Statement of Commissioner Allison Herren Lee on the Continued Repeal of the Volcker Rule
Jan. 30, 2020
Today we continue the march toward effective repeal of the Volcker Rule. The rule is premised on the common sense proposition that banks should not be allowed to gamble with taxpayer money and that taxpayers should never again be forced to rescue banks and their highly compensated executives from the consequences of their bad decisions.
The Volcker Rule seeks to protect taxpayers by prohibiting short-term, speculative trading by banks and restricting their investments in high-risk funds (referred to as “covered funds”). Last fall, we significantly weakened the former,[1] and today we propose to undermine the latter.[2]
Today’s proposal would increase banks’ ability to add risk to their balance sheets in two significant ways. It would broaden the categories of private funds in which banks can invest—most notably by including venture capital and credit funds. And, it would allow banks to evade certain investment restrictions by permitting a greater degree of “parallel investment” alongside covered funds, thus allowing exposure to these often high-risk holdings.
As with the rule last fall, this proposal replaces clear, common sense restrictions with just the hope that banks will self-police and remain diligent in identifying and mitigating their own risks—an expectation that flies in the face of experience. The structures of large financial institutions, including bankers’ compensation, still strongly incentivize the kind of risk taking that led to the financial crisis. Hope will not protect investors from banks’ appetite for risk in the pursuit of yield. I cannot support the proposal.[3]
Once again, the proposal has not provided evidence or analysis in support of the proposed changes.[4] The changes are, by and large, not correcting unforeseen complications or making adjustments to reflect changes in circumstances since the rule’s adoption in 2013.[5] In fact, many of the changes proposed today were specifically considered and rejected by the agencies in adopting the final rule in 2013.[6] While I have numerous issues with the ways in which the proposal would erode the basic protections of the Volcker Rule[7], I want to highlight two of my more significant concerns.
Venture Capital Funds
The proposal states, without any supporting evidence, that permitting banks to invest in venture capital funds “could promote and protect the safety and soundness of banking entities and the financial stability of the United States.”[8] The proposal, however, provides no meaningful analysis of the high-risk nature of venture capital. These funds are speculative by design, and yet the proposal illogically concludes that investing in them will make banks safer. The need for the changes is also unclear, especially in light of the historic growth in venture capital over the past two years.[9] In glossing over the risk—a consideration that should be central to any changes in the covered fund provisions—the proposal strays from Congressional intent and ignores recent experience that illustrates the significant hazards in this part of the market.[10]
Prior to the adoption of the final rule in 2013, numerous industry commenters on the proposed rule requested a carve-out for venture capital funds.[11] The agencies determined, however, that the very changes we propose today are inconsistent with the statutory mandate of the Volcker Rule.[12] Specifically, the agencies stated that “the statutory language of [the Volcker Rule] does not support providing an exclusion for venture capital funds from the definition of covered fund.”[13] Despite calls to differentiate venture capital funds from other forms of private equity, the agencies explained that “the activities and risk profiles for banking entities regarding sponsorship of, and investment in, venture capital funds and private equity funds are not readily distinguishable.”[14]
Today, the agencies simply reverse course. The proposal would now adopt the Commission’s definition of “venture capital fund” from an unrelated rule and use that to distinguish venture capital from private equity[15]—an argument that was also considered and rejected by the agencies in 2013.[16] The agencies determined at the time that Congress did not intend to permit banks to invest in speculative private funds, and the contours of the Commission’s venture capital fund definition do not reasonably differentiate these funds for purposes of the Volcker Rule. Congress’ intent in adopting the Volcker Rule in 2010, as interpreted by the agencies in 2013, does not change with the passage of time, nor does today’s proposal support this fundamental reinterpretation.[17] Significantly, had Congress held the view that the 2013 interpretation was wrong or in need of adjustment, it could have addressed this in the legislative changes to the Volcker Rule that it adopted in 2018, but it did not.[18]
The proposal’s reliance on the Commission’s separate definition of “venture capital fund” also raises two additional concerns. First, by incorporating the Commission’s definition into today’s proposal, the agencies give the Commission substantial control over the degree of risk that is acceptable for banks to take with these types of investments. The Commission is not a prudential regulator; our mission is not anchored in principles of safety and soundness for banking institutions. However, to the extent that the Commission makes changes that broaden the current definition of “venture capital fund”—and we are receiving calls to do so[19]—we will concomitantly permit increased risk-taking by banks.
Second, the actions taken today have the potential to increase the level of risk that venture capital funds present to the financial system. When Congress adopted the Volcker Rule—which was intended to keep banks out of speculative private funds such as venture capital—it also adopted a provision relieving advisers to venture capital funds of the requirement to register with the Commission.[20] In providing this exemption, Congress relied heavily on the notion that venture capital funds, because of the nature of their operations, are less likely to present systemic risk than other types of private equity or hedge funds.[21] Congress believed that their “activities are not interconnected with the global financial system” and that the high level of risk inherent in these funds is borne by fund investors and not the broader economy.[22] Today’s proposal would allow banks greater flexibility to invest in venture capital funds. If this proposal is adopted, both Congress and the Commission should consider whether permitting banks to pursue speculative investments in venture capital funds calls into question the rationale for the registration exemption.[23]
Parallel Investments
The proposal would also lift certain restrictions on banks’ investing alongside a covered fund, or “parallel investment,” thus opening the door to evasion of the rule’s investment prohibitions.
The 2013 Adopting Release limited banks’ ability to engage in certain types of investment activity in parallel with covered funds. The agencies stated that if a bank invests in substantially the same positions as a covered fund, “then the value of such investments shall be included for purposes of determining the value of the banking entity’s investment in the covered fund.”[24] The agencies took the same position with respect to commitments by a bank to co-invest with a covered fund in a privately negotiated transaction.[25] The rule limits the value of a bank’s investments in any covered fund to a de minimis amount, and the agencies’ position on these parallel investment activities was meant to ensure that such activity was counted toward that de minimis limitation.[26] After all, substantial investment alongside of a covered fund raises many of the same concerns as direct investments in the fund.
Today’s proposal, however, reverses course and would specifically instruct banks that such parallel investments need not be counted toward the de minimis limitation.[27] Thus, parallel investments could be used to evade the prohibitions on investing in covered funds. [28]
Moreover, a bank may be motivated to make such investments in order to artificially maintain the value of a fund it has sponsored and the underlying assets to which the bank also has direct exposure. While the proposal asserts that banks still could not use parallel investments “for the purpose of artificially maintaining or increasing the value of the fund’s positions,”[29] it goes on to explain that a bank may now “market a covered fund it organizes and offers . . . on the basis of the banking entity’s expectation that it would invest in parallel with the covered funds in some or all of the same investments.”[30] Thus, despite the assertion that banks still may not artificially maintain the value of sponsored covered funds, the proposal specifically suggests that banks pursue the very arrangements that could create market pressure and incentives for them to do just that. It is hard to imagine that this is what Congress intended in adopting the Volcker Rule.
Nothing in today’s proposal would reduce the potential for systemic risk or subject banks to more meaningful oversight of high-risk investment activity. The proposal does not balance competing concerns; it does not seek to enhance protections in some areas while dialing them back because of new evidence in others. Rather, it uniformly allows banks to take on greater risk, especially in the form of investments in venture capital and credit funds, and increases opportunities for evasion of the restrictions that remain. In the case of venture capital funds, this not only imports the risks of such funds into the banking system, but, in doing so, undermines the rationale for exempting advisers to venture capital funds from registration with the Commission.
Although I cannot support the proposal in its current form, I look forward to receiving comment from the public about how the agencies can address the risks inherent in the proposed changes.
[1] See Final Rule: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, Bank Holding Company Act Rel. No. 7 (Sept. 18, 2019).
[2] See Proposed Rule: Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds [citation forthcoming] (Jan. 30, 2020) (“Proposing Release”).
[3] While I am unable to support today’s proposal, I want to thank the staff from the Division of Investment Management, Division of Trading and Markets, Division of Economic and Risk Analysis, and the Office of the General Counsel for their work on today’s recommendation.
[4] The agencies state in today’s release that the changes are “intended to improve and streamline the covered fund provisions and provide clarity to banking entities.” See Proposing Release, supra note 2, at 14. Notably, all of the so-called improvements operate to provide more flexibility and reduce limitations on risk.
[5] See Final Rule, Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships With, Hedge Funds and Private Equity Funds, Bank Holding Company Act Rel. No. 1 (Dec. 10, 2013) (“2013 Adopting Release”).
[6] Compare 2013 Adopting Release, supra note 5, at 543 (adopting requirement for distribution “predominantly” through public offerings to avoid evasion of the rule’s requirements) with Proposing Release, supra note 2, at 28-30 (discussing elimination of the requirement for distribution “predominantly” through public offerings); compare 2013 Adopting Release, supra note 5, at 580 (stating that “[t]he Agencies believe the purpose underlying section 13 is not to expand the scope of assets in an excluded loan securitization beyond loans”) with Proposing Release, supra note 2, at 28-30 (stating that “the agencies are proposing to allow a loan securitization vehicle to hold up to five percent of assets in non-loan assets”); compare 2013 Adopting Release, supra note 5, at 648 (stating that the agencies were “unable effectively to distinguish credit funds from other types of private equity funds or hedge funds in a manner that would give effect to the language and purpose of section 13 and not raise concerns about banking entities being able to evade the requirements”) with Proposing Release, supra note 2, at 46-52 (discussing a proposed exclusion for credit funds and claiming that such an exclusion is consistent with Congressional intent); compare 2013 Adopting Release, supra note 5, at 644 (stating that “the statutory language of section 13 does not support providing an exclusion for venture capital funds from the definition of covered fund”) with Proposing Release, supra note 2, at 60 (stating that “the agencies are proposing to exclude from the definition of ‘covered fund’ qualifying venture capital funds”); compare 2013 Adopting Release, supra note 5, at 812-814 (referring to the plain language of the statute as prohibiting any “covered transaction, as defined in Section 23A” of the Federal Reserve Act) (emphasis in original) with Proposing Release, supra note 2, at 90-99 (claiming that the agencies have authority to permit certain covered transactions, as defined in Section 23A, notwithstanding the statute’s plain prohibition on such transactions); compare 2013 Adopting Release, supra note 5, at 765 (requiring banks to count certain parallel investments toward de minimis limitations because the agencies “believe that the potential for evasion of these limitations may be present where a banking entity coordinates its direct investment decisions with the investments of covered funds that it owns or sponsors”) with Proposing Release, supra note 2, at 112-120 (describing a proposed rule of construction that would instruct banks that they are not required to count such parallel investments toward the de minimis exemptions).
[7] In addition to my concerns about how the proposed changes with respect to venture capital and parallel investments disregard Congressional intent and will increase risk in the banking sector, I note that the agencies’ proposal contains a specific provision meant to facilitate greater access to investment services for billionaires. See Proposing Release, supra note 2, at 74-82 (discussing a new exclusion from the “covered funds” definition for “family wealth management vehicles”). While the provision of such services to billionaires may not present the same level of risk that is typical of certain other covered fund activities, the agencies might better serve the capital markets and the public at large by reallocating staff time and agency resources to facilitate greater access to investment services by Main Street investors and the middle class. Additionally, as my colleague from the Commodity Futures Trading Commission, Commissioner Dan Berkovitz, observed recently, “[t]he aggregate amount of wealth managed by family offices is staggering.” See Dissenting Statement of Commissioner Dan M. Berkovitz, Rulemaking to Provide Exemptive Relief for Family Office CPOs: Customer Protection Should be More Important than Relief for Billionaires (Nov. 25, 2019). Exempting banks from Volcker Rule compliance with respect to their relationships with such funds creates a significant incentive for banks and their clients to restructure other types of funds in an attempt to fit into this new carve-out.
[8] Proposing Release, supra note 2, at 69. Of course, this is what the agencies must claim; after all, that is the high bar that Congress set for increasing the range of permissible activities under the Volcker Rule. See Section 13(d)(1)(J) of the Bank Holding Company Act, 12 U.S.C. § 1851 (stating that the agencies may expand the list of permissible activities for banking entities “as the [agencies] determine, by rule, . . . would promote and protect the safety and soundness of the banking entity and the financial stability of the United States.”).
[9] Interestingly, some industry commenters made apocalyptic predictions about the impact of the Volcker Rule’s failure to exclude venture capital funds from the definition of “covered fund.” See, e.g., 2013 Adopting Release, supra note 5, at 643 (“One commenter argued, therefore that ‘preventing banks from investing in venture thus could depress U.S. GDP by roughly 1.5% (or $215 billion annually) and eliminate nearly 1% of all U.S. private sector employment over the long term.’”). The same commenter also argued that the funding gap left by banks’ exit from venture capital would not be filled by other market participants. Id. It seems, however, that venture capital funds have not suffered from a lack of capital, achieving record investment amounts in both 2018 and nearly matching those amounts in 2019. See, e.g., Pitchbook, 18 Charts to Illustrate US VC in 2018 (Jan. 28, 2019) (“There’s no contest for the biggest headline of the year in VC: Capital invested surpassed $100 billion for the first time since 2000. The $130.9 billion invested . . . smashed the previous record [from 2000] of $105 billion.”); Pitchbook and NVCA, Venture Monitor Q4 2019 (Jan. 13, 2020).
[10] See, e.g., Yuliya Chernova, WeWork Debacle Highlights the Risks of High Valuations Set by Existing Investors, Wall St. J. (Oct. 14, 2019) (“SoftBank Group Corp. led WeWork’s August 2017 fundraising round at a $20 billion valuation, then another valuing the provider of shared office space at $47 billion in January this year. Now, SoftBank is preparing a financing deal that could value We Co., WeWork’s parent, at less than $10 billion, The Wall Street Journal reported, citing people familiar with the matter. The company needs funding to stave off a cash crunch in the wake of a failed effort to go public.”); Robert Smith, WeWork Could be the Venture Capital Boom’s ‘Burning Bed’ Moment, Financial Times (Oct. 15, 2019) (“In the 1980s, investment banks backed these dubious deals in the belief they could easily flip the debt on to bond investors. Today, venture capital funds chase companies with no immediate path to profitability, believing that public equity markets will buy them at even higher valuations.”).
[11] See, e.g., Comment Letter of SIFMA et al. (Feb. 13, 2012), Comment Letter of SVB Financial Group (Feb. 13, 2012); Comment Letter of National Venture Capital Association (Feb. 3, 2012).
[12] 2013 Adopting Release, supra note 5, at 642-647.
[13] Id. at 644.
[14] Id. at 645.
[15] See Proposing Release, supra note 2, at 65-68. See also 17 C.F.R. § 275.203(l)-1 (“Rule 203(l)-1”). Rule 203(l)-1 was adopted prior to the agencies’ adoption of the current covered fund provisions in 2013. See Final Rule: Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Rel. No. 3222 (June 22, 2011) (“VCF Adopting Release”). It is not as though the definition represents new information or a change in circumstances that might warrant revisiting the agencies’ determination from 2013.
[16] See, e.g., 2013 Adopting Release, supra note 5, at fn. 2066. Interestingly, some industry commenters also made apocalyptic predictions about the impact of the Volcker Rule’s failure to exclude venture capital funds from the definition of “covered fund.” See, e.g., id. at 643 (“One commenter argued, therefore that ‘preventing banks from investing in venture thus could depress U.S. GDP by roughly 1.5% (or $215 billion annually) and eliminate nearly 1% of all U.S. private sector employment over the long term.’”). The same commenter also argued that the funding gap left by banks’ exit from venture capital would not be filled by other market participants. Id. It seems, however, that venture capital funds have not suffered from a lack of capital, achieving record investment amounts in both 2018 and nearly matching those amounts in 2019. See, e.g., Pitchbook, 18 Charts to Illustrate US VC in 2018 (Jan. 28, 2019) (“There’s no contest for the biggest headline of the in VC: Capital invested surpassed $100 billion for the first time since 2000. The $130.9 billion invested . . . smashed the previous record [from 2000] of $105 billion.”); Pitchbook and NVCA, Venture Monitor Q4 2019 (Jan. 13, 2020).
[17] In an attempt to support today’s reinterpretation of Congressional intent, the agencies cite the statements of a number of individual members of Congress. Again, these statements do not reflect new information that would warrant a reconsideration and reversal on the agencies’ considered decisions from 2013. At the time of adoption in 2013, the agencies acknowledged those very same statements—see, e.g., 2013 Adopting Release, supra note 5, at fn. 2060—in addition to contrary opinions of members of Congress that are notably absent from today’s proposal. See id. at fn. 2068. See also Comment Letter of Senators Jeff Merkley and Carl Levin (Feb. 13, 2012) (responding to questions about whether venture capital should be excluded from the definition of covered funds: “It should not. The statute does not provide for these additional permitted activities. Recent studies have suggested that bank capital makes up only about seven percent of the capital presently in venture capital funds. Basic economics tells us that such capital can be made up from elsewhere in the economy, as capital flows to its most profitable use. In addition, investing in venture capital funds is a high risk activity with significant risk of loss. The vast majority of banks have not traditionally invested in venture capital funds and overall are not major players in the venture capital arena. Rather than investing in venture capital funds, banks can and should issue loans directly to new businesses which they judge creditworthy.”).
[18] See Economic Growth, Regulatory Relief, and Consumer Protection Act, Pub. L. No. 115-174 (2018).
[19] See, e.g., Letter to Dalia Blass, Director, Division of Investment Management, SEC from Bobby Franklin, President and CEO, National Venture Capital Association (Nov. 29, 2018) (calling for changes to the definition of “venture capital fund” including, among others: 1) permitting investment in a broader range of companies; 2) allowing investments in other venture capital funds; 3) flexibility to allow greater borrowing; and 4) investments in initial coin offerings, cryptocurrencies, and other digital assets). A proposal considered during the last Congress would have permitted venture capital funds to engage in more secondary investments, rather than the primary investments currently required under the definition. See Developing and Empowering our Aspiring Leaders (DEAL) Act of 2018, S. 3576, 115th Cong. (2018). The Commission has previously highlighted—and the agencies acknowledge in today’s proposal—the “critical role this condition played in differentiating venture capital funds from other types of funds, such as leveraged buyout funds.” See VCF Adopting Release, supra note 15, at 24; Proposing Release, supra note 2, at 64 and fn. 142. Expanding venture capital funds’ ability to hold secondary investments would undermine a key benefit of venture capital funds; rather than providing capital directly to early-stage companies, venture capital funds would instead be providing liquidity to other investors.
[20] See Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. 111-203, Section 407 (2010). See also Investment Advisers Act of 1940, Section 203(l), 15 U.S.C. § 80b-3.
[21] See S. Rep. No. 111-176, at 74-75 (2010) (“The Committee believes that venture capital funds, a subset of private investment funds specializing in long-term equity investment in small or start-up businesses, do not present the same risks as the large private funds whose advisers are required to register with the SEC under this title. Their activities are not interconnected with the global financial system, and they generally rely on equity funding, so that losses that may occur do not ripple throughout world markets but are borne by fund investors alone.”).
[22] Id. In fact, the agencies selectively quote from the VCF Adopting Release relating to the definition of “venture capital fund” to suggest that these funds will pose lower risks to banks. The Commission was not, however, suggesting that venture capital funds are not speculative or do not present a high level of investment risk. Rather, the Commission was explaining why these funds, on their own, might not present systemic risk.
[23] Investment by banks in venture capital funds creates a clear path for the risk of such funds to move into the banking sector and other parts of the public markets. Assuming that the agencies finalize today’s proposal in its current form, we should consider whether we can continue to view venture capital funds as somehow disconnected from those markets such that it would justify exempting the advisers from registration.
[24] 2013 Adopting Release, supra note 5, at 766.
[25] See id. at 765-766.
[26] See Section 13(d)(4)(B)(ii) of the Bank Holding Company Act, 12 U.S.C. § 1851 (“[I]nvestments by a banking entity in a hedge fund or private equity fund shall: I) not later than one year after date of establishment of the fund, be reduced . . . to not more than 3 percent of the total ownership interests of the fund; and II) be immaterial to the banking entity . . . but in no case may the aggregate of all the interests of the banking entity in all such funds exceed 3 percent of the Tier 1 capital of the banking entity.”).
[27] See Proposing Release, supra note 2, at 115-116.
[28] In fact, the release specifically acknowledges how today’s proposal will aggravate this risk, but suggests that those risks are outweighed by helping banks make such investments on their own balance sheets and touting the quality of the funds alongside which the bank is investing. See Proposing Release, supra note 2, at 212-213 (“The SEC recognizes that the proposed approach may increase the risk that some banking entities may seek to use parallel investments for the purpose of artificially maintaining or increasing the value of the assets of a fund that is organized and offered by the banking entity. Supporting a fund in such a manner would increase these banking entities’ exposures to the fund’s assets and would generally be inconsistent with the 2013 rule’s restriction on a banking entity guaranteeing, assuming, or otherwise insuring the obligations or performance of such a covered fund . . . In addition to removing impediments for banking entities’ otherwise permissible investments, the proposed rule of construction may enable banking entities to make investments alongside a covered fund that will signal the quality of the investment(s) to the banking entities’ clients and investors in the fund, and may also help align the incentives of banking entities, and their directors and employees, with those of the covered funds and their investors.”). Of course, allowing this would align incentives between banks and their sponsored funds, but those aligned incentives could also exacerbate existing risks with respect to a bank’s willingness to bail out such a fund.
[29] See Proposing Release, supra note 2, at 117. However the release also states that, with the proposed changes, a bank would not be prohibited from having “investment policies, arrangements or agreements to invest alongside a covered fund in all or substantially all of the investments made by the covered fund.” Id. at 119. The proposal’s over-reliance on an ability to determine a bank’s “purpose” calls to mind the colorful quote from Jamie Dimon about the Volcker Rule’s requirements relating to investment intent: “If you want to be trading, you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something.” See Dan Fitzpatrick & Scott Patterson, Dimon Applauds Certainty with Final Volcker Rule, Wall St. J (Dec. 11, 2013). If today’s proposal is ultimately adopted, both the industry and the agencies will lose the benefit of a clearer standard and we will instead need to confront how to evaluate a bank’s intent.
[30] Proposing Release, supra note 2, at 119.