Friday, August 13, 2010

Senator Merkley Explains the Workings of Dodd-Frank Volcker Rule Banning Bank Sponsoring of Hedge Funds

Sections 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act codifies the Volcker Rules and broadly prohibits bank proprietary trading and bank sponsoring of hedge funds, while nevertheless permitting certain activities that may technically fall within the definition of proprietary trading but which are, in fact, safer, client-oriented financial services. Senator Jeff Merkley, a principal author of Section 619 explained how these provisions will work. Section 619 establishes the basic principle that a banking entity must not engage in proprietary trading or acquire or retain ownership interests in or sponsor a hedge fund or private equity fund, unless otherwise provided in the section.

Congress found it appropriate for the Volcker provisions to restrict investing in or sponsoring hedge funds and private equity funds Clearly, reasoned Senator Merkley, if a financial firm were able to structure its proprietary positions simply as an investment in a hedge fund or private equity fund, the prohibition on proprietary trading would be easily avoided, and the risks to the firm and its subsidiaries and affiliates would continue. A financial institution that sponsors or manages a hedge fund or private equity fund also incurs significant risk even when it does not invest in the fund it manages or sponsors. . (Cong. Record, July 15, 2010, p. S5895).

Although piercing the corporate veil between a fund and its sponsoring entity may be difficult, said Senator Merkley, recent history demonstrates that a financial firm will often feel compelled by reputational demands and relationship preservation concerns to bail out clients in a failed fund that it managed or sponsored, rather than risk litigation or lost business. Knowledge of such concerns creates a moral hazard among clients, attracting investment into managed or sponsored funds on the assumption that the sponsoring bank or systemically significant firm will rescue them if markets turn south, as was done by a number of firms during the 2008 crisis. That is why setting limits on involvement in hedge funds and private equity funds is critical to protecting against risks arising from asset management services. (Cong. Record, July 15, 2010, p. S5895).

Dodd-Frank sets forth a broad definition of hedge fund and private equity fund, not distinguishing between the two. The definition includes any company that would be an investment company under the Investment Company Act, but is excluded from such coverage by the provisions of sections 3(c)(1) or 3(c)(7). Although market practice in many cases distinguishes between hedge funds, which tend to be trading vehicles, and private equity funds, which tend to own entire companies, both types of funds can engage in high risk activities and it is exceedingly difficult to limit those risks by focusing on only one type of entity.

Section 619 also permits a banking entity to engage in risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other
holdings of the entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings. According to Senator Merkley, this activity is permitted because its sole purpose is to lower risk.

While this is intended to permit banking entities to utilize their trading accounts to hedge, said Senator Merkley, the phrase in connection with and related to individual or aggregated positions was added to the final version in the conference report in order to ensure that the hedge applied to specific, identifiable assets, whether it be on an individual or aggregate basis. Moreover, hedges must be to reduce specific risks to the banking entity arising from these positions. This formulation is meant to focus banking entities on traditional hedges and prevent proprietary speculation under the guise of general hedging. For example, for a bank with a significant set of loans to a foreign country, a foreign exchange swap may be an appropriate hedging strategy.

On the other hand, purchasing commodity futures to hedge inflation risks that may generally impact the banking entity may be nothing more than proprietary trading under another name. Distinguishing between true hedges and covert proprietary trades may be one of the more challenging areas for regulators, and will require clear identification by financial firms of the specific assets and risks being hedged, research and analysis of market best practices, and reasonable regulatory judgment calls. (Cong. Record, July 15, 2010, p. S5896). Congress believes that vigorous and robust regulatory oversight of this issue will be essential to the prevent hedging from being used as a loophole in the ban on proprietary trading.


Section 619 provides exceptions to the prohibition on investing in hedge funds or private
equity funds, if such investments advance a public welfare purpose. It permits investments in small business investment companies, which are a form of regulated venture capital fund in which banks have a long history of successful participation. It also permits investments of the type permitted under the paragraph of the National Bank Act enabling banks to invest in a range of low-income community development and other projects. It also specifically mentions tax credits for historical building rehabilitation administered by the National Park Service, but is flexible enough to permit the regulators to include other similar low risk investments with a public welfare purpose.


Section 619 also permits firms to organize and offer hedge funds or private equity funds as an asset management service to clients. According to Senator Merkley, it is important to remember that nothing in Section 619 otherwise prohibits a bank from serving as an investment adviser to an independent hedge fund or private equity fund. Yet, to serve in that capacity, a number of criteria must be met. First, the firm must be doing so pursuant to its provision of bona fide trust, fiduciary, or investment advisory services to customers. Given the fiduciary obligations that come with such services, these requirements ensure that banking entities are properly engaged in responsible forms of asset management, which should tamp down on the risks taken by the relevant fund. Second, the section provides strong protections against a firm bailing out its funds by prohibiting banks from entering into lending or similar transactions with related funds, and prohibiting them from directly or indirectly guaranteeing, assuming, or otherwise insuring the obligations or performance of the hedge fund or private equity fund.

To prevent banking entities from engaging in backdoor bailouts of their invested funds, the section extends to the hedge funds and private equity funds in which such hedge funds and private equity funds invest. Third, to prevent a bank from having an incentive to bailout its funds and also to limit conflicts of interest, the section restricts directors and employees of a bank from being invested in hedge funds and private equity fund organized and offered by the bank, except for directors or employees directly engaged in offering investment advisory or other services to the hedge fund or private equity fund. Fund managers can have ‘‘skin in the game’’ for the hedge fund or private equity fund they run, but to prevent the bank from running its general employee compensation through the hedge fund or private equity fund, other management and employees may not.

Fourth, by stating that a firm may not organize and offer a hedge fund or private equity fund with the firm’s name on it, the section further restores market discipline and supports the restriction on firms bailing out funds on the grounds of reputational risk. Similarly, it ensures that investors recognize that the funds are subject to market discipline by requiring that funds provide prominent disclosure that any losses of a hedge fund or private equity fund are borne by investors and not by the firm, and the firm must also comply with any other restrictions to ensure that investors do not rely on the firm, including any of its affiliates or subsidiaries, for a bailout.

Fifth, the firm or its affiliates cannot make or maintain an investment interest in the fund, except in compliance with the limited fund seeding and alignment of interest provisions provided in the section. This provision allows a firm, for the limited purpose of maintaining an investment management business, to seed a new fund or make and maintain a de minimis co-investment in a hedge fund or private equity fund to align the interests of the fund managers and the clients, subject to several conditions. As a general rule, firms taking advantage of this provision should maintain only small seed funds, likely to be $5 to $10 million or less. Large funds or funds that are not effectively marketed to investors would be evasions of the restrictions of this section. Similarly, co-investments designed to align the firm with its clients must not be excessive, and should not allow for firms to evade the intent of the restrictions of this section.

These ‘‘de minimis’’ investments are to be greatly disfavored, emphasized Senator Merkley, and are subject to several significant restrictions. First, a firm may only have, in the aggregate, an immaterial amount of capital in such funds, but in no circumstance may such positions aggregate to more than 3 percent of the firm’s Tier 1 capital. Second, by one year after the date of establishment for any fund, the firm must have not more than a 3 percent ownership interest. Third, investments in hedge funds and private equity funds must be deducted on, at a minimum, a one-to-one basis from capital. As the leverage of a fund increases, the capital charges must be increased to reflect the greater risk of loss. This is specifically intended to discourage these high-risk investments, and should be used to limit these investments to the size only necessary to facilitate asset management businesses for clients. (Cong. Record, July 15, 2010, S5897).


Section 619 allows a very limited exception for the provision of limited services under the rubric of prime brokerage between a bank and a third party advised fund in which the fund managed, sponsored, or advised by the bank has taken an ownership interest. Essentially, it was argued that a bank should not be prohibited, under proper restrictions, from providing limited services to unaffiliated funds, but in which its own advised fund may invest. Accordingly, the exception is intended to only cover third-party funds, and should not be used as a means of evading the general prohibition. Put simply, a firm may not create tiered structures and rely upon the narrow exception to provide these types of services to funds for which it serves as investment advisor. Further, in recognition of the risks that are created by allowing for these services to unaffiliated funds, several additional criteria must also be met for the bank to take advantage of this exception. S5898

For example, banks are prohibited from bailing out funds they manage, sponsor, or advise, as well as funds in which those funds invest. The permitted services provisions are intended to permit banks to maintain certain limited prime brokerage service relationships with unaffiliated funds in which a fund-of-funds that they manage invests, said Senator Merkley, but are not intended to permit fund-of-fund structures to be used to weaken or undermine the prohibition on bailouts. Given the risk that a banking entity may want to bail out a failing fund directly or its investors, the permitted services exception must be implemented in a narrow, well-defined, and arms-length manner and regulators are not empowered to create loopholes allowing high-risk activities like leveraged securities lending or repurchase agreements. (Cong. Record, July 15, 2010, S5901. While Congress implements a number of legal restrictions designed to ensure that prime brokerage activities are not used to bail out a fund, Congress expects the regulators will nevertheless need to be vigilant.

On top of the flat prohibitions on bailouts, the statute requires the chief executive officer of firms taking advantage of this limited prime brokerage services exception to also certify that these services are not used directly or indirectly to bail out a fund advised by the firm. (Cong. Record, July 15, 2010, S5898).

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