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From Securities Regulation Daily, December 27, 2013

ABA asks court to stay Volcker Rule provisions on trust-preferred securities-backed CDOs

By Jim Hamilton, J.D., LL.M.

The American Bankers Association (ABA) and other petitioners have asked the D.C. Circuit to stay the trust-preferred securities provisions of the Volcker Rule, because the five federal financial regulators that adopted the Volcker Rule acted arbitrarily and capriciously by ignoring the Rule’s devastating impact on small community banks. In an emergency motion, the petitioners noted that the final Volcker Rule unexpectedly requires financial institutions to divest their holdings in a debt instrument known as a trust-preferred securities-backed collateralized debt obligation (CDO), and under GAAP to take an immediate and irrevocable hit to earnings and capital as a result. They argued that the final Volcker Rule’s last-minute expansion of the term “ownership interest” to sweep in trust-preferred securities-backed CDOS will have an unexpected, significant, immediate and irreversible impact on hundreds of financial institutions and the customers they serve (American Bankers Association, et al v. Board of Governors of the Federal Reserve System, et al, No. 13-1310, Dec. 24, 2013).

The petitioners contend that the Volcker Rule cannot stand because it is contrary to law by impermissibly treating a debt instrument with no participation in profits and losses as a prohibited, equity-like ownership interest and its sweeping expansion of the term “ownership interest” is not a logical outgrowth of the proposed rule and therefore violates the Administrative Procedure Act. Also, the utter disregard of the great costs imposed on community banks was arbitrary and capricious.

Dodd-Frank Act Sec. 619 codified the Volcker Rule to prohibit financial institutions from engaging in proprietary trading or sponsoring hedge funds. One provision of Sec. 619 provides that financial institutions may not acquire or retain any equity, partnership, or other ownership interest in a covered fund. Under the statute, the Federal Reserve, FDIC, OCC, SEC, and CFTC were required to issue regulations implementing these requirements through a coordinated rulemaking.

At the end of what the petitioners described as a “ragtag process,” the financial regulators dramatically expanded the definition of “ownership interest,” which swept within its embrace a type of debt instrument known as collateralized debt obligations backed by trust-preferred securities.

Trust-preferred securities. A trust-preferred security is created when a bank issues debt to a trust created by that bank, and then sells its right to receive interest and principal payments on that to third-party investors. A trust-preferred securities-backed CDO is created when an investment bank purchases multiple trust-preferred securities, packages those securities into a single security, and issues new debt instruments based on that security to investors. These debt instruments entitle the holder only to fixed returns without any sharing of profits.

Ownership interest. The petitioners contended that the statutory phrase “other ownership interest” is limited. An ownership interest as envisioned by Dodd-Frank requires an equity-like interest in the sense of taking on risk, and participation in profits and losses. Congress enacted the Volcker Rule to prevent large financial institutions from taking large risks. The petitioners pointed out that this purpose is the reason why “ownership interest” cannot be given meaning wholly disconnected from the problem of financial firms holding risky equity investments.

Notwithstanding the statutory text, context, and purpose, the Volcker Rules enumerates seven triggers in defining an ownership interest, some of which bear no relationship to the features of equity with which Congress was concerned, the motion alleged. In the agencies’ view, for example, a debt interest can qualify as ownership based solely on the holder’s right to participate in the removal of managers.

Trust preferred securities-backed CDOs bear all of the traditional characteristics of debt, including the key characteristics of debt instruments: the expectation of fixed payments and no share of profits. Yet, the Volcker Rule still treats them as a purportedly equity-like ownership interest. In other words, continued the motion, the Volcker Rule prohibits the holding of debt instruments that do not expose the holder to the type of investment risk Congress actually sought to address.

By displacing Congress’ requirement of an equity-like ownership interest with a sweeping list of independent triggers unmoored from the statute, the petitioners contended, the federal financial regulators acted contrary to law.

SEC statement. The SEC issued a statement on behalf of the five federal financial regulators that adopted the Volcker Rule stating that they are reviewing whether it would be appropriate and consistent with the Dodd-Frank Act to not subject CDOs backed by trust-preferred securities to the investment prohibitions of the Volcker Rule. The SEC said that the agencies would address the matter by January 15, 2014. Further, the accounting staffs of the agencies believe that, consistent with GAAP, any actions in January 2014 that occur before the issuance of December 31, 2013, financial reports should be considered when preparing those financial reports.

This case is No. 13-1310.

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