Volcker Rule: Agencies Release New Guidance

[June 12, 2015], the staffs of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the “Agencies”) provided two important additions to their existing list of Frequently Asked Questions (“FAQs”) addressing the implementation of section 13 of the Bank Holding Company Act of 1956, as amended (the “BHC Act”), commonly known as the “Volcker Rule.”

The Volcker Rule imposes broad prohibitions on proprietary trading and investing in and sponsoring private equity funds, hedge funds and certain other investment vehicles (“covered funds”) by “banking entities” and their affiliates. The Volcker Rule, as implemented by the final rule issued by the Agencies (the “Final Rule”), provides exclusions from the definition of covered fund for certain foreign public funds and joint ventures.

Foreign Public Funds

In the first of the new FAQs, [1] the staffs of the Agencies clarify the circumstances under which a foreign public fund excluded from the definition of covered fund could be deemed to be a banking entity subject to the Volcker Rule’s restrictions on proprietary trading and covered fund activities. There has been industry uncertainty as to whether a foreign public fund could, as a result of its legal or corporate governance structure or other relationships with a banking entity, be deemed to be “controlled” by the banking entity for BHC Act purposes and therefore itself be considered a banking entity. [2]

The FAQ provides that the staffs of the Agencies “would not advise” that the activities and investments of a foreign public fund be attributed to a banking entity for purposes of the Volcker Rule, or that a foreign public fund be deemed a banking entity solely by virtue of its relationship with a sponsoring banking entity, where the following conditions are met:

• The foreign public fund meets the conditions of the exclusion from the definition of covered fund provided under Section _.10(c)(1) of the Final Rule; [3]
• The banking entity does not own, control or hold with the power to vote 25% or more of the voting shares of the foreign public fund after the applicable seeding period [4] (which remains subject, in the case of a foreign public fund sponsored by a U.S. banking entity, to the 15% ownership interest limitation (together with shares held by the foreign public fund, affiliates, directors and employees) under Section _.10(c)(1)(ii) of the Final Rule); [5] and
• If the banking entity sponsors, provides investment advisory, commodity trading advisory, administrative or other services to the fund, such activities are in compliance with limitations under applicable regulation, order or other authority, including applicable limitations in the relevant foreign jurisdiction. [6]

As the staffs of the Agencies acknowledge in the FAQ, subjecting foreign public funds to the proprietary trading and covered fund restrictions applicable to banking entities would frustrate the purposes of excluding foreign public funds from the definition of covered fund—namely, treating foreign public funds consistently with similar U.S. funds (i.e., U.S. mutual funds and other types of U.S. registered investment companies sold to retail investors) and limiting the extraterritorial application of Volcker Rule, including by permitting U.S. banking entities and their foreign affiliates to carry on traditional asset management businesses outside the United States. [7]

The new FAQ indicates that the Final Rule’s exclusion for foreign public funds was intended to recognize that foreign jurisdictions have established their own frameworks governing the details of the operation and distribution of foreign public funds. In this regard, the FAQ acknowledges that sponsors of foreign public funds in some foreign jurisdictions select the majority of the fund’s directors or trustees or otherwise control the fund for purposes of the BHC Act by contract or through a controlled corporate director, and that these and other corporate governance structures had created uncertainty as to whether such funds are banking entities subject to the Volcker Rule’s restrictions on proprietary trading and covered fund activities. The FAQ should provide welcome clarification to banking entity sponsors of foreign public funds meeting the requirements set forth in the FAQ.

Joint Ventures

The second of the new FAQs [8] clarifies the scope of the exclusion from the definition of covered fund for certain joint ventures. Under the Final Rule, this exclusion is available to any joint venture between a banking entity or any of its affiliates and one or more unaffiliated persons that: (1) consists of no more than 10 unaffiliated co-venturers; (2) engages in activities that are permissible for the banking entity or affiliate, other than investing in securities for resale or other disposition; and (3) is not, and 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. [9]

The new FAQ explains that the exclusion is designed to allow a banking entity to manage more efficiently the risks of its banking operations by, for example, seeking to obtain or share complementary business expertise, while preventing the exclusion from being used as a vehicle to raise funds from investors for investment purposes (including merchant banking activities). [10] In this regard, the new FAQ specifies that the exclusion would not be available to an issuer that:

• Raises money from a small number of investors primarily for the purpose of investing in securities, whether the securities are intended to be traded frequently, held for a longer duration, held to maturity or held until the dissolution of the entity;
• Raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities merely because one of the purposes for establishing the vehicle may be to provide financing to an entity to obtain and hold securities; or
• Raises money from investors primarily for the purpose of sharing in the benefits, income, gains or losses from ownership of securities—as opposed to conducting a business or engaging in operations or other non-investment activities—even if the vehicle may have other purposes.

The FAQ notes that any determination of whether an arrangement is a “joint venture,” which is not defined separately in the Final Rule, will depend on the facts and circumstances, though the “basic elements of a joint venture are well recognized, including under state law.” Specifically, the FAQ indicates that the staffs of the Agencies expect that a person must have some degree of control over the business of an entity in order to be considered to be participating in “a joint venture between a banking entity or any of its affiliates and one or more unaffiliated persons” for purposes of the exclusion.

The interpretation of the joint venture exclusion described in the new FAQ appears more restrictive than the scope of the exclusion as set forth in the Final Rule and as described in the Supplementary Information. In light of the additional restrictions imposed by the FAQ, it is not clear whether, as a practical matter, the joint venture exclusion will have meaningful utility for banking entities.

A copy of the new FAQs is attached to the complete publication as Appendix A.

Endnotes:

[1] See Federal Reserve, Volcker Rule, Frequently Asked Questions (June 12, 2015) available at
http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm#14.
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[2] The Final Rule’s definition of banking entity generally excludes covered funds. Final Rule
§ _.2(c)(2)(i). Funds that are not covered funds, such as foreign public funds, could be deemed to themselves be banking entities and therefore subject to the Volcker Rule’s prohibitions. A banking entity generally includes any insured depository institution, any depository institution holding company, any foreign company treated as a bank holding company under the International Banking Act of 1978 and any affiliate or subsidiary of any of the foregoing. Final Rule § _.2(c). The Final Rule defines the terms “affiliate” and “subsidiary” to have the same meanings as under Section 2 of the BHC Act. Final Rule §§ _.2(a), _.2(dd). Under the BHC Act, “the term ‘affiliate’ means any company that controls, is controlled by, or is under common control with another company,” and “[a]ny company has control over a bank or over any company if—(A) the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 per centum or more of any class of voting securities of the bank or company; (B) the company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (C) the [Federal Reserve] determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company.” BHC Act §§ 2(k), 2(a)(2). The BHC Act defines the term “subsidiary” similarly to mean “with respect to a specified bank holding company … (1) any company 25 per centum or more of whose voting shares (excluding shares owned by the United States or by any company wholly owned by the United States) is directly or indirectly owned or controlled by such bank holding company, or is held by it with power to vote; (2) any company the election of a majority of whose directors is controlled in any manner by such bank holding company; or (3) any company with respect to the management of policies of which such bank holding company has the power, directly or indirectly, to exercise a controlling influence, as determined by the [Federal Reserve], after notice and opportunity for hearing.” BHC Act § 2(d).
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[3] Final Rule § _.10(c)(1) excludes from the definition of covered fund any issuer that: (1) is organized or established outside the United States; (2) is authorized to offer and sell ownership interests to retail investors in the issuer’s home jurisdiction; and (3) sells ownership interests predominantly through one or more public offerings outside the United States. The Agencies have stated that they “generally expect that an offering is made predominantly outside of the United States if 85 percent or more of the fund’s interests are sold to investors that are not residents of the United States.” Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5536, 5678 (Jan. 31, 2014) (the “Supplementary Information”).
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[4] See Final Rule § _.20(e). The Agencies have indicated that an issuer that will become a foreign public fund would be treated during its seeding period in the same manner as an issuer that will become a U.S. registered investment company—i.e., the issuer would not itself be viewed as violating the Volcker Rule during the seeding period so long as the banking entity that establishes the seeding vehicle operates the vehicle pursuant to a written plan, developed in accordance with the banking entity’s compliance program, that reflects the banking entity’s determination that the vehicle will become a foreign public fund within the time period provided for seeding a covered fund. See 79 Fed. Reg. at 5676–77 (discussing treatment of U.S. registered investment companies during seeding period) and Federal Reserve, Volcker Rule, Frequently Asked Questions (June 10, 2014) available at http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm#5 (noting that seeding vehicles for foreign public funds will be treated similarly to seeding vehicles for U.S. registered investment companies during the seeding period).
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[5] For a U.S. banking entity, or a banking entity controlled directly or indirectly by a U.S. banking entity, to rely on this exclusion with respect to a foreign public fund that the banking entity sponsors, ownership interests in the issuer must be sold “predominantly” to persons other than the sponsoring banking entity, the issuer, their affiliates and directors and employees of the foregoing. Final Rule § _.10(c)(1)(ii). The Agencies have stated that they “generally expect that a foreign public fund will satisfy this additional condition if 85 percent or more of the fund’s interests are sold to persons other than the sponsoring U.S. banking entity and certain persons connected to that banking entity.” 79 Fed. Reg. at 5678.
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[6] As noted in the new FAQ, the latter two of these three requirements are analogous to those that must be met in order for a foreign public fund, U.S. registered investment company or business development company to not be considered an affiliate of a banking entity for purposes of the limitations on covered fund investments under Final Rule § _.12.
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[7] See 79 Fed. Reg. at 5678.
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[8] See Federal Reserve, Volcker Rule, Frequently Asked Questions (June 12, 2015) available at
http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm#15.
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[9] Final Rule § _.10(c)(3).
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[10] The Supplementary Information notes that the joint venture exclusion may not be relied upon to engage in merchant banking activities otherwise prohibited under the Volcker Rule because these activities “involve[] acquiring or retaining shares, assets, or ownership interests for the purpose of ultimate resale or disposition of the investment.” 79 Fed. Reg. at 5681.
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