On December 10, 2013, the federal financial agencies (the “Agencies”) approved joint final regulations (the “Final Regulation”) implementing section 619 of the Dodd-Frank Act, commonly referred to as the Volcker Rule. Section 619 added a new section 13 to the Bank Holding Company Act of 1956 (the “BHCA”), which generally prohibits any banking entity from engaging in proprietary trading and acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with, a hedge fund or a private equity fund. Banks and other lending institutions (“Lenders”) commonly provide loan facilities to private equity funds (“Funds”) that are secured by, or otherwise look to repayment from, the uncalled capital commitments of the Fund’s limited partner investors (each a “Subscription Facility” or a “Facility”). In the typical Facility, the Lender does not directly sponsor, invest in or manage its Fund borrower, but rather only provides extensions of credit.1 Lenders frequently inquire to ensure their Facilities are in compliance with the Final Regulation. This Legal Update clarifies why most Facility structures will not run afoul of the Final Regulation’s prohibition against acquiring or retaining an ownership interest in a covered fund and what parameters a Lender should maintain to ensure continuing compliance.2
Covered Funds as Subscription Facility Borrowers
In order to be subject to the Volcker Rule, a Fund must be a “covered fund,” as defined under the Final Regulation. A “covered fund” includes any issuer that relies solely on the section 3(c)(1) or 3(c)(7) exceptions from the definition of “investment company” under the Investment Company Act of 1940 (the “1940 Act”). It also includes any “commodity pool” under the Commodity Exchange Act that shares characteristics of an entity excluded from the 1940 Act under section 3(c)(1) or 3(c) (7). With respect to US banking entities only, a covered fund would also include any non-US fund owned or sponsored by the US entity itself or an affiliate if the fund would rely on section 3(c)(1) or 3(c)(7) if it were subject to US securities laws.3 A majority of Fund borrowers in Facilities, in our experience, will be covered funds, as they frequently rely on section 3(c)(1) or 3(c)(7).
Subscription Facility Loans, not Ownership Interests
To the extent that an entity is a covered fund and is not covered by an exclusion, a Lender that is a banking entity under the Volcker Rule is generally prohibited from acquiring or retaining any “ownership interest” in the covered fund.
While it may seem inherent on its face that a debt facility like a Facility is not an “ownership interest” in even the most expansive interpretation, the Final Regulation does define “ownership interest” broadly to mean any equity, partnership or “other similar interest.” The Final Regulation provides that “other similar interest” includes an interest that (i) has the right to participate in the selection or removal of a general partner, director, investment manager or similar entity (excluding certain creditor’s rights); (ii) has the right to receive a share of the fund’s income, gains or profits; (iii) has the right to receive underlying assets of the fund after all other interests have been redeemed or paid in full (excluding certain creditor’s rights); (iv) has the right to receive excess spreads under certain circumstances; (v) has exposure to certain losses on underlying assets; (vi) receives income on a pass-through basis; or (vii) has a synthetic right to receive rights in the foregoing. Accordingly, while a debt interest generally would not be considered an ownership interest, to the extent that a debt security or other interest in a covered fund exhibits any of the foregoing characteristics, it would be considered an ownership interest. The “other similar interest” component makes the definition of “ownership interest” broad and requires specific application to the facts of a given transaction.
The good news for Lenders is that debt interests held in a classic Facility, absent some atypical degree of control over the Fund or pricing mechanic, are unlikely to be considered an “ownership interest” because the loan documents for a Facility generally do not provide the Lender with any of the rights described in subclauses (i)–(vii) above. The Agencies additionally provided explicit clarifying guidance on this: An “ownership interest” generally does not include “typical extensions of credit the terms of which provide for payment of stated principal and interest calculated at a fixed rate or at a floating rate based on an index or interbank rate.”4 Thus, the Lender in a Facility does not directly have an equity stake in the Fund or any rights that amount to an ownership interest under the Volcker Rule.
Default Remedies and Collateral Foreclosures
While certain events may give rise to an event of default under a Facility and provide the Lender with the ability to accelerate the debt and enforce remedies against the Fund, including the ability to charge step-up default interest, such enforcement rights are in line with typical extensions of credit and are not akin to “an ownership interest” for Volcker purposes. The Agencies expressly carved out such rights in the commentary: “the Agencies believe[d] that a loan that provides for step-up in interest rate margin when a covered fund has fallen below or breached a NAV or other negotiated covenant would not generally be an ownership interest.”5 Similarly, rights to participate in the selection or removal of the fund’s management are expressly subject to a creditor’s right to exercise remedies upon the occurrence of an event of default as well.6
Even where a Lender obtains an ownership interest in a Fund by the exercise of remedies during a default (a circumstance potentially relevant to Lenders under hybrid structures that also take a security interest in the underlying assets or in the insolvency of a fund of funds borrower), the rulemakers provided an exception. This exception for ownership interests acquired in the ordinary course of collecting a “debt previously contracted” (“DPC”) means that a Lender, as a secured party, that has covered fund ownership interests as collateral securing a Facility may foreclose on its security interest and thereby take possession and dispose of such ownership interests without violating the Volcker Rule. The Final Regulation expressly sanctions the ownership and sale of the covered fund ownership interest in such a DPC context, provided that the Lender acquiring an ownership interest in a covered fund “divests the financial instrument as soon as practicable, and in no event may the banking entity retain such instrument for longer than such period permitted by [its primary regulator],” typically within approximately two years, subject to possible extensions.7
We do advise Lenders to be conscious of the definition of “other similar interest” and curtail their creativity to structures that will not run afoul of the Final Regulation. For example, any sort of warrant or other equity kicker, equity conversion feature, step-up in spread based on Fund performance or the like would all require a hard look under the Final Regulation.
We think it is highly unlikely that a Facility Lender, absent unusual control or profit-sharing mechanics in respect of a Fund borrower, could be deemed to hold an ownership interest in such covered fund under the Final Regulation solely as result of the typical Facility lending relationship.
1 If the Lender is the sponsor, investment advisor or investment manager of the Fund, significant additional compliance obligations are implicated which are beyond the scope of this Legal Update. Similarly, if the Fund borrower is itself sponsored or advised by a banking entity subject to the Final Regulation, additional analysis is required by the Lender.
2 For an in-depth review of the Volcker Rule, please see Mayer Brown’s Legal Update, “Final Regulation Implementing the Volcker Rule.”
3 A fund that is not an “investment company” in the first place or that is able to rely on an exception or exemption under the 1940 Act other than section 3(c)(1) or 3(c)(7) generally is not a covered fund. For example, a real estate fund that invests solely in real property rather than in securities is not an investment company, while a real estate fund that invests in a mix of real property and real estate-related securities may be able to rely on section 3(c)(5)(C) of the 1940 Act. In either case, the fund would not be a covered fund. In addition, even if an entity relies on section 3(c)(1) or 3(c)(7) of the 1940 Act, the entity is not a covered fund if it falls within a Volcker Rule exclusion. The Final Regulation expressly excludes from the definition of a “covered fund” various types of entities, including, among others, certain “foreign public funds” that are analogous to US-registered investment companies, foreign pension and retirement funds, and qualifying loan securitizations and asset-backed commercial paper conduits. If a fund is not an investment company in the first place or is covered by a Volcker Rule exclusion, a banking entity may not only invest in or sponsor the fund without needing to comply with a Volcker Rule exemption but it may also engage in covered transactions with the entity without regard for the so-called Super 23A prohibition.
4 Final Regulation Preamble at 5706.
5 Final Regulation Preamble at 5707.
6 Final Regulation Preamble at 5706. 7 Final Regulation Preamble at 5782.