Recently published amendments to the Volcker Rule—effective October 1, 2020—could have significant market impact for affected stakeholders, and will liberalize certain key aspects of the Volcker Rule’s regulations and quell or eliminate its impact for several investment product categories. This LawFlash summarizes the amendments, addresses key interpretive issues, and provides our early observations on expected business impacts and market opportunities.
On June 25, the Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, US Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (collectively, the Agencies) issued final amendments (2020 Amendments) to certain provisions of the Volcker Rule’s implementing regulations (Regulations) for covered and foreign (non-US) funds.
This was the second major rulemaking initiative undertaken by the Agencies over the past two years to better align the provisions of the Volcker Rule with its intended purposes and to reduce the overall compliance burdens on regulated institutions. The 2020 Amendments are intended to facilitate capital formation, protect safety and soundness, promote financial stability, and provide greater clarity and certainty about permitted fund-related activities.
Market participants—including banks and bank-affiliated entities that sponsor, manage, invest in, or provide services to private funds, as well as independent managers seeking to attract banking group capital—will find that the 2020 Amendments liberalize certain key aspects of the Regulations and either exclude or substantially mitigate the impact of the Volcker Rule for several significant categories of investment products.
THE 2020 AMENDMENTS – OVERVIEW
EXCLUSIONS FROM THE DEFINITION OF “COVERED FUND”
The Volcker Rule generally prohibits a banking entity from acquiring or retaining an ownership interest in, or having certain relationships with, a “covered fund”. In practice, this definition covers not only the “hedge funds and private equity funds” originally targeted by the statute, but also many other types of collective investment vehicles that rely on the Investment Company Act of 1940 (1940 Act) exemptions that give rise to covered fund status.
The 2020 Amendments do not revise the definition of a “covered fund.” However, they do clarify and revise certain existing exclusions and also add several new exclusions to the Regulations, thus materially narrowing the overall scope of collective investment vehicles that will be restricted by the Volcker Rule.
REVISIONS TO EXISTING EXCLUSIONS
The 2020 Amendments expand and relax certain conditions of three of the existing “covered fund” exclusions:
1. Foreign Public Fund Exclusion. The 2020 Amendments remove the current requirements that a foreign public fund be (a) authorized to sell to retail investors in the issuer’s home jurisdiction and (b) sold “predominantly” through one or more public offerings outside the United States—replacing these requirements with a requirement that a foreign public fund be authorized to offer and sell ownership interests and that such interests are offered and sold through one or more public offerings. Thus, the Regulations will no longer require that a foreign public fund be authorized for retail sale in the jurisdiction where it is organized nor that public offerings be the “predominant” method by which the fund is distributed.
The 2020 Amendments also provide greater detail on the meaning of a “public offering” in this context, specifically defining it as a distribution of securities outside the United States, including to retail investors, provided that (a) the distribution is subject to substantive disclosure and retail investor protection law or regulations, (b) the distribution does not restrict availability to investors having a minimum level of net worth or net investment assets, and (c) the issuer has filed or submitted offering disclosure documents that are publicly available.
2. Loan Securitization Exclusion. The 2020 Amendments permit qualifying loan securitizations to hold a small amount (up to 5%) of assets in the form of debt securities (excluding asset-backed and convertible securities). Thus, collateralized loan obligation (CLO) issuers and other vehicles relying on this exclusion will once again be permitted to hold a traditional “bond bucket” to supplement loan assets, which in practice had generally been eliminated for CLOs organized since the initial adoption of the exclusion in 2014.
3. Public Welfare Fund and SBIC Exclusion. The 2020 Amendments include several changes to expand the scope of the public welfare fund exclusion. The exclusion will now apply to all funds the business of which is to make investments that qualify for consideration under the Community Reinvestment Act. With respect to small business investment companies (SBICs), the 2020 Amendments provide that an SBIC will remain eligible for the exclusion after it has voluntarily surrendered its license in connection with a wind-down of the vehicle, provided that the SBIC makes no new investments. In addition, the public welfare fund exclusion has been expanded to include Qualified Opportunity Funds and Rural Business Investment Companies.
The 2020 Amendments add four new exclusions to the Regulations, allowing banking entities to invest in or sponsor additional types of investment entities without triggering the covered fund restrictions of the Volcker Rule:
1. Credit Fund Exclusion. The new exclusion for credit funds applies to issuers (other than issuers of asset-backed securities) the assets of which are limited to loans; debt instruments that would be permissible for the banking entity relying on the exclusion to hold directly; certain rights or assets related or incidental to the loans or debt instruments, including equity securities (or rights to acquire an equity security) received on customary terms in connection with such loans or debt instruments; and certain interest rate and foreign exchange derivatives.
A fund seeking to rely on the credit fund exclusion is not permitted to engage in activities that would constitute proprietary trading under the Volcker Rule, such as short-term trading of debt securities (generally, trading involving positions held for fewer than 60 days). In addition, banking entities acting as sponsor or investment adviser to a credit fund generally must observe the Volcker Rule Super 23A and 23B restrictions as if the credit fund were a covered fund.
2. Venture Capital Fund Exclusion. This new exclusion applies to issuers that satisfy the SEC’s definition of “venture capital fund” in Rule 203(l)-1 of the Investment Advisers of 1940. Such funds must pursue a qualifying “venture capital strategy,” adhere to restrictions on the amount of non-qualifying assets and leverage, and impose restrictions on investors’ ability to withdraw or redeem their interests in the fund except in extraordinary circumstances.
In addition to satisfying these definitional restrictions, as with credit funds, a venture capital fund relying on the exclusion is not permitted to engage in activities constituting proprietary trading under the Volcker Rule, and a banking entity acting as sponsor or adviser to the venture capital fund must observe Volcker Rule Super 23A and 23B limitations as if the fund were a covered fund.
3. Family Wealth Management Vehicle Exclusion. The new exclusion for family wealth management vehicles is available to an entity that (1) is not, and does not hold itself out as being, an entity that raises money from investors primarily for the purpose of investing in securities or otherwise trading in securities, and (2) is either (a) a trust, the grantors of which are all family customers; or (b) an entity other than a trust, a majority of the voting interests of which are owned by family customers; a majority of the interests of which are owned by family customers; and which is owned only by family customers and up to five “closely related persons” (with a de minimis allowance for interests held by other entities for purposes of establishing corporate separateness or addressing bankruptcy/insolvency concerns).
4. Customer Facilitation Vehicle Exclusion. This new exclusion applies to any issuer formed by or at the request of a customer of the banking entity for the purpose of providing the customer (which may include one or more affiliates of such customer) with exposure to a transaction, investment strategy, or other service of the banking entity.
QUALIFYING FOREIGN EXCLUDED FUNDS
In a significant development for non-US asset managers subject to the Volcker Rule, the 2020 Amendments make permanent the relief from “banking entity” status that had been extended to “qualifying foreign excluded funds” through a series of time-limited policy statements going back to 2017.
Thus, investment funds organized outside the United States, and offered and sold solely outside the United States, generally will be exempt from the Volcker Rule’s proprietary trading and covered fund investment restrictions at the fund level, as well as any Volcker Rule compliance program obligations, even if the fund is “controlled” by a non-US banking organization for purposes of the US Bank Holding Company Act of 1956 (BHCA).
In order to rely on the exemption for qualifying foreign excluded funds, a fund that would otherwise be treated as a banking entity must satisfy the following conditions:
- The fund must be organized or established outside the United States, and ownership interests in the fund must be offered and sold solely outside the United States.
- The fund would be a covered fund if it were organized or established in the United States, or 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.
- The fund would not otherwise be a banking entity except by virtue of the acquisition or retention of an ownership interest in, sponsorship of, or relationship with the fund, by a banking entity that meets the following conditions:
- The banking entity is not organized—or directly or indirectly controlled by a banking entity that is organized—under the laws of the United States.
- The banking entity’s acquisition of an ownership interest in or sponsorship of the fund meets the requirements the “SOTUS Exemption.”
- The fund is established and operated as part of a bona fide asset management business.
- The fund is not operated in a manner that enables the banking entity that sponsors or controls the fund, or any of its affiliates, to evade the requirements of the Volcker Rule.
LIMITED RELAXATION OF THE “SUPER 23A” PROHIBITION
Prior to the 2020 Amendments’ issuance, the “Super 23A” provisions of the Volcker Rule generally prohibited any transaction between a banking entity and a covered fund for which the banking entity or an affiliate serves as sponsor or investment adviser (a “related covered fund”) to the extent that the transaction would be a “covered transaction” under Section 23A of the Federal Reserve Act. The original Regulations generally did not incorporate the various exceptions found in Section 23A or the Federal Reserve’s Regulation W.
The 2020 Amendments provide some limited relaxation of the Super 23A prohibition to allow a banking entity to engage in certain covered transactions with a related covered fund that would be exempt from the quantitative limits, collateral requirements, and low-quality asset prohibitions under Section 23A and Regulation W (subject to the same conditions applicable to those exemptions under Regulation W). This includes certain intraday extensions of credit and transactions secured by US government securities.
In addition, the 2020 Amendments provide new exceptions from the Super 23A prohibition for (1) riskless principal transactions between a banking entity and a related covered fund and (2) extensions of credit to, or purchases of assets from, a related covered fund that satisfy the following conditions:
- Each extension of credit or purchase of assets is in the ordinary course of business in connection with payment transactions, settlement services, or futures, derivatives and securities clearing.
- Each extension of credit is repaid, sold or terminated by the end of five business days.
- The banking entity making each extension of credit meets the requirements of Section 23A of the Federal Reserve Act and Section 223.42(l)(1)(i) and (ii) of Regulation W (i.e., certain policies and procedures and credit monitoring and control obligations), as if the extension of credit was an intraday extension of credit, regardless of the duration of the extension of credit.
The 2020 Amendments establish a rule of construction—reversing the position adopted by the Agencies in connection with the issuance of the original Regulations—providing that a banking entity is not required to treat parallel investments or co-investments made by the banking entity alongside a covered fund as an investment in the covered fund for purposes of applicable Volcker Rule ownership limits, including for purposes of both the 3% “per fund” ownership limit under the asset management exemption and the aggregate 3% limit on investments in all covered funds. This relief requires that the banking entity making the parallel investment does so in accordance with applicable law, which would include having an independent authority to make the investment under section 4 of the BHCA.
CHANGES TO DEFINITION OF “OWNERSHIP INTEREST”
Under the Regulations, an “ownership interest” in a covered fund is defined broadly to include any equity, partnership, or other “similar interest,” including any interest that has the right to “participate” in the selection or removal of a general partner, managing member, member of the board of directors or trustees, investment manager, investment adviser, or commodity trading advisor of a covered fund. The expansiveness of this definition has raised substantial uncertainty in the market regarding whether a debt instrument carrying such a right other than in a default scenario could be regarded as an ownership interest, even where it otherwise lacked equity-like characteristics.
The 2020 Amendments revise the definition of “ownership interest” to clarify that a debt instrument will not be treated as an ownership interest solely because it affords the creditor a right to participate in the removal of an investment manager for “cause” independent from the occurrence of an event of a default or acceleration event, or to nominate or vote on a nominated replacement manager upon an investment manager’s resignation or removal.
The 2020 Amendments define “cause” in this context as one or more of the following events:
(i) The bankruptcy, insolvency, conservatorship or receivership of the investment manager.
(ii) The breach by the investment manager of any material provision of the covered fund’s transaction agreements applicable to the investment manager.
(iii) The breach by the investment manager of material representations or warranties.
(iv) The occurrence of an act that constitutes fraud or criminal activity in the performance of the investment manager’s obligations under the covered fund’s transaction agreements.
(v) The indictment of the investment manager for a criminal offense, or the indictment of any officer, member, partner or other principal of the investment manager for a criminal offense materially related to his or her investment management activities.
(vi) A change in control with respect to the investment manager.
(vii) The loss, separation, or incapacitation of an individual critical to the operation of the investment manager or primarily responsible for the management of the covered fund’s assets.
(viii) Other similar events that constitute ‘‘cause’’ for removal of an investment manager, provided that such events are not solely related to the performance of the covered fund or the investment manager’s exercise of investment discretion under the covered fund’s transaction agreements.
The events included in clauses (i)–(vii) of the “cause” definition above are similar to those found in market standard CLO management agreements, and clause (viii) appears to be intended to provide market participants some flexibility to the extent the specific contractual provisions (which are typically negotiated) deviate to some degree from the text of the rule.
To give further certainty on the treatment of debt, the 2020 Amendments provide a safe harbor excluding senior loans and senior debt instruments from the definition of “ownership interest,” provided that
- holders of the debt interests receive only interest payments that are not determined by reference to the performance of the underlying assets of the covered fund, and repayment of a fixed principal amount on or before a maturity date;
- the holders’ entitlement to payments is absolute and may not be reduced due to losses arising from the underlying assets of the covered fund, such as allocation of losses, write-downs or charge-offs of the outstanding principal balance, or reductions in the principal and interest payable; and
- holders of the interest are not entitled to receive the underlying assets of the covered fund after all other interests have been redeemed and/or paid in full (excluding the rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event).
INTERPRETIVE ISSUES, BUSINESS IMPACT & MARKET OPPORTUNITIES
The clear and intended thrust of the 2020 Amendments is to reduce the impact of the Volcker Rule and its attendant regulatory drag on pooled investments and capital formation in areas where there is a sound argument that the concerns to which the Volcker Rule covered funds prohibition was directed are not materially present.
The 2020 Amendments also address and resolve several key interpretive issues and technical glitches in the Regulations—some unintended—that had proven disruptive to permissible investment fund-related activities without yielding material benefits in terms of safety and soundness or financial stability.
While we regard the 2020 Amendments as consisting mainly of incremental adjustments that more appropriately tailor the Regulations—i.e., as opposed to “game changing” revisions that materially rollback or fundamentally alter the Volcker Rule—certain of the amendments nevertheless will be significant for market participants, and surely some will invite further questions of their own. We offer below some initial observations on several key interpretive issues and the potential market impact of the 2020 Amendments.
Credit Funds: When Opportunity Knocks. Given recent COVID-related and other dislocations in the credit markets, as well as the possibility that further distress in the credit markets could motivate banks to reduce certain loan exposures as they shore up capital, the blanket exclusion of credit funds from the Volcker Rule may prove one of the more consequential aspects of the 2020 Amendments. Credit opportunities funds, direct lending funds, and similar vehicles seeking to capitalize on developments in the credit markets may well be able to attract additional capital and do so more efficiently without the overhang of the Volcker Rule.
Among other things, non-US managers in this space—which prior to issuance of the 2020 Amendments may have been incentivized to avoid seeking US investors for such funds (i.e., in order to rely on the relief for qualifying foreign excluded funds and largely sidestep the Volcker Rule)—should have greater flexibility to take on US capital given that doing so will no longer result in a credit fund being treated as a covered fund. The new exclusion will only be meaningful, however, for credit funds that are able to avoid “short-term” debt trading activities that would constitute proprietary trading under the Regulations, so managers may well be incentivized to adopt strategies that include controls to restrict short-term trades and ensure that positions are generally held for a minimum of 60 days.
Fund Custody Services: Homecoming Season. Another potentially significant market impact arising from the 2020 Amendments, specifically the relaxation of the Super 23A prohibitions, is the expanded authority for banking entities to provide custody services for related covered funds (i.e., those sponsored by the banking entity or an affiliate or for which the banking entity or an affiliate serves as investment adviser).
Under the Super 23A provisions in the initial Regulations, such services for related covered funds were effectively prohibited (excluding entities that were able to rely on the prime brokerage exemption), as the provision of clearing and settlement services for a related covered fund generally requires short-term (i.e., intraday or overnight) extensions of credit. As a result, many banking groups that would have preferred to perform these services “in-house” have been forced to rely on unaffiliated custodians.
The new exemptions to Super 23A for intraday and other short-term extensions of credit to related covered funds should permit banking groups capable of performing these functions internally to recapture this business. Institutions seeking to do so will, however, need to carefully review and address the compliance infrastructure obligations, including policies and procedures and internal controls, as set forth both in the Regulations and in the Federal Reserve’s Regulation W. In addition, institutions will need to ensure compliance with the “market terms” requirement of 23B.
No Good Deed: “Bona Fide Asset Management Business” & Anti-Evasion Considerations for Qualifying Foreign Excluded Funds. The permanent exemptive relief for qualifying offshore funds from being treated as banking entities is clearly a welcome development for many non-US asset managers affiliated with foreign banking organizations. Such managers will no longer need to anticipate and undertake contingency planning for the possibility that their offshore funds might become subject to Volcker Rule trading or investment restrictions (or be obligated to adopt fund-level compliance programs), thus putting them on more equal footing with competitors outside the United States that are not subject to the Volcker Rule.
At the same time, market participants that have not already done so will need to assess carefully and develop internal policies and procedures related to the “bona fide asset management business” and anti-evasion conditions of the exemption. For example, institutions will need to contend with what level of ownership in an offshore fund by the sponsoring/advising banking group itself and what other factors might cause a particular fund to be characterized as not arising in the context of a bona fide asset management business and/or as “enabl[ing] the foreign banking entity to evade the requirements” of the Volcker Rule.
At a minimum, where a non-US manager is managing both outside client capital and capital of the banking group itself, the relief afforded qualifying foreign excluded funds and the conditions of that relief will likely incentivize managers to ensure that a substantial portion of the fund’s capital comes from non-affiliates and thereby reduce the potential evasion risk.
Foreign Public Funds & the New Public Offering Requirement…or Safe Harbor? The 2020 Amendments raise a somewhat similar question for funds relying on the foreign public fund exclusion—namely, how “public” must the fund really be? Under the plain language of the 2020 Amendments, a fund may qualify for the exclusion based on just a single “public offering” outside the United States. Clearly, that public offering must itself satisfy conditions intended to ensure that the fund is “retail” in nature and generally analogous to a US mutual fund.
However, the 2020 Amendments suggest that just one such offering—regardless of its significance to the overall distribution of the fund—will essentially “inoculate” the fund and ensure it qualifies for the exclusion, even if the substantial majority of the fund’s interests in the aggregate are sold, for example, via private offerings in other jurisdictions. The requirement that a foreign public fund be sold “predominantly” or 85% via public offerings outside the United States will no longer apply.
Once again, market participants will need to carefully assess the relief and flexibility afforded by the revisions while remaining cognizant of the general anti-evasion provisions of the Volcker Rule, as well as the fallback safeguard provisions related to high-risk activities.
Merchant Banking Back in Business: Structuring Options Via Parallel Investment & Co-Investments. The express exclusion of parallel investments made alongside a related covered fund from the per fund and aggregate covered fund ownership interest limits is a potentially significant development for banking entities that rely on the asset management exemption to organize and offer covered funds to clients.
While that exemption is subject to several conditions, the “gating” issue for many structures is the 3% ownership interest limit (after seeding) applicable to the fund sponsor and its affiliates. Once the 2020 Amendments are in place, banking entities generally will be able to take on substantially more exposure to the underlying assets held by a covered fund—thus putting additional skin in the game alongside clients—via parallel investments. Of course, the banking entity and its affiliates making such parallel investments will require their own investment authority, principally under section 4 of the BHCA; the “relief” afforded under the Volcker Rule does not operate as an independent source of investment authority.
Accordingly, and particularly in the case of private equity, venture, real estate, and infrastructure funds where the underlying portfolio investments may not be financial in nature, this amendment to the Regulations is likely to be most useful for financial holding companies that can acquire direct interests in these kinds of assets under the merchant banking authority, a somewhat curious development given the Federal Reserve’s 2016 recommendation—not since acted on—that merchant banking authority be eliminated altogether.
Bond Buckets: Don’t Call It a Comeback. In a demonstration that everything old is, indeed, new again, the 2020 Amendments will permit CLOs and other vehicles relying on the loan securitization exclusion once again to hold a bond bucket not to exceed 5% of the vehicle’s total assets—a common practice for these vehicles prior to 2014.
While substantially all earlier vintage CLOs have been “Volckerized” for some time via the elimination of non-loan collateral and CLOs established after adoption of the initial Regulations generally have been structured to be Volcker-compliant from the outset without any bond bucket, we expect that the next generation of CLOs and other forms of loan securitizations will likely take advantage of the relief provided by the 2020 Amendments and get back—at least in this regard—to where they were prior to adoption of the original Regulations.
Ownership Interest Changes: Removing Volcker from the CLO Market Completely? Market participants are already beginning to make arguments that one or both of the ownership interest amendments should effectively be read to exclude all CLO-issued debt from the definition of ownership interest.
Under such an interpretation, even if a CLO were to be treated as a covered fund, only the subordinated notes would be viewed as an ownership interest. Subordinated notes are the most junior tranche in a CLO, and one not typically purchased by banks. Thus, in theory, a CLO could go beyond the limitations of the loan securitization exclusion—such as by purchasing debt securities comprising more than 5% of its assets—without precluding banking entities from investing in its debt securities.
While the market itself is expected to impose some discipline here, particularly around the size of any bond bucket, market participants are making a push to rely on the ownership interest changes in order to gain flexibility with respect to actions CLOs may take to address workout negotiations related to defaulted loans.
 The prior Volcker Rule amendments, published in October 2019, primarily addressed the Volcker Rule’s proprietary trading restrictions.
 A “covered fund” is defined as any issuer that would be an “investment company,” as defined in the 1940 Act, but for Section 3(c)(1) or 3(c)(7) of the act; certain privately offered commodity pools; and solely with respect to US banking entities, certain foreign investment vehicles offered and sold outside the United States. See 12 C.F.R. § 248.10(b)
 Where the banking entity relying on the foreign public fund exclusion serves as the investment manager, investment adviser, commodity trading advisor, commodity pool operator, or sponsor of the fund, the distribution also must comply with all applicable requirements in the jurisdiction in which such distribution is being made (or else the exclusion is lost). The 2020 Amendments do not impose a burden of “policing” compliance with this requirement on a banking entity that is merely investing in a foreign public fund.
 These new exclusions generally apply to pooled investment funds that often must rely on the 1940 Act exemptions that trigger covered fund status under the Volcker Rule, while at the same time not raising the types of concerns that the rule’s covered fund restrictions were designed to address.
 The revisions to the Super 23A prohibition appear to represent a reversal in the position that the Agencies took in 2013 when the Regulations were first adopted, to the effect that the Agencies concluded at that time that they lacked the authority to create exceptions to the Super 23A prohibition that were not specifically set forth in the statute.