June 12, 2015

Volcker Rule

Agencies Release New Guidance Providing Clarification Regarding Banking Entity Status of Certain Foreign Public Funds and Restricting Scope of Joint Venture Exclusion

Earlier today, the staffs of the Board of Governors of the System (the “Federal Reserve”), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the “Agencies”) provided two important additions to their existing list of Frequently Asked Questions (“FAQs”) addressing the implementation of section 13 of the Bank Holding Company Act of 1956, as amended (the “BHC Act”), commonly known as the “Volcker Rule.”

The Volcker Rule imposes broad prohibitions on and investing in and sponsoring private equity funds, hedge funds and certain other investment vehicles (“covered funds”) by “banking entities” and their affiliates. The Volcker Rule, as implemented by the final rule issued by the Agencies (the “Final Rule”), provides exclusions from the definition of covered fund for certain foreign public funds and joint ventures.

A. FOREIGN PUBLIC FUNDS

In the first of the new FAQs,1 the staffs of the Agencies clarify the circumstances under which a foreign public fund excluded from the definition of covered fund could be deemed to be a banking entity subject to the Volcker Rule’s restrictions on proprietary trading and covered fund activities. There has been industry uncertainty as to whether a foreign public fund could, as a result of its legal or corporate governance structure or other relationships with a banking entity, be deemed to be “controlled” by the banking entity for BHC Act purposes and therefore itself be considered a banking entity.2

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The FAQ provides that the staffs of the Agencies “would not advise” that the activities and investments of a foreign public fund be attributed to a banking entity for purposes of the Volcker Rule, or that a foreign public fund be deemed a banking entity solely by virtue of its relationship with a sponsoring banking entity, where the following conditions are met:

 The foreign public fund meets the conditions of the exclusion from the definition of covered fund provided under Section _.10(c)(1) of the Final Rule;3  The banking entity does not own, control or hold with the power to vote 25% or more of the voting shares of the foreign public fund after the applicable seeding period4 (which remains subject, in the case of a foreign public fund sponsored by a U.S. banking entity, to the 15% ownership interest limitation (together with shares held by the foreign public fund, affiliates, directors and employees) under Section _.10(c)(1)(ii) of the Final Rule);5 and  If the banking entity sponsors, provides investment advisory, commodity trading advisory, administrative or other services to the fund, such activities are in compliance with limitations under applicable regulation, order or other authority, including applicable limitations in the relevant foreign jurisdiction.6

As the staffs of the Agencies acknowledge in the FAQ, subjecting foreign public funds to the proprietary trading and covered fund restrictions applicable to banking entities would frustrate the purposes of excluding foreign public funds from the definition of covered fund—namely, treating foreign public funds consistently with similar U.S. funds (i.e., U.S. mutual funds and other types of U.S. registered investment companies sold to retail investors) and limiting the extraterritorial application of Volcker Rule, including by permitting U.S. banking entities and their foreign affiliates to carry on traditional asset management businesses outside the .7

The new FAQ indicates that the Final Rule’s exclusion for foreign public funds was intended to recognize that foreign jurisdictions have established their own frameworks governing the details of the operation and distribution of foreign public funds. In this regard, the FAQ acknowledges that sponsors of foreign public funds in some foreign jurisdictions select the majority of the fund’s directors or trustees or otherwise control the fund for purposes of the BHC Act by contract or through a controlled corporate director, and that these and other corporate governance structures had created uncertainty as to whether such funds are banking entities subject to the Volcker Rule’s restrictions on proprietary trading and covered fund activities. The FAQ should provide welcome clarification to banking entity sponsors of foreign public funds meeting the requirements set forth in the FAQ.

B. JOINT VENTURES

The second of the new FAQs8 clarifies the scope of the exclusion from the definition of covered fund for certain joint ventures. Under the Final Rule, this exclusion is available to any joint venture between a banking entity or any of its affiliates and one or more unaffiliated persons that: (1) consists of no more than 10 unaffiliated co-venturers; (2) engages in activities that are permissible for the banking entity or affiliate, other than investing in securities for resale or other disposition; and (3) is not, and does not hold

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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.9

The new FAQ explains that the exclusion is designed to allow a banking entity to manage more efficiently the risks of its banking operations by, for example, seeking to obtain or share complementary business expertise, while preventing the exclusion from being used as a vehicle to raise funds from investors for investment purposes (including merchant banking activities).10 In this regard, the new FAQ specifies that the exclusion would not be available to an issuer that:

 Raises money from a small number of investors primarily for the purpose of investing in securities, whether the securities are intended to be traded frequently, held for a longer duration, held to maturity or held until the dissolution of the entity;  Raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities merely because one of the purposes for establishing the vehicle may be to provide financing to an entity to obtain and hold securities; or  Raises money from investors primarily for the purpose of sharing in the benefits, income, gains or losses from ownership of securities—as opposed to conducting a business or engaging in operations or other non-investment activities—even if the vehicle may have other purposes.

The FAQ notes that any determination of whether an arrangement is a “joint venture,” which is not defined separately in the Final Rule, will depend on the facts and circumstances, though the “basic elements of a joint venture are well recognized, including under state law.” Specifically, the FAQ indicates that the staffs of the Agencies expect that a person must have some degree of control over the business of an entity in order to be considered to be participating in "a joint venture between a banking entity or any of its affiliates and one or more unaffiliated persons" for purposes of the exclusion.

The interpretation of the joint venture exclusion described in the new FAQ appears more restrictive than the scope of the exclusion as set forth in the Final Rule and as described in the Supplementary Information. In light of the additional restrictions imposed by the FAQ, it is not clear whether, as a practical matter, the joint venture exclusion will have meaningful utility for banking entities.

A copy of the new FAQs is attached as Appendix A.

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ENDNOTES 1 See Federal Reserve, Volcker Rule, Frequently Asked Questions (June 12, 2015) available at http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm#14. 2 The Final Rule’s definition of banking entity generally excludes covered funds. Final Rule § _.2(c)(2)(i). Funds that are not covered funds, such as foreign public funds, could be deemed to themselves be banking entities and therefore subject to the Volcker Rule’s prohibitions. A banking entity generally includes any insured depository institution, any depository institution holding company, any foreign company treated as a bank holding company under the International Banking Act of 1978 and any affiliate or subsidiary of any of the foregoing. Final Rule § _.2(c). The Final Rule defines the terms “affiliate” and “subsidiary” to have the same meanings as under Section 2 of the BHC Act. Final Rule §§ _.2(a), _.2(dd). Under the BHC Act, “the term ‘affiliate’ means any company that controls, is controlled by, or is under common control with another company,” and “[a]ny company has control over a bank or over any company if— (A) the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 per centum or more of any class of voting securities of the bank or company; (B) the company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (C) the [Federal Reserve] determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company.” BHC Act §§ 2(k), 2(a)(2). The BHC Act defines the term “subsidiary” similarly to mean “with respect to a specified bank holding company . . . (1) any company 25 per centum or more of whose voting shares (excluding shares owned by the United States or by any company wholly owned by the United States) is directly or indirectly owned or controlled by such bank holding company, or is held by it with power to vote; (2) any company the election of a majority of whose directors is controlled in any manner by such bank holding company; or (3) any company with respect to the management of policies of which such bank holding company has the power, directly or indirectly, to exercise a controlling influence, as determined by the [Federal Reserve], after notice and opportunity for hearing.” BHC Act § 2(d). 3 Final Rule § _.10(c)(1) excludes from the definition of covered fund any issuer that: (1) is organized or established outside the United States; (2) is authorized to offer and sell ownership interests to retail investors in the issuer’s home jurisdiction; and (3) sells ownership interests predominantly through one or more public offerings outside the United States. The Agencies have stated that they “generally expect that an offering is made predominantly outside of the United States if 85 percent or more of the fund’s interests are sold to investors that are not residents of the United States.” Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5536, 5678 (Jan. 31, 2014) (the “Supplementary Information”). 4 See Final Rule § _.20(e). The Agencies have indicated that an issuer that will become a foreign public fund would be treated during its seeding period in the same manner as an issuer that will become a U.S. registered investment company—i.e., the issuer would not itself be viewed as violating the Volcker Rule during the seeding period so long as the banking entity that establishes the seeding vehicle operates the vehicle pursuant to a written plan, developed in accordance with the banking entity's compliance program, that reflects the banking entity's determination that the vehicle will become a foreign public fund within the time period provided for seeding a covered fund. See 79 Fed. Reg. at 5676–77 (discussing treatment of U.S. registered investment companies during seeding period) and Federal Reserve, Volcker Rule, Frequently Asked Questions (June 10, 2014) available at http://www.federalreserve.gov/bankinforeg/volcker- rule/faq.htm#5 (noting that seeding vehicles for foreign public funds will be treated similarly to seeding vehicles for U.S. registered investment companies during the seeding period). 5 For a U.S. banking entity, or a banking entity controlled directly or indirectly by a U.S. banking entity, to rely on this exclusion with respect to a foreign public fund that the banking

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entity sponsors, ownership interests in the issuer must be sold “predominantly” to persons other than the sponsoring banking entity, the issuer, their affiliates and directors and employees of the foregoing. Final Rule § _.10(c)(1)(ii). The Agencies have stated that they “generally expect that a foreign public fund will satisfy this additional condition if 85 percent or more of the fund’s interests are sold to persons other than the sponsoring U.S. banking entity and certain persons connected to that banking entity.” 79 Fed. Reg. at 5678. 6 As noted in the new FAQ, the latter two of these three requirements are analogous to those that must be met in order for a foreign public fund, U.S. registered investment company or business development company to not be considered an affiliate of a banking entity for purposes of the limitations on covered fund investments under Final Rule § _.12. 7 See 79 Fed. Reg. at 5678. 8 See Federal Reserve, Volcker Rule, Frequently Asked Questions (June 12, 2015) available at http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm#15. 9 Final Rule § _.10(c)(3). 10 The Supplementary Information notes that the joint venture exclusion may not be relied upon to engage in merchant banking activities otherwise prohibited under the Volcker Rule because these activities “involve[] acquiring or retaining shares, assets, or ownership interests for the purpose of ultimate resale or disposition of the investment.” 79 Fed. Reg. at 5681.

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Foreign Public Funds Sponsored by Banking Entities

14. How does the final rule apply to a foreign public fund sponsored by a banking entity?

The final rule excludes foreign public funds from the definition of covered fund.1 To qualify for this exclusion, these funds must, among other conditions, be authorized to offer and sell ownership interests to retail investors in the foreign public fund’s home jurisdiction and must sell ownership interests predominantly in public offerings outside of the United States.2 The Agencies stated that this exclusion was “designed to prevent...the definition of covered fund from including foreign funds that are similar to U.S. registered investment companies, which are by statute not covered by section 13.”3 The Agencies also stated that the “foreign public fund exclusion is designed to treat foreign public funds consistently with similar U.S. funds and to limit the extraterritorial application of section 13 of the BHC Act, including by permitting U.S. banking entities and their foreign affiliates to carry on traditional asset management businesses outside of the United States.”4

Staffs of the Agencies understand that, unlike in the case of U.S. registered investment companies,5 sponsors of foreign public funds in some foreign jurisdictions select the majority of the fund’s directors or trustees, or otherwise control the fund for purposes of the BHC Act by contract or through a controlled corporate director. These and other corporate governance structures abroad therefore have raised questions regarding whether foreign public funds that are sponsored and distributed outside the U.S. and in accordance with foreign laws are banking entities by virtue of their relationships with a banking entity.

As noted by the Agencies in the preamble to the final rule, the definition of private equity fund and in section 619 of the Dodd-Frank Act appears to reflect Congressional

1 See § 248.10(c)(1). The final rule defines the term “covered fund” to include certain funds that rely on section 3(c)(1) or 3(c)(7) of the Investment Company Act; certain commodity pools as defined in section 1a(10) of the Commodity Exchange Act; and certain foreign funds. See § 248.10(b)(1). 2 See § 248.10(c)(1). 3 79 FR at 5673. The Agencies also noted more generally that the exclusions from the covered fund definition were designed, among other purposes, “to address the potential over-breadth of the covered fund definition and related requirements without such exclusions by permitting banking entities to invest in and have other relationships with entities that do not relate to the statutory purpose of section 13.” 79 FR at 5677. 4 79 FR at 5678. The Agencies explained in the preamble that they “tailored the final definition [of covered fund] to include entities of the type that the Agencies believe Congress intended to capture in its definition of private equity fund and hedge fund in section 13(h)(2) of the BHC Act by reference to section 3(c)(1) and 3(c)(7) of the Investment Company Act. Thus, the final definition focuses on the types of entities formed for the purpose of investing in securities or derivatives for resale or otherwise trading in securities or derivatives, and that are offered and sold in offerings that do not involve a public offering, but typically involve offerings to institutional investors and high-net worth individuals (rather than to retail investors).” 79 FR at 5666. 5 See 79 FR at 5676 (recognizing that the Federal Reserve Board’s regulations and orders have long recognized that a bank holding company may organize, sponsor, and manage a registered investment company, including by serving as investment adviser to the registered investment company, without controlling the registered investment company for purposes of the BHC Act). concerns regarding less regulated private funds as well as an intention not to disrupt registered investment companies, such as U.S. mutual funds.6 The final implementing regulations issued by the Agencies adopted the same approach toward foreign public funds in order to make clear that U.S. banking entities and their foreign affiliates, as well as foreign banking organizations, could continue to carry on their traditional asset management businesses involving foreign public funds outside of the United States.7 The final rule imposes conditions to ensure that the foreign public fund is distributed predominantly through public offerings outside the United States, is offered to retail investors in the issuer’s home jurisdiction, is distributed in accordance with all applicable requirements for distributing public funds in the jurisdiction in which the distribution is being made, and includes publicly available offering disclosure documents. These requirements were designed to mirror the characteristics of U.S. mutual funds that are outside the applicability of section 619 of the Dodd-Frank Act.8

By referring to characteristics common to publicly distributed foreign funds rather than requiring that foreign public funds organize themselves identically to U.S. mutual funds or other types of U.S. regulated investment companies, the final rule recognized that foreign jurisdictions have established their own frameworks governing the details for the operation and distribution of foreign public funds.

Section 248.12 of the final rule further provides that, for purposes of complying with the covered fund investment limits, a U.S. registered investment company, SEC-regulated business development company, or foreign public fund will not be considered to be an affiliate of the banking entity so long as the banking entity: (i) does not own, control, or hold with the power to vote 25 percent or more of the voting shares of the fund; and (ii) provides investment advisory, commodity trading advisory, administrative, and other services to the fund in compliance with the limitations under applicable regulation, order, or other authority. The staffs of the Agencies note that these limitations would include those imposed by an authority in the relevant foreign jurisdiction.9

Staffs of the Agencies would not advise that the activities and investments of a foreign public fund that meets the requirements in section 248.10(c)(1) and section 248.12(b)(1) of the

6 See, e.g., 79 FR at 5675 (“Section 13’s definition of private equity fund and hedge fund by reference to section 3(c)(1) and 3(c)(7) of the Investment Company Act appears to reflect Congress’ concerns about banking entities’ exposure to and relationships with investment funds that explicitly are excluded from SEC regulation as investment companies.”). (emphasis in original) See also e.g., 79 FR at 5666. 7 79 FR at 5678 (stating “the Agencies’ view that the foreign public fund exclusion is designed to treat foreign public funds consistently with similar U.S. funds and to limit the extraterritorial application of section 13 of the BHC Act, including by permitting U.S. banking entities and their foreign affiliates to carry on traditional asset management businesses outside of the United States”). 8 79 FR at 5678. 9 See § 248.12(b)(1)(ii). See also 79 FR at 5732 (“[F]or purposes of section 13 of the BHC Act and the final rule, a registered investment company, SEC-regulated business development company, and a foreign public fund as described in §__.10(c)(1) of the final rule will not be considered to be an affiliate of the banking entity if the banking entity owns, controls, or holds with the power to vote less than 25 percent of the voting shares of the company or fund, and provides investment advisory, commodity trading advisory, administrative, and other services to the company or fund only in a manner that complies with other limitations under applicable regulation, order, or other authority.”) final rule be attributed to the banking entity for purposes of section 619 of the Dodd-Frank Act or the final rule where, consistent with section 248.12(b)(1) of the final rule, the banking entity does not own, control, or hold with the power to vote 25 percent or more of the voting shares of the foreign public fund (after the seeding period),10 and provides investment advisory, commodity trading advisory, administrative, and other services to the fund in compliance with applicable limitations in the relevant foreign jurisdiction. Nor would the staffs advise that a foreign public fund be deemed a banking entity under the final rule solely by virtue of its relationship with the sponsoring banking entity where the foreign public fund meets the requirements of section 248.10(c)(1) of the final rule and the sponsoring banking entity’s relationship with the foreign public fund meets the requirements of section 248.12(b)(1) of the final rule, including the requirement that the sponsoring banking entity’s relationship with the fund is in compliance with applicable limitations in the foreign jurisdiction in which the foreign public fund operates.

10 See §§ 248.10(c)(12) and 248.20(e). The preamble to the final rule makes clear that, consistent with the Board’s precedent regarding bank holding company control of and relationships with funds, a seeding vehicle that will become a registered investment company would not itself be viewed as violating the requirements of section 13 during the seeding period so long as the banking entity that establishes the seeding vehicle operates the vehicle pursuant to a written plan, developed in accordance with the banking entity’s compliance program, that reflects the banking entity’s determination that the vehicle will become a registered investment company within the time period provided for seeding a covered fund. See 79 FR at 5676-77. The staffs of the Agencies have explained that an issuer that will become a foreign public fund would be treated during its seeding period in the same manner as an issuer that will become an excluded registered investment company. http://www.federalreserve.gov/bankinforeg/volcker- rule/faq.htm#5. Joint Venture Exclusion for Covered Funds

15. May an issuer that would be a covered fund rely on the joint venture exclusion from the definition of covered fund under § 248.10(c)(3) of the final rule?

Section 248.10(c)(3) of the final rule provides that a covered fund does not include a joint venture between a banking entity or any of its affiliates and one or more unaffiliated persons, provided that the joint venture:

 Is comprised of no more than 10 unaffiliated co-venturers;

 Is in the business of engaging in activities that are permissible for the banking entity or affiliate, other than investing in securities for resale or other disposition; and

 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.

As explained in the preamble to the final rule, one of the purposes of section 13 of the Bank Holding Company Act (“BHC Act”) is to limit investment and sponsorship activities of banking entities in hedge funds and private equity funds, which section 13 of the BHC Act generally defines as entities that rely on certain specified exclusions in the Investment Company Act of 1940.1 The final rule defines hedge funds and private equity funds collectively as “covered funds.”2 The preamble to the final rule explains that the definition of covered fund focuses on the types of entities formed for the purpose of investing in securities or derivatives for resale or other trading activity that are not subject to all of the securities law protections applicable to funds that are registered with the SEC as investment companies. A joint venture that qualifies for the joint venture exclusion in the final rule, however, is excluded from the definition of covered fund.

The conditions to the joint venture exclusion reflect that the exclusion is designed to be used by a banking entity to conduct businesses and operations in conjunction with a limited number of co-venturers and that the exclusion is not intended to include entities that invest in securities for resale or other disposition. Similarly, the exclusion would not apply to entities or arrangements that raise money from investors primarily for the purpose of investing in securities for the benefit of one or more investors and sharing the income, gain or losses on securities acquired by that entity. The limitations in the joint venture exclusion are meant to ensure that the joint venture is not an investment vehicle and that the joint venture exclusion is not used as a means to evade the limitations in the BHC Act on investing in covered funds.3

1 See, e.g., Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 FR 5536 (Jan. 31, 2014) at 5670-5671. 2 The final rule generally defines the term “covered fund” to include certain funds that rely on section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940; certain commodity pools as defined in section 1a(10) of the Commodity Exchange Act; and certain foreign funds. See section 248.10(b)(1) of the final rule. 3 The joint venture exclusion is subject to conditions, as noted above. As an initial matter, the entity seeking to rely on the exclusion must be a joint venture. While the term “joint venture” is not defined separately in the final rule, the This exclusion is not met by an issuer that raises money from a small number of investors primarily for the purpose of investing in securities, whether the securities are intended to be traded frequently, held for a longer duration, held to maturity, or held until the dissolution of the entity. The exclusion also is not met by an entity that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities merely because one of the purposes for establishing the vehicle may be to provide financing to an entity to obtain and hold securities. As the preamble explains, the exclusion is designed to allow a banking entity to more efficiently manage the risks of its banking operations by, for example, seeking to obtain or share complementary business expertise. The conditions imposed on the exclusion are specifically intended to prevent the exclusion from being used as a vehicle to raise funds from investors primarily for the purpose of profiting from investment activity in securities for resale or other disposition or otherwise trading in securities.4 Thus, for example, a vehicle that raises funds from investors primarily for the purpose of sharing in the benefits, income, gains or losses from ownership of securities--as opposed to conducting a business or engaging in operations or other non-investment activities--would be raising money from investors primarily for the purpose of “investing in securities,” even if the vehicle may have other purposes.5

Agencies’ staffs note that the basic elements of a joint venture are well recognized, including under state law. Although any determination of whether an arrangement is a joint venture will depend on the facts and circumstances, the Agencies’ staffs generally would not expect that a person that does not have some degree of control over the business of an entity would be considered to be participating in “a joint venture between a banking entity or any of its affiliates and one or more unaffiliated persons” as specified in § 248.10(c)(3) of the final rule. 4 See 79 FR 5536 at 5680-82. 5 See, e.g., 79 FR 5536 at 5681 (stating that the limit on the number of co-venturers “allows flexibility in structuring larger business ventures without involving such a large number of partners as to suggest the venture is in reality a hedge fund or private equity fund established for investment purposes” and that “[t]he Agencies will monitor joint ventures--and other excluded entities--to ensure that they are not used by banking entities to evade the provisions of section 13”; also stating that “[t]he final rule’s requirement that a joint venture not be 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 prevents a banking entity from relying on this exclusion to evade section 13 of the BHC Act by owning or sponsoring what is or will become a covered fund”).