The five federal financial regulators adopt Volcker 2.1 amendments.
The Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Federal Reserve Board, along with the Commodity Futures Trading Commission and Securities and Exchange Commission, finalized a rule modifying the Volcker Rule's prohibition on banking entities investing in or sponsoring hedge funds or private equity funds—known as covered funds. The final rule is effective Oct. 1, 2020.
SEC, CFTC reaction swift. The SEC’s press release announcing the final regulation emphasized that the Volcker rule amendments would ease limits imposed by the Volcker rule on banks' investments in hedge funds and private equity funds. For example, Rule 6 of the SEC’s version of the proprietary trading rules is amended to provide that the proprietary trading ban will not apply to a qualifying foreign excluded fund that meets criteria about, among other things, its organization and ownership being located outside the U.S.
Other examples include the amendment of Rule 12 to provide that a registered investment company, SEC-regulated business development company, or foreign public fund will not be considered an affiliate of a banking entity if the banking entity cannot vote 25 percent or more of the company’s or fund’s voting shares and the banking entity provides investment advisory services to the company or fund in compliance with applicable regulations. Rule 12 imposes investment limits for banks regarding numerous permitted investments in covered funds. The final regulation also contains provisions regarding loan securitizations, qualifying venture capital funds, and family wealth management vehicles. Many of the provisions are discussed in greater detail below.
SEC Commissioner Allison Herren Lee dissented from the final Volcker rule amendments because financial regulators’ "interpretive re-imagining" of the proprietary trading curbs would allow the accumulation of risk on banks’ balance sheets at a time when the economic effects of the COVID-19 pandemic remain uncertain. Lee observed that the pandemic’s affects were considered only regarding the decision not to extend the comment period but apparently had no impact on the final regulatory amendments.
SEC Commissioners Hester Peirce and Elad Roisman jointly supported adoption of the Volcker rule amendments. "As originally formulated, the implementing regulations were overly broad; prohibited domestic banking entities from engaging in traditional banking activities that did not implicate the concerns underlying the rule and imposed disproportionate burdens on funds outside the United States," said Peirce and Roisman. "Bank customers paid the price in the form of inhibited access to capital." With respect to the COVID-19 pandemic, Roisman and Peirce characterized the amendments as "timely" in light of government ordered pandemic lockdowns and business-related hardships. Moreover, both commissioners said they remain open to ideas to further amend the Volcker rule to revise the definition of covered funds to exclude long-term investment vehicles.
CFTC commissioners likewise divided along political lines. CFTC Chairman Heath Tarbert lauded the amendments as a step towards a more accurate understanding of the Volcker rule: "While today’s final rule does not fix the fundamental flaws of the Volcker Rule—only congressional action can do that—it at least represents a more accurate reading of the law Congress actually passed and brings us a step closer to a reasonable implementation of the rule" (footnotes omitted). Commissioner Dan Berkovitz’s dissent cited the risks associated with the venture capital funds exclusion. Commissioner Rostin Behnam also dissented and quoted the late Paul Volcker’s warning that further amendments to the rule could "amplify[y] risk in the financial system."
Analysis of Volcker rule amendments. The Volcker Rule, which is Section 619 of the Dodd-Frank Act and codified as Section 13 of the Bank Holding Company Act, generally prohibits banking entities from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund.
The agencies’ final rule, which some have dubbed as "Volcker 2.1," modifies three areas of the of the Volcker Rule by:
- streamlining the covered funds portion of the rule;
- addressing the extraterritorial treatment of certain foreign funds; and
- permitting banking entities to offer financial services and engage in other activities that do not raise concerns that the Volcker rule was intended to address.
Extraterritorial treatment. The final rule addresses the extraterritorial treatment of foreign excluded funds by exempting the activities of certain funds that are organized outside of the United States and offered to foreign investors—qualifying foreign excluded funds—from the restrictions of the agencies’ implementing regulations.
This provision of the final rule codifies an existing policy statement issued by the federal banking agencies that addressed the potential attribution to a foreign banking entity of the activities and investments of qualifying foreign excluded funds.
Specifically, the provision will exempt the purchase or sale of a financial instrument by a qualifying foreign excluded fund and the acquisition or retention of any ownership interest in, or the sponsorship of, a covered fund by a qualifying foreign excluded fund, if any acquisition of an ownership interest in, or sponsorship of, the qualifying foreign excluded fund by the foreign banking entity meets the requirements for permitted covered fund activities and investments solely outside the United States.
Covered funds exclusions. The final rule simplifies the eligibility criteria for certain exclusions from the definition of "covered fund," making it easier for banking entities to use and confirm compliance with such exclusions.
Low-risk transactions. The final rule will permit certain low-risk transactions, including intraday credit and payment, clearing, and settlement transactions, between a banking entity and covered funds for which the banking entity serves as investment advisor or sponsor. Allowing these types of transactions would give banking entities greater flexibility to provide custody and other traditional financial services to a related covered fund, rather than requiring such services to be provided by an unaffiliated service provider. In addition, permitting the low-risk transactions will reduce operational risks associated with the use of unaffiliated service providers and, therefore, reduce interconnectedness among financial institutions in the U.S. financial system.
The final rule also will simplify existing provisions of the Volcker Rule related to foreign public funds, loan securitizations, small business investment companies, and public welfare investments.
Foreign public funds. Under the current provisions of the agencies’ Volcker Rule regulations, foreign public funds are excluded from the definition of "covered fund" if they meet certain eligibility requirements; namely, a fund is authorized to be offered and sold to retail investors in the fund’s home jurisdiction and ownership interests be sold predominantly through public offerings.
To address consistency and compliance concerns and better align the treatment of foreign public funds with that of U.S. registered investment companies, the final rule eliminates the home jurisdiction requirement and replaces the requirement that a fund be sold predominantly through public offerings with a requirement that a fund be offered and sold through at least one public offering.
Loan securitizations. The agencies’ Volcker Rule regulations exclude loan securitizations from the definition of "covered fund," provided the securitization’s issuers meet various eligibility criteria, such as issuing asset-backed securities and only holding loans and certain other permitted assets. The final rule amends two key eligibility criteria to qualify for the exclusion. First, the final will permit five percent of the total assets of a qualifying loan securitization to consist of non-loan assets. Second, the final rule clarifies that a loan securitization vehicle may hold servicing assets that are not securities, such as mortgage insurance policies supporting the mortgages in a loan securitization.
SBIC exclusion. Small business investment companies (SBICs) are excluded from the definition of "covered fund," as long as the SBIC’s license has not been revoked. The final rule addresses the situation where a SBIC may surrender its license during a wind-down period, thereby calling into question its continued eligibility for the SBIC exclusion.
The final rule clarifies that an SBIC could remain eligible for the exclusion from the covered fund provisions during a wind-down period, provided that it makes no new investments, other than investments in cash equivalents, after surrendering its license. Allowing SBICs to retain their eligibility for the exclusion from the covered fund definition during their wind-down periods will help facilitate banking entities’ investments in SBICs and give appropriate effect to the statutory exemption for SBIC investments.
Public welfare investments. The final rule amends the exclusion from the covered fund definition for public welfare investments to clarify that it includes investments that qualify for consideration under the banking agencies’ regulations implementing the Community Reinvestment Act. The draft final rule will also exclude rural business investment companies and qualified opportunity funds from the covered fund definition, because such funds serve a similar purpose as public welfare investments.
Permitted funds. The final rule will also permit banking entities to invest in or sponsor certain types of funds that do not raise the concerns the Volcker Rule was intended to address, such as credit funds, venture capital funds, customer facilitation funds, and family wealth management vehicles;
Credit funds. Banking entities will be able to invest in or sponsor "qualifying credit funds" since this activity is generally considered to be a traditional lending activity outside the scope of the Volcker Rule’s prohibition on activities by private equity funds and short-term-focused hedge funds.
Under the final rule, a qualifying credit fund is a fund whose assets consist solely of: (1) loans; (2) debt instruments; (3) other assets that are related or incidental to acquiring, holding, servicing, or selling loans; and (4) certain interest rate or foreign exchange derivatives.
Venture capital funds. The final rule will allow banking entities to acquire or retain ownership interests in, or sponsor, certain venture capital funds, to the extent the banking entity is permitted to engage in such activities under applicable law. For example, a banking entity that has elected to be treated as a financial holding company may be permitted to make an investment in a venture capital fund pursuant to its merchant banking investment authority, provided the banking entity complies with applicable merchant banking investment requirements.
To be excluded from the definition of a covered fund, a venture capital fund must meet the regulatory requirements set forth by the SEC and cannot engage in proprietary trading. Also, an entity that acts as a sponsor or investment adviser to the venture capital fund will be prohibited from guaranteeing the fund’s performance, required to disclose this prohibition to fund investors, and required to comply with the transaction with affiliate restrictions found in Section 23A of the Federal Reserve Act as if the fund were a covered fund.
Customer facilitation funds. Funds designed to facilitate transactions between a banking entity and a single customer, such as a derivative, will be excluded from the covered funds restrictions. The new exclusion is intended to provide banking entities with greater flexibility to provide banking and financial services to customers. Banking entities sponsoring customer facilitation funds will be subject to the same restrictions and requirements that apply with respect to family wealth management vehicles so as to ensure that banking entities do not evade the requirements of the Volcker Rule.
Family wealth management vehicles. The final rule will afford banking entities more flexibility to provide traditional banking and asset management services to family wealth management vehicles, which are funds set up on behalf of a family. The fund would qualify as a family wealth management vehicle under the draft final rule if the fund were owned only by members of a single family and a limited number of closely related persons to the family customers.
Ownership interests clarified. The final rule also clarifies that credit exposures to a covered fund will generally not constitute fund ownership interests under the Volcker Rule.
Currently, "ownership interest" is defined to include any equity, partnership, or other "similar interest." "Similar interest" is defined by reference to a list of characteristics, including the right to participate in the selection or removal of a general partner, managing member, member of the board of directors or trustees, investment manager, investment adviser, or commodity trading adviser of a covered fund.
The final rule amends the list of characteristics to clarify that a loan or debt interest with certain traditional creditor rights would not be an ownership interest and provides an express safe harbor for senior loans and senior debt. The final rule also clarifies the limited types of creditor rights that will be considered within the scope of the definition of "ownership interests."
Parallel investments. When the agencies adopted their regulations implementing the Volcker Rule, the preamble to that 2013 final rule created confusion as to whether the covered fund limits in the Volcker Rule apply to direct side-by-side investments by a banking entity, and whether a banking entity has a legal obligation to track and monitor its side-by-side investments in the same assets held by a covered fund organized and offered by the banking entity.
To clarify this confusion, the final rule adds a rule of construction to address investments made by banking entities alongside covered funds. Specifically, the final rule provides that a banking entity need not include its investments made alongside a covered fund in these limits to the extent that the investment is made in compliance with applicable laws and safety and soundness standards. This rule of construction is intended to simplify compliance with the applicable covered fund limits and would be consistent with the scope of the statute.
More efficient framework. During a June 25, 2020, meeting of the FDIC’s board of directors, Chairman Jelena McWilliams stated, "I support this rule, and I would like to thank the staff for their tremendous work to complete this effort, especially through these challenging times. With over 30 interagency issuances to implement the Volcker Rule—including proposals, final rules, and FAQs—I believe we now have a more efficient framework. This result would not be possible without the tireless work and continued diligence of the FDIC staff. I greatly appreciate your work on this important rule."
Volcker Rule severely weakened. On the other hand, FDIC board member Martin J. Gruenberg opposed the final rule. He noted that the final rule "would severely weaken the Volcker Rule restrictions on bank investments in, and relationships with, hedge funds and private equity funds." He added, "Today’s Final Rule would allow the largest, most systemically important banks and bank holding companies once again to engage in investments and relationships with high risk funds that resulted in large losses, and contributed to the failure or near failure of large financial firms in the 2008-2009 financial crisis. Weakening this important prudential protection at the present time, given the economic and financial uncertainty caused by COVID-19, risks repeating the mistakes of the last crisis."
Support the economy. Commenting on the FDIC’s action, Rob Nichols, president and CEO of the American Bankers Association said, "We welcome the measured steps taken today by the FDIC, which will allow banks to further support the economy at this challenging time for the nation. Providing for covered fund exclusions and affiliate transaction reforms under the Volcker Rule will bolster capital formation, customer choice and community development efforts, while preserving traditional banking services."
Companies: American Bankers Association
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