In November 2011, under Section 619 of the Dodd-Frank Act, also known as the “Volcker Rule,” the SEC, the OCC, the FDIC and the FRB (collectively, the “Agencies”) jointly issued a notice of proposed rulemaking (the “Proposal”) containing certain prohibitions and restrictions on the ability of a banking entity and nonbank financial company supervised by the FRB to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund. Under the Dodd-Frank Act, the Volcker Rule is scheduled to go into effect on July 21, 2012, whether or not the Agencies have a final rule in place. Given the approximately 17,000 comments received, the Agencies have noted that it is not likely that a version of the Volcker Rule will be ready to implement by the July deadline. In order to avoid confusion regarding complying with a rule that does not yet exist, legislation is being proposed to push back the start date of the Volcker Rule until one year after the rule is finalized. If the Proposal were to be accepted in its current form, it would have the effect of prohibiting banks from proprietary trading in more than half of outstanding municipal bonds1 and would prohibit banks from sponsoring tender offer bond (“TOB”) trusts and providing liquidity for TOB trusts. This would increase funding costs to municipal bond issuers and virtually decimate the market for short-term municipal debt.

The Volcker Rule includes an exemption to the proprietary trading restrictions for “obligations of any State or of any political subdivision thereof.”2 However, in the Proposal, the Agencies take a very narrow interpretation and note that the exemption does not extend “to transactions in obligations of any agency of any State or political subdivision thereof.”3 Such a narrow interpretation is not consistent with existing Federal statutes. For example, the National Bank Act lists State agencies and authorities as examples of political subdivisions of States. The National Bank Act states:

“In addition to the provisions in this paragraph for dealing in, underwriting or purchasing securities, the limitations and restrictions contained in this paragraph as to dealing in underwriting, and purchasing investment securities for the national bank’s own account shall not apply to obligations (including limited obligation bonds, revenue bonds, and obligations that satisfy the requirements of section 142(b)(1) of title 26) issued by or on behalf of any State or political subdivision of a State, including any municipal corporate instrumentality of 1 or more States, or any public agency or authority of any State or political subdivision of a State, if the national bank is well capitalized (as defined in section 1831 of this title). [emphasis added]”4

This provision of the National Bank Act permits well‑capitalized banks to deal in, underwrite or purchase securities issued by public agencies and authorities. If the Proposal is adopted, it would have the effect of repealing this provision.

The Volcker Rule’s exemption for government‑issued securities, as interpreted by the Proposal, would bifurcate municipal securities based on a meaningless distinction. The primary source of financing for important government projects, such as health care facilities, housing developments, and universities, is the issuance of municipal obligations. Revenue‑generating projects of States or political subdivisions will often be financed by bonds backed by the revenues instead of the taxes. For a variety of reasons, a political subdivision may choose to issue debt through a local agency. In any case, the debt is supported by revenue‑generating projects — the credit risk does not differ whether a State, a political subdivision or an agency thereof is the issuer. The Proposal would yield a result where determining whether municipal securities are subject to the Volcker Rule would be based solely on whether or not the issuer is an agency of a State or political subdivision thereof, a distinction which is not otherwise made in the municipal bond market or in other Federal statutes and which has no relation to the level of credit risk associated with the municipal securities.

The Proposal refers to hedge funds and private equity funds together as “covered funds,” but then goes further to define covered funds to include entities that would be investment companies under the Investment Company Act of 1940, but for the exemptions in sections 3(c)(1) and 3(c)(7). Applying the Volcker Rule using this broad definition of “covered funds” would subject TOB trusts to the Volcker Rule — another unintended and undesirable consequence of the Proposal.

The TOB structure was designed to preserve the tax-exempt character of the interest on a municipal bond while creating short-term municipal debt which money market funds can invest in. In a TOB program, one or more highly rated tax-exempt municipal bonds are put into a trust that issues two classes of securities: (1) a floating rate class (“Floaters”) and (2) an inverse floating rate, or residual, class (“Inverse Floaters”). A key feature of the Floaters is that the holders have the option to put the Floaters for purchase at par plus accrued. This feature is made possible by a remarketing agreement and a liquidity agreement by a highly rated bank to provide liquidity in case the bonds cannot be remarketed. Traditionally, national banks invest in, sponsor and provide liquidity for TOBs.

If the Proposal is adopted, national banks would not be able to invest in or sponsor TOBs, which would have a detrimental effect on the municipal bond market. Another consequence of being a “covered fund” is that a bank is prohibited from purchasing assets from, extending credit to, or investing in a covered fund. As noted above, an essential feature of the TOB structure is a liquidity arrangement with a highly rated bank. If TOBs are considered covered funds, then banks would not be able to provide the requisite liquidity required for these structures.

While many advocates of the Volcker Rule want to leave it as is, it seems likely, and certainly just, that exceptions for municipal securities and TOB programs will be made. Without these exceptions, there will be increased costs in borrowing for State and local governments, the municipal bond market will be disrupted, and a key class of short-term debt available for money market investors will be eliminated.