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.
Sound off on this buzz in the Comments Section.
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:
Who Is Covered?
The Volcker Rule prohibitions apply to any "banking entity," which is defined as any of the following:
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:
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 http://www.pepperlaw.com/publications_update. 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:
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
Pepper Hamilton LLP
Pepper Hamilton LLP is a multi-practice law firm with more than 500 lawyers nationally. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world.
Our firm has grown from a two-person law office formed in 1890 in Philadelphia to a sophisticated, large law firm with a national and international practice. While much about Pepper Hamilton is new and different from its beginnings, we retain traditional values passed down through the decades: respect for the rule of law, pride in an excellent work product and commitment to the client's cause. Today, Pepper Hamilton is a diverse firm of men and women from a broad spectrum of backgrounds, united in these values.
Pepper Hamilton's Funds Services Group counsels sponsors, managers, advisers and investors from all over the United States, and globally, regarding the complex structuring, operational, and regulatory challenges they face on a daily basis in the investment management business. Honed from representing hundreds of pooled investment vehicles over the course of more than two decades, our judgment and experiences enable us to help clients successfully navigate the legal landscape in which investment managers are required to operate.
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.