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Sen. Merckley Explains Limited Prime Brokerage Exception to Dodd-Frank Volcker Provisions

By Jim Hamilton

Section 619 of the Dodd-Frank ACT allows a very limited exception from the prohibition on banks sponsoring hedge funds for the provision of limited services under the rubric of prime brokerage between a bank and a third party advised fund in which the fund managed, sponsored, or advised by the bank has taken an ownership interest. Essentially, it was argued that a bank should not be prohibited, under proper restrictions, from providing limited services to unaffiliated funds, but in which its own advised fund may invest. According to Senator Jeff Merkley, a co-author of Section 619, the exception is intended to only cover third-party funds, and should not be used as a means of evading the general prohibition. Put simply, a firm may not create tiered structures and rely upon the narrow exception to provide these types of services to funds for which it serves as investment advisor. Further, in recognition of the risks that are created by allowing for these services to unaffiliated funds, several additional criteria must also be met for the bank to take advantage of this exception. (Cong. Record, July 15, 2010, S5898)

For example, banks are prohibited from bailing out funds they manage, sponsor, or advise, as well as funds in which those funds invest. The permitted services provisions are intended to permit banks to maintain certain limited prime brokerage service relationships with unaffiliated funds in which a fund-of-funds that they manage invests, said Senator Merkley, but are not intended to permit fund-of-fund structures to be used to weaken or undermine the prohibition on bailouts. Given the risk that a banking entity may want to bail out a failing fund directly or its investors, the permitted services exception must be implemented in a narrow, well-defined, and arms-length manner and regulators are not empowered to create loopholes allowing high-risk activities like leveraged securities lending or repurchase agreements. S5901. While Congress implements a number of legal restrictions designed to ensure that prime brokerage activities are not used to bail out a fund, Congress expects the regulators will nevertheless need to be vigilant.

On top of the flat prohibitions on bailouts, the statute requires the chief executive officer of firms taking advantage of this limited prime brokerage services exception to also certify that these services are not used directly or indirectly to bail out a fund advised by the firm. S5898

Full post as published by Jim Hamilton's World of Securities Regulation on August 11, 2010 (boomark / email).