The Volcker Rule Hedge Funds and Private Equity Funds Presentation by Randall D. Guynn Davis Polk & Wardwell LLP Annual Risk Management and Regulatory Examination Compliance Issues Seminar October 20, 2010
Two Key Elements of the Volcker Rule Restrictions on proprietary trading Restrictions on sponsoring or investing in hedge funds or private equity funds I will focus on the restrictions on hedge funds and private equity funds 1
What changes? What stays the same? Volcker Rule is an amendment to the Bank Holding Company Act Merchant banking and other investment powers survive QFBO exemptions for non-u.s. investments survive But investment powers are now subject to Volcker Rule Direct or indirect investments through wholly-owned subsidiaries are still permitted But investments through hedge funds or private equity funds will soon be severely limited 2
When do I have to comply? Not Effective for Two Years (July 2012) Then, 2 Years to Conform (July 2014) Up to 3 Additional Years Up to 5 Additional Years for Illiquid Funds 3
What happens next? Financial Stability Oversight Council Study Regulations implementing transition rules Regulations implementing Volcker Rule 4
What does the Volcker Rule look like? Source: The Economist 5
What is a hedge fund or private equity fund? General definition Any issuer that would be an investment company under the 1940 Act but for Sections 3(c)(1) or 3(c)(7) Similar funds designation Any similar funds designated as such by the agencies through rulemaking 6
General Definition Overbroad Any issuer that would be an investment company under the 1940 Act but for Sections 3(c)(1) or 3(c)(7) Sweeps in most traditional hedge funds or private equity funds Also sweeps in all sorts of corporate structures that have never been considered to be hedge funds or private equity funds Acquisition vehicles Joint ventures Many others 7
Oops! Did we really do that? Frank-Himes Colloquy: The general definition could technically apply to lots of corporate structures, not just hedge funds and private equity funds. We didn t intend that, did we? Absolutely, not. And we will there to make sure the regulators don t construe it that way. Dodd-Boxer Colloquy: I believe the intent of the rule was not to harm venture capital funds, is that correct? Yes, we intended to stop excessive risk-taking, not properly conducted venture capital funds. 8
Why did they choose an overbroad general definition? No generally agreed upon definition of hedge funds or private equity funds SEC and other regulatory agencies have failed in the past Characteristics and activities have evolved and expanded, and continue to evolve and expand Can t define an evolving target with a static definition 9
Does anything fall outside the general definition? Registered investment company Issuer that qualifies for any other exemption from the 1940 Act wholly owned subs that qualify under 3(b)(3) bank common trust funds [3(c)(3)] consumer finance subs [3(c)(4)] real estate finance or investment funds [3(c)(5)] public foreign funds [7(d)] employee investment funds [6(b)] similarly managed separate accounts [Rule 3a-4] asset-backed vehicles [Rule 3a-7] 10
Similar funds designations Purpose: Discretion to cover hedge funds or private equity funds not captured by general definition Volcker Rule can evolve with evolution of private funds Procedures Only by affirmative agency rulemaking Subject to public notice and comment under Administrative Procedures Act Not by order or formal or informal staff action Safe harbors: Agencies free to create safe harbors by rulemaking, order or staff action 11
What could be designated as a similar fund? Registered investment companies? Issuer that qualifies for any other exemption from the 1940 Act wholly owned subs that qualify under 3(b)(3)? bank common trust funds? consumer finance subs? real estate finance or investment funds? public foreign funds? employee investment funds? similarly managed separate accounts? asset-backed vehicles? 12
The Volcker Rule and the Uncertainty Principle 13
The Need for Safe Harbors 14
Exceptions (d)(1)(g): Organizing and offering funds if certain conditions are satisfied engaged in trust, fiduciary or investment advice organized and offered in connection with providing trust, fiduciary or investment advice to customers/clients ownership interest limited to seed capital or 3% (not more than 3% of tier 1 capital in the aggregate) comply with Super 23A no guarantee of fund s performance or obligations no name sharing no employee investments except by managers or service-providers warning about no bailouts 15
Exceptions (cont d) (d)(1)(i): acquisition or retention of ownership interest in, or sponsorship of, hedge fund or private equity fund if: permitted by 4(c)(9) or 4(c)(13); solely outside the United States; no ownership interest is offered or sold to a U.S. resident; and banking entity not controlled by entity organized under U.S. law. Open issues: What has to be solely outside the United States? What about investments in unaffiliated funds that are offered or sold to U.S. residents? Morrison v. National Australia Bank 16
Exceptions (cont d) (d)(1)(b): acquisition of securities in connection with market-making or underwriting; (d)(1)(c): risk-mitigating hedging activities; (d)(1)(e): public welfare (e.g., CRA) funds; (d)(1)(j): any other activity as the regulators determine by rulemaking would promote and protect the safety and soundness of the banking entity and the financial stability of the United States. 17
Super 23A No banking entity (including a foreign bank and its affiliates) may enter into a covered transaction with a fund that it sponsors, manages, advises or organizes and offers, or any other fund that such fund controls Exception for prime brokerage transactions with funds invested in by any sponsored, managed, advised or organized and offered fund Not effective until July 21, 2012 Does it have extraterritorial application outside the United States? Morrison v. National Australia Bank 18
Internal inconsistencies, absurd results, unintended consequences Source: The Economist 19
Internal contradictions, absurd results, unintended consequences Example of internal contradiction: Volcker Rule expressly permits de minimis investments in affiliated funds and contemplates investments by sponsored funds in other affiliated funds. Super 23A flatly prohibits any such investments because covered transactions includes any investment in securities issued by an affiliate. Example of absurd result: The prohibition on name sharing would prevent a banking entity from using the same name for a family of controlled funds, even if completely different from the name of the bhc or affiliated banks Instead, each fund would be required to have a unique name. 20
The Volcker Rule Hedge Funds and Private Equity Funds Presentation by Randall D. Guynn Davis Polk & Wardwell LLP Annual Risk Management and Regulatory Examination Compliance Issues Seminar October 20, 2010