On April 1, 2014, the final regulations implementing the “Volcker Rule”1 became effective. The regulations were jointly adopted on December 10, 2013 by the Board of Governors of the Federal Reserve System (FRB), 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 (CFTC). The regulations, among other things, prohibit banking entities and nonbank financial companies from engaging in proprietary trading and severely restrict their investments in, and relationships with, hedge funds and private equity funds (collectively, Private Funds). In taking this action, the adopting agencies have initiated a sea change in the way many financial institutions will conduct their operations.2
This Client Alert is intended for fund managers who either currently manage a banking entity’s proprietary investments in their Private Funds or seek future capital commitments from such banking entities. Fund managers need to understand how the regulations restrict such investments and where there is some flexibility.
While the Volcker Rule’s “proprietary trading” provisions seek to prevent banking entities from trading directly, as a principal, in financial instruments, the “covered funds” provisions seek to prevent banking entities from doing the same thing indirectly, by circumventing the proprietary trading prohibitions through an ownership interest in a “covered fund.” A “covered fund” is defined as any issuer that would be an investment company under the Investment Company Act of 1940 (ICA) but for the exemptions provided by Section 3(c)(1) or Section 3(c)(7) of the ICA. These exemptions generally apply to Private Funds that do not intend to engage in a “public offering”3 of its securities and have outstanding securities beneficially owned either by no more than 100 persons (3(c)(1)) or by only qualified purchasers (3(c)(7)). Covered funds also include certain (i) types of commodity pools and (ii) foreign funds that are sponsored by a U.S. banking entity or in which a U.S. banking entity invests, if the foreign fund would not be an investment company under the ICA (if the ICA applied) by reason of the exemption in Section 3(c)(1) or Section 3(c)(7). If another ICA exemption applied, the foreign fund would not be a covered fund. Covered funds do not include separately managed accounts or Small Business Investment Companies (SBICs).
- Managers offering foreign funds should be careful not to engage in any activities in the U.S., as doing so could make them “covered funds.”
- Non-U.S. investment vehicles that are not offered to U.S. persons are free to accept investments from non-U.S. banking entities, as such investment vehicles do not rely on Sections 3(c)(1) or 3(c)(7) to be exempt from the ICA.
- Due to special integration rules, foreign feeder funds could be considered “covered funds” if the underlying master fund relies on Sections 3(c)(1) or 3(c)(7) to be exempt from the ICA.
New Restrictions on Fund Investments by Banking Entities
Under the regulations, banking entities4 are now generally prohibited from directly or indirectly acquiring or retaining an ownership interest, as a principal, in a covered fund, except in the case of certain limited exceptions. An “ownership interest” is any equity, partnership or other similar interest. The term “similar interest” encompasses, for example, any 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 the covered fund; the right to receive a share of the income, gains or profits of the covered fund (other than in exchange for services); or the right to receive a rate of return based on the performance of the covered fund’s underlying assets.
Importantly, an “ownership interest” does not include a carried interest. Thus, a banking entity is not prohibited by the Volcker Rule from owning a portion of a Private Fund’s carried interest, such as when it serves as a Private Fund’s investment manager, investment advisor, commodity trading adviser or other service provider. However, four criteria must be met for the banking entity to be allowed to own a piece of the carry in a Private Fund:
(A) the interest is solely to allow the banking entity to share in the profits of the covered fund as performance compensation for the services provided
(B) all such profit must be distributed to the banking entity promptly after being earned or, if not distributed, must be retained by the covered fund solely as a reserve to satisfy contractual obligations with respect to subsequent losses of the covered fund and such undistributed profit of the banking entity cannot share in the subsequent investment gains of the covered fund
(C) any amounts invested in the covered fund, including any amounts paid by the banking entity for the carried interest, generally may not exceed the “per-fund limit” of 3 percent of the total number or value of the covered fund’s outstanding interests, and the value of all investments of the banking entity in all covered funds may not exceed the “aggregate limit” of 3 percent of the banking entity’s tier 1 capital, and
(D) the interest cannot be transferrable by the banking entity except in limited situations, such as to an affiliate or in connection with a sale of the business to an unaffiliated party that provides investment management, investment advisory, commodity trading advisory or other services to the fund.
In short, a banking entity can participate in the carry if:
- its investment does not exceed 3 percent of the Private Fund and does not cause the banking entity’s aggregate investments in all covered funds to exceed 3 percent of the banking entity’s tier 1 capital
- its investment is non-transferable except in limited circumstances, and
- the carry is compensation for services, is distributed in “real time” or held by the fund as a reserve against future carry offsets (i.e., losses).
Because of delays in issuing the regulations, the original July 21, 2014 conformance deadline was extended by one year by the Federal Reserve. Banking entities now have until July 21, 2015 to conform their investment activities to the new requirements.5 While the Federal Reserve may grant up to two more one-year extensions of the conformance deadline, fund managers would be well-advised to take the FRB’s warning to heart that “banking entities should not expand activities and make investments during the conformance period with an expectation that additional time to conform those activities or investments will be granted.”6 The Federal Reserve has reinforced that warning against newly restricted investment activities during the delayed conformance period by stating its expectation that each banking entity engage in good-faith efforts during such time not just in evaluating its activities and investments in light of the Volcker Rule but also in developing and implementing a conformance plan so that such activities or investments fully conform by the end of the conformance period.
- Fund managers should confirm with their banking entity investors about the banking entity’s written plan for bringing itself into conformance with the Volcker Rule by July 21, 2015 and should periodically inquire as to the status of the banking entity’s implementation of the plan.
- Fund managers are likely to experience the effects of the FRB’s warning by receiving redemption, withdrawal and transfer requests from banking entity clients restructuring their activities and investments during the Volcker Rule’s conformance period.
- Any such transfers will need to comply with the securities laws applicable to transfers generally. Most Private Fund governing agreements require the consent of the general partner or managing member of the Private Fund to allow such transfers. As a fiduciary matter, the general partner or managing member needs to watch out for adverse developments that can come about from having new owners (such as under ERISA or tax rules).
Permitted Fund Investments by a Banking Entity as a Non-Principal
The regulations distinguish between a banking entity making a fund investment as a principal (directly or indirectly) and those investments undertaken as a non-principal, which are outside the scope of the Volcker Rule’s general prohibition on investments in covered funds. Under the regulations, there are four categories of such non-principal investment activities, and banking entities that engage only in these (or in any of these) will not be deemed in violation of the Volcker Rule’s general prohibitions on investments in Private Funds:
(A) investments by a banking entity acting solely as agent, broker or custodian, provided the activity is conducted for the account of a customer, and the banking entity does not have beneficial ownership of such ownership interest
(B) investments by a banking entity through a deferred compensation, stock-bonus, profit-sharing or pension plan of the banking entity that is established and administered in accordance with U.S. or foreign law, provided the ownership interest is held or controlled (directly or indirectly) by the banking entity as trustee for the benefit of persons who are or were employees of the banking entity
(C) investments by a banking entity in the ordinary course of collecting a debt previously contracted in good faith, provided the banking entity divests the ownership interest as soon as practicable and does not retain the ownership interest for longer than the permitted period, or
(D) investments by a banking entity on behalf of customers as trustee or in a similar fiduciary capacity for a customer that is not a covered fund, provided the activity is conducted for the account of a customer, and the banking entity does not have beneficial ownership of such ownership interest.
Alternative Structures Available to Fund Managers for Raising Client Bank Capital
Because of the Volcker Rule’s covered funds restrictions, banking entities are now severely limited from investing in Private Funds as a principal. Since the vast majority of Private Funds rely on the exemptions in Section 3(c)(1) or Section (3)(c)(7) of the ICA to operate and raise capital, fund managers wishing to retain or seek new capital commitments from banking entities must now think about alternative structures that can accommodate such bank investments in a manner permitted under the regulations. The following are some of the entities expressly excluded from the definition of “covered funds.” These may present fund managers with viable, albeit limited, opportunities to manage client bank investments:
(1) Foreign Public Funds. These are investment funds that are organized or established outside the U.S., are authorized to offer and sell ownership interests to retail investors in the issuer’s home jurisdiction, and sell ownership interests predominantly through public offerings outside the U.S.7
(2) SBICs and Public Welfare Investment Funds. A “Small Business Investment Company” (SBIC), as defined in the Small Business Investment Act of 1958, or an issuer that has received from the Small Business Administration notice to proceed to qualify for a license as an SBIC, will not be considered a covered fund. Nor will an issuer that is in the business of making investments that are designed primarily to promote certain types of public welfare (e.g., the welfare of low- and moderate-income communities or families).
(3) Joint Ventures. A joint venture between a banking entity and one or more unaffiliated persons will not be considered a covered fund if the joint venture is comprised of no more than 10 unaffiliated co-venturers, is in the business of engaging in activities that are permissible for the banking entity (other than investing in securities for resale or other disposition), and is not an entity that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities.8
- The limitation on 10 partners provides a banking entity with flexibility in structuring larger business ventures.
- The 10 partner limitation is not intended as a means to otherwise own a Private Fund for investment purposes – including any Private Fund that intends to own only private securities and hold them for ultimate sale years later.
- The adopting agencies propose to monitor such joint ventures to ensure they are not being used to evade the Volcker Rule’s restrictions on ownership of Private Funds.9
(4) Foreign Pension or Retirement Funds. A plan, fund or program providing pension, retirement or similar benefits that is organized and administered outside the U.S., is a broad-based plan for employees or citizens that is subject to regulation as a pension, retirement or similar plan under local law and established for the benefit of citizens or residents of one or more non-U.S. jurisdiction will not be considered a covered fund.10
(5) Loan Securitizations. An issuing entity of asset-backed securities whose assets are comprised solely of loans, servicing rights associated with such loans, certain interest rate and foreign exchange derivatives and special units of beneficial interest and collateral certificates that satisfy certain requirements will not be considered a covered fund if such entity does not hold any assets constituting a security, including an asset-backed security, or an interest in an equity or debt security, a derivative (excluding certain permitted derivatives) or a commodity forward contract.
- The adopting agencies have resisted broadening the scope of assets in an excluded loan securitization.
- An excluded loan securitization may, however, hold securities that are cash equivalents11 or that are received in lieu of debts previously contracted with respect to the loans supporting the entity’s securities.
- The adopting agencies believe other types of securities held as assets could be misused to circumvent the Volcker Rule’s restrictions on proprietary trading and covered funds.
(6) Registered Investment Companies and Excluded Entities. A registered mutual fund or business development company will not be considered a covered fund. In addition, a fund that is exempt from the definition of an “investment company” under the ICA other than by the exemptions provided in Sections 3(c)(1) and 3(c)(7) will not be considered a covered fund.
By way of example, funds that are not covered funds could include:
- REITS and other real estate funds exempt from ICA registration by means of Section 3(c)(5)(C)
- funds whose businesses substantially consist of owning or holding oil, gas or other mineral royalties or leases and are exempt from ICA registration by means of Section 3(c)(9), and
- funds that qualify for Sections 3(c)(1) and/or 3(c)(7) as well as another exemption section.
The foregoing is not an exhaustive list12 of permissible alternative investment vehicles in which banking entities can invest under the Volcker Rule. Last but not least, the adopting agencies may, in the future, jointly define other types of entities that are to be excluded from the definition of covered funds. However, as is generally the case under the Volcker Rule, a banking entity may not rely on any exemption if the activity would result in a conflict of interest, result in exposure to high-risk assets or trading strategies, or threaten the safety and soundness of the entity or the financial stability of the U.S.
Concluding Pepper Points
- Effective April 1, 2014, banking entities are severely restricted from making new investments in Private Funds, and by July 21, 2015, they must have brought themselves into conformance with the Volcker Rule on all of their Private Fund investments.
- The regulations provide banking entities with some, albeit limited, flexibility to keep or make investments in Private Funds.
- Fund managers should anticipate redemption, withdrawal and transfer requests from banking entity clients as they restructure their activities and investments during the Volcker Rule’s conformance period.
Pepper is available to assist our clients with analyzing their fund documents (e.g., operating agreements, partnership agreements and side letters) to address any such redemption, withdrawal or transfer requests or explore viable options for restructuring banking entity investments.
1 The Volcker Rule was added to the Bank Holding Company Act of 1956 by Section 619 of the Dodd-Frank Act.
2 Previous Pepper Client Alerts have described important other aspects of the Volcker Rule regulations:
“Observation 1.0 on the Volcker Rule: ‘You Know It When You See It’ – Or Do You?”
“Observation 1.1 on the Volcker Rule: Community Banks – Size Does Matter”
“Observation 1.1.1 on the Volcker Rule: Community Banks – Compliance”
“Observation 18.104.22.168 on the Volcker Rule: Community Banks – Compliance Redux,” and
“Observation 1.2 on the Volcker Rule: Foreign Banking Entities – Location, Location, Location.”
3 The statute prohibits a public offering as a gating matter; the JOBS Act modified the application of this limitation for offerings made generally under Regulation D and where a Form D is filed, and where all investors are in fact accredited investors as defined in Regulation D.
4 “Banking entities” are defined under the Volcker Rule as insured depository institutions (IDIs); companies that control IDIs (BHCs), including foreign banking organizations treated as BHCs; and affiliates and subsidiaries of IDIs and BHCs. An “IDI” is any FDIC-insured bank or savings institution but this definition does not include certain trust or fiduciary institutions described in Section 2(c)(2)(D) of the Bank Holding Company Act of 1956 (BHC Act).
The following entities are expressly excluded from the definition of “banking entities” and, therefore, are not subject to the Volcker Rule’s restrictions on proprietary trading and covered fund investments: a covered fund that is not itself a banking entity constituting an IDI, BHC or foreign banking organization treated as a BHC; a portfolio company held under the merchant banking and insurance company authorities under Section 4(k)(4)(H) or (I) of the BHC Act, or a portfolio concern that is controlled by a small business investment company (as defined in the Small Business Investment Act of 1958), so long as the portfolio company or concern is not itself a banking entity constituting an IDI, BHC or foreign banking organization treated as a BHC; and the FDIC, acting in its corporate capacity or as a conservator or receiver under the Federal Deposit Insurance Act or Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
5 Banking entities with significant trading activities are still required to report quantitative measurements beginning in July 2014.
6 FRB, Order Approving Extension of Conformance Period, effective December 31, 2013.
7 See Pepper’s Client Alert “Observation 1.2 on the Volcker Rule: Foreign Banking Entities – Location, Location, Location.”
8 In the Preamble to the new regulations, the adopting agencies stated that “[a]s with wholly owned subsidiaries, if a banking entity owns 25 percent or more of the voting securities of the joint venture or otherwise controls an entity that qualifies for the joint venture exclusion, the joint venture would then itself be a banking entity …” and be subject to all of the Volcker Rule restrictions on that entity’s activities and investments.
9 Preamble, page 518.
10 See Pepper’s Client Alert “Observation 1.2 on the Volcker Rule: Foreign Banking Entities – Location, Location, Location.”
11 Cash equivalents are interpreted by the adopting agencies as high-quality, highly liquid short-term investments maturing with the securitization’s anticipated need for funds (e.g., deposits insured by the FDIC, CDs issued by a regulated U.S. financial institution, obligations backed by the United States, investments in registered money market funds, and commercial paper).
12 Others include wholly owned subsidiaries of a banking entity (subject to limitations on the amount of the subsidiary’s ownership interests held by employees or directors of the banking entity or by a third party for the purpose of establishing corporate separateness or addressing bankruptcy, insolvency or similar concerns), certain qualifying asset-backed commercial paper conduits, qualifying covered bonds, insurance company separate accounts, bank-owned life insurance separate accounts, and issuers in conjunction with the FDIC’s receivership or conservatorship.
Julia D. Corelli and Benjamin Mittman
Julia D. Corelli and Benjamin Mittman are members of Pepper Hamilton's Fund Services Group, a national group of more than 25 lawyers focused on fund formation, operations, regulation and compliance. The Funds Services Group is a core component of the firm’s Investment Funds Industry Group (IFIG), which is an interdisciplinary industry group comprised of more than 60 lawyers who focus their practices in areas vital to the success of all types of investment funds throughout their entire life cycle.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.