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From Banking and Finance Law Daily, December 27, 2013

Lawsuit seeks halt to Volcker Rule treatment of TruPS-backed CDOs; agencies to review issue

By John M. Pachkowski, J.D.

Following its Dec. 23, 2013, letter to the Office of the Comptroller of the Currency, Federal Reserve Board, and Federal Deposit Insurance Corporation, the American Bankers Association (ABA), and a group of financial institutions—holding companies and community banks—have filed a lawsuit in the U.S. District Court for the District Columbia seeking relief from a provision of the recently-adopted regulations implement Section 619 of the Dodd-Frank Act, commonly known as the Volcker Rule.

The ABA, along with, Citizens Bank & Trust Company, CB&T Bancshares, Inc., MBT Financial Corporation, and Monroe Bank & Trust Company are challenging application of the Volcker Rule regulations as they apply to collateralized debt obligations backed by trust-preferred securities, which are commonly called “TruPS-backed CDOs.” Under that provision of the regulations, any bank holding any interest in TruPS-backed CDOs will have to sell that interest by July 2015.

In their complaint, the plaintiffs allege that “[t]o the shock of community banks, the Final Rule unexpectedly requires banks to divest their holdings in a commonly held debt instrument known as a ‘TruPS-backed CDO’ by 2015 and, under Generally Accepted Accounting Principles [(GAAP)], to take an immediate and irrevocable hit to earnings and capital as a result.”

They also claim that the application of the Volcker Rule regulations to TruPS-backed CDOs “cannot stand” since: (1) it is contrary to law, impermissibly treating a debt instrument with no participation in profits and losses as a prohibited, equity-like “ownership interest;” (2) sweeping expansion of the term “ownership interest” is not a logical outgrowth of the Proposed Rule and therefore violates the notice-and-comment requirements of the Administrative Procedure Act; and (3) the Agencies’ utter disregard of the great costs imposed on community banks, despite a statutory obligation to consider these costs and their avowed objective of minimizing the burden on these small institutions, was arbitrary and capricious.

Immediate relief. Based on these claims, the plaintiffs seek a preliminary injunction and a temporary restraining order (TRO) suspending application of the Volcker Rule regulations to TruPS-backed CDOs prior to Dec. 31, 2013.

The December 31st date is important since GAAP treatment of TruPS-backed CDOs requires banks to “recognize significant and unexpected losses on these investments at the end of their fiscal year—i.e., on December 31, 2013 in many cases.” Once community banks recognize these significant and unexpected losses they will also see their Tier 1 capital be impacted, which in turn, could subject them to higher funding costs, increased deposit insurance premiums, increased regulatory scrutiny and oversight, and in “extreme cases” being placed into receivership by the FDIC.

Irreparable harm. To support the claims for a preliminary injunction and a TRO, the ABA estimates that least 275 banks, which collectively hold $3.5 billion in TruPS-backed CDOs are affected by the regulations’ treatment of TruPS-Backed CDOs and that these banks will loss approximately $600 million by Dec. 31, 2013. The trade group added that the regulations “would have an especially devastating impact on smaller banks—i.e., those with less than $500 million in assets” and estimates that 110 of these smaller banks would suffer a loss of $78.6 million which “amounts to about 4.2 percent of these small banks’ Tier 1 capital.”

Balance of hardships. The plaintiffs also allege that “neither the Agencies nor anyone else would suffer any harm if Plaintiffs’ relief were granted” since banks would continue to own their existing TruPS-backed CDOs until at least July 2015. The complaint noted that banks affected by the regulations “would have no recourse to remedy these significant harms” since “once a bank realizes the loss in a TruPS-backed CDO’s fair market value on December 31, 2013, that charge—and the corresponding impact on a bank’s capital levels—is irreversible” and they could not “obtain a monetary recovery from the Agencies for these significant reputational and financial harms, as the Defendants are government agencies entitled to sovereign immunity.”

Public interest. Finally, the complaint states that “The public interest would also be served by issuing a temporary restraining order and preliminary injunction. If hundreds of small, community banks are unexpectedly required to take significant capital losses on December 31, 2013, they likely will be forced to immediately decrease their lending activity. This would have a devastating impact on their prospective borrowers, including on the many small businesses that rely on local community banks.”

Agencies reviewing TruPS CDOs. On Friday, Dec. 27, 2013, the OCC, Fed, FDIC, and Securities and Exchange Commission issued a statement that they are reviewing whether it would be appropriate and consistent with the Dodd-Frank Act not to subject TruPS-backed CDOs to the investment prohibitions of the Volcker Rule regulations. They intend to address the matter no later than Jan. 15, 2014.

In their statement, the agencies noted that Dodd-Frank Act section 171, which grandfathered certain TruPS-backed CDOs for regulatory capital purposes, is important to community banking organizations and, based on information recently received, understand that the investments and capital levels of a number of these organizations might be adversely affected if pooling vehicles formed for the purpose of holding TruPS are treated as “covered funds” under the Volcker Rule regulations. Therefore the agencies are “evaluating whether it is appropriate not to cover pooling vehicles that invest in TruPS in order to eliminate restrictions that might otherwise have consequences that are inconsistent with the relief Congress intended to provide community banking organizations under section 171(b)(4)(C) of the Dodd-Frank Act.”

The agencies added that their respective accounting staffs believe that, consistent with generally accepted accounting principles, any actions in January 2014 that occur before the issuance of Dec. 31, 2013, financial reports, including FR Y-9C and the Call Report, should be considered when preparing those financial reports.

Companies: American Bankers Association; CB&T Bancshares, Inc.; Citizens Bank & Trust Company; MBT Financial Corporation; Monroe Bank & Trust Company

MainStory: TopStory BankingOperations DoddFrankAct FinancialStability SecuritiesDerivatives VolckerRule

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