On November 26, 2010, the Federal Reserve Board (FRB) published in the Federal Register (75 Federal Register 72741 (Nov. 26, 2010)) a proposal to implement the conformance periods imposed by section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which prohibits and restricts banking entities from engaging in proprietary trading or from investing in, sponsoring, or having certain relationships with hedge funds and private equity funds (the Volcker Rule). The FRB requests comments on or before January 11, 2011. The proposal establishes the standards and procedures under which the FRB would grant extensions to divest of prohibited investments or to conform restricted or prohibited activities. The proposal defines key terms such as “illiquid fund,” “illiquid assets,” “principally invested,” and “contractually committed to principally invest” that are essential to determining whether a fund investment qualifies for the 10-year holding period for illiquid funds under the Volcker Rule.
I. Effective Dates and Conformance Periods
The restrictions and prohibitions of the Volcker Rule, which comprises a new section 13 of the Bank Holding Company Act of 1956, as amended (BHC Act), will be effective 12 months after issuance of final rules by the agencies, or July 21, 2012, whichever is earlier.  The FRB is solely charged with adopting rules to implement the provisions of the Volcker Rule that provide a banking entity  a period of time after the effective date of the Volcker Rule to bring the activities, investments and relationships of the banking entity commenced, acquired, or entered into before the effective date of the Volcker Rule into compliance with the Volcker Rule and the agencies’ implementing regulations. The FRB is required to issue final rules no later than January 21, 2011.
The prohibitions and restrictions of the Volcker Rule do not take effect until the earlier of July 21, 2012, or 12 months after the agencies issue final regulations under section 13(b)(2) of the BHC Act. However, the Volcker Rule also provides banking entities an additional conformance period during which the entity may wind down, sell, or otherwise conform its activities, investments and relationships to the requirements of the Volcker Rule. Under the statute, this conformance period generally extends through the date that is two years after the date on which the prohibitions become effective.
The FRB may by rule or by order extend the generally available two-year conformance period by up to three additional one-year periods, for an aggregate conformance period of five years.
II. Procedures and Standards for Obtaining an Extension
In order to grant any extension, the FRB must determine that the extension is consistent with the purposes of the Volcker Rule and would not be detrimental to the public interest. A banking entity that seeks a one-year extension of the conformance period would be required to submit a request to the FRB (i) in writing at least 90 days prior to the expiration of the applicable time period; (ii) describing the reasons why the banking entity believes the extension should be granted; and (iii) providing a detailed explanation of the banking entity’s plan for divesting or conforming the activity or investment.
An extension request by a banking entity would be required to address up to11 individual factors to the extent relevant, including current market conditions, the total exposure of the banking entity to the activity or investment and the risks that disposing of, or maintaining, the investment or activity may pose to the banking entity or the financial stability of the United States, the cost to the banking entity of disposing of the activity or investment within the applicable period, and any other factors the FRB deems appropriate.
III. Additional Extension Period Available for Illiquid Funds
The Volcker Rule includes a special provision to address the difficulty a banking entity may experience in conforming investments in illiquid funds. This provision expressly permits the FRB to grant a banking entity’s request for an additional extension of up to five years in order to permit the banking entity to meet contractual commitments in place as of May 1, 2010, to a hedge fund or private equity fund that qualifies as an “illiquid fund.” Specifically, the FRB may extend the period during which a banking entity may take or retain an ownership interest in, or otherwise provide additional capital to, an illiquid fund, but only if the extension is necessary to allow the banking entity to fulfill a contractual obligation that was in effect on May 1, 2010. Any extended transition period with respect to an illiquid fund may not exceed five years and may be in addition to the conformance period available under other provisions of the Volcker Rule. The procedures and standards that apply to other conformance extensions under the Volcker Rule would also apply to additional extensions related to illiquid funds.
A. Definition of an “Illiquid Fund”
Consistent with the statutory language of the Volcker Rule, the proposed rule defines an “illiquid fund” to mean a hedge fund or private equity fund that: (i) as of May 1, 2010, was principally invested in illiquid assets, or was invested in, and contractually committed to invest principally in, illiquid assets; and (ii) makes all investments under, and consistent with, an investment strategy to invest principally in illiquid assets.
B. Definition of “Liquid Assets”
The proposed rule generally defines an “illiquid asset” as any asset that is not a liquid asset. In turn, “liquid assets” are defined to include:
These standards would treat as a liquid asset: (i) equity and debt securities, derivatives, and commodity futures traded on a registered securities exchange, board of trade, alternative trading system, electronic trading platform or similar market that provides independent, bona fide offers to buy and sell; (ii) assets traded on an electronic inter-dealer quotation system, such as OTC Bulletin Board or the system maintained by PINK OTC Markets, Inc., as well as over-the-counter derivatives, debt securities (such as corporate bonds), and syndicated commercial loans for which active inter-dealer markets exist; and (iii) financial instruments for which indicative price data is supplied by an electronic service, such as Markit Group Limited.
C. Assets Regarded as Illiquid
The FRB indicated that this proposed approach to defining illiquid assets should result in treatment as illiquid assets investments in portfolio companies, investments in real estate (other than those made through publicly traded REITs), venture capital investments, and investments in other hedge funds or private equity funds that both are not publicly traded and invest in illiquid assets. The proposed rule also provides that an asset—including a liquid asset such as a security—may be considered an “illiquid asset” if, because of statutory or regulatory restrictions applicable to the hedge fund, private equity fund or asset, the asset cannot be offered, sold, or otherwise transferred by the hedge fund or private equity fund to a person that is unaffiliated with the banking entity. However, the proposed rule expressly provides that an asset may be considered an illiquid asset under this provision only for so long as and to the extent that the relevant statutory or regulatory restriction is effective.
Investment Objectives of an Illiquid Fund
The proposed rule provides that a hedge fund or private equity fund will be considered to be “principally invested” in illiquid assets only if at least 75 percent of the fund’s consolidated total assets are, or are expected to be, comprised of illiquid assets or risk-mitigating hedges entered into in connection with, and related to, individual or aggregated positions in, or holdings of, illiquid assets. 
The proposed rule also provides that a fund will be considered “contractually committed to principally invest” in illiquid assets as of May 1, 2010, if the fund’s organizational documents (such as the limited partnership agreement), or other documents that constitute a contractual obligation of the fund (such as a binding side letter agreement entered into with investors) that was in effect as of May 1, 2010, provide for the fund to be principally invested in illiquid assets during the period beginning on the date when capital contributions are first received by the fund for the purpose of making investments and ending on the fund’s expected termination date. This definition is intended to recognize that an illiquid fund may have more than 25 percent of its assets in cash or money market instruments during its initial pre-investment organizational period, while the fund seeks to meet its investment objective of investing principally in illiquid assets.
A fund would be considered to have an “investment strategy to principally invest” in illiquid assets if the fund either: (i) markets or holds itself out to investors as intending to invest principally in illiquid assets; or (ii) has a documented investment policy of principally investing in illiquid assets. In considering whether a hedge fund or private equity fund’s organizational documents, marketing materials, or investment policy provide for the fund to invest principally in illiquid assets, the FRB expects a banking entity to consider whether the assets the fund expects to acquire are of the type and nature that would make the assets “illiquid assets” or “liquid assets” for purposes of the rule.
Under the proposal, a fund generally would be considered to invest in illiquid assets if the fund’s organizational documents provide for the fund to invest in the equity of early-stage nonpublic companies, even if the fund’s documents do not specify that the equity of such companies must not be traded or quoted in the manner that indicates an asset might be liquid.
E. “Contractual Obligation” to Remain Invested
The proposed rule provides that a banking entity will be considered to have a “contractual obligation” to remain invested in a fund only if the banking entity, under the contractual terms of its equity, partnership, or other ownership interest in the fund or other contractual arrangements with the fund that were in effect as of May 1, 2010, is prohibited from both: (i) redeeming all of its equity, partnership, or other ownership interests in the fund; and (ii) selling or otherwise transferring all such ownership interests to a person that is not an affiliate of the banking entity. Similarly, the proposed rule specifies that a banking entity has a contractual obligation to provide additional capital to an illiquid fund only if the banking entity is required, under the contractual terms of its equity, partnership, or other ownership interest in the fund or other contractual arrangements with the fund that were in effect as of May 1, 2010, to provide additional capital to the fund.
In order to address situations in which a banking entity could obtain a waiver of a required investment from a general partner or other investors of a fund the proposed rule provides that the banking entity’s obligation to remain invested in, or provide additional capital to, a fund cannot be terminated by the banking entity itself or through its reasonable best efforts.
A banking entity should review its current activities and investments that would be affected by the Volcker Rule to determine if an extension of the conformance period might be necessary and whether the standards and information requirements that would be applied by the FRB sufficiently address the circumstances of the particular case to permit the FRB to approve an extension. In the case of illiquid fund investments, an entity should review whether the definitions proposed by the FRB create any ambiguity as to whether a particular fund would qualify as “illiquid” for purposes of the extended holding period.
As a general matter, authority for developing and adopting regulations to implement the prohibitions and
restrictions of the Volcker Rule is divided between the FRB, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC) in the manner provided in section 13(b)(2) of the BHC Act. The FRB and these other agencies are directed to adopt implementing rules not later than nine months after the Financial Services Oversight Council (FSOC) completes a mandated study on Volcker Rule issues. The FSOC study is due January 21, 2011.
A “banking entity” includes a bank or thrift holding company, a foreign banking organization that is subject to the BHC Act, an insured depository institution, and any affiliate or subsidiary of the foregoing. Thus, a company could be affiliated with a bank through common control by an individual or group of individuals and would be subject to the Volcker Rule. The definitions of “banking entity,” “private equity fund,” and “hedge fund” are ultimately subject to the joint agency rulemaking on the substantive provisions of the Volcker Rule. The FRB adopted the statutory definitions of these terms in recognition of the broader rulemaking. The proposal also would apply to nonbank financial companies that will be supervised by the FRB.
The proposal would allow a fund to count risk-mitigating hedging positions that are related to the fund’s holdings of illiquid assets towards the 75 percent asset test because such positions are, by definition, associated with the fund’s illiquid holdings. The FRB stated that this approach is consistent with safe and sound risk-management practices and other provisions of the Volcker Rule.
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