June 30, 2020 - Last week, the federal banking agencies together with the SEC and the CFTC published a final rule on the “Covered Funds” portion of the Volcker Rule. The immediate stakes for CLOs were actually relatively modest, boiling down to whether US banks would be permitted to purchase and hold debt securities of a CLO that hold assets other than loans and cash equivalents. And, in that context, the CLO market got what it (reasonably) wanted. However, banks and CLO managers also obtained relief from restrictions that would have been much more impactful (perhaps even existential) in a potential scenario in which loans were characterized as securities. Below, we explain the good results on both fronts.
Background. Under the original Volcker Rule, banks were prohibited from purchasing the notes of any CLO that held any assets other than loans and cash equivalents. This is because under the Volcker Rule banks are not permitted to own “ownership interests” in “covered funds”. Most securitizations are considered covered funds and, oddly, the agencies determined that because CLO debt securities usually allow the holder to remove and replace a manager “for cause”, the security must be considered an ownership interest. Fortunately, the Volcker Rule also included a carve-out from the definition of covered fund for “Loan Securitizations” which the agencies determined were securitizations that invested only in loans and cash equivalents. Indeed, since the publication of the original Volcker Rule, the CLO market evolved to meet the Loan Securitization model, i.e., issuing new CLOs that hold loans and cash equivalents only and laboriously “Volckerizing” pre-existing CLOs.
The final rule. Many CLO practitioners expressed an interest in reverting to the pre-Volcker days by including modest buckets to purchase non-loan assets and three different changes to the Volcker Rule accommodate that desire: CLO managers will henceforth be able to purchase and hold non-loan assets. The most important and broadest change was the agencies’ revised interpretation of ownership interest. To wit, the agencies clarified that they will no longer consider a debt security to be an ownership interest solely because it contains the right to remove and replace a manager for cause. Importantly, the agencies no longer require that that right be triggered by an event of default. Instead, they describe eight circumstances that qualify as sufficient “cause” to remove a manager. The final rule also allows CLOs to hold up to 5% of their value in debt securities and provided a “safe harbor” that excludes from the definition of ownership interest senior loans or debt instruments that are “ordinary debt securities” that have certain enumerated characteristics. Each of these would provide limited relief to CLO managers to own non-loan securities. However, the “for cause” change to the definition of ownership interest is far broader and more flexible (inasmuch as the loan securitization carve out would be limited to 5% and the senior loan safe harbor arguably applies only to AAA securities).
Volcker and the Kirschner Case. But the importance of the change in the definition of ownership interest goes far beyond the bond-bucket issue. As we’ve explained at length, under the original Volcker Rule, if loans had been characterized as securities as advocated by the plaintiffs in Kirschner v. JP Morgan Chase, the Loan Securitization exemption for CLOs would no longer have been available (because term loans would be ineligible securities). Thus, the $100 billion of CLO notes currently held by banks would have become prohibited investments, and banks would no longer have been able to invest in new CLO notes. While the court in the Kirschner case correctly ruled that syndicated term loans were not securities, that decision is subject to appeal (and other similar cases may one day follow). So the change to the ownership interest definition (and, to a more limited extent, the safe harbor for senior securities) takes that issue off the table for good, irrespective of whether loans are ever characterized as securities. (Whether or not existing CLO indentures would permit CLOs to purchase loans if they were characterized as securities is a different question and beyond the scope of this article).
LSTA Advocacy. The LSTA has been engaged with federal regulators on the Volcker Rule since its inception. More recently, when the agencies re-proposed the rule, the LSTA submitted a comment letter urging the federal agencies to acknowledge that the right to remove a manager for cause was not a characteristic of ownership and CLO debt securities were not ownership interests. We also met with each of the five agencies responsible for implementing the rule. We are gratified that the agencies accepted our position and revised the Volcker Rule accordingly.