The five U.S. federal regulatory agencies responsible for implementing the Volcker rule — the Board of Governors of the Federal Reserve System (Federal Reserve), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC and, collectively with the foregoing agencies, the Agencies) — have issued a final rule (the Final Rule) revising their regulations implementing the covered funds aspects of the Volcker rule. The Final Rule becomes effective October 1, 2020. The Volcker rule is a provision of the Bank Holding Company Act (BHCA) that generally prohibits banking entities from engaging in proprietary trading and from sponsoring, investing in and having certain relationships with covered funds.
The Final Rule modifies existing exceptions from the definition of covered fund, adds new exclusions from the definition of covered fund and provides relief in other areas. Unless otherwise noted in the Final Rule or its adopting release, the Final Rule does not modify or revoke any previously issued guidance provided by the Agencies’ staff in the form of answers to frequently asked questions. A summary of the changes made by the Final Rule follows.
Existing Exclusions from the Definition of Covered Fund
Foreign Public Funds — The Final Rule revises the foreign public fund exclusion from the Volcker rule by eliminating the requirement that a foreign public fund be offered in the jurisdiction in which it is organized and that ownership interests in the fund be sold predominantly through public offerings. Instead, the Final Rule replaces those requirements with a requirement that the fund be authorized to offer and sell ownership interests and that such interests be offered and sold through one or more public offerings. The Final Rule adds a new requirement that the distribution be subject to substantive disclosure and retail investor protection laws or regulations similar to requirements that apply to mutual funds in the United States. The Final Rule also limits application of the requirement that distribution of ownership interests in a foreign public fund comply with all applicable requirements in the jurisdiction where it is made to instances in which the banking entity acts as the investment manager, investment adviser, commodity trading advisor, commodity pool operator, or sponsor. The Final Rule also eliminates the restriction on sales of interest in a foreign public fund to employees, but a domestic or domestically controlled banking entity must ensure that more than 75% of ownership interests are sold to persons other than the banking entity, the issuer, their affiliates, and directors and executive officers of these entities. The Final Rule also clarifies that ownership interests in covered funds held by a foreign public fund will not be attributed to a banking entity if the banking entity (and its affiliates) hold less than 25% of the voting shares of the foreign public fund and the banking entity or an affiliate provides advisory, administrative or other services to the fund.
Loan Securitization Exclusion — The Final Rule incorporates in the Volcker rule implementing regulation guidance provided by the Agencies in 2014 in the form of a response to a frequently asked question which clarifies that assets other than securities can be servicing assets for purposes of the loan securitization exclusion. However, assets that are securities would still need to qualify as permitted securities, which consist of high quality, liquid cash equivalents and securities received in lieu of a debt previously contracted. The Final Rule also permits loan securitization vehicles to hold a small amount of debt securities, other than asset-backed securities and convertible securities, as long as the value of such securities does not exceed 5% of the aggregate value of loans, cash and cash equivalents and debt securities.
Public Welfare Funds — The Volcker rule permits a banking entity to make and retain investments that are designed primarily to promote the public welfare of the type permitted for national banks under Section 24(Eleventh) of the National Bank Act. Under the OCC’s regulations implementing this provision, public welfare investments include those that would receive consideration under the Community Reinvestment Act, even though this type of investment is not explicitly mentioned in Section 24(Eleventh). The current Volcker rule implementing regulation refers to Section 24(Eleventh) and does not explicitly incorporate the OCC’s regulations implementing this investment authority. In the Notice of Proposed Rulemaking that preceded the Final Rule, the Agencies requested public comment on “whether any change should be made to clarify that all permissible public welfare investments, under any agency’s regulation, are excluded from the covered fund restrictions.” However, the Final Rule simply provides that a covered fund does not include an issuer, the business of which is to make investments that are designed to promote the public welfare of a type permitted for national banks under Section 24(Eleventh), including investments that qualify for consideration under the Community Reinvestment Act.
Small Business Investment Company (SBIC) Exclusion — The Final Rule revises the exclusion for SBICs to clarify the status of an SBIC that surrenders its license while winding down. Under the Final Rule, the SBIC exception from the definition of covered fund would continue to apply to an issuer that was an SBIC but that that has voluntarily surrendered its license to operate as an SBIC and does not make new investments (other than investments in cash equivalents) after such voluntary surrender.
New Exclusions from the Definition of Covered Fund
Credit Funds — The Final Rule adds a new exclusion from the definition of covered fund for credit funds that invest in loans or debt instruments of a type that banking entities may hold directly. Currently, credit funds are generally treated as covered funds; however, funds that invest in first mortgage loans or certain types of receivables may not be treated as covered funds if they can rely upon the exclusion provided by Section 3(c)(5) of the Investment Company Act. Under the new exception, a fund would not be treated as a covered fund if its assets consist solely of loans, certain debt instruments and related rights, and other assets that are related or incidental to acquiring, holding, servicing, or selling such loans or debt instruments, and certain interest rate or foreign exchange derivatives that relate to the fund’s other assets and are entered into for risk mitigation purposes. However, any incidental or related right or asset that is a security must be a cash equivalent, a security received in lieu of a debt previously contracted with respect to underlying loans or debt instruments held by the fund, an equity security (or right to acquire an equity security) received on customary terms in connection with such loans or debt instruments (e.g., a warrant received in lieu of or in addition to interest). Such rights or assets may not include commodity forward contracts or any derivative. In addition, to qualify for the credit fund exclusion, an issuer may not engage in proprietary trading or issue asset-backed securities.
If a banking entity acts as a sponsor, investment adviser, or commodity trading advisor to a fund that relies upon the credit fund exclusion, the following requirements apply:
- The banking entity must provide disclosures to actual and prospective investors in the fund that are similar to those that must be provided under the rules currently applicable to funds organized and offered by a banking entity in reliance upon the asset management exemption from the Volcker rule;
- The fund’s activities must be consistent with safety and soundness standards; and
- The banking entity and its affiliates must comply with the so-called Super 23A limitation in connection with transactions with the fund (except the banking entity may acquire and retain ownership interest in the issuer).
In addition, a banking entity may not rely upon the credit fund exclusion unless the banking entity complies with the following additional requirements:
- The banking entity may not guarantee, assume, or otherwise insure the obligations or performance of the credit fund or of any entity to which the fund extends credit or in which it invests;
- The fund’s assets must be permissible for the banking entity to acquire and hold directly;
- The banking entity must comply with the so-called backstop provision of the Volcker rule as if the issuer were a covered fund; and
- The banking entity must conduct its activities in connection with the fund in compliance with, and subject to, applicable banking laws and regulations, including applicable safety and soundness standards.
The adopting release to the Final Rule explains that the Final Rule does not permit a banking entity that is an insured depository institution or subsidiary of an insured depository institution to invest in a credit fund through a contribution to a credit fund of troubled loans and debt previously contracted assets from the banking entity’s portfolio.
Venture Capital Funds — The Final Rule creates a new exclusion from the definition of covered fund for qualifying venture capital funds. To qualify for the exclusion, an investment fund must be a venture capital fund as defined under the venture capital adviser exemption provided by Rule 203(l)-1 under the Investment Advisers Act of 1940 (Advisers Act) and may not engage in proprietary trading. In general, this definition is intended to distinguish venture capital funds from other types of funds such private equity funds, hedge funds, leveraged buyout funds, and funds that engage in secondary transactions. In addition, a banking entity that acts as a sponsor, investment adviser, or commodity trading advisor to a qualifying venture capital fund must:
- Provide actual and prospective investors in the fund disclosures that are similar to those required in connection with funds organized and offered by a banking entity under the asset management exemption from the Volcker rule;
- Ensure that the fund’s activities are consistent with safety and soundness standards; and
- Comply with the Super 23A provision of the Volcker rule in connection with its relationship with the fund (except the banking entity may acquire and retain ownership interests in the issuer).
In addition, a banking entity that relies upon this exclusion must not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the issuer, and the banking entity must comply with the backstop provision of the Volcker rule. The relationship between the banking entity and the qualifying venture capital fund must be conducted in compliance with, and subject to, applicable banking laws and regulations, including applicable safety and soundness standards.
Family Wealth Management Vehicles — The Final Rule creates a new exclusion from the definition of covered fund for certain family wealth management vehicles. An entity will qualify as a family wealth management vehicle if it is not, and does not hold itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities. If the entity is a trust, the grantor or grantors of the entity must all be “family customers.” If the entity is not a trust, (1) a majority of the voting interests in the entity must be owned, directly or indirectly, by family customers, and (2) the entity must be owned only by family customers and up to five closely related persons of the family customers (except that up to 0.5% of the issuer’s outstanding equity interests may be held by other persons for the purpose of and to the extent necessary to establish corporate separateness or to address bankruptcy, insolvency or similar concerns). For this purpose, a “family customer” is a family client, as defined in Rule 202(a)(11)(G)-1(d)(4) under the Advisers Act or any natural person who is a father-in-law, mother-in-law, brother-in-law, sister-in-law, son-in-law, or daughter-in-law of a family client, or a spouse or spousal equivalent of any of these persons. A closely related person is defined as an individual (including the estate and estate planning vehicles of such person) who has longstanding business or personal relationships with any family customer. A banking entity would only be permitted to rely on this exclusion with respect to an entity to which the banking entity (or an affiliate) provides bona fide trust, fiduciary, investment advisory, or commodity trading advisory services. In addition, the banking entity may not guarantee, assume, or otherwise insure the obligations or performance of such entity, and it must comply with the certain disclosure obligations similar to those that apply with respect to funds organized and offered by a banking entity as part of an asset management business. A banking entity generally would not be permitted to acquire an ownership interest in a family wealth management vehicle, except that it would be permitted to acquire up to 0.5% of the entity’s outstanding ownership interests for the purpose of and to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency, or similar concerns. The banking entity would need to comply with the backstop prohibition in the Volcker rule. The Final Rule does not require a banking entity to comply with the Super 23A provision of the Volcker rule in relation to a family wealth management vehicle, except that the banking entity and its affiliates would be prohibited from purchasing low quality assets from the family wealth vehicle other than in riskless principal transactions, and any transactions between the banking entity and its affiliates and the family wealth vehicle would need to be conducted on terms and under conditions that are at least as favorable to the banking entity as market terms.
Customer Facilitation Vehicles — The Final Rule excludes a “customer facilitation vehicle” from the definition of covered fund. For this purpose, a customer facilitation vehicle is an entity formed by or at the request of a customer of a banking entity for the purpose of providing the customer (including one or more affiliates of the customer) with exposure to a transaction, investment strategy, or other service provided by the banking entity. The banking entity and its affiliates must maintain documentation outlining how the banking entity intends to facilitate the customer’s exposure to such transaction, investment strategy, or service. In general, the customer and its affiliates must own all of the ownership interests in the customer facilitation vehicle. However, the banking entity and its affiliates may acquire up to 0.5% of the entity’s outstanding ownership interests to establish corporate separateness or address bankruptcy, insolvency, or similar concerns. A banking entity may not guarantee, assume, or otherwise insure the obligations or performance of a customer facilitation vehicle established for a customer. The banking entity must provide disclosures that are similar to those required in connection with a covered fund organized and offered by a banking entity in connection with an asset management business. The banking entity must comply with the backstop provision in the Volcker rule. The Final Rule does not require a banking entity to comply with the Super 23A provision of the Volcker rule, except that the banking entity and its affiliates may not purchase low quality assets from a customer facilitation vehicle other than through a riskless principal transaction, and any transactions between the banking entity and its affiliates and the customer facilitation vehicle would need to be conducted on terms and under conditions that are at least as favorable to the banking entity as market terms.
Rural Business Investment Companies (RBIC) and Qualified Opportunity Funds (QOF) — the Final Rule provides exceptions from the definition for an issuer that has elected to be regulated or is regulated as a RBIC (or that has terminated its participation as a RBIC and does not make new investments other than investments in cash equivalents) and for an issuer that is a QOF as defined in Section 1400Z-2(d) of the Internal Revenue Code.
Foreign Excluded Funds
Because the definition of banking entity for purposes of the Volcker rule generally includes affiliates and subsidiaries of non-U.S. banking entities that are subject to the BHCA, the Volcker rule has inadvertently limited the activities of certain non-U.S. investment funds. More specifically, if a non-U.S. banking entity controls an investment fund that is organized outside of the U.S. but is not a covered fund, the fund will generally be treated as a banking entity and subject to the prohibitions on proprietary trading and sponsoring, investing in and maintaining certain relationships with covered funds. In 2017, the federal banking agencies issued a policy statement in which they indicated that they would not take action during a one year period ending July 21, 2018, against a foreign banking entity based on attribution of the activities and investments of a so-called qualifying foreign excluded fund to a foreign banking entity, or against a qualifying foreign excluded fund as a banking entity. The banking agencies extended this relief for an additional period of one year, until July 21, 2019, and later further extended this relief to July 21, 2021.
The Final Rule exempts from the Volcker rule certain activities of foreign excluded funds. As a result, foreign excluded funds may engage in proprietary trading, sponsor a covered fund, and acquire or retain an ownership interest in a covered fund. To qualify for this relief, a foreign excluded fund must be:
- Organized or established outside the United States, and all of its ownership interests must be offered and sold solely outside the United States;
- An issuer that would be a covered fund if it were organized or established in the United States, or it must be or hold itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;
- A banking entity solely by virtue of the acquisition or retention of an ownership interest in, sponsorship of, or relationship with the fund, by a non-U.S. banking entity that is not controlled by a U.S. banking entity (and the non-U.S. banking entity’s relationship with the covered fund must meet the requirements for permitted covered fund activities outside the United States under the so-called SOTUS exemption);
- Established and operated as part of a bona fide asset management business; and
- Not operated in a manner that enables the banking entity that sponsors or controls the qualifying excluded fund, or any of its affiliates, to evade the requirements of the Volcker rule.
The adopting release explains that the last requirement is intended to mitigate the possibility that a banking entity may operate a foreign excluded fund in a manner that enables the banking entity that sponsored or controls the qualifying excluded fund, or any other banking entity (other than a qualifying excluded fund) from evading the requirements of the Volcker rule. In addition, the Final Rule provides relief from the reporting and additional documentation requirements of the Volcker rule compliance program requirements for foreign excluded funds. However, the Final Rule does not provide any special exceptions from the requirements of the Super 23A limitation for foreign excluded funds with respect to transactions between a foreign excluded fund and a related covered fund
Relief from Super 23A
The Super 23A provision of the Volcker rule imposes restrictions on relationships between a banking entity and its affiliates and a covered fund for which the banking entity directly or indirectly serves as investment manager, investment adviser, or sponsor, or that the banking entity organizes and offers pursuant to the asset management exemption from the Volker rule, and any other covered fund controlled by such a covered fund. Specifically, the banking entity and its affiliates may not enter into any transaction with such a related covered fund if the transaction would be regarded as a “covered transaction” for purposes of Section 23A of the Federal Reserve Act, applied as if the banking entity or its affiliate was a member bank and the covered fund was an affiliate.
The Final Rule provides limited exceptions from the Super 23A prohibition to permit a banking entity to:
- Enter into a transaction with a covered fund that would be a covered transaction exempted from the qualitative limits, collateral requirements, and prohibition on purchasing low quality assets of Section 23A. These transactions include extensions of credit fully collateralized by U.S. government obligations, purchasing assets having a readily identifiable and publicly available market quotation if the assets price is quoted routinely in a widely disseminated publication that is readily available to the general public and the asset is purchased at or below the current market quotation, purchasing certain marketable securities and municipal securities, and certain intraday extensions or credit.
- Enter into riskless principal transactions with a covered fund;
- Extend credit to or purchase assets from a covered fund in the ordinary course of business in connection with payment transactions, settlement services, or futures, derivatives and securities clearing as long as each extension of credit is repaid, sold or terminated within five days and the banking entity maintains appropriate policies and procedures and does not have any reason to believe that the covered fund will have difficulty repaying the extension of credit.
The Final Rule requires that these transactions must comply with safeguards to address conflicts of interests and considerations related to risk management and safety and soundness and must be conducted in accordance with the market terms requirement of Section 23B of the Federal Reserve Act.
Clarification of Status of Debt Interests
The Final Rule modifies the definition of “ownership interest” to clarify that a debt interest in a covered fund does not constitute an ownership interest in the covered fund in certain circumstances. Specifically, the provision in a debt obligation of creditors’ remedies upon the occurrence of an event of default or an acceleration event, including the right to participate in the removal of an investment manager for cause or participate in the selection of a replacement manager upon an investment manager’s resignation or removal, will not cause the debt instrument to be treated as an ownership interest in a covered fund.
In addition, the Final Rule provides a safe harbor from the definition of ownership interest, for certain senior debt interests. More specifically, a senior loan or other senior debt interest would not be considered an ownership interest in a covered fund if holders of the interest do not receive any profits of the covered fund but only receive (1) interest payments which are not dependent on the performance of the covered fund and (2) fixed principal payments. In addition, the right to receive principal and interest payments must be absolute and not subject to reduction because of losses arising from the covered fund. Further, the holders of the interest may not have any entitlement to receive the underlying assets of the covered fund after all other interests have been redeemed and/or paid in full except for the rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event.
The Final Rule clarifies how parallel investments are treated under the Volcker rule for purposes of determining the amount of a banking entity’s investment in a covered fund. In the adopting release to the current Volcker rule implementing regulation, the Agencies suggested that a banking entity may in some circumstances need to include the value of investments made “side by side in substantially the same positions as [a] covered fund” for purposes of determining whether the banking entity was in compliance with the 3% of ownership interests limitation on certain permitted investments in a covered fund. However, under the Final Rule, a banking entity would not need to treat investments made alongside a covered fund, such as parallel investments or co-investments, as an investment in the covered fund as long as certain conditions are met. To qualify for this relief, any investment made alongside a covered fund must be made in compliance with applicable laws and regulations, including applicable safety and soundness standards.
Attribution of Ownership Interests
The Final Rule amends the Volcker rule implementing regulation to clarify that restricted profit interests held by employees or directors of a banking entity will only be attributed to the banking entity if financed by the banking entity.
For more information on the Volcker rule covered fund restrictions, contact the author, William Stern.