Agencies Propose Amendments to Volcker Rule Covered Fund Provisions

On January 30, 2020, five federal agencies (the “Agencies”)[1] proposed amendments to the rules implementing section 13 of the Bank Holding Company Act of 1956 (the “Volcker Rule”) related to the prohibition on investing, sponsoring, and having certain relationships with “covered funds” (the “Proposed Funds Rule”).[2] The Proposed Funds Rule comes on the heels of the conclusion of a separate rulemaking process dealing primarily with the Volcker Rule’s proprietary trading and compliance program requirements. 

The preamble to the Proposed Funds Rule also solicits comments in response to 87 interpretive questions. These questions range from soliciting ideas on additional amendments to the rule to soliciting comments on the potential effects of the proposed changes and whether they are workable. The number and scope of questions suggests that the Agencies are still considering their approach to addressing the issues presented by the 2013 Rule’s covered funds provisions. Comments on the Proposed Funds Rule are due by April 1, 2020.

Background

The Volcker Rule generally prohibits banking entities from engaging in proprietary trading or from investing in, sponsoring, or having certain relationships with hedge funds and private equity funds (“covered funds”). In 2013, the Agencies adopted regulations to implement the Volcker Rule (the “2013 Rule”).[3] With more than five years of experience living under the 2013 Rule, banking entities generally have found certain of the 2013 Rule’s restrictions unduly complex and compliance burdensome. On their part, the Agencies have acknowledged that certain aspects of the 2013 Rule have been difficult to implement in practice and have identified opportunities for improvement consistent with the statute.

Recent legislative and regulatory initiatives have focused on reducing the burden of the Volcker Rule and tailoring its application. Such initiatives include statutory and regulatory changes pursuant to the Economic Growth, Regulatory Relief, and Consumer Protection Act, enacted in 2018.[4] In addition, the Agencies proposed in 2018, and finalized in 2019, a rule that amended the provisions of the Volcker Rule primarily related to the prohibition on proprietary trading and compliance program requirements (the “2019 Final Rule”).[5] The 2019 Final Rule also codified certain guidance previously published in the form of Frequently Asked Questions (“FAQs”).[6] The Proposed Funds Rule was forecast in the preamble to the 2019 Final Rule, which indicated that the Agencies planned to propose further amendments related to the covered fund provisions of the Volcker Rule in a separate rulemaking.[7] 

The changes in the Proposed Funds Rule can be organized into five categories:

(i) codification of relief previously provided for so-called “qualifying foreign excluded funds;”

(ii) modifications to certain existing exclusions from the definition of a “covered fund;”

(iii) adoption of a number of additional exclusions to the definition of a “covered fund;”

(iv) amendments to the Volcker Rule’s provisions related to transactions with “covered funds”, i.e., the “Super 23A provisions;” and

(v) revisions related to the calculation of a banking entity’s “ownership interest” in a covered fund. 

This Client Alert discusses these proposed changes in more detail after providing a brief overview of the covered fund provisions as set forth in the 2013 Rule.

Overview of Covered Fund Provisions

Section 13 of the Bank Holding Company Act of 1956 (the “BHC Act”) prohibits banking entities from investing in, sponsoring, or having certain relationships with hedge funds and private equity funds. To implement this prohibition, the 2013 Rule established the term “covered fund” to include hedge funds and private equity funds as follows:

(i) an issuer that would be an investment company, as defined in the Investment Company of 1940 (the “1940 Act”), but for Section 3(c)(1) or 3(c)(7) of the 1940 Act;

(ii)  certain “commodity pools” as defined under Section 1a(10) of the Commodity Exchange Act that have characteristics similar to funds exempt from registration under the 1940 Act under Section 3(c)(1) or 3(c)(7) of that Act; and

(iii) for any U.S. banking entity,[8] an entity that:

a. is organized or established outside the United States and the ownership interests of which are offered and sold outside the United States; and

b. 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; and either (1) has its sponsor that banking entity (or an affiliate thereof); or (2) has issued an ownership interest that is owned directly or indirectly by that banking entity (or an affiliate thereof).

Under the 2013 Rule, a banking entity is prohibited from investing in or sponsoring entities that meet the definition of a “covered fund” unless an exclusion or exemption applies. The definition of a “covered fund” is broad and is not limited to hedge funds and private equity funds.

In addition, subject to exemptions, section 14(a) of the 2013 Rule prohibits banking entities (and their affiliates) that (i) advise or sponsor a covered fund; (ii) organize and offer a fund pursuant to the Asset Management Exemption[9] or the ABS Issuer Exemption;[10] or (iii) hold an interest in a fund that is an ABS issuer, from entering into covered transactions, as defined in Section 23A of the Federal Reserve Act, with such funds. These are referred to as the “Super 23A” restrictions because, unlike Section 23A itself, which allows affiliated transactions within limits, the prohibitions under the 2013 Rule are absolute. 

In addition, transactions between banking entities and certain covered funds[11] are subject to Section 23B of the Federal Reserve Act as if the banking entity were a member bank and the covered fund were its affiliate. This requires that such transactions generally must be on market terms. 

Finally, the 2013 Rule imposes so-called “prudential backstops,” which restrict certain covered fund activity that would otherwise be permissible under the rule.[12] Specifically, covered fund activity is prohibited, regardless of whether the conditions of an exemption are met, if the activity: (i) involves or results in a material conflict of interest between the banking entity and its clients, customers, or counterparties; (ii) results, directly or indirectly, in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or (iii) poses a threat to the safety and soundness of the banking entity or to the financial stability of the United States.

The Proposed Funds Rule

Qualifying Foreign Excluded Funds

The Proposed Funds Rule would exempt all “qualifying foreign excluded funds” from the Volcker Rule’s proprietary trading and covered fund restrictions.[13] As further explained below, this relief comes after a more than two-year period during which the Agencies provided no-action relief to avoid the extraterritorial application of the Volcker Rule to these funds.

Qualifying foreign excluded funds are banking entities that:[14]

(i) are organized or established outside the United States, and the ownership interests of which are offered and sold solely outside the United States;

(ii) either (a) would be a covered fund if the entity were organized or established in the United States; or (b) is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of trading in financial instruments;

(iii) would not otherwise be banking entities except by virtue of investment or sponsorship by, or relationships with, another banking entity that meets the following conditions:

a. the banking entity is not a U.S. banking entity; and

b. the banking entity’s investment or sponsorship is permissible under the exemption for covered fund activities that occur solely outside the United States;[15]

(iv) are established and operated as part of a bona fide asset management business; and

(v) are not operated in a manner that enables any other banking entity to evade the requirements of the Volcker Rule.

Under the 2013 Rule, while foreign excluded funds[16] are excluded from the definition of a “covered fund,” foreign excluded funds affiliated with or controlled by a banking entity (through sponsorship or other means) are deemed to be banking entities and subject to the prohibitions of the Volcker Rule. This creates an anomaly pursuant to which foreign funds, with potentially no jurisdictional nexus to the United States, become subject to the Volcker Rule’s restrictions.

On July 21, 2017, the Federal Reserve, OCC, and FDIC (the “Banking Agencies”) announced that they would not enforce the prohibitions and restrictions of the Volcker Rule with respect to the activities of qualifying foreign excluded funds controlled by non-U.S. banking entities (the “No-action Relief”).[17] The No-action Relief provides that, as long as certain conditions are met, the Banking Agencies would not propose to take action against a foreign banking entity based on attribution of the activities and investments of a “qualifying foreign excluded fund” to the foreign banking entity, or against the qualifying foreign excluded fund as a banking entity. 

The Proposed Funds Rule would codify the No-action Relief, without any substantive changes, by providing specific exemptions for this category of banking entities. 

Changes to Existing Exclusions to the definition of “Covered Fund”

Foreign Public Funds

Under the 2013 Rule, certain foreign funds are excluded from the definition of a “covered fund” if they qualify as a “foreign public fund.”[18] The exclusion for foreign public funds was designed to exclude foreign funds that are sufficiently equivalent to U.S.-registered investment companies (“RICs”) from coverage of the Volcker Rule.

Under the 2013 Rule, a fund is a foreign public fund if it meets the following three conditions:

(i)  the fund is organized or established outside of the United States;

(ii) the fund is authorized to offer and sell ownership interests to retail investors (i.e., no minimum net worth or net investment asset requirement) in its home jurisdiction; and

(iii) the fund sells ownership interests predominantly through one or more public offerings outside of the United States. An ownership interest is considered to be “predominantly” sold in one or more public offerings outside the United States if 85% of the issuer’s interests are sold to non-U.S. persons.[19] 

An additional condition applies with respect to funds sponsored by U.S. banking entities. Such funds may be deemed to be foreign public funds only if ownership interests in the funds are predominantly sold to persons other than: (1) the banking entity; (2) the fund; (3) affiliates of the banking entity or fund; and (4) directors and employees of the banking entity or fund.

The Proposed Funds Rule would make a number of changes to these requirements to ease the conditions and compliance burden associated with relying on the exclusion. 

First, the Agencies propose eliminating the requirement that ownership interests must be sold in the fund’s home jurisdiction. This proposed amendment responds to concerns raised that many foreign funds that are equivalent to RICs do not qualify for the exclusion because they are authorized to sell to investors only outside their home jurisdiction. 

Second, the Agencies propose eliminating the requirement that ownership interests be “predominantly” sold outside the United States.[20] A foreign public fund would still be required to be sold in one or more “public offerings,” which, as described below, is defined as a distribution outside the United States (that meets certain conditions).

Third, for U.S. banking entities, the Proposed Funds Rule would dial back the restriction on selling ownership interests to directors or employees of the banking entity or fund. Instead, the Proposed Funds Rule would impose a restriction on selling only to directors and senior executive officers.[21]

Finally, the Proposed Funds Rule would amend the definition of a “public offering.”[22]  Under the 2013 Rule, a “public offering” is a distribution[23] of securities in any jurisdiction outside the United States to investors, including retail investors, provided that:

(i) the distribution complies with all applicable requirements in the jurisdiction in which the distribution is being made;

(ii) the distribution does not restrict availability to investors having a minimum level of net worth or net investment assets; and

(iii) the issuer has filed or submitted, with the appropriate regulatory authority, offering disclosure documents that are publicly available.

The Agencies propose to amend requirement (i) above so it would apply only with respect to funds for which the banking entity serves as the investment manager, investment adviser, commodity trading adviser, commodity pool operator, or sponsor. In addition, the Proposed Rule would add a new requirement to this definition that the distribution is subject to substantive disclosure and retail investor protection laws and regulations. The Agencies have solicited comments on a number of aspects of the proposal to determine whether the new conditions are workable.

Loan Securitizations

Under the 2013 Rule, an issuing entity of ABS is excluded from the definition of a “covered fund” if the assets held by the entity are comprised solely of the following:[24]

(i) loans;

(ii) rights or other assets designed to assure the servicing or timely distribution of proceeds to holders of such securities and rights or other assets that are related to or incidental to purchasing or otherwise acquiring and holding the loans, subject to conditions (“Servicing Assets”); or

(iii) certain specified types of financial instruments, including interest rate or foreign exchange derivatives, among other things. 

In 2014, the Agencies published an FAQ regarding whether Servicing Assets must also fall within the exception for “permitted securities.”[25]  Permitted securities include cash equivalents and securities received in lieu of debts previously contracted.[26] In the FAQ, the Agencies stated that Servicing Assets may be any type of asset, but Servicing Assets that are securities, must fall within the exception for permitted securities. The Agencies also provided further guidance on the meaning of “cash equivalents.” The FAQ provides that the Agencies would interpret the term to mean “high quality, highly liquid short term investments whose maturity corresponds to the securitization’s expected or potential need for funds and whose currency corresponds to either the underlying loans or the asset-backed securities.”

The Proposed Funds Rule would codify the guidance provided in the 2014 FAQ, described above.[27]  In addition, the Proposed Funds Rule would permit funds relying on the loan securitization exclusion to hold non-loan assets that amount to 5% or less of the total assets of the fund.

Small Business Investment Companies (SBICs)

The 2013 Rule provides an exclusion from the definition of “covered fund” for certain small business investment companies, as defined in section 103(3) of the Small Business Investment Act of 1958 (15 U.S.C. 662).[28] The Proposed Funds Rule would revise the exclusion to cover any company that has voluntarily surrendered its license to operate as an SBIC in accordance with 13 C.F.R. § 107.1900 and does not make any new investments after the voluntary surrender (subject to limited exemptions).[29] This proposed amendment is designed to avoid discouraging banking entities from investing in SBICs due to a concern that the SBIC would not qualify for the exclusion during its wind-down phase.

New Exclusions to the Covered Fund Definition

Credit Funds

The Agencies propose a new exclusion from the “covered fund” definition for credit funds.[30] Under the new exclusion, a fund would not be a covered fund if its assets consist solely of the following:

(i) loans;

(ii) debt instruments;

(iii) rights and other assets that are related to or incidental to acquiring, holding, servicing, or selling such loans or debt instruments (subject to a number of conditions); or

(iv) interest rate or foreign exchange derivatives (subject to conditions).

For the proposed exclusion to apply, credit funds would be subject to activity limitations. Specifically, such funds would be treated as if they were banking entities for purposes of the proprietary trading restrictions, and would not be permitted to issue asset-backed securities. 

A number of requirements would also apply to a banking entity seeking to rely on the proposed exclusion for credit funds.  First, the banking entity would not be permitted to 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 the fund invests. In addition, all assets held by the fund must be permissible for the banking entity to hold directly. Further, any banking entity that acts as a sponsor, investment adviser, or commodity trading advisor to the credit fund would be required to (i) issue certain disclosures to prospective and actual investors;[31] and (ii) ensure that the activities of the fund are consistent with safety and soundness standards substantially similar to those that would apply as if the banking entity engaged in the activity directly.

Finally, the banking entity’s investment in, and relationship with, the fund would be subject to the Super 23A and 23B restrictions (except the banking entity may hold an ownership interest in the issuer) as well as the prudential backstop provisions. The investment and relationship must also be conducted in compliance with, and subject to, applicable banking laws and regulations, including applicable safety and soundness standards.

Venture Capital Funds

The Proposed Funds Rule would add a new exclusion from the covered funds definition for certain venture capital funds. [32]  To qualify for the exclusion, the venture capital fund would be required to meet the definition of a venture capital fund set forth in 17 C.F.R. § 275.203(l)-1[33] and would not be permitted to engage in proprietary trading, as if the fund were a banking entity.

A number of requirements would also apply to a banking entity seeking to rely on the proposed exclusion for venture capital funds. First, the banking entity would not be permitted to directly or indirectly guarantee, assume, or otherwise insure the obligations or performance of the fund. In addition, any banking entity that acts as a sponsor, investment adviser, or commodity trading advisor to the venture capital fund would be required to (i) issue certain disclosures to prospective and actual investors;[34] and (ii) ensure that the activities of the fund are consistent with safety and soundness standards substantially similar to those that would apply as if the banking entity engaged in the activities directly.

Finally, the banking entity’s investment in, and relationship with, the fund would be subject to the Super 23A and 23B restrictions (except the banking entity may hold an ownership interest in the issuer) as well as the prudential backstop provisions. The investment and relationship must also be conducted in compliance with, and subject to, applicable banking laws and regulations, including applicable safety and soundness standards.

In the preamble to the Proposed Funds Rule, the Agencies stated that they are also considering an additional restriction.  Namely, that a qualifying venture capital fund would not be permitted to invest in companies that have more than a specified amount of total annual revenue at the time of investment. The Agencies are considering what threshold may be appropriate, and have identified $50 million as a potential limitation.[35]

Family Wealth Management Funds

The Proposed Funds Rule would add a new exclusion for funds used by banking entities to provide family wealth management services.[36] To qualify for the exclusion, family wealth management funds that are organized as trusts must have grantor(s) that are all family customers[37] of the banking entity. For those funds that are not trusts, (i) a majority of the voting interests must be owned by family customers; and (ii) the fund must be owned only by family customers and up to three closely related persons[38] of family customers.  In addition, the fund may not hold itself out as being an entity or arrangement that raises money from investors primarily for the purpose of trading in securities.

Banking entities would be permitted to rely on this proposed exclusion only if they provide the fund with bona fide trust, fiduciary, investment advisory, or commodity trading advisory services. In addition, the banking entity would not be permitted to directly or indirectly guarantee, assume, or otherwise insure the obligations or performance of the fund and would be required to issue certain disclosures.[39] Further, the banking entity may hold only a maximum of 0.5% of the fund’s outstanding ownership interests and only for the purpose of and to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency, or similar concerns.

Transactions between the banking entity and the fund would not be subject to Super 23A. However, restrictions would be placed on the banking entity’s ability to purchase a low-quality asset from the fund;[40] any transaction between the banking entity and the fund would be subject to Section 23B’s market terms requirement; and the prudential backstop provisions would apply to the relationship.

Customer Facilitation Vehicles

The Proposed Funds Rule would exclude funds from the definition of a covered fund if they are formed by or at the request of a customer of a banking entity for the purpose of providing the customer with exposure to a transaction, investment strategy, or other service provided by the banking entity.[41]

To qualify for the exclusion, all of the ownership interests of the fund would need to be held by the customer or its affiliates, other than a maximum of 0.5%, which may be held by the banking entity for the purpose of and to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency, or similar concerns.

In addition, to rely on the exclusion, the banking entity and its affiliates must maintain documentation outlining how the banking entity intends to facilitate the customer’s exposure to the transaction, investment strategy, or service. The Agencies explained that this requirement is intended to facilitate examination of compliance with the conditions of the exclusion.[42]

Further, the banking entity would not be permitted to directly or indirectly guarantee, assume, or otherwise insure the obligations or performance of the fund and would be required to issue certain disclosures

Transactions between the banking entity and the fund would not be subject to Super 23A. However, restrictions would be placed on the banking entity’s ability to purchase a low-quality asset from the fund;[43] any transaction between the banking entity and the fund would be subject to Section 23B’s market terms requirement; and the prudential backstop provisions would apply to the relationship.

Super 23A Provisions

The Proposed Funds Rule would revise the Super 23A provisions to enable certain transactions to occur, as long as they comply with the prudential backstop provisions.

Specifically, transactions with a covered fund would be permitted if they are an “exempt covered transaction” under Section 23A of the Federal Reserve Act or 12 C.F.R. § 223.42.[44] Exempt covered transactions include transactions secured by cash or U.S. government securities; purchasing certain liquid assets; purchasing certain marketable securities; among other things.

In addition, certain short-term extensions of credit and asset purchases would be permitted if they are conducted in the ordinary course of business in connection with payment transactions, settlement services, or futures, derivatives and securities clearing.[45] These transactions would have to be repaid, sold, or terminated by the end of five business days.  In addition, the transactions would have to meet certain conditions set forth in 12 C.F.R. §§ 223.42(l)(1)(i) and (ii) as if the extension of credit was an intraday extension of credit, regardless of its duration. These conditions include the establishment and maintenance of certain policies and procedures and a requirement that the banking entity has no reason to believe that the borrower will have difficulty repaying the extension of credit in accordance with its terms.

Ownership Interest Calculations

Definition of “Ownership Interest”

The 2013 Rule defines “ownership interest” to include “any equity, partnership, or other similar interest.”[46] The term “other similar interest” is further defined to include interests, regardless of their form, that provide the ability to participate in the selection or removal of a general partner, managing member, director, trustee, investment manager, investment adviser, or commodity trading advisor of a covered fund (excluding certain rights of creditors upon the occurrence of a default or acceleration event). The term “other similar interest” also includes interests that have one of a number of rights listed in the 2013 Rule, for example, the right to receive a share of income, gains, or profits. The rights that constitute an “other similar interest” generally all provide the holder of the interest some exposure to the profits and losses of the covered fund.

As a result, under the definition in the 2013 Rule, certain debt instruments could be considered ownership interests to the extent they include the type of rights listed as constituting an “other similar interest.” In the Proposed Funds Rule, the Agencies propose to limit the extent that debt instruments would fall within the definition of an “ownership interest” in two ways. 

First, the Proposed Funds Rule would clarify that a creditor would not hold an ownership interest in a fund solely because, upon the occurrence of a default or acceleration event, it held the right to participate in the removal of an investment manager for cause or to nominate or vote on a nominated replacement manager upon an investment manager’s resignation or removal.[47] 

Second, the Proposed Funds Rule would establish a safe harbor for certain debt instruments that meet a number of conditions.[48]  Under the safe harbor, senior loans and senior debt interests would not be deemed ownership interests if:

(i) Under the terms of the interest the holders do not have the right to receive a share of the income, gains, or profits of the covered fund, but are entitled to receive only:

a. Interest at a stated interest rate and commitment fees or other fees that are not determined by reference to the performance of the underlying assets of the fund; and

b. Fixed principal payments on or before a maturity date (including certain prepayment premiums).

(ii) The entitlement to payments of the interest is absolute and cannot be reduced based on losses arising from the underlying assets of the covered funds; and

(iii) The holders of the interest are not entitled to receive the underlying assets of the covered fund after all other interests have been redeemed or paid in full (except for remedies upon default or acceleration).

Parallel Funds

Under the 2013 Rule, banking entities are generally required to limit their investment (including investments of their affiliates) in funds established under the Asset Management Exemption and ABS Issuer Exemption to less than 3% of the total number or value of outstanding ownership interests in the fund, after a seeding period.[49] Various attribution rules apply to determine whether an ownership interest should be included in the calculation.[50]

The text of the 2013 Rule does not address investments made by banking entities in parallel with funds they sponsor pursuant to these exemptions. However, in the preamble to the 2013 Rule the Agencies explained that “if a banking entity makes investments side by side in substantially the same positions as the covered fund, then the value of such investments shall be included for purposes of determining the value of the banking entity’s investment in the covered fund.”[51] The Agencies also noted that banking entities should not make any co-investments alongside a fund they sponsor if such investments would exceed the investment limitations.

In a deviation from the approach in the preamble to the 2013 Rule, the Agencies propose to permit parallel investments without attribution to the banking entity as long as the investment is made in compliance with applicable laws and regulations, including applicable safety and soundness standards.[52] The Proposed Funds Rule would codify the new approach. The Agencies note in the preamble to the Proposed Funds Rule that parallel investments would be subject to the prudential backstop provisions, since those provisions apply with respect to any funds organized pursuant to the Asset Management Exemption or ABS Issuer Exemption.[53] This would be especially relevant to the extent a parallel investment would result in a material conflict of interest.

Allocation of Investments by Employees and Directors

In addition to the per-fund investment limitations described above, the 2013 Rule, as revised by the 2019 Rule, imposes a limit on the aggregate amount of ownership interests that a banking entity may hold in all covered funds it organizes or offers pursuant to the Asset Management Exemption or ABS Issuer Exemption (including any underwriting and market making activity for funds organized under such exemptions). [54] In addition, U.S. banking entities must deduct from their tier 1 capital calculations an amount based on the ownership interests held in such covered funds. [55] Both the aggregate limitation and the capital deduction require the banking entity to include amounts paid by the banking entity, or its employees, in connection with obtaining a “restricted profit interest.”[56]

Under the Proposed Funds Rule, amounts paid by employees to obtain restricted profit interests would be included in the calculation only if the banking entity provided financing to the employee for the acquisition.[57] This would make the attribution rules for restricted profit interests consistent with the rules for ownership interests held by employees and directors.[58] 

Conclusion

The Proposed Funds Rule represents a significant step toward liberalizing the covered funds provisions of the Volcker Rule and, if adopted, will provide welcome regulatory relief to banking entities. In particular, banking entities would have greater latitude to conduct customer and other activities through a fund structure.

[1] The five federal agencies (i.e., the “Agencies”) responsible for implementing the Volcker Rule are: the Office of the Comptroller of the Currency (“OCC”); the Board of Governors of the Federal Reserve System (“Federal Reserve”); the Federal Deposit Insurance Corporation (“FDIC”); the U.S. Securities and Exchange Commission; and the U.S. Commodity Futures Trading Commission.

[2] The Proposed Funds Rule has not yet been published in the Federal Register.  The Proposed Rule is available here: Proposed Funds Rule Text. Since all five Agencies codify the Volcker Rule in their respective regulations, citations in this Client Alert to the Proposed Funds Rule and 2013 Rule are to generic sections.

[3]  Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds; Final Rule, 79 Fed. Reg. 5535 (Jan. 31, 2014).

[4] For more information regarding the statutory changes made to the Volcker Rule by S. 2155, as well as the other reforms enacted by S. 2155, please see our Client Alert, available at: Financial Regulatory Reform Legislation Proceeds through Congress. See also 84 Fed. Reg. 35008, available at: Final Rule Implementing S. 2155 Amendments. For more information regarding the final rule adopting conforming changes to S. 2155, please see our Client Alert, available at: Agencies Issue Final Rule Conforming Volcker Rule Regulations to 2018 Regulatory Relief Act. 

[5] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 84 Fed. Reg. 61974 (Nov. 14, 2019), available at: 2019 Final Rule Text.   For our client alert discussing the 2019 Final Rule, please see: Amendments to Volcker Rule Regulations.

[6] Volcker Rule: FAQs, available at: Volcker Rule: Frequently Asked Questions.

[7] The 2019 Final Rule generally did not address the covered funds provisions, aside from the exemptions for hedging, market making and underwriting covered fund interests and the exemption for covered fund activity solely outside the United States.

[8] For purposes of this Client Alert the term “U.S. banking entity” includes a banking entity that is, or is controlled directly or indirectly by a banking entity that is, located in or organized under the laws of the United States or any state therein.

[9] Under the 2013 Rule, investments in and sponsorship of certain customer funds are permitted as long as a number of conditions are met.  For purposes of this Client Alert, we refer to this exemption as the Asset Management Exemption.  See 2013 Rule § _.11(a).

[10] Under the 2013 Rule, investments in and sponsorship of certain issuers of asset-backed securities (“ABS”) are permitted as long as a number of conditions are met.  For purposes of this Client Alert, we refer to this exemption as the ABS Issuer Exemption.  See 2013 Rule § _.11(b).

[11] This applies to covered funds (i) for which the banking entity serves as investment manager, investment adviser, commodity trading advisor, or sponsor; (ii) which are organized and offered pursuant to the Asset Management Exemption; or (iii) which are organized and offered, or invested in, pursuant the ABS Issuer Exemption. 

[12] 2013 Rule §_.15.

[13] To provide this exemption, the Agencies would rely on their authority pursuant to section 13(d)(1)(J) of the BHC Act.  Notwithstanding the prohibitions on proprietary trading and covered funds activity, section 13(d)(1)(J) of the BHC Act permits “[s]uch other activity as the [Agencies] determine, by rule . . . would promote and protect the safety and soundness of the banking entity and the financial stability of the United States.”

[14] Proposed Funds Rule §§ _.6(f); _.13(d).

[15] Investments in and sponsorship of covered funds is permissible as long as the activity complies with a number of conditions pursuant to 2013 Rule § _.13(b) designed to ensure the activity occurs solely outside the United States.

[16] A “foreign excluded fund” is generally understood to be a fund: (i) in which a non-U.S. banking entity invests or that it sponsors; (ii) that is organized under the laws of a foreign jurisdiction; (iii) the ownership interests of which are offered and sold solely outside the United States; and (iv) that 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. 

[17] For more information regarding the No-action Relief, please see our Client Alert, available at: Federal Banking Agencies Announce No-action Position on Certain Foreign Excluded Funds Under the Volcker Rule. This No-action Relief was initially set to expire on July 21, 2018 but, in connection with consideration and adoption of the 2019 Final Rule, was extended, first, until July 21, 2019 and, then again, until July 21, 2021. See Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of the Comptroller of the Currency, Statement regarding Treatment of Certain Foreign Funds under the Rules Implementing Section 13 of the Bank Holding Company Act (July 17, 2019), available at: No-action Relief Text.

[18] 2013 Rule § _.10(c)(1).

[19] See 79 Fed. Reg. 5678.

[20] See Proposed Funds Rule § _.10(c)(1)(i)(B).

[21] See Proposed Funds Rule § _.10(c)(1)(ii).

[22] See Proposed Funds Rule § _.10(c)(1)(iii).

[23] A “distribution” is an offering that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods, or, an offering that is made pursuant to an effective registration statement under the Securities Act of 1933. 2013 Rule § _.4(a)(3).

[24]2013 Rule § _.10(c)(8).

[25] FAQ No. 4, available at: FAQ No. 4 Text.

[26] 2013 Rule § _.10(c)(8)(iii).

[27] See Proposed Funds Rule §§ _.10(c)(8)(i)(B); _.10(c)(8)(iii)(A); _.10(c)(8)(i)(E).

[28] 2013 Rule §_.10(c)(11).

[29] Proposed Funds Rule §§ _.10(c)(11)(i).

[30] Proposed Funds Rule §§ _.10(c)(15).

[31] The required disclosures are set forth in 2013 Rule §_.11(a)(8).

[32] Proposed Funds Rule §§ _.10(c)(16).

[33] The definition of a “venture capital fund” under 17 C.F.R. § 275.203(l)-1 includes certain private funds that: (1) represent to investors and potential investors that they pursue a venture capital strategy; (2) immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, hold no more than 20% of their aggregate capital contributions, and uncalled committed capital in assets that are not “qualifying investments;” (3) do not incur leverage in excess of 15% of the private fund’s aggregate capital contributions and uncalled committed capital and any such leverage is for a non‑renewable term of no longer than 120 calendar days (subject to an exception); (4) only issue securities which do not entitle the holder to withdraw, redeem, or require the repurchase of such securities, except in extraordinary circumstances (although pro rata distributions are permitted); and (5) are not registered under section 8 of the 1940 Act and have not elected to be treated as a business development company pursuant to section 54 of that act.

[34] The required disclosures are set forth in 2013 Rule §_.11(a)(8).

[35] Preamble to the Proposed Funds Rule at 66.

[36] Proposed Funds Rule §§ _.10(c)(17).

[37] “Family customer” means: (1) a family client, as defined in 17 C.F.R. § 275.202(a)(11)(G)-1(d)(4); or (2) any natural person who is a father-in-law, mother-in-law, brother-in-law, sister-in-law, son-in-law, or daughter-in-law of a family client, or a spouse or a spousal equivalent of any of the foregoing.

[38] “Closely related person” means a natural person (including the estate and estate planning vehicles of such person) who has long-standing business or personal relationships with any family customer.

[39] The required disclosures are set forth in 2013 Rule §_.11(a)(8).

[40] Specifically, under the Proposed Funds Rule, the requirements of 12 C.F.R. § 223.15(a) would apply as if the banking entity were a member bank and the fund were its affiliate. This provision prohibits member banks from purchasing low-quality assets from their affiliates except in certain circumstances.

[41] Proposed Funds Rule §§ _.10(c)(17). In the preamble to the Proposed Funds Rule, the Agencies explain that banking entities that market their services through the use of customer facilitation vehicles, or discuss the potential benefits of structuring a vehicle prior to its formation, would not be foreclosed from relying on the exclusion. Preamble to the Proposed Funds Rule at 85-86.

[42] See Preamble to the Proposed Funds Rule at 86.

[43] Specifically, under the Proposed Funds Rule, the requirements of 12 C.F.R. § 223.15(a) would apply as if the banking entity were a member bank and the fund were its affiliate. This provision prohibits member banks from purchasing low-quality assets from their affiliates except in certain circumstances.

[44] Proposed Funds Rule §§ _.14(a)(2)(iii).

[45] Proposed Funds Rule §§ _.14(a)(2)(iv).

[46] 2013 Rule § _.10(d)(6).

[47] Proposed Funds Rule §§ _.10(d)(6)(i)(A).

[48] Proposed Funds Rule §§ _.14(d)(6)(ii)(B).

[49] See 2013 Rule § _.12(a)(2).

[50] See 2013 Rule § _.12(b).

[51] 79 Fed. Reg. 5734.

[52] See Proposed Funds Rule § _.12(b)(5). Under this approach, parallel investments by employees and directors would also not be attributed to the banking entity, regardless of whether the banking entity provides financing for the investment.  Also, any employees or directors would be permitted to make parallel investments, not just those that are directly engaged in providing services to the covered fund (which is a requirement for employee investment in covered funds pursuant to the Asset Management Exemption). Preamble to Proposed Funds Rule at 118-119; see also 2013 Rule § _ .11(a)(7).

[53] Preamble to Proposed Funds Rule at 116-117.

[54] See 2013 Rule § _.12(a)(2)(iii).

[55] See 2013 Rule § _.12(d).

[56] Under the 2013 Rule, “restricted profit interests” are excluded from the definition of an “ownership interest” if they meet a number of conditions. 2013 Rule § _.10(d)(6)(ii). Generally, the exclusion for “restricted profit interests” is designed to track what are commonly referred to as carried interests.

[57] Proposed Funds Rule § _.12(c)(1)(ii); 12(d)(2). 

[58] 2013 Rule § _.12(b)(iv).