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Financial Institutions Advisory & Financial Regulatory, Time and Money

Jul 13, 2020

Volcker Rule Update: Amendments to the Covered Funds Provisions

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VOLCKER RULE UPDATE: AMENDMENTS TO THE COVERED FUNDS PROVISIONS

The Federal Reserve Board (the Federal Reserve), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (collectively, the Agencies) issued a final rule[1] amending the “covered fund” provisions of the Volcker Rule (the Covered Fund Amendments). The Covered Fund Amendments are substantially similar to the changes that were proposed earlier this year[2] and will be effective on October 1, 2020.

The “covered fund” provisions of the Volcker Rule generally restrict or prohibit a “banking entity” from investing in, or sponsoring or having certain other relationships with, a covered fund. Overall, the Covered Fund Amendments make targeted, not sweeping, modifications to the existing covered fund restrictions by attempting to clarify the treatment of foreign funds; simplify certain compliance requirements, including by limiting the extraterritorial impact of the Volcker Rule; and permit banking entities to engage in certain fund-related activities that were previously limited by the Volcker Rule regulations.

Permanent Relief for Qualifying Foreign Excluded Funds

The Covered Fund Amendments limit the extraterritorial impact of the Volcker Rule on so-called “foreign excluded funds,” which are offshore funds that are not “covered funds” but are nevertheless subject to the Volcker Rule as “banking entities” if they are controlled by a foreign banking entity. The Federal Reserve, the OCC and the FDIC have previously provided informal regulatory relief for such foreign excluded funds from the application of the Volcker Rule.[3] The policy statement reflecting such regulatory relief was scheduled to expire on July 21, 2021.

The Covered Fund Amendments resolve this technical issue by providing permanent regulatory relief, exempting “qualifying foreign excluded funds” from the restrictions on proprietary trading and investing in or sponsoring covered funds. A qualifying foreign excluded fund is one that satisfies the following conditions:

  • The foreign banking entity’s investment in or sponsorship of the fund complies with the exemption for certain covered fund activities conducted “solely outside of the United States” (known more commonly as the SOTUS exemption).
  • The fund:
    • is organized or established outside the United States and its ownership interests are offered and sold solely outside the United States;
    • would be a covered fund were the entity 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;
    • would not otherwise be a banking entity except by virtue of the foreign banking entity’s acquisition or retention of an ownership interest in, or sponsorship of, or relationship with, the fund;
    • is established and operated as part of a bona fide asset management business; and
    • is not operated in a manner that enables the foreign banking entity that sponsors or controls the qualifying foreign excluded fund, or any of the foreign banking entity’s affiliates, to evade the requirements of the Volcker Rule or the implementing regulations.

In addition to being exempted from the proprietary trading and covered fund prohibitions, a qualifying foreign excluded fund would not need to comply with the compliance program and metrics reporting requirements, nor would its activities be attributable to a foreign banking entity that invests in or sponsors such fund. However, a banking entity that owns or sponsors a qualifying foreign excluded fund is still required to have in place appropriate compliance programs for itself and its other subsidiaries and to meet compliance program and metrics reporting requirements. 

Qualifying foreign excluded funds are still banking entities, and they are still subject to the “Super 23A” and Section 23B requirements of the Volcker Rule regulations.

Changes to Existing Covered Fund Exclusions

Foreign Public Funds

The Volcker Rule excludes foreign public funds from the definition of “covered fund.” A foreign public fund was defined under the original Volcker Rule regulations as a fund that is organized or established outside the United States and the ownership interests of which are (1) authorized to be offered and sold to retail investors in the issuer’s home jurisdiction; and (2) sold predominantly through one or more public offerings outside the United States. The intent was to provide a consistent treatment for U.S. registered investment companies and their foreign equivalents.

The Covered Fund Amendments modify the Volcker Rule’s exclusion for foreign public funds in several respects.

  • The Covered Fund Amendments eliminate the requirement that the fund be authorized to be offered and sold to retail investors in the fund’s home jurisdiction.
  • The Covered Fund Amendments also eliminate the requirement that ownership interests be sold “predominantly through public offerings outside the United States.”

Instead, under the Covered Fund Amendments, the fund must be organized or established outside the United States and authorized to offer and sell ownership interests and such interests must be offered and sold through one or more public offerings outside the United States.

The definition of “public offering” is further refined by the Covered Fund Amendments, adding a new requirement that the distribution is subject to substantive disclosure and retail investor protection laws or regulations. The Covered Fund Amendments would only apply the “home jurisdiction” condition, i.e., that the distribution comply with all applicable requirements in the jurisdiction where the fund is organized or established, to instances in which the banking entity serves as the fund’s investment manager, investment adviser, commodity trading advisor, commodity pool operator or sponsor.

U.S. Banking Entity Sponsored Foreign Public Fund

The Covered Fund Amendments eliminate the restriction on share ownership by employees (other than senior executives and directors) of a U.S. banking entity that sponsors a foreign public fund.

The Covered Fund Amendments also clarify the requirement that ownership interests in a U.S. banking entity-sponsored fund must be sold predominantly to persons other than the banking entity, the issuer, their affiliates or their senior executive officers and directors, by specifying that more than 75% of the fund must be sold to persons other than such persons.

Loan Securitizations

The Volcker Rule excludes “loan securitizations” from the definition of “covered fund” so long as the loan securitizations are comprised of loans or other qualifying assets (e.g., cash equivalents, servicing assets, certain rate or foreign exchange derivatives, interests in a tax subsidiary or similar entity formed by the issuer for legal or tax purposes and assets acquired by the issuer in a workout or foreclosure). The Covered Fund Amendments clarify the permissible assets that can be held in loan securitizations.

The Covered Fund Amendments largely codify the relief that was provided through FAQs regarding permissible assets, including the scope of permissible loan servicing assets and the scope of permissible cash equivalents.

  • The Covered Fund Amendments clarify that “cash equivalents” in the context of permitted securities means high quality, highly liquid 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 Covered Fund Amendments allow loan securitizations to hold up to 5% of certain of the fund’s assets in debt securities, other than asset-backed securities and convertible securities. The percentage of non-convertible debt securities must be calculated at the time of the most recent acquisition of such assets, and is measured against the aggregate value of loans, cash and cash equivalents, and debt securities held.
  • The aggregate value of the loans, cash and cash equivalents and debt securities must be calculated at par value at the most recent time any such debt security is acquired, except that the issuing entity may instead determine the value of any such loan, cash equivalent or debt security based on its fair market value if (i) the issuing entity is required to use the fair market value of such assets for purposes of calculating compliance with concentration limitations or other similar calculations under its transaction agreements; and (ii) the issuing entity’s valuation methodology values similarly situated assets consistently.

Small Business Investment Companies

The Volcker Rule provides an exclusion from the “covered fund” definition for small business investment companies (SBICs) as long as the SBIC’s license has not been revoked. Under the Covered Fund Amendments, this exclusion would continue to apply for an SBIC that voluntarily surrenders its license during its “wind-down period” in accordance with 13 CFR 107.1900, as long as it does not make any new investments, other than investments in cash equivalents, after surrendering its license.

Public Welfare Investment Funds

The Volcker Rule contains an exclusion from covered funds for certain public welfare investments. The Covered Fund Amendments make explicit that the exclusion for public welfare investments incorporates funds, the business of which is to make investments that qualify for consideration under the federal banking agencies’ regulations implementing the Community Reinvestment Act (CRA). In addition, the Covered Fund Amendments include explicit exclusions from the definition of covered fund for rural business investment companies (RBICs) and qualified opportunity funds (QOFs).

New Covered Fund Exclusions

The Covered Fund Amendments create four new exclusions from the definition of covered fund for: (i) credit funds, (ii) venture capital funds, (iii) family wealth management vehicles; and (iv) customer facilitation vehicles.

Credit Funds

A fund meets the new credit fund exclusion if the fund’s assets consist solely of (i) loans; (ii) debt instruments; (iii) rights or other assets that are related or incidental to acquiring, holding, servicing or selling such loans or debt instruments (excluding commodity forward contracts or any derivative and subject to certain limitations[4]); and (iv) certain interest rate or foreign exchange derivatives that directly relate to the assets referenced above and reduce the interest rate and/or foreign exchange rate risks associated with the assets. Qualifying credit funds are prohibited from issuing asset-backed securities and engaging in any activity that would constitute proprietary trading as if the issuer were a banking entity.

For a banking entity to invest in such a fund, it must: (i) not guarantee, assume or otherwise insure the obligations or performance of the fund or of any entity to which such fund extends credit or in which such fund invests; and (ii) ensure that any assets of the fund would be permissible for the banking entity to acquire and hold directly under applicable federal banking laws and regulations. A banking entity’s investment must also comply with limitations regarding material conflicts of interest, high-risk investments, safety and soundness and financial stability, in each case as if the credit fund were a covered fund.

Additionally, if a banking entity sponsors or advises a credit fund, the banking entity is required to: (i) provide certain disclosures to prospective and actual investors, including to the effect that the banking entity does not guarantee the performance of the fund or insure against loss; (ii) ensure that the fund’s activities 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; and (iii) comply with the Super 23A and Section 23B restrictions as if the fund were a covered fund (except that the banking entity may acquire and retain an ownership interest in the fund).

Venture Capital Funds

A “venture capital fund,” as defined by the SEC in 17 CFR § 275.203(l)-1, is excluded from the covered fund definition, provided that it does not engage in proprietary trading as if it were a banking entity. To qualify as a venture capital fund under SEC rules, the fund must (i) hold itself out as pursuing a venture capital strategy (which generally involves investing in small and start-up businesses); (ii) hold no more than 20% of its aggregate capital commitments in non-qualifying investments (other than cash or cash equivalents); (iii) not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of the fund’s capital contributions and uncalled committed capital; (iv) not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; and (v) not be registered under the Investment Company Act of 1940 or be treated as a business development company.

A banking entity relying on this exclusion must, among other things, comply with limitations regarding material conflicts of interest, high-risk investments, safety and soundness and financial stability, in each case as if the qualifying venture capital fund were a covered fund.

As with a credit fund, if a banking entity acts as a sponsor or adviser to a qualifying venture capital fund, then it is required to (i) provide certain disclosures to prospective and actual investors, including to the effect that the banking entity does not guarantee the performance of the fund or insure against loss; (ii) ensure that the fund’s activities 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; and (iii) comply with the Super 23A and Section 23B restrictions as if the fund were a covered fund (except that the banking entity may acquire and retain an ownership interest in the fund).

Family Wealth Management Vehicles

A “family wealth management vehicle” would be excluded from the covered fund definition if it does not hold 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 is either (i) a trust of whom the grantor(s) of the entity are all family customers; or (ii) not a trust, but an entity in which a majority of the voting interests are owned (directly or indirectly) by family customers; a majority of the interests in the entity are owned (directly or indirectly) by family customers; and only family customers and up to five closely related persons of the family customers own the entity.[5]

 A banking entity that sets up a family wealth management vehicle may provide it with bona fide trust, fiduciary, investment advisory or commodity trading advisory services; would be prohibited from guaranteeing the vehicle’s performance; and would need to disclose that prohibition to fund investors as if the issuer were a covered fund. Such documentation may be modified so as not to be misleading and the manner of disclosure may be modified to accommodate the specific circumstances of the issuer. In addition, the banking entity would be prohibited from acquiring low-quality assets from the family wealth management vehicle, apart from riskless principal transactions, and would need to comply with Section 23B requirements and limitations regarding material conflicts of interest, high-risk investments, safety and soundness and financial stability, in each case as if the vehicle were a covered fund.

The banking entity acting as principal would be prohibited from acquiring or retaining an ownership interest in the entity, other than up to 0.5% of the vehicle’s outstanding ownership interests to the extent necessary for establishing corporate separateness or addressing bankruptcy, insolvency or similar concerns.

Customer Facilitation Vehicles

A “customer facilitation vehicle” is excluded from the definition of covered fund when it has been formed by or at the request of a customer of the banking entity for the purpose of providing such customer (or one or more affiliates of such customer) with exposure to a transaction, investment strategy or other banking service by the banking entity.

A banking entity relying on this exclusion would be required to maintain documentation outlining how it intends to facilitate the customer’s exposure to such transaction, investment strategy or service and would be required to disclose to the customer that the banking entity is prohibited from guaranteeing the fund’s performance as if the issuer were a covered fund. Such documentation may be modified so as not to be misleading and the manner of disclosure may be modified to accommodate the specific circumstances of the issuer.

The banking entity would also be prohibited from acquiring or retaining as principal an ownership interest in the customer facilitation vehicle. The Covered Fund Amendments specify that a de minimis exception applies for a banking entity or any other entity with up to 0.5% of the vehicle’s outstanding ownership interests to the extent necessary for establishing corporate separateness of the fund from the customer or to address similar considerations. The banking entity also generally would be prohibited from acquiring low-quality assets from such vehicle other than in riskless principal transactions. In addition, the banking entity must comply with Section 23B requirements and limitations regarding material conflicts of interest, high-risk investments, safety and soundness and financial stability, in each case as if the vehicle were a covered fund.

Revisions to Super 23A

The so-called Super 23A provisions of the Volcker Rule generally prohibit “covered transactions” between a covered fund and a banking entity (and the affiliates of such banking entity) that sponsors or advises or organizes and offers such fund. As a result of Super 23A, a banking entity and its affiliates may not, for example, lend money to a covered fund that the banking entity sponsors or advises (a “related covered fund”), nor may the banking entity purchase assets from such covered fund or engage in other covered transactions with such fund. By contrast, Section 23A of the Federal Reserve Act (Section 23A) merely restricts covered transactions between a member bank and its affiliates, subject to certain requirements such as quantitative limits and collateral requirements.

Although the original Volcker Rule regulations incorporated the definition of “covered transaction” by reference to the definition used in Section 23A, they did not include any of the exemptions set forth in Section 23A itself or in the Federal Reserve’s Regulation W. The Covered Fund Amendments address this gap in part by incorporating into Super 23A the exemptions for transactions that are available under Section 23A and Section 223.42 of Regulation W. These transactions include certain intraday extensions of credit, transactions that are secured by U.S. government securities, and purchases of certain loans and marketable securities. In each case, the exemption for Super 23A purposes is subject to existing limitations on the exemptions under Regulation W. Importantly, one of the limitations applicable to certain of these exemptions is that the affiliate must be (and thus a covered fund must be) a securities affiliate of the banking entity. A securities affiliate is a broker or dealer registered with the SEC or other securities broker or dealer approved by the Federal Reserve.

In addition, the Covered Fund Amendments provide a separate exception for “riskless principal” transactions between a banking entity and a related covered fund (this exception does not incorporate the securities affiliate requirement that is a part of the Regulation W exemption). The Covered Fund Amendments also provide a separate exception for extensions of credit to, or purchases of assets from, a related covered fund, provided that:

  • 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; and
  • 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 as if the extension of credit was an intraday extension of credit, regardless of the duration of the extension of credit.

Under the Covered Fund Amendments, such riskless principal, credit and asset purchase transactions are subject to the prudential backstop provisions covering material conflicts of interest, high-risk assets and trading strategies, and safety and soundness of the banking entity and financial stability of the United States.

Changes to the “Ownership Interest” Definition

Under the Volcker Rule, an “ownership interest” is defined broadly to include an equity, partnership or other “similar interest,” which includes 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 Volcker Rule’s regulations also regard a debt interest in a covered fund to be an “ownership interest” if the interest has the same characteristics as an equity or other ownership interest.

The Covered Fund Amendments clarify and streamline the definition of “similar interest” under the Volcker Rule in two areas. First, a similar interest does not exist solely because a creditor has the right, in the event of a covered fund’s default or acceleration event, to participate in the removal of an investment manager “for cause”[6] or to nominate or vote on a nominated replacement manager upon an investment manager’s resignation or removal.

And second, a similar interest does not include certain ordinary debt interests, particularly senior loans and senior debt, for which the Covered Fund Amendments provide an express safe harbor as long as:

  • the holders of such interest receive only interest payments (as well as commitment fees or other fees) 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 (which may include prepayment premiums intended solely to reflect, and compensate holders of the interest for, forgone income resulting from an early repayment);
  • the holders’ entitlement to payments on the interest is absolute and may not be reduced because of 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
  • the 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 credit to exercise remedies upon the occurrence of an event of default or an acceleration event).

Revised Approach to Restricted Profit Interests

The Covered Fund Amendments limit the attribution to the banking entity of an employee’s or director’s restricted profit interest in a covered fund organized or offered by the banking entity to only those circumstances in which the banking entity has directly or indirectly financed the acquisition of the restricted profit interest. Without this change, a banking entity would continue to be obligated, when calculating the banking entity’s compliance with the aggregate fund limit, to include any amounts paid by the banking entity’s employees or directors to obtain a restricted profit interest in a sponsored covered fund.

Revised Approach to Parallel Investments and Co-Investments

The original Volcker Rule regulations did not restrict the ability of banking entities to invest in the same assets invested in by a covered fund, but the preamble to the adopting release stated that a banking entity must include, for purposes of its calculation of the per-fund and aggregate fund limitations, the value of any investments made in parallel with those of the covered fund. The Covered Fund Amendments make it explicit that a banking entity need not include in the calculation of its investment in a covered fund any parallel or co-investments the banking entity makes alongside the covered fund, as long as the investment is made in compliance with applicable laws and regulations, including applicable safety and soundness standards.

In addition, under the Covered Fund Amendments, direct investments (whether a series of parallel investments or a co-investment) by a director or employee of a banking entity (or an affiliate thereof) made alongside a covered fund in compliance with applicable laws and regulations will not be attributed to the banking entity as an investment in the covered fund, regardless of whether the banking entity arranged the transaction on behalf of the director or employee or provided financing for the investment.

In addition to being exempted from the proprietary trading and covered fund prohibitions, a qualifying foreign excluded fund would not need to comply with the compliance program and metrics reporting requirements, nor would its activities be attributable to a foreign banking entity that invests in or sponsors such fund. However, a banking entity that owns or sponsors a qualifying foreign excluded fund is still required to have in place appropriate compliance programs for itself and its other subsidiaries and to meet compliance program and metrics reporting requirements.

For questions regarding the Volcker Rule and the impact of the recent changes, please contact a member of our team.

Footnotes

[1] Board of Governors of the Federal Reserve System, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Securities Exchange Commission, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds (June 25, 2020). Each agency has issued a substantially similar regulation to implement the Volcker Rule. See, e.g., 12 CFR Part 248 (Federal Reserve).

[2] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 85 FR 12120 (Feb. 28, 2020).

[3] Statement regarding Treatment of Certain Foreign Funds under the Rules Implementing Section 13 of the Bank Holding Company Act (July 17, 2019).

[4] Permitted rights and other assets that are securities would need to be: (i) a cash equivalent (i.e., high quality, highly liquid investments whose maturity corresponds to the issuer’s expected or potential need for funds and whose currency corresponds to either the underlying loans or the debt instruments); (ii) a security received in lieu of debts previously contracted with respect to such loans or debt instruments; or (iii) an equity security (or right to acquire an equity security) received on customary terms in connection with such loans or debt instruments.
[5] Under the Covered Fund Amendments, a “closely related person” means a natural person (including the estate and estate planning vehicles of such person) who has longstanding business or personal relationships with any family customer. In addition, a “family customer” means a family client, as defined in Rule 202(a)(11)(G)-1(d)(4) of the Investment Advisers Act of 1940 (17 CFR 275.202(a)(11)(G)-1(d)(4)); or 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.
[6] “For cause” means 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; or (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.

Authors and Contributors

Reena Agrawal Sahni

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7324

+1 212 848 7324

New York

Mark Chorazak

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7100

+1 212 848 7100

New York

Timothy J. Byrne

Counsel

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7476

+1 212 848 7476

New York

Le-el Sinai

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7550

+1 212 848 7550

New York