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American Bankers Association Files First Legal Challenge to the Volcker RuleDecember 27, 2013
On December 24, the American Bankers Association (“ABA”) filed a lawsuit in the D.C. District Court, along with an emergency motion in the D.C. Circuit Court of Appeals, asking those courts to stay, and ultimately vacate and remand the Volcker Rule’s definition of a prohibited “ownership interest” in a covered fund. According to the ABA, as that rule is currently written, it could require some banks holding collateralized debt obligations (“CDO”) backed by trust-preferred securities (“TruPS”) to sell or otherwise divest such interests. Because such divestment could cause some banks to incur losses, the ABA argues that certain banks holding CDOs backed by TruPS may be required to take immediate write-downs in their December 31 financials in anticipation of expected losses. In its emergency petition, the ABA notes that if a stay is not granted, the rule could “require [ ] banks to recognize significant and unexpected losses on these investments at the end of their fiscal year, typically December 31. ABA estimates that 275 banks will immediately realize $600 million in capital losses as early as next week, and many of the nation’s smallest banks will face (on average) a staggering 4.2 percent loss of capital.”
Below is a summary of the TruPS issue.
The Volcker Rule, or Dodd-Frank §619, generally prohibits proprietary short-term trading by banks, as well as certain fund investments by banks. On December 10, 2013, five agencies issued the final regulation implementing the Volcker Rule. With a number of exceptions, banks may not “retain any ownership interest” in covered funds. §___.10(a) . An issuer is generally a covered fund if it would be an investment company, as defined in the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of that Act. §___.10(b). Notwithstanding section 3(c)(1) or 3(c)(7), the issuing entity for asset-backed securities will not be a covered fund if its assets or holdings are comprised solely of loans, qualifying interest rate and foreign exchange derivatives, and certain other assets. §___.10(c)(8)(i). Loans are defined as “any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative.” §___.2(s). Thus, banks may issue, or invest in, CDOs backed by such assets.
An issuer of asset-backed securities could, however, be a covered fund if the fund holds derivatives, commodity forward contracts, or securities. §___.10(c)(8)(ii). Security has the meaning specified in section 3(a)(10) of the Exchange Act. There is a limited exception to this rule for securities that are a type of cash equivalent or a security received in lieu of debts previously contracted with respect to the loans supporting the asset-backed security. §___.10(c)(8)(iii). The ABA is concerned that bank investments in CDO or other asset-backed securities holding TruPS (“Pooled TruPS”) could be treated as prohibited covered fund investments, requiring potential divestment, which, in turn, might require immediate write-downs of losses that could potentially arise out of the divestments.
TruPS are created when a bank issues debt to a trust, which then issues the TruPS to investors. They were popular for a variety of reasons, including favorable tax and accounting treatment and certain advantages afforded to them under an earlier version of the Basel capital rules. To make TruPS more marketable, banks, insurance companies, and other issuers often pooled their TruPS together and issued an asset-backed security, such as a CDO backed by the pool, and many banks also invested in such issuances.
Prior to the lawsuit, banking regulators had responded to the ABA’s concerns by reminding banks that the term “ownership interest” is a term of art, and that banks should review whether their investments in Pooled TruPS were prohibited ownership interests and, if so, to consider restructuring the investment to avoid such ownership interests. The regulators noted a number of considerations in making that judgment. The banking regulators also noted that Pooled TruPS could be restructured to no longer be a covered fund, stating that if a Pooled TruPS “could rely on any exclusion or exemption from the definition of ‘investment company’ under the Investment Company Act other than the exclusions contained in section 3(c)(1) or 3(c)(7) of that Act...at the end of the conformance period, no further action is necessary, and the banking entity does not need to divest its holdings...”
The above guidance was far short of the clear exemption asked for by the ABA. The ABA argues that investments in Pooled TruPS are akin to debt holdings, and should not be characterized as an “ownership interest” in a covered fund, which they believe was reserved for equity-like investments. The ABA’s petition states that “debt instruments such as TruPS-backed CDOs...are not generally understood to be equity interests or substantially similar to equity interests...Unlike equity interests, community banks did not acquire TruPS-backed CDOs hoping to profit from fluctuations in market value; they instead expected to receive a fixed income akin to that generated by other debt instruments.” 
On December 27, the five agencies that adopted the Volcker Rule issued an interagency statement announcing that they are currently reviewing the TruPS matter and intend to address it no later than January 15, 2014.
Why You Should Care:
This is a matter of importance to financial institutions that invest in Pooled TruPS. A favorable judicial resolution of the ABA’s application for a stay could be of substantial assistance to any such institution. The ABA lawsuit also could shed light on how courts might interpret aspects of the Volcker Rule and respond to lawsuits challenging its controversial aspects.
The lawsuit raises substantial questions of a type we assume will be raised in subsequent litigation, whether by the ABA or others. The Volcker Rule necessitated numerous choices on the part of the regulators tasked with implementing the statute via the final regulation and ongoing interpretations. To the extent such choices are perceived to have been made in an arbitrary and unreasoned manner, they will lead to legal challenges. Banks and fund sponsors may wish to monitor such challenges and the success of their arguments to ensure they are undertaking appropriate conformance efforts with the Volcker Rule and to react, on an informed basis, to the conformance efforts of others.
If You Want Further Information:
For a copy of the ABA’s December 17, 2013 letter to the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, see here. For those regulators’ December 19, 2013 response to the ABA’s concerns, see here. For the ABA’s December 23, 2013 demand letter, see here. The American Bankers Association’s suits were filed as case no. 13-2050 in the U.S. District Court for the District of Columbia and no. 13-1310 in the U.S. Court of Appeals for the District of Columbia Circuit; its emergency petition in the latter case can be viewed here. The December 27, 2013 Interagency Statement Regarding Treatment of Certain Collateralized Debt Obligations Backed by Trust Preferred Securities under the Rules implementing Section 619 of the Dodd-Frank Act may be viewed here.
If You Want Further Analysis:
Contact Brian Boyle, (202) 383-5327 email@example.com, Ted McAniff, (213) 430-6470 firstname.lastname@example.org or Heather Traeger, (202) 383-5232 email@example.com.
 Emergency Motion of Petitioners at 16,19, American Bankers Association et al., Board of Governors of the Federal Reserve System, et al., (D.C. Cir. Dec. 24, 2013) (No. 13-1310); See also Press Release, Zions Bancorporation Announces Preliminary Assessment of the Impact from the Finalization of the Volcker Rule (Dec. 16, 2013) (“Zions Bancorporation...today announced that it believes substantially all of its portfolio of bank and insurance trust preferred collateralized debt obligation (CDO) securities, and certain other asset-backed CDO securities, will be considered disallowed investments under the revised, final ‘Volcker Rule’ of the Dodd-Frank Act...Applying this accounting treatment resulting from the Volcker Rule to our September 30, 2013 financial statements on a pro forma basis, using Zions' valuation of these securities as of that date, would result in...[a]n estimated pro forma one-time non-cash charge to earnings of $629 million, pre-tax, and $387 million, after tax.”)
 12 U.S.C. §1851.
 The Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the Office of the Comptroller of the Currency (“OCC”), the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”). The FRB’s regulation will be codified in 12 C.F.R. Part 248, the FDIC’s in 12 C.F.R. Part 351, the OCC’s in 12 C.F.R. Part 44, the CFTC’s in 17 C.F.R. Part 75, and the SEC’s in 17 C.F.R. Part 255.
 As noted in footnote 3 above, §___.10(a) of each of the banking regulators’ codifications would be the same, but would be separately codified as 12 C.F.R. §248.10(a) in the FRB’s regulation, 12.C.F.R. §351.10(a) in the FDIC’s regulation and 12 C.F.R. §44.10(a) in the OCC’s regulation.
 These exemptions are used by issuers for privately offered investment pools, most commonly hedge funds and private equity funds.
 15 U.S.C. §78c(a)(10). Commenting on the issue of when a loan is a security, the preamble to the regulation, at p. 530, states:
The definition of loan in the final rule excludes loans that are securities or derivatives, including securities or derivatives of or based on such instruments. The definition of “loan” does not specify the type, nature or structure of loans included within the definition, other than by excluding securities and derivatives. In addition, the definition of loan does not limit the scope of parties that may be lenders or borrowers for purposes of the definition. The Agencies note that the parties’ characterization of an instrument as a loan is not dispositive of its treatment under the federal securities laws or federal laws applicable to derivatives. The determination of whether a loan is a security or a derivative for purposes of the loan definition is based on the federal securities laws and the Commodity Exchange Act. Whether a loan is a “note” or “evidence of indebtedness” and therefore a security under the federal securities laws will depend on the particular facts and circumstances, including the economic terms of the loan. See 15 U.S.C. 77b(a)(1) and 15 U.S.C. 78c(a)(10); Reves v. Ernst & Young, 494 U.S. 56 (1990) ; Trust Company of Louisiana v. N.N.P. Inc., 104 F.3d 1478 (5th Cir. 1997); Pollack v. Laidlaw Holdings, 27 F.3d 808 (2d Cir. 1994); but see Marine Bank v. Weaver, 455 U.S. 551 (1982) ; Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51 (2d Cir. 1992); Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577 (6th Cir. 2000); Piaubert v. Sefrioui, 2000 WL 194140 (9th Cir. 2000). For example, loans that are structured to provide payments or returns based on, or tied to, the performance of an asset, index or commodity, or provide synthetic exposure to the credit of an underlying borrower or an underlying security or index may be securities or derivatives depending on their terms and the circumstances of their creation, use, and distribution. Id. Regardless of whether a party characterizes the instrument as a loan, these kinds of instruments, which may be called “structured loans,” must be evaluated based on the standards associated with evaluating derivatives and securities in order to prevent evasion of the restrictions on proprietary trading and ownership interests in covered funds.
 Sometimes, when collecting on past-due loans an issuer will receive a security. The implementing regulation makes it clear that a security received by the issuer under such circumstances will not cause that issuer to be a covered fund.
 See e.g. Cordell, Hopkins and Huang, The Trust Preferred CDO Market: From Start to (Expected) Finish, Federal Reserve Bank of Philadelphia Working Paper 11-22 (2011) (“[TruPS CDOs were] [d]eveloped as a way to provide capital markets access to smaller banks, thrifts, insurance companies, and real estate investment trusts (REITs) by pooling the issuance of TruPS into marketable CDOs[.]”)
 See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule, at p. 3 (Dec. 19, 2013).
[T]he banking entity would consider, for example, whether the security provides the right to participate in the selection or removal of the CDO’s directors or investment adviser, the right to receive a share of the income, gains or profits, the right to receive the underlying assets of the CDO after all other interests have been redeemed or paid in full, the right to receive excess spread, has a rate of return tied to the performance of the CDO, or whether the security provides that amounts payable may be reduced based on losses in the CDO. In addition to evaluating options regarding the status of the TruPS CDO, the banking entity also may consider the likelihood of a modification or change to the rights of the security held so that it is no longer within the definition of ownership interest.
Id. These factors are also stated in §___.10(d)(6).
 Id. at p. 2 (emphasis in original).
 Emergency Motion of Petitioners at 6, 8, American Bankers Association et al., Board of Governors of the Federal Reserve System, et al., (D.C. Cir. Dec. 24, 2013) (No. 13-1310).
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Brian Boyle, an O'Melveny partner licensed to practice law in California and the District of Columbia, Ted McAniff, an O'Melveny of counsel licensed to practice law in California, the District of Columbia, and New York, and Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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