Volcker Rule Covered Fund Amendments Provide Clarity and Opportunities
The Situation: The Federal Reserve, Office of the Comptroller of the Currency ("OCC"), Federal Deposit Insurance Corporation ("FDIC"), Securities and Exchange Commission ("SEC"), and Commodity Futures Trading Commission ("CFTC") recently modified their regulations under the Volcker Rule (Section 13 of the Bank Holding Company Act of 1956 (the "BHC Act")), effective October 1, 2020.
The Result: These modifications permit banking entities to engage in certain fund activities, expand permissible transactions with covered funds, reduce the extraterritorial effects on foreign funds, confirm existing Volcker Rule FAQs, generally, and otherwise clarify the Volcker Rule.
Looking Ahead: The changes directly expand opportunities under, and indirectly by providing certainty to, the Volcker Rule. These will enable banking organizations, domestic and foreign, to offer greater services to their customers and support to the economy, while reducing compliance burdens consistent with financial institution safety and soundness.
The Federal Reserve, OCC, FDIC, SEC, and CFTC have modified their Volcker Rule Regulations effective October 1, 2020. These changes permit banking entities to engage in certain fund activities, expand permissible transactions with covered funds, reduce the extraterritorial effects on foreign funds, confirm existing Volcker Rule FAQs, generally, and otherwise clarify the Volcker Rule.
The Volcker Rule and related regulations prohibit FDIC-insured depository institutions and their holding companies and affiliates ("banking entities") from investing in and sponsoring hedge funds and private equity funds, and generally any issuer that would be an investment company under the Investment Company Act of 1940, if it were not otherwise excluded by Sections 3(c)(1) or 3(c)(7) of that Act. Certain foreign funds and commodity pools are also covered funds. Proprietary trading is generally prohibited directly or indirectly through covered funds.
The amendments permit banking entities to invest in or sponsor:
- Credit funds whose assets consist solely of loans and debt instruments, cash equivalents and other assets related to acquiring, holding, servicing, disposing, or selling loans and debt instruments, including interest rate or foreign exchange derivatives that reduce the risks of the permitted assets ("Related Derivatives"). Proprietary trading is prohibited as if the fund were a banking entity, and the fund must otherwise comply with applicable banking law;
- Venture capital funds, as defined in Rule 203(l)-1 under the Investment Advisers Act;
- Family wealth management vehicles for "family customers," provided 0.5% may be owned by third parties to provide bankruptcy remoteness; and
- Customer facilitation vehicles by a banking entity upon a customer request to provide the customer exposure to a transaction, investment strategy, or other service of the banking entity.
Simplified Criteria for Exclusions From "Covered Fund"
Simplified criteria also are provided for excluding the following from "covered funds":
- Public welfare funds, as defined in National Bank Act, Section 24(11), subject to the federal bank regulators' varying criteria for determining such investments' eligibility for Community Reinvestment Act consideration;
- Rural Business Investment Companies;
- Qualified Opportunity Funds with 90% or more of their assets in designated low-income areas; and
- Small Business Investment Companies that have surrendered their licenses as part of their wind down.
Parallel and Co-Investments and Other Transactions
Parallel and co-investments by banking entities with covered funds are no longer included in calculating the permissible amount invested in a covered fund. Low-risk transactions with a related covered fund are now permitted, including riskless principal transactions and ultra-short-term credit incidental to payment, clearing, and settlement of securities, futures, and derivative transactions, as permitted by Federal Reserve Act, Section 23A, subject to Section 23B's market price and terms requirements.
Securitizations and Loan Sales
BHC Act Section 13(g) states "that [this] … section shall [not] be construed to limit or restrict the ability of a banking entity … to sell or securitize loans in a manner otherwise permitted by law." The amendments clarify the permissibility of securitizations and collateralized loan obligations ("CLOs") and exclude certain rights of senior debt holders, including customary rights to remove asset managers, from "ownership interests" subject to the Volcker Rule. Securitizations and CLOs may hold 5% of cash equivalents, non-loan debt securities (excluding asset-backed and convertible securities), and Related Derivatives. Leases are included as "loans" (see Jones Day Commentary, "Volcker Rule Covered Fund Amendments: What They Will and Will Not Do for CLOs").
Private and Public Foreign Funds
BHC Act Section 13(d)(1)(I) permits ownership interests in, and the sponsorship of hedge and private equity funds by banking entities solely outside of the United States, provided no ownership interests are offered or sold to a resident of the United States and that the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or its States (the "SOTUS Exemption").
Volcker Rule amendments in 2019 codified the Federal Reserve's Volcker Rule FAQ 13 that a foreign fund is not deemed sold in an offering targeting U.S. residents where the banking entity or its affiliates do not participate in the offering. If the banking entity or an affiliate sponsors or serves, directly or indirectly, as the investment manager, investment adviser, commodity pool operator, or commodity trading advisor to a covered fund, it is deemed to participate in such an offering. The latest amendments codify the temporary Federal Reserve policy statements regarding "qualified foreign excluded funds" due to expire in 2021. Qualified foreign excluded funds are largely exempted from the Volcker Rule's proprietary trading restrictions, "covered fund" restrictions, and from being a "banking entity."
The amendments define a "qualified foreign excluded fund" with respect to a foreign banking entity as an entity that:
- Is organized or established outside the United States and the ownership interests of which are offered and sold solely outside the United States;
- Would be a covered fund if organized or established in the United States, or is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;
- Would not otherwise be a banking entity except by virtue of the foreign banking entity's acquisition or retention of ownership interests in, or sponsorship of, the entity, where the banking entity (i) is not organized, or directly or indirectly controlled by a banking entity that is organized, under the laws of the United States or its States; and (ii) the ownership interest in or sponsorship of the fund by the foreign banking entity meets the requirements for permitted covered fund activities and investments solely outside the United States, as provided in Federal Reserve Reg. § 248.13(b);
- Is established and operated as part of a bona fide asset management business; and
- Is not operated in a manner that enables the banking entity that sponsors or controls the qualifying foreign excluded fund, or any of its affiliates, to evade the Volcker Rule's requirements.
In addition to foreign private funds that are qualified foreign excluded funds, the latest amendments provide greater consistency between U.S. and foreign public funds permitted by the Volcker Rule. Foreign excluded fund interests may be sold in one or more public offerings, subject to substantive disclosure and retail investor protection and other laws, provided 75% or more of the interests cannot be owned by a U.S.-controlled banking entity and its affiliates. This amendment further recognize that foreign funds' seeding periods may vary and exceed three years.
These rules clarify and expand permissible banking activities and relationships under the Volcker Rule. Banking entities may engage with greater certainty in a fuller range of financial activities through permissible fund structures "to support the real economy through the broadest means possible under the law." Banking entities cannot guarantee fund performance or "bail out" sponsored funds and remain subject to regulatory capital requirements and conflicts of interest limitations with covered funds. Banking organizations, their customers, and potential investors should plan now to enable them to take advantage of the new opportunities when these rules become effective.
Two Key Takeaways
1. The amended regulations permit:
- Banking entities to sponsor and invest in credit funds, venture capital funds, family wealth management vehicles, and customer facilitation funds;
- Securitizations, loan sales, and CLO rules consistent with the Volcker Rule's provisions allowing these activities;
- Foreign private and public funds to be offered more easily;
- Other "covered fund" exclusions for public welfare and similar investments; and
- Low-risk transactions between banking entities and covered funds.
2. These practical changes will facilitate the expansion of credit to the economy, reduce the extraterritorial effects of the Volcker Rule on foreign funds, promote public welfare investments, and reduce compliance burdens.
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