Securitization has been the focus of many rulemaking initiatives in the wake of the financial crisis. The Volcker Rule is not directly targeted at securitization and expressly states that nothing in it should be construed to limit or restrict the ability of a banking entity to securitize loans. Nevertheless, the proposed regulations, if enacted in their current form, would prohibit or restrict banking entities from engaging in many common securitization practices in the asset-backed commercial paper market and in other sectors. The most significant issues arise because the definition of “covered fund,” which is intended to target hedge funds and private equity funds, also encompasses many issuers of asset-backed securities (ABS), including collateralized debt obligations (CDOs) and asset-backed commercial paper (ABCP) conduits. Banking entities will be prohibited from holding an ownership interest in or sponsoring a covered fund under the proposed regulations, subject to narrow exceptions. The proposed regulations effectively would mean that a U.S. bank could not sponsor and lend to an ABCP conduit in the manner that most such conduits are currently structured and could not hold an ownership interest in a CDO. In addition, the prohibition in the proposed regulations on proprietary trading would require banking entities, which could include bank-sponsored issuers of ABS that do not fall under the definition of covered funds, to establish and implement compliance programs and satisfy recordkeeping and reporting requirements.
Prohibition on Banking Entity Investment in Covered Funds
The proposed regulations prohibit banking entities from directly or indirectly acquiring or retaining an ownership interest in or sponsoring a covered fund, subject to certain exceptions. A “covered fund” is defined to include “[a]n issuer that would be an investment company, as defined in the Investment Company Act of 1940 … but for section 3(c)(1) or 3(c)(7) of that Act.”2
Section 3(c)(1) of the Investment Company Act excludes from the definition of investment company any issuer whose outstanding securities (other than commercial paper) are beneficially owned by no more than 100 persons and are not offered in a public offering in the United States.3 Section 3(c)(7) is an exclusion for issuers who do not offer their securities in a public offering in the United States and who restrict the offering to “qualified purchasers,” a category of large investors similar to those who would qualify as “qualified institutional buyers” for the purposes of Rule 144A under the Securities Act.4 These exclusions are utilized for many types of securitization transactions including CDOs, collateralized loan obligations (CLOs) and ABCP conduit transactions.
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