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Proposed Volcker Rule regulation on fund activities

Wednesday, October 26, 2011
Opalesque Industry Update – American banking lawyers should be forgiven if they’re not returning calls right away, quipped a Reuters blog; they’re busy trying to digest the 298-page proposed Volcker Rule.

On 11th October, the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board, and the Office of the Comptroller of the Currency issued a joint Notice of Proposed Rulemaking to implement the Volcker Rule.

International law firm Schulte Roth & Zabel LLP (SRZ) issued an alert on the proposed regulation as it would affect a bank’s investments in, or sponsorship of private investment funds. This alert was authored by Joseph P. Vitale and Brian W. Canida, lawyers at SRZ. (Vitale produced another notice on proprietary trading: Exceptions to Volcker Rule’s general prohibition on proprietary trading).

The Volcker Rule is part of the Dodd-Frank Act and restricts the proprietary trading and private investment fund activities of banks, generally in the U.S. Many aspects of the rule are still open to interpretation. The Notice is open to general comments till Jan.13, 2012. Once finalised, banks will have till July 2014 to comply, although the Fed could grant them up to three one-year extensions.

Just as a reminder, the Dodd–Frank Wall Street Reform and Consumer Protection Act is a federal statute in the U.S. that was signed into law by President Barack Obama on July 21, 2010.

The proposed (Volcker Rule) regulation has two parts, says the SRZ alert. First, banks are barred from acquiring or retaining an ownership interest (own) in a covered fund (a fund) subject to certain exceptions. Second, banks may no longer sponsor any covered fund unless they observe certain new requirements.

“Covered fund” is defined by SRZ to include any issuer that is an investment company under the Investment Company Act of 1940; commodity pools as per the Commodity Exchange Act; foreign funds that would be covered if based in the U.S. “Ownership interest” means any equity, partnership, or similar interest in a covered fund, as well as any derivative of such interest.

Exception to the prohibition

SBICs and related investments: banks may own a fund that is a small business; or designed to promote public welfare; or a “qualified rehabilitation expenditure”.

Risk-mitigating hedging investments: banks may own a fund to hedge risks (1) when acting as an intermediary on behalf of a customer (that is not a bank), and (2) to cover a compensation arrangement with an employee who provides advisory services.

Non-U.S. activity: Some non-U.S. banks can own a fund if the activity solely happens outside the U.S. Those eligible are organised in a non-U.S. jurisdiction; or must be a “qualifying foreign banking organization” (if under the Fed’s Regulation K); or its non-U.S. assets, revenues and income must exceed the U.S. equivalent.

Loan securitization: banks may own a fund that is an issuer of asset backed securities, the assets of which are solely comprised of loans, rights, interest rate or FX derivatives.

Bank-owned life insurance: banks may hold a fund that is a separate account, used solely for purchasing bank-owned life insurance (BOLI).

Non-funds: the proposed regulation makes exception for three more types of entities: joint venture operating companies; single acquisition vehicles; and wholly-owned subsidiaries engaged in providing bona fide liquidity management services.

Interests arising from a DPC: banks may own a fund where it acquires such interest in the ordinary course of collecting on a debt previously contracted in good faith.

Sponsorship of funds

Banks may no longer sponsor a covered fund unless the fund is eligible for the above-mentioned exceptions; and unless they observe new requirements.

A “sponsor” is an entity that serves as a general partner, managing member, trustee, or commodity pool operator of a covered fund; in some way selects or control directors, trustees or management of the fund; and shares with a covered fund the same name or a variation of it.

Permitted organizing and offering of covered funds
• banks can organise or offer a fund if they provide bona fide trust, fiduciary, investment advisory, or commodity trading advisory services;
• banks cannot guarantee or insure the fund’s obligations or performance;
• covered funds may not share the same name as banks or have “bank” in their name;
• bank directors and employees cannot own in a fund (unless directly engaged in providing services to the fund);
• banks must provide written disclosure to investors that all losses of the fund are borne solely by investors and ensure that they are not liable for any fund losses;
• banks must not own a fund except as consistent with the de minimis and seeding exceptions (below);
• and finally banks must comply with certain restrictions when engaging in any transaction with covered funds (below).

Permitted investments in a sponsored fund
De minimis exception: a bank may own a fund if it does not represent more than 3% of the total outstanding ownership interests of the fund, and if it is not exposed to more than 3% of the losses of the fund.

Seeding exception: a bank can invest up to 100% in a fund that it organises and offers if it seeks unaffiliated investors to reduce or dilute its interests and if such interest complies with the de minimis exception within a year of the fund’s launch.

Aggregate limitation: All investments under the above two exceptions must not exceed 3% of a bank’s Tier 1 capital.

Limitations on transactions with a sponsored or managed fund
Market term requirement: banks may not provide any services or sell any assets to a fund that it organises or offers (except on market or better terms).

Prohibited transactions: banks may not engage in any transaction with a fund that it organises or offers if the transaction would be a “covered transaction” (loans to the fund, purchase of assets from the fund, and using its securities as collateral for extension of credit to a third party) as defined in Section 23A of the Federal Reserve Act. This prohibition does not apply to prime brokerage transactions.

Other prohibited activities: a) a bank cannot engage in activities that would involve a “material conflict of interest” between itself and their clients or counterparties (unless the other party is given prior disclosure of the conflict or the bank has good information barriers); b) materially expose itself to an asset or trading strategy that would significantly increase the likelihood of substantial loss or failure; c) or pose a threat to its own safety and soundness or the financial stability of the United States.

These are necessarily subjective analyses that a banking entity will have to undertake, but that will ultimately be judged by its primary federal regulator, concludes the alert.
B. Gravrand

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