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Volcker proposal adds legal safe harbor for CLOs

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Banking regulators are proposing to update a portion of the Volcker Rule that would, in essence, permit collateralized loan obligations to again hold high-yield bond buckets.

But another change being considered is getting more attention as a potential shield to a possible federal court ruling that loan industry officials say could disrupt the CLO space.

In January, regulators from five financial regulatory authorities approved a re-proposal to update a portion of the Volcker Rule and allow banks to take stakes in certain investment funds.

The proposal revises the definition of a so-called covered fund, and allows financial institutions to invest in funds that many stakeholders say were not meant to be the target of the Volcker Rule established in 2013 to enforce a proprietary trading ban for regulated banks.

The original rule, mandated by the Dodd-Frank Act and first conceived by former Fed Chairman Paul Volcker, allowed banks to take direct stakes in individual startup companies but not funds containing multiple investments.

The proposal would ease that provision by allowing banks to invest in instruments such as credit funds, venture capital funds, customer facilitation funds and family wealth management vehicles — even if those funds contained multiple investments.

The change affecting CLOs would establish that CLO debt securities would no longer represent ownership interests for banks under the rule. That’s a reversal from the original Volcker Rule, which maintained that the notes gave banks equity-like stakes in the funds since investors have the capacity to remove a manager from a fund.

Loan securitizations were exempt from the original covered fund, so CLO managers wanting to maintain their primary investor base of large U.S. financial institutions stripped out high-yield bonds from their deals to qualify for the loans-only exemption for the collateral.

Federal Reserve chairman Jerome Powell (left), Fed vice chair Randal Quarles

Elliot Ganz, general counsel for the Loan Syndications and Trading Association, said the changes were welcome news for CLO managers. “Obviously, we’ve been suggesting this interpretation of ownership interest for a very long time,” he said. “We think the right to remove and replace the manager for cause is much more like a remedy. It’s not really an equity-like characteristic. We’re happy that the agencies are seeing it that way.”

The new covered-fund definition will permit CLOs to hold a small portion of nonloan assets, which would include high-yield bonds.

But the proposal’s exemption of nonloan assets from the covered fund definition was also expanded to include CLO debt securities themselves, primarily the AAA-rated senior notes in CLO transactions.

The LSTA said this “safe harbor” carve-out for loans from the definition of ownership interest could play an important role in staving off a potentially disruptive federal court ruling that might come later this year.

Kirschner v. JPMorgan, et al. is a high-profile 2017 lawsuit filed by a trustee in the controversial 2015 bankruptcy filing by Millennium Health LLC. The suit complains that investors in Millenium’s $1.8 billion term loan B should have been warned of a federal investigation of Millennium at the time the loan was issued in 2014. (JPMorgan was among several underwriting banks of the syndicated loan.)

In a filing in the U.S. Southern District of New York court, the plaintiff is seeking a ruling to establish that term loans be considered securities under federal law, requiring higher standards of investor disclosure like those of high-yield corporate bonds.

If loans were to be declared securities, market observers say CLOs would lose the loan-securitizaiton exemption to the current Volcker Rule ... and, overnight, U.S. banks investing in those CLOs would be holding prohibited covered funds.

“It seems possible that if loans are classified as securities, CLOs may be labelled as covered funds, and dealers would then be limited in owning CLO equity on account of its ownership interest in the covered fund,” David Preston, a CLO market analyst at Wells Fargo, said in a Jan. 31 research report.

Banks, the LSTA noted, “would immediately have to divest themselves of approximately $86 billion in interests in CLOs holding syndicated term loans — 25% of CLOs’ AAA notes,” the LSTA asserted in a May 2019 membership letter.

“Such a result would severely disrupt CLO formation and the funding for corporate loans that come from it,” driving most of the business into the expanding direct-lending market led by private-equity fund giants, the LSTA argued.

The “Volcker 3.0” re-proposal, which follows a “Volcker 2.0” rule revamp last fall, would provide bank investors with a “complete ‘safe harbor' from the definition of ownership interst for senior loans and senior debt securities,” the LSTA stated in a January newsletter.

“The safe harbor is an overriding carve out and would apply irrespective of whether the CLO had removal/replacement rights.”

The Office of the Comptroller of the Currency, Federal Reserve, Federal Deposit Insurance Corp., Securities and Exchange Commission and the Commodity Futures Trading Commission will be accepting public comments through April 1, prior to the issuance of a final rule.

Mixed industry views
In a January statement, Fed Chair Jerome Powell said the agencies “now have considerable supervisory experience putting that common sense prohibition into practice, and we have learned that a simpler, clearer approach to implementing the rule makes it easier for both banks and regulators to carry out the intent of the rule,”

In addition, the proposal maintains the original rule’s restriction on allowing a bank to engage in proprietary trading through a fund structure, restricts banks from bailing out any funds it sponsors and limits conflicts of interest between a bank and a fund.

But the proposal has drawn mixed reactions, with industry groups saying the changes would represent a prudent refinement of the post-crisis regime and Dodd-Frank supporters charging that the regulators were going too far.

“Today’s proposal will allow banks to get back to some important traditional commercial banking and asset management activities that the current rule prohibits, helping businesses grow and consumers build savings,” Greg Baer, president and CEO of the Bank Policy Institute, said in a statement. “These are client-focused, non-proprietary activities that the Dodd-Frank Act didn’t intend to prohibit, so this proposal is all gain and no pain.”

Dennis Kelleher, CEO of Better Markets, said the proposal “will allow banks to do indirectly what they are prohibited from doing directly.”

“Today’s proposal undermines the Volcker Rule prohibition and its objectives by opening more loopholes that will allow Wall Street’s biggest taxpayer-backed banks to again engage in substantial proprietary trading,” Kelleher said.

FDIC Chairman Jelena McWilliams took aim at those who have criticized both the proposal as well as the previous revision of the proprietary trading ban, suggesting that they were being reactionary.

“Any adjustments to the Volcker Rule seem to elicit criticism that just about any change, no matter how many guardrails are in place, would somehow create a gaping hole in our regulatory framework. Such criticism is simply unfounded,” she said at the agency’s board meeting.

Allowing banks to invest in a fund structure rather than taking more direct stakes in companies would help them to diversify risk, which could in turn bolster safety and soundness, agency officials said in a press briefing.

The decision to propose permitting these activities is bolstered by the congressional record, agency officials added.

Former Sen. Chris Dodd, D-Conn., a principal author of Dodd-Frank, said himself in 2010 that “properly conducted venture capital investment will not cause the harms at which the Volcker Rule is directed.”

The proposal would also simplify parts of the covered-funds provision on how foreign public funds small-business investment companies are treated.

Hannah Lang contributed to this story.

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Volcker Rule CLOs CDOs Compliance Dodd-Frank Federal Reserve OCC
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