Volcker Rule changes will expand banks’ investment abilities
- Five federal agencies collectively acted to formulate changes to the Volcker Rule.
- Banks may invest in “qualifying venture capital funds.”
- Rural Business Investment Companies and Qualified Opportunity Funds are excluded from the definition of “covered funds.”
- Credit funds, family wealth management vehicles and customer facilitation vehicles are also excluded from the covered funds definition.
Five federal regulatory agencies – the U.S. Department of the Treasury, Federal Reserve System, Federal Deposit Insurance Corporation, Commodity Futures Trading Commission and U.S. Securities and Exchange Commission – finalized much-anticipated modifications to the Bank Holding Company Act’s (BHCA) prohibition on banking entities’ proprietary investment in venture capital funds (also known as the Volcker Rule) and now will permit investments in other types of vehicles that the BHCA originally set out to promote. The Volcker Rule generally prohibits banking entities from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring or having certain relationships with unregistered funds. The changes create additional exclusions for credit funds meeting specific definitions, family wealth management vehicles and customer facilitation vehicles. The final rule, which will take effect in October 2020, includes the following modifications:
- Streamlines the “covered funds” portion of the rule.
- Addresses the extraterritorial treatment of certain foreign funds.
- Permits banking entities to offer financial services and engage in other activities that do not raise concerns the Volcker Rule was intended to address.
These changes come after various financial industry associations and investment firms argued for nearly a decade that the prohibition on financial institution investment in covered funds, which was broadly defined, had created an unnecessary limitation on capital formation and access to capital throughout various portions of the capital stack.
Qualifying Venture Capital Funds Investments Allowed
Under the original Volcker Rule, all private funds that rely on statutory exclusions to the Investment Company Act of 1940, as amended (’40 Act), under Section 3(c)(1) or 3(c)(7) were treated as "covered funds." This meant that venture funds were treated the same as hedge funds and private equity funds, unless the fund could rely upon a different statutory exclusion or it qualified for an exclusion under the implementing regulations. Venture funds traditionally invest in small and startup business, often driving new industry and job creation. In arguing for a rule change to exclude venture funds from the covered funds definition, several commenters urged that an exclusion for venture funds would allow underserved regions greater access to investment capital. Prior to enactment of the Volcker Rule, banks had historically been important providers of investment capital in small and regional venture funds, and the inclusion of venture funds in the covered funds definition served to chill that capital access and deployment.
The final rule proposes to exclude “qualifying venture capital funds” from the covered funds definition if
- the fund is a venture capital fund as defined in Rule 203(l)-1; and
- the fund does not engage in any activity that would constitute proprietary trading as if it were a banking entity.
A banking entity that acts as a sponsor, investment adviser or commodity trading adviser to the issuer and that relies on the exclusion to sponsor or acquire an ownership interest in the qualifying venture capital fund will be required to
- provide specific disclosures in writing to any prospective or actual investor as if the issuer were a covered fund; and
- ensure that the issuer’s activities are consistent with safety and soundness standards that are substantially similar to those that would apply if the banking entity engaged in the activities directly and comply with certain restrictions imposed as if the issuer were a covered fund.
A banking entity that relies on the exclusion may not, directly or indirectly, guarantee, assume or otherwise insure the issuer’s obligations or performance.
The five agencies concluded that this exclusion for qualifying venture capital funds will support capital formation, job creation and economic growth, particularly for small businesses and startup companies. By permitting banking entities to invest in qualifying venture capital funds, the agencies argued that the broader financial system would be improved by permitting the flow of more capital to small businesses and startups for innovation.
RBICs and QOFs Excluded from Covered Funds Definition
Remaining consistent with their overarching themes of capital access and availability, particularly in underserved and underdeveloped markets, the five agencies clarified that, like public welfare investment funds (investments designed primarily to promote the public welfare, including that of low- and moderate-income communities or families), Rural Business Investment Companies (RBICs) and Qualifying Opportunity Funds (QOFs) will also be excluded from the definition of covered funds going forward to give full effect to the statutory exemption for public welfare investments. RBICs are licensed under a program designed to promote economic development and job creation in rural communities by investing in communities involved in the production, processing and supply of food and agriculture-related products. QOFs arose from the Opportunity Zone tax deferral program that provides tax incentives for long-term investing in designated economically distressed areas. A QOF requires that at least 90% of its assets be deployed in designated low-income zones. The new rule will explicitly address RBICs and QOFs, the business of which is to make investments that qualify for consideration under the federal banking agencies’ regulations implementing the Community Reinvestment Act. This clarification will reduce the uncertainty banking entities previously felt around such public welfare investments.
Additional Covered Fund Exclusions
Credit funds, family wealth management vehicles and customer facilitation vehicles are now also carved out from the Volcker Rule’s reach.
At the time of the Volcker Rule’s initial drafting, the agencies declined to exclude credit funds from the definition of covered funds, citing concerns about whether they could be distinguished from hedge funds and private equity funds. The new rule permits a credit fund to be excluded if the issuer’s assets consist solely of:
- Debt instruments
- Related rights and other assets that are related or incidental to acquiring, holding, servicing or selling loans or debt instruments
- Certain interest rate or foreign exchange derivatives
The final rule prevents a banking entity from relying on the credit fund exclusion unless debt instruments and equity securities (or rights to acquire an equity security) held by the credit fund and received on customary terms in connection with its loans or instruments are permissible for the banking entity to acquire and hold directly. The credit fund sponsor must also ensure that the fund complies with certain safety and soundness standards. Additionally, the credit fund may not engage in activities that would constitute proprietary trading, nor may it issue asset-backed securities.
Family wealth management vehicles are also excluded from the covered fund definition, an exclusion available to any entity that is not, and does not hold itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities. This exclusion was added to appropriately allow banking entities to structure services or transactions for customers or to otherwise provide traditional customer-facing banking and asset management services through a vehicle, even if the vehicle may rely on a ’40 Act exemption via 3(c)(1) or 3(c)(7) or would otherwise be a covered fund under the implementing regulations.
Lastly, the new rule will have an exclusion for any issuer that acts as a “customer facilitation vehicle,” which will be available for any issuer formed by or at the request of the banking entity customer for the purpose of providing the customer with exposure to a transaction, investment strategy or other service provided by the banking entity. For the customer facilitation vehicle exclusion to apply, all of the issuer’s ownership interests must be owned by the customer for whom the vehicle was created and the banking entity must satisfy certain compliance and record maintenance requirements around its facilitation.