Don’t Sell Your TruPS Investments Just Yet
It's time for the federal banking agencies to correctly interpret the final Volcker Rule.
The Honorable Martin J. Gruenberg
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20552
The Honorable Thomas Curry
Comptroller of the Currency
Office of the Comptroller of the Currency
400 7th Street, SW
Washington, DC 20219
The Honorable Ben S. Bernanke
Board of Governors of the Federal Reserve System
20th and C Streets, NW
Washington, DC 20551
Re: Volcker Rule and Treatment of CDO TruPS
Dear Chairman Gruenberg, Comptroller Curry and Chairman Bernanke:
Your joint report 'The Volcker Rule: Community Bank Applicability' dated December 10, 2013 (the 'Community Bank Guide'), which accompanied the issuance of the final regulation implementing the Volcker Rule last week, has engendered hasty conclusions in the banking industry and among its advisors that all investments in collateralized debt obligations backed by trust preferred securities ('TruPS' or 'TruPS investments') would be considered equity-like 'ownership interests' in a covered fund requiring divestiture by July 21, 2015.
The Report states:
Only a small number of community banks own…collateralized debt obligations (CDOs) (including CDOs backed by trust-preferred securities) that meet the definition of covered funds in the Final Rule. If a community bank did not organize and offer the particular covered fund (e.g., act as the securitizer or asset manager), the bank will have to divest in accordance with the conformance period in the Final Rule.
The negative consequences from this statement, which we believe to be in error, have already been felt. Earlier this week, Zions Bancorporation announced it would be writing off over $629 million as a result of the interpretation that the final rule requirement requires the divestiture of TruPS investments and related accounting adjustments. We don't believe that the issue only affects a small number of community banks. Based on calls we have received so far, it is a far more significant issue.
It is essential that this week the agencies clarify the statement in the Community Bank Guide. In our view, the final rule does not require divestiture just because the investment is in a 'covered fund'; it also requires that the investment constitute an 'ownership interest' or, in the final rule's language, a 'similar interest' to an equity investment. To be considered an 'ownership interest', the investment is required to be an equity investment or an equity-like investment as defined in the final rule. If the TruPS investment is not tantamount to an equity interest, then the investment in TruPS would not be subject to divestiture.
AABD retained BuckleySandler to review the final Volcker Rule. Its counsel's preliminary report is enclosed. All but one of the characteristics of an 'other similar interest' appears to be clearly inapplicable to TruPS investments. Only one is somewhat ambiguous and seems to require additional guidance before it is applied. In any event, at the very least, application of the Volcker Rule would require a case by case analysis of the indenture for each TruPS to determine whether investments in them are or are not ownership interests.
There are probably over a hundred different indentures outstanding. They are lengthy and complex documents. Any conclusion that they would constitute 'ownership interests' would not be readily apparent, although in the experience of BuckleySandler attorneys, it is believed that most of the TruPS could lack the requisite equity-like characteristics required for investments in them to be considered 'ownership interests,' and should not be considered such.
It should be noted that Section 619 of the Dodd-Frank Act, which is the Volcker Rule in its statutory form, does not define 'ownership interest' but clearly states that the purposes of the Rule are to promote safety and soundness and minimize risk for the banking industry. Forcing a divestiture of investments in TruPS and causing a substantial reduction in capital has the opposite effect. In addition, while TruPS did not fare well during the Great Recession, they have rebounded in the past two years and many are now considered investment grade once again, although they have not fully regained the market value lost during the recession. However, if they become subject to a 'fire sale' as a result of the forced divestiture, the market for these investments may decline significantly, thereby increasing the writedown of these investments and magnifying the loss to a bank's capital base.
The definition of 'ownership interests' in the rules proposed in 2011 was substantially different from the final rule. Based upon the language of the proposed rule, industry participants expected that only the lowest tranches of TruPS would constitute ownership interests. Thus, the final rule's definition, which was not subject to the review and comment of the banking industry and the general public, comes as a shock and surprise to many institutions who had believed they had overcome the earnings and capital issues related to these securities.
In interpreting the definition of 'ownership interests' in the final rule, the agencies should take into account the legislative purposes of the Volcker Rule and whether the effects of their interpretation comport with the objective of promoting and protecting the safety and soundness of banks and the banking system.
Section 619 permits the agencies to create other exemptions from the prohibitions on acquiring or retaining an ownership interest in a covered fund if they determine that the exemption would promote and protect the safety and soundness of the banking entity and the financial stability of the United States.
In January 2011, the Financial Stability Oversight Council issued a study and set of recommendations to the agencies that should guide the agencies in responding to the apparent widespread misinterpretation of the final Volcker Rule.
Its study stated that the purpose of the prohibition on making investments in or sponsoring hedge funds or private equity funds was to ensure that banking entities do not invest in or sponsor such funds as a 'way to circumvent the Volcker Rule's restrictions on proprietary trading; confine the private fund activities of banking entities to customer-related services; and eliminate incentives and opportunities for banking entities to bail out funds that they sponsor, advise, or where they have a significant investment.'
None of these purposes are served by requiring divestiture of investments in TruPS made by banks that are not sponsors of such funds.
We appreciate your immediate review of this matter and ask that you immediately clarify that the final rule and the statements in the Community Bank Guide do not mean that all investments in TruPS are disallowed. Additionally, we ask that you provide further guidance on the application of the characteristics which make a security an 'other similar interest', particularly in the context of debt securities subject to waterfall distributions of available cash flows. Finally we ask that you suspend application of the rule with respect to TruPS investments until such guidance is finalized, in order to avoid the dramatic, and potentially irreversible, accounting driven earnings and capital impacts to the holders of these securities.
Executive Director, AABD
 In particular, we note that the characteristic in Section __.10(d)(6)(i)(E) of the common rule, which could be interpreted to make any instrument which is subject to a reduction in the amount received (but not the amount owed) because of a shortfall in the cash flows of a TruPS issuer an equity-equivalent ownership interest. We do not think that the risk relating to such securities are so significantly different from those of ordinary lending activities as to consider them an ownership interest.