The Volcker Rule Provisions in the Dodd-Frank WallStreet Reform and Consumer Protection Act
July 14, 2010
On June 30, 2010, the U.S. House of Representatives passed the Dodd-Frank Wall Street Reformand Consumer Protection Act (the “Dodd-Frank Act”), which is widely expected to be passedby the U.S. Senate and signed into law by President Obama. Among the most consequential
features of the Dodd-Frank Act is the so-called “Volcker Rule”. Named after Paul Volcker, theformer chairman of the Board of Governors of the Federal Reserve System (the “Federal
Reserve”) and the current head of the President’s Economic Recovery Advisory Board, theVolcker Rule will, subject to limited exceptions, ban banking organizations from engaging inproprietary trading and sponsoring or investing in hedge funds and private equity funds. Our
July 6, 2010 memorandum, “U.S. Congress Nears Completion of Landmark Financial Services
Reform Legislation”, provided an overview of the Dodd-Frank Act. This memorandum
provides additional detail on the Volcker Rule.
A.

THE BASIC PROHIBITION

Under the Dodd-Frank Act, a new Section 13 is added to the Bank Holding Company Act (the“BHC Act”) to provide that “a banking entity shall not (A) engage in proprietary trading; or (B)acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge
fund or a private equity fund.”
1.

Key Terms Contained in the Prohibition(i)“Banking Entity”

A “banking entity” is defined to include (i) an insured depository institution (i.e., banks, thrifts,
credit card banks, industrial banks, but excluding limited purpose trust companies that satisfy
certain requirements), (ii) any company that controls an insured depository institution (i.e.,bank holding companies, savings and loan holding companies, and any company that directly
or indirectly controls a nonbank bank, such as an industrial loan company or a credit card bank,including any private equity and industrial firms, such as BMW and General Electric, that
control industrial loan companies or federal savings banks); (iii) any company that is treated asa bank holding company under the International Banking Act (i.e., a foreign bank that has a U.S.
branch, agency or commercial lending subsidiary, and any company that directly or indirectly
controls such a bank); and (iv) any “affiliate” or subsidiary”1 of any of these entities.

1

For purposes of the BHC Act, a “subsidiary” is any company that is controlled by anothercompany, and “control” conclusively exists when 25% or more of the voting shares of a company
are held by another company (although control can also be found at lower ownership levels).

Memorandum – July 14, 2010

As discussed below, a nonbank financial company that becomes subject to the supervision of
the Federal Reserve by virtue of a determination by the Financial Stability Oversight Council
that such company is systemically important is not a “banking entity” under the Volcker Rule.
(ii)“Hedge Fund or Private Equity Fund”

The term “hedge fund or private equity fund” is defined in Section 13 to mean an issuer thatwould be an investment company but for the exemptions contained in Section 3(c)(1) (fundswith 100 or fewer beneficial owners) or Section 3(c)(7) (funds all the holders of which are“qualified purchasers”) of the Investment Company Act of 1940 (the “ICA”) “or such similarfunds as the appropriate Federal banking agencies, the [SEC] and the [CFTC] may determine”
in the implementation of the Volcker Rule regulations that such regulators are required to issue
pursuant to Section 13(b)(2) (referred to in this memorandum as the “Section 13(b)(2)
Regulations”).
(A)“Similar Funds”

As a general matter, private funds that are exempt from the ICA based on exemptions otherthan those provided by Sections 3(c)(1) and 3(c)(7) of the ICA are not subject to the restrictionsof Section 13 of the BHC Act. For example, funds exempt under ICA Rule 3a-1 (issuers thatprimarily own stock of their subsidiaries), Section 6(b) of the ICA (employees’ securities
companies) and Section 3(c)(5)(C) of the ICA (funds that hold mortgages) are not covered.
However, in their Section 13(b)(2) Regulations, the regulators have the authority to extend therestrictions of Section 13 to relationships of banking entities with “similar funds.” Theregulators are required to coordinate with each other and seek consistency in their Section
13(b)(2) Regulations. However, the key role in defining what constitutes a “similar fund” islikely to be played by the Federal Reserve because funds that will become subject to therestrictions of Section 13 will typically be directly or indirectly controlled by a bank holding
company and the SEC would likely not have jurisdiction over such funds under Section 13
because its responsibility under that section for investment companies is limited to those thatare required to be registered under the ICA.
As discussed below, in adopting their Section 13(b)(2) Regulations, the regulators are to be
guided by a study to be conducted by the Financial Stability Oversight Council, which is in turnto be guided by criteria specified in the Dodd-Frank Act that may be summarized as follows:
safety and soundness of banks; fair competition between those affiliated with banks and those
not; and reduction of conflicts of interests between banking entities and their customers. These
criteria ultimately should guide what other funds are treated as “similar funds.”

Note that, if more than 25% of the voting shares of a company are held by a banking entity as amerchant banking investment, then the portfolio company is itself a “banking entity” forpurposes of this section. An “affiliate” is any company that controls, is controlled by, or is undercommon control with, another company.

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Memorandum – July 14, 2010

A managed account for a banking entity that invests in lock step with a fund that is a “hedge
fund or private equity fund” might be found to be a similar fund or might be proscribed by theregulators under their separate authority (discussed below) to prevent evasions of Section 13.
(B)

Private Funds that are Bank Holding Companies

There are a number of private equity funds that are engaged in the business of acquiringcontrolling interests in banking entities. Typically, the fund is controlled by an entity, which is
the general partner or managing member of the fund, and the fund acquires controllinginterests in banks, thrifts and their holding companies. The fund relies on Section 3(c)(1) or
3(c)(7) of the ICA. The controlling entity in the structure is a “banking entity” because it is abank holding company and under Section 13 that controlling entity will be permitted to sponsor
the fund, including by acting as its general partner, only if it satisfies the terms of the exemption
for private funds sponsored by banking entities (discussed below). That exemption has anumber of limitations, including a requirement that the controlling banking entity not own
more than 3% of the fund and that its aggregate investments in such funds not exceed 3% of its
capital.
(iii)“Sponsor”

To “sponsor” is defined for purposes of Section 13 to mean: (i) “to serve as a general partner,
managing member, or trustee of a fund,” (ii) “in any manner to select or to control . . . a majorityof the directors, trustees, or management of a fund,” or (iii) “to share with a fund, for corporate,
marketing, promotional, or other purposes, the same name or a variation of the same name.”(iv)“Proprietary Trading”

The term “proprietary trading” is defined for purposes of Section 13 to mean “engaging as aprincipal for the trading account of the banking entity . . . in any transaction to purchase or sell .
. . any security, any derivative, any contract of sale of a commodity for future delivery, . . . or
any other security or financial instrument” that the regulators may, under their Section 13(b)(2)
Regulations, determine.
The term “trading account” is defined to mean “any account used for acquiring or taking
positions in [such] securities and instruments . . . principally for the purpose of selling in thenear term (or otherwise with the intent to resell in order to profit from short-term pricemovements) and any other accounts” that the regulators may, under their Section 13(b)(2)
Regulations, determine. Although Section 13 does not include definitions of “near term” or“short-term”, it seems clear that proprietary trading should not include merchant banking
investments by banking entities where the intention is to hold the investment for a year or
more.
A number of bank holding companies have obtained authority to trade commodities andcommodity derivatives. The definition of “proprietary trading” covers certain commodity
derivatives, but it is much less restrictive than the definition of that term in the bill that passed
the Senate in May, which included all “commodities”.

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2.

Rule of Construction for Sale or Securitization of Loans

The Dodd-Frank Act explicitly provides that the restrictions in Section 13 are not to beconstrued to limit or restrict the ability of a banking entity or nonbank financial company
supervised by the Federal Reserve to sell or securitize loans. The Section 13(b)(2) Regulations
will presumably exempt vehicles established for that purpose.
B.

EXCLUSIONS FROM THE PROHIBITION
1.

Regulatory Discretion to Permit Otherwise Prohibited Activities

The language of Section 13(a)(1), which contains the basic prohibition, leaves out the languagein the bill that passed the Senate in May, which made the prohibition “subject to therecommendations and modifications” of the Financial Stability Oversight Council. However,the federal banking agencies, the SEC and the CFTC, are required to consider the Financial
Stability Oversight Council’s recommendations in writing their Section 13(b)(2) Regulations andthe regulators are expressly authorized to permit “activities” (which presumably would include
both proprietary trading and private fund activities) that they determine by rule “would
promote and protect the safety and soundness of the banking entity and the financial stability of
the United States.”2.

Expressly Permissible Types of Proprietary Trading

The following activities are exempt from the Volcker Rule’s basic prohibition on proprietary
trading by banking entities:

Purchases and sales of securities issued by the U.S. government and certain
government-sponsored enterprises.

Purchases and sales of securities in connection with underwriting and marketmaking activities to the extent such activities “are designed not to exceed thereasonably expected near term demands of clients, customers or counterparties.”“Risk-mitigating hedging activities in connection with and related to individual oraggregated positions, contracts, or other holdings of the banking entity that aredesigned to reduce the specific risks to a banking entity in connection with andrelated to such positions, contracts, or other holdings.”



Purchases and sales on behalf of customers.



Investments by insurance companies that are banking entities for the general accountof the insurance company (discussed further below).

Proprietary trading by foreign banking organizations in reliance on Section 4(c)(9) or
Section 4(c)(13) of the BHC Act (discussed further below).

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Memorandum – July 14, 2010

Insurance company investments are subject to the Section 13 prohibition in the first instanceonly if the insurance company is a “banking entity” because it controls or is under common
control with either an insured depository institution or a foreign bank that is treated as a bankholding company.
A number of insurance companies own limited purpose trust companies. As long as such trust
companies fit within the limited purpose trust company exemption from the definition of“banking entity” in the Volcker Rule, then ownership of such trust companies will not cause theinsurance company or its affiliates to be subject to the Volcker Rule. Also, a number of
insurance companies acquired thrift institutions prior to 1999 and, prior to the Dodd-Frank Act,
were permitted to own such thrift institutions without the insurance company or its affiliates(other than the thrift) being subject to activity restrictions or capital requirements. Under the
Dodd-Frank Act, such insurance companies will be subject to capital requirements and, undersome circumstances, to activity restrictions, including the application of Section 13. We expectthat some insurance companies may evaluate whether divestiture of the thrift institution ispreferable to compliance with the new restrictions.
The Section 13 prohibition does not extend to investments by an insurance company for its
general account in accordance with state insurance laws unless the Federal banking regulators
jointly determine that such laws are insufficient to protect the safety and soundness of thebanking entity or the financial stability of the United States. This limitation on the applicationof the Volcker Rule to insurance companies, however, does not serve to expand otherwise
applicable limitations on the activities of insurance companies that are subject to the BHC Act.
In particular, this exemption from the prohibition of the Volcker Rule does not appear to affect
the Federal Reserve’s interpretation of the insurance company merchant banking provisions in
the BHC Act. To date, the Federal Reserve has interpreted the ability of insurance companies
that are financial holding companies to make merchant banking investments in real estate in thesame restrictive manner in which the Federal Reserve has interpreted the provision for otherfinancial holding companies.
The Volcker Rule also permits proprietary trading conducted pursuant to Section 4(c)(9) or4(c)(13) of the BHC Act by certain foreign banking organizations. This exemption will beavailable for proprietary trading activities of qualifying foreign banking organizations so longas they do not engage in such activities in the United States. Section 4(c)(9) and Section 4(c)(13)
are implemented by the Federal Reserve under Regulation K. Regulation K defines the term to“engage in an activity in the United States” to mean that the activity may not be conducted
through an office (other than a representative office) or subsidiary that is located in the UnitedStates. However, in the interest of competitive equality with U.S. banking organizations,
Regulation K has sometimes been interpreted by Federal Reserve staff to include transactions
with U.S. persons that are not conducted through an office or subsidiary in the United States.
3.

Expressly Permitted Sponsorships of and Investments in Private Funds

The prohibition against a banking entity sponsoring or investing in private funds does not
apply in the following circumstances:

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Memorandum – July 14, 2010



Small business investment company investments.

Sponsorship of and investments in hedge and private equity funds pursuant to Section
4(c)(9) or 4(c)(13) of the BHC Act by a banking entity that is not directly or indirectly
controlled by a banking entity that is organized under U.S. law solely outside of the U.S. andprovided that no ownership interest in such fund is offered or sold to a resident of the UnitedStates.



Private equity and hedge funds that are sponsored by the banking entity itself, subject to thefollowing conditions:o“[T]he fund is organized and offered only in connection with the provision of
bona fide trust, fiduciary, or investment advisory services and only topersons that are customers of such services of the banking entity.”
The inability of a banking entity to offer interests in such a fund to persons
that are not already trust, fiduciary or investment advisory clients of thebanking entity, if interpreted narrowly, will significantly limit the value of
this exemption.

o2

The banking entity’s investment in the fund is for the purpose of making a deminimis investment or providing seed money andNot later than 1 year after establishment of the fund (which theFederal Reserve may extend for an additional 2 years if consistent
with safety and soundness and in the public interest) the investment
is reduced to 3% or less of the fund’s total ownership interests;

The investment is not material to the banking entity (as defined by theregulators in their Section 13(b)(2) Regulations) and in aggregate allsuch investments do not exceed 3% of the tier 1 capital of the banking
entity; andThe aggregate amount of such investments is deducted from both theassets and the tangible equity of the banking entity “and the amountof the deduction shall increase commensurate with the leverage of thehedge fund or the private equity fund.”2

It is unclear what is meant by “commensurate” in the quoted language. A requirement that allleverage of such a fund be deducted from the capital of the investing banking entity would
effectively prohibit banking entities from investing in significantly leveraged funds.

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Memorandum – July 14, 2010

It is important to observe that this authority of a banking entity tomake de minimis investments in private equity and hedge funds islimited to funds that are sponsored by the banking entity and thatmeet all of the requirements for such sponsored funds. This provision
does not authorize de minimis investments in third party funds.
oNo director or employee of the banking entity—other than those that are“directly engaged in providing investment advisory or other services” to thefund—takes or retains an ownership interest in the fund.
This provision may be extended by the regulators to restrict employee
investment vehicles for employees of a banking entity (such as employees’
securities companies under Section 6(b) of the ICA) from investing side-byside with a fund sponsored by the same banking entity.

oThe banking entity does not directly or indirectly guarantee the obligations
or performance of the fund or share its name or a variation of its name withthe fund, and informs investors that any fund losses will be borne byinvestors.

oThe banking entity complies with the affiliate transaction restrictions
discussed below under “Restrictions on Transactions with Private Funds”.

The regulators may also exempt from the Volcker Rule “[s]uch other “activity” as theappropriate Federal banking agencies, the [SEC] and the [CFTC] determine, by rule . . .
would promote and protect the safety and soundness of the banking entity and the financial
stability of the United States.”
In addition to those expressly permitted activities, the regulators are given thediscretion to exempt from the ban on proprietary trading and on investing orsponsoring private funds activities specifically determined to promote and protect
both the safety and soundness of the institution engaging in it and U.S. financial
stability. However, it is unlikely that the regulators will use that authority
aggressively, at least initially. Also, as discussed below, the regulators are notallowed to deem an activity permissible if it would have certain adverse effects, suchas creating a material conflict of interest, so it is possible that rather than use thisdiscretion to expand the list of permissible activities, the regulators may impose
additional restrictions on activities that the statute expressly permits.



There is no express exemption for investments in private funds by insurance companies.
Insurance companies that are banking entities are generally subject to Section 13.
There is an exemption, discussed above, for investments by such insurancecompanies for their general account in securities and other instruments that aredescribed in the definition of “proprietary trading”. There is no similar exemption
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Memorandum – July 14, 2010

for insurance company investments in hedge funds and private equity funds. (Incontrast, there are separate exemptions under Section Sections 4(c)(9) and 4(c)(13) of
the BHC Act for qualifying foreign banking organizations with respect to theirproprietary trading and their investments in hedge funds and private equity funds).
On the face of the statute, insurance companies that are banking entities are subject
to the same restrictions on investing in and sponsoring private funds as are bankholding companies. It is possible that the Financial Stability Oversight Council,
which in the study it is to conduct (discussed below) that is to inform the Section
13(b)(2) Regulations is required to “appropriately accommodate the business of
insurance within an insurance company,” will conclude that the absence of an
exemption for insurance company investments in funds was an oversight and will
recommend that such an exemption be provided.
4.

Limitations on Exclusions and Anti-Evasion

Notwithstanding the statute’s designation of an activity as generally permissible, an activity
will not be permitted if it would involve a material conflict of interest (to be defined by theregulators in their Section 13(b)(2) Regulations) between the banking entity and its clients,
customers or counterparties; result in a material exposure of the banking entity to high-risk
assets or trading strategies (as defined by the regulators in their Section 13(b)(2) Regulations);
pose a threat to the safety and soundness of the banking entity; or pose a threat to the financial
stability of the United States. The regulators in their Section 13(b)(2) Regulations may also
impose additional capital requirements and quantitative limitations (including diversification
requirements) regarding permitted activities if appropriate to protect the safety and soundnessof the banking entities engaged in them.
Whenever a regulatory agency has reasonable cause to believe that a banking entity or anonbank financial company that is supervised by the Federal Reserve has made an investment
or engaged in an activity “in a manner that functions as an evasion” of Section 13, theregulatory agency may order the banking entity or company to terminate the activity and, if
applicable, divest the investment.
5.

Restrictions on Transactions with Private Funds(i)

Prohibition on “Covered Transactions”(A)

Section 23A of the Federal Reserve Act

Section 23A is intended to protect an insured depository institution (and, indirectly, the Deposit
Insurance Fund) from transactions with its parent and cross-stream affiliates that are
disadvantageous to the insured depository institution. Section 23A applies to specified“covered transactions,” including loans, extensions of credit, purchases of assets and affiliate
securities, and issuance of guarantees by the insured depository institution. These transactions
are subject to quantitative restrictions (in aggregate, such transactions with all affiliates may notexceed 20% of the capital of the depository institution) and, in the case of loans and other

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Memorandum – July 14, 2010

extensions of credit, must be fully collateralized with U.S. government securities or, if othercollateral is used, must be collateralized up to 140% of the amount of the loan.
(B)

The Volcker Rule Prohibition on Covered Transactions

Section 13 prohibits a banking entity, and any affiliate of the banking entity, from entering into
any covered transaction with a hedge fund or a private equity fund for which the banking
entity serves as investment advisor or that it sponsors pursuant to the exemption discussed
above. This is a prohibition on entering into “covered transactions,” which is much more
restrictive than subjecting such transactions to the quantitative and other restrictions of Section
23A. (The prohibition presumably will not be read to prohibit otherwise permitted investments
in up to 3% of a sponsored fund, which, as an investment in a security issued by an affiliate,
comes within the definition of “covered transaction.”)In contrast to the language of the “Levin Amendment,” the proposal offered by Senators Carl
Levin and Jeff Merkley during the Senate’s initial consideration of the Volcker Rule in May andwhich arguably applied only to the parent bank holding company and the affiliate that served
as investment adviser, the Section 13 prohibition on covered transactions applies to the banking
entity and all of its “affiliates.”
Section 13 does not clearly prohibit transactions between the banking entity and portfolio
companies controlled by the private fund. The prohibition by its terms applies to transactions
by a banking entity with “the fund, or with any other hedge fund or private equity fund that iscontrolled by such fund.” If the intent were to cover portfolio companies, the language could
have been written to say “the fund, or with any company that is controlled by such fund.”Also, the prohibition on covered transactions specifically mentions affiliates of the banking
entity in several places but not affiliates of the private funds, which suggests that it was notintended to cover transactions between a banking entity, on the one hand, and portfolio
companies of private funds that are advised or sponsored by the banking entity, on the other.
While it could be argued that such transactions give rise to the same conflicts of interest that theVolcker Rule was intended to address, it is not clear that such conflicts are as pronounced
where the banking entity has no or a nominal investment in the fund.
There is an exception from the prohibition on covered transactions for “any prime brokeragetransaction” with a hedge fund or private equity fund advised or sponsored by a banking entity
if the Federal Reserve determines that the transaction is consistent with the safe and soundoperation of the banking entity or a nonbank financial company that is supervised by theFederal Reserve. Such transactions are not subject to the covered transaction ban, but theregulators have the authority to impose restrictions on them, as discussed below. Exemption ofprime brokerage transactions from the covered transactions ban does not exempt them from therequirement that they satisfy Section 23B (discussed below).
(ii)

Imposition of Section 23B Restrictions

Section 23B of the Federal Reserve Act imposes a qualitative restriction on transactions between
an insured depository institution and its affiliates, generally requiring that such transactions be

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on arm’s length or better terms from the perspective of the insured depository institution.
Section 23B applies not only to “covered transactions,” but also to any transaction in which anaffiliate is receiving a fee for providing services; a transaction involving the payment of moneyor the furnishing of services to an affiliate; a transaction involving the sale of assets or securities
to an affiliate; and any transaction with a third party in which an affiliate has a financial
interest.
Section 13 provides that any transaction between a banking entity and a hedge fund or a private
equity fund for which the banking entity serves as investment advisor or that it sponsors
pursuant to the exemption discussed above shall be subject to Section 23B as if the banking
entity were an insured depository institution and “such hedge fund or private equity fund werean affiliate thereof.”
Unlike the prohibition on “covered transactions”, which applies to transactions between abanking entity and all of its affiliates on the one hand and a private fund that is sponsored oradvised by the banking entity, the Section 23B restriction, by its terms, applies only totransactions between the private fund and the banking entity that is actually serving as
investment advisor or sponsor.
6.

Treatment of Nonbank Financial Companies Supervised by the Federal Reserve

A nonbank financial company that the Financial Stability Oversight Council has determined issystemically important enough to require supervision by the Federal Reserve System is not a“banking entity” for purposes of the prohibition. However, Section 13(a)(2) provides that,
under the regulations adopted by the Federal Reserve to implement this section, suchcompanies “shall be subject . . . to additional capital requirements for and additional
quantitative limits” with regard to their proprietary trading and private fund activities (otherthan those that are permitted for banking entities).
While nonbank financial companies that are supervised by the Federal Reserve are not subject
to the ban on covered transactions with private funds that they advise or in which they invest or
to Section 23B with respect to those transactions, the Section 13(b)(2) Regulations are required toinclude “additional capital requirements or other restrictions” on such companies to address“the risks to and conflicts of interest” that the ban on covered transactions is intended toaddress in the case of banking entities.
C.

IMPLEMENTATION OF THE VOLCKER RULE
1.

Study by the Financial Stability Oversight Council

The Financial Stability Oversight Council is required to study and issue recommendations
regarding Section 13 within 6 months of enactment. The Dodd-Frank Act incorporates a variety
of matters that the Financial Stability Oversight Council is to consider (including conflicts ofinterest, financial stability, and the cost and availability of financial services) in issuing such
recommendations. However, the listed considerations are probably less significant than the fact

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that, in contrast to the bill that passed the Senate last May, the Financial Stability OversightCouncil is not given explicit authority to modify the prohibitions.
2.

Section 13(b)(2) Regulations

Within 9 months of completion of the Financial Stability Oversight Council’s study, the federalbanking, securities and commodities regulators are to issue regulations implementing theSection 13 provisions, and such regulations are to become effective not later than 2 years fromthe date of enactment of the Dodd-Frank Act. As noted previously, although a number ofregulators will be issuing such rules, it appears that the Federal Reserve will have the lead role
because most banking organizations engage in sponsorship of and investment in private funds
and investing (as opposed to trading) in non-government securities through bank holding
company entities that are not insured depository institutions.
3.

Transition Rules(i)

The Effective Date

The Volcker Rule becomes effective the earlier of (i) 12 months after the Section 13(b)(2)
Regulations are issued or (ii) 2 years from enactment. Because it seems very unlikely that such
regulations will be issued three months prior to the date when they are required to be issued (15months after enactment), in all likelihood the Volcker Rule will become effective two years afterenactment. This section of the memorandum assumes that the legislation will be enacted in2010 and that the Volcker Rule will become effective two years from enactment.
(ii)

The Conformance Period(A)

The General Rule: 4 Years (2014)

The general rule is that Section 13 takes effect (i.e., a subject entity needs to conform by nolonger sponsoring or making or retaining investments in private funds or engaging inproprietary trading) within (presumably the later of) 2 years from the effective date of the rules(i.e., not more than 4 years from enactment) and the date on which the entity or company
became a bank holding company or nonbank financial company supervised by the Federal
Reserve. This conformance period may be extended under certain circumstances, as described
below.
Notwithstanding this conformance period, on the date on which the “Commission”3 issues
rules implementing Section 13 (which will be not later than 15 months after enactment), theFederal banking agencies, the SEC and the CFTC shall issue rules “to impose additional capitalrequirements, and any other restrictions, as appropriate, on any equity partnership, or

3

The “Commission” is defined in the statute to refer to the SEC or the CFTC, depending on thecontext. It may be that this provision should have referred to the Federal Reserve rather than the“Commission,” but, if so, this appears to be a harmless error.

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ownership interest in or sponsorship of a hedge fund or private equity fund by a banking
entity”, which restrictions will apply during the conformance period.
(B)

Federal Reserve Extensions: Up to 7 Years (2017)

The Board, by rule or order, may extend the conformance period, one year at a time, for up to 3
additional years (i.e., 7 years from enactment) if it determines such extensions to be “consistent
with the purposes of this section and not detrimental to the public interest.
(C)

Federal Reserve Extensions for Illiquid Funds: Up to 12 Years (2022)(1)

Definition of “Illiquid Fund”

Section 13 defines an “illiquid fund” to be a hedge fund or private equity fund that as of May 1,
2010, was principally invested in or was invested in and contractually committed to principallyinvest in, illiquid assets, such as portfolio companies, real estate investments, and venture
capital investments. In issuing regulations to implement this provision, the Federal Reserve is
to consider the fund’s contractual obligations and the ability of the fund to divest assets, andany other factors the Federal Reserve determines are appropriate.
For purposes of this provision, “hedge fund” includes any fund that comes within the generaldefinition of “hedge fund and private equity fund,” while “private equity fund” excludes“private equity funds” as that term is used in Section 203(m) of the Investment Advisers Act.
The cited section, which was added by the Dodd-Frank Act and exempts from registration
investment advisers with less than $150 million in assets under management, does not, in fact,
use the term “private equity fund”. This drafting glitch does not appear to have any practical
implications.
(2)

The “Illiquid Fund” Extension

The Federal Reserve is authorized to grant additional extensions upon the application of abanking entity to take or retain its equity, partnership, or other ownership interest in, orotherwise provide additional capital to, an illiquid fund “to the extent necessary to fulfill acontractual obligation that was in effect on May 1, 2010.” Such extensions permit additional
investments, not just retention of an interest, to fulfill a contractual obligation.
Instead of multiple one-year extensions, this provision contemplates a single five-year
extension. There seems to be no reason that this extension could not be added on to the 3 oneyear extensions, but it is subject to the limitation that the extension is required to satisfy acontractual obligation in effect on May 1, 2010.
The illiquid fund provisions state that divestiture is required on the earlier of the date that “thecontractual obligation to invest” in the illiquid fund terminates and the date on which any
illiquid fund extension granted by the Federal Reserve expires. This language seems to beinconsistent with the remainder of the conformance provisions, under which any extension
beyond the initial two-year conformance period (i.e., 4 years from enactment) are within theFederal Reserve’s discretion.
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(D)

Federal Reserve Regulations Regarding the Conformance Period

Although the Section 13(b)(2) Regulations are not required to be issued until 15 months afterenactment of the Dodd-Frank Act, the Federal Reserve is required to issue rules regarding theconformance period within 6 months of enactment. The issuance of the conformance
regulations relatively early in the transition period should help banking entities plan for thetransition by providing some guidance on the question whether they are likely to qualify forextensions from the Federal Reserve to bring their activities into conformance.
***

For more information about the recent legislation and its potential implications, please contact amember of our Private Funds or Financial Institutions groups.
This memorandum is for general informational purposes and should not be regarded as legal advice.
Furthermore, the information contained in this memorandum does not represent, and should not be
regarded as, the view of any particular client of Simpson Thacher & Bartlett LLP. Please contact yourrelationship partner if we can be of assistance regarding these important developments. The names andoffice locations of all of our partners, as well as additional memoranda, can be obtained from our website,www.simpsonthacher.com.

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any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

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UNITED STATESASIANew York

Beijing

425 Lexington Avenue
New York, NY 10017-3954+1-212-455-2000

3119 China World Office 1
1 Jianguomenwai Avenue
Beijing 100004
China+86-10-5965-2999

Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500

Palo Alto
2550 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600

Tokyo

1155 F Street, N.W.
Washington, D.C. 20004+1-202-636-5500

Ark Mori Building
12-32, Akasaka 1-Chome
Minato-Ku, Tokyo 107-6037
Japan+81-3-5562-6200

EUROPE

SOUTH AMERICA

LondonSão Paulo

Washington, D.C.

CityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

Av. Presidente Juscelino Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000

www.simpsonthacher.com