Volcker Rule: Agencies Release New Volcker Rule FAQ with Critical Guidance for Foreign Banking Entities and Fund Sponsors; Clarify That U.S. Marketing Restriction Under “SOTUS” Covered Fund Exemption Does Not Apply to Third Parties

Sullivan & Cromwell LLP - February 27, 2015

Earlier today, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the “Agencies”) provided an important addition to their existing list of Frequently Asked Questions (“FAQs”) addressing the implementation of section 13 of the Bank Holding Company Act of 1956, as amended (the “BHC Act”), commonly known as the “Volcker Rule.”
The Volcker Rule imposes broad prohibitions on proprietary trading and investing in and sponsoring private equity funds, hedge funds and certain other investment vehicles (“covered funds”) by “banking entities” and their affiliates.  The Volcker Rule, as implemented by the final rule issued by the Agencies (the “Final Rule”), provides an exemption from the covered fund prohibitions for foreign banking entities’ acquisition or retention of an ownership interest in, or sponsorship of, a covered fund “solely outside of the United States” (the “SOTUS covered fund exemption”).
One of the conditions of the SOTUS covered fund exemption is that “[n]o ownership interest in the covered fund may be offered for sale or sold to a resident of the United States” (the “marketing restriction”).  Following the issuance of the Final Rule, the marketing restriction became the subject of uncertainty and industry comment, as it was unclear whether foreign banking entities would be able to rely upon the SOTUS covered fund exemption with respect to investments in third party covered funds, such as offshore feeder funds with U.S. tax-exempt investors or other covered funds, where the fund sponsor or investors other than the foreign banking entity had engaged in U.S. marketing activities.
The newly released FAQ clarifies that, in the context of a foreign banking entity’s acquisition or retention of an ownership interest in a third party covered fund, the marketing restriction applies only to the activities of the foreign banking entity (including its affiliates) that is seeking to rely upon the SOTUS covered fund exemption and not to the activities of third parties, including the sponsor of the covered fund, other investors and the covered fund itself.  Thus, a foreign banking entity’s ability to rely on the exemption would not be lost as a result of third parties’ marketing or selling activities to residents of the United States, provided that the foreign banking entity has not itself offered for sale or sold an ownership interest in the fund to a resident of the United States or participated in such an offer or sale.  The FAQ notes that, where a banking entity sponsors or serves, directly or indirectly, as the investment manager, investment adviser, commodity pool operator or commodity trading advisor to a covered fund, the banking entity will be viewed by the Agencies as participating in any offer or sale by the covered fund of ownership interests in the covered fund.  Such a foreign banking entity would not qualify for the SOTUS covered fund exemption with respect to its investment in the covered fund if the covered fund offers or sells ownership interests to a resident of the United States.

Prior to the release of the new FAQ, industry participants had expressed concerns that interpreting the marketing restriction to apply to third parties’ activities would have significantly limited the practical use of the SOTUS covered fund exemption and entailed significant costs of compliance, as foreign banking entities would in many cases have been required to redeem, divest or restructure their investments in third party funds.  As the Agencies acknowledged in the new FAQ, such a broad interpretation of the marketing restriction would have been inconsistent with the goal of “limiting the extraterritorial application of [the Volcker Rule] to foreign banking entities while seeking to ensure that the risks of covered fund investments by foreign banking entities occur and remain solely outside of the United States.”  The new FAQ should provide welcome confirmation to both foreign banking entities and fund sponsors in this regard.
A copy of the new FAQ is included as Appendix A in the link above.