§ 5.11 The Volcker Rule
| Jurisdiction | United States |
| Publication year | 2022 |
§ 5.11 The Volcker Rule
The "Volcker Rule,"668 originally proposed by former Federal Reserve Chairman and White House economic adviser Paul Volcker, was enacted as part of Dodd-Frank and generally prohibits, among other things, U.S. banks and their affiliates, as well as foreign banks with banking operations in the United States and their affiliates (referred to hereinafter, collectively, as "banking entities") from "sponsoring" and "investing in" most private funds (referred to hereinafter as "covered funds"),669 subject to certain exceptions and potential extensions.
Specifically, a hedge fund generally would constitute a covered fund if it would be an investment company under the Investment Company Act but for the exceptions contained in Sections 3(c)(1) or 3(c)(7) therein. For U.S. banking entities (and their worldwide subsidiaries) the definition would also extend to a hedge fund that is domiciled outside the United States and does not offer or sell its interests in the United States (and thus is not subject to the Investment Company Act) (each, a "foreign fund"), if such foreign fund would need to avail itself of either of the aforementioned exceptions were its shares offered in the United States.670 However, the same foreign fund would not constitute a covered fund from the perspective of any non-U.S. banking entity sponsoring or investing in such fund (provided, as noted above, that such non-U.S. banking entity were not a subsidiary of a U.S. banking entity).671
Notwithstanding the foregoing, hedge funds that fit the Volcker Rule's definition of a "credit fund" would not constitute covered funds. Such credit funds are those whose assets consist solely of (1) loans; (2) debt instruments; (3) rights and other assets that are related or incidental to acquiring, holding, servicing or selling such loans or debt instruments; and (4) certain interest rate or foreign exchange derivatives. Qualifying credit funds are not permitted to engage in "proprietary trading" (as defined under the Volcker Rule) or issue asset-backed securities.672
[1]—Fund Investments by Banking Entities
The Volcker Rule prohibits a banking entity from holding, as principal, any "ownership interests"673 in a covered fund, subject to certain limited exceptions. It is important to note that because the Volcker Rule only applies when a banking entity acts "as principal," it does not apply to investments held by a banking entity acting as a fiduciary, custodian, broker, or agent for an unaffiliated third party, nor would it apply to investments made by qualifying employee benefit plans controlled by the banking entity.674 Moreover, because covered funds are carved out of the definition of banking entity, the Volcker Rule does not prohibit bank-affiliated covered funds from investing in other covered funds.675
In general, a U.S. banking entity (or any of its worldwide subsidiaries) is not able to invest in any covered fund that is not sponsored (or otherwise organized and offered) by such banking entity or an affiliate, except pursuant to certain underwriting or market-making activities.676 By contrast, non-U.S. banking entities that are not controlled by a U.S. banking entity and that satisfy certain criteria are permitted to invest in a covered fund sponsored by an unaffiliated third party, provided neither the banking entity nor any of its affiliates participates in marketing or selling the fund's ownership interests to "U.S. persons" (as defined under Regulation S).677
Both U.S. and non-U.S. banking entities are permitted to hold ownership interests in a covered fund they (or their affiliates) organize and offer, under two exceptions. First, a banking entity may hold up to 3% of the total ownership interests of any covered fund it...
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