Volcker Agencies Provide Guidance Regarding Treatment of Registered Funds and Foreign Public Funds During Their Seeding Period
As the general July 21, 2015 deadline approached to conform with the implementing regulations (Final Rules) for the Volcker Rule, a key issue remained with respect to the sponsoring, organizing and seeding of investment companies registered under the Investment Company Act of 1940 (1940 Act) (Registered Funds) and foreign public funds (FPFs).
The preamble (Adopting Release)1 to the Final Rules created uncertainty as to whether such funds would be treated as banking entities – and therefore be subject to unworkable restrictions on proprietary trading under the Volcker Rule during an initial seeding period when a banking entity sponsor is likely to own more than 25 percent of a fund’s outstanding voting shares. On July 16, 2015, the staff of the five agencies responsible for implementing the Volcker Rule (Agencies)2 released Frequently Asked Question #16 (FAQ) providing some guidance – but no clear bright line – as to when newly formed Registered Funds or FPFs might be deemed banking entities during their initial seeding period.3 Based on references to other seeding periods in the Final Rules, it appears that the staff of the Agencies would allow a seeding period of three years, and possibly more, for Registered Funds and FPFs.
The Volcker Rule’s restrictions on “proprietary trading”4 and sponsoring or investing in “covered funds”5 generally apply only to banking entities. A “banking entity” is defined broadly, however, to include not only depository institutions and companies that control them, but also foreign banks that have branch or agency offices in the United States and any affiliate of such a banking entity.6 An “affiliate” of a banking entity is defined by reference to the Bank Holding Company Act (BHC Act) and the FRB’s Regulation Y, which provide that a company that controls, is controlled by, or is under common control with, another company is an affiliate of that other company. Thus, if a banking entity were deemed to “control” a Registered Fund, then that Registered Fund itself could be viewed as a banking entity subject to the Volcker Rule. The uncertainty regarding a Registered Fund’s7 status as a banking entity stems from ambiguity in the Final Rules’ treatment of newly formed funds. The Final Rules exclude from the definition of “covered fund” both Registered Funds and any issuer that would otherwise be a covered fund but is formed and operated pursuant to a written plan to become a Registered Fund (a “seeding vehicle”).8 The Final Rules effectively allow seeding vehicles a one-year initial seeding period (with the possibility for two separate one-year extensions) through a cross-reference to the time period in which a banking entity must reduce its seed capital investment in a covered fund.9 While the Final Rules do not expressly state that a seeding vehicle would not be a banking entity, the Adopting Release states that a seeding vehicle would not be viewed as violating the requirements of the Volcker Rule during the seeding period so long as it is operating pursuant to the written plan.10
Unfortunately, the Final Rules do not take into account that most new Registered Funds are seeded by their sponsor only after the fund is initially registered under the 1940 Act. While the entire discussion of seeding vehicles in the Final Rules evidences the Agencies’ intent to permit banking entities to provide seed capital to Registered Funds, the lack of consideration of the impact of seed capital contributed or held after an investment company becomes a Registered Fund raises concerns that seed capital investments might cause a Registered Fund to be treated as a “banking entity” – and thus, directly subject to the Volcker Rule’s restrictions on proprietary trading.
Importantly in this respect, “control” under the BHC Act is defined to include the ownership or control of 25 percent or more of a company’s outstanding voting securities, as well as the ability to exercise a controlling influence over a company. Moreover, the Adopting Release indicates that ownership by a banking entity of 25 percent or more of a Registered Fund’s voting securities would generally cause the banking entity to control the Registered Fund, thereby resulting in the Registered Fund being a banking entity.11
There is a clear need for a seeding period for new Registered Funds – during which they would not be considered banking entities – because the prohibition on engaging in proprietary trading effectively would prevent a Registered Fund from implementing its investment strategy. The length of the seeding period is also key, given the importance of a meaningful track record (generally three years) before a Registered Fund will be recommended by most consultants or allowed on most fund platforms.
This uncertainty about the status of Registered Funds as banking entities, as well as the importance of an adequate seeding period, has led to numerous discussions between the staff of the Agencies and the Registered Fund industry – culminating in the FAQ, which provides in relevant part:
Staff of the Agencies would not advise the Agencies to treat a [Registered Fund] or FPF as a banking entity under the implementing rules solely on the basis that the [Registered Fund] or FPF is established with a limited seeding period, absent other evidence that the [Registered Fund] or FPF was being used to evade [the Volcker Rule] and the [Final Rules]. The staffs of the Agencies understand that the seeding period for an entity that is a [Registered Fund] or FPF may take some time, for example, three years, the maximum period of time expressly permitted for seeding a covered fund under the implementing rules. The seeding period generally would be measured from the date on which the investment adviser or similar entity begins making investments pursuant to the written investment strategy of the fund. Accordingly, staff of the Agencies would not advise the Agencies to treat a [Registered Fund] or FPF as a banking entity solely on the basis of the level of ownership of the [Registered Fund] or FPF by a banking entity during a seeding period or expect an application to be submitted to the Board to determine the length of the seeding period (emphases added).
The FAQ reflects a welcome level of flexibility on the part of the staff of the Agencies with respect to the seeding period for Registered Funds and FPFs. Importantly, the FAQ recognizes that the seeding period may take an indeterminate amount of time. Moreover, by citing three years as an example – and not the outer limit – of an acceptable seeding period, the FAQ both establishes a presumption that a three-year seeding period will (and suggests a possibility that a longer seeding period may) be acceptable, provided, of course, that there is no evidence that the Registered Fund or FPF is being used to evade the Volcker Rule’s requirements. Similarly, by stating that the staff of the Agencies would not expect a banking entity that sponsors a Registered Fund to submit an application to determine the length of the seeding period, the FAQ endorses the view that it should not be necessary for Registered Funds and FPFs (unlike covered funds) to seek extensions of the seeding period.
1) 79 Fed. Reg. 5536 (Jan. 31, 2014).
2) The Agencies are the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System (FRB), Federal Deposit Insurance Corporation, Securities Exchange Commission, and Commodity Futures Trading Commission.
3) The FAQ is available here. The Agencies also recently released two other important FAQs. FAQ #14 addresses how the Volcker Rule applies to FPFs sponsored by banking entities that, because of local practices, select a majority of the FPF’s directors; FAQ #15 clarifies the circumstances under which an issuer may rely on the “joint venture exclusion” from being a covered fund.
4) “Proprietary trading” is defined as engaging as a principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments. A “trading account” is an account used by a banking entity to purchase or sell one or more financial instruments principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements). For a more detailed explanation of the Volcker Rule and the Final Rules, please see Dechert OnPoint, Volcker Rule Regulations Issued: Understanding the Practical Implications for U.S. and Foreign Banking Entities, Funds and Securitization Vehicles.
5) The Final Rules define a “covered fund” to include: an issuer that would be an investment company under the 1940 Act but for Section 3(c)(1) or Section 3(c)(7) of the 1940 Act; and certain “commodity pools” under the CFTC’s regulations. See Final Rules §__.10(b)(1).
6) See Final Rules §__.2(b). Excluded from the definition of “banking entity” are covered funds (supra note 5) that are not, and do not control, an insured depository institution.
7) References to Registered Funds also generally apply to similarly situated FPFs. Although the Final Rules do not directly extend the concept of a seeding vehicle to an FPF, in FAQ #5, the staffs of the Agencies provided that seeding vehicles for FPFs should be treated as equivalent to seeding vehicles for Registered Funds.
8) See Final Rules §__.10(c)(12)(i).
9) See Final Rules §__.20(e)(3).
10) See Adopting Release at 5676-5677 (text accompanying note 1740).
11) See Adopting Release at 5676 (citing prior interpretive guidance from the FRB, the Adopting Release also indicates that a bank holding company under certain circumstances may own less than 25 percent of a class of voting shares of a Registered Fund and provide investment advisory and other services to the fund without being deemed to control the fund). It should be noted that one of the authorized activities for a financial holding company is the organizing, sponsoring and managing of a mutual fund – so long as the fund does not exercise managerial control over the entities in which the fund invests, and the holding company reduces its ownership (if any) in the fund to less than 25 percent of the equity of the fund within one year of sponsoring the fund (or such additional period as the FRB permits). 12 C.F.R. § 225.86(b)(3).