October 17, 2018 - In May, the federal bank regulatory agencies and the SEC approved a sweeping 373 page proposal to revise the 2013 Volcker Rule and the proposal was formally published in the Federal Register in July kicking off a 90 day comment period. This week, the LSTA submitted its comment letter, with one full day to spare! Importantly for the loan and CLO markets, the proposal puts into play the issue of whether banks can own the debt securities of CLOs that hold bonds. While not taking a position on this issue, the agencies requested comments on a number of questions, such as the definitions of “covered fund”, “ownership interest” and “loan securitization”, changes to any of which could result in the end of the current prohibition.
Background. The Volcker Rule was intended to limit banks’ investments in the equity of PE and hedge funds (“covered funds”). Because the definition of covered funds was very broadly drafted, securitizations, including CLOs that hold any amount of bonds were included. (Notably, CLOs that are “loan-only” are specifically carved out of the Volcker Rule). Moreover, the agencies oddly ruled that even the most senior debt securities of such “non-compliant CLOs” are considered “ownership interests” equivalent to equity and thereby forbidden to banks, because holders have the contingent right to remove and replace CLO managers for cause. The LSTA has long and consistently argued that non-compliant CLOs should not be considered covered funds and that CLO debt securities are not ownership interests. It has also supported the view that the definition of “loan securitization” should be broadened to include CLOs with small buckets for debt securities.
The Comment Letter. The LSTA’s comment letter focuses on two points. First, it suggests that the final rule’s “loan securitization” exclusion be modified 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 argues that the final rule’s definition of “ownership interest” that provides that the “rights of a creditor to exercise remedies upon the occurrence of an event of default…” include the right to participate in the removal of an investment manager “for cause” or participate in the replacement of a manger 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. For more information please contact LSTA general counsel Elliot Ganz at email@example.com.