Agencies Finalize Amendments To Volcker Rule Covered Fund Provisions

Morrison & Foerster LLP

On June 25, 2020, five federal agencies (the “Agencies”)[1] finalized 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 “Final Funds Rule”). The Final Funds Rule is largely consistent with the Agencies’ proposal of January 30, 2020 (the “Proposed Funds Rule”)[2] and is the final anticipated amendment in a series of recent changes to the Volcker Rule. The Final Funds Rule will take effect on October 1, 2020.

Background

The Volcker Rule generally prohibits banking entities[3] from engaging in proprietary trading and from investing in, sponsoring, or having certain relationships with hedge funds and private equity funds (“covered funds”). It is not an authorizing statute: to determine if a particular investment is permissible, a banking entity must also consider whether the investment is authorized by the banking entity’s governing banking regulations. This Client Alert does not address such authorizing regulations.

In 2013, the Agencies adopted regulations to implement the Volcker Rule (the “2013 Rule”).[4] 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.[5] 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”).[6] The 2019 Final Rule also codified certain guidance previously published in the form of Frequently Asked Questions (“FAQs”).[7]

Federal Reserve Governor Lael Brainard dissented from the Federal Reserve’s approval of the Final Funds Rule.[8] While she supported certain aspects of the Final Funds Rule, she argued that several of the liberalizations, which were considered and rejected when the 2013 Rule was adopted, inject risk into the financial system without sufficient justification. In particular, she expressed concerns with the new exclusions for venture capital funds and credit funds as well as the Final Funds Rule’s treatment of parallel investments in sponsored funds. 

In general, the changes effected by the Final Funds Rule can be organized into five categories:

  1. codification of relief previously provided for so-called “qualifying foreign excluded funds;”
  2. modifications to certain existing exclusions from the definition of a “covered fund;”
  3. adoption of a number of additional exclusions to the definition of a “covered fund;”
  4. amendments to the Volcker Rule’s provisions related to transactions with “covered funds”, i.e., the “Super 23A provisions;” and
  5. revisions related to the determination of a banking entity’s “ownership interest” in a covered fund.

In this Client Alert, we provide an overview of the changes and highlight where those changes deviate from the Proposed Funds 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 such funds, but the definition is broad and encompasses additional types of entities. A “covered fund” is:

  1. 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;
  2. 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
  3. for any U.S. banking entity,[9] an entity that:
    1. is organized or established outside the United States and the ownership interests of which are offered and sold outside the United States; and
    2. 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 general definition of a “covered fund” set forth above, unless an exclusion or exemption applies.

In addition, subject to exemptions, section 14(a) of the 2013 Rule prohibits banking entities that (i) advise or sponsor a covered fund; (ii) organize and offer a fund pursuant to the Asset Management Exemption[10] or the ABS Issuer Exemption;[11] or (iii) hold an interest in a fund that is an ABS issuer, and affiliates of such banking entities 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[12] 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.[13] 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 Final Funds Rule

Qualifying Foreign Excluded Funds

Under the 2013 Rule, while foreign excluded funds[14] 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 certain foreign excluded funds controlled by non-U.S. banking entities (the “No-action Relief”).[15] The No-action Relief provided that, as long as certain conditions were 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 Final Funds Rule codifies the No-action Relief without any substantive changes by exempting all “qualifying foreign excluded funds” from the Volcker Rule’s proprietary trading and covered fund restrictions.[16] “Qualifying foreign excluded funds” are banking entities that:[17]

  1. are organized or established outside the United States, and the ownership interests of which are offered and sold solely outside the United States;
  2. 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;
  3. 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:
    1. the banking entity is not a U.S. banking entity; and
    2. the banking entity’s investment or sponsorship is permissible under the exemption for covered fund activities that occur solely outside the United States (i.e., it complies with the so-called “SOTUS Funds Exemption”);[18]
  4. are established and operated as part of a bona fide asset management business; and
  5. are 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 requirements of the Volcker Rule.

The Final Funds Rule deviates from the Proposed Funds Rule in two respects concerning qualifying foreign excluded funds. First, the anti-evasion provision (i.e., item (v) in the above definition) was clarified to provide that it applies only with respect to banking entities, and their affiliates, that sponsor or control such funds. Under the Proposed Funds Rule, the anti-evasion provision would have applied to “any other banking entity,” which would have caused some ambiguity as to the scope of its application.

Second, the Final Funds Rule amends certain compliance program requirements so they are not applicable to qualifying foreign excluded funds.[19] Since qualifying foreign excluded funds are banking entities, such compliance program requirements would have applied absent this amendment.

Notably, the Agencies declined to exempt qualifying foreign excluded funds from the Super 23A and 23B requirements.[20] The Agencies believe that these requirements are not overly burdensome since, in their view, they apply only in very limited circumstances, and would help prevent risks from flowing to U.S. banking entities.

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

Foreign Public Funds

The 2013 Rule excludes “foreign public funds” from the definition of a “covered fund.”[21] This exclusion was designed to provide rough parity to foreign funds that are sufficiently comparable to U.S.-registered investment companies (“RICs”). RICs are not “covered funds.”

Under the Final Funds Rule, a fund is a “foreign public fund” if it meets the following conditions:

  1. the fund is organized or established outside of the United States; and
  2. the fund is authorized to offer and sell ownership interests, and such interests are offered and sold, through one or more “public offerings.”

An additional condition applies with respect to such funds sponsored by U.S. banking entities. Such funds may be deemed to be foreign public funds only if more than 75% of the ownership interests in the funds are 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 (together with (1) through (3), “Associated Parties”).

The term “public offering” is defined in the Final Funds Rule as a distribution[22] of securities in any jurisdiction outside the United States to investors, including retail investors, provided that:

  1. the distribution is subject to substantive disclosure and retail investor protection laws or regulations;
  2. with respect to issuers for which the banking entity serves as investment manager, investment advisor, commodity trading advisor, commodity pool operator, or sponsor, the distribution complies with all applicable requirements in the jurisdiction in which the distribution is being made;
  3. the distribution does not restrict availability to investors having a minimum level of net worth or net investment assets; and
  4. the issuer has filed or submitted, with the appropriate regulatory authority, offering disclosure documents that are publicly available.

The Final Funds Rule changes certain requirements of the 2013 Rule to ease the conditions and compliance burden associated with relying on this exclusion.

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

Second, the Agencies eliminated the requirement that ownership interests be “predominantly” sold outside the United States.[23] A foreign public fund is still required to be sold in one or more “public offerings,” which, as described above, is defined as a distribution outside the United States (that meets certain conditions).

Third, for U.S. banking entities, the Final Funds Rule dials back the restriction on selling ownership interests to directors or employees of the banking entity or fund. Instead, the Final Funds Rule imposes a restriction on selling only to directors and senior executive officers.[24] In addition, in a deviation from the Proposed Funds Rule, the Final Funds Rule permits up to 24.9% (rather than 14.9%) of a foreign public fund to be held by Associated Parties. This aligns foreign public funds with a similar requirement applicable to RICs.

Fourth, the Final Funds Rule amends the definition of “public offering.”[25] The condition that the distribution must comply with applicable requirements in the jurisdiction where it is made now applies 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. The Final Funds Rule also adds a new condition: the distribution must be subject to substantive disclosure and retail investor protection laws and regulations.

Finally, in a change from the Proposed Funds Rule, the Agencies clarified the application of the attribution rules set forth in section 12(b)(1)(ii). That section provides that neither a RIC, nor an SEC-regulated business development company nor a foreign public fund will be considered an affiliate of a banking entity as long as the banking entity (i) does not own, control, or hold with the power to vote 25% of the voting shares of the entity; and (ii) provides investment advisory, commodity trading advisory, administrative, and other services to the entity. The Final Funds Rule clarifies that voting shares owned, controlled or held by an affiliate of a banking entity must be included in the ownership calculation and that the requirement that advisory (or other) services are provided to the entity may be satisfied by an affiliate of the banking entity.

Loan Securitizations

Under the 2013 Rule, a loan securitization is excluded from the definition of a “covered fund” if the assets held by the issuer are comprised solely of the following:[26]

  1. loans;
  2. 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 or incidental to purchasing or otherwise acquiring and holding the loans, subject to conditions (“Servicing Assets”); or
  3. certain specified types of financial instruments, including interest rate or foreign exchange derivatives, among other things.

The Final Funds Rule codifies guidance provided in a 2014 FAQ[27] to the effect that a Servicing Asset that is a security[28] must also be a “permitted security.” [29] Permitted securities include cash equivalents and securities received in lieu of debts previously contracted.[30] In addition, consistent with the FAQ, under the Final Funds Rule, “cash equivalents” means “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 2013 Rule did not permit loan securitizations relying on the exclusion to hold debt securities. The Final Funds Rule permits the holding of debt securities (other than asset-backed securities and convertible securities) that amount to 5% or less of the sum of the loans, cash and cash equivalents and debt securities. The Proposed Funds Rule, would have permitted the holding of such debt securities only up to 5% of any non-loan assets. The Final Funds Rule also contains valuation guidance for making the calculation.

Public Welfare Funds

The 2013 Rule excludes from the definition of “covered fund” any fund in the business of making investments that:

  1. are designed primarily to promote the public welfare, as permitted under 12 U.S.C. 24(11), including the welfare of low- and moderate-income communities or families and including investments that qualify for consideration under the Community Reinvestment Act; or
  2. are qualified rehabilitation expenditures with respect to a qualified rehabilitated building or certified historic structure (as defined in section 47 of the Internal Revenue Code of 1986 or a similar State historic tax credit program).

The Final Funds Rule expands the exclusion for public welfare funds. The Proposed Funds Rule did not expand the exclusion but sought comment as to whether to add it. The Agencies agreed with commenters that expansion was appropriate.

Under the Final Funds Rule,[31] the public welfare exclusion extends to:

  1. funds that have elected to be regulated or are regulated as rural business investment companies (“RBICs”),[32] (or that have terminated their participation as RBICs and do not make any new investments (subject to limited exceptions) after such termination); and
  2. qualified opportunity funds.[33]

Small Business Investment Companies (SBICs)

The Final Funds Rule revises the exclusion for certain small business investment companies (“SBICs”), as defined in section 103(3) of the Small Business Investment Act of 1958,[34] 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).[35] This 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

In the Final Funds Rule, consistent with the Proposed Rule, the Agencies adopted a new exclusion from the “covered fund” definition for credit funds,[36] which is modeled on the loan securitization exclusion. Under the new exclusion, a fund is not a covered fund if its assets consist solely of the following:

  1. loans;
  2. debt instruments;
  3. rights and other assets[37] that are related to or incidental to acquiring, holding, servicing, or selling such loans or debt instruments (subject to a number of conditions specified in the Final Funds Rule); or
  4. interest rate or foreign exchange derivatives (subject to conditions specified in the Final Funds Rule).

Under the “rights and other assets” prong, such credit funds are permitted to hold equity securities (or rights to acquire equity securities) that are received on customary terms in connection with loans or debt instruments held by the fund. The Agencies determined not to include a quantitative limit on the amount of equity securities that may be held in an excluded credit fund under this authority. However, in the Preamble to the Final Funds Rule, the Agencies stated that they “generally expect that the equity securities or rights…in connection with an investment in loans or debt instruments of a borrower (or affiliated borrowers) would not exceed five percent of the value of the fund’s total investment in the borrower (or affiliated borrowers) at the time the investment is made.”[38]

Credit funds qualifying for this exclusion are subject to activity limitations. Such funds are treated as if they are banking entities for purposes of the proprietary trading restrictions, and are not permitted to issue asset-backed securities. While the Agencies declined to include specific authority for credit funds to engage in activities exempt or excluded from the proprietary trading prohibition, the Preamble to the Final Funds Rule states that an excluded credit fund would not be precluded from engaging in such activity in accordance with the conditions of an exclusion or exemption.[39]

A number of additional requirements apply to a banking entity seeking to rely on the exclusion for credit funds. First, the banking entity may not 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 under applicable federal banking laws and regulations.[40] Further, any banking entity that acts as a sponsor, investment adviser, or commodity trading advisor to the credit fund is required to (i) issue certain disclosures to prospective and actual investors;[41] 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.

A banking entity’s relationship with an excluded credit fund is subject to the Super 23A and 23B restrictions (except the banking entity may hold an ownership interest in the issuer). In a change from the Proposed Funds Rule, the Super 23A and 23B restrictions would not apply with respect to banking entities that merely invest in an excluded credit fund (as opposed to a banking entity that serves as a sponsor or advisor).

Finally, a banking entity’s investment in and relationship with an excluded credit fund is subject to the Volcker Rule’s 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

Consistent with the Proposed Funds Rule, the Final Funds Rule adds a new exclusion from the covered funds definition for certain venture capital funds.[42] To qualify for this exclusion, a venture capital fund is required to meet the definition of a venture capital fund set forth in 17 C.F.R. § 275.203(l)-1[43] and may not engage in proprietary trading, as if the fund were a banking entity. However, as with excluded credit funds, an excluded venture capital fund may engage in permitted trading activity in accordance with the conditions of an exclusion or exemption from the prohibition on proprietary trading.[44]

A number of requirements apply to a banking entity seeking to rely on the exclusion for venture capital funds. First, the banking entity may not 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 is required to (i) make certain disclosures to prospective and actual investors;[45] 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.

Further, the banking entity’s relationship with the fund is subject to the Super 23A and 23B restrictions (except the banking entity may hold an ownership interest in the issuer). In a change from the Proposed Funds Rule, the Final Funds Rule, the Super 23A and 23B restrictions would not apply with respect to banking entities that merely invest in an excluded venture capital fund (as opposed to a banking entity that serves as a sponsor or advisor).

Finally, a banking entity’s investment in and relationship with an excluded venture capital fund is subject to the Volcker Rule’s 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.

Family Wealth Management Funds

The Final Funds Rule adds a new exclusion for funds used by banking entities to provide family wealth management services.[46] To qualify for the exclusion, 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.

In addition, family wealth management funds organized as trusts must have grantor(s) that are all family customers[47] of the banking entity. For those funds that are not trusts, (i) a majority of the voting interests must be owned by family customers; (ii) a majority of the interests must be owned by family customers; and (iii) the fund must be owned only by family customers and up to five closely related persons[48] of family customers.[49]

Notwithstanding these requirements, up to an aggregate of 0.5% of the fund’s outstanding ownership interests may be held by one or more entities that are not family customers or closely related persons as long as the ownership interests are held for the purpose of and to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency, or similar concerns.[50]

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.[51] In a change from the Proposed Funds Rule, the specified disclosure requirements may be modified to accommodate the specific circumstances of the fund and to prevent the disclosure from being misleading.

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;[52] 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. Although, in a change from the Proposed Funds Rule, banking entities will be permitted to engage in riskless principal transactions[53] that involve the purchase of low-quality assets from an excluded family wealth management fund.

Customer Facilitation Vehicles

Under the Final Funds Rule, customer facilitation vehicles are excluded 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.[54]

To qualify for the exclusion, all of the ownership interests of the fund would need to be held by the customer or its affiliates. Notwithstanding this requirement, up to an aggregate of 0.5% of the fund’s outstanding ownership interests may be held by one or more entities that are not customers of the banking entity as long as the ownership interests are held for the purpose of and to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency, or similar concerns.[55]

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.

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. In a change from the Proposed Funds Rule, the required disclosure requirements may be modified to accommodate the specific circumstances of the fund and to prevent the disclosure from being misleading.

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;[56] 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. Although, in a change from the Proposed Funds Rule, banking entities will be permitted to engage in riskless principal transactions that involve the purchase of low-quality assets from an excluded customer facilitation vehicle.

Super 23A Provisions

The Final Funds Rule revises the Super 23A provisions to enable certain transactions to occur between a banking entity and certain covered funds, as long as the transactions comply with the prudential backstop provisions.[57]

Transactions with a covered fund will be permitted if they are an “exempt covered transaction” under Section 23A of the Federal Reserve Act or 12 C.F.R. § 223.42.  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, in a change from the Proposed Funds Rule, the Final Funds Rule establishes a standalone exemption for banking entities to engage in riskless principal transactions. While a riskless principal transaction is an “exempt covered transaction” under 12 C.F.R. § 223.42 and therefore would have been permitted under the Proposed Funds Rule, as a result of this change, banking entities need not comply with the conditions set forth under 12 C.F.R. § 223.42 associated with riskless principal transactions.

Finally, certain short-term extensions of credit and asset purchases are permitted under the Final Funds Rule if they are conducted in the ordinary course of business in connection with payment transactions, settlement services, or futures, derivatives and securities clearing. These transactions must be repaid, sold, or terminated by the end of five business days. In addition, the transactions must 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 Determinations

Treatment of Debt Instruments

The Final Funds Rule limits the extent to which debt instruments could fall within the definition of an “ownership interest.”[58] This limitation addresses an issue caused by the 2013 Rule’s definition of “ownership interest” which includes “any equity, partnership, or other similar interest.”[59] The term “other similar interest” is 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 included the type of rights listed as constituting an “other similar interest.”

The Final Funds Rule addresses this issue in two ways.

First, under the Final Funds Rule, a creditor will not hold an ownership interest in a fund solely because, upon the occurrence of a default or acceleration event, it has the right to participate in the removal of an investment manager for cause or to participate in the selection of a replacement manager upon an investment manager’s resignation or removal.[60]

Second, the Final Funds Rule establishes a safe harbor for certain debt instruments. Under the safe harbor, senior loans and senior debt interests are not deemed ownership interests if:

  1. 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:
    1. 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
    2. Repayment of a fixed principal amount, on or before a maturity date, in a contractually- determined manner (including certain prepayment premiums).[61]
  2. 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
  3. 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

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[62] to less than 3% of the total number or value of outstanding ownership interests in the fund, after a seeding period.[63] Various attribution rules apply to determine whether an ownership interest should be included in the calculation.[64]

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.”[65] The Agencies also noted in the preamble to the 2013 Rule that banking entities should not make any co-investments alongside a fund they sponsor if such investments would exceed the investment limitations.

The Final Funds Rule overrules this rule of construction. Banking entities will now be permitted to make parallel investments alongside covered funds without attribution of the value of such investments for purposes of these limitations as long as the investment is made in compliance with applicable laws and regulations, including applicable safety and soundness standards.[66]

Such parallel investments remain 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. 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 Final 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). [67] 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. [68] 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.”[69]

Under the Final Funds Rule, amounts paid by employees to obtain restricted profit interests are included in the calculation only if the banking entity provided financing to the employee for the acquisition.[70] This makes the attribution rules for restricted profit interests consistent with the rules for ownership interests held by employees and directors.[71]


[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] Our Client Alert discussing the Proposed Funds Rule is available here.

[3]  As defined in the Volcker Rule and its implementing regulations.

[4] 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).

[5] 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.

[6] 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.

[7] Volcker Rule: FAQs, available at: Volcker Rule: Frequently Asked Questions. The Final Funds Rule does not modify or revoke any FAQs unless specifically noted.

[8] Statement by Governor Brainard (June 25, 2020), available at: Brainard Dissenting Statement.

[9] 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.

[10] 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).

[11] 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).

[12] 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.

[13] 2013 Rule §_.15.

[14] 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.

[15] 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.

[16] To provide this exemption, the Agencies 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.”

[17] Final Funds Rule §§ _.6(f); _.13(d).

[18] Investments in and sponsorship of covered funds is permissible as long as the activity complies with a number of conditions pursuant to § _.13(b) designed to ensure the activity occurs solely outside the United States, also referred to as the SOTUS Funds Exemption.

[19]  Final Funds Rule §§ _.20(a); _.20(d); _.20(e).

[20] Preamble to the Final Funds Rule at 22-23. The Final Funds Rule has not been published in the Federal Register as of the date of this Client Alert. Accordingly, citations to the Preamble to the Final Funds Rule are to the version as published on the website of the Federal Reserve.

[21]  2013 Rule § _.10(c)(1).

[22] 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).

[23] See 2013 Rule § _.10(c)(1)(i)(C).

[24]  See Final Funds Rule § _.10(c)(1)(ii).

[25]  Final Funds Rule § _.10(c)(1)(iii).

[26] 2013 Rule § _.10(c)(8).

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

[28] Other than special units of beneficial interest and collateral certificates meeting the requirements of §_.10(c)(8)(v).

[29] See Final Funds Rule §§ _.10(c)(8).

[30] 2013 Rule § _.10(c)(8)(iii).

[31] Final Funds Rule § _.10(c)(11)(ii).

[32] See 15 U.S.C. 80b-3(b)(8)(A) or (B).

[33] See 26 U.S.C. 1400Z-2(d).

[34] 15 U.S.C. § 662.

[35] Final Funds Rule § _.10(c)(11)(i).

[36] Final Funds Rule §§ _.10(c)(15).

[37] In a change from the Proposed Funds Rule, the Final Funds Rule clarifies that derivatives may not be held under the “rights and other assets” prong.

[38] Preamble to the Final Funds Rule at 70.

[39] Preamble to the Final Funds Rule at 76-77.

[40] The Final Funds Rule clarified the Proposed Funds Rule in this regard. The Proposed Funds Rule suggested that the banking entity’s investment in the assets of the fund would need to be permissible under any law, not just federal banking laws and regulations.

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

[42] Final Funds Rule §§ _.10(c)(16).

[43] 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. This definition of “venture capital fund” was promulgated by the SEC for purposes of certain requirements under the Investment Advisers Act of 1940.

[44] Preamble to the Final Funds Rule at 96.

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

[46] Final Funds Rule §§ _.10(c)(17).

[47] “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.

[48] “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.

[49] In a change from the Proposed Funds Rule, the Final Funds Rule has added the second requirement for non-trust funds and increased the number of closely related persons that can own the fund from three to five persons.

[50] The Proposed Funds Rule would have permitted only the sponsoring banking entity and its affiliates to hold up to 0.5% of the fund’s ownership interests.

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

[52] 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.

[53] The Final Funds Rule adds a new definition of “riskless principal transaction” which means “a transaction in which a banking entity, after receiving an order from a customer to buy (or sell) a security, purchases (or sells) the security in the secondary market for its own account to offset a contemporaneous sale to (or purchase from) the customer.” ­Final Funds Rule § _.10(d)(11).

[54] Final Funds Rule §§ _.10(c)(18). 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. See Preamble to the Final Funds Rule at 124.

[55] The Proposed Funds Rule would have permitted only the sponsoring banking entity and its affiliates to hold up to 0.5% of the fund’s ownership interests.

[56] Specifically, under the Final 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.

[57] Final Funds Rule § _.14.

[58] Final Funds Rule § _.10(d)(6).

[59] 2013 Rule § _.10(d)(6).

[60] The Proposed Funds Rule limited this text to rights to participate in the removal of the investment manager or to nominate or vote on a nominated replacement manager. In addition, in a change from the Proposed Funds Rule, the Final Funds Rule includes an exemplary list of what would constitute “cause” for purposes of this provision.

[61] The fact that repayment may be made “in a contractually-determined manner” is a deviation from the Proposed Funds Rule. This is intended to clarify “that the safe harbor is available to senior loan and senior debt interests where contractual principal payments vary over the life of a senior loan or senior debt interest for reasons such as amortization and acceleration provided that the total amount of principal required to be repaid over the life of the instrument does not change.” Preamble to the Final Funds Rule at 153-154.

[62] For definitions of “Asset Manager Exemption” and “ABS Issuer Exemption” please see supra notes 11-12.

[63] See 2013 Rule § _.12(a)(2).

[64] See 2013 Rule § _.12(b).

[65] 79 Fed. Reg. 5734.

[66] See Proposed Funds Rule § _.12(b)(5).

[67] See 2013 Rule § _.12(a)(2)(iii).

[68]  See 2013 Rule § _.12(d).

[69] 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.

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

[71] 2013 Rule § _.12(b)(iv).

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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