The first legal challenge to the Volcker rule has emerged, with the American Bankers Association seeking emergency relief from a provision it claims will immediately hurt community banks, costing some millions of dollars. A Christmas Eve filing with the U.S. Court of Appeals for the District of Columbia requests a stay of agency action and the threat of additional legal action was made in a letter to bank regulators.

At issue is the inclusion of collateralized debt obligations backed by trust preferred securities (TruPS CDOs) under the Volcker rule's definition of “covered funds.”

A trust-preferred security is created when a bank issues debt to a trust it created, and then sells its right to receive interest and principal payments to third-party investors. A TruPS-backed CDO is created when an investment bank purchases multiple trust-preferred securities, packages those securities into a single security, and issues new debt instruments based on that security to investors. ABA draws a distinction that, unlike equity interests, community banks did not acquire TruPS-backed CDOs “hoping to profit from fluctuations in market value” and instead expected to receive fixed income similar to what is generated by other debt instruments.

Those particular securities represent a small subset of those covered by the Volcker rule – which makes good on a Dodd-Frank Act ban on proprietary trading using insured deposits – but community banks fret that rapidly unwinding them will be costly. Many face “steep and imminent losses,” ABA's court filing says.

“The financial crisis caused TruPS-backed CDOs to decline in value, but most community banks decided to hold their investments until they recovered,” ABA  wrote. “The final rule, however, guarantees that these banks cannot hold [them]until they recover. As a result, Generally Accepted Accounting Principles require the banks immediately to recognize the full current loss in value of a TruPS-backed CDO at the end of their fiscal year.”

ABA estimates that, barring court intervention, more than 275 banks will collectively suffer $600 million in capital losses as early as next week. Although the Volcker rule's requirements don't begin until 2015, ABA says that accounting rules would require community banks "to recognize an unexpected and, in many cases, significant write-down to their capital accounts on or before Dec. 31."

By “impermissibly treating a debt instrument with no participation in profits and losses as a prohibited, equity-like ownership interest,” the Volcker rule violates the Administrative Procedure Act and the “utter disregard of the great costs imposed on community banks” was arbitrary and capricious, it told the court.

Lawsuits were threatened in a letter ABA delivered earlier this week to three of the five regulatory agencies that approved the Volcker rule. Those agencies are the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Because neither the Securities and Exchange Commission nor Commodity Futures Trading Commission have jurisdiction over TruPS-backed CDOs, they were not included.

“Banking entities investing in pooled TruPS that do not pose the kind of systemic risk the Volcker rule is intended to capture are facing unexpected and precipitous write-downs on these investments that are not justified by any safety and soundness concern,” ABA CEO and President Frank Keating wrote. “The financial harm, while dispersed throughout the industry and impacting some banking entities more than others, is real, imminent, and irreparable.”

Bank regulators are trying to allay community bank concerns. A recent “Frequently Asked Questions” document says banks with holdings in TruPS CDOs may not need to immediately sell them and can instead meet rule requirements within a conformance period that ends on July 21, 2015. It may be possible to restructure or modify holdings to achieve compliance, or take advantage of exclusions built into the final rule, the guidance says.

The FAQ did little to alleviate concerns, the ABA says in its court filing. “The agencies instructed banks to ‘evaluate' whether a TruPS CDO is an ‘ownership interest,' but neither acknowledged nor disputed banks' widespread understanding that their securities are captured,” it wrote.

A statement issued Friday afternoon by regulators said they agreed to “review whether it would be appropriate and consistent with the Dodd-Frank Act not to subject TruPS CDOs to the [Volcker rule.]” They intend to address the matter no later than Jan. 15, 2014. A court order in response to ABA's delay request gives them until Jan. 17  to respond.

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