Volcker Rule: Federal Reserve Extends Conformance Period Through July 21, 2016 for Investments in and Relationships with Legacy Covered Funds; Intends to Grant Additional Extension Through July 21, 2017

Sullivan & Cromwell LLP - December 18, 2014

Earlier today, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued an order (the “Order”) with respect to Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), commonly known as the Volcker Rule, to give all banking entities until July 21, 2016 to conform “investments in and relationships with covered funds and foreign funds” that were in place prior to December 31, 2013 (“legacy covered funds”) to the requirements of the Volcker Rule.
The Federal Reserve also stated that it intends to act next year to grant an additional one-year extension of the conformance period, until July 21, 2017, for the same legacy covered fund investments and relationships.  As the Federal Reserve acknowledged, the Order follows a period of widespread industry comment regarding the need for additional time for banking entities to conform or divest legacy covered fund investments and relationships in an orderly manner.  It appears that the Federal Reserve concluded that these extensions enhance the safety and soundness of the banking industry by avoiding losses that would occur from precipitate divestitures into largely illiquid markets and are consistent with Congress’ purpose in providing for an extended conformance period.
The Order does not expressly enumerate the specific “relationships” with legacy covered funds that are within the scope of the relief.  However, the examples of comments provided in the Order and the discussion of those comments indicate that the Order applies to sponsorship of and advisory relationships with legacy covered funds as well as transactions with such funds that would, as a result of such relationships, be subject to the so-called “Super 23A” provisions of the Volcker Rule and the final implementing rules thereunder (the “Final Rule”).

The relief also covers other requirements of the Volcker Rule’s covered funds provisions as they apply to banking entities’ investments in and relationships with legacy covered funds, including the restrictions on director and employee investments in organized and offered covered funds, per-fund and aggregate investment limitations and the required deduction of certain interests in covered funds from a banking entity’s Tier 1 capital.

The Order is not explicit about relief for foreign private and public funds that may be included within the definition of “banking entity” as a result of governance, ownership or control by another banking entity.  However, it appears that banking entities will not be required to conform their activities with respect to such funds during the extended conformance period provided by the Order, as long as the relevant governance, ownership or control relationships with the funds were in place as of December 31, 2013.

The Order expressly states that the relief does not cover investments in or relationships with a covered fund made after December 31, 2013.  As a result, banking entities may be restricted in their ability to engage in trading, market-making or other market transactions involving interests in legacy covered funds that are covered funds following July 21, 2015, absent a separate affirmative extension of the conformance period that may be requested from the Federal Reserve.  The Order also makes clear that the relief does not apply to proprietary trading activities, which must be conformed by July 21, 2015.
The Order reiterates the expectation that banking entities must engage in good-faith efforts during the conformance period to conform all activities and investments to the Volcker Rule by no later than the end of the applicable conformance period.  The Order notes that banking entities are expected to make plans “well in advance” of the end of the extended conformance period regarding how they will conform or divest legacy covered fund investments in an orderly and safe and sound manner.  As banking entities engage in planning conformance efforts, we believe it is reasonable for them to take into account the Federal Reserve’s stated intent to extend the conformance period to July 21, 2017.
The Federal Reserve statement notes that the other agencies responsible for enforcing the Volcker Rule will apply the Final Rule in accordance with the Order.

The Federal Reserve did not propose amendments to its prior rulemaking or otherwise provide guidance with respect to the additional transition period of up to five years for banking entities’ investments in certain “illiquid funds,” other than to state that the Federal Reserve will consider whether to take action regarding illiquid funds.