Volcker Rule implications

The Volcker Rule (Section 619 of the Dodd-Frank Act) restricts banks from proprietary trading and from owning interests in “covered funds.” For ABF, the covered fund restriction is what matters. If your ABF vehicle is a covered fund, banking entities cannot acquire ownership interests, which can dramatically shrink your investor universe.

This guide covers the covered fund definition, exclusions relevant to ABF, and structuring approaches.

Why Volcker matters for ABF

The basic prohibition

Banking entities (banks and their affiliates) cannot:

Engage in proprietary trading
Acquire or retain an “ownership interest” in a “covered fund”
Sponsor a covered fund (with limited exceptions)

Who is a banking entity?

Covered:

Insured depository institutions (banks, thrifts)
Bank holding companies
Foreign banking organizations
Affiliates and subsidiaries of the above

Scope:

Very broad: includes broker-dealers affiliated with banks
Asset management affiliates of banks
Insurance company affiliates of bank holding companies
Foreign bank branches and affiliates

Not covered:

Independent investment managers (not affiliated with banks)
Insurance companies (if not owned by bank holding company)
Credit funds with no bank affiliation
Pension funds

Impact on ABF

If your ABF vehicle is a covered fund:

Banks cannot invest in equity
Bank-affiliated asset managers cannot manage the vehicle
Bank affiliates cannot be sponsors
Dramatically limits investor universe

Why this matters:

Bank-affiliated asset managers control significant capital
Insurance companies affiliated with banks are covered
Excluding “banking entities” excludes substantial demand

Covered fund definition

A “covered fund” generally includes:

Issuers that would be investment companies under the Investment Company Act but for Section 3(c)(1) or 3(c)(7)
Certain commodity pools

3(c)(1) and 3(c)(7) create covered fund status

This is the critical link:

Most ABF vehicles rely on 3(c)(7) for Investment Company Act exemption
Relying on 3(c)(7) creates covered fund status by default
Need an exclusion to escape covered fund treatment

What counts as an ownership interest?

Ownership interests include:

Equity interests in the fund
Partnership interests
Membership interests in LLCs
Any interest that provides share of profits/losses
Any interest that gives holder equity-like participation

What is NOT an ownership interest:

Senior debt (fixed payments, no profit participation)
Routine fees paid to administrators or servicers
Carried interest in limited circumstances (with restrictions)

Key point: Banks can often hold senior debt positions in a covered fund without violating Volcker. The prohibition is on “ownership interests” not all interests.

Exclusions from covered fund definition

Several exclusions can take your ABF vehicle out of covered fund treatment. These are the key tools for structuring.

Loan securitization exclusion

The most important exclusion for ABF:

A vehicle is excluded if:

Assets consist solely of “loans” (as defined)
Certain rights or assets related to such loans
Contractual rights to acquire loans
Certain securities that are not permissible investments (up to 5%)

What qualifies as a “loan”:

Extension of credit directly to borrower
Originated by the issuer or purchased (not in a secondary market offering)
Includes whole loans, revolving credit facilities, letters of credit

What doesn’t qualify:

Securities (bonds, ABS tranches)
Syndicated loans acquired in secondary market transactions (with some exceptions)
RMBS/CMBS positions

The 5% securities bucket:

Up to 5% of assets can be securities
Cash equivalents, interest rate derivatives for hedging
Securities received in workout scenarios

Why this matters:

Whole loan ABF vehicles (auto, consumer, mortgage whole loans) typically qualify
Securitization of loans fits the exclusion
But mixed-asset vehicles or funds holding ABS tranches may not qualify

Rule 3a-7 exclusion

If your vehicle qualifies under Rule 3a-7 of the Investment Company Act, it is excluded from covered fund definition:

3a-7 requirements (refresher):

Fixed-income securities dependent on cash flow from self-liquidating financial assets
Trustee administration
Limited activities (no active management)

Why 3a-7 helps twice:

Provides Investment Company Act exclusion
Also provides Volcker Rule exclusion

Practical implication:

Many term ABS structures qualify under 3a-7
Static pools, traditional securitizations, pass-through structures
Managed CLOs with active trading typically don’t qualify

ABCP exclusion

Asset-backed commercial paper conduits meeting specific requirements are excluded:

100% liquidity support
Sponsor provides liquidity and credit support
Meets other structural requirements

This matters for bank-sponsored ABCP programs but is less common in private ABF.

Public offering exclusion

Vehicles making public offerings (registered under the Securities Act) are excluded:

Registered investment companies
Business development companies (BDCs)

Most private ABF doesn’t qualify, but this explains why public vehicles are not covered funds.

Foreign covered fund exclusion

Vehicles organized outside the United States and offered only to non-U.S. persons may be excluded:

No U.S. investors
Foreign organization
Additional requirements

Limited application for most ABF targeting U.S. institutional investors.

Structuring for Volcker compliance

Strategy 1: Qualify for loan securitization exclusion

When it works:

Whole loan portfolios (auto, consumer, mortgage)
Direct lending (equipment, small business)
Trade receivables (if structured as loans)

How to structure:

Ensure assets are “loans” under the definition
Limit securities to 5% or less
Document the exclusion analysis

Documentation:

Volcker Rule compliance memo from counsel
Asset composition monitoring
Investor representations regarding Volcker

Strategy 2: Qualify for 3a-7 exclusion

When it works:

Term securitizations with static pools
Pass-through structures
Deals with limited discretion

How to structure:

Fixed-income securities only
Self-liquidating assets
Independent trustee
Limited activities (no trading)

Ongoing compliance:

Monitor reinvestment restrictions
No discretionary trading
Maintain trustee independence

Strategy 3: Debt-only structure for banks

Even if the vehicle is a covered fund, banks can hold debt if it’s not an “ownership interest”:

Senior debt positions:

Fixed payments (interest and principal)
No profit participation
No equity-like features (conversion, warrants)
No share in residual value

How to structure:

Bank holds senior notes only
Equity/residual held by non-bank investors
Clean separation between debt and equity features

Documentation:

Note terms clearly debt-like
No contingent payments tied to residual
Subordination clearly establishes seniority

Strategy 4: Investment by non-affiliated entities

If banking entities cannot invest, focus on:

Insurance companies not affiliated with banks
Independent credit funds
Pension funds
Family offices
Non-U.S. investors

Practical consideration:

Many large investors are bank affiliates
Understand investor’s Volcker status before marketing
May need to adjust target investor universe

Volcker compliance documentation

Pre-closing analysis

Counsel should prepare:

Covered fund analysis
Exclusion qualification analysis
Asset composition review
Ownership interest analysis (for each security type)

Key questions to address:

Is the vehicle relying on 3(c)(1) or 3(c)(7)?
Does an exclusion apply?
If covered fund, are bank investments limited to non-ownership interests?

Offering document disclosure

Standard disclosure includes:

Covered fund status (or exclusion qualification)
Volcker Rule limitations on bank investors
Investor representations regarding Volcker compliance

Sample language: “The Issuer has not been registered as an investment company under the Investment Company Act and relies on [Section 3(c)(7) thereof][Rule 3a-7 thereunder]. [The Issuer qualifies for the loan securitization exclusion under the Volcker Rule and is not a ‘covered fund.’][The Issuer is a ‘covered fund’ under the Volcker Rule, and banking entities are prohibited from acquiring ownership interests in the Issuer.]”

Investor representations

For bank investors (or potential bank investors):

Certifications may include:

Investor is not a banking entity, or
Investor is a banking entity but investment is not an “ownership interest,” or
Investor is a banking entity acquiring only permitted debt positions

Transfer restrictions:

May need to restrict transfers to banking entities if covered fund
Or require transferee representations

Practical considerations

When to worry about Volcker

Volcker is critical when:

Targeting bank balance sheet as investors
Bank-affiliated asset managers in investor universe
Insurance companies affiliated with bank holding companies
Structure involves equity or profit participation

Volcker is less critical when:

Targeting independent credit funds only
No bank-affiliated investors contemplated
Structure is clearly loan securitization

Common Volcker issues

Mixed-asset pools:

Portfolio of loans plus ABS tranches
May not qualify for loan securitization exclusion
May need to limit ABS to 5% bucket

CLOs:

BSL CLOs: loan securitization exclusion analysis required
Middle market CLOs: may be originators, different analysis
Managed vs. static: affects 3a-7 analysis

Warehouses:

Often structured as credit facilities, not funds
But warehouse SPV may be a covered fund
Structure warehouse lender position as debt

Market practice

Rating agency considerations:

Rating agencies don’t directly address Volcker
But Volcker status affects investor base and liquidity

Investor expectations:

Sophisticated bank investors will conduct own analysis
They’ll want to see your counsel’s memo
Be prepared to discuss exclusion analysis

Interaction with other regulations

Investment Company Act

The link:

Covered fund status derives from ICA exemption (3(c)(1) or 3(c)(7))
3a-7 provides both ICA exclusion and Volcker exclusion
ICA analysis comes first, then Volcker analysis

Risk retention

Separate analysis:

Volcker doesn’t affect risk retention requirements
Can be covered fund and still subject to risk retention
Or qualify for Volcker exclusion and still retain

Securities Act

Independent requirements:

Volcker status doesn’t affect Securities Act registration
Covered funds can still do private placements
Exclusions from covered fund status don’t create Securities Act exemptions

Compliance checklist

Pre-closing:

Identify primary Investment Company Act exemption
Analyze covered fund status
Determine if exclusion applies (loan securitization, 3a-7, other)
If covered fund, identify which interests are “ownership interests”
Prepare Volcker Rule compliance memo
Include appropriate disclosure in offering documents
Draft investor representations (if bank investors expected)

Structuring (if banks are targets):

Structure for exclusion qualification (loan securitization or 3a-7)
Or structure bank positions as non-ownership interests (senior debt)
Monitor asset composition for loan securitization exclusion
Document compliance with exclusion requirements

Ongoing:

Monitor asset composition (5% securities limit)
Track 3a-7 compliance (limited activities)
Update analysis if structure changes
Reconfirm investor status on transfers

Common questions

Can banks buy any part of a covered fund?

Yes, if the interest is not an “ownership interest.” Senior debt with fixed payments, no profit participation, and no equity features is generally not an ownership interest. Banks can often buy the senior tranches of a covered fund structure.

What if we’re not sure if an asset is a “loan”?

Consult counsel. The loan securitization exclusion has a specific definition of “loan” that has been refined through regulatory guidance. Secondary market purchases of loans, participations, and certain other structures require careful analysis.

Do foreign banks care about Volcker?

Yes, if they have U.S. operations. Foreign banking organizations with U.S. branches, agencies, or subsidiaries are “banking entities” under Volcker. But purely foreign banks with no U.S. presence are not covered.

What happens if we violate Volcker?

Banking entities that violate Volcker face regulatory consequences:

Required divestiture
Potential enforcement action
Regulatory criticism

For the ABF vehicle itself, there’s no direct penalty, but bank investors may be forced to exit, disrupting the capital structure.