Alarm bells sounded last week when the American Bankers Association and others concluded that collateralized debt obligations backed by trust preferred securities may be “covered funds” under the final Volcker Rule. A small clarification from the federal banking agencies and closer analysis of a typical TruPS CDO indicate that many TruPS CDOs may, in fact, not be covered funds under the final Volcker Rule because they fall within the exemption for asset-backed securities provided by Rule 3a-7 under the Investment Company Act. Banks holding TruPS CDOs should not rush to judgment on their investments and, instead, should analyze the specific terms of their holdings to determine whether they may be excluded from the definition of a covered fund and, therefore, fall outside the scope of the final Volcker Rule.
Under the Volcker Rule, a “covered fund” is defined to include a pooled investment vehicle that relies on exemptions under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. These sections of the Investment Company Act provide exclusions from the definition of “investment company” for privately offered funds sold to fewer than 100 investors or only to qualified purchasers. If a bank or bank holding company has an ownership interest in a TruPS CDO that is a covered fund, it must divest itself of its interest by July 21, 2015. However, under applicable accounting guidelines, once a company determines that it no longer has the intent and ability to hold a security to maturity, if that security is underwater the company must write down the security to fair market value and recognize the decline in market value through a charge to earnings. This accounting requirement means that the impact of the Volcker Rule will be felt immediately, even if the impermissible investment isn’t divested until the deadline.
In response to questions regarding the impact of the final Volcker Rule on TruPS CDOs, the federal banking regulators issued an FAQ on December 19 in which the regulators clarified that transactions that could rely on a different exemption from the definition of investment company under the Investment Company Act would not be considered a covered fund and, therefore, would not be subject to the Volcker Rule. In particular, the federal banking regulators noted that some issuers of CDOs may qualify for exemption under Investment Company Act Rule 3a-7, which exempts non-managed fixed income funds from the definition of investment company. If the issuer of a CDO meets the requirements of Rule 3a-7, the CDO will not be subject to the Volcker Rule, even if the sponsors of the CDO did not expressly rely on Rule 3a-7 for exemption from the Investment Company Act.
Rule 3a-7 is intended to exclude issuers that pool income-producing assets and issue securities backed by those assets from the definition of investment company. Specifically, Rule 3a-7 provides that an issuer who is engaged in the business of acquiring and holding eligible assets and who does not issue redeemable securities will not be deemed to be an investment company if it meets certain conditions. Most TruPS CDOs should satisfy the prerequisites for Rule 3a-7 insofar as the business of the issuer is limited to issuing debt securities, purchasing the underlying trust preferred securities, possibly entering into swaps (related to the trust preferred securities) and other incidental activities. The fixed income securities sold by the pooled vehicle are not redeemable securities under the Investment Company Act if they do not entitle the holder to “upon its presentation to the issuer or to a person designated by the issuer…receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.”
The additional requirements for the exemption under Rule 3a-7 are as follows:
- The issuer issues fixed-income securities or other securities that entitle their holders to receive payments that depend primarily on the cash flows from eligible assets. Eligible assets are financial assets that by their terms convert to cash within a finite period of time.
Most TruPS CDOs should satisfy this condition. The issuer – in this case the special purpose vehicle created to issue the CDOs to investors – issues fixed-income securities that entitle their holders to receive payments that depend on the cash flows from the trust preferred securities held by the issuer. The trust preferred securities held by the issuer are eligible assets because they have maturity dates at which time they convert to cash.
- Fixed-income securities sold to the public must be rated in one of the four highest long-term debt categories. Other fixed-income securities may be sold only to certain accredited investors.
Most TruPS CDOs should satisfy this condition. In most cases, TruPS CDOs were sold to institutional investors, which means that the securities need not have been rated in order for the Rule 3a-7 exemption to be available.
- The issuer is permitted to acquire additional eligible assets or to dispose of eligible assets only if the assets are acquired or disposed of under the term of the indenture or other instruments pursuant to which the issuer’s securities are issued, the acquisition or disposition does not result in a downgrading of the issuer’s fixed-income securities, and the assets are not acquired or disposed of for the primary purpose of recognizing gains or decreasing losses resulting from market value changes.
Most TruPS CDOs should satisfy this condition. A CDO constitutes a passive investment in a fixed pool of assets. It is unlikely that the indenture would permit the issuer to acquire additional assets or to dispose of any assets that secure the obligations of the issuer under the fixed-income securities that it has issued.
- There is an independent trustee who (i) is not affiliated with the issuer or with any person involved in the organization or operation of the issuer, (ii) executes an agreement stating that it will not resign until the financing has been completely liquidated or until a successor has been designated, (iii) has a perfected security interest or ownership interest in the eligible assets that generate the cash flow needed for payment on the fixed-income securities, and (iv) causes the cash flows from the assets to be deposited in a segregated account that is maintained or controlled by the trustee.
Most TruPS CDOs should satisfy all elements of this condition. First, TruPS CDOs are typically issued pursuant to an indenture for which there is an independent trustee. Second, while a typical indenture permits the trustee to resign, a typical indenture also provides that no resignation or removal of the trustee shall become effective until the successor trustee has accepted its appointment. The third elements of this condition is satisfied by the granting of a security interest in the assets of the issuer to the trustee and the perfection of the security interest through possession of the collateral by the trustee or the filing of a UCC financing statement. The final element of this condition is satisfied if, as is typical, the indenture requires the issuer to establish a segregated trust account with the trustee and to deposit payments of principal and interest received by it in the trust account.
The above discussion is intended as guidance only and should not be substituted for analysis of the specific security in your portfolio. It is important to review the actual terms of the securities issued by the pooled investment vehicle, the underlying debt securities held by the issuer of the CDO and the terms of the indenture under which the CDO was issued before concluding that Rule 3a-7 is available for a particular issuer and that the Volcker Rule does not apply to your investment.