Alert April 15, 2014

FRB to Extend Volcker Rule Conformance Period for Existing CLOs

The FRB announced its intention to provide banking entities with two additional one-year extensions to conform their ownership interests in and sponsorship of certain collateralized loan obligations (“CLOs”) to the requirements of the Volcker Rule.  Unless an exemption applies, the Volcker Rule prohibits banking entities from sponsoring, acquiring or retaining an ownership interest in any covered fund, which generally includes any fund that would be an investment company but for reliance upon Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.  The definition of “covered fund” provides several exceptions, including a loan securitization exception for certain vehicles that hold loans and do not hold securities except in limited circumstances. 

Certain CLOs are currently sponsored by banking entities or have issued interests to banking entities that may be deemed to be ownership interests for purposes of the Volcker Rule (e.g., the senior class of notes may have the right to replace the investment manager).  Many CLOs rely on Section 3(c)(7) to avoid investment company status, and if they include, as they often do, a small bucket for debt securities (as opposed to loans), such CLOs are captured by the “covered fund” definition and are not able to avail themselves of the loan securitization exception.  Therefore, banking entities will not be permitted to sponsor or maintain an ownership interest in such CLOs once the conformance period ends (assuming no substantive changes to the rule or unless the banking entity can avail itself of a separate exemption for certain issuers of asset-backed securities).  As a result, banking entities may be required to divest certain holdings in certain CLOs prior to the end of the conformance period.

The FRB’s actions would give banking entities until July 21, 2017, to conform their ownership interests in and sponsorship of CLOs to the statute.  The relief would be limited to CLOs in place as of December 31, 2013, and that do not qualify for the exclusion in the final rule for loan securitizations.  The FRB announced its intention to enact the extensions in August, 2014 and then again in August, 2015. 

The FRB noted that the other federal agencies involved with enforcing the Volcker Rule will recognize the further extensions of the conformance period; those agencies stated in a letter to the Chairman of the House of Representatives Committee on Financial Services that they “support the statement issued by the Federal Reserve Board” extending the conformance period with respect to CLOs.  The FRB had previously extended the conformance period until July 21, 2015. 

The reaction of members of Congress and industry participants was generally one of disappointment, because the FRB’s extension of the conformance period, without additional relief, is still expected to force write-downs of investments and fire sales of assets as banks are forced to divest non-conforming assets prior to the end of the conformance period.