Volcker Rule

April 8, 2014

Volcker Rule

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

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.1 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,2 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

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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).”3 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.4 No applications or similar actions appear to be required of banking organizations to avail themselves of the additional extension periods.5

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.6 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.7

The Federal Reserve statement notes that the other agencies responsible for enforcing the Volcker Rule (together with the Federal Reserve, the “Agencies”) 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.8

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 -2- Volcker Rule April 8, 2014

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.9

A copy of the Federal Reserve statement is attached as Appendix A.

* * * ENDNOTES 1 Please see our Memorandum to Clients, dated January 27, 2014, U.S. Agencies Approve Final Volcker Rule, Detailing Prohibitions and Compliance Regimes Applicable to Banking Entities Worldwide, for an overview of the Final Rule. 2 See Final Rule § _.10(c)(8) (excluding from the definition of “covered fund” certain “loan securitizations” comprised solely of loans, servicing assets, certain interest rate or foreign exchange derivatives, certain special units of beneficial interest and collateral certificates, and certain permitted securities (cash equivalents and securities received in lieu of debts previously contracted)). “Loan” is defined as any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative. Final Rule § _.2(s). 3 Although the Federal Reserve does not define the term “predominantly,” it has been interpreted in other bank regulatory contexts to mean at least 85%. See, e.g., 12 U.S.C. § 1843(n)(2); 12 C.F.R. § 217.2 (defining “financial institution”); 12 C.F.R. § 242.3; Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5678 (Jan. 31, 2014) (discussing Final Rule § _.10(c)(1)(ii)). 4 Although the Federal Reserve statement did not comment on the reason for addressing the extensions as a matter of the Federal Reserve’s intent rather than granting the extensions now, the Federal Reserve presumably took that approach because it has interpreted the Volcker Rule to permit only annual extensions. See 12 C.F.R. § 225.181(a)(3). 5 In connection with the issuance of the Final Rule, the Federal Reserve granted the first of the three one-year extended conformance periods available under the Volcker Rule. The grant of the two additional one-year extended conformance periods for CLOs would exhaust the remaining extensions available under the Volcker Rule, other than the five-year extended conformance period that may be available for certain “illiquid funds.” See 12 C.F.R. §§ 225.181(a)(3) & (b). 6 See Final Rule § _.12. 7 See Final Rule §§ _.14 & _.15. 8 Although we believe that the statement as published applies to all CLOs established as of December 31, 2013 regardless of when a banking organization makes an investment in the CLO, the Federal Reserve statement is not free from doubt on this point. Using the date of establishment of the CLO has the benefit of permitting banking organizations to continue to engage in trading, market-making or other regular market transactions involving interests in CLOs that are covered funds during the conformance period. In addition, banking organizations would not be required to deduct interests in such CLOs acquired in a market-making capacity from Tier 1 capital during the extended conformance period. 9 On January 14, 2014, the Agencies issued an interim final rule (the “Interim Final Rule”) providing relief for certain collateralized debt obligations backed by trust preferred securities under the Final Rule. Neither the Interim Final Rule nor the Federal Reserve statement changes the definition of “ownership interest” or “covered funds.” Please see our Memorandum to Clients, dated January 14, 2014, Agencies Issue Interim Final Rule Exempting Certain TruPS-Backed CDOs from the Volcker Rule’s Prohibition on Banking Entities’ Holding Ownership Interests in or Sponsoring Covered Funds.

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-5- Volcker Rule April 8, 2014 SC1: 3621877.3

Statement Regarding the Treatment of Collateralized Loan Obligations Under Section 13 of the Bank Holding Company Act

Introduction

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act

(“Dodd-Frank Act”) added a new section 13 to the Bank Holding Company Act of 1956

(“BHC Act”) (codified at 12 U.S.C. 1851) that generally prohibits banking entities from

engaging in proprietary trading and from acquiring or retaining an ownership interest in,

sponsoring, or having certain relationships with a hedge fund or private equity fund.

These prohibitions are subject to a number of statutory exemptions, restrictions and

definitions.

Section 13 provides that a banking entity must conform its activities and

investments to the prohibitions and restrictions of that section and any final implementing

regulation no later than 2 years after the statutory effective date of section 13, which is

July 21, 2012, unless extended by the Board. Under the statute, the Board may, by rule or order, extend the two-year conformance period not more than one year at a time, for a total of not more than 3 years, if in the judgment of the Board, an extension is consistent with the purposes of section 13 and would not be detrimental to the public interest.

In December 2013, the Board, OCC, FDIC, SEC and CFTC (collectively, “the

Agencies”) approved a final regulation implementing the provisions of section 13 of the

BHC Act.1 In December 2013, the Board also extended the conformance period until

July 21, 2015.

1 See 79 FR 5536 (Jan. 31, 2014).

After approval of the final rule, a number of banking entities, trade associations and

members of Congress expressed concern that the final rule would require divestiture by

banking entities of ownership interests in collateralized loan obligation vehicles

(“CLOs”) that would be covered funds under the final rule. CLOs are securitization

vehicles backed predominantly by commercial loans. CLOs may also hold, or have the

right to acquire, a certain amount of nonconforming non-loan assets (e.g., debt

securities). To address this issue, the Board is issuing this statement to confirm that the

Board intends to exercise the authority granted by section 13 of the BHC Act to extend

beyond July 21, 2015 the period provided to banking entities to conform their ownership

interests in and sponsorship of covered funds that are CLOs.

Background

In keeping with the statute, the final rule excludes from the definition of covered

fund “loan securitizations” that are comprised solely of loans and related servicing assets,

as well as entities that are similar to loan securitizations, such as qualifying asset-backed commercial paper conduits and qualifying covered bonds.2 These securitizations of loans are excluded in part because the statute itself provides that it is not to be construed to limit or restrict the ability of a banking entity to sell or securitize loans in a manner otherwise permitted by law.3 A securitization, including a CLO that holds some non-

conforming non-loan assets, may be a covered fund under the rule. A banking entity

2 See final rule § __.10(c)(8)-(c)(10), 77 FR at 5788-89. The final rule defines “loan” to include any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or a derivative. See final rule § __.2(s), 77 FR at 5780. 3 See 12 U.S.C. § 1851(g)(2).

must conform or divest its ownership interests in and sponsorship of these CLOs that are

covered funds by the end of the conformance period.

As noted above, under the statute, the Board may, by rule or order, extend the

conformance period for not more than one year at a time, for a total of not more than

three years, if in the judgment of the Board, an extension is consistent with the purposes

of section 13 and would not be detrimental to the public interest.4 The Board already

extended the conformance period for one year, until July 21, 2015, when the final implementing rules were adopted in December, 2013.

As noted in the legislative history of section 13, the conformance period for banking entities is intended to give markets and firms an opportunity to adjust to the prohibitions and requirements of that section and any implementing rules adopted by the

Agencies.5 Consistent with this purpose and the statute, the Board intends to grant two

additional one-year extensions of the conformance period under section 13 of the BHC

Act 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 final rule for loan securitizations. The Board intends to act on these extensions in August of this year and next year.

During the conformance period, a banking entity is not required to include ownership interests in CLOs for purposes of determining compliance with the investment limits of § __.12 of the final rule. Similarly, a banking entity is not required to deduct its

4 See 12 U.S.C. § 1851(c)(2). Section 13 also permits the Board, upon application of a banking entity, to provide up to an additional 5 year transition period for certain illiquid funds. See 12 U.S.C. § 1851(c)(3). 5 See 156 Cong. Reg. S5898 (daily ed. July 15, 2010) (statement of Sen. Merkley)).

CLO investments from its tier 1 capital as required under § __.12(d) of the final rule until

the end of the relevant conformance period.

The other agencies charged with enforcing the requirements of section 13 of the

BHC Act and the final rule will apply section 13 and the final rule in accordance with the

Board’s conformance rule, including any extension of the conformance period applicable to CLOs.

Nothing in this guidance restricts in any way the authority of any agency to use its supervisory or other authority to limit any activity the agency determines to be unsafe or unsound or otherwise in violation of law.