Volcker Rule and Bank Capital: Agencies Release Guidance on Capital Treatment of Banking Entity Investments in TruPS CDOs

Sullivan & Cromwell LLP - March 4, 2016

Earlier today, staffs of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the “Agencies”) provided an addition to their existing list of Frequently Asked Questions (“FAQs”) addressing the implementation of section 13 of the Bank Holding Company Act of 1956, as amended, commonly known as the “Volcker Rule.” The FAQ clarifies that a banking entity is not required to deduct from its tier 1 capital an investment in certain qualifying issuers of collateralized debt obligations backed by trust preferred securities (“TruPS CDOs”) unless the investments are held in a market-making capacity.

The Volcker Rule, as implemented by the final rule issued by the Agencies (the “Final Rule”), imposes broad prohibitions on proprietary trading and investing in and engaging in certain relationships with private equity funds, hedge funds and certain other investment vehicles (“covered funds”) by “banking entities” and their affiliates. In January 2014, the Agencies adopted an interim final rule (the “Interim Final Rule”) permitting banking entities to retain an interest in, or act as sponsor (including as trustee), of TruPS CDOs, so long as:  (i) the issuer was established, and the interest was issued, before May 19, 2010; (ii) the banking entity reasonably believes that the offering proceeds received by the issuer were invested primarily in Qualifying TruPS Collateral; and (iii) the banking entity’s interest in the vehicle was acquired on or before December 10, 2013 (or acquired in connection with a merger or acquisition of a banking entity that acquired the interest on or before December 10, 2013) (a “Qualifying TruPS CDO”).

The Volcker Rule permits banking entities to make and retain investments in a covered fund that the banking entity organizes and offers, subject to certain limitations and restrictions, for the purposes of: (i) establishing the fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors; or (ii) making a de minimis investment. The Volcker Rule requires that the banking entity deduct from its tier 1 capital the full amount of such interests for purposes of calculating compliance with applicable regulatory capital requirements.

The FAQ states that a banking entity is not required to deduct from its tier 1 capital an investment in a Qualifying TruPS CDO retained pursuant to the Interim Final Rule because the Interim Final Rule provides an additional and independent exemption for Qualifying TruPS CDOs. If, however, a banking entity acts as a market-maker with respect to interests in a Qualifying TruPS CDO that is a covered fund, then such interests are required to be deducted from the banking entity’s tier 1 capital. The guidance does not apply to a TruPS CDO that is a covered fund but not a Qualifying TruPS CDO.
A copy of the new FAQ is attached to this Memorandum as Appendix A.