Wednesday, October 12, 2011

SEC and Banking Agencies Propose Regulations Implementing Dodd-Frank Volcker Rule; Exceptions to Hedge Fund Ban Spelled Out

The SEC and the federal banking regulators have proposed regulations implementing Section 619 of the Dodd-Frank Act, the Volcker Rule, which prohibits two activities of banking entities: short-term proprietary trading of any security, derivative, and certain other financial instruments for the entity’s own account and owning, sponsoring, or having certain relationships with a hedge fund or private equity fund (called covered funds under the regulations.

The proposal would exempt from the prohibition on relationships with covered funds the organizing and offering of a hedge fund or private equity fund under certain conditions, including limiting investments in such funds to a de minimus amount, the making of risk-mitigating hedging investments, and the making of investments in certain non-U.S. funds.

A banking entity that makes or retains an investment in a covered fund under the proposed regulations is generally subject to three principal limitations related to such investment. First, the banking entity’s investment in a covered fund may not represent more than 3 percent of the total outstanding ownership interests of such fund. Second, the banking entity’s investment in a covered fund may not result in more than 3 percent of the losses of the covered fund being allocable to the banking entity’s investment. Third, a banking entity may invest no more than 3 percent of its tier 1 capital in covered funds.

Consistent with the statute, the proposed regulations require a banking entity to actively seek unaffiliated investors to ensure that the its investment conforms with the stated limits and reduce through redemption, sale, dilution, or other methods the aggregate amount and value of all ownership interests of the banking entity in a single fund held to an amount that does not exceed 3 percent of the total outstanding ownership interests of the fund not later than 1 year after the date of establishment of the fund or such longer period as may be provided by the Board.

The Fed can extend for up to 2 additional years the period of time within which a banking entity must reduce its attributable ownership interests in a covered fund to no more than 3 percent of the fund’s total ownership interests. The statute provides the possibility of an extension only with respect to the per-fund limitation, and not to the aggregate funds limitation. The proposal would implement this provision of the statute.

In order to grant any extension, the Fed must determine that the extension would be consistent with safety and soundness and would not be detrimental to the public interest.

A banking entity seeking an extension must submit a written request to the Board at least 90 days prior to the expiration of the applicable time period, providing the reasons why the extension should be granted and a detailed explanation of the banking entity’s plan for reducing or conforming its investments.

In addition, the extension request must address a number of relevant factors, including whether the investment involves or would result in material conflicts of interest between the banking entity and its clients, customers or counterparties; result in a material exposure to high-risk assets or high-risk trading strategies; pose a threat to the safety and soundness of the banking entity or to US financial stability.

The extension request must also address market conditions; the contractual terms governing the banking entity’s interest in the covered fund; the date on which the covered fund is expected to have attracted sufficient investments from unaffiliated investors so as to enable the banking entity to comply with the limitations; the total exposure of the banking entity to the investment and the risks that disposing of, or maintaining, the investment in the covered fund may pose to the banking entity or US financial stability: the cost of divesting the investment within the applicable period and whether the divestiture would involve a material conflict of interest between the banking entity and unaffiliated clients, customers or counterparties to which it owes a duty, as well ass prior efforts to divest or sell interests in the covered fund, including activities related to the marketing of interests in such covered fund.

Finally, as a catch all, the Board may add any other factor that the Board believes appropriate. The proposed regulations would also allow the Board to impose conditions on any extension granted if the Board determines the conditions are necessary or appropriate to protect the safety and soundness of banking entities or US financial stability, address material conflicts of interest or other unsound practices, or otherwise further the purposes of the stature and the regulations.

The proposed definition of covered fund generally parallels the statutory definition of “hedge fund” and “private equity fund,” and explains the universe of entities that would be considered a covered fund, including entities determined by the SEC and the banking agencies to be similar funds. The proposed definition of “ownership interest” provides further guidance regarding the types of interests that would be considered to be an ownership interest in a covered fund. Ownership interests may take various forms. The definition of ownership interest explicitly excludes carried interest whereby a banking entity may share in the profits of the covered fund solely as performance compensation for services provided to the covered fund by the banking entity.

The proposed regulations also implement the exemption for organizing and offering a covered fund provided for in the statute and outlines the conditions that must be met in order for a banking entity to organize and offer a covered fund under this authority. These requirements are intended to allow a banking entity to engage in certain traditional asset management and advisory businesses in compliance with section 13 of the Bank Holding Company Act

Specifically, the proposed regulations permit a banking entity to acquire and retain, as an investment in a covered fund, an ownership interest in a covered fund that the banking entity organizes and offers, or for which it acts as sponsor, for the purposes of establishing the covered fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors, or making a de minimis investment in the covered fund in compliance with applicable requirements.

Similarly, the proposed regulations implement the statutory exemptions allowing a banking entity to acquire and retain an ownership interest in, or act as sponsor to, one or more small business investment companies, a public welfare investment, or certain qualified rehabilitation expenditures; to acquire and retain an ownership interest in a covered fund as a risk-mitigating hedging activity; and in the case of a non-U.S. banking entity, to acquire and retain an ownership interest in, or act as sponsor to, a foreign covered fund.

The agencies propose to permits a banking entity to acquire and retain an ownership interest in, or act as sponsor to, a small business investment company or certain public interest investments, without limitation as to the amount of ownership interests it may own, hold, or control with the power to vote.

Also, a banking entity could use an ownership interest in a covered fund to hedge, but only with respect to individual or aggregated obligations or liabilities of a banking entity that arise from the firm acting as intermediary on behalf of a customer that is not itself a banking entity to facilitate the customer’s exposure to the profits and losses of the covered fund (similar to acting as a “riskless principal”); or a compensation arrangement with an employee of the banking entity that directly provides investment advisory or other services to that fund.

The hedge must represent a substantially similar offsetting exposure to the same covered fund and in the same amount of ownership interest in the covered fund arising out of the transaction that the acquisition or retention of an ownership interest in the covered fund is intended to hedge or otherwise mitigate. The banking entity would be required to document, at the time the transaction is executed, the hedging rationale for all hedging transactions involving an ownership interest in a covered fund.

Under the proposed regulations, foreign banking entities could acquire or retain an ownership interest in, or to act as sponsor to, a covered 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 proposal also would permit the sale and securitization of loans, clarifying that a banking entity may acquire and retain an ownership interest in, or act as sponsor to, a covered fund that is an issuer of asset-backed securities, the assets or holdings of which are solely comprised of loans; contractual rights or assets directly arising from those loans supporting the asset-backed securities; and a limited amount of interest rate or foreign exchange derivatives that materially relate to such loans and that are used for hedging purposes with respect to the securitization structure. This authority would therefore allow a banking entity to acquire and retain an ownership interest in a loan securitization vehicle that the banking entity organizes and offers, or acts as sponsor to, in excess of the 3 percent limits.

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