On December 10, 2013, the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission, and the Commodity Futures Trading Commission (CFTC) (collectively, the Agencies) issued the final rule (Final Rule) implementing the “Volcker Rule” requirements of section 13 (section 13) of the Bank Holding Company Act (BHC Act), which were added by section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Final Rule is effective April 1, 2014, but banking entities generally have until July 21, 2015, to conform their activities to the Final Rule.

Section I of this memo sets out key takeaways for private funds. Section II summarizes the Final Rule’s main provisions.  Section III focuses on the Final Rule’s prohibition (subject to exemptions) of a banking entity’s sponsoring, or having an ownership interest (Ownership Restriction) in, private funds meeting the definition of “covered fund,” and Section IV addresses the Final Rule’s prohibition of a banking entity’s having certain relationships (Relationship Restriction) with covered funds, including “Super 23A” and other relevant restrictions.

I. Key Takeaways

• Parallel Investments. Instead of investing via a covered fund subject to the Final Rule’s restrictions, banking entity sponsors are incentivized to make direct investments in portfolio companies where they are permitted under the BHC Act’s merchant banking authority. As a result, banking entity sponsors of private equity funds may look where possible to take advantage of their merchant banking authority via parallel investments. See Section III.C. below.
• Closed-End Funds. Private fund managers may for some fixed income and alternative strategies consider using a closed-end fund registered under the Investment Company Act of 1940 (1940 Act) if it is important for them to attract seed money or significant investments by U.S. financial holding companies or other banks. The 1940 Act’s constraints on leverage may determine if 1940 Act registration is feasible for a particular fund strategy. See Section III.D. below.
• BDCs. Instead of investing via a covered fund subject to the Final Rule’s restrictions on investment, some banking entity sponsors of covered funds may in some cases look to use registered funds or business development companies (BDCs) as collective investment vehicles; the use by Goldman Sachs of a BDC to invest in qualifying private equity is one example. See Section III.D. below.
• Potential Investment Opportunities. The broad definition of covered funds may require that banking entities divest a variety of pre-Volcker securitizations, which could result in investment opportunities for hedge funds. Asset-backed securities (ABS) that are “covered funds” may include certain:
  • collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs),
  • pass-through real estate investment trusts (REITs),
  • interests in cash collateral pools,
  • tender option bonds,
  • venture capital funds,
  • credit funds, or
  • securities of certain legacy special purpose entities.

See Section III.B. below, which includes a summary of the American Banker Association’s (ABA) lawsuit and the Agencies’ response.

• Rule 3a-7. Banks would not be constrained by the Volker Rule’s limitation on covered fund investments if they invest in securities of issuers excluded from registration by Rule 3a-7 under the 1940 Act. The outer bounds of Rule 3a-7 may be tested.
• Loan Securitization Exemption. Securitizations complying with Rule 3a-7 may not, however, acquire additional eligible assets, or dispose of eligible assets, for the primary purpose of recognizing gains or decreasing losses resulting from market value changes. Some market-value CLOs may therefore seek to rely on the Final Rule’s exemption for qualifying loan securitizations. See Section III.D. below. 
• Changes to Non-Agency Securitization Deals. The Final Rule may result in changes to some non-agency securitizations, since wherever possible bank underwriters and their client sponsors will prefer to distribute ABS that are not covered funds and hence qualify for investment by banking entities. Issuers of non-qualifying ABS may be required to pay a premium to compensate for the less liquid nature of such securities vis-a-vis qualifying ABS.

II. The Main Provisions of the Final Rule

• The Final Rule covers any banking entity, meaning, subject to limited exceptions, (i) an insured depository institution, (ii) any foreign bank operating a branch or agency in the U.S., and (iii) any affiliate of (i) or (ii). An affiliate is defined as any company that controls, is controlled by, or is under common control with another company¹ and includes non-bank affiliates such as insurers and finance companies;
• The Final Rule imposes limitations on the short-term proprietary trading (Proprietary Trading Restriction) of financial instruments by any banking entity; and prohibits or limits a banking entity from sponsoring or having an ownership interest in, or certain relationships with, covered funds.
• Regulatory Capital: The Final Rule requires a banking entity to deduct the greater of (1) the historical cost, plus earnings, and (2) the fair market value of all qualifying de minimis covered fund investments made by the entity from the entity’s tier 1 capital. The banking agencies recognize that the final Basel III² rules impose risk weights and deductions that do not correspond to the deduction for covered fund investments imposed by the Final Rule. The banking agencies intend to review the interaction between the requirements of the Final Rule and the Basel III rules, and expect to propose “steps to reconcile the two rules.”³

III. Ownership Restriction

Subject to certain exceptions, a banking entity generally may not sponsor, or as principal acquire or retain any ownership interest in, covered funds.⁴ Non-qualifying ABS—i.e., ABS that are “covered funds”—may include a variety of pre-Volcker securitizations.

A. Key Definitions: Ownership Interest and Covered Fund

An “ownership interest”⁵ means an “equity, partnership, or other similar interest.” For this purpose, “other similar interest” is defined more broadly in the Final Rule than it was in the notice of proposed rulemaking⁶ (NPR) and includes, in addition to interests typically associated with a holder of equity, any interest that:

• has the right to participate in the selection or removal of a general partner, managing member, member of the board, investment manager, investment adviser, or commodity trading advisor of the covered fund; or
• has the right to receive a share of the income of the covered fund; or
• provides that the amounts payable by the covered fund with respect to such interest could be reduced based on losses arising from the underlying assets.

A “covered fund”⁷ generally includes:

• an issuer that would be an investment company under the Investment Company Act of 1940 but for exemptions under sections 3(c)(1) or 3(c)(7) of that Act (hereinafter referred to as a “section 3(c)(1) or (7) issuer”). These exemptions are generally available to privately offered companies whose securities are beneficially owned by 100 or fewer persons or owned exclusively by qualified purchasers;
• a commodity pool:
  • that is an “exempt pool” under CFTC Rule 4.7, i.e., a pool whose participation units are sold in certain unregistered offerings and whose units are offered only to qualified eligible persons; or
  • whose operator is registered with the CFTC as a commodity pool operator, if qualified eligible persons own substantially all of the pool’s participation units and such units have not been publicly offered to persons who are not qualified eligible persons under 17 CFR §§ 4.7(a)(2) and (3); and
• a foreign fund,⁸ which is a term that applies only to a U.S. banking entity (including the U.S. branch, agency, or subsidiary of a foreign banking organization) and means any fund that:

(A) is offered and sold outside the U.S.,
(B) is not a foreign public fund,
(C) raises money primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities, and
(D) is sponsored or owned by such banking entity.

B. ABA Lawsuit and House Bill

The broad definitions of “ownership interest” and “covered fund” result in debt-like interests in certain non-loan securitizations being covered by the Final Rule’s Ownership Restriction. This is problematic for some small banks that are apparently significant buyers of Collateralized Debt Obligations backed by Trust Preferred Securities (TruPS CDOs), a securitization of trust-preferred securities that some of these banks have classified as hold-to-maturity and carry at amortized cost, which now exceeds their fair value. The potential consequence of the Ownership Restriction is the realization of an accounting loss that would hit both earnings and regulatory capital.

This potential consequence was first reported on December 16, 2013, when Zions Bancorp disclosed that it would have to sell TruPS CDOs and take a $387 million charge to write down the value of the securities. After reclassifying the CDOs from hold-to-maturity to available-for-sale, Zions estimated that its tier 1 common equity ratio would fall from 10.47% to 9.74%.⁹

In response to inquiries from members of Congress regarding potentially similarly situated community banks, the FRB responded with a FAQ¹⁰ on December 19 reminding banks that an issuer than can rely on a 1940 Act exemption other than sections 3(c)(1) or 3(c)(7) would not be a covered fund and indicating that:

• a banking entity should evaluate if a security issued by a TruPS CDO is an ownership interest as defined under the Final Rule,
• if the CDO issuer is not a covered fund at the end of the conformance period, the banking entity would not need to divest its CDO holdings, and
• to the extent that a banking entity initiates actions to conform its interests in the CDO to the Final Rule, the banking agencies would expect the entity to develop a conformance plan that is appropriately specific.

Unassuaged by the FRB’s FAQ, and apparently concerned by the prospect that some small banks could potentially suffer significant capital hits as a result of their TruPS CDO holdings, the ABA and four banks on December 24, 2013, brought an action against the FRB, the OCC and the FDIC, requesting a temporary restraining order and an injunction that would void the definition of the term “other similar interest.” In response, the Agencies (excluding the CFTC) issued a joint statement on December 27, 2013, indicating that they were evaluating if it was “appropriate not to cover pooling vehicles that invest in TruPS in order to eliminate restrictions that might otherwise have consequences that are inconsistent with the relief Congress intended to provide community banking organizations under section 171(b)(4)(C) of the Dodd-Frank Act.”¹¹  The Agencies (excluding the CFTC) stated that they intended to address the subject of TruPS CDOs no later than January 15, 2014. The ABA then reportedly dropped its request for a temporary restraining order, but did not withdraw its lawsuit.¹²

On January 2, 2014, the Loan Syndications and Trading Association (LSTA) reportedly asked federal regulators to confirm by January 15, 2014, that the right to remove a manager in breach of obligations would not result in an “ownership interest” in CLOs.¹³ 
House Financial Services Committee Chairman Jeb Hensarling is reportedly planning to introduce a bill that would remove any obstacle to banking entities’ owning TruPS CDOs. The amendment of the Volcker Rule may reportedly also create a loophole that would allow banking entities to own a wide range of ABS, so long as the ABS pool includes at least one qualifying TruPS CDO security, instead of the limited range of qualifying ABS described in Section II.D.2. below.¹⁴

C. Qualifying De Minimis Investments

A banking entity may sponsor a covered fund and (together with affiliates) retain an ownership interest, subject to a single fund limit of 3% (3% fund limit) of the ownership interests of the fund (or such greater amount – typically 5% – as is required by the credit risk retention rules implementing section 15G of the Securities Exchange Act of 1934), so long as:

• the banking entity organizes and offers the covered fund in connection with the provision of bona fide trust, fiduciary, investment advisory or commodity trading advisory services, or the banking entity organizes and offers a covered fund that is an ABS issuer,
• the total amount of the covered fund investments held by such entity and its affiliates is not greater than 3% of the entity’s tier 1 capital, and
• the banking entity complies with Super 23A and other applicable requirements.¹⁵

If a banking entity sponsor’s investment in a hedge fund or private equity fund currently is greater than the 3% fund limit, the entity will seek to bring its investment into compliance with the 3% fund limit by the end of the conformance period. To do so, the banking entity may seek to restructure its investment.

If a banking entity makes a parallel direct investment (for example under its merchant banking authority) in one or more companies in which a fund organized and offered by the banking entity also invests, the direct investment would not, in some circumstances, count against the 3% fund limit. In the Final Rule, the banking agencies did not draw a clear line between the direct investments that will, and those that will not, count against the 3% fund limit, but did define some limits with respect to co-investment.

Where, for example, a banking entity sponsors a covered fund and a covered fund’s investment manager determines that the covered fund does not have sufficient capital, or it would not be suitable for the covered fund, to make the entire investment in a portfolio company, the banking entity should not itself make any side by side privately negotiated co-investment with the covered fund, unless the value of such co-investment is less than 3% of the value of the total amount co-invested by others in such investment.  And if a banking entity sponsor makes investments side by side in substantially the same positions as a covered fund, then the value of such investments should be included for purposes of determining the value of the banking entity’s investment in the covered fund.

The Final Rule also clarifies how a banking entity is to apply the 3% fund limit in the case of a master-feeder structure or fund of funds that a banking entity organizes and offers.

In the case of a master feeder, the 3% fund limit will apply not to the feeder but only to the master fund; and the investment in the master fund will include:

• any direct investment in the master fund, and
• a pro rata share of any ownership interest in the master fund that is held indirectly through the feeder fund.

Likewise, for a fund of funds, the banking entity’s permitted investment in the underlying fund will include:

• any direct investment in such fund, and
• a pro rata share of any ownership interest in such fund that is held indirectly through the fund of funds.

A banking entity’s ownership interest in a covered fund excludes the entity’s “restricted profit interest” (carried interest) in the fund.¹⁶

D. Certain Permissible Bank Investments

1. Registered Investment Companies and BDCs.
To originate ABS that qualify for investment by U.S. banking entities, a bank may structure a transaction in which the issuer:

• relies on a 1940 Act exclusion or exemption from the definition of “investment company” other than section 3(c)(1) or section 3(c)(7), e.g., Rule 3a-7 (for qualifying structured finance transactions) or section 3(c)(5) (for securitizations of accounts receivable, mortgages, and certain other asset types), or
• registers under the 1940 Act (registered company).

The Final Rule does not:

• restrict a banking entity’s ability to invest in and sponsor registered companies or BDCs; or
• apply to the holdings of BDCs or registered companies in which a banking entity invests, so long as the relevant registered company is not itself an “affiliate” of the banking entity investor.

Accordingly, so long as the bank holding company does not directly or indirectly control the BDC or registered company under the BHC Act, a bank holding company may generally invest in a BDC or registered company without being subject to the Ownership Restriction or the Relationship Restriction or, with respect to portfolio companies, the Proprietary Trading Restriction.¹⁷

Also, a seeding vehicle that will become a BDC or registered investment company would not itself be viewed as violating the requirements of the Final Rule during the seeding period so long as the banking entity that establishes the seeding vehicle operates the vehicle pursuant to a written plan, developed in accordance with the banking entity’s compliance program, that reflects the banking entity’s determination that the vehicle will become a BDC or registered investment company within the time period provided for seeding a covered fund under the Final Rule.

2. Qualifying ABS. A banking entity may own a defined range of ABS, whose issuers are not “covered funds” even if issued or guaranteed by section 3(c)(1) or (7) issuers, including qualifying loan securitizations. The only “permissible securitization assets” that may be held by a qualifying loan securitization are:

• loans, including residential mortgages, commercial mortgages, student loans, credit card receivables, auto loans, auto leases and equipment leases,
• servicing or certain other rights incidental to holding the loans,
• cash equivalents, including certain high quality, highly liquid short-term securities,
• qualifying rate or currency derivatives, and
• certain special units of beneficial interest or collateral certificates.¹⁸

The Agencies also indicated that “esoteric asset classes supported by loans may also be able to rely on the loan securitization exclusion, such as time share loans, container leases, and servicer advances.”¹⁹

IV. Relationship Restriction and Other Restrictions

A. Super 23A Restrictions

The Final Rule generally prohibits a banking entity that, directly or indirectly, serves as investment manager, investment adviser, commodity trading advisor, or sponsor to a covered fund, or that organizes and offers a covered fund, or that retains an ownership interest in certain covered funds,²⁰ as well as any affiliate of such banking entity, from entering into a transaction with the covered fund, or with any other covered fund that is controlled by such covered fund, that would be a “covered transaction” as defined in section 23A of the Federal Reserve Act, as if such banking entity were a member bank, and the covered fund were an affiliate thereof (Super 23A Restrictions).²¹  Covered transactions include certain loans and extensions of credit to a covered fund, guarantees of a covered fund’s obligations, or a credit exposure to a covered fund arising from a derivatives transaction.

The Final Rule provides an exception from the Super 23A Restrictions for any prime brokerage transaction with a second-tier covered fund (i.e., a covered fund in which a covered fund managed, sponsored, or advised by such banking entity (or affiliate) has taken an ownership interest) so long as certain conditions are met, including that the CEO (or equivalent officer) of the banking entity certifies in writing that the banking entity does not, directly or indirectly, guarantee or otherwise insure the obligations or performance of the covered fund or of any covered fund in which such covered fund invests.²²

B. Other Restrictions

A banking entity’s permitted activities and investments are subject to the following overriding limitations: no transaction or activity may be deemed permissible under the Final Rule’s provisions concerning organizing, offering, owning, and performing certain other activities with respect to covered funds if the transaction or activity would: (i) involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties; (ii) result, directly or indirectly, in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or (iii) pose a threat to the safety and soundness of the banking entity or the financial stability of the United States.²³

We have also prepared a comprehensive summary of the final Volcker Rule if you would like additional information.

        
¹  Final Rule § __.2(c).
² 78 FR 62,018, 62,072 (Oct. 11, 2013) (Board/OCC/FDIC Basel III Final Rule): 78 FR 55,340, 55,391 (Sept. 10, 2013) (FDIC Basel III interim final rule).
³  Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, And Relationships With, Hedge Funds And Private Equity Funds, Supplementary Information, p. 698.
⁴ Final Rule § __.10 and § __.11.
⁵ Final Rule § __.10(d)(6)(i).
⁶ Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With Hedge Funds and Private Equity Funds, 76 Fed. Reg. 68,846 (Nov. 7, 2011), § __.10(b)(3)(i).
⁷  Final Rule § __.10(b).
⁸  Final Rule § __.10(b); § __.10(c)(1).
⁹  Financial Times, December 17, 2013, p. 13.
¹⁰ FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule (Dec. 19, 2013).
¹¹ Statement regarding Treatment of Certain Collateralized Debt Obligations Backed by Trust Preferred Securities under the Rules implementing section 619 of the Dodd-Frank Act, p. 2. Under section 171, depository institution holding companies must phase out the inclusion of TruPS in their calculation of tier 1 capital, but section 171(b)(4)(C) permanently grandfathered TruPS issued before May 19, 2010, by certain companies with total assets of less than $15 billion.
¹² Bloomberg News, December 31, 2013.
¹³  Bloomberg News, January 2, 2014. According to Bloomberg News, the LSTA is considering a separate lawsuit. Bloomberg News, January 13, 2014.
¹⁴ New York Times Dealbook, January 7, 2014.
¹⁵ Final Rule § __.11.
¹⁶ Final Rule § __.10(d)(6)(ii).
¹⁷ Final Rule § __.12(b). A U.S. financial holding company may, without being deemed to control a registered company for the purpose of the BHC Act, both serve as an investment adviser to a registered investment company and hold less than 25% of such company’s voting shares.
¹⁸ See BHC Act § 13(g)(2).
¹⁹ Supplementary Information, p. 570.
²⁰ I.e., ownership interests in ABS of issuers organized and offered under Final Rule § __.11(b).
²¹ Final Rule § __.14(a).
²² § __.14(a)(2)(ii)(B).
²³ Final Rule § __.15(a).