The final rules (the “Final Rules1 implementing the Volcker Rule2 adopted on December 10, 2013, placed significant restrictions on the ability of “banking entities3 to sponsor and make investments in private funds. In the last edition of the Private Equity Report, we laid out the ways in which banking entities may invest in unaffiliated private funds.4 In this brief “cheat sheet,” we focus on the ways in which banking entities can navigate the substantial restrictions in the Final Rules on the sponsorship of private funds. Banking entities must come into conformance with these sponsorship restrictions by July 21, 2015 (subject to certain extensions). All guidance provided below is preliminary; of course, specific facts and circumstances should also be considered in any analysis.
Options for a U.S. Banking Entity
Under the Final Rules, a U.S. banking entity generally is not permitted to sponsor a “covered fund,”5 unless one or more of the exemptions noted below applies.
- Customer Funds. A U.S. banking entity may sponsor (and invest in) a so-called “customer fund” subject to a number of restrictions, including (i) a 3% per-fund investment limit and an aggregate customer fund investment limit of 3% of Tier 1 capital, (ii) a prohibition on using a name similar to the name of the banking entity or its affiliates or any sponsored non-covered funds (discussed below), (iii) a limitation on employee investments unless the employee provides services to the customer fund and (iv) a restriction on any guarantee by the banking entity of the fund’s obligations or performance (and required disclosure of this restriction).
Investors in a customer fund would not be required to have a pre-existing relationship with the banking entity sponsoring the customer fund. In addition, a banking entity that sponsors a customer fund may also organize the customer fund as a “foreign non-covered fund” or a “SOTUS fund” (discussed below) in order to attract investments from non-U.S. banking entities.
Subject to the anti-evasion provisions of the Volcker Rule, a U.S. banking entity may be permitted to make direct investments alongside the customer fund using its merchant banking authority or through a non-covered fund (discussed below).
- Funds Sponsored by Insurance Companies. An insurance company and its affiliates may sponsor (and invest in) a covered fund under the exemption in the Final Rules applicable to insurers; however, the investment must either be (i) a de minimis investment to provide the basis for the desired tax treatment of a “restricted profit interest” (e.g., certain carried interest), or (ii) solely for the general account of the insurance company (or for one or more separate accounts established by the insurance company) and subject to and in compliance with applicable insurance company investment laws. (Note: an insurance company or its affiliates could also sponsor covered funds under other exemptions.)
- Funds that Are Not Covered Funds. A U.S. banking entity generally may sponsor (and invest in) investment funds that are not covered funds, including: U.S. registered investment companies; business development companies; foreign public funds; employees’ securities companies; certain oil, gas and mineral funds; certain real estate funds; bank common trust funds; certain joint ventures; and certain single investor vehicles or separately managed accounts. However, a non-covered fund sponsored by a U.S. banking entity may itself be subject to Volcker Rule prohibitions on proprietary trading or investments in covered funds if the non-covered fund is “controlled” by the U.S. banking entity, including, for example, where the U.S. banking entity acts as general partner of the fund or holds more than 25% of the fund’s voting shares.
Options for a Non-U.S. Banking Entity with a U.S. Banking Presence
- Foreign Non-Covered Funds. A non-U.S. banking entity with a U.S. banking presence may sponsor (and invest in) a foreign non-covered fund. A foreign non-covered fund generally must be organized outside of the United States, must not make any offering of securities in the United States and must not be a covered commodity pool. As noted above, non-covered funds may themselves be subject to Volcker Rule restrictions if they are controlled by a banking entity.
- SOTUS Funds. A non-U.S. banking entity with a U.S. banking presence may sponsor (and invest in) a covered fund that is “solely outside of the United States” (a “SOTUS fund”) if (1) the interests in the SOTUS fund are not sold pursuant to an offering that targets U.S. persons, (2) any investment by the non-U.S. banking entity satisfies certain risk criteria (i.e., decision making, accounting treatment and financing all outside of the United States) and (3) the non-U.S. banking entity must either be a qualifying foreign banking organization under the Federal Reserve Board’s Regulation K or a majority of at least two of the banking entity’s total assets, revenue or net income must be derived from business outside of the United States.
- Other Options. A non-U.S. banking entity also would have the same options as a U.S. banking entity, described in the preceding section, to sponsor (and invest in) covered funds and non-covered funds.
Options for a Non-U.S. Banking Entity with No U.S. Banking Presence
- A non-U.S. banking entity with no U.S. banking presence is not subject to the Volcker Rule and should be able to sponsor (and invest in) all types of funds (including both U.S. and non-U.S. covered funds). A non-U.S. banking entity is not subject to the Volcker Rule even if it has a U.S. affiliate (e.g., a U.S. broker-dealer or investment adviser) so long as the non-U.S. banking entity does not have a U.S. banking presence (e.g., a U.S. bank branch or agency).
1 The final rules and regulations implementing the Volcker Rule are contained in “Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds,” SEC Release No. BHCA-1 (Dec. 10, 2013). Debevoise & Plimpton LLP participated actively on behalf of our private equity, hedge fund and financial institution clients throughout the rulemaking process. The Final Rules incorporate many comments made on behalf of our private fund clients.
2 The Volcker Rule was added as Section 13 of the Bank Holding Company Act by the Dodd-Frank Financial Reform and Consumer Protection Act of 2010.
3 Subject to certain exclusions, a “banking entity” generally is (a) any insured depository institution, (b) any company that controls an insured depository institution, (c) any foreign banking organization that is treated as a bank holding company by the International Banking Act of 1978 and (d) any affiliate or subsidiary thereof. Thus, the term “banking entity” can include insurance companies, investment banks and asset management firms that have affiliated banks in the corporate family.
4 Options Under the Volcker Rule for Bank Investment in Unaffiliated Private Equity and Hedge Funds, Debevoise & Plimpton Private Equity Report, Fall 2013, Vol. 13, Number 4, available at http://www.debevoise.com/newseventspubs/publications/detail.aspx?id=36abce6e-f108-4d47-8543-de28a8b5c4d1.
5 A “covered fund” is defined as (i) an issuer that relies on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, (ii) a commodity pool (as defined under the Commodity Exchange Act) for which either (A) the commodity pool operator has claimed an exemption under 17 CFR 4.7, or (B) the commodity pool operator is registered, substantially all the participant units are owned by qualified eligible persons and there has been no public offering to persons other than qualified eligible persons (a “covered commodity pool”) or (iii) for U.S. banking entities only, a non-U.S. fund that if offered into the United States would be required to rely on either Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (a “foreign covered fund”).