There is some (at least regulatory) good news for CLOs this summer. In late June, the Federal Reserve Board, the Treasury Department, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission (the “Agencies”) approved an amendment (the “Amendment”) to the regulations that implement Section 13 of the Bank Holding Company Act, which are commonly referred to as the “Volcker Rule”. A copy of the Amendment, which will become effective on October 1, 2020, is available here.
What does the Amendment do for CLOs?
The Amendment’s impact on CLOs, which, no doubt, will be welcome by the CLO industry, is four-fold.
1. The Amendment enables the return of a (5%) “bond bucket” for non-convertible debt securities.
The Volcker Rule prohibits banks from having an ownership interest in a “covered fund” and defines the term “covered fund” in a way that captures most CLOs. However, the Volcker Rule also includes an exclusion from the definition of the term “covered fund” – the so-called “loan securitization” exclusion – that, since the implementation of the rule, many CLOs have relied upon in order to permit banks to invest in them. Under the loan securitization exclusion, a CLO is not a covered fund if, generally speaking, it invests only in loans and is prohibited from owning or holding any “security, including an asset-backed security, or an interest in an equity or debt security . . . .” The CLO industry’s reliance on the loan securitization exclusion put an end to a structural feature that was common to many pre-Volcker CLOs: the “bond bucket,” a feature that allowed CLOs to hold a certain amount of non-loan assets, primarily high-yield bonds.
Under the Amendment, the loan securitization exclusion will be modified to allow CLOs to invest in “[d]ebt securities, other than asset-backed securities and convertible securities” if the aggregate “value” of such debt securities does not exceed five percent of the “aggregate value” of all loans, cash, cash equivalents and debt securities held by it. The Amendment provides for the calculation of “aggregate value” to be made by reference to the par value (not a discounted or marked-to-market value) of each asset held by the CLO at the time that the CLO acquires a debt security, but also permits the use of the fair market value of the CLO’s assets if (i) the CLO is required to use the fair market value of its assets for purposes of complying with its concentration limits or other similar calculations and (ii) the CLO’s “valuation methodology values similarly situated assets consistently.”[1]
2. The Amendment clarifies what “cash equivalents” are.
The Amendment also seeks to clarify (at least to some extent) what types of assets should be regarded as cash equivalents that a CLO can hold. According to the Amendment, cash equivalents are “high quality, highly liquid investments whose maturity corresponds to the [CLO’s] expected or potential need for funds and whose currency corresponds to either the [CLO’s] underlying loans or [its] asset-backed securities . . . .”
3. The Amendment allows for banks that hold CLO notes to participate in the selection or removal of CLO collateral managers.
The original Volcker Rule prohibits banking entities from holding any “ownership interest” in a covered fund and defines the term “ownership interest” to include any “interest” (like certain senior CLO notes) that includes “the right to participate in the selection or removal of [an] investment manager [or] investment adviser” of the covered fund outside of the context of the exercise of a creditor’s remedies upon the occurrence of an event of default. Since the right to remove a CLO’s collateral manager is one of the rights commonly associated with certain classes of CLO notes, the prohibition operated as an impediment to banks investing such CLO notes.
The Amendment eliminates the impediment by harmonizing the Volcker Rule with the “for cause” removal rights that typically appear in CLOs. The Amendment provides that an ownership interest will not include “the right to participate in the removal of an investment manager ‘for cause’ or . . . the selection of a replacement investment manager upon an investment manager’s resignation or removal” and defines “cause” as the following non-default-related events or circumstances: the bankruptcy or other insolvency of the investment manager, the investment manager’s breach of any material provision of the covered fund’s transaction agreements or any material representation or warranty made by it, fraud or criminal conduct by the investment manager in the performance of its obligations under the covered fund’s transaction agreements, the indictment of the investment manager for a criminal offense or the indictment of a related party for a criminal offense materially related to investment management activities, a change in control of the investment manager, the loss of a key person critical to the operation of the investment manager or primarily responsible for the management of the covered fund, or “other similar events that constitute ‘cause’ for removal of an investment manager” that are not “solely related to the performance of the covered fund or the investment manager’s exercise of investment discretion under the covered fund’s transaction agreements.”
4. The Amendment clarifies that debt interests (like most CLO notes) are not “ownership interests” in covered funds that are prohibited to banks.
Finally, in what is welcome news to banks that are CLO investors, the Amendment clearly provides that a “senior loan or debt interest” in a covered fund, such as a triple-A or other investment-grade CLO note, is not an ownership interest in the covered fund if it (like most CLO notes) has the following three characteristics:
- Its holders do not have the right to receive a share of the income, gains, or profits of the covered fund, but are entitled to receive only: “(i) [i]nterest at a stated interest rate, as well as commitment fees or other fees, which are not determined by reference to the performance of the underlying assets of the covered fund; and (ii) repayment of a fixed principal amount, on or before a maturity date, in a contractually-determined manner (which may include prepayment premiums intended solely to reflect, and compensate holders of the interest for, forgone income resulting from an early prepayment);”
- Its entitlement to payments under its terms “are absolute and [can]not be reduced based on losses arising from the underlying assets of the covered fund, such as allocation of losses, write-downs or charge-offs of the outstanding principal balance, or reductions in the amount of interest due and payable on [it];” and
- Its holders “are not entitled to receive the underlying assets of the covered fund after all other interests have been redeemed or paid in full (excluding the rights of a creditor to exercise remedies upon the occurrence of an event of default or an acceleration event).”
Orrick’s expectation is that what was old will soon be new again, and that new-issuance CLOs will soon resurrect many of the “bond bucket” features that appeared in CLOs prior to the effectiveness of the Volcker Rule in 2014.
[1] It remains to be seen how this – the use of fair market value in the calculation – will apply in practice. Although market-value-based amounts are often used in the calculation of a CLO’s compliance with its overcollateralization and interest coverage tests, the vast majority of CLOs use par amounts when calculating their compliance with asset concentration limits.
