The Pros and Cons of the New Volker Rule

Posted by Jim January 17, 2014 12:05pm

Photo Credit: freedigitalphotos.net

The “Volker Rule” was issued by the usual joint federal regulators, plus the SEC and CFTC on December 10, 2013. The first adjustment to “grandfather” some TruPS pool CDO securities was issued on January 14, 2014. The rule is based on the former FRB chairman’s proposal to prohibit “risky” proprietary trading activities by insured financial institutions. His idea was picked up in the Dodd-Frank law. The final rule (for now) runs to about 990 pages, including all appendices. The rule also refers to language in other laws (e.g., BHC and ’40 Acts).

Overview:

The length and complexity of the rule has generated negative comments by the industry and may be simplified for community banks, as it is generally deemed to be too complex.  One almost feels that he/she needs a lawyer to answer the simple question of “Can I buy or sell security XXXX today?”.  Because of the adverse reactions, the rule may still be delayed or changed for community banks who do not really engage in the kinds of activities the rule seeks to prevent. But until then it still has an effective date of April 1, 2014 and a final conformance date set at July 21, 2015 Additional guidance is expected to be published over the next two years, starting with a just issued “interim final rule” which identifies many (but not necessarily all) Trups CDO securities that can be “grandfathered” if owned on December 10, 2013.  A listing can be found at the FDIC web site referenced above. Banks can continue to hold the securities on the list if they were owned on December 10, 2013.

Generally speaking, the rule has two parts: a proprietary trading prohibition, and a prohibition on ownership of certain “covered funds”. The “covered funds” ban is designed to prevent the evasion of the proprietary trading ban by owning a “fund” which perform the kinds of trading the bank cannot do for itself under the rule.

These prohibitions should not be a great concern to most community banks, so long as they don’t:

• Engage in proprietary “trading” in securities or derivatives, unless hedging or as a fiduciary. Trading here means hold assets less than 60 days unless there are mitigating circumstances 
• Own or have ownership interest in “covered funds”, such as unregistered hedge/private equity funds or commodity trading pools (except as a fiduciary, or when the ownership interest was obtained as a part of loan collection efforts and the bank intends to sell/redeem the fund interest as soon as possible).  

Prohibited Trading:

The rule bans proprietary trading for short term gains for a bank’s own trading account. Exempted from the ban are trading for clients and related fiduciary transactions, since the bank is not a principal. True hedging is also exempt, but such hedge contracts (e.g., FX or interest rate swaps) need to specifically hedge other existing assets or asset groups and a bank’s hedging activity must be closely monitored, so there will probably be some additional compliance burden for any bank which hedges its balance sheet. Details on such requirements are contained in the rule.

Specifically exempt from the rule are “trading” activities in connection with repos, FX trading, securities lending activities and trades pursuant to a liquidity plan/policy. Trading in specific types of securities is also exempted from the ban, including: all Govies, Agencies, GSE issues, small business investment company issues (SBIC) and Munis.

Our expectation regarding “proprietary trading” is that community banks will generally be OK. This is because community banks generally buy/sell “plain vanilla” securities, they have no trading account and only own securities with the intent to hold,(e.g.,  classify securities as AFS or HTM), they do not turn securities over in less than 60 days, and they do not have a “trading desk” or person trading only for short-term gains. This is probably true of most small community banks.  Nevertheless, such community banks should bolster their compliance effort by adopting investment policies which prohibit proprietary trading and ownership of “covered funds”. This should be backed up by policy /procedures to monitor and control purchases and sales of securities and derivatives in order to eliminate proprietary trading as defined in the rule.

Prohibited investments:

The rule prohibits holding investments in certain entities called “covered funds”. “Covered” (i.e., prohibited) funds generally means ownership interests in entities which, in turn, own a pool of assets and would normally be considered “investment companies” as defined in the ’40 Act, but are exempted from registration because they are not publicly offered and  have only a small number (under 100) of investors  or whose investors are all deemed “accredited”  or  “qualified”. This definition could include some asset backed securitizations.

 The regulators may also specifically name other investment vehicles as “covered” if they deem it necessary, depending on what assets are owned by the fund or pool, the complexity of the security, the amount of leverage, the trading strategy, and who/how many fund shareholders there are. Bank affiliates, directors and employees are also covered by the prohibition on involvement with “covered” funds.

The “covered funds” prohibitions may require some additional attention by banks. The most certain thing is that all hedge/private equity fund, and unregulated commodity pool interests appear to be “covered” (i.e., prohibited).

Not “covered” (i.e., not prohibited) are securities that are registered with the SEC, including publicly owned, ’40 Act company shares (e.g., regulated mutual funds). The definition “covered” funds also specifically exempts securitizations of loans and asset backed commercial paper conduits. Exemptions are also made for certain corporate structural entities, such as ownership of a subsidiary, a joint venture or acquisition company. Finally the rule also exempts “public welfare investment funds” and some types of pension funds; these should be reviewed by counsel.

Asset-backed securitizations (e.g., CDO’s) may need additional review to determine whether they are “covered funds” (i.e., prohibited). If so, they need to be sold by July 21, 2015, unless the regulators modify the rule to “grandfather” existing holdings. If the assets being securitized are loans (e.g., mortgages, car loans, student loans, credit cards, etc.) they are exempted and not “covered” as noted above. However, if the underlying assets include securities or derivatives they may be “covered”. For example, a “private-label” CMO representing ownership of a pool of other mortgage-backed securities. If such a CMO  is also exempt from registration based on either of the two restrictions on ownership outlined above, it is probably a covered fund under the rule.

Trust preferred CDO’s, e.g., Pretsl’s, represent ownership of pools of trust preferred securities and generally restrict ownership to “qualified” investors were initially deemed “covered”.  There has been discussion in the press recently suggesting that the rule would result in costly disposal of some trust preferred CDO securities  by Zion Bank. Their estimate was a potential  loss of about $387 million. Other industry observers estimate that the industry could have faced losses on trust preferred CDO dispositions of about $600 million. As noted above, an exemption has now been added to grandfather some trust preferred CDO issues. To be grandfathered, a securitization of a pool of trust preferred securities must be meet the conditions of the interim final rule issued on January 14, 2014, which includes the requirement that the trust preferred securities in the pool be mainly issued by small (under $15 billion) banks and that the CDO had to be issued before  May 19, 2010. The details and a listing of many of the “grandfather-able” Trup CDO’s can be found at the FDIC site referenced above.

Private label CMO’s,  CDO’s and any other unregistered securities which represent ownership interests in pools of other securities and/or derivatives, need to be reviewed and may have to be disposed of unless a “grandfather” exception is added to the rule for them, as has just been done for some Trups CDO’s. For securities representing ownership of a pool of securities or non-loan assets, the key attribute, as noted above, is whether the ownership interest (e.g., stock, note or partnership unit) is registered and regulated by the SEC or CFTC. Registered securities are specifically not “covered” funds.  Also, unregistered securities whose exemption from registration is not based on limited ownership by ”qualified” or  “accredited” investors or ownership by a small number of investors (under 100) are not “covered”.  Finally, “public welfare” funds and certain pension funds are specifically not “covered”.

First, check the Offering documents:

In reviewing an asset backed security to determine whether it may be “covered fund”, the first thing to check is the offering document to see if the security is registered. If so, it is not “covered”. Then check to see if the security is an ownership interest in a pool of only loans and cash. If so, it is not “covered”. If the  security is not registered and the asset pool is not loans, then check the reason for the exemption from registration. If the registration exemption is not based on limited offering and / or distribution only to “qualified” or “accredited” investors, then the security is not “covered”.  Finally, see if the security has been exempted of “grandfathered” like the Trups CDO’s referenced above or a “public welfare” fund.. If none of these exemptions apply, the security is probably covered and need to be disposed of by July 21, 2015. Such determinations may require consultation with counsel.

One additional caveat here is that the regulators can, at any time, choose to include as “covered” any other ownership interest in any entity which is deemed too “risky”.  Going forward, unregistered ownership interests in any unregulated investment vehicle, unless specifically exempted, should be reviewed by securities counsel to determine if they are “covered” funds, prior to purchase. 

Underwriting, Market-making and Hedge Fund Sponsorship:

These activities may be allowed under the rule, but there are significant compliance requirements. While not of importance to most community banks, there are exemptions which allow banks to engage in trading in connection with underwriting and distributing securities and to be market makers in specific securities.  Such activity can take place, but only under guidelines set forth in the rule regarding how much of the security can be held at any time, relative to market demand. Appropriate policies, controls and record keeping must be put in place. The rule outlines such requirements. Counsel should be consulted if a bank engages in these activities.

 Another exemption is that a bank may sponsor and provide advice and services to hedge funds and other “covered” (i.e., prohibited) funds, if it doesn’t actually own more than 3% (directly or through affiliated parties or entities), doesn’t lend to the fund or engage in assets purchase/sale  transactions with the fund, and does not take on any fund losses. In addition various conflict of interest controls must be in place and appropriate, specific notifications must be made to other investors, as specified in the rule. Again, counsel should be consulted if a bank intends to engage in these activities.

Summary:

 Since there will be additional implementation guidance from the regulators, we expect the situation to evolve. For now, however, a review of all buys/sells and holdings of securities/investments which are not “plain vanilla” bonds,  are not registered, or are not issued by Agencies, GSE’s, SBIC’s or public welfare investment funds  is in order. Also, a Bank should review its investment-related policies, trade monitoring processes, limits, and controls with a view to prohibiting: (1) proprietary trading activities and (2) the ownership of unregistered securities of “covered funds”, which are prohibited by the rule. At minimum the bank’s investment policy should exclude these activities by referring to the rule and stating that the bank’s policy is to fully comply with the rule (i.e., incorporate the rule by reference).

The situation is different for any bank which wants to engage in active proprietary trading and / or sponsor hedge funds. Such banks should review the rule carefully with counsel and implement policies, limits, and monitoring/reporting processes to ensure compliance.  This can be a time consuming and expensive process. There are extensive compliance and reporting requirements related to these activities detailed in the new rule.

 The rule may be simplified, and some additional securitizations may be “grandfathered”, but caution now dictates that a bank should begin a review of its investment holdings and its policies/procedures to identify required changes. Most community banks do not engage in the activities prohibited by the rule at present. In some cases, however, specific legal guidance may be necessary regarding holdings of unregistered asset-backed securities. On balance, we believe that there should be little impact on most community banks, except for those owning unregistered securitizations, and even this impact may be reduced if existing holdings are exempted or “grandfathered”. Stay tuned for further developments.

References:

Davis, Polk published a 27 page flowchart trying to explain the first half (the ban on proprietary trading) of the rule; they have additional info on their website (see   http://www.davispolk.com/download.php?file=sites/default/files/DavisPolk_Final_Volcker_Rule_Flowcharts_Prop_Trading_0.pdf)

Skadden, Arps has also prepared a brief write-up (see   http://www.skadden.com/newsletters/FSR_The_Volcker_Rule.pdf )

The text of the rule is also on-line at Davis, Polk (see http://volckerrule.com/docs/Volcker.Final.Rule.with.TOC.pdf   ).

An outline of the “grandfathered” Trups CDO exemption and an initial list of “grandfather-able”  Trups CDO’s can be found at:

http://www.fdic.gov/news/news/press/2014/pr14003b.pdf

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