United States: A Critical Analysis Of The Potential Impact Of The Volcker Rule On Municipal Bonds

Last Updated: December 28 2011
Article by Lary Stromfeld, Kathryn Andrews, Scott A. Cammarn, Jed B. Miller and Steven D. Lofchie

Most Read Contributor in United States, September 2017

Federal regulators1 (the "Agencies") recently issued a notice of proposed rulemaking (the "Proposal") under Section 619 of the Dodd-Frank Act,2 commonly known as the "Volcker Rule." The Volcker Rule generally restricts banks and all of their affiliates (collectively, "banking entities") from engaging in proprietary trading activities, subject to exemptions that include proprietary transactions in securities that are "obligations of any State or of any political subdivision thereof." The Volcker Rule also restricts banking entities from investing in or sponsoring "hedge funds" or "private equity funds," although it defines those terms to encompass a far broader range of entities than those commonly thought of as hedge funds or private equity funds. For example, for purposes of the Volcker Rule, these terms include special purpose vehicles used in securitizations and financings. In addition, the Volcker Rule prohibits certain transactions between a banking entity and any "hedge fund" or "private equity fund" for which the banking entity or any of its affiliates is the investment adviser, investment manager, or sponsor. The Volcker Rule is scheduled to go into effect on July 21, 2012,3 although banking entities will have until July 21, 2014 (and possibly longer through Federal Reserve Board extensions) to bring their activities into compliance.4

If the Proposal were to be adopted in its present form, the Agencies' narrow interpretation of the types of government securities exempted from the Volcker Rule would prohibit banking entities from proprietary trading in over half of the municipal bonds outstanding in the markets. Likewise, by the Agencies' narrow interpretation, banking entities would be effectively prohibited from sponsoring or acquiring an ownership interest in municipal tender option bond ("TOB") trusts and from entering into the liquidity facilities that are an essential feature of TOB trusts.5

Thus, as we describe below, the Volcker Rule regulations as set forth in the Proposal would have the unintended consequence of causing significant disruption to the municipal bond markets and would impede the goals and policy underlying the Dodd-Frank Act. Given the very negative, and we believe wholly unintended, consequences likely to result from the Proposal, the Agencies should revise the Proposal (i) to adopt a broader definition of municipal securities that is consistent with the scope of the current municipal bond market and (ii) to exclude TOB trusts from the Volcker Rule's restrictions.

The Volcker Rule's Policies, Prohibitions and Exemptions

The policy underlying the Volcker Rule is that U.S. banks, U.S. nonbank banks, and foreign branches operating in the U.S. enjoy an implied subsidy by virtue of their bank status and deposit taking authority and should not use that subsidy to engage in certain inherently risky activities that are not consistent with the intended role of banking institutions. The Volcker Rule was seemingly accepted by Congress without significant debate, and the Volcker Rule was adopted without any evidence that proprietary trading or fund investing activities had posed any significant risk to the financial system or had played any material role in triggering the recent financial crisis.6 Likewise, the Volcker Rule was enacted without consideration of the costs either to banking entities or to the issuers of the securities ordinarily underwritten or traded by banking entities, including, as is the focus of this memorandum, municipal issuers.

The Dodd-Frank Act's Volcker Rule is codified as Section 13 to the Bank Holding Company Act ("BHC Act").7 The Volcker Rule's general prohibition, codified at Section 13(a)(1) of the BHC Act, states:


(1) PROHIBITION.—Unless otherwise provided in this section, a banking entity shall not—

(A) engage in proprietary trading; or

(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.8

That general prohibition in the Volcker Rule contains exemptions for certain permitted activities. One of the exemptions applies specifically to governmental obligations, including municipal obligations, and reads as follows:


(1) IN GENERAL.—Notwithstanding the restrictions under subsection (a), to the extent permitted by any other provision of Federal or State law, and subject to the limitations under paragraph (2) and any restrictions or limitations that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, may determine, the following activities (in this section referred to as 'permitted activities') are permitted:

(A) The purchase, sale, acquisition, or disposition of obligations of the United States or any agency thereof, obligations, participations, or other instruments of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), and obligations of any State or of any political subdivision thereof.9

The above exemption (the "Government Securities Exemption") provides that transactions involving securities issued by State or any political subdivision are exempt from the Volcker Rule's prohibitions. Notably, Congress did not limit the Government Securities Exemption to only certain obligations of these entities based upon the nature of the issuer's obligation under the municipal security or otherwise. Thus, the Government Securities Exemption applies to both (i) general obligations of a municipality and (ii) limited obligations such as revenue bonds. There is a critical and universally-understood distinction between a "general obligation" of a State or local governmental issuer versus any other "obligation" of such an issuer. Acknowledging this, in the Proposal the Agencies agreed that the Government Securities Exemption encompasses "limited as well as general obligations of the relevant government entity."10

This result is consistent with existing banking law. Banks historically have been permitted to trade in both types of obligations. The National Bank Act permits all national banks to invest in, underwrite, and deal in general obligations,11 and separately permits national banks to invest in, underwrite, and deal in limited obligations, provided that the national bank is well capitalized.12 In the Volcker Rule, Congress did not limit the Government Securities Exemption to either type. In the Proposal, the Agencies rightly construed the Government Securities Exemption to apply to both general and limited obligations of a State or political subdivision.

Unfortunately, and we think incorrectly, the Agencies took a quite narrow view of the Government Securities Exemption in other respects. In particular, the Agencies asserted that "consistent with the statutory language, the ... [Proposal] does not extend the government obligations exemption to transactions in obligations of an agency of any State or political subdivision thereof."13 The Agencies' apparent reasoning is that the statutory language of the Volcker Rule expressly encompasses federal government agencies, but is silent with respect to agencies of States or their political subdivisions. However, it would appear that the Agencies recognize that this narrow view is not dictated by the statutory language, and, in the Proposal, the Agencies do request comment whether a more expansive definition that encompasses agencies of State or political subdivisions is warranted.14

The Exemption for Municipal Obligations Should not be Given a Narrow Interpretation

Municipal obligations are the primary source for financing important governmental projects and programs including those that finance healthcare facilities, affordable housing developments, universities, airports, infrastructure projects and other important municipal and community projects. These types of projects are often financed by agencies of State or local governments. As explained above, in the Proposal the Agencies have proposed a narrow interpretation of the Government Securities Exemption that effectively excludes municipal agency securities from the scope of the exemption. As explained below, this narrow interpretation is unwarranted.

The Volcker Rule's Goals are Not Served by a Narrow Interpretation of the Government Securities Exemption

Every State has the constitutional power to exercise its sovereign powers through agencies and other instrumentalities, to form its own political subdivisions and to grant them such powers as it sees fit. A State may also authorize its political subdivisions to carry out their various public purposes by creating agencies or other entities of the political subdivisions. All are governed and limited by State law, including State constitutional limits. In sum, there is no universal means by which a State may exercise its purposes and powers or authorize its political subdivisions to do so.

Similarly, the nature of the credit underlying an obligation issued by a State or political subdivision is dependent upon a broad range of factors, including State constitutional and statutory issues and the type of project or program being financed. A political subdivision will generally choose to finance a revenue-generating project through the issuance of bonds backed by those revenues and not by taxes. On the other hand, for a variety of reasons, including economic and State law considerations, a political subdivision may choose to finance a revenue-generating project through the creation of a local agency to issue the debt. That same project may also be financed by the State or a State agency for the benefit of the political subdivision. Regardless of whether that project is financed with debt issued by the State, a State agency, a political subdivision or an agency of the political subdivision, the debt will be supported by the same underlying credit source, i.e., the revenue-generating project.

In sum, the same type of entity may have different powers and purposes from State to State (or even within a single State). Even the same specific entity may issue different types of obligations backed by different sources of credit. Therefore, the regulation of risk related to obligations issued by a State or political subdivision cannot be differentiated in any meaningful way by the type of municipal entity issuing the obligation. In fact, such a distinction would arbitrarily affect bonds having the same credit risk but issued by different entities or in different states. Given the absence of Congressional intent to the contrary, the Agencies should not adopt a narrow interpretation of the types of entities listed in the Government Securities Exemption that would, for entirely artificial reasons, exclude agencies and other entities created by States and their political subdivisions and would disadvantage their ability to raise financing.

The Proposed Interpretation of the Government Securities Exemption is Inconsistent with Existing Banking Law

As mentioned above, Section 24 (Seventh) of the National Bank Act expressly permits national banks to invest in, underwrite, or deal in a broad range of municipal securities. However, the National Bank Act also permits a national bank to invest in, underwrite, or deal in municipal agency securities, provided only that the national bank is well capitalized. The National Bank Act states:

In addition to the provisions in this paragraph for dealing in, underwriting, or purchasing securities, the limitations and restrictions contained in [12 U.S.C. § 24 (Seventh)] as to dealing in, underwriting, and purchasing investment securities for the national bank's own account shall not apply to obligations (including limited obligations bonds, revenue bonds, and obligations that satisfy the requirements of section 142(b)(1) of Title 26) issued on behalf of any State or political subdivision of a State, including any municipal corporate instrumentality in 1 or more States, or any public agency or authority of any State or political subdivision of a State, if the national bank is well capitalized ....15

While well-capitalized national banks are expressly permitted to invest in, underwrite, and deal in municipal agency securities under Section 24 (Seventh), under the Agencies' Proposal the same national bank would be prohibited from engaging in proprietary trading of those same agency securities. Inasmuch as the Volcker Rule's definition of "proprietary trading" is deemed to encompass underwriting and dealing activities, the Agencies' Proposal to exclude municipal agency securities from the scope of the Government Securities Exemption will cause an untenable result – the Agencies' proposed interpretation would effectively repeal the statutory authority of a wellcapitalized national bank to deal in municipal agency securities in Section 24 (Seventh).16 Nothing in the Volcker Rule or its legislative history suggests that Congress intended this result.

Thus, in interpreting the Government Securities Exemption to the Volcker Rule, the Agencies should not adopt a restrictive definition of "State or political subdivision" that effectively repeals this existing statutory authority. Rather, the Agencies should recognize that Congress has already authorized well-capitalized national banks to invest in, underwrite, or deal in securities issued by an agency of a State or political subdivision.17 In sum, the Agencies should, consistent with existing law, construe "State or political subdivision" to include State or local agencies.

A Narrow Interpretation of the Government Securities Exemption would have a Negative Impact on Safety and Soundness and Financial Stability

The Agencies' narrow reading of the Government Securities Exemption would have a negative impact on the safety and soundness of banking entities and on the financial stability of the United States. Many studies have demonstrated that virtually all categories of municipal obligations have a significantly lower risk of default than corporate and other debt.18 Under existing law, banks are given broad authority to invest in, underwrite and deal in municipal obligations.19 Restricting their ability to engage in proprietary trading of these bonds, and from financing them in a cost-efficient manner, would be contrary to the purposes of the Dodd-Frank Act.20

The Agencies' interpretation of the Government Securities Exemption would exclude more than half of the outstanding municipal securities,21 which would be not merely detrimental to, it would be affirmatively disruptive of, the municipal markets. For example, it can be expected that inconsistency between banking and securities laws definitions22 of "municipal securities" would have a negative impact on pricing and liquidity in the municipal market. By creating separate classes of municipal securities, the Proposal would also increase the cost and impede the ability of banking entities to effectively manage municipal risks. Moreover, the Proposal's impact on nonexempt municipal securities will likely affect the price and liquidity of exempt municipal securities, since they are often issued by the same or closely-related governmental entities.

There is no evidence that the purposes of the Volcker Rule would be served by creating these distinctions. The Agencies should therefore adopt an interpretation of the Government Securities Exemption that includes municipal agency securities within its scope. We believe the definition of "municipal securities" under the Exchange Act would serve the goals of the Volcker Rule and be consistent with existing securities and banking laws.

Tender Option Bond Trusts Should be Excluded from the Volcker Rule

Under the Volcker Rule, institutions deemed to be "banking entities"23 are prohibited, subject to certain exceptions, from acquiring an "ownership interest" in or becoming a "sponsor" of a "private equity fund" or "hedge fund."24 The terms "hedge funds" and "private equity funds" are broadly defined in the Volcker Rule to encompass any issuer or similar fund that would be an investment company under the Investment Company Act but for the exemptions set forth in Section 3(c)(1) or 3(c)(7) thereof.25 In the Proposal, the Agencies simply use the term "covered fund" to refer to a "hedge fund" or "private equity fund" as defined by the Volcker Rule.26

The Volcker Rule also flatly bars any transaction between a covered fund and the banking entity (or its affiliate) if such a transaction would be considered a "covered transaction" within the meaning of Section 23A of the Federal Reserve Act.27 Generally speaking, this provision effectively bars the ability of the banking entity (or its affiliate) to purchase assets from, extend credit to, or invest in a covered fund, if the banking entity or its affiliate is the investment adviser, investment manager, or sponsor of the covered fund. This provision of the Volcker Rule is generally referred to as "Super 23A."

To the extent that a TOB is considered a "covered fund" under the Volcker Rule, a banking entity would be restricted from investing in or sponsoring a TOB.28 Moreover, to the extent that a banking entity is serving as the sponsor, investment adviser, or investment manager to a TOB, the Volcker Rule would prohibit the banking entity (or any of its affiliates) from entering into certain transactions with the TOB, including liquidity facilities and credit enhancement. We believe that these results were not intended by Congress, as explained below.

Overview of the TOB Structure

A TOB is a financing arrangement in which one or more highly-rated, tax-exempt municipal bonds is deposited into a trust that issues two classes of securities: a floating-rate class (the "Floaters") and an inverse floating-rate, or residual, class (the "Inverse Floaters"). Each class evidences an ownership interest in the underlying municipal bonds.29 The Floaters bear interest at a short-term floating rate, and are designed to be eligible for investment by tax-exempt money market funds and other short-term institutional investors. A critical feature of the Floaters is that investors (e.g., the money market funds) have the option, typically on 7-days' notice, to put the Floaters for purchase at par plus accrued interest. To support this put feature, the TOB trust enters into (1) an agreement with a broker-dealer under which Floaters that have been put by investors are remarketed to new investors and (2) a liquidity facility with a highly-rated bank to purchase any Floaters that cannot be remarketed.30 Above all else, the TOB must be designed so that payments of interest to Floater investors retain their tax-exempt character and so that the Floaters receive credit ratings that make them eligible for investment by tax-exempt money market funds.31

The Inverse Floaters issued by TOBs are either retained by the sponsor of the TOB or are sold to long-term institutional municipal bond investors, including banks and mutual funds. Like the Floaters, the Inverse Floaters typically receive interest on a tax-exempt basis32 and have long-term ratings that are based upon the ratings of the municipal bonds held by the TOB.33 Unlike the Floaters, the Inverse Floaters are not subject to a put by their holders. Rather, investors in the Inverse Floaters are exposed to changes in the market value of the municipal bonds held in the TOB trust, subject to certain exceptions that are necessary for interest on the bonds to flow through to TOB investors on a tax-exempt basis.34

The securities issued by TOB trusts (i.e., the Floaters and Inverse Floaters) are generally sold to institutional investors in reliance upon the "private placement"35 and "qualified institutional buyer" ("QIB") exemptions36 from registration under the Securities Act of 1933. TOB trusts also rely upon the private placement or "Qualified Purchaser" exemptions of the Investment Company Act of 1940 (the "Investment Company Act").

National banks have long since been authorized to own, organize and sponsor TOBs.37 However, as described below, because of TOB trusts' reliance on certain exemptions from the Investment Company Act, TOB trusts may be argued to fall within the broad definition of a "hedge fund" or "private equity fund" and, as a result, would be subject to the Volcker Rule's prohibitions.38

The Function of TOBs in the Municipal Markets

The U.S. municipal bond market had $3.73 trillion in outstanding principal amount as of September 30, 2011. As of that date, the municipal mutual fund market was $906 billion, of which $292 billion was comprised of short-term money market funds.39

The great preponderance of municipal bonds are issued with fixed interest rates and long-term maturities to better enable state and local governments to manage their borrowing costs. On the other hand, money market funds, which represent a significant portion of the investment demand for municipal debt, are required by the Investment Company Act to invest only in short-term debt. As a result, there is a chronic mismatch of supply and demand for short-term debt in the municipal market. For over 20 years, this mismatch between supply of, and demand for, short-term municipal debt has been partially relieved by adding a short-term put to a long-term bond through the TOB structure.

TOB trusts also provide the equivalent of "repo financing" for long-term investors in municipal bonds, including banks and mutual funds. There is no traditional repo market for municipal bonds. Rather, investors rely upon the TOB structure to provide efficient short-term financing of municipal bonds while preserving the tax-exempt character of their interest payments. To achieve that result, ownership of the bonds must be held by a trust (which for tax purposes is treated as a partnership).

While the TOB structure – utilizing a trust to hold the municipal bonds and the "put" – both enables investment by money market funds and preserves the tax-exempt character of the interest on the municipal bond, this structure also happens to cause the TOB to fall within the broad definition of "hedge fund" and "private equity fund" as used in the Volcker Rule, because the underlying trust traditionally relies on Section 3(c)(1) or 3(c)(7) of the Investment Company Act, as explained more fully below.

The Potential Effect of the Volcker Rule on TOBs

If adopted in the form proposed by the Agencies, the Volcker Rule Proposal would effectively prohibit TOBs. Any vehicle that limits the issuance of its securities to private transactions or to sophisticated investors so that it falls within Section 3(c)(1) or 3(c)(7) of the Investment Company Act is conclusively deemed to be a "covered fund" under the Volcker Rule. Needless to say, this is a very broad net. If a TOB trust is considered a "covered fund," the Volcker Rule would prevent a banking entity from investing in or sponsoring it—with very negative consequences for the municipal bond market.

Another negative consequence of being a "covered fund" is that the banking entity (and its affiliates) would be prohibited under the Super 23A provisions of the Volcker Rule from entering into "covered transactions" with the TOB trust if the banking entity (or its affiliates) acted as the investment adviser, investment manager, or sponsor of the TOB trust. Consequently, the banking entity would be barred from providing liquidity to the TOB trust under a liquidity facility, which is a necessary feature of the TOB structure.40 The vast majority of TOB sponsors provide liquidity to their own programs. The inability to do so would increase the costs of TOB programs and likewise have a material adverse effect on the municipal market.41

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