United States | Publication | November 2020
The UK Financial Conduct Authority has warned that the London Interbank Offered Rate (LIBOR for short) is not likely to be published after 2021. What will happen to LIBOR-based municipal securities, loans, and derivatives that extend beyond 2021 if and when LIBOR goes away? The contracts could be remediated by pending New York and possible federal LIBOR relief legislation. For new contracts, municipal securities issuers and conduit borrowers1 may be asked to incorporate a new "hard-wired" fallback rate recommended by ARRC or ISDA. For existing (or legacy) contracts, they may soon be asked to enter into bilateral amendments or, in the case of derivatives, to adhere to a recently announced ISDA remediation protocol. What should they do to protect themselves?
In this client update, we explain the challenges and explore possible protective action.
Many municipal issuers are parties to legacy contracts based on LIBOR. They include floating rate notes (FRNs), i.e., debt securities that pay interest at a LIBOR-based (typically 30-day or 90-day) rate. They include bank loans that pay interest at a LIBOR-based rate (commonly called Eurocurrency loans) or, if the borrower elects, a rate based on prime or Federal Funds. They include interest rate swaps and caps where one party's payments are based on LIBOR. LIBOR-based contracts are sometimes used in combination, e.g., a LIBOR-based FRN or loan hedged by a LIBOR-to-fixed rate interest rate swap. Municipal issuers may wish to enter into similar contracts while LIBOR continues to be published.
Most, but not all, legacy LIBOR-based contracts substitute a "fallback" rate for LIBOR when it is not available or, in more recent contracts, when it is no longer representative of short-term borrowing rates. For older contracts, fallback rates are commonly an average of quotes to make interbank loans or the last announced LIBOR. For more recent contracts, fallbacks are commonly a substitute index selected by the municipal issuer, the bank lender, or a third party. Only very recent contracts have included an automatic conversion to an alternate index rate. Fallback rates are sometimes inconsistent among LIBOR-based contracts used in combination. Accordingly, many LIBOR-based legacy contracts may produce unexpected, uneconomic results, if and when LIBOR is discontinued or no longer adequately represents short-term borrowing rates, unless they are remediated.
LIBOR is an interest rate index administered by the Intercontinental Exchange Benchmark Administration (IBA). It is published for five different currencies, including US Dollars (USD), for loan terms (referred to as maturities) of one day, one week, one month, two months, three months, six months, and one year. Each rate is an average of the rates quoted by banks in the London market for making unsecured loans to other banks in the stated currency for the stated maturity, with a waterfall giving preference to actual as opposed to theoretical loans. "One month USD LIBOR" is therefore the average rate that banks in the London interbank lending market quoted to make unsecured USD-denominated one-month loans to each other.
As a consequence of a LIBOR rigging scandal, reduced interbank lending, and resulting reduced confidence in LIBOR, the UK Financial Conduct Authority (UKFCA) announced in 2017 that it would no longer compel banks to provide data to determine LIBOR after the end of 2021, signaling its likely demise. If LIBOR is no longer announced after 2021, then fallback rates, if any, specified in LIBOR-based contracts will become effective. In many cases, especially in older contracts, the fallback rates may not approximate LIBOR or even maintain a floating interest rate, leading to a significant change in contract economics or uncertain outcomes.
The IBA and globally active banks are exploring the possible continued publication of widely-used LIBOR rates after 2021, if necessary to provide a safety net for users with legacy contracts that cannot be readily converted to a substitute index (e.g., widely held FRNs, as discussed below) and if continued publication can comply with regulations intended to assure "representativeness." IBA may not be able to publish any LIBOR rates after 2021. The United Kingdom is considering legislation that would authorize the UKFCA to require the IBA to publish a "synthetic" version of USD LIBOR if the UKFCA determines that LIBOR is not representative.
Since the UKFCA announcement, financial regulators and banking and derivatives groups have been working to identify substitute indices. A substitute index could be used in new FRNs, loans, and derivatives either (1) in lieu of LIBOR or (2) as a fallback rate to be substituted for LIBOR upon the occurrence of a trigger event.
To recommend a replacement for USD LIBOR in the cash markets (FRNs and loans) and an orderly transition plan, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC), a group of private market participants, industry trade groups, and governmental agencies. ARRC has recommended initial or fallback rates and trigger events for inclusion in new FRNs, syndicated loans, and bilateral business loans. In addition, two industry groups, The Loan Syndication and Trading Association, Inc. (LSTA) and the International Swap and Derivatives Association (ISDA), are represented on ARRC, and ISDA has recommended substantially similar initial or fallback rates and trigger events for new derivatives contracts.
The substitute for USD LIBOR recommended by both ARRC and ISDA is the Secured Overnight Financing Rate (SOFR). SOFR is the weighted average interest rate paid on overnight borrowings that are collateralized by U.S. Treasury securities. It is reported by the Federal Reserve Bank of New York at the beginning of each business day. It differs from LIBOR in at least three important respects: (1) it reflects actual borrowing rates reported in arrears, rather than quoted forward-looking borrowing rates; (2) it reflects a rate for secured, rather than unsecured, borrowings (i.e., it does not include a credit premium); and (3) it reflects a rate for a one-day loan, rather than a one-month, three-month, or other term loan. Due to these differences, adjustments must be made to the reported SOFR to preserve contract economics, if and when SOFR replaces LIBOR in a contract.
ARRC recently issued an RFP to engage an administrator to calculate and publish "term" SOFRs for one month, three month, and possibly six month and one year terms, beginning in the first half of 2021, "if liquidity in SOFR derivatives markets has developed sufficiently." Despite the incongruity of a term "overnight" rate, the published term SOFR rates appear to contemplate an average of fixed rates for which SOFR is swapped in the derivatives market for the relevant term.
An alternative to SOFR that may appeal to regional and smaller commercial banks for use in business loans is the American Interbank Borrowing Rate, or AMERIBOR®, a new interest rate benchmark created by the American Financial Exchange (AFX). AMERIBOR® reflects borrowing costs of small, medium and regional banks in the US based on overnight unsecured lending on the AFX. Like SOFR, it is an overnight rate reported in arrears. Unlike SOFR, it includes a credit spread for unsecured borrowings.
Municipal issuers who enter into LIBOR-based contracts (including FRNs, loans, and swaps) should include a workable fallback rate mechanism to enable the contract to perform substantially as expected, if and when LIBOR is discontinued.
To achieve an orderly transition, ARRC has recommended that (a) new FRNs not be issued with a LIBOR-based rate after December 31, 2020, (b) new loans not be made with a LIBOR-based rate after June 30, 2021, and (c) LIBOR-based FRNs and loans made before then incorporate "hard wired" provisions recommended by ARRC that substitute a robust fallback rate for LIBOR upon a specified trigger event. ARRC has also recommended versions of SOFR as the fallback rate, as explained more fully below. The recommendations do not constitute binding rules or regulatory guidance. However, federal bank and securities regulators have urged banks and brokers to assess and remediate LIBOR transition risk and said they will be examined for it, so it seems likely that ARRC transition guidelines will be followed by regulated banks and brokers. Banks will be given latitude to choose among available robust fallback rates, however.2
For derivatives, the International Swap and Derivatives Association (ISDA) has published both a supplement to its 2006 definitions, amending USD LIBOR definition fallbacks as used in new contracts, and, as discussed below, a protocol by which adhering parties can amend the definition in legacy contracts. Like the ARRC recommendation, the amendment introduces an adjusted SOFR rate at the head of a waterfall of fallback rates. The amendment is not effective until January 25, 2021, but can be incorporated into contracts before then.
Both the ARRC recommendations and the ISDA supplement (a) specify trigger events that will cause LIBOR to be replaced, (b) identify an adjusted SOFR rate as the initial replacement rate, and (c) require a specified adjustment (spread) to compensate for differences between SOFR and LIBOR.
Both the ARRC recommendations and the ISDA supplement identify the following as trigger events: (1) a public statement by the LIBOR administrator, its insolvency official, authority, or tribunal, its regulatory supervisor, or the US Federal Reserve System that the administrator has ceased or will cease to provide LIBOR for the relevant maturity or (2) a public statement by the administrator's regulatory supervisor that LIBOR for the relevant maturity is no longer representative. These trigger events are referred to as "cessation" and "pre-cessation" events, respectively.
Both the ARRC recommendations and the ISDA supplement choose an adjusted SOFR rate as the alternative index to replace LIBOR after a trigger event. For FRNs and loans, ARRC recommends a term SOFR rate for the relevant LIBOR maturity, if available, and otherwise simple SOFR for loans and, for FRNs, SOFR compounded through the relevant term (with an issuer-designated lookback or suspension provision to enable interest to be calculated before interest payment dates). For swaps and other derivatives, unlike the ARRC recommendations for FRNs and loans, the ISDA supplement replaces LIBOR with compound SOFR for the relevant LIBOR maturity whether or not term SOFR rates are available.
Some banks have raised concerns about using SOFR as a replacement index for LIBOR, because it less adequately reflects their cost of capital. Bank regulators have agreed that they may use other replacement rates, provided that they are robust.3 AMERIBOR® has been found to be a benchmark that complies with principles developed by the International Organization of Securities Commissions (IOSCO), so should therefore be deemed sufficiently robust for regulatory purposes. Accordingly, banks whose cost of funds is better reflected by AMERIBOR® may require amendments to loan agreements (rather than hard-wiring a fallback rate) if and when LIBOR is discontinued or is no longer representative, and they may propose AMERIBOR® or another IOSCO-compliant alternative index in amendments replacing LIBOR.
CAUTION: A term SOFR is a forward-looking rate fixed at the beginning of an interest rate term. Simple or compound SOFRs and AMERIBOR® change throughout an interest rate term and are calculated in arrears over the term. Consequently, if liquidity in the derivatives market permits term SOFRs to be published and fallback rates are triggered, new FRNs and loans hedged by new LIBOR interest rate swaps would introduce basis risk in a steep or flat short-term yield curve or changing interest rate environment. In addition, computing simple or compound SOFR daily in arrears will likely complicate accrued interest calculations upon transfers or early redemption of FRNs.
Both the ARRC recommendations and the ISDA supplement add a spread to the relevant SOFR to adjust for the difference between secured repurchase agreements and unsecured bank loans. The ISDA-recommended spread is the median difference between the replaced LIBOR rate and the adjusted SOFR over the five years preceding the rate set date. ARRC has recommended the same spread adjustment for the cash markets (FRNs and loans). In either event, the spread adjustment would be added to the spread to LIBOR specified by the contract.
Of course, rather than issuing LIBOR-based FRNs or obtaining a LIBOR-based loan that requires a robust fallback rate, municipal issuers could issue FRNs or obtain loans that bear interest at SOFR or AMERIBOR® from the start, if investors and lenders are willing to extend credit at that rate plus a reasonable spread.4
Since fallback rate provisions in many legacy LIBOR-based contracts are not workable, both municipal issuers and their counterparties should have an interest in remediating legacy contracts that extend beyond 2021. Remediation could occur by legislation or contract amendments, with special challenges posed by publicly sold FRNs.
ARRC has recommended that the New York State legislature adopt legislation "to minimize costly and disruptive litigation by providing legal certainty for the issues that are likely to arise under New York law." In response, Senate Bill S 9070 has been introduced in the New York State legislature to add a new article to the New York State Uniform Commercial Code. The bill is expected to be acted on in 2021. For LIBOR-based contracts (including instruments and securities) that contain no fallback provisions or only fallback provisions based on LIBOR or the solicitation of quotes, the bill would replace LIBOR with a replacement index-based rate recommended by the Federal Reserve Board, the Federal Reserve Bank of New York, or ARRC (a Fed-recommended rate) upon the occurrence of one of the ARRC-recommended trigger events. For other LIBOR-based contracts, the bill would authorize (but not require) any person charged with designating a replacement rate (or calculating interest accrued at a LIBOR rate) to choose a Fed-recommended rate as a replacement rate. The bill would also enact certain safe harbor and exculpatory provisions. The bill would not, however, alter a replacement rate that is not based on LIBOR (e.g., prime or Fed Funds) or interfere with any cap, floor, modifier, or spread adjustment to which LIBOR had been subject pursuant to the terms of the contract or any agreement by the parties to opt out of the bill's effect.
At this writing, substantially similar federal legislation was being considered for introduction by the chairman of the U.S. House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets.
CAUTION: Any such legislation could be challenged as a possible violation of the Contract Clause or Due Process Clause of the U.S. Constitution. In addition, the New York State bill would apply only to contracts governed by New York law. Contracts entered into by municipal issuers often elect to be governed by the laws of the state of the municipal issuer's jurisdiction.
Bank regulators have urged banks to take steps to identify and address LIBOR-based contracts with inadequate fallback language in order to comply with safety and soundness standards and to begin transitioning from LIBOR without delay.5 Accordingly, it is likely that municipal issuers will soon be approached by bank lenders and swap counterparties to agree to amend LIBOR-based loans and derivatives contracts that extend beyond 2021 and do not contain robust fallback rate provisions.
ISDA has released a LIBOR transition protocol to enable derivatives market participants to amend legacy LIBOR-based derivatives (as well as other master agreement transactions) if each party has adhered to the protocol. The protocol may be adhered to by completing an online submission of an adherence letter. If a legacy LIBOR-based derivatives contract references previously published ISDA definitions to establish the floating LIBOR rate (as almost all do) and both parties adhere to the protocol, then the contract is amended to replace the previous LIBOR definition (including the trigger event and fallback provisions) with the definition included in the ISDA Amendments to the 2006 ISDA Definitions to include new IBOR fallbacks.
CAUTION: By adhering to the ISDA protocol, municipal issuers will amend, or give their counterparties an option to amend, their LIBOR-based derivatives contracts without making consistent (or any) amendments to hedged LIBOR-based contracts. If the hedged contract is not similarly amended, the hedge could become less effective. For example, if a municipal issuer has obtained a LIBOR-based loan from and entered into a hedging LIBOR-based interest rate swap agreement with an adhering bank, adhering to the protocol would amend the swap but not the loan. Similarly, if an issuer has entered into a LIBOR-based interest rate swap agreement with an adhering bank to hedge LIBOR-based FRNs or loans, adhering to the protocol would amend the swap but not the FRNs or loans. The protocol does not permit adhering for less than all affected derivatives contracts. The protocol extends to PSA and TBMA Master Repurchase Agreements and master securities lending agreements in addition to ISDA derivatives agreements. Accordingly, by adhering to the protocol, municipal issuers could amend existing investment transactions as well as derivatives transactions, but not FRNs or loans.
In lieu of adhering to the ISDA protocol, municipal issuers can consider bilateral amendments to existing LIBOR-based contracts, e.g., simultaneously and consistently amending a loan from and interest rate swap with the same bank. ISDA has published a form of bilateral amendment. It can be used to apply the protocol to all or a limited subset of LIBOR-based derivatives and investment contracts with the same counterparty as well as to override provisions of the protocol as incorporated or its application to particular contracts. In addition, the LSTA is developing a model loan agreement amendment to substitute the ARRC-recommended fallback rates for LIBOR.
CAUTION: It may be impractical to amend LIBOR-based FRNs, which would require unanimous consent of the owners, unless the FRNs incorporate the indenture or other authorizing document in such a way as also to incorporate amendments to the document and the document permits the interest rate to be amended without unanimous consent (which is rare at best). Accordingly, unless legislation is enacted and effective to remediate the interest rate borne by LIBOR-based FRNs, municipal issuers may be stuck with legacy fallback provisions except to the extent that they can refund the FRNs or mount a successful exchange offer.6 For that reason, it is possible that IPA will continue to publish certain LIBOR rates after 2021.
Amending a tax-exempt FRN or loan to replace (or provide a new or amended fallback to) a LIBOR-based interest rate could cause the obligation to be reissued for federal income tax purposes. A reissuance could result in taxability or other adverse consequences, such as a requirement to make an arbitrage rebate payment to the US Treasury. In addition, if a swap or other derivative contract is integrated with the obligation for purposes of arbitrage investment limits and rebate requirements, an amendment of the contract or obligation could result in a deemed termination of the contract and a loss of integrated status. In that event, the variable rate on the hedged FRN or loan, without regard to payments under the hedge, would determine the permitted investment rate on unspent proceeds, including replacement proceeds, of the obligation after the amendment.
To enable municipal issuers to avoid these consequences with clarity, the US Treasury has issued proposed regulations and Revenue Procedure 2020-44.
The proposed regulations provide that amending a debt obligation (or a derivative or other non-debt contract) to replace (or provide a new or amended fallback to) a LIBOR-based interest rate will not result in a reissuance of the obligation or deemed termination of the contract, if (1) the replacement, new, or amended rate is based on the same currency as the existing rate and is contained in a list of potential "qualified rates" set forth in the proposed regulations (which include SOFR) and (2) the fair market value of the obligation or contract after the amendment is substantially equivalent to its fair market value before the amendment. The proposed regulations contain safe harbors for complying with the fair market value requirement. They further provide that amending an integrated interest rate swap or other hedge will not result in a loss of integrated status, if the amendment satisfies the above conditions and existing requirements for qualified hedges. Finally, the proposed regulations provide that they may be relied on before publication as final regulations.
The Revenue Procedure is more specific. It provides that amending a LIBOR-based FRN, loan, or derivative contract to incorporate fallback language recommended by ARRC or ISDA (or identified deviations) will not in itself trigger a reissuance of the obligation, deemed termination of the contract, or loss of integrated status.
Under generally accepted accounting principles (GAAP) in the US, modifications to certain contracts can require that they be re-measured or, in the case of hedges, that qualification for hedge accounting be re-evaluated, for financial reporting purposes. To avoid these results when entities amend LIBOR-based contracts to substitute an adjusted SOFR rate, both the US Government Accounting Standards Board (GASB), which governs accounting standards for governmental entities, and the Financial Accounting Standards Board (FASB), which governs accounting standards for conduit borrowers and other nongovernmental entities, have issued statements providing relief from these requirements if certain conditions are met.7 Municipal issuers should consult their accounting advisors to understand, manage, and report the financial accounting consequences of remediating LIBOR-based contracts.
Municipal issuers (including conduit borrowers) should make an inventory of their LIBOR-based FRNs, loans, derivatives, and other contracts, including (a) when they expire and, if after 2021, (b) the LIBOR fallback rate provisions, if any, that they include (including both fallback rates and the events that trigger them), and (c) how the contracts may be amended. For contracts extending beyond 2021 that do not include a workable fallback rate (or do not trigger a workable fallback rate if and when LIBOR continues to be announced but is no longer representative of short-term borrowing rates), they should consult with their financial, accounting, and legal advisors and develop a remediation strategy. Depending on the extent and variety of their inventory, adhering to the ISDA protocol could be wisely efficient or could unnecessarily risk the effectiveness of hedges. For FRNs, remediation could include a refunding (by exercising a redemption option or mounting an exchange offer), if feasible. Alternatively, it may be prudent to await word on whether LIBOR (or a "synthetic" version, if recognized by applicable contracts) for the applicable maturity will continue to be published after 2021 or a robust term SOFR will be published.
Municipal issuers should seek professional financial, accounting, and legal advice (a) if and when they are approached by lenders or derivatives counterparties to adhere to the ISDA protocol or execute an bilateral amendment to update LIBOR fallback rates and (b) when considering new LIBOR-based transactions.8
Norton Rose Fulbright has assembled a group of its attorneys from around the globe to stay on top of these issues and assist clients in the transition to new reference rates, including the use of artificial intelligence (AI) programs to assist in reviewing large contract inventories. See more information.
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