Under the final version of the Volcker Rule issued this week, issuers and sponsors of new CLO issuances should consider structuring CLOs to conform to the exclusions contained in the rule, and banks and bank affiliates that own tranches in existing CLOs will need to evaluate whether those CLOs conform with the exclusions contained in the rule and, if not, whether they need to amend the CLO documents, divest those interests by July 2015 or seek interpretive guidance.
On December 10, 2013, the Office of the Comptroller of the Currency, Treasury, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and the Securities and Exchange Commission (the “Agencies”) adopted a final rule (the “Final Rule”) to implement section 13 of the Bank Holding Company Act of 1956 (the “BHC Act”), which was added by section 619 of the Dodd-Frank Act.1 Section 13 of the BHC Act contained what has become commonly known as the “Volcker Rule,” which generally prohibits insured banks and their affiliates from proprietary trading or from acquiring or retaining any equity, partnership, or other ownership interest in, sponsoring, or having certain other relationships with a hedge fund or a private equity fund.2 To define “hedge fund or private equity fund,” Section 13 of the BHC cross-referenced the Investment Company Act of 1940 (the “40 Act”), saying that any entity that relied on the exclusions contained in section 3(c)(1) or 3(c)(7) to not qualify as an “investment company” under the ’40 Act was a “hedge fund or private equity fund.”3 Because many CLOs rely on these exclusions, such CLOs would be subject to the same rules restricting bank ownership and sponsorship as hedge funds unless specifically excluded by the Final Rule.
Fortunately, the Final Rule provides a number of possible exclusions, but meeting the exclusion criteria would require changes to common CLO structures currently used in the market. And as the Final Rule provides no grandfathering for existing deals, existing CLOs that do not meet the exclusion criteria will be subject to substantially the same limits imposed by the Final Rule on bank relationships with hedge funds and private equity funds.
As implemented, the Final Rule prohibits any “banking entity”4, either “as principal, directly or indirectly,” from acquiring or retaining any ownership interest in or sponsoring a “covered fund.” A “covered fund” includes any issuer “that would be an investment company, as defined in the [’40 Act], but for section 3(c)(1) or 3(c)(7) of that Act,” but subject to a number of specific exclusions.5
The Final Rule includes a number of carve-outs from the definition of “covered fund.” One provision, discussed in more detail below, excludes all “loan securitizations.”6 Another clarifies that an issuer “that may rely on an exclusion or exemption from the definition of ‘investment company’ under the [’40 Act] other than the exclusions contained in section 3(c)(1) and 3(c)(7) of that Act” – including, for example, an issuer that relies on the exclusion for issuers of asset-backed securities contained in Rule 3a-7 of the ’40 Act – is not a covered fund under the Final Rule.7 A related provision excludes any entity that “has elected to be regulated as a business development company . . . and has not withdrawn its election, or that is formed and operated pursuant to a written plan to become a business development company” and that files a written plan of its election meeting certain requirements under the Final Rule.8
Any banking entity that had more than $10 billion in consolidated assets as of December 31 of the two prior years must retain records documenting “the exclusions or exemptions other than sections 3(c)(1) and 3(c)(7) . . . relied on by each fund sponsored . . . in determining that such fund is not a covered fund,” as well as “documentation supporting the banking entity’s determination that [any fund it sponsors] is not a covered fund pursuant to” the “loan securitization” provision or several other exclusions under the Final Rule.9
The Final Rule defines a loan securitization as “an issuing entity of asset-backed securities” that holds nothing other than:
“(A) Loans as defined in § __.2(s) of subpart A;
(B) Rights or other assets designed to assure the servicing or timely distribution of proceeds to holders of such securities and rights or other assets that are related or incidental to purchasing or otherwise acquiring and holding the loans, provided that each asset meets the requirements of paragraph (c)(8)(iii) of this section;
(C) Interest rate or foreign exchange derivatives that meet the requirements of paragraph (c)(8)(iv) of this section; and
(D) Special units of beneficial interest and collateral certificates that meet the requirements of paragraph (c)(8)(v) of this section.”10
The defined term “loans” includes “any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative.”11 The Supplementary Information published by the Agencies to accompany the Final Rule (the “Supplementary Information”) notes that the question of whether a loan is a security “will depend on the particular facts and circumstances,” but “the parties’ characterization of an instrument as a loan is not dispositive,” and ultimately “whether a loan is a security or a derivative for purposes of the loan definition is based on the federal securities laws and the Commodity Exchange Act.”12 It is clear that some assets commonly held by CLOs, including bonds or notes issued by other CLOs, would clearly not be permissible as loans for purposes of the Final Rule.
The Final Rule sets forth several categories of assets that loan securitizations are not permitted to have. These impermissible assets include any “security, including an asset-backed security, or an interest in an equity or debt security,” other than “cash equivalents for purposes of” the “rights or other assets” basket in clause (B) above, or “securities received in lieu of debts previously contracted with respect to the loans supporting the asset-backed securities.”13 “Cash equivalents” were not further defined in the Final Rule itself, but the Supplementary Information gives examples of “cash equivalents” that are more narrow than many CLO indentures currently define “permitted investments.”14 Those structuring CLO indentures to comply with the “loan securitization” definition should consider whether any contemplated “permitted investments” may fall outside the scope of this permission (such as highly rated corporate bonds or repos not issued by federally insured banks), and if so, whether those additional categories convey benefits worth risking “loan securitization” treatment under the Final Rule.
In addition, the Final Rule prohibits loan securitizations from being party to any derivative other than interest rate or foreign exchange derivatives that, by their written terms, relate directly to the loans, the asset-backed securities, or the contractual rights of other assets held by the issuer and that actually reduce interest rate and/or foreign exchange risk.15 Finally, the Final Rule specifically forbids loan securitizations from holding commodity forward contracts.16
Prohibited Activities with respect to Covered Funds
If a CLO issuer relying on the 3(c)(7) exclusion from the ’40 Act does not meet the definition of “loan securitization” (or another carve-out contained in the Final Rule such as relying on Rule 3a 7 for exclusion from the ’40 Act), then it will be considered a covered fund, severely limiting its relationships with banks and bank affiliates. As discussed above, a banking entity generally may not sponsor17 or own an interest in a covered fund,18 subject to various exceptions. The Final Rule also references the “covered transaction” provisions of section 23A of the Federal Reserve Act to provide that, subject to certain exceptions, a banking entity that serves as “investment manager, investment adviser, commodity trading advisor, or sponsor to a covered fund, that organizes and offers a covered fund pursuant to [the Final Rule] or that continues to hold an ownership interest” in a covered fund in connection with acting as a securitizer thereof or retaining risk retention with respect thereto under Section 15G of the Exchange Act, and any affiliate of such an entity, may not:
- loan or extend credit to the covered fund,
- purchase or invest in securities of the covered fund,
- purchase assets from the covered fund,
- accept securities or other debt obligations issued by the covered fund as collateral for a loan to any person or company,
- issue a guaranty, acceptance or letter of credit on behalf of the covered fund,
- enter into any transaction with the covered fund that involves borrowing or lending securities, to the extent the transaction would cause the banking entity or a subsidiary to have credit exposure to the covered fund, or
- enter into any derivative transaction with the covered fund, to the extent the derivative transaction would cause the banking entity or a subsidiary to have credit exposure to the covered fund.19
Notwithstanding this list, the Final Rule permits banking entities to hold very limited interests in covered funds. Banking entities are permitted to sponsor, acquire and retain ownership interests in a covered fund in connection with providing trust, fiduciary or advisory services to customers (which may be new customers),20 and in connection with an offering of asset-backed securities when the banking entity acts as a securitizer or acquires or retains an ownership interest in the issuer as required by the risk retention rules under section 15G of the Exchange Act and otherwise complies with the Final Rule.21 In connection with such an offering, the banking entity is permitted to establish the fund and provide it with “sufficient initial equity for investment to permit the fund to attract unaffiliated investors,” as long as, within one year after the date on which assets are initially transferred into the fund, the banking entity sells down its interest to no more than three percent of the total value of outstanding interests in the fund. The banking entity can hold more than three percent of the ownership interests if required to meet its risk retention obligations under section 15G of the Exchange Act.22 However, no banking entity is permitted to hold ownership interests in covered funds with an aggregate value of more than 3% of the tier 1 capital of the banking entity under the foregoing authorities.23
Of particular relevance to the CLO market, the ownership exceptions to the covered transaction provisions do not permit lending money to the covered fund by a banking entity or any affiliate thereof subject to such covered transaction provisions. This means that certain warehouse facilities would be a prohibited transaction under the Final Rule if the issuer is a covered fund and the lender is a banking entity or an affiliate thereof subject to such covered transaction provisions.
In addition to the ownership and relationship restrictions, the Final Rule also subjects “any banking entity that serves . . . as the investment manager, investment adviser, commodity trading advisor or sponsor to a covered fund, or that organizes and offers a covered fund” pursuant to the above exemptions, to section 23B of the Federal Reserve Act “as if such banking entity were a member bank and such covered fund were an affiliate thereof,” which will require “covered transactions” between the banking entity and a covered fund be on arms’-length terms.24
Finally, the Final Rule contains a blanket prohibition on any transaction involving a covered fund that would “involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties,”25 although a banking entity may avoid a material conflict of interest by offering to the ultimate client, customer or counterparty timely disclosure and an opportunity to negate or mitigate the effects of the conflict, or by establishing information barriers (and formal policies to maintain those barriers) designed to prevent the conflict.26
Reporting and Recordkeeping
To the extent a banking entity holds any interest in or sponsors any covered fund, the Final Rule imposes substantial monitoring and reporting requirements.27 This includes “provid[ing] a process, which must include appropriate management review and independent testing, for identifying and documenting covered funds that each unit within the banking entity’s organization sponsors or organizes and offers, and covered funds in which each such unit invests,” establishing compliance procedures that sets forth how the banking entity monitors and prohibits conflicts of interest relating to covered funds, prohibits transactions that threaten the soundness of the banking entity and prevents exposure to high-risk assets or trading strategies, and establishing internal controls to monitor holdings in covered funds. The compliance program must also explain how the bank plans to “actively seek unaffiliated investors” to ensure that it is able to sell down an investment in a covered fund it sponsors to the permitted level within the permitted timeframe.
A provision that appeared unexpectedly in the Final Rule is an expansive definition of “ownership interest” in a covered fund that could encompass many currently outstanding CLO debt tranches. Under the Final Rule, “ownership interest” is defined as “any equity, partnership, or other similar interest,” including any interest that “has the right to participate in the selection or removal of a general partner, managing member, member of the board of directors or trustees, investment manager, investment adviser, or commodity trading advisor of the covered fund (excluding the rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event).”28
Many CLO indentures permit either the controlling class of notes or the holders of equity interests to remove the manager for cause (but outside of an event of default), and permit the controlling class and the equity, acting together, to select a new manager. This limited control right of the controlling class appears to fall within the definition of “ownership interest” under the Final Rule, thereby preventing any banking entity from acquiring or retaining notes after July 21, 2015 if the notes were issued by a CLO that is a covered fund at the end of the conformance period. However, amending the indenture to remove any bond basket and make sure the permitted investments and permitted hedge agreements comply with the definition of “loan securitization” in the Final Rule, or modifying the deal structure in such a way that the issuer could rely on the exclusion contained in Rule 3a-7, would remove the issuer from the universe of “covered funds,” and permit banking entities to invest in and continue to own notes issued by the CLO. We also anticipate that market participants will attempt to clarify to the Agencies that CLO noteholders exercising the right to participate in the removal of a manager for cause (outside of an event of default) and the selection of a replacement manager after such removal or resignation by the prior manager are exercising creditor remedies, and will request guidance from the Agencies that such a right does not give rise to an ownership interest.
Application to Existing CLOs and Conformance
The Agencies acknowledged in the Supplementary Information the request by commenters to grandfather certain existing funds and so not require them to comply with the provisions of the Final Rule, but explicitly rejected this approach, instead noting that “section 13 specifically addresses a banking entity’s preexisting investments in covered funds by providing a conformance period, which banking entities may use to bring their activities and investments into compliance with the requirements of section 13 and the final rule.”29 In a separate action the Agencies extended this conformance period for most provisions of the Final Rule, including the prohibition on acquiring or owning interests in or sponsoring covered funds, for one year until July 21, 2015.30
Implications for the CLO Market
Given the harsh consequences of being considered a “covered fund” under the Final Rule, we expect that CLO issuers and sponsors will increasingly structure new deals to avoid treatment as a covered fund, either by fitting their deals within the definition of “loan securitization,” or by relying on Rule 3a-7 for exclusion from the ’40 Act rather than section 3(c)(1) or 3(c)(7).
For a CLO structure to conform to the definition of “loan securitization,” one obvious change is the removal of bond and CLO note baskets and any other investments that fall outside the definition of "loan," which, as securities or derivatives, are prohibited assets for loan securitizations under the Final Rule. Several deals that went to market in the immediate aftermath of the release of the Final Rule followed this approach; as an alternative, permission to hold such investments may be left in the indenture, but the issuer would be prohibited from acquiring or holding any such investment unless the trustee receives an opinion of counsel that the acquisition thereof by the issuer would not cause the issuer to constitute or be deemed a “covered fund” as defined in and subject to the Volcker Rule. As additional precautions, parties should provide that issuers are only permitted to enter into interest rate and foreign exchange derivative transactions that actually reduce interest rate or foreign currency risk, and make sure they are comfortable that only “cash equivalents” (as loosely defined in the Final Rule) are permitted investments.
If issuers and managers want to keep the ability to invest in bonds, they may try to avoid the Volcker Rule entirely by relying on Rule 3a-7 of the ’40 Act rather than section 3(c)(1) or 3(c)(7). However, managers may find that the limitations and burdens of Rule 3a-7 outweigh the benefits. An issuer relying on Rule 3a-7 cannot acquire or sell assets “for the primary purpose of recognizing gains or decreasing losses resulting from market value changes.”31 Among other things, this can impose a compliance burden, as a manager typically must keep records showing that they traded for reasons other than to recognize gains or decrease losses, and certify as such to the trustee.
Finally, we encourage interested readers and relevant trade associations to request guidance from the Agencies that the exercise of a noteholder’s right to participate in the removal of a manager for cause, and participate in the selection of a replacement manager when a manager is removed or resigns, even outside of the context of an event of default, would be deemed the equivalent of the exercise of a creditor’s right to remove the manager following an event of default, and as such would not cause the related CLO notes to be deemed “ownership interests.” Absent such guidance, banks and banking affiliates holding interests in debt tranches in existing CLOs will need to review the terms of those CLOs carefully, and in the event that (i) the CLO is a covered fund (for example, because the issuer may hold bonds or CLO notes), and (ii) their notes constitute an ownership interest (for example, because they may grant the right to direct removal of the manager for cause or participate in the selection of a replacement (other than following an event of default)), they should consider seeking amendments to the CLO documents to allow the related CLO issuers to rely on the loan securitization exclusion or on Rule 3a 7 to the ’40 Act so as not to be a “covered fund” subject to the Final Rule, or otherwise carefully evaluate whether they will be required to divest those interests by July 21, 2015.