On July 21, 2017,1 the Board of Governors of the Federal Reserve System (“the Board”), the Federal Deposit Insurance Corporation (the “FDIC”), and the Office of the Comptroller of the Currency (the “OCC,” and, together with the Board and the FDIC, the “Volcker Banking Agencies”) issued a statement (the “Guidance”)2 clarifying the agencies’ position with respect to certain foreign investment funds under the Volcker Rule.3
The Guidance provides for a one-year period4 during which the Volcker Banking Agencies will not take enforcement action against foreign banking entities on the basis of the attribution of activities or investments of certain “qualifying foreign excluded funds,” defined as discussed below, as long as certain conditions are met. The Volcker Banking Agencies are evaluating potential changes to the text of the final regulations implementing the Volcker Rule to address the problem permanently. However, the Guidance also warns that a permanent resolution of the problem, which arises from the Volcker Rule’s statutory definition of the term “banking entity,”5 may require Congressional action.
The Volcker Rule generally prohibits banking entities from engaging in proprietary trading or from acquiring or holding investments in certain “covered funds.”
It defines “banking entity” to include (1) an insured depository institution (“IDI”), (2) any company that controls an IDI, (3) any company treated as a bank holding company under the International Banking Act of 1978, and (4) any affiliate or subsidiary of any of the first three types.6
A “covered fund” is, subject to certain exceptions and exemptions, (1) an issuer that relies on section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 to avoid registration as an investment company,7 (2) a commodity pool under Section 1a(10) of the Commodity Exchange Act for which the commodity pool operator meets certain criteria,8 or (3) an entity organized or established outside the United States, for which ownership interests are offered and sold solely outside the United States, that is, or holds 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.9 In the case of this “third prong” of the Volcker Rule covered fund definition, the entity is only a covered fund with respect to a U.S. banking entity or banking entity controlled by a U.S. banking entity that sponsors or holds ownership interests in the fund.10
If an entity is a covered fund, it is excluded from the definition of a “banking entity.”11 But a fund that meets an exception or exemption from the covered fund definition is thus not a covered fund and therefore is not per se excluded from the definition of a “banking entity.” Many foreign excluded funds are controlled, for BHCA purposes, by virtue of their board structures, with directors selected by a banking entity, or by contractual provisions that create a “controlling influence” under the BHCA. A fund that is a foreign excluded fund and an affiliate or subsidiary of a banking entity12 is also a banking entity, and therefore is itself subject to the Volcker Rule’s prohibitions on proprietary trading and investment in covered funds within the United States.
For a hedge fund or private equity fund, such activities would often be significant activities of the fund. Thus, this definitional quirk of the Volcker Rule presents real problems for foreign banking entities that control foreign excluded funds – problems that the Volcker Banking Agencies have long been aware of and that they have now attempted to address, if only for one year.
The Volcker Banking Agencies had addressed the analogous problem with respect to foreign public funds, which, rather than being excluded from the covered fund definition, have their own exemption.13 A foreign public fund will not be treated by the Volcker Banking Agencies as a banking entity due to a control relationship with a banking entity as long as the banking entity “does not own, control, or hold with the power to vote 25 percent or more of the voting shares of the fund.”14
The Volcker Banking Agencies’ One-Year Solution
Under the Guidance, a two-step analysis is required to determine whether a foreign excluded fund receives relief: the fund must be a “qualifying foreign excluded fund,” and the banking entity’s relationship with the fund must fit within the terms of the exemption in the Volcker Rule allowing foreign banking entities to sponsor or invest in covered funds “solely outside the United States” (the “SOTUS” exemption).15
“Qualifying foreign excluded funds” are those funds that would be covered funds under the “third prong” of the covered fund definition if they were organized or established in the United States, and that are only classified as banking entities because of the foreign banking entity’s sponsorship of or ownership interest in the fund. The definition also requires that the fund be “established and operated as part of a bona fide asset management business,” 16 and that it not be operated in a manner that allows the foreign banking entity affiliate to evade the Volcker Rule.
Funds that are qualifying foreign excluded funds are eligible for relief under the Guidance only if the requirements of the SOTUS exemption would be met if the qualifying foreign excluded fund were a covered fund. (On its face, the SOTUS exemption only applies to covered funds.) The SOTUS exemption requires, among other things, that the foreign banking entity may not offer or sell ownership interests in the covered fund to a U.S. resident, and that its own investment or activity occurs solely outside the United States.17
It is important to note that the relief provided in the Guidance is a moratorium on enforcement and not a change of status. Controlled foreign excluded funds that qualify for the relief will formally remain banking entities during (and presumably after) the one-year period covered by the Guidance. The relief provided for foreign public funds, by contrast, is not time-limited.18
The Volcker Banking Agencies’ agreement on suspending any enforcement action against a foreign banking entity that controls a fund that therefore meets the banking entity definition, or against any such fund, should be a welcome development, but on its own timeframe is not a permanent solution. The Volcker Banking Agencies are constrained by the statutory language. While both houses of Congress may or may not pass an omnibus financial reform package in the second half of 2017 (though the House has passed one), sufficient consensus between the parties in Congress and the White House may exist to allow for the enactment of a set of smaller, more targeted financial reforms. Correcting the banking entity definition to prevent the unintended extraterritorial application of the Volcker Rule highlighted herein could be on Congress’s to-do list, in either case.