On December 10, 2013, the U.S. Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and the Securities and Exchange Commission issued final rules implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, also known as the “Volcker Rule.”
While the final rules clarify a number of important questions regarding implementation of the Volcker Rule, they also serve to distinguish investment companies registered under the Investment Company Act of 1940, as amended (the 1940 Act), as well as closed-end funds that have elected to be treated as a business development company, or BDC, under the 1940 Act, from traditional private funds that rely on exemptions from registration under the 1940 Act. The final rules also exempt small business investment companies, or SBICs, from the definition of covered fund, thus providing BDCs with the possibility of pursuing SBIC licenses either for the BDCs themselves or for their subsidiaries. In doing so, the final rules arguably create incentives for insured depository institutions and their affiliates to seek opportunities to sponsor, invest in, and potentially manage registered investment companies and BDCs.
The Volcker Rule, which is intended to curb potentially risky bank practices, generally prohibits insured depository institutions and their affiliates, typically referred to as “banking entities,” from:
- Engaging in short-term proprietary trading, or
- Investing in, or having certain relationships with, hedge funds and private equity funds, referred to as “covered funds” under the Volcker Rule.
The Volcker Rule effectively seeks to prohibit banking entities, directly or indirectly, from acquiring or retaining an ownership interest in covered funds. Under the Volcker Rule, covered funds include:
- An issuer that would be an investment company under the 1940 Act, but for an exclusion set forth under 3(c)(1) or 3(c)(7) of the 1940 Act,
- Certain commodity pools, and
- Funds organized outside of the United States that are sponsored by a U.S. banking entity or in which a U.S. banking entity is an investor.
However, the final rules specifically exclude registered investment companies, as well as BDCs and SBICs, from the scope of the term “covered fund” for purposes of the Volcker Rule, since Section 619 only references funds that rely on Sections 3(c)(1) or 3(c)(7) of the 1940 Act. In addition, the final rules clarify that neither registered investment companies nor BDCs will be considered “affiliates” of a banking entity so long as that banking entity:
- Does not own, control, or hold the power to vote 25% or more of the voting shares of the registered investment company or BDC; and
- Provides investment advisory, commodity trading advisory, administrative, and other services to the registered investment company or BDC in compliance with the limitations under applicable regulation, order, or other authority.
As a result, a banking entity generally may invest in a registered investment company or BDC, including one that potentially engages in activities subject to restriction under the Volcker Rule so long as that banking entity does not hold the power to vote more than 25% of such registered investment company or BDC’s voting shares, provided that it is otherwise permitted to do so under applicable banking law. Likewise, a banking entity may manage such a registered investment company or BDC, so long as it does so in compliance with applicable securities and banking law, including the Bank Holding Company Act of 1956, and the applicable provisions under the 1940 Act and the Investment Advisers Act of 1940, in each case as amended.
While registered investment companies and BDCs remain subject to substantial regulation under the 1940 Act, including limits on the use of leverage, the above benefits may provide potential opportunities for banking entities to sponsor, invest in, and manage investment vehicles with attributes and investment objectives similar to the types of hedge funds and private equity funds that would otherwise be subject to restriction under the Volcker Rule.