Federal Reserve Extends Deadline for CLO Divestiture Under Volcker Rule
Author: Anne Coughlan
On April 7, 2014, the Federal Reserve Board announced it would give banks two additional one-year extensions to conform their ownership interests in or divest certain collateralized loan obligations (CLO) covered by the Volcker rule. This falls short of the exemption sought by various banking industry lobbyists—banks hold roughly $120 billion of the estimated $300 billion CLO market.
The Volcker Rule generally prohibits banking entities from engaging in proprietary trading or from acquiring or retaining ownership interest in a hedge fund or private equity fund, also called “covered funds.” The rule took effect April 1, 2014, with an original conformance period until July 21, 2015. This ruling extends the effective date to July 21, 2017, for CLOs in place as of December 31, 2013, that do not qualify for the loan securitization exclusion.
The four other U.S. regulators cosigning the Volcker rule—including the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission—would grant a similar delay.
Loan Securitization Exclusion
The Volcker rule excludes from the definition of a covered fund an issuer of asset-backed securities (ABS) if its underlying assets are comprised solely of loans and certain interest rate or foreign-exchange derivatives. In addition, the issuer may not hold any of the following:
- A security, including an ABS, or an interest in an equity or debt security
- A derivative, other than as permitted above; credit default swaps are prohibited
- A commodity-forward contract
Frequently, a CLO asset manager is permitted to invest a small percentage of the pool in senior secured bonds. Since these bonds are considered securities, their presence in a CLO structure would disallow the loan securitization exclusion. An exemption can be applied if the manager were to remove all nonloans from the structure prior to the end of the conformance period.
Definition of “Ownership Interest”
Assuming an investment falls under the definition of a covered fund, an entity must then determine if the investment would be considered an “ownership interest.” Ownership interest is broadly defined to include an interest, however structured, that results in a banking entity having similar exposure as an owner to the profits and losses of a fund.
Many CLOs provide rights to a “controlling class” of senior debt security holders to participate in the designation of investment managers or investment advisors. This creates the possibility that even the most senior highly rated debt securities may be considered an “ownership interest.”
To conform to the Volcker rule, it might be possible to restructure an existing CLO to modify the rights of debt security holders.
Note: While the Fed ruling gives the banks more time, it may be difficult for banks to change CLO ownership terms to conform to the Volcker rule.
It is important to review the actual terms of each security held, as well as all underlying securities and the issuance terms of the securitization. Relevant information may be held by custodians, trustees or sponsors of the securitization. Given the complexity of these securities structures, it would be prudent to seek legal advice from a firm specializing in securities law in making a final determination if a particular security is subject to the Volcker rule.
BKD will continue to follow this issue. For further information, contact your BKD advisor.