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Dodd-Frank and Hedge Funds

On July 21, 2010 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. One of the more notable provisions contained in the act is referred to as the Volcker Rule. A portion of the Volcker Rule deals with the relationship between banking entities and hedge funds and/or private equity funds.

The general rule is that “a banking entity shall not acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.” ((12 U.S.C. § 1851(a)(1)(B).)) Dodd-Frank’s definition of banking entity includes insured depository institutions, bank holding companies or companies that are treated as bank holding companies, and affiliates and subsidiaries of the aforementioned entities. ((12 U.S.C. § 1851(h)(1).)). However, the act contains an exception for insured depository institutions that function “solely in a trust or fiduciary capacity . . . .” ((Id.)) Such institutions qualify for this exception if all or substantially all of its deposits are in trust funds and are in received in a fiduciary capacity, its FDIC insured deposits are not “offered or marketed through an affiliate of such institutions”, it does not accept deposits that can withdrawn by check or similar means, and the institution does not obtain payment or exercise discount or borrowing privileges from the Federal Reserve. ((Id.))

Dodd-Frank defines hedge funds and private equity funds as entities that would be investment companies under the Investment Company Act of 1940 but for 3(c)(1) OR 3(c)(7) exceptions, commodities pools, or foreign entities that would be covered if they were organized in the United States. ((12 U.S.C. § 1851(h)(2).)). The 3(c)(1) exception refers to entities with not more than 100 beneficial owners. ((15 U.S.C. § 80a-3(c)(1).)) The 3(c)(7) exceptions refers to entities whose outstanding securities are own exclusively by qualified purchasers. ((15 U.S.C. § 80a-3(c)(7).))

Under the proposed rule, equity interest means any equity, partnership, or other similar interest in a covered fund. ((Proposed rule __.10(b)(3)(i).)) The rule specifies that it in includes a share, equity security, warrant, option, partnership interest, or membership interest. ((Id.)) However, the proposed rule specifies that ownership interest does not include carried interest. ((Proposed rule __.10(b)(3)(ii)(A).)) Under the proposed rule, sponsorship means “to serve as a general partner, managing member, trustee, or commodity pool operator of a covered fund”, to select or control a majority of the directors, trustees, or management of a covered fund, or to a share a name or variation of the same name with a covered fund. ((Proposed rule __.10(b)(5).))

As noted, the Volcker Rule prohibits banking entities to retain an ownership interest in covered funds. However, the rule does not prohibit banking entities from offering or organizing a covered fund subject to various restrictions. First, organization and offering of the fund is permitted if the entity offers bona fide trust, fiduciary, investment advisory, or commodity trading services. ((Proposed rule __.11(a).)) The fund must also be organized and offered only in connection with the provision of bona fide trust, fiduciary, investment advisory, or commodity trading advisory services. ((Proposed rule __.11(b).)) Furthermore, the entity cannot acquire or retain ownership interest other than a de minimis investment. ((Proposed rule __.11(d).)) A a de minimis investment is an investment that does not exceed 3 percent of the total outstanding ownership interest in the fund the entities aggregate investments in covered funds may not exceed 3% of its tier 1 capital. The entity must also comply with super 23A and 23B restrictions. ((Proposed rule __.11(d).)) That is, the entity cannot enter into transaction that would violate affiliate transaction rules in section 23A of the Federal Reserve Act if the banking entity and fund were affiliates. Also, the entity cannot guarantee, assume, or insure the obligations or performance of the fund and the entity must clearly and conspicuously disclose, in writing, to investors that all losses of the fund are borne by investors and not by banking entity, ownership interests are not FDIC insured, and the role of the banking entity. ((Proposed rule __.11(a).)) Finally, the fund cannot share the same name or a variation of the same with the banking entity or use the word bank in its name, and directors and employee of the entity cannot take or retain ownership interest except for those directly engaged in providing investment advisory services to the fund. ((Proposed rule __.11(h).))

The proposed rule also list various forms of permitted investment. This includes investments in small business investment companies, bank owned life insurance, joint ventures that do not make investments that violate the Volcker Rule, acquisitions vehicles, and wholly owned subsidiaries that are carried on balance sheet and used for liquidity management services. ((Proposed rule __.14.))

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Joseph Guerra

Vol. 3 Associate Editor

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