September 29, 2020

Losing LIBOR in the Capital Markets — Are You Ready?

As legal and business communities continue to work in a largely virtual world, it is time to refocus on the impending demise of the London Interbank Offered Rate (LIBOR). Careful consideration of industry recommendations and thoughtful planning should be prioritized now.

LIBOR is a widely used benchmark rate for U.S. dollar-denominated floating rate debt securities and other financial products. LIBOR represents the arithmetic mean of the offered rates by banks in the London market for deposits in specified currencies over various time horizons, or terms. LIBOR’s reliance on bank input allowed it to become the subject of widespread market manipulation. Evidence of rate manipulation, as well as ineffective regulation, caused the Chief Executive of the United Kingdom Financial Conduct Authority (FCA) to announce in July 2017 the FCA’s intention to stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021.

The announcement indicated that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. Given that debt securities linked to LIBOR did not previously contemplate LIBOR’s discontinuance, the absence of a LIBOR rate will generally cause the interest rate on existing floating rate notes to become fixed based on the last available LIBOR rate. This long-term application of a fixed rate to a floating rate note was not intended by the issuers of floating rate debt securities or the investors in those securities. The need to stop perpetuating the LIBOR problem created an opportunity to select an alternative for LIBOR in U.S. dollar-denominated floating rate notes.

In the U.S. market, the Board of Governors of the Federal Reserve System (the Federal Reserve) and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to identify LIBOR alternatives and robust fallbacks for use in debt securities and other financial products. The ARRC finalized its fallback language for use with new issuances of U.S. dollar-denominated LIBOR floating rate notes in April 2019. With the introduction of the ARRC-recommended fallbacks, issuers can continue to issue debt securities linked to LIBOR, while providing a framework that contemplates LIBOR’s discontinuance and a rate transition waterfall. While issuers have some flexibility with respect to adoption of all of the provisions of the ARRC structure, the ARRC waterfall, upon discontinuance of LIBOR, provides for a term version of the Secured Overnight Financing Rate (SOFR) and then Compounded SOFR as the immediate LIBOR fallbacks. While the ARRC waterfall can be added to a new LIBOR-based note, the ARRC recommends that issuers stop issuing new LIBOR-linked debt securities by the end of 2020.

Because Term SOFR does not yet exist, issuers who choose to link to the rate prospectively need to use a fixed-to-floating rate structure that immediately contemplates the unavailability of Term SOFR. Beyond Term SOFR, issuers can calculate the interest rate payable on a new issue of SOFR-linked notes by simple average or by compounded average. While the market for floating rate notes currently favors Compounded SOFR, the ARRC recommendations for calculating Compounded SOFR include three different variations for establishing the rate for a given interest period. Further, internal systems need to be established to support the preferred version of SOFR. System implementation takes time, particularly when many company resources have been diverted into addressing the day-to-day challenges presented by COVID-19.

For issuers who need to issue floating rate debt securities, the most conservative way to address LIBOR discontinuance is to immediately transition to a SOFR-linked security. While recommended, SOFR is not directly comparable to LIBOR. First, SOFR is a secured rate, while LIBOR is an unsecured rate. Second, SOFR is currently only an overnight rate, while LIBOR is a forward-looking rate that represents interbank funding over different maturities. As noted, even though Term SOFR is contemplated, the rate does not yet exist. Finally, SOFR is too new for a market standard to be present, while LIBOR has been the market standard for decades. Issuers have also noted that use of SOFR has the potential to create mismatched hedges for certain products and that it is susceptible to market volatility.

Despite the availability of SOFR, transitioning from LIBOR to another rate has not been easy given LIBOR’s entrenchment within financial products. In fact, the Federal Reserve utilized LIBOR as the benchmark in its Main Street Lending Program to facilitate timely lending activity during the COVID-19 crisis. Even with the economic hardships and competing business initiatives triggered by COVID-19, the FCA has not suggested it will delay LIBOR’s end date.

Issuers who are evaluating floating rate debt should discuss with their advisers the preferred version of SOFR, how such rate will be calculated and how investors will react. For nonfinancial issuers in particular, a key gating item will be the identification of an entity willing to serve as the calculation agent to determine the SOFR-based rate or the determination of whether the company can calculate the rate. If immediately switching to SOFR is not possible, issuers should (1) immediately implement the ARRC fallback language to account for the discontinuance of LIBOR, (2) consider the inclusion of redemption provisions and/or (3) evaluate alternate structures or rates beyond SOFR. One structural means to facilitate market entry is to utilize a fixed-to-floating rate structure that allows the issuer to redeem the debt securities before the debt flips to a floating rate.

For existing LIBOR-linked debt securities that do not incorporate the ARRC fallback language, issuers should evaluate options to eliminate the debt. The easiest option would be to leverage any existing redemption provision. While redemption is an efficient option, not all debt is issued with a redemption feature or a redemption option exercisable in advance of LIBOR discontinuance, and the redemption price may be unattractive to the issuer. Issuers can then turn to typical liability management transactions, including open market or negotiated repurchases of debt securities, but these approaches require careful orchestration to avoid an inadvertent tender offer. A tender offer or an exchange offer are next in the set of possible tools, but these approaches come with no guarantees for 100% participation and may require premiums to encourage participation. Finally, a consent solicitation to obtain holder consent to amend the terms of LIBOR-linked debt securities is another option that can be combined with a tender offer. However, there is no guarantee that holders will agree to an amendment, particularly if the debt bears a beneficial fixed rate upon LIBOR discontinuance. Ultimately, a number of liability management transactions may need to be stacked together to eliminate LIBOR exposure or a market-based approach to addressing LIBOR may need to be approved by regulators and/or courts.

The pandemic has made 2020 a challenging year for the vast majority of companies. While some have speculated that a so-called “zombie” version of LIBOR could be maintained to support legacy LIBOR debt securities, there can be no assurance that any form of LIBOR will be available after 2021 or that any hold-over would be accepted by the market.

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