The Volcker Rule

The Volcker Rule

February 01, 2014

The Volcker Rule does not appear to prevent national banks from supplying tax equity to renewable energy projects structured as partnership flip transactions after federal bank regulators issued final rules on the subject in December.

However, the bank should invest directly in the project company that owns the project or in a holding company one tier up from the project company.

An investment in an entity more than one tier up from the project company could be a problem.

The Volcker rule was enacted in July 2010 as part of the Dodd-Frank Act. It prevents banks with federally-insured deposits and their affiliates from engaging in “proprietary trading” — defined as trading in securities for the bank’s own account to benefit from short-term price movements — and from investing in any “covered fund” — which the bank regulators have defined as a subset of entities that would be considered “investment companies” by the US Securities and Exchange Commission. While it is not always clear whether an entity is an “investment company,” a company that is engaged directly in an active business or as a holding company whose sole assets are shares or other ownership interests in an active business company is generally not an investment company.

Banks have until July 21, 2015 to restructure or sell any investments that are not permitted under the Volcker rule.

The Volcker rule, named after former Federal Reserve Board Chairman Paul Volcker, is supposed to keep banks out of risky investments that might cause a bank to collapse and draw on federal insurance for bank deposits. Volcker wrote out his original idea in a page and a half. The preamble and text implementing it now run to more than 900 pages.

The Volcker rule does not apply to tax equity transactions that benefit the “public welfare,” meaning bring housing, services or jobs to low-income communities, and in transactions involving tax credits for rehabilitating old buildings. It also does not apply where the federal bank regulators view the bank’s role as essentially that of a lender, even though the transaction is set up in form to make the bank look like a partner.

The US Comptroller of the Currency, which regulates national banks, declined last fall to make a blanket determination that all renewable energy projects are public welfare investments, but suggested that many utility-scale projects qualify because they are in rural areas.

The Comptroller characterized participation by a bank in November in what may be a partnership flip financing of a US solar project near the border with Mexico as “substantially identical to a loan transaction.” The characterization is in Interpretative Letter 1139.

The letter said the bank had to limit the dollar amount of this and similar transactions to no more than 3% of its capital and surplus.

The bank said it would have approximately a 70% interest in a limited liability company that owns the project. It said it would use the same credit evaluation of the project before deciding to invest that it would do for making a loan, and that it would not place “undue reliance” in the credit evaluation on any residual value after the tax benefits have run.

National banks may not take equity positions in real property. The letter said the solar project itself should not be considered real property, relying in part on its understanding that the US tax authorities do not consider it real property, and any interest the bank would hold through the project company in a site lease for the project was merely “incidental to the financing.” The bank suggested it was not assigning value to the site lease in its credit evaluation.

The letter made it a condition to the approval that the project developer had to have a call option to buy out the bank for the fair market value of the bank’s interest after the bank reached its target return and the bank had also to clear the transaction with its bank examiner. 

By Keith Martin