Proposed Revisions to the Volcker Rule
06 February 2020
On January 30, 2020, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission and the Commodity Futures Trading Commission (together, the Agencies), proposed rules (the Proposed Rules) that, if adopted, would further amend the existing rule under Section 13 of the Bank Holding Company Act of 1956, as amended (the BHC Act), commonly known as the Volcker Rule.
The Volcker Rule generally prohibits a banking entity from engaging in proprietary trading and from acquiring or retaining an ownership interest in, or sponsoring or having certain relationships with, a covered fund. The Proposed Rules do not amend the definition of “covered fund,” but seek to clarify and relax some of the existing prohibitions. They codify approaches already followed by the Agencies to some extent, but also modify existing exclusions and propose new exclusions that generally demonstrate the Agencies’ desire to clarify and simplify compliance, to limit the Volcker Rule’s extraterritorial application, and to permit market participants to undertake certain fund activities that do not present the risks that the Volcker Rule was intended to address. Notable proposals include:
The Scope Of “Ownership Interest” Would Be Reduced
Certain prohibitions of the Volcker Rule limit the ownership interests of banking entities in covered funds. The Agencies propose to amend the definition of “ownership interest” to address concerns of market participants that the current definition of “ownership interest” is overly broad. The proposals include:
- Clarifying that creditors’ remedies upon the occurrence of an event of default or acceleration event include the right to remove, nominate, or vote on the replacement of an investment manager and, as a result, such right (in the context of a creditors’ remedy following an event of default or acceleration event) would not, in and of itself, constitute an “ownership interest”; and
- Providing for a new safe harbor from the definition of “ownership interest” for senior loan or other senior debt interests that have the following characteristics (but note that the term “senior” is not defined, and it is currently unclear whether this safe harbor would apply to any tranche other than the most senior tranche in a securitization):
- The holders of such an interest must not receive any income, gains or profits of the covered fund except for (i) a stated rate of interest, as well as commitment fees or other fees, which are not determined by reference to the performance of the underlying assets of the covered fund and (ii) fixed principal payments on or before a maturity date (which may include limited prepayment premiums);
- The entitlement to payments under the terms of such an interest are absolute and could not be reduced based on losses arising from the underlying assets of the covered fund; and
- The holders of such an interest are not entitled to receive the underlying assets of the covered fund after all other interests have been redeemed and paid in full (other than creditor rights to exercise remedies upon the occurrence of an event of default or acceleration event).
The Loan Securitization Exclusion Would Be Expanded
The Proposed Rules expand and clarify the loan securitization exclusion to address concerns by market participants that certain conditions unnecessarily restrict their ability to utilize the existing exclusion. The proposals include:
- Permitting a loan securitization vehicle to hold non-loan assets (in addition to servicing assets and securities received in lieu of debts previously contracted), provided that the aggregate value of such assets would not exceed five percent of the vehicle’s assets;
- Codifying the guidance provided in the Loan Securitization Servicing FAQ  that a servicing asset may include assets other than a security, but that if a servicing asset is a security, it must be a permitted security under the exclusion, which includes cash equivalents and securities received in lieu of debts previously contracted; and
- Codifying the guidance provided in the Loan Securitization Servicing FAQ that “cash equivalents” refer to high quality, highly liquid investments whose maturity corresponds to the securitization’s expected or potential need for funds and whose currency corresponds to either the underlying loans or the asset-backed securities, and removing the requirement that such interest must be “short term.”
Some Restrictions on Foreign Public Funds Would Be Lifted
The Agencies propose to simplify the exclusion for Foreign Public Funds to address concerns that certain conditions present compliance and operational difficulties for foreign banking entities and may not be necessary to ensure consistent treatment of foreign public funds and U.S. registered investment companies. The proposals include:
- Replacing the home jurisdiction requirement and the requirement that ownership interests be sold “predominantly” through public offerings with a requirement that the fund is authorized to offer and sell ownership interests, and such interests are offered and sold through one or more public offerings;
- Modifying the definition of “public offering” to specify that the distribution must be subject to substantive disclosure and retail investor protection laws or regulations; and
- Addressing the potential difficulty a banking entity investing in a third-party sponsored fund may have in determining whether the distribution of such fund complied with all of the requirements in the jurisdiction where it was made, by limiting the condition only to circumstances in which the relevant banking entity acts as the investment manager, investment adviser, commodity trading advisor, commodity pool operator or sponsor.
Some Credit Funds Would Be Excluded from the Definition of Covered Fund
The Agencies have also proposed the addition of a new exclusion available to credit funds that make loans, invest in debt, or otherwise extend the type of credit that banking entities may directly provide under applicable law. Under the Proposed Rules, the credit fund exclusion would be available to an issuer:
- Whose assets consist solely of loans, debt instruments, related rights and instruments or other assets that are related or incidental to acquiring, holding, servicing or selling loans or debt instruments (which may include equity securities received on customary terms in connection with such loans or debt instruments), and certain interest rate or foreign exchange derivatives; and
- That does not (i) engage in activities which would constitute proprietary trading if it were a banking entity or (ii) issue asset-backed securities.
Certain banking entities investing in or sponsoring the qualifying credit fund must satisfy additional requirements to rely on this exclusion. The banking entity would be required to provide disclosures specified in Section __.11(a)(8) of the Volcker Rule (relating to investment risks and related matters), and ensure that the activities of the credit fund are consistent with safety and soundness standards that are substantially similar to those that would apply if the banking entity engaged in the activities directly.
Activities of Qualifying Foreign Excluded Funds Would Be Excluded
The Agencies propose the codification of relief from the Volcker Rule that was first granted to eligible foreign funds in 2017 to address concerns about the possible unintended consequences and extraterritorial impact of Section 13 of the BHC Act and the rule for foreign excluded funds (under the 2013 implementation of the Volcker Rule). Under the Volcker Rule, there was a possibility that certain foreign excluded funds would be treated as if they were “banking entities” and made generally subject to the prohibitions under the Volcker Rule. Beginning in 2017, the Agencies stated that they would not propose to take action against a foreign banking entity based on attribution of the activities and investments of a qualifying foreign excluded fund to the foreign banking entity, or against a qualifying foreign excluded fund as a banking entity, in each case where the foreign banking entity’s acquisition or retention of any ownership interest in, or sponsorship of, the qualifying foreign excluded fund would meet the requirements for permitted covered fund activities and investments solely outside the United States. The Proposed Rules would codify this undertaking to exempt from the proprietary trading prohibitions and covered fund restrictions of the Volcker Rule the purchase and sale of financial instruments by a “qualifying foreign excluded fund” if the transaction meets the requirements for permitted covered fund activities and investments, and is solely outside of the United States.
Certain Qualifying Venture Capital Funds Would Be Excluded
Contemporaneous with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, several members of Congress made statements indicating that Section 13 of the BHC Act should not restrict the activities of venture capital funds. Later, the Financial Stability Oversight Council released a report providing recommendations concerning implementation of Section 13 of the BHC Act and noting that the treatment of a venture capital fund as a covered fund was a significant issue. In response, the Agencies have proposed an exclusion from the definition of covered fund for certain “qualifying venture capital funds,” which would allow banking entities to fully engage in this type of investment activity in areas where such financing may not be readily available, while also allowing banking entities to allocate resources to a more diverse array of long-term investments.
The proposed exclusion defers to the SEC rules in order to determine what constitutes a venture capital fund. Under the Proposed Rules, a “qualifying venture capital fund” is an issuer that is a venture capital fund as defined in Rule 203(l)-1 of the U.S. Investment Advisers Act of 1940, as amended, which among other things requires the fund to hold itself out as pursuing a venture capital strategy and to conform to certain leverage limits. A qualifying venture capital fund may not engage in any activity that would constitute proprietary trading.
Certain banking entities investing in or sponsoring the qualifying venture capital fund must satisfy additional requirements to rely on this exclusion. The banking entity would be required to provide disclosures specified in Section __.11(a)(8) of the Volcker Rule (relating to investment risks and related matters), and ensure that the activities of the venture capital fund are consistent with safety and soundness standards that are substantially similar to those that would apply if the banking entity engaged in the activities directly.
The Proposed Rules also (i) clarify the small business investment companies exclusion, (ii) propose a new exclusion for family wealth management vehicles, (iii) propose a new exclusion for customer facilitation vehicles, (iv) clarify ambiguities to parallel and co-investment limits, (v) would permit banking entities to engage in certain Super 23A transactions with related covered funds and (vi) would amend the manner in which a banking entity must calculate its ownership interest for purposes of complying with the restrictions that apply to investments in covered funds organized and offered by a banking entity.
- Codified as part of the Bank Holding Company Act of 1956, 12 USC § 1851, the Volcker Rule is intended to prohibit “banking entities” from engaging in proprietary trading or certain relationships with hedge funds and private equity funds. The Agencies last amended the Volcker Rule in late 2019, effective January 1, 2020, which focused on certain proprietary trading restrictions. CFTC, FRB, FDIC, FHFA, OCC, SEC, Final Rule, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 84 Fed. Reg. 61974 (November 14, 2019). In that rulemaking, the Agencies foreshadowed the current proposal focusing on the covered fund provisions of the Volcker Rule.
- Loan Securitization Servicing FAQ. See https://www.fdic.gov/regulations/reform/volcker/faq/loan-securitization.pdf
- See https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20190717a1.pdf - A “qualifying foreign excluded fund” means, with respect to a foreign banking entity, an entity that: (i) is organized or established outside the United States and the ownership interests of which are offered and sold solely outside the United States, (ii) would be a covered fund were the entity organized or established in the United States, or is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments, (iii) would not otherwise be a banking entity except by virtue of the foreign banking entity’s acquisition or retention of an ownership interest in, or sponsorship of, the entity, (iv) is established and operated as part of a bona fide asset management business and (v) is not operated in a manner that enables the foreign banking entity to evade the requirements of Section 13 of the BHC Act or implementing regulations.
- A “venture capital fund” is any private fund that (i) represents to investors and potential investors that it pursues a venture capital strategy, (ii) immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund, (iii) does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days, except that any guarantee by the private fund of a qualifying portfolio company’s obligations up to the amount of the value of the private fund’s investment in the qualifying portfolio company is not subject to the 120 calendar day limit, (iv) only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata and (v) is not registered under Section 8 of the Investment Company Act of 1940[…], and has not elected to be treated as a business development company pursuant to Section 54 of that Act[…].