March 4, 2020 - As we noted recently, the loan and CLO markets seem to have dodged a material Volcker Rule bullet that could have arisen out the Kirschner v. JP Morgan litigation (which asserts that broadly syndicated loans are subject to the securities laws). Under the existing Volcker Rule, if loans are determined to be securities, $100 billion of CLO notes currently owned by US banks would become prohibited investments. The good news is that, if the revised Volcker Rule proposal is adopted as is, senior debt securities such as AAA CLO notes will be effectively exempt. The less good news is that loans would be significantly impacted by the proprietary trading restrictions imposed by the Volcker Rule in the event loans become subject to the securities laws and there is no obvious fix.
The implementing Volcker Rule regulations define “proprietary trading” to mean engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments. They define “financial instruments” to include, among other things, a security and a derivative. The implementing regulations also make clear that a financial instrument does not include a “loan” and it is based on this carve-out that broadly syndicated loans are exempt from the prop trading restrictions. However, “Loan” is defined to mean “any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative.” (emphasis added). Notably, while the definition of “derivative” in the implementing regulations excludes any “identified banking product,” there is no such exclusion for identified banking product from the definition of “security.”
What would happen if loans became subject to the securities laws? Banking entities would be required to treat syndicated loans as financial instruments subject to the Volcker rule. First, a banking entity would need to analyze whether accounts that hold syndicated loans meet any of the prongs of the definition of “trading account” described above or any exclusion from that definition. Second, if the syndicated loan is in the trading account and no exclusion applies, a banking entity would have to determine if its syndicated loan positions and activities meet the terms of one of the exemptions of the Volcker Rule and implementing regulations, such as the exemption for market making-related activities. The banking entity would need to meet all the requirements of the exemption. The Volcker Rule proprietary trading issue is just one of many issues the LSTA has identified that could materially and negatively impact the syndicated loan market if loans were treated as securities. In coming newsletters we will continue to identify and describe many other such issues.