The Volcker Rule and Private Funds:
Final Regulations Are Out
December 16, 2013
On December 10, the five federal agencies responsible for writing regulations implementing theVolcker Rule (the “Agencies”) approved final rules (the “Final Rules”) that restrict banking
entities from engaging in proprietary trading and from investing in or sponsoring private
equity funds and hedge funds. The Final Rules differ in significant respects from the rules
initially proposed in October 2011 (the “Proposed Rules”). 1
The text of the Final Rules, together with explanatory background from the Agencies, is nearly
1,000 pages, which is reflective of the complexity inherent in implementing the Volcker Ruleand addressing the largest number of public comments received on any Dodd-Frank proposal
to date. Despite their length, the Final Rules leave a number of questions unanswered and the
Agencies may need to issue formal or informal interpretations or clarifications as banking
entities face the deadline to comply.
This memorandum focuses on the portion of the Final Rules relating to banking entities’
activities with private funds. Key provisions and changes from the Proposed Rules include:

1•

More Time to Comply—Banking entities will generally have until July 21, 2015 tocomply with the Volcker Rule, a delay of one year. The Federal Reserve has
authority to grant only two more one-year extensions.

•

Scope of Banking Entities Covered—The Final Rules largely track the statute and the
Proposed Rules on what constitutes a “banking entity,” with only a few carve-outs
for entities the inclusion of which would have clearly created unintended
consequences.

•

Scope of Funds Covered—The definition of a “covered fund” is more circumscribedunder the Final Rules. In contrast to the Proposed Rules, the Final Rules explicitly
exclude a number of entities from coverage, such as foreign public funds, joint
ventures, insurance companies’ separate accounts, business development companies
and loan securitization vehicles. However, the Agencies were unpersuaded byindustry comments that employee security companies (or ESCs) not subject to an
SEC order, venture capital funds, pass-through entities holding shares of REITs andcredit funds (which are generally formed as partnerships with third-party capitalthat invest in loans or make loans or otherwise extend the type of credit that banks
are authorized to undertake on their own balance sheet) should also be excluded.

76 Fed. Reg. 68846 (Nov. 7, 2011).

Memorandum – December 16, 2013

A.

•

Foreign Banks and Offshore Parallel Funds—The Final Rules appear to provide more
flexibility with respect to the use of offshore parallel funds. Among other things, theFinal Rules more consistently make clear that they cover foreign bank investments inas well as sponsorship of funds, clarify that only the entity (and its personnel) of aforeign banking entity that makes the decision to invest in a fund must be locatedoutside the United States, and require only that ownership interests in a covered
fund not be sold in an offering “targeted” to U.S. residents. Secondary trading in
offshore markets would be permitted.

•

Sponsored Funds Exemption—The Final Rules continue to provide banking entities
with leeway to sponsor private funds (as long as they are primarily a way to provide
investment management and certain other services to others) and to invest in suchsponsored funds, subject to a 3% per-fund limit (based on a single fund’s total
outstanding ownership interests) and a 3% aggregate limit (based on the banking
entity’s Tier 1 capital).

•

CEO Attestation—Unlike the Proposed Rules, the Final Rules specifically require abanking entity’s CEO to make a written attestation, on an annual basis, that thebanking entity has processes to review and enforce its Volcker-related complianceprogram.

A NEW DEADLINE FOR COMPLIANCE

By statute, banking entities must conform their activities and investments to the Volcker Ruleby July 21, 2014, 2 a deadline the Federal Reserve affirmed in a policy statement it issued in April
2012. 3 However, in recognition of the substantial delay in issuing the Final Rules, the Federal
Reserve has ordered a blanket, industry-wide one-year extension to the statutory deadline.
Accordingly, banking entities now have until July 21, 2015 to conform their activities andinvestments to the Volcker Rule. The extension, however, does not apply to the various datareporting and recordkeeping requirements applicable to certain banking entities with“significant trading activities.”
The Federal Reserve, which has sole authority to grant extensions, 4 cautioned that banking
entities “should not expand activities and make investments” during the extended conformance
period “with an expectation that additional time to conform those activities or investments will
be granted.”2

12 U.S.C. § 1851(c)(2).

3

77 Fed. Reg. 33949 (June 8, 2012).

4

The Final Rules did not amend the rules regarding the extension process that were issued in 2011. See
76 Fed. Reg. 8265 (Feb. 14, 2011)(12 C.F.R. § 225.181). The Federal Reserve is authorized to grant up
to three one-year extensions and a single five-year extension for funds that qualify as illiquid funds.
Because the number of one-year extensions cannot exceed an aggregate of three years, the extension
granted in conjunction with the release of the Final Rules counts toward the statutorily imposed limit.

Page 2

Memorandum – December 16, 2013

B.

THE PROHIBITION ON INVESTING IN AND SPONSORING PRIVATE FUNDSThe Volcker Rule, as enacted in Dodd-Frank, was intended to generally prohibit a banking
entity from sponsoring or investing in private equity funds and hedge funds. 5 The Final Rules
implement this prohibition by generally prohibiting a “banking entity,” “as principal,” fromdirectly or indirectly acquiring or retaining an equity, partnership or other “ownership interest”
in, or acting as “sponsor” to, a “covered fund.”
1.

“Banking Entity”

Consistent with the statute and the Proposed Rules, the Final Rules define a “banking entity” asincluding: (i) any insured depository institution; (ii) any company that controls an insured
depository institution (i.e., bank holding companies and thrift holding companies, but also any
company that directly or indirectly controls a “nonbank bank,” such as a credit card bank or
industrial loan company); (iii) any foreign bank or other company that is treated as a banking
holding company under the International Banking Act of 1978 (i.e., foreign banks that have a
U.S. branch, agency or commercial lending subsidiary); and (iv) any affiliate or subsidiary of
any of the foregoing entities.
The Final Rules expressly provide that the following entities do not constitute banking entities:•

Permitted Covered Funds—any covered fund that is not itself a banking entity (i.e.,
insured depository institution, insured depository institution holding company or
foreign bank subject to the Bank Holding Company Act of 1956 (the “BHC Act”)),
which would include fund entities, such as a “fund-of-funds,” that a banking entity
controls and invests through to make permitted investments pursuant to a specified
exemption; and•Merchant Banking and Insurance Related Portfolio Companies—any portfolio company ofa banking entity that is held pursuant to the merchant banking authority of Section
4(k)(4)(H) of the BHC Act or the insurance company investment authority of Section
4(k)(4)(I) of the BHC Act.

2.

“Covered Fund”

As a general matter, a “covered fund” includes any issuer that would be an investmentcompany but for the exemptions provided by Section 3(c)(1) (funds with 100 or fewer holders) or
Section 3(c)(7) (funds sold only to “qualified purchasers”) of the Investment Company Act of1940 (the “ICA”). It also includes any (i) “commodity pool” under the Commodity Exchange
Act that shares characteristics of an entity excluded from the ICA under Sections 3(c)(1) or
3(c)(7); and (ii) certain foreign funds which a U.S. banking entity has sponsored or invested in
and which, if they were subject to U.S. securities laws, could not rely on any exemption or
exclusion from the ICA other than Sections 3(c)(1) or 3(c)(7).

5

12 U.S.C. § 1851(a)(1).

Page 3

Memorandum – December 16, 2013

The Final Rules expressly exclude from the definition of a covered fund various types ofentities, including the following:•

Foreign Public Funds—that are organized or established outside the United States,
authorized to offer and sell ownership interests to retail investors in the issuer’s
home jurisdiction, and sell ownership interests predominantly through public
offerings outside the United States (such as retail Undertakings for Collective
Investments in Transferable Securities, or UCITS).

•

Joint Ventures—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, engages only in activities that are permissible for thebanking entity or affiliate (other than investing in securities for resale or otherdisposition) and does not hold itself out as being an “entity or arrangement thatraises money from investors primarily for the purpose of investing in securities forresale or other disposition or otherwise trading in securities” (the Proposed Rules,
which did not contain such conditions, instead required that the joint venture be an
operating company and not engaged in any activity or investments prohibited by the
Volcker Rule). 6•

Acquisition vehicles—formed solely for the purpose of engaging in a bona fide merger
or acquisition and that exist only for such period as necessary to effectuate thattransaction (or if it exists thereafter, if it falls under another exemption).

•

Foreign pension or retirement funds—that are organized and administered outside theUnited States, established for the benefit of non-U.S. citizens or residents andconstitute broad-based plans subject to applicable local regulation. 7•

Insurance company separate accounts—that are only used by the insurance company
and do not involve any other banking entity participating in the account’s profits orlosses.

•Bank owned life insurance (BOLI) separate accounts—that are used solely for the
purpose of allowing one or more banking entities to purchase a life insurance policy
for which the banking entity is a beneficiary, provided that no banking entity thatpurchases the policy has control over investment decisions or participates in theaccounts’ profits or losses.

6

Although joint ventures that meet such criteria will not be treated as a covered fund, based on thepreamble, the Federal Reserve would not permit a banking entity that is a financial holding company
to use a joint venture (at least one defined under the Final Rules) to engage in activities under themerchant banking authority. By definition, the merchant banking authority is premised on afinancial holding company acquiring ownership interests in a portfolio company and selling its
investment after a period of time to realize a profit, rather than as a means for the financial holding
company to engage in the nonfinancial activities in which the portfolio company is engaged.

7

By definition, U.S. pension and retirement funds that are ERISA-qualified funds that rely on Section
3(c)(11) of the ICA are not covered funds because they do not rely on Sections 3(c)(1) or 3(c)(7).

Page 4

Memorandum – December 16, 2013•

Wholly-owned subsidiaries—of a banking entity or its affiliate, except that up to 5% of
any subsidiary’s outstanding ownership interests may be held by employees ordirectors and up to 0.5% may be held by a third party if the ownership interest is
acquired or retained by the third party for the purpose of establishing corporate
separateness or addressing other bankruptcy, insolvency or similar concerns (notethat, unlike under the Proposed Rules, there is no requirement that the subsidiary be
principally engaged in performing bona fide liquidity management activities or be
carried on the balance sheet of the banking entity).

•

Loan securitization vehicles—certain issuers of securitized loans (including residential,commercial, auto and credit card loans) that meet specified criteria. Generally,issuers of other securitized obligations, including collateralized loan obligations(CLOs), insurance-linked securities and corporate debt re-packagings, will not
qualify for this exemption. Because of the broad definition of “ownership interest”(discussed below), interests in some asset securitization vehicles held by banks forinvestment purposes may in fact be prohibited by the Volcker Rule.

•

Registered investment companies and excluded entities under the ICA—issuers that areregistered investment companies under the ICA, such as many mutual funds, andissuers that are exempt from the definition of an “investment company” under the
ICA other than pursuant to Sections 3(c)(1) and 3(c)(7). These exempt entities would
include, for example, REITs (which are exempt pursuant to Section 3(c)(5)(C) of the
ICA).

•

Business development companies (BDCs), small business investment companies (SBICs) andpublic welfare investments—that qualify under applicable provisions of federal law.

The Final Rules also exclude certain other entities, such as qualifying asset-backed commercial
paper conduits and other issuers of securities that the Agencies jointly determine to exclude.
The Agencies are working to establish a process within which to evaluate requests for
additional exclusions from the “covered fund” definition, and expect to provide additional
guidance on this matter as the Agencies gain experience with the Final Rules.
3.

“As Principal”

The general prohibition on a banking entity investing in covered funds applies only when thebanking entity is investing “as principal,” either directly or indirectly. While this term isundefined, the Final Rules explicitly clarify that the prohibition on investing or retaining anownership interest in a covered fund does not apply to investments made or held by a banking
entity (i) acting solely as agent, broker or custodian (so long as the activity is conducted for theaccount of, or on behalf of, the customer, and the banking entity and its affiliates do not have or
retain beneficial ownership of such ownership interest); (ii) on behalf of customers as trustee orin a similar fiduciary capacity for a customer that is not a covered fund (same as previous
parenthetical); (iii) through a deferred compensation, stock-bonus, profit-sharing or pension
plan where the banking entity is acting as trustee for the benefit of participants of such plans; or(iv) in the ordinary course of collecting a debt previously contracted (DPC) in good faith,
provided that the banking entity divests the ownership interest as soon as practicable.
However, the Agencies cautioned that they intend to monitor these activities and investments
Page 5

Memorandum – December 16, 2013

for efforts to evade the Volcker Rule’s restrictions on banking entities’ investments in andrelationships with covered funds.
4.

“Ownership Interest”

An “ownership interest” in a covered fund is defined broadly to include any equity, partnershipor “other similar interest” in a covered fund. The “other similar interest” concept includes thefollowing types of interests in covered funds:•

Participation in Management Selection—interests that carry a right to participate in theselection or removal of a general partner, managing member, member of the boardof directors or trustees, investment manager, investment advisor, or commodity
trading advisor of the covered fund, excluding interests of creditors that carry suchrights upon the occurrence of an event of default or an acceleration event;•Profit Sharing—interests that carry a right to receive a share of the income, gains or
profits of the covered fund;•

Excess Spread Sharing—interests that have the right to receive all or a portion of thepositive difference, if any, between the aggregate interest payments received fromthe covered fund’s underlying assets and the aggregate interest paid to the holdersof other outstanding interests in the covered fund;•

Loss Sharing—interests whose terms provide that the amounts payable by thecovered fund to such interest could be reduced based on losses arising from theunderlying assets of the covered fund;•Residual Claimant—interests that have the right to receive the underlying assets of thecovered fund after all other interests have been redeemed and/or paid in full,
excluding interests of creditors that carry such rights upon the occurrence of anevent of default or an acceleration event;•Pass-Through or Structured Products—interests that receive income on a pass-throughbasis from the covered fund, or have a rate of return that is determined by reference
to the performance of the covered fund’s underlying assets; and•Synthetic Interests—interests that carry any synthetic rights to receive any of therights listed above.

The Final Rules generally provide that profits or carried interests 8 do not constitute “ownershipinterests” (and therefore are not subject to, among other restrictions, the 3% limits described
below). These exempted interests are defined as interests held by a banking entity (or by an
employee or former employee thereof) in a covered fund for which the entity (or employee
thereof) serves as investment manager, investment advisor, or other service provider, provided
that:

8

Carried interests are referred to as “restricted profit” interests in the Final Rules.

Page 6

Memorandum – December 16, 2013•

the sole purpose of the interest is to allow the entity (or employee or former
employee thereof) to share in the profits of the covered fund as compensation forinvestment management, investment advisory, commodity trading advisory or otherservices 9 provided to the fund;•such profits are distributed to the entity (or employee or former employee of theentity) promptly after being earned or otherwise are retained by the covered fund forthe sole purpose of covering subsequent losses pursuant to contractual obligations,and such profits do not share in the subsequent investment gains of the covered
fund;

•

any amounts invested in the covered fund, including amounts paid in connection
with acquiring the interest, are within the Volcker Rule’s 3% limits addressed in
Section C.2 below; and•the interest is not generally transferrable by the entity (or employee or former
employee thereof).

5.

“Sponsor”

The definition of sponsorship under the Final Rules is substantially the same as the definition
used in the Proposed Rules and the statute. An entity will be the “sponsor” of a covered fund if
it: (i) serves as a general partner, managing member, or trustee (unless such trustee does not
exercise investment discretion) of a covered fund, or serves as a commodity pool operator withrespect to a covered fund; (ii) in any manner, selects or controls (or has employees, officers,
directors or agents who constitute) a majority of the directors, trustees or management of acovered fund; or (iii) shares with a covered fund the same name or a variation of the same namefor corporate, marketing, promotional or other purposes.
C.

THE EXEMPTIONS

Following is a summary of the main exemptions from the Volcker Rule’s general prohibition onbanking entities sponsoring or investing in covered funds.
1.

The Foreign Fund Exemption

The Volcker Rule contains a so-called “foreign fund” exemption to allow foreign banking
organizations (“FBOs”), including certain sovereign wealth funds, to acquire or retain anownership interest in, or act as sponsor to, a covered fund provided certain requirements are
met. As a threshold matter, this exemption is only available to foreign banking entities that are
not directly or indirectly controlled by a banking entity that is organized under U.S. law and

9

The Final Rules do not specify what “other services” would make a service provider eligible toreceive a restricted profit interest, but seem to adopt a broad understanding of the “other services”
concept. For example, the Final Rules note that a service provider serving in a capacity as sub-adviser
or placement agent would be eligible receive or hold a restricted profit interest.

Page 7

Memorandum – December 16, 2013that meet certain tests of “foreignness,” which the Final Rules adopted with only minor,
technical changes from the Proposed Rules. 10
For foreign banking entities that seek to invest in or sponsor a covered fund, the two
requirements that must be satisfied for this exemption to apply relate to (i) whether theinvestment or sponsorship activity occurs “solely outside of the United States” and (ii) whether
ownership interests in the covered fund are offered and sold only to non-U.S. residents.
The Final Rules significantly refine the conditions that the Proposed Rules had contained for a
foreign banking entity to invest in or sponsor a fund offshore. A covered fund investment orsponsorship will be considered to occur solely outside of the United States if:•

the banking entity making an investment as principal in or sponsoring the covered
fund is not itself, and is not controlled directly or indirectly by, a banking entity thatis located in the United States or organized under U.S. law;•

the banking entity and its “relevant personnel” that make the decision to acquire or
retain the ownership interest in or act as sponsor to the covered fund are not locatedin the United States;•

the investment or sponsorship, including any transaction arising from riskmitigating hedging related to an ownership interest, is not accounted for as principal
directly or indirectly on a consolidated basis by any U.S. branch or U.S. affiliate of
the banking entity; and•no financing for the banking entity’s ownership or sponsorship is provided, directly
or indirectly, by any U.S. branch or U.S. affiliate of the banking entity.

As for determining whether interests are offered and sold to U.S. residents, the Final Rules go
beyond the Proposed Rules, which had merely repeated the statutory language on thisparticular requirement. Under the Final Rules, this requirement will be considered met ifinterests in the fund are sold pursuant to an offering that does not “target” residents of theUnited States. For this purpose, a U.S. resident means a “U.S. person” as defined in the SEC’s
Regulation S.
There are a number of other key observations on how the Agencies have implemented thisexemption. First, the Final Rules do not make the exemption dependent on the location of theassets in which the covered fund invests or on where the investment manager for those assets is
10

For FBOs, the relevant test is whether they meet the so-called “qualifying foreign banking
organization” (“QFBO”) requirements of the Federal Reserve’s Regulation K, which requires that
more than half of their worldwide business is banking and more than half of their banking business is
outside the United States. For foreign companies that are not FBOs (because they control a thrift or“nonbank bank,” such as an industrial loan company, and therefore are not bank holding companies
for BHC Act purposes, but are “banking entities” under the Volcker Rule), a modified QFBO test
applies. This modified test is generally satisfied if a majority of the foreign company’s business(whether banking or nonbanking) is outside the United States.

Page 8

Memorandum – December 16, 2013

located. And technically, the Final Rules do not explicitly require that the fund which theforeign banking entity sponsors or invests in pursuant to this exemption be organized in a nonU.S. jurisdiction.
Second, the Final Rules do not include the Proposed Rules’ requirement that no subsidiary,
affiliate or employee of the banking entity that is involved in the offer or sale of an ownershipinterest in the covered fund be incorporated or physically located in the United States. Instead,the issue is whether the foreign banking entity’s “relevant personnel”—the personnel that makeinvestment decisions with respect to a covered fund investment—are offshore. The exemption
does not restrict U.S. personnel of the foreign banking entity from providing investment advice
or making investment recommendations to the fund. Also, there are no restrictions on “backoffice” personnel who provide various administrative services or similar functions, such asrecordkeeping, clerical support, clearing/settlement or the furnishing of statistical and researchdata, all of which may be conducted in the United States.
Third, the Agencies have provided some relief to foreign banking entities that had concerns
regarding whether the exemption could continue to be relied upon in cases where another nonU.S. investor in the fund subsequently sold or transferred its interest to an unaffiliated U.S.
investor, such as in a secondary market transaction. In the preamble to the Final Rules, theAgencies note that, “[a]bsent circumstances otherwise indicating a nexus with residents of theUnited States,” an offering of a foreign fund’s interests targeted to non-U.S. residents would not
be viewed as targeting U.S. residents if (i) the relevant offering materials contain prominent
disclaimers that the interests are not being offered or sold to U.S. residents and (ii) there areother reasonable procedures in place to restrict access to offering and subscription materials topersons that are not U.S. residents. If ownership interests that are issued in foreign offerings arelisted on a foreign exchange, secondary market transactions in fund interests will not cause thefund to lose its “foreign fund” exemption.
Finally, the Agencies indicated that certain “complex fund structures,” such as multi-tiered
fund structures, will be integrated when determining whether the ownership interest in acovered fund is offered or sold to a U.S. resident. According to the Agencies, “a banking entity
may not be able to rely on the foreign fund exemption to sponsor or invest in an initial covered
fund (that is offered for sale only overseas and not to residents of the United States) that is itself
organized or operated for the purpose of investing in another covered fund (that is sold or
pursuant to an offering that targets U.S. residents) and that is either organized and offered or isadvised by that banking entity” (emphasis added). Significantly, the Agencies did not indicatethat attribution would apply to a structure in which the fund that targets U.S. investors isneither organized/offered nor advised by the foreign banking entity, or to offshore parallel
funds that invest in tandem with U.S. funds.

Page 9Memorandum – December 16, 2013

2.

Exemption for Sponsoring Covered Funds and for Certain Underwriting andMarket Making Activitiesa.

Sponsoring Covered Funds

The so-called “sponsored funds” exemption permits banking entities to organize and offer orsponsor a covered fund and to acquire and retain an ownership interest in such a fund, subject
to significant limitations. The exemption does, however, generally allow banking entities tocontinue to sponsor “feeder” funds with private equity and hedge funds sponsored andmanaged by others.
The following requirements must be satisfied for this exemption to apply:•

the covered fund is organized and offered only in connection with the provision of
bona fide trust, fiduciary, investment advisory or commodity trading advisory
services and only to persons that are customers of such services of the banking entity
or any of its affiliates, pursuant to a written plan by the banking entity outlining how
the banking entity intends to provide such services to its customers (as such, no preexisting customer relationship is required);•the investment by the banking entity and its affiliates in the covered fund does notexceed 3% of the total amount or value of the outstanding ownership interests ofsuch fund at any time after one year from the date of the fund’s establishment (the“per-fund limit”) and the aggregate investment of the banking entity and its
affiliates in all covered funds does not exceed 3% of its Tier 1 capital, as calculated ona quarterly basis (the “aggregate limit”); however:othe Federal Reserve may grant up to a two-year extension to the one-year“seeding” exemption from the 3% per-fund limit; andothe per-fund limit is increased to 5% for funds subject to the risk-retention
requirements in Section 15G of the Securities Exchange Act;•the banking entity and the covered fund do not share the same name (or any variant)for corporate, marketing, promotional or other purposes;•

the covered fund does not use the word “bank” in its name;•the banking entity and its affiliates do not, directly or indirectly, guarantee, assume,or otherwise insure the obligations or performance of the covered fund (or any othercovered fund in which the first covered fund invests);•

the banking entity ensures that the relevant offering documents contain specified
written disclosures regarding, among other things, that any losses will not be borneby the banking entity or any of its affiliates and on the role of the banking entity andits affiliates and employees in sponsoring or providing any services to the fund;•no director or employee of the banking entity or any affiliate thereof takes or retains
an ownership interest in the covered fund, excluding directors and employees who
are directly engaged in providing investment advisory, commodity trading
Page 10Memorandum – December 16, 2013advisory, or other services 11 (the “Covered Services”) to the fund at the time thedirector or employee takes the ownership interest (subject to attribution to thebanking entity if it or any affiliate extends credit or a guarantee against loss to thedirector or employee); and•the banking entity (including its affiliates) and the covered fund may not engage inany “covered transactions” (as defined by reference to Section 23A of the Federal
Reserve Act) with each other, and all transactions that do not constitute covered
transactions must satisfy the qualitative “market” terms requirements of Section 23Bof the Federal Reserve Act.

In addition, a banking entity relying on this exemption will need to deduct from its Tier 1
capital, on a dollar-for-dollar basis, the greater of (i) the fair market value of its ownershipinterests (including any amounts paid for restricted profit interests) in covered funds under thisexemption; and (ii) the sum of all amounts paid or contributed by the banking entity inconnection with acquiring or retaining such interests, on a historical cost basis, plus any
earnings received.
These requirements generally track what the Agencies had initially proposed, but below aresome observations:•

The calculation of the 3% per-fund limit is based on investments made and theoutstanding ownership interests held, without regard to committed funds not yet
called for investment. In determining the aggregate value of outstanding ownershipinterests held by a banking entity, the Agencies will look to the aggregate fair market
value of all investments in and capital contributions made to the covered fund by thebanking entity, divided by the fair market value of all investments in and capital
contributions made to that fund. 12•

The Final Rules do not automatically count toward the 3% per-fund limit any
investment by a banking entity in the same target company as a fund it sponsors(unlike the Proposed Rules, which required such aggregation if, among other things,
the banking entity was found to be “acting in concert” with the sponsored fund).
Under the Final Rules, however, aggregation may still be required if the banking
entity co-invests to supplement the capital of the fund (for example, when theinvestment opportunity exceeds the investment capacity of the fund and the banking
entity is invited to co-invest to fill the deficit) or where there is a pattern of thebanking entity regularly co-investing with the fund.

11

The Final Rules do not define “other services” but the preamble states that directors or employees
who provide services that “enable the provision of” investment advice or investment management,such as oversight and risk management, deal origination, due diligence, administrative and othersupport services, may invest in the fund.

12

If the fair market value of such investments and capital contributions cannot be determined, thenhistorical cost basis should be used for valuation purposes.

Page 11

Memorandum – December 16, 2013•

The Final Rules contain language on how the 3% per-fund limit will be calculated for“master-feeder” fund investments and “fund-of-fund” investments. In the case of
master-feeder funds, a banking entity’s permitted investment will be measured only
by reference to the value of the master fund. For “fund-of-funds” investments, abanking entity’s permitted investment will be measured by looking both at theinvestment it has in the underlying fund and at the pro rata share it has in such
underlying fund when looking through the fund-of-funds.

•

While the 3% per-fund limit will be based on the fair market value of the interests in asingle covered fund, the 3% aggregate limit, which is calculated by reference to thebanking entity’s Tier 1 capital, is based on the historical cost of all covered fundinvestments.

•

With respect to the participation of directors and employees of a banking entity or
any of its affiliates in covered fund investments, the Final Rules specify that these
individuals must be directly engaged in providing Covered Services at the time theytake an ownership interest in the fund (former directors and employees may retaininterests they received while serving in such capacities and providing such services).
Based on the preamble, the scope of Covered Services also includes services that“enable the provision of investment advice or investment management, such as
oversight and risk management, deal origination, due diligence, administrative orother support services.”b.

Underwriting and Market Making in Covered Fund Interests

The Final Rules include an exemption for engaging in underwriting and market making
activities related to the ownership interests of a covered fund, provided that certain conditions
are met to ensure that these activities do not exceed the reasonably expected near term demandof clients, customers and counterparties. Any ownership interests that a banking entity
acquires or retains pursuant to such activities, however, will be attributed to the banking entity
for purposes of calculating the 3% per-fund and 3% aggregate limits.
3.

Hedging-Related Exemption

The Final Rules provide a very narrow exemption for a banking entity to hold an ownershipinterest in a covered fund in order to reduce risks arising when a banking entity offers an
incentive-compensation that is tied to the performance of a particular covered fund to an
employee of the banking entity or an affiliate that directly provides investment advisory,commodity trading advisory or other services to the covered fund. The hedging activity must
demonstrably reduce or significantly mitigate one or more specific risks of the incentivecompensation scheme that are identifiable at the inception of the hedge, and may not give riseto any significant new or additional risk. Consistent with the Proposed Rules, the Final Rules
also require the banking entity establishing such a hedge to implement and enforce an internal
compliance program that includes reasonably designed policies and procedures, internal
controls and ongoing monitoring, management and authorization procedures, and the hedge
must be made in accordance with that program. In addition, the incentive-compensation
arrangement to which the hedge relates must provide that any losses incurred by the banking
Page 12

Memorandum – December 16, 2013

entity on the ownership interest be offset by a reduction in the amounts payable to theemployee.
The Final Rules eliminate an exemption from the Proposed Rules that would have allowed abanking entity to hold an ownership interest in a covered fund when acting as intermediary on
behalf of a non-banking entity customer to facilitate exposure by the customer to the profits andlosses of the covered fund. In eliminating this exception, the Agencies noted that suchtransactions expose the banking entity to the risk that the customer will fail to perform, a riskthat is particularly acute when the value of the covered fund declines, thus exposing thebanking entity to the risks of the covered fund. The Agencies recognized that without thisexemption, U.S. banking entities may no longer be able to offer certain innovative financial
products, such as fund-linked swaps and shares of covered funds referenced by fund-linked
products.
4.

Insurance Company Exemption

While a significant number of insurance companies have de-registered as savings and loan
holding companies or bank holding companies in the past year, insurance companies still
affiliated with depository institutions are “banking entities” subject to the Volcker Rule.
However, the statute allows a banking entity that is a regulated insurance company or anaffiliate of an insurance company to purchase and sell covered financial instruments for thegeneral account of the insurance company. The Proposed Rules included this exemption withrespect to proprietary trading but did not address investments in private funds by insurancecompanies (arguably due to the statutory silence on whether an exemption was available forfund investments).
The Final Rules clarify this point by permitting an insurance company or its affiliate to acquireor retain an ownership interest in, or act as sponsor to, a covered fund solely for the generalaccount of the insurance company or one or more separate accounts established by the
insurance company. Such an investment is permissible if made in compliance with insurance
regulations of the state or jurisdiction in which the insurance company is domiciled, unless the
Financial Stability Oversight Council determines such regulations pose safety and soundness
concerns.
D.

LIMITATIONS ON TRANSACTIONS WITH ADVISED COVERED FUNDS

Consistent with the statute and the Proposed Rules, the Final Rules flatly prohibit a banking
entity that serves as an investment manager, advisor or sponsor to a covered fund (or thatorganizes and offers a covered fund pursuant to an exemption), including any of the banking
entity’s affiliates, from entering into any “covered transaction” with the covered fund or any
covered fund that is controlled by the first-tier covered fund. The Final Rules also apply thisprohibition to a banking entity acting as originator or securitizer that retains an ownershipinterest in a covered fund that is an issuer of asset-backed securities, and any affiliates of suchbanking entity.

Page 13

Memorandum – December 16, 2013

The term “covered transaction” comes from Section 23A of the Federal Reserve Act andincludes loans, extensions of credit, purchases of assets and affiliate securities, issuances ofguarantees by an insured depository institution and credit exposures from derivatives
transactions. Unlike Section 23A, which permits covered transactions between a bank and its
affiliate so long as such transactions meet specified quantitative and other requirements, theVolcker Rule prohibits such covered transactions outright. Accordingly, none of the
exemptions contained in Section 23A or the Federal Reserve’s Regulation W are incorporated
into the Final Rules.
The prohibition on covered transactions does not extend to a covered fund’s transactions withother covered funds in which it invests, nor does it extend to transactions between a banking
entity and portfolio companies of a covered fund (assuming that such portfolio companies are
not themselves covered funds). 13 The prohibition also does not apply to prime brokeragetransactions with a covered fund that is controlled by a first-tier covered fund, subject to certain
conditions, including an attestation by the CEO of the banking entity that the banking entity
does not directly or indirectly guarantee, assume or insure the obligations of the covered fund.
Prime brokerage transactions include any transaction that would be a covered transaction
under Section 23A that is provided in connection with custody, clearance and settlement,
securities borrowing or lending services, trade execution, financing, data, operational andadministrative support. Investments and ownership interests in covered funds expressly
permitted by the Volcker Rule (for example, the acquisition of up to 3% of a sponsored fund’s
total ownership) are also not prohibited, even though they might otherwise fall within theboundaries of Section 23A.
The Final Rules also require that all transactions between a covered fund and a banking entitythat serves as its investment manager, advisor or sponsor (or that organizes and offers suchcovered fund pursuant to an exemption) and all transactions between a covered fund issuer ofasset-backed securities and a banking entity that serves as the originator or securitizer of such
asset-backed securities satisfy the qualitative standard set forth in Section 23B of the Federal
Reserve Act. Section 23B generally provides that transactions between a bank and an affiliate beon “market” terms and under circumstances that are substantially the same or at least as
favorable to the bank as those prevailing at the time for comparable transactions with
unaffiliated companies. Section 23B applies broadly to most commercial transactions with anaffiliate, including prime brokerage transactions and any transaction in which an affiliate isreceiving a fee for providing services.

13

The statutory text of the Volcker Rule does not clearly prohibit transactions between a banking entityand portfolio companies controlled by the private fund. The prohibition by its terms applies totransactions by a banking entity with “the fund, or with any other hedge fund or private equity fundthat is controlled by such fund.” 12 U.S.C. § 1851(f)(1). 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 not intended 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.

Page 14

Memorandum – December 16, 2013

E.

CONFLICTS OF INTEREST AND HIGH-RISK TRANSACTIONSThe Volcker Rule prohibits any transaction that would otherwise be permissible under an
exemption to its prohibitions on proprietary trading and investing in or sponsoring private
funds that would (i) involve a material conflict of interest between the banking entity and its
clients, customers, or counterparties, (ii) result, directly or indirectly, in a material exposure by
the banking entity to a high-risk asset or high-risk trading strategy, or (iii) pose a threat to thesafety and soundness of the banking entity or the financial stability of the United States.
Consistent with the Proposed Rules, the Final Rules allow a banking entity to resolve a material
conflict of interest by (A) providing clear, timely and effective disclosure to the client, customer
or counterparty in reasonable detail and in a manner sufficient for the client, customer orcounterparty to understand and mitigate adverse effects, or (B) establishing an information
barrier that is reasonably designed to prevent the conflict of interest from materially adversely
affecting the client, customer or counterparty, provided that the banking entity may not rely on
an information barrier if it knows or should reasonably know that any given transaction may
materially adversely affect the client, customer or counterparty notwithstanding such barrier.
“High-risk” assets and trading strategies are those that, if held or employed by a banking entity,
would significantly increase the likelihood of the banking entity incurring a substantial financial
loss or would pose a threat to the financial stability of the United States.
F.

COMPLIANCE AND REPORTING MATTERS
1.

Minimum Compliance Requirements

Under the Final Rules, banking entities engaged in proprietary trading or covered fundactivities and investments will need to establish a compliance program reasonably designed toensure and monitor compliance with the Volcker Rule and related regulations. The complianceprogram must be appropriate for the types, size, scope and complexity of the banking entity’s
activities and business structure. At a minimum, the compliance program must include thefollowing elements:•

Written policies and procedures designed to document, describe, monitor and limit
proprietary trading and covered fund activities and investments;•

Internal controls to monitor compliance with the Volcker Rule;•

A management framework that delineates responsibility and accountability forcompliance with the Volcker Rule, and includes appropriate management review of
trading limits, strategies, hedging activities, investments, incentive compensationand other matters identified in the Final Rules or by management as requiring
attention;•

Independent testing and audits of the compliance program’s effectiveness, which
may be conducted either by qualified personnel of the banking entity or by aqualified outside party;

Page 15

Memorandum – December 16, 2013•

Training for trading personnel, managers and other appropriate personnel toeffectively implement and enforce the compliance program; and•Records sufficient to demonstrate compliance, which a banking entity must retain
for at least five years. The Final Rules allow the Agencies to require a banking entity
to retain its compliance records for a period of more than five years.

2.

Simplified Compliance for Smaller, Less Complex Banking Entities

The Final Rules include modifications that reduce the compliance burden on small banking
entities. While the Proposed Rules required a banking entity not engaged in any proprietary
trading or private fund activity to establish compliance policies and procedures designed toprevent the entity from becoming engaged in such activities, the Final Rules do not require anychange to the compliance program of a banking entity not engaged in any covered activities orinvestments other than investing in government obligations. Additionally, the Final Rules
allow a banking entity with total consolidated assets of $10 billion or less at the end of theprevious two calendar years that does engage in covered activities to satisfy its complianceobligations by including in its existing compliance policies and procedures appropriate
references to the Volcker Rule.
3.

Enhanced Compliance Requirements

The Final Rules maintain the requirement from the Proposed Rules that certain banking entities
meeting minimum thresholds must satisfy additional minimum standards for each element of
the compliance program. However, the Final Rules revise the minimum triggering thresholds
such that a banking entity will be subject to the enhanced compliance requirements if it has anaverage gross sum of trading assets and liabilities of at least $10 billion or total consolidated
assets of at least $50 billion (or total U.S. assets of at least $50 billion in the case of foreignbanking entities). Compared to the Proposed Rule, the Final Rules increase the threshold levelof trading assets and liabilities that will trigger the enhanced compliance requirements from $1
billion or 10% of total assets to $10 billion, and substitute the total consolidated assets test for
the Proposed Rules’ threshold of $1 billion in covered fund investments or sponsorships. The
Final Rules further reserve for the Agencies the authority to notify a banking entity that it mustsatisfy the enhanced compliance requirements even if the banking entity does not otherwise
meet the triggering thresholds.
Among other requirements, a banking entity subject to the Final Rules’ enhanced compliancerequirements must adopt a written compliance program approved by the board of directors andsenior management, and must ensure that its compliance program is periodically reviewed bysenior management. Based on a review of the banking entity, the CEO of the banking entity
must provide an annual written attestation to the relevant agency that the banking entity has inplace processes to establish, maintain, enforce, review, test and modify the compliance programin a manner reasonably designed to achieve compliance. In the case of a U.S. branch or agencyof a foreign banking entity, the attestation may be provided by the senior management officer of
the U.S. operations of the foreign banking entity who is located in the United States, and may
relate only to the U.S. operations of the foreign banking entity. Significantly, however, thisPage 16

Memorandum – December 16, 2013attestation requirement does not require the banking entity’s CEO to certify that the banking
entity is actually in compliance.
4.

Documentation for Covered Funds

The Final Rules add the requirement that banking entities that sponsor one or more funds andthat have more than $10 billion in total consolidated assets as reported on December 31 of theprevious two calendar years must document the exclusions or exemptions on which thebanking entity and the sponsored fund have relied in determining that such fund is not acovered fund under the Volcker Rule.
G.

VIOLATIONS AND ANTI-EVASION AUTHORITY

If a banking entity were to engage in any activity or make any investment in violation of the
Volcker Rule, or act in a manner that functions as an evasion of the Volcker Rule’s
requirements, the Final Rules require that the banking entity terminate the activity or dispose of
the investment promptly upon discovery of the violation. The Final Rules authorize the relevant
Agencies to take any action permitted by law to enforce compliance whenever the agency finds
reasonable cause to believe that a banking entity has violated the Volcker Rule, includingordering the banking entity to limit or terminate any or all proprietary trading activities orcovered fund investments.
The Agencies’ anti-evasion authority under the Volcker Rule is in addition to their inherent
authorities under otherwise applicable provisions of banking, securities, and commodities laws
to bring enforcement actions against banking entities, their officers and directors, and otheraffiliated parties for violations of law. For example, a banking entity that violates the Volcker
Rule may be subject to criminal and civil penalties under Section 8 of the BHC Act, formal
enforcement actions under Section 8 of the FDI Act, or safety and soundness orders under
Section 39 of the FDI Act.
H.

TREATMENT OF NONBANK FINANCIAL COMPANIES SUPERVISED BY THE
FEDERAL RESERVEThe Volcker Rule does not apply to nonbank financial institutions that are designated assystemically important by the Financial Stability Oversight Council and, as a result, are subject
to supervision by the Federal Reserve. However, Dodd-Frank requires the Federal Reserve toimpose on such companies that engage in activities prohibited by the Volcker Rule additional
capital requirements, quantitative limits, or other restrictions. The Final Rules do not address
such restrictions, which the Agencies believed would be premature in light of the fact that, todate, the Council has designated as systemically significant only three nonbank financial
institutions, two of which are affiliated with insured depository institutions and are therefore“banking entities” subject to the Volcker Rule.
**

Page 17*

Memorandum – December 16, 2013

For more information about the Final Rules and how they may impact your organization, pleasecontact any of the members of our Financial Institutions or Private Funds groups, as listed
below.
Financial Institutions
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Andy Keller(212) 455-3577
akeller@stblaw.com

Joyce Xu
(212) 455-3680
jxu@stblaw.com

Randy Benjenk(212) 455-2307
randy.benjenk@stblaw.com

Spencer Sloan(212) 455-7821
spencer.sloan@stblaw.com

Private Funds
Michael Wolitzer(212) 455-7440
mwolitzer@stblaw.com

Tom Bell(212) 455-2533
tbell@stblaw.com

Barrie Covit(212) 455-3141
bcovit@stblaw.com

Glenn Sarno(212) 455-2706
gsarno@stblaw.com

Michael Nooney(212) 455-5070
mnooney@stblaw.com

Tom Wuchenich(212) 455-7505
twuchenich@stblaw.com

Olga Gutman(212) 455-3522
ogutman@stblaw.com

Jonathan Karen(212) 455-3274
jkaren@stblaw.com

Jason Herman(212) 455-3697
jherman@stblaw.com

Page 18

Memorandum – December 16, 2013

The contents of this publication are for informational purposes only. Neither this publication nor the
lawyers who authored it are rendering legal or other professional advice or opinions on specific facts ormatters, nor does the distribution of this publication to any person constitute the establishment of an
attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability in connection with theuse of this publication.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we informyou that any tax advice contained in this memorandum was not intended or written to be used, andcannot be used, for the purpose of avoiding tax-related penalties under federal, state or local tax law.
Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independenttax advisor.

Page 19

Memorandum – December 16, 2013

UNITED STATESASIANew York

Beijing

425 Lexington Avenue

3919 China World Tower

New York, NY 10017+1-212-455-2000

1 Jian Guo Men Wai Avenue
Beijing 100004
China+86-10-5965-2999

Houston2 Houston Center
909 Fannin Street
Houston, TX 77010+1-713-821-5650

Hong Kong
ICBC Tower
3 Garden Road, Central

Los Angeles

Hong Kong+852-2514-7600

1999 Avenue of the Stars
Los Angeles, CA 90067

Seoul+1-310-407-7500

Palo Alto
2475 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

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

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

West Tower, Mirae Asset Center 1
26 Eulji-ro 5-gil, Jung-gu
Seoul 100-210
Korea+82-2-6030-3800

Tokyo
Ark Hills Sengokuyama Mori Tower
9-10, Roppongi 1-Chome
Minato-Ku, Tokyo 106-0032
Japan+81-3-5562-6200

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

www.simpsonthacher.com