June 25, 2020 - The five federal regulatory agencies responsible for implementing the Volcker Rule published today a final revised rule addressing “ownership interests” in certain “covered funds”.  The Volcker Rule generally prohibits banks from holding equity-like ownership interests in covered funds which includes most securitizations.  The agencies had previously taken the view that CLO debt securities are prohibited ownership interests because they provide owners with the right to remove and replace the managers for cause, although CLOs have been carved out from the definition of covered funds under the exclusion for “Loan Securitizations”.  The good news is that under the final rule, the agencies have revised the definition of ownership interest to effectively exclude CLO debt securities from being prohibited ownership interests even if at some point, CLOs were deemed to be covered funds.  Below is a very preliminary and high level summary of what the final rule does in the context of CLOs.  We will analyze more deeply and provide further detail later.

A. Loans securitization exclusion is amended to permit CLOs to hold loans, cash equivalents and up to 5% in debt securities (excluding ABS and convertibles).  The 5% is to be calculated at the time the debt security is acquired.

B. Ownership interest will not include CLO notes that permit removal and replacement of the manager for cause even in the absence of an event of default.  “Cause” is defined as one of the following: 

1. the bankruptcy, insolvency, conservatorship or receivership of the investment manager; 2) the breach by the investment manager of any material provision of the covered fund’s transaction agreements applicable to the investment manager;3) the breach by the investment manager of material representations or warranties; 4) the occurrence of an act that constitutes fraud or criminal activity in the performance of the investment manager’s obligations under the covered fund’s transaction agreements; 5) the indictment of the investment manager for a criminal offense, or the indictment of any officer, member, partner or other principal of the investment manager for a criminal offense materially related to his or her investment management activities; 6) a change in control with respect to the investment manager;7) the loss, separation or incapacitation of an individual critical to the operation of the investment manager or primarily responsible for the management of the covered fund’s assets; or 8) other similar events that constitute “cause” for removal of an investment manager, provided that such events are  not solely related to the performance of the covered fund or to the investment manager’s exercise of investment discretion under the covered fund’s transaction agreements.
   
2. Safe Harbor for Senior Debt.  Senior debt securities with certain characteristics will not be considered prohibited ownership interests so long as they have certain enumerated characteristics.  The Agencies did not adopt recommendations that any investment grade debt be considered senior Debt, so it is still unclear whether the safe harbor covers anything other than AAA CLO notes.  Nevertheless, because the right to remove a manager for cause no longer turns a CLO debt security into a prohibited ownership interest, all CLO debt liabilities should be permissible investments for banks even if CLOs were deemed to be covered funds.