Funds Talk: December 2017
Topics covered in this issue include:
- Tax Reform Bills Seek Largest Restructuring of Tax Code in More Than a Generation The Tax Cuts and Jobs Act would overhaul the U.S. tax code, which could have significant effects on the investment management industry.
- SEC Investor Advisory Committee Discusses Blockchain’s Effect on Markets SEC Chairman Jay Clayton recently discussed the SEC’s approach to applying securities law to technology-based offerings and the importance of developing a regulatory framework while still benefitting from new methods of raising capital.
- Trump Administration Issues Guidance on Asset Management and Insurance Regulation The Trump Administration released guidance, including a list of seven “core principles” underlying the Federal government’s regulatory efforts in the financial sector, that will have wide-ranging effects on various aspects of the asset management and insurance industries.
- Court of Appeals Ruling Eases the Way for Shareholders to Bring Derivative Suits Against Cayman Islands Companies in the New York Courts
A recent decision from the New York Court of Appeals determined a Cayman Islands rule was procedural, not substantive. As a result, the rule does not apply to derivative actions brought in New York, removing a hurdle for shareholders of Cayman Islands-based firms.
- Interval Alts and Insurance-Linked Securities As natural disasters such as hurricanes and wildfires become more frequent, insurers are increasingly using alternative funds for risk protection, with benefits to both sponsors and clients.
- Replacing LIBOR in Indentures In July 2017, the U.K. Financial Conduct Authority (FCA), announced that it will discontinue the London interbank offered rate (LIBOR) at the end of 2021. A phaseout of LIBOR will be a major undertaking raising many issues, including the treatment of existing floating rate indentures with maturities past 2021 and preparation of new indentures that will be executed prior to the phaseout of LIBOR.
Tax Reform Bills Seek Largest Restructuring of Tax Code in More Than a Generation
On Nov. 16, 2017, the House of Representatives passed its version of the tax reform bill, the Tax Cuts and Jobs Act. The Senate Budget Committee voted on Nov. 28, 2017, to send the Senate version of the bill to the floor, after two Republican holdouts dropped their objections. A Senate vote on that bill, which differs in several respects from the bill passed by the House, could take place shortly.
The tax reform bills represent the largest proposed overhaul of the tax code in more than 30 years. Should tax reform successfully navigate a course through Congress and to the Oval Office for signature into law, it would have a significant effect on the investment management industry.
At this time, the exact provisions of any tax reform that may ultimately be enacted are uncertain, and it is not clear how differences between the House and Senate tax reform bills will be reconciled. However, the following notable changes (among others) that would affect the investment management industry are under consideration:
A. Tax Rates
1. Corporations. The corporate tax rate would be reduced to 20 percent. 2. Individuals. The tax rates on individual taxpayers would be reduced, though the reduction for the highest bracket ($500,000 for individuals and $1 million for couples) would be relatively small. 3. Income from pass-through entities. Under the House bill, the tax rate on income from pass-through entities engaged in a trade or business would be reduced to 25 percent (for “passive” investors). The Senate bill would generally permit a partner in a partnership to deduct 17.4 percent of the partner's share of the partnership’s U.S. trade or business income, but limited to 50 percent of the partner's share of the wages paid by the partnership. 4. Foreign earnings. The tax on dividends from foreign subsidiaries would be eliminated. There would be a one-time tax (payable with interest over eight years) on unrepatriated earnings of foreign subsidiaries. Illiquid assets would be taxed at 5 percent (7 percent in the House bill); liquid assets, such as cash, would be taxed at 14 percent (10 percent in the House bill). Certain anti-base erosion measures would be added to discourage shifting profits overseas. 5. Alternative Minimum Tax. Both the corporate and the individual AMT would be repealed.
B. Carried interest. Under the House bill, a partner’s share of long-term capital gains would be treated as short-term capital gain (taxed at ordinary income rates) to the extent the gain is attributable to the sale of assets held for three years or less, if the partnership interest is transferred to, or held by, the partner in connection with the performance of substantial services in an investment management business. This should not have an effect on managers of funds that trade frequently, and therefore generate short-term capital gains in any event, or on managers of funds (such as private equity or venture capital funds) that hold interests in their portfolio companies for more than three years.
1. Business interest. Deductions for interest expense incurred in most trades or businesses would be limited to business interest income plus 30 percent of adjusted taxable income (computed without taking into account business interest income or expense). This limitation would generally be determined at the partnership (or S corporation) level. Disallowed deductions could be carried forward to later years. 2. NOLs. The use of NOLs would be limited to 90 percent of taxable income (possibly dropping to 80 percent after 2022 in the Senate bill), and provisions relating to carrybacks and carryovers would be modified. 3. Expensing and depreciation. 100 percent expensing would generally be extended through 2022, and the Senate bill would shorten the recovery period for certain real property to 25 years. 4. State and local tax deductions. Deductions for state and local income and sales taxes not paid or accrued in carrying on a trade or business are eliminated. Most other deductions are also eliminated, except for deductions for charitable donations, property taxes up to $10,000 a year (retained only in the House bill) and mortgage interest deductions, which would be capped at debt of $500,000 in the House bill; the Senate bill would retain the $1 million limit.
1. Sale of partnership interests by foreign partners. The IRS position in Revenue Ruling 91-32 — that foreign partners are subject to U.S. income tax on the sale of a partnership interest to the extent the gain is attributable to assets used in the partnership’s U.S. trade or business — would be codified into law under the Senate bill. The purchaser of the partnership interest would be required to withhold 10 percent of the purchase price of the partnership interest. 2. Timing of income recognition. Under the Senate bill, income would need to be recognized no later than the year in which it is included for financial reporting purposes.
SEC Investor Advisory Committee Discusses Blockchain’s Effect on Markets
The effect of Bitcoin on securities markets and enhanced measures related to retail investors were the focus at the October meeting of the Securities and Exchange Commission’s (SEC) Investor Advisory Committee (Committee).
In addition to those agenda items, SEC Chairman Jay Clayton also remarked on various topics, including disclosure requirements of Regulation S-K, distributed ledger technology (DLT) and so-called pump-and-dump schemes.
Established under Section 911 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Committee’s mandate is to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and initiatives to protect investor interests, and to promote investor confidence and the integrity of the securities marketplace. The Committee may also submit findings and recommendations for review and consideration by the SEC.
During his introductory comments, Clayton addressed several topics set to be explored in panel discussions later in the day, as well as some other issues. First, he highlighted the SEC’s proposal the previous day to implement a mandate under the Fixing America's Surface Transportation (FAST) Act, which included measures to “modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies” under Regulation S-K.
“These amendments are also intended to improve the readability and navigability of disclosure documents and discourage repetition and disclosure of immaterial information,” Clayton said at the Committee meeting, before deviating from his prepared remarks on the subject.
“I want to emphasize something I said yesterday in our open meeting. And that is, we very much want to encourage companies to discuss their business from the perspective of the way they manage their business.”
Clayton then turned to the topics on the agenda for the day’s panels, the first of which was blockchain technology and its implications for securities markets. He stated that “financial technology and innovation are essential to robust competitive markets,” with the SEC seeking to identify a balance between fostering innovative ways to raise capital and ensuring investors remain protected. Specifically, Clayton said the SEC wants to improve clarity regarding how federal securities laws apply to DLT or blockchain technology to raise capital. He said the SEC will continue to study the effects of DLT and keep investors informed of technological developments, highlighting a recently issued bulletin from the SEC’s Office of Investor Education Advocacy warning investors regarding the risk of bad actors using new technology to engage in familiar frauds.
Clayton again deviated from his prepared remarks to specifically emphasize the potential for new technology to be used in so-called pump and dump schemes.
“If we don’t get that right, we won’t get the benefits of this technology,” Clayton warned.
Distributed Ledger Technology Panel
The event’s morning panel featured several expert speakers from industry, regulatory and academia. Each discussed various aspects of DLT, including the future of blockchain, initial coin offerings and the implications for the investors and regulators of securities markets. Although participants acknowledged the need for regulators to adapt to the new technology in order to continue protecting investors and financial markets, they shared a largely positive vision of its potential to offer investors and regulators alike additional information and control.
For example, Jeff Bandman, the principal of Bandman Advisors, a former fintech advisor at the Commodity Futures Trading Commission (CFTC) and director and architect of LabCFTC, described blockchain as a “collaborative technology” that will require broad adoption in order to succeed. He suggested this could lead to greater transparency and oversight, since “most blockchain initiatives are developed in the open to attract participants and, therefore, they are actually more visible to regulators compared to some other innovations and other technologies.” He also discussed the potential for the SEC to develop what he called “real-time regulation” that would allow regulators to harness real-time data from distributed ledgers and enhance its ability to effectively regulate market activities — or, as he described it, “to see through the windshield instead of the rearview mirror.”
Although the panel reached few definitive conclusions, the discussion highlighted the SEC’s focus on blockchain and its associated effects on larger securities markets — a focus that appears likely to continue as regulators and market participants adapt to the disruption.
The Committee’s next meeting is scheduled for Dec. 7, 2017. Topics on the agenda for that meeting include: recommendation of the Investor as Purchaser Subcommittee regarding electronic delivery of information to retail investors; a discussion regarding cybersecurity risk disclosures; a discussion regarding dual-class share structures; and a discussion of what works, what doesn’t and best practices related to retail investor disclosure.
Trump Administration Issues Guidance on Asset Management and Insurance Regulation
On Oct. 26, 2017, the U.S. Treasury Department (Treasury) released the latest installment in a series of reports on financial regulation required by the president’s Feb. 3 executive order on the financial system. That order lists seven “core principles” underlying all Federal regulatory efforts in the financial sector — generally, (i) empowering American customers, (ii) preventing bailouts, (iii) fostering economic growth, (iv) enabling American competitiveness, (v) advancing American interests in international negotiations, (vi) making regulation efficient and (vii) restoring accountability.
The Oct. 26 report addresses asset management and insurance. Others in the series address banking (released June 12, 2017); capital markets (Oct. 6, 2017); and nonbank financial institutions, financial methodology and financial innovation (pending). A related executive order issued in April requires additional reports on the Orderly Liquidation Authority established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, 111 P.L. 203 (Dodd-Frank), which is pending, and the process set forth in Dodd-Frank for identifying so-called systemically important financial institutions, or SIFIs, for regulation by the Federal Reserve Board of Governors (the Fed), which was released on Nov. 17, 2017.
Some of the notable observations and recommendations of the Oct. 26 report are as follows.
In Asset Management:
- Prudential regulation of asset management is unlikely to be effective for mitigating systemic risk, if any, arising from this sector. This is mainly due to the relatively low level of leverage and liquidity management employed by the sector as opposed to banking.
- While the Administration agrees in principle with the historical practice of limiting a mutual fund’s (e.g., a registered investment company, or RIC) illiquid holdings to 15 percent of net assets, implementation of the “highly prescriptive” securities bucketing regime for liquidity risk management adopted by the Securities and Exchange Commission (the SEC) in 2016 should be postponed.
- “Swing pricing” for redemptions by a RIC (in which non-redeeming investors are protected from some of the dilutive effects of redemptions) should be studied further. The SEC’s permission of swing pricing on a voluntary basis, set to go into effect in November 2018, is noted by the report.
- The SEC is called on to develop new rules (or reactivate an earlier proposal that stalled after 2008) to allow exchange-traded funds (ETFs) easier access to the capital markets by streamlining the process by which ETFs are cleared by the SEC for issuance and trading. Currently ETFs must obtain exemptive orders, on a case-by-case basis, from registration requirements of the Investment Company Act of 1940.
- Rules of the Commodities and Futures Trading Commission (the CFTC) should be amended to exempt a RIC and its adviser from dual registration by the CFTC as a commodity pool operator (a CPO).
- The CFTC and the SEC should work together in order to identify a single regulator (the SEC or the CFTC) in cases where de facto commodity pools operate without sufficient oversight.
- The report also calls for greater cooperation between the SEC and the CFTC to share information, so that information filed by an entity with one of these bodies might satisfy the informational needs of the other body relating to the entity.
- The CFTC should exempt private funds and their advisers from registration as a CPO if the adviser is “subject to regulatory oversight by the SEC.”
- Regulators and self-regulatory organizations should “rationalize and harmonize” reporting regimes to minimize reliance on redundant forms and submissions.
- Treasury supports the prospective adoption by the SEC of a derivatives risk management program for RICs, but indicates a preference for risk-adjusted measures rather than the notional calculations under the rule proposed in 2015.
- The Report notes the Treasury’s recommendations, set forth in its Report on Banking, on relaxing some of the restrictions of the Volcker Rule (Section 619 of Dodd-Frank and the Federal agencies’ final rule thereunder). The Volcker Rule generally imposes restrictions on the ability of banks and non-bank SIFIs to engage in proprietary trading and to hold “ownership interests” in certain types of private funds. The report urges further efforts to “reduce the burden” of the Volcker Rule on asset managers and investors, including continued forbearance from enforcing
- the proprietary trading restrictions against foreign private funds that are not “covered funds” under the Rule and
- the restriction on funds’ ability to share names with banking entities.
- Treasury also recommends amending Dodd-Frank to limit stress testing requirements for investment companies and investment advisers, either by eliminating all such obligations or by deeming money market fund stress testing pursuant to SEC Rule 2a-7 and liquidity risk management programs pursuant to SEC Rule 22e-4 as satisfying Dodd-Frank mandates.
- In addition, the 2016 SEC proposal requiring registered investment advisers to adopt written business continuity plans should be withdrawn as overly costly and onerous.
- In the area of international financial regulatory negotiations, financial stability risk assessments should be tailored to industry sectors. The United States should play a leading role in international standard-setting bodies such as the Financial Stability Board and the International Organization of Securities Commissions and should work to improve the operations of these bodies.
- The Report calls for delay in implementation of the Fiduciary Rule.
- The rule, proposed in April 2016 by the Department of Labor (the DOL) and effective in June 2017, subject to transition relief recently extended from Jan. 1, 2018 to July 1, 2019, would generally expand the scope of persons deemed to be “fiduciaries” for purposes of the Employee Retirement Income Security Act of 1974 (ERISA)) and Section 4975 of the Internal Revenue Code. This would have the effect of, among other things, prohibiting commission-based compensation from being used when providing financial advice to owners of individual retirement accounts, or IRAs, unless the adviser observes certain impartiality covenants pursuant to the so-called “best interest contract exception.”
- Citing the risk that financial professionals might adopt different practices for accounts that “are nearly identical,” the report warns of “unintended consequences” and harm to investors if the Fiduciary Rule in its current form is put into full effect.
- The report also calls for the SEC, the DOL and the states to work together to implement a regulatory framework appropriately tailored to both preserve investor choice and protect retirement investors in an efficient and effective manner, and to analyze the effects of different standards of care on the availability of annuities in the retirement market.
- States generally should continue as the prime engines of insurance law and regulation, with the Federal Insurance Office (the FIO) and other federal bodies consulting with the states regularly on insurance matters being addressed at the Federal level. This should mitigate the risk of duplicative mandates.
- As with asset management, entity-based systemic risk assessments are not the best approach for mitigating sector-wide risks. The United State should support the International Association of Insurance Supervisors (the IAIS) in its focus on an activities-based approach and should take steps to improve the IAIS’s methodology for identifying global systemically important insurers, or G-SIIs.
- The group capital standards being developed and implemented by the National Association of Insurance Commissioners (the NAIC), the states and the Fed should be harmonized to avoid unnecessary redundancy.
- The FIO’s mission should be confined to five “pillars” — (i) promoting the U.S. state-based regulatory system in international discussions, (ii) providing insurance expertise to the U.S. government, (iii) providing leadership and cooperation between the federal government and state regulators, (iv) protecting the financial system by advising Treasury and the Financial Stability Oversight Council on insurance-related matters that may pose threats and (v) promoting insurance products and administering the Terrorist Risk Insurance Program.
- The FIO should be more transparent and should engage more regularly with state regulators.
- The Fed is called on to leverage information received by state insurance regulators and the NAIC on savings and loan holding companies that are insurance companies, in order to avoid duplicative regulatory efforts.
- The report calls on Congress to clarify what is included in the “business of insurance” for purposes of Dodd-Frank’s grant of authority to the Consumer Financial Protection Bureau, which is proscribed from regulating insurance matters.
- The Department of Housing and Urban Development should reconsider its “disparate impact” rule, pursuant to which housing practices may be deemed discriminatory as to a protected class, regardless of intent, if the practices unevenly affect access to housing. The report explains that disparate impact could adversely affect availability of homeowner’s coverage and may be inconsistent with state, rather than federal, primacy in the regulation of insurance.
- On data security and cyber risks, Treasury endorses the NAIC’s model law on Insurance Data Security(formally adopted by the NAIC mere days before the report was released) and calls on states to adopt it promptly. If uniform state laws for insurance company data security are not in place in five years, Congress should adopt legislation, but this should be administered by the states.
- States that have not entered the Interstate Insurance Product Regulation Compact should do so in order to further the use of uniform standards in regulating life insurance products.
- States should adopt the NAIC’s Producer Licensing Model Act and should generally try to ease compliance burdens imposed on insurance agents and brokers.
- The report calls for the IAIS to postpone the next version of its capital standard for internationally active insurance groups, or IAIGs, beyond its anticipated 2019 completion date in order to accommodate further discussion and refinement.
- The IAIS should take additional steps to increase transparency and collaboration with all of the IAIS’s stakeholders (such as U.S., NAIC and state officials).
- The FIO should coordinate the efforts of the federal government, state insurance regulators and the NAIC to speak with one voice at the IAIS and advance American interests.
- The report notes approvingly the September 2017 completion of the Covered Agreement between the United States and the European Union (the EU) providing for reciprocal treatment in certain regulatory areas for insurers doing business across those jurisdictions, as well as the administration’s policy statement issued in conjunction therewith, affirming the state insurance regulatory system.
- The Treasury calls for exploring whether a Covered Agreement between the U.S. and the U.K. would be mutually beneficial “should the United Kingdom (U.K.) withdraw from the EU.”
- States should consider a more “calibrated” approach to insurance company investments in infrastructure, including revisions to risk-based capital laws, to make these investments more attractive from a regulated-capital perspective.
- The DOL and Treasury should pursue steps to encourage the use of annuities in defined contribution retirement plans covered by ERISA. The report cites ERISA compliance as a reason for the decline in defined-benefit pensions in the private sector.
- Treasury will convene an interagency task force among interested federal agencies to develop policies to “complement reforms at the state level” in the area of long-term care insurance. The task force is called on to collaborate with the NAIC on its efforts.
 12 CFR Parts 44, 248, and 351 17 CFR Part 255.
Court of Appeals Ruling Eases the Way for Shareholders to Bring Derivative Suits Against Cayman Islands Companies in the New York Courts
On Nov. 20, 2017, the New York Court of Appeals held that in a derivative action brought in a New York court against a company incorporated in the Cayman Islands, the plaintiff need not comply with Rule 12A of the Cayman Islands Grand Court. Under Rule 12A (the Rule), a plaintiff proceeding in a Cayman Islands court is required to seek leave of court before pursuing a derivative claim. Reversing the appellate court ruling below, the unanimous decision from New York’s highest court permits a shareholder of a Cayman Islands corporation — assuming personal jurisdiction and other substantive requirements have been met — to bring a derivative action in New York without leave of court where such permission would have been necessary if the action had been filed in the Cayman Islands, the place of the corporation’s formation.
A derivative action is a lawsuit brought by a shareholder that seeks recovery on behalf of the corporation itself, typically for mismanagement of some kind. Here, Paul Davis, an investor in the Cayman Islands company, Scottish Re Group, Limited (Scottish Re), sued members of its board and certain other parties, asserting that Scottish Re engaged in a series of transactions that allegedly unfairly enriched majority shareholders at the expense of minority shareholders like himself.
The issue presented in Davis was whether, since the derivative action was brought in a New York court against a Cayman Islands company, the plaintiff needed to comply with Rule 12A of the Cayman Islands Grand Court and seek leave from a Cayman Islands court before pursuing his derivative claim in New York. In a derivative action, a New York court generally applies the substantive law of the jurisdiction of incorporation under the internal affairs doctrine, but the procedural rules of the New York courts. The court therefore focused its discussion on whether Rule 12A is a procedural rule or a substantive point of Cayman Islands law.
After parsing the language of the Rule, the Court of Appeals construed Rule 12A as procedural, not substantive, and therefore not binding on New York courts. The court concluded that Rule 12A was intended to apply to actions brought in the Cayman Islands courts, pointing out that the Rule only purports to apply to “action[s] begun by writ” and after the defendant has “given notice of intention to defend” the derivative action. The Court noted that these are references to procedural aspects of Cayman Islands litigation that do not take place in New York courts, where derivative actions are not begun by writ and defendants do not serve notices of intention to defend.
Defendants argued that Rule 12A acts as a substantive “gate-keeper” provision under Cayman Islands law,and pointed to similar rules in other nations. Indeed, the Court of Appeals acknowledged that other jurisdictions can and do have substantive “gate-keeping” provisions that limit a plaintiff’s ability to bring derivative actions abroad. For example, the British Virgin Islands’ Business Companies Act requires that any shareholder bringing a derivative action first obtain leave from a court in the British Virgin Islands, and the Canada Business Corporations Act requires that a shareholder first obtain leave from a Canadian court and, once granted leave, only commence the derivative action in certain Canadian courts. The Court of Appeals, however, did not find such an intention in the Cayman Islands rule: “Had the Rules Committee . . . intended that Rule 12A apply to derivative actions involving Cayman Islands companies anywhere in the world, it could have expressly provided as such,” Justice Feinman wrote for the unanimous court. Davis, No. 111, slip op. at 9.
In the end, the Court of Appeals declined the invitation to read Rule 12A as a “gate-keeping” provision applicable in New York actions, noting that New York has its own “gate-keeping” provisions: “New York applies other states’ and countries’ substantive laws with regularity. . . . We also have our own ‘gatekeeping’ statutes, CPLR 3211 and 3212, that effectively weed out claims which are insufficient or meritless; these are the procedural rules that apply when a Cayman company is sued in New York.” Id. at 13–14.
Having found that Cayman Islands Grand Court Rule 12A did not apply in this New York action, the Court of Appeals remitted the case to the Appellate Division without deciding the question whether the plaintiff has standing to bring a derivative action under Cayman Islands substantive common law. That question turns on an application of the rule of the 1843 English case, Foss v. Harbottle (2 Hare 461 ). The Foss case gives a shareholder plaintiff standing to bring a derivative claim only: “(1) if the conduct infringed on the shareholder’s personal rights; (2) if the conduct would require a special majority to ratify; (3) if the conduct qualifies as a fraud on the minority; or (4) if the conduct consists of ultra vires acts.” See Davis v. Scottish Re Grp. Ltd., 46 Misc. 3d 1206(A) at *15, 9 N.Y.S.3d 592 (Sup. Ct. N.Y. Co. 2014). The Supreme Court had dismissed the case on this ground as well, but neither the Appellate Division nor the Court of Appeals reached that issue.
 Davis v. Scottish Re Grp. Ltd., No. 111, 2017 WL 5557936 (N.Y. Nov. 20, 2017).
 Upon receiving the plaintiff’s application for leave, Rule 12A allows the Cayman Islands court to grant the application, dismiss the action, or to request “the filing of further evidence, discovery, cross examination of deponents and otherwise as it may consider expedient.”
Interval Alts and Insurance-Linked Securities
We are seeing Interval Alts (registered investment funds featuring hedge fund-like liquidity) being used for dedicated insurance-linked securities (ILS) strategies. ILS, such as catastrophe, or "cat," bonds, provide sponsoring insurance and reinsurance companies with contingent funds to hedge the risk of specified insurable events, e.g., hurricanes, wildfires and earthquakes. With the recent natural catastrophes this summer and fall, insurer demand for loss protection is expected to rise, which could improve pricing for providers of risk protection, such as reinsurers or ILS investors. Interval Alt funds employing ILS strategies tend to be non-correlated with other financial products and offer their investors additional liquidity and execution benefits, as illustrated below.
Replacing LIBOR in Indentures
In July 2017, the CEO of the U.K. Financial Conduct Authority (FCA), Andrew Bailey, announced that the FCA will discontinue the London interbank offered rate (LIBOR) at the end of 2021. LIBOR is an interest rate index which is currently used in calculating floating or adjustable rates on trillions of dollars in bonds, loans, derivatives and other financial agreements.
A phaseout of LIBOR will be a major undertaking raising many issues, including the selection of a successor rate for new transactions and the fallback rate for existing transactions. Many of these issues remain unresolved for now. Their ultimate outcome will have consequences for both existing floating rate indentures with maturities past 2021 and new indentures that will be negotiated and executed prior to the phase out of LIBOR.
Why LIBOR is being Replaced
The interbank offering rates (IBORs) are floating rates based on the actual or purported interbank offered rates for short-term loans in various currencies and maturities based on daily surveys of major banks. There are IBORs for each major currency (USD-LIBOR/GBP-LIBOR/EUR-EURIBOR/JPY-TIBOR). Following alleged manipulation of LIBOR after the financial crisis, the U.K. government decided to regulate the setting and administration of LIBOR, as well as the submission of rates by banks used to create LIBOR, and placed these activities under the supervision of the FCA.
The alleged manipulation also prompted a review of major financial benchmarks, and in 2014, both the Financial Stability Board (FSB) and the Financial Stability Oversight Council (FSOC) in the U.K. reported concerns over the reliability and robustness of IBORs.1 The main issues raised by the FSB and the FSOC were the following. The rates that banks report in order for these benchmark rates to be created do not have to be based on actual transactions. And the benchmark rates rely too heavily on transactions in a relatively low-volume market, which increases the potential for manipulation. As a consequence, the FSB recommended that IBORs, and other similar benchmark rates, be determined based to the greatest extent possible on real transaction data. The FSB also recommended the development of alternative nearly risk-free reference rates (RFRs), because counterparty risk, which is accounted for in the IBORs, does not necessarily make sense for many of the transactions using the IBOR benchmarks.
In the U.S., following the FSB recommendations, the Federal Reserve assembled a group of financial institutions representatives known as the Alternative Reference Rates Committee (ARRC) in order to identify alternative, transaction-based reference interest rates to replace USD-LIBOR. In June 2017, ARRC announced that it had identified an overnight “broad Treasuries repo financing rate,” based on transaction-level data from certain tri-party and bilateral repo clearing platforms, as a potential successor to the USD-LIBOR (the RFR Replacement Rate).2
The following month, the FCA announced that despite its efforts to improve the process of setting LIBOR, it had proven difficult to ensure that rates and submissions were linked to actual transactions. The FCA concluded that it was unsustainable for market participants to indefinitely rely on reference rates that are not supported by an active underlying market, and announced that LIBOR would be phased out by the end of 2021.
There will not be a “ban” on LIBOR at the end of 2021, and in fact, LIBOR may still be published after that date by the LIBOR administrator,3 if it can obtain sufficient submissions from major dealers. There is no assurance that this will be the case, however. The FCA has the regulatory power to compel major dealers to provide submissions, although the dealers currently, if reluctantly, provide submissions on a voluntary basis. The FCA has announced that after 2021, it will not use its regulatory power to compel submissions, and given the environment, it is questionable whether the dealers will continue to voluntarily provide the submissions.
Transition to a LIBOR Successor/Fallback Rate
The replacement of LIBOR has direct consequences for derivatives transactions, and in 2016 the International Swaps and Derivatives Association (ISDA) established working groups on the development of alternative risk-free rates and fallbacks. Recently ISDA arranged a webcast to provide an update on the direction taken by its working groups.4 Although no consensus has emerged regarding a replacement rate, ISDA confirmed that the current approach (which may change) is to consider the RFR Replacement Rate as the successor/fallback rate for USD-LIBOR. However, since the RFR Replacement Rate is a risk-free rate — which doesn’t take into account the bank credit risk reflected in LIBOR — and is also an overnight rate — whereas LIBOR has different rates for specified tenors — there exists a concern that a significant value transfer would occur for existing transactions upon switching from USD-LIBOR to the RFR Replacement Rate. The ISDA working groups are currently discussing solutions to address these and many other issues.
While ISDA working groups are active in the context of derivatives, the issues they are grappling with are also relevant to floating rate note indentures, and the work conducted by ISDA working groups could influence the selection of a consensus successor to LIBOR in the indenture context as well.
LIBOR Successor/Fallback Rate in Existing Indentures
In existing indentures, the standard fallback mechanism is very similar to the standard mechanism for derivatives. Typically in indentures, if LIBOR is unavailable, the fallback rate will be determined by the calculation agent based on rates at which U.S. dollar deposits are offered by major banks to prime banks in the London interbank market for the relevant interest period. If at least two quotations are provided, the arithmetic mean is used. If fewer than two rates are provided, then the rate for the immediately preceding interest period continues in effect.
The rate resulting from this standard fallback mechanism, if used as a permanent replacement for LIBOR in floating rate indentures after 2021, could differ substantially from a new benchmark rate (such as the RFR Replacement Rate), could create uncertainty and inconsistencies in the financial markets, and may generally be unsatisfying for noteholders.
In derivatives transactions, the fallback mechanism can be changed as long as both parties to the agreement agree to amend the transaction.5 With indentures, it is not so easy.
Indentures typically permit amendments without noteholder consent to cure ambiguities, omissions, mistakes, defects or inconsistencies, or where the amendments do not adversely affect the rights of any holder. It is difficult to argue, however, that changing the benchmark rate of a floating rate indenture, which will directly affect interest payments, is a ministerial change. The replacement of LIBOR with a risk-free rate could result in value transfer from noteholders to issuers. And, because the replacement rate may result in lower interest payments to noteholders, unanimity may be required for amendment. Also, LIBOR may continue to be supported by its administrator, undercutting the justification for replacing LIBOR without noteholder consent under the guise of defect correction.
LIBOR Successor/Fallback Rate in New Indentures
How issuers will deal with existing LIBOR-based floating rate indentures whose securities mature after 2021 is unclear. But drafters of new indentures have the opportunity to address the issue before it ripens into what may be an intractable situation.
At present, it may not be possible to specify with particularity a fallback rate to replace LIBOR. Although the attentions of ISDA and ARRC are focused on the RFR Replacement Rate, no market consensus on a successor to LIBOR has yet emerged. Instead, drafters should provide issuers with flexibility to designate an industry-standard replacement rate when a consensus on a successor to LIBOR does emerge. One challenge will be adjusting for intrinsic differences between LIBOR and any successor rate, such as the risk adjustment discussed above, so as to preserve the bargained-for economics of the debt.
One recent floating rate indenture6 has taken the approach of tying a successor rate to the benchmark rate in the issuer’s credit facility, on the theory that an amendment to the credit agreement can be accomplished more readily than modification of the indenture. The provision there for a LIBOR replacement reads as follows:
If the rate previously quoted on the Reuter Page LIBOR 01 has been discontinued or is otherwise no longer in effect, LIBOR shall mean a successor rate, including any adjustments thereto, applied in a manner consistent with market practice, selected by the Company in its reasonable good faith judgment to maintain the then-current yield on the Notes to the extent reasonably practicable, and consistent with the definition of LIBOR employed by the Company and the administrative agent under the Credit Agreement, if applicable, which successor rate shall be identified in an Officer’s Certificate delivered to the Calculation Agent not less than 30 days prior to the date that such successor rate shall become effective.
In addition to the tie-in to the credit agreement, the provision:
- gives the issuer leeway to adjust spreads to reflect differences between LIBOR and the replacement; and
- provides for advance notice of the replacement to the calculation agent, thereby affording an opportunity for some independent check on the replacement benchmark and any related adjustments.
An alternative approach could be to modify the amendment provisions of the indenture, as to allow an amendment without noteholder consent to designate a successor to LIBOR, subject to appropriate parameters that assure a transition to the new reference rate that is economically neutral to the extent possible.
Although many issues remain unresolved at this time, a consensus on one or maybe multiple successor rates to LIBOR will likely emerge in the near future. The successor rate(s) may come from the work currently being conducted by ISDA, the Federal Reserve, or other industry or regulatory initiatives. Issuers are advised to monitor developments in the area, especially if they are contemplating the issuance of floating rate debt with maturities that extend beyond 2021.
There does not appear as yet to be any industry solution that addresses substitution of LIBOR in existing floating rate indentures with debt maturing after 2021. Issuers, underwriters and investors currently negotiating with respect to the issuance of new floating rate debt securities have the opportunity to address the problem at the drafting stage. They should consider providing for the substitution for LIBOR in 2021 with a to-be-identified market-approved reference rate, with a mechanism that will be workable and flexible, and will provide for an economically neutral transition, to the extent possible.
2 “The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate,” June 22, 2017, is available here.
3 Currently the ICE Benchmark Association.
4 “Benchmarks – Fallbacks for LIBOR and other key IBORs,” the webinar slides can be found here.
5 ISDA typically facilitates such industrywide amendments by publishing a protocol amending all relevant derivatives transactions between two signatories of the protocol. During the ISDA webcast it was reported that ISDA will most likely adopt the same approach in this instance.
6 Indenture of VICI Properties 1 LLC, dated Oct. 6, 2017, with respect to First-Priority Secured Floating Rate Notes due 2022. The notes were issued to former first-lien noteholders of Caesars Entertainment Operating Co. in a bankruptcy reorganization. Kramer Levin served as counsel to certain of the former first-lien noteholders.