On September 18, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (the Board), the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission  (collectively, the Agencies) adopted amendments to the 2013 rules (the 2013 Rules) under Section 13 of the Bank Holding Company Act (BHC), commonly known as the Volcker Rule (the 2019 Amendments).

The Volcker Rule and the 2019 Amendments.  The Volcker Rule imposes complex restrictions on the ability of a “banking entity” and a “nonbank financial company” supervised by the Board to engage in proprietary trading and to have certain interests in, or relationships with, non-registered, private funds, such as hedge funds and private equity funds (each, a Covered Fund).[i] As stated in the Release adopting the 2019 Amendments (the Release),[ii] the “amendments are intended to provide banking entities with clarity about what activities are prohibited and to improve supervision and implementation of section 13.”   The Release provides that banking entities must comply with the final amendments by January 1, 2021 and that the 2013 Rules will remain in effect until their compliance date. Alternatively, the Release provides that a banking entity may voluntarily comply, in whole or in part, with the 2019 Amendments prior to the compliance date, “subject to the agencies’ completion of necessary technological changes.”

The 2019 Amendments are based upon the amendments proposed by the Agencies in May 2018 (the 2018 Proposal). As was the case with respect to the 2018 Proposal, the most significant aspects of the 2019 Amendments relate to the proprietary trading provisions of the Volcker Rule, and specifically the definition of “trading account.”[iii]  An analysis of the trading provisions is beyond the scope of this overview. The following is a brief summary of the provisions of the 2019 Amendments that relate specifically to “Covered Funds.”

Covered Fund Provisions. As noted in the Release, the restrictions imposed on banking entities with respect to a Covered Fund are “designed to ensure that banking entities do not rescue investors in those funds from loss, and do not guarantee nor expose themselves to significant losses due to investments in or other relationships with these funds.”[iv] The 2019 Amendments, however, are a work-in-progress; they do not cover any aspects of the Covered Fund provisions of the 2018 Proposal for which specific rule text was not proposed.

The Release notes that: “the [A]gencies intend to issue an additional notice of proposed rulemaking that would propose additional, specific changes to the restrictions on covered fund investments and activities and other issues related to the treatment of investment funds under the regulations implementing section 13 of the BHC Act.”[v]

For example, the 2018 Proposal sought comment on the Volcker Rule’s general approach to defining the term “Covered Fund,” as well as the existing exclusions from the Covered Fund definition and potential new exclusions from this definition.” However, “[i]n light of the number and complexity of issues under consideration,” the Agencies did not take definitive action on those  issues and merely stated their intent “to address these and other comments received on the covered fund provisions in a subsequent proposed rulemaking.”[vi]

Notwithstanding this vacillation, the Agencies did adopt as proposed the few specific Covered Funds changes in the 2018 Proposal, including:

Risk-Mitigating Hedging: The 2019 Amendments permit banking entities to acquire and retain ownership interests in Covered Funds to hedge certain customer-driven transactions, including for fund-linked products. The Agencies also adopted without change the elimination of the requirement that a risk mitigating hedging transaction “demonstrably” reduces or otherwise significantly mitigates the relevant risks.[vii]

Market Making and Underwriting: The Agencies eliminated the aggregate fund limit and the capital deduction requirement for the value of ownership interests in third-party Covered Funds acquired or retained in accordance with the underwriting or market-making exemption (i.e., Covered Funds that the banking entity does not advise or organize and offer. The Agencies stated that they believe that this change will better align the compliance requirements for underwriting and market making involving Covered Funds with the risks those activities entail.[viii]

Solely Outside the United States: The 2013 Rule imposed several conditions on the availability of the exemption that permits foreign banking entities to acquire or retain an ownership interest in, or act as sponsor to, a Covered Fund, provided that those activities and investments occur solely outside of the United States and certain other conditions are met. Those conditions included that “no financing for the banking entity’s ownership or sponsorship is provided, directly or indirectly by any branch or affiliate that is located in the United States or organized under the laws of the United States or of any State.”  The Agencies adopted without change the proposal to remove the financing condition.[ix]

More to Come, But When? As noted above, the amendment of the Volcker Rule with respect to the Covered Fund issues is a work-in-progress without any deadline for completion. In the meantime, banking entities and their counterparties having relationships and holding interests in a Covered Fund must continue to proceed cautiously taking into consideration the complex provisions of the 2019 Amendments.

Please do not hesitate to contact Edward G. Eisert, Senior Counsel, at eeisert@orrick.com with any questions that arise.

[i] As defined in the 2013 Rules, a “covered fund” includes:  “an issuer that would be an investment company, as defined in the Investment Company Act of 1940 . . . but for section 3(c)(1) or 3(c)(7) of that Act . . . .” and certain commodity pools under the Commodity Exchange Act.

[ii] A copy of the entire Release can be found here

[iii] As stated in the Release: “The definition of ‘trading account’ is a threshold definition that determines whether the purchase or sale of a financial instrument by a banking entity is subject to the restrictions and requirements of section 13 of the BHC Act and the 2013 rule.”  The BHC, in turn, provides a complex definition of “trading account” to mean: “any account used for acquiring or taking positions in [certain securities and instruments] principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the [A]gencies, by rule determine.”  IV. Section by Section Summary of the Final Rule,  Subpart B—Proprietary Trading Restrictions.

[iv] Section I. Background.

[v] Section III.  Overview of the Final Rule and Modifications from the Proposal, A. The Final Rule.

[vi] IV. Section by Section Summary of the Final Rule, Subpart C – Covered Fund Activities and Investments, 1. Overview of Agencies’Approach to the Covered Fund Provisions.

[vii] IV. Section by Section Summary of the Final Rule, Subpart C – Covered Fund Activities and Investments,  3.  Section __.13:  Other Permitted Covered Fund Activities, a. Permitted Risk-Mitigating Hedges.

[viii] IV. Section by Section Summary of the Final Rule, Subpart C – Covered Fund Activities and Investments, 2.  Section _.11 Permitted Organizing and Offering, Undeerwriting and Market Making with Respect to a Covererd Fund.

[ix] IV. Section by Section Summary of the Final Rule, Subpart C – Covered Fund Activities and Investments, 3.  Section __.13:  Other Permitted Covered Fund Activities, b. Permitted Covered Fund Activities and Investments Outside the United States.