Monday, November 08, 2010

American Bankers Association Urges Regulators Not to Read Volcker Rule Definitions of Hedge Fund and Sponsor Too Broadly

Unless appropriate clarifications are made through the regulatory process, noted the American Bankers Association, the definitions of ``hedge fund’’ and ``sponsor’’ in the Dodd-Frank Volcker provisions could be read so broadly that they would adversely impact traditional banking activities, while not addressing the intended focus of the Volcker Rule to reach situations where there are significant conflicts of interest. In a letter to regulators charged with implementing the Volcker Rule, the association said that the terms hedge fund and private equity fund are overly broad in the Act, encompassing investment vehicles that are beyond the intended scope of the Volcker Rule. Codified as Section 619 of Dodd-Frank, the Volcker Rule prohibits banks from engaging in proprietary trading and from sponsoring a hedge fund or private equity fund.

According to the ABA, Section 619 defines “hedge fund” and “private equity fund” not by the nature of the investment activities in which they are engaged, but instead by reference to sections in the Investment Company Act of 1940 excluding them from the definition of investment company, which means that they are not required to register with the SEC. The public policy underlying those exclusions, which revolve around whether there is any federal interest in requiring such funds to register with the SEC, is very different from the focus of the Volcker Rule.

Thus, the ABA believes that there are many investment vehicles that rely on the Section 3(c)(1) and 3(c)(7) exclusions in the 1940 Act that have never been considered to be a hedge fund or private equity fund and have few, if any, of the typical characteristics of hedge funds and private equity funds that the Volcker Rule was intended to restrict. Hedge funds and private equity funds share certain common characteristics, including being organized as blind pooled investment vehicles managed by a professional investment manager that would be registered investment companies but for Sections 3(c)(1) or 3(c)(7); having an investment manager with sole discretion for investment and reinvestment; and being formed not for the purpose of making a specific investment but instead to make a large number of investments. These funds also have numerous investors that are subject to high investment minimums.

In addition, substantially all hedge funds utilize a number of different sophisticated investment techniques, such as significant leverage, short selling, and derivatives to enhance returns. In the case of private equity funds, they generally make equity investments, and their assets primarily consist of unregistered and illiquid equity securities for which there is little or no market. As a result, investors in hedge funds or private equity funds may have limited redemption rights due to liquidity, valuation, or marketability of the underlying portfolios.

Rather than focusing on the exclusions on which hedge funds or private equity funds rely to avoid registration under the Investment Company Act, the ABA urged regulators to identify the systemically important characteristics of the type of fund that the Volcker Rule is trying to reach while also removing those investment vehicles that are clearly not hedge funds or private equity funds in the traditional sense. Absent clarification, warned the ABA, the current language could be read to sweep in investment vehicles that Congress never intended to treat as hedge funds or private equity funds. Entities that are commonly utilized by financial firms to facilitate permissible activities include acquisition vehicles or joint ventures relating to a single underlying investment, finance subsidiaries, credit funds, employee pension funds, bank-owned life insurance policies, and foreign funds regulated under the laws of other countries.

The ABA urged regulators to focus on whether the particular fund imposes restrictions on redemptions, whether it invests substantially in illiquid securities, and whether the fund makes use of significant leverage. For example, the ABA suggested that the definition of “hedge fund” and “private equity fund” could exclude those funds whose investment portfolio primarily consists of securities for which market quotations are readily available, are able to offer daily redemption rights at net asset value, and whose investment portfolio does not contain more than 15 per cent in illiquid securities, which happens to be the percent illiquidity standard the SEC uses for mutual funds. Defining the term “hedge fund” or “private equity fund” in terms of the activities in which they would engage would allow financial institutions to continue to offer funds that rely on Section 3(c)(7) for exclusion from registration but generally share certain investment and risk characteristics of mutual funds, and not hedge funds, without the risk of being subject to the restrictions in the Volcker Rule.

Regulators should also look at the nature of the legal vehicles that hedge funds typically utilize. In the US, for tax efficiency, hedge funds and private equity funds are almost always organized as either Limited Partnerships or Limited Liability Companies. The ABA proposes that a definition of hedge fund that limits the application of the rule to funds that rely on Sections 3(c)(1) and 3(c)(7) and that are organized as Limited Partnerships or Limited Liability Companies, would exclude from the application of the definition group trusts organized pursuant to IRS Revenue Rulings 81-100 and 2004-28 for the pooled investment of retirement plan assets.

Finally, the statutory definition contains a catch-all phrase “or such similar funds.” In context, the ABA believes that this phrase should be interpreted to mean funds that are similar to hedge funds or private equity funds and not other funds that might be excluded from the definition of investment company by virtue of Section 3(c) of the Investment Company Act.

The Volcker provisions define the term “sponsor” to mean acting as a general partner, managing member, or trustee of a fund. If interpreted too broadly, this definition of “sponsor” would capture situations where the financial institution acts as a directed trustee under which the grantor of the trust delegates the authority to manage, acquire, or dispose of the assets of the plan to one or more third-party investment managers in duties akin to administrative functions. The role of directed trustee is quite different from, and should not be equated with, the more substantive involvement that a trustee with investment discretion has with a fund.

The ABA believes that, where a banking entity is a directed trustee, a specific set of activities should not be governed by the provisions of the Volcker Rule. Otherwise, the intended prohibition on sponsoring hedge funds would accidentally and improperly apply to state statutory investment trusts relying on the exclusion in Section 3(c)(1) or 3(c)(7) of the 1940 Act. These types of investment vehicles pose nominal risk to the financial institution, posited the ABA, because these assets are held in trust and the firm is directed in its largely administrative actions. However, since these funds often rely on either the Section 3(c)(1) or 3(c)(7) exclusion and the bank acts as a directed trustee, the fund could be deemed to be a sponsored hedge fund even if the fund is managed by an unaffiliated third-party manager. In keeping with the intent of the Volcker Rule, the ABA urged regulators to continue to allow banks to act as a directed trustee for these types of statutory investment trusts without subjecting them to the prohibitions in the Volcker Rule.

Finally, the ABA noted that the term sponsor is used in various provisions of the Investment Company Act, although it is not defined. The SEC staff has usually taken the position that a person serving as a sponsor is tantamount to the investment adviser or principal underwriter of a registered investment company in order to impose the prohibitions on conflicts of interest in Section 17 of the 1940 Act upon a sponsor of a registered investment company. In that situation the investment adviser has organized the investment company and will have investment discretion over its portfolio. In contrast, the ABA said that its suggestions are addressing the situation where the grantor of the trust, not the bank, has dictated the terms of the relationship and has elected to have the bank serve as directed trustee with administrative but not investment responsibilities. A third-party investment adviser will be responsible for investment discretion

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