The Regs that Bind

by Dechert LLP

photo of Rick JonesIn the world of magical realism which produced that paragon of legislative genius known as Dodd-Frank, I have had energy for only a bit of remote intellectual annoyance over the impact of the part of the Rule commonly known as “Volcker”.

Among the joys of the Volcker Rule, and there is much, much more here to celebrate or loath, is a limitation on the ability of a bank to invest more than a de minimus amount of capital in a private equity vehicle or hedge fund. This sort of transaction has been deemed by the political class as an unremittedly bad thing.

The Volcker Rule theoretically became effective on July 21, 2012 in the complete absence of critically important enabling regulations, subject to a two-year conformance period. Back last October (i.e., yes, a year ago now), the FDIC, Fed, OCC and the SEC (but oddly not the CFTC which must, under the statute, join in the issuances of any applicable rules) published a Proposed Interagency Rule. A comment period ensued, about a billion comments were submitted and then…crickets. No Rule. I am shocked to think the thought, and I’ll probably deeply regret it, but we’d be better off if we had actual regulations. The ultimate rules may be wrong-headed and damaging to entrepreneurship and enterprise, but at least we’ll know what we have. The Rule, as written is so theoretical, so remote from the hurley-burley of everyday business, that it’s chilly penumbra impacts deals and structures that, perhaps, with real regulations, might (might) be seen as OK. This endless limbo of yet to be finalized rules is infinitely worse.

There are no detailed regulations yet, though, for good reason. The regulatory community cannot, for its life, figure out what the implementing regulation should actually say. The statute sets a lot of fundamentally quixotic standards which are more classroom than boardroom. The rationale for the Rule, sensible on its face, is that banks shouldn’t be making risky private bets with publicly guaranteed deposits. But it’s not easy in the real world to distinguish, in many cases, the conduct which inspired the Rule (bad) from legitimate business deals (good)

More in a moment about why Volcker has graduated from merely inexplicably annoying to a bona fide pants-on-fire problem for me, but let’s detour for a moment on the idiocy of wasting time on proprietary trading and PE fund investment right now in the first instance. This law was given birth and justified by the credit crisis and the recession which started in 2007 and, in some material way, continues today. If memory serves, the credit crisis was brought to us by the bubbles in housing and commodities and the riptide when it collapsed. Anyone hear prop trading or PE funds in that pithy summary? That’s because it had little or nothing to do with the credit crisis and attendant recession. So here’s Volcker, in a nutshell: A wildfire almost burned down the village and, after long deliberation and much chest thumping, the City Fathers decided that the clear and obvious thing to do was to put a new Stop sign on Main Street. Come again? Reducing the risk of running down Granny is, to be sure, something of a public good. But, excuse me, the town just burnt down; shouldn’t we be a scooch more focused on fire safety? Okay, I don’t want to push this analogy too far, but no credible member of the economic chattering class has said that the prop trading was anywhere near the epicenter of the financial meltdown. At a time when we have plenty else to worry about, why in the world are we tying ourselves into knots about prop trading?

Ah, it’s the populism, stupid. The political calculus was compelling: the financial sector caused the recession. The financial sector is full of banks run by, ugh, bankers. If we punish banks and bankers, virtue will ensue.

Enough. Back to why I’m now really annoyed by the Volcker Rule. The Rule purports to limit a bank’s ability to invest in a hedge fund or private equity fund. Now, as I said at the outset, there’s a core of sensibility to the rule. There is certainly an argument that banks, with the benefit of the government guaranty of the deposit base, shouldn’t be playing private equity investors with customer deposits. But with an atom bomb to kill a mosquito sensibility, our elected leaders carpet bombed all bank investments in private equity vehicles and funds. Consequently, the Rule greatly impairs a bank's ability to do legitimate, bank-like things with private equity vehicles and funds. Just a few examples: Can a bank take an equity kicker to compensate it for risk? Probably not. Is an elevated interest rate or a higher fee structure good debt architecture or impermissible bad investment? What happens when the bank exercises remedies? My Lord, the bank may end up with more than the maximum allowable 3% interest! The statute sort of addresses this but creates artificially hard deadlines for disposing of the collateral, which is often inherently illiquid, chilling the willingness to fund these enterprises in the first instance. Moreover, why can't a bank invest funds in private vehicles, which are structured like funds but which are, in actuality, specialty finance companies providing financing to meet needs unmet by the conventional bank market? If we can structure these as operating companies, they are OK, but maybe that's not the deal. Why shouldn't a fund vehicle be used for lending? This is basic banking. This is the stuff that makes the economy work. Here we see the big flat foot of a Volcker giant stomping on customary non-nefarious banking, all to honor a narrative that, if tested, would be found wanting.

Oddly, the law excludes from the restrictions on investments in PE funds, funds exempt from registration under the ’40 Act under Section §3(c)(5). §3(c)(5) is the real estate fund exception. Not that I’m complaining, but why is investing in a real estate fund OK whereas investing in others is not? Moreover, investing in an operating company is also OK. What’s the difference between an operating company and a fund? Mighty fine stuff when you get down to it.

And so, like much in Dodd-Frank, we have a statute hurriedly put together, some proposed regulations that everyone agrees don’t work, no clarity and a lot of energy being spent figuring out what is and what is not permissible, at a time when time could be much better spent on entrepreneurship and enterprise. And all in the name of a populist conceit that prop trading and PE fund investment caused the financial crises. We should have better things to do.


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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