[author: Walter Donaldson, II CFE]

In Observation 1.1.1, we discussed the surprise treatment under the new Volcker Rule regulations1 of collateral debt obligations (CDOs) backed by trust preferred securities (TruPS) as “covered funds,” which would force banking entities to divest their interests in these securitizations from their portfolios. Since a number of community banks are among the largest holders of TruPS-CDOs, they faced particularly severe economic consequences from the adverse impact of the regulations on their Tier 1 capital.

Authority for Continued Ownership and Sponsorship of TruPS-CDOs

In response to intense criticism from trade associations, community banks and congressional leaders, including initiation of a court action and introduction of remedial legislation, the federal banking agencies, together with the Securities and Exchange Commission and the Commodity Futures Trading Commission, approved an Interim Final Rule on January 14, 2014, permitting the retention of ownership in TruPS-CDOs under certain prescribed conditions.

Compliance Note

Specifically, the Interim Final Rule creates a new section of the regulations that exempts ownership of interest in, or sponsorship of, TruPS-CDOs if all three of the following tests are met:

  • the TruPS-CDO was established, and the interest was issued, before May 19, 2010
  • the banking entity reasonably believes2 that the offering proceeds received by the TruPS-CDO were invested primarily in trust preferred securities or subordinated debt instruments issued before May 19, 2010 by a bank holding company with less than $15 billion in assets or a mutual holding company, and
  • the banking entity acquired its interest in the TruPS-CDO no later than December 10, 2013 (or through merger with a banking entity that had acquired its interest by that date).

The Interim Final Rule makes expressly clear that a banking entity may also act as a market maker for TruPS-CDOs that qualify for the new exemption, whether or not it is a sponsor of, or otherwise owns interests in, these instruments. All actions as such a market maker must be consistent with all requirements prescribed by the regulations for permissible market making-related activities.

Pre-approved TruPS-CDOs

To facilitate compliance with the investment authority granted by the Interim Final Rule, the federal banking agencies have issued a non-exclusive list of TruPS-CDOs that are automatically acceptable as meeting the requirements of the new regulations. TruPS-CDOs that are not on the list still may receive exempt treatment if a banking entity can make a persuasive case. Nonetheless, the agencies caution that banking entities must continue to measure, monitor and control the risks associated with TruPS-CDOs, following all relevant regulations and supervisory guidance, as well as principles of safety and soundness.

Pepper Point: The regulators decided to take an across-the-board approach, authorizing banking entities of any size to retain their investments in TruPS-CDOs. In doing so, they did not single out community banks for special treatment, but rather have acted without interfering with either the grandfathering of authority for community banks (assets under $15 billion) to count trust preferred securities as Tier 1 capital or the prohibition against such counting for larger banking entities, as established under Section 171 of the Dodd-Frank Act (the Collins Amendment). At the same time, the regulators have aligned the Interim Final Rule with the date and size thresholds recognized by the Collins Amendment.

Pepper Point: Other than providing the flexibility inherent in the “reasonable belief” standard in the second of the three qualifying tests and the non-exclusivity of the pre-approved list of TruPS-CDOs, the regulators have not given any indication how a banking entity can demonstrate to their satisfaction that the reasonable belief is justified, nor have they offered any criteria for determining that a non-listed TruPS-CDO qualifies for the new exemption. Until further guidance is issued, we think that best practice calls for banking entities to assemble as many relevant facts as are available, follow a formal, justifiable methodology and reasoned analysis in making each determination, and maintain careful documentation of their actions.

Pepper Point: The authority to act as a market maker may be less of an opportunity than it initially appears. Since banking entities are prohibited from acquiring ownership interests in TruPS-CDOs after December 10, 2013, they no longer can be buyers in the marketplace. Consequently, market makers face a smaller pool of potential buyers limited to non-banking entities, such as pension funds, non-bank-affiliated insurance companies and other general business investors.

Pepper Point: As specially detailed in Observation 1.1.1, it is debatable whether or not the agencies met the requirement of the Regulatory Flexibility Act (RFA) that they consider the economic impact of the Volcker Rule regulations on small entities. Although the agencies declare that the RFA does not apply to the Interim Final Rule because it qualifies for the “good cause” exception, that fact would not appear to overcome the deficiency in promulgation of the comprehensive Final Rule. Therefore, if community banks and their advocates find fault with the attempt at remediation in the Interim Final Rule, the option remains for them to revive court action to block the regulations from taking effect.

Pepper Point: The new regulation is issued as an interim final rule with a request for public comment. Absent legislation being enacted, it is more likely than not that the interim rule will be adopted as a final rule after the 30-day comment period concludes and the comments are considered. It is entirely possible that certain aspects of the regulation will be altered, particularly as legislation continues to advance through Congress. Accordingly, we will be closely tracking the evolution of the relevant compliance parameters.

Endnotes

1 On December 10, 2013, the federal banking agencies jointly issued final regulations to implement the “Volcker Rule,” added to the Bank Holding Company Act by Section 619 of the Dodd-Frank Act, to prohibit banking entities and nonbank financial companies from engaging in proprietary trading and severely restrict investments in covered funds.

2 It is our view that the agencies included the “reasonable belief” standard in the second test, because they recognize that relevant documentation for TruPS-CDOs that were structured and sold to banking entities many years ago may not be readily available to categorically prove the test has been met.