FRB clarified that it retains authority to grant an extension for less than the full five year period.
  • The Final Rule continues to classify a fund as “illiquid” only if at least 75% of its consolidated total assets are or are expected to be comprised of illiquid assets.  The FRB declined to adopt the suggestion of some commenters that this threshold should be significantly lower.   In addition, the FRB declined to adopt the suggestion of some commenters that an asset should be considered illiquid if it cannot be sold at a reasonable price either because of the size of the position or market conditions.  Instead, the FRB confirmed that the definition of “illiquid asset” refers to assets that are illiquid by their nature.

Some commenters suggested that a banking entity should only be required to use “commercially reasonable efforts” to obtain any third party consents and approvals necessary to terminate existing contractual commitments to a fund.  However, the Final Rule retains a “reasonable best efforts” standard.