Volcker Rule Conformance Periods: Federal Reserve Adopts Final Rule Implementing Volcker Rule Conformance Periods

Sullivan & Cromwell LLP - February 11, 2011

On February 9, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) adopted a final rule (the “Final Conformance Rule”) implementing the conformance periods during which banking entities and nonbank financial companies supervised by the Federal Reserve must bring their activities and investments into compliance with the so-called “Volcker Rule” (the “Volcker Rule”) provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The Final Conformance Rule includes some significant changes in response to public comments but was in most respects adopted as proposed. As a result, among other things, the availability of the special extension period for illiquid funds is likely to remain quite limited. In the Final Conformance Rule, the Federal Reserve:

  • Expanded the definition of “illiquid asset” to include assets that are subject to a contractual restriction on sale or redemption for a period of three years or more;
  • Added that a hedge fund or private equity fund may be “contractually committed” to principally invest in illiquid assets or be “contractually obligated” to invest or remain invested in the fund based on written representations in offering materials;
  • Extended the deadline for a request for an extension of a conformance period from 90 days to 180 days before the end of the relevant conformance period and clarified that the Federal Reserve expects to act on an extension request within 90 days after receipt of a complete record;
  • Removed a qualification that assets that are illiquid because of a restriction on transfer will become liquid if the restriction expires and otherwise confirmed that the “principally invested in illiquid assets” test is a one-time test, but added that the Federal Reserve will consider the extent to which illiquid assets have become liquid when acting on extension requests;
  • Allowed funds to use financial statements prepared under U.S. Generally Accepted Accounting Principles or other applicable accounting standards as of any date between February 28, 2010 and May 1, 2010 instead of specially prepared May 1 financial statements to determine if they are “principally invested” in illiquid assets;
  • Added factors that the Federal Reserve will consider when acting on extension requests, including whether divestiture or conformance would result in a material conflict of interest between the banking entity and unaffiliated clients, customers or counterparties to which it owes a duty; and
  • Clarified that the Federal Reserve will consider unreasonable demands by an unaffiliated sponsor or investor in determining whether a banking entity has used “reasonable best efforts” to obtain consent to withdraw from an illiquid fund.

According to the Federal Reserve, the Final Conformance Rule does not address definitional or other aspects of the Volcker Rule that will be addressed in the interagency rulemaking process implementing the substantive provisions of the Volcker Rule. For example, key terms in the Volcker Rule, such as the definitions of “banking entity”, “hedge fund” and “private equity fund”, were included without modification from the statutory text. The Federal Reserve expects to review the Final Conformance Rule after completion of the interagency rulemaking process to determine whether modifications are necessary.

The adoption of the Final Conformance Rule substantially as proposed reflects a narrow view by the Federal Reserve of the availability of extension periods. It remains to be seen, however, whether the Federal Reserve will take a restrictive approach in ruling on individual extension applications. That said, rulemaking on extension periods does not necessarily presage a restrictive view of the substantive provisions of the Volcker Rule.