Alarm bells sounded last week when the American Bankers
Association and others concluded that collateralized debt
obligations backed by trust preferred securities may be
"covered funds" under the final Volcker Rule. A small
clarification from the federal banking agencies and closer analysis
of a typical TruPS CDO indicate that many TruPS CDOs may, in fact,
not be covered funds under the final Volcker Rule because they fall
within the exemption for asset-backed securities provided by Rule
3a-7 under the Investment Company Act. Banks holding TruPS CDOs
should not rush to judgment on their investments and, instead,
should analyze the specific terms of their holdings to determine
whether they may be excluded from the definition of a covered fund
and, therefore, fall outside the scope of the final Volcker
Rule.
Under the Volcker Rule, a "covered fund" is defined to
include a pooled investment vehicle that relies on exemptions under
Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940.
These sections of the Investment Company Act provide exclusions
from the definition of "investment company" for privately
offered funds sold to fewer than 100 investors or only to qualified
purchasers. If a bank or bank holding company has an ownership
interest in a TruPS CDO that is a covered fund, it must divest
itself of its interest by July 21, 2015. However, under applicable
accounting guidelines, once a company determines that it no longer
has the intent and ability to hold a security to maturity, if
that security is underwater the company must write down the
security to fair market value and recognize the decline in market
value through a charge to earnings. This accounting requirement
means that the impact of the Volcker Rule will be felt immediately,
even if the impermissible investment isn't divested until the
deadline.
In response to questions regarding the impact of the final Volcker
Rule on TruPS CDOs, the federal banking regulators issued an FAQ on
December 19 in which the regulators clarified that transactions
that could rely on a different exemption from the
definition of investment company under the Investment Company Act
would not be considered a covered fund and, therefore, would not be
subject to the Volcker Rule. In particular, the federal banking
regulators noted that some issuers of CDOs may qualify for
exemption under Investment Company Act Rule 3a-7, which exempts
non-managed fixed income funds from the definition of investment
company. If the issuer of a CDO meets the requirements of Rule
3a-7, the CDO will not be subject to the Volcker Rule, even if the
sponsors of the CDO did not expressly rely on Rule 3a-7 for
exemption from the Investment Company Act.
Rule 3a-7 is intended to exclude issuers that pool income-producing
assets and issue securities backed by those assets from the
definition of investment company. Specifically, Rule 3a-7 provides
that an issuer who is engaged in the business of acquiring and
holding eligible assets and who does not issue redeemable
securities will not be deemed to be an investment company if it
meets certain conditions. Most TruPS CDOs should satisfy the
prerequisites for Rule 3a-7 insofar as the business of the issuer
is limited to issuing debt securities, purchasing the underlying
trust preferred securities, possibly entering into swaps (related
to the trust preferred securities) and other incidental activities.
The fixed income securities sold by the pooled vehicle are not
redeemable securities under the Investment Company Act if they do
not entitle the holder to "upon its presentation to the issuer
or to a person designated by the issuer...receive approximately his
proportionate share of the issuer's current net assets, or the
cash equivalent thereof."
The additional requirements for the exemption under Rule 3a-7 are
as follows:
1. The issuer issues fixed-income securities or other securities
that entitle their holders to receive payments that depend
primarily on the cash flows from eligible assets. Eligible assets
are financial assets that by their terms convert to cash within a
finite period of time.
Most TruPS CDOs should satisfy this condition. The issuer
– in this case the special purpose vehicle created to issue
the CDOs to investors – issues fixed-income securities that
entitle their holders to receive payments that depend on the cash
flows from the trust preferred securities held by the issuer. The
trust preferred securities held by the issuer are eligible assets
because they have maturity dates at which time they convert to
cash.
2. Fixed-income securities sold to the public must be rated in one
of the four highest long-term debt categories. Other fixed-income
securities may be sold only to certain accredited investors.
Most TruPS CDOs should satisfy this condition. In most cases,
TruPS CDOs were sold to institutional investors, which means that
the securities need not have been rated in order for the Rule 3a-7
exemption to be available.
3. The issuer is permitted to acquire additional eligible assets or
to dispose of eligible assets only if the assets are acquired or
disposed of under the term of the indenture or other instruments
pursuant to which the issuer's securities are issued, the
acquisition or disposition does not result in a downgrading of the
issuer's fixed-income securities, and the assets are not
acquired or disposed of for the primary purpose of recognizing
gains or decreasing losses resulting from market value
changes.
Most TruPS CDOs should satisfy this condition. A CDO
constitutes a passive investment in a fixed pool of assets. It is
unlikely that the indenture would permit the issuer to acquire
additional assets or to dispose of any assets that secure the
obligations of the issuer under the fixed-income securities that it
has issued.
4. There is an independent trustee who (i) is not affiliated with
the issuer or with any person involved in the organization or
operation of the issuer, (ii) executes an agreement stating that it
will not resign until the financing has been completely liquidated
or until a successor has been designated, (iii) has a perfected
security interest or ownership interest in the eligible assets that
generate the cash flow needed for payment on the fixed-income
securities, and (iv) causes the cash flows from the assets to be
deposited in a segregated account that is maintained or controlled
by the trustee.
Most TruPS CDOs should satisfy all elements of this condition.
First, TruPS CDOs are typically issued pursuant to an indenture for
which there is an independent trustee. Second, while a typical
indenture permits the trustee to resign, a typical indenture also
provides that no resignation or removal of the trustee shall become
effective until the successor trustee has accepted its appointment.
The third elements of this condition is satisfied by the granting
of a security interest in the assets of the issuer to the trustee
and the perfection of the security interest through possession of
the collateral by the trustee or the filing of a UCC financing
statement. The final element of this condition is satisfied if, as
is typical, the indenture requires the issuer to establish a
segregated trust account with the trustee and to deposit payments
of principal and interest received by it in the trust
account.
The above discussion is intended as guidance only and should not be
substituted for analysis of the specific security in your
portfolio. It is important to review the actual terms of the
securities issued by the pooled investment vehicle, the underlying
debt securities held by the issuer of the CDO and the terms of the
indenture under which the CDO was issued before concluding that
Rule 3a-7 is available for a particular issuer and that the Volcker
Rule does not apply to your investment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
