On January 30, 2020, the U.S. Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency, Treasury (OCC), the Board of Governors of the Federal Reserve System (Fed), the Federal Deposit Insurance Corporation (FDIC) and the Commodity Futures Trading Commission (CFTC), or the “agencies,” issued a proposal to amend certain regulations under the “Volcker Rule” set forth in section 13 of the Bank Holding Company Act (BHC Act). The Volcker Rule generally prohibits banks and certain other financial institutions from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring or having certain other relationships with a “covered fund”. The agencies’ proposal would, among other things, add new exclusions to the definition of “covered fund” and provide clarity on various pre-existing exclusions.
Presently, “covered fund” is defined as any company that would be an investment company under the Investment Company Act of 1940, or the 1940 Act, but for the exceptions contained in Sections 3(c)(1) or 3(c)(7) of the 1940 Act. Section 3(c)(1) excepts companies with fewer than 100 beneficial owners from being investment companies, with a number of look-throughs for funds-of-funds. Section 3(c)(7) excepts companies that are owned only by “qualified purchasers” – typically entities with greater than $25 million of investments, individuals with greater than $5 million of investments, qualified institutional buyers and certain knowledgeable employees. While this was originally intended to prevent banks from circumventing the prohibition on proprietary trading by indirectly doing so through hedge funds and other investment vehicles, this captured a much wider swathe than intended. The result is that banks no longer can have exposure to a number of asset classes that normally would be considered low-risk, such as venture capital, real estate funds and certain collateralized loan obligations.
Proposed Additional Covered Fund Exclusions
The proposal would also add several new exclusions to the definition of “covered fund”:
- Venture capital funds;
- Credit funds;
- Entities created and used to facilitate a customer’s exposures to a transaction, investment strategy or other service (i.e., special purpose vehicles or SPVs); and
- Wealth management vehicles that manage the investment portfolio of a family and certain other persons (i.e., single family offices).
The proposal lifts the definition of “venture capital fund” from the venture capital fund adviser exemption under Investment Advisers Act of 1940, or the Advisers Act, with a number of additional requirements. Under the Advisers Act, a venture capital fund is defined as a private fund that: (i) holds no more than 20% of the fund‘s capital commitments in non-qualifying investments (other than short-term holdings); (ii) does not borrow or otherwise incur leverage, other than limited short-term borrowing (excluding certain guarantees of qualifying portfolio company obligations by the fund); (iii) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; (iv) represents itself as pursuing a venture capital strategy to its investors and prospective investors; and (v) is not registered under the 1940 Act and has not elected to be treated as a business development company under the 1940 Act. In addition to the requirement that the fund must be a venture capital fund, a “qualifying venture capital fund” under the proposal must not engage in any activity that would constitute proprietary trading and financial institutions seeking to rely on this exclusion may not guarantee, assume or otherwise insure the obligations or performance of the issuer. If the financial institution wishes to sponsor a venture capital fund, it must also ensure that the fund’s activities are in line with safety and soundness standards applicable to banking entities generally. Notably, while the bank may not guarantee obligations of the fund itself, there is no such restriction with respect to portfolio companies.
The proposal would exclude credit funds that make loans, invest in debt or otherwise extend the type of credit that banking entities may provide directly under applicable banking law. As used in the proposed exclusion, a credit fund is an issue whose assets consist solely of: (a) loans; (b) debt instruments; (c) related rights and other assets that are related to or incidental to acquiring, holding, servicing or selling loans, or debt instruments; and (d) certain interest rate or foreign exchange derivatives. To use the exclusion, however, the credit fund must not engage in activities that would constitute proprietary trading and must not issue asset-backed securities. As proposed, this is a hair trigger test without any de minimis exceptions for other assets. Further, since this does not include warrants, it would still preclude banking entities from investing in or sponsoring venture debt funds.
The proposal would also exclude family wealth management vehicles from the definition of “covered fund”. This exclusion would be available to an entity that (a) if organized as a trust, the grantors of the entity are all family customers and (b) if not organized as a trust, a majority of the voting interests in the entity are owned by family customers and the entity is owned only by family customers and, in each case, up to 3 closely related persons of the family customers. The entity also must not hold itself out as an entity that raises capital from third parties for investment purposes. This too borrows the definition of “family customer” from the Advisers Act, using the same definition as “family client” thereunder.
Finally, the proposal would exclude any issuer that acts as a customer facilitation vehicle from the definition. For the purpose of the proposal, a “customer facilitation vehicle” is any issuer that is formed by or at the request of a customer of the banking entity for the purpose of providing such customer with exposure to a transaction, investment strategy or other service provided by the banking entity. This proposed exclusion recognizes the reality that certain investments need to be structured as entities, even when it is a fund-of-one.
As a general matter, for a banking entity to rely on any of these exemptions, it must provide the investor with certain disclosures that normally would be made with respect to covered funds. Further, the family office and customer facilitation vehicle exclusions require that the bank not guarantee, assume or insure the obligations of the issuer, that the banking entity not retain, as principal, an ownership interest in the issuer other than an interest of up to 0.5% for certain legal purposes.
The Volcker Rule permits banking entities to securitize loans through covered funds that hold only a limited set of assets and financial instruments. While most mortgage loan securitizations are completely outside the definition of “covered fund” because they rely on other exemptions under the Investment Company Act, many asset-backed securities include assets outside of all of the exclusions. This has limited the ability of banking entities to participate in certain types of securitizations and hampered their ability to structure complex instruments. In 2018, the agencies released a Loan Securitization Servicing FAQ to clarify the scope of what constitutes a “loan” and servicing rights. The proposed amendment would codify that FAQ.
Modifications to Existing Public Welfare Exclusions
The BHC Act permits banking entities to make and retain investments that are designed primarily to promote the public welfare, such as investments in affordable housing vehicles, but whether an investment qualifies as promoting the public welfare varies depending on the agency issuing the implementing regulation. Further, there are many investments that arguably could be for public welfare, but there is insufficient specificity in the rules to make an appropriate determination. The agencies are seeking comments on whether any change should be made to clarify that all permissible public welfare investments, under any agency’s regulation, are excluded from the covered fund restrictions. Specifically, the agencies are seeking comment on whether qualified opportunity funds or QOFs and rural business investment companies should be expressly excluded from the definition of covered funds, rather than relying on the general public welfare exclusion to exclude such funds.
Additional Changes to the Volcker Rule
In addition to those mentioned above, the proposal would make the following changes to the Volcker Rule:
- Clarify that small business investment companies (“SBICs”) continue to stay outside of the definition of covered fund if the SBIC voluntarily surrenders its license to operate as an SBIC, so long as no new investments were made after the voluntary surrender;
- Excluding qualifying foreign excluded funds – in general terms an entirely foreign fund that is deemed sponsored by a bank solely due to common control with a US bank under the BHC Act – from the definition of “covered funds;”
- Permit a banking entity to engage in a limited set of covered transactions with a covered fund the banking entity sponsors or advises or with which the banking entity has certain other relationships; and
- Clarify certain aspects of the definition of “ownership interest,” including specifically exempting bona fide senior loans or senior debt instruments from that definition.
The comment period for the proposal is scheduled to end on April 1, 2020.