Federal Agencies Amend the Volcker Rule’s Covered Fund Restrictions – Implications for Investment Managers

In July 2018, the U.S. federal agencies that administer the Volcker Rule (collectively, the Agencies)¹ initiated a series of proposed rulemakings² to amend the original regulations implementing the Volcker Rule.³ The Agencies amended the Volcker Rule’s covered fund restrictions on June 25, 2020 (the 2020 Revisions).⁴ The 2020 Revisions generally leave intact the original regulation’s core restrictions on covered fund activities and proprietary trading, while providing relief from many of the Volcker Rule’s restrictions and simplifying how banking entities may comply with the restrictions as they remain.

This Sidley Update focuses on the 2020 Revisions, specifically the addition of credit funds and venture capital funds as new exclusions from the definition of “covered fund.” This also describes additional guidance from the Agencies on how a banking entity may make direct investments in parallel with investments made by a covered fund. We use the term Original Rule to refer to the original regulations implementing the Volcker Rule and the term Revised Rule to refer to the Volcker Rule as amended.

The 2020 Revisions will take effect October 1, 2020.

New Exclusions From the Definition of “Covered Fund”

The base definition of “covered fund” is broad, covering any issuer that would be an investment company, as defined in the Investment Company Act of 1940 (the Investment Company Act) but for the application of Section 3(c)(1) or 3(c)(7) of the Investment Company Act. The Original Rule included 14 exclusions from the definition of “covered fund.” The 2020 Revisions will add four new exclusions:

• credit funds
• venture capital funds
• family wealth management vehicles
• customer facilitation vehicles

Credit Funds

The 2020 Revisions add an exclusion for issuers that are qualifying credit funds, which will complement the existing exclusion for issuers that are qualifying loan securitization entities (LSEs). Both kinds of issuers hold fixed income assets. Both kinds of issuers might rely on the investment company exemption set forth in Section 3(c)(1) or 3(c)(7) of the Investment Company Act and thus are “covered funds” (before the application of any exclusion).

The key differences between the two kinds of issuers:

• Credit funds may not be issuers of asset-backed securities (unlike LSEs, which must be issuers of asset-backed securities).
• Credit funds are permitted to hold many kinds of fixed income obligations, including bonds and other debt securities, and also certain equity securities received in connection with its fixed income activities (unlike LSEs, which may hold loans and generally may not hold debt or other securities — though, as described below, the 2020 Revisions now will permit LSEs to hold a small amount of debt securities).⁵

To be eligible for the exclusion, a credit fund’s assets must be limited to loans, debt instruments, certain rights and other assets that are related or incidental to acquiring, holding, servicing, or selling such loans or debt instruments (for example, securities received in lieu of debt previously contracted, or equity “kickers” or warrants received on customary terms) and certain interest rate or foreign exchange derivatives that reduce interest rate or foreign exchange risk of other permissible assets of the credit fund.

In addition, the credit fund will also be subject to limitations on its activities, including not issuing asset-backed securities (as noted above) and not engaging in proprietary trading (as defined in the Volcker Rule’s short-term intent prong). Moreover, a banking entity may not rely on the exclusion with respect to a given credit fund if (i) the banking entity guarantees or insures the obligations of the issuer or (ii) the credit fund holds assets that would be impermissible for the banking entity to acquire and hold directly under applicable federal banking laws and regulations. A banking entity’s investment in and relationships with the excluded credit fund must satisfy the prudential backstop restrictions of the Volcker Rule (e.g., the provisions that address material conflicts of interest generally) and otherwise be in compliance with applicable safety and soundness standards.

If the banking entity acts as the issuer’s sponsor, investment adviser, or commodity trading adviser, the banking entity will be required (i) to make certain related disclosures to investors, similar to those required under the asset management exemption, (ii) to ensure that the activities of the issuer 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, and (iii) to comply with the Volcker Rule’s Super 23A restrictions⁶ as if the issuer were a covered fund, except that the banking entity may acquire and retain ownership interests in the credit fund.

Venture Capital Funds

Venture capital funds generally rely on the investment company exemption set forth in Section 3(c)(1) or 3(c)(7) of the Investment Company Act and thus are “covered funds” (before the application of any exclusion). The exclusion for venture capital funds in the Revised Rule is based on the premise that venture capital funds can be distinguished from private equity funds of the kind that the Volcker Rule is intended to cover.

A venture capital fund is eligible for the exclusion if it does not engage in proprietary trading (as defined in the Volcker Rule’s short-term intent prong) and satisfies the SEC’s existing definition of “venture capital fund.” That definition requires that any qualifying venture capital fund

• represent to investors and potential investors that it pursues a venture capital strategy
• immediately after the acquisition of any asset (with limited exceptions) hold 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) other than equity securities of companies typically held by venture capital funds
• 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 or that has a term no longer than 120 days
• only issue 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
• register as an investment company, and not be treated as a business development company, under the Investment Company Act⁷

Like the exclusion for credit funds, the exclusion for venture capital funds is conditioned on the relying banking entity’s not insuring or guaranteeing the excluded venture capital fund. In addition, the banking entity’s investment in and relationships with the excluded venture capital fund must comply with the prudential backstop restrictions of the Revised Rule (e.g., the provisions that address material conflicts of interest generally) and otherwise be in compliance with applicable safety and soundness standards.

In addition, any banking entity that acts as the excluded venture capital fund’s sponsor, investment adviser, or commodity trading adviser will be required (i) to make related disclosures to investors similar to those required under the Volcker Rule’s asset management exemption, (ii) to ensure that the activities of the excluded venture capital fund are consistent with safety and soundness standards, and (iii) to comply with Super 23A restrictions as if the excluded venture capital fund were a covered fund.

Family Wealth Management Vehicles and Customer Facilitation Vehicles

The family wealth management vehicle exclusion will be available to entities that, broadly speaking, are wholly owned by members of the same family and, at most, five closely related nonfamily members. A banking entity must provide bona fide trust, fiduciary, investment advisory, or commodity trading advisory services to the entity in order to rely on the exclusion. Certain additional conditions will also apply.

Banking entities will generally be permitted to offer customer facilitation vehicles if the issuer is formed by or at the request of a customer for the purpose of providing such customer with an investment strategy, transaction, or other service normally provided by the banking entity and all the ownership interests of the issuer are owned by the customer.

The exclusion for family wealth management vehicles and customer facilitation vehicles are likely not relevant to investment advisers independent of banking entities. More information about these exclusions may be found in "Federal Agencies Amend the Volcker Rule’s Covered Fund Restrictions, Completing Series of Related Rulemakings."

Parallel Investments

Section 11 of the Original Rule permits banking entities to organize and offer covered funds in certain circumstances. Section 12 of the Original Rule sets forth quantitative limitations on the ability of banking entities to invest in the covered funds that they organize and offer.

When the Original Rule was adopted, the Agencies stated that “if a banking entity makes investments side by side in substantially the same positions as the covered fund, then the value of such investments shall be included for purposes of determining the value of the banking entity’s investment in the covered fund.”⁸

The Revised Rule includes a rule of construction that will permit banking entities to exclude certain parallel investments from the limitations in Section 12. The rule of construction will apply to any “any investment the banking entity makes alongside a covered fund as long as the investment is made in compliance with applicable laws and regulations, including applicable safety and soundness standards.” A banking entity (i) will not be required to include the investment in the calculation of the investment limits under Section 12 and (ii) will not be otherwise restricted under Section 12 in the amount of any such investment.

Other Key Changes Made by the 2020 Revisions

In addition to the changes discussed above, other key changes made by the 2020 Revisions include

• narrowing the existing definition of “ownership interest”
• broadening certain existing exclusions from the definition of “covered fund”
• codifying the Agencies’ prior no-action position with respect to certain “foreign excluded funds”
• providing a range of exemptions from the Original Rule’s “Super 23A” restrictions, which otherwise prohibit certain transactions between banking entities and certain covered funds that they sponsor or advise

These other changes are described more fully in "Federal Agencies Amend the Volcker Rule’s Covered Fund Restrictions, Completing Series of Related Rulemakings."

¹ The Agencies are the Board of Governors of the Federal Reserve (the Federal Reserve Board), the Office of the Comptroller of the Currency (the OCC), the Federal Deposit Insurance Corporation (the FDIC), the Securities and Exchange Commission (the SEC), and the Commodity Futures Trading Commission (the CFTC).

The Volcker Rule statutory requirements are set forth in Section 13 of the Bank Holding Company Act of 1956 (the BHCA), which was added to the BHCA by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

² See Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 83 Fed. Reg. 33432 (July 17, 2018) (the 2018 Rule Proposal), available at https://www.govinfo.gov/content/pkg/FR-2018-07-17/pdf/2018-13502.pdf; Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 85 Fed. Reg. 12120 (February 28, 2020) (the 2020 Rule Proposal), available at https://www.govinfo.gov/content/pkg/FR-2020-02-28/pdf/2020-02707.pdf.

³ The Agencies published lengthy supplementary information when they adopted the original regulations. See 79 Fed. Reg. 5536 (Jan. 31, 2014) (Federal Reserve Board, FDIC, OCC and SEC), available at https://www.govinfo.gov/content/pkg/FR-2014-01-31/pdf/2013-31511.pdf; 79 Fed. Reg. 5808 (Jan. 31, 2014) (CFTC), available at: https://www.govinfo.gov/content/pkg/FR-2014-01-31/pdf/2013-31476.pdf.

⁴ See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, Final Rule (June 25, 2020) (the 2020 Adopting Release), available at https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200625a1.pdf.

⁵ Both kinds of issuer are permitted (i) to own certain kinds of servicing assets and assets that are incidental or related to their other assets and (ii) to enter into certain derivative transactions for purpose of reducing interest rate and foreign exchange risks. See Revised Rule, Sections 10(c)(8)(i)(B), 10(c)(8)(i)(C), 10(c)(15)(i)(C), and 10(c)(15)(i)(D).

⁶ See "Federal Agencies Amend the Volcker Rule’s Covered Fund Restrictions, Completing Series of Related Rulemakings" for a discussion of revisions to Super 23A.

⁷ 2020 Adopting Release at 91-92 (describing SEC Rule 203(l)-1, adopted pursuant to the Investment Advisers Act of 1940).

⁸ Id. at 160 (quoting the adopting release for the Original Rule).