Controversy over the Volcker Rule and Trust-Preferred CDOs

by Ballard Spahr LLP

The banking industry’s recent challenge to the newly promulgated Volcker Rule focuses on collateralized debt obligations backed by trust-preferred securities (TruPS CDOs). Even though TruPS CDOs do not represent the kind of “gambling” originally targeted by the rule, the final rule’s expansive interpretation of what constitutes an “ownership interest” is causing concern among banks with such holdings, particularly community banks.

While these institutions are not required to divest their TruPS CDO holdings until July 21, 2015, they claim they are forced under generally accepted accounting principles (GAAP) to recognize losses (and take corresponding hits to their capital accounts) as of December 31, 2013. Those hits to capital would diminish the amount of credit that could be extended by those banks and might well lead in some cases to prompt corrective action or other supervisory or enforcement action.

Earlier this week, the U.S. Court of Appeals for the District of Columbia Circuit gave three bank regulatory agencies that participated in promulgating the Volcker Rule until January 17, 2014, to respond to the Administrative Procedure Act (APA) challenge. The petition for review, filed on December 23, 2013, sought a stay of the rule and a hearing on January 2. The petitioners—a number of banks and the American Banking Association—and the agencies jointly persuaded the court, however, to grant an extension of time to allow the parties to reach an accommodation.

The focus on TruPS CDOs arises from the prohibition in the statutory Volcker Rule (Section 13 of the Bank Holding Company Act) against a banking entity holding an “equity, partnership, or other ownership interest” in a covered fund. As TruPS CDOs entitle the holder to only a fixed return and not any sharing in profits, they carry the characteristics primarily of debt and not equity. The final rule’s interpretation of what constitutes an “ownership interest,” however, seems to sweep TruPS CDOs within the rule’s ambit.

Shortly after issuance of the final Volcker Rule on December 10, several banking trade associations wrote to the agencies and sought regulatory relief. The petition was filed because the petitioners were dissatisfied with the initial response of the agencies in an FAQ release. That release suggested that holders of TruPS CDOs could use the conformance period (i.e., until July 21, 2015) to unload their holdings, but there is doubt whether that period will be long enough for the sale of such instruments without taking a loss.

Perhaps the conformance period could have been better employed to defer the accounting treatment (i.e., year-end 2013 recognition of loss) that exacerbates the issue and provide adequate time for regulators and regulated to reach agreement on the appropriate Volcker Rule treatment for TruPS CDOs and possibly other instruments as well. The current litigation is forcing that result on an extremely abbreviated timetable.

The petition for review invoked the APA standard that the rule is arbitrary, capricious, an abuse of discretion, or not in accordance with law and sought a stay to prevent “substantial, immediate, and irreparable harm” to the banks in question.

The five agencies that promulgated the Volcker Rule are the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission, and the Securities and Exchange Commission. The latter two were not named as respondents in the petition for review, as neither of them regulates banks that hold TruPS CDOs.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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