On February 27, 2015, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the Agencies) released new guidance under the Volcker Rule1 in the form of an addition to their Frequently Asked Questions2 (the New FAQ). The New FAQ clarifies the circumstances under which a foreign banking entity may continue to hold, or may make, investments in a “third-party covered fund.” The New FAQ provides useful guidance to foreign banking entities and the managers of third-party covered funds in which foreign banking entities invest. The guidance will limit the need for managers to restructure their third-party covered funds to accommodate many existing – and future – investments by foreign banking entities.
The Final Rule provides that a banking entity (including a foreign banking entity) may not, as principal, directly or indirectly, acquire or retain any “ownership interest” in a “covered fund.”3 The Final Rule includes an exception that permits a foreign banking entity to acquire or retain an ownership interest in, or to sponsor, a covered fund “solely outside of the United States” (the SOTUS Exemption).4 One of the four criteria of the SOTUS Exemption is that no ownership interest in the covered fund may be offered for sale or sold to a resident of the United States (the Marketing Restriction).5 Before the New FAQ, it was unclear whether the Marketing Restriction limited the marketing and sales activities only of the foreign banking entity seeking to take advantage of the SOTUS Exemption or, alternatively, applied more generally. In other words, it was unclear whether a foreign banking entity could invest in a covered fund offered and sold in the United States even if the covered fund was not sponsored, organized, offered or advised by the foreign banking entity (e.g., a third-party sponsored Cayman Islands-domiciled “feeder fund” marketed to both U.S. tax exempt investors and non-U.S. investors).6 While the Final Rule does not impose restrictions on non-banking entities, the non-bank sponsors of such funds have been concerned about the impact of the Final Rule on their ability to retain foreign banking entity investors and to continue to market to such foreign banking entity investors.7
The New FAQ confirms that the SOTUS Exemption imposes the Marketing Restriction only on the activities of the foreign banking entity seeking to rely on the SOTUS Exemption and not on the activities of unaffiliated third parties. In particular, the New FAQ states that a foreign banking entity may invest in a covered fund in reliance on the SOTUS Exemption even if the covered fund is sold to U.S. residents so long as: (i) neither the foreign banking entity nor any of its affiliates acts as sponsor of – or serves, directly or indirectly, as the investment manager, investment adviser, commodity pool operator or commodity trading advisor to – the covered fund (a third-party covered fund); and (ii) the foreign banking entity otherwise complies with the provisions of the SOTUS Exemption.8
As the New FAQ notes, the focus on the activities of the foreign banking entity “is consistent with limiting the extraterritorial application of [the Volcker Rule] to foreign banking entities while seeking to ensure that the risks of covered fund investments by foreign banking entities occur and remain solely outside of the United States.” With the clarification provided by the New FAQ, the Agencies have acknowledged that a more restrictive view of the SOTUS Exemption would limit its availability in unintended ways and could unduly hamper the activities of unaffiliated third parties. At the same time, the New FAQ emphasizes that the SOTUS Exemption broadly limits a foreign banking entity’s ability to be involved in the marketing of ownership interests of a covered fund to residents of the United States. This position is consistent with one of the policy goals of the Volcker Rule, namely that the Volcker Rule should not provide foreign banking organizations a competitive advantage over U.S. banking entities with respect to offering covered fund services in the United States.
With the release of the New FAQ, the Agencies have clarified that the SOTUS Exemption does not impose any restriction on the marketing of ownership interests in a third-party covered fund by its sponsor or its investment manager, investment adviser, commodity pool operator or commodity trading advisor. In practice, this means that a manager of a third-party covered fund organized on a standard “feeder fund” model (e.g., a Cayman Islands-domiciled investment vehicle that is open to investment by U.S. tax-exempt investors and non-U.S. investors) does not need to restructure such vehicle to permit a foreign banking entity to retain its investment and does not need to alter such structure for new investments by foreign banking entities.
1 The Volcker Rule refers to Section 13 of the Bank Holding Company Act of 1956 (the BHC Act), which was added by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the final rule implementing such section (the Final Rule).
2 The FAQs, as updated from time to time, may be found on the Federal Reserve’s website: http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm.
3 The definitions of “covered fund” and “ownership interest” are discussed in more detail in our earlier Sidley Update, Volcker: The Final Rule (December 20, 2013).
4 Final Rule §_.13(b).
5 A “resident of the United States” is defined by reference to the definition of a “U.S. Person” under Regulation S promulgated under the Securities Act of 1933.
6 The lack of clarity led Sidley Austin LLP to join a group of law firms to issue a letter reflecting the consensus view that a foreign banking entity could invest in a “parallel fund” (i.e., a fund that invested in parallel with one or more covered funds that offered and sold ownership interests in the United States) in reliance on the SOTUS Exemption so long as the parallel fund was organized, offered and advised by a sponsor other than the investing foreign banking entity. However, there remained some uncertainty in the industry as to whether a foreign banking entity could rely on the SOTUS Exemption to invest in the standard “feeder fund” structure.
7 A fund could itself be deemed to be a subsidiary of a bank holding company under the BHC. The determination as to whether a particular fund is a subsidiary of a bank holding company requires a review of the relationship(s) between the fund and its manager, on the one hand, and the bank holding company and its subsidiaries and affiliates, on the other hand. Nothing in the New FAQ has altered the analysis required to be made of such relationship(s).
8 The other criteria require that: (i) the foreign banking entity is not organized or directly or indirectly controlled by a banking entity that is organized under the laws of the United States or of one or more states; (ii) the activity or investment by the foreign banking entity is pursuant to paragraph (9) or (13) of section 4(c) of the BHC Act; and (iii) the foreign banking entity’s investment occurs solely outside of the United States.
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