Understanding the Newly Proposed Credit Fund Exclusion Under the Volcker Rule

Kramer Levin Naftalis & Frankel LLP

Section 13 of the Bank Holding Company Act of 1956 (the BHC Act) generally prohibits any insured depository institution (as defined in Section 3(c) of the Federal Deposit Insurance Act, but excluding institutions that function solely in a trust or fiduciary capacity, subject to certain conditions), any company that controls an insured depository institution, any company that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978, and any affiliate or subsidiary (as defined in the Bank Holding Company Act of 1956, which contains a 25 percent voting share ownership or control trigger) of any of the foregoing (each, a “Banking Entity” and, collectively, “Banking Entities”) from, among other things, acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (a “Covered Fund”).

However, Section 13 of the BHC Act currently contains an exemption that permits Banking Entities to organize and offer, including sponsor, Covered Funds, subject to certain restrictions, including that (i) the Banking Entities do not rescue investors in those funds from loss, and are not themselves exposed to significant losses due to investments in or other relationships with these funds; (ii) the Banking Entity provides bona fide trust, fiduciary or investment advisory services; (iii) the fund is organized and offered only to customers in connection with the provision of such services; (iv) the Banking Entity does not have an ownership interest in the fund, except for a de minimis investment; (v) the Banking Entity complies with certain marketing restrictions related to the fund; (vi) no director or employee of the Banking Entity has an ownership interest in the fund, with certain exceptions; and (vii) the Banking Entity discloses to investors that it does not guarantee the performance of the fund.

Authority under Section 13 of the BHC Act for developing and adopting regulations to implement the prohibitions, restrictions and exemptions of Section 13 of the BHC Act is shared among the Office of the Comptroller of the Currency, Treasury (OCC), the Board of Governors of the Federal Reserve System (Federal Reserve Board), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) (each, an “Agency” and, collectively, the “Agencies”). Those jointly adopted regulations are referred to collectively as the “Volcker Rule.”

On Jan. 30, 2020, the Agencies proposed revisions to the Volcker Rule to improve and streamline the provisions of the Volcker Rule that restrict Banking Entities from investing in or sponsoring Covered Funds. The full text of the proposed revisions to the Volcker Rule can be found here. One of the proposed revisions is to create a new exclusion from the definition of Covered Fund for Credit Funds.

A “Credit Fund,” for the purposes of the proposed exclusion, is a fund whose assets consist solely of:

  • Loans
  • Debt instruments
  • Related rights and other assets that are related or incidental to acquiring, holding, servicing, or selling loans or debt instruments (provided that each such right or asset that is a security is either a cash equivalent, a security received in lieu of debts previously contracted with respect to such loans or debt instrument, or an equity security (or right to acquire an equity security) received on customary terms in connection with such loans or debt instruments, but in no event may include commodity forward contracts)
  • Interest rate or foreign exchange derivatives if the written terms of the derivative directly relate to the loans, debt instruments, or such other permitted rights or assets, and the derivative reduces the interest rate and/or foreign exchange risks related to the loans, debt instruments, or such other permitted rights or assets.

The Credit Fund exclusion also would be subject to certain additional restrictions to ensure that the issuer is actually engaged in providing credit and credit intermediation and is not operated for the purpose of evading the provisions of Section 13 of the BHC Act. Under the proposal, a Credit Fund would not be a Covered Fund, provided that:

  • The fund does not engage in activities that would constitute proprietary trading under the Volcker Rule as if the fund were a Banking Entity.
  • The fund does not issue asset-backed securities.

If a Banking Entity sponsors or serves as an investment adviser or commodity trading advisor to a Credit Fund, the Banking Entity would be required to clearly and conspicuously disclose, in writing, to any prospective and actual investor in the Credit Fund (such as through disclosure in the Credit Fund’s offering documents):

  • That any losses in the Credit Fund will be borne solely by investors in the Credit Fund and not by the Banking Entity or its affiliates; therefore, the Banking Entity’s losses in the Credit Fund will be limited to losses attributable to the ownership interests in the Credit Fund held by the Banking Entity and any affiliate in its capacity as investor in the Credit Fund or as beneficiary of a restricted profit interest held by the Banking Entity or any affiliate
  • That such investor should read the fund offering documents before investing in the Covered Fund
  • That the ownership interests in the Credit Fund are not insured by the FDIC, and are not deposits, obligations of, or endorsed or guaranteed in any way by any Banking Entity
  • The role of the Banking Entity and its affiliates and employees in sponsoring or providing any services to the Credit Fund

In addition, the Banking Entity would be required to ensure that the activities of the Credit Fund are consistent with safety and soundness standards that are substantially similar to those that would apply if the Banking Entity engaged in the activities directly. Furthermore, except as described below, no Banking Entity that serves, directly or indirectly, as the investment manager, investment adviser, commodity trading advisor, or sponsor to a Credit Fund, that organizes and offers a Credit Fund, or that holds an ownership interest in a Credit Fund and no affiliate of such Banking Entity, may enter into a transaction with the Credit Fund, or with any other Credit Fund that is controlled by such Credit Fund, that would be a “covered transaction” as defined in Section 23A of the Federal Reserve Act, as if such Banking Entity and the affiliate thereof were a member bank and the Credit Fund were an affiliate thereof.

The term “covered transaction” under Section 23A of the Federal Reserve Act means, with respect to an affiliate of a member bank:

  • A loan or extension of credit to the affiliate, including a purchase of assets subject to an agreement to repurchase
  • A purchase of or an investment in securities issued by the affiliate
  • A purchase of assets from the affiliate, except such purchase of real and personal property as may be specifically exempted by the Federal Reserve Board by order or regulation
  • The acceptance of securities or other debt obligations issued by the affiliate as collateral security for a loan or extension of credit to any person or company
  • The issuance of a guarantee, acceptance, or letter of credit, including an endorsement or standby letter of credit, on behalf of an affiliate
  • A transaction with an affiliate that involves the borrowing or lending of securities, to the extent that the transaction causes a member bank or a subsidiary to have credit exposure to the affiliate
  • A derivative transaction, with an affiliate, to the extent that the transaction causes a member bank or a subsidiary to have credit exposure to the affiliate

Notwithstanding the foregoing, a Banking Entity may acquire and retain any ownership interest in a Credit Fund in accordance with the requirements described herein and enter into any prime brokerage transaction with the Credit Fund if the chief executive officer (or equivalent officer) of the Banking Entity certifies in writing annually to the applicable Agency (with a duty to update the certification if the information in the certification materially changes) that the Banking Entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the Credit Fund and the Federal Reserve Board has not determined that such transaction is inconsistent with the safe and sound operation and condition of the Banking Entity.

A Banking Entity that serves, directly or indirectly, as the investment manager, investment adviser, commodity trading advisor, or sponsor to a Credit Fund, or that organizes and offers a Credit Fund or that holds an ownership interest in a Credit Fund shall be subject to Section 23B of the Federal Reserve Act, as if such banking entity were a member bank and such covered fund were an affiliate thereof. Section 23B of the Federal Reserve Act requires that a member bank and its subsidiaries may only engage in transactions with its affiliates on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to such bank or its subsidiary, as those prevailing at the time for comparable transactions with or involving other nonaffiliated companies, or in the absence of comparable transactions, on terms and under circumstances, including credit standards, that in good faith would be offered to, or would apply to, nonaffiliated companies.

In addition, the Banking Entity’s relationship with the Credit Fund may not involve a transaction, class of transactions, or activity if the transaction, class of transactions, or activity would:

  • Involve or result in a “material conflict of interest” between the Banking Entity and its clients, customers or counterparties
  • Result, directly or indirectly, in a material exposure by the Banking Entity to a “high-risk” asset or a “high-risk trading strategy”
  • Pose a threat to the safety and soundness of the Banking Entity or to the financial stability of the United States

A “material conflict of interest” between a Banking Entity and its clients, customers, or counterparties exists if the Banking Entity engages in any transaction, class of transactions, or activity that would involve or result in the Banking Entity’s interests being materially adverse to the interests of its client, customer, or counterparty with respect to such transaction, class of transactions, or activity, and the Banking Entity has not taken at least one of the following actions:

  • Has made clear, timely, and effective disclosure of the conflict of interest, together with other necessary information, in reasonable detail and in a manner sufficient to permit a reasonable client, customer, or counterparty to meaningfully understand the conflict of interest; and such disclosure is made in a manner that provides the client, customer, or counterparty the opportunity to negate, or substantially mitigate, any materially adverse effect on the client, customer, or counterparty created by the conflict of interest
  • Has established, maintained, and enforced information barriers that are memorialized in written policies and procedures, such as physical separation of personnel, or functions, or limitations on types of activity, that are reasonably designed, taking into consideration the nature of the Banking Entity’s business, to prevent the conflict of interest from involving or resulting in a materially adverse effect on a client, customer, or counterparty (a Banking Entity may not rely on such information barriers if in the case of any specific transaction, class or type of transactions or activity, the Banking Entity knows or should reasonably know that, notwithstanding the Banking Entity’s establishment of information barriers, the conflict of interest may involve or result in a materially adverse effect on a client, customer or counterparty)

For purposes of the foregoing, “high-risk asset” means an asset or group of related assets that would, if held by a Banking Entity, significantly increase the likelihood that the Banking Entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States.

For purposes of the foregoing, “high-risk trading strategy” means a trading strategy that would, if engaged in by a Banking Entity, significantly increase the likelihood that the Banking Entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States.

A Banking Entity’s investment in and relationship with a Credit Fund also would be required to comply with applicable safety and soundness standards. Finally, a Banking Entity that invests in or has a relationship with a Credit Fund would continue to be subject to capital charges and other requirements under applicable banking law. Furthermore, the Banking Entity may not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the Credit Fund or of any entity to which such Credit Fund extends credit or in which such Credit Fund invests. Lastly, and in addition, any assets the Credit Fund holds would need to be permissible for the Banking Entity to acquire and hold directly.

[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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