Volcker Rule Covered Fund Amendments: What They Will and Will Not Do for CLOs
The Situation: The regulatory agencies responsible for administering the Volcker Rule have amended the covered fund provisions of the rule.
The Result: Modifications to the definitions of "ownership interest" and "loan securitization" should ease regulatory restrictions that have limited the asset types in which collateralized loan obligations ("CLOs") can invest. Future U.S. CLOs may no longer feel compelled to adhere to the definition of loan securitization, and even those that do should have additional flexibility to make non-loan investments.
Looking Ahead: For most extant CLOs, absent amendments to documentation, these regulatory changes will not provide any relief from the opportunistic strategies that have been employed in recent restructurings at the expense of CLOs.
Since the Volcker Rule took effect on April 1, 2014, U.S. CLOs generally have been restricted from investing in securities (and virtually any assets other than loans). On June 25, however, the Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and Commodity Futures Trading Commission finalized amendments (the "Modifications") to the Volcker Rule (a broader summary of these modifications can be found here). The Modifications, which become effective on October 1, 2020, include certain changes that provide these CLOs with additional regulatory flexibility.
The Volcker Rule prohibits "any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund ("covered fund"), subject to certain exemptions." It defined a covered fund as "an issuer that would be an investment company, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act." These exemptions from the definition of "investment company" are relied upon by hedge funds and private equity funds, as well as CLOs. As a result, absent an exemption, a CLO would be a covered fund, and ownership interest could not be held by banking entities under the Volcker Rule.
Of course, banks do not typically "own" CLOs; they tend to provide financing to CLOs by investing in senior debt tranches. The definition of "ownership interest" in the Volcker Rule, however, has included not only an equity or partnership interest but also any "other similar interest," which has in turn been defined to include an 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)."
CLO documentation typically provides holders of the most senior notes (the "Controlling Class") with the right to remove the collateral manager "for cause," even if no event of default or acceleration event has occurred. The combination of this traditional Controlling Class right and the definition of "ownership interest" in the Volcker Rule caused enough concern regarding bank entities' ability to hold Controlling Class notes that the vast majority of "2.0" U.S. CLOs have relied on the loan securitization exclusion from the definition of covered fund in order to be "Volcker compliant." To rely on this exclusion, these CLOs have only been able to hold loans and a small set of other financial instruments, but not securities (unless received in lieu of loan interests). European CLOs, instead, often permit Controlling Class notes to be exchanged for otherwise identical notes that lack the collateral manager removal right.
The Modifications change the definition of "ownership interest" and should obviate the need for this feature and allow U.S. CLOs to evolve beyond the regulatory confines of a loan securitization without jeopardizing the ability of banking entities to hold senior notes. Subject to certain conditions, (i) the definition of ownership interest will no longer include rights of a creditor to participate in the removal or replacement of an investment manager for cause; and (ii) a safe harbor from the definition of ownership interest will be created for senior debt interests. The Modifications also amend the loan securitization exclusion to permit up to 5% of a loan securitization's assets to be made up of debt securities.
The Modifications may also enhance the ability of U.S. CLOs to participate in loan restructurings. In several recent restructurings, non-CLO lenders have structured transactions to benefit themselves at the expense of CLOs by exploiting restrictions in CLO documents. One such strategy has involved rights offerings that reward lenders who are able to inject additional capital with super-sized shares of the restructured company's equity. Restrictions in CLO documentation preclude many of them from participating in such transactions on an equal footing with other lenders.
Will that automatically change after October 1? In most cases, not without changes to CLO documentation. For existing CLOs, which are likely to remain outstanding for an extended period under current market conditions, the managers, equity investors, or perhaps other junior noteholders would need to convince the Controlling Classes to execute appropriate amendments to give effect to flexibility provided under the Modifications. At least one manager appears to be engaged in a systemic amendment campaign to do this, but it remains to be seen whether it will succeed or others will follow. In new CLOs, the parties would need to strike bargains that provide managers with the requisite flexibility while protecting senior noteholders from excessive risk-taking.
Three Key Takeaways
- The changes to the loan securitization exclusion and the definition of ownership interest contained in the Volcker Rule Modifications provide additional regulatory clarity and flexibility for CLOs.
- These changes, without amendments to CLO documentation, do not provide CLO managers with the flexibility needed to combat restructuring strategies exploiting the restrictions CLOs currently face.
- The use of opportunistic restructuring strategies will accelerate in the months ahead. Parties to existing CLOs will need to retain sophisticated restructuring counsel and evaluate the extent to which their interests may diverge from other lenders in their loans and develop strategies, including documentation amendments, to protect their interests.
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