Volcker Rule - Leaked Draft Of Proposed Rule Offers A Possible Shot In The Arm To The CLO Market

Those closely following the implementation of the Volcker Rule received an advanced look at the proposed regulations likely to be issued by four federal agencies this week, made possible by the circulation last week of a 205-page confidential September 30 staff draft of the proposal (the "Draft Proposal"). The Draft Proposal suggests that the agencies can be expected to adopt a reasonable approach to several difficult issues posed by the Volcker Rule's statutory provisions relating to collateralized loan obligation (CLO) transactions while at the same time remaining faithful to the Volcker Rule's objectives.

In brief, the Volcker Rule prohibits any "banking entity" from (i) sponsoring, (ii) acquiring or retaining an ownership interest in or (iii) having certain relationships with, a hedge fund or private equity fund (referred to in the Proposed Draft as a "covered fund").1

Under Dodd-Frank, the Volcker Rule defined a "hedge fund" or "private equity fund" as any entity that is exempt from registration under the Investment Company Act of 1940 (the "1940 Act") under Section 3(c)(1) or Section 3(c)(7) of that Act (known as the "100-holder" and "qualified purchaser" exceptions). The Volcker Rule also authorized the Federal banking agencies, the SEC and the CFTC to expand the types of entities that should be treated as hedge funds or private equity funds for these purposes.

Despite language in Dodd-Frank to the effect that nothing in the Volcker Rule should be construed to limit or restrict the ability of a banking entity to sell or securitize loans in a manner otherwise permitted by law, the Volcker Rule nevertheless raised the specter of significant new burdens on the CLO activities of banking entities by defining as "hedge funds" and "private equity funds" all entities that rely on Sections 3(c)(1) and 3(c)(7) of the 1940 Act, including CLO issuers that bear little resemblance to typical hedge funds and private equity funds. To date, almost all CLO issuers have relied on Section 3(c)(7).

Based on what we have seen in the Draft Proposal, we are cautiously optimistic that implementation of the Volcker Rule will not impede basic loan securitization transactions. Among other reasons:

The Draft Proposal explicitly confirms that funds satisfying all of the requirements of Section 3(a)(5) of, or Rule 3a-7 under, the 1940 Act will not be treated as "covered funds". This will be the case even if the fund's offering documents require that the fund...