The federal regulators (the FDIC, the FRB, the OCC and the SEC, with the CFTC to follow separately) have published for comment a proposed Volcker rule as required by the Dodd-Frank Act. Among other things, the relevant provision of the Dodd-Frank Act generally prohibits banking entities from owning, sponsoring, or having certain relationships with, a hedge fund or private equity fund (which the rule refers to as “covered funds”), subject to certain exemptions. The proposal as written, however, permits a bank to hold a carried interest in a covered fund.
Many banking entities that serve as investment adviser or commodity trading advisor to a covered fund are compensated for services they provide to the fund through receipt of so-called “carried interest.” In recognition of the manner in which such compensation is traditionally provided, the proposed rule also clarifies that an ownership interest with respect to a covered fund does not include an interest held by a banking entity in a covered fund for which the banking entity (or an affiliate, subsidiary or employee thereof) serves as investment manager, investment adviser or commodity trading advisor, so long as:
- the sole purpose and effect of the interest is to allow the banking entity to share in the profits of the covered fund as performance compensation for services provided to the covered fund by the banking entity, provided that the banking entity may be obligated under the terms of such interest to return profits previously received;
- all such profit, once allocated, is distributed to the banking entity promptly after being earned or, if not so distributed, the reinvested profit of the banking entity does not share in the subsequent profits and losses of the covered fund;
- the banking entity does not provide funds to the covered fund in connection with acquiring or retaining this carried interest; and
- the interest is not transferable by the banking entity except to an affiliate or subsidiary.
The proposed rule therefore permits a banking entity to receive an interest as performance compensation for services provided by it or one of its affiliates, subsidiaries, or employees to a covered fund, but only if the enumerated conditions are met.
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