On Jan. 30, 2020, the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the U.S. Securities and Exchange Commission and the U.S. 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.”
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 at https://www.federalreserve.gov/aboutthefed/boardmeetings/files/volcker-rule-fr-notice-20200130.pdf. Comments are due by April 1, 2020.
The day the Proposed Rule was approved, we published an Alert that provided an executive summary. This Memorandum supplements that Alert by examining each of the Proposed Rule’s provisions in detail.
Under the Volcker Rule, a banking entity 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-U.S. 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. 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.
New Categories of Funds Would Be Made Exempt
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 instruments; and (4) certain interest rate or foreign exchange derivatives. 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:
- If the banking entity sponsors or serves as investment manager or commodity trading advisor to the fund, the banking entity must (i) provide certain disclosures to prospective and actual investors as if the fund were a covered fund (“Disclosure Requirement”); and (ii) ensure that the activities of the fund are consistent with safety and soundness standards;
- The banking entity must not, directly or indirectly, guarantee, assume or otherwise insure the obligations or performance of the fund or of any entity to which the fund extends credit or in which such fund invests (“Anti-Guarantee Requirement”);
- Any debt instruments or equity securities (or rights to acquire equity securities) that the fund holds must be among those the banking entity would be permitted to acquire and hold directly;
- The banking entity must comply with (i) the “Super 23A” prohibitions of the Current Rule and (ii) the requirements of Section 23B of the Federal Reserve Act as if the fund were a covered fund (“Transaction Restrictions”); and
- The banking entity’s investment in, and relationship with, the fund must comply with the rules regarding material conflicts of interest, high-risk investments, safety and soundness and financial stability as if the fund were a covered fund (“Prudential Backstop Requirement”) and be conducted in compliance with, and subject to, applicable banking laws and regulations, including applicable safety and soundness standards.
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. 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. The following criteria must also be satisfied for a banking entity to rely on the venture capital fund exclusion:
- The fund must not engage in proprietary trading (as defined under the Current Rule);
- If the banking entity sponsors or serves as investment manager or commodity trading advisor to the fund, the banking entity must (i) satisfy the Disclosure Requirement and (ii) ensure that the activities of the fund are consistent with safety and soundness standards;
- The banking entity must satisfy the Anti-Guarantee Requirement;
- The banking entity must comply with the Transaction Restrictions; and
- The banking entity’s investment in, and relationship with, the fund must satisfy the Prudential Backstop Requirement and applicable banking laws and regulations, including applicable safety and soundness standards.
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. 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 persons 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:
- Provide bona fide trust, fiduciary, investment advisory or commodity trading advisory services to the entity;
- Satisfy the Disclosure Requirement;
- Satisfy the Anti-Guarantee Requirement;
- Not acquire or retain, as principal, an ownership interest in the entity, other than up to 0.5% of the entity’s outstanding ownership interests that may be held by entity and its affiliates for the purpose of and to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency or similar concerns;
- Comply with the requirements of section 23B of the Federal Reserve Act as if the entity were a covered fund;
- Comply with the requirements of section 23A of the Federal Reserve Act regarding the prohibition on purchases of low-quality assets as if such banking entity and its affiliates were a member bank and the issuer were an affiliate thereof (but not the requirements of Super 23A of the Current Rule); and
- Satisfy the Prudential Backstop Requirement.
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.
Certain Existing Exemptions Would Be Made More Available
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 U.S. registered investment companies (which are not covered funds) and their foreign equivalents.
The Proposed Rule would amend two requirements of this exclusion, one of which would codify prior Agency guidance.Loan Securitizations
Public Welfare and Small Business Funds
The Proposed Rule does not make any modifications to the exclusion for public welfare funds, 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.
Foreign Excluded Funds Would Be Granted Permanent Relief from Potential Extraterritoriality
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. 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:
- Organized or established outside of the United States and does not offer or sell its ownership interests in the United States;
- Structured such that it (i) would be a covered fund if it were organized or established in the United States or (ii) raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;
- Only a banking entity on account of the foreign banking entity’s ownership interest in, or sponsorship of, the fund;
- Established and operated as part of a “bona fide asset management business”; and
- Not operated in a way that allows the foreign banking entity to evade the requirements of the Volcker Rule.
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 Limits on a Banking Entity’s Transactions with Related Covered Funds Would Be Relaxed
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).
The “Ownership Interest” Definition Would Be Modified to Exclude Certain Debt Relationships
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.
Parallel Investments and Co-Investments
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.