“… [T]he discontinuation of LIBOR should not be considered a remote probability ‘black swan’ event. Firms should treat it is [sic] as something that will happen and which they must be prepared for.”1
Dramatic changes are on the horizon for the most widely used benchmarks for interest, investment and derivatives rates: the London Interbank Offered Rate (LIBOR) for various currencies. Notwithstanding efforts by regulators and market participants to increase confidence in LIBOR in the wake of the last decade’s global financial crisis and years of manipulation of the benchmark, the lack of reliable and sufficient transactional data to bolster LIBOR has led to regulatory action that could lead to LIBOR’s demise. As a result, a broad swath of market participants, including lenders, borrowers, debt issuers, investors and derivatives counterparties are (or should be) evaluating the consequences of and alternatives to address the potential cessation of LIBOR.
This Legal Alert discusses regulatory and industry efforts to prepare for the anticipated changes to LIBOR, including their potential cessation, focusing on US Dollar LIBOR (USD LIBOR).2 Part I of this Legal Alert provides background on LIBOR and its potential cessation; Part II describes the development of alternatives to USD LIBOR; Part III summarizes some of the significant measures US regulators and trade associations have been taking in anticipation of the transition away from LIBOR; and Part IV describes the steps market participants should be taking now.
I. Why LIBOR may go away
On July 27, 2017, Andrew Bailey, the Chief Executive of the UK Financial Conduct Authority (FCA), announced that the FCA, which regulates ICE Benchmark Administration, the administrator of ICE LIBOR, will no longer compel panel banks to provide submissions for LIBOR after December 31, 2021.3 Bailey argued that reliance on LIBOR may no longer be sustainable because of insufficient bank unsecured wholesale term lending activity. Such lending activity is the underlying market that LIBOR measures, and without sufficient data, panel banks are unable to formulate submissions based on actual data. Instead, the banks often rely on “expert judgment” in formulating their submissions,4 which introduces subjectivity and potential manipulation into the rate.
The impact of Bailey’s announcement has been widespread since the LIBORs for various currencies (including US dollars, British pounds sterling, Euros, Swiss francs and Japanese yen) are primary benchmarks for rates of interest or for determining other payments used in myriad loans, deposits, derivatives, debt securities and other investments.
Bailey’s announcement did not say that LIBOR would cease to exist after 2021 and there are some indications that it may survive in some form.5 However, it was a public acknowledgement of the possible cessation of LIBOR as a reference rate6 and the need to accelerate development and utilization of alternative rates. Regulators, including the UK government7 and the Financial Stability Board’s (FSB) Official Sector Steering Group (OSSG),8 as well as industry participants, had been considering such alternative rates in the wake of scandals involving the manipulation of LIBOR9 and the diminishing transaction data from which to establish reliable LIBOR rates. Such regulators are now strongly encouraging, and, in some cases, requiring, market participants to take steps to anticipate the cessation of benchmark rates like the LIBORs.10
II. The development of alternatives to USD LIBOR11
The Alternative Reference Rates Committee (ARRC)
In 2014, the Board of Governors of the Federal Reserve System (Board) and the Federal Reserve Bank of New York (New York Fed) established the ARRC, which includes government sponsored enterprises, banks and insurance companies. The ARRC’s initial objectives were to identify an alternative reference rate to USD LIBOR and draft a paced transition plan to transition from USD LIBOR to the identified alternative reference rate.
The Secured Overnight Financing Rate
In the US, the ARRC has identified the Secured Overnight Financing Rate (SOFR) as the most robust alternative to US dollar LIBOR.12 SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.13 It includes all trades in the Broad General Collateral Rate, a measure of rates on overnight Treasury general collateral repurchase agreement (repo) transactions14, and bilateral Treasury repo transactions cleared through the Delivery-versus-Payment service offered by the Fixed Income Clearing Corporation, provided that a portion of transactions considered “specials” are removed.
The New York Fed commenced publication of SOFR and rates related to SOFR, which are described below, on April 3, 2018.15 The rates are published each day at approximately 8:00 a.m. Eastern Time.16 The New York Fed also publishes statistics, including the distribution of volumes on a daily basis, the total dollar amount of transactions used to calculate each rate (rounded to the nearest billion) and the volume-weighted 1st, 25th, 75th, and 99th percentiles.17
Use of SOFR Going Forward
The introduction of SOFR more than three years before the anticipated demise of LIBOR reflects regulators’ acknowledgement that sufficient lead-time is necessary for the market to transition to an alternative rate that is market based and to resolve the sorts of issues that can be expected to occur during such a major transition.18 It is expected that SOFR and SOFR-based rates will be used on a standalone basis going forward and as a fallback for LIBOR transactions entered into during the period until December 31, 2021, when LIBOR may no longer be available. To minimize the economic impact of the change to the fallback rate, the fallback rates used for LIBOR-based transactions will include a spread or spreads to address the credit and duration differences between those fallback rates and the LIBOR-based rate. In addition, a term curve for SOFR needs to be developed by injecting adequate liquidity into products such as SOFR futures and other products that reference SOFR for durations beyond a one-day duration. In furtherance of this goal, LCH and CME started clearing products referencing SOFR and will clear additional products on an ongoing basis, including SOFR futures19 and over-the-counter swaps linked to SOFR.20 In addition, certain issuers have started issuing SOFR securities.21
In addition to identifying an alternative reference rate for floating rate transactions going forward, there needs to be a solution for legacy transactions, i.e., those transactions that use a USD LIBOR-based reference rate for transactions entered into before, and that will still exist after, December 31, 2021. Issues regarding legacy transactions may impact over-the-counter and exchange traded derivatives, as well as commercial and retail loans (both secured and unsecured), floating rate bonds and notes, repurchase and securities lending agreements, securitized products (including retail and commercial mortgage backed securities and other asset backed securities), and other investments that use a USD LIBOR-based rate to determine interest or a rate of return. To the extent transactions based on USD LIBOR do not have fallbacks that anticipate (or are otherwise adequate to address) the cessation of, or material changes to, USD LIBOR, market participants will need to amend transaction documentation to avoid adverse consequences of such cessation or changes, such as premature termination of transactions, application of a non-market rate, or disputes, litigation or regulator enforcement actions.
III. US Regulator and Trade Association Efforts to Address the Cessation of LIBOR
Subsequent to the identification of SOFR as the alternative reference rate for USD LIBOR, the ARRC has been reconstituted to further address fallbacks and provide guidance with respect to legacy transaction issues.22 In particular, ARRC 2.0 released Principles for Fallback Contract Language in July of 2018, which are intended to help market participants in structuring newly issued cash products including business loans, securitizations, and floating rate notes referencing LIBOR.23
Certain industry trade associations, including, among others, the International Swaps and Derivatives Association (ISDA), the Securities Industry and Financial Markets Association (SIFMA), and the Loan Syndications & Trading Association (LSTA), are working in parallel to the ARRC, developing their own fallback protocols to replace LIBOR with alternative reference rates.24 Some of these trade associations are members of the ARRC and actively participate in its subgroups. Other trade associations in other relevant market sectors are taking a wait-and-see approach and may adopt a version of ISDA’s documentation (discussed in further detail below) or solutions proposed by the ARRC working groups for particular markets, to address the potential LIBOR change. Consequently, market participants should keep abreast of ISDA’s efforts regarding the phase-out of LIBOR.
ISDA is working with regulators and market participants to adopt amendments to its 2006 Definitions25 to take into account LIBOR’s potential cessation and replacement rates.26 Several ISDA working groups are considering fallbacks that address how industry participants should transition away from LIBOR. In particular, the ISDA GBP, EUR, CHF Benchmark Working Group, the ISDA JPY Benchmark Working Group, and the ISDA USD Benchmark Working Group (together, the Interbank Offered Rates (IBOR) Benchmark Working Groups) are considering fallback rates and/or other fallback mechanisms that would apply upon the permanent discontinuation of an applicable IBOR.27
These IBOR Benchmark Working Groups are expected to propose amendments to the fallbacks included in the 2006 ISDA Definitions for IBOR transactions which would apply to transactions going forward, i.e., after the amendments.28 In addition, the IBOR Benchmark Working Groups are tasked with proposing a strategy to amend legacy contracts referencing the applicable IBORs (i.e., those transactions entered into prior to the amendments to the 2006 ISDA Definitions become effective), including developing a protocol mechanism to facilitate multilateral amendments to legacy transactions that would apply the amendments to the 2006 ISDA Definitions to those transactions. An alternative solution for legacy contracts may be to provide for reliance on a “synthetic” version of LIBOR that does not necessarily rely on transaction data and serves as a proxy beyond 2021.29
In order to develop a market standard fallback to LIBOR that minimizes the economic impact of the transition to a new rate, ISDA is working with a broad array of sell side and buy side market participants to develop a spread or spreads that take into account the credit and duration differences between the new fallback rates based on SOFR and the current LIBOR rates. In this regard, ISDA has published a consultation30 concerning the term fixings31 and credit spreads that will apply to the alternative reference rates that covers British pounds sterling, Japanese yen, Swiss francs, Australian dollars, and, to a lesser extent, US dollars and Euros. The consultation includes various options for the calculation of term fixings and credit spreads, and example calculations to demonstrate the effects of each option. All market participants (i.e., users of derivatives) will be able to vote on the options for term fixings and credit spread methodologies, including market participants that are not members of ISDA.
- European Benchmark Regulation (BMR)
The BMR largely is focused on addressing European regulators’ concerns regarding the need to have fallbacks in place for significant benchmarks such as the LIBORs. The BMR also addresses a broad range of benchmarks beyond LIBOR, including other interest rate benchmarks and benchmarks used for foreign exchange (FX), foreign currency and equity transactions. Given its broad application32 and its effectiveness as of January 1 of this year, the BMR must be addressed both in connection with how it may impact derivatives transactions with entities covered by the regulations as well as with the development of fallbacks to LIBOR.
Article 28(2) of the BMR (which implements the International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks in EU law)33 requires that “supervised entities” that make use of benchmarks create and maintain “robust” contingency plans that describe the actions supervised benchmark users will take if a benchmark materially changes or ceases to be provided.34 The plan must also be reflected in contracts with clients of supervised benchmark users and must be made available to competent authorities upon request.35 Based on this regulatory requirement, the ISDA Article 28(2) EU Benchmarks Regulation Working Group determined that the fallbacks contained in certain of the ISDA Definitional Booklets are not sufficiently “robust” to address cessation or a material change of a benchmark. As a result, the working group has drafted supplements to the 2006 ISDA Definitions Benchmarks Annex, the 2002 ISDA Equity Derivatives Definitions, the 2005 ISDA Commodity Definitions, the 1998 FX and Currency Option Definitions, and the 2008 ISDA Inflation Derivatives Definitions (the Benchmarks Supplements). The development of the Benchmarks Supplements is in its final stages and is expected to be published in the fall of this year. ISDA anticipates that parties will adhere to a universal Benchmarks Supplements protocol it develops, which may apply to prospective transactions only or also include legacy transactions. Parties may also apply the Benchmarks Supplements on a bilateral basis by incorporating the Benchmarks Supplements by reference in their trading documentation.
The IBOR Working Groups, industry participants, and regulatory bodies that are considering the phase-out of LIBOR will undoubtedly consider the triggers and fallbacks of the Benchmarks Supplements to the 2006 ISDA Definitions Benchmarks Annex. In addition, to the extent the BMR overlaps with the efforts of other ISDA working groups focused specifically on developing IBOR fallbacks, groups are working together in their drafting efforts to ensure that the BMR will not frustrate the IBOR fallbacks currently being developed.
IV. What Market Participants Are or Should be Doing to Prepare for the Cessation of LIBOR
In addition to tracking the efforts by regulators, the ARRC, the ISDA working groups and other trade associations, market participants should be taking stock of how the phase-out of LIBOR may impact their obligations, hedging, regulatory requirements, and tax and accounting treatment of their LIBOR-based transactions.36 Relevant parties should evaluate the tenors, fallbacks that may or may not already exist, and the amendment procedures of particular agreements. In particular, market participants should:
- Review and evaluate whether their existing derivatives trading, commercial loan,37 consumer loan and mortgage, bond, and securitization agreements that reference LIBOR have adequate triggers and fallbacks to address the cessation of LIBOR, including which party determines the application of the triggers and the (order of the) fallbacks. In addition, market participants should evaluate whether LIBOR (e.g., the last published LIBOR as a fixed rate) or other interim rate would apply on an interim or potentially permanent basis while fallbacks are being determined.
- If relevant, market participants should review their offering and other disclosure documentation relating to transactions with payment or other obligations based on LIBOR to ensure that the possibility of the cessation of LIBOR and the consequences thereof have been adequately disclosed. In particular, market participants should consider including in their disclosure documentation language and risk factors regarding the possible cessation of LIBOR, the possibility of an alternative reference rate, which party will have the discretion to determine if cessation were to occur, and which fallback applies.38
- On a going forward basis, market participants should consider including language in LIBOR-based transaction documentation that, for example, acknowledges the possible cessation of LIBOR, fallbacks, and the methodology and person(s) to determine the appropriate fallback as well as when such fallback would apply.
- If relevant documents do not include LIBOR triggers and fallback provisions or do not contemplate the permanent cessation of LIBOR, market participants should review relevant amendment procedures to see if such documentation can be amended to mitigate economic impacts and windfall profits both for transactions going forward and for legacy transactions. Market participants should also anticipate the possibility that amendments may not be possible or may be problematic for certain transactions and that this could lead to defaults due to frustration or other adverse consequences, including claims for damages and economic losses (such as those resulting in nonpayment or receipt of less than anticipated value), payments of higher amounts than anticipated, ineffective hedges and adverse tax consequences.
- All market participants should consider the accounting and tax issues that may arise in connection with the transition to an alternative risk-free rate and the transition of legacy contracts.39
- Market participants should prepare for other legal changes that may arise due to the transition away from LIBOR, including, among others: (1) capital impacts; (2) securities, commodities, and banking law ramifications (e.g., triggering margin, clearing, or reporting requirements as a result of the change40); and (3) consumer protection laws.
- In addition to legal, tax, accounting, and regulatory issues, market participants should also assess the impact on back-office, operation and other “plumbing” issues that will arise from a change from LIBOR to another rate.
- Market participants should consider that the transition away from LIBOR, including the application of fallbacks and amendment procedures, could result in litigation and other adverse consequences, including damage to reputation, when amounts paid or received by a counterparty are more or less than expected and no express agreement to change an alternative rate or settlement was agreed to by the parties.
The potential cessation of LIBOR is an ongoing, multidimensional issue that will continue to keep market participants focused until December 31, 2021, and likely beyond. As a result, market participants should keep abreast of the ongoing developments described above and take steps now to ensure that they are ready for the transition away from LIBOR in December 2021.