PRIMER: the Volcker Rule – covered funds

Author: John Crabb | Published: 29 Jun 2018
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Two of the main provisions of the Volcker rule prohibit banking entities from proprietary trading, and from attaining or retaining an ownership interest in or sponsoring of a covered fund. This primer will look at the covered fund specific aspects of the rule, go here for a more general account of the Volcker rule from IFLR, or here for a look at proprietary trading.

What are covered funds?

A covered fund under the Volcker Rule is an entity that (i) relies on section 3(c)(1) or 3(c)(7) of the Investment Company Act; (ii) is a commodity pool whose operator relies on CFTC Rule 4.7 (and certain similar pools); or (iii) a foreign fund that either relies on section 3(c)(1) or 3(c)(7) with respect to US investors or satisfies other criteria.

Loosely put, the Rule defines a covered fund as anything not considered an investment company in the Investment Company Act, including private equity and hedge funds, as well as commodity pools with certain exclusions, and funds sponsored by a US banking entity where the affiliate holds ownership interests.


"It's not an easy definition to navigate. So, it's unhelpful to ignore and not deal with the Treasury report recommendations and fail to address this very basic definition"


Similarly to proprietary funds, the Volcker Rule prevents banking entities and insured depository institutions from investing, or owning, any assets into covered funds or vehicles, suggesting that this sort of activity incorporates too much risk and does not benefit the customer base.

"A banking entity may not, as principal, directly or indirectly, acquire or retain any ownership interest in or sponsor a covered fund," reads the Rule.

What are the exclusions?

The Rule provides for several exclusions that fall into the covered funds category, and that as such are not subject to the Volcker Rule. These include foreign public funds, wholly-owned subsidiaries, joint ventures, acquisition vehicles, securitisation related vehicles, funds regulated under the 1940 Act such as mutual funds, exchange traded funds or business development companies, foreign pension or retirement funds, insurance company separate accounts, small business investment and finally entities used by the Federal Deposit Insurance Corporation to dispose of assets as receiver or conservator.

What is the problem with covered funds?

The aforementioned list is fairly extensive, which leaves a lot of room for objections, loopholes and debate. It is a lawyer’s paradise, according to Simpson Thacher, partner Keith Noreika. He told IFLR in an interview during his time as the acting Comptroller of the Currency at the Office of the Comptroller of the Currency (OCC) that "it is entirely an odd construct that can be maneuvered around with skilled lawyering, I’m not sure why we have it other than to keep lawyers fully employed. An observation as a policy maker that I think we have to be mindful of, we shouldn’t just have useless compliance exercise".

For the June edition of magazine, IFLR surveyed a number of in-house counsel and compliance officers at major banks to identify some of the current issues with the Volcker Rule. One of the questions posed to respondents was if the definition of covered funds remains unchanged, whether they thought exclusions or additional exclusions should be amended. Around 70% suggested that the exclusions should be indeed be amended.

"We tend to use more laymen terms, and rules that are closer to the industry, than use difficult to understand legal terms to define some like this," said one overseas control officer.

"It should be more laymen in this sense. Making it more layman is the difficult part, private equity funnels, hedge fund, there must be some tax definitions – even that or sticking to the legal rules. Of course it will be more up to the regulators themselves to strike a balance," he explained.

The policy objective was aimed at hedge funds and private equity funds. The actual definition has been seen as bringing in more than what was intended and has created some confusion. It is a highly contested issue, but if a way was found to simply say that banking entities should not be permitted to invest more than a certain amount in hedge funds or in private equity, this could address the concern.

Volcker newReferring to the foreign fund aspects of the Rule, one respondent, a Volcker control officer at a major foreign bank, said that many banking institutions operate under a global universal banking model, which as an entity that operates outside the US it is difficult to adapt to. "Whatever entities may relate to the US, we can adopt this exemption, but it is counterintuitive. They all have their pros and cons," he said.

There is always a difference between how the rules are crafted and what expectations they put on institutions. With this many definitions there is always room for modification in the expectations that the agency would have for institutions. Certain institutions will have to go through the process of scrubbing their portfolios and justifying that they don’t include any covered funds, to avoid engaging in any impermissible trading activities to prove they are compliant.

What about the definition of banking entity?

The definition of what constitutes a banking entity is also up for debate. The definition is broad and covers not only banks but also their affiliates and subsidiaries. Some suggest narrowing the definition to apply only to banks that are systemically important to the US financial system and some call for the it to apply only to US banks and their US affiliates and subsidiaries.

Laura Biddle, counsel at Hogan Lovells, suggests that the definition is picking way too much up in its scope in the rest of the world, when it is really having no effect on what is happening in the rest of the US, which was unintentional.

"I would it amend it to include banks and bank holding companies and affiliates in the US, and foreign banking organisations to the extent that straight down the line to the US entity or affiliation it is not creating a lot of difficulty," she said.

Another general counsel, this time at a foreign bank, does not advocate changing the definition. "All regulations need definitions and carve outs. It makes sense for some senior rates to include that, I don’t think right now when firms complain that Volcker is unclear, it is anything to do with the banking entities. I think that part itself, there is no problem."

So, what steps are being taken to simplify things?

Since the change of administration in 2016 there have been great steps taken to deregulate the financial industry. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which contains the text of the Volcker Rule within its 2,300 pages, is enemy number one as far as the administration is concerned, and Volcker is no exception. Most recently, the Federal Reserve Board has introduced a number of proposals to revamp the Rule, which generally somewhat further than expect but were well received. This is in part due to the fact that rather than repeal much of it, they have attempted to simplify it. All proposals are out for comment, and any changes will have to be ratified by all of the five agencies that regulate Volcker.

One thing that immediately becomes apparent throughout the document, however, is that there are more questions than there are answers. The Fed posed a lot of questions and asked for comment on those, but with respect to the actual proposals that are in there they seem to be fairly modest, said Mark Nuccio, Ropes & Gray partner. The covered funds section specifically leaves a lot open. "They asked a lot of questions. They are opening the door for a more technical review of the scope of that section - for entities that are either trying to invest in some kind of complex fund like item or those that are creating those," he said.

"The proposal would modify these requirements with respect to covered fund ownership interests for third-party covered funds to generally allow for the same types of activities as are permitted for other financial instruments. The proposal would also expand a banking entity’s ability to engage in hedging activities involving an ownership interest in a covered fund," reads the Fed paper.


"Whatever entities may relate to the US, we can adopt this exemption, but it is counterintuitive. They all have their pros and cons"


For Anna Pinedo, partner at Mayer Brown, the covered fund proposals were an area of disappointment. The Treasury report that addressed the banking sector in 2017 had many more suggestions on how to rework covered funds, including looking at its definition, and then when the OCC requested comments on possible changes to Volcker, a lot of the requests for comment related to covered funds.

"Then in the amendments to Volcker there wasn’t actually a specific change to the definition of covered funds," she said. "We continue to have this very legalistic definition of covered fund that refers to Section 3(c)(1) or 3(c)(7), and honestly most foreign non-US lawyers are not all that familiar with the Investment Company Act, are not necessarily familiar with Section 3(c)(1) or 3(c)(7) and aren’t familiar with the other exemptions under the US Investment Company Act."

"I don’t think it is a very easy definition to navigate. So, I don’t think that is helpful to ignore and not deal with the Treasury report recommendations and fail to address this very basic definition," she added. "It's helpful that the agencies requested comments, but when are we going to see actual changes? It is disappointing that there wasn’t more there on covered funds."

See also

  PRIMER the Volcker Rule – proprietary trading

PRIMER the Volcker Rule