FacultyFaculty/Author Profile

The Volcker Rule - Funds


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SPEAKER 1: Which focuses on funds. Our panelists today, to my immediate left, and question asker on the prior panel is Yosef Ibrahimi, who's a director in the General Counsel department of Credit Suisse. He's lead bank regulatory lawyer for Credit Suisse's Asset Management business, and advises on Bank Holding Company Act, Volcker Rule, and other issues that have emerged from Dodd-Frank.

And on his left is Satish Kini, who's a partner at Debevoise and Plimpton. He's head of the Banking group, and a member of its Financial Institutions group. He advises on a wide range of regulatory and transactional banking issues, including Dodd-Frank, Volcker Rule, and related issues.

And we have on our far left, Whitney Chatterjee, who's a partner Sullivan and Cromwell in the firm's investment management and financial services groups, and serves as the head of the Alternative Investment Management sub-practice. She also advises on investment management issues and Volcker issues, as well. Whitney is going to have to leave us before the panel is over today. But graciously agreed to join us for the time she can spare.

As a reminder, just to remark on Derek's point. The statements here are not for attribution or quotation. And with that, I will turn it over to the panel.

WHITNEY CHATTERJEE: Great. Thank you very much. I am going to kick off and just kind of provide a bit of an overview. I understand there are people in the audience both with a depth of experience in Volcker, and others not as much. But with that in mind, just taking a step back, and looking at the covered funds provisions and their origin and significance, including in the current environment as to where we are. Unlike the prop trading section, the legislative history and specific rationale for the covered fund provisions, which prevent a banking entity from sponsoring or investing in a hedge fund or private equity fund, a so-called covered fund, is a little less clear, or at least a little less full in the record than the prop trading provisions.

What is relatively clear is that by prohibiting a banking entity from sponsoring or investing in a hedge fund or private equity fund, Congress was attempting to eliminate the ability for a banking entity to be exposed to or engage in what would otherwise be viewed as risky prop trading activities through fund vehicles. And then in addition, as evidenced in particular by the prohibition on bailing out a sponsored fund, there was a concern that banks would expose themselves to risk by stepping in and bailing out fund vehicles that they sponsor.

This is an important backdrop, I think, in considering the issues that we face now, as we're sort of through the conformance period, and dealing with the rule, and people living with the rule, and with the prospect of changes to the rule, as to what is practical and impractical about the definition of covered fund. And so I'm sure there's a lot we can talk about on that front, but I'll start with the most obvious, which is that the definition refers to section 3(c)(1) and 3(c)(7) of the Investment Company Act, both of which are tests that are not based on what activities a fund is engaged in, and therefore in and of themselves have nothing to do with risk, but is based on who the owners of the vehicles are, and what kind of offering that vehicle's conducted.

So commonly these are used for hedge funds and private equity funds, without a doubt. But they are unfortunately used for lots and lots of other vehicles. And this is something that has been widely discussed in comments, even in the proposed rule phase. And it's very well known to the regulators and to the industry that that is a challenge. There have been a couple of issues associated with whether the regulators have scope to change that. We'll come to that in a minute.

But before even getting to that, just to make sure that the full scope of the issues are understood, the ICA, the Investment Company Act, has very limited exceptions, which have somewhat limited utility and impose meaningful constraints, particularly in the context of asset management businesses, and customer-driven businesses that banking organizations would regularly engage in. Satish will talk about what some of the exceptions are that have been created in the Volcker Rule itself in recognition of those limitations. But nevertheless, I think the experience has been, for our clients, certainly that there is really an inordinate amount of time spent analyzing legal entities and performing investment company status tests on those entities to try to figure out whether or not they're covered funds.

In addition to that, Investment Company Act test referencing 3(c)(1) or 3(c)(7), the rule picks up for an equivalence for US banking entities that have involvement in them, and also picks up commodity pools for which a CPO has claimed 4.7 exemption, or that could qualify for that if offered to QEPs. Again, given the expansive definition of commodity interest, like the expansive definition of securities for 40 Act purposes-- which, of course, in the context of commodity interests was expanded under Dodd-Frank-- and the limited exceptions available, this also has the effect of sweeping in a lot of pooled vehicles into the definition of covered fund.

So I think people obviously have a lot of things that are subject to this, and therefore are living with the other restrictions associated with covered funded status. Maybe we can talk about potentially what a proposed scope there is for change, which may fall because the statutory definition specifically says that it's something that would be an investment company, but for 3(c)(1) or 3(c)(7) or such similar funds as the agencies determine.

For reasons I think we'll elaborate on during this panel, we think that that gives the agencies broad scope to identify characteristics or particular features of those funds in addition to 3(c)(1) or 3(c)(7). For example, engaged in what otherwise would be prop trading activity that would help limit the scope of that definition in a way that would make it easier for banking entities to live with.

SATISH KINI: I think this has been, as Whitney rightly says, this has been a hot topic in the covered fund section of the Volcker Rule and the implementing regulations. And how to deal with this very expansive language has been something that there has been lots of comments on, and trying to try and find a way to narrow it. One of the things that the agencies traditionally have said is that they're bound by this language. And yet, they've created exceptions for the language within the implementing regulations.

So on the one hand, they say they're bound by it and can't create a lot of flexibility in how they interpret it. On the other hand, that they have seen a way to interpret certain exceptions. So one would hope that they'd be able to find a way to narrow the scope of the term covered fund to be more proportional to what is actually intended in the rule. And we'll have to see if any Volcker 2.0 captures any of that.

WHITNEY CHATTERJEE: I mean, maybe it's a good time to talk about what some of those particular exceptions are that they did find scope to put in. I think-- and I can certainly provide additional examples of how much is swept in. But maybe we should focus on what's not.

SATISH KINI: Sure. So as Whitney said, the coverage fund definition in the implementing regulations is very broad. And what the agencies then did in recognizing that it did go to broadly is carve out numerous exceptions from the definition of covered fund. And what that means is that the game under the covered funds section of the Volcker Rule is all about categorization. Does it fit within one of these different buckets? So you can get out of the-- well, first off, is that a vehicle that relies on 3(c)(1) or 3(c)(7) to avoid the Investment Company Act? If you can say it doesn't, then you don't have a covered fund.

Second, even if it does, can you fit it within one of the buckets of exceptions that has been created? And there are a number of them. And we won't walk through all of those, because many of you probably have lived and breathed many of them. But it is, as I said, a categorization exercise.

One of the tricks, however, has been covered funds are excluded from the definition of banking entity. And if you fall into an exception, either by accident or on purpose, then you can get swept back into the definition of banking entity. So what that means is if you have a vehicle that's not a covered fund, you can avoid the restrictions on investing in and having different types of transactions with that vehicle. But if the vehicle itself is swept back into the definition of banking entity, then the Volcker rules, trading restrictions, and investing in other covered funds restrictions applies at that vehicle level.

So you have a little bit do that categorization, and then you may have to, as well, do a little bit of picking your poison, as to which of the two devils you'd rather wrestle with. Some of the exceptions that-- maybe just to spend a little bit of time on particular ones that we've seen pose challenges, or have been causing some issues.

One has been a wholly owned subsidiaries. So these are subsidiaries that, as the name suggests, are wholly owned. Except they may be held up to 5% by employees or directors of the banking entity. And then in addition, up to 0.5% may be held by a third party for corporate separateness or other similar reasons.

The interesting thing that's happened that we've seen as a marketplace trend-- and I don't know Yosef, and Whitney, you've seen this, as well. Is some investors have said, if they're forming a fund of one, we do not want this vehicle to be only us. And they'll insist that the sponsor or someone else at least have a point 0.6% so that they can make sure that they don't fall into the wholly owned subsidiary exception to the definition of covered fund. They'd rather have that vehicle be a covered fund. So it's something, again, another little tightrope that some institutions have felt the need to cover.

Similarly, there's exceptions for foreign public funds, which has been defined, and we'll talk about that a little bit later in this panel. But these are funds that were designed to be analogs of US registered investment companies, which also are excepted out from the definition of covered funds. But foreign public funds are defined to be organized outside the United States, authorized to sell ownership interest to retail investors in the home jurisdiction, sell ownership interest predominantly in public offerings outside the United States. And for US banking entities, their ownership interests have to be predominantly sold to unaffiliated persons.

I think that's this definition has proven to cause lots of different issues, including, for example, the requirement to sell ownership interests in the home jurisdiction. Many foreign public funds, I gather, in many markets may be organized in one jurisdiction but sold in another one. So there is a lot of narrowness in the definition, and a lot of requirements to fit into it that have proven to be challenging for many institutions.

Another exception in the covered funds definition is for joint ventures. No more than 10 unaffiliated co-venturers are permitted under the joint venture exception. And the joint venture exception is only allowed for purposes other than investing in securities for resale or other disposition.

So I think the idea was that you couldn't create a joint venture among a bunch of different entities, and then engage in proprietary trading through that joint venture. But that, and I don't know if you've seen this, Whitney. I'm sure you have. That question about what is investing-- other than investing in securities for resale or other disposition.

WHITNEY CHATTERJEE: I think that's been a real practical challenge. I mean, the agencies issued an FAQ relating to the joint venture restriction, which indicated that they interpreted that prong to be also, among other things, irrespective of the amount of time that the position was held, whether it's short or long-term. So even if you had gotten yourself through an analysis as to being able to conclude you weren't engaged in prop trading, the fact that there's this guidance out there that says even if you're holding it for the long term, you have an issue.

I mean, from our perspective at this point, with that FAQ the JV exception is of very limited, if any, value. And I think the agencies may not see the extent to which they tightened down or eliminated that. And there are particular vehicles under very limited circumstances where it may be available. But it does sort of underscore the idea that parties may be getting together to do some sort of long-term investment activity. Again, back to the Investment Company Act-- I mean, the Investment Company Act can find a company where there is an organized group of persons acting together. So you don't even necessarily need to have a legal entity in the structure. So with that kind of framework for the Investment Company Act, I think the JV exception was a great idea at first, to provide people some comfort around those types of things. But again, we don't think it's of much use.

YOSEF IBRAHIMI: Satish and Whitney, correct me if I'm wrong, but the JV exclusion requires that the entity not be engaged in merchant banking activities. And since we're in the perspective of a bank making the investment, that, I think, essentially means that the bank has to find a way to fit the investment within the scope of 4(c)6, 4(k)1, or possibly 4(c)8.

WHITNEY CHATTERJEE: That's exactly right.

YOSEF IBRAHIMI: Which--

WHITNEY CHATTERJEE: Further limits the--

YOSEF IBRAHIMI: Further limits the utility. And I think there is some rump of what you can do with the JV exclusion, but essentially most things that would fit into the criteria of not being merchant banking would be some form of operating company, which probably wouldn't even fall within the definition of a covered fund in the first instance.

SATISH KINI: I agree, I agree. It's a very limited-- it goes back to, I think, the point we were making earlier that it's all about fit. Because the covered fund is so broad, and then you have to fit it within the exception. Then when you start looking at the exception and all the different requirements of it, it becomes quite difficult, because you do have to meet-- whether it's JV exception, or foreign public funds, or others of these-- very specific requirements, that then in practice have proven to be quite challenging for firms as they're trying to categorize themselves in that way.

YOSEF IBRAHIMI: And I think turning from the exceptions to the exemptions, or the permitted activities, generally these are meant to capture what the rule, and what the preamble, and the discussions around the rule would consider to be traditional asset management activities. And so the two principal types of exempt covered funds would be asset management funds, and asset backed securities issuers.

And generally, as a matter of choosing your poison, there are limits on the ownership interests the banking entity may maintain, the application of Super 23A, and Super 23B restrictions on employee investments, required disclosures, a prohibition on guaranteeing or bailing out the affiliated fund. So there are a considerable number of hurdles that you would have to clear when proceeding with an exempt fund, though, I think those generally would be considered fairly well understood in the industry.

So it's really more of a matter of working through perhaps some of the more difficult issues involved with an exempt covered fund. For example, some issues around Super 23A and 23B, and issues around employee investments, I think, are two points that have required or involved a lot of thought.

SATISH KINI: I can talk a little bit about Super 23A and B, just to set the stage. Of course, the Super 23A and B restrictions borrow from, but then-- the word super, like in supersize-- expand upon the traditional 23A and B. And it does it in two ways, which many in the audience may be very familiar with. One is, unlike 23A and B, which apply to covered transactions between, in most instances, between an insured depository institution and one of its affiliates. Super 23A applies, on the one hand, from transactions between the banking entity as a whole and a covered fund. So it's much more expansive. It covers the banking entity across the board.

The second is, as many of you know, 23A and B impose requirements that are designed to ensure the transactions take place on market terms and then put quantitative and qualitative limits on certain covered transactions. Whereas Super 23A, again, in the super size me kind of mode, says no covered transactions may occur between the banking entity that is a sponsor of or advisor to a covered fund and the covered fund.

And also, any covered fund that is a second tier covered fund that is controlled by the first tier covered fund. Although, there is an exception for certain prime brokerage transactions, which-- it's not quite defined exactly what might fit into that exception. But that's an exception with respect to that second tier fund.

YOSEF IBRAHIMI: Interestingly, I think one of the threads in the previous panel is that there is some degree of difference between how a prudential regulator looks at issues, and how a market regulator looks at issues. And I think Super 23A kind of highlights one of those tensions.

Because a bank-affiliated asset management fund may, for example, in the interest of its customers, want to execute a transaction with the affiliated bank who may occupy a significant part of the market for that type of product, and actually be precluded from doing so with the affiliate because of Super 23A, even when that may represent the so-called best execution for the clients of that fund. So in some circumstances, super 23A is anti-market and anti-consumer interest.

WHITNEY CHATTERJEE: Yeah. I think one other interesting thing, just taking a step back to the history and the way that the rule is designed. I think that there is-- because of those major issues associated with Super 23A, there's the sense that it's completely unnecessary from the perspective of dealing with the purpose for which it's in there, which is to prevent banks from being incentivized to bail out their fund, or creating extension of credit relationships that put the bank in a position where it's exposed.

And I think the statutory language on Super 23A is-- it's certainly clear in that it applies in addition to the anti-bailout provision. I think we would hope that there's scope to interpret what transactions are covered there. But it is, I think, important to recognize that by potentially fixing or by not fixing the definition of covered fund, the scope of the problem either contracts or expands dramatically.

Because right now, you can have, for example, a cryptocurrency vehicle that has assets in it, which it's unclear whether or not they're investment securities or commodities. But in either case, it's probably likely to be picked up as a covered fund, in terms of creating some customer-specific structured vehicle. And then should that vehicle want to engage in a derivative transaction with the bank, that's not going to work under the way that the rule currently operates.

So while the asset management exception is certainly clear for maybe regular way hedge fund, private equity fund raising, it becomes much more difficult to apply in the context of any kind of novel product. At least in our experience.

YOSEF IBRAHIMI: I mean, I think one of the interesting things about the Volcker Rule is that it's sort of rehabilitated the depth of thinking on other ICA exemptions. Because pre-Volcker Rule, there was almost no reason to choose an ICA exemption other than 3(c)(1) or 3(c)(7). And everyone's shaking off the cobwebs, and trying to figure out, is this something we can do under Rule 3(a)5? Is this potentially within the scope of 3(c)(5)(c) real estate exemption? But I think--

WHITNEY CHATTERJEE: Yeah, and on that note, that's very true. I think one of the most difficult aspects of that is that the 40 Act, unlike the 33 and 34 Act, picks up loans as securities. And therefore, vehicles that hold only loans are in-scope for 40 Act purposes in a way that is not always intuitive to people, particularly people engaged in lending activity at financial institutions.

So I point that one out, because it's a great example of what you're saying, which is that there is a specific exemption created under the Volcker Rule for loan securitization vehicles. There is some scope to consider whether 3(c)(5)(a) and (b), depending on the type of lending activity may be available. But it's still a lot of trying to put a square peg in a round hole in terms of the way that these vehicles may be designed.

Satish made the comment to me before we started this panel, that unlike the prop trading side, the fund side has numerous prescriptive, specific requirements throughout all elements of all of these things. So the interpretive questions, there are many, many of them. I don't know if I'm characterizing properly that observation. But I very much agree with it. Even within each exception or each consideration, there are so many layers of things that are uncertain that it makes the practical application of this really challenging.

YOSEF IBRAHIMI: And on top of all of those nuances, there is also wrestling with the anti-evasionary element of the Volcker Rule, as well, which sort of underlies all of that analysis that Whitney noted.

SATISH KINI: No, I agree with all that. And loan securitization is a great example. There's an exception, as Whitney noted, for loans securitization vehicles. So if you fall within the exception, you don't get to be in covered fund definition. But the exception is narrow, because, as I recall, it excludes vehicles that hold securities. And my understanding is, many loans securitization vehicles do hold securities--

WHITNEY CHATTERJEE: Debt securities.

SATISH KINI: Debt securities. And certainly that was the case for loan securities vehicles that were created pre-Volcker Rule. My understanding is the market may be evolving in some ways to create some pure loan securitization vehicles that don't have securities post-Volcker. But that's another indication of the market having to change to fit the rule in a way that isn't necessarily evident, was ever intended as a purpose behind what was originally the Volcker Rule, and what it was designed to address.

Similarly, in super 23A and B, there are lots of practices-- custody practices, derivatives clearing practices-- that all have to be ceased because of Super 23A and B. One of the decisions that the agencies made in implementing Super 23A and B in the regulation was to say the prohibition on covered transactions is complete, and does not pick exceptions that, in the term covered transaction, which are in the statute itself. They made that decision.

They also said we weren't going to pick up Attribution Rule covered transactions. The latter of which, I think many were very grateful for and thought it was the right decision. The former of which, again, I hope that some of that may be addressed in a Volcker 2.0. There would be some hope, and I think there have been some comments to the OCC and the other agencies in their request for comment earlier-- because it was last year-- saying, hey, you really ought to revisit that. It didn't make sense under the statute. And it leads to a lot of results that, quite frankly, don't make a lot of sense in terms of in market and the marketplace.

WHITNEY CHATTERJEE: I think just to pick up on another example of the interplay between the definition of covered fund and banking entity, and Satish had mentioned this earlier, but it probably is worth highlighting, because it remains sort of an issue on hold, that also I think we're hopeful will be addressed in Volcker 2.0, which is that foreign funds that are excluded from the definition of covered fund, mostly applicable to foreign banks in dealing with those entities. If the bank has a sufficient level of ownership, or governance, or other things that may be relevant under the particular jurisdiction, or required under the particular jurisdiction where that foreign vehicle is formed, that is then scoped back into the definition of banking entity. And then, as Satish was explaining before, reimposes the proprietary trading restrictions, and all of the other restrictions that a banking entity is subject to.

And the agencies did provide some temporary relief for that. I think there was many years of discussions around the issues with that, with the agencies and the industry. Particularly from an extraterritorial application perspective, it just really is a very challenging thing for those vehicles to be swept back into the rule. But I think it's something that is-- the level of relief is not right now under the FAQ permanent or clear as to how it will ultimately end up. And so I think people are very eager to have that resolved in a clear way, so that they can conduct those activities, and form those vehicles, and go about that business outside of the US.

SATISH KINI: Yeah, I mean, I think to pick up on Whitney's point, the super 23A provisions are worldwide, as is a lot of what ends up happening under this part of the Volcker Rule, because of the fact that it applies to funds for US banking entities, for example, that if offered into the United States would have to rely on 3(c)(1) or 3(c)(7). So you can get foreign structures that are covered funds for US banking entities, and then have Super 23A and B apply.

So if you have a fund in Brazil, to give an example, that may have a variety of Brazilian market requirements to be offered to Brazil to protect Brazilian investors, you still have a Volcker overlay to it. Which, again, in various rounds of the comment process and discussions with the agency staff, people have made the point that that's is not a rational result, because you're interfering in the local market's asset management activities.

If you're a Brazilian investor, to be told, well, these structures are in place because of the Volcker Rule, it doesn't make a lot of sense. And what it does do is, particularly to the extent that these requirements fall on US-affiliated firms that maybe are operating these local markets, disadvantages US competitors versus non-US competitors, who may be able to do things without having that global operation of comfort fund apply.

YOSEF IBRAHIMI: And it also may disadvantage you as US investors. Using your example, if an institution had a Brazilian organized fund that would be outside the scope of the Volcker Rule governed under Brazilian law, they could set up some sort of feeder vehicle, and offer that investment indirectly to investors in Europe without undergoing any substantially different compliance or regulatory obligations. But if they were to set up a feeder and offer that fund to US investors, they may have to reconfigure the entire nature of not just the US feeder fund, but the parent fund as well, given, perhaps a conservative reading of the Aggregation Rules and the anti-evasionary rule.

SPEAKER 1: So were you suggesting, Satish, that the regulatory review process might be able to effect some diminution of the extraterritorial impact on US institutions operating outside the US, since there's no legislative proposal on that at this point?

SATISH KINI: I mean, I certainly wouldn't know what the regulatory process will be able to achieve on all of these different funds. I think as, Whitney was saying, there are limits under the statute as to what the agencies can achieve. However, I think there are ways to be creative, as well, under the statute. Whether it is through the reading, such as Whitney advanced about how broadly you need to read covered fund, or how to interpret the prohibitions of Super 23A and B.

To my mind, at least, in some regards, the agencies have taken an easy way out in saying, well, we're bound by the statutory text. And they've done so, again, to my view, somewhat at their convenience. Whereas I think they've shown some flexibility in terms of taking things out of the scope of covered fund, creating all the exceptions, which, arguably, were created by a regulatory process that one could argue may not have been in the statute, or clearly in the statute in all cases.

So there is ways in which the agencies have chosen to be flexible and thoughtful. And hopefully as they re-examine it, and look at the practices that have emerged after a number of years of living with the Volcker Rule, that there could be ways for them to be more flexible, and be more thoughtful, and dial some of this back.

One of the things that we have gone in, on behalf of clients, and spoken with the agency staff have said, you have an evasion backdrop. You have supervisory authority. You don't have to regulate to the 10th degree. You can regulate to the mean, and then catch things that are done as evasions by using the evasion authority, and using your supervisory authority. You don't have to try and regulate--

YOSEF IBRAHIMI: I mean, as an example, I think one of the exclusions you mentioned were mutual fund and registered investment companies. And I think most people at first felt relatively comfortable that that was pretty exhaustive exclusion, but for the unintentional banking entity. And so if, for example, you were to have a mutual fund which complies with all aspects of the relevant exclusion, and you were to experience client redemptions, and the banking entity were to effectively hold greater than 25% of the mutual fund after the seeding period under the relevant FAQ, you would then theoretically subject a highly regulated mutual fund to the proprietary trading restrictions. Which, I would think is not in the not consistent with the purpose of the rule.

SATISH KINI: I fully agree. I mean, I think one thing that we can probably all agree with is since the definition of covered fund is based off of exceptions to the definitions in the Investment Company Act, and the mutual fund doesn't make use of those exceptions, but instead is a registered vehicle that it falls within the framework of the ICA, that regulated US mutual funds were never intended to be affected by any part of the Volcker Rule. And that's certainly the argument that's been consistently made by participants in the US-regulated fund space.

Just as you said, Yosef, the issue has been that-- you can, because there is a carve out for mutual funds from the definition of covered funds, and that they don't rely on 3(c)(1 or 3(c)(7) in many instances anyway, you're not within that space. But you could be within the banking entity definition. And that can happen in the seeding period when you're trying to set up the fund. It can happen in the middle of the life of the fund.

As I understand it, sometimes with mutual funds, there may be a situation where the fund, in order to be distributed on a different platform, needs to be of a certain size. There may be a large redemption of a particular investor in a fund. There may be end of life issues, where the fund is winding down. And again, the banking entity needs to put in its own capital into the fund to allow an orderly wind down.

In all of those instances, you could have situations in which the fund is deemed to be controlled by the banking entity, therefore an affiliate of the banking entity, therefore subject to the full scope of the Volcker Rule's proprietary trading restrictions at the fund level, which seems really outside of what was ever anticipated. The agencies, I think, in devising the implementing regulations said, well, that's not really going to be a problem, because we have this long set a precedent under the Bank Holding Company Act that says mutual funds are not ordinarily controlled by their advisor or their sponsor. And so we can get out of those problems.

The beginning of life seeding problems then became more apparent, and they did issue a helpful FAQ to address those problems. But I think they still haven't addressed middle of life and end of life problems. And I think that is a hope that maybe they will see themselves in a way in Volcker 2.0 to addressing those issues. Because I think those are real and palpable issues that I think many are dealing with. And again, it seems very much an unintended consequence to affect a product that had nothing to do with Volcker, had nothing to do with any of the issues that were germane to why Volcker was enacted.

YOSEF IBRAHIMI: And that are already highly regulated.

SATISH KINI: And that are highly regulated to begin with, right. And in which there was never a sense of banking entities taking-- this is a classic case of a solution waiting for a problem. I'm not aware of a situation in which banking entities were doing prop trading through their RICs. I don't think that happened. So this is an entirely unintended consequence that was created because of these definitional interplays. Which, again, probably in the defense the agencies were not all apparent to anybody when the implementing regulations were issued. And only became apparent over time, as people started to deal with marketplace practices.

YOSEF IBRAHIMI: And I would sort of just note that to the extent that foreign public funds are roughly supposed to have parity with US mutual funds and RICs. You had many of the same issues present with respect to foreign public funds, simply without the breadth of prior precedent under the Bank Holding Company Act that mutual funds have.

SATISH KINI: Exactly so whereas with mutual funds, the Fed has said, ordinarily if you have, as is required under the Investment Company Act, independent directors, majority of those being non-affiliated with the advisor or sponsor, so you have an independent board, independent directors. They control the fund, therefore wouldn't fall within the control of the banking entity that's the advisor to the fund. You don't have a banking entity issue in those situations. Whereas for foreign public funds, they take a variety of forms. I think in some markets there are no independent directors. The fund may have a banking entity serving as a

WHITNEY CHATTERJEE: Corporate director or--

SATISH KINI: Right. ACD, I think, in some jurisdictions, where it's the banking entity that has a director role, an oversight role as if it was a board, that puts it in control. There are lots of other circumstances in the foreign public funds that, I think, raise exactly the issues there.

YOSEF IBRAHIMI: And generally, the calculation that such foreign regulators make is that they think generally that it's a consumer protection measure to require the bank or the bank affiliate to control the fund.

SATISH KINI: Right, exactly. Yeah again it goes to the point we were making earlier about these practices impacting foreign public funds to offering to retail investors where they have their own market requirements and structures. And again, impacting those markets in ways that you would not have expected.

SPEAKER 1: So we have a question from the audience. I just wanted to get this in. Although, Whitney, I don't know if you have any other observations, because I know you've got to go shortly.

WHITNEY CHATTERJEE: I just want to make sure I leave before all the hard questions get asked.

SPEAKER 1: Wait a second, wait until we have all the answers.

WHITNEY CHATTERJEE: I don't think so. I mean, I think the bottom line that you're hearing as a consensus on this panel is that there's a hope that Volcker 2.0 will address both the practical lessons that have been learned over time about the lack of clarity around even some of the things that were attempts at being helpful to the industry in running their asset management and customer facing businesses, as well as really thinking about revisiting the definition of covered funded itself. Because without that element of change, there remains significant scope of the rule that seems to have been unintended. I'm happy that stay for a couple of minutes of questions, and then leave it to these guys.

YOSEF IBRAHIMI: I mean, just to comment on something that I think seemed, I'm sure, or at least the regulators thought were particularly helpful. An asset management covered fund has a one year seeding period, with the possibility of an extension for two additional years. Extension requests are due 90 days before the end of the applicable period. So you are looking at having to make a decision at some point before day 270 of your seeding period on filing an extension request.

And the Fed very helpfully provided guidance. And those are now submitted to the applications department of the relevant Federal Reserve Bank. But essentially, I would think that the way this works at most institutions is on the basis of five, six, seven months worth of track record, you have to prepare and submit an extension request. And I think ideally, in the Volcker 2.0, we see something beyond an initial one year period, possibly allowing the full three years to seed without the need for an application.

SATISH KINI: In the registered fund context, there is an FAQ that gives exceeding period exception from the banking entity definition. So again, allows it-- it says that a seeding period is permitted. And I don't I don't recall the exact language, but it says, for example, three years. And there's been some questions about, well, is three years an outer bound, or is it extended even longer than that?

For one thing, you don't have that come back to the agencies and ask after one year for the registered funds, which is helpful. But I think we, at least, have interpreted that FAQ, and I don't think there's industry consensus around this, but we've interpreted it to mean longer than three years is permitted, provided that that's per seeding plan, and all of that.

Because we understand that in certain types of vehicles and certain markets, long seeding periods are necessary. If you have a life cycle fund, if you have other types of funds, even in three years, you may not have enough time to really know if the fund strategy is successful. And it really creates an impediment on product creation if you really have to say after three years, you have to get down below 25%. It may not be possible for all registered investment companies.

So even where they have given three years clearly, and we would argue longer than three years, it still would be nice to see in a Volcker 2.0 that kind of codified and very clear, that you can have extended seeding periods where it's necessary. Because it is frequently necessary in different product types.

YOSEF IBRAHIMI: And to hearken back to something that Derek said during the previous panel, as part of sort of the regularization of Volcker, and compliance procedures, and the like, you likely would see many of these requirements being incorporated into existing business-as-usual processes, product memos, standard approval processes, where you might have to consider these types of issues around seeding period, projected plans, and whatnot. And document them through that type of process.

SATISH KINI: Yeah. I think that's exactly right.

SPEAKER 1: Well two things, a question for the audience, which we need for every panel-- which is, how many people in the audience are involved in advising on investment management issues generally, whether or not you get involved with Volcker issue? Can we just have a show of hands whether that comes across your desk at all? OK. We can check that box.

So we have a question. Satish, you mentioned earlier that rather than rely upon the subsidiary exemption, the institutions will sometimes choose to have an investor who will make a fund into a covered fund. And the question was why would you want to make something a covered fund that would otherwise not be covered fund? So if you could kind of lay that out.

SATISH KINI: Sure. No, it's a great question. I think it comes back to this whole interplay between covered fund and banking entity. I think the concern that some investors have is that they would prefer to be a covered fund. If it's an investor that is, say, a non-US banking organization that may be able to invest from outside of the United States in reliance on a different exception from the sponsorship and investment limits for SOTUS. And we have a panel later that we'll talk a lot about the foreign banks, and what they can do. So I won't dive into that deeply here.

But in the context of those types of investments, foreign banking organizations may be able to make investments in vehicles that they want to make sure those vehicles are in fact covered funds, because covered funds are excluded from the definition of banking entity. So that vehicle then can trade, can invest in other funds, can do other things without worrying about the covered funds restrictions. And if they are a third party investor into that fund, they don't have to worry about Super 23A because they're not the sponsor of that fund. So those would be reasons to fall within covered fund, and thereby make sure they're not subject to the banking entity definition.

If by contrast, they, I think, are concerned that if they are 100% of the fund without at least some portion being held by the sponsor and other third party investor, that then they would fall within the exception to the covered fund definition that exists for wholly owned subsidiaries. Arguably, it's still not a wholly owned subsidiary. And I think you could probably make an interpretation that even if they own 99.9% that still is a covered fund. But I think for purposes of certainty and clarity on that, they prefer to have a third party who's also in with some percentage, or the sponsor that's in with some percentage so they're not 100%.

YOSEF IBRAHIMI: And it's not just a consequence of whether you can do the type of activities that you would like to do. For example, having a unrelated third party make an investment in the fund so a foreign institution could, for example, hold it in reliance on SOTUS. Versus having it be a wholly owned subsidiary, possibly subject to treatment as a banking entity and the proprietary trading rules, and relying on TOTUS.

You may likely be able to do the same types of activities. But the compliance burden, and the hoops that you have to jump through to establish compliance with TOTUS are much more substantial than sort of going through the structuring steps of getting a small investment from an unrelated third party to clearly bring yourself within the covered funds realm.

SATISH KINI: I think that's right. That's a very good point. You may be able to, even if it's a banking entity, rely on other exceptions just as you do for a real banking entity, and get out of Volcker restrictions. But it's again, as we were talking about earlier, all of these then end up being choices that institutions end up making. Which is the poison and you would rather have? Would you rather fall within the banking entity definition? Rely on other exceptions that might be there? Or would you rather try and fit within covered funds? You then have limits on what activities you might be able to engage in with that fund. But then have the fund vehicle be able to be more free in its--

YOSEF IBRAHIMI: And I think to a certain degree, as we're talking about what we might like to see in a revision of the Volcker Rule with respect to cover funds, that's, I think, subject to the overall comment that it also depends on how the treatment of banking entities and the application of the proprietary trading restrictions are altered. Because that may change what need there is to expand, contract, or modify any of the exemptions or exclusions from the covered fund definition.

SATISH KINI: It's a good point. I agree. They are interlinked in that way, because you do have-- right, presumably if you have a more narrow set of restrictions or more tailored set of restrictions on the proprietary trading, it takes away some of the pressures on the covered fund exclusions. Because they become much more important if those exceptions don't work properly as, at least, some would argue right now, the proprietary trading provisions don't. Yeah, it's a great point.

SPEAKER 1: So we heard from Anna Harrington on the earlier panel what her view was of the focus of a lot of the comments that went into the OCC, the attention mostly on proprietary trading issues, market making, hedging, and banking entity status. I assume you've spent some time at least taking a look at those comments.

And going back to what Whitney had talked about, which is that the fund issues are sort of never-ending from beginning to end. You're always looking at another issue. It's not just once you've set up a compliance program, you can run a program as in the trading area. Do you have a sense as to what the priorities are for the industry, apart from dealing with a banking entity issue for foreign banks? Because there is such a long list of things we've gone through, there's got to be some which more players have lined up before.

SATISH KINI: That's a very difficult question, because I think it really depends upon each institution's activities. So I suspect-- Yosef may have a priority list that another institution may not. But I think there are some common themes. At least I'll try. And you may have your own set of common themes that people would highlight. And I think a lot of them we've talked about.

So one is, I think, as you said, the banking entity definition, and trying to create a mechanism to address kind of the overbreadth of that, vis-a-vis fund structures. Second, I think a number of the exceptions that we've talked about have very particular requirements. So for example, the definition of foreign public fund. We were talking about how it has multiple prongs, such as the requirement that it be offered in its home country jurisdiction to retail investors. And I'm paraphrasing. I don't think that's exactly correct.

But there are vehicles that, for example, my understanding is, many Japanese retail vehicles are not created in Japan but are actually offshore, and then are offered into Japan because of tax and other consequences in Japan. They're retail vehicles. They are classically foreign public funds. But not all of them may fit within the foreign public fund definition. So I think there are definitional issues like that that are replete in all of the different definitions that, I think, require clarification

I think Super 23A and B is another one where, again, custody and many other issues come up there. And I think there's a desire for real clarification there. Those are, at least, a handful. Probably ones that I'm missing that are--

YOSEF IBRAHIMI: I would say, and I think this is fairly common across the industry, a longer seeding process. I would say the pegging of a de minimis investment at 3% is probably a point that a number of banks would like to see set to some degree of a higher number, simply because clients of asset management funds generally like to see skin in the game from the banking institution. And they may not feel that that's present at 3%.

SATISH KINI: Although, on that one, I think, again, institutions vary, because some, I think, like the fact--

SPEAKER 1: Yeah, some have said, I've got protection.

SATISH KINI: I can't go more.

SPEAKER 1: You want to--

SATISH KINI: Yeah. And that one also may require a statutory change, as well.

YOSEF IBRAHIMI: Yes, I would say probably some institutions would like to see some relaxing or broadening of employee investments in covered funds. I think to some degree, the notion of employee investment plans have sort of been killed at bank-affiliated asset managers, because there's simply no way to broadly offer investments in in-house funds due to the employee service provider restriction under Volcker.

SPEAKER 1: Do you want to talk about what that restriction is, just for--

YOSEF IBRAHIMI: Sure, so under the asset management restriction, an employee, director, or. officer of the bank may only invest in a covered fund if they're deemed to be a service provider. And now, there are certain activities that are mentioned as permitted to service providers, such as employees engaged in an investment advisory, investment management, oversight, risk management, deal origination, or due diligence type of function. But the rule also says other services. And I think there's probably some degree of range of comfort or choice of how different institutions have made the decision of what other services constitute sufficient services to authorize an employee to invest.

I guess I would also note that this is just for purposes of the Volcker Rule, you would also have to comply with all of the relevant Securities Act and ICA issues around offering an investment to an employee. But essentially, there's been much more conservatism. And previously, a number of institutions have authorization from the SEC to set up various types of employee investment plans, which were generally broadly disseminated to the employees of an institution, which is sort of at conflict with the restrictive nature of the service provider restriction under the Volcker Rule.

SATISH KINI: Yeah, and one of the key aspects of that is the requirement be that the services be provided directly--

YOSEF IBRAHIMI: Directly to the fund.

SATISH KINI: --to the fund. So that's a difficult standard to know if you've met. You may have people who are providing services across the asset management function, but is it to that fund?

YOSEF IBRAHIMI: And I think that maybe, very rarely, is there a person who, for example, will provide risk management to a specific fund. They may cover a broad range, or a division, or a segment of a bank's offerings. And it can be a bit difficult to substantiate a specific nexus between an employee and a fund, unless they're directly engaged in managing the portfolio of that fund.

SATISH KINI: Right, and these issues about employee investment also come up in foreign public funds because, for US banking entities, there is the restriction that I mentioned previously. A foreign public fund has to be predominantly offered to non-employees and non-affiliated persons. And predominantly, the preamble suggests is an 85% test. Whatever the number of that test, the implementation has become a big challenge, as I understand, for many US banking institutions.

Because as in the United States and many foreign markets, the retail product is sold and distributed through third party channels. So you have underwriters and brokers who are selling the stuff. And banking entities don't have a sense of, well, is it 85% owned by people who are affiliated with us or not? We don't know because it's sold through a broker. And all we know are the register shares are held in the name of the broker. So another way in which the employee ownership restrictions, in a very different context, are bedeviling, I think, institutions.

YOSEF IBRAHIMI: And I think it's a fair thing to note that these are restrictions that a bank-affiliated asset manager would be subject to that a non-bank affiliated asset manager would not be subject to. And I don't really-- if the underlying principle of the covered funds prohibition is to sort of also effectuate this prohibition on speculative proprietary trading. I don't know if that differentiation and treatment between a bank-affiliated asset manager and an unaffiliated asset manager is necessarily well-founded.

SATISH KINI: That's a fair point.

SPEAKER 1: Do we have questions from the audience? I've got more questions I'll go through. But I want to make sure we've got some. Yes?

AUDIENCE: On this exact point, I mean, in the context of an examination, say, for example, you do have foreign public funds, and a substantial portion of the investors in those funds sit behind a nominee, a nominee structure of some kind. We can't see into who is actually sitting there. I mean, in the opinion of the panel, is this something that a regulatory examiner would say this is problematic? You must be able to identify whether these are US investors or not?

SPEAKER 1: Question.

SATISH KINI: Yep, so repeat-- the question-- good question was, well, what do you do in a situation in which you have nominee investors and foreign public funds, and you can't tell if they are your affiliated persons or not? Can an examiner raise this as an issue?

And I think the answer is an examiner could raise it as an issue, because it is an issue. I think different firms have tried, to my understanding-- and I don't know if you have insights on it-- but I think different firms have tried to come up with different practical solutions to try and give themselves some comfort that they're likely within the bounds of the 85% test.

YOSEF IBRAHIMI: I would say that this is probably an area where industry practice plays a role. And I think in that type of situation, as well as in a number of other situations where the content of the intermediate vehicle or nominee structure might be an issue, the institution that needs to maintain the appropriate treatment will ordinarily seek to get a representation from the organizer or sponsor of the intermediate vehicle as to the general content of the nature of investors in that intermediate vehicle. Now, there may not necessarily be a means of testing or validating that representation. But I think, not to put it glibly, but there's a lot of very broad representation letters being sent back and forth between a number of different institutions.

SPEAKER 1: Thank you. And there was other question. Yes.

AUDIENCE: I have a Super 23A question. One of the many issues with Super 23A is that Dodd-Frank and added two prongs to the covered transaction definition. And one being a derivative that results in credit exposure to the fund, or in the case of a [INAUDIBLE] affiliate, or in the case of section 14 to the related covered fund.

What is your view on cleared swaps, because in that case, at least under US rules, there's just a brief moment in time where there's an exposure between the banking entity and the fund. And then the swap is submitted for clearing. And under US rules, that has to happen instantaneously. If it's rejected from clearing, it's void ab initio, so there's no transaction to begin with.

So there's potentially an argument that there is no credit exposure ever between the banking entity and the related covered fund, the section 14 covered fund. Would that change in you view if there's-- under foreign clearing rules, there is an amount of time between the swap being executed and the swap being submitted for clear?

YOSEF IBRAHIMI: Well, I guess the first thing I would say is that was probably one of the questions Whitney was going to answer.

[LAUGHTER]

SATISH KINI: I can repeat the question, then I can tell you what-- so I think your question was for the Super 23A restrictions, how do we deal with cleared swaps, including both those that arguably do not have a credit exposure that lasts beyond intraday, and those that may, certainly in foreign markets, that may have a broader credit exposure?

One, our firm has dealt with, and there's a lot of expertise on the panel, so I'd welcome others to join in answering this. We've dealt with different types of derivatives products. And I think where there has been, certainly an overnight exposure, we have taken a view that that's probably a 23A and Super 23A issue, and causes a problem.

I think it's more instantaneous in that there is none. There may be arguments that you don't have a Super 23A issue. But I probably would want to understand the mechanism more closely. And I can't say that we've dealt with that precise question before. I don't know whether Bill, or Derek, or Yosef.

YOSEF IBRAHIMI: I mean, I would just say as a global matter, temporality is very significant in terms of analyzing Super 23A.

SATISH KINI: You know this highlights, of course, again, in terms of the provisions of Dodd-Frank that added to 23A and B, and one of the things that everyone has waited for is a Fed revision to regulation W to answer some of these questions about these types of exposures. And how to think about them, and how to deal with them. And at various times, we've heard that the Fed staff was working on something. But we haven't gotten it. So I think market practices, to my knowledge, vary here. Because there isn't clear guidance from the agencies on how to deal with all of this.

YOSEF IBRAHIMI: And, well, regulation W, and all of the exemptions, and the attribution rules aren't necessarily applicable to Super 23A and Super 23B, I think we can certainly be informed in terms of broader structural approaches to how regulation W works in terms of viewing Super 23A and Super 23B issues.

SATISH KINI: Yep, I agree.

SPEAKER 1: Any other questions from the audience? Yes?

AUDIENCE: Hi, so funds typically make an assessment to certain entities as a covered fund at the onset of the investment. Are the funds expected to continuously monitor the status of such? And let's say, for example, that it is excluded from the covered fund definition as a loan securitization. Are the firms expected to monitor the nature of that fund has not changed during the life of the fund? And if so, have the firms implemented any such compliance program on their covered funds nature, or the status, to continuously monitor the status after the initial assessment that it is not a covered fund?

YOSEF IBRAHIMI: So to repeat the question. If there is an assessment at inception that an entity is or is not a covered fund, is there a requirement to continually validate that over time to determine whether the status of the non-covered fund may have changed?

SATISH KINI: You want--

YOSEF IBRAHIMI: Sure. And I think the answer to that broadly is yes. Or rather, yes there should be a compliance process around that type of issue. I think continuously monitor may be infeasible, but there probably should be some type of process to determine on a commercially reasonable basis whether the characterization of any type of entity may have changed.

And not just with, for example, particular regard to the loan securitization exemption. But if there is a type of event where the underlying assets of a covered or non-covered fund may have changed, or a development in how the fund is offered-- those would seem to be significant events that would warrant a re-evaluation.

And I think going back to one of the points that Satish and Whitney have made, we're kind of operating in the backdrop or the construct of the 3(c)(1), 3(c)(7) exemptions from registration under the ICA. And historically, your precise ICA exemption didn't matter. As long as you had some basis for exclusion from registration, you could change what ICA exemption you were relying on over time. Given the overlay of the Volcker Rule, and the particular emphasis on 3(c)(1), 3(c)(7), I don't think that you can take that cavalier approach any more where there is the potential that you may rely on 3(c)(1) or 3(c)(7).

And I would sort of conservatively state that if you have a non-covered fund, that for some period of time relies on 3(c)(1 or 3(c)(7) as an exemption, I don't necessarily know if you can say, well, we've now established compliance with this other exclusion. We're no longer a covered fund as a matter of course.

SATISH KINI: Yeah, I agree with that. I think what many will do is, of course, in the fund constitutional documents, define how the fund will operate so that you avoid the fund straying. So if it's a loan securitization vehicle that will rely on the loan securitization exception, for example, you very much restrict what the fund can invest in. So it will only be able to invest in those loans that will fit within the loan securitization exception of Volcker.

Similarly, if for some reason you're relying on something, and you want to be sure that it's a covered fund, as we were talking about, you insist that there be a 0.6% sponsor money, or third party money into the vehicle. So in the establishment of the vehicle, I think there are ways in which the vehicle is established so it creates guardrails. So it's harder to fall out of the particular exception that you're relying upon.

YOSEF IBRAHIMI: I think one area where there may be some degree of flexibility is in the wind down or dissolution process. If you have something that was previously a covered fund, and it's been reduced to cash or cash equivalents, or there aren't a sufficient number of investment securities held by the fund, it may no longer fall within the definition of an investment company. And I think in the context of conforming or winding down a fund, you could probably reasonably conclude that you've conformed it, and it's no longer a covered fund.

SPEAKER 5: Would it be fair to say, too, that some of the compliance and monitoring depends on the temporal characteristic of the requirement itself? So may be different in the foreign public fund, different in the SOTUS context? And then there are others like you talked about, the portfolio level restrictions.

SPEAKER 1: Yes, one more question, and then we're going to have to go for break.

AUDIENCE: This is a take up on that question. If there's a clear rep in the documentation that says they are not a covered fund, does that change your answer as far as compliance and the continual checking in on the status?

YOSEF IBRAHIMI: I think the--

SPEAKER 1: Where there's a rep in--

YOSEF IBRAHIMI: Where there is a rep in the documents, does that change the answer on compliance? And I think the answer is, it depends on how reasonably you can rely on that rep, and the nature and the content of the particular representation. I think there are certain circumstances in which you can reasonably rely on a representation, and not inquire further. And there are other situations where there may be a need for continued vigilance.

SPEAKER 1: OK. Well, with that, we have concluded our time period. And we're going to thank Satish and Yosef for their time, and Whitney, as well, for the time she was here. And go to break. And we'll be back in 15 minutes to deal with prop trading.

[APPLAUSE]

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