The so-called Volcker Rule included in the Dodd-Frank Act will significantly limit the ability of financial institutions to invest in or sponsor hedge funds or private equity funds, effectively undoing much of the flexibility that was created under the Gramm-Leach-Bliley Act. One result may be a renewed prominence for small business investment companies (SBICs) as one of the only remaining vehicles for banking entities to engage in such activities.
The Volcker Rule is embodied in Section 619 of the Financial Reform Act, which adds a new Section 13 to the Bank Holding Company Act. The starting point for the Volcker Rule is a broad prohibition against any banking entity:
- engaging in proprietary trading, or
- having an ownership interest in or sponsoring a hedge fund or private equity fund.
The prohibitions of the Volcker Rule apply to any “banking entity,” which is defined to include an insured depository institution, any company that controls an insured depository institution, any entity that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 and any affiliate or subsidiary of any such entity.
In addition, certain nonfinancial institutions determined to be systemically significant may be subject to additional capital requirements and quantitative limits as established by regulation in connection with the types of activities covered by the Volcker Rule.
The Volcker Rule goes into effect on the earlier of 12 months after adoption of regulations implementing the Volcker Rule, or two years after the date of enactment. Once the Volcker Rule goes into effect, there will be divestiture periods, within which banking entities must bring their activities into compliance.
For banking entities looking to organize and offer a private equity or hedge fund as a product for their clients, there is an exception that allows such activity if the banking entity provides bona fide trust, fiduciary or investment advisory services, and the fund is organized and offered in connection with the provision of those services and only to persons that are customers of such services of the banking entity. In this context, the sponsoring banking entity may serve as a general partner, managing member or trustee of the fund and may select or control (or have employees, directors or agents who constitute) a majority of the directors, trustees or management of the fund. The organizing banking entity may provide seed capital to the fund, but the amount of all such investments cannot exceed 3 percent of Tier 1 capital at any time (or such lower limit as may be set by regulation as an “immaterial” amount), and within one year after establishing the fund the investment of the institution must be below 3 percent of the total ownership interests of the fund. In addition, there are a number of restrictions on the relationship between the banking entity and the fund.
For banking entities looking to invest in private equity or hedge funds for their own account, the Volcker Rule leaves little authority. Thus, the Volcker Rule not only rolls back the ability to use the merchant banking authority added by the Gramm-Leach-Bliley Act for investments in private equity or hedge funds, it also overrides in this context the authority under Section 4(c)(6) of the Bank Holding Company Act to invest in equity securities representing less than 5 percent of any class of voting stock, which is often relied on by bank holding companies to make limited partner investments.
However, subject to any restrictions or limitations that may be imposed by regulation, an exception to the Volcker Rule is provided for investments in one or more SBICs to the extent otherwise permitted, and accordingly SBICs can be expected to take on renewed significance for banking entities. Under the SBIC Act and related provisions, banks and bank holding companies are generally permitted to invest in SBICs up to five percent of their capital and surplus.
The Volcker Rule exception also covers investments designed primarily to promote public welfare as described in paragraph (11) the National Bank Act, or investments under certain historic tax credit programs.
The ultimate effect of the Volcker Rule will depend on the coordinated regulations that come out of the required rulemaking process. Key matters left to the regulators to determine include:
- any further exceptions to the prohibitions of the Volcker Rule
- additional capital requirements and/or quantitative limitations to be imposed on any activities permitted as an exception under the Volcker Rule
- possible limitations on the statutory exceptions to the Volcker Rule, including to address material conflicts of interest, material exposure to high-risk assts or trading strategies; and threats to the safety and soundness of the banking entity or to the financial stability of the United States.
Given the political climate and the statutory directives that will guide the regulations under the Volcker Rule, there may not be much hope for dramatic liberalization through the rule-making process. And pending the outcome of the rule-making process, fund raising and new fund formation may be significantly affected as banking entities may be reluctant to commit new funds to any private equity or hedge funds. But it seems likely that SBICs will be an important tool for banking entities under the new framework.