On January 30, 2020, five federal financial regulators jointly issued a proposed rule that would modify existing regulations implementing the Volcker Rule’s general prohibition on banking entities investing in, sponsoring, or having certain relationships with hedge funds or private equity funds (collectively, “covered funds”). The proposal, which follows a 2019 final rule revising the Volcker Rule’s proprietary trading provisions, is intended to simplify the covered fund provisions, and permit banking entities to engage in additional fund-related activities that do not present the risks that the Volcker Rule was intended to address.
1. The proposal would add four new regulatory exclusions to the definition of “covered fund” for credit funds, venture capital funds, family wealth management vehicles, and customer facilitation funds
The most significant aspect of the proposal is the addition of four new exclusions from the definition of “covered fund,” each of which would be subject to several key restrictions. According to the preamble to the proposal, these exclusions are intended to address the potential over-breath of the current “covered fund” definition. Specifically, the proposal would exclude:
- Credit funds, defined as funds whose assets consist solely of loans, debt instruments, and related or incidental assets (including certain interest rate and foreign exchange derivatives). To be eligible for the exclusion, the credit fund could not engage in proprietary trading, could not hold assets that a banking entity is not permitted to hold directly, and could not issue asset-backed securities. In addition, a banking entity that invests in the credit fund must (i) not guarantee the performance of the fund, (ii) comply with the so-called “Super 23A” and “Super 23B” prohibitions on the banking entity’s covered transactions with the fund, and other affiliate transaction limits, and (iii) where the banking entity sponsors or serves as investment advisor to the fund, make certain disclosures to investors.
- Venture capital funds, defined by existing SEC regulations to refer to private funds that represent to investors that they pursue a venture capital strategy, primarily invest in qualifying portfolio companies (defined to cover the typical characteristics of investments made by venture capital funds, as opposed to private equity funds or hedge funds), limit investors’ withdrawal rights, and limit their use of leverage, among other limitations. To be eligible for the exclusion, the venture capital fund could not engage in proprietary trading, and any banking entity that invests in the venture capital fund would be required comply with the same guarantee, affiliate transaction, and disclosure requirements that would apply to credit funds.
- Family wealth management vehicles, defined as funds owned only by members of a single family and no more than three closely related persons of the family customers. A banking entity would be permitted to maintain an ownership interest of up to a 0.5 percent in the vehicle if necessary in order to establish corporate separateness. To be eligible for the exclusion, a banking entity must (i) provide bona fide trust, fiduciary, or advisory services to the vehicles, (ii) comply with “Super 23B” prohibitions on the banking entity’s covered transactions with the fund, and other affiliate transaction limits, (iii) not purchase low-quality assets from the vehicle, and (iv) comply with the same guarantee and disclosure requirements that would apply to credit funds.
- Customer facilitation funds, defined as funds that facilitate transactions between the banking entity and a single customer, and typically take the form of structured finance and synthetic SPVs. A banking entity would be permitted to maintain an ownership interest of up to a 0.5 percent in the fund if necessary in order to establish corporate separateness. To be eligible for the exclusion, a banking entity must (i) document how the banking entity intends to facilitate the customer’s exposure to the transaction, (ii) comply with “Super 23B” prohibitions on the banking entity’s covered transactions with the fund, and other affiliate transaction limits, (iii) not purchase lowquality assets from the fund, and (iv) comply with the same guarantee and disclosure requirements that would apply to credit funds.
2. The proposal would for the first time incorporate some of the exemptions for “covered transactions” under section 23A of the Federal Reserve Act into the Volcker Rule framework, thus permitting banking entities to enter into certain low-risk transactions with related funds.
The Volcker Rule generally prohibits a banking entity from entering into transactions with a related fund that would be a covered transaction under section 23A of the Federal Reserve Act if the banking entity were a member bank and the fund were its affiliate. However, the Volcker Rule currently does not clearly incorporate any of section 23A’s longstanding exemptions from the definition of “covered transaction.” The proposal would incorporate certain of these exemptions – specifically, those transactions permitted under section 23A “without limit” – explicitly. For example, the proposal would permit a banking entity to extend credit to a related fund on an intraday basis or if the credit is fully secured by U.S. Treasury securities. In addition, the proposal would permit a banking entity to purchase assets from or extend credit to a related fund on a short-term basis (i.e., five business days) in the ordinary course of business in connection with payment transactions; securities, derivatives, or futures clearing; or settlement services. The market terms requirement of “Super 23B” and other safety and soundness conditions would still apply.
3. The proposal would provide permanent regulatory relief for qualifying foreign excluded funds.
The proposal would codify current no-action relief that exempts qualifying excluded funds that are “banking entities” from the Volcker Rule’s proprietary trading prohibition and covered fund provisions. To qualify, a fund would have to satisfy certain criteria, including the following: (i) the fund must be organized or established outside of the United States, (ii) the fund’s ownership interests must be offered or sold solely outside the United States, (iii) the fund would not otherwise be a banking entity except by virtue of a foreign banking entity’s acquisition or retention of an ownership interest in, or sponsorship of, the fund, and (iv) the fund must be established and operated as part of a bona fide asset management business.
4. The proposal would significantly simplify the requirements to qualify as a foreign public fund, which are exempt from the definition of “covered fund.”
Under the current Volcker Rule, foreign funds that are equivalent to U.S. registered investment companies are excluded from the definition of “covered fund.” To qualify, these “foreign public funds” must satisfy several conditions, including that the fund is authorized to sell ownership interests to retail investors in the fund’s home jurisdiction predominantly through one or more public offerings outside the United States. Under the proposal, an investment fund organized outside of the United States would qualify as an excluded foreign public fund if its ownership interests were offered through one or more public offerings that are subject to substantive disclosure and retail investor protection laws. This change would thus permit, for example, a foreign fund organized in one foreign country and offered in another to qualify for the “covered fund” exclusion.
5. The proposal would slightly expand the type of loan securitizations that are exempt from the definition of “covered fund.”
The proposal would codify existing staff guidance (and confirm industry practice) regarding the conditions for the exemption of loan securitizations from the definition of “covered fund.” The proposal would (i) permit issuers to hold a small pool of non-loan assets (up to 5 percent of the loan securitization’s total assets), (ii) clarify that servicing assets held by a loan securitization vehicle may include assets other than securities (e.g., mortgage insurance policies in the case of a mortgage loan securitization), and (iii) clarify the types of cash equivalents that loan securitizations are permitted to hold.
6. The proposal would clarify the definition of “ownership interest” to explicitly exclude senior loans, senior debt, and other debt interests with certain creditor rights.
The Volcker Rule permits banking entities that organize or offer covered funds to hold certain ownership interests. The proposed rule would clarify the definition of “ownership interest” by including additional characteristics that are features of an ownership interest (e.g., the right to participate in the selection or removal of a general partner, board director, investment manager, etc.). The proposal would clarify that loan or debt interests with certain creditor rights are not ownership interests and expressly exempt senior loans and senior debt.
7. The proposal would clarify that the Volcker Rule does not restrict parallel direct investments and co-investments.
Although the existing Volcker Rule regulations do not explicitly limit a banking entity’s ability to invest directly in the same assets invested in by a covered fund, language in the preamble to the 2013 final rule could have been read to suggest an intent to impose such a limitation. The proposal would clarify that for purposes of calculating an ownership interest in a covered fund, a banking entity need not include parallel direct investments and coinvestments, provided such investments are made in compliance with other laws.