Volcker Rule: Agencies Reviewing Applicability of Volcker Rule to TruPS-Backed CDOs; Intent Appears to Be to Forestall Immediate Write-Downs

Sullivan & Cromwell LLP - December 27, 2013

Earlier this afternoon, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), Office of the Comptroller of the Currency (the “OCC”), Federal Deposit Insurance Corporation (the “FDIC”) and Securities and Exchange Commission (collectively, the “Agencies”) issued a joint statement (the “Joint Statement”) regarding the treatment of certain collateralized debt obligations backed by trust preferred securities (“TruPS-backed CDOs”) under the final rule (the “Final Rule”) implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), commonly known as the “Volcker Rule.” The Volcker Rule imposes broad restrictions on proprietary trading and investing in and sponsoring private equity and hedge funds (“covered funds”) by banking organizations and their affiliates.

The Final Rule, issued by the Agencies and the Commodity Futures Trading Commission on December 10, 2013, included an expanded definition of “ownership interest” with respect to covered funds, potentially prohibiting banking organizations from owning TruPS-backed CDOs. As a result, banking organizations have been concerned that they would be required to divest their ownership of TruPS-backed CDOs by the end of the conformance period under the Volcker Rule and, therefore, be required under generally accepted accounting principles to take an immediate write-down of any of these securities with a fair value less than their carrying value, either by moving them from a held-to-maturity classification to an available-for-sale classification or by recognizing an other than temporary impairment.

In response to concerns raised by a number of banking organizations after release of the Final Rule, the Federal Reserve, the OCC and the FDIC issued an “FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred” on December 19, 2013. The FAQ did not, however, resolve the issue of whether banking organizations would be required to divest certain TruPS-backed CDOs and, therefore, to take immediate write-downs in many cases.

The Joint Statement notes that the Agencies are currently considering whether it is appropriate and consistent with the provisions of the Dodd-Frank Act not to subject TruPS-backed CDOs to the prohibitions on ownership of covered funds under the Volcker Rule and that the Agencies intend to address this matter no later than January 15, 2014. The Joint Statement also notes that “the accounting staffs of the Agencies believe that, consistent with generally accepted accounting principles, any actions in January 2014 that occur before the issuance of December 31, 2013 financial reports, including the FR Y-9C and the Call Report, should be considered when preparing those financial reports.” The intent of this last statement appears to be to forestall immediate write-downs of TruPS-backed CDOs by banking organizations before the end of the year, although such write-downs might still ultimately be reflected in December 31, 2013 financial reports depending on further guidance from the Agencies.

In discussing the rationale for their ongoing consideration, the Agencies note that they are aware that the provisions of the so-called “Collins Amendment” to the Dodd-Frank Act, which provides for the permanent grandfathering of TruPS issued before May 19, 2010 by certain depository institution holding companies with total consolidated assets of less than $15 billion, are important to community banking organizations and 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.”

A copy of the Joint Statement is attached as Appendix A.

In the coming weeks, Sullivan & Cromwell LLP expects to publish a more detailed memorandum summarizing and analyzing the Final Rule. In addition, Sullivan & Cromwell LLP will be co-hosting a second web-based presentation with Promontory Financial Group on the Final Rule on January 15, 2014. For more information, please contact Nathalie-Claire Chiavaroli (+1-212-558-3976; [email protected]).