Two final rules affecting the scope of bank involvement in the asset management industry went into effect September 30, 2020. The first revises the Federal Reserve Board’s rules regarding the definition of control in the Bank Holding Company Act (“BHC Act”) (the “Control Rule”)1 to provide greater clarity as to what constitutes “controlling influence” of a given investment. The second revises the Volcker Rule’s covered funds provisions to remove various activities from the purview of the Volcker Rule’s restrictions on banks’ involvement in the private fund space.2
Together, these rules could facilitate partnerships within the asset management industry, including between banks and fintech companies and banks and other asset managers, by redefining non-controlling relationships and encouraging bank participation in the private fund industry. Each is discussed briefly below.
1. Revisions to the Federal Reserve Board’s Control Framework
Control is a fundamental concept in the BHC Act and the banking regulations. Structuring investments to avoid situations where a bank or its affiliate would be deemed to have control of an entity for bank regulatory purposes is often a threshold goal of a transaction. Control introduces a host of unpalatable consequences, including Federal Reserve Board supervision and regulation and certain activities limitations. The control framework generally applies to investments by banks in other companies (including, for example, fintechs), as well as investments in banks.
The Federal Reserve Board issued the Control Rule in January 2020, which adopted the general form of the April 2019 proposed rule.3 The effective date was initially April 1, 2020 but was delayed until September 30, 2020 due to the impact of COVID-19.
The statutory definition of control for bank regulatory purposeshas three prongs. The BHC Act’s control definition includes two bright line tests for control—(A) directly or indirectly owning, controlling or having power to vote 25% or more of any class of voting securities; and (B) controlling in any manner the election of a majority of the directors or trustees—and a third test dependent on facts and circ*mstances: the ability to directly or indirectly exercise a “controlling influence” over management or policies.
The Control Rule mainly addresses what “controlling influence” means in the context of the third prong.
Tiered Presumptions of Control. The Control Rule sets forth certain objective thresholds to apply to the “controlling influence” analysis. These thresholds are arranged in tiers based on the level of ownership of any class of voting securities—less than 5%; 5‒9.99%; 10‒14.99%; and 15‒24.99%.
A voting interest exceeding the particular threshold combined with the presence of one or more other specified relationships would trigger a presumption of control. The tiered framework is designed to incorporate the major factors and thresholds that the Federal Reserve Board has historically viewed as presenting controlling influence concerns.
The presumptions are structured on a sliding scale: as an investor’s ownership percentage of voting shares in a company increases, the other relationships and factors through which the investor could exercise a controlling influence must decrease in order to avoid triggering a presumption of control. Depending on an investor’s ownership percentage of any class of voting shares, the permissible level of other relationships and factors vary. These relationships include:
- the size of the total equity investment (in each case, must be less than one third, measured at the time of investment);
- the rights to director and committee representation on the board of directors;
- the use of proxy solicitations;
- management, employee or director interlocks;
- covenants or other agreements that allow for influence or restrict management or operational decisions, such as investment management agreements; and
- the scope of the business relationships (based on revenue and measured on an ongoing basis.
The final rule clarifies that the statutory presumption of non-control for investments of less than 5% of voting equity under Section 4(c)(6) of the BHC Act will not be jeopardized due to the presence of other relationships but will remain subject to the one-third total equity limitation.
Summary of Tiered Presumptions Chart.
| Less than 5% voting | 5-9.99% voting | 10-14.99% voting | 15-24.99% voting | |
| Directors | Less than half | Less than a quarter | Less than a quarter | Less than a quarter |
| Director Service as Board Chair | N/A | N/A | N/A | No director representative is chair of the board |
| Director Service on Board Committees | N/A | N/A | A quarter or less of a committee with power to bind the company | A quarter or less of a committee with power to bind the company |
| Business Relationships | N/A | Less than 10% of revenues or expenses | Less than 5% of revenues or expenses | Less than 2% of revenues or expenses |
| Business Terms | N/A | N/A | Market Terms | Market Terms |
| Officer/Employee Interlocks | N/A | No more than 1 interlock, never CEO | No more than 1 interlock, never CEO | No interlocks |
| Contractual Powers | No management agreements | No rights that significantly restrict discretion | No rights that significantly restrict discretion | No rights that significantly restrict discretion |
| Proxy Contests (directors) | N/A | N/A | No soliciting proxies to replace more than permitted number of directors | No soliciting proxies to replace more than permitted number of directors |
| Total Equity (BHCs) | Less than one third | Less than one third | Less than one third | Less than one third |
Control of Advised Investment Funds and One-year Seeding Period Exemption. The final rule adopts as proposed the approach to control of advised investment funds, including 1940 Act-registered investment companies, investment companies exempt from registration under the 1940 Act (including, generally, REITs and commodity funds) and their foreign equivalents. Under the final rule, subject to a one-year exception for the initial seeding period, an investment adviser owning 5% or more of the voting equity, or 25% or more of the total equity, of an investment fund will be presumed to control the fund.
Permissible Defensive Rights Attached to Investment Fund Interests. The final rule spells out certain defensive rights common to limited partnerships and limited liability companies that will not cause the ownership interests bearing such defensive rights tobe considered voting securities for purposes of the control analysis. These include the right to vote on the removal of a general partner or managing member for cause; the right to vote for a replacement general partner or managing member following removal for cause or incapacitation; and voting on continuing or dissolving the fund following removal of the general partner or managing member.
Treatment of Various Instruments as Equity. The final rule confirms that convertible securities such as warrants, options and other exercisable or exchangeable instruments must be looked through—or considered as presently converted or exercised—for purposes of the control analysis, subject to certain exceptions.
The final rule also sets out factors to determine when a debt instrument must be treated as equity for purposes of the control analysis. Under the final rule, an instrument will be considered “functionally equivalent” to equity if it has equity-like characteristics, such as entitling its owner to a share of the profits. In the context of debt instruments, the final rule includes a list of examples of equity-like characteristics, including:
- extremely long-dated maturity;
- subordination to other previously issued debt instruments;
- qualification as regulatory capital under applicable regulatory capital rules;
- qualification as equity under applicable tax law;
- qualification as equity under U.S. GAAP or other applicable accounting standards;
- inadequacy of the equity capital underlying the debt at the time of the issuance; or
- issuance not on market terms.
Divestiture of Control. The final rule substantially revises the Federal Reserve Board’s standards regarding divestiture of control. The final rule generally provides that a company that previously controlled a second company during the preceding two years would be presumed to continue to control such companyif it owned 15% or more of any class of voting securities. The divestiture presumption would not apply if a majority of each class of voting securities would be controlled by a single unaffiliated individual or company after the divestiture.
2. Volcker Rule Covered Funds Final Rule—Prohibitions and Restrictions on Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds
On June 25, 2020, the Federal Reserve Board issued a final rule to simplify, streamline and tailor the “covered fund” provisions under the regulation implementing section 13 of the BHC Act (commonly known as the “Volcker Rule”).
The final rule is the first targeted update to the implementing regulations related to the Volcker Rule’s general prohibition on banking entities investing in or sponsoring hedge funds or private equity funds—known as “covered funds.”4 The general purpose of the Volcker Rule’s covered fund provisions was to ensure that a banking entity was not able to do indirectly via a fund structure that which it was prohibited from doing directly under the proprietary trading restrictions of the Volcker Rule—conceptually, putting taxpayer funds (i.e., insured deposits) at risk through excessive exposure to speculative and risky investment activity.
The final rule is largely similar to the proposed rule, with certain notable changes addressing public comments.5 The final rule adds four new exclusions from the definition of covered fund (credit funds, venture capital funds, family wealth management vehicles and customer facilitation vehicles) and simplifies three existing exclusions. In addition, the final rule expands the scope of permissible relationships that a banking entity may have with covered funds under Super 23A, codifies existing guidance related to certain foreign funds and clarifies issues surrounding ownership interests and permissible parallel investments.
Credit Funds, Venture Capital Funds, Family Wealth Management Vehicles and Customer Facilitation Vehicles. The final rule adds new exemptions that permit banking entities to invest in and/or sponsor four specific types of funds subject to limitations and guardrails. The four new exemptions target types of investment funds that may rely on Section 3(c)(1) or 3(c)(7) from exemption from registration under the Investment Company Act of 1940 but the Agenciesdo not view as posing the types of risks that the Volcker Rule is intended to address. Certain aspects are discussed below.
| Credit Funds | |
| Overview | Although the Volcker Rule excludes loan securitizations from the definition of covered fund, the regulations implementing the Volcker Rule had limited the ability of banking entities to invest in or sponsor substantially similar investment funds that make loans, invest in debt securities or otherwise extend credit.6The new credit fund exclusion addresses that incongruence. The final rule does not prescribe limits on a banking entity’s investment in the credit fund, but other applicable limitations and restrictions still apply.7 |
| Asset Criteria | Assets must consist solely of:
The agencies declined to adopt a quantitative limit on permissible other assets held in connection with an investment in loans or debt instruments but noted that such other assets generally would not exceed 5% of the value of the fund’s total investment in a given borrower at the time of investment. |
| Activities Restrictions | May not engage in short-term proprietary trading; |
| Banking Entity (“BE”) Sponsor or Adviser | May not directly or indirectly guarantee, assume or otherwise insure the fund’s obligations or performance (and must disclose this prohibition to investors); |
| Venture Capital Funds | |
| Overview | The final rule excludes qualifying venture capital funds that invest in small and startup businesses from certain restrictions associated with the Volcker Rule.8 The definition of “venture capital fund” for purposes of this exception includes significantlimitations on leverage and secondary transactions, whichmean that this exemption likely will have limited use for most traditional private equity sponsors. |
| Eligibility Criteria | Limited to qualifying “venture capital funds” as defined in existing regulations under the Investment Advisers Act of 1940.9Requirements include, very generally:
|
| Activity Restrictions | May not engage in short-term proprietary trading.10 |
| BE Involvement | The banking entity must be permitted to engage in such activities under laws applicable to it. |
| BE Sponsor or Adviser | Same as for credit funds. |
| Family Wealth Management Vehicles (FWMVs) | |
| Overview | The final rules allow banking entities more flexibility to provide traditional banking and integrated asset management services to investment funds set up on behalf of a family and its closely related persons. The agencies declined to adopt a requirement in the proposal that a banking entity sponsor would need to comply with Super 23A limits with respect to such a fund. |
| Eligibility Criteria | May not raise money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities; |
| BE Sponsor or Adviser | Must provide bona fide trust, fiduciary or advisory services to the fund; |
| Customer Facilitation Vehicles | |
| Overview | The final rule excludes any issuer that is formed by or at the request of a customer of the banking entity for the purpose of providing such customer (which may include one or more affiliates of such customer) with exposure to a transaction, investment strategy, or other service provided by the banking entity. The exclusion permits a banking entity to offer financial products to its customers through a fund structure in situations where it could otherwise enter into a contract directly with a customer to provide the same economic exposure to the underlying financial product (e.g., a derivative). |
| Eligibility Criteria | Must be formed by or at the request of the customer;12 |
| BE Sponsor or Adviser | Documentation requirements; |
Existing Covered Fund Exclusions Simplified: Loan Securitizations, Foreign Public Funds and Public Welfare Funds.
Loan Securitizations. The Volcker Rule expressly permits banking entities to sell and securitize loans in a manner otherwise permitted by law. In order to provide banking entities with flexibility to sell and securitize loans, the final rule permits an issuer to hold up to 5% of the loan securitization’s total assets in “debt securities” (which may not include asset-backed securities or convertible securities).13 The final rule also codifies existing guidance clarifying that “servicing assets” held by a loan securitization vehicle may include assets other than securities (e.g., mortgage insurance policies supporting the mortgages in a loan securitization).
Foreign Public Funds. Under the final rule, the foreign public fund exclusion is available for a fund that (i) is organized or established outside of the U.S.; and (ii) is authorized to offer and sell ownership interests, and such interests are offered and sold through one or more public offerings.14 If a banking entity sponsors or advises the fund, it must comply with all applicable requirements in the jurisdiction in which such distribution is made. The final rule permits a banking entity sponsoring a fund to own, together with affiliates, up to 24.99% of the fund—up from 14.99%—similar to the treatment of registered investment companies.
Public Welfare Exclusion. The final rule clarifies that a small business investment company will remain eligible for the exclusion from the covered fund provisions during a wind-down period (during which time it may surrender its license), provided it makes no new investments after surrendering its license other than investments in cash equivalents. The final rule adds an exclusion for rural business investment companies and certain investments under the Community Reinvestment Act.
Super 23A: Permissible Low-risk Transactions with Related Funds. The Volcker Rule generally prohibits all covered transactions between a banking entity and a covered fund that it advises or sponsors (a “related fund”). Specifically, with respect to a related fund, a banking entity is generally prohibited from entering into a transaction of a type that would be covered by section 23A of the Federal Reserve Act.15 While section 23A of the Federal Reserve Act includes certain exceptions from its prohibitions, the Volcker Rule did not initially incorporate those exceptions, leading to its nickname “Super 23A.”
The final rule permits a banking entity to provide traditional banking services to related funds by incorporating certain section 23A and Regulation W exemptions, including permitting intraday extensions of credit, entering into riskless transactions, and entering into short-term extensions of credit and purchase assets in the ordinary course of business relating to payment transactions, settlement services or futures, derivatives and securities clearing.
Qualifying Foreign Excluded Funds. The final rule codifies an existing policy statement by the agencies addressing unintended extraterritorial consequences when a foreign banking entity controls certain foreign funds.16 Under the final rule, a qualifying foreign excluded fund is still a banking entity but is expressly exempt from the proprietary trading and covered fund restrictions and the compliance program requirement.
Ownership Interests Safe Harbor. The implementing regulations define an “ownership interest” in a covered fund to mean any equity, partnership or “other similar interest,” and the final rule addresses the meaning of “other similar interest.” The final rule provides a safe harbor for bona fide senior loans or senior debt instruments that do not permit the investor to participate in income, gains or profits of the covered fund. It also clarifies the types of creditor rights that would be within the scope of ownership interest, and it modifies the calculation methods for purposes of complying with the ownership limits and conditions applicable to investments in related covered funds of a banking entity.
Parallel Banking Entity Investments. The final rule adds a new rule of construction to clarify that banking entities are not required to treat certain types of direct investments alongside a covered fund as an investment in the covered fund, so long as certain conditions are met.
* * *
Please contact Joel Wattenbarger, Gideon Blatt or your usual legal advisor at Ropes & Gray with any questions about this Alert.
Stay Up To Date with Ropes & Gray
Subscribe to Our Podcast
Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Follow Us on Social
Stay in the loop with all things Ropes & Gray, and find out more about our people, culture, initiatives and everything that’s happening.
Join Our Mailing List
We regularly notify our clients and contacts of significant legal developments, news, webinars and teleconferences that affect their industries.
Join Our Mailing List
