October 2, 2019 - As we noted recently, because of recent litigation over whether term loan Bs should be considered securities, the implications for CLOs of the current interpretation of the Volcker Rule have suddenly become a critical issue. Fortunately, the SEC and a number of banking agencies are currently deliberating over potential amendments to the Volcker Rule providing an opening to address this potential issue.
Last week LSTA General Counsel Elliot Ganz and Phillip Black, Research Associate in its Policy Group, met with members of the SEC’s Investment Management and Trade Practices groups (including Dalia Blass, the Director of IM) to discuss this topic.
What is the issue? The second part of the Volcker Rule prohibits banks from owning the equity (“ownership interests”) in “covered funds”, including securitizations, other than “Loan Securitizations”, which were excluded by a rule of construction in the Volcker Rule. 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. They also strictly limited the scope of loan securitizations to those whose assets include only loans and short term cash equivalents.
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 comes from it.
What can be done? 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 NPR is available here. Importantly in our context, the agencies specifically asked whether the term “ownership interests” should continue to include CLO debt securities.
On October 16, 2018 the LSTA submitted a comment letter, available here. The LSTA argued 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.
At this week’s meeting with the SEC the LSTA reiterated its position on ownership interests and explained the sudden urgency of the issue in light of the Kirschner litigation. What’s next?The LSTA will continue to engage with regulators and closely monitor the rulemaking. Please direct any questions on the Volcker Rule to LSTA General Counsel Elliot Ganz.