Rolling Back the Impact of the Volcker Rule on CLOs

Last week the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the “Agencies”) published a notice of proposed rulemaking that seeks public comment on the Agencies’ proposal (the “Proposal”) to amend section 13 of the Bank Holding Company Act, commonly known as the Volcker Rule.[1] At least two components of the Proposal would roll back the Volcker Rule’s years-long impact on the ability of banks to invest in CLOs and, therefore, are highly noteworthy to bank-investors and other participants in the CLO industry:

1. The first of these would modify the so-called “loan securitization exemption” in order to permit CLOs that rely on the exemption to invest in a limited – but not yet specified – amount of non-loan assets. Since the Volcker Rule was implemented in 2013, CLOs that relied on the loan securitization exemption, for the most part, have been fully prohibited from investing in assets that were not loans. By contrast, prior to 2013, it was common for CLO portfolios to include so-called “buckets” for investments in assets that were not loans, such as high-yield bonds, CLOs, CDOs, and derivatives.
2. The second would create a safe harbor that would permit banks to make “senior loans” to, or to invest in other “senior debt interests” issued by, CLOs if such loans or other debt interests were to have all of the characteristics prescribed by the safe harbor. Ever since the Volcker Rule was adopted, uncertainty has existed around whether banks could invest in CLO debt tranches (even AAA-rated debt tranches) if one of the rights associated with an investment in the CLO debt tranche was the investor’s right to vote on the removal or replacement of the CLO’s collateral manager. The uncertainty was created by the rule’s definition of the types of “ownership interests” that banks are prohibited from owning, which captured interests (not just conventional equity interests) that “[have] the right to participate in the selection or removal of [an] investment manager [or] investment adviser.”[2]

Here is what we think, for now, participants in the CLO market should know about these two components of the Proposal.

The Potential Return of the “Bond Bucket” (and Other “Buckets”)

According to the Proposal, the Agencies are considering an amendment to the loan securitization exemption that would permit CLOs that rely on it to invest in both (A) “loans[3]” and (B)”[a]ny other assets provided that the aggregate value of any such other assets . . . do not exceed five percent of the aggregate value of the issuing entity’s assets.”[4] The wording of the amendment is quite clear. If it were to be adopted as currently proposed, it would allow banks to invest in CLOs that permit a small portion of their asset portfolios to include an array of unspecified, non-loan assets -- not just bonds.

However, the devil is always in the details; and the Agencies have invited comment on a number of questions, the answers to which could have a significant impact on the final shape of the amended exemption if and when it is adopted. For example, in the Proposal, the Agencies pose the following questions:

1. “[S]hould the maximum percentage of non-loan assets be five or ten percent, or some other amount?” This question might signal the Agencies’ willingness to be flexible on the size of the non-loan bucket: As noted above, the proposed amendment, as it is currently drafted, refers to “five percent of the aggregate value of the issuing entity’s assets.”
2. “[W]hat should be the method of calculating compliance with the limit (e.g., market value, par value, principal balance, or some other measure)?” Here, the proposed amendment, as it is currently drafted, uses the undefined term “value” to cap the limit.
3. “In what ways, if any, should the agencies limit the type of permissible non-loan assets (e.g., only debt securities or any permissible asset, such as a derivative)? Would the inclusion of certain financial instruments – such as derivatives and collateralized debt obligations – raise safety and soundness concerns?”

Clarifying That A Debt Interest Is Not a Prohibited “Ownership Interest”

Another aspect of the Volcker Rule that has impacted a bank’s ability to invest in CLOs has been the rule’s prohibition of a bank’s ability to purchase and hold an “ownership interest” in a CLO. Although banks typically invest in the most senior debt tranches of CLOs, the Volcker Rule defines the term “ownership interest” broadly (and perhaps ambiguously) to include “any equity, partnership or other similar interest” in a covered fund and, in turn, defines the term “other similar interest” to mean any interest that has associated with it “the right to participate in the selection or removal of a[n] . . . investment manager [or] investment advisor . . . of the covered fund . . ..” As CLO market participants know, whenever a debt tranche of a CLO constitutes the CLO’s so-called “Controlling Class,” the holders of that tranche almost always have the ability to remove and replace the CLO’s collateral manager upon the occurrence of certain “for-cause” events, such as fraud, breach of agreement or the departure of specified key individuals. (These for-cause events are distinct and independent from conventional events of default.) For this reason, banks have been concerned that investing in CLO debt could be construed as a prohibited investment in an ”ownership interest” in a CLO.

In the Proposal, the Agencies attempt to clarify that banks should be permitted to own CLO debt, but they appear to do so imperfectly. They do so by proposing a safe harbor that would provide that a “senior loan” to, or a “senior debt interest” in, a CLO not be considered a prohibited ownership interest if the loan or debt interest satisfies the following three criteria:

1. The loan or debt interest cannot have associated with it “the right to receive a share of income, gains or profits of the [CLO],” but can only receive “(i) [i]nterest at a stated interest rate, as well as commitment fees or other fees . . . not determined by reference to the performance of the [CLO and](ii)[f]ixed principal payments on or before a maturity date . . . .”
2. “The entitlement to payments under the terms of the interest [must be] absolute and [can]not be reduced based on losses arising from the underlying assets of the [CLO], such as allocation of losses, write-downs or charge-offs of the outstanding principal balance, or reductions in the amount of interest due and payable on the interest.”
3. “The holders of the interest [can]not [be] entitled to receive the underlying assets of the [CLO] after all other interests have been redeemed or paid in full (excluding the rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event).”[5]

As we see it, the first criterion falls short of the mark – at least from a bank-investor’s perspective – in that, although most CLO debt tranches provide (as the criterion requires) for “principal payments on or before a maturity date,” can it be said that those principal payments are “fixed”? As those who are familiar with CLOs know, the entitlement of a CLO debt investor to principal payments prior to maturity varies according to a number of factors, such as the end of a CLO’s reinvestment period, the sufficiency of principal proceeds and the passing or failing of portfolio and coverage tests. It seems that the Agencies may themselves be aware of this shortcoming. In one of the questions that they pose to the market, they ask: “[S]hould the reference to ‘fixed principal payments’ under the safe harbor . . . be replaced with ‘contractually determined principal payments,’ ‘repayment of a fixed principal amount,’ or any other similar wording that may be more representative of typical principal distributions . . . ?”

In the coming weeks, industry groups and CLO market participants, including the CLO Group at Orrick, will be preparing comments on the proposal for submission to the Agencies. We here at Orrick would be glad to hear of your views or concerns as we do it, so please feel free to call or e-mail any of the authors at the numbers and e-mail addresses that appear beneath their photos.

*Daniel Goldstein, a senior associate in Orrick’s Structured Finance group, is also an author of this article.

[1] See “Agencies propose changes to modify Volcker rule "covered funds" restrictions,” January 30, 2020 (available at https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200130b.htm). Comments are due by April 1, 2020.
[2] See 12 C.F.R. § 248.10(d)(6).
[3] The Volcker Rule currently defines the term “Loan” to mean any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative. Although not discussed in this article, the exemption also permits investments in certain servicing rights, certain interest rate or foreign exchange derivatives directly related to or reducing the interest rate or foreign exchange risks related to the CLO’s assets, and certain collateral certificates and special units of beneficial interest issued by special purpose vehicles.
[4] See proposed 12 C.F.R. § 248.10(c)(8)(E).
[5] See proposed 12 C.F.R. § 248.10(d)(6)(ii).