Volcker Rule: Federal Reserve Issues Statement of Intent to Extend the Volcker Rule Conformance Period Through July 21, 2017 for CLOs

Sullivan & Cromwell LLP - April 8, 2014

Late yesterday afternoon, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) released a statement regarding the treatment of collateralized loan obligations (“CLOs”) under Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), commonly known as the “Volcker Rule.”  The Volcker Rule imposes broad restrictions on proprietary trading and investing in and sponsoring private equity funds, hedge funds and certain other investment vehicles (“covered funds”) by banking organizations and their affiliates.
The Federal Reserve statement follows a period of significant uncertainty with respect to the treatment of banking organizations’ existing investments in debt securities issued by CLOs under the Volcker Rule as a result of two aspects of the final rule implementing Section 619 of the Dodd-Frank Act, issued on December 10, 2013 (the “Final Rule”).  First, under the Final Rule, many CLOs and other similar securitization vehicles are covered funds.   Although the Final Rule provides an exclusion from the definition of covered fund for certain “loan securitizations” that are comprised solely of loans and certain related assets,  securitization vehicles that hold certain non-loan assets, such as debt securities, are not eligible for this exclusion.  CLOs are typically permitted under their governing documents to own small amounts of these non-loan assets.  Second, the Final Rule includes an expanded definition of “ownership interest” with respect to covered funds, potentially prohibiting banking organizations from owning debt securities issued by CLOs.  Consequently, banking organizations have been concerned that they would be required to divest debt securities of many CLOs as early as July 21, 2015, the end of the current conformance period under the Volcker Rule.  Banking organizations own substantial amounts of CLO debt securities, and a rapid, forced divestiture could cause significant write-downs and, ultimately, substantial losses.
The Federal Reserve statement provides that the Federal Reserve “intends to grant two additional one-year extensions of the conformance period under [the Volcker Rule] that allow banking entities additional time to conform to the statute ownership interests in and sponsorship of CLOs in place as of December 31, 2013, that do not qualify for the exclusion in the [F]inal [R]ule for loan securitizations.”  The statement refers to CLOs broadly as “securitization vehicles backed predominantly by commercial loans” and notes that “CLOs may also hold, or have the right to acquire, a certain amount of nonconforming non-loan assets (e.g., debt securities).”   The Federal Reserve statement does not provide any guidance on how a banking organization may be required to document its eligibility for the extended conformance periods with respect to its ownership or sponsorship of such vehicles, but notes that the Federal Reserve intends to grant the additional one-year extensions in August 2014 and August 2015, respectively.   No applications or similar actions appear to be required of banking organizations to avail themselves of the additional extension periods.
The Federal Reserve statement makes clear that, during the extended conformance period, a banking organization would not be required to include ownership interests in CLOs for purposes of determining compliance with the 3% per-fund and 3% of Tier 1 capital aggregate fund limits in the Final Rule and would not be required to deduct its CLO investments from its Tier 1 capital.   The statement does not address either the application of the so-called “Super 23A” provisions of the Volcker Rule or the prudential limitations on investment in covered funds.
The Federal Reserve statement notes that the other agencies responsible for enforcing the Volcker Rule will apply the Volcker Rule and the Final Rule in accordance with the Federal Reserve’s conformance rule, including any extension of the conformance period applicable to CLOs.
The Federal Reserve statement identifies the CLOs for which relief will be granted by using the term “in place as of December 31, 2013” so that the critical date for the exemption appears to be the date of establishment of the CLO rather than the date on which a banking organization must have an investment in the CLO.  This approach would provide more flexibility than an approach based on the date of investment in the CLO.
Although the Federal Reserve statement should provide some measure of relief for the holders of CLOs that do not meet the conditions of the loan securitization exclusion, banking organizations would still ultimately need to divest their ownership interests in these CLOs if the CLOs have not run off or been unwound by July 21, 2017.  Because this may be the case for a substantial portion of outstanding CLOs, the Federal Reserve’s announced approach has been criticized by some as providing only a temporary solution, and one that does not fully address the potential need for banking organizations to write-down CLO debt securities with a fair value less than their carrying value under generally accepted accounting principles.  Further, the Federal Reserve statement does not provide any relief for CLOs established after December 31, 2013 or other types of securitization vehicles.