In our previous post we discussed some of the structural challenges and opportunities facing CLO market participants since the Final Rule was released in December.  Today we tackle the age old question, “what is an ownership interest”.  The question is important because the tentacles of Volcker’s provisions prohibit banking entities from holding ownership interests in covered funds.  We will also briefly summarize a few other restrictions related to CLO transactions brought about by the Final Rule.

To the surprise of many CLO market participants (and their lawyers) the Final Rule contained an additional gloss on the definition of “ownership interest” that results in a very typical CLO right being characterized as an “ownership interest” under Volcker. Under the Final Rule, an ownership interest is an equity, partnership or similar interest.  The term “similar interest” in the Final Rule includes an interest that has the right to participate in the selection or removal of, among other things, the investment manager, investment adviser, or commodity trading advisor of the covered fund (excluding the rights of a creditor to exercise remedies upon the occurrence of an event of default or acceleration event).

CLO indentures often include provisions that permit the controlling class of notes and/or the holders of equity interests to remove the manager for cause (which has not historically required the existence of an event of default) and permit the controlling class of notes and the equity, acting together, to select a new manager.  To the surprise of CLO market participants this limited removal and/or replacement right appears to qualify as a “similar interest” (and therefore qualify as an “ownership interest”) under the Final Rule.  Absent regulatory clarification that this change was not intended to capture these rights typically exercised by the controlling class of Notes,  banking entities will not be permitted to acquire or retain notes issued by a CLO that possess such rights after July 21, 2015.

In addition to the restrictions on sponsoring or acquiring ownership interests in covered funds, the Final Rule also prevents banking entities from entering into “covered transactions” (as defined in Section 23A of the Federal Reserve Act) with a covered fund for which the banking entity serves as investment manager, investment adviser, commodity trading advisor, or which it sponsors or organizes and offers, or in respect of which the banking entity holds an ownership interest (or any covered fund controlled by the covered fund).  Notably, covered transactions include loans or other extensions of credit to covered funds and would prohibit some warehouse facilities.  The Final Rule also prohibits transactions that would result in a material conflict of interest between the banking entity and its clients, customers or counterparties.

The CLO market’s reaction to Volcker is still coalescing.  Absent guidance from the Agencies that the typical rights of controlling class noteholders to participate in the replacement of a manager for cause does not constitute an ownership interest, affected noteholders will need to review the terms of CLOs carefully to determine (i) if the CLO is a covered fund and (ii) if their notes constitute an ownership interest.  If the answers to these questions is yes (as it may very well be), affected parties may need to consider amending their transactions to alleviate the impact of the Final Rule.  As the amendment process gets underway, please see the Dechert OnPoints dated December 16 and December 17.

By: Sean Solis and  Daniel J. Colaizzi