,
Michael R. Butowsky ,
Charles M. Horn ,
Olga A. Loy 
,
Lennine Occhino and
David R. Sahr
Originally published June 10, 2010
Keywords: Financial reform legislation, Volcker Rule, private fund sponsorship, banking organizations, Financial Stability Act, non-US banks
On May 20, 2010, the US Senate passed its version of comprehensive financial services reform legislation, the "Restoring American Financial Stability Act of 2010" (the "Senate Bill"). The Senate Bill, coupled with the House of Representatives' action last December passing its version of financial reform legislation, the "Wall Street Reform and Consumer Protection Act of 2009" (the "House Bill"), is about to enter a formal House-Senate conference to resolve differences between the two bills. It is possible that final legislation could be sent to President Obama for signature as early as the July 4 recess.
Section 619 of the Senate Bill contains the so-called "Volcker Rule," which would broadly restrict banking organizations from engaging in private fund sponsorship, management and investment activities (see http://frwebgate.access.gpo.gov/cgi-bin/getpage.cgi?dbname=2010_record&page=S4286&position=all). It is likely that the final legislation coming out of conference will contain the Senate Bill's current Volcker Rule or substantially similar language.1
What Types of Firms Would be Covered by the Volcker Rule?
The Volcker Rule would apply to any FDIC-insured depository institution, any company that controls an insured depository institution or is treated as a bank holding company under the Bank Holding Company Act of 1956 (BHCA) and any subsidiary of an insured depository institution or company. Thus, the prohibition would apply to: (i) FDIC-insured commercial banks, savings banks, industrial loan companies and limited-charter depository institutions; (ii) any company that controls such a depository institution—no matter what the size of the depository institution; and (iii) anynon-US banking organization (and any parent thereof) that has a US branch, agency, commercial lending company or depository institution subsidiary (covered banking organizations). Non-US banking organizations that do not have such banking operations in the US, such as non-US banking organizations with only US representative offices, generally would not be subject to the Volcker Rule.
How Would the Volcker Rule Affect the Private Fund Activities of Covered Banking Organizations?
The Volcker Rule would require the federal banking regulators to adopt rules that prohibit covered banking organizations from sponsoring or investing in certain types of private funds. It also would impose higher capital requirements and quantitative limitations on nonbank financial services firms that are designated as systemically important by the proposed Financial Stability Oversight Council (the "Council").
What Constitutes Prohibited "Sponsoring" or "Investing" in a Private Fund Under the Volcker Rule?
"Sponsoring" is defined as: (i) serving as a general partner, managing member or trustee of a private fund; (ii) selecting or controlling in any manner (or having employees, officers, directors, or agents who constitute) a majority of the directors, the trustees, or the management of a private fund; or (iii) sharing with a private fund, for corporate, marketing, promotional or other purposes, the name or a variation of the name of the private fund.
What Types of Private Funds are Included Within the Volcker Rule's Prohibitions?
Any private fund that relies on either section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 for its exemption from registration would be covered under the Volcker Rule (a "covered fund"), including private funds that ordinarily are not considered to be the market equivalent of hedge funds or private equity funds (e.g., collateralized debt obligations or other bank loan funds, and securitization special purpose entities). Private funds that rely on other Investment Company Act exemptions (e.g., bank-sponsored collective funds or mortgage-backed security issuers that rely on section 3(c)(5)(C) under the Investment Company Act), would not be covered. The federal bank regulatory agencies, however, would have the authority to extend the Volcker Rule's coverage to other types of unregistered private funds.
Does the Volcker Rule Apply to Non-US Banking Organization Private Fund Activities?
The Volcker Rule prohibitions would not apply to private fund activities conducted "solely" outside of the United States within the meaning of sections 4(c)(9) and 4(c)(13) of the BHCA, as long as the non-US entity is not controlled by a US company. This should mean that, at a minimum, many private funds sponsored by non-US banking organizations that are organized and governed by non-US law, and that are not offered and sold to investors in the United States, would not be affected. However, non-US funds that make significant investments in US equities potentially could be affected to the extent that their US investments could cause their activities to be treated as not solely outside of the United States.
What Nonbank Financial Firms Would be Affected by the Volcker Rule?
Any nonbank firm that is engaged predominantly in financial activities, and which is designated as "systemically important" under the legislation, would be subject to the heightened capital adequacy requirements and quantitative limits adopted by Federal Reserve Board. In the case of designated foreign nonbanking firms (which would be subject to designation if they have "substantial" US assets or operations), these additional requirements would apply to their US operations.
Are there Exceptions from the Volcker Rule for Any Types of 3(c)(1) or 3(c)(7) Funds?
In addition to the offshore exemptions discussed above, investments in small business investment companies (SBICs) and covered funds that are "designed primarily to promote the public welfare" would be exempt from the Volcker Rule's coverage. However, because the language of this public welfare exemption provides that the prohibition shall not apply with respect to an "investment" in those funds, it is unclear from the Volcker Rule's language whether sponsorship of such funds would be allowed. The federal banking regulators would appear to have limited authority to exempt other types of covered funds, but the actual scope of this authority is not clear.
Are There Private Fund Activities that Would Not be Covered by the Volcker Rule?
Under the Volcker Rule, covered banking organizations would continue to be permitted to act as investment managers and service providers to covered funds, but a banking organization would be prohibited from entering into any transaction with an advised covered fund that would constitute a "covered transaction" under section 23A of the Federal Reserve Act (in general: loans to covered funds, purchases of covered fund assets or securities, or financial guarantees to, or on behalf of, covered funds). In addition, covered banking organizations that advise covered funds would be subject to the "market terms" and other restrictions of section 23B of the Federal Reserve Act with respect to those funds.
If Enacted, When Would the Volcker Rule Become Effective?
The Council would have 6 months from the effective date of the legislation to conduct a study and make its Volcker Rule coverage and other recommendations to the federal bank regulatory agencies. Thereafter, the federal bank regulators would have 9 months to adopt new Volcker Rule regulations, with an effective date not later than 2 years after their adoption, although the bank regulators would have the discretion to grant up to 3 one-year extensions to individual firms. Therefore, the regulations implementing the Volcker Rule would become generally effective approximately 3 years after the effective date of the legislation.
Would the Federal Banking Agencies Have the Ability to Modify or Limit the Volcker Rule?
The Council is charged with making recommendations for the implementation of the Volcker Rule, and these recommendations could provide greater flexibility, such as a regulatory mechanism that accommodates de minimis investments in covered funds and allows more financial or operational flexibility to fund managers. The federal banking agencies then would be required to adopt rules implementing the Volcker Rule "which shall reflect" the recommendations of the Council. At the same time, there are political pressures on the House-Senate conference to limit the amount of discretion that regulators would have to implement the Volcker Rule. Accordingly, the agencies' authority to modify (either by expanding or limiting) the Volcker Rule's coverage in a manner that departs from the recommendations of the Council may well be very limited.
Footnote
1. The Volcker Rule would also impact the ability of covered financial institutions and their affiliates to engage in proprietary trading activities. This Legal Update focuses on private fund activities, and thus, the topic of proprietary trading is not discussed here.
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