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From Banking and Finance Law Daily, March 2, 2015

FAQ clears up SOTUS marketing restriction as to third-party covered fund

By John M. Pachkowski, J.D.

The Federal Reserve Board has updated its Frequently Asked Questions regarding the application of section 13 to the Bank Holding Company Act of 1956 (BHC Act), commonly referred to as the Volcker Rule, and regulations adopted by the Fed, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and Commodity Futures Trading Commission. The Fed noted that while the FAQs apply to banking entities for which the Fed has jurisdiction under section 13 of the BHC Act, they have been developed by staffs of all five agencies.

Marketing restriction. The latest FAQ, No. 13, discusses the scope of the “marketing restriction” found in the “SOTUS covered fund exemption” which is codified at 12 C.F.R. §248.13(b) of the Fed’s final rule. Under that exemption, certain covered fund activities conducted by foreign banking entities provided that, among other conditions, "no ownership interest in such hedge fund or private equity fund is offered for sale or sold to a resident of the United States"—the marketing restriction.

In their analysis, the agencies’ staff stated that the marketing restriction serves to limit the SOTUS covered fund exemption so that it "does not advantage foreign banking entities relative to U.S. banking entities with respect to providing their covered fund services in the United States by prohibiting the offer or sale of ownership interests in related covered funds to residents of the United States."

Third-party covered fund. The scope of the marketing restriction was raised by a number of sponsors of covered funds and foreign banking entities. Specifically, they asked the agencies’ staff how the marketing restriction would apply to a "third-party covered fund." This type of transaction would arise when a foreign banking entity, or its affiliates, has made, or intends to make, an investment in a covered fund where the foreign banking entity, including its affiliates, does not sponsor, or serve, directly or indirectly, as the investment manager, investment adviser, commodity pool operator or commodity trading advisor to, the third-party covered fund.

Limiting extraterritorial reach. The agencies’ staff determined that the marketing restriction, as implemented in the final rule, constrains the foreign banking entity in connection with its own activities with respect to covered funds rather than the activities of unaffiliated third parties, thereby ensuring that the foreign banking entity seeking to rely on the SOTUS covered fund exemption does not engage in an offering of ownership interests that targets residents of the United States. They noted that this “view is consistent with limiting the extraterritorial application of section 13 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.

Third-party application. The staff added that if the marketing restriction were applied to the activities of third parties, such as the sponsor of a third-party covered fund, rather than the foreign banking entity investing in a third-party covered fund, the SOTUS covered fund exemption may not be available in certain circumstances where the risks and activities of a foreign banking entity with respect to its investment in the covered fund are solely outside the United States. They noted, “The Agencies' discussion of the SOTUS covered fund exemption in the preamble does not suggest that the Agencies understood the SOTUS covered fund exemption to have such a limited application.”

Previous FAQs. The Fed issued its first set of FAQs in June 2014. That first set elaborated on applicable definitions and exemptions, and was designed to assist banking entities in maintaining compliance with recordkeeping and reporting obligations. They also covered: the breadth of the term “trading desk” and related reporting obligations; how to comply with the conformance period requirements; application of the “covered fund” exclusions for loan securitizations and foreign public funds; and the naming of covered funds and banking entities (see Banking and Finance Law DailyJune 11, 2014).

In a September 2014 update, the agencies’ staff discussed when a banking entity, which is subject to the enhanced minimum standards for compliance program requirements under the agencies’ regulations, must file its annual first annual CEO attestation to the relevant agency (see Banking and Finance Law DailySept. 11, 2014).

third update was released in November 2014 and discussed metrics reporting during the conformance period and treatment of mortgage-backed securities issuers sponsored by government-sponsored enterprises treated under the final rule's covered funds provisions (see Banking and Finance Law DailyNov. 14, 2014).

An update, in late December 2014, examined whether the metrics data that a banking entity must report under Appendix A of the final rule is protected by the Freedom of Information Act (see Banking and Finance Law DailyDec. 29, 2014).

The first update of 2015 clarified the metrics reporting deadlines during the conformance period for proprietary trading activities; and discussed the applicability of the proprietary trading exceptions found in the agencies’ regulations to the principal and interest components of the Treasury Department’s Separate Trading of Registered Interest and Principal of Securities or STRIPS program (see Banking and Finance Law DailyFeb. 2, 2015).

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