On December 19, 2013, the Federal Reserve, FDIC and OCC issued an Interagency FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule. While roundly criticized by most trade associations and others following the industry as constituting “Frequently Asked Questions Without Answers,” the FAQ does provide additional potential insight on whether banks will ultimately need to dispose of their investments in CDOs backed by TRuPS portfolios (as well as other CDOs).
The greatest weakness in the FAQ, and a generally nasty side-effect of issuing final Volcker Rules shortly before calendar (and thus fiscal) year-ends, is whether accounting firms will force institutions to recognize unrealized market losses, based on an inability to hold the investment to maturity. This question will ultimately be answered by the accounting firms, although still subject to second guessing by the banking regulators. The tone and style of the December 19, 2013 FAQ suggests that the regulators are continuing to explore the issue, and intend to take advantage of the delayed compliance deadline of July 2015, to reach more conclusive determinations. Whether this ambiguity is sufficient for institutions to appropriately determine they maintain the requisite intent to hold the securities through maturity will be a judgement call for institutions and their accountants.
Without providing definitive answers, the FAQ does indicate that the banking regulators do not believe that bank investments in CDOs backed by TRuPS portfolios are universally prohibited by the final Volcker Rule. Rather, they point to two specific areas for further analysis in determining the Volcker Rule’s applicability to any particular investment.
First, the underlying governance and offering documents for the CDO need to be reviewed to determine whether the CDO could rely on an exclusion from the Investment Company Act of 1940 other than 3(c)(1) or 3(c)(7). For better or worse, the literature related to other exemptions under the Investment Company Act is generally limited, as most issuers historically have relied on 3(c)(1) and 3(c)(7), as these exemptions generally addressed most situations where registration under the Investment Company Act was unnecessary. Even if the CDO originally relied on 3(c)(1) and 3(c)(7), the final Volcker Rule makes clear that an investment would not be considered a Covered Fund so long as it also satisfies the conditions of another Investment Company Act exemption or exception.
In the FAQ, the banking regulators specifically indicate that they believe that some issuers of CDOs backed by TRuPS may qualify for exclusion pursuant to Rule 3a-7 under the Investment Company Act. Rule 3a-7 provides an exclusion from registration as an investment company for certain issuers in the business of holding “eligible assets” (and other activities related or incidental thereto) who do not issue redeemable securities, and issues securities that depend primarily on the cash flow from such eligible assets, among other criteria. “Eligible assets” are defined as financial assets, either fixed or revolving, that by their terms confer into cash within a finite time period. Depending on the circumstances, Rule 3a-7 can also require rating agency and/or trustee involvement. A specific analysis of the availability of Rule 3a-7 is going to depend on the underlying documents for each particular investment, but as a matter of general impression, it does appear that Rule 3a-7 may cover issuers of CDOs backed by TRuPS, which would thus exclude such CDOs from being Covered Funds under the Volcker Rule.
Second, the FAQ highlights whether the bank’s investment in the TRuPS CDO would constitute an “ownership interest” of a Covered Fund under the Volcker Rule. In determining whether a security issued by a TRuPS CDO is an ownership interest (as defined under the final rules), the banking entity would need to determine whether the security provides the right to participate in the section or removal of the CDO’s directors or investment advisor, the right to receive a share of the income, gains or profits, the right to receive the underlying assets of the CDO after all other interests have been redeemed or paid in full, the right to receive excess spread, has a rate of return tied to the performance of the CDO, or whether the security provides that amounts payable may be reduced based on losses in the CDO. Even if the answers result in a determination that the investment would currently constitute an ownership interest, if the terms could be modified or changed prior to July 2015, then the Volcker Rule would not require disposition. We believe the “ownership interest” analysis likely varies from CDO to CDO, as well between various tranches within each CDO.
In order to address the availability of either of these potential exemptions, the first step is to obtain and review the underlying governance and offering documents of the individual investments. Attorneys with Bryan Cave are ready and able to assist in this review.
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As a last thought, while much of the trade press has been critical of the Volcker Rule’s potential application to TRuPS CDOs, it is worth remembering that the financial crisis has still left banks in a weak position from a societal viewpoint, as indicated by this New York Times story titled “Loophole Slowly Tightens on a Bank.” As a brief preview, the article provides that the Volcker Rule will prevent the bank from being “able to continue to obscure losses that it has incurred but has yet to show on its income statement.”
On the other hand, I personally kind of like the article, as it refers to “some clever financiers” have found ways to recapitalize troubled banks using the bankruptcy code. I don’t think I’ve ever been referred to as a “clever financier” but I’ll take it!