Volcker Rule challenged in Court: Will Regulators Accede or Demur?

The American Banker’s Association (ABA) filed a petition on December 24, 2013, in the United States Court of Appeals for the District of Columbia challenging a provision of the recently approved final version of the Volcker Rule (the Final Rule) requiring community banks to divest their holdings in a commonly held debt instrument known as Collateralized Debt Obligation backed by Trust-Preferred Securities or TruPS-backed CDO.

The complaint alleges that this would cause substantial, immediate, and irreparable harm to small community banks and their customers by forcing the banks to significantly write-down their capital accounts thereby constricting their ability to lend to individuals and businesses. The petition seeks a temporary stay on such an application of the Final Rule.

However, the ABA withdrew its request for the temporary restraining order following an announcement by the regulatory agencies on December 27, 2013, that they would review the Final Rule to determine whether it would be “appropriate and consistent” with the Volcker Rule to allow an exemption for TruPS-backed CDOs. The regulators said that they would address the matter by January 15, 2014.

The complaint alleges that the Final Rule is contrary to law because:

  • it impermissibly treats a debt instrument with no participation in profits and losses as a prohibited, equity-like “ownership interest”;
  • its expansive and sweeping definition of the term “ownership interest” is not a logical outgrowth of the proposed rule under the statute and therefore violates the Administrative Procedure Act; and
  • the regulatory agencies’ disregard of the great costs imposed on community banks is arbitrary and capricious.

Section 619 (12 U.S.C. § 1851) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), commonly known as the Volcker Rule, essentially prohibits a banking entity from engaging in proprietary trading and from acquiring or retaining any equity, partnership or other ownership interest in or sponsoring a hedge fund or private equity fund.

The provision, named after its originator Paul Volcker, an American economist and former Chairman of the United States Federal Reserve, is part of the sweeping financial overhaul introduced by the Dodd-Frank Act in response to the financial crisis of 2007-2010. The Volcker Rule is among the most contentious provisions of the Dodd-Frank Act and was met with staunch resistance and lobbying from the banking industry.

The rulemaking authority for the implementation and enforcement of the provision was vested with five federal financial regulatory agencies – the Securities and Exchange Commission, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission. On December 10, 2013, the regulatory agencies approved the Final Rule that is set to go into effect on April 1, 2014. 

The petition filed by the ABA was triggered by the unexpected inclusion of TruPS-backed CDOs under the definition of prohibited “ownership interests” in a covered fund. The regulators when they first issued the Notice of Proposed Rulemaking on November 7, 2011, explained that the definition of prohibited “ownership interests” focuses on the “attributes of the interest and whether it provides a banking entity with economic exposure to the profits and losses of the covered fund” and that if a debt security exhibits substantially the same characteristics as an equity or other ownership interest, it could be covered by the residuary phrase “other similar instrument” in the definition. The ABA’s petition alleges that TruPS-backed CDOs are not generally understood to be equity interests or substantially similar to equity interests and therefore the expansive definition of “ownership interests” in the Final Rule, which would cover certain TruPS-backed CDOs cannot stand. 

The ABA alleges that the Final Rule distorts the phrase “ownership interest” beyond recognition. The Final Rule identifies seven features or characteristics of equity interests, and provides that any interest or security issued by a covered fund that exhibits any of these seven features would trigger the Rule’s prohibitions. As a result, TruPS-backed CDOs held by many community banks that entitle the holder only to fixed returns without any sharing of profits, may still be covered under one of the seven triggering features, such as the right to remove the collateral manager.

If the controversy results in an exemption for TruPS-backed CDOs, it would be viewed as a victory for the banking industry and this might provide them a superior foothold in their continuing battle to water down the rule.