On Jan. 30, 2020, the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the US Securities and Exchange Commission and the US Commodity Futures Trading Commission (collectively, the “Agencies”) approved a notice of proposed rulemaking (“Proposed Rule”) to simplify and tailor the “covered fund” provisions of the regulations implementing section 13 of the Bank Holding Company Act, commonly known as the “Volcker Rule.”1
The Proposed Rule spans more than 160 pages (in its original format) and poses 87 separate questions on which it solicits comments (many with multiple subparts). A copy of the Proposed Rule is available here. Comments are due by April 1, 2020.
The day the Proposed Rule was approved, we published an alert that provided an executive summary.2 This memorandum supplements that alert by examining each of the Proposed Rule’s provisions in detail.
The Proposed Rule does not offer sweeping changes, as many in the banking and fund industries would have preferred.
Joseph P. Vitale and Jessica Romano, Schulte Roth & Zabel
Under the Volcker Rule, a banking entity3 is generally barred from acquiring or retaining, as principal, an ownership interest in a “covered fund,” subject to certain exceptions. Further, a banking entity generally cannot sponsor a covered fund unless (i) it abides by a series of requirements or (ii) the sponsorship falls within an exception for non-US activities.
In November 2019, the Agencies finalized numerous amendments to the “proprietary trading” provisions of the Volcker Rule regulations, but only relatively minor changes to the “covered fund” provisions.4 The Agencies, however, stated that they would propose a separate rulemaking regarding the “covered fund” provisions (i.e., the Proposed Rule).
While the Proposed Rule does not offer sweeping changes, as many in the banking and fund industries would have preferred, it does proffer several important changes designed to eliminate aspects of the current Volcker Rule regulations (“Current Rule”) that were deemed to be unduly complex or burdensome, unnecessarily broad or the cause of unintended consequences.
While the Proposed Rule would retain the basic structure and principles of the Current Rule’s covered fund provisions, it would (1) add new exclusions for certain types of funds; (2) add additional flexibility for certain existing exclusions; (3) eliminate certain extraterritorial outcomes; (4) permit low-risk transactions with sponsored covered funds; (5)provide greater flexibility for debt relationships with covered funds; and (6) increase the ability to co-invest with sponsored covered funds.
The Proposed Rule would add four new exclusions to the definition of “covered fund” — credit funds, venture capital funds, family wealth management vehicles and customer facilitation vehicles — thereby exempting them from the scope of the Volcker Rule.
The Proposed Rule would exempt a fund whose assets consist solely of (1) loans; (2) debt instruments; (3) rights and other assets that are related or incidental to acquiring, holding, servicing or selling such loans or debt instruments5; and (4) certain interest rate or foreign exchange derivatives.6 Qualifying credit funds would not be able to engage in proprietary trading (as defined under the Current Rule) or issue asset-backed securities. The following criteria must also be satisfied for a banking entity to rely on the credit fund exclusion:
The Agencies are seeking comment regarding any quantitative limit on the amount of equity securities (or rights to acquire equity securities) held by the credit fund and the method for calculating such limit.
Venture capital funds
The Proposed Rule would exempt an issuer that meets the definition of venture capital fund in 17 CFR § 275.203(l)-1.7 A banking entity would only be able to invest in such funds to the extent the banking entity is permitted to engage in such activities under applicable law.8 The following criteria must also be satisfied for a banking entity to rely on the venture capital fund exclusion:
While not in the Proposed Rule, the Agencies are seeking comment on whether the exclusion should be limited to funds that do not invest in companies that, at the time of the investment, have more than a specified dollar amount of total annual revenue, calculated as of the last day of the calendar year (e.g., $50 million).
Family wealth management vehicles
The Proposed Rule would exempt an entity that 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 organized as a trust, the grantor(s) of the entity must all be family customers.9 If the entity is not organized as a trust, (i) a majority of the voting interests in the entity must be owned (directly or indirectly) by family customers; and (ii) the entity must be owned only by family customers and up to three closely related persons10 of the family customers. In addition, to rely on the family wealth management vehicle exclusion, a banking entity (or any affiliate of the banking entity) must also:
Customer facilitation vehicles
The Proposed Rule would exempt an issuer that is formed by or at the request of a customer of a banking entity for the purpose of providing such customer (which may include one or more affiliates of such customer) with exposure to a transaction, investment strategy or other services provided by the banking entity. A banking entity must also maintain documentation outlining how it intends to facilitate the customer’s exposure to such transaction, investment strategy or service. In order to rely on the customer facilitation vehicle exclusion, a banking entity (or any affiliate of the banking entity) must also satisfy each of the bullet points listed above for family wealth management vehicles, except the requirement to provide bona fide trust, fiduciary, investment advisory or commodity trading advisory services.
The Proposed Rule contains modifications to three existing covered fund exclusions — foreign public funds, loan securitizations and public welfare and small business funds — to simplify the eligibility criteria and make it easier for banking entities to use and confirm compliance with these exclusions.
Foreign public funds
Under the Proposed Rule, the foreign public fund exclusion would be modified to provide more consistent treatment between US registered investment companies (which are not covered funds) and their foreign equivalents.
A foreign public fund is a public fund organized and established outside the United States, provided that:
(a) It is authorized to offer and sell ownership interests to retail investors in its home jurisdiction; and
(b) It sells such interests “predominantly” through one or more public offerings outside the United States.
(c) For any US banking entity (or any non-US banking entity that is directly or indirectly controlled by a US banking entity) to rely on this exemption to sponsor a non-US public fund, the fund’s ownership interests must be sold “predominantly” to persons other than (i) the banking entity;(ii) the issuer;(iii) their affiliates or (iv) employees or directors of such entities.
“Predominantly” means 85% or more of the fund’s ownership interests.
A “public offering” is any distribution of securities in any jurisdiction outside the United States to investors, including retail investors, provided that the public offering must (i) comply with all applicable requirements in the applicable jurisdiction; (ii) not be restricted based on investor net worth; and (iii) include the filing of publicly available disclosure documents.
The home jurisdiction requirement in (a)would be removed. Authorization in any non-US jurisdiction will suffice. Moreover, the “predominantly” requirement in (b) would be removed. While the fund’s interests still must be offered and sold, through one or more public offerings, there is no outcome test.
For US banking entities (or any non-US banking entity that is directly or indirectly controlled by a US banking entity) that sponsor the fund, the “predominantly” requirement would remain in (c). However, ( iv) would be amended to only count interests held by senior executive officers and directors, instead of all employees and directors.
The definition of “public offering”would also bemodified to add a new requirement that the distribution be subject to substantive disclosure and retail protection laws or regulations.
The requirement that the distribution complies with all applicable requirements in the applicable jurisdiction would only apply to a banking entity that serves as the investment manager, commodity trading advisor, commodity pool operator or sponsor of the fund.
The Proposed Rule would amend two requirements of this exclusion, one of which would codify prior Agency guidance.
A loan securitization is an issuer of asset-backed securities provided that it holds only loans, certain rights and assets (“servicing assets”), and a small set of other financial instruments.
Would also permit a loan securitization to hold “any other assets,” provided that such other assets did not exceed 5% of the value of its total assets.
Clarifies that servicing assets may include assets other than securities, but any servicing assets that are securities must meet additional eligibility requirements.11
Public welfare and small business funds
The Proposed Rule does not make any modifications to the exclusion for public welfare funds,12 but does ask for comments on the public welfare fund exclusion. With respect to the exclusion for small business investment companies (“SBICs”), the Proposed Rule would make certain changes to clarify how the exclusion would apply to SBICs that surrender their licenses as part of wind-downs.
An SBIC is an issuer that holds a SBIC license from the Small Business Administration or has received a notice therefrom to proceed to qualify for a license, which notice or license has not been revoked.
Proposed Rule clarifies that exclusion would still be available if the SBIC voluntarily surrendered its license in accordance with 13 CFR § 107.1900 and does not make new investments (other than investments in cash equivalents) after such voluntary surrender.
Under the Current Rule, certain foreign funds that are organized and offered outside the United States are excluded from the definition of a covered fund. The Current Rule, however, has the unintended consequence of treating certain qualifying foreign excluded funds as “banking entities” if they are affiliates or subsidiaries of a foreign banking entity. As such, the funds themselves would be subject to the Volcker Rule, including its restrictions on proprietary trading and investing in covered funds.
To address this issue, the Agencies issued a moratorium on enforcement against a foreign banking entity if the qualifying foreign excluded fund met certain criteria.13 The Proposed Rule would codify this moratorium by exempting a foreign fund from the proprietary trading prohibition and restrictions on investments in the sponsorship of covered funds (and would not attribute the foreign fund’s activities to a foreign banking entity that invests in or sponsors the fund), so long as the fund is:
Further, to qualify for this exemption, a foreign banking entity’s acquisition or retention of any ownership interest in, or sponsorship of, the qualifying foreign excluded fund must meet the requirements for permitted covered fund activities and investments outside the United States (commonly referred to as the “SOTUS” exemption).
The Proposed Rule would permit a banking entity to enter into certain limited, low-risk transactions (currently prohibited by Super 23A) with covered funds it sponsors, manages or advises (or third-party covered funds, in which such related funds hold a “controlling” investment).
Banking entities generally are prohibited from entering into a transaction with a covered fund for which it serves as sponsor, investment manager, investment adviser, commodity trading advisor, or which it otherwise organizes or offers (or any other covered fund, in which such fund holds a “controlling” investment) if such transaction would be a “covered transaction” under Section 23A of the Federal Reserve Act, without regard to whether such transactions would generally be exempt from the limits, requirements or prohibitions under Section 23A by its own terms or by Regulation W, its implementing regulation. (These provisions of the Current Rule are commonly referred to as “Super 23A.”)
Proposed Rule would exempt from Super 23A:(i) covered transactions that would be permissible without limit for a state member bank to enter into with an affiliate under Section 23A of the Federal Reserve Act or Regulation W; and (ii) short-term extensions of credit (or asset purchases) in connection with payment, clearing and settlement transactions.
Any transaction or activity permitted by these exemptions in the Proposed Rule must comply with the Prudential Backstop Requirement.
The Agencies are proposing to clarify that a debt relationship with a covered fund would typically not constitute an “ownership interest” and, therefore, would not be subject to the Volcker Rule.14
An “ownership interest”is any equity or partnership interest, or any other interest, that exhibits certain features or characteristics on a current, future or contingent basis (such as the right to participate in the selection or removal of a fund’s general partner, managing member, directors, investment manager, etc.). Under the Volcker Rule, a debt interest in a covered fund can be an ownership interest if it has the same characteristics as an equity or other ownership interest.
Rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event, which includes the right to participate in the removal of an investment manager for cause or to nominate or vote on a nominated replacement manager upon an investment manager’s resignation or removal, would not be considered an ownership interest.
Any senior loan or other senior debt interest that meets all of the following characteristics would not be considered to be an ownership interest:
The Proposed Rule would add a new rule of construction to clarify that certain direct investments made by a banking entity alongside a covered fund should not be treated as an investment in the covered fund as long as certain conditions are met.
For any covered fund that a banking entity organizes and offers, (i) the aggregate investments of the banking entity and its affiliates cannot exceed 3% of the total number or value of that fund’s outstanding ownership interests (i.e., the “per-fund limit”); and (ii) the aggregate value of all covered fund ownership interests held by the banking entity and its subsidiaries cannot exceed 3% of the tier 1 capital of the banking entity (i.e., the “aggregate limit”).10
The preamble to the Current Rule provides that if a banking entity makes investments side by side in substantially the same positions as the covered fund, then the value of such investments shall be included for purposes of determining the value of the banking entity’s investment in the covered fund.
Further, the preamble notes that a banking entity that sponsored the covered fund should not itself make any additional side-by-side co-investment with the covered fund in a privately negotiated investment unless the value of such co-investment is less than 3% of the value of the total amount co-invested by other investors in such investment.
An investment by a director or employee of banking entity who acquires an ownership interest in his or her personal capacity in thecovered fund sponsored by the banking entity is attributed to the banking entity if the banking entity, directly or indirectly, extends financing for the purpose of enabling the director or employee to acquire the ownership interest in the fund and the financing is used to acquire such ownership interest in the fund.
A banking entity would not be required to include in the calculations for the per-fund limit and the aggregate limit any investment the banking entity makes alongside a covered fund (and is not restricted in the amount of any such investment) as long as the investment is made in compliance with applicable laws and regulations, including applicable safety and soundness standards.
Direct investments (whether a series of parallel investments or a co-investment) by a director or employee of a banking entity (or affiliate thereof) made alongside a covered fundi n compliance with applicable laws and regulations would not be treated as an investment by the director or employee in the covered fund and not be attributed to the banking entity as an investment in the covered fund, regardless of whether the banking entity arranged the transaction on behalf of the director or employee or provided financing for the investment.
This article was first published in The Banking Law Journal, published by LexisNexis.