The staffs of the Federal Reserve Board, the Office of the Comptroller of the Currency, the FDIC, the SEC and the CFTC (collectively, the “Agencies”) have issued updated FAQs addressing the manner in which the Volcker rule applies to foreign public funds and to joint ventures. With respect to foreign public funds, the new guidance clarifies that a foreign public fund that meets certain requirements will not be treated as a banking entity for purposes of the Volcker rule. With respect to joint ventures, the Agencies have clarified the circumstances in which an entity may qualify for the joint venture exception from the definition of covered fund.
Background
By way of background, the Volcker rule generally prohibits banking entities—which include insured depository institutions, companies that control one or more insured depository institutions (such as a bank or savings and loan holding company), foreign banking organizations that are subject to the Bank Holding Company Act by virtue of maintaining a branch, agency or commercial lending company subsidiary in the United States, and affiliates and subsidiaries of these types of entities—from engaging in proprietary trading and from sponsoring and investing in certain types of investment funds, called covered funds.
The final Volcker rule implementing regulation adopted by the Agencies in December 2013 (the “Final Rule”) excludes most covered funds from the definition of banking entity, which means that a covered fund is generally permitted to engage in proprietary trading and to invest in other covered funds. The Final Rule also contains several exceptions from the definition of covered fund, including an exception for certain so-called foreign public funds and an exception for certain joint ventures. A banking entity may sponsor and invest in a fund that does not fall within the definition of covered fund or that is excluded from the definition of covered fund, but if the banking entity’s relationship with the fund results in the banking entity having control over the fund for purposes of the Volcker rule, then the fund will itself become a banking entity subject to the Volcker rule’s prohibitions on proprietary trading and relationships with covered funds. This aspect of the Volcker rule is potentially problematic for investment funds outside of the United States that are similar to U.S. mutual funds, since they may engage in proprietary trading that would be prohibited from the Volcker rule if they are treated as banking entities. Among other circumstances, a banking entity would be regarded as having control over a fund if the banking entity owns 25% or more of a class of voting securities of the fund, has the ability to select a majority of the fund’s directors, or controls the fund through a contract or through a controlled corporate director.
Foreign Public Funds
The new guidance states that the staffs of the Agencies would not advise that the activities and investments of a foreign public fund sponsored by a banking entity be attributed to the banking entity as long as the foreign public fund meets certain requirements and provided the banking entity does not owns, control or hold with power to vote 25% or more of the voting shares of the foreign public fund (following the end of a one year seeding period). The guidance goes on to state that the staffs of the Agencies would not advise that such a foreign public fund be treated as a banking entity. This guidance should make it easier for a banking entity that sponsors a foreign public fund to conclude that the fund will not be subject to the Volcker rule even if the banking entity may be deemed to control the fund for purposes of the Bank Holding Company Act as a result of the fund’s governance structure.
In general, to qualify for this relief, a foreign public fund must meet the requirements of Section __.10(c)(1) and Section __.12(b)(1) of the Final Rule. Section __.10(c)(1) of the Final Rule excludes from the definition of “covered fund” a foreign public fund that (i) is organized outside of the United States, (ii) is authorized to offer and sell ownership interests to retail investors in its home jurisdiction, and (iii) sells ownership interests predominantly through one or more public offerings outside of the United States. When a U.S. banking entity sponsors a foreign public fund, to qualify for the exclusion from the definition of covered fund, ownership interests in the foreign public fund most be sold predominantly to persons other than the sponsoring banking entity, the foreign public fund, affiliates of the sponsoring banking entity or the foreign public fund and directors and employees of such entities. The Agencies have stated that an offering is made predominantly outside of the United States if 85 percent or more of the fund’s interests are sold to investors that are not residents of the United States and that a foreign public fund sponsored by a U.S. banking entity would generally satisfy the additional limitation on sales of interests in the fund to persons other than the sponsoring U.S. banking entity and certain related persons if at least 85% of the fund’s interests are sold to persons other than the sponsoring U.S. banking entity and related persons. Section __.12(b)(1) of the Final Rule provides that a foreign public fund will not be treated as an affiliate of a banking entity for certain purposes so long as the banking entity (i) does not own, control or hold with power to vote 25% or more of the voting shares of the fund, and (ii) provides investment advisory, commodity trading advisory, administrative and other services to the fund in compliance with the limitations regulation, or authority. The new guidance states that this second requirement means that the sponsoring banking entity’s relationship with the foreign public fund must comply with applicable limitations in the jurisdiction in which the foreign public fund operates.
Notably, the guidance does not provide relief when a banking entity owns, controls or holds power to vote 25% or more of the voting shares of a foreign public fund; (U.S. banking entities are subject to a lower threshold to meet the “predominantly” standard, as described above), and it does not provide any additional detail on the circumstances in which the Federal Reserve Board may grant an extension of the one year seeding period for various types of funds, including foreign public funds.
Join Ventures
The Final Rule excludes from the definition of covered fund certain joint ventures between a banking entity or any of its affiliates and one or more unaffiliated persons. To qualify for the exclusion, the joint venture (i) must be comprised of not more than 10 unaffiliated co-venturers, (ii) must be in the business of engaging in activities that are permissible for the banking entity or affiliate other than investing in securities for resale or other disposition, and (iii) must not hold itself out as an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other distribution or otherwise trading in securities. The new guidance states that this exclusion is not intended to apply to entities that invest in securities for resale or other disposition or to entities or arrangements that raise money from investors primarily for the purpose of investing in securities for the benefit of one or more investors and sharing the income, gain or losses on securities acquired by that entity. The guidance goes on to state that an issuer will not qualify for the exclusion if the issuer raises money from investors primarily for the purpose of investing in securities, whether the securities are intended to be traded frequently, held for a longer duration, held to maturity, or held until the dissolution of the entity, nor will an entity qualify for the exclusion if raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities even if the entity has other purposes.