Thursday, October 13, 2011

Proposed Regulations Implementing Volcker Rule Contain Foreign Fund Exemption

Under a foreign fund exemption provision in the proposed Volcker regulations, foreign banking entities could acquire or retain an ownership interest in, or act as sponsor to, a hedge fund or private equity fund so long as such activity occurs solely outside of the United States. This exemption limits the extraterritorial application of the statutory restrictions on covered fund activities and investments to foreign firms that, in the course of operating outside of the United States, engage in activities permitted under relevant foreign law outside of the United States, while preserving national treatment and competitive equality among U.S. and foreign firms within the United States.

The regulations define both the type of foreign banking entities that are eligible for the exemption and the circumstances in which covered fund activities or investments by such an entity will be considered to have occurred solely outside of the United States, including clarifying when an ownership interest will be considered to have been offered
for sale or sold to a resident of the United States.

The exemption is conditioned on the activity occurring solely outside of the United States, no ownership interest in such fund being sold to a resident of the United States; and the banking entity being not directly or indirectly controlled by a banking entity that is organized under US law. Consistent with the statutory language, banking entities organized under federal or state law may not rely on the exemption. Similarly, the U.S. subsidiaries or U.S. branches of foreign banking entities would not qualify for the exemption.

Under the proposed regulations, a transaction or activity will be considered to have occurred solely outside of the United States only if the following three conditions are satisfied. First, the transaction or activity is conducted by a banking entity that is not organized under federal or state law. Second, no subsidiary, affiliate, or employee of the banking entity that is involved in the offer or sale of an ownership interest in the covered fund is incorporated or physically located in the US. Third, no ownership interest in such covered fund is offered for sale or sold to a US resident.

These three criteria reflect statutory constraints and are intended to ensure that a transaction or activity conducted in reliance on the exemption does not involve either investors that are US residents or a relevant US employee of the banking entity, as such involvement would appear to constitute a sufficient locus of activity in the US marketplace so as to preclude the availability of the exemption.

The proposed definition of a US resident is designed to capture the scope of US counterparties, decision-makers and personnel that, if involved in the transaction, would preclude that transaction from being considered to have occurred solely outside the United States. The proposed definition is similar to the definition of “U.S. person” for purposes of SEC Regulation S, which governs securities offerings and sales outside of the US that are not registered under the Securities Act.

Specifically, a resident of the United States is defined to include any natural person resident in the US; any partnership, corporation or other business entity organized or incorporated under federal or state law; any estate of which any executor or administrator is a US resident; any trust of which any trustee, beneficiary or, settlor is a US resident; any agency or branch of a foreign entity located in the US; any discretionary or non-discretionary account or similar account (other than an estate or trust) held by a dealer or fiduciary for the benefit or account of a US resident; any discretionary account or similar account (other than an estate or trust) held by a dealer or fiduciary organized or incorporated in the United States, or (if an individual) a US resident, or any partnership or corporation organized or incorporated under the laws of any foreign jurisdiction formed by or for a US resident principally for the purpose of engaging in one or more transactions described in the proposed rule

This aspect of the proposal reflects the intent of the foreign fund exemption to avoid extraterritorial application of the restrictions on covered funds activities and investments outside the United States, while preserving competitive parity within the US market. The proposal does not evaluate solely whether the risk of the transaction or activity, or management or decision-making with respect to such transaction or activity, rests outside the United States. The proposal also provides that foreign banking entities may not structure a transaction or activity so as to be outside of the United States for risk and booking purposes while simultaneously engaging in transactions within US markets that are prohibited for US banking entities.

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