OCC Advises Banks to Carefully Evaluate Venture Capital Fund Investments – Corporate/Commercial Law

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The Office of the Comptroller of the Currency issued a bulletin advising national banks that many equity investments as principal in venture capital funds are not permitted for national banks. The authors of this article discuss the Bulletin, which reminds banks to carefully assess any potential investment in a venture capital fund to ensure that the investment is legally permitted, consistent with prudential expectations for equity investments by banks and their own risk appetite, and in accordance with applicable risk management controls.

The Office of the Comptroller of the Currency (“OCC”) has issued Bulletin 2021-54 (the “Bulletin”) advising domestic banks that many equity investments as principal in venture capital funds are not not allowed for domestic banks.1The key points of the Bulletin, which is published against the backdrop of a substantial increase in global venture capital investment activity,2 are set out below.

  • Banks are generally not allowed to make passive equity investments in venture capital funds.

  • Equity investments in venture capital funds may be permitted if they are public social investments or investments in small business investment companies specifically authorized by law.3

  • Eligibility for the Volcker Rule’s “covered funds” exclusion for “qualifying venture capital funds” does not make a fund a permitted investment for a bank.4

  • Before a bank invests in a venture capital fund, it must determine whether the investment is legally permitted and appropriate for that institution. Ineligible and improper investments may subject the bank and its affiliated parties to enforcement action and civil monetary penalties. In addition, directors of domestic banks may be personally liable for ineligible investment losses.5

INVESTMENT RESTRICTIONS

Restrictions on investments by “banking entities” (as defined for the purposes of the Volcker Rule as banks and companies controlling, controlled by or under common control with the bank – with certain exceptions) as principal in venture capital funds were eased in one respect in July 2020 when federal banking agencies, the Securities and Exchange Commission and the Commodity Futures Trading Commission amended regulations implementing the Volcker Rule to exclude from the rule ban Volcker investments in “covered funds” of banking entities for qualifying venture capital fund investments.

In adopting the exclusion, the agencies said the activities and risk profiles of venture capital funds differed from those of hedge funds and other private funds that Congress intended to fall under the investment ban. in the “covered funds” of the Volcker Rule and that the exclusion would support capital formation, job creation and economic growth of small businesses and start-ups.6

VENTURE CAPITAL FUNDS

A venture capital fund is defined according to the applicable rules7 as a private fund that:

(a)(1) discloses to existing and potential investors that it is pursuing a venture capital strategy; (2) immediately after acquiring any assets, other than qualifying investments or short-term assets, does not hold more than 20% of the amount of the fund’s total capital contributions and uncalled committed capital in the assets ( other than short-term assets) that are not eligible investments, measured at cost or fair value, consistently applied by the fund;

(3) does not borrow, issue debt, post collateral or leverage more than 15% of the fund’s total capital contributions and uncalled committed capital, and such borrowings, debts, guarantees or leverage are for a non-renewable term of not more than 120 calendar days, except that any guarantee by the fund of the bonds of a qualifying holding company up to the amount of the value of the fund’s investment in the qualifying holding company is not subject to the 120 calendar day limit;

(4) issue only securities the terms of which do not entitle the holder thereof, except in extraordinary circumstances, to withdraw, redeem or require the redemption of such securities, but may entitle the holders to receive distributions made to all holders on a pro rata basis;

(5) is not registered as an “investment company” under section 8 of the Investment Companies Act 1940 and has not elected to be treated as an “investment company” commercial development” under article 54 of this law; and

(b) does not engage in “proper account trading” as that term is defined by the Volcker Rule and its regulations.8

Notwithstanding the exclusion of “covered funds” from the Volcker Rule for investments in qualifying venture capital funds of banking entities, this amendment to the Volcker Rule did not allow banks and their operating subsidiaries to invest in venture capital or other equity investments. Banks must be able to identify an independent authority establishing that such investments are investments authorized by the bank.

As noted in the Bulletin, in some cases investments in venture capital funds may fall under the investment powers of banks or small business investment firms; however, such investments may also be permitted under a national bank’s powers to establish and invest in operating subsidiaries or to take non-controlling interests in entities which engage in activities permitted by the bank – provided, in each case, that such investments are practical and useful to the business of the bank and not merely passive investments, and the other applicable conditions are satisfied.9

EVALUATE BANK INVESTMENTS

The Bulletin also highlights the need for senior management and the boards of national banks to assess every bank investment, including investments in venture capital funds, to ensure that investments are up to standard. security and soundness as well as the bank’s risk profile and appetite. Such an assessment requires an understanding of the nature and structure of the investment, any specialized risk posed by the investment (e.g. interest rate risk, credit risk, liquidity risk, etc.), the practical reason(s) for the investment and, if applicable, discussed above, the legal authority which provides a basis for the bank to make the investment.

In summary, as the venture capital market continues to grow, the Bulletin reminds national banks (and indeed all banking organisations) to carefully assess any potential investment in a venture capital fund in order to to ensure that the investment is legally permitted, consistent with prudential expectations for banks’ equity investments and their own risk appetite, and made in accordance with applicable risk management controls.

Footnotes

1 OCC Bulletin 2021-54, Investments: Venture Capital Funds (Nov. 23, 2021).

2 See, for example, Guarav Dogra and Patturaja Murugaboopathy, Global venture capital investments hit record high, REUTERS, 21 July 2021.

3 See 12 USC § 24 (Eleventh); 15 USC § 682(b); 12 CFR Part 24 & § 7.1015.

4 See 12 USC § 1851(a)(1)(B); 12 CFR § ___.10(c)(16).

5 See 12 USC § 93(a).

6 See Prohibitions and Restrictions on Proprietary Trading and Certain Interest and Relationships with Hedge Funds and Private Equity Funds, 85 Fed. Reg. 46,422, 46,444 (July 31, 2020).

7 12 CFR § ___.10(c)(16)(i); 17 CFR § 275.203(l)-1(a).

8 See 12 USC § 1851(a)(1)(A); 12 CFR § ___.3.

9 See 12 CFR §§ 5.34 & 5.36

Originally published by The Banking Law Journal

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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