In this Ropes & Gray podcast, asset management partner Joel Wattenbarger and associate Gideon Blatt discuss the federal banking agencies’ proposed amendments to the Volcker Rule’s covered fund provisions. They address the existing landscape, the agencies’ notice of proposed rulemaking and the potential impact it may have on the asset management industry.
Joel Wattenbarger: Hello, and thank you for joining us today on this Ropes & Gray podcast. We hope this podcast finds you all well. During today’s podcast, we will be discussing the federal banking agencies’ proposed amendments to the Volcker Rule’s covered fund provisions, addressing the existing landscape, the agencies’ notice of proposed rulemaking and our expectations about the potential impact on the asset management industry. I’m Joel Wattenbarger, a partner in Ropes & Gray’s asset management practice group, based in New York. Joining me for today’s discussion is Gideon Blatt, an associate in our Boston office and a fellow member of Ropes’ asset management practice group.
Joel Wattenbarger: Sure. The Volcker Rule has two prongs: restrictions on proprietary trading, and provisions regulating banking entities’ relationships with so-called “covered funds.” The idea is that, if “banking entities”, that is, banks and their affiliates, are prohibited from engaging in proprietary trading, then they should also be prohibited from doing indirectly, using a fund structure, what they are prohibited from doing directly. To that end, the rule also imposed limits on banks' investments in, and other relationships with, hedge funds or private equity funds—covered funds.
Gideon Blatt: What was the reasoning behind these limitations?
Joel Wattenbarger: The main policy goal is to limit risk-taking by FDIC-insured banks in order to minimize bank failures that would end up leaving U.S. taxpayers footing the bill through FDIC insurance.
Gideon Blatt: Today we are talking about the recent notice of proposed rulemaking to amend the Volcker Rule’s covered fund provisions. The Dodd-Frank Act added a new Section 13 to the Bank Holding Company Act. The implementing regulations, known as the Volcker Rule, came into effect in late 2013. In the years since, industry has grappled with many aspects of the rule, and eventually the regulators recognized that the rule was overly restrictive in some places and resulted in unintended consequences in others. So, how did we get to where we are today?
Joel Wattenbarger: In July 2018, the agencies proposed rulemaking and invited public comment on both the proprietary trading prong and covered funds prong of the Volcker Rule. Amendments to the proprietary trading prong were finalized in the fall of 2019 and became effective January 1, 2020. That rule release noted that the covered fund provisions would be addressed in a separate rulemaking. The proposal to modify the regulations implementing the Volcker Rule’s general prohibition on banking entities investing in or sponsoring hedge funds or private equity funds—known as "covered funds"—was issued in January 2020. The comment deadline was initially April 1, 2020, but has been extended until May 1, 2020 due to COVID-19.
Gideon Blatt: Could you highlight the changes addressed in the notice of proposed rulemaking?
Joel Wattenbarger: Sure. The rule proposes several new exclusions from the covered fund definition, as well as modifications to existing exclusions and changes to the so-called “Super 23A” provisions that limit certain relationships a bank may have with a covered fund it sponsors or controls. In general, these would allow banking entities greater flexibility to provide asset management services, customer facilitation services and financing to U.S. businesses and their customers, including start-ups, through fund structures.
Gideon Blatt: Let’s dive into the proposed changes in more detail, starting with the new exclusions from the definition of covered fund. Prior to the proposed rule release, there had been talk about getting rid of the covered fund definition entirely and starting over with a new definition. The rule defines a covered fund as an issuer that is exempt from registration as an investment company under the 1940 Act by way of Section 3(c)(1) or 3(c)(7), as well as certain commodity pools. What are the new, proposed exclusions, and were you surprised with the approach the regulators took to add the new exclusions rather than revamp the existing definition?
Joel Wattenbarger: I think the regulators’ approach makes sense. The industry has gotten comfortable over the past six or so years with the current definition, and people generally see it as a workable definition with some rough edges that needed smoothing out. The four new exclusions in the proposed rule are for credit funds, venture capital funds, family wealth management vehicles and customer facilitation vehicles – these are the types of funds that regulators have concluded do not raise the concerns that the Volcker Rule was intended to address. The proposal would allow banking entities to invest in or sponsor these funds, provided certain eligibility criteria and guardrails are met, such as issuer restrictions and specific limitations on banking entities with respect to investing and/or sponsoring. As I mentioned earlier, the policy reasoning behind the covered funds prong of the Volcker Rule is to not allow an end-around of the proprietary trading restrictions through a fund structure. In general, these new exclusions cover long-term funds that don’t engage in proprietary trading and are used to provide traditional asset management services. Moreover, given the current state of the economy relative to when the new exclusions were proposed a few months ago, it seems safe to assume that regulators will be particularly focused now on any actions that may ease market participants’ ability to raise and deploy capital. The agencies have proposed several specific questions for comment concerning the new exclusions, and it will be interesting to see how these play out in the final rule.
Gideon Blatt: That’s right. Thanks, Joel. The SEC was particularly focused on opening up venture capital funds for use by banks. You can find more specifics in the related Ropes & Gray client alert on the covered funds rule proposal on our website. The proposal would also simplify the eligibility criteria for certain existing exclusions from the definition of covered fund in order to enable banking entities to use and confirm compliance with these existing exclusions. The two main ones addressed in the Notice of Proposed Rulemaking are for loan securitizations and foreign public funds. Could you speak to those?
Joel Wattenbarger: Sure. The exclusions for loan securitizations and foreign public funds were ripe for review, and the proposals are a step in the right direction, but of course we will need to see what ends up in the final rule. The Notice of Proposed Rulemaking proposed two changes to the loan securitization exclusion. First, the proposal would permit an issuer to hold a small pool of non-loan assets up to five percent of the loan securitization’s total assets in order to provide banking entities with greater flexibility to sell and securitize loans. Second, the proposal would codify existing guidance to clarify that ‘servicing assets’ held by a loan securitization vehicle may include assets other than securities, for example, mortgage insurance policies supporting the mortgages in a loan securitization. With respect to the foreign public funds exclusion, the proposal would simplify the eligibility requirements for foreign public funds to qualify for the exclusion from the definition of covered fund in order to provide consistent treatment between mutual funds and their foreign equivalents. The main change would replace two of the more troublesome requirements in the existing foreign public funds exclusion with a new requirement that ownership interests in such a fund must be offered and sold through at least one public offering, meaning that the distribution must be subject to substantive disclosure and retail investor protection laws or regulations in the jurisdiction where it is made.
Gideon Blatt: On the topic of foreign funds, the proposal would also provide permanent relief to resolve the unintended, extraterritorial impact the Volcker Rule has had on certain foreign funds that, but for lacking a U.S. nexus, would otherwise be covered funds. The U.S. bank regulatory system generally takes a “water’s edge” approach, and U.S. banking regulators don’t generally get involved in the activities of foreign banks that take place outside of the U.S. The current rule excludes covered funds from the definition of banking entity. While the agencies’ rules exclude certain foreign funds that are organized and offered outside of the U.S. from the definition of covered fund—which is generally a desired result—if these foreign funds are sponsored by a foreign bank or otherwise affiliated with a banking entity, then the funds themselves could become banking entities subject to the Volcker Rule’s proprietary trading and other restrictions. In order to permit foreign banking entities to conduct certain activities in accordance with the same laws and regulations applicable to their non-U.S. competitors, the proposal would exempt qualifying foreign excluded funds from the proprietary trading prohibition and covered fund provisions using the same eligibility criteria set forth in existing policy statements. Finally, the Notice of Proposed Rulemaking also makes some changes to the “Super 23A” provisions that would permit certain low-risk transactions between a banking entity and covered funds for which the banking entity serves as investment adviser or sponsor.
Joel Wattenbarger: That’s right. Under the Volcker Rule, a banking entity is generally prohibited from entering into a transaction of a type that would be covered by Section 23A of the Federal Reserve Act. While Section 23A of the Federal Reserve Act includes certain exceptions from its prohibitions, the Volcker Rule did not incorporate those exceptions, leading to its nickname “Super 23A.” The existing Super 23A limits banking entities from providing certain traditional banking services—such as standard payment, clearing and settlement services—to related funds, meaning those services had to be outsourced to unaffiliated service providers. Permitting these “low-risk” transactions between a banking entity and a related fund should reduce both the operational risks associated with the use of unaffiliated service providers and the interconnectedness among financial institutions in the U.S. financial system.
Gideon Blatt: Thanks, Joel. I’ll just mention that the proposed rule also addresses the scope of ownership interests and treatment of parallel investments by a banking entity. Joel, is there anything else that you’d like to add?
Joel Wattenbarger: I would only note that while some of the proposed changes to the covered funds provisions of the Volcker Rule, such as the Super 23A provisions we just discussed, seem largely technical in nature and unlikely to generate substantial opposition. Other provisions, including in particular the establishment of new covered fund exclusions for credit funds and venture capital funds, have already generated expressions of concern from Commissioner Lee of the SEC and Governor Brainerd of the Federal Reserve, and may prove controversial as the regulatory agencies with jurisdiction over the Volcker Rule seek to finalize and adopt these amendments. We will continue to follow developments as regulators seek to move forward on these amendments during an election year.
I’d like to conclude by thanking you for joining me here today, Gideon. And thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management community, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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