Alert December 23, 2013

Banking Regulators Say That Volcker Rule Does Not Require Immediate Sale of Collateralized Debt Obligations Backed by Trust Preferred Securities

The FRB, the FDIC, and the OCC (the “Agencies”) issued a joint FAQ clarifying certain aspects of the treatment of interests in collateralized debt obligations backed by trust preferred securities (“TruPS CDOs”) under the Volcker Rule.

The Agencies noted that the final Volcker Rule implementing regulation generally defines a Covered Fund as an issuer that would be an investment company, as defined in the Investment Company Act of 1940 (the “Investment Company Act”), but for Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.  The Agencies then state that a TruPS CDO that could satisfy the conditions of another Investment Company Act exclusion, such as the exclusion provided by Rule 3a-7 under the Investment Company Act for certain issuers of asset backed securities, would not be a Covered Fund, and therefore a banking entity need not divest its interests in such a TruPS CDO. 

If a TruPS CDO is currently a Covered Fund, however, the Agencies state that the TruPS CDO could potentially be restructured to permit the use of another exclusion or exemption under the Investment Company Act, which would remove it from the “Covered Fund” definition.  The Agencies provide that if the TruPS CDO is restructured such that it is not a Covered Fund as of the end of the conformance period (currently scheduled for July 21, 2015), then it is not necessary for a banking entity to divest its interests.  The Agencies’ position appears to permit banking entities to divest their interest in TruPS CDOs that are Covered Funds, and will not or cannot be restructured so that they will no longer be Covered Funds, during the length of the conformance period rather than requiring immediate divestment of such interests.

The FAQ also lists criteria that banking entities should evaluate to determine whether a security issued by a TruPS CDO is an ownership interest.  Such criteria include whether the security provides the right to participate in the selection or removal of the CDO’s directors or investment adviser, the right to receive a share of the income, gains or profits, and whether the rate of return or amounts payable may increase or decrease based on the CDO’s performance.

As reported in the financial press, banking trade associations have expressed industry concerns that the FAQ leaves several key questions, such as the treatment of collateralized loan obligations, unanswered.  Some industry members also expressed disappointment that the FAQ did not provide a blanket exemption for debt securities issued by TruPS CDOs.  On December 23, 2013 the American Bankers Association (the “ABA”) sent a letter to the Agencies asking them to “suspend” the provisions of the Volcker Rule that treat interests in such securities as ownership interests in a Covered Fund.  The ABA’s letter threatened that the ABA would file a lawsuit in the event the Agencies do not suspend the above-mentioned provisions of the Volcker Rule.