Fed’s Volcker Relief for Foreign Funds

Dan Ryan is Leader of the Financial Services Advisory Practice at PricewaterhouseCoopers LLP. This post is based on a PwC publication by Mr. Ryan, David Harpest, Scott Levine, and Armen Meyer.

On Friday, June 12, 2015, the Federal Reserve (Fed) began addressing the question of whether foreign funds should be considered “banking entities” under the Bank Holding Company Act (BHCA), and therefore be subject to the Volcker Rule’s proprietary trading restriction. The Fed’s guidance (provided in the form of a “Frequently Asked Question,” or FAQ) clarifies that foreign public funds (e.g., UCITS [1]) will not be considered banking entities merely due to their boards being controlled by an affiliate (i.e., an affiliate within the BHC capable of holding a majority of a fund’s director seats). [2]

However, with only weeks to go before the July 21, 2015 deadline, the FAQ does not resolve two other questions that have vexed foreign banks regarding the application of “banking entity” to foreign funds. First, the board control provision still applies to foreign private funds (i.e., foreign funds that are privately offered to institutional or high net worth investors in a manner similar to US hedge fund offerings). Second, another BHCA provision which establishes control when 25% or more of a fund’s voting shares are owned by an affiliate still applies to foreign private funds, and to a lesser extent to foreign public funds.

The big question of whether foreign funds would be subjected to Volcker’s proprietary trading restriction as a result of being controlled by an affiliate became the major remaining interpretive issue facing foreign banks after the Fed provided a conformance extension for legacy covered funds (i.e., funds in place prior to December 31, 2013) in December 2014 [3] and clarified the “solely outside the US” exception’s marketing restriction in February 2015.

  1. No relief is provided for foreign private funds: While US private funds (i.e., “covered funds” under the Volcker Rule [4]) are exempt from the control provisions of the BHCA, foreign private funds are not exempt and have been afforded no relief. As a result, these funds—which are set up for the purpose of taking risk through securities investments that are often long term (and fall outside of the “covered funds” definition)—will be unable to execute on their business model if Volcker’s proprietary trading ban is applied to them.
  2. Limited relief is provided for foreign public funds whose affiliate owns 25% or more of their voting shares: While foreign private funds receive no relief from the 25% ownership control provision, foreign public funds gain relief during the fund seeding period. Like the rules applied to US mutual funds, under the FAQ affiliates may own 25% or more of a foreign public fund during the initial one year seeding period (with the possibility of two additional years upon Fed approval). This limited relief will challenge the industry since banks often own more than 25% of foreign funds beyond a three year seeding period in order to develop a sufficient track record (which is also true of BHC investments in US mutual funds) or in order to facilitate hedging activities related to fund-linked notes.
  3. Legacy foreign funds (public and private) likely have an additional two years before conformance is required: The conformance extension provided to legacy foreign funds remains intact, [5] thus limiting disruption to foreign banks’ fund businesses on July 21, 2015. For non-legacy foreign funds, as a practical matter, we do not believe that foreign banks will be able to restructure their control by July 21st.
  4. The industry will advocate for more relief: Advocacy from foreign banks and industry groups will continue in order to obtain additional relief. They will argue that it makes little sense to have excluded foreign funds from the Volcker Rule’s definition of covered funds, only to then pull them back into Volcker by treating them as banking entities.
  5. Additional regulatory relief by July 21st is an unlikely priority: It would be difficult for regulators to provide more relief by July 21st, given the Fed’s desire to reach consensus with the four other agencies overseeing Volcker (the SEC, CFTC, FDIC, and OCC) and given bandwidth issues at the agencies. However, since legacy foreign funds (i.e., most foreign funds) are not impacted until well after July 21st, hope remains that there will be more helpful relief. The Fed’s response to banks’ foreign fund extension requests filed in January 2015 did not close the door on this possibility, and several are still pending. It is likely that the Fed limited its relief to foreign public funds because it was easier to gain consensus for them by July 21st, and because the agencies were closer to the issue given its applicability to US banks. But only one thing really is certain: the Volcker theme of hurry-up-and-wait will continue as the industry continues to press its case and the regulators slowly take their next step.

Endnotes:

[1] The EU’s UCITS are similar to US mutual funds.
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[2] This has not been a concern for US funds because US law generally requires that boards of mutual funds and other registered investment companies (RICs) be independent from affiliates.
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[3] See PwC’s First take, Ten key points from the Fed’s Volcker Rule covered funds extension (December 2014).
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[4] See PwC’s Regulatory brief, Volcker Shrugged (December 2013).
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[5] See note 3.
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