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From Banking and Finance Law Daily, December 23, 2013

ICBA seeks suspension of Volcker Rule over TruPS CDO ambiguities; ABA may file lawsuit

By John M. Pachkowski, J.D.

The Independent Community Bankers of America (ICBA) has called on the Office of the Comptroller of the Currency, Federal Reserve Board, and Federal Deposit Insurance Corporation to temporarily suspend the application of the Volcker Rule as it applies to collateralized debt obligations (CDOs) backed by trust preferred securities (TruPS) held by community banks due to enough ambiguities and questions concerning this issue.

Agencies’ FAQ. The agencies had issued a Frequently Asked Question (FAQ), on Dec. 19, 2013, explaining that CDOs backed by trust preferred securities might not be covered funds depending on the structure of the specific CDO and the interest held by the specific bank. The FAQ continued that even if the CDO currently is a covered fund, it could be restructured during the conformance period so that divestiture would not be necessary. Finally, the FAQ also suggested that banks evaluate CDOs to determine whether they constitute ownership interests. Factors to be considered include whether the bank: can participate in the selection of the CDO’s directors or investment advisor; has the right to share in the CDO’s income, gain, or profits; has a right to the assets underlying the CDO after all other interests are paid in full; or enjoys any of several other incidents of ownership.

No further guidance. In its letter to the agencies, the ICBA appreciated the recent FAQ but was “deeply disappointed that there was not further guidance on some of the legal questions concerning what is an ‘ownership interest’ in a ‘covered fund.’ Specifically, most community banks own either junior, senior or debt tranches of TruPS pools and receive only principal and interest from the pool. They had no idea that a non-equity ownership in CDO TruPS would ever be considered an ownership interest in a covered fund.”

The trade association added, “To further complicate matters, the last paragraph of the FAQ does little to clarify the issue of whether they have an ownership interest.” It queried the agencies “does an investment in a TruPS pool become an “ownership interest” when the pool makes no income/loss determination but reduces payments from time to time when there is a shortfall in cash flow?”

The ICBA continued that the FAQ indicates that “banks and their CDO sponsors” should determine whether the TruPS CDO pool can be restructured such that it becomes an entity that is not a “covered fund.” However, the FAQ offers no recommendations as to how the pool could be restructured to make it a “conforming entity” and how the underlying TruPS instruments could be amended so that divestiture would not be required.

Complete exemption. The ICBA concluded that debt-like community bank investments in CDO TruPS should be completely exempted from the Volcker Rule as was originally proposed; however, “if the agencies do want to make these investments subject to the final rule, then they need to clearly indicate that position and whether there is a way to make these investments conform to the rule. Until then, we believe suspending that part of the rule pertaining to CDO TruPS while the underlying issues are being resolved is the appropriate action regulators should take to avoid an immediate and harmful impact to the community banking industry.”

Imminent litigation? In a breaking development, the American Bankers Association (ABA) sent a one-page letter to the agencies on Dec. 23, 2013, indicating that if the agencies do not suspend the Volcker Rule as it pertains to CDO TruPS, the ABA will shortly file a lawsuit challenging the rule under the Administrative Procedures Act and seek emergency relief.

Companies: American Bankers Association; Independent Community Bankers of America

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