On December 12, 2016, the Board of Governors of the Federal Reserve System (the FRB) released its Statement of Policy Regarding Illiquid Fund Investments Under Section 13 of the Bank Holding Company Act (the SOP)

and SR Letter 16-18 (collectively, the Guidance) clarifying how banking entities may request additional time to divest or conform their investments in certain illiquid funds to the Volcker Rule. The Guidance establishes that the FRB will follow a streamlined process to determine whether a banking entity meets the FRB's standards for granting a one-time extension of up to five years. Banking entities that desire to take advantage of this additional time to bring their illiquid investments into compliance must act quickly to ensure they meet the January request deadline.

The Volcker Rule generally prohibits banking entities from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a covered fund, subject to certain exemptions. The FRB has permitted banking entities until July 21, 2017 to conform with the Volcker Rule's requirements. Market participants, as described in the SOP, have argued that investments in illiquid funds present especially difficult challenges to conforming with the Volcker Rule. Specifically, illiquid funds are largely private equity, real estate, and venture capital funds that support start-up companies and long-term real estate development, and that require the commitment of funds for a specified and extended term, after which the fund is liquidated. Market participants also argue that difficulties exist in exiting sponsored funds and terminating contractual relationships.

Due to the nature of banking entities' investments in legacy illiquid funds and to avoid market disruption, Congress authorized the FRB to provide an additional transition period to conform such investments, which are defined generally as hedge funds or private equity funds that are principally invested in illiquid assets and hold themselves out as employing strategies to invest principally in illiquid assets. Importantly, the extension period is only available to banking entities whose retention of ownership interest in the fund, or provision of additional capital to the fund, is necessary to fulfill a contractual obligation of the banking entity that was in effect on May 1, 2010.

Extension Request Requirements. The Guidance outlines the requirements for filing a request for an extended transition period for illiquid funds, which generally include:

  • a list or simple chart of illiquid funds for which an extension is sought;
  • a short description of each fund;
  • a description of the banking entity's specific efforts to divest or conform its illiquid funds;
  • a certification by the General Counsel or Chief Compliance Officer of the entity that sponsors or invests in the illiquid funds that each fund meets the definition of illiquid funds and that the extension is necessary; and
  • the length of the requested extension and the banking entity's plan for divesting or conforming each illiquid fund prior to the end of such extension period.

Extension Request Standards. The FRB stated that it expects that the illiquid funds of banking entities will generally qualify for extensions, though extensions may not be granted in certain cases, such as where the banking entity has not demonstrated meaningful progress to conform or divest its illiquid funds, has a deficient compliance program under the Volcker Rule, or where the FRB has concerns about evasion. The Federal Reserve Banks have been delegated the authority to grant extension requests and will apply the following standards:

  • the extension request relates only to illiquid funds;
  • no significant issues have been identified regarding the banking entity's compliance program;
  • the banking entity's primary federal regulator tasked with ensuring compliance with the Volcker Rule does not object to the extension;
  • the banking entity has made meaningful progress toward conforming the majority of its covered fund investments as of the date of the request; and
  • the banking entity provides supporting information regarding its efforts to conform the illiquid funds for which an extension is being sought.

Timing. The Guidance states that a banking entity must submit extension requests at least 180 days prior to the expiration of the general conformance period of July 21, 2017 (i.e., January 22, 2017). Extensions will be granted for the shortest of: (i) five years from the date of the expiration of the general conformance period; (ii) the date by which each remaining fund is expected to mature by its terms or be conformed to the Volcker Rule; or (iii) a shorter period determined by the FRB. Requests should be made to the Federal Reserve Bank by the top-tier banking entity in the district where it is headquartered, and the banking entity must provide a copy of the request to the primary federal regulator of any of its subsidiaries, to the extent it is not the FRB. The Federal Reserve Banks are expected to act on an extension request within 30 days of receiving all required information.

Strategic Considerations

The timing of the FRB's guidance presents specific challenges and considerations. First, the banking entity must evaluate whether its illiquid investments meet the standards prescribed in the guidance and whether it would benefit from an extension. If so, it must quickly compile the information required by the Guidance and draft an extension request by January 22, 2017.

It is possible that the Volcker Rule will be repealed by Congress prior to July 21, 2017. The House Financial Services Committee, under the leadership of Chairman Jeb Hensarling, is expected to advance the Financial CHOICE Act of 2016, H.R. 5983, early in 2017. That Bill contains a provision repealing the Volcker Rule, including its prohibition on banking entities owning interests in covered funds. Banking entities that currently own illiquid covered funds acquired prior to May 1, 2010 should nonetheless promptly seek a five-year extension of the divestiture period from the FRB under the new guidelines.