Proposed Revisions to the Volcker Rule: Prohibitions and Restrictions with respect to Covered Funds

On January 30, 2020, the Federal Reserve Board issued a notice of proposed rulemaking and asked for comments on a proposed rule to simplify, streamline and tailor the “covered fund” provisions under the regulation implementing section 13 (commonly known as the “Volcker Rule”) of the Bank Holding Company Act (“BHC Act”) (the “Proposal”).

The Proposal is the culmination of a process first announced in March 2018 to significantly revise all aspects of the Volcker Rule’s implementing regulations in light of the experience of the federal banking agencies—the Federal Reserve Board, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Deposit Insurance Corporation (together, the “Agencies”)—since the final rule was issued in December 2013 (the “Final Rule”). It is the first time the Agencies have targeted the implementing regulations related to the Volcker Rule’s general prohibition on banking entities investing in or sponsoring hedge funds or private equity funds—known as “covered funds.”

The Proposal will be of interest to the asset management industry. Working within the confines of the statute, the Proposal would introduce four new exclusions from the definition of covered fund (credit funds, venture capital funds, family wealth management vehicles and customer facilitation vehicles) and simplify three existing ones. In addition, it would expand the scope of permissible relationships that a banking entity may have with covered funds, codify existing guidance related to certain foreign funds and clarify issues surrounding ownership interests and permissible parallel investments by a banking entity and its employees.

Background of the Covered Fund Provisions

The general purpose of the Volcker Rule’s covered fund provisions was to ensure that a banking entity was not able to do indirectly via a fund structure that which it was prohibited from doing directly under the proprietary trading restrictions of the Volcker Rule—conceptually, putting taxpayer funds (i.e., deposits) at risk through excessive exposure to speculative and risky investment activity.

In the years following the Final Rule, covered fund-related issues emerged as practitioners grappled with the new concepts and unprecedented breadth of the Final Rule. The Agencies from time to time acknowledged and addressed certain unintended consequences in policy statements and FAQ guidance.

In July 2018, the Agencies proposed rulemaking and invited public comment on both the proprietary trading prong and covered funds prong of the Volcker Rule. The Agencies tackled the proprietary trading provisions first and issued a final rule in November 2019, in which they noted that revisions to the covered fund provisions would follow in a separate rulemaking.

Drawing from the Agencies’ experience with the rule over six years of implementation, the Proposal seeks to codify permission for certain fund-related activities that the Agencies believe do not present the risks that the Volcker Rule was intended to address. Notable topics are described below:

1. Four New Types of Permitted Funds

Banking entities are allowed to make limited investments in covered funds, subject to a number of restrictions designed to ensure that banking entities do not rescue investors in these funds from loss and are not themselves exposed to significant losses from investments in or other relationships with these funds.

The Proposal would add new exemptions that would permit banking entities to invest in and/or sponsor four specific types of funds, subject to limitations and guardrails. Notable requirements are below:

2. Simplify Existing Covered Fund Exclusions: Loan Securitizations, Foreign Public Funds and Small Business Investment Companies

The Proposal would simplify the eligibility criteria for certain existing exclusions from the definition of covered fund in order to enable banking entities to use and confirm compliance with these existing exclusions.

(i) Loan Securitizations. The Volcker Rule expressly permits banking entities to sell and securitize loans in a manner otherwise permitted by law. In order to reflect this intent, the Proposal would amend two of the eligibility criteria required for a loan securitization to be excluded from the definition of covered fund.

First, the Proposal would permit an issuer to hold a small pool of non-loan assets (no more than five (5) percent of the loan securitization’s total assets) in order to provide banking entities with greater flexibility to sell and securitize loans. Second, the Proposal would codify existing guidance to clarify that “servicing assets” held by a loan securitization vehicle may include assets other than securities (e.g., mortgage insurance policies supporting the mortgages in a loan securitization).

(ii) Foreign Public Funds. In order to provide consistent treatment between mutual funds and their foreign equivalents, the Proposal would simplify the eligibility requirements for foreign public funds to qualify for the exclusion from the definition of covered fund. Specifically, it would replace two requirements—the home jurisdiction requirement and the “predominantly” sold through one or more public offerings requirement—with a single new requirement that ownership interests must be offered and sold through at least one public offering. In order to ensure that these funds are sufficiently similar to mutual funds, the Proposal also would modify the definition of “public offering” to add a new requirement that the distribution must be subject to substantive disclosure and retail investor protection laws or regulations in the jurisdiction where it is made.

(iii) Small Business Investment Companies. In order to give appropriate effect to the statutory exemption for Small Business Investment Company (SBIC) investments, the Proposal would clarify that an SBIC could remain eligible for the exclusion from the covered fund provisions during a wind-down period (during which time it may surrender its license), provided it makes no new investments after surrendering its license.

3. Super 23A: Permissible Low-risk Transactions with Related Funds

The Volcker Rule generally prohibits all covered transactions between a banking entity and a covered fund that it is advises or sponsors (a “related fund”). Specifically, with respect to a related fund, a banking entity is generally prohibited from entering into a transaction of a type that would be covered by section 23A of the Federal Reserve Act. While section 23A of the Federal Reserve Act includes certain exceptions from its prohibitions, the Volcker Rule did not incorporate those exceptions, leading to its nickname “Super 23A.”

The existing Super 23A limits prevented banking entities from providing certain traditional banking services—such as standard payment, clearing and settlement services—to related funds, meaning those services had to be outsourced to unaffiliated service providers.

The Proposal would permit a banking entity to provide those traditional banking services to related funds. The Proposal would also allow a banking entity to enter into transactions with a related fund that would be permissible without limit under section 23A of the Federal Reserve Act. The Agencies note that permitting these “low-risk” transactions between a banking entity and a related fund would reduce both the operational risks associated with the use of unaffiliated service providers and the interconnectedness among financial institutions in the U.S. financial system.

4. Relief for Qualifying Foreign Excluded Funds

The Proposal would provide permanent relief to resolve the unintended extraterritorial impact that the Volcker Rule has had on certain foreign funds that, but for lacking a U.S. nexus, would be covered funds (and, therefore, not banking entities).

In order to permit foreign banking entities to conduct qualifying activities in accordance with the same laws and regulations applicable to their non-U.S. competitors, including investing in U.S. companies, the Proposal would exempt qualifying foreign excluded funds from the proprietary trading prohibition and covered fund provisions of the Volcker Rule using the same eligibility criteria set forth in existing policy statements.

5. Clarifications on Ownership Interests and Parallel Investments

(i) Ownership Interests Safe Harbor. The implementing regulations define an “ownership interest” in a covered fund to mean any equity, partnership or “other similar interest.” Currently, some loans by banking entities to covered funds could be deemed to be ownership interests based on standard covenants. To clarify that an ownership interest does not include certain credit instruments in the fund, the Proposal would provide a safe harbor for bona fide senior loans or senior debt instruments.

The Proposal would also clarify the types of credit rights that would be within the scope of ownership interest and adjust the calculation methods for purposes of complying with the ownership limits and conditions that apply to investments in related covered funds of a banking entity.

(ii) Parallel Banking Entity Investments. The Proposal would add a new rule of construction to clarify that banking entities are not required to treat certain types of direct investments alongside a covered fund as an investment in the covered fund, so long as certain conditions are met. Neither section 13(d)(4) of the BHC Act nor the text of the Final Rule require that a banking entity treat an otherwise permissible investment the banking entity makes alongside a covered fund as an investment in the covered fund.

The complete publication, including footnotes, is available here.