This is a piece in our continuing series exploring the effects of the Volcker Rule; for previous alerts please click here.
It is an axiom of statutory and regulatory construction that words adopted as law must have some meaning capable of being applied.1 But what in the world does the joint venture exclusion to the Volcker Rule's covered fund restrictions mean?
The Volcker Rule, codified as Chapter 13 of the Bank Holding Company Act of 1956,2 as amended (the "BHC Act"), generally prohibits banking entities3 from engaging in proprietary trading or in making certain investments in (or having certain relationships with) so-called "covered funds."4 The purported purpose of the latter prohibition is to ensure that banks do not engage indirectly in activities that they would be prohibited under the Volcker Rule from engaging in directly. Many observers assume that the Volcker Rule essentially represents a blanket prohibition on bank investment activity, but as we analyzed in a prior Client Alert, this is incorrect.5
Nevertheless, there is an inherent tension between the ability of a banking entity to exercise its otherwise permissible bank investment powers and the broad sweep of the Volcker Rule's prohibitions. In promulgating the final Volcker Rule, the five issuing agencies (the "Agencies")6 appeared to recognize this tension. Rather than imposing a blanket prohibition on covered fund activities, the Agencies acknowledged that certain entities and arrangements should be carved out of the general prohibition on covered fund activities, whether by virtue of an exemption from the general ban or through an exclusion from the definition of covered fund.7 One such excluded entity is a "joint venture."8
From the moment the Volcker Rule was promulgated, however, practitioners have struggled to determine what investments, if any, would meet the standards to qualify as an excluded joint venture. On June 12, 2015, the Agencies issued a response to a "Frequently Asked Question" directed at providing additional guidance on this point ("FAQ 15").9 Unfortunately, FAQ 15 raised as many questions as it purported to answer.
Below, we attempt to discern what structures are eligible for the joint venture exclusion. We have no magic answers; we merely believe that the market's understanding of this exclusion can be meaningfully furthered by having a more rigorous discussion than has to this point taken place.
WHAT IS A JOINT VENTURE AND WHY IS IT EXCLUDED FROM THE VOLCKER RULE?
Section _.10(c)(3) of the final rule provides that a joint venture will be excluded from the definition of a covered fund (and therefore the prohibitions under the Volcker Rule) if it "(i) is composed of no more than ten unaffiliated co-venturers, (ii) is in the business of engaging in activities that are permissible for the bank, other than investing in securities for resale or other disposition; and (iii) is not, and does not hold itself out being, an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities."10
The preamble to the Volcker Rule provides background to the Agencies' decision to exclude qualifying joint ventures from the prohibition on covered fund activities.11 The proposed rule would have limited the joint venture exclusion to "operating companies" that did not engage in activities prohibited under the Volcker Rule.12 Commenters requested that this limitation be broadened so as to permit routine corporate structures and risk sharing that may not meet the definition of an operating company. The Agencies decided to adopt some, but not all, of these suggestions; as stated by the Agencies, "[banks] will continue to be able to share the risk and cost of financing their banking activities through these types of entities which, as noted by commenters ..., may allow banking entities to more efficiently manage the risk of their operations."13 In FAQ 15, the Agencies followed the preamble in noting that the exclusion is "designed to allow a banking entity to more efficiently manage the risks of its banking operations by, for example, seeking to obtain or share complementary business expertise."14
The three prongs of the joint venture exclusion may be described as one quantitative prong and two prudential prongs. The quantitative limitation—no more than ten co-venturers—is random and without statistical justification, but largely simple to apply. The Agencies further explained this point in FAQ 15 when they noted "The conditions to the joint venture exclusion reflect that the exclusion is designed to be used by a banking entity to conduct businesses and operations in conjunction with a limited number of co-venturers and that the exclusion is not intended to include entities that invest in securities for resale or other disposition."15
The prudential ones are more tricky to apply. The Agencies' underlying concern is easy enough to understand: banks should not be able to use the joint venture exclusion to engage in the types of activities that the Volcker Rule otherwise prohibits. Hence, "the exclusion is not intended to include entities that invest in securities for resale or other disposition."16 The Agencies describe this limitation as preventing "a banking entity from relying on this exclusion to evade section 13 of the BHC Act ...," and state that the "Agencies will monitor joint ventures ... to ensure that they are not used by banking entities to evade the provisions of section 13."17
However, the Agencies struggle to translate that underlying concern into clear, easily applicable prudential limitations. On the one hand, they identify a banking power that may not be used in conjunction with the joint venture exclusion: "a banking entity may not use a joint venture to engage in merchant banking activities because that involves acquiring or retaining shares, assets, or ownership interests for the purpose of ultimate resale or disposition of the investment."18 On the other hand, they fail to identify any entities or arrangements that would qualify for the joint venture exclusion, outside of operating companies that are unlikely to be considered covered funds in the first place.
Ultimately, therefore, these prudential limitations may be redundant. As the Volcker Rule defines a "covered fund" largely by reference to the exemptions under 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the "1940 Act"), it is unclear what set of entities could both (x) meet the prudential limitations of the joint venture exclusion and also (y) need to rely upon the exemptions for registrations set forth in 3(c)(1) and 3(c)(7).19 It is only to such entities—a hazy group of structures that might, for one reason or other, inadvertently be considered covered funds but which do not primarily invest in securities for resale or other disposition—that the joint venture exclusion could possibly apply.
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1 See, e.g., 1A Norman Singer & Shambie Singer, Sutherland Statutes and Statutory Construction § 21.1 (7th ed. 2015).
2 Chapter 13 of the BHC Act was added by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds, Public Law 111–203, 124 Stat. 1. (2010). Final rules implementing the statute were published in the Federal Register in early 2014. Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5536 (Jan. 31, 2014).
3 The final rule defines covered "banking entities" to include any of the following, unless otherwise exempted:
(i) Any insured depository institution;
(ii) Any company that controls an insured depository institution;
(iii) Any company that is treated as a bank holding company for purposes of section 8 of the International Banking Act of 1978; and
(iv) Any affiliate or subsidiary of an entity described above.
4 The final rulemaking generally defines "covered fund" to include any issuer that would be an Investment Company within the meaning of the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of that Act.
5 Things the Media believes the Volcker Rule says...but it actually doesn't (Feb. 5, 2015), available at https://www.milbank.com/images/content/1/9/19707/NYT-Volcker-Alert.pdf.
6 The five Agencies are the Office of the Comptroller of the Currency ("OCC"); Board of Governors of the Federal Reserve System ("Board"); Federal Deposit Insurance Corporation ("FDIC"); Securities and Exchange Commission ("SEC"); and the Commodity Futures Trading Commission ("CFTC"). The Federal Reserve, OCC, FDIC, and SEC issued a joint rulemaking; the CFTC separately issued a virtually identical rulemaking. The citations to the final regulations in this client alert refer to version codified by the Federal Reserve at 12 C.F.R. Part 248.
7 Exclusions from the definition of covered fund are listed in 12 C.F.R. § 248.10(c). Exemptions from the general prohibition on covered fund activity are found in 12 C.F.R. §§ 248.11-13.
8 12 C.F.R. § 248.10(c)(3).
10 12 C.F.R. § 248.10(c)(3). As the Agencies note in the preamble to the final regulations, however, if a banking entity owns 25 percent or more of the voting securities of the joint venture or otherwise controls an entity that qualifies for the joint venture exclusion, the joint venture would then itself be a banking entity subject to the restrictions of the Volcker Rule. See 79 Fed. Reg. 5536, 5681.
11 See 79 Fed. Reg. 5536, 5680-81.
12 Id., at 5680.
13 Id., at 5681.
14 See FAQ 15 at http://www.federalreserve.gov/bankinforeg/volcker-rule/faq.htm#1.5
17 79 Fed. Reg. 5536, 5681. Of course, the Volcker Rule itself contains an anti-evasion clause that would prohibit use of the joint venture exclusion (or any exclusion or exemption) to evade the purposes of the Volcker Rule. See 12 C.F.R. § 248.21(a).
18 79 Fed. Reg. 5536, 5681 n. 1790 and accompanying discussion. As we note later in this client alert, however, many banking entities have used their merchant banking powers to make investments that they could otherwise hold indefinitely under other sources of authority, but have chosen to hold such investments under their merchant banking authority for convenience.
19 15 U.S.C. § 80a-3(c).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.