Befitting the holiday season the regulators recently decided to bestow upon us all the much anticipated (dreaded?) Volcker Rule. At 1100 pages of truly riveting reading material, Volcker has certainly given all of us plenty to wade through during these recent cold winter weeks and much to the surprise of the structured credit industry there were material provisions sprinkled throughout the 1100 pages that significantly affected the collateralized loan obligation market.
By way of background, Section 619 of Dodd-Frank added Section 13 to the Bank Holding Company Act of 1956, which has become commonly known as the “Volcker Rule”. On December 10, 2013, the regulatory agencies tasked by Dodd-Frank with implementing rules adopted the “Final Rule” just in time for the holidays. As an added stocking stuffer, the Final Rule did not grandfather existing transactions, making Volcker the gift that will truly keep on giving as the market begins to amend current CLOs to comply with Volcker’s various mandates.
Volcker’s main thrust is to prevent the next credit crisis by prohibiting banks from proprietary trading, sponsoring or trading in hedge funds or private equity funds – which are defined as entities that rely on the exclusions contained in section 3(c)(1) or 3(c)(7) of the 1940 Act to not qualify as an “investment company.”
CLOs that rely on the 3(c)(1) or 3(c)(7) exclusions will be subject to the rules restricting bank sponsorship and ownership, absent an applicable exemption. We will discuss the important changes to the “ownership” rules contained in the Final Rule in a subsequent post. For now, we will focus on two of the more notable “exclusions” to “covered fund” status.
Because Volcker’s prohibitions apply to entities that rely on the oft utilized 3(c)(1) and 3(c)(7) ’40 Act exemptions, an entity that relies on an exclusion or exemption other than 3(c)(1) or 3(c)(7) will not fall within the purview of Volcker. So why don’t CLOs market participants simply structure CLO’s to comply with Rule 3a-7 and avoid being considered a “covered fund” you ask? Because, Rule 3a-7 prohibits an issuer from acquiring or selling assets “for the primary purpose of recognizing gains or decreasing losses resulting from market value changes.” At a minimum this will impose a compliance burden as managers are required to keep records showing that they traded for reasons other than recognizing gains or decreasing losses.
A second (and perhaps more palatable) approach that CLO market participants may adopt is to utilize the “loan securitization” exclusion. In its simplest form, a “loan securitization” is an issuer of asset-backed securities that owns nothing other than loans (as defined with typical regulatory verbosity in the Final Rule) and a few limited types of other assets. Notably, “loan securitizations” may not own bonds or notes issued by other CLOs, eliminating a source of collateral which many pre-crisis CLOs are allowed to purchase even if typically subject to a small basket. The definition also narrows the type of short term investments that “loan securitizations” may own (i.e., the “Permitted Investments” in which CLOs may invest cash which are not currently being used for the purpose of purchasing loan assets) and prohibits certain swap and derivative transactions. It is expected that a number of market participants will begin to amend current CLOs in the coming months to remove bond baskets and limit the scope of “Permitted Investments”.
The CLO market reaction to Volcker has just begun to take affirmative shape and the market is starting to deal in a concrete way with the challenges presented by the “covered fund” restrictions and the “loan securitization” exclusion. In a subsequent post, we will discuss how an unexpected change in how the Final Rule defines what constitutes an “ownership interest” presents additional structural complexities for existing and future CLOs.