What Is a Covered Fund Under the Volcker Rule?

A “covered fund” is a specific financial term with significant implications for banking entities. Understanding this term is important because it defines investment vehicles subject to particular rules. The classification of a fund as “covered” directly influences how financial institutions can interact with it, delineating permissible activities.

What a Covered Fund Is

The term “covered fund” originates from the Volcker Rule, which restricts certain activities of banking entities, including proprietary trading and relationships with investment funds. A covered fund is defined as any issuer that would be considered an “investment company” under the Investment Company Act of 1940, but for specific exemptions provided in that Act.

These crucial exemptions are Investment Company Act Section 3(c)(1) and Section 3(c)(7). Section 3(c)(1) generally exempts private funds that have 100 or fewer beneficial owners and do not make a public offering of their securities. Section 3(c)(7) provides an exemption for issuers whose outstanding securities are owned exclusively by “qualified purchasers” and do not make a public offering. A qualified purchaser is a more sophisticated investor, typically an individual with at least $5 million or an institution with $25 million in investments.

Beyond these primary exemptions, the definition also extends to certain commodity pools whose operators claim an exemption under specific Commodity Futures Trading Commission (CFTC) rules, such as Rule 4.7. Foreign funds relying on Investment Company Act Section 3(c)(1) or 3(c)(7) exemptions for U.S. investors may also be covered funds. This broad definition is designed to capture various private investment vehicles that operate outside the direct registration requirements of the Investment Company Act.

Examples of Covered Funds

Many common investment structures typically fall under the definition of a “covered fund” due to their reliance on specific exemptions from the Investment Company Act. Hedge funds are a prime example, as they generally pool capital from a limited number of investors and employ diverse investment strategies. These funds frequently rely on Section 3(c)(1) or 3(c)(7) exemptions to avoid registration with the Securities and Exchange Commission (SEC).

Private equity funds similarly operate by raising capital from investors to acquire equity stakes in companies, often with the goal of improving their operations and eventually selling them for a profit. Like hedge funds, private equity funds typically limit their investor base and do not offer their securities to the general public, thereby relying on Section 3(c)(1) or 3(c)(7) exemptions. This structural reliance classifies them as covered funds under the Volcker Rule.

The operational models of both hedge funds and private equity funds, which involve pooling investor money for investment purposes without being publicly registered investment companies, align directly with the criteria for covered funds. Their private nature and the sophistication of their investors allow them to bypass certain regulatory burdens that apply to publicly offered funds. These types of funds are central to the Volcker Rule’s focus on limiting speculative activities by banking entities.

Entities Not Considered Covered Funds

While the definition of a “covered fund” is broad, the Volcker Rule explicitly excludes several types of entities. Certain securitization vehicles, such as those that primarily hold loans or other debt instruments, can be excluded under specific conditions. Loan securitization entities, including collateralized loan obligations (CLOs), are often structured to be outside the covered fund definition, particularly if their assets consist solely of loans and certain related instruments.

Joint ventures and wholly-owned subsidiaries are also typically excluded from the covered fund definition. These entities are generally formed for specific business purposes, and their structure does not align with the speculative investment characteristics targeted by the Volcker Rule. Similarly, certain registered investment companies, such as mutual funds, exchange-traded funds (ETFs), and business development companies (BDCs), are not considered covered funds because they are already subject to comprehensive regulation under the Investment Company Act.

Recent amendments to the Volcker Rule have further expanded the categories of excluded entities to provide additional clarity and flexibility. These new exclusions include credit funds, which primarily invest in loans and debt instruments, and venture capital funds, which focus on investments in early-stage companies. Family wealth management vehicles and customer facilitation vehicles, formed to provide specific services to clients, have also been explicitly excluded.

Why Covered Fund Status Matters

The classification of an entity as a “covered fund” carries significant implications, primarily due to the restrictions it places on banking entities under the Volcker Rule. Banking entities, which include banks and their affiliates, are generally prohibited from acquiring or retaining an ownership interest in, or sponsoring, a covered fund. This prohibition aims to reduce the exposure of federally insured institutions to speculative investments and potential financial instability.

There are, however, limited exceptions to these prohibitions that allow banking entities to engage in certain activities with covered funds. For example, banking entities may make de minimis investments in covered funds, which are typically small ownership interests intended for organizational purposes or limited passive investments. Banks are also permitted to make seed investments in covered funds they organize and offer, provided they divest these interests within a specified timeframe, generally three years.

Another important exception involves risk-mitigating hedging activities, where a banking entity can acquire an ownership interest in a covered fund to hedge specific risks arising from its permitted activities, such as market-making or underwriting. These hedging activities must be designed to reduce risks and not to engage in speculative trading. The Volcker Rule also includes provisions known as “Super 23A” and “Super 23B,” which impose strict limitations on transactions between a banking entity and a covered fund it sponsors or advises, treating them as if they were affiliates subject to stringent anti-abuse rules. These restrictions collectively work to limit banking entities’ direct and indirect exposure to the risks associated with covered funds, thereby enhancing financial stability.