January 24, 2020 - The Federal Reserve Board (the “Fed”) announced this week that it will meet on Thursday, January 30th, to consider a proposed rulemaking regarding the Volcker Rule. This proposal will address the part of the Volcker Rule that pertains to prohibitions on U.S. banks’ ability to invest in private equity companies, hedge funds and securitizations (“covered funds”). (In fact, the proposed rulemaking is actually a re-proposal. In July 2018, the federal agencies published a Notice of Proposed Rulemaking in which they requested comments on the rules implementing both parts of the Volcker Rule. The LSTA’s summary of the original NPR is available here).
Why do we care? As we noted recently, because of recent litigation over whether term loan Bs should be considered securities, the implications of this rulemaking for CLOs and the leveraged loan of the current interpretation of this part of the Volcker Rule could be profound.
What is the issue? The second part of 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 and AAs) 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. So what’s the problem?
As we explained in previous posts (available here and here), in Kirschner v. J.P. Morgan et al., the plaintiff argues that a term loan underwritten by J.P. Morgan and a number of banks was a security and thus subject to “Blue Sky” laws which are the state equivalent of the federal securities laws. Under the current interpretation of the Volcker Rule, if broadly syndicated term loans were determined to be securities, not only would U.S. banks be prohibited from purchasing CLO notes, they might also be required to divest themselves of their present CLO note holdings (currently around $90 billion). Such a result would likely severely limit CLO formation and the funding for corporate loans that come from it.
What can we expect in the Fed’s coming re-proposal? We are hoping that the agencies will propose a change to their original interpretation of “ownership interest” such that it will no longer include CLO AAA liabilities simply because they include the right to remove and replace managers for cause. In the original rulemaking, the regulatory agencies specifically asked whether the term “ownership interest” should continue to include CLO debt securities and on October 16, 2018 the LSTA submitted a comment letter, available here, arguing that the final rule’s definition of “ownership interest” should not include debt securities that provide creditors the right to participate in the removal of an investment manager “for cause” or in the replacement of a manager in such circumstances. The LSTA asserted that CLO debt securities do not have any of the characteristics of equity and, in particular, the ability to participate in the removal and replacement of a manager for cause more closely resembles a creditor’s right upon default to protect its interest, as opposed to rights that may be more typically associated with equity interests. More recently, the LSTA has continued its advocacy efforts by meeting with each of the five regulatory agencies responsible for implementing the Volcker Rule.
What’s next? Once the Fed and the other agencies approve the re-proposal, it will be published in the Federal Register and the agencies will likely open a 30 or 60 day comment period. The LSTA expects to take advantage of that opportunity by filing another comment letter. Sometime thereafter the agencies will issue a final rule. The LSTA will continue to closely monitor the rulemaking. Please direct any questions on the Volcker Rule to LSTA General Counsel Elliot Ganz.