July 8, 2016 - July 7, 2016 – With just two weeks to go before the deadline, the Board of Governors of the Federal Reserve (“FRB”) this afternoon released an order extending the conformance period for the Volcker Rule to July 21, 2017. Although widely expected, had the FRB not acted, banks would have been forced to sell within the next two weeks any non-conforming CLO liabilities they held. The order is available by clicking here and the press release is available by clicking here.
Section 619 of the Dodd-Frank Act (the “Volcker Rule”) prohibits banking entities from proprietary trading in most instruments and from acquiring or retaining ownership interests in hedge funds or private equity funds (“covered funds”).
As we have discussed previously, the federal regulators, rejecting the views and proposals of the LSTA and other market participants, interpreted the second part of the Volcker Rule very broadly. The regulators issued final rules in December 2013 that categorized collateralized loan obligations (“CLOs”) that were not 100% invested in loans or cash equivalents as “covered funds” and ruled that all liabilities of a non-conforming CLO were “ownership interests” that could not be acquired or retained by banks. What this meant, as a practical matter, was that banks would have to divest any CLO notes they held, even AAA and AA rated instruments, on the effective date of the Volcker Rule. The OCC itself estimated that, if forced to sell their CLO liabilities at the original effective date of July 2015, banks could suffer billions of dollars of losses. (This is despite the fact that AAA and AA CLO notes have never suffered a principal loss).
After the final rule was published, the LSTA and other trade associations advocated for legislation that would carve out most legacy CLO notes from the Volcker Rule and otherwise extend the effective date until December 2018. Although the legislation passed the House, it was not considered by the Senate and did not become law.
However, in response to requests by the LSTA and other market participants, in December 2014, the FRB granted a limited extension until July 21, 2016 and announced its intention to issue another extension until July 21, 2017 to allow banks to conform their ownership interests in and relationships with legacy covered funds. The order today gives effect to their announced intention by formally pushing out the conformance period until July 21, 2017.
The impact of these two extensions has been, and continues to be, profound. First, banks have not been forced into a fire sale of non-conforming 1.0 and 2.0 CLOs that have now been repaid in full or refinanced (or are expected to be repaid in full or refinanced prior to the extended effective date). Second, banks, working with managers and other investors have amended many other CLOs to make them conform to the Volcker Rule (primarily by converting to loan-only structures). As a result, banks have avoided and are not expected to recognize significant losses from the implementation of the Volcker Rule.