Volcker Rule Funds Provisions-Impact on Asset Managers

Presented by Peter T. Fariel, Partner, Rimon, P.C.

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Overview

Section 619 of the Dodd Frank Act is commonly known as the Volcker Rule.

On December 10, 2013, the federal banking agencies, SEC and CFTC issued final regulations to implement the Volcker Rule.

The Final Regulations are highly technical, with their scope and impact largely driven by a number of definitional terms.

The Final Regulations generally prohibit banking entities from owning, sponsoring or entering into certain transactions with funds covered by the Volcker Rule, subject to certain permitted activity exemptions.

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Key Definitional Terms

The Final Regulations restrict a banking entity from acquiring or

retaining as principal an ownership interest in a covered fund or

acting as a sponsor of a covered fund, subject to certain

permitted activity exemptions. In order to evaluate the impact of

the funds provisions of the Volcker Rule, the terms banking entity,

ownership interest, covered fund and sponsor are critical.

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What is a Banking Entity?

Includes any insured depository institution, any company that controls an insured

depository institution (e.g. a bank holding company), any foreign bank with a U.S.

branch, agency or U.S. commercial lending company subsidiary, and any affiliate or

subsidiary of these entities.

Under this definition, most deposit taking institutions will be considered banking entities,

including national banks, state-chartered banks and federally and state chartered

savings associations.

Covered funds, portfolio company investments held under the merchant banking

authority of the Bank Holding Company Act, and insured depository institutions

functioning solely in a trust or fiduciary capacity are not treated as banking entities.

Note: An affiliate of a banking entity includes an entity that is controlled by the banking

entity. Under certain circumstances, a bank may be viewed as controlling a registered

investment company (RIC) or foreign public fund, resulting in their treatment as banking

entities.

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What is an Ownership Interest?

Any equity, partnership or "other similar interest."

An interest in a covered fund that exhibits any one of a specified list of characteristics will be treated as an "other similar interest."

Right to participate in the selection or removal of the general partner,

managing member, investment manager, investment adviser or member of

the board of directors of the fund.

Right to receive a share of the fund’s income, gain and profits, a residual

interest in the underlying assets of a fund, and the allocation of losses from

underlying assets, among other characteristics.

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What is an Ownership Interest?

In adopting the Final Regulations, the regulators refused to provide a specific exclusion for debt instruments.

The Final Regulations exclude a “restricted profits interest” (i.e. carried interest) held by a banking entity or a current or former employee in a covered fund from treatment as an ownership interest.

The Final Regulations do not restrict a banking entity from acquiring or retaining an ownership interest in a covered fund when acting solely as agent, broker or custodian, or as a trustee or in a similar fiduciary capacity as long as the interest is held or the activity is conducted for the account of a customer and the banking entity does not have or retain a beneficial interest in the ownership interest.

Note: Regulators recently provided a carve-out from the Volcker Rule for debt

securities issued by collateralized loan obligations (CLOs) that hold trust-

preferred securities issued by banks.

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What is a "Covered Fund"?

The following issuers will be treated as covered funds unless covered by a specific

exclusion:

Issuers Relying on Section

3(c)(1) or Section 3(c)(7).

Under the Final Regulations, a

covered fund includes any fund that relies on one of these two

widely-used exclusions from the

definition of an “investment

company” under the Investment Company

Act of 1940.

Commodity Pools

The Final Regulations apply covered fund

status to a commodity pool operated by a

registered commodity pool operator (CPO) that (1) relies on CFTC Rule 4.7 or (2) a privately

offered commodity pool with substantially all of

the units owned by qualified eligible persons (QEPs) that does publicly offer units to non-QEPs.

Foreign Funds

A foreign fund sponsored by, or invested in, by a banking entity that is, or is controlled, directly or indirectly, by a banking entity located in the United States or organized under U.S. law that:• Is organized or established

outside the U.S. • Ownership interests in which

are offered and sold solely outside of the U.S.

• Is or holds itself out as an entity that raises money from investors primarily for purpose of investing in securities for resale or otherwise trading in securities.

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What issuers are specifically excluded from being treated as covered funds?

Applies to mutual funds, 1940 Act registered closed-end funds, exchange traded funds and business development companies.Also applies to private funds with written plan to become a 1940 Act registered fund/BDC within seeding period.

Examples include real estate funds relying on Section 3(c)(5) or bank collective investment funds relying on Section 3(c)(11).

Limits permissible assets to loans, cash equivalents, rights and other assets designed to assure servicing or timely distribution of proceeds and certain interest rate and foreign exchange derivatives.

Registered Investment Companies; Business

Development Companies

Private Funds Relying on Exclusions Other

Than Section 3(c)(1) or Section 3(c)(7).

Certain Loan Securitizations

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The agencies did not provide exclusions for venture capital funds, tender option bond programs, cash collateral pools, pass-through REITS, financial

market utilities, credit funds and employee securities companies.

Fund organized and established outside of the United States that is authorized to offer and sell interests to retail investors in its home jurisdiction, and that sells interests predominately through one or more public offerings predominantly outside the U.S.

Wholly-owned subsidiaries, joint ventures, acquisition vehicles, qualified asset-backed commercial paper conduits, qualified covered bonds, certain foreign pension or retirement funds, insurance company separate accounts, bank-owned life insurance, small business investment companies and public welfare investment funds.

Foreign Public Funds

Other Exclusions

What issuers are specifically excluded from being treated as covered funds?

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What is a Sponsor of a Covered Fund?

The Final Regulations provide that a banking entity is a sponsor if the banking entity:

Serves as general

partner, managing

member or trustee of a

covered fund or serves

as a commodity pool

operator of a commodity

pool that is a covered

fund;

1In any manner selects or

controls (or has

employees, officers,

directors or agents who

constitute) a majority of

the directors, trustees

or management of the

covered fund; or

2

Shares the same name

or a variation of the

same name as the

covered fund for

corporate, marketing,

promotional or other

purposes.

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Practical Observation – Sponsor Status

There is no clear guidance on what amount of

authority is sufficient to represent control of

“management” of a covered fund. Authority to

take key actions (e.g. hiring and termination of

service providers, liquidation of the fund),

increases the risk that the banking entity would

be viewed as controlling management and

therefore acting as a sponsor.

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Asset Management Exemption

The Final Regulations include several

exemptions from the covered funds

restrictions that apply to specified

permitted activities.

The asset management or customer

fund exemption allows a banking entity

to sponsor or invest in a covered fund in

connection with organizing and offering

a covered fund for customers of the

banking entity in connection with

providing bona fide trust, fiduciary,

investment advisory or commodity

trading advisory services. The customer

relationship does not need to be pre-

existing.

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Asset Management Exemption

In order to rely on the asset management exemption, a banking entity must comply with the following conditions (in addition to the requirements on the prior slide):

1 The ownership interest in the fund may not exceed 3% (except during a permitted one-year seeding period). Banking entity may apply to the Federal Reserve for an additional two-year extension to hold investments above the 3% fund limitation.

2 Aggregate ownership interests in all covered funds may not exceed 3% of bank's Tier 1 capital.

3 Written plan or similar documentation outlining how the services will be provided.

4 Compliance with the Volcker Rule’s Super 23A and 23B restrictions (discussed below).

5 The banking entity does not guarantee the obligations or performance of the covered fund.

6 The covered fund does not share the same name or a variation of the same name with the banking entity and does not use the word “bank” in its name.

7 Only directors and employees of the fund that are directly engaged in providing investment advisory or other services to the fund may invest in the fund.

8 The banking entity provides certain written disclosures to prospective and actual investors in the fund.

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Attribution Rules

In calculating the 3% per fund

limit on ownership of covered

funds under the asset

management exemption, a

banking entity must include

interests held by its affiliates.

However, the Final Regulations

provide a methodology for

calculating ownership interests

held through master-feeder and

fund of funds structures that will

avoid attribution of customer

holdings to the banking entity.

FEEDER FUND

MASTER FUND

BANKING ENTITY CUSTOMERS

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Asset Management Exemption

The Final Regulations also include “backstop” prohibitions that restrict an otherwise permitted activity if the transaction, class of transaction or activity would: 1 Involve or result in a material conflict of interest (i.e. results in the

banking entity’s interest being materially adverse to the interests of its clients, customers or counterparties); unless the banking entity (x) provides sufficient disclosure of the conflict to permit a reasonable client, customer or counterparty to meaningfully understand the conflict and negate or substantially mitigate any material adverse effect or (y) establishes and enforces information barriers that are reasonably designed to prevent the conflict from resulting in a material conflict of interest;2 Result in a material exposure to a high-risk asset or high-risk trading strategy; or

3 Pose a threat to the safety and soundness of the banking entity or the financial stability of the United States.

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2 Banks will also need to implement procedures to comply with the other

conditions of the asset management exemption, including the required

written plan or similar documentation outlining how the banking entity

intends to provide the services covered by the asset management

exemption and the restriction on officer and director investments.

Practical Observations

1Banks relying on the asset management exemption will need to establish

procedures for calculating and monitoring the 3% per fund limit as well as

the aggregate limitation that is based on 3% of the bank’s Tier 1 capital.

3 Non-bank affiliated hedge fund and private equity fund sponsors that offer

fund interests to banking entities should consider inclusion of appropriate

representations, warranties and covenants in subscription agreements from

the banking entity regarding compliance with the Volcker Rule, including the

availability of a permitted activity exception supporting the investment in

the fund by the banking entity.

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Super 23A Restrictions on Transactions with Related Covered Funds

Under the “Super 23A” restrictions, a banking entity is prohibited from entering into certain transactions with covered funds if the banking entity is serving as sponsor, investment manager, investment adviser or commodity trading adviser, or for funds that it organizes and offers under the asset management exemption (related covered funds).

These prohibited transactions include extending credit to the fund, investing in

the fund, guaranteeing the obligations of the fund, purchasing assets from the

fund or any credit exposure to the covered fund from a derivative transaction,

repurchase agreement transaction, reverse repurchase agreement transaction,

securities lending or securities borrowing transaction.

The agencies refused to provide certain exemptions from the Super 23A

restrictions that are provided for in Federal Reserve Regulation W.

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Narrow carve-out for certain prime brokerage transactions between a banking

entity and an underlying covered fund in which a covered fund managed,

sponsored or advised by a banking entity invests.

Transactions with a covered fund are also subject to Section 23B of the Federal

Reserve Act (i.e. requires that any transaction between a banking entity and a

covered fund be on terms at least as favorable to the banking entity as those

prevailing with an unaffiliated third party).

The Super 23A restrictions do not prevent a bank from extending credit to a

customer that is secured by covered fund interests.

Super 23A Restrictions on Transactions with Related Covered Funds

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Practical Observation

As part of conformance planning, banking entities should inventory current

relationships with related covered funds to identify existing transactions that

are prohibited under the Super 23A restrictions.

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Extraterritorial Reach of the Volcker Rule

The Final Regulations narrowed the extraterritorial reach of the Volcker Rule in

comparison to the proposed regulations in several ways:

Narrower definition of foreign funds treated as covered

funds. Exception for foreign public funds.

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Extraterritorial Reach of the Volcker Rule

The SOTUS exemption uses a risk-based approach for determining whether an

activity or investment is conducted solely outside of the United States (requires

that the foreign banking entity not be organized as or controlled by a U.S. banking

entity, restricts a U.S. banking entity from making the decision to sponsor the

fund or make the investment, and requiring that the activity or investment not be

accounted for or financed by a U.S. banking entity).

The definition of U.S. person in Regulation S under the Securities Act of 1933 is used

for purposes of determining whether a foreign fund is offering interests to a resident of

the United States.

SOTUS Exemption: Permitted activity exemption that applies to qualifying foreign

banking entities that conduct their activities solely outside of the United States

and do not offer or sell fund interests to residents of the United States.

Foreign fund may not target investors in the United States.

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Practical Observation

Foreign banking entities will need to evaluate the extent of any nexus to the

United States that trigger Volcker Rule requirements under the final regulations.

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Compliance and Certification Requirements

No Volcker Activities/Investments: No requirement for compliance program.

Assets of $10 Billion or Less : Include appropriate Volcker Rule references in existing compliance program.

Assets of $10 Billion or Greater: Written policies and procedures, internal controls, management framework, independent testing and audit, training and recordkeeping.

Assets of $50 Billion or Greater:

 Enhanced compliance program that includes written policies and procedures appropriate for types, size, complexity and activities/investments of the banking entity with covered funds. Annual written attestation from chief executive officer that procedures exist to establish, maintain, enforce, review, test and modify the compliance program.

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Practical Observations

Given that the extent of the Volcker Rule compliance requirements depends on

the size of the banking entity, a bank should first determine the requirements

that apply to it based on its size. Optimal if initial compliance program is in

place by April 1, 2014, the effective date of the rule.

DETERMINE COMPLIANCE REQUIREMENTS

For banks with greater than $50 billion in assets: Develop a framework for sub-

certifications from bank personnel in divisions that engage in Volcker Rule

activities and investments in order to ensure adequate due diligence is

supporting the CEO certification.

DEVELOP SUB-CERTIFICATION FRAMEWORK

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Conformance Date

2013 2014 2015 2016 2017

Conformance Period

Agencies issue Final

Regulations

April 1, 2014 Effective date of Final Regulations

July 21, 2015 Final conformance date

Banking entities may ask Federal Reserve for up to two

one-year extensions and an additional 5 years for illiquid

funds

Federal Reserve Board guidance: Use good faith efforts, consistent with activities

and investments, to conform to Volcker Rule requirements by conformance date.

Good faith efforts – evaluate extent to which banking entity engaged in non-

conforming activities/investments. Develop and implement related conformance

plan.

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Practical Observations

2 Each banking entity will need to decide on the pace with which it brings its

activities and investments into compliance during the approximately 18-

month long conformance period.

1Banking entities should now adjust the terms of their existing conformance

plans to reflect the terms of the Final Regulations. As a first step, banks

should update their inventory of existing activities and investments to reflect

the Final Regulations. Banking entities should also inventory any

transactions between a covered fund and the bank that are restricted

covered transactions under Super 23A.

3 Each banking entity will need to decide on the method for bringing non-

conforming activities/investments into compliance. Options include (1)

modifying the activity/investment to bring it outside of the Volcker Rule’s

scope; and (2) ceasing the activity or divesting the investment.

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Practical Observations

5 Banks will need to evaluate the extent to which they will need to apply for

additional extensions as permitted by the Volcker Rule.

4Each bank will need to evaluate, based on its own risk appetite, the extent

to which it will permit new non-conforming activities and investments during

the conformance period.

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Questions????

peter.fariel@rimonlaw.com

617.505.1786

Peter T. Fariel