August 20, 2019 - Earlier today the Federal Deposit Insurance Company (FDIC) and the Office of the Comptroller of the Currency (OCC) separately approved final rules amending rules originally published in November 2013 that implemented the Volcker Rule. Importantly, today’s amendments do not affect loans and CLOs. The FDIC signaled that amendments to the part of the Volcker Rule pertaining to CLOs would be forthcoming sometime in the future. Today’s amended rules are available here.
The Volcker Rule. The Volcker Rule was passed in July 2011 as part of the sweeping financial services regulatory reform bill, the Dodd-Frank Act. Final rules implementing the Volcker Rule were published in November 2013. The first part of the Volcker Rule was designed to limit the ability of banks to engage in proprietary trading but the 2013 rules specifically carved out loans from those limitations. The second part of the Volcker Rule was designed to prohibit banks from owning the equity (“ownership interests”) of hedge funds and private equity funds (“Covered Funds”) but the 2013 rules extended the definition of Covered Funds to include securitizations (other than “Loan Securitizations”, which were excluded by a rule of construction in the Volcker Rule). The regulatory agencies also defined the term “ownership interest” very broadly to include not just the equity of a securitization but also debt securities (including AAAs and AAs) because those securities typically include the right to remove and replace a manager for cause. Finally, the regulatory agencies defined the meaning of “Loan Securitization” quite narrowly, limiting the exclusion to securitizations that held only loans, cash and short term cash-equivalent securities. The bottom line is that under the Volcker Rule and its implementing 2013 rules, U.S. banks are permitted to own CLO debt securities only if the underlying CLO is a “Loan Securitization”, i.e., a securitization that owns only loans and cash equivalents, but does not own any bonds or other securities.
The Notice of Proposed Rulemaking. 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. With respect to the issue of investments by banks in Covered Funds the agencies asked whether the term “ownership interests” should include CLO debt securities and whether the definition of “Loan Securitization” should be expanded to include CLOs that own small buckets of securities.
The LSTA Comment Letter. On October 16, 2018 the LSTA submitted a comment letter, available here. The comment letter first urged the agencies to modify the final rule’s “Loan Securitization” exclusion to include even traditional CLOs that have modest baskets for bonds or assets other than loans. Including traditional CLOs in the definition of loan securitizations would be consistent with the congressional intent as reflected in the Volcker Rule’s “rule of construction” regarding loan securitizations since CLOs that existed at the time of the passage of Dodd-Frank did include bond baskets. Second, the comment letter 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 participate in the replacement of a manager in such circumstances. This simply reflects the fact that CLO debt securities do not have any of the characteristics of equity and, in particular, that 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.