SEC and Banking Agencies
Propose Regulations Implementing Volcker Rule; Exceptions to Hedge
Fund Ban Detailed
The SEC and the federal banking regulators have proposed regulations
implementing Section 619 of the Dodd-Frank Act, the Volcker Rule,
which prohibits two activities of banking entities: short-term
proprietary trading of any security, derivative, and certain other
financial instruments for the entity’s own account and owning,
sponsoring, or having certain relationships with a hedge fund or
private equity fund (called covered funds under the regulations).
The
proposal would exempt from the prohibition on relationships with
covered funds the organizing and offering of a hedge fund or private
equity fund under certain conditions, including limiting investments
in such funds to a de minimis amount, the making of risk-mitigating
hedging investments, and the making of investments in certain non-U.S.
funds.
A banking entity that makes or retains an
investment in a covered fund under the proposed regulations is
generally subject to three principal limitations related to such
investment. First, the banking entity’s investment in a covered fund
may not represent more than 3 percent of the total outstanding
ownership interests of such fund. Second, the banking entity’s
investment in a covered fund may not result in more than 3 percent
of the losses of the covered fund being allocable to the banking
entity’s investment. Third, a banking entity may invest no more than
3 percent of its tier 1 capital in covered funds.
Consistent with the statute, the proposed
regulations require a banking entity to actively seek unaffiliated
investors to ensure that its investment conforms with the stated
limits and reduce through redemption, sale, dilution, or other
methods the aggregate amount and value of all ownership interests of
the banking entity in a single fund held to an amount that does not
exceed 3 percent of the total outstanding ownership interests of the
fund not later than 1 year after the date of establishment of the
fund or such longer period as may be provided by the Board.
The Fed can extend for up to 2 additional years
the period of time within which a banking entity must reduce its
attributable ownership interests in a covered fund to no more than 3
percent of the fund’s total ownership interests. The statute
provides the possibility of an extension only with respect to the
per-fund limitation, and not to the aggregate funds limitation. The
proposal would implement this provision of the statute.
In order to grant any extension, the Fed must
determine that the extension would be consistent with safety and
soundness and would not be detrimental to the public interest.
A banking entity seeking an extension must
submit a written request to the Board at least 90 days prior to the
expiration of the applicable time period, providing the reasons why
the extension should be granted and a detailed explanation of the
banking entity’s plan for reducing or conforming its investments.
In addition, the extension request must address
a number of relevant factors, including whether the investment
involves or would result in material conflicts of interest between
the banking entity and its clients, customers or counterparties;
result in a material exposure to high-risk assets or high-risk
trading strategies; pose a threat to the safety and soundness of the
banking entity or to U.S. financial stability.
The extension request must also address market
conditions; the contractual terms governing the banking entity’s
interest in the covered fund; the date on which the covered fund is
expected to have attracted sufficient investments from unaffiliated
investors so as to enable the banking entity to comply with the
limitations; the total exposure of the banking entity to the
investment and the risks that disposing of, or maintaining, the
investment in the covered fund may pose to the banking entity or
U.S. financial stability: the cost of divesting the investment
within the applicable period and whether the divestiture would
involve a material conflict of interest between the banking entity
and unaffiliated clients, customers or counterparties to which it
owes a duty, as well as prior efforts to divest or sell interests in
the covered fund, including activities related to the marketing of
interests in such covered fund.
Finally, as a catch all, the Board may add any
other factor that the Board believes appropriate. The proposed
regulations would also allow the Board to impose conditions on any
extension granted if the Board determines the conditions are
necessary or appropriate to protect the safety and soundness of
banking entities or U.S. financial stability, address material
conflicts of interest or other unsound practices, or otherwise
further the purposes of the statute and the regulations.
The proposed definition of covered fund
generally parallels the statutory definition of “hedge fund” and
“private equity fund,” and explains the universe of entities that
would be considered a covered fund, including entities determined by
the SEC and the banking agencies to be similar funds. The proposed
definition of “ownership interest” provides further guidance
regarding the types of interests that would be considered to be an
ownership interest in a covered fund. Ownership interests may take
various forms. The definition of ownership interest explicitly
excludes carried interest whereby a banking entity may share in the
profits of the covered fund solely as performance compensation for
services provided to the covered fund by the banking entity.
The proposed regulations also implement the
exemption for organizing and offering a covered fund provided for in
the statute and outlines the conditions that must be met in order
for a banking entity to organize and offer a covered fund under this
authority. These requirements are intended to allow a banking entity
to engage in certain traditional asset management and advisory
businesses in compliance with section 13 of the Bank Holding Company
Act.
Specifically, the proposed regulations permit a
banking entity to acquire and retain, as an investment in a covered
fund, an ownership interest in a covered fund that the banking
entity organizes and offers, or for which it acts as sponsor, for
the purposes of establishing the covered fund and providing the fund
with sufficient initial equity for investment to permit the fund to
attract unaffiliated investors, or making a de minimis investment in
the covered fund in compliance with applicable requirements.
Similarly, the proposed regulations implement
the statutory exemptions allowing a banking entity to acquire and
retain an ownership interest in, or act as sponsor to, one or more
small business investment companies, a public welfare investment, or
certain qualified rehabilitation expenditures; to acquire and retain
an ownership interest in a covered fund as a risk-mitigating hedging
activity; and in the case of a non-U.S. banking entity, to acquire
and retain an ownership interest in, or act as sponsor to, a foreign
covered fund.
The agencies propose to permit a banking entity
to acquire and retain an ownership interest in, or act as sponsor
to, a small business investment company or certain public interest
investments, without limitation as to the amount of ownership
interests it may own, hold, or control with the power to vote.
Also, a banking entity could use an ownership
interest in a covered fund to hedge, but only with respect to
individual or aggregated obligations or liabilities of a banking
entity that arise from the firm acting as intermediary on behalf of
a customer that is not itself a banking entity to facilitate the
customer’s exposure to the profits and losses of the covered fund
(similar to acting as a “riskless principal”); or a compensation
arrangement with an employee of the banking entity that directly
provides investment advisory or other services to that fund.
The hedge must represent a substantially similar
offsetting exposure to the same covered fund and in the same amount
of ownership interest in the covered fund arising out of the
transaction that the acquisition or retention of an ownership
interest in the covered fund is intended to hedge or otherwise
mitigate. The banking entity would be required to document, at the
time the transaction is executed, the hedging rationale for all
hedging transactions involving an ownership interest in a covered
fund.
Under the proposed regulations, foreign banking
entities could acquire or retain an ownership interest in, or to act
as sponsor to, a covered fund so long as such activity occurs solely
outside of the United States. This exemption limits the
extraterritorial application of the statutory restrictions on
covered fund activities and investments to foreign firms that, in
the course of operating outside of the United States, engage in
activities permitted under relevant foreign law outside of the
United States, while preserving national treatment and competitive
equality among U.S. and foreign firms within the United States.
The regulations define both the type of foreign
banking entities that are eligible for the exemption and the
circumstances in which covered fund activities or investments by
such an entity will be considered to have occurred solely outside of
the United States, including clarifying when an ownership interest
will be considered to have been offered for sale or sold to a
resident of the United States.
The proposal also would permit the sale and
securitization of loans, clarifying that a banking entity may
acquire and retain an ownership interest in, or act as sponsor to, a
covered fund that is an issuer of asset-backed securities, the
assets or holdings of which are solely comprised of loans;
contractual rights or assets directly arising from those loans
supporting the asset-backed securities; and a limited amount of
interest rate or foreign exchange derivatives that materially relate
to such loans and that are used for hedging purposes with respect to
the securitization structure. This authority would therefore allow a
banking entity to acquire and retain an ownership interest in a loan
securitization vehicle that the banking entity organizes and offers,
or acts as sponsor to, in excess of the 3 percent limits.