The Anticipated Discontinuance of Publication of USD-LIBOR
Market Reactions To, and Proactive Measures To Be Taken In Connection With, The Anticipated Discontinuance of Publication of USD-LIBOR
John R. Stokes, Esq.
Watson Sloane PLLC
In July 2017, the Financial Conduct Authority of the United Kingdom (FCA), the body overseeing the London Interbank Offered Rate (LIBOR) announced the possible phase out of publication of LIBOR (for all currencies, including USD) by the end of 2021. While the announcement may not have come as a surprise after previous rate fixing practices among banks came to light, the fact is that USD-LIBOR is used in the calculation of interest rates on trillions of dollars of debt instruments (e.g. notes, bonds, loans), derivative and other financial products. The rate is based on information gathered from a panel of submitting banks estimating the daily interest rate for each submitting bank to borrow money from another bank over an identified period. Such banks will no longer be required to provide submissions after 2021. Rates could still be submitted or stop altogether. Without submissions, or with inadequate submissions, LIBOR will stop being published altogether. Even with a material decrease in submissions, the value of the index to the market will not be as robust or reliable. This article briefly discusses the proposed alternative to USD-LIBOR and some of the steps Lenders, Borrowers and Issuers should consider taking with respect to both existing and new USD-LIBOR based contracts.
Even prior to the FCA’s announcement of the planned phase out of the mandatory reporting requirements necessary to the publication of LIBOR, the Board of Governors of the United States Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) in response to its concerns over the reliability of the information used to compile LIBOR. The ex-officio members of ARRC originally included the Board of Governors of the Federal Reserve System, the Treasury Department, the Commodity Futures Trading Commission and the Office of Financial Research. ARRC was reconstituted in 2018 with an expanded membership.
ARRC was tasked with identifying one or more nearly risk-free alternative reference rates to USD-LIBOR. In 2017 ARRC identified the Secured Overnight Financing Rate (SOFR) as the rate that represents the best replacement for USD-LIBOR. SOFR is a robust overnight, secured (collateralized by U.S. Treasury securities in the repo market) rate that meets international standards. Unlike USD-LIBOR, SOFR is based on actual transactions (i.e. where banks or investors borrow or loan U.S. Treasury Bonds overnight), not estimates. Daily publication of SOFR by the New York Federal Reserve, in cooperation with the Office of Financial Research, began on April 3, 2018. SOFR is currently only calculated from overnight transactions. In April 2019 ARRC published “A User’s Guide to SOFR”, which can be found on ARRC’s website referenced below.
It is important to note that SOFR does not line up exactly with USD-LIBOR for several reasons. First, unlike USD-LIBOR, SOFR is a secured, nearly risk-free rate that does not incorporate credit risk, liquidity and other premiums/factors into its calculation. Second, USD-LIBOR is published for different rate periods than overnight (e.g. 30,90,180 days). At some point, SOFR may be published for different averaged rate periods (the Federal Reserve recently announced plans to produce SOFR averages over various terms as well as a SOFR Index in early 2020). In any event, these differences will need to be considered when applying SOFR to new contracts generally, and especially in cases where SOFR is being used as either a replacement or fallback rate for existing USD-LIBOR based contracts. Such adjustments may take the form of a one-time payment from one of the parties to the contract to the other and/or a spread or percentage adjustment. Any such spread or percentage adjustment would be separate from any credit adjustment for a borrower or counterparty.
ARRC also developed a Paced Transition Plan which includes steps and time periods to encourage adoption of SOFR by market participants used to relying on USD-LIBOR in both debt and non-debt instruments. The Plan has been complemented by ARRC’s 2019 Incremental Objectives to support and prepare the U.S. markets for the transition to SOFR. Finally, on April 25, 2019 ARRC released its recommendations for fallback language to be voluntarily included in new USD-LIBOR based contracts with the goal of reducing significant market disruption in the event USD-LIBOR is discontinued or no longer considered a viable market rate index. ARRC has also released its implementation list. All of this information can be found on ARRC’s website at www.newyorkfed.org/arrc/index.html.
By some accounts, derivatives account for more than 90% of IBOR based exposure. On November 15, 2019 the International Swaps and Derivatives Association (ISDA), a trade organization for derivative market participants, published a report prepared by The Brattle Group that summarizes responses to a Consultation on Final Parameters for the Spread and Term Adjustments in Derivatives Fallbacks for Key IBORS. A copy of The Battle Group Report can be found on ISDA’s website at www.isda.org. There may be a separate consultation focusing specifically on USD-LIBOR. ISDA, in conjunction with Bloomberg, expects to publish alternative mathematical formulas for spread adjustments and adjusted fallback rates to IBORs. It is also drafting changes to the fallback rates language included in the 2006 ISDA Definitions used in IBOR based derivative contracts. Much of the current fallback language anticipates getting quotations from major banks in the relevant interbank market if there is a publication disruption, but such quotations become problematic and even impossible in the event the IBOR either becomes unusable or is permanently discontinued as is being discussed with LIBOR. Some fallback language may also anticipate using the most recent published rate in the event of a market disruption in the publication of a rate. In the event publication of such rate is terminated, this effectively converts the contract to a fixed rate instrument, not something anticipated at the time the contract was executed. Once published, it is expected that new USD-LIBOR based derivatives will incorporate the new fallback provisions and that the parties to existing contracts will voluntarily amend their existing fallback language to conform with the updated protocols.
Both the Governmental Accounting Standard Board (GASB) and Financial Accounting Standards Board (FASB) have also taken note of the anticipated transition away from USD-LIBOR to different indices (including SOFR). For example, on September 26, 2019 GASB issued an Exposure Draft, Replacement of Interbank Offered Rates which, among other proposals, contained proposed language to allow the use of SOFR and the Effective Federal Funds Rate as benchmark interest rates and providing clarification to hedge accounting treatment upon the occurrence of a change in reference rates. More information can be found on GASB’s website www.gasb.org and on FASB’s website at www.fasb.org.
It should be noted that while SOFR is the rate index selected by ARRC to replace USD-LIBOR, other indices are available (e.g. Fed Funds Effective Rate and SIFMA) that can be used either as the primary index in a contract or incorporated as part of the fallback language in legacy USD-LIBOR based contracts, in each case depending on the desires of the contracting parties. This may be especially true during this period of uncertainty in the market caused both by the lack of confidence in the current LIBOR indices and the long-term viability of any LIBOR based index.
Implementation of Fallback Rates
As previously noted, SOFR and USD-LIBOR are not perfectly matched indices which complicates crafting fallback rate language for both new and existing USD-LIBOR based contracts. It seems clear that some upward adjustment (spread) to a transition from USD-LIBOR to SOFR will be needed to reflect the move from an uncollaterized index to a collateralized index. Further, SOFR is based on actual transactions and LIBOR is based on forward looking estimates. By way of example, in a three-month construction, the three-month LIBOR is a forward-looking index while SOFR is a prior three-month index, so the two just don’t line up. The solution appears to be coming up with an agreed upon spread taking into consideration both the differences in the indices and the underlying credit of the borrower and/or counterparty. The solution may also involve a one-time payment to one of the parties to the contract from the other as part of any changeover from USD-LIBOR to SOFR.
USD-LIBOR contracts entered before the selection of SOFR as the replacement rate for USD-LIBOR by ARRC do not contain SOFR based fallback language and may need to be amended to account for a new index (whether or not SOFR based). And, to the extent that existing fallback language in a contract is premised on a disruption in the publication of USD-LIBOR, rather than the discontinuance of a meaningful LIBOR based index altogether, such language should be amended to avoid confusion should that occur. The amendment issue is more complicated in situations where there is both a debt instrument and a related derivative (swap). For example, a borrower enters into a swap with a counterparty in the notional amount of $10,000,00 pursuant to which the borrower pays a fixed rate of interest on the notional to the counterparty and receives 67% on one-month USD-LIBOR in return which borrower uses to pay on a debt instrument with a like principal amount bearing interest at 67% of one-month LIBOR. In such a case both the swap and the related debt instrument need to be amended. To further complicate matters, if a third-party issuer (such as a conduit public authority) is involved in that portion of the transaction related to the issuance of the debt instrument (e.g. loan, note or bond), the issuer may have to be involved in the amendment process, depending on the amendment provisions of the underlying financing documents.
Any amendment process takes time. If a third-party issuer is involved it takes more time especially if action is needed at a noticed public meeting. Do rating agencies need to be brought into the mix? Does the borrower need board approval?
All lenders, borrowers and counterparties should continue to monitor the market closely and be proactive in closely examining the appropriateness and viability of any fallback language (or whether there is fallback language) in their existing USD-LIBOR based contracts and developing appropriate fallback language for both new and existing USD-LIBOR based contracts extending past 2021.
Special Tax Considerations for Tax-Exempt and Other Tax Advantaged Debt
Tax-exempt and other tax advantage debt that bears interest based on the USD-LIBOR based rate index have additional potential tax issues related to any amendments to existing documents regarding the calculation of interest on the debt. The primary issue relates to whether, for federal tax purposes, the debt has been “reissued” when the underlying debt instrument has been amended to either (i) immediately replace the USD-LIBOR index with another index such as SOFR or (ii) replace the fallback language in the event USD-LIBOR publication is interrupted or has either deteriorated to the point it is no longer deemed viable or is no longer published.
Generally, the analysis in this area revolves around whether or not there has been a “significant modification” of the terms of the debt instrument as such term is generally defined in 26 CFR Part 1 of the Federal Regulations (including, without limitation, Proposed Regulations amending section 1.1001-3 (Modifications of debt instruments)). A “significant modification” results in the deemed exchange of the original debt instrument for a modified instrument that differs in kind or in extent. (See Proposed Regulations 1.1001-3(c) for the definition of “modification” and section 1.1001-3(e) for information of whether or not a modification is deemed “significant”). If a “significant modification” occurs, the debt instrument is deemed to have been exchanged for a new debt instrument at the time of the modification. In the case of tax-exempt and other tax advantaged debt this means that certain actions need to be taken to retain the tax preferred status of the “new” or “exchanged” debt. This may be as simple as filing a new 8038 and getting an updated tax opinion (or no adverse effect opinion). However, it could also mean the loss of the tax advantage if there has been a change in law between the date of the original issue and the new “deemed issue” date. In essence, a deemed exchange requires the retesting of all of the requirements related to the issuance of the debt under sections 103 and 141-150 of the IRC (or any other applicable provisions for other tax advantaged debt). Even if the tax exempt or other tax advantage status can be salvaged, the additional costs associated with filings, updated tax and other opinions and issuer involvement could prove substantial. Even if no “significant modification” occurs there are other considerations such as how to treat one-time payments for accounting and arbitrage yield purposes. In transactions where there are integrated and even super integrated swaps, how does the borrower retain the tax treatment in those situations to be able to finance termination payments on a tax exempt basis and/or maintain the yield on the super integrated swap as the bond yield?
The Proposed Regulations contain examples of what does and does not constitute a “significant modification”. (See Proposed Regulations section 1.1001-3(d)). These include such modifications as a change in collateral or security enhancement, change in obligor, change from recourse to non-recourse debt, changes in yield and/or timing of payments, etc. The most applicable example of what constitutes a “significant modification” is contained in section 1.1001-3(e)(2)(ii) which generally states that a change in yield on an obligation is a significant modification if the new yield exceeds the old yield by more than the greater of (i) one quarter (1/4) of one percent (25 basis points) or (ii) 5 percent of the annual yield of the unmodified instrument. This calculation takes place at the time of modification (from the original documents) of the yield on the debt obligation, which in the case of replacement fallback language, may or may not take place in the future.
In submissions to the United States Treasury Department and IRS on April 8, 2019 and June 5,2019, ARRC identified potential tax issues associated with the elimination of IBORS (including USD-LIBOR) and the associated need to modify IBOR based debt instruments as describe above. As previously noted, such modifications would include the substitution of a new index (such as SOFR) with appropriate adjustments and/or one-time payments from one party to the other to account for differences in the rate indices. The ARRC letters urged the Treasury Department and IRS to produce broad and flexible specific guidance on tax issues that may arise as result of the expected transition. Specifically, ARRC requested recognition that an amendment to a debt instrument, derivative or other contract to replace an IBOR reference rate or to include to fallback language in anticipation of the elimination of an IBOR reference rate not be treated as an exchange under Section 1001 of the IRC. They also asked for clarification of the treatment of any one-time payments. Once again, ARRC requested recognition of SOFR as a permitted alternative rate to USD-LIBOR.
In response to these requests, on October 9, 2019 the Treasury Department and the IRS published proposed guidance on tax issues related to the change to debt instruments resulting from the potential elimination of certain IBOR reference rates in the form of Proposed Treasury Regulations section 1.1001-6 and Proposed Amendment to Treasury Regulation section 1.1275-2. In its explanation of the provisions of Prop. Treas. Reg. 1.1001-6 the Treasury and IRS state that “[t]he proposed regulations under section 1.1001-6(a) generally provide that, if the terms of a debt instrument are altered or the terms of a non-debt contract, such as a derivative, are modified to replace, or to provide a fallback to, an IBOR-referencing rate and the alteration or modification does not change the fair market value of the debt instrument or non-debt contract or the currency of the reference rate, the alteration or modification does not result in the realization of income, deduction, gain, or loss for purposes of section 1001”. The proposed regulations specifically provide that alterations to debt and non-debt instruments for the purpose of incorporating a “qualified rate” in place of an existing IBOR (whether as an existing or fallback rate) and “associated alterations” will not be treated as a deemed exchange of property differing materially in kind or extent. “Qualified rates” are listed in Section 1001-6(b)(1)(i)-(x) of the Proposed Regs. and includes SOFR as well as any rates “determined by reference to” a describe rate “including a rate determined by adding or subtracting a specified number of basis points to or from the rate by multiplying the rate by a specified number”. Modifications utilizing a “qualified rate” are still subject to the substantial equivalence of fair market value test discussed earlier in this paragraph (See Proposed Treasury Regulations Section 1001-6(b)(2)). Such rules are intended to “apply to both the issuer and holder of a debt instrument and to each party to a non-debt contract or by an exchange of a new debt instrument or non-debt contract for the existing one”. The Proposed Regulations and Amendments contain other provisions related to modifications of debt and non-debt instruments and contracts and the treatment of one-time payments.
On November 25, 2019 the National Association of Bond Lawyers (NABL) sent its comments on the Proposed Regulations and Amendments to Treasury in response to the Treasury’s and IRS’s request for comments. The comments focus on the effect of such Regulations and Amendments on tax advantaged debt instruments, requesting special consideration be given to tax advantaged bonds regarding reissuance similar to what exists in existing or proposed Regulations. In addition to a request for special consideration for tax-advantaged instruments, NABL recommends modifications to the arm’s length safe harbor contained in the Proposed Regulations and to treatment of one-time payments for both tax advantaged bonds and interest rate hedges, as well as requesting clarification on the applicability of the Proposed Regulations and Amendments to modifications made in debt and non-debt instruments before publication of final Regulations.
It seems clear that industry market groups and trade associations are taking the anticipated elimination of LIBOR as a reliable market index seriously and are being proactive in identifying viable and robust alternatives. They are also urging parties entering new USD-LIBOR debt and non-debt contracts to consider the use of another primary index or, in the event they continue to use USD-LIBOR or a different IBOR, to incorporate fallback language recognizing an alternative index such as SOFR in such contracts and amending legacy contracts to include new fallback language.
While publication of SOFR and trading in contracts utilizing SOFR has commenced, much remains to be done before SOFR, as the alternative to USD-LIBOR selected by ARRC, becomes a robust and accepted published alternative with recognized spreads and terms. Publication by the ISDA of amendments to the fallback language for IBORS contained in its 2006 Definitions will also bring some clarity to the issue in the derivative market.
All parties to existing debt instruments being modified to incorporate the new indices or to incorporate new indices in to the fallback provisions need to be cognizant of the tax and accounting issues that are involved in the event such modifications are deemed significant and an exchange occurs for tax purposes. The same concerns hold true for any payments between parties in exchange for such modifications. For those parties to debt and non-debt related tax advantaged instruments there are additional concerns relating to reissuance. In all cases, parties should consult their financial advisors, counsel, tax counsel and/or bond counsel before proceeding with such modifications.