On November 16th, the Federal Reserve Board (“Fed”) issued a proposed rule (the “Proposed Rule”) relating to the conformance periods for section 619 of Dodd-Frank, more commonly known as the “Volcker Rule.” The Volcker Rule prohibits banking entities from investing in, sponsoring, or having certain relationships with a hedge fund or private equity fund, subject to certain exceptions. Nonbank financial companies that are supervised by the Fed that engage in such activities may be subject to additional capital requirements, quantitative limits, or other restrictions, but they are not precluded, as are banking entities, from investing in, or sponsoring, a hedge fund or private equity fund. As explained further below, the Volcker Rule does not immediately come into effect and, even when it does, there may be extended periods before full compliance with the Volcker Rule is mandatory. These potential “conformance periods” are the sole subject of the Proposed Rule.
The Volcker Rule’s implementation period will commence once the Financial Stability Oversight Council (“FSOC”) completes a required study, which must be accomplished by January 21, 2011. Once the FSOC completes its study, the Fed along with a number of other agencies must then adopt implementing rules within 9 months. The restrictions and prohibitions of the Volcker Rule then would become effective 12 months after issuance of the final rules by the agencies, or July 21, 2012, whichever is earlier. (Note that we anticipate the Volcker Rule will become effective on July 21, 2012 because the final rules are not required to be issued until October 21, 2011.) Once the restrictions and prohibitions of the Volcker Rule become effective, however, banking entities and nonbank financial companies will have a period of time to bring their affected activities into conformance with the rule. This conformance period generally extends through the date that is two years after the date on which the prohibitions become effective or, in the case of a nonbank financial company supervised by the Fed, two years after the company is designated by the FSOC for supervision by the Fed, if that period is later. In addition to the statutory conformance period of two years, the Volcker Rule permits the Fed to extend the conformance period by up to three additional one-year periods, for an aggregate conformance period of five years. In the case of illiquid funds, the Fed may extend the conformance period for an additional five-years beyond the three one-year extensions, for an aggregate conformance period of 10 years (including the two-year statutory conformance period).
Extension of Conformance Period
The Fed, by rule or by order, generally may extend the two-year conformance period by up to three additional one-year periods, for an aggregate conformance period of five years. For each additional extension of one year, a banking entity must submit a request to the Fed: (1) in writing at least 90 days prior to the expiration of the applicable time period; (2) provide the reasons why the extension should be granted; and (3) provide a detailed explanation of the banking entity’s plan for divesting or conforming the investment(s). Once the request is submitted, the Fed must determine that the extension is consistent with the purposes of the Volcker Rule and would not be detrimental to the public interest. If an extension is granted, the Proposed Rule would allow the Fed to impose any additional conditions on the extension that the Fed finds appropriate.
Extended Transition Period for Illiquid Funds
Banking entities that may experience difficulty in conforming investments in illiquid funds in the initial five-year extended conformance period may request that the Fed extend the conformance period by an additional five years in order to permit the banking entity to meet contractual commitments in place as of May 1, 2010 to a hedge fund or private equity fund that qualifies as an “illiquid fund.” Specifically, the Volcker Rule provides the Fed the authority to extend the period during which a banking entity may take or retain an ownership interest in, or otherwise provide additional capital to, an illiquid fund, but only if the extension is necessary to allow the banking entity to fulfill a contractual obligation that was in effect on May 1, 2010. The banking entity would apply for an extended transition period for illiquid funds in the same manner as a general extension request. The Fed may only grant one extended transition period with respect to any illiquid fund.
For a banking entity to qualify for the extended transition period for illiquid funds, it must meet two sets of criteria. The first set of criteria focuses on the nature, assets and investment strategy of the hedge fund or private equity fund itself. The second set of criteria focuses on the terms of the banking entity’s investment in the hedge fund or private equity fund.
The Proposed Rule defines an “illiquid fund” to mean a hedge fund or private equity fund that: (i) as of May 1, 2010, was principally invested in illiquid assets, or was invested in, and contractually committed to principally invest in, illiquid assets; and (ii) makes all investments pursuant to, and consistent with, an investment strategy to principally invest in illiquid assets. To determine whether a fund is an illiquid fund, the Proposed Rule defines several terms or phrases, including: “illiquid asset,” “principally invested” in illiquid assets, “contractually committed to principally invest” in illiquid assets,” and “investment strategy to principally invest” in illiquid assets.
The Proposed Rule defines illiquid asset indirectly, by defining what is a liquid asset. In those terms, any asset that is not a liquid asset is an illiquid asset. The definition of liquid asset is designed to capture the wide range of instruments and assets that a hedge fund or private equity fund would actively or routinely trade on markets or trading facilities, including equity and debt securities, derivatives, commodity futures, and instruments with a short-term duration that can be monetized or converted at maturity into a liquid asset. The Proposed Rule also grants the Fed the authority to determine that any other asset is a liquid asset, based on all the facts and circumstances.
The Proposed Rule does, however, treat as illiquid assets investments in portfolio companies, investments in real estate, venture capital investments, and investments in other non-publicly traded hedge funds or private equity funds that invest in illiquid assets. The Proposed Rule also provides that an asset—including a liquid security—may be considered an illiquid asset if, because of statutory or regulatory restrictions, the asset is precluded from being traded. However, the asset would only be considered illiquid for as long as the relevant statutory or regulatory restriction is applicable.
The Proposed Rule provides that a hedge fund or private equity fund will be “principally invested” in illiquid assets only if at least 75 percent of the fund’s consolidated assets are, or are expected to be, comprised of illiquid assets or risk-mitigating hedges entered into in connection with, and related to, individual or aggregated positions in, or holdings of, illiquid assets. The Proposed Rule includes risk-mitigating hedges in the 75 percent equation because they are definitionally associated with the fund’s illiquid holdings.
“Contractually Committed to Principally Invest”
A fund will be considered to be “contractually committed to principally invest” in illiquid assets as of May 1, 2010, if the fund’s organizational documents (e.g., limited partnership agreement), or other contractual documents (e.g., binding side letter agreement) that was in effect as of May 1, 2010, provide for the fund to be principally invested in illiquid assets during the period beginning on the date when capital contributions are first received by the fund for the purpose of making investments and ending on the fund’s expected termination date.
“Investment Strategy to Principally Invest”
Under the Proposed Rule, a fund would be considered to have an “investment strategy to principally invest” in illiquid assets if the fund either: (i) markets or holds itself out to investors as intending to principally invest in illiquid assets; or (ii) has a documented investment policy of principally investing in illiquid assets.
Banking Entity’s Investment-focused Criteria
A banking entity’s interest in a hedge fund or private equity fund qualifies for the extended transition period for illiquid funds only if the banking entity’s retention of that ownership interest in the fund, or provision of additional capital to the fund, is necessary to fulfill a contractual obligation of the banking entity that was in effect on May 1, 2010. A banking entity will be considered to have a “contractual obligation” if it is prohibited from both: (i) redeeming all of its equity, partnership, or other ownership interests in the fund; and (ii) selling or otherwise transferring all such ownership interests to a person that is not an affiliate of the banking entity. In addition, the Proposed Rule specifies that a banking entity has a “contractual obligation” to provide additional capital to an illiquid fund only if the banking entity has a contractual obligation in effect as of May 1, 2010, to provide additional capital to the fund. Finally, a banking entity only will be considered to have a “contractual obligation” if (i) the obligation cannot be terminated by the banking entity under the terms of the agreement with the fund and (ii) to the extent that the obligation may be terminated with the consent of other persons, the banking entity has used reasonable best efforts to obtain such consent and the consent has been denied.
Nonbank Financial Companies
The Volcker Rule provides that the Fed or other appropriate agency impose additional capital charges, quantitative limits, or other restrictions on nonbank financial companies supervised by the Fed or their subsidiaries, but it does not prohibit them from having investments in, or relationships with hedge funds or private equity funds. Nonbank financial companies, however, will also have a two-year period to conform with the additional restrictions after the date the company is determined to be a nonbank financial company supervised by the Fed by the FSOC. Similarly to banking entities, the Fed can extend the two-year conformance period by up to three additional one-year periods. The same procedures for submitting a request apply to nonbank financial companies as they do to banking entities.
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