With the publication of proposed rules (Proposed Rules) to implement section 619 of the Dodd-Frank Act (DFA), the four federal agencies issuing the proposal (the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency (collectively, the Agencies)) delineated the contours of the Volcker Rule's prohibition on sponsoring and investing in private equity and hedge funds.
Among the provisions addressed in detail is one which has given asset managers affiliated with banks heartburn since the DFA was first enacted: the exemption from the general prohibition on sponsoring and investing in funds for banking entities "organizing and offering" funds meeting certain conditions. Will the implementing rule be so narrow as to destroy these businesses? Or will it take into account how investment advisory services are provided in the real world and allow bank-affiliated asset managers (BAAMs) to continue to provide their services to clients, in the manner that clients demand? The answer is a mixed bag. On the one hand, the Agencies have recognized and allowed for critical features of typical fund structures, such as the carried interest. On the other, compliance burdens, narrow employee investment rights, strict prohibitions on affiliate transactions and an investment limit below the current market standard could squeeze BAAMs, drive away talented personnel and lead customers to choose non-bank affiliated fund organizers in the future.
The Proposed Rules prohibit a banking entity from, "as principal, directly or indirectly, acquir[ing] or retain[ing] any ownership interest in or sponsor[ing] a covered fund," unless otherwise permitted under the Proposed Rules. However, a banking entity may organize and offer a fund where the following conditions apply:
- the banking entity provides bona fide trust, fiduciary, investment advisory, or commodity trading advisory services;
- the covered fund is organized and offered only to persons that are customers of such services;
- the banking entity complies with limitations on investments in covered funds;
- the banking entity complies with restrictions on certain transactions with covered funds;
- the banking entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of a covered fund;
- the covered fund does not use the name of the banking entity or the word “bank” in its title;
- only directors or employees directly providing advisory or other services to the covered fund are permitted to take an ownership interest in the fund; and
- the banking entity discloses to investors that losses in the covered fund will not be borne by the banking entity.
Below we look at how the Proposed Rules address some of the questions that most concern BAAMs in respect of the prohibition on fund investments and the exemption for organizing and offering funds.
Scope of the Prohibition on Fund Investments
The most important question for all BAAMS and similar bank-affiliated institutions is what the scope of the prohibition on investments by banking entities will be, prior to consideration of any exemptions. It is clear from the text of section 619 of the DFA that all “banking entities” – defined to include (i) any insured depository institution, (ii) any company that controls an insured depository institution, (iii) any company treated as a bank holding company for purposes of the International Banking Act of 1978 (which would include foreign banking organizations with branches or agencies in the United States), and (iv) any affiliate or subsidiary of any of the foregoing – will be subject to the prohibition. There are a few key terms in the language of the prohibition, quoted above, that must be unpacked to determine this scope. What does it mean to invest “as principal”? What is an “ownership interest”? And finally, what is a “covered fund”?
INVESTMENT “AS PRINCIPAL”
The “as principal” language qualifying the ban on a banking entity acquiring or retaining an ownership interest in a covered fund is new in the Proposed Rules, as compared to the original text of section 619, and is a welcome clarification that the ban does not extend to ownership interests that may be held by a banking entity in a custodial or other fiduciary capacity. The Agencies in their commentary indicate that under this language, acquiring or retaining an ownership interest in a covered fund in the following capacities would not be covered by the prohibition:
- by a banking entity in a fiduciary capacity (except when held by a trust that constitutes a company under the Bank Holding Company Act (the BHC Act));
- by a banking entity in its capacity as a custodian, broker or agent for an unaffiliated third party;
- by a retirement plan that is a “qualified plan” under section 401 of the Internal Revenue Code (if the ownership interest would be attributed to the banking entity solely by operation of the BHC Act’s definition of control); or
- by a director or employee of the banking entity who acquires the interest in his or her personal capacity, so long as the banking entity has not extended credit to the director or employee to acquire such ownership interest.
Of particular interest to asset managers is the confirmation that retirement plans affiliated with their (or other) banking institutions will continue to be able to invest their large pools of capital in hedge funds and private equity funds. Barring these retirement plans from investing in funds would remove from the pool of potential fund investors a major source of capital historically, and for the retirement plans themselves, impose a major limitation on the investments available to them.
While the “as principal” limitation serves to set some parameters on what investments might be attributed to a banking entity, and therefore restricted, the definition of “ownership interest” cuts in the opposite direction, sweeping broadly to include “any equity, partnership, or other similar interest (including, without limitation, a share, equity security, warrant, option, general partnership interest, limited partnership interest, membership interest, trust certificate, or other similar instrument) in a covered fund, whether voting or nonvoting, as well as any derivative of such interest.”
The breadth of the ownership interest definition is likely of more concern to banking entities in respect of structures and platforms outside of their traditional asset management businesses than to traditional asset managers. In particular, the Agencies indicate in their commentary that the definition is intended to focus on the “attributes of the interest,” including “whether it provides a banking entity with economic exposure to the profits and losses of the covered fund,” rather than its specific form, and whether the exposure is direct or “pursuant to a contract or synthetic interest.” In other words, derivatives providing synthetic exposure to a covered fund’s profits and losses will be picked up by this definition, which when combined with the broad definition of covered funds (see below), will sweep in structured products (and banking entities organizing them) well beyond what is traditionally thought of as hedge fund or private equity fund activity.
Of more direct interest to traditional asset managers is the fact that the Agencies have explicitly carved out from the definition of ownership interest so-called “carried interests” in funds, the means through which investment advisers of funds typically receive performance-based compensation. There are, however, conditions placed on the structure of the carried interest to qualify for the exclusion. In particular, (i) the “sole purpose and effect” of the interest must be to allow the banking entity (or its affiliate – it is not required that the investment adviser itself receive the carried interest) “to share in the profits of the covered fund as performance compensation” for its services, “provided that the covered banking entity … may be obligated under the terms of such interest to return profits previously received”; (ii) all profits in respect of the carried interest must be distributed when allocated, or if not immediately distributed, then the reinvested portion may not share in profits and losses of the fund; (iii) the banking entity may not provide funds to the covered fund in connection with acquiring the carried interest and (iv) the interest may not be transferable, except to an affiliate.
These conditions are generally consistent with the manner in which asset managers typically structure their carried interest. Nonetheless, the conditions do take away some flexibility in how the carried interest may be structured going forward. Further, it is unclear how investment advisers will show that the “sole purpose and effect” of a carried interest structure is to provide performance compensation, and this vague language has the potential to be used as a regulatory hook by the Agencies to object to any carried interest arrangement they do not like going forward.
In addition, it is not clear whether the language regarding return of profits received in respect of carried interests, under prong (i), is intended to be a requirement, or merely an acknowledgement of the clawback mechanisms that are already a common feature of fund structures. The latter would seem to be the better interpretation, given that the Proposed Rules say that the banking entity “may” be obligated to return such amounts, but confirmation of the Agencies’ intention on this point would be helpful to BAAMs in structuring funds going forward.
Prong (ii), requiring distribution of the carried interest while allocated or, alternatively, no reinvestment of such distributable funds if not distributed immediately, could affect escrow arrangements that are an aspect of many fund structures. The Proposed Rules contemplate that such funds may not be distributed immediately, but does not make clear the scenarios in which this would be permissible. As the Institutional Limited Partners Association’s Private Equity Principles become ever more popular, investors increasingly seek escrow arrangements to ensure funds are available for clawback of the carried interest as required, and this provision of the Proposed Rules draws into question how these arrangements could or should work. Would allowing the escrow amount to earn modest interest qualify as “sharing in the subsequent profits and losses of the fund,” and therefore be impermissible? Can escrow arrangements be set up at all? If BAAMs cannot offer escrow arrangements, investors may flee to non-bank affiliated asset managers.
Prongs (ii) and (iii) also raise potential concerns from a tax perspective. Under prong (ii), it is not clear whether "allocated" refers to profit allocation for tax or for economic purposes. Even in the case of pooled waterfall distribution mechanisms in which allocation and distribution in accordance with the waterfall occur only at the end of the fund's life, tax allocation occurs annually. Presumably the intention is to refer to allocation for economic purposes, but this should be clarified. Prong (iii) could prove problematic from a tax perspective because it is questionable whether an entity can be considered a "partner" of a fund if it makes no contribution whatsoever. Often the specific banking entity that is to receive the carried interest will contribute a de minimis amount to the fund for this reason. The Agencies should clarify that such a de minimis contribution for tax purposes will continue to be permissible.
“Covered fund” as defined in the Proposed Rules encompasses the terms “hedge fund” and “private equity fund” as defined in the Volcker Rule and includes any issuer that would be an investment company, as defined in the Investment Company Act of 1940 (the Investment Company Act), but for section 3(c)(1) or 3(c)(7) of that Act. The Agencies have additionally designated commodity pools, as defined under the Commodity Exchange Act, and foreign equivalents of covered funds – i.e., “any issuer … that is organized or offered outside the United States that would be a covered fund … were it organized or offered under the laws, or offered to one or more residents, of the United States or of one or more States” – as covered funds for the purposes of the Proposed Rules. As we have observed previously, this definition could sweep in many entities not colloquially understood to be hedge funds or private equity funds, which (like the broad definition of “ownership interest”) could be a major concern for banking entities not engaged in asset management in the traditional sense, including potentially certain activities related to collateralized loan obligations and other securitization products (a point we will explore in greater detail in a future e-Alert). For traditional asset managers, the aspect of this definition likely to have the largest impact is the Agencies’ inclusion, based on their powers to designate similar funds, of commodity pools and foreign equivalents. These additions are logical, given the Volcker Rule’s apparent purpose of limiting banking entities’ exposure to risky activities (such activities can be equally risky whether undertaken in commodities or securities, or inside or outside the US), but nonetheless expand the range of funds covered by the prohibition (and the exemptions thereto). As discussed in our previous e-Alert, the inclusion of foreign equivalents would also further expand the extraterritorial effects of the Volcker Rule for foreign banks.
Scope of Permissible Fund Investments
The second question for BAAMs is the scope of permissible investment in a covered fund under the exemption for organizing and offering such funds. The text of section 619 of the DFA is clear that such investments must be limited to seed money to establish the fund and attract investors, which must within one year be reduced to three percent of the total ownership interests of the fund, and from that time the aggregate of the banking entity’s investments in covered funds may not exceed three percent of the banking entity’s Tier 1 capital. But what will be included in “investments”? How will total ownership interests be measured? And how will Tier 1 capital be calculated for banking entities not already required to make such calculations?
WHAT COUNTS TOWARD PERMITTED INVESTMENT LIMITS
The Proposed Rules provide that a banking entity’s permitted investment in a covered fund includes (i) “any ownership interest held under [the section of the Proposed Rules exempting investments in funds organized and offered by a banking entity from the general prohibition] by any entity that is controlled, directly or indirectly, by the covered banking entity for purposes of this part” and (ii) “the pro rata share of any ownership interest held under [such section] by any covered fund that is not controlled by the covered banking entity but in which the covered banking entity owns, controls, or holds with the power to vote more than 5 percent of the ownership interests.”
While the intention seems to be that investments that are not included in the general prohibition by virtue of the “as principal” language, as discussed above, should not count toward the banking entity’s investments for the purposes of the single fund limitation, there is some concern that the reference to holdings by “any entity that is controlled, directly or indirectly, by the covered banking entity” could inadvertently pick up qualified plans, which may be considered controlled by a banking entity by virtue of Section 2(g)(2) of the BHC Act. The Agencies should clarify in the final rule that investments by these entities are not included.
With respect to the pro rata prong, the threshold of five percent is very low. While this threshold is consistent with the general BHC Act presumption of non-control when a financial institution holds less than five percent of any class of voting securities of a company, in this case inclusion in permitted investments is mandatory, not merely a presumption that could lead to a determination of control when combined with other factors. The compliance burden on firms to monitor ownership interests at such a low percentage may be significant.
In addition to the above, the Proposed Rules provide that co-investments alongside a covered fund in the same underlying investment will be counted toward the three percent limitation on the banking entity’s investment in that covered fund. Specifically, such investments of a banking entity are counted toward the limitation if the banking entity is “contractually obligated” to make the investment, or if it is “found to be acting in concert through knowing participation in a joint activity or parallel action toward a common goal of investing in” the investment with the covered fund.
The Agencies’ commentary further indicates that, in order to prevent banking entities from using the provision of the exemption allowing certain directors and employees of a fund to invest as a backdoor means for the banking entity to invest beyond the single fund investment limitation, if such a director or employee investment is supported by an extension of credit from the banking entity to the employee, if the banking entity provides a guarantee to the fund of the employee’s commitment or if the banking entity provides a guarantee to the employee against loss, the investment will be attributed to the banking entity.
CALCULATION OF THE SINGLE FUND LIMITATION
The single fund limitation must be applied in respect of both the value of all capital contributions made to the covered fund and the total number of ownership interests held by investors in the covered fund – but, interestingly, not on amounts of committed (but not yet contributed) capital. In addition, the banking entity’s investment may not result in more than three percent of the losses of the covered fund being allocable to the banking entity’s investment. The calculation must be made in the same manner and according to the same standards used by the covered fund for determining the aggregate value of the fund’s assets and ownership interests. It must be made no less frequently than the fund performs such calculation, and at least quarterly.
CALCULATION OF THE AGGREGATE LIMITATION
The Proposed Rules propose various methods of calculating a banking entity’s Tier 1 capital, depending on the type of banking entity in question:
- For a banking entity that already reports Tier 1 capital, the calculation of the aggregate fund investment limitation will look to the Tier 1 capital reported to the relevant Federal banking agency as of the last day of the most recent calendar quarter.
- For a banking entity that is not itself required to report Tier 1 capital but is a subsidiary of a reporting banking entity that is a depository institution (e.g., a subsidiary of a national bank), the calculation of the aggregate fund investment limitation will apply the amount of Tier 1 capital reported by such depository institution.
- For a banking entity that is not itself required to report Tier 1 capital but is a subsidiary of a reporting bank entity that is not a depository institution (e.g., a nonbank subsidiary of a bank holding company), the aggregate fund investment limitation will apply the amount of Tier 1 capital reported by the top-tier affiliate of such banking entity that holds and reports Tier 1 capital.
- For a banking entity not fitting any of the above categories, the Tier 1 capital will be the total amount of the shareholders' equity of the top-tier entity within such organization as of the last day of the most recent calendar quarter, as determined under applicable accounting standards.
Coming out of all of the above, the major questions for BAAMs are whether, in the aggregate, these limitations on investments will be significant enough to (i) fundamentally undermine their business model or (ii) influence customers to leave BAAMs.
On the first point, the single fund and aggregate limitations will no doubt reduce the amount of gains banking entities are able to make on fund investments. With the inclusion of co-investments in the single fund limitation, the differential between what banking entities were previously able to earn and what they can earn now will be even larger. In addition, a number of factors can change the value of the banking entity’s fund investments, both in dollar terms and as a percentage of overall fund investments or Tier 1 capital, throughout the life of the fund, including a change in value of underlying assets, redemptions by other fund investors, defaults on capital calls by some fund investors, exercise of excuse mechanisms allowing certain investors to opt out of investments of specified types, currency fluctuation and fluctuation in the banking entity’s own Tier 1 capital levels. In order to ensure compliance on an ongoing basis, banking entities will have to set their initial investment levels well below the officially permissible threshold, perhaps closer to two percent. It is also unclear under the Proposed Rules what actions should be taken by a banking entity to bring itself into compliance when it falls out of compliance due to a change in one of these factors. Particularly in the case of funds investing in illiquid assets, it may be difficult for a banking entity to redeem its interests on economically favorable terms. The penalties for failure to comply – both in the case of the permitted investments limitation and throughout the Proposed Rules – are also unclear.
A related point arises in respect of the limitations on employees’ ability to invest. First, a significantly smaller number of employees will be eligible to invest – now only those “directly engaged in providing investment advisory or other services” to the particular covered fund in which they are investing, whereas previously the much broader pool of “knowledgeable employees” as defined under the Investment Company Act could invest. Second, for those that are permitted to invest, banking entities are unlikely to be willing to provide any credit support whatsoever for such investments, for fear of such investments counting toward the banking entity’s own investment limitations. These limitations have the potential to drive the best and the brightest out of banks and into independent hedge funds and private equity funds that do not impose such limitations.
There are also good reasons customers could decide to opt instead for independent asset managers. First, customers will have to weigh their trust in the major financial institutions, on the one hand, against the larger chunk of “skin in the game” that independent asset managers can offer, on the other, in deciding who to entrust with their investments, and it is difficult to say where they will come out. Second, as with many aspects of the exemption for organizing and offering a covered fund, the compliance burden to make the required calculations and keep adequate records will be significant, and banking entities are likely to find ways to pass the cost of compliance on to their customers as a fund expense. Increased fund expenses could prove to be another factor driving investors toward independent asset managers.
"BONA FIDE" INVESTMENT ADVISORY SERVICES AND "CUSTOMERS" OF SUCH SERVICES
As noted above, in order to permissibly organize and offer a fund, the banking entity must provide bona fide trust, fiduciary, investment advisory, or commodity trading advisory services and the covered fund must be organized and offered only to persons that are customers of such services. This double-pronged requirement raises questions as to both what constitutes a "bona fide" service and who qualifies as a "customer of such service."
The Proposed Rules are generally helpful to BAAMs on both fronts. The Agencies’ commentary recognizes the “wide range” of investment advisory and related services offered by banking entities and the “potential variations” in such services, and indicates that the language is kept general to provide for such variation. In addition, the Proposed Rules do not require that investors be preexisting customers of the banking entity; rather, the customer relationship may be established by the investor’s investment in the covered fund (and thereby utilization of the services the banking entity is providing to the fund). However, a potential problem arises from deeming investors to be “customers” by virtue merely of their investment in a fund utilizing the banking entity’s investment advisory services. Under the Investment Advisers Act of 1940 (the Advisers Act), it is generally understood that the client of the investment adviser is the fund itself, not the individual investors – and this is the relational arrangement preferred by asset managers, because if each investor were a client, further noncontractual duties under the Advisers Act would be owed to each of them. Does stipulating that investors are “customers” for purposes of the Volcker Rule suggest a shift in the way investors will be viewed for purposes of the Advisers Act as well? Is there potential for confusion in deeming investors to be “customers” for one regulatory purpose, but not “clients” for another?
Problems mount with the Proposed Rules' requirement that such services be offered to customers “pursuant to a credible plan or similar documentation outlining how the covered banking entity intends to provide advisory or similar services to its customers through organizing and offering” the fund. This language again reinforces the notion that each investor is a direct customer of the banking entity. In addition, it is unclear what the required documentation will entail. Will offering memoranda, already typically prepared by investment advisers in respect of their funds, providing details of investment strategy as well as the services to be provided and fees to be paid to the investment adviser (but replete with disclaimers and risk warnings advising investors to seek independent counsel on the investment), among other matters, be sufficient? Or will the Agencies require a separate document in a prescribed form? The answer to this question will be critical, since the former would impose little, if any, additional burden on asset managers, while the latter would add yet another layer of documentary compliance to an already complex regulatory regime.
Restriction on Affiliate Transactions
The Proposed Rules prohibit a banking entity that serves as an investment manager, investment adviser, commodity trading adviser or sponsor to a covered fund, or that organizes or offers a covered fund pursuant to the conditions described above, from engaging in certain transactions with a covered fund that would be “covered transactions” under section 23A of the Federal Reserve Act (FR Act). The language of the DFA is ambiguous as to whether the intention is to apply the quantitative and qualitative restrictions on covered transactions in the FR Act to such transactions, or to prohibit them entirely. The Proposed Rules come down solidly and clearly on the side of prohibition. In other words, no affiliate within a bank holding company group may extend credit, purchase assets or engage in similar activities that would fall within the definition of “covered transactions” with a covered fund managed or advised by it or any other entity within the bank holding company group (unless otherwise exempted as discussed below). This prohibition goes way beyond the traditional scope of section 23A, which applies its quantitative and qualitative restrictions – not prohibition – only to covered transactions between depository institutions and their affiliates. In addition, while section 23A gives the agencies responsible for administering it exemptive powers for specific transactions, no similar power is granted to the Agencies under section 619 of the BHC Act.
The Proposed Rules do provide for certain exceptions to the general prohibition on covered transactions between covered funds and the banking entities that advise, manage, sponsor or invest in them. The restriction does not bar a banking entity from acquiring or retaining ownership interests in covered funds that are otherwise permissible under the Proposed Rules. In addition, banking entities may enter into “prime brokerage transactions” with covered funds, so long as they meet the requirements for organizing and offering such funds and such transactions are conducted on an arms-length basis consistent with section 23B of the FR Act. The Proposed Rules provide additional clarity on what is considered a “prime brokerage transaction,” defining it to mean one or more products or services provided by a banking entity to a covered fund, such as custody, clearance, securities borrowing or lending services, trade execution or financing data, operational, and portfolio management support. Finally, because “covered funds” themselves are excluded from the definition of “banking entity,” this provision will not prohibit transfer of assets between parallel funds, nor will it prevent fund-of-fund structures that otherwise comply with the Proposed Rules.
This prohibition could have significant effects on the asset management businesses of banking entities. In particular, to the extent that BAAMs have historically looked to their affiliates to provide support beyond prime brokerage, including, for example, extensions of so-called “subscription line” credit facilities to facilitate smooth investment processes for funds, those avenues will no longer be available. In addition, under changes to section 23A of the FR Act, derivative transactions will be considered covered transactions under section 23A, making any derivative arrangements between a covered fund and any affiliate of the investment adviser subject to the prohibition. This is one area of the Proposed Rules that simply levels the playing field as between bankaffiliated and independent asset managers, in that it does not allow BAAMs to rely on its affiliated institutions for this support. Nonetheless, for BAAMs accustomed to relying on these relationships to efficiently address fund needs, the changes necessitated by the prohibition on covered transactions may be painful.
The Proposed Rules are walking a narrow path between a tough, but administrable regime in which banking entities will have sufficient (if tight) space to continue to conduct their asset management businesses, and constraints so tight that, due to a combination of diminished profits, increased compliance burden and employee and investor flight to the more open spaces of funds offered by independent asset managers, these businesses will suffocate. Of most concern to BAAMs are likely the Proposed Rules' investment limitations and questions surrounding what counts toward those limitations, the burden of compliance with the Proposed Rules' requirements for calculation of investment limits and documentation of services provided to customers and the breadth of the prohibition on transactions with affiliates. There is good news, however: the scope of the Volcker Rule’s exemption for organizing and offering covered funds is not yet fully settled. The Proposed Rules put to the public open questions on every aspect of the proposal, including those discussed above. While BAAMs cannot eliminate the Volcker Rule entirely, they do have the opportunity to push for more breathing room around the edges. The comment period ends on January 13, 2012.