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How to get a Volcker rule extension for illiquid funds

Joe Mont | December 14, 2016

The Federal Reserve Board has released additional details on how banks may seek an extension for conforming their investments in illiquid funds to the Dodd-Frank Act's prohibition on proprietary trading known as the Volcker Rule.

Dodd-Frank's Section 619 generally prohibits insured depository institutions and any company affiliated with an insured depository institution from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund. These prohibitions are subject to a number of statutory exemptions, restrictions, and definitions.

The rules to implement the Volcker rule were implemented by the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission in December 2013. The new guidance relates only to the period for conforming relationships with funds defined by the statute as illiquid funds. An illiquid fund is defined by the statute as a fund that is “principally invested” in illiquid assets and holds itself out as employing a strategy to invest principally in illiquid assets.

In commentary to regulators, banking entities argued that it is particularly difficult to exit sponsored funds because the other investors expect the banking entity to retain its investment alongside the fund’s investors and early exit would lead to reputational harm to the banking entity. Reductions that have taken place to date for banking entities with large co-investments in illiquid sponsored funds generally are the result of harvesting of underlying investments in older vintage sponsored illiquid funds.

Banking advocates also contend that the sponsored funds that remain hold the most illiquid assets (including real estate and infrastructure) and have had the least amount of time to execute their multiyear harvesting plan. Also, it is difficult to sell or terminate contractual commitments to third-party illiquid funds for a variety of reasons, including that the terms on which a banking entity is able to terminate a contractual obligation and sell these interests are often commercially unreasonable. Buyers often demand deep discounts ranging from 20 percent to 90 percent relative to current net asset value, and may have little interest in the purchase of the fund if they do not want additional exposure to the general partner of the fund or the remaining assets of the fund.

Some banks have also argued that additional time is needed to conform investments made by employees in sponsored legacy illiquid funds. In addition to limiting investments in covered funds by banking entities, the statute prohibits employees from investing in covered funds sponsored by the banking entity, with some exceptions. In particular, employees who do not provide investment advisory or other services to the funds are not permitted to invest in the fund under the Volcker rule.

The Board expects that the illiquid funds of banking entities will generally qualify for extensions, though extensions may not be granted in certain cases. Among those reasons: where the banking entity has not demonstrated meaningful progress to conform or divest its illiquid funds; it has a deficient compliance program under the Volcker rule; or where the Federal Reserve Board has concerns about evasion.

The Dodd-Frank Act permits the Board, upon application, to provide up to an additional five years to conform investments in certain legacy illiquid funds where the banking entity had a contractual commitment to invest in the fund as of May 1, 2010.  The five-year extension for certain legacy illiquid funds is the last conformance period extension that the Federal Reserve is authorized to provide banking entities under the statute.

According to the Fed’s guidelines, firms seeking an extension should submit information that includes details about the funds for which an extension is requested, a certification that each fund meets the definition of illiquid fund, a description of the specific efforts made to divest or conform the illiquid funds, and the length of the requested extension and the plan to divest or conform each illiquid fund within the requested extension period.

More on the guidance can be found here, and in a letter delivered to supervised institutions.