Last week, testimony by top US financial regulators before the House Financial Services Committee showed how much the Volcker Rule continues to pose serious open issues and questions for the banking industry. Already in mid-January the regulators issued a fix to the treatment of collateralized debt obligations backed by trust preferred securities (see Legal Update, Volcker Rule Exemption Issued for Collateralized Debt Obligations Backed by Trust Preferred Securities.)

Now top agency officials have said they are re-examining the Volcker Rule's treatment of collateralized loan obligations (CLOs). As it currently stands, the Volcker Rule could require banks to divest most of their interests in CLOs, which may send shock waves through a market valued at over $300 billion.

Under the December 2013 final regulations implementing the Volcker Rule, banks are prohibited from acquiring or retaining an ownership interest in CLOs that hold any assets other than loans, including bonds. (CLOs that exclusively invest in loans are exempted from the Volcker Rule prohibition.) Most of the CLOs held by banks hold some relatively small interest in bonds, and almost all CLOs are at least authorized to invest in bonds. Banks typically hold senior tranches in CLOs, which they typically view as debt interests. However, under the terms of the CLOs, banks typically have the right to remove a collateral manager for cause. Under the Volcker Rule final rules, this right may cause banks' interests in CLOs to be deemed prohibited ownership interests. Banks would therefore be required to divest almost all of the CLO holdings before the end of the Volcker Rule conformance period (currently, July 21, 2015, but it could be extended until as late as July 21, 2017). Alternatively, banks could require that CLOs liquidate their existing bond holdings and amend the CLO documentation so that it may only invest in loan obligations. However, the feasibility of this latter option is questionable. Amendments to CLOs typically require majority approval from all tranches of investors.

Last week's testimony raises the possibility of regulatory relief for this issue. Actions the regulators may take could include:

Practical Law will continue to monitor and comment on this and other Volcker Rule developments as they progress. For background material on the Volcker Rule, see:

Practical Law will soon publish a more in-depth article on the Volcker Rule treatment of CLOs.