On June 25, 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 (the Fed), the Federal Deposit Insurance Corporation (FDIC) and the Commodity Futures Trading Commission (CFTC), or the “agencies,” adopted amendments to the “Volcker Rule” set forth in section 13 of the Bank Holding Company Act (the “BHC Act”). The Volcker Rule generally prohibits banks and certain other financial institutions from engaging in proprietary trading and severely limits the ability of those institutions to acquire or retain an ownership interest in, or sponsor or have certain other relationships with, a “covered fund.” The adopting release largely adopts the January 2020 proposed rules with a few clarifying changes based on comments.
Most significantly, the amended Volcker Rule will exclude from the definition of “covered fund” (a) venture capital funds, (b) credit funds, (c) family wealth management vehicles (i.e., single-family offices), and (d) customer facilitation vehicles (i.e., special purpose vehicles or “SPVs”). In addition, the release adopts a number of technical and clarifying amendments, many of which codify positions that the agencies already had been taking.
Additional Covered Fund Exclusions
“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 complicated rules for determination of beneficial ownership. 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 doing so indirectly through hedge funds and other investment vehicles, this captured a much wider swathe than intended. The result is that banking institutions no longer can sponsor or have exposure to a number of asset classes that normally would be considered lower-risk, such as venture capital, real estate funds, and certain collateralized loan obligations.
With the adoption of the final rules, the agencies are creating four new exclusions from the definition of “covered fund” for venture capital funds, credit funds, family wealth management vehicles, and customer facilitation vehicles.
Venture Capital Funds
The final rule lifts the definition of “venture capital fund” from the venture capital fund adviser exemption under the 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:
- holds no more than 20% of the fund’s capital commitments in non-qualifying investments (other than short-term holdings);
- does not borrow or otherwise incur leverage, other than limited short-term borrowing (excluding certain guarantees of qualifying portfolio company obligations by the fund);
- does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;
- represents itself as pursuing a venture capital strategy to its investors and prospective investors; and
- is not registered under the 1940 Act and has not elected to be treated as a business development company under the 1940 Act.
For purposes of this exemption, a “qualifying investment” is (i) an equity security issued by a qualifying portfolio company (defined below) that has been acquired directly by the fund from the qualifying portfolio company (i.e., not in a secondary sale), (ii) any equity security issued by a qualifying portfolio company in exchange for a security described in (i) above, or (iii) any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and is acquired by the fund in exchange for a security described in (i) or (ii) above. “Short-term holdings” mean cash and cash equivalents, treasuries with a remaining maturity of 60 days or less, and shares of a registered open-end management investment company. Last, a “qualifying portfolio company” means a portfolio company that (a) at the time of any investment by the fund, is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded, (b) does not borrow or issue debt obligations in connection with the fund's investment in such company and distribute to the fund the proceeds of such borrowing or issuance in exchange for the fund's investment, and (c) is not an investment company, a fund, an issuer that would be an investment company but for issuers of asset-backed securities, or a commodity pool.
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 fund. Any financial institution wishing to sponsor a venture capital fund must also ensure that the fund’s activities are in line with safety and soundness standards applicable to banking entities generally, provide certain disclosures to investors, and comply with certain other restrictions as if the fund were a covered fund.
The final rule excludes 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. Under the final rule, a credit fund is an issuer whose assets consist solely of (a) loans; (b) debt instruments that would be permissible for the banking entity to hold directly; (c) related rights and other assets that are related to or incidental to acquiring, holding, servicing or selling loans, or debt instruments, including equity securities (or rights to acquire equity securities) received on customary terms in connection with the loans or debt instruments; and (d) certain related interest rate or foreign exchange derivatives. This adds the clarification that certain equity securities, such as warrants stapled to debt on market terms, are permitted assets. To use the exclusion, however, the credit fund must not engage in activities that would constitute proprietary trading, issue asset-backed securities, hold commodity forwards, or guarantee the performance of the fund. Further, a banking entity that is a sponsor, investment adviser, or commodity trading advisor to a credit fund would need to provide investors with certain specific disclosures to investors and ensure that the activities of the fund are consistent with safety and soundness standards substantially similar to those that would apply as if the banking entity engaged in the activity directly.
The final rule also excludes family wealth management vehicles from the definition of “covered fund”. This exclusion is available to an entity that (a) does not hold itself out as an entity that raises capital from third parties for investment purposes, (b) if organized as a trust, the grantors of the entity are all family customers and (c) if not organized as a trust, the entity and a majority of the voting interests in the entity are owned by family customers and, in each case, up to 5 closely related persons of a family customers. A “closely related person” is a natural person who has longstanding business or personal relationships with any family customer. The definition of “family customer” is borrowed from the definition of “family client” under the Advisers Act, which includes lineal descendants of a person no more than 10 generations prior, along with certain former family members, key employees, family trusts, family foundations, and controlled companies. In addition to sponsoring or advising such a family wealth management vehicle, the banking entity may retain, as principal, up to 0.5% of the entity’s outstanding ownership interests in order to establish corporate separateness or to address bankruptcy, insolvency, or similar concerns.
Finally, the final rule excludes any issuer that acts as a customer facilitation vehicle, or what may be more commonly thought of as a special purpose vehicle or SPV, from the definition of covered fund. Under the final rule, the “customer facilitation vehicle” exception will be available to 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. The final rule creates new recordkeeping requirements for the banking entities relying on this exclusion, including the requirement to maintain documentation outlining how the banking entity intends to facilitate the customer’s exposure to a transaction, investment strategy or service offered by the banking entity. This exclusion recognizes the reality that certain investments need to be structured as entities, even when it is a fund-of-one.
The adopting release made a number of other amendments, including:
- Qualified Opportunity Funds and RBICs. The Volcker Rule contains a carve-out for investments that promote public welfare. This ‘public welfare exception’ is being revised to explicitly state that it incorporates all (a) qualified opportunity funds (QOFs), (b) rural business investment companies (RBICs), and (c) funds whose business is to make investments that qualify for consideration under Federal banking agencies’ regulations implementing the Community Reinvestment Act. The prior lack of clarity may have had a chilling effect on banking entities sponsoring or making investments in QOFs. This change does not, however, carve these entities out from the definition of “banking entity.”
- SBICs. The amendments clarify that a small business investment company (“SBIC”) that voluntarily surrenders its license and does not make new investments after such voluntary surrender will continue to stay outside the definition of “covered fund” even though it no longer qualifies for the SBIC exclusion.
- Qualifying Foreign Excluded Funds. A previously released policy statement regarding foreign excluded funds will be codified, subject to a few modifications. There may have been Volcker Rule issues where a foreign bank that is subject to the U.S. Bank Holding Company Act is deemed to control an overseas fund that otherwise wouldn’t be subject to U.S. jurisdiction. While the definition of “foreign excluded fund” was tweaked, this exclusion was passed largely as proposed in order to put these funds “on a level playing field with their foreign competitors.”
- Loan Securitization Servicing. The amendments codify the Loan Securitization Servicing FAQ and additionally permit loan securitizations to hold a small amount of debt securities (excluding asset-backed securities and convertible securities), consistent with past industry practice, as well as servicing assets that arise from the structure of a loan securitization or the loans supporting the securitizations. This may happen when collateralized loan obligations don’t otherwise qualify 1940 Act exceptions other than 3(c)(1) or 3(c)(7), such as the exceptions for issuers of asset-backed securities or for commercial financing and mortgage banking businesses.
- Foreign Public Funds. The definition of foreign public funds was expanded, eliminating the requirements that interests be sold primarily through public offerings and that the fund must be authorized to be offered and sold to retail investors in the issuer’s jurisdiction of organization. These made it difficult for managers to utilize favorable fund structures in countries other than where the listing would be located and for sponsors to utilize private structures to achieve a public listing. A prohibition on U.S. employees of the sponsor owning shares of the public fund was also eliminated. This removes many impediments that made it difficult for many banking entities to sponsor overseas listed funds.
- Covered Transactions. Banking entities will be permitted to enter into certain “covered transactions” with related covered funds. These transactions must still meet the eligibility requirements for the particular transactions, and the banking entity must also comply with certain conflict of interest, high-risk, and safety and soundness restrictions with respect to the transactions. This would expressly include certain riskless principal transactions as long as the related fund is not a securities affiliate. This would exempt certain covered transactions with a related covered fund that would be exempt from the qualitative limits, collateral requirements, and low-quality asset prohibition under the Federal Reserve Act and Regulation W. Certain clearing and settlement transactions would also be permitted.
- Ownership Interests. The Volcker Rule covers both ownership interests and “other similar interests,” which has been interpreted very broadly. The amendments clarify that rights exercisable on default or another acceleration event of a loan, such as removal rights, do not constitute other similar interests that might be impermissible under the Volcker Rule. This includes bankruptcy, material breaches, fraud, criminal activity, indictments, changes of control, key person events, and other similar events that may constitute cause under the fund documents so long as such cause is not solely related to performance or the manager’s exercise of investment discretion. Certain other characteristics of senior debt interests are also carved out from the definition of ownership interest.
- Restricted Profit Interests. The amendments carve out from the restrictions the ability of officers and directors of a banking entity to acquire restricted profits interests in a fund sponsored by that banking entity. This opens the ability for those officers and directors to get carried interest and other incentive compensation, to the extent permitted by other laws. This does not eliminate the per-fund limit, aggregate fund limit, or covered fund deduction requirements.
- Parallel Funds. Parallel funds of a banking entity that invest alongside a covered fund will now be aggregated with the main fund so that limits are combined for purposes of the 3% rule, among other things. This is intended to permit banking entities to structure their investments in a parallel manner and not require them to invest in the main fund. This does not appear to explicitly address alternative investment vehicles, or AIVs, although it is possible that the language could capture that situation.
The final rule is scheduled to become effective October 1, 2020.