On the heels of financial regulators releasing a final version of the Volcker rule, the first batch of what will likely be voluminous guidance has arrived. It is intended to assure community banks that they may not need to immediately divest certain holdings.

Three of the five agencies that jointly enacted the ban on proprietary trading by banks earlier this month – the Federal Reserve Board, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation – released a “Frequently Asked Questions” document to provide clarification and guidance on whether collateralized debt obligations backed by trust preferred securities (TruPS CDOs) would fall under the Volcker rule's definition of “covered funds.”

TruPS were frequently bundled with collateralized debt obligations by banks prior to the financial crisis. By combining characteristics of equity and debt issues these holdings achieve favorable tax and regulatory treatment and are considered to be capital, not debt.

The FAQ says that banks with holdings in TruPS CDOs may not be required to immediately sell them and can instead determine if they can meet rule requirements within a conformance period that ends on July 21, 2015. The guidance suggests that before concluding that an investment in them is subject to the rule, banks should review the terms and information from other parties, including the CDO sponsor. It may be possible to restructure or modify holdings to achieve compliance, or take advantage of exclusions from the definition of Covered Fund that are found in the final rule.

When evaluating whether a TruPS CDO is a Covered Fund, the FAQ advises banks to also determine whether a security is defined as an “ownership interest.” This can be done by considering, among other matters: whether the security provides the right to participate in the selection or removal of the CDO's directors or investment adviser; the right to receive a share of the income, gains or profits; the right to receive the underlying assets of the CDO after all other interests have been redeemed or paid in full; and the right to receive excess spread.

The agencies' guidance comes amid outcry from community banks over the rule's treatment of TruPS CDOs, which are commonly held and can be costly to unwind. Recently, for example, Utah-based Zions Bancorp took a $387 million charge to slice away those securities.

?“Community banks were reassured that the Volcker Rule wouldn't affect them, as they pose no conceivable systemic risk, but they have found out otherwise – and with only two weeks before the end of the year,” Frank Keating, president and CEO of the American Bankers Association, said in a statement. “The consequences of this unexpected bureaucratic bombshell are millions of dollars in losses that will undermine affected banks' ability to serve their customers and communities.”

Similar concerns were aired by U.S. Sen. Michael Crapo (R-Idaho) in a recent letter to financial regulators. Although regulators sought to assure small- and mid-sized entities they would not be subject to market disruptions or “have to implement new, costly compliance programs,” many of them were “taken by surprise” by provisions in the final rules that pertain to bank ownership of collateralized debt obligations, he wrote.

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