September 5, 2019 - (This updates an August 20th article to discuss the relationship between the Volcker Rule and litigation around whether term loan Bs could be considered securities.)
On August 20th, 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, while those amendments do not affect loans and CLOs, the agencies signaled that amendments to the part of the Volcker Rule pertaining to CLOs would be forthcoming sometime in the future. And, because of recent litigation over whether term loan Bs could be considered securities, the outcome of forthcoming amended rules could be of utmost importance. The 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-equivalents but no other securities.
The Potential Impact of the Litigation.
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, a ruling by a court that broadly syndicated term loans are securities could eliminate U.S. banks’ ability to purchase CLO notes, and because banks are a primary source of CLO capital, this could severely limit CLO formation and the funding for corporate loans that comes from it. Moreover, if loans were to be deemed to be securities, banks might also be required to divest themselves of their present CLO note holdings (currently around $90 billion).
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. The agencies specifically 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, and more importantly in light of the litigation, 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. The LSTA asserts 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.What’s next? The LSTA will continue to closely monitor and report on what has the potential to become an enormously important issue. Please direct any questions on the Volcker Rule to LSTA General Counsel Elliot Ganz.