On January 14, 2014, the five agencies principally responsible for banking and financial market regulation in the United States (the Agencies)1 adopted an interim final rule (theTruPS CDO Rule)2 as a companion to the final rule adopted December 10, 2013 (the Final Rule) implementing the so-called Volcker Rule.3 We analyzed the Final Rule in a Banking and Financial Services Update (the Sidley Volcker Rule Update) dated December 20, 2013.4
Like the Final Rule, the TruPS CDO Rule will become effective on April 1, 2014. The comment period for the TruPS CDO Rule will conclude 30 days after publication in the Federal Register.
The TruPS CDO Rule provides relief from the covered fund prohibitions under the Final Rule to banking entities that sponsor or hold ownership interests in certain legacy issuers of collateralized debt obligations (CDOs) that are primarily backed by trust preferred securities (TruPS) issued by community banks.5 As discussed in more detail below, the relief is available with respect to CDOs of TruPS only where:
- the CDO issuer was established, and the interest was issued, before May 19, 2010;
- the banking entity reasonably believes that the offering proceeds received by the issuer were invested primarily in Qualifying TruPS Collateral;6 and
- the banking entity acquired such interest on or before December 10, 2013 (or acquired such interest in connection with a merger with or acquisition of a banking entity that acquired the interest on or before December 10, 2013).
Concurrently with adoption of the TruPS CDO Rule, the Agencies released a non-exclusive list of 85 CDOs of TruPS that qualify under the TruPS CDO Rule.7 The Agencies believe that the tailored approach of the TruPS CDO Rule will provide relief with respect to all CDOs of TruPS formed primarily for the purpose of investing in Qualifying TruPS Collateral, and in the cited release they requested comment if that is not the case. The Agencies confirmed in the TruPS CDO Rule that the separate exemption for market-making activity generally available under Sections .4 and .11 of the Final Rule remains applicable to such activity in respect of CDOs of TruPS.
Background and Final Rule
A banking entity, as principal, is prohibited under the Final Rule from sponsoring or holding an ownership interest in a covered fund, subject to various exclusions and exemptions.8 The Final Rule defines a covered fund to include 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 3(c)(7) thereunder.
CDOs of TruPS typically rely exclusively on Section 3(c)(7) under the Investment Company Act,9 and accordingly, in the absence of an exclusion, are covered funds under the Final Rule. Such CDO issuers are typically unable to take advantage of any of the exclusions to the definition of covered fund under the Final Rule. For example, CDOs of TruPS cannot rely on the loan securitization exclusion, which is anticipated to be the primary exclusion for asset-backed securities issuers that would otherwise be subject to the restrictions on a banking entity’s activities with, and ownership of, covered funds.10
A banking entity, as principal, may hold a security issued by (or another interest in) a covered fund as long as that exposure is not an “ownership interest” under the broad definition specified in the Final Rule. An ownership interest would include any equity, partnership or “other similar interest,” which is further defined with reference to a disjunctive list of various economic and non-economic rights and characteristics, including the right to participate in the selection or removal of an investment manager or similar entity.11 Thus, under the Final Rule, a banking entity holding debt securities of CDOs of TruPS that have the right to participate in the selection or removal of the collateral manager would be other similar interests under the Final Rule and, in turn, ownership interests in the covered fund. There may also be other interpretive issues regarding the definition of ownership interests as applied to CDOs of TruPS.
Developments Leading to the TruPS CDO Rule
Following release of the Final Rule on December 10, 2013, advocates scrutinized the treatment of bank ownership of not only CDOs of TruPS but also collateralized loan obligations (CLOs) for which the Final Rule provided no exclusion from the definition of covered fund.12 During this period, banking entities, industry groups, members of Congress and other interested parties expressed views supporting various forms of relief for CDOs of TruPS. Initially, a number of smaller banks that hold ownership interests in CDOs of TruPS issued press releases indicating that, absent relief, they would record immediate accounting losses that would adversely affect their earnings and tier 1 capital levels.13
The Agencies then issued a guidance and clarification release on December 19, 2013 with respect to the treatment of holdings of CDOs of TruPS that generally reiterated elements of the Final Rule and the guidance provided in the supplemental information that accompanied the Final Rule.14 Shortly thereafter, the American Bankers’ Association (ABA) filed two actions seeking an emergency stay of the applicable portions of the Final Rule that treat certain debt securities issued by CDOs of TruPS as prohibited ownership interests, and correspondingly would compel divestiture of those securities.15 Immediately prior to the end of 2013, the Agencies stated that they were considering whether it would be appropriate and consistent with the provisions of the Dodd-Frank Act not to subject CDOs of TruPS to the prohibitions on ownership of covered funds, and would address the matter no later than January 15, 2014.16 During the first two weeks of 2014, activity among members of Congress increased.17
TruPS CDO Rule
As noted above, the relief granted under new Section .16 is limited to securities issued by CDOs of TruPS prior to May 19, 2010. The Agencies also require that a banking entity relying on the provision reasonably believe that the offering proceeds received by the CDO of TruPS issuer were invested primarily in Qualifying TruPS Collateral. This latter term generally comprises trust preferred securities and subordinate instruments issued prior to May 19, 2010 by community banking organizations.18 The relief purports to align the Final Rule with the grandfathering of legacy TruPS (issued by certain community banking organizations prior to May 19, 2010) for capital adequacy purposes under Section 171 of the Dodd-Frank Act. Community banks have contended that CDOs of TruPS were perhaps the sole source of liquidity for their trust preferred securities, and that, absent relief under the Final Rule, the grandfathering of such instruments under Section 171 would be undermined.
The third prong of Section .16(a) requires that the banking entity have acquired the interest (or have acquired the interest through certain business combinations with a banking entity that acquired the interest) on or before December 10, 2013.
Section .16(c) makes clear that a banking entity may act as market maker with respect to the interests subject to the TruPS CDO Rule in accordance with the applicable provisions of Section .4 and .11.19
Interestingly, the TruPS CDO Rule extends the relief to a banking entity’s sponsorship of a covered fund meeting the specified qualifications. It is not clear, however, whether this exemption is meaningful without a corresponding exemption from the covered transaction restrictions under the Final Rule’s implementation of Super 23A.20 A banking entity that sponsors a CDO of TruPS or one or more of its affiliates may be contractually obligated to enter into certain covered transactions with the CDO of TruPS, both currently and after the scheduled end of the conformance period. Whether a banking entity and its affiliates could bring its activities into compliance within the conformance period is not clear.
Notably, the TruPS CDO Rule does not provide relief to banking entities that sponsor or hold an ownership interest in debt securities of CLO issuers that are covered funds under the Final Rule.21 Nor is any express solicitation for comment made with respect to debt securities of CLO issuers.