The Volcker Rule- What It Means for Bank Investment In or Sponsoring of Hedge Funds or PE Funds

J. Bradley Boericke at Pepper Hamilton LLP

Original Title: The Volcker Rule: What It Means for Bank Investment In or Sponsoring of Hedge Funds or Private Equity Funds


The so-called Volcker Rule included in the Dodd-Frank Wall Street Reform and Consumer Protection Act will significantly limit the ability of financial institutions to invest in or sponsor hedge funds or private equity funds, effectively undoing much of the flexibility that was created under the Gramm-Leach-Bliley Act.

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What Is the Volcker rule?

The Volcker Rule is embodied in Section 619 of the Dodd-Frank Act, which adds a new Section 13 to the Bank Holding Company Act. The Volcker Rule broadly prohibits any banking entity:

  • engaging in proprietary trading; or
  • having an ownership interest in or sponsoring a hedge fund or private equity fund.

Who Is Covered?

The Volcker Rule prohibitions apply to any "banking entity," which is defined as any of the following:

  • an insured depository institution
  • any company that controls an insured depository institution
  • any entity that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978
  • any affiliate or subsidiary of any such entity.

The Dodd-Frank Act also provides for nonfinancial institutions that are determined to be systemically significant to be supervised by the Federal Reserve Board. Nonfinancial institutions supervised by the Federal Reserve Board are not subject to the outright prohibitions of the Volcker Rule, but will be subject to additional capital requirements and quantitative limits as established by regulation.

When does the Volcker Rule go into effect?

Within six months after enactment, the new Financial Stability Oversight Council is required to complete a study and make recommendations on implementing the Volcker Rule provisions, and within nine months after completion of this study the appropriate regulatory agencies (the banking regulators, the Securities and Exchange Commission and the Commodities Futures Trading Commission) are required to adopt coordinated regulations. The Volcker Rule goes into effect on the earlier of 12 months after adoption of such regulations or two years after the date of enactment.

Once the Volcker Rule goes into effect, entities subject to the rule have a two year divestiture period to bring their activities and investments into compliance. The Federal Reserve Board may extend the divestiture period by rule or order in one-year increments, not to exceed an aggregate of three years. In addition, the Board may extend the period when a banking entity may take or retain an ownership interest in or otherwise provide capital to an illiquid fund, to the extent necessary to fulfill contractual obligations entered into before May 1, 2010, but any extension must not exceed five years. The Board is required to adopt regulations implementing the divestiture provisions separately from the coordinated rulemaking discussed above, within six months following the date of enactment.

Organizing and Offering a Private Equity or Hedge Fund

An exception allows banking entities to organize and offer a private equity or hedge fund as a product for their clients, if the banking entity provides bona fide trust, fiduciary or investment advisory services, and the fund is organized and offered in connection with the provision of those services and only to customers of such services of the banking entity.

In this context, the sponsoring banking entity may serve as a general partner, managing member or trustee of the fund and may select or control (or have employees, directors or agents who constitute) a majority of the directors, trustee or management of the fund.

The organizing banking entity may provide seed capital to the fund, but the amount of all such investments cannot exceed 3 percent of Tier 1 capital at any time (or such lower limit as may be set by regulation as an "immaterial" amount), and within one year after establishing the fund the investment of the institution must be below 3 percent of the total ownership interests of the fund.

In addition, a number of restrictions apply to the relationship between the banking entity and the fund, including:

  • the banking entity cannot extend credit to or enter into any other "covered transactions" under Section 23A with the fund
  • the banking entity may not guarantee or insure the obligations or performance of the fund
  • the fund must not share the same name or a variation of the same name with the banking entity for corporate, marketing, promotional or other purposes
  • no director or employee of the banking entity may have an ownership interest in the fund except for directors and employees directly engaged in providing investment advisory or other services to the fund
  • the banking entity must disclose to investors that any losses in the fund are borne solely by the investors in the fun and not by the banking entity.

Investing In a Private Equity or Hedge Fund

The Volcker Rule leaves only very limited authority for a banking entity to invest in private equity or hedge funds for its own account.

Subject to any restrictions or limitations which may be imposed by regulation, an exception is provided for investments in one or more Small Business Investment Companies to the extent otherwise permitted, and accordingly, SBICs can be expected to take on renewed significance for banking entities. Under the SBIC Act and related provisions, banks and bank holding companies are generally permitted to invest in SBICs up to 5 percent of their capital and surplus. (See related article online at aspx?ArticleKey=1883.)

The Volcker Rule exception also covers investments designed primarily to promote public welfare as described in paragraph 11 of the National Bank Act, or investments pursuant to certain historic tax credit programs.

Investments solely outside the United States are permitted for a foreign banking entity that is not a subsidiary of a U.S. banking entity, but only if no ownership interest in the hedge fund or private equity fund is offered or sold to a resident of the United States.

Regulators also have authority to approve other activities as part of their coordinated rule making if they determine such activity "would promote and protect the safety and soundness of the banking entity and the financial stability of the United States."

The Impact of the Volcker Rule Will Depend on the Rule- Making Process

The ultimate effect of the Rule will depend on the coordinated regulations that come out of the required rulemaking process. Key matters left to the regulators to determine include:

  • any further exceptions to the prohibitions of the Volcker Rule
  • additional capital requirements and/or quantitative limitations to be imposed on any activities permitted as an exception under the Volcker Rule
  • possible limitations on the statutory exceptions to the Volker Rule, including to address material conflicts of interest, material exposure to high risk assets or trading strategies; and threats to the safety and soundness of the banking entity or to the financial stability of the United States.

Given the political climate and the statutory directives that will guide the regulations under the Volcker Rule, there may not be much hope for dramatic liberalization through the rule-making process. And pending the outcome of the rule-making process, fund raising and new fund formation may be significantly affected as banking entities may be reluctant to commit new funds to any private equity or hedge funds.

J. Bradley Boericke, Partner,

J. Bradley Boericke is a partner of Pepper Hamilton LLP and a member of the Financial Services Practice Group in the Commercial Department, working from London and Philadelphia. He focuses his practice on complex financing transactions, including leveraged acquisition financing, securitization and other structured financing, and restructurings and DIP financing.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Pepper Hamilton LLP.