Financial Regulatory Forum

Regulators have several options in dealing with CLOs under Volcker rule – law firm analysis

By Guest Contributor
February 20, 2014

 By Henry Engler, Compliance Complete

NEW YORK, Feb. 20 (Thomson Reuters Accelus) – In assessing what to do with collateralized loan obligations under the Volcker rule, regulators have several options, some that are better than others for the banking industry, a leading law firm advised clients on Monday this week.

The five regulatory agencies charged with implementation of the Volcker rule have come under fire from U.S. legislators over the Volcker rule’s treatment of collateralized loan obligations (CLOs), an issue the regulators said was at the top of their list of unintended consequences. In essence, CLOs are treated as hedge fund investments under the rule, which was finalized on December 10, 2013. Such treatment came as shock to the industry, and led to a sharp decline in new issuance, with RBS reporting a 60 percent drop in January.

The issue for regulators is that not all CLOs are “pure,” a description used by Fed governor Daniel Tarullo to describe CLOs that only contained loans. In practice, many CLOs contain a subset of bonds, which in the eyes of regulators mean they can be classified as “covered funds” and therefore not allowed under the Volcker rule.

According to a note published by Margaret Tahyar, a partner in the financial institutions group at Davis Polk and Wardwell, industry analysts estimate “that most legacy CLOs hold at least some bonds, and nearly all CLOs are authorized to purchase and hold bonds. The typical bond bucket is in the range of 10% of the assets in the CLO.”

Best option: exclude CLOs from covered-fund definition

The simplest and cleanest way that regulators could deal with the controversial inclusion of CLOs is simply to not recognize them as covered funds, and thereby retain the first principles and objectives of the Volcker rule.

“Given that barring banking entities from holding CLOs backed in part by bonds does little or nothing to further the Volcker Rule’s objectives, the most straightforward solution is not to treat CLO vehicles as if they were hedge funds,” writes Tahyar.

“. . . the Volcker rule’s prohibition on hedge fund investments was never meant to bar the banking sector from investing in any type of fund. Rather, the Volcker rule’s prohibition on banking entities investing in hedge funds was meant to be a prophylactic against evasion of the Volcker rule’s prohibition on proprietary trading,” she added.

But while sensible in the industry’s view, such a step might be “too much to expect” from regulators in deciding what to do next.

Alternatives focus on ownership interests

What else might regulators do in practice? Tahyar outlines three other possibilities:

  • Grandfather Legacy CLOs: One option regulators should consider is a grandfathering of all CLOs that were established before December 10, 2013, the date the final Volcker rule regulations were published.
  • Clarify the Definition of Ownership Interest: As urged by some industry groups, regulators could also clarify that certain rights regarding the removal/selection of a collateral manager should not convert debt interests in CLOs into ownership interests for purposes of the Volcker rule. This solution would provide relief for banking entities that hold only senior-tranche debt securities in CLO vehicles.
  • Waiver of Ownership-Interest Rights: Another potential solution for debt tranches of CLO vehicles that include collateral manager removal rights is for a banking entity to waive such rights by committing to its regulators not to exercise them without regulatory consent.

    If regulators choose none of the above, the options for the industry become quite adverse. They would include:

  • Bond Sell Off and Contractual Amendments: Without regulatory action, if banking entities are to continue to hold interests in CLOs that are deemed to be ownership interests under the final Volcker rule regulations and be confident of not violating the Volcker rule, CLOs that currently hold bonds will need to sell off their bond portfolios and amend their governing documents to prohibit purchases of bonds in the future.
  • Banking Entities Divest CLOs: If all else fails, banking entities will be required to divest their interests in CLOs that hold bonds by the end of the Volcker rule conformance period, if the interests would be characterized as ownership interests under the final Volcker rule regulations. Whether markets can absorb the magnitude of sales of these CLO interests by banking entities without disruptions in the lending and securitization channels remains to be seen.

In their testimony last week, the heads of the five agencies did not give a timetable on when they might reach a decision on the treatment of CLOs.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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