January 30, 2020 - The previous version of this article contained an inaccurate summary of the provisions in the Volcker Rule re-proposal relating to the removal and replacement of managers for cause. We sincerely apologize for the mistake.
Five financial regulatory agencies approved this week a re-proposed rulemaking regarding the Volcker Rule. For the loan and CLO markets, the re-proposal is very good news. In a nutshell, the proposal recommends that senior AAA CLO debt liabilities that have certain enumerated characteristics should no longer be considered equity-like “ownership interests” under Volcker, and, second, that the “loan securitization” carve-out from the definition of “covered funds” (which otherwise includes securitizations) should permit the holding of a small bucket of non-loan assets. While this is only a proposal and not yet a final rule, we explain below why this is a very big deal.
What is the issue? The Volcker Rule prohibits banks from owning the equity (“ownership interests”) in “covered funds”, including most securitizations. The regulatory agencies defined the term “ownership interest” very broadly to include not just the equity of a securitization but also debt securities (including AAAs) on the ground that those securities typically include the right to remove and replace a manager for cause. However, “loan securitizations” were excluded by a rule of construction from the definition of covered funds, thus permitting banks to purchase the securities issued by CLOs so long as the CLOs hold assets comprised only of loans and short term cash equivalents. But, as we explained in previous posts (available here and here), in Kirschner v. J.P. Morgan et al., the plaintiff argues that term loans are effectively subject to the federal securities laws. If broadly syndicated term loans were determined to be securities, not only would U.S. banks be prohibited by the current Volcker Rule from purchasing CLO notes, they might also be required to divest themselves of their current CLO note holdings (approximately $90 billion at this writing). Such a result would severely disrupt CLO formation and the funding for corporate loans that come from it.
What does the re-proposal say? The re-proposal provides a complete “safe harbor” from the definition of ownership interest for senior loans and senior debt securities that meet a number of objective tests. AAA CLO securities typically include all of the characteristics enumerated in the re-proposal and thus would qualify for the safe harbor. The safe harbor is an overriding carve out and would apply irrespective of whether the CLO had removal/replacement rights.
What about the definition of “loan securitization”? The re-proposal expands the definition of loan securitization to permit the acquisition and holding of up to 5% of non-loan assets such as bonds. What’s next? The federal agencies will accept comments through April 1st and will sometime thereafter issue a final rule. The LSTA will use that opportunity to file another comment letter. Please direct any questions on the Volcker Rule to LSTA General Counsel Elliot Ganz.