Volcker Rule Compliance in the Face of Regulatory Uncertainty: An Update on Covered Fund Structures

    View Author 9 July 2014

    The “Volcker Rule,”[1] adopted in December 2013, is designed to reduce risk and banking system instability by restricting U.S. banking entities from investing in or engaging in proprietary trading and speculation, while also imposing a complex framework of exemptions for underwriting, market making, and hedging activities. This Client Alert will specifically focus on the Volcker Rule’s prohibition on acquiring or retaining an ownership interest in, or having certain relationships with, a covered fund. 

    Pursuant to the Volcker Rule, and absent an exclusion or exemption from the definition of a “covered fund,” banking entities must conform their activities and investments to the rule’s restrictions on covered funds by July 21, 2015.[2] As the compliance deadline draws near, market participants continue to find themselves with questions about the rule’s technical requirements, as was evidenced by regulators’ publication of guidance on collateralized debt obligations (“CDOs”) backed by trust preferred securities (“TruPS”) due to regulatory uncertainty. 

    A Compliant Tender Option Bond Structure?

    Questions about Volcker Rule-compliant fund structures abound, and regulators have issued very little guidance thus far. Many market participants have begun affirmatively reaching out to regulators with questions about whether certain activities and investments would be considered Volcker Rule-compliant. For example, earlier this month, the Securities Industry and Financial Markets Association (“SIFMA”) sent a letter to federal banking regulators suggesting that a joint venture structure used to sell tender option bonds (“TOBs”) is Volcker Rule-compliant. While the Volcker Rule prohibits banking entities from sponsoring a TOB program, owning a residual certificate issued by a TOB trust, or providing credit enhancement, liquidity, or remarketing services to TOB programs, joint ventures between banking entities (or their affiliates) and unaffiliated parties are exempt from this prohibition, provided that there are not more than 10 unaffiliated co-venturers and that the bank only engages in permitted activities. While regulators have yet to confirm whether this joint venture structure is in fact Volcker Rule-compliant, it represents an effort on the part of market participants “to move forward in an orderly fashion.”[3]

    Are There Similar Volcker Rule-Compliant Fund Structures?

    In light of all the questions that remain about Volcker Rule compliance, Securities and Exchange Commission (“SEC”) Chair Mary Jo White indicated at a recent Investor Advisory Committee meeting that “[regulators] can expect a continued need for guidance regarding questions that will arise as market participants seek to comply with the final rule.”[4] However, federal regulators have yet to publish substantial guidance on Volcker Rule compliance. While it is expected that regulators will provide formal guidance in the form of FAQs before the first reporting deadline for the largest banks in September, the onus is currently on banking entities to implement and comply with the Volcker Rule.

    As banking entities attempt to move forward, they must evaluate the structure of their current investments (or funds in which they are investing) to ensure that none of their investments would be considered a “covered fund” under the Volcker-Rule. Pursuant to the Volcker Rule, banking entities are generally prohibited from owning and sponsoring hedge funds and private equity funds, as well as certain foreign funds and commodity pools.[5] A technical analysis of each type of investment against the Volcker Rule’s regulatory requirements, including the numerous exclusions from the definition of a “covered fund,” should be undertaken to reveal whether a particular investment is Volcker Rule-compliant.

    Since banking entities have traditionally sponsored or invested in many of these prohibited “covered funds,” a review of an entity’s investments may suggest that certain investments are not Volcker Rule-compliant. Thus, banking entities must consider whether implementing certain structuring or restructuring options will help ensure that their investments are Volcker Rule-compliant.[6] In addition to the joint venture structure described above, the Volcker Rule provides more than a dozen exclusions from the definition of a “covered fund,” thus providing both banks and fund sponsors with an opportunity to structure or restructure investments in a workable manner that is in compliance with the rule. For example, the Volcker Rule permits banking entities to sponsor and invest in funds designed to promote the “public welfare.”[7] This exclusion and many others could allow banks to create a compliant alternative to their traditional investment portfolios.  Importantly, it will also enable banks to continue to play a vital role in keeping the U.S. capital markets working to drive the “innovation that has been the hallmark of the American economy.”[8]

    Squire Patton Boggs (US) LLP has the regulatory and transactional expertise to advise clients across the globe on the Volcker Rule’s covered fund prohibitions, exclusions, and exemptions. We are currently working with both banks and fund sponsors to help them understand the Volcker Rule, evaluate banks’ investment portfolios and strategies, and consider how best to structure or restructure investments to ensure compliance with the Volcker Rule’s restrictions.

    [1] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds (“Volcker Rule”), 79 Fed. Reg. 5,536 (Jan. 31, 2014).  

    [2] The first set of banking entities (those with more than $50 billion in trading assets and liabilities) must begin reporting certain trade data to the Office of the Comptroller of Currency (“OCC”) on September 2, 2014. In fact, the OCC recently issued interim examination procedures to assist examiners in determining whether banks’ business activities or investments are subject to the Volcker Rule and, if found to be subject to the rule, to assist examiners in assessing banks’ plans to comply with the rule’s requirements. Notably, “[d]uring the conformance period, the OCC will augment these interim procedures with in-depth procedures that examiners should use to assess banks’ ongoing adherence to the regulations.”

    [3] Letter from the Securities Industry and Financial Markets Association, to the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of Currency, Securities and Exchange Commission, and Commodity Futures Trading Commission (June 13, 2014), available at http://www.sifma.org/comment-letters/2014/sifma-writes-to-volcker-regulators-to-describe-a-tax-exempt-bond-joint-venture-structure-under-the-volcker-rule/.

    [4] The Impact of the Volcker Rule on Job Creators, Part II Before the House Financial Services Committee, 113th Cong. (2014) (statement of Mary Jo White, Chairman, Securities and Exchange Commission).

    [5] See Volcker Rule § 10.

    [6] Structuring and restructuring may be possible for certain funds. However, for those funds where it is not possible for a banking entity to divest its interests in excess of three percent (3%) of the total number or value of the outstanding ownership interests of the covered fund by the end of the conformance period, the banking entity may nevertheless be able to apply for an extended transition period during which it may conform its activities and investments to the Volcker Rule’s restrictions on covered funds. While the Volcker Rule generally provides that banking entities must conform their activities and investments to the rule’s restrictions on covered funds by July 21, 2015, the Board of Governors of the Federal Reserve (“Federal Reserve) may provide an extended transition period of up to five (5) additional years (beyond any conformance period already granted) for certain illiquid instruments if necessary to fulfill a contractual obligation of the banking entity that was in effect on May 1, 2010. Notably, any extension shall terminate automatically when no longer necessary for the banking entity to fulfill its contractual obligations.  See 12 C.F.R. § 225.181 (2014). We are happy to provide further detail on how to seek such an extension. 

    [7] Volcker Rule § 10(c)(11).

    [8] President Barack Obama, Remarks by the President on the Economy (July 1, 2014), available at http://www.whitehouse.gov/the-press-office/2014/07/03/remarks-president-economy.