By: Ashlee Kuan
In June of 2019, the Office of the Comptroller of the Currency (“OCC”), Board of Governors of the Federal Reserve System (“Board”), Federal Deposit Insurance Corporation (“FDIC”), Securities and Exchange Commission (“SEC”), and Commodity Futures Trading Commission (“CFTC”) (collectively the “Agencies”) issued a final rule where the Agencies announced adoption of amendments to the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that enforces section 13 of the Bank Holding Company Act.[1] The Volcker Rule prohibits all banking entities “[f]rom engaging in propriety trading, acquiring or retaining ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund,” which is also known as a covered fund.[2] The final rule came into effect on October 1, 2020, and this time the modifications will largely benefit collateralized loan obligations (“CLOs”) as a result of the Agencies adjusting the definitions of ownership interest as it pertains to covered funds, and loan securitization as it pertains to debt securities.
The first significant change is that the new rule will permit CLOs to take on up to five percent in debt securities, excluding asset-backed securities and convertible securities.[3] This amendment allows CLOs to purchase a “bond bucket” for up to five percent of the value of their assets, which essentially allows CLOs to purchase non-loan assets.[4] The Volker Rule regulations of 2013 initially prohibited this type of behavior.[5] Indeed, giving CLOs the ability to reinvest in bond buckets reflects a trading and lending environment similar to that of CLOs prior to the 2008 financial crisis. However, the Agencies stated in the final rule that they did not believe modification to this provision is unwarranted because the post-crisis issues present when the 2013 Volcker Rule provisions were originally enacted are no longer present.[6]
The second major change impacting CLOs is that the new rule expands the scope of the definition of ownership interest as it pertains to covered funds.[7] The definition of ownership interest under the original enactment of the Volcker Rule provisions in 2013 was very broadly defined.[8] In recognition of this issue, the new rule clarifies that it will not consider a debt security an ownership interest just because it includes a creditor’s right “[t]o participate in the removal or replacement of an investment manager for cause. . . .”[9] The final rule also includes a provision that provides a safe harbor for certain senior loans or other debt interests that meet certain particularized criteria to be excluded from the definition of ownership interest.[10] This modification should allow banking entities to hold senior notes while also allowing CLOs structural flexibility in loan securitization.[11]
This final rule is significant for CLO market participants and banks and financial institutions that are holders of CLO notes because it is allowing the type of activity the Volcker Rule originally sought to eliminate. The modifications should benefit CLOs because the new rule will allow CLOs to use the bond bucket as a debt instrument, which could incentivize banks and other financial entities to finance more CLOs. The adjusted definitions for ownership interest and loan securitization also reflect commenters concerns during the Agencies’ rule making process.[12] Thus, the new rule should not be met with much criticism; however, changes in regulations are usually met with associated compliance costs, which could be seen as a downside to the modifications.
The Agencies claim the modifications to the Volcker Rule are being implemented because pre-crisis issues are not currently present.[13] However, the Agencies should be cautious of the CLOs trading and lending activity as the implementation of the rule takes effect. It probably will not be as easy for issuers to take advantage of the flexibility in these Volcker Rule modifications, but there is the potential for bad actors to still take on risky investments, especially related to the possibility of CLOs purchasing junk bonds.[14] The effect of the Volcker Rule modifications should not result in drastic changes for issuers, but the Agencies should still closely monitor CLO trading and lending activity to ensure behavior the Volcker Rule originally sought to eliminate will not be duplicated in light of relaxing those regulations.
[1] 12 U.S.C. § 619 (2014); 12 U.S.C. §§ 5301–5628 (2010); 12 U.S.C. § 1851 (2011); Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 85 Fed. Reg. 46,422, 46,422 (July 31, 2020).
[2] See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 85 Fed. Reg. at 46,422 (citing 12 U.S.C. § 1851 (2011)).
[3] Id. at 46,433.
[4] See Barry L. Zubrow, Comment Letter on the Notice of Proposed Rulemaking Implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, JPMorgan Chase & Co. (Feb. 13, 2012), https://www.sec.gov/comments/s7-41-11/s74111-267.pdf (explaining that bond buckets enable CLOs to access credit when other loan assets are unavailable); see also Howard Goldwasser & Skanthan Vivekananda, Recent Amendments to the Volcker Rule Will Benefit CLOs and the Banks that Invest in Them, Orrick, Herrington & Sutcliffe LLP, (July 20, 2020), https://www.jdsupra.com/legalnews/recent-amendments-to-the-volcker-rule-39036/ (explaining that a bond bucket permits “[C]LOs to hold a certain amount of non-loan assets, primarily high-yield bonds.”).
[5] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 85 Fed. Reg. at 46,432.
[6] See id. at 46,424 (acknowledging that amendments are necessary because the current trading and lending environment does not present the same risks that section 13 of the Bank Holding Company Act intended to prohibit).
[7] Id. at 46,460.
[8] Id. at 46,424.
[9] Id. at 46,462.
[10] Id. at 46,460.
[11] Jayante W. Tambe, et al., Volcker Rule Covered Fund Amendments: What They Will and Will Not Do for CLOs, Jonesday (July 2020), https://www.jonesday.com/en/insights/2020/07/volcker-rule-covered-fund-amendments-and-clos.
[12] See Securities Industry and Financial Markets Association, Comment Letter on Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds, and Private Equity Funds, (Mar. 11, 2020), https://www.sifma.org/wp-content/uploads/2020/03/SIFMA-Comment-Letter-on-Volcker-Funds-NPR.pdf (supporting the proposed loan securitization amendment allowing CLOs to invest in debt instruments between five percent and ten percent of total assets); see also Comment Letter On Proposed Revisions to Prohibitions and Restrictions on Propriety Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, (Apr. 1, 2020), https://www.fdic.gov/regulationS/laws/federal/2020/2020-prohibitions-restrictions-proprietary-trading-3064-af17-c-016.pdf.
[13] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 85 Fed. Reg. at 46,424.
[14] See SEC, Office of Investor Education and Advocacy, https://www.sec.gov/files/ib_high-yield.pdf (last visited Oct. 20, 2020) (defining junk bonds as high-yield corporate bonds, which have highe rates of default because of the high interest rate); see also Lisa Lee, CLOs Get Volcker Rule Reprieve to Buy More Than Leveraged Loans, Bloomberg Law, (June 29, 2020), https://www.bloomberglaw.com/product/blaw/document/XB5R27TO000000?criteria_id=573b8c0aa5153ad57ac60cb34c9d4ae5&searchGuid=0fe41a6d-669c-4030-80be-b51815a9b1a6&search32=WVe9LBehb1pL4QuwP2Hy6w%3D%3DSBUrWNdKspPSgVlSrkcLjGp_9k1A_NjVtF1jA7FUlUDcbJtLFM4pMp2fPfNZf89_tGgEe_S-qyM1NCr-cRJC610ipCnQmQkYRwmSHc_M5ckeo8gUa-QX9y61SWZq9BON.
