United States: Regulatory Agencies To Review Volcker Rule Provisions For Foreign Funds

Last Updated: August 8 2017
Article by Scott A. Cammarn

Most Read Contributor in United States, August 2018

Five federal financial regulatory agencies will review the treatment of certain funds under section 13 of the Bank Holding Company Act ("BHCA"), as added by the Volcker Rule.

According to a joint statement, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the SEC, and the CFTC (collectively, the "agencies") will undertake a coordinated review of how the Volcker Rule (codified at BHCA Section 13) applies to certain foreign funds that are excluded from the definition of "covered funds." The purpose of the review is to examine "possible unintended consequences" and impacts of the Volcker Rule.

The agencies stated that market participants are concerned about potential competitive disadvantages that could arise as a result of certain foreign funds being subjected to the Volcker Rule's requirements due to their affiliations with a foreign banking entity, while other foreign funds remain exempt from the Volcker Rule's requirements because they are not affiliated with a banking entity. Such foreign funds often fall outside (or are excluded from) the Volcker Rule's definition of "covered fund," and thus foreign banking organizations are free to invest in or sponsor such funds without violating the Volcker Rule. Nonetheless, the act of sponsoring or investing in the so-called "foreign excluded funds" can create certain problems for the funds themselves.

A foreign banking entity's investment in or sponsorship of such a foreign excluded fund can cause the fund to be viewed as "affiliated" with the foreign banking entity. If deemed to be affiliated, foreign excluded funds are themselves "banking entities" and the funds themselves must comply with the Volcker Rule's requirements – in particular, such funds are prohibited from engaging in proprietary trading or investing in other covered funds, absent an exception in the Volcker Rule. In addition, such funds must maintain a Volcker compliance program.

In this regard, the agencies noted that the Volcker Rule incorporates the BHCA's existing concept of "affiliation." For example, a foreign excluded fund would be "affiliated" with a foreign banking entity if the foreign banking entity were the general partner of the foreign excluded fund, or if the foreign banking entity were to own more than 25% of the voting shares of the fund.

The agencies also are not willing to simply exempt all foreign excluded funds from the scope of the Volcker Rule. There is no clear definition of what is a "foreign excluded fund" – other than an entity that isn't a Volcker Rule regulated "covered fund." The agencies expressed concern that exempting all foreign excluded funds from the "banking entity" definition could enable foreign banking organizations to use structures self-described as foreign excluded funds to engage in proprietary trading or covered fund investing in a manner that the foreign banking organization could not do so directly.

The agencies stated that until July 21, 2018, the agencies will not treat as a "banking entity" any foreign excluded fund that meets the agencies' definition of a "qualified foreign excluded fund." A "qualified foreign excluded fund" is defined as an entity that:

(1) Is organized or established outside the United States and the ownership interests of which are offered and sold solely outside the United States;

(2) Would be a covered fund were the entity organized or established in the United States, or is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;

(3) Would not otherwise be a banking entity except by virtue of the foreign banking entity's acquisition or retention of an ownership interest in, or sponsorship of, the entity;

(4) Is established and operated as part of a bona fide asset management business; and

(5) Is not operated in a manner that enables the foreign banking entity to evade the requirements of the Volcker Rule or its implementing regulations.

The agencies further noted that ultimately any relief may require Congressional action to amend the Volcker Rule itself.

Commentary / Scott Cammarn

The joint agency statement attempts to address the longstanding and thorny problem created by the statutory language of the Volcker Rule. The Volcker Rule's statutory language defines a "banking entity" as any entity affiliated with a U.S. or foreign banking organization and, in doing so, incorporates the BHC Act's concept of "affiliation." The statutory language then subjects all such-defined "banking entities," wherever located, to the restrictions of the Volcker Rule, subject to narrow carve-outs, including one for transactions "solely outside of the United States."

While the statutory language seems to have been adopted in order to create a level playing field between U.S. banking organizations and foreign banking organizations, Congress failed to appreciate that, prior to the enactment of the Volcker Rule in 2010, U.S. banking law essentially stopped "at the shores of the U.S." and did not attempt to regulate a foreign banking organization's non-U.S. activities or entities. Prior to 2010, affiliates of foreign banking organizations were largely outside of the scope of BHC Act regulation unless the affiliate engaged in business in (meaning, maintained physical operations in) the U.S. Thus, prior to the Volcker Rule, the non-U.S. activities of foreign banking organizations were largely exempt from U.S. banking regulation. Foreign banking organizations were thus free to structure their non-U.S. entities without having to concern themselves with whether such entities were deemed "affiliated" for purposes of U.S. law; it simply didn't matter whether they were affiliate or not, since U.S. law didn't apply.

The Volcker Rule changed this longstanding notion. The Volcker Rule applies U.S. concepts of "affiliation" to foreign banking organizations when determining which of the foreign banking organization's overseas entities are subject to the Volcker Rule. Now, when determining the impact of the Volcker Rule, foreign banking organizations are required to apply U.S. concepts of "affiliation" across their entire global enterprise. Foreign banking organizations wishing to limit the application of the Volcker Rule to their non-U.S. fund structures must ensure that the funds are not "affiliated."

For example, prior to the Volcker Rule, it may have been perfectly acceptable, if not commonplace, for a foreign banking organization to be the general partner of a European equity fund. Now, being the general partner causes the fund to become a "banking entity" and subjects the fund to the Volcker Rule's prohibition on proprietary trading and investing in or sponsoring private equity or hedge funds.

The agencies are on the horns of a dilemma. Exempting all foreign excluded funds from the Volcker Rule would, in theory, enable foreign banking organizations to establish controlled vehicles characterized as "foreign excluded funds" in order to engage in proprietary trading and fund activities that are barred to the foreign banking organization itself, thus upsetting the "level playing field" envisioned by Congress. On the other hand, failing to exempt foreign excluded funds requires foreign banking organizations either (i) to apply U.S. concepts of "affiliation" to funds operating outside the U.S. – including in jurisdictions where it previously was completely acceptable for the foreign banking organization to be the general partner or have an ownership interest exceeding 25%, or (ii) to subject the funds to the restrictions of the Volcker Rule.

As a result, the agencies have announced the temporary exemption for "qualified foreign excluded funds." While the agencies' goal is laudable, the solution advanced is in itself problematic. In particular, certain of the agencies' criteria in the "qualified foreign excluded fund" definition are highly subjective and open to interpretation. For example, how is it to be determined whether the fund is "established and operated as part of a bona fide asset management business"? How will it be decided whether the fund is being "operated in a manner that enables the foreign banking entity to evade the requirements of [the Volcker Rule] or [its] implementing regulations"? The agencies provide no insight as to how these difficult determinations will be made.

Nor is there any discussion of any process to be followed. Are foreign banking organizations expected to make their own determinations whether these standards are to be met, and suffer the consequences if the agency later disagrees? Or are they expected to obtain some form of confirmation from the respective agencies, which itself could take months?

Ultimately, whether "qualified foreign excluded fund" status is available may come down to a number of "facts and circumstances" factors not discussed in the agencies' release, such as:

  • Is it customary and usual in the jurisdiction where the fund is organized for a banking organization to serve as general partner or own more than 25%? Is it customary and usual in the jurisdiction where the banking organization is formed?
  • Is there an objective reason – apart from Volcker Rule considerations – for the foreign banking organization to structure the fund in this fashion?
  • Will a majority of the ownership interests in the fund be held by persons not affiliated with the foreign banking organization?
  • Will the foreign excluded fund engage in proprietary trading with U.S. counterparties or invest in covered funds open to U.S. investors?
  • Will the foreign excluded fund be consolidated with the foreign banking organization under applicable accounting standards?
  • Are the aspects of the fund structure resulting in "affiliation" intended to be permanent features of the fund's structure? Or is this a temporary arrangement, for example, as part of the fund's formation?

In any event, the agencies' release is a welcome event, in that it publicly acknowledges the longstanding problem with the "banking entity" definition and exhibits an apparent willingness to find a solution. However, it seems that we are still some way away from having a solution that the industry is able to rely upon.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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